Should banks lower lending rates to productively utilise growing volume of excess liquidity? According to press reports, excess liquidity now stands at around BDT 1.15 trillion. Advance-deposit ratio has fallen to 70 per cent compared to 80-85 per cent in previous years. Pressure on the banking sector to reduce lending rates has intensified from regulators, think-tanks and leading figures in the business community. Many have argued that double-digit lending rate stands as a key barrier to far greater private sector investments and reaching the elusive 7 per cent growth rate. In this context, this article covers two interconnected and highly pressing issues facing the banking sector.
The first issue is related to an observed disconnect between falling lending rate and lack of improvement in private sector investment. Bangladesh Bank (BB) data shows (weighted-average) lending rate has declined steadily from 13.73 per cent in January 2013 to 11.35 per cent in October 2015. Yet during the same time, private sector credit growth barely picked up from 12-13 per cent compared to 17-18 per cent seen in previous years (when lending rate was much higher). Certainly, political uncertainty had played a major role in last two years. Given relatively improved political climate this year, why has private sector investment not improved despite steadily-declining lending rate? Will lower lending rate reduce this disconnect?
The second issue is about how to adjust the deposit rate if and when banks decide to bring down lending rate to single digit. Taking into consideration medium-term risks to both banking sector as well as broader macro-economy, this note makes a case for banks to reduce their interest rate spread (difference between lending and deposit rate).
GOING BEYOND NOMINAL LENDING RATE: The relationship between interest rates and investment should be evaluated in price-adjusted or real terms, according to traditional investment theory. Higher investment requires lower real interest rates. Chart 1 shows that while nominal lending rate has come down markedly in Bangladesh, real lending rate (nominal rate minus inflation) has hovered between 5-6 per cent in the last 2-3 years. Relatively unaffected real lending rate suggests banks have been lowering lending rate broadly in line with inflation to protect their real returns. From a borrowers' perspective, 'real' cost of capital has remained relatively unchanged, in part explaining the lack of responsiveness of private sector credit growth to lower nominal lending rates.
In recent months, we do observe a marginal reduction in real lending rate, but it is still much higher than comparable countries like China, India and Vietnam and needs to be ideally brought down to around 4 per cent or lower. If banks want to lower entrepreneurs' real cost of capital and stimulate investment, they will have to sacrifice real return on lending. Assuming inflation remains at current level or even rises slightly in the short-term (for instance, due to BB's continuous foreign exchange market intervention), real lending rate is expected to go down if banks indeed bring down nominal rates further. Lower real lending rate, while reducing banks' price-adjusted return, is expected to revive investment and subsequently private sector credit growth. In the medium-term, if BB is successful in lowering inflation further, banks will have to reduce lending rates at proportionate (or higher than proportionate) rate to minimise borrower's real cost of capital and sustain investment demand.
INTEREST RATE DIFFERENTIAL WITH FOREIGN LENDERS: Lack of credit demand from domestic banks is also attributable to rising foreign currency loans. Regulators have understandably eased access to foreign loans since borrowing rate is much lower and international lenders can facilitate much larger loans than domestic banks. In this context, lower domestic lending rate is expected to reduce the interest rate differential with foreign lenders (which is about 6-8 per cent at present depending on borrower's credit profile). If domestic banks bring down lending rates to single digit, the interest rate differential with foreign lenders could fall to around 4-5 per cent. This differential could be even lower given that the US central bank is expected to soon start raising interest rates, and this should be reflected in the London-Interbank Offered rate (for details, see 'US monetary tightening: Implications for Bangladesh', The Financial Express, Nov 2015). Given that domestic banks cannot facilitate loans beyond certain capacity, analysts may argue that demand for domestic loans from top entrepreneurs may not rise even if interest rate differential with foreign lenders falls. In this regard, a study conducted by BB in 2014 showed that foreign credit availed by a large number of companies is, in local currency terms, within the capacity of domestic banks to facilitate (Source: Bangladesh Bank). This implies big entrepreneurs who do not need loans beyond the capacity of domestic banks, will prefer local sources if interest rate differential falls.
BARRIERS TO DOING BUSINESS: These interest-rate related incentives notwithstanding, sustained investment requires proper infrastructural support and adequate energy supply. Bangladesh is seriously lagging behind in these aspects, as shown by the World Bank's latest Doing Business Report. Overall ranking, out of 189 countries, slipped from 172 to 174 this year whereas neighbouring economies like India, Vietnam, Cambodia and Indonesia all improved their rankings. Closer inspection shows Bangladesh's ranking is among the lowest (in World Bank's 189-country sample) in areas such as getting electricity, registering property, enforcing contracts and trading across borders. There is scant evidence of improvement in these areas in the short-term. The drop in productive fiscal expenditure in the first quarter of fiscal year 2015-16 is worth mentioning in this regard. Without dramatic improvements in these prerequisites for investment, lowering lending rate may not increase demand for fresh capital high enough for banks to invest their entire stock of excess liquidity. This will result in banks still rushing towards BB's 30-day bills which yield only about 3.0-4.0 per cent. Â
SHOULD INTEREST-RATE SPREAD BE REDUCED AMID PROFITABILITY CONCERNS? Now, if banks lower lending rates, how should they adjust deposit rate? The difference between what banks earn on their loans and what they pay for their deposits (and other borrowings) is generally termed as Net Interest Income. This is the sector's major revenue driver and associated decisions need to be thoroughly evaluated in the context of potential outcome. Should banks reduce deposit rate and maintain their interest rate spread?
Interest-rate spread remains virtually constant at around 5.0 per cent, give-or-take 10 basis points. As is widely known, this relatively large spread is attributable to high non-performing loans (NPL) and subsequent loan-loss provisioning requirements. At present, there is little indication of an expected reduction in NPL. Indeed NPL actually went up in the first quarter of the current fiscal year, suggesting a reduction in interest rate spread will substantially shrink profit margins. This line of reasoning implies that banks will be tempted to lower deposit rates in line with lower lending rates to protect profitability.
On the other hand, reducing deposit rate is likely to divert savings away from banks to alternate financial assets offering significantly higher returns like National Savings Schemes or Term Deposits offered by non-banking financial institutions. Banks have already felt the brunt of such misaligned interest rates. As Chart 2 shows, reduction in bank deposit rates has sharply reduced deposit growth to around 12-13 per cent this year from around 20 per cent in early 2013.
For banks which have excess liquidity, lower growth in deposit may not be a major challenge in the short-term. But for those which are not awash with surplus liquidity, for instance the new banks, lower deposit growth will create serious obstacles to growth. These new entrants are already facing tremendous challenges in attracting low-cost deposits and lowering deposit rate will only exacerbate their situation and hamper asset growth while complicating asset-liability management. Reduced deposit growth could eventually force banks to look for alternative channels of funding which could be less stable and/or more expensive. A prolonged reduction in deposit growth (due to growing interest-rate differential with alternate financial assets) will certainly hamper the entire sector's ability to extend credit in the medium term, constraining asset growth. Limited capacity to extend credit could eventually hurt the government's investment and development targets in the new five year plan, suggesting longer-term macroeconomic spill-overs.
It is worth mentioning that real return on deposit has been shrinking relatively rapidly in recent months. As of October 2015, depositor's real return (weighted-average deposit rate minus inflation) stood at 0.39 per cent, compared to 1.22 per cent in January, 2015 (see Chart 3). If lending rate is brought down to single-digit levels, meaning reduction of around 1.5-2.0 per cent from current level of 11-11.5 per cent, banks cannot maintain 5 per cent spread if they want to give depositors positive real return. This view assumes inflation remains at or around current level in the short-term. Certainly, negative real return on deposits cannot be good for savers and will only serve to expedite shift of savings from banks to alternate financial assets. This puts the sector in a tricky situation - should banks reduce interest spread, sacrificing immediate profitability, or maintain interest-rate spread and risk lower growth in deposit base, creating longer-term financial stability, asset growth as well as macroeconomic concerns? Based on the reasoning provided and if we take a medium-term view, reducing interest rate spread is the logical path to follow.
As a final remark, if banks do their part in lowering lending rate and interest rate spread - as popularly demanded - the fiscal authorities will have to play their role in complementing this initiative. Going beyond the banking sector's central role in Bangladesh's financial system, the government's tax revenue and by extension fiscal policy targets are highly dependent on the sector's profitability. If the fiscal authorities are serious about improving investment-GDP ratio as envisaged in the 7th five year plan, they will have to promptly address infrastructural and energy supply issues. Further reduction in NSS rates should also be considered. Only through such combined initiatives can Bangladesh maximise the benefits of lower lending rate and reach the cherished 7-8 per cent growth target.
—The writer currently works as a macroeconomic analyst for an organisation in Washington D.C. He is a Fellow at the Asian Center for Development in Dhaka. Â
shaque4@jhu.edu