Would the monetary policy be useful after 9pc interest?
The big question on economists' mind is, how will the 9 per cent ceiling on bank lending rates impact the conduct of monetary policy?
Currently, the Bangladesh Bank practises a quantity-based monetary policy framework. At the start of the fiscal year, the BB announces reserve and broad money targets to support the GDP growth and inflation objectives. The monetary programme will not set the amount of rates of interest or the exchange rate.
These are left to be market-determined through practices customary in the lending-borrower (interest rate) and buyer-seller (exchange rate) relationships embedded within a couple of regulatory code of conduct.
Remember, under a market-determined setting, there is absolutely no such thing as "the interest".
Deposit rates vary by types and tenure, while lending rates vary by borrower risk profile and loan tenor. Supply and demand forces generally determine the amount of interest levels in each market segment.
The BB influences interest levels by influencing the number of liquidity offered by any given time in the amount of money market at the mercy of its stance in the foreign exchange market.
The regime under which the BB can conduct the monetary policy will change from April 1, 2020. Interest rate will be fixed at 9 % for some lending (except bank cards).
However the BB notice promulgating the interest rate ceiling is silent on the deposit rate. So, formally only the lending rate has been capped.
The assumption is apparently that the lending rate cap will automatically lower the deposit rate below 6 per cent. After all, how many banks, if any, are able to operate with just 3 % spread?
The main element question is whether the BB is left with any choice on setting the levels of reserve and broad money.
Remember that the 9 per cent ceiling is binding for some bank loan market segments. Interest rates on loans to large corporates, small- and medium-sized enterprises (SMEs) and home owners are in double digits, ranging between 9.5 and 16.5 %.
The imposition of interest below these market rates makes it a binding ceiling. Other activities equal, this will certainly reduce the supply and improve the demand for loanable funds, thus creating excess demand at the ceiling rate.
Since lenders can't be forced to lend a lot more than what they are prepared to, the short side of the marketplace will prevail, i.e. the total amount lent will equal the full total the lenders are willing to lend -- rather than the full total the borrowers are prepared to borrow.
The BB gets the substitute for make it equal the total amount the borrowers are prepared to borrow.
It can do that by lowering prudential controls such as the cash reserve ratio (CRR), increasing the loans-deposit ratio or providing liquidity support at reduced policy rates.
The BB implemented an assortment of these policies in 2018 and 2019. The average lending rate stayed above 9 %. More will, therefore, be had a need to accommodate the excess credit demand caused by the 9 per cent ceiling.
Absent such regulatory and/or direct BB accommodation, the impact of the ceiling will be contractionary as the supply of liquidity in the economy will fall through credit rationing.
This, in turn, will decrease consumption and investment demand due to tighter financing constraints.
The high-risk sectors including the cottage, micro and small enterprises will be excluded as will all borrowing categories where the marginal cost of providing loans (including risk premia) exceed 9 per cent.
The demand-induced recession in the excluded sectors may subsequently ripple through the rest of the economy -- with consequences for the entire degree of employment and incomes.
The alternative is to accommodate the increased demand for loanable funds.
The ability to relax regulation to improve the way to obtain loanable funds has its limits. The CRR can at best be zero and the loan-deposit ratio cannot exceed 100 %.
Policy rates can, in theory, be negative, however in practice it really is highly unlikely in Bangladesh.
The BB can take part in open market businesses to inject liquidity straight into the banking system.
Whatever the technique used, the immediate impact will be to increase the supply of loanable funds beyond the particular level demanded before the interest ceiling became effective.
A monetary expansion will ensue.
Sustaining the ceiling at 9 % over time will demand the BB to totally accommodate the growth popular for credit irrespective of what the macroeconomic targets of the monetary programme warrant.
Such expansions risk rising inflation that is already cost-pushed by gas, electricity and water price increases.
The end result is that the area for manoeuvring monetary policy when faced with expanding demand for credit is severely constrained by the interest ceiling.
Interest rate can't react to upside aggregate demand shocks to stabilise the economy. For instance, in the lack of the ceiling, a growth in demand for credit will increase both the quantity of money traded in the credit markets and also the interest rate.
The latter will soak part of the initial increase in demand, thus limiting its impact on aggregate demand for goods and services and therefore on inflation.
A binding ceiling will prevent such upsurge in the lending rates and invite credit to expand just as much as originally as a result of accommodation from the BB. All that the central bank can choose is how exactly to accommodate the surplus demand.
It could administer a yet-to-be-fully-specified set of directives to banks for allocation of credit to various sectors at the desired level and make certain that they have sufficient liquidity to implement such directives.
The known unknowns in cases like this are the credit market outcomes.
One opportunity is a fall in credit in the absence of monetary accommodation.
Another possibility is a growth in credit permitted by easing regulatory controls while introducing directives on credit allocation and ensuring their enforcement.
If this proves to be inadequate, the BB can inject additional liquidity.
The extent of liquidity decline if it decreases and that of liquidity increase if it does increase will rely upon the extent of monetary accommodation and the potency of credit directives at the level of borrowers and lenders.
A range of intermediate outcomes are conceivable between these two extremes.
Interest rate ceiling will consume monetary policy space through increased fiscal dominance.
Any upsurge in domestic financing of budget deficit will generate pressure for monetary accommodation.
If non-bank borrowing can be used, the supply of loanable funds to the private sector will dry. This will ought to be met by regulatory easing and forbearance, which there is not much room, or direct liquidity support from the BB.
Using bank borrowing could have the same effect on the way to obtain loanable funds, the difference being a possible rise in risk-free rates available to banks, which further acts as deterrent to lending to the private sector at the ceiling rate.
Remember that there are no ceilings on the risk-free T-bills and T-bonds rates. Yields on these instruments of short and long maturities currently range between 7 and 9.1 per cent.
Domestic financial markets in Bangladesh don't have enough depth to soak up the keeping public debt.
The BB could have no option but to support increased domestic financing needs of the federal government to mitigate any adverse influence on private credit growth due to expanded options to banks to place funds at attractive risk-free rates.
This will amplify the impact of fiscal expansion on aggregate demand.
The exigencies of the budget will need precedence over controlling inflation and supporting growth. Fiscal policy considerations are certain to get primacy in conducting monetary policy.
The above discussion assumes the regulatory changes introduced to create it easier for banks to lend at 9 per cent don't have any unintended consequences. Such consequences tend when monitoring and enforcement are weak.
Credit misallocation and asset price bubbles often result from lending rate repression both theoretically and in practice.
Influential borrowers availing excessive cheap credit may put them to speculative investments in asset markets, thus leading to credit misallocation and asset price bubbles.
Rise in financial disintermediation can't be ruled out either. By increasing systemic risk to financial stability, these will generate formidable new challenges for financial regulation.
If we accept the proposition that interest levels in Bangladesh are high because risk premia are high, and not predominantly because of non-competitive behaviour by banks, then your ceiling cure is most probably to be worse compared to the disease.
Risk premia are high because of high inflation risk, as evident from BB surveys of inflationary expectations and high business risk as evident from high rates of wilful loan default.
Interest ceiling cannot address either the inflation risk or the default risk, never to talk about broader business risks.
Inflation risk is best handled through sound macroeconomic management. A pre-requisite in this regard is a central bank in a position to conduct monetary policy with some extent of independence to keep inflation low and predictable.
Structural problems require structural policy responses. Structural reforms, including regulatory and legal reforms in the financial sector, are had a need to address business risks.
Fixing lending rate uniformly at a predetermined level is the same as not only shooting the messenger but also disabling the monetary policy apparatus.
Interest rate can no longer serve as an computerized stabiliser and a web link in the transmission of monetary and fiscal policies.
Additionally, when both credit controls and liquidity support are imperfect and also unpredictable, the BB will also have problems with credibility gap, thus further undermining the traction of its policies in shaping macroeconomic stability and regulating the financial sector.
The author can be an economist
