Interest rate is a much-talked-about issue as far as savings and investment are concerned. Though Bangladesh's growth has achieved a new height by crossing the 8 percent mark, private investment has been hovering only around a little over 23 percent of gross domestic product. For a fast-growing country, such low investment reduces the possibility of higher job creation. Investors complain about high interest rate as a constraining factor. In fact neoclassical investment theory sees investment having a negative relationship with interest rate—that is, a rise in interest increases cost of capital leading to high cost of doing business. This, in turn, negatively impacts investment level. However, in reality, such a straightforward relationship is not observed.

With a view to attract private investment, there have been initiatives to reduce the difference between lending and deposit rates, termed as interest rate spread, by the central bank. The weighted average interest rate spread in case of the scheduled banks has slightly declined from 4.41 percent in January 2018 to 4.15 percent in January 2019. The downward trend has prevailed since the last spike in June 2014. However, many banks continued to take advantage of lax regulations and a lenient monetary policy to keep their average interest rate spreads above 6 percent.

Indeed, the prevailing interest rates are not market determined as envisaged by the central bank's monetary policy statement for January-June 2019. Instead, the interest rates are being set by the banks. It appears that some banks have set their lending rates in tune with their own business interests. A high lending rate is not only a reflection of motivation for high profits, but also a sign of inflationary pressure and loan default risks, as manifested in the high volume of non-performing loans (NPLs) in the banking sector in recent years. In the eight out of nine years between 2010 and 2018, the amount of NPLs was so high that they would have been sufficient to pay for the combined national expenditures of education and healthcare as outlined in the budget.

Conventional economic theory suggests that higher risk should be compensated with higher return. In the context of banking, this implies that risky loans should be charged higher interest rates than the better ones. In recent times, it has been quite the contrary in Bangladesh. Looking into sector-by-sector interest rate and NPL status reveals that in 2017, credit provided for consumer finance had a weighted average lending rate of 11 percent even though its average NPL rate was only 4 percent of total loan provided to the sector, while credit provided for trade and commerce had a weighted average lending rate of 10 percent, despite its average NPL rate being as high as 11 percent of total loan given to the sector. Thus, good borrowers were being punished with high interest rates while bad borrowers were being rewarded with low interest rates. This reflects a distorted market which calls for urgent attention on the part of the regulators.   

It is shocking to notice that if inflation rate is accounted for, the real weighted average deposit rate in scheduled banks turns out to be below zero since January 2017. Hence, common people have little incentive to save their hard-earned money in the banks and watch it lose its value over time. The real interest rates on various forms of national savings directorate (NSD) certificates were around 6 percent. Thus, savings continued to be diverted into NSD certificates and away from the banks.

Ironically, in the absence of adequate social protection, the NSD certificate has transcended its role as a financial product, and transformed into a de facto social safety net mechanism. High real rate of interest on the NSD certificates means that the government is engaging in expensive borrowing to finance public expenditures. If national savings are directly channelled from the public to the government, then not only are banks deprived of deposits, but also the role of banks as financial intermediaries is seriously compromised. High dependency on NSD certificates also creates debt burden on the economy, as the government has to borrow at a high interest rate.  

While the impact of interest rates on the behaviour of savers can be understood to some extent, the impact of interest rates on investment behaviour is not straightforward. A number of studies on the interest rate and investment nexus in Bangladesh have found a weak negative relationship between real lending rate and investment. This implies that high interest rate may influence investment only insignificantly. This finding is consistent with the ground reality. It is also in line with the World Bank's Doing Business reports, which have repeatedly mentioned that in the context of Bangladesh, factors such as enforcing contracts, registering property and obtaining electricity are more important determinants of investment than getting credit. The "Bangladesh Business Environment Study 2018" also indicated that factors such as corruption, inadequate infrastructure and inefficient bureaucracy are more important than access to finance for investment in Bangladesh.

Among several challenges of the banking sector, high interest rate spread is only one. The government has to take the unpleasant task of reforms to rejuvenate the banking sector. This is not an easy task, as the banking sector is suffering from several problems due to poor governance for a prolonged period of time. Consequently, the government will have to address the problems of the sector in an uncompromising manner, in order to fulfil its promises for reforms.

Dr Fahmida Khatun is Executive Director and Syed Yusuf Saadat is Research Associate at the Centre for Policy Dialogue.