Cost of borrowing rises as policy rate hiked yet again

The Bangladesh Bank has increased its key policy rate by 50 basis points to 7.75% to control inflation by making borrowing more expensive for commercial banks and the private sector.

With the new hike, the policy rate saw an increase by 125 basis points in less than two months as the central bank increased it by 75 basis points in October. The policy rate, or repo rate, is the interest at which the central bank lends to commercial banks.

Also, the interest margin with the SMART (six-month moving average rate of treasury bills), which is the reference lending rate, has been hiked by 25 basis points to 3.75%, leading to a calculated lending rate of 11.18%, meaning that loans will be costlier, and the costs of doing business for the private sector will shoot up.

The new rates will be effective from today, according to a Bangladesh Bank release issued on Sunday.

The decisions were made at the inaugural meeting of the Monetary Policy Committee, aiming to reduce inflation to 8% by December and 6% by June next year.

The US Federal Reserve hiked rate for 11 times since March last year and neighbouring India went for a massive 250 basis points at one go in May last year to cool surging prices. Both economies have now chosen to keep their rates unchanged at high levels after significantly containing inflation that reached their peaks in decades for most Western economies.

A central bank policymaking official present at the monetary policy meeting told The Business Standard that after the policy rate hike, it takes up to a few months for its impact to be visible. The policy rate hike in early October is gradually beginning to show its impact, he said.

"The policy rate which was increased on Sunday, we need to wait until January or February of next year to fully observe its impact on the economy. We anticipate that two significant policy rate hikes will bring inflation under control," the central banker said.

Impact to be visible later

Zahid Hussain, former lead economist at World Bank's Dhaka office told TBS, "The central bank's policy rate and lending rate hikes aim primarily to control inflation. However, it will take some time for the impact to be visible on the market."

He said Bangladesh has also increased the direct consumer level lending rate by 25 basis points which will have a direct impact on the customers' cost of funds. "On the other hand, if the policy rate increases, the fund cost of the banks will increase, but the loan cost of the customers will also rise."

With the increase in rates, private sector credit growth will slow down and new investment will be hampered, affecting new job creation, the economist said.

He also said, "Due to the increase in the policy rate, the deposit rate will increase further. For this, the short-term deposit rate of general customers will also increase. Then there will be saving tendency among consumers by reducing consumption."

An IMF study that examined how policy rate change impacts inflation in some central Asian economies suggests 1 percentage point increase in the policy rate results in 0.5 percentage point in inflation and 1 percentage point exchange rate appreciation results in a 0.3 percentage point decrease in inflation in the first year.

But the Bangladesh Bank has so far been slow in hiking policy rates considering its impact on private sector investment and cost of import.

The latest hike in policy rate came at a time when private sector credit growth slowed for the tenth consecutive month, hitting a 23-month low to 9.69% in September, due to a decrease in the opening of letters of credit (LCs) for imports and a reduction in loanable funds in banks.

Selim RF Hussain, CEO and managing director of BRAC Bank, said, "If this hike in policy rate was done a year ago, it would have been good for the market. Now the increase in policy rate will increase the landing rate, which should reduce the demand for loans. But we don't see much demand for loans right now. The demand for big loan for starting any project is also not seen.

The managing director of a sharia-based bank told TBS that people are reducing their spending as the loan interest rates are gradually increasing. The prices of several current commodity products are decreasing slightly as the supply is increasing compared to the demand for commodity products in the market, he said.

"The interest rates in the world market has increased a lot due to which inflation has come under their control. We need to increase the policy rate further which will help in controlling inflation," the banker said.

If the interest rate increases, the private sector will have a lot of impact, he said, adding that at present, the growth of fresh loans to the private sector is not more than 5%. If the utilisation of money decreases, people will reduce buying land, constructing buildings, buying gold and other major expenses, he said.

'Only policy rate hike cannot tame inflation'

Dr Mustafa K Mujeri, former director general of BIDS, said, "There is a trend of increasing the policy rate in all countries of the world to control inflation. We have also followed them. But it is difficult to control inflation in our country only by increasing the policy rate. Because, there is weakness in our market management. Here a group controls the market to increase the price of goods. Besides, there is a lack of governance in the economic sector. 

"A vested quarter is destabilising the financial sector. Therefore, in order to reduce the price inflation, the members of the law and order forces and the relevant ministries and departments must play an effective role. The central bank alone cannot control inflation, it requires coordinated action."

Rate hike implications for banking sector and economy

Increase in deposit and lending rates: Landing rate will increase due to increase in margin of interest rate in determining landing rate. Banks will have the opportunity to increase the interest rate on deposits. As a result, people will now get more returns on bank deposits and deposits in the bank sector will increase

Interbank rate will increase: As the cost of borrowing money from the central bank will increase due to the increase in policy rate, banks will increase the interest rate for interbank lending. Banks had to pay 8.19% interest for interbank overnight loans on Sunday. Bankers say that it could reach 8.70% this week.

Increase in liquidity: Due to the increase in the lending rate, businesses will now show less interest in taking new loans, while on the other hand, the amount of deposits will increase. As a result, the ongoing liquidity stress in banks will decrease.

Decrease in dollar demand: Business owners generally take loans from banks to open import letter of credits (LCs). With the increase in the interest rate, as an impact, businesses will open fewer LCs. Consequently, there will be a decrease in the demand for dollars.

Consumers may reduce their spending: When borrowing becomes more expensive, consumers may reduce their spending on big-ticket items like homes and cars.

Demand may fall: Falling consumption may dampen economic growth.

Investment: Higher interest rates can also deter private investment. Companies may delay or scale back capital expenditures, which may cut jobs.

Stock markets: Rising interest rates can lead to lower stock prices.

Government finances: Governments may face higher interest payments, which may hike public expenditure and widen the budget deficit.

Housing market: Higher interest rates can make housing less affordable.