The Financial Express

Inflation and distortion in the financial market

Inflation and distortion in the financial market

In the second week of August, Bangladesh Bank issued a circular asking the banks not to pay or set interest rates on deposits below the inflation rate. This is a piece of unparalleled advice or direct intervention defying the market mechanism, especially when the central bank has several instruments to deal with inflation. The circular argued that as a result of the banks' offering of an interest rate that is lower than the inflation rate, the purchasing power of the depositors who depend on the interest incomes from their savings was eroding.

The central bank's concern about the erosion of the depositors' real income from bank interest islaudable. Nevertheless, before appreciating the instruction, one needs to review some other factors of the financial market and the monetary management of Bangladesh Bank. In the circular, the central bank also argued that depositors are losing interest in parking their savings in banks due to lower returns, which leads to a tendency to invest in unproductive sectors. Thus, the banks should consider the inflation rate while determining the interest rates on fixed-term deposits with periods of three months and above. According to the central bank, it would protect the interest of depositors and prevent an imbalance of liabilities in the banking sector.

Erosion of real income from the interest of deposit is not a sudden or new phenomenon. During the last couple of years, interest rates on deposits in banks mostly hovered below the inflation rates over some months. Central bank statistics also show that the weighted average deposit rate fell below the average inflation rate since February 2020. Thus, the actual income from bank deposits turned negative. The trend has been continuing until now.

When banks are offering low-interest rates on deposits, it is also necessary to know the rates on interests of government securities or yields of the treasury bills and bonds. These are generally considered as benchmarks of the interest rates structure in the financial market. For example, in June this year, the weighted average yield of the 364-day treasury bill was 1.21 per cent which was 2.44 per cent for a 2-year treasury bond and 3.84 per cent for the 5-year treasury bond.  In this month, the average inflation rate was 5.56 per cent. Thus, the return on investing in long-term government securities is well below the inflation rate.

Of course, these securities are used mostly to meet the government's regular spending and finance the budget deficit.

So, these are usually not for the millions of ordinary depositors, although individual investors can purchase the securities.  For them, non-tradable fixed securities or savings certificates are bearing high rates of profit or interest.  Currently, there are four types of savings certificates available, and anyone can invest in these. The annual average profit rate is 10 per cent in these certificates, and these are providing a maximum return to the individual investors or depositors.

The purchasers of the certificate get a much higher return in real terms, on average around 4.50 per cent above the inflation rate. There is a significant demand for these certificates, which is also reflected in the net sales of savings certificates. The sales amount stood at Tk 419.60 billion in the last fiscal year (FY21) against the revised budget target of Tk 303.02 billion. A savings certificate is a tool of the government to borrow directly from the people to finance the budget deficit. Overshooting the annual borrowing target by a significant margin increased the government's interest repayments burden. It also indicates that people desperately invested in these certificates to get some relief from the continued inflationary pressure. However, a small number of people can invest in these certificates due to mandatory Tax Identification Number (TIN).  It is actually the higher-income people who used to purchase more of these savings certificates. 

Again, the huge difference in yields of treasury bills and bonds and profit rates of savings certificates show the country's financial market distortion, especially in the interest rate structure.  The profit rates of savings certificates are not market-based as these certificates are not tradable in the market. On the other hand, interest rates of deposits in banks and yields of treasury bills and bonds are largely determined by market forces.

Nevertheless, bowing to the pressure from the government and business lobbies, the central bank compelled the banks to fix the interest rates of deposits and advances at 6.0 per cent and 9.0 per cent, respectively. By forcing the banks to return to the dictated regime of interest rates, Bangladesh Bank has further distorted the financial market.  In reality, the fixed rate on deposit is not fully working, and there is no reason why it shouldbe. A financial market with a number of generally competitive players can't absorb the dictated or fixed regime of interest rates. Instead, such effort turns into a distorted one.

Now, dictating the banks to set deposit rates above the inflation rate is another move to distort the market. The central bank should mop up excess liquidity from the money market, which compelled the banks to offer lower rates on deposits.  To reduce the surplus liquidity, the monetary authority also needs to increase the rates on bills and bonds.  It appeared that Bangladesh Bank is not interested in increasing the rate. In the second week of August, the central bank held auctions of two kinds of Bangladesh Bank Bill where the maximum cut of yield was set at 0.75 per cent against the auction participants, banks to be precise, offer of maximum 2.97 per cent interest rate. The big gap resulted in lower investment by the banks in the bills.  Following the government instruction, the central bank also cancelled two auctions of treasury bills and bonds in the fourth week of this month.

All these developments indicate that the central bank is facing some difficulties operating its monetary policy and has already lost some control of the financial market. If inflation is a concern for Bangladesh Bank, it needs to apply its monetary tools prudently and timely. It should also pursue the government to reduce or rationalise the profit rates of savings certificates. Without addressing the current distortion of the money market, no move will bring any optimal result.

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