Policy rate hike: Balancing inflation control with economic growth

Recently, the Bangladesh Bank raised the policy rate by 50 basis points, bringing it to 10%. While the central bank's primary goal with this move is to control inflation, examining how such an increase could affect other aspects of the economy, such as small and medium-sized enterprises (SMEs), employment, and the banking sector, is crucial. 

The rise in policy rates may introduce new challenges, including reduced business credit access and an increase in non-performing loans (NPLs). To assess the broader implications of this decision, it's essential to understand Bangladesh's economic structure and draw insights from other countries' experiences with similar measures.

The SME sector plays a significant role in Bangladesh's economy, contributing about 25% to the country's GDP and providing employment for over 7.8 million people. According to the SME Foundation's 2022 report, this sector is responsible for 70-80% of new job creation. 

However, with the increase in the policy rate, the cost of borrowing will rise, potentially hampering growth in this sector. Small businesses, many of which rely on loans to fund their operations and expand, will now face higher interest rates, making it more difficult for them to access necessary financing.

Higher borrowing costs tend to discourage entrepreneurs from making new investments, leading to reduced business expansion and slower job creation. This is particularly worrying for SMEs, which often rely heavily on working capital loans to manage their day-to-day operations. 

For instance, during the Covid-19 pandemic in 2020, when credit flow to the SME sector shrank, around 50% of small and medium-sized businesses were forced to scale back their operations, leading to a significant drop in job creation (SME Foundation, 2020). The policy rate hike could trigger similar effects, limiting the capacity of SMEs to contribute to employment and economic growth.

The banking sector is another area where the impact of the policy rate hike will be felt. As interest rates rise, banks may become more cautious about lending, particularly to small entrepreneurs, who are already seen as riskier borrowers. A 2018 World Bank study found that increases in policy rates are often associated with a rise in non-performing loans (NPLs).

In Bangladesh, between 2011 and 2017, when the policy rate was raised from 6.25% to 7.25%, the NPL ratio grew from 10% to 13%. Data from the Bangladesh Bank as of September 2023 shows that the current NPL ratio stands at 9.48%, a significant increase from the previous year. If borrowers, particularly SMEs, struggle to repay loans in the face of higher interest rates, the NPL ratio could rise further, threatening the stability of the banking sector.

While raising policy rates is a conventional tool for controlling inflation, it primarily targets demand-side inflation—where too much money is chasing too few goods. However, Bangladesh's current inflation is largely driven by supply-side factors such as rising food prices, higher import costs, and increased fuel prices. This makes the challenge more complex, as raising interest rates alone may not fully address the issue. Controlling inflation in Bangladesh requires more than just limiting the demand; it also involves addressing supply chain disruptions and external economic pressures.

Internationally, it has been observed that while raising policy rates can help control inflation, it often comes with trade-offs. For example, in 2014-2015, India raised its policy rate to 8% in an attempt to curb inflation. However, this move led to a slowdown in credit flow, particularly in the SME sector, and resulted in slower job creation. Similarly, in 2018, the Philippines raised its policy rate to combat inflation, but the central bank also took steps to improve supply chain management and import practices, which helped keep inflation under control without severely affecting business growth (Philippine Central Bank, 2018).

There are alternative measures that countries can take to manage inflation more effectively, especially in developing economies like Bangladesh. One option is to focus on supply-side policies, which involve improving production efficiency and ensuring a steady supply of goods. Countries like the Philippines and Vietnam have invested in enhancing their food and fuel supply chains, which helped ease inflationary pressures. Bangladesh could consider similar steps, such as investing in agricultural subsidies, reducing import tariffs on essential goods, and improving the efficiency of its logistics networks.

Another approach to controlling inflation is through government spending control. In 2022, South Korea limited its public expenditure and redirected funds toward essential sectors, which helped reduce inflationary pressure without stifling economic growth. Bangladesh could take similar steps by cutting unnecessary spending on development projects and ensuring that government resources are allocated efficiently. This would not only reduce fiscal deficits but also create a more stable economic environment that could help curb inflation.

Direct government intervention in controlling prices can also be an effective tool. For instance, in Vietnam, the government worked closely with businesses to regulate the prices of basic commodities such as food and fuel, which helped protect lower-income households from the full impact of inflation. Bangladesh could adopt similar policies, especially during times of global supply chain disruptions, to ease inflationary pressures on the most vulnerable segments of society.

Tax policy reforms can also play a role in reducing inflation. By cutting taxes on essential goods or reducing indirect taxes, the government can help lower the overall cost of living. Additionally, adjusting income tax policies to provide relief to lower- and middle-income groups can help balance the economic burden during periods of high inflation.

Looking at Bangladesh's experience with policy rate changes, the outcomes have been mixed. Between 2011 and 2013, when the policy rate was raised, credit flow to the banking sector—particularly for SMEs—dropped significantly. Similarly, in 2017, the policy rate was raised to 7.25%, which temporarily helped control inflation but also led to a significant decline in credit flow to the SME sector. Given this context, the recent policy rate hike in 2023 could produce similar effects. While inflation may come under some control, the ability of small entrepreneurs to access credit will likely be constrained, and the NPL ratio could rise, putting additional strain on the banking sector.

While the Bangladesh Bank's decision to raise the policy rate is aimed at controlling inflation, it comes with significant risks to the SME sector, employment, and the overall banking system. The experiences of other countries suggest that simply increasing policy rates is not always sufficient to manage inflation. 

A more comprehensive approach involving supply chain improvements, government spending control, and tax reforms will be crucial for Bangladesh. By adopting a coordinated policy framework that addresses both the demand and supply sides of the economy, the country can ensure sustainable economic growth while keeping inflation in check.

Shaiful Hossain is the author of The Art of Personal Finance Management, a columnist, a YouTuber and a finance and business strategist. 

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.