Interest Rates and Other Critical Determinants of Investment Spending in Bangladesh

Interest Rates and Other Critical Determinants of Investment Spending in Bangladesh

Background

Investment, which is a spending devoted to enhancing or maintaining the existing stock of capital in the economy provides goods and services necessary for better standard of living. Moreover, it has greater importance as a policy tool. Policymakers often try to achieve target growth in GDP by influencing the level of investment. They do so by undertaking policies that influence the rate of interests. The underlying assumption is that investment is negatively related with the rate of investment.

Historically, economic theories have suggested negative relationship between investment and interest rates. Changes in either nominal or real interest rates translate into a direct impact on investment spending leading to desired movements in the real economy. Specifically, the Keynesian framework suggests that a decrease in lending rate reduces the cost of investment resulting in higher profit margin for the investors. On the other hand, Mckinnon and Shaw (1973) established that increase in deposit rates encourages depositors to accumulate enough savings for financing investment spending in an economy and vice versa.

The difference between lending and deposit rates, called the spread is a crude measure of the cost of efficient resource intermediation process in the economy. LDCs with financial market imperfections are characterized by higher spreads due to factor such as lack of competition, non-performing loans, high administrative costs etc. To reduce the financial intermediation cost and achieve higher economic growth developing countries of Latin America and Asia started implementing various Financial Sector Reform Programs (FSRPs) during the mid 1970s. Bangladesh initiated the FSRP at the beginning of the 1990s.

Efficient allocation of credit in the financial market was one of the key objectives of FSRP in Bangladesh. It attempted to develop a well functioning financial system by moving towards a market based interest rate regime from an administered interest rate regime thereby promoting economic growth. In this backdrop, it is legitimate to investigate role of interest rates on investment spending in Bangladesh.

Objectives

Although interest rate is believed to be the key determinant of the level and direction of investment spending, non-economic factors have undermined investment potential of Bangladesh by a great extent. In fact, the available literature shows little evidence of valid and significant relationship between interest rate and investment spending in Bangladesh. Our study will