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 attempt to conduct a comprehensive analysis to find the relationship between interest rate and investment. Besides, we will examine the relationships among other variables such as the rate on deposit, level of savings, income etc. that are influential to the determination of the level and direction of investment spending. Finally, this paper will attempt to find if there is one or more key factors that may be addressed to influence the level of investment effectively.

Scope of the Paper

Within the scope of literature, it becomes very much undermined that a study in the investment determinant in Bangladesh would be relatively useful for the sake of its policy planning and strategy. Henceforth we can conduct an in-depth research in this area of largely sought issue of developing economy. We can analyze the role of interest rate in determining the level of investment spending to justify its ability to enhance economic growth. Taking into account of various determinants of investment spending, the best suitable determinant could be explored and recommendation might be consequential through an analysis from statistical point of view. Analysis of simple correlation between different sets of variables, and a regression function of various influencing variables can be done to assess the most influencing factors.

Methodology

The methodology involves estimating an econometric model as well as simple statistical indicators like correlation, and trend analysis. To investigate the impact of interest rates on investment spending, we use a simple regression function for the two variables but add several slightly different variables. The starting point of model formulation is;

I= f (LR, SR, S, Y, ER)Ð'...Ð'...Ð'...Ð'...Ð'...Ð'...Ð'...Ð'...Ð'...Ð'...Ð'...Ð'...Ð'... (1)

Where, I = Investment

LR = Interest rate on loans

SR = Interest rate on savings

S = Gross Domestic Savings

Y = GDP

ER = Exchange rate

Investment is not a function of interest rate alone. Factors like income, savings, and saving rate along with lending rate are important issues in setting the level of investment. That is why we need to incorporate all of them in the regression function and test the marginal impact of each of them on investment.

Accordingly, the estimating equation used in this study is;

where, the term e is the stochastic error term that captures the impact of all other variables not included in the model.

Model Validation

The coefficient , which gives the change in investment due to one unit change in lending rate is expected to be negative. Other slope coefficients ( are expected to have positive values since their associated variables, interest on savings, savings, and income respectively should influence investment positively. The coefficient can take positive or negative values depending on how a rising trend in exchange rates influence the level of domestic saving. The expected impact is determined by the composition of our import and export commodities. In case of heavy import of capital machineries will be negative while a positive will probably indicate heavy spending on production of export commodities.

Date Source

All the data to be used are in nominal terms in 1995-06 constant price. The time series data are taken from the revised national income estimates by BBS. Under the revised accounting system the BBS provides comparable data for