SV\/P672

Evaluation of Financial Policy

Credit Allocation in Bangladesh

Arvind Virmani

WORLD BANK STAFF WORKING PAPERSNumber 672

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WORLD BANK STAFF WORKING PAPERSNumber 672

Evaluation of Financial Policy

Credit Allocation in Bangladesh

Arvind Virmani

The World BankWashington, D.C., U.S.A.

Copyright (© 1984The International Bank for Reconstructionand Development/THE WORLD BANK1818 H Street, N.W.Washington, D.C. 20433, U.S.A.

All rights reservedManufactured in the United States of AmericaFirst printing October 1984

This is a working document published informally by the World Bank. To presentthe results of research with the least possible delay, the typescript has not beenprepared in accordance with the procedures appropriate to formal printed texts, andthe World Bank accepts no responsibility for errors. The publication is supplied at atoken charge to defray part of the cost of manufacture and distribution.

The World Bank does not accept responsibility for the views expressed herein, whichare those of the author and should not be attributed to the World Bank or to itsaffiliated organizations. The findings, interpretations, and conclusions are the resultsof research supported by the Bank; they do not necessarily represent official policy ofthe Bank. The designations employed, the presentation of material, and any maps usedin this document are solely for the convenience of the reader and do not imply theexpression of any opinion whatsoever on the part of the World Bank or its affiliatesconcerning the legal status of any country, territory, city, area, or of its authorities, orconcerning the delimitation of its boundaries, or national affiliation.

The full range of World Bank publications, both free and for sale, is described in theCatalog of Publications; the continuing research program is outlined in Abstracts ofCurrent Studies. Both booklets are updated annually; the most recent edition of each isavailable without charge from the Publications Sales Unit, Department T, The WorldBank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or from the EuropeanOffice of the Bank, 66 avenue d'I6na, 75116 Paris, France.

Arvind Virmani is an economist in the Development Research Department of theWorld Bank.

Library of Congress Cataloging in Publication Data

Virmani, Arvind, 1949-Evaluation of financial policy.

(World Bank staff working papers ; no. 672)1. Credit control--Bangladesh. 2. Finance--Bangladesh.

I. Title. II. Series.HG3711.B3V57 1984 332.7'09549'2 84-20985ISBN 0-8213-0429-1

Abstract

The Bangladesh Goverrnment has used a variety of policies to

influence the allocation of credit to specific borrower groups like poor

farmers, uses such as housing, and sectors such as agriculture. These

policies have also been used tc reduce allocation for certain uses such

as inventory holding ("speculative purposes"). The policies used have

included interest controls credit guarantees, refinance and margine

requirements. This paper attempts a systematic analysis of all the

policies used by the Bangladesh government in the light of the explicit

or implicit objectives of the government. The effect of each of the

policies used, alone or in combination, is analysed with a view to

evaluating their usefulness and efficiency. The analysis then provides

the basis for suggested policy charges in Bangladesh, as well as lessons

for financial policy makers in other countries.

ABREGE

Le Gouvernement du Bangladesh, souhaitant orienter les pratiquesdu credit bancaire de maniere a favoriser certaines categories d'emprunteurstels que les agriculteurs defavorises et certains secteurs comme le logementet l'agriculture, ou, au contraire, a d6courager le detention de stocks ades fins speculatives, a mis en oeuvre tout un eventail de mesures. C'estainsi qu'il agit notamment sur les taux d'int6r&t, les garanties de creditet les criteres regissant les refinancements et les marges ben6ficiaires.Le present document s'efforce de proc6der a une analyse systematique detoutes les mesures appliquees par le Gouvernement, a la lumiere de sesobjectifs explicites ou implicities. II examine l'impact de chacune deces politiques, utilisee isolement ou en association avec d'autres, afinde juger de son utilit6 et de son efficacit6. Sur la base de cette etudecritique, il propose des modifications et tire un certain nombre deconclusions dont peuvent slinspirer les responsables de la politiquefinanciere d'autres pays.

Extracto

El Gobierno de Bangladesh ha utilizado diversas politicas parainfluir en la asignaci6n del credito a grupos especificos de prestatarios,como los agricultores pobres, iy a ciertos usos y sectores, como la vivienday la agricultura. Estas polit-icas se han utilizado ademas para reducir laasignaci6n del cr6dito a deterrninados usos, como el mantenimiento de exis-tencias ("fines especulativos"). Entre las politicas aplicadas cabe citarel control de los intereses, garantias de creditos, refinanciamiento y exi-gencias de margenes. En este trabajo se intenta hacer un analisis sistema-tico de todas las politicas ap]Licadas por el Gobierno de Bangladesh a la luzde los objetivos explicitos o implicitos del mismo. Se analiza el efecto decada una de las politicas util:izadas, por si sola o en combinaci6n conotras, con vistas a evaluar su utilidad y eficacia. El analisis proporcionaluego la base para sugerir cambios de politicas en Bangladesh, asi como paraextraer ensenianzas de posible utilidad para los responsables de elaborar laspoliticas financieras en otros paises.

CURRENCY EQUIVALENTS

The Bangladesh Taka (abreviated TK) is fixed in relation to abasket of reference currencies, with the Pound Sterling serving asintervention currency. On January 11, 1982, the exchange rate was setat TK 38.372 buying and TK 38.472 selling per Pound Sterling. Dependingon exchange rate movements between Sterling and the US Dollar, theTaka/Dollar cross-rate is subject to change. In recent months, thisrate has fluctuated between TK 19 and TK 20.9 per US$.

MEASURES

1 Crore = 10 million

1 Lakh = 100 thousand

FISCAL YEAR

The Bangladesh Fiscal Year (FY) runs from July 1 to June 30.

Chapter Table of Contents Page

I., Introduction 1

1.1 Objectives - Explicit 1

1.2 Objectives - Implicit 1

1.3 Types of Policies 2

1.4 Overall Allocation 3

II. Interest Rate Policy 8

2.1 First Major Revision 8

2.2 Second Major Revision 8

2.3 Effect of Credit Ceilings 10

2.4 Guarantees and Collateral 11

2.5 Distributional Effects 15

2.6 Speculative Credit 16

2.7 Interest Ceilings and Interest Subsidy 16

2.8 Penalty Interest Rates 17

2.9 Objectives and EfEfects of Second Revision 19

2.10 Intra-Bank Lending Rates 22

2.11 Real and Nominal Interest Rates 23

III. Credit Allocation Polic 24

3.1 Overview 24

3.2 The Target Approach 25

3.3 Ceilings and Prohibitions 30

3.4 Margin Requirements: Overview and Analysis 32

3.5 Margin Requirements: Differential Impact 37

3.6 Refinance and Counter Finance: Overview 47

Table of Contents (continued) Page

3.7 Refinance Usage, Intentive Effects and Usefulness 52

3.8 Guarantee Programs 62

3.9 Urban-Rural Branch Licensing 64

IV. Issues of Financial Policy 69

4.1 Efficiency or Inefficiency in Credit Markets 69

4.2 Welfare Objectives and Credit Markets 70

4.3 Differential Interest Rates: Availability vs. Cost 72

4.4 Financing of Specialized Banks: Refinance, Debentures 73or Deposits

4.5 Buffer Stocks: Alternative for Margin Requirements 79and Refinance

4.6 Term Finance 80

V. Agricultural Credit 81

5.1 Introduction 81

5.2 Expected Marginal Product of Loans 82

5.3 Targets and Disbursements; Differential Performance 85

5.4 The Special Agricultural Program and Commercial 88Bank Performance

5.5 Introduction of Urban Organized Banks into 91Agricultural Lending

5.6 Interest Ceilings and BKB Performance 92

5.7 Recovery Performance 94

5.8 Bad Debts vs. Liquidity Problems 101

Footnotes 103

References 103

List of Tables

Table Number Page

1. Sectoral Distr.Lbution of Advances by 4Scheduled Banks

2. GDP in Current Prices by Sectors 6

3. Credit Allocation Index 7

4. Interest Rates on Loans and Advances 9

5. Advances Classified by Size of Accounts 12

6. Advances Classified by Securities 13

7. Loans to Agricuiltural Hunting, Forestry, 14Fishing

8. Advances Classified by Rates of Interest 18

9. Advances to Small Loans and Small Industry, 27House Building and Transport

10. Rates of Growth of Prices and Imposition 33of Margin Requirements

11. Distribution of Advances by Margins for 38Specified Securities, and Average Loan Sizeby Margin for the same Securities

12. Distribution of Advances by Rates of Margin 40for Related Securities

13. Distribution of Advances by Rates of Margin 41

14. Distribution of Advances by Securities 44

15. Distribution of Advances by Economic Purpose 46

16. Use of Refinancie by Bangladesh Krishi Bank 48(BKB) and Bangladesh Samabya Bank (BSB)

17. Average (weighted) Deposit Rate 53

18. Refinance: Usage as a Percentage of 57Entitled Limits

19. Advances and Deposits of Scheduled Banks 59excluding BKB and BSB

List of Tables (continued) Page

20. Payment of Government Guarantees to the 63Banks Under Special Agricultural Credit Program

21. Rural Branch Expansion 65

22. Administrative Costs of Rural Branches 67

23. Sonali Bank Statistics 68

24. Credit-Deposit Ratio by District 78

25. Marginal Product of Loans in Agriculture 83

26. Agricultural Credit 86

27. Special Agricultural Credit Program 89

28. Bangladesh Krishi Bank Borrower Characteristics 93

List of Figures

1. Rationing Equilibrium 36

2. Recovery Profiles by Banks for the Special 96Agricultural Credit Program

3. Recovery Profiles: BKB, Sonali, Agrani and 97Janata Banks

4. Recovery Profiles: Janata, Uttara, Rupali 98and Pubali Banks

5. Recovery Profiles by SACP Programs 100

DEFINITIONS AND ABREVIATIONS

Bangladesh Bank (BB): The Central Bank of Bangladesh.

Co-operative Banks: Consist of an apex co-operative bank and 62central co-operative banks.

Bangladesh Samabaya Bank Limited (BSBL): The apex co-operative bank;sometimes referred to as the Bangladesh Jatiya Bank (BJSB).

Scheduled Banks: Banks permitted to carry out all normal bankingoperations including the taking of deposits from thepublic. They are therefore subject to reserve requirements.

Nationalized Commercial Banks (NCBs): The six commercial banks(Sonali, Janta, Agrani, Rupali, Pubali, Uttara) owned by thegovernment.

Specialized (Scheduled) Banks: Special Purpose Banks which areallowed to take deposits. Consist of:

Bangladesh Krishi Bank (BKB): The Agricultural development bank;Bangladesh Shilpa Bank (BSB): Specialized bank for making medium

and long term loans to industry.

Foreign Commercial Banks': 'Branches of foreign owned banks.

Bangladesh Shilpa Rin Sangst'ha (BSRS): Specialized Institution formaking long and medium-term loans to heavy-mediumindustries. Not a sc'heduled bank.

House Building Finance Corporation (HBFC): Specialized Institutionfor making loans for Housing.

Integrated Rural Development Program (IRDP): A two-tier co-operative system separate from and independent of the co-operative banks. Financed through the Sonali Bank.

PREFACE

This paper applies thet analytical framework developed earlier

by the author in The Nature of Credit Markets in Developing Countries:

A Framework for Policy Analysis, (World Bank Staff Working Paper

No.524). The paper was prepared originally as a report for the

Bangladesh Financial Sector Review Mission. Many of the issues before

this mission and its objectives were similar to those which motivated

the author's earlier work. The current paper was therefore conceived

from inception as a practical application of this policy framework.

A distinction between empirical testing and practical

application needs to be borne in mind in reading the paper. The former

was not attempted, given the data limitations and time constraints under

which the paper was written. It is presented more as a practical guide

to others wishing to apply the siame framework in the context of similar

limitations.

Arvind Virmani

I. INTRODUCTION

1.1 Objectives - Explicit

The Bangladesh government has outlined three operational objectives

of financial policy. These are-I/

(a) Macro-Economic Objective:

To control the expansion of bank credit so as to contain inflation

while stimulating production and investment. As with most governments no

explicit trade-off is considered and the relative emphasis on one or other

sub-objective has varied with economic and social conditions.

(b) Credit Allocation Objective:

To channel credit into priority and essential sectors and away from

speculative activities and hoarding. Agriculture, small industry and exports

were the earliest sectors to be defined as priority sectors. The emphasis on

agriculture as a priority/essential sector has remained throughout. The

emphasis given to other sectors has varied however. Small industry expanded

to include small businesses and trade, new sectors like residential housing

and Transport were added and then detleted from the list.

(c) Institutional Objective:

To consolidate and strengthen the banking system, to provide new

financial institutions and to promote money markets.

1.2 Objectives - Implicit

Underlying these explicit or apparent objectives of financial policy

are deeper or implicit objectives which guide their application. This is

particularly true of the credit allocation and institutional objectives. The

implicit objectives are:

- 2 -

(a) Efficiency Objective:

To correct imperfections in the credit market which lead to

economically or socially inefficient use of credit. This clearly influences

the choice of sectors and borrower categories for both positive and negative

credit allocation measures. It also influences the institutional objectives.

(b) Welfare Objective:

To provide welfare subsidies to target groups, to transfer income

between different groups of borrowers, and to change the division of gains in

transactions between traditional lenders and borrowers.

(c) Subsidy Objective:

To correct imperfections or impediments in other markets, or to

mitigate these effects, by providing subsidies through the credit system.

1.3 Types of Policies

The most important financial policies used to meet the overall

objectives can be divided broadly into three groups. This is done on the

basis of the sub-set of the objectives they are primarily directed towards.

They can and often do have effects on other objectives, but it is useful as a

first step to make the categorisation, as follows:

(a) Credit Ceilings and Prohibitions:

These were directed primarily at controlling the flow of total

credit, but often have an allocation component. They include ceilings on

total lending by individual banks, lending to private and public sectors,

lending to different loan size classes, and lending for certain economic

purposes. The allocation component is designed primarily to countervene the

likely allocational impact of overall credit control policies.

-3 -

(b) Allocational Instruments-

These included lending targets and guidelines, margin requirements,

refinance policies, government guarantees, and linking to new urban and rural

branches. Specialized banks when coupled with refinance policy have been

another instrument for this purpose. Further the effects of refinance policy

have been most strongly influenced by the credit ceiling instrument.

(c) Int:erest Rate Policy:

Interest rate policies, including the use of penalty rates, of

course have the broadest ramifications. Ceillgns on (loan) interest rates

have been directed primarily towards the welfare and subsidy objectives. A

secondary objective has beenm the stimulation of investment. Interest rate

policies of course influence the allocation of credit, and the viability of

financial institutions. The use of penalty rates of interest on loan

overdues, has been used as an indirect means of couiiteracti g some of these

secondary effects.

1.4 Overall Allocation

The present paper focuses on the post 1975 period, and on the issue

of credit allocation. Clearly however issues can seldom be so neatly

compartmentalized. To the extent that Macro-economi and institutional issues

interact with credit allocation Issues they will be dealt with.

Table 1 gives an overview of the allocation of credit by broad

economic sectors. Over the period from June 1975 to December 1975 the

proportion of total advances to the agricultural sector rose from 10.8% to

18.6%, while those to manufacturin;v declined from 52.4% to 40.0%. The

proportion of advances going to the transport eector also showed a declining

trend while those to the construction sector in reased. The proportion of

advances going to wholesale and retail trade fluctuated considerably over the

Table 1: Sectoral Distribution of Advances by Scheduled Banks

(Percentage of Total)

Sectors 30-6-75 30-6-76 30-6-77 30-6-78 30-6-79 30-6- 80

Agriculture, Forestry, Fishing 10.76 10.78 11.31 14.13 16.65 18.59

Manufacturing 52.38 48.73 43.81 42.76 40.12 40.02

Construction .76 .69 1.14 1.37 2.67 1.43

Transport and Communications 3.56 4.89 3.93 3.86 3.62 3.17

Transport 4.31 4.87 3.89 3.82 3.50 3.14

Trade and Catering 23.59 27.50 27.64 22.94 26.18 25.82

Trade-Wholesale and retail 23.09 26.65 27.23 22.71 25.98 25.60

Jute goods and Tea + 11.80 6.43 6.29 9.48 9.32

+ Data not available.

Source: Calculated from Bangladesh Bank Bulletin.

- 5 -

period. These figures suggest a redirection of credit away from transport and

communication and manufacturing, into construction and agriculture, forestry

and fishing.

Table 2 shows however that the share of the different sectors in

total GDP varied considerably over time. Any shifts in the pattern of credit

allocation between sectors would therefore be partly due to changes in GDP

share and partly to government policy and other factors. It is therefore

useful to construct an index which removes this effect, and is presented in

Table 3. The doubling of the index for agriculture over this period confirms

the profound shift of institutiona)l credit towards the agricultural sector.

The index for the transport and communication sector also continues to show a

down trend over the whole period. None of the other sectors now show a clear

trend over the entire period, with the construction sector replacing the trade

and catering sector as the most erratic.

The only other information of note in Table 3 is the kink which

occurs in the index for Trade and Catering in June 1978. Trade and Catering

follow the inverse sawtooth pattern with the rising trend interrupted by a

full in 1977-78. It is likely that a general reduction in loan interest

ceilings in May 1977 is responsible for this effect which occured between .June

1977 and June 1978.

Table 2: GDP in Current Prices, by Sectors (Percentage)

GDP in Market Prices 1974-75 1975-76 1977-76 1977-78 1978-79 1979-80

Agriculture, Forestry, Fishing 62.53 53.36 50.94 55.45 54.39 54.10

Manufacturing 6.66 7.61 8.22 7.22 7.12 7.25

Construction 4.51 5.13 5.51 4.72 4.25 5.39

Transport and Communications 4.49 6.17 6.96 6.77 6.59 6.68

Trade & Catering 8.73 10.00 9.86 9.85 10.80 11.05

Soulrce: "Bangladesh: Recent Economic Dlevelopments and Selected Development Issues,"' March 3, 1982.(This is an internal document with restricted circulation.)

Table 3: Credit Allocation Index; Ratio of Advance Proportions to GD? Proportions

1974-75 1975-76 1976-77 1977-78 1978-79 1979-80

Sector

Agriculture .172 .201 .222 .255 .306 .344

Manufacturing 7.865 6.403 5.330 5.922 5.635 5.520

Construction .168 .135 .207 .290 .628 .265

Transportation .793 .793 .565 .570 .549 .475

Trade 2.702 2.750 2.803 2,329 2.424 2.337

Source: Tables 1 and 2.

II. INTEREST RATE POLICY

2.1 First Major Revision

Table 4 gives an overview of changes in interest rate ceilings on

loans and advances. Over the period there have been two major changes in loan

interest ceilings. The one in May 1977 reduced the nominal ceilings on almost

all loans by one percentage point; from 13% to 12% on general borrowing and

from 11.5 to 10.5 on exports. The exceptions to this were the rates on Jute,

Jute goods and Tea and rates charged by the specialised banks and co-

operatives, which remained essentially unchanged. The effect of this way to

reduce the gap between the interest charged by these institutions and by

others, with the exception of the Bangladesh Samabaya Bank (BSB).

Interestingly BSB which makes medium to long-term loans retained a higher

ceiling rate of 13%.

The professed objective of this reduction in ceilings was to provide

a stimulus to economic activity, particularly to commerce and trade. Credit

ceilings had been in effect since the IMF borrowing in 1974-74. These had

been raised periodically. In particular they had been raised some months

before the lowering of the interest rate ceilings. Credit ceilings were

therefore not on effective constraint in the succeeding period. In 1975-76

and 1976-77 the implicit GDP deflator declined by 23.9% and 3.2% respectively

indicating a strong though decelerating deflation. In 1977-78 this process

was reversed by an inflation rate of 14.9%.

2.2 Second Major Revision

The other major change in interest rate policy occured in October

1980 (also Table 4). The effect of this set of changes was to differentiate

loan interest ceilings by economic sectors. Thus intra-sectoral rates were

unified while intersectoral ceilings were made different for agriculture and

Table 4: Interest Rates on Loans and Advances (Scheduled Banks)

Since Since SinceJuly 1974 July 1976 May 1977 1978/79 October 1980 1981

General Borrowers 12.0-13.0% * 11.0-12.0% * 15.5% 16.0(i.e. all those notseparately specified)

Export Commodities 12.0-13.0% 11.5% 10.5% * 12.0% *(except Jute, JuteGoods and Tea)

Industry 12.0-13.0% * 11.0-12.0% * 14.0% 14.5% 1/

BSB General Lending 12.0-13.0% * 11.5-13.0% * 14.0%

Agriculture 12.0-13.0% * 11.0-12.0% * 19n0% *

Jute, Jute Goods andTea 10.5% * * * 12.0% *

BKB 11.0-11.5% * * * 12.0% *

Co-Operatives 12.0% * * * 12.0% *

Loans for Socio-EconomicPurposes 12.0-13.0% 12.0% 2/ 11.0% 11.0-11.5% 13.0% *

Bangladesh Bank Rate 8.0% 2/ * * * 10.5%(Discount Rate)

Concessional Discount 6.0% 3/ * * * *Rate for lending toBKB and BSB

X Unchanged from previous period.1/ Except Long term loans which remain at 14%.2/ Effective June 1974.31 Effective September 1976.

BKB: Bangladesh Krishi BankBSB: Bangladesh Samabaya Bank

10

industry. The lowest ceiling was on agricultural advances at 12%, followed by

industry at 14% and all others at 15.5%. One exception to this classification

were loans for socia-economic objectives which had an overall interesst rate

ceiling of 13%. The other apparent exception was export credit (pre-shipment,

packing and post-shipment) at 12%. However interest ceilings on export

commodities had always been relatively low. Jute, Jute goods and Tea were

traditionally the most important export commodities and agricultural exports

continue to constitute the majority of exports. Thus the rise in the ceiling

rate on export commodities can be seen as consistent with intra-sectoral

unification of ceilings.

This revision in the interest rate structure was designed primarily

as a resource mobilisation measure. It was hoped that the increase in the

relative return to an asset competing with speculative stocking activities

would shift assets out of the latter, and thus reduce inflationary

expectations. However it was also expected to result in more efficient use of

credit. Though in the case of both major changes in interest policy the

primary objectives were macro-economic, the effects on credit allocations were

equally if not more important. It is on these we focus.

2.3 Effect of Credit Ceilings

In case of credit for productive purposes, I have shown earlier 2/

that an effective ceiling on loan interest rates would reduce loan amounts and

increase collateral requirements. This effect would be stronger for thse who

were just meeting credit requirements but now run into a collateral

constraint. T1hose who are already constrained by collateral may get no loans

at all. The funds thus made surplus reduce the opportunity cost of funds.

This reduces the direct impact and also results in loans being provided for

the first time to less productive borrowers having sufficient collateral. The

- 11 -

net effect is to shift credit from those having less collaterable wealth to

those with more.

In Tables 1 and 3 it was noted that there was no significant change

in trends of credit allocation to productive (non-trade) sectors between June

1977 and June 1978. As there is no particular reason to expect the

availability of effective collateral to differ significantly across sectors

the facts are consistent with our analysis. Table 5 shows that between June

1977 and June 1978 there was a small but significant increase in the

proportion of loans going to smaller borrowers. Thus the proportion of loans

in the TK 1000 to TK 3000 category increased from 4.44 to 5.79% while

proportion of total loans iln size less than TK 3000 increased from 8.82% to

10.31% (see also section 2,5). The previous analysis suggests that this may

represent a shift of credit to somewhat less productive small producers who

however had sufficient collateral available. This is consistent with the

usual observation that small (indiustrial) producers have lower debt-equity

ratio.

2.4 Guarantees and Collateral

Table 6 gives a distribution of credit by securities. What is

surprising in this table is the slharp decreases, from TK 143 crores on June

1977 to T1K 23 crores on June 1978, in the use of machinery and other fixed

assets as security. As such assets are most prevalent in manufacturing this

would suggest a decline in loans to the manufacturing sector. This conclusion

is contradicted by the data in Tables 1 and 3, however. The correct

explanation is found in the corresponding, and even sharper, increase from

TK 252 crores to TK 509 crores, in use of miscellaneous securities over the

same period. This category includes other secured advances, advances secured

by guarantees and unsecured advances. In 1976-77 TK 56.5 crores of advances

- 12 -

Table 5: Advances Classified by Size of Accounts - All Banks

(% of all Loans)

Loan Size (Taka) 30-6-Z5 30-6-76 30-6-77 30-6-78 30-6-79 30-6-80

< 1,000 4.66 3.63 4.38 4.52 3.16 2.73

1,000 to < 3,000 3.73 3.53 4.44 5.79 6.97 7.64

3,000 to < 10,000 1.45 2.21 2.03 2.09 2.16 2.04

10,000 to < 25,000 1.67* 1.56* 2.50 2.34 2.73 2.36

25,000 to < 50,000 2.49* 2.91* 2.43 2.68 2.15 1.77

50,000 to < 100,000 3.16 3.40 4.78 3.98 4.12 3.13

100,000 to< 10,000,000 14.10 14.00 15.20 17.55 16.74 16.54

> 1,000,000 68.74 68.76 64.24 61.05 61.97 63.79

Cummulative %

< 1,000 4.66 3.63 4.38 4.52 3.16 2.74

< 3,000 8.39 7.16 8.82 10.31 10.13 10.37

< 10,000 9.84 9.37 10.85 12.40 12.29 12.41

< 25,000 11.51* 10.93* 13.35 14.74 15.02 14.77

< 50,000 14.00 13.84 13.35 14.74 15.02 14.77

< 100,000 17.16 17.24 20.56 21.40 21.29 19.67

< 1,000,000 31.26 31.24 35.76 38.95 38.03 '36.21

Total 100.00 100.00 100.00 100.00 100.00 100.00

* 10,000 to 20,000** 20,000 to 50,000+ < 20,000

Source: Bangladesh Bank Bulletin pp. 24-25.

Table 6: Advances Classified by Securities - All Banks

30-6-75 30-6-76 30-6-77 30-6-78 30-6-79 30-6-80

A. Gold etc. 0.47 0.67 0.95 0.95 0.92

B. Stock Exchange Sec. 0.96 1.08 1.02 0.23 1.31 0.68

C. Merchandise 57.86 58.03 53.98 52.90 60.60 62.63

i. Export Commodities 33.26 26.01 20.77 22.55 30.52 31.99ii. Imported intermediaries 13.69 23.13 23.27 20.94 18.43 16.11

iii. Imported Ind. Machineries 10.41 8.40 9.77 8.54 11.34 14.16iv. Imported Agric. Products

nDe MAchiner- ar.d Other Fixed 14.87 1,.01 12.4, 1.57 2.10% 1.89

E. Real Estate 8.12 6.77 7.25 7.15 7.69 7.69

F. Financial Obligations 2.50 2.65

G. Miscellaneous 16.32 16.75 21.85 35.16 24.82 24.18

Source: Bangladesh Bank Bulletin, pp. 58-59.

- 14 -

Table 7: Loans to Agriculture, Hunting, Forestry and Fishing:Classified by Size of Accounts

Size of Account (Taka) 30-6-76 30-6-77 30-6-78 30-9-78 30-6-79 30-9=80

- Loan amounts (1,000 Takas)

< 10OO0 3361.10 4780.19 6083.06 6593.65 5298.45 6592.211,000 to < 3,000 2616.34 4268.14 7617.50 7027.70 11629.47 18675.553,0O0 to < 10,000 102.82 242.62 809.05 897.46 1648.02 2456.0310,000 to < 20,000 63.93 40.46 316.29 469.36 1081.76 3096.7520,000 to < 50,000 49.97 90.32 230.32 345.86 624.73 636.4950,000 to < 100,000 76.95 216.11 143.01 340.34 395.77 455.01> 1,000,000D 3838.93 3409.85 5852.91 6822.76 10542.71 18357.15

Total 10112.68 13047.69 21052.14 22497.13 31220.91 50269.19

Proportion of Total Loans (%)

<( 1,000 33.24 36.64 28.90 29.31 16.97 13.111,000 to < 3,000 25.87 32.71 36.18 31.24 37.25 37.153,000 to < 10 000 1.07 1.86 3.84 3.99 5.28 4.8910,000 to < 20,000 .63 .31 1.50 2.09 3.46 6.1620,000 to < 50,000 .49 .69 1.09 1.54 2.00 1.2750,000 to < 100,000 .76 1.66 .68 1.51 1.27 .91> 100,000 37.96 26.13 27.80 30.33 33.77 36.52

Total 100.00 100.00 100.00 100.00 100.00 100.00

Cumulative Propotio~n(.

< 1,000 33.24 36.64 28.90 29.31 16.97 13.11< 3,000 59.11 69.35 65.08 60.55 54.22 50.26< 10OO 60.18 71.21 68.92 64.54 59.50 55.15< 2-OGO- 60.81 71.52 70.42 66.63 62.96 61.31< 50,000 61.30 72.21 71.51 68.17 64.96 62.58< 100,000 62.06 73.87 72.19 69.68 66.23 63.49

Total 100.00 100.00 100.00 100.00 100.00 100.00

Source: Bangladesh Bank Bulletins

- 15 -

to the public sector Jute industry were rescheduled. This was followed in

1977-78 by rescheduling and restructuring of the debt of the public sector

Jute and Tea industry. This was done under the condition that the debt would

now be backed by government guarantees. The change in the nature of

securities therefore primarily represents a reclassification of this debt from

fixed capital as collateral to government guarantees as collateral.

2.5 Distributional Effects

The distributional effects of credit ceilings, arising from the

unequal distribution of wealth and consequently of collateral among households

are best demonstrated for the agricultural sector. In this sector there is a

high co-relation between the distribution of land and the distribution of

wealth. land is of course the best form of implicit or explicit collateral in

agriculture. In addition, productivity and credit requirements would also be

linked to the value of land. Therefore among the land owners we would expect

small landowners to obtain smaller loans, while most of the landless creditors

would fall in the smallest category.

Table 7 gives the allocation of credit to the agricultural sector,

by loan size. Between June 1.977 and June 1978 there was a sharp reduction in

the proportion of loans of less than TK 1000 from 36.6% to 28.9%. Some of

these were shifted into the next loan size category of TIC 1000 to TK 3000,

which increased from 32.7% to 36.2%. However the table of cumulative

percentages shows clearly the decrease in the proportion of total loans going

to smaller loan categories. As our analysis indicated this would be the

direct effect of a decrease in interest ceiling. A word of caution is in

order, however: As the loan classes are in monetary terms, a proportional

increase in the size of all loans, for example due to inflation, would shift

the entire distribution to higher loan sizes. This would result in a

- 16 -

reduction of the proportion of loans in the lowest and a rise in that of the

highest size classification. The proportions in the other loan size groups

would remain approximately the same. This is not however the pattern in Table

7. Otherwise a Gini type coefficient is to be preferred.

2.6 Speculative Credit

An analysis of pure speculative credit is somewhat different from

that of productive credit as applied above. The speculator/trader is assumed

to use his own funds as well as any borrowed funds for buying a commodity

stock. The return to this stock arises purely from the anticipated increase

in its price. In effect we separate out the productive aspects of trade from

this analysis. The traders own contribution or margin constitutes the

security or collateral as far as the bank is concerned. It can be shown that

a reduction in credit ceilings in this case will tend to eliminate credit for

the less speculative commodities: That is the commodities for which price

rises are expected to be low may not obtain any credit.

In tables 1 and 3 and the accompanying discussion it was pointed out

that the reduction in credit ceilings in May 1977 led to a downward kink in

the rising share of output-adjusted credit going to the trade sector. This is

consistent with the above analysis.

2.7 Interest Ceilings and Interest Subsidy

It is useful at this point to draw a distinction between interest

ceilings and interest subsidies. Both may be motivated by a desire to provide

subsidies, as for example the lower than average credit ceilings on Jute, Jute

goods and Tea and on other export goods which prevailed before October 1980

(Table 4). However they can have quite different effects on the efficiency of

credit use and on the distribution of credit. As already indicated interest

ceilings have negative consequences in both these cases. On the other hand,

- 17 -

that when the banking system is inefficient in allocating credit to specific

sub-sectors or sets of borrowers, an interest subsidy to the bank can remove

this inefficiency [see Virmani (1982)]. In such a situation an interest

subsidy increases loans to the neglected sector and to borrowers with

inadequate collateral (wealth). However this policy has not been tried in

Bangladesh.

2.8 Penalty Interest Rates

In February 1979 the government introduced a system of penalty rates

of interest on overdue loans. Scheduled banks were allowed under the system,

to charge a penalty rate of interest, which could be incremented by 1% every

month, until total rate (normal plus penalty) became 20%. The objective of

this penalty was to decrease the disincentive for lending to sectors where

repayment of loans has been a problem. Loan overdues can create a liquidity

problem in addition to reducing the expected return to the bank. As borrowers

who are delaying payments are likely to be the more risky customers it is

logical to charge them a higher rate. The penalty rate does this without

imposing a cost on good borrowers and is therefore an efficient mechanism for

doing so.

The application of penalty rates, particularly in agriculture, has

been somewhat erratic, with differeni: banks having different rules. Thus

Sonali bank charges the full penalty while BKB limits itself to a maximum

penalty rate of 2.5% and Pubali to 11'. It is also reported that in other

economic sectors, banks often charge penalty rates only to the public sector

borrowers and seldom to the private sector. However this is quite consistent

with the rationale given above, if the public sector is more erratic and

deficient in its repayment performance than the corresponding private sector

borrowers.

Table 8: Advances Classif ied by Rates of Interest All Banks(Percent of total Loans)

30-6-76 30-6-77 30-6-78 30-6-79 30-6-80

Interest Rate

110,0%: 0.19 0.28 0.15 6.79 0.12 0.11

10.5% 26.41 23.31 16.34 18.93 25.25 19,86

11.0% 1.78 1.68 3.49 6.79 7.40 10.20

11.5- 7.28 5.85 5.87 5.49 8;38 7.26

12.O% 16.10 15.66 41.52 38,39 38.10 37.56

> 12.0 to < 13.0% 2.37 2.53 1,32 1.19 0.69 0,53 H

13.0% 33.38 40.57 17.46 9.04 5.01 3.89

> 13.0% 0 0 0 0.07 3.80 3.29

- 19 -

Table 8, giving the disl:ribution of advances by rate of interest,

shows that the proportion of loans carrying a rate of interest rate of more

than 13% jumped from .07% of total advances in June 1978 to 3.8% in June

1979. They remained at approximately that level in June 1980. A small

proportion of these of course constitute high interest loans under the Rural

Finance Experimental Project. The rest are due to the use of penalty rates

and give an approximate measure of the extent of usage of such rates.

As late repayment is a major problem in the agricultural sector,

penalty rates will be discussed further under agricultural credit. Such rates

can be a very useful instrument of policy, when the repayment period is

carefully defined to take account of natural agricultural fluctuations.

2.9 Objectives and Effects of the Second Revision

Detailed data of the kind used above is not available for June , so

the effects of the October 1980 revision of interest ceilings are not fully

visible. However some preliminary conclusions can be drawn. As previously

noted this revision involved a change-over to a sectorally oriented system of

interest ceilings. This involved the setting up of an implicit hierarchy of

sectors; agriculture and exports are on top with a ceiling rate of 12%,

followed by manufacturing with a ceiling of 14%, while all other sectors have

a ceiling rate of 15.5%. Small loans and loans in less developed areas, which

do not fit into the sectoral classiLfication, fall between the ceiling rates

for the agricultural and the manufacturing sectors, with a ceiling rate of

13%.

There are two possible justifications for this hierarchy. One is

based on the supposition that production and investment are sufficiently

sensitive to interest rates, and that the economic rate of return has the

hierarchical pattern postulated. T'hrough a plausible case can be made for the

- 20 -

second proposition, the first is highly dubious. However even if it has some

merit it must be questioned whether the provision of implicit subsidies to

creditors is the appropriate means of providing incentives. Thus it is

necessary to look more closely at other policies, like exchange rates and

tariffs, which directly affect exports and manufacturing.

The other possible justification is to provide welfare subsidies to

target groups. Thus the largest numbers of poor are thought to be in the

rural areas, and lower interest rates to agricultural creditors may be thought

of as providing a subsidy. However even if these justifications are accepted

credit ceilings can have unexpected and harmful effects. To understand this

it is very important to draw a distinction between interest ceilings and

interest subsidies, and between cheaper credit and sufficient credit.

Many policy makers and even economic analysts may see the

differential interest rate ceilings as a cross-subsidisation scheme from

general creditors to farmers, exporters, small loanees and industrial

borrowers. This is quite misleading. A true cross subsidisation scheme would

involve an interest tax (or a tax per loan) on all bank lending to general

borrowers and an appropriate interest subsidy (or subsidy per loan) on the

favoured borrowers. This would provide the correct incentives for channeling

credit into the desired sectors. The effect of the differential credit

ceilings will be to redirect credit away from agriculture and exports and to a

lesser extent from industry into general lending. This perverse effect would

be accompanied by redirection of credit within each sector to those with

sufficient collateral and away from those with little collateral. Thus the

poor would tend to get relatively less credit than they would in the absence

of effective credit ceilings. Though adverse intersectoral flows may be

partly stemmed by forced lending through specification of targets, this has

- 21 -

its own limitations. Among these are ineffectiveness against adverse

distributional effects and the fungability problem (discussed in a later

section).

Two observed effects of the differential credit ceiling support the

above analysis. Firstly these havre a differential impact among the

Nationalized Commercial Banks (NCBs). A rise in deposit interest rates also

raises the interest costs of all banks, and may have a differential impact

across banks depending on the distribution of each bank's deposits.

Profitability is more strongly affected, however, by the sectoral distribution

of a bank-s existing loan portfolio. Thus the Pubali Bank which was strongly

oriented towards small loans, exports and fisheries will now earn 12% or 13%

on most of its loans. This has put a profit squeeze and provided a

disincentive to expand further into these sectors. Thus, it is being forced

to expand into areas of related expertise in industry and trade in which

higher interest rates are allowed.

A similar reduction in profits is taking place for the specialized

banks such as the Bangladesh Krishi Bank (BKB). Though the rise in deposit

rates affects only a small fraction of its funds, the relative profitability

of agricultural lending vis a vis agriculture related commercial lending has

declined. Given that in 1979 approximately 70% of its loans went to

agriculture the lower interest rate of 12% on such loans puts a profit squeeze

on the BKB (discussed further in agricultural section). As a result the BKB

is planning to reduce the proportion of agricultural loans to 60% and to

expand faster into sectors like agro-industries, storage, transport and

banking to which higher credit ceilings are applicable.

- 22 -

2.10 Intra-Bank Lending Rates

The rates charged by banks on their internal transfer of funds

between branches and between branches and headquarters are of course not

directly relevant to final borrowers. They affect the incentive structure of

banks, however, and can affect credit flows to final borrowers. For

commercial banks, these rates vary from 11% to 14% at the present time, as

shown below

Bank Headquarters to Branch Branch to Headquarters

Sonali 11% 11%

Janata and Agrani 12% 12%

Pubali 14% 13%

Thus Pubali bank branches have clearly no incentive to borrow funds from

headquarters for lending to agricultural and export sectors (12%) and for

socioeconomic purposes (13%), and little incentives for lending to industry

(14%). If the average administrative costs for all lending operations (1 to

2%) are taken account of, even Sonali bank branches have little or no

incentive to borrow internally for lending to these sectors.

Banks should of course be free to set intra-bank lending rates

according to their particular circumstances. Given the current structure of

interest rates, however, we can calculate the approximate range in which these

rates should lie. The average interest cost of deposits is currently about 7%

of total business. The average administrative costs of lending are about 4%,

though the administrative costs of rural lending by commercial banks are

somewhat higher at about 5%. As the lowest loan rate is 12%, and taking the

4% cost as divided equally between the deposit and lending sides intra-bank

lending rates should be approximately 9 to 10%.

- 23 -

2.11 Real and Nominal Interest Rates

The anlysis presented in this chapter, as in the rest of the paper,

is in nominal interest rate terms. Given the established practice of using a

rate constructed by subtracting actual or expected inflation from the nominal

rate (the 'real' rate) this requires an explanation. The framework on which

the analysis of the paper is based, divides the basic financial market into

two submarkets: The deposit marlket and the loan market. The former is

supplied with funds by depositors and has banks as demanders of funds. In

conventional terms this is the savings side of the market. When savings are

treated in aggregate clearly a 'real' rate of interest must be used in the

analysis. If deposit markets are perfect, changes in the rate of inflation

have no effect on aggregate saving. If deposit rates are controlled by the

government, however, changes in ithe rate of inflation will influence both the

total amount of savings and the amount flowing into deposits. This in turn

will affect the opportunity shadow cost of funds to the banks (termed s in the

present paper).

our analysis focuses on the loan sub-market. The shadow

(opportunity) cost of funds (s) is of curse an input into this market. In the

loan market, competitive banks will make a loan to a borrower as long as their

expected profits are positive; the loan amount, the loan interest rate and

other variables are all expressed in nominal terms. The firm similarly

maximizes its expected profit evaluated in nominal terms. In deciding whether

to take a loan or not it merely compares these net profits with the nominal

opportunity cost of own funds. The terms of the loan contract, including the

loan interest rate, will differ for firms with different characteristics (e.g.

returns). The allocation of loans will therefore be determined by the

distribution of these characteristics across firms. If we compare two

- 24 -

situations; one in which all prices are double that in the other, there is no

reason to expect any difference in the distribution of these characteristics

across firms. Therefore the allocation of credit should not be affected if

other things remain unchanged.

If the deposit interest rate is controlled, however, the flow of

deposits into the banking system might fall. This in turn would raise the

shadow cost of funds to the banks. Our analysis shows that in this case loan

amounts must fall and loan interests rates rise for every existing borrower.

In addition collateral requirements may rise or fall for each borrower, and

this could affect the distribution of loans. Without more detailed

information, however, it is not possible to determine the direction of change

for any particular borrower. The first order approximation is therefore to

assume no effect of inflation on credit allocations; the analysis can be

carried out in nominal terms.

III. CREDIT ALLOCATION POLICY

3.1 Overview

Several different policy instruments have been used for different

sectors at different times. Among these are targets, prohibitions and

ceilings, margin requirements, refinance or counter finance, guarantees and

urban-rural branch approval. One way of organizing these instruments is in

terms of positive and negative instruments. The negative instruments are

designed to reduce or eliminate the flow of credit to certain individuals or

for certain purposes. Ceiling and prohibitions and margin requirements fall

into this category. The positive instruments are designed to channel the flow

of credit into specified areas. All the other instruments mentioned fall into

this category. Logically of course the categories are complementary in the

- 25 -

sense that if a negative instrunient is successful it must have a positive

aggregate effect on the unspecified areas, and similarly for a positive

instrument.

The banking system (i.e. the financial system excluding the Central

Bank and the government) can be conceptually seen as having an inflow of funds

on the deposit side and an outflow of funds on the loan side. In other words,

instruments can be classified in terms of how far they are from the final

borrower. Right on the outflow side are instruments like lending targets,

lending ceilings and prohibitions, exemptions from overall credit ceilings,

and margin requirements. In the middle are collateral guarantees and urban-

rural linked branch expansion. Farthest away, on the inflow side, are

instruments like refinance and liquidity guarantees.

3.2 The Target Approach

Loans to small businesses, small loans and exports were the earliest

to be designated as priority sectors (1973). In February 1975 banks were

notified that the small loan category be given priority in any credit

allocation following from an increase in deposits. In September 1975 a

lending target of TK 1 crore per bank was fixed for nationalised commercial

banks' lending to this category. During the same financial year (1975-76)

restrictions on housing loans were lifted.

In 1976-77, deposit-linked targets were imposed on each nationalised

commercial bank. The targets were 1 1/2% of deposits (as on June 1976) to be

loaned to the small loan category, 1 1/2% to the transport sector, and 1% of

deposits for residential housing. Informal guidelines were also issued for

increased lending in less developed areas at a controlled rate one percent

below the general interest rate ceilings (i.e. initially at 12%). In 1977-78,

the loan target for small loans was raised to 2% and maintained at that level

- 26 -

for the next three years. In contrast, targets for house building and

transport were maintained at the same level in 1977-78 and then eliminated the

following year. In 1977-78 loan interest ceilings of 11% on loans for rural

housing and 5% on loans for multistoried buildings were imposed. These

compared with the general ceiling of 12%.

Table 9 shows, for the three nationalised commercial banks the loans

made to the three targeted sectors as a percentage of their total loans and as

a percentage of target. The data for the three banks suggest that banks were

quite successful in meeting the small loan targets, but not those for housing

and transport. There is some variation among banks however: Sonali bank was

successful in small loans and unsuccessful in the other two; Agrani bank was

successful in transport and partially unsuccessful in small loans and housing;

and Janta bank was successful in both small loans and transport.

This variability in success (as measured against targets) suggests

that it is not useful to impose uniform targets on banks. Each bank has its

own special orientation and expertise. Given the different sources of

information and information links the banks would tend to specialise in

special segments. Uniform targets reduce the flexibility of the system. A

recognition of this probably lead to the elimination of targets on house

building and transport loans after a trail period of two years.

Table 9 also gives the allocation of credit to each priority sector

as a proportion of the total advances of each bank. In table 1, the share of

advances of all scheduled banks going to the transport sector showed a

declining trend over the 1978-80 period; it went from 4.3% in 1975 to 3.1%. in

1980. The allocation of credit by the three commercial banks in table 9, is

_ 27 -

Table 9: Advanees to Small toans rnd Smatl Tndtstry. HouRse Pu1ldfnr andTransport as a proportion of targeted amounts - Three Banks

kec. 1975 Dec. 1976 Dec. 1977 Dec. 1978 Dec. 1979 Dec. 19801. SONALI BANK (S)

Small loan. and small lndustryAs a percentage of total advanceti 2.19 2.o9 2.44 2.72 2.43 2.25As percentage of target: N.A. 701.00 126.56 109.51 97.82 98.80

House Building

Percentage of total advances .07 .17 .46 .74 .64 .54Percentage of target IIA. N.A. 36.46 59.55 N.A. N.A.

Trans porlt

As a percentage of total advanceo .82 .89 .71 .94 .49 .37As a percentage of target. NA. N.A. 36.89 50.26 N.A. NA.

2. AGRANI BANK (A)

Small loans

As a percentage of total advanceis .80 1.91 3.63 2.43 1.61 1.38As a percentage of target N.A. 291.00 201.18 95.67 62.47 53.15

Rouse Building

As percentage of total advances a .07 .91 1.29 1.26 2.13As percentage of target N.A. N.A. 75.34 101.48 N.A. N.A.

Transport

is percentage of total advance. * 1.14 1.18 1.27 1.00 1.10as percentage of target N.A. N.A. 65.54 67.02 N.A. .A.

3. JANATA BANK (J)

small Loans

As percentage of total advances .0 1.71 1.87 2.59 2.19 *As percentage of target N.A. 608.00 117.91 129.77 112.09 a

Rouse Building

As percentage of total advances a * * .89 1.56 *As percentage of target N.A. N.A. C 89.03 N.A. N.A.

Traaport

As percentage of total advances 2.72 2.11 1.89 1.92 1.91 aAs percentage of target N.A. N.A. 118.89 128.67 N.A. N.A.

4. ThREE BANKS (S. J, A)

Smll Loana (S, J, A)

As percentage of total advances .96 1.45 2.43 2.61 2.18 aAs percentage of target V.A. 364.00 138.58 114.02 95.71 a

House building (S & A only)

A percentage of total advances a .13 .63 .93 .83 .98As percentage of target N.A. N.A. 49.97 74.09 N.A. N.A.

Transport (S, J, A)

As percentage of total advances a 1.52 1.33 1.42 1.16 aAs percentage of target N.A. N.A. 75.84 83.04 N.A. N.A.

N.A. a Not applicablea - Data not availableSorce: Annual Reports of the respective banks

- 28 -

broadly consistent with this trend. It can be concluded therefore that the

setting of a formal lending target for the transport sector had little effect

on this down-trend.

Loans for housebuilding, by Sonali and Agrani banks, rose fairly

rapidly from 0.13% of advances in December 1976 to 0.93 of advances in

December 1978 (Table 9). This rising trend was maintained by the Agrani Bank

during the next year, while that of Sonali Bank was reversed leading to a

i small overall decline. Clearly the increase is not solely due to targeting

policy, as the removal in 1975-76 of restrictions on lending to this sector,

would have led to some re-allocation towards it.

The earlier analysis of loan rate ceilings also suggests that

differentially lower ceilings on rural housing loans (-1%) and multistoreyed

housing (-6%) might have been responsible for breaking the uptrend in housing

loans. However rural housing loans were an insignificant part of the

institutional loans for housing, before the special scheme was introduced in

1977-78. Similarly multistoreyed housing is a relatively new phenomenon in

the housing market and would not have had an immediate impact on total housing

credit. This is consistent with the different effect on the three banks.

I have shown elsewhere [Virmani (1982)] that there are certain problems

of information flows and interpretation which can lead to inefficiency in the

form of exclusion of certain types of borrowers and certain types of economic

activity. The analysis suggests that there may be a discrepancy between the

social and private returns to loans which requires a short term subsidy to the

banks. It is also suggested there that the subsidy will (probably) have to be

linked with a requirement to lend to the identified borrower categories. Any

element of forced lending, must however be only for a short introductory

period. This induces banks to collect information and generate links with the

- 29 -

neglected sector, a kind of forced learning by doing. A policy of

targeting/guidelines when accompanied by appropriate incentives can therefore

be justified for short periods for new and unfamiliar activities. Thus the

initial success in increasing the share of house building loans may have been

partly due to the guideline targeting approach.

This analysis is also supported by the differential performance of

banks in terms of loan share of the small loan category. Thus targeting had

little effect in the case of Sonali bank which already had a proportion of its

advances going to this sector, and already had information links. On the

other hand the Agrani and Janata banks had only .8% and 0% respectively of

their loan portfolio going to the small loan category on December 1975. This

had increased to 3.63% for Agrani by December 1977 and 2.59% for Janata by

December 1978. In both cases it declined after the peak. Three years in one

case and four years in the other was probably more than enough time for the

initial information links and learning to take place. Normal criteria would

eventually begin to apply. Thus the final stable level of lending to this

sector represents a relatively efficient level of lending compared both to the

low initial levels as well as to the peaks reached under pressure.

In 1979-80 banks were asked to raise their credit deposit ratios in

less developed areas, including the Chittagong Hill-Tracks to 75%. It is

highly unlikely that general development problems can be addressed solely or

even primarily by forced lending. Widespread experience, including that of

many banks in Bangladesh, indicates that a package of inputs and programme

(technology, marketing etc.) is necessary. Moreover with the interest changes

in October 1980, interest ceilings for these areas are at 13%, that is 2.5%

below the general rate. This provides a disincentive to bank lending.

Further as the target is linked to deposits from the same areas, if the target

- 30 -

is forcefully imposed, this would also provide a disincentive for raising

deposits from these areas.

A target of 1% of bank deposits for lending for non-traditional

exports was introduced in 1979-80 and continued thereafter. Policies directly

related to export profitability need to be examined very carefully as

suggested in the introduction. If there are also information problems in

export lending, guidelines and targets can be useful for a few years if

accompanied by adequate incentives. However from October 1980 the interest

ceiling for export lending at 12% was 3.5% below the general ceiling.

Informal targets were also set for agricultural lending. However as

target setting was not the major policy tool for agriculture, credit to this

sector will be considered in the section of the primary policy tool used.

3.3 Ceilings and Prohibitions

In the pre-1975 period of high inflation, there were many

restrictions on the use of various types of financial securities, capital

equipment and real estate as collateral. These were gradually lifted. In the

absence of interest rate ceilings such restrictions tend to raise interest

costs to borrowers (see Virmani 1982). Thus credit would be shifted from

those borrowers whose interest rates were previously against the ceiling to

those who were below. The latter would now be paying higher rates but getting

relatively more credit. Inefficiency is increased and credit tends to shift

from unfamiliar, more risky borrowers to familiar less risky borrowes as

perceived by the bank. Such restrictions would also tend to shift credit from

productive to speculative purposes as the latter are less likely to be based

on explicit collateral than on implicit collateral; for example, the margin of

stock value constituting the borrowers equity in a commodity stock. Implicit

collateral (e.g. the value of accounts receivable) can of course be used even

- 31 -

on production loans; but this is done only for a bank's best or prime

customers.

The most widely used ceilings, usually in times of general

inflation, are those on credit to large borrowers, or to all borrowers. Thus

for example in February 1979 banks were exhorted to limit credit to borrowers

and reduce it where possible. Later in the year inventory norms were set and

the banks were told to reduce credit gradually in accordance with these

norms. The objective was to reduce credit to those with high inventories and

large credit. For producers this acts basically as a loan amount ceiling. In

December 1979 formal ceilings were imposed on all borrowers. Industrial

borrowers were limited to 90% of their maximum outstandings in the previous

year. Traders were limited to 85% while export finance, term finance and

special programmes were exempt. In August 1980 the cuts were withdrawn.

Though credit ceilings are usually used for controlling general credit

expansion they have allocational effects which are the primary focus of our

paper. Credit ceiling may also be applied selectively; to mitigate the harsh

effect of general ceilings on particular sectors or borrowers. To this extent

they can be seen directly as an allocational instrument. I have shown

elsewhere (Virmani, 1982) that ceilings on loan amounts to producers, when

effective, reduce the cost of loans to the borrower, through a lowering of

interest rates. Further they are likely to be more effective against the

larger, more organised better placed borrowers, mainly because they are easier

for a government to police. Thus they are likely to have perverse welfare

effects within the set of borrowers. When applied to all existing borrowers

they are likely to channel loans away from current borrowers to new less

productive borrowers. When applied to a subset of borrowers they will tend to

shift credit to those not subject to these restrictions, while lowering

- 32 -

interest rates to the former. But a better way of rechanelling without

adverse distributional effects is to put an interest tax on lending to non-

favored borrowers. Overall efficiency in use of credit will deteriorate under

both policies, unless all favored creditors were previously getting less than

the efficient amount of credit. This is unlikely to be true.

Loan ceilings on credit which is going into stocking for speculative

purposes has somewhat different effects. In this case it can be shown that an

effective ceiling on loan amounts per borrower will increase the interest rate

on loans. However if these rates cannot be raised because of interest rate

ceilings then no loans will be made to the potential borrowers. Loan ceilings

can therefore be useful in this case if they are effective.

3.4 Margin Reguirements: Overview and Analysis

In Bangladesh, as in many other countries, government setting of

minimum margin requirements have been used primarily as an instrument for

controlling "speculation and hoarding", in specific commodities. Thus they

were in most active use when prices of particular commodities considered to

have large adverse social consequences started to rise very rapidly. Among

the specific commodities have been rice and paddy, sugar, oil and oil seeds,

jute and jute goods, onions and chillies, salt, cotton yarn and textiles, and

synthetic yarn and textiles.

As shown in Table 10, at the start of the period under consideration

the margin requirement on Jute and Jute goods was implicitly 100% as all

lending for this purpose was banned. This was motivated by the high rates of

growth of prices, which rose by 63% in 1974-75. As price growth eased to 4.4%

in 1975-76, credit was allowed to this sector. However a sharp rise of 40% in

the prices of these goods in 1977-78 following on the heels of a rise of 11%

the previous year does not seem to have led to an increase in margin

Table 10: Rate of Growth of Prices and Imposition of Margin Requirements (In percentages)

1974-75 1975-76 1976-77 1977-78 1978-79 1979-80

1. Jute and Jute GoodsMargin 100. 0(?)Rate of price growth 63.00 4.37 11.32 39.99 1.18

2. SaltMargin 50 0 b/Price growth 751.0 -66.84 20.47-' 5.8&- -17.9

3. Sugar (Alloted by food Dept)t¶argin 0(?) 50Rate of growth of crude prices 0 -21.10 1.60 12.00

4. Oil & Oil Seeds (Oil Mills-Margins)Local 0(?) 50Imported 25 0Finished Product 100(?) 50

Mustard Oil Prices (Rate of Growth) -32.18 -15.00 35.20 -0.20

5. Cotton, Yarn & Textiles and 50 0 50Synthetic Yarn & TextilesRates of Growth in;Sari Prices -0.47 -1.45 10.65 26.49 2.81WPI for Manufactures 49.73 -43.07 -2.63 5.97 7.41

6. General Merchandise TradeMargins 0(?) 50 60

Rate of Growth ofCOL Index for Middle Income Groups 67.17 -8.40 2.40 12.60 8.30 18.50COL Index for Non-Food 52.10 11.40 4.40 9.50 9.30 14.60COL Index for Food -16.00 1.05 15.64 6.80 20.96

a/ There were informal guidelines in margins during this period.b/ Informal norms were prescribed to banks.

Sources: Resume of Financial Institutions, Finance Ministry, Various Issues.Bangladesh Bank, Annual Reports.Statistical Absgract of the Bangladesh (-ov,rnmnt.

- 34 -

requirements. Thus the use of this instrument seems to decline over time,

perhaps corresponding to a decline in concern over hoarding. Similarly the

margin requirement of 50% on advances against salt was accompanied in 1974-75

by rate of growth of 751% in salt prices. These margin requirements were

eliminated the next year as prices fell by 66.8%. Guidelines were issued in

1976-77 as prices again rose by 20.5% and inventory-credit norms were

established the following year. The sharp decline of 18% in salt price in

1978-79 led to some positive credit measures. Lending, for sugar alloted by

the food department, could be done at 50% margin in 1977-78. As sugar prices

were controlled throughout the period, the best available (though imperfect)

measure of tightness or rationing in the sugar market was gur prices

(jaggery). Thus gur prices, after falling by 21.1% in 1976-77 increased by

1.6% in 1977-78 suggesting a corresponding increase in demand pressure

relative to supply in the sugar market. This is confirmed by the still higher

price rise of 12% in gur prices in 1978-79.

Credit margins on borrowing by oil mills against local oil seeds and

oils were put at 50% in 1977-78. Similarly a 25% margin requirement was

specified on imported oils and oil seed during the same year. Prices of

mustard oil, which constitutes the most important local oil, provide the

answer. Price declines of 32% and 15% in 1975-76 and 1976-77 were followed by

a price rise of 35% causing alarm to the government. A decline of 0.2% in

mustard oil prices in 1978-79 led to a removal of margin requirements on

imported oils and seeds and a fall in margin requirement to 50% on finished

products of oil mills.

Margin requirements seem to have been directed primarily against

agricultural commodities, and within that primarily on goods of common

consumption. Thus, for example, lending to private rice and paddy traders has

- 35 -

been banned for most of this period, giving an effective margin requirement of

100%. The other major good in the consumption basket is clothing. As we

might expect both cotton yarn and textiles and synthetic yarn and textiles

have been subject to margin requirements (Table 10). The early period also

witnessed wider use of margin requirements on industrial inputs suggesting use

of margin requirement as a more general credit control and inflation fighting

device. As recently as 1978-79 margin requirements on general merchandise

trade were raised from 50% to 60%, following observation of accelerating

inflation in 1977-78 and 1978-79 (Table 10).

Before determining the effects of this policy instrument in

different contexts, it is useful Ito analyse the effect of margin requirements

in a simplified context. Consider a situation in which credit is being used

purely for speculative purposes, that is to buy and hold commodity stocks in

anticipation of a price rise. Consider a bank and a speculator who are

neutral in their attitude to risk and are therefore interested only in the

expected returns. To begin with we assume that the speculator has a fixed

amount of outside funds or equity available to him for purchase of

commodities. Given this equity, we can define a loan supply curve for each

borrower-lender pair which is limited at one end by the condition that banks'

have positive expected profits. The speculator's demand curve is perfectly

elastic; if at any interest rate it is profitable for him to borrow it will be

profitable to borrow an infinite amount. Thus a 'rationing equilibrium' can

emerge as shown below (r*, L*), if banks act competitively. In such a

situation, if government imposes a margin requirement m (m > e which ise + L* e wi is

effective, it is equivalent to a loan ceiling

- 36 -

Figure 1

LS

L~~~~~~~~~~LE ~ ~~~~ X

, .~~~~~~~~~~~~~~~~~~~~.

1~~ e

L = e (--1) (from m = e+ L , e is the value of the stock). As shown in the

ceilings exist, and the new interest required is higher than these ceilings no

loans will be made.

Even when the effect of government imposed margin requirements falls

on loans for productive purposes, it still acts as a loan ceiling. The effect

of loan ceilings has been shown above (section 12). When commodity stocks are

used as collateral by producers, the ratio of the loan value to the collateral

is of course referred to by banks as the 'margin'. This ratio, or bank set

,margin requirement' will, in general, be different for different producers,

even for the same collateral commodity. This is because the returns from and

riskiness of the productive activity in which the loan is used varies across

borrowers. All the terms of the loan contract will therefore differ: more

productive borrowers will obtain better terms than less productive ones. This

will tend to result in lower effective margins for the former than for the

latter.

Returning to the case of speculator borrowing, the speculator's

equity contribution may not be fixed as assumed. If, instead, the speculator

has a rising marginal cost of equity funds, similar results are obtained. The

- 37 -

only difference is that an effective margin requirement raises the marginal

return to speculator equity and therefore brings forth additional equity funds

into speculation. As a result interest rates do not rise as much as in the

fixed equity case, and the number of eliminated borrowers will be smaller.

Thus effective margin requirements can reduce the flow of funds for

speculative purposes and raise the cost to current borrowers.

3.5 Margin Requirements: Differential Impact

In Table 11 and 12 we present data on the distribution of credit by

margin requirements for some of the commodities reviewed above for which data

is available for the relevant time periods. These statistics relate to

Nationalised Commercial banks (NCBs). The results for sugar, and oil and oil

seeds are broadly consistent with the above analysis. Thus for sugar the

imposition of a 50% margin requirement in April 1978 resulted in a substantial

change: Between June 1977 and June 1978, the proportion of credit with no

margin requirements, went from 84% to 53%, while that with 50% margin

requirement went from 5% to 28%. This was accompanied by an increase in

proportion of credit subject to 25% margin. As this credit includes credit

going to public sector sugar mills, this represents a fairly effective

shift. This shift in the allocation of credit by margins was accompanied by a

fall in loan size per borrower from TK 6280 to TK 1040. Total loans against

sugar also declined from TK 408 thousand to TK 281 thousand. Both these are

consistent with our analysis.

By June 1979 however virt:ually no loans were at 50% margin, with

about 90% of the loans being at margins of 25% or less. The average loan size

had increased back to TK 5820, evert though total loans against sugar were

still at a reduced level of TK 245 thousand.

- 38 -

Table 11: Distribution of Advances by MarpinR for Specified Securities, and Average Loan Sizeby tlrgl, for saae Seeurities

1. 01 Seeds - Proportion 30-6-76 30-6-77 30-6-78 30-9-78 3-6-79 30-9-80

Percent of Advances

ex 88.00S 35.98S 4.512 17.73X 10.32S202 4.54 8.03 11.05 7.00251 33.76 9.94 12.81 6.6830S 15.53 11.224O250S 3.45 2.65 70.63 63.00 75.23 75.13> 502 .52 .79 .0 4.68 11.19

Total (All margins) 100.00 io0.0o 100.00

Average Loan Size (in 1000 TK) *

OS 66.01 (11) 14.13 .91 (18) .76 1.92202 1.51 (25) 1.44 11.25 2.55

25Z (17) (39) 3.73 3.37 (2) 11.28 3.72302 1.86 (3) 6.59402502 (9) .94 (10) 1.14 (49) 2.93 (64) 2.63) (67) 1.64> 502 (1) 1.56 (1) 3.43 0 (54) 2.06 (5) 2.09) (15) 1.09

Total (All margins) (89) 8.81 (125) 3.45 (102) 2.00 (241) .73 (88) 2.54 (100) 1.46

Total Aeount 299.80 431.92 203.49 223.74 146.09

2. 2D111E OIL

Percent of Advances

0 95.35% 36.412 21.782 38.612 43.782

10 87.56S152025 4.04 52.16230 61.34X4050 57.18> 50 (99.99S) 0 0 52.69S

Average loan size (in 1000 TV)*

0 (4) 119.48 (4) 49.82 (5) 2.75 (4) 31.94 (4) 203.4610 (1) 104.122025 (6) 3.37 (4) 43.1530 (5) 67.144050> 50 (99.992) (1) .67 (1) .67 (2) 18.07 (14) 69.96

Total (All mArgins) (14) 35.80 (18) 30.40 (46) 1.37 (38) 3.13 (15) 22 .06 (28) 66.38Total Advances 501.23 547.26 63.20 118.91 330.93 185.82

3. Sugar 4 GUR

Percent of Advances

0 84.332 84.41S 53.04X 56.962 48.842

10 16.9325 9.842 10.312 18.60S 22.12 24.0430so 4.74 27.72 14.15

Averae Loan Size (in TKI 1000)*

0 (20) 21.94 (50) 6.89 (236) .63 (13) 10.65 (14) 8.5310 (3) 13.8025 (5) 10.24 (3) 13.02 ".) 52.22 (1) 53.80 (1) 58.783050 (10) 1.93 (30) 2.59 (20) 1.72

> 50 (1) .99

Total (39) 13.34 (65) 6.28 (270) 1.04 (44) 5.53 (42) 5.82520.38 408.04 280.70 243.19 244.60

* Numbers In brackets are the total nuuber of borrowers taking nans at specifted margins.

Source: Scheduled Bank Statistics, variouR lisues. NCR: Nationslited Consercial banks.

- 39 -

The 50% margin requiremLent on oil and oil seeds was imposed in April

1978. In the case of oil seeds, the proportion of advances with this margin

increased from 3% in June L977 to 71% in June 1978; for oils the proportions

went from virtually 0 to 57% over the same period. Total loans advanced

against oil seed and oils fell from TK 432 thousand to TK 203 thousand and

from TK 547 thousand to TK 63 thousand respectively. Average loan size

similarly fell from TK 3450 to TK 2000 for oil seeds and from TK 30 thousand

to TK 1 thousand for oils.

The margin requirement on finished products was reduced to 50% in

July 1978 while that on imported oils and oil seeds was eliminated in August

1978. As imports consist largely of oils, both these would affect the loans

advanced against oil. By June 1979 the proportion of advances at 50% margin

was virtually zero, while total loans had increased to TK 119 thousand and

loan size per borrower to TK 3 thousand. In contrast, by June 1979 the

proportion of advances against oiLseeds subject to 50% or higher margin had

increased from 10% to 80%. This wias accompanied by a marginal increase in

total amount loaned and loan amount per borrower. Again these results support

the analysis.

The common feature of these two cases is that both were agricultural

consumer goods considered to be of socio-political importance. As far as

urban markets are concerned production trade and consumption are quite clearly

separated. Both goods are not very important as intermediate inputs.

Therefore, it is relatively easy t:o distinguish between stock holding for

speculative from that for productive purpose. In addition, in both cases

margin requirements were imposed at the start of a sharp upswing in prices.

These features contrast with the case of textile goods.

- 40 -

Table 12: Distribution of Advances by Rates of Margin for Related Securities

Nationalizred commercial Banks

(Percent of advances for all margins)

1. Cotton Textiles, Yarn - Export 30-6-76 30-6-77 30-7-78 30-6-79

0 5.87% 6.43% 5.622 *10/15 2.6220 50.35 18.35% 23.24 12.1325 35.54 41.15 38.17 40.2230 3.19 30.02 9.3635/4050 2.31 19.80 28.3375

Total Advanices (in 1000 TK) 2427.77 587.01 986.82 931.70Average Loan size* (1432) 1.69 (172) 3.41 (946) 1.04 (358) 2.60

2. Cotton Textiles - Irmport

0 1.07% 53.92% 41.77 75.85%10/1520 3.65Z 1.87 4.41 9.1125 83.52% 38.18 44.33 3.273040 7.96% 1.47 3.2050 3.13 4.20 7.78

Total Advances (in 1000 Taka) 2394.02 7205.20 6584.11 3746.16Average Loan size (174) 13.76 (323) 22.30 (236) 27.90 (429) 8.92

3. Cotton & Synthetic Yarn - Imp.

0 19.97% 55.66% 71.47% 51.43Z5-15 13.56 7.8920 5.572. j 5.69 7.83 9.6630 27.42% 10.94X 17.64%40 24.571 2.37 3.3550 12.82% 5.98 8.68 3.3475 5.82

Total Advances (in 1000 Taka) 424.91 1321.68 2617.09 2078.27Average Loan size (191) 2.22 (342) 3.86 (358) 7.31 (374) 5.56

4. other Textiles

0 55.20% 2.47% 16.92% 27.00%15 18.67% 17.85 15.7622 5.58 14.2425 32.86% 38.52 26.05 33.53;1, 3.07 5.77 16.0650 4.252 4.58 . 10.37

Total Advances (in 1000 TK) 381.51 246.83 466.33 419.33Average Loan slze (62) 6.15 (83) 2.97 (170) 2.74 (126) 3.33

30-6-75 30-6-76 30-6-77 30-6-78 30-6-79 30-6-80

5. Merchandise

No. of Accounts 9377 11030 57774 143437 112005 153609Amount (in 1000 'TY) 46999.00 54422.00 622S4.00 78112.00 111896.00 160603.00Average Loan Size 5.01 4.93 1.08 .54 1.00 1.05

Average Loan Size (in 1000 Taka)1. Export Conmoditles 10.78 4.93 1.07 1.82 2.48 2.49

(Jute, Cotton, lextileS4 Yarn, etc.)

iI. Import Commodities 2.77 3.89 3.19 3.24 3.30 3.55iiI. Other Import Herchandise 3.06 2.91 .27 .11 .27 .34

(wheat, rice, oilseeds, oll,sugar, olives)

* No. of borrowersSource: Scheduled Bank Statistics, Various Issues.

- 41 -

Table 13: Distribution of Advances by Rates of Margin: All Advances of NCBs

(In percent)

30-6-78 30-6-77 30-6-78 30-9-78 30-6-79 30-6-80

Margin

50% .2.19% 3.21% 6.30% 6.54% 6.18% 4.98%

60% .07 .07% .05% .51 1.40 1.38

99.99% .24 1.55% .98% .28 .28 0.37

Total Volume

(in 1000 Taka) 69239.15 88351.33 115516.37 131177.94 142627.00 210419.38

Average Loan Size (in 1000 Taka)

50% .22 .L8 .16 .16 17.23 .16

60% .06 .04 .02 .20 .29.20 .26

99.99% .10 .69 .14 .05 .03 .05

Total .66 44.87 .15 .16 16.30 .14

NCBs: Nationalized Commercial Barnks.

Source: Scheduled Bank Statistics, Bangladesh Bank.

- 42 -

In September 1975 margin requirements on cotton and synthetic goods

(yarn and textiles), was reduced from 50% to 0%. In June of 1976 therefore

there were virtually no advances against cotton textiles and yarn (export

commodities/Category 1) and cotton textiles (import commodities/Category 2)

carrying a margin of 50% or higher. Approximately 86% of advances under each

category had margins of 20 or 25%. In the use of cotton and synthetic yarn

(import commodities/Category 3), 12.8% of advances were at 50% margin with

substantial percentages having margins of 0, 30 and 40%. Similarly other

textiles (Category 4) had 87% of advances with margins between 0 and 25%, and

4% of advances at 50% margin.

The imposition of a 50% margin requirement on cotton and synthetic

goods (yarn and textiles) in March 1977 had a gradual effect on margins

applicable to cotton textiles and yarn (export). Proportion of advances

carrying a 50% margin increased to 2.3% in June 1977 and 19.8% in June 1978.

However the initial fall in total advances from TK 2428 thousand to TK 587

thousand was reversed by June 1978. The immediate effect on average loan size

was to double it from TK 1.7 to TK 3.4 thousand. This fell back to TK 1.0

thousand by June 1978. In the other three textile categories there were very

little or no effect on proportion of advances having margins of 50% or

higher. Thus the proportion of advances having a margin requirement of 50% in

June 1976, 1977 and 1978 for category 2 were 0%, 3.1% and 4.2% respectively;

for category 3 were 12-8%, 6-0% and 8-7% respectively, and for category 4 were

4.3%, 4.6% and 0% respectively. Similarly total advances and average loan

size decreased for category 4 and increased for categories 2 and 3 between

June 1976 and June 1977.

Part of the reason for these contradictory effects are, the plethora

of special policies applicable to imports and exports and the freedom to

- 43 -

import under the Wage Earners' Schieme since April 1977. The major reason is,

however, the difficulty in separating use for consumption from use as an

intermediate input, and the holding of stocks for speculation from holding of

stocks for production. Thus, borrowing at 0% margin went up between June 1976

and 1977, from 1% to 54% for category 2 and from 20% to 56% to category 3.

These were the two categories of goods for which perverse effects were

strongest. This suggests borrowing by textile production units, and among

them the public sector textile corporations which are major borrowers. Thus

the imposition of margin requirements was largely ineffective as credit was

diverted from existing trader-borrowers, to new borrowers and to producers.

Over a longer time period, new traders can also enter the business if entry

(information) conditions are not too difficult. This would further reduce the

effectiveness of the policy.

General margin requirements on merchandise were increased to 50% in

August 1977. The effects of this are shown in Tables 13, 14 and 15. The

proportion of all NCB advances having a margin requirement of 50% doubled from

3.2% to 6.3% between June 1977 and June 1978 (Table 13). The increase of 3%

points appears small; but the margin requirement was increased only on

merchandise and not on other securities. The former constitute approximately

65% of total loans (Table 14). By making a simple adjustment we can say that

the re-chanelling was approximately 4.8% (instead of 3%) within the advances

which had merchandise as security. Over the same period, the proportion of

all loans by NCBs going to trade declined from 35% to 28% (Table 15). This is

consistent with our analysis. A similar conclusion emerges for all banks if

we look at the proportion of loans going into trade credit (Table 1).

Margin requirements on mtsrchandise were increased further to 60% in

July 1978. As a result, by June 1979 the proportion of advances with 60%

Table 14: Distribution of Advances by Securities

Nationalized Commercial Banks

FY 75 FY 76 FY 77 FY 78 FY 79 FY 80

A. Gold and Precious Metals .7 .9 1.2 1.2 1.2 1.0

B. Securities 1.3 1.2 1.1 1.4 1.4 1.0

C. Merchandise 74.0 72.6 65.0 62.0 64.2 68.3

(i) Raw Jute 21.9 15.4 6.5 6.1 12.6 11.6

(ii) Jute Manufacture 14.8 11.5 11.3 14.1 11.8 7.8

(iii) Other Export Commodities 6.2 6.4 8.2 7.5 6.4 14.4

(iv) Imports 31.11 39.3 38.9 34.3 33.3 34.4

D. Machinery and Fixed Assets 2.0 2.4 2.1 2.0 2.6 2.1

E. Real Estate 2.6 2.3 2.7 2.9 3.2 2.9

F. Financial Assets 1.9 2.2 3.1 2.4 2.3 1.6

G Miscellaneous 17.5 18.5 24.8 28.1 25.2 23.5

(i) Secured 11.4 12.3 17.6 16.5 19.0 16.9

(ii) Unsecured 6.1 6.1 7.3 11.6 6.47 6.6

Source: Scheduled Bank Statistics, Bangladesh Bank.

- 45 -

margin increased to 1.4% from .05% in the previous year; an increase of only

1.35% points (Table 13). The proportion of advances going to the trade sector

increased to 32% (from 28%, Table 15), along with the use of merchandise as a

security (Table 16). The following year the advances having a margin of 50%

or over declined to 6.7% of total advances from 7.9% the previous year (Table

13). Thus the results were quite mixed; any effects of the increased margin

requirements appear to be quite transitory when applied on such a broad

scale. The reason is that both borrowers and equity funds can move much more

easily between production and trade, and between different types of

securities. Even if immediate movement is precluded, given time such movement

seems almost inevitable.

Thus the use of margin requirements appears most effective for

agricu'ltural consumer goods for wlhich short run price movements have adverse

socio-political effects. But even in this case the policy may not be

effective for very long, as the possibility of speculative stock holding

within the agricultural sector would increase over time. This could also lead

to a diversion of agricultural credit from productive to speculative usage.

In fact one of the banks gave us an example of diversion of credit from

agricultural production to stockinig of chillies in anticipation of a price

rise.

Table 15: Distribution of Advances by Economic Purposes '

Nationalized Commercial Banks

FY 75 FY 76 FY 77 FY 78 FY 79 FY 80

Agriculture, Hunting, Forestry and Fishing 2.2 3.86 4.5 7.98 10.6 11.5

Mining and Quarrying 0.1 .1 1.4 .77 .1 1.5

Manufacturing 50.4 43.42 39.2 40.2 39.2 39.4

Construction 1.0 .9 1.5 1.7 1.7 1.6

Electricity, Gas and Water .1 .1 .1 .32 .7 .5

Wholesale Trade 30.4 36.2 35.0 28.2 32.2 31.4

Finance.and Real Estate 4.1 2.6 2.8 2.6 3.2 2.9

Transport, Storage and Communication 6.1 7.1 6.8 5.7 4.9 4.2

Others 5.5 5.7 8.8 12.6 7.5 6.8

Source: Scheduled Bank Statistics, Bangladesh Bank

- 47 -

3.6 Refinance and Counter Finance: Overview

Central Bank (Bangladeslh Bank) loans to scheduled banks go under

several names, including refinance, counterfinance and back-to-back finance.

The percentage of refinance has varied between 30% and 100%. One way of

organizing these different programs is to separate the ones which have 100%

counterfinance or back-to-back finance from those which have less. In the

first case the bank is acting puretly as an intermediary between the central

bank and the final borrowers. In the second case a proportion of the lending

must be financed out of deposits and therefore the allocation of deposits

between refinanced and non-refinanced lending becomes relevant.

An alternative way of looking at it, which is more fruitful in the

present case is in terms of specialised banks which direct lending to specific

sectors or sub sectors, and commercial banks. For the purpose of the

refinance issue, the agriculture oriented banks - BKB and BSBL - are of

relevance to the first category. All agricultural sector lending of these two

banks has been refinanced at 100% by the Bangladesh banks (though very

recently the proportion has been reduced to 95% for BSBL). The refinance rate

has been 6% since 1974. It has thus been subsidized to the extent of 2%

points (below the regular discount rate of the Bangladesh bank) between June

1974 and October 1980 and by 4.5% since the discount rate was raised to 8.5%

in 1980.

Table 16 shows the sanctions and disbursement of loans from the

Bangladesh bank to the agricultural banks (BKB and BSBL). The amounts that

these banks are entitled to have refinanced is calculated at 100% of their

disbursements. Disbursements as a proportion of sanctions fluctuated

considerably over the period but showed a rising trend; going from 78% in

1975-76 to 100% in 1979-80. However in 1979-80 disbursements exceeded

Table 16: Use of Refinance by Bangladesh Krishi Bank (BKB) and Bangladesh Samabya Bank (BSBL)

Bangladesh Bank Loans to BKB & BSBL 1974-75 1975-76 1976-77 1977-78 1978-79 1979-80 1980-81

1. Sanctioned 2489 3300 4616 8885 8734 12970 15859

2. Disbursed 2075 2589 3922 6347 8617 13015 16739

3. Cumulative Disbursement (from 1974-75) 4664 8586 14933 23550 36565 53304

4. Cumulative Sanctions (from 1974-75) 5789 10405 19290 28024 40994 56889

Agricultural Banks (BKB & BSBL)

5. Entitled Borrowing /1 2605 2768 4301 5434 8189 14600. 21102(at 100 of disbursement)

6. Cumulative Entitlement 5373 9674 15108 23297 37897 58999

7. Disbursed/Sanctioned (Row 2 - 1) .83 .78 .85 .71 .99 1.00 1.06

8. Disbursed/Entitled (Row 2 5) .80 .94 .91 1.17 1.05 .89 .79

9. Cumulative Disbursement/Cumulative entitlement (Row 3 *- 6) .87 .89 .91 1.01 .96 .90

10. Average of Rows 7 and 8 .815 .86 .88 .945 1.02 .945 .925

11. Cumulative Disbursement/Cumulative Sanctions(Row 3 * 4) (.83) .80 .83 .77 .84 .89 .95

1/ It is not entirely clear from the data whether disbursements are for agricultural credit alone or alsoinclude trade, storage marketing of agricultural goods.

Source: Bangladesh Bank, Annual Reports

- 49 -

sanctions for the first time and in 1980-81 this reversal become more

pronounced. This peculiar situation arises because of delay in disbursement

of loans committed in the previous year.

The proportion of refinancing actually provided can be measured

approximately by the loans disbursed by the Central Bank divided by the

entitlement, as measured by the agricultural banks advances for the year.

These rise to a peak of 117% in 1977-78 and then decline to 79% in 1980-81.

Because of the carry-over of previously committed loans and the partial carry

over of previously sanctioned loans, a better (but still approximate; because

of the abrupt start at 1974-75) measure is the cumulative disbursement divided

by the cumulative entitlement. This shows refinance proportion rising from

87% in 1975-76 to 101% in 1977-78, suggesting that most backlogs were cleared

by this time. Refinance remained aLt the fairly high level of 96% in 1979-80

but fell sharply to 90% in 1980-81. This suggests that even though actual

refinancing by the Bangladesh bank may have fallen below 100%, due to the

application of constraints ona general credit expansion, the goal remained at

100%. In contrast, in 1979-80 and 1980-81 loan sanctions are actually below

loan entitlements for the first time, suggesting an implicit movement away

from the goal of 100% refinancing of agricultural banks.

The commercial banks, and the BKB for its non-agricultural lending,

are entitled to refinance on a wide variety of items. The current rates of

refinance are as follows:

Food and Fertilizers (BADC), Petroleum and Petroleum Corp. 100

Exports Non-Traditional 100%

Traditional 50%

Small Loans 0% (100% until late )Sugar 50%

Jute 50%

SACP 50%

- 50 -

The refinance rate for the special agricultural programe (SACP),

like the agricultural lending of BRB and BSBL, carried a 2% subsidy on the

Bangladesh bank rate. All other sectors got refinace at the discount rate

which was 8% between June 1974 and October 1980 and 10.5% thereafter (Table

4).

The total amount of refinance taken under these catagories rose

steadily from 251.53 lakhs in 1979 to 703.88 lakhs in December , a growth of

180%. The annual compound growth rate from June 1979 to June was 67% a year,

representing a fairly substantial increase in refinance. Jute was the largest

user of refinance throughout the period, but grew by only 23.5% from 119 lakhs

in June 1979 to 146.98 lakhs in December . Refinance to the petroleum

corporation started in December 1979 and has been the second largest since

December 1980. Food and fertilizer have changed places for the next position.

Given the diverse items for which refinance is provided it is useful

to look at some of the explicit and implicit objectives. Both food and jute

are subject to annual fluctuations in production. Refinance is seen as a

means of providing credit for holding stocks in a deflationary situation. Our

earlier analysis of speculative credit suggests that commercial banks would

tend to provide little credit in this situation. But this question really

needs to be looked at in terms of the buffer stocking policy of the

government. Macroeconomic issues are also important. A properly worked out

buffer stocking policy would trade off sectoral effects and macro economic

effects, and work out a self supporting buffer-stock policy. Any desired

subsidies, should in general go direct to the producer and not to private

traders.

Sugar production has a strong seasonal pattern. Both lender banks

and potential borrowers know that prices will fluctuate in a seasonal pattern

- 51 -

over the year. The analysis of speculative credit does not indicate that

banks will not provide credit in this situation. However a seasonal buffer

stocking policy which is self-supporting could be worked out if necessary. If

it is thought necessary to provide subsidies to producers or consumers these

could be provided directly.

Provision of refinance to the petroleum corporation is used

essentially to fill the gap between the rise in oil prices and the rise of

final product prices. Thus it can be seen as a means of providing a

consumption subsidy to oil consumers. Even if such a subsidy is to be given

there does not appear to be significant reasons for using the banking system

for this purpose. The provision of refinance to BADC for fertilizer has a

completely different purpose. Subsidies are provided explicitly through the

budget: Delays in receipt of the subsidy or short term liquidity problems are

however met by providing 100% refinance to banks for their lending to BADC.

This appears to be a more satisfactory method for achieving a similar purpose.

In the case of non-traditional exports information problems can

effect the flow of credit, as I have shown elsewhere (Virmani 1982). A

determination must be made, however, whether this is the primary, or even a

major problem. This requires a prior examination of the foreign exchange

markets and the policies which impinge directly on exports and imports. In

addition one should also look at more general agricultural or industrial

policies which impinge on sectors which are potential exporters. Given

appropriate policies in these areas, credit policies can be used to remove any

inefficiencies in loan markets. These generally relate to new export products

with which bankers are unfamiliar. Credit policies when used for an initial

period can be useful in removing inefficiences.

- 52 -

3.7 Refinance Usage, Incentive Effects and Usefulness

The use of refinance policy as an instrument for redirecting credit

allocation can be examined in the context of the analysis in Virmani (1982). We

start by considering the simplest case of a perfect deposit market, in which a

bank acts as a price taker at a deposit interest rate of i (a more realistic

case is considered below). Let the refinance proportion be h and the

refinance rate p. If the refinance rate is greater than or equal to the

deposit rate, no refinance would be availed of and refinance provides no

incentive. If the refinance rate is less than the deposit rate, the cost of

funds for the refinanced sector becomes i = hp + (1 + h)i which is less than

i the deposit rate. I have shown that the direct effect of this is to

increase loan amounts and reduce interest rates to borrowers. Loans would

also be made for the first time to previously marginal potential borrowers.

Both these would shift credit allocation towards the refinanced sectors.

If interest ceilings exist, the effect of refinancing is to reverse,

partially, the harmful effects of such ceilings. The lowering of the 'free'

interest rate on loans means that on the margin borrowers are shifted from

having an effective credit ceiling to not having one. The effect of refinance

policy on collateral requirements is uncertain, as these may rise or fall. For

those borrowers who are still constrained by the loan interest ceilings, the

adverse distributional consequences of interest ceilings on the poor (little

wealth), may be countered or enhanced by refinance policy.

Table 17 gives the average weighted deposit costs over the period.

The refinance rate for the agricultural banks has been 6% since 1974. (The

refinance rate is of course 8.0/10.5 for the other sectors). This compares

with a interest rate of 3.5 to 4.3% till 1980 and 7.0% in respectively.

Under such a situation our analysis suggests that these banks would not have

Table 17: Average (weighted) Deposit Rate

FY74 FY75 FY76 FY77 FY78 FY79 FY80 FY81

A. Weighted AverageDeposit Rate 3.0 3.5 4.2 4.3 4.2 4.3 4.3 7.0

B. Deposit Cost Adjusted forReserve Requirements

i- - i - 2.3 1.3 2.4 2.5 3.4 2.5 3.4 3.4 7.03

Co A -B 1.7 1.1 1.7 0.9 1.7 0.9 0.9 0

Ln

JI

- 54 -

taken any refinance, at least till October 1980. Because of the existence of

reserve requirements, however, we might expect that the effective cost of

funds is higher than the average interest rate. It is easily shown that the

effective rate i is as follow

i - bai baii g = - - g

1-a 1-a 1-a

where a is the total reserve requirement, b is the proportion of reserves

required to be put in government or other securities earning a rate rg . It

is assumed that a proportion (1-b) of reserves is held as cash which earns no

nominal interest rate. For Bangladesh a = 0.25, ab = 0.2 and

it = 8.5% (rate on ad hoc treasury bills). Using these amounts we

find that the adjusted cost of funds is less than the unadjusted (table 17).

This happens because deposits can costlessly earn a net return of (8.5 -

i)%. On the other hand we have not adjusted for the transaction cost of

dealing in government securities, or for the administrative cost of servicing

depositors. The first would reduce the negative adjustment in the above

formula. The second means, that the effective cost of deposits is i + t and

that adjustment raises both the effective interest cost and the effective

administrative cost. A rough calculation suggests an administrative cost of

1.3 to 2% of deposits. Use of these would reduce the gap between the adjusted

and unadjusted (effective) cost by 0.5%-0.7%, still leaving the former less

than the latter. If we take the unadjusted values as an upper limit, there

would have been no refinance taken under this situation till October 1980.

This contrasts sharply with what actually happened.

Clearly the perfect deposit market approximation is not useful for

current purposes. The more appropriate assumption is to assume that deposit

- 55 -

rates are fixed by the government: and total deposits available are therefore

fixed exogenously or given. We also make the approximation that the deposits

with each bank are also not subject to their control in any way. In this case

it is easily shown that banks will earn rates equal to s - i (positive) times

their deposits, where s is the opportunity cost of funds (a shadow-price).

The loan decisions of the bank, and the effects of various policies, can

effectively be analyzed by using s instead of i. Consider the question of

refinance. In this case refinance policy can be effective as long as the

refinance rate p is less than the opportunity cost s. The effective cost of

funds for the refinanced sectors is therefore p hp + (l-h)s which is less

than s. As an aside it should be noted that as the agricultural banks were

getting refinace at 6% their opportunity cost of funds (s) must be higher than

this.

The allocative effect is virtually the same here as in the previous

case both with and without interest ceilings. To restate, there would be a

shift in credit allocation towards; the refinanced sector, and the full amount

of entitled refinance would be used. The experience of the agricultural banks

is broadly consistent with this analysis. As shown in the beginning of this

section (and Table 16) the banks were taking virtually 100% of this refinance

entitlement till 1979-80. In Table 1, and the accompanying discussion it was

shown that the allocaton of credit has increased progressively from 11% of

total credit to 30.6.75 to 19% in 30.6.80. It was also shown that the index

for output adjusted credit to agriculture similarly doubled from .17 to .34

over the same periods. The contrast between the performance of the

agricultural banks and the commercial banks (to be analyzed subsequently)

suggests that refinance policy combined with the existence of specialized

agricultural banks was an important causative factor.

- 56 -

Table 18 gives the usage of refinance by the scheduled banks

(including limited usage by BKB for non-agricultural purposes) by purpose and

by bank. Only for rural credit, small loans and petroleum is there anywhere

near fuil usage of refinance, with a simple average over the period of 96%,

97% and 97% respectively. The lowest usage is in the food sector with an

average of 50%. Usage for all sectors taken together ranges form 69% to 87%

with a simple average of 79%. There is a similar variability in bank wide

usage. This underusage appears inconsistent with the analysis presented

above. The reason for this discrepancy lies in the existence of bank wide

ceilings on total advances.

Consider a situation prior to the introduction of refinance. There

is some division of loanable deposits (total minus required reserves) between

sectors which are to be refinanced and those that are not, say LR and LNR

respectively. When refinance policy is introduced with refinance proportion

h(O < h < 1), hLR of extra funds become available. This is equivalent to an

amount hLR Of the loanable deposits of banks becoming free. In the absence of

credit ceilings, loans to the refinanced sector would rise as alreadyLR

analysed. If they rise to an amount L = (lh) it would mean that all the

excess funds have been used up, and s and LNR would remain unchanged. If

initial Li is less than LR must fall and LNR rise, and vice versaR ~~~(1-h) s

if initial LR is greater than LR/(l-h). In either case, after fullRR

adjustment, there would tend to be an absolute and relative increase in credit

going to the refinanced sector.

- 57 -

Table 18: Refinance: Usage as a Percentage of Entitled Limits:Nationalized Commercial Banks

June 1979 Dec. 1979 June 1980 Dec. 1980 June 1981 Dec. 1981All Banks

Rural Credit 100.00 100.00 98.35 83.07 96.96 96.96Small Loans 99.93 95.40 87.54 100.00 100.00 97.65Export Bills 55.24 88.30 57.56 79.41 86.98 93.27Food 67.70 48.77 74.26 -50.57 39.97 15.88Jute 79.43 97.14 91.17 96.15 81.98 85.92Fertilizer 84.86 79.79 53.66 79.25 75.69 99.69Sugar Mills 100.00 87.48 100.00 35.05 100.00 100.00Petroleum - 100.00 100.00 100.00 94.35 92.37Textiles - - - - 75.91 100.00Other 0 86.98 80.36 74.17 75.60 96.68Total 68.8 86.45 80.61 82.44 75.63 79.92

All Sectors

Sonali 74.7 97.93 96.57 84.81 91.44 82.84Janata 85.1 88.51 76.71 94.00 78.69 85.79Agrani 56.3 69.85 45.75 60.44 15.14 33.82Pubali 50-4 89.02 72.28 49.19 55.71 81.35Ruaalu 74.70 78.00 92.05 84.94 80.11 76.15Uttara 75.10 7Z.36 73.80 85.27 84.19 90.00BKB /_ 36.4 100.00 20.00 - - -

- No refinance related lendingi/ Non-agricultural refinance.Source: Bangladesh Bank

- 58 -

If overall credit ceilings exist, which are totally independent of

the refinance policy, total loans cannot increase. Existing deposits are

enough to finance these loan. This means that any refinance taken goes into

free reserves. If the net return from allowed investment out of free reserves

is lower than the refinance rate, no refinance would be taken. If the net

return is initially greater than the refinance rate full refinance would be

taken. Only if the marginal net return falls with amount invested would

partial refinance be taken.

In the case of NCBs, until October 1980 the refinance rate was 8%,

while ad hoc treasury bills had a rate of return of 8.5%. If an adjustment

for administrative costs were factored in, this would suggest at most a

marginally higher net return on allowed investment. For the refinance rate

at 10.5% is clearly greater than the gross return which remains at 8.5%. The

peak rate of calculated reserves, which generally occur in June due to

seasonal factors, were 26.9% in 1979, 26.6% in 1980 and 27.9% in . Given that

reserves in other months can be significantly lower than these values, and

that the required minimum ratio is 25%, there seem to be no excess reserves

over this period. In the context of the above analysis (credit ceilings

operative), the absence of free reserves is consistent with the low

profitability of allowed investment.

Leaving aside food and export (bills) financing, which is exempted

from credit ceilings, this still leaves open the problem of explaining usage

of refinance at greater than zero rates (Table 18). The explanation lies in

the fact that credit ceilings have not been independent of refinance policy.

Another element which also enters is forced lending. Credit ceilings for a

forthcoming year start from the previous years ceilings. Increases in credit

ceilings, though based primarily on expected increases in deposits and on past

Table 19: Advances and Depo;:its of Scheduled Banks excluding BKB & BSB(In 1000 Taka)

1975 June Dec. 1975 June 1976 Dec. 1976 June 1977 Dec. 1977 June 1978 Dec. 1978 June 1979 Dec. 1979 June 1980 Dec. 19801. Demand and

Time Deposits 93434 194909 107564 128125 133413 156708 160146 194664 211362 244209 248818 .294633

2. Total Credit

Advances & Bills 67927 84883 82136 96548 100544 129965 127568 162434 159775 200739 224316 249290

3. Govt., Foodcredit 443597 195212 1718%6 70339 47341 241127 349689 441905 370256 125757 1290545

4. Credit tMet ofFood 6349103 8293088 8041794 9584461 t 12522559 12515673 15893711 15535595 19703644 22305843 23638455

5. BJMC borrowing (Jute) 1856499 2111395 1677290 1987770 ' 22644883 2440136 3382444 1887549 2508468 1698779 2667808

6. Credit Net ofFood and Jute 4492604 6181693 6364504 7696691 * 10257676 10075537 12511267 13648046 17195176 20607064 20970647

Textile7. Sugar 895278 1661799 1277283 1608189 i 2165125 2123377 2277115 2106665 2932503 4485495 4404240

BADC

8. Net Credit 3597326 4519894 5087221 5988502 8092551 7957160 10234152 11541381 14262673 16121569 16566407

9. Petroleum Corp. 0(?) 933 1758 . 426 4275

10. Net Credit 7781360 11498781 15694069

Credit/Deposit Ratio

It. (a) Total 0.6795 0.7905 0.7476 0.7481 0.7991 0.7815 0.8164 0.7350 0.8068 0.8964 0.8023

12. (b) Minius Foodand BJMCCredit 0.4808 0.5892 0.5917 0.5429 * 0.6546 0.6291 0.6427 0.6457 0.7041 0.8282 0.7176

13. (c) Minus Food,BJMC Credit,Textile Corp.Sugar Corp.BADC 0.3850 0.4308 0.4729 0.4674 * 0.5164 0.4965 0.5257 0.5460 0.5840 0.6479 0.5623

14. (d) Minus (c) sadPetroleum * 0.4859 0.5440 0.6307

* Not avallable.Source; Bangladesh Bank

- 60 -

performance are also influenced by priority sector lending. Small loans and

rural credit are among the more important priority sectors. As already

indicated they are the two sectors with the highest (close to 100%) usage

(Table 18). This means that at least over the period 1979 to 1980 credit

ceilings were sufficiently and consistently adjusted for such lending to make

refinance an operational incentive.

In the case of petroleum and jute goods government has often

virtually forced banks to make loans to meet unexpected situations. In such

cases both refinance and credit ceilings have been wholly or partially

adjusted as an inducement. In the case of sugar mills, BADC (fertilizer) and

food, a similar linking of forced lending, provision of refinance and ceiling

adjustment has evolved as a general long run policy. In effect the last two

are decided by tacit negotiation. In such a situation refinance policy has a

highly erratic incentive effect, and implicit or explicit pressure has to be

applied at various points to maintain or expand lending.

A very approximate measure of the application of this policy package

of forced lending, refinance and credit ceilings can be obtained by getting an

estimate of the non-refinance lending or the proportions of free deposits

available for refinanced sector lending. In Table 19 this is done by

calculating modified credit-deposit ratios; first by subtracting food and jute

credit to the public sector jute mills, and then by further subtracting credit

to BADC and the textile and sugar mills corporation. This final modified

credit-deposit ratio rose from .39 in June 1975 to .56 in December 1980. If

we take the average of June-December figures for 1975 and 1980 the rise was

from .41 to .60, an increase of 46%. This suggests that the deposits

available for refinance related lending declined almost continuously over the

period. Further the total credit-deposit ratio rose from a June-December

- 61 -

average of .74 in 1975 to one of .85 in 1980, a rise of only 15%. Both these

facts suggest an increase in forced lending over the period.

As export bills currently lie outside the credit ceilings, our

analysis suggests that refEinance should be fully used as long as the

opportunity cost of funds (s) is larger than the refinance rate (p). Though

usage has averaged 77% over the period, it has risen from 55% in June 1979 to

93% in December , showing a rising trend. A possible explanation is that

export bills have only recently been exempted from the credit ceilings.

In the absence of a wide market for government securities, provision

of refinance has been an important means of expanding the monetary base. With

deposit interest rates fixed, the opportunity cost of funds (s) is greater

than the deposit interest cost (i). Refinance provides a profit to the banks

as long as the finance rate (p) ls less than s (assuming no excess funds i.e.

no credit ceilings or adjustable ceilings). If the goverment provided general

refinance this would merely transfer seigneurage from the government to the

banks. In this situation, use of refinance as a means of subsidizing credit

to particular sectors where lending is inefficient entails little budgetary

costs, and can be an effective alternative to a policy of interest subsidy to

banks. The two policies differ only in their effect on collateral

requirements. An interest subsidy reduces collateral requirements while

refinance may raise or lower them. Even though a rise in collateral will be

compensated by a greater decrease in the interest rate borrowers with

inadequate collateral will not benefit fully. Thus the poorest might not

benefit from the refinance policy. This effect could be mitigated by

providing a collateral subsidy for loans to the poorest borrowers.

- 62 -

3.8 Guarantee Programs

There are two types of guarantee programs in existence. One can be

termed a liquidity guarantee and the other a loan guarantee. The liquidity

guarantee is applicable to the normal lending programs of the BKB and BSBL.

As already noted these two banks have been getting 100% refinace from the

Bangladesh Bank for their agricultural lending programs. Moreover, this

refinance is only available on their total outstanding loans net of

overdues. In other words the refinance loan is made only on fresh advances.

It has to be repayed in full to the Bangladesh Bank when the loans become due

from final borrowers irrespective of whether they repay their loans to the BKB

and BSBL. The guarantee program allows these two banks to borrow from the

government, up to 30% of the value of the loans disbursed, to cover overdues

and late repayments.

The interesting thing is that BKB has never used this program while

the BSBL has always used it (Table 20). The reason for not using is ofcourse

that it involved a shift from 6% financing to 11% financing, while deposit

costs are much lower than the latter. The other reason is that overdues have

not been a very serious problem for BKB. In contrast, the BSBL does not take

(discussed further in section on agricultural credit).

The loan guarantee is applicable to all banks participating in the

Special Agricultural Program (SACP) often referred to as the TK 100 crore

program. This allows banks to borrow upto 30% of all (SACP) loans

defaulted/overdue on the due date. 30% of all amounts recovered after due

date have to be repayed. Actual payment of loan guarantees under this program

have, however, been less than entitlements, due to budgetary reasons.

Table 20: Payment of Givernment Guarantee to the BanksUnder Special Agrscultural Credit Programme

Name of the 1977-72R iQ77_7R 1978-79 _Bar.ks Guarantee Guarantee Guarantee Guarantee Guarantee Guarantee Guarantee Guarantee Balance remain- Guarantee Guarantee

-_______ claim money Paid claim m R claim money paid claim money paid ing unpaid claim money naid

Sonali Bank 184.90 184.90 184.90 184.90 215.72 215.72 388.58 323.11 65.47 566.21

Janata Bank 140.83 140.83 140.83 140=83 160.95 L60.95 193.35 163.65 29.70 260.85

Agrani Bank 127.07 127.07 127.07 127.07 166.00 66.00 210.40 175.35 . 35.05 97.74

Rtupali Bank 105.87 105.87 105.87 105.87 118.15 !.18.15 131 22 1Q9.36 21 .6 115.45

Pubali Bank 111.42 111.42 111.42 111.42 86.34 .86.34 257.76 215.46 42.30 72.39

Uttara Bank 38.06 38.06 38.06 38.06 23.82 23.82 56.63 47.20 9.43 34.80

Krishi Bank 221.10 221.10 221.10 221.10 210.90 :10.90 601.00 500.87 100.13 241.22

Total 929.25 929.25 929.25 929.25 981.88 981.88 1838.94 1535.00 303.94 1388.66

Source: Bangladesb Bank

- 64 -

In Virmani (1982) I showed that a collateral subsidy (a lump sum or

a proportion of effective collateral available from a borrower) has effects

similar to an interest rate subsidy. Thus it increases loan size and lowers

interest rate and collateral requirements. Therefore if inefficiencies are

present, either due to information problems or due to lack of collateral with

poor producer-borrowers such a subsidy will improve efficiency in a way that

benefits the less wealthy. When banks are risk averse we would expect the

collateral subsidy to be more effective than the interest subsidy, though this

case was not explicitly analyzed.

This analysis can be extended to the loan guarantee as used in

Bangladesh. This essentially involves paying to the bank a fraction of the

under-repayment by the borrowers. In this case too loan size would rise and

loan interest rates fall. However the effect on collateral requirements is

ambiguous, and consequently so is the relative benefit to the less wealthy.

There is however an extra problem in the way in which the Special

Agricultural Program (SACP) is implemented. This is the requirement that no

collateral be taken when giving loans under this program. This restriction

would tend to lower loan amounts an raise interest rates to borrowers. Many

potential borrowers would be excluded. The distributional effects are not

totally clear.

3.9 Urban-Rural Branch Licensing

The Nationalised Commercial Banks (NCBs) were inducted into

agricultural credit by the goverment for the following reasons.

(a) To use the existing deposit base of NCBs to redirect credit

toward agriculture

- 65 -

Table 21: Rural Branch Expansion (No. of Branches)

1974 1975 1976 1977 1978 1979

No. of Branches

INCB's Rural June of Year 648 743 949 1505 1822

Urban 762 833 917 1030 1144

Sonali Rural Dec. of Year 193 222 250 367 439 566Urban 156 178 200 233 270 281

No. of New Branches during past yeat-

NCB's Rural 95 206 556 317Urban 71 84 113 114Ratio of Rural toUrban 1.34 2.45 4.92 2.78

Sonali Rural 29 28 117 72 127Urban 22 22 33 37 11Ratio of Rural toUrban 1.32 1.27 3.55 1.95 11.55

NCBs: Nationalized Commercial BanksSource: Bangladesh Bank Bulletin, :Scheduled Bank Statistics and Sonali Bank

Annual reports.

- 66 -

(b) The use of BKB would have necessiated provision of refinance,

which would inevitably have been limited by overall monetary base

expansion

(c) The NCBs growing branch network in rural areas and their latent

capacity for rapid expansion of the branch network in rural areas.

In addition to the Special Agricultural Program (SACP) the linkage

between the rural and urban branch licensing was a major method used. These

licenses for new branches were linked in a theoretical ratio of 1 urban to 2

rural. Table 21 gives the urban and rural branches for all NCBs and for

Sonali bank. Between 1976 and the ratio actually fluctuated between 1.3 and

4.9 with an average ratio of 2.7 over the entire period. There was also

considerable variation among banks as is shown by the case of Sonali bank

where the ratio varied between 1.3 and 11.6. For Sonali the average for the

period 1976 to 1980 was 2.9. Thus the expansion was forced by the Bangladesh

Bank and the government at an even faster rate than suggested by the professed

ratio of 2.

As there is an excess demand for urban branch licences, the idea of

the linkage is of course to cross subsidize rural banking operations with

urban. Table 22 gives an estimate of the administrative costs for rural

branches. If the very high initial costs when volume of business is very low,

were ignored, the average cost lies between 4.2% and 5.3% of the volume of

business (deposits plus loans). Total administrative costs (for Sonali bank)

as a percentage of business volume, are between 1.5% and 1.7% (table 23). If

this is taken as the upper limit of costs for urban branches, the minimum

difference in costs is between 2.7% and 3.6% (The minimum ratio of rural to

urban costs is 3).

- 67 -

Table 22: Administrative Cost of Rural Branches

Average Size Business Administrative Cost as a(Taka thousand) Percentage of Business

477 17.3'1,028 8.41,623 5.31,945 5.02,509 4.82,991 4.83,733 5.34,765 4.2

Note: The national average for the size of business of a Sonali branch was16,669 (Thousand Taka) in 1979 and 19,164 (Thousand Taka) in 1980; theadministrative cost as a percentage of business was about 1.8% for thetwo years.

* Computed from a sample of 10 rural branches that have been inoperations since 1978 or earlier. -

** Size of Business is defined as the sum of total deposits andoutstanding advances.

Table 23: Sonali Bank Statistics(in 1000 Taka or p.9 as applicable)

Dec.1976 Dec.1977 Dec.1978 Dec.1979 Dec.1980

Deposits 38441 46615 59950 83879 109666

Advances 24189 36248 48330 67559 96263

Total Business 52620 82863 108280 151438 205929

Interest Paid 1118.96 1479.63 2104.23 2759.46 4742.38

Expenditures 921.45 1230.99 1889.19 2387.90 3485.22

Interest Cost/Advances 4.63% 4.08% 4.35% 4.08% 4.93%

Interest Costs/Deposits 2.91% 3.17% 3.51% 3.29% 4.32%

Admin. Costs/Advances 3.81% 3.40% 3.91% 3.53% 3.62% 0

Admin. Costs/Total Business 1.75 1.49 1.74 1.58 1.68

Ratio of Rural to Urban Branches 1.25 1.58 1.63 2.01 2.09

Growth in Expenditures 309.54 658.20 498.71 1097.32

Rate of Growth 33.59% 53.47% 26.40% 45.45%

Source: Sonali Bank Annual Reports

- 69 -

To calculate the approximate profitability we take all costs as a

proportion of deposits. From Table 22 we can take an average cost of 4.8%

which translates approximately as 9.2% of advances. We can similarly use 3.2%

(1.6x2) as the corresponding figure for urban branches. Interest costs as a

proportion of deposits similarly averaged 4.4% of deposits over the period

1977 to 1980. Interest ceilings were at 12% during this period. Therefore

rural loses are approximately 1.6% of advances while urban profits are

approximately 4.2% a ratio of 2.6. This is very similar to the ratio of new

rural to urban branches for Somali. This is (merely) suggestive of the fact

that not too much incentive existed and pressure had to be applied by the

government. The declining ratio of total new rural to total new urban

branches since 1978 is also consistent with this picture. So is the recent

proposal by the NCB's suggesting Et transfer of their unprofitable rural

branches to BKB.

IV. ISSUES OF FINANCIAL POLICY

4.1 Efficiency or Inefficiency in Credit Markets

I have shown elsewhere that when an inefficiency exists in the

credit market the expected marginal product of the loan will be different from

the marginal cost of funds to the banks (deposit rate i in free market) plus

the marginal cost of transferring these funds from depositors to borrows

(marginal administrative costs of the banks). In the case of usual concern,

when loans are thought to be inadequate, the expected marginal product of

loans will be greater than the marginal costs mentioned above.

The important thing to note is that the relevant interest rate is

not the loan interest rate (r). It: is sometimes thought that r is just the

marginal costs of funds or the deposit interest rate i (or i+t) adjusted for

- 70 -

risk. This is not true. Both the loan rate (r) and collateral (C) take

account of the risk of non-repayment, and the loan interest rate r does not

bear any definite relationship to the marginal product of loan or capital even

in an efficient market Virmani (1982).

Given the scope of the study it was not possible to. estimate the

marginal product of loans in the various subsectors where inefficiency may be

a possible justification of intervention in the credit market. Some attempt

was made for the agricultural sector (see section 5.2). We are therefore left

to make intuitive judgement.

4.2 Welfare Objectives and Credit Markets

There are two welfare issues which are directly related to the way

in which credit markets function, and which can therefore legitimately be

addressed through credit policy. The more important one relates to the

unequal distribution of wealth or land: this can lead to an inefficient

distribution of credit for productive purposes and possibly even for

consumption purposes. To some extent this is not really a welfare issue but

an issue of inefficiency. The less wealthy or landless producers have little

collateral and can therefore run into a collateral constraint. This results

in less than efficient flow of loans to them at higher interest rates. A

collateral subsidy has been analyzed and suggested as the best policy

intervention in this case.

This is a welfare issue only in the sense that a distributional

problem results in credit problems which can in turn worsen income

distribution. One can of course argue that we should go to the source of the

problem; the unequal distribution of land or total wealth. To the extent that

it is the credit factor which adversely effects income flows and subsequent

wealth distribution, however, this is the causitive factor.

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The second issue is one of the distribution between lender and

borrower of the gains from the credit transaction. This question has most

often arisen in terms of monopolLstic money lenders. It can be shown [Virmani

(1982)] that when there are no informational inefficiencies present,

competitive and monopolistic credlit markets are equally efficient as far as

production loans are concerned. However in the latter case the lender obtains

the benefits from the credit transaction. In effect most of the productive

surplus generated by the use of credit is transferred to the monopolist. In

addition when information problemns exist, a monopolist will be less efficient

than a competitive market, given the same information problems. In a dynamic

context, however, the monopolist has a greater incentive to collect

information which will eliminate the inefficiency (this case was not

explicitly modeled).

Nevertheless, it can be legitimate for government financial policy

to attempt to promote competition and eliminate monopoly. In addition to any

distributional gains this may also have possitive production effects (again in

a dynamic sense) which must be weighed against the costs of intervention. It

is necessary at this point to consider the faulty logic and emotionalism that

characterises policy related to money lenders. Usually they are thought of as

exploitative monopolists who charge very high rates of the order of 100% to

150%. If this is true, tremendous welfare gains would be made if

institutional banks could make cr,edit available in these areas even at rates

of 30-35%. Absolutely no case can be made in this context for putting loan

interest ceilings which are even 'Lower than in competitive institutional

credit markets.

On the other hand if the money lender's loan rates are in the 30-35%

range, these could still be due to monopoly, but can also be due to several

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other factors. The most important [see Virmani (1982)] are information

problems which can provide (ineffect) an informational monopoly by

moneylenders in small localized regions. The effect of these is to severely

fragment the credit market and impair the flow of funds within the rural

areas. In such a situation it is worth considering policies which increase

the incentive for moneylenders to compete in areas outside their traditional

information field. Among the possible policies are increased competition from

formal banks, increased supply of funds to moneylenders in deficit areas, and

increased opportunities for financial investment/savings deposits in surplus

areas and in the surplus (usually post-harvest) periods.

The Rural Financial Experiment project in Bangladesh has used

(experimental) interest rates ranging from 15 to 36%. The recovery

performance has been quite satisfactory at the end of this range. This may of

course be due to the tremendous subsidy provided to banks for recovering

loans. On the whole, however, the evidence from this project is consistent

with the above analysis.

4.3 Differential Interest Rates: Availability vs. Cost

In the simplest terms the institution of interest rate ceilings on

credit has been seen as a conflict between credit availability and costs.

Those who get the loans are seen to have got subsidized credit, while many

people end up not getting it. The actual picture is more complicated: The

direct effect of (loan) interest rate ceilings will be to reduce credit to all

borrowers. Indirect effects can reverse this fall for favored borrowers if

ceilings are economy wide. In addition a (direct) rise in collateral

requirements will result in some borrowers not getting credit at all (for the

first time).

- 73 -

The simple picture when used for the case in which ceilings are

applied only to one sector concludes that borrowers in that sector get

subsidized credit. It usually neglects both the reduction in credit to

individual borrowers as well as the reduction in the number of borrowers.

More importantly, there will also be a shift of credit away from the chosen

sector, further reducing credit. Thus instead of getting 'subsidized' credit

many borrowers within the sector would get less credit.

The differential credit ceilings introduced in Bangladesh in 1981,

presumably to 'subsidize' certain sectors like agriculture and exports would

have a perverse effect on these sectors. There is already some

impressionistic evidence of an unfavorable intersectoral shift. Once this

becomes clearer the government will have to choose between maintaining the

have a perverse effect on these sectors. There is already some

impressionistic evidence of an unfavorable intersectoral shift. Once this

becomes clearer the government wiLll have to choose between maintaining the

inverted structure and forcing btnks to maintain the desired portion of

lending, or evening out the pattern of ceilings. I would recommend the latter

solution; to be achived by a rise in the interest rates. If a subsidy is to

be provided it should be an interest rate subsidy to banks for lending to

favored sectors. This could be financed by a tax on all other lending. Both

these would shift credit in the desired direction.

4.4 Financing of Specialized Banks: Refinance, Debentures or Deposits

There are many different specialised banks, and many different ways

of financing them. The three most important are Refinacing, Reserve

Debentures, and Deposits. Refinancing is the primary means of financing the

agricultural banks -- BKB and BSBL. A secondary and much smaller source of

deposits for BKB, a scheduled bank, is bank deposits. BSBL being an apex co-

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operative bank is allowed to collect deposits from members only. Reserve

Debentures eligible for fulfillment of reserve requirements by commercial

banks are a major source of funds for the House Building Finance Cooperative

(HBFC), and also a source for the Bangladesh Shilpa Rin Sangstha (BSRS) which

makes medium/longterm loans to industry. The third major source is

deposits. The IRDP Co-operative system is financed indirectly by Sonali Bank

deposits, while the Bangladesh Shilpa Bank (BSB) which can directly take

deposits, has deposits and foreign financing as its primary source.

In economic terms direct provision of refinance to a specialized

bank is exactly equivalent to allowing the bank to issue debentures, and

increasing the reserve requirements of deposit taking institutions to ensure

absorbtion of these debentures (I assume that the public market is limited as

it is in Bangladesh). This follows from the assumption that monetary

expansion is equal in the two cases. In other words any practical difference

arises only if the goverment is led to expand money supply by different

amounts in the two cases. All other things can be made equal by an

appropriate choice of the interest rate on debentures.

Consider first the provision of refinance R to the specialized bank,

which is then fully on-lent by the bank. If money supply is to be unchanged,

the reserves of the banking system must fall by an amount R ; because the

first round effect is -(l-a)R, we must have R' - R= a This can be done by

increasing the reserve requirement by a proportion da - R where MB isa (l-a)MB

the monetary base. If the same amount of finance is to be provided to the

specialized banks through issue of debentures, the value of such debentures is

equal to R. To accomodate these into reserves, reserve requirements must

change by R (i.e., da - R/D) where D is the amount of deposits. The first

round effect is to reduce commercial bank loans by Dda which is equal to R, so

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that money supply is unchanged.

Both these policies transfer loanable funds from the commerical

system to the specialized banks. The required change in reserve requirements

will in general be different (1 - a)MB in the first case and -D in the

second. However both policies provide a cross subsidy from the commercial to

the specialized bank, and the interest rate on debentures can be set to make

the subsidy equivalent.

Consider first the simple free deposit market case. We have shown

earlier that, if transaction costs; are ignored, the effective cost of deposits

to the commercial banks is given by i = i big where i is the nominal cost1a

of deposits, a the reserve requirement, and b the proportion of reserves held

in a debentures earning interest ig. It is easy to show that a change in

reserves will raise, leave unchanged or lower the effective cost i' as i is

greater than, equal to or less than bi . In the present case

b = .2 - 4 Thus setting ig around 1.25i would mean that both policies have.25 5'

no effect on the commercial banks. As the current average i = 7% and the

current rate on government securities is 8.5% we have big = 6.8 which shows

approximate neutrality of interest with respect to reserve requirements. A

provision for equal taxation of commercial banks in the two policy cases would

involve setting the interest rate on debentures (igl - ig2) lower than 8.5 andi - abi 1 i-abig2

making (1-a)MB aD

In the more realistic case of government fixed deposit interest

rates and exogenously given deposits, the banks earn an oligopoly profit per

unit of loan equal to the difference between the shadow/opportunity cost(s)

and the interest cost. Loanable funds would be changed by .R in the

refinance policy case, and by R in the reserve debenture policy case.

Therefore in addition to the factors considered above tax equivalence must

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also adjust for the different amounts of rent transferred under the two

policies i.e. [ R (i-abig) (1 + (1 - a)(iabi)(1 + (1-a)2 ga1 -B) - a a) g2J aD

In this exogenous deposit case, if deposits could be switched

(somehow) from commercial banks to the specialised banks without changing

reserve requirements, there would be no monetary affects. Only a transfer of

oligopoly rent woud take place. In the Sonali Bank -- IRDP case it is not

really a transfer of deposits from a bank to a specialised program, but an

induced transfer of loans from one sort of borrower to another. An implicit

deposit transfer mechanism is involved in BSRS financing: To an extent it was

favored in the grant of licences to open urban branches, and allowed to pay

higher interest rates (still less than s) to depositors.

Some of the more practical considerations can now be illustrated by

evaluating different means of financing the agricultural credit system (BKB,

BSBL, IRDP). The main criticism of the use of refinance as a method of

supplying funds to BKB and BSBL is that agricultural credit becomes too

dependent on global monetary policy and inflation considerations. This is

particularly true in times of high government deficits when there is internal

and external pressure to reduce inflation. Our analysis shows that this is

only valid if reserve requirements are held fixed. If reserve requirements

are made flexible, monetary policy can be delinked from the use of refinance

or the reserve-debenture policy.

When macro policy considerations dictate injection of liquidity into

the system refinance policy is a more direct and simple way of providing

funds. The reserve debenture policy is more disruptive, requiring injection

of reserves into the whole system followed by changes in reserve

requirements. Until about 1979/1980 Bangladesh government deficits and public

sector losses were such as to provide sufficient scope for injection of

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liquidity through refinance. It was therefore the preferred policy during the

period. With the recent reversal of this position pressure has grown on the

BKB to depend to a greater extent on its own deposit resources.

In such a situation an alternative deposit based policy can be

considered. At present both BSBL and the IRDP system are permitted to take

deposits only from members. Serious consideration should be given to allowing

them to collect deposits from, or offer short-term financial instruments to,

the rural public. This would bring them on par with BKB. BKB (and the

cooperatives) is not permitted to have urban branches, while the commercial

banks can open rural branches and in fact have been forced and/or encouraged

to do so.

One possibility would be to allow BKB to open urban branches. This

would tend, however, to progressively dilute the agriculture-rural orientation

of the BKB. An alternative possibility emerges from looking at Table 20 which

gives the credit-deposit ratios by district. The credit deposit ratios for

the rural areas have grown progressively from 32% in 1976 to 69% in 1980, but

still remain below the 75% level possible without any refinancing (at the

prevailing reserve ratio). Even though there is considerable variation

between districts -- 27% in Chittagong to 160% in Mynemsingh -- the 69% ratio

suggests that agricultural lending; could be suppported by rural deposits,

without any need for external finance or refinance. Two methods for doing

this are available.

One method for increasing the flow of deposits to BKB, is to

transfer all rural branches of the NCBs to BKB. This alternative is suggested

by the expressed desire of NCBs to get rid of their many unprofitable

branches. As we shall show below their agricultural lending experience has

not been entirely satisfactory. In addition BKB is quite willing to take over

Table 24: Credit/Deposit Ratios by District (x)

FY 76 FY 77 FY 78 FY 79 FY 80

Urban Rural Urban Rural Urban Rural Urban Rural Urban Rural

A. CHITTAGONG 43 25 47 29 53 45 48 31 54 42

Chittagong 48 18 51 63 56 36 53 19 60 27

Chittagong Hill tracts 21 141 21 35 30 48 34 46 24 193

Comilla 27 47 40 63 49 74 43 46 47 83

Noakhali 37 31 53 44 61 63 55 65 65 77

Sylhet 32 14 27 19 34 32 26 23 30 27

B. DACCA 119 45 110 52 112 72 11 77 119 84

Dacca 126 41 115 45 116 55 1l1(?) 50 122 53

Faridpur 33 41 61 56 56 82 50 90 58 107

Mymensingh 31 57 40 79 56 113 55 160(?) 61 160 X

Tangail 23 38 40 28 40 66 46 82 48 92

Jamalpur NA NA NA NA NA NA 101(?) 123 103 172

C. KHULNA 57 28 66 56 74 60 77 47 78 98

Barisal 20 30 29 56 36 81 33 54 40 79

Jessore 34 22 99 43 53 58 54 82 57 122

Khulna 85 25 84 60 96 59 100 65 94 94

Kushtia 28 13 45 45 49 52 53 15 74 69

Patuakhali 27 69 53 110 57 103 56 129 69 178

D. RAJSHAHI 27 33 37 50 42 76 46 82 47 92

Bogra 30 32 35 43 47 55 52 59 51 66

Dinajpur 27 58 31 97 32 143 31 128 40 135

Pabna 14 22 65 30 38 58 52 63 38 65

Rajshahi 21 19 33 91 37 52 33 57 34 67

Rangpur 42 51 56 71 58 100 68 127 50 150

Total 86 32 84 43 89 59 86 51 95 69

Source: Bangladesh Bank

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these branches. If rural branches were transferred to BKB the primary

responsibility for providing funds; to BSBL and IRDP would be transferred to

BKB.

An alternative method for linking the flow of funds to agricultural

banks with rural deposit mobilization is to make it mandatory for nationalized

banks to transfer all excess reserves from their rural operations to BKB, BSBL

and IRDP. This transfer would be in the form of loans at rates which take

account of interest payments and administrative costs. In other words BKB,

BSBL and IRDP would have the right to borrow from the NCBs the difference

between the loanable funds generated by rural deposits and the loans made in

rural areas. This proposal is likely to be more acceptable to NCBs, but more

difficult to implement because of the problem of defining rural areas and

rural loans. Some mix of the two maethods may prove to be more feasible.

4.5 Buffer Stocks: Alternative for Margin Requirements and Refinance

When analysing margin requirements it was suggested that they may be

useful for agricultural commodities. As buffer stocks fulfill the same price

stabilizaton function it is useful to briefly consider the two together. As a

general principle buffer stock policy is more relevant for commodities whose

prices fluctuate regularly on a seasonal and/or annual basis. Margin

requirement changes are more appropriate for unexpected and temporary changes

in prices. Put somewhat differently buffer stocks are more appropriate when

production fluctuates from year to year or when havesting is concentrated at

one point in a year, resulting in a strong seasonal fluctuation in prices

(i.e., demand is uniform). Margin requirements are more appropriate when

unexpected economic events lead to strong speculative demand.

Buffer stocking and refinance are not as clearly separable. Buffer

stocking would itself give rise to a cyclical, seasonal or annual, pattern of

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demand for credit. In the seasonal case the cycle is exactly the inverse of

the demand for credit for agricultural production of the corresponding

commodity. Therefore if both sets of borrowers were supplied from an

integrated financial system, cyclical demand fluctuation would be eliminated

and there would be no need for special refinance. On the other hand annual

cycles would still lead to annual fluctuation in credit demand from the

stocking agency. If the buffer stocking operation is self supporting (after

taking account of explicit budgetary subsidies) the banking system woud

generally be willing to supply the required credit.

4.6 Term Finance

In the agriculture area there is strong push for providing medium,

and long term finance for irrigation improvement. In industry the specialised

banks, Bangladesh Shilpa Bank (BSB) and Bangladesh Shilpa Rin Savings (BSRS),

are there specially for providing term finance. I have shown elsewhere that

term lending creates special problems for banks because of the difficulty of

distinguishing between productive and unproductive, and honest and dishonest

borrowers. Both problems have arisen in the case of term lending for

industry. Industrial lenders can borrow up to 70% of the cost of a new

project from BSB. Additional loans of up to 15% can be obtained from ICB and

IFC. By inflating the cost of imported machinery (overinvoicing) and of land,

and covering the difference from the public (shares) the promoters can end up

by not using any of their own funds. Thus they may have little commitment to

the success of the project, resulting in poor repayment performance.

As I have shown it is necessary in such situations to develop

procedures for distinguishing between productive and honest borrowers and the

rest, and restricting loans to the former. A World Bank research project on

Kenya is attempting to develop such procedures. Similar work has also been

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done in a neighboring country. Use should be made of these and other

attempts, to do the same thing in Bangladesh. Other suggestions are made in

the financial review of Industrial Sector lending.

V. AGRICULTURAL CREDIT

5.1 Introduction

The explicit purpose of agricultural credit policy has been to

promote the growth of output and the welfare of farmers. The first goal

implies either that rural credit markets are inefficient or that credit is an

effective means of providing a production/investment subsidy to

agricultural. If rural credit markets are inefficient, then effective

intervention could promote output growth by improving efficiency. On the

other hand a determination of whether a production subsidy should be provided

through credit requires a prior exaLmination of the incidence of taxes and

subsidies on fertilizer, irrigation water, irrigation equipment and output.

Once a neutral policy environment is created, it cannot be ruled out a priori

that an explicit credit subsidy (not interest ceilings) may be one component

of an integrated subsidy package.

The second policy objective of increasing farmer welfare can relate

to the entire agricultural sector, or to sub-sets of farmers, usually the poor

and landless. An appropriate production subsidy package is one means of

increasing farmer welfare if accompanied by measures to market the output and

minimize any adverse impact on output prices. The other welfare question

relates to the distribution of gains between traditional lenders and farmer

borrowers. This has been addressed earlier.

Returning to the question of credit market efficiency, there are two

opposing views on the matter. One view is that if agricultural productivity

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increases due to introduction of HYVs enough credit will be generated to meet

demand. In other words the existing level of technology and non-credit

related constraints-risk, availability of water, technical knowledge etc., are

significantly more important factors. The other view is that rural credit

markets are very fragmented, and excess funds do not flow smoothly from

surplus to deficit areas. This causes inefficiencies in credit markets.

5.2 Expected Marginal Product of Loans

In an earlier paper I have given a method for measuring the degree

of inefficiency, if any, in the market. I have also shown that if there is

any inefficiency in rural markets it is probably not due to the physical

problem of moving funds. Any inefficiencies arise due to informational

problems which constrain traditional lenders, and new potential lenders, from

providing credit in unfamiliar areas and to unfamiliar borrowers. I have

shown that if the credit market is functioning efficiently, the expected

marginal product of loans must be equal to the opportunity cost of loans. The

latter is the marginal cost of raising deposits plus the marginal cost of

transferring them to borrowers (marginal administrative costs). The average

cost of funds in 1979-80 was 4.3% of deposits (Table 17). The rural

administrative cost, for commercial banks have ranged around 10.6% of deposits

(from a sample of Sonali branches, 2 x 5.3). This yields an approximate

average cost of 15%. Though administrative costs for the agricultural banks

may be lower, a figure of 15% can be used for illustrative purposes.

To obtain the marginal product of loans, we use the fact that

fertilizer input and the output resulting from it are separated by the

produttion period for crops. Consider a simple case in which fertilizer input

is separated from agricultural output by T months. Use of fertilizer

therefore requires use of own funds or credit to purchase fertilizer. Any

Table 25: Marginal Product of Loans in Agriculture

Marginal Product Price Fertilizer 1 2 Time Period Annualizedof Fertilizer at (Adjusted) Price p 3 1 of Production Rate or ReturnAug. level of use (TK/md) A 3 (months) 5 x 12/T

1 2 3 4 5 6

1. Aman 1979, Local, Broadcast 2.03 125 137.4 .846 10 1.02HVUW, Transplant 2.46 120.9 137.4 1.165 9 1.55

2. Boro 1979-80, Local 4.53 122.65 180.5 2.078 7 3.56HYU 2.74 109.51 180.5 .642 7 1.10

3. Aus 1980, H UW, Broadcast 2.01 93.60 182.7 .029 6 .06

4. Aman, 1980, Local Transplanted 3.91 117.38 186.6 1.460 9 1.95

Source: IFDC/BARC, Agricultural Production, Fertilizer Use and EquityConsiderations, Results and Analysis of Form Survey Data, 1979/80,Bangladesh 1981.

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credit taken is then repaid T periods later. It is easy to show that the T

month rate of return on loans is (p. MPF/pF - 1) where p is the output price,

PF the fertilizer price and MPF the marginal product of fertilizer. If

fertilizer is not used efficiently because of rationing, the marginal product

of loans will be less than this amount.

Table 25 presents estimates for the marginal product of loans using

estimates of the marginal products of fertilizer at average levels of usage.

A reasonable assumption might be to assume that fertilizer usage is efficient

in HYV crops, but may not be so in traditional. The second thing, to keep in

mind is that high rates of return for short periods do not necessarily

translate into the high rates suggested by simple annualization. This is

because the opportunities available for the rest of the periods may be quite

restricted due to market inefficiencies. The estimated annualized rate of

return on loans for HYV crops varies from 6% for 1980 Broadcast Aus to 155%

for 1979 Transplant Aman, with 1979 Boro in the middle with 110%. Given a

cost of funds of 15% a rate of return of 6% would suggest an excessive use of

fertilizer which is very unlikely at average levels of fertilizer usage. Some

upward adjustment may also be required for the fact that 1979 and 1980 were

bad crop years and what we need is an average of the marginal product over

several years. As most HYV are grown in irrigated areas, fluctuations in

their output is much less (flooding, can still be a problem). A 9 percentage

point difference is hard to explain on this basis given the high returns from

other crops in the same period.

A possible explanation for the 1980 Aus and 1979 Boro is under use

of fertilizer due to shortages and rationing. In such a situation the

calculated rates provide an upper limit, and actual returns on loans would be

less. However there is no evidence to suggest that there was a shortage

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during this period. Sample testing done by BADC indicates that free market

prices were not significantly diffierent from controlled prices.

The rates of return calculated from traditional varieties show

somewhat less variation ranging from 102% through 195% to 365%. Such high

rates are somewhat unbelievable, particularly in bad agricultural years. The

caution about annualizing rates is of course very relevant here, but even the

unadjusted returns range from 64% t:o 146%. The tentative hypothesis about

more efficient use of fertilizer in HYVs than in traditional crops, is

supported by the 1979-80 Borro returns but contradicted by the 1979 Aman

returns.

If one could ignore the 6% return, the rest of the data become

fairly consistent, indicating a minimum expected marginal product of loans of

100%. This suggests enormous inefficiency in the agricultural credit market.

We cannot just ignore the anomalous observation, however, and any judgment of

credit market inefficiency mtust be tempered by caution.

5.3 Targets and Disbursements: Differential Performance

Almost the entire gamut of policy instruments has been applied to

agricultural credits. This includes targets, refinance, guarantees, branch

licensing and special programs. In addition interest rate policies, margin

requirements and credit ceilings also impinge on agricultural credit. Among

the earliest to be used was the target guideline approach. Table 26 presents

the targets, disbursements and achievements of BKB, BSBL and the NCBs for the

1975-81 period.

In 1975-76 the target for total disbursements was TK 49.56 crore

while achievement was at TK 48.29 crore or 97% of the target. By 1980-81 the

targeted disbursements had more than tripled to TK 3438.31 crore while

disbursement had increased only to TK 279.6 crore showing a performance of

Table 26: Agricultural Credit

(in lakh takas)

TARGET 1974-75 1975-76 1976-77 1977-78 1978-79 1979-80 1980-81

BKB 1672 2200 3635 4323 6588 10300 17986BJSB/BSBL 1300 1550 2000 2200 2475 2900 3800

Sub-Total 2972 3750 5635 6523 9063 13200 21786NCB's 1600 1206 2835 4714 6654 7530 13045

Total 4572 4956 8470 11237 15717 20730 34831

DISBURSEMENT

BKB * * 3168 3729 5867 11896 18532BJSB/BSBL * * 1133 1705 2010 14600 2570

Sub-Total 2605 2768 4301 5434 7877 14600 21102NCB' 881 2061 2194 3654 5069 5536 6858

Total 3486 4829 6495 9088 12946 20136 27960

ACHIEVEWC'NT: Disb/Target X(%)

BKB 87.15 86.25 89.05 115.49 103.04BJSB 56.65 77.5 81.21 93.24 67.63

Sub-Total 87.65 73.81 76.33 83.31 86.91 110.61 96.86NCB's 55.06 170.89 77.38 77.51 76.79 73.52 52.57

Total 76.25 97.44 76.68 80.88 82.37 97.13 80.27

Rate of Growth of Disbursement

BKB 17.71 57.33 102.76 55.78BJSB/BSBL 50.48 17.88 34.53 -4.96

Sub-Total 6.25 55.38 26.34NCB's 133.94 6.45 66.55 38.72 9.21 23.28

Total 38.53 34.50 39.92 42.45 55.75

* Not availableBKB: Bangladesh Krishi BankBJSB/BSBL Bangladesh Jatigo Sumabaya Bank/Bangladesh Samabaya Bank Limited.Source: Annual Reports of the Bangladesh Bank

- 87 -

80%, the lowest level since 1976-77. Just as targets were designed to provide

an impetus to disbursement the actual disbursement performance influences the

setting of targets. Nevertheless the disbursement performance has varied

considerably over time and between the banks.

Both BKB and BSBL showed improved performance in terms of targeted

disbursement over the period 1976-77 to 1979-80, but then performance

plummeted quite sharply in 1980-81 (Table 26). In contrast the commercial

banks' performance shows a deteriorating trend over the period, going from 77%

in 1976-77 to 53% in 1980-81. BKB performed the best in terms of targets,

with a peak of 115% in 1979-80, and with 103% even in 1980-81. After the

early period BSBL's performance and has remained between these two in terms of

targets.

Total disbursements rose at a rate of 44% a year between 1976-77 to

1980-81, from TK 64.95% crore to TK 279.6 crore. However much of this growth

was due to expansion in lending by BKB which rose from TK 31.68 to TK 185.32

crore an overall compound rate of growth of 56% a year. The growth rate for

the commercial banks was 33% a year, and for BSBL only 23% a year. This

contrasts with the relative posiltion of the last two when compared on a

target-achievement basis. It also suggests that the government and the

Central Bank, perhaps, expected tWoo much from the commercial banks. The 33%

growth rate includes Sonali Bank lending to the IRDP co-operative system, in

which the former acts merely as a conduit. The commercial banks' performance

viz a viz direct lending to fina:L borrowers may not match this growth.

The BKB's performance sieems by and large to have matched

expectations. Thus for example the rise in targets from TK 65.88 crore in

1978-79 to TK 103.0 crore in 1979-80, was accompanied by a rise in

disbursement performance from 89% to 115% of target (A 102% growth of

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disbursement). As a consequence BKB's share of total disbursements has risen

from 49% in 1976-77 to 66% in 1980-81. A major policy instrument affecting

this performance has been the refinance policy coupled with specialization.

Refinance policy was analyzed earlier. Being a specialized agricultural bank

BKB is excluded from non-agricultural lending, though trade, storage and

processing activities, particularly in rural areas, come within its purview.

In addition specialization has yielded information economies which resulted in

better performance. This is independently indicated by its recovery

performance which will be analysed below. An additional factor in past growth

performance is that the BKB has not been formally subject to credit ceilings

on agricultural lending (nor has the BSBL).

5.4 The Special Agricultural Program and Commercial Bank Performance

Table 27 gives the targets and disbursements under the Special

Agricultural Credit Program (SACP/TK 100 crore program). Disbursements

increased from TK 60.78 crore during 1977 (calender year) to TK 72.68 crore in

1980-81 (financial year), a total growth of only 20%. Achievements as a

proportion of targets were equally disappointing, declining progressively from

61% in the 1977 program to 36% in 1980-81 program (Table 27). For the first

two years the program was on a calendar year basis, so that the data is not

directly comparable to that in Table 26. If we take an average of the total

disbursement for 1976-77 and 1977-78 from this table, however, we obtain an

approximate figure of TK 77.92 crore for calender year 1977. Of this,

disbursement under SACP 1977 which started only in February was TK 60.78 crore

or 78% of the total. This gives some idea of the (initially) ambitious scope

of the program and the pressure put on commercial banks to increase

agricultural lending.

- 89 -

Table 27: Special Agricultural Program (SACP/100 crore)(In 1000 Taka)

SACP Program of: 1977 1978 1979 1979-80 1980-81

Total Under SACPTARGET 10000 10000 5715 10000 20000DISBURSEMENT 6078 5347 2370 4127 7268

ACHIEVEMENT 60.78 53.47 41.46 41.27 36.34(Target/Disbursement)

As of: Dec.1977 Dec.1978 Dec.1979 Dec.1980

Outstandings

Sonali BankSACP 1000 1659 2737 4250Normal Program 653 971 1556 3050IRDP 721 1084 1960 3514Total 2374 3714 6253 10814

Agrani BankSACP 745 1002 1302 1620Normal 43 40 304Total 7138 1042 1606 *

NCB sTotal 3938 9216 15063 10570@

* Not available@/ Provisional.

- 90 -

The push didn't last long however, as by the next year, SACP

disbursements at TK 53.47 crore were only 49% of total (again taking 1977-78

and 1978-79 average for total disbursement). By 1980-81 SACP disbursements

were only 26% of total disbursements.

As one of the major purposes of the SACP was to bring NCBs into

agricultural lending, we would expect its greatest impact on their

agricultural lending. The data on the outstanding loans of Sonali Bank and

Agrani Bank (Table 27) is consistent with this. Though the figure for

outstandings includes overdues, the SACP outstandings for December 1977 will

include no overdues while those for the normal program do. Leaving aside IRDP

lending by Sonali, both banks had a major proportion of their disbursements

channeled through the SACP (Table 27). This clearly remains true for the

Agrani Banks until 1980-81; but less so for Sonali Bank, if allowance is made

for the possibility of higher overdues under SACP than under the normal

program. The major increase in the rate of growth of commercial banks

disbursements (Table 26), from 6% in 1976-77 to 67% in 1977-78 can be largely

attributed to the SACP program.

The rate of growth of loan disbursements by NCBs slackened somewhat

to 39% in 1978-79 and then plummeted to 9% in 1979-80. We have already shown

that disbursements by all banks under SACP as a proportion of total

disbursements also declined in absolute terms. Therefore part of the still

fairly high growth rate of 39% in NCB loan disbursements must be due to

increased lending under the normal program. This is suggested by the

gathering momentum of the rural branch expansion program. The ratio of new

rural to new urban branches of NCB grew from 1.3 in 1976-7 to 2.5 in 1977-8

and to a peak of 4.9 in 1978-9 (Table 21). The banks' loan disbursements

under SACP continued to slacken, however, and reached 68% of first year (1977)

- 91 -

levels in 1979-80. The growth oil rural branches also registered lower rates

in 1978-79 and 1979-80 (Table 21), suggesting a slackening of the rural

program. Loan disbursements by 21CBs therefore increased only by 9% in 1979-

80. A major causative factor was the much more rigorous application of credit

ceilings on commercial banks in 1.979-80. Though these ceilings had been in

operation for sometime, and NCBs' agricultural lending fall within their

ambit, aggregate inflationary pressures and IMF related contacts led to

increasingly forceful application.

5.5 Introduction of Urban Organised Banks into Agricultural Lending

Throughout this experience or experiment of getting the NCBs into

agricultural lending there has been a feeling that the distribution of credit

has not been satisfactory. In particular it has been felt that tenants and

small farmers are not getting enough credit. These effects are predicted by

my earlier analysis (competitive monopoly, Virimani (1982)), and I will briefly

outline the implications of the amalysis.

Given the importance of information and knowledge in the operation

of credit markets, urban organized banks are specilized to operate in that

environment. Basically they have developed procedures for dealing with

organized and established firms. When these banks are forced into the rural-

agricultural environment they are confronted with a completely different

informational problem. They will therefore seek out and lend to agricultural

producers who bear the greatest similarity to urban clients. These are

usually the largest, most educatedl and most modern (in terms of irrigation and

HYV technology). This is the group which benefits most from the introduction

of Urban banks. The medium farmers would tend to get some benefit because of

the erosion of monopoly profits of traditional lenders (arising mainly from

informational problems). But they would continue to borrow from them. The

- 92 -

smallest farmers do not benefit at all because the banks have so little

knowledge or competence in dealing with them that they cannot even offer any

potential competition to traditional lenders.

5.6 Interest Ceilings and BKB Performance

Table 28 gives the distribution of BKB loans by land holding and by

size of loans. The proportion of loans going to borrowers having 12.5 acres

to 33 acres of land rose sharply from 5% in 1976-77 to 11% in 1977-78.

Similarly the proportion of loans of amount greater than TK 3000 increased

from 12% to 40% of all loans. There was a decrease in the interest ceilings

in May 1977, but this was not applicable to the BKB and BSBL which already had

lower applicable ceilings. In August 1977 margin requirements of 50% were

imposed on all merchandise. We have shown in the analysis on margin

requirements, that for traditional borrower/merchants there would be a

tendency for loan interest rates to rise and loan amounts to fall. Further

some traders would now not get any loans at all. This provides an opportunity

for large farmers who do not normally engage in trade or in speculative

stocking to do so. Only the largest farmers would tend to have enough own

fund to meet margin requirements. They would thus take larger loans using the

increased part for speculative stocking. This is consistent with the shift in

loans towards the largest land owners from 5% to 11% of total loans. However

there is an increase in loan proportion from 28% to 39% in the 2.5 acre to 7.5

acre group. This suggests that some of the medium size land owners with

surplus funds may also have engaged in speculation.

Different land owners would tend to have different amounts of liquid

funds available for providing margin money. Therefore we do not expect a

proportional shift in the loan amounts taken. Table 28 shows that the

- 93 -

Tables 28: Banfgladesh Krishi Bank Borrower Characteristics

I. Distribution of Loans According to Size of Holding (Excluding Tea, Cold StorageTobacco Marketing & Processing); II. According to Size of Loans; III. According toSecurity Type.

1976-77 1977-78 1978-79 1979-80 1980-81I. % of all loans for year

Land holding of borrowers

Landless and upto 2.5 acres 54.70 39.13 42.74 35.72 32.082.5 to 7.5 acres 27.58 34.19 30.26 26.05 31.337.5 to 12.5 acres 13.10 15.37 13.80 25.36 16.5112.5 to 33 acres 4.62 11.31 13.20 12.87 20.08Total 100 100 100

Cumulative %

< 2.5 54.70 39.13 42.74 35.72 32.082.5 to 7.5 82.28 73.32 73.00 61.77 63.417.5 to 12.5 95.38 88.69 86.80 87.13 79.9212.5 to 33 1001 100 100 100 100

II. % of all loans for year

Loan Size

< TK 1000 53.86 32.83 34.69 24.67 8.231000 to < 3000 34.20 26.50 26.15 18.41 27.753000 to < 10,000 4.07 24.41 20.67 14.53 18.9210,000 to < 20,000 5.38 9.33 11.05 22.06 8.6820,000 to < 50,000 0.19 2.78 4.81 16.39 13.66> 50,000 2.30 4.15 2.63 3.94 22.76

100 100 100 100 100

Cumulative %

53.86 32.83 34.69 24.67 8.2388.06 59.93 60.84 43.08 35.9892.13 83.74 81.51 57.61 54.9097.51 93.07 42.56 79.67 63.5897.70 95.85 97.37 96.06 77.24

100 100 100 100 100

Ill. % of all loans for yearSecurity

Real Estate 33.79 53.16 53.89 38.26 45.01Hypotecation (incl SACE') 61.20 41.86 35.34 55.86 26.04Stored Crop Pledge 2.38 0.26 3.54 3.46 25.87

Source: BKB annual reports.

- 94 -

greatest shift was in the TK 3000 to less than TK 10,000 category, from 4% of

total loans to 24%.

In October 1980 the structure of interest ceilings was changed so

that agriculture was subject to a ceiling of 12%. The general ceiling,

applicable to storage, transport, trade, etc. was much higher at 15.5%. In

the section on interest ceilings it was shown that there would be a tendency

to shift out of agricultural lending into general lending (here it could be

agriculture related). It was shown earlier that BKB's disbursement

performance both in terms of growth rates and in terms of achievement of

targets rose progressively from 1976-77 to 1979-80. This trend was sharply

reversed in 1980-81; The growth rate declined from 103% to 58%, while

performance as percentage of target declined from 115% of target to 103% of

target (Table 26). This was accomplished by a shift of the loan distribution

away from the smallest loans of TK 1000 and less, to those of between TK

1000 and TK 10,000. The former declined from 25% of total in 1979-80 to only

8% in 1980-81, while the later increased from 33% to 47%.

5.7 Recovery performance

Many different measures of recovery performance have been used.

When it is not possible to separate out loans by maturity and by initial

starting time of loan, the best measure is the following: A ratio of the

total repayment during the year to the value of loans plus interest falling

due during that year. Another possible measure is the ratio of the repayment

of principal to the principal due during the year. The latter measure may be

useful when comparing different institutions and programs, with different

mandated interest ceilings or other restrictions. This runs into an

accounting problem, however. Banks which compound interest, transfer all

overdue interest to the principle account, in effect converting it to an

- 95 -

overdue loan. The problem of recovery performance varying merely because of

differences in rates of interest charged, may not be solved.

Another problem with both these measures, when used in a comparative

analysis, is that recovery performance can differ merely because of different

rates of growth of disbursement. ]Non repayment at the due date does not mean

that no further repayments will be made in future years. In fact repayments

are often stretched out over several years. For example, many banks in

Bangladesh are still receiving repayments on loans made in pre-liberation

times. For this reason banks with faster growth in disbursements would tend

to show poorer recovery performance.

A unique set of data is available for Bangladesh which allows us to

look at the pattern of loan repayment for a given loan. This relates to the

SACP/100 crore program, which was started in 1977. In this program all loans

had approximately the same term. Accounts were kept separately for each

years' program. These were initially on a calender year basis, but in 1979

were switched to a financial year basis, with the intervening program lasting

only 6 months. Data on accumulated recovery of principle is available for

each bank and each program at four points of time. A recovery profile can

therefore be constructed given total disbursements under each program for all

banks. A linear regression of accumulated recovery on time from

effective/average due date is used for this purpose. The results for the six

nationalized commercial banks and BKB are presented in Figures 1, 2 and 3.

The results by program are presented in Figure 4.

From Figure 1 it is clear that the recovery profile of the

Bangladesh Krisi Bank (BKB) lies entirely above that of others. This

superiority is more noteworthy given that the BKB's recovery performance under

the SACP is known (even to it) to be inferior to its recovery performance

Figure 1: Recovery Profiles by Banks for the Special Agricultural Credit Program

SONFLL

----------- MRAWRsN*JRNSRT

-. - JAnaT- RUPVLt

*---* PU-MLI

1 40.0- - 140. 0

120.0- 120.0

100.0 1 100.0

80.0 - 80.0

60.0- 60.0

40.0- - 40.0

20. 0 - / - 20. 0

0.0 20.00.0 10.0 20.0 30.0 40.0 50.0

Figure 2: Recovery Profiles: BKB, Sonali, Agrani and Janata Banks

--------

120.0- - 120.0

1 00/ a 10 e.o

60.0- va0,0

40.0 -u40.0

20.20.0 Io.o 10.0 20.0 30.0 40.0 50.

Figure 3: Recovery Profiles: Janata, Uttarg. Rupali and Pubali Banks

1_ _ __ _ _ __0_ __ _ __ _ _ __ _ _ - 2 .

UJJ.I .I 0.0

80.0 .- 80.0

60.0 ,' 60.0 0

°I~~~t-

40.0 . ' 40.0

20.0 - / -0.0

0.0 I -0.00.0 10.0 20.0 30.0 40.0 50.0

- 99 -

under normal programs. From Figures 1 and 2 we can also conclude that Sonali

bank's performance is quite close to that of BKB. It thus comes in the second

position even though initial recovery is lower than for Uttara and Agrani

banks. Given the differences in the intercept terms and slopes it is more

difficult to rank the others. Broadly speaking however, figures 1 to 3 show

that the performance of the BKB, the Sonali bank and the Uttara bank is better

than that of the Janata, Rupali and Pubali banks, with Agrani bank in an

intermediate position. Among the commercial banks the better performance of

the Sonali Bank is probably due to its larger rural branch network at the

start of the program, and its involvement with the IRDP program. The BKB-s

better performance is clearly due to its deeper and longer involvement in

agricultural lending.

Figure 4 compares the recovery performance for the different

programs for all banks taken together. The 1977 and 1978 programs are treated

separately while the 1979 and 1979-80 program data are aggregated so as to

have enough data points. The performance under the 1978 program was

definitely worse than that of the L977 program. There have been wide-spread

complaints of politicisation of the program in terms of the choice of

recipients. If true, this provides an explanation of the deterioration;

political pressures would take time! to build up and take effect. The 1979 and

1979-80 programs show significant improvement over the 1978 program. Their

performance relative to the 1977 pxogram is more difficult to evaluate:

initially lower recovery is made up in subsequent periods because of the

higher marginal recovery rate. At the end of 1979-80 banks were given

permission, independently and directly to select borrowers for the 1980-81

program. This depoliticisation affects the most recent programs more

strongly, but would also effect recovery from older programs. This is a

Figure 4: Recovery Profiler by SACP Programs

...... -------- PRO678

120.0-- 120.0

100.0 _ 100.0

80.0 80.0

40.0 40.0

20.0- - 20.00.0 10.0 20.0 30.0 40.0 50.0

- 101 -

possible explanation for the upward movement in recovery rates for the 1979

and 1979-80 programs.

Another explanation for the improvement in the 1979-80 program is

the introduction of penalty rates in February 1979. Banks were allowed under

this scheme to charge a penalty rate of 1% a month up to a maximum of 20%.

Given the normal interest of 12%, this permitted a rise in the interest rate

on overdue loans by as much as 8%. As all the banks considered, compound

interest, penalty interest rates would tend to raise the average interest

payable, in proportion to the delay in repayment. This would tend to increase

the slope of the recovery profile line for the 1979 and subsequent programs.

The application of penalty rates has however been quite variable, largely

because of lack of clarity about its applicability to SACP and other

agricultural lending. Only Sonali bank is known to apply the full penalty.

The BKB uses a maximum penalty of 2.5%, while Agrani bank uses a penalty of

only 1% for rural loans.

5.8 Bad Debts versus Liquidity Problems

The existence of such a recovery time profile suggests that bad

debts may not be a serious problem in agricultural lending. This is in fact

what most bankers involved in agricultural lending in Bangladesh believe. It

would be wrong to conclude, as some dlo, that there is no problem of bad debts

,,r non-repayment risk; this aspect is not captured well by the indices used

above. The analysis shows, however, that even with the best performance,

recovery of loans may normally be stretched over as much as three years.

I1lerefore liquidity may become a ser3Lous problem, particularly for

1antitutions which depend on refinancing of loans (or total loans minus

wverdues) such as BKB, BSBL and the lRDP system.

- 102 -

In the discussion about the liquidity guarantee it was noted that

BSBL has always used this facility, while BKB has never used it. The previous

section's analysis suggests that this may at least partly be due to the

latter's superior recovery performance (BSBL is not involved in the SACP).

Nevertheless, given the rapid growth of BKB lending in the past five years

liquidity could become a serious problem in future. In addition the

significantly lower rates of interest will no longer be a problem because BKB

can now charge penalty rates on overdues. Therefore the BKB's policy on use

of penalty rates may have to be reviewed to allow full use of permisable

penalty rates.

- 103 -

Footnotes

1/ Resume of Financial Institutions, Ministry of Finance, Government of

Bangladesh 1973 and 1975.

2/ See Introduction and Section 4.5 of Virmani (1982).

R_ferences

1. Virmani, Arvind, The Nature of Credit Markets in Developing Countries: A

Framework for Policy Analysis,World Bank Staff Working Paper No.

524, 1982.

World Bank An Analysis of Developing NEWCountry Adjustment

Publicationis Experiences in the 1970s: Low- Compounding and Discounting

of Related Income Asia Tables for Project AnalysisChristine Wallich (with a Guide to Their

Interest Staff Working Paper No. 487. 1981. 43 Applications)pages (including references). Second Edition, Revised aildStock No. WP 0487. S3. Expanded

Adjustment Experience and Aspects of Development Bank J. Price GittingerGrowth Prospects of the Senm- Management Project planners and analvsts will findIndustrial Countries William sDiMment . this book a convenient and time-sav-Frederick Jaspersen William Diamond and ing reference for the preparation andStFfederikin Pasperseno.47 913 Raghavan- analysis of development projects. Six-Staff Working Paper No. 477. 1981. 132 Deals exclusiveIv with the manage- decimal tables for 1 percent through 50pages (mcludtag 3 appendzxes). ment of development banks. The book percent show the compounding factorStock No. WP 0477. $5. is divided into eight sections, each for I and for I per annum, the sinking

dealing w,ith one aspect of manage- fund factor, the discount factor, theAdjustment in Low-Income ment of its problems, and of the var- present worth of an annuitv factor,Africa ious ways of dealing with them. and the capital recoverv factor. TheRobert Liebenthal EDI Series in Economic Development. The first edition of this book underwentStaff Working Paper No. 486. 1981. 62 Johns Hopkins University Press, 1982. seven printings in ten vears and waspages (including bibliography). 2nd printing, 1983. 311 pages. translated into Arabic, Chinese,Stock No. WP 0486. $3. LC 81-48174. ISBN 0-8018-2571-7, Stock French, and Spanish. This new edi-

No. H 271.$29.5 hrdcver;ISB 0- tion-with narrow-interval compound-Aggregate Demand and 8018-2572-5, Stock No. JH 2572, S12.95 tabes added frhier interestMacroeconomic Imbalances in paperback. rates, updated project examples, aThailand: Simulations with the Capital Accumulation in lators to perforu n the cocputar onsSIAM 1 Model Eastern and Southern Africa: A discussed, and an annotated bibliog-Wafik Grais Decade cf Setbacks raphv increases the proven usefulnessStaff Working Paper No. 448. 1981. 132 Ravi Gulhati and Gautam Datta of its predecessor, both in the class-pages (including 3 appendixes). Analyzes the magnitude of the setback room and at the project site.Stock No. WP 0448. $5. in capital accumulation in eastern and May 1984. About 208 pages.

southem Africa. This phenomenon is ISBN 0-8018-2409-5. Stock No. BK 2409.examined in twentv-eight statistical ta- $10.95.

NEW bles. The authors sample sixteen coun- Translations of this new edition will betries and rely on expert observations to available in 1985. Still available are theexplore the proximate causes of the following translations of the first editzon:

Alternative Mechanisms for setbacks. French: Tables d'interets composes et d'ac-Financing Social Security World Bank Staff Working Paper No. 562. tualistation. Economica, 4th printing,Parthasarathi Shome and Lyn 1983. 74 pages. 1979.Squire ISBN 0-8213-0169-1. Stock No. WP 0562. ISBN 2-7178-0205-3, Stock No. IB 0542,Reviews, clarifies, and evaluates theo- S3. $6.retical literature about the effect of so-cial securitv on capital accumulation Capital Market Imperfections Spanish: Tablas de interes compuesto y deand labor supply. Analyzes empirical and Economic Development descuento para evaluaci6n de proyectos.studies using U.S. data, the impact of Vinayak V. Bhatt and Alan R. Roe Editorial Tecnos, 1973; 4th printing, 1980.pay-as-you-go financed and fully Staff Working Paper No. 338. 1979. 87 ISBN 84-309-0716-5. Stock No. IB 0526.funded social security schemes, and zaages (including footnotes). S6.characteristics of optimal social secu- Stock No. WP 0338. $3.ritv svstems. This studv provides astarting point for evervone interestedin the relevance of existing theories for The Changing Nature of Export A Conceptual Approach to thefinancing social security in developing Finance and Its Implications Analysis of External Debt ofcountries. for Developing Countries the Developing CountriesStaff Working Paper No. 625. 2983. 62 Albert C. Cizauskas Robert Z. Aliberpages. Staff Working Paper No. 409. 1980. 43 Staff Working Paper No. 421. 1980. 25ISBN 0-8213-0292-2.Stock No. WP 0625. pages (including 3 annexes). pages (including appendix, references).$3. Stock No. Wr 0409. 53. Stock No. WP 0421. $3.

- NEW Staff Working Paper No. 632. 1984. 144 Growth and Structuralpages. Adjustment in East Asia

Development Finance Stock No. WP 0632. $5. Parvez HasanC.ompanies, State and Privately Staff Working Paper No. 529. 1982. 42C)wned: A Review NEW pages.David L. Gordon ISBN 0-8213-0102-0. Stock No. WP 0529.An informative guide to the function Economic Liberalization and $3.and design of development finance Stabilization Policies in Interest Rate Management incompanies as they are set up in devel- Argentina, Chile, and Developing Countries: Theoryoping countries. Case histories high- Uruguay: Applications of the and Simulation Results forlight the differences among these com- Monetary Approach to the adSmlto eut opanies-their institutional structure, Blnetof paymets South Koreamanagement stvle, financial perfor- Balance of Payments Sweder van Wijnbergenmance, and other features. Looks at Edited by Nicolas Ardto Barletta,ee gethe problems of resource mobilization Mario I. Blejer, and Luis Landau deposit rates raise output and lowerand strategies to overcome them. Twenty-eight leading intemational inflation in the short run, and increaseStaff Working Paper No. 578. 1983. 84 economists and regional specialists re- growth through their favorable impactpages. view the salient characteristics of the on savings rates. It concludes that thisISBN 0-8223-0226>4. Stock No. WP 0578. monetary approach to the balance of theory depends heavilv on the as-S3. pavments, examine the vanations in sumption that portfolio shifts into timeits application, and evaluate its suc- deposits come out of unproductive as-Development Prospects of cesses and failures. Emphasizes the sets, providing less intermediationCapital Surplus Oil-Exporting empirical evidence and dvnamic as- than the banking svstem. Impact ofCountries: Iraq, Kuwait, Libya, pects and costs. Provides an important changes in time deposit rates on infla-Catriesa Arabia, U ibAEr examination of economic policies and tion, capital, capital accumulation andQzatar, Saudi Arabia, UAE their effects in a region that looms medium term growth are discussed,Rudolf Habliitzel large in current deliberations about in- and empirical relevance is demon-Staff Working Paper No. 483. 1981. 53 ternational indebtedness and finance. strated through simulation runs with apages (including statistzcal tables). June 1984. About 240 pages. macroeconomic model of South Korea.Stock No. WP 0483. S3. ISBN 0-8213-0305-8. 517.50 paperback. World Bank Staff Working Paper No. 593.

Developments in and Prospects Energy Prices, Substitution, ISBN 0-8213-0288-8. Stock No. WP 0593.for the External Debt of the and Optimal Borrowing in the $3Developing Countries: 1970-80 Short Run: An Analysis ofand Beyond Adjustment in Oil-Importing International Adjustment inNicholas C. Hope Developing Countries the 1980sStaff Working Paper No. 488. 1981. 70 Ricardo Martn and Marcelo Vijay Joshipages (including 2 annexes, references). Selowsky Staff Working Paper No. 485. 1982. 57Stock No. WP 0488. S3. Staff Working Paper No. 466. 1981. 77 pages.

pages (including footnotes, references). ISBN 0-8213-0062-8. Stock No. 0485. S3.Stock No. WP 0466. S3.

NEW NEWExchange Rate Adjustment

Domestic Resource under Generalized Currency Links between Taxes andMobilization in Pakistan: Floating: Comparative Analysis Economic Growth: SomeSelected Issues among Developing Countries Empirical EvidenceNizar Jetha, Shamshad Akhtar, Romeo M. Bautistaand M. Govinda Rao Staff Working Paper No. 436. 1980. 99 Keith MarsdenFouses on the relationship between pages (including appendix). Reviews the experience with growthtaxation and the three main compo- Stock No. WP 0436. S3. and taxation in twentv developing andnents of savings. Emphasizes tax re- developed countries, spanning a wideformn with a view to raising additional A General Equilibrium spectrum of incomes. Do countriesrevenues and encouraging household Analysis of Foreign Exchange with lower taxes experience moreand business savings. Proposals for tax Shortages in a Developing rapid expansion of investment, pro-reform take account of equityvconsid- Economy ductivity, employment, and govern-erations and the need to keep tax-in- Kemal Dervis, Jaime de Melo, and sheds new light on this and other kev

resources to a minimum. Highlights Sherman Robinson questions especiallv relevant to devel-appropriate policies on current ex- Staff Working Paper No. 443. 1981. 32 opment economists. It also examinespenditures, subsidies, user charges, pages (including references). the mechanisms bv which fiscal poli-public enterprise pricing, self-financing Stock No. WP 0443. 53. cies mav affect growth rates.of investment bv public enterprises. Staff Working Paper No. 605. 1983. 48Includes three annexes that examine pages.direct taxes, indirect taxes, and tax Prices subject to change without notice ISBN 0-8213-0215-9. Stock No. WP 0605.changes in Pakistan's 1983/84 budget. and may vary by country. $3.

NEW The Policy Experience of Private Bank Lending toTwelve Less Developed Developing Countries

Municipal Accounting for Countries, 1973-1978 Richard O'BrienDeveloping Countries Bela Balassa Staff Working Paper No. 482. 1981. 60David C. Jones Staff Working Paper No. 449. 1981. 36 pages (including appendix, bibliography).This manual is based on British prac- pages (inc,'uding appendix). Stock No. WP 0482. S3.tices and terminology of municipal ac- Stock No. WP 0449. P3.counting, modified to suit the needs of Private Capital Flows toother countries, especiallv those lack- The Political Structure of the Developing Countries anding a core of appropriately trained ac- New Protectionism Their Determinations:countants. Provides the basic princi- Doulas R. Nelson Historical Perspective, Recentples of municipal accounting tor those g * v acnwith little or no bookkeeping experi- Staff Working Paper No. 471. 1981. 57 Experience, and Futureence and proceeds through successive pages (including references). Prospectslevels of difficulty to some of the most Stock No. WP 0471. 53. Alex Flemingadvanced concepts currently in use, Staff Working Paper No. 484. 1981. 41including the pooling of loans. An im- pages.portant feature is the multitude ofpractical applications and examples of NEW Stock No. WP 0484. 53.forms and records. Private Direct ForeignA joint publication of the Chartered Price Distortions and Growth Investment in DevelopingInstitute of Public Finance and Ac- in Developing Countries Countriescountanc and the World Bank. Ramgopal Agarwala K. Billerbeck and Y. YasugiJune 1984. About 900 pages. Sixteen informative tables trace the Staff Working Paper No. 348. 1979, 101

ISBN 0-8213-0350-3. Stock No. BK 0350. distortion in Prices of foreign exchange pages (including 2 annexes).S30. and other factors affecting the growth Stock No. WP 0348. 55.

of developing countries. Based on sta-The Nature of Credit Markets tistics frorn thirtv-one developingin Developing Countries: A countnes. NEWFramework for Policy Analvsis Staff Working Paper No. 575. 1983. 78Arvind Virmani pages. Savings Mobilization throughStaff Working Paper No. 524. 1982. 204 ISBN 0-8213-0242-6. Stock No. WP 0575. Social Securitv: The Case ofpages. 53. Chile, 1916-1977ISBN 0-8213-0019-9. Stock No WP 0524. Christine Wallich

S5. Pricing "Policy for Development Describes the savings mobilization po-The Newly Industrializing Manage:ment tential in Chile and in five Asian pro-Developing Countries after the Gerald MI. Meier grams. Some sort of social securityOil Crisis Presupposing no formal training in program functions in almost all devel-economics, it explains the essential oping countries. Programs are oftenBela Balassa elements of a price svstem, the func- costly, whether measured in relationStaff Working Paper No. 437. 1980. 57 dons of prices, the various poiicies to GNP, government expenditure,pages (including appendix). that a government might pursue in government revenue, or the wage bill.Stock No. WP 0437. S3. cases of market failure, and the princi- This paper compares the successful

ples of public pricing of goods and systems.Notes on the Analysis of services provided by government en- Staff Working Paper No. 553. 1983. 109Capital Flows to Developing terprises. ;It also provides the would-be pages.Nations and the "Recycling" practitioner with an appreciation of the ISBN 0-8213-0123-3. Stock No. WP 0553.underlying logical structure of cost-Problem benefit project appraisal. To give sub-Ralph C. Bryant stance to the applied and policv di Short-Run Macro-EconomicStaff Working Paper No. 476. 1981. 67 mensions, manv of the readings are A P ipages. drawn from the experience of develop- Adjustment Polices m SouthStock No. WP 0476. S3. ment praclitioners and relate to such Korea: A Quantitative Analysis

important sectors as agriculture, in- Sweder van WijnbergenNotes on the Mechanics of dustrv, power, urban services, foreign Staff Working Paper No. 510. 1981. 182Growth and Debt trade, and emplovment. The principles pages (including 3 appendixes).Benjamin B. King outlined are therefore relevant to a ISBN 0-8213-0000-8. Stock No. WP 0510.A Practical model to explore the ay host of development problems.

in which cpai- The Johns Hopkins University Press. 1983.in which capital inflow from abroad af- 2772 pages (including bibliography and in-fects economic growth. dex).The Johns Hopkins University Press, 1968. LC 82-716. ISBN 0-8018-2803-1, Stock69 pages (including 4 annexes). No. TH 2803, 535 hardcover; ISBN 0-LC 68-8701. ISBN 0-8018-0338-1, Stock 8018-2804-X, Stock No. JH 2804, 512.95 Prices subject to change without noticeNo. IH 0338. 55 paverback. paperback. and may vary by country.

State Finances in IndiaA three-volume set of papers that ex-plores a range of issues relating to thenature of intergovernmental fiscal rela- Th p suc f Wtions in India. The pnmary source for World DebtTablesVol. 1: Revenue Sharing in India medium- and long-term E , ,' c .Christine WallichViol. rI: India-Studies in State Fi- extemal debt of mnanynalnces developing countries. =Christine WallichVol. III: The Measurement of Tax Ef- Suhas Ketkar, Asia-Pacificfcrt of State Governments, 1973-1976 Economist and Vice President,Raja J. Chelliah and Narain Sinha Marine Midland Bank, N.A.Staff Working Paper No. 523. 1982. vol.1, 85 pages, vol. 1I, 186 pages, vol. 11i, 85pages. ScOften the only reliableISB1N 0-8213-0013-X. vol. I, Stock No..ir WVP 1523, $3, vol. II, Stock No. WP source of information for2523, $5, vol. Ili, Stock no. WP 3523, S3. countries for which data

is hard to come by... Used quantitatively formacroeconomnic detail as well as qualitatively in

Structural Adjustment Policies reports discussing the debt picture. I find thein Developing Economies projected servicing payments a strong feature.09Bela BalassaBelaf WorkingsPaper No. 464. 1981. 36 Jonathan Kayes, InternationalStaff Working Paper No. 464. 1982. 36 Economist, RepublicPages. National Bank of New YorkStock No. WP 0464. 53.

Structural Aspects of Turkish World Debt Tables, 1983-84 EditionInflation: 1950-1979 The World Bank's invaluable reference Also available for the first timeM. Ataman Aksov guide to the external debt of develop- SStaff Working Paper No. 540. 1982. 118 ing countries. Essential planning tool ummary Reportpages. for economists, bankers, countrv risk Debt and the DevelopingISBN 0-8213-0098-9. Stock No. WP 0540. analysts, financial consultants and all World Current Trends55. thos~e interested in the global system Wol:CretTnd

of trade and pavments. Provides data and Prospectson the external debt of 103 developing Includes an overview and summary ta-

Thailand: An Analysis of countries augmented bv information, bles from the 1983-84 edition.Structural and Non-Structural where available, on major economic 1984. 64 pages.Adjustments aggregates plus indicators used to ana-Ame Drud, Wafik Grais, and lyze debt and creditworthiness. Shows Stock No. BK 0319, $6.50.IDusan Vujovic statistical tables by country, including Companion computerized datafigures for extemnal public debt out-Staff Working Paper No. 513. 1982. 93 standing, commitments, disburse- basepages (including appendix). ments, service payments, and net bor- Includes all debt information given in.'SBN 0-8213-0023-7. Stock No. WP 0513. rowings. Reports on private the unabridged volume, and, where'$3. nonguaranteed debt of 19 countries. available, offers continuous historical

Gives aggregate position of 13 major series for 1970-82 and projected debt-borrowers-countries with disbursed service payments for 1983-92. Write for

Trends in Rural Savings and and outstanding medium- and long- sample purchase agreement.Private Capital Formation in term total debt in excess of $13.5 bil- (9-track, phase-encoded, recordingIndia lion at the end of 1982. Includes peri- densitv 1600 bpi)Raj Krishna and G.S. odic supplements as fresh data are re- Stock No. IB 0500, $5,000 (service bur-Raychaudhuri eaus for reselling to their clients); StockWorld Bank Staff Working Paper No. 382. 1984. 328 pages. No. IB 0667, $2,000 (banks and commer-1980. 43 pages (including 2 tables, 3 ap- Stock No. BK 0315 $75 (annual subscrip- cial corporations); Stock No. IB 0666, $500pendixes, references). tion) (universities and libraries).

Stock No. WP 0382. $3.

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