Rise of inflation and formation of interest rate on loans in industrial sector: A VECM approach to assess the impact on total industrial production from evidence of Bangladesh

Industrial development is the prerequisite for sustainable economic growth. This study has examined the impact of the interest rate imposed on advances in the small and medium enterprise (SME) industrial sector, the large industrial (LI) sector, and inflation on the total industrial development of Bangladesh. For this purpose, we have used monthly data from January 2015 to June 2021. The weighted average interest rate of advances (WAIRA) is used as a substitute for the interest rate imposed on advances that were sourced from Bangladesh Bank (BB). We have applied Johansen co integration and the VECM technique to investigate long- and short run relationships, and the results have revealed the existence of both. We have observed that, in the short run, only WAIRA on SME industries has a significant negative impact on total industrial development. In the long run, inflation and WAIRA on SME and large industry have a significant impact on industrial development. The long run relationships have indicated that, inflation and WAIRA in the SME sector have a negative influence on total industrial development, but WAIRA in the large industry (LI) sector has a positive influence. Finally, considering the entire situation of the economy of Bangladesh, especially the growing industrial sector, these findings are highly momentous for policy implications and achieving sustainable development in this sector.


Introduction
Bangladesh has gone through significant structural changes in its economy during the last 50 years.When it was founded in 1971, Bangladesh was described as an agrarian-based country.At that time, agriculture's contribution to the total economy was more than 50 %.According to World Bank statistics, the contribution of the agricultural sector to the economy of Bangladesh was 51.03 %, whereas the contribution of the industrial sector was only 7.68 %.During the last five decades, both the agricultural and industrial sectors have gone through indicatory transformations, but if we look at the present situation, rapid growth in the industrial sector has been observed.The establishment of industrial parks, an increase in foreign direct investment, and rapid growth in small and medium also discourage high-risk investments [12].Consequently, an increase in interest rates affects both investment and consumer spending.As an emerging country, many researchers have already focused their research on the challenges facing the SME industry in Bangladesh and suggested valuable policies.The effect of increasing SME loan rates has a significant impact on economic growth as a whole.SME financing is vital not only for launching a SME business, but also for fostering its growth [13].This study also asserts that despite their great potentials, SMEs cannot enter the manufacturing business due to finance issues.And one of the major impediments to a growing SME industry is getting funding at high interest rates.Access to capital is the greatest barrier to the development of small and medium-sized enterprises in both developing and industrialized nations ( [14][15][16]).The growth of industrial production in emerging developing nations such as Bangladesh relies heavily on the SME sector.According to Qamruzzaman and Jianguo [17] SME financing innovation is positively related to both long-run and short-run growth in Bangladesh.Ali et al. [18] had pointed out a gap between the demand and supply of SME lending.They found that in addition to the interest on institutional credit, SMEs have to endure some other expenses besides the interest on institutional credit.
Inflation is an important macroeconomic variable.The inflation rate is a significant factor in the development and expansion of the industrial sector of a country.The rate of inflation is a crucial metric that has significant implications for the economy.High rates of inflation, in particular, often deter investment and result in lower long-term growth.A very low inflation rate also indicates the availability of fewer goods and services than required and shows slow economic growth.Inflation can affect industrial production by raising input costs and decreasing output value.Stable and low inflation boosts industrial production and economic growth [11].The monetary policy, where interest rates and other instruments are used by the central authorities to influence the economy, can affect the interest rate, inflation, and industrial production [19].
Several empirical studies reveal the effects of inflation in different ways.GDP buffers financial development from inflation [20].According to Ehigiamusoe et al. [21], the inflation rate promotes economic growth.Despite the fact that lower inflation has accelerated economic growth [22].Again, the behavior of inflation in relation to economic or financial growth may differ depending on long-term or short-term considerations.Svigir and Milos [23] discovered a long-run negative association between inflation and financial growth that coexists with a short-run positive relationship.Kim and Lin [24] have investigated the factors that influence inflation and economic growth in Pakistan.According to their findings, inflation has a detrimental impact on economic growth in the short run.However, scholars emphasize financial development or economic growth, although industrial development might be regarded an essential component in determining the state of the economy.Industrial growth optimizes price reduction, job creation, national income, technology, transportation, agriculture, production, trade, and all other economic activities.In addition, it enhances employment possibilities, training, educational growth, labor productivity, regional development, resource allocation, and usage [25].However, there is no explicit econometric study for Bangladesh that can infer the impact of interest rates and inflation on industrial growth as a whole.This gap in the literature motivated us to conduct the present investigation.
There are few studies that have focused on industrial development while taking into account various macroeconomic control variables.Maroof et al. [26] defined the pro-poor group in their study and established the association with inflation.The output of their study has suggested that a low inflation rate has a significant association with pro-poor growth, whereas the term "pro-poor" is defined as growth that benefits the poor proportionately more than the non-poor.Son and Kakwani [27], utilizing an ARDL-bounding testing strategy to analyze the short-run and long-run causal link between inflation, investment, and growth in Tanzania, discovered a unidirectional causal flow from inflation to development.Odhiambo [28] conducted a study to determine the effect of monetary inflation on the investment decisions of Jordanian industrial firms.Azra et al. [25] examined the industrial growth of south Asian nations, including Bangladesh.They used Panel ARDL to explore the long-term relationship.There was evidence for Bangladesh that, in the short term, inflation has a strong positive effect on industrial production, as measured by industrial value added as a proxy variable.According to the findings of the long-term estimations, inflation has a positive and substantial impact on the industrial growth of South Asian economies [28].Shimu and Islam [29] have evaluated the impact of inflation on the expansion of Bangladesh's RMG industry.As a result, the impact of our concerned macroeconomic variables on Bangladesh's industrial development is superficial; thus, this study aims to fill this knowledge gap.This study examines how inflation and interest rates (imposed on SME and LI) affect overall industrial production in Bangladesh to explain industrial growth.Therefore, the following questions are addressed in this research: 1. How do imposed interest rates in SME and LI affect industrial development in the short run? 2. How does inflation affect industrial development in the short run? 3. Do inflation and interest rates affect industrial development in the long run? 4. If there is a long-run association, how do these dynamic relationships can be explained?
The rest of this study is divided into five sections to answer these stated questions.Section 2 describes the data and methodology, Section 3 concentrates on econometric model specification, Section 4 explains empirical results and findings and focuses on robustness checking, Section 5 concludes the result and suggests some policies, and Part 6 shows the limitations of this study.

Data and methodology
Monthly data from January 2015 to June 2021 were extracted for this study.We have used the following variables: the industrial production index as a proxy variable for total industrial development (TIPI), the interest rate imposed on advances in the small and medium enterprise industry sector (SME), the interest rate imposed on the large industry sector (LI), and inflation.The weighted average interest rate on advances (WAIRA) is used as a substitute for the interest rate imposed on advances.All variables were collected from the Bangladesh Bank and transformed into natural logarithms.

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Since the aim of this research is to analyze the nexus between inflation, levying interest rates on industrial sectors, and industrial development, the following econometric model is specified: All variables are considered in their logarithmic form to remove stochastic error and determine the elasticity of study variables.Therefore, the following equation ( 2) is the natural logarithm of equation ( 1): Where, subscript t denotes the year, ε t indicates the error term, LnTIPI is the natural logarithm of total industrial production index, LnLIWAIRA and LnSMEWAIRA are natural logarithm of weighted average interest rate of advances on large industry sector and small and medium enterprise industry sector respectively, LnINF is the natural logarithm of inflation rate.
This empirical study requires some pre-test to estimate equation ( 2).As a result, we checked the econometric validation of our proposed model by using the Breusch -Pagan [29] test to check the heteroscedasticity and the Shaprio-Wilk test [30] to check the normality respectively.

Econometric model specification
To specify the econometric model, in this research, the unit root test is led by adopting the Augmented Dickey Fuller (ADF) test [31] to identify the non-stationarity features of the study variables.Unit root checking is one of the vital parts of econometric analysis, as non-stationary time series lead to spurious regression.The null hypothesis of an ADF test is that the data contain a unit root.When the series becomes stationary, it must determine whether or not the variables are integrated, as well as the integrated level.This study determines the best lag by using various lag selection criteria.
The co-integration analysis has been conducted, which helps trace the long-run relationship among variables.This study used the Johansen co-integration test [32] to ascertain the long-run relationship between variables.According to the Johansen co-integration test, the Vector Error Correction Model (VECM) is applicable if the co-integration test can establish the presence of long run dynamics between variables.VECM is used to assess the long-term and short-term associations between variables.The details of the model specification are given below.

Augmented Dickey Fuller (ADF) test
To evaluate if the time series data has a unit root, an augmented Dickey-Fuller (ADF) test was utilized.Equation (3) represents the theoretical model [31], where, Δ is a first difference operator, Y t denotes any time series variables (interest rate imposed on advances in the SMEs, the interest rate imposed on the large industry sector (LI), inflation), β 0 is a constant, β 1 is a coefficient on a time trend, p isthe lag order of the autoregressive process, and ε t denotes the random error term.The tested hypotheses of the above model (Equation (3)) are, which follows the t-distribution and the decision of this test is determined in current study by considering 5 % level of significance.

Johansen's co-integration test
By creating spurious regression, trended time series can cause major problems in empirical econometric studies.Johansen's cointegration test has been used to determine the presence of co-integrating vectors.The following model, described by equation ( 4), is used to carry out this test [32], where, Y t is an (n x 1)-dimension vector of variables ∼ I(1), and ϑ t is an (n x 1)-dimension vector of innovations.
A. Chowdhury et al. where, If Π has the rank r < n, then there will be (n x r) matrices γ and δ, both having rank r in a way that Π = γδ ′ , whereas δ ′ Y t is stationary.Two likelihood ratio tests (LRTs) utilized to test the significance of the reduced rank of Π are defined as below.

Trace test
The likelihood ratio test about the trace matrix has considered the test statistic, which is defined in the following equation ( 8) [32], where, T isthe sample size and λi denotes estimated eigen values ranked from largest to smallest.The hypothesis of this test can be defined as, H 0 : There are at most r co − intregating equations .
H 1 : there are n co − intregating equations

Maximum eigen value test
The likelihood ration test about the Eigen value matrix has considered the following test statistic which is defined by following equation ( 9) [32].
where, N and Ĵi are defined the same as for the trace test.

VECM model
If either Eigen value test or trace test results co-integrating equation then there exists a long-run association.Let, two I(1) series x and y are co-integrated, then there are unique α 0 and α 1 and presented by the following equation (10), Here, equation ( 10) is I(0).If y is the dependent variable and x is an exogenous regressor in the single-equation model of cointegration, the error-correction model is stated in equations ( 11) and (12), But in the specification of a vector auto regressive model, all variables are regarded identically, therefore, for two variables with lag 1 and one co-integrated equation system is presented in equations ( 13) and ( 14) as, The error-correction coefficients, λ measure each variable's response to the previous period's degree of divergence from long-run equilibrium, and we expected it will be − 2 < λ < 0 [33].
For our current study, considering VECM framework short run equations are expressed below: A. Chowdhury et al. ) From the above equations 15-18, Δ denotes the first difference and λ, γ, μ, π are the coefficients of the lagged predictor variables and ε t− 1 indicates the error term.For this research work we consider total industrial production as the dependent variable, so our concern is only equation (3).Furthermore, various diagnostic tests were conducted to check the reliability of the dynamic model.We applied Jarque-Bera test [34] to check the error normality, and LM test [35] to check the presence of autocorrelation.

Fully Modified Ordinary Least Squares method (FMOLS)
The present research utilizes the Fully Modified Ordinary Least Squares (FMOLS) method to assess the robustness of long-run parameters derived from the VECM model.The FMOLS method was developed by Phillips and Hansen [36].In order to estimate the long-run parameters, FMOLS utilizes a semi-parametric framework ( [37][38][39]).The FMOLS method provides consistent coefficients for small sample sizes, evaluates the reliability of the findings, and addresses the endogeneity problem, serial correlation factors, and long-run coefficients of heterogeneity ( [39,40]).To apply the FMOLS methods, all study variables should be integrated in order one, I (1) [41].

Empirical results and findings
The findings of our current study are basically divided into two portions.In the first portion, econometric validation tests are applied to confirm data validation, and then to quantify the dynamic effect of study variables, the rest of the analysis has been done under the Vector Error Correction Model (VECM) framework.In the second portion, we have performed model validation and robustness tests for our selected dynamic model.

Econometric validation & VECM framework findings
The results of the data validation tests are shown in Table 1 and the findings confirm that residuals are normally distributed along with constant variance.
To verify the stationary characteristics of our study variables, we have used the ADF test.Findings of the ADF test are summarized in Table 2.The null hypothesis of the ADF test is that there is a unit root in the data, whereas the alternative hypothesis describes the data as stationary.The result of the ADF test has suggested that the variables are integrated at order one, I(1), at the 5 % level of significance.These supports applying the Johansen co-integration test to confirm the long-run association among variables.Hence, Table 3 points out the optimal lag for our study, and the results suggest lag 2 for further analysis.
Table 4 exposes the maximum Eigen-value test statistic, which implies the presence of one co-integrating equation that reveals a long-run relationship among the study variables.Table 5 presents the output of the normalized long-run equation.The findings show that all our predictor variables have a significant impact on total industrial production in the long run.According to the output, a 1 % increase in interest rates imposed on the large industry sector (LI) will cause a 2.817 % rise in total industrial production.That implies that, in the long run, if the imposed interest rate on large industry is increased, the large industrial output may flourish by doing good business, which will have a significant positive impact on total industrial development.
Moreover, we noticed that small and medium industry has a negative and significant effect on total industrial production.Hence, the estimated long-run coefficients of − 2.899 indicate that a 1 % increase in interest rates imposed on small and medium industry leads to a 2.899 % decrease in total industrial production.Besides, the inflation rate has yielded a negative and significant dominance on total industrial production.Furthermore, from following output, 1 % increases in inflation responds to 1.547 % decrease in total industrial production.A positive industrial development also refers to positive financial or economic growth [25].From this point of view, the impact of inflation on industrial growth may line up with the result of Kim and Lin [23].Table 6 summarizes the output of short-run dynamics.Here, the error correction term is statistically significant at 5 %.The Note: ADF refers the Augmented Dicky-Fuller test, and **, refers significant at 5 % levels.Note:** indicates significance at 5 %.

Table 5
Results of normalized long-run equation.Note: ** refers significant at 5 % levels.
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estimated error correction term is − 0.6658 and implies that short-run dynamics converge to the equilibrium point at a speed of 66.58 %.Furthermore, the findings show that only the weighted average interest rate imposed on SMEs has a negative and significant relationship with total industrial production in the short run.Therefore, it may be concluded that an immediate increase in the interest rate in SME will decrease the total industrial production by 2.04 %, which is in line with the traditional expectation [17].

Diagnostic tests of proposed VEC model & robustness checking
Table 7 captures the outcomes of the diagnostic tests of our proposed VECM model.The residuals of our proposed model are free from serial correlation and normality problems.Moreover, we have applied the CUSUM test proposed by Brown et al. [42] to verify the stability of our estimated parameters, as illustrated in Fig. 1.In addition, if all roots have modulus smaller than one and remain within the unit circle, then the estimated VAR model is considered stable [43].Fig. 2 supports this statement for our current study.Hence, we can conclude that our proposed VECM model is statistically stable.
Table 8 presents the output of the estimated VECM and FMOLS models, and the scenario of the considered macroeconomic variables toward total industrial production is almost the same.

Conclusion
This study attempts to empirically investigate the responsiveness of industrial growth with respect to changes in interest rates on loans and the inflation rate.In addition, the evidence reveals that the interest rate on loans and the inflation rate have a considerable influence on the overall industrial growth of Bangladesh.VECM framework results in the short run imply that the interest rate imposed on SME loans has a negative and significant connection to total industrial production.A rapid increase in the interest rate on SME loans impedes the output of SMEs, which in turn results in a reduction in the SMEs' overall revenue.This is because SMEs must contend with limited production capacity while still generating revenue for their businesses and also endure some other expenses [18].But the result becomes inconclusive for large industries in the short run.
However, the answer to the long-run equation indicates that the interest rates that are imposed on loans made to both large industries (LI) and small and medium-sized enterprises (SMEs), in addition to the inflation rate, have a considerable impact on the overall level of industrial production in Bangladesh.The conclusion that can be drawn from this is that when the rate of inflation rises, the expansion of the industrial sector will slow down as a direct consequence of the rising cost of production.In the case of the interest rate on large-scale industries, in order for the industries to be able to deal with the increasing interest rate on loans, the industries will need to, over the course of time, expand their production output [12].An increase in the interest rate on loans given to small and medium-sized businesses (SME) has a major and detrimental effect on the expansion of industry in Bangladesh, even over the long term.An increasing rate of interest on SME loans is a burden because small and medium-sized enterprises (SME) industries already face a number of challenges, including limited production capacity, a limited workforce, limited access to better technology, and so on ( [13,15]).So, low interest rates are highly recommended for developing countries like Bangladesh [44].
In light of the cited literature and empirical findings, we are able to draw the following conclusions: 1.The accessibility of credit, especially to small and medium-sized enterprises (SME) and major businesses plays an essential role in propelling industrial production and economic progress in Bangladesh.2. Increasing the amount of credit available to small and medium-sized enterprises (SME) and major sectors at a reduced interest rate can result in increased investment, expansion, and overall output.3. High inflation can have a detrimental effect on industrial production by increasing the cost of producing items for businesses, lowering the purchasing power of consumers, and lowering the value of loans.As a result, it is essential to maintain the rate of inflation at a general level at which investment is encouraged while also ensuring that it does not undermine the broader economy and our recommendation is the central bank should try to maintain inflation and the interest rate at a low level in the short run which in line with [45].

Recommendations
The effect that loans to small and medium-sized businesses (SME loans), loans to large industries (large industry loans), and inflation have on industrial production is complex and multifaceted.For policymakers and economists who want to promote economic growth and stability, it is important to understand the interplay between these factors.Therefore, for the policymakers of Bangladesh, it is recommended that: 1.From a macroeconomic standpoint, monetary policy should be formulated in such a way that the transition effect of the money supply and interest rates does not hamper industrial growth by increasing inflation.2. The interest rate structure of loans should be segmented according to the purpose of the loan.That is, if credit is given to SMEs, then the interest rate should be formulated according to that firm's ability to repay the loan and still make revenue.On the other hand, for providing credit facilities to the large industrial sector, a stable interest rate structure should be maintained.

Limitations and future implications
This study is conducted using only the data of the formal banking sector in Bangladesh.But there are other organizations, such as non-bank financial institutions, co-operatives, and microcredit organizations, that provide credit facilities to SMEs and, in some cases, large industries.Due to the unavailability and incoherent structure of their data, those could not be included in this study.Therefore, if all the data from all credit-granting organizations could be included, it would give a much better picture of the overall situation in Bangladesh and help policymakers formulate more effective policies.Again, there is scope to calculate the optimum level of inflation rate for maximum industrial production in the context of Bangladesh.

Table 1
Diagnostic tests result.

Table 2
Unit Root test results.

Table 4
Johansen co-integration test summary.

Table 7
Diagnostic test results.

Table 8
Results of long-run parameters of VECM and FMOLS method.
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