Hats off to Bangladesh Bank(BB) for maintaining macro stability even as economic growth edges higher. There's no doubt that monetary policy has come a long way. The era of easy money that stoked double-digit inflation, burnt up foreign reserves and bloated stock prices some years ago was rightfully dislodged by a more cautious approach. Tighter monetary policy, salted with lower commodity prices and favorable domestic harvests, cooked up a healthier concoction of lower inflation and interest rates. So steady accumulation of US dollar reserves insured the economy from external shocks and swelled the Export Development Fund, which might even be joined by a historic Sovereign Wealth Fund.
Yet, there are fault lines. Much has been said about the banking sector. But sure enough, weak balance sheets still remain weak. Now we have to wait and see if the latest idea floating around - a banking commission - makes any headway with a problem that appears to have become immortal!
In the meantime, the central bank's list of conundrums appears to be growing longer. Consider the state of monetary affairs. Dollars are gushing in through exports, foreign aid, foreign direct investment, private borrowings and, albeit with less vigor, remittances. The only major source of outflow is through imports, which remain lukewarm without the infrastructure impetus. Resident corporations cannot invest overseas and make productive use of their excess savings. So even with the recent decline in remittances, Bangladesh Bank (BB) will be left with a bulging surplus in its balance of payments (BOP).
So the BB will devour excess dollars to hold the exchange rate steady. It will then have to sell bonds to soak up local currency that it injected into the system, a practice known as "sterilization" in central banking parlance. Sounds like a foolproof plan, at least in theory, but financial markets have a way of defying textbook logic. After all, banks may not want to absorb swathes of low-yield bonds. So what becomes apparent is a conflict between the need to contain money growth and the need to secure exchange rate stability. Add to that the cost of paying for domestic bonds with reserves that hardly earn any interest, and the free lunch of a BOP surplus no longer appears "free"!
Meanwhile, the slow decay in trade competitiveness is well under way. With the Taka tightly managed relative to the dollar, there will be no stopping the Real Effective Exchange Rate (REER). Not that it should be wildly surprising. The dollar is appreciating against other major currencies fueled by hopes of greater fiscal stimulus and faster monetary tightening in America, taking the Taka along for the ride. While 5+ per cent domestic inflation, though lower than before, adds fuel to the fire of real effective appreciation in an era where many advanced economies are barely outrunning deflation. One could argue that infrastructure investment, and consequent import boom, might weaken the currency but considering external conditions, further REER appreciation looks the most immediate outcome.
If REER stabilisation is a priority, a basket, or trade-weighted average, of major currencies as benchmark for foreign exchange intervention could be considered. The added flexibility will absorb shocks from divergent monetary policies that are taking shape in developed countries (tightening in America and easing in Europe/Japan). It will also shore up remittance inflows from countries like the United Kingdom the currency of which depreciated significantly against Taka recently.
To be sure, inflation target must be reduced as well, preferably to 4.5-5.0 percent with a medium-term vision of below 4.0 per cent. Worries over choking off growth by being more careful with money supply are overdone. The seductive fragrance of higher money growth and strong real economic activity will not go together for long anyway. All it will do is feed into inflation, disproportionately benefiting the asset-rich. Considering 7.2 per cent real growth target, broad money does not really need to rise by more than 13.0-13.5 per cent. Take India and China for instance. Both averaged 7+ per cent growth with broad money expanding by 12.02 and 12.64 per cent respectively during 2013-2015.
In the meantime, regulators face yet another conundrum: capital leaking out of the country through over-invoicing of imports. Though capital controls (official restrictions on capital flows) remain tightly screwed in place, the expansion of trade and consequent rise in manipulation of trade invoices provide an easy conduit for money to escape. And despite its best intentions, restricting access to foreign exchange ends up pushing people to pay a premium in the informal currency market (Hundi). By extension, remittance inflows get diverted by more attractive rates there. At the end of the day, there will always be some demand for capital transfer and perhaps even more so as income rises. Capital controls are easy but dangerous substitutes for what's really needed: supply-side reforms in institutions, infrastructure, business-regulations, governance and national security that build more confidence in the economy.
On the other hand, institutional savings that are cooped up in low-yield bank deposits remain starved of more profitable avenues like direct investment abroad. So a more liberal foreign exchange regime needs to find its way into the agenda. Greater financial openness will also reduce the need for the BB to make substantial and costly intervention to keep the exchange rate stable.
To be sure, detractors will fret about instability and balance of payment difficulties. Such risks will remain contained if capital controls are relaxed gradually (following a medium-term plan) and political conditions remain, by and large, stable. In fact, some of the foundations that merit a more liberal foreign exchange regime are already in place: a large tank of reserves, low external debt with very little short-term obligations, prudent macroeconomic policies and stable growth rate.
In an ideal world, there are two more preconditions. First, bring more flexibility into the exchange rate. A REER-based approach mentioned above would be a small step in that direction. Second, shift gears from money-stock management to interest-rate targeting. Managing inflation with broad money target becomes futile once capital flows a bit more liberally across borders. And herein lies the need for a vibrant local currency bond market, a prerequisite for targeting interest rates and enhancing overall monetary policy transmission. Sadly, a deep bond market characterised by long-term debt instruments remains far from seeing the light of the day.
And so some bold steps, departing from established conventions are necessary. Things might seem harmless right now, but eventually the "double-edged swords" could leave scars that will prove difficult to heal.
The writer is a
macroeconomic analyst
sharjilmuktafi.haque@gmail.com
Monetary policy conundrums
Sharjil M. Haque | Published: January 30, 2017 00:00:00 | Updated: February 01, 2018 00:00:00
0
Share if you like