Economic expansion with monetary contraction

The monetary policy statement (MPS) for the second half of FY2023-24 was recently unveiled by the governor of Bangladesh Bank (BB). With a disillusioned nation suffering from severe economic hardships, this was certainly a difficult task which was made even more difficult by the International Monetary Fund (IMF) breathing down his neck to ensure compliance with its conditionality. It was important to appear to be diligently working for compliance since some conditions for the continuation of the IMF loans were not met before the last meeting.

The standard monetary policy response to a situation such as the one Bangladesh is in is monetary contraction, which involves raising the policy interest rate. This is expected to reduce the inflationary bubbles and provide some support to the external value of the taka and the balance of payments. Since the inflation rate, the exchange rate, international reserves and bank management are of special interest to IMF in deciding on the release of funds, the voluminous MPS devoted much space to these issues.

In more mature economies some rules are used in deciding on the broad parameters of the monetary policy. However, a structural problem of the monetary policy designed by BB is that there is apparently no rule guiding the policy. Earlier, a quantity equation framework was used to guide the periodic changes in money, but it was not made public (see Bangladesh Development Studies, Vol. XXVII, December 2003 for details). The recent switch to interest rate as the policy tool has made this framework less useful. In the absence of a known rule that disciplines the periodic changes in the policy rate the declared changes would appear to be ad hoc and subject to pressures from internal and external interest groups. 

The policy rate was raised to 8 per cent and the ceiling for commercial bank advance (loan) rate was fixed at the Six months Moving Average Rate of Treasury bill (SMART) plus 3.75 per cent. The SMART rate for December was 8.14 per cent. Accordingly the ceiling for the loan rate during this period would be 11.89 per cent which is obviously much above the previous noi-choi rate. The increase in the interest rate is projected to reduce the monetary growth to 9.7 per cent.

BB was under some pressure for a long time from the local economics and international finance specialists to let the official external value of taka move closer to the free market rate, which it resisted stubbornly for years. However, the dark shadow of an imminent economic and payment crisis which brought in IMF with a US$ 4.7 billion honey pot forced its hand. It devalued the taka incrementally by 29 per cent between March 2022 and November 2023.

To protect the stock of international reserves, BB, in collaboration with other government agencies, cracked down on import through LC value verification to prevent misinvoicing and matching LC with payment records to ensure repatriation of export earnings. LC margins were raised to increase the cost of import. These measures did succeed in reducing import, and the current account deficit declined from a massive $18.7 billion in 2021-22 to only $3.3 billion the next year due mostly to a reduction in import.  The current account has turned into a surplus for the period July-December 2023.

These steps taken by BB will be regarded as contractionary by many. Just to make sure no one has any doubt about the direction of the monetary policy, the word 'contractionary' is mentioned umpteen times in the MPS. But how much contractionary is it really?

In standard economic parlance a contractionary or tight policy is one that contracts aggregate demand so as to create a slack which is expected to reduce any inflationary pressure. A rather novel aspect of the MPS is that it expects its contractionary monetary measures to accelerate economic expansion from 6.03  per cent last year to 6.5 per cent this year, and the inflation rate is expected to fall to 7.5 per cent from the current 9.4 per cent. The numbers are made consistent perhaps by a mechanical application of the quantity equation. 

The principal monetary tool to calm the economy is the interest rate. The loan rate was arbitrarily set at 9 per cent a few years ago. The inflation rate up to 2021-22 was mostly below 6 per cent, but rose rapidly since then. Hence, the real interest rate till 2021-22 was mostly above 3 per cent. The newly introduced SMART-plus interest rate is about 11.9 per cent and the current inflation rate is about 9.5 per cent, which yield a real interest rate of 2.4 per cent. Since aggregate demand responds inversely to the real interest rate, the real domestic expenditure should actually rise in this situation. A higher inflation rate might be necessary to achieve the output goal.

Perhaps the most important consideration in the current economic hardship is the state of the external balance, which may be described in terms of the foreign exchange rate, the stock of international reserves and the current account. BB has almost always kept the domestic currency overvalued despite repeated calls from economists to align it with the market. The overvaluation became very large in the wake of a massive current account deficit in 2021-22, and BB was forced to a cumulative annual devaluation of more than 15 per cent, and a farther 12 per cent the next year. But a large gap of over 10 per cent between the market rate and the official rate still exists. Despite internal and external pressures BB has stubbornly persisted with its incremental devaluation approach or crawling peg system that does not remove the market disequilibrium.

The external value of the taka deteriorates because of the deterioration in the overall balance of payments which is caused by the net current, capital and financial account deficits. Since capital account is very small and financial account of a small country cannot deteriorate indefinitely, the health of the longer term balance of payments is determined to a large extent by the current account. The current account of Bangladesh was in surplus from 2001-02 to 2015-16 (except one year). During this period the international reserves increased from a paltry $1.7 billion to $30.4 billion.

Even though the current account moved into large deficits thereafter, the stock of reserves continued to increase because of large inflows of borrowed money till 2020-21, when it stood at an all-time high of $46.4 billion. The massive current account deficit of $18.7 billion in 2021-22 broke the back of the reserves which fell by $4.6 billion. The next year it fell by another $10.6 billion. This year it has already fallen by $4.1 billion (July-December) despite the fact that the current account had a surplus of $1.9 billion. Alarmingly, the gross reserves estimated by IMF's BPM6 method have fallen below the import spending of the first four months of 2023-24. With external loans drying up and past loan repayment liabilities mounting, Bangladesh is on the cusp of a payment crisis.

MPS identified the rising inflation and exchange rates, the depletion of the stock of international reserves and the rising external debt as the major challenges facing the economy. However, these are actually the symptoms of a more fundamental problem that MPS did not discuss.

These challenges arise when a nation persistently spends more than what it earns. This was starkly demonstrated by the Sri Lankan crisis.  A convenient measure of the excess spending over income is the current account deficit. This deficit has to be offset by either inflows of funds from overseas in the form of grants, loans and investment, or a depletion of the international reserves. Bangladesh has resorted to both to cover the current account deficits. Consequently the external debt of the nation shot up and the stock of reserves plummeted.

The current account deficit is also an indication of the excess demand for foreign exchange. Unless this can be fully offset by fresh external loans and reserve depletion, there will be pressure on the exchange value of taka to depreciate. The depletion of reserves may instigate an expectation of depreciation, which could create further pressure on the taka. The money borrowed to finance the current account deficit will eventually have to be repaid, and the greater the amount borrowed the greater will be the burden and difficulties of debt servicing liabilities.

The excess expenditure indicated by the current account deficit could translate into excess aggregate demand that could push up the market prices. This is accentuated by the depreciation that pushes up import prices of all imported consumer goods. Consequently the consumer price index tends to spiral upward.

The foregoing strongly suggests that the current account deficit is a major cause of what BB has identified as the principal challenges facing the nation. The current account deficit is the sum of the government budget deficit and the private sector deficit. Since the private sector is in surplus, the current account deficit is owing to the budget deficit. It increased from a modest 2.8 per cent of GDP in 2008-09 to 5.1 in 2022-23. It is projected to rise to 5.2 per cent in 2023-24.

The appearance of the large current account deficits and budget deficits in recent years is no coincidence. The appropriate way to bring the current account into balance is to rein in excessive government spending. But the government has instead chosen to extract more net saving from the private sector by imposing more restrictions such as higher import costs, various taxes, fees and charges, and negative deposit interest rates leading to a greater deprivation of the ordinary people.

These measures have consequences which have already manifested themselves. The chief mechanisms of deprivation of the ordinary people are increasing inflation and unemployment which have not only reduced the real income of a large section of the people but also pushed many of them into abject poverty. The greater trade restrictions and higher interest rates have had a negative impact on the import of production related goods which could constrict trend national output. The outlook for the economy is grim which warrants corrective remedial policies and action.

The author is a Professor of Economics, Independent University, Bangladesh. [email protected]