Monetary policy and the price of appeasement

Coming out of a meeting on the April Fool's Day the Finance Minister (FM) announced a reduction in the cash reserve ratio (CRR) from 6.5 to 5.5 per cent. Shortly thereafter Bangladesh Bank (BB) reduced the REPO rate by 75 basis points to 6.0 per cent. These were unmistakably indications of an easing of the monetary policy only two months after the January-June 2018 Monetary Policy Statement (MPS) had charted a relatively conservative course for the monetary sector. FM had earlier promised bankers that the public institutions would be instructed to put half of their deposits with private banks notwithstanding the fact that it would jeopardise the safety of their deposits.

A chorus of protests and criticisms rang out after these changes were announced. Virtually all economists, who spoke to the media, expressed strong reservations against these arbitrary changes. There are good reasons for their sharp reaction. The decision to make these important policy changes was arrived at in an extraordinary manner and announced by the FM who had no business meddling with monetary policy. The BB governor was reportedly called in by the FM to attend a meeting at a local hotel with the directors of private banks some of whom are widely known to be a rather unsavoury lot. They have been aggressively lobbying the government for an easing of the monetary policy and other concessions claiming a liquidity shortage. A shocked former BB deputy governor said that it was most unethical to throw the governor among a pack of bank owners in such a meeting. It was never done previously, not even during the Pakistan days. A bemused former governor commented that "this certainly wasn't proper in any way to cut important tools of the economy like CRR and repo interest rate at a meeting in a hotel."  Obviously both these eminent persons interpreted the event as a crude tactic to force the governor to reverse policy on the run.

To make matters more intriguing these bankers were then invited with their spouses to a party by the Prime Minister. Immediately before this meeting, BB had announced a reduction in the REPO rate. The star of the bank owners must have been shining brightly upon them.

The one per cent reduction in the CRR translates into almost Tk100 billion in additional funds for the commercial banks. Since this amount will be in the form of reserve money, the banks could expand their credit operation by more than Tk500 billion and keep credit at the higher level as long as CRR remains at 5.5 per cent. This alone could increase money supply by more than 5.0 per cent making a mockery of the recently announced MPS. Furthermore, when BB lends money to these banks through its open market operations, they will make a saving of Tk7500 for every million taka borrowed. This may encourage them to borrow more and thereby further raise the money supply. With an additional 25 per cent of public body deposits channelled to them (at the expense of the state-owned banks) they will have additional funds to lend out from. All these amount to a very hefty pre-budget free gift to the richest people of the country - a courtesy of the FM and the governor. Only a few months ago the government was struggling to find even a small fraction of this amount to fund the relief operations for the millions of flood-affected people!

The ordinary public will ultimately bear the risks of the deposits in these misgoverned banks. Any subsidy provided by the government, such as recapitalisation, will also be paid from the public exchequer. The implied encouragement given by the aforementioned official measures will almost certainly increase moral hazards in the banking sector that could lead to worse crisis in the future.

What the bank owners have gained from this sordid saga is clear enough; but what was the stake of the government that it so quickly submitted to their demand? Was it just a ploy to secure their support for the next election or did it have additional objectives? Hopefully, informed people will look for an answer to this question.

Over many years, and several governors, BB had made a sustained effort to contain inflationary expectations and enhance its credibility by making advance commitments about future growth of important monetary variables. These commitments (or targets) were contained in the MPS announced biannually. Although BB was not always successful in not breaching the targets, it seldom changed the targets during the tenure of the Statement, and its intentions were starting to appear credible. But in one fell swoop the governor, presumably goaded by FM, seemed to have undone much of the good work done over all these years. The relevance of MPS would be in question and BB might see an erosion of its credibility in the coming years. Its calming influence on inflationary expectations will also dwindle. It could take years to restore confidence. Meanwhile, the ability of BB to control inflation will become that much more difficult.

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