Transmission channel of monetary policy in Bangladesh

Mirza Azizul Islam | Published: July 09, 2019 20:49:17 | Updated: July 13, 2019 21:06:53

A central bank is the term often used to describe the authority responsible for policies that affect a country's supply of money and credit. It has become a symbol of a country's sovereignty in the arena of money and finance.

The central bank, in one form or another, has a long history. It dates back at least to the seventeenth century (1668) when the Swedish Riksbank, the first institution recognised as a central bank, was established. It was charged with the responsibility of lending funds to the government and acting as a clearing house for commerce. A few decades later, the most famous central bank of the era, the Bank of England was founded in 1694 to purchase government debt. The central bank of France, Banque De France, was established in 1800 to stabilise the currency after the hyperinflation during the French Revolution. A severe financial crisis that hit the United States in 1907 led to the creation of the country's central bank, the Federal Reserve, in 1913. It was mandated to provide a common currency which would respond to the changing seasonal, cyclical and secular needs of the economy and to serve as a lender of the last resort.

OBJECTIVES AND FUNCTIONS: Based on diverse experiences, both positive and negative with respect to economic growth, inflation and financial sector stability as well as in response to change in intellectual perceptions, the central banks have been entrusted with multiple responsibilities.

These include:

* Conduct of monetary policy so as to control money supply and influence inflation and interest rates

* Development and supervision of financial market institutions and their prudential regulation

* Performing the role of a lender of last resort.

* Use of directed credit to cater to the financial needs of socially desirable sectors which do not benefit from the usual channels of transmission of monetary policy

* Implementing exchange rate policy

These functions find reflection in the Bangladesh Bank Order No. 127 of 1972. It is worth noting that these functions are not necessarily mutually complimentary. The performance of one function, in some cases, may undermine the implementation of another. The subsequent paragraphs deal with the challenges faced by the central banks, with some references to Bangladesh.

CONDUCT OF MONETARY POLICY: To set the stage for the analysis, two quotations from two outstanding Nobel-laureate economists are cited below. The first one is from Milton Friedman who is known to be a staunch monetarist. In an article published in 1955 he wrote:

"There seems little doubt that a large change in the money supply within a relatively short period will force a change in the same direction in income and prices…..But when the money changes are moderate the other factors come into their own….there are thus definite limits to the possibility of any fine control of the general level of prices by a fine adjustment of monetary change…"

The second quotation is from Paul Samuelson who wrote in a 1967 article:

"In the debate what should a central banker watch, should he watch the money stock or should he watch the interest rate structure….I think when the Good Lord gave us two eyes, He had a purpose in that. He didn't want us to watch just one thing, He wanted us to watch both of these things".

The messages that come out from these quotations are:

* It requires large changes in money supply within a short period to have an effect on income and price level. The effect of small changes in money supply is likely to be swamped by other factors.

* Monetary policy should exert control over both stock of money and interest rate. It is generally held that the transmission channel is from money supply to interest rate and then to flow of credit to and investment by the private sector. Higher money supply leads to lower interest and thereby promotes growth through investment.

It goes to the credit of the Bangladesh Bank that in its Monetary Policy Statements due recognition is usually given to both broad money and interest rates as intermediate targets with a view to ensuring sustainable growth and moderate inflation. This is consistent with Samuelson's prescription, but raises two questions:

* To what extent can Bangladesh Bank exercise control over broad money? (b) How does broad money affect interest rate?

CONTROL OVER MONEY SUPPLY: With regard to the first question, control over money supply, a large chunk of broad money comprising net foreign asset and credit to the public sector remains outside the control of Bangladesh Bank. Net foreign asset is determined by exports, remittances and inflow of foreign capital-none of these elements can be effectively controlled by Bangladesh Bank. Similarly, the central bank cannot exercise any control over government borrowing and little, if at all, borrowing by other public sector entities some of which receive government guarantee. The incapacity explained above constitutes a major challenge for monetary policy in Bangladesh.

Another challenge arises from the fact that the instruments available at the disposal of the central bank, namely variations in cash reserve/statutory liquidity requirements and operations in treasury bonds, cannot exert significant influence on the target variable, namely, money supply. The principal explanation is that the banks in Bangladesh, up until very recently, typically maintained large excess liquidity. In this situation, it would be a futile effort to expand money supply through reduction in cash reserve requirement/ statutory liquidity requirement or treasury bond operations because if demand conditions permitted, the banks would prefer to earn higher income by expanding credit anyway instead of maintaining excess liquidity. Similarly, reasonable increases in cash reserve requirement/statutory liquidity requirement or treasury bond operations would not be of much help in inducing banks to restrain credit since they can fall back upon excess liquidity.

THE NORMAL TRANSMISSION CHANNEL: DOES IT WORK IN BANGLADESH?: With regard to the second question, that is, effect on money supply on interest rate, the normal transmission channel of monetary policy is that an increase in money supply would cause a reduction in interest rate; this would lead to increase in investment and thereby higher aggregate demand and higher GDP. Along the way there may be some increase in inflation, depending on constraints on the supply side. Conversely, a reduction in money supply would cause an increase in interest rate, fall in investment and aggregate demand leading to lower inflation and possibly lower GDP. In the context of Bangladesh, policy stance favoring reduced money supply and thereby higher interest is out of question as acceleration of GDP growth remains the overriding development objective.

At any rate, the first link in the above mentioned chain of causation runs from money supply to interest rate. The experience in Bangladesh shows that this link does not work effectively. An examination of data shows that movements in interest rate (lending rate) were in the predicted direction in only few years. In most years, higher growth of broad money relative to the preceding year was accompanied by higher interest or a lower growth of money supply was accompanied by lower interest.

One reason for the breakdown of the link between money supply and interest rate most likely is that the financial system of Bangladesh does not operate under the principles of competition. The banks, particularly the private ones, collusively determine the lending rate with little regard for money supply conditions.

In the above scenario, it is no wonder that money supply has no discernible impact on inflation either. I have argued elsewhere that in an open, import-dependent economy like Bangladesh, domestic prices are largely determined by international prices. Hence, effectiveness of monetary policy in containing inflation is bound to limited.          

In the context of the role of interest rate, the analysis of relevant data suggests that a reduction in interest rate is likely to boost private sector credit and private sector investment. There is, therefore, a plausible case for adoption of policies to reduce interest on loans and advances.

Then the question is what actions can be taken to reduce interest. A few suggestions in this regard may be considered.

* There are too many banks in Bangladesh. It can be reasonably assumed that in any business if the volume is low the businessmen will try to charge higher price in order to reach their revenue targets. This seems to characterise the banking system of Bangladesh. The scenario is one of too many banks, small volume of business for each and higher interest charged on loans and advances. The concerned authorities should, therefore, consider how the number of banks can be reduced by implementing mandatory mergers.

* Though there are too many banks they do not operate competitively, as noted before. Some bankers privately admit that they fix a ceiling on rate of interest for deposits and a floor rate of interest for advances through their Associations. The central bank may, therefore, consider whether an upper limit should be fixed for loans and advances. This move is likely to be opposed by multilateral institutions such as the World Bank and the International Monetary Fund as this would tantamount to restoration of administered interest rate regime. But even the staunchest neoclassical economists would admit that when a market does not function competitively, there is a strong case for price fixation by government authorities, However, implementation of this policy would require strong monitoring to ensure that the ceiling is not subverted by adopting unfair means such as charging higher processing fee or bribes to process loan applications.

* Efforts should be strengthened to recover non-performing loans and deal with the underlying causes. Bangladesh Bank should take the initiative to bring about legal reforms needed to penalise the defaulters quickly and visibly.

In addition, there are certain characteristic features of money and capital markets in many low-income developing countries, including Bangladesh, which tend to limit the efficacy of the conventional monetary policy in influencing interest rate. Among these are:

* Presence of a sizable non-monetised sector in the economy

* Narrow markets with few discountable commercial bills, corporate stocks and government securities,

* Unintegrated interest rate structure and a fragmented market in which interest rates prevalent in the informal markets or charged by NGOs are hardly sensitive to actions by monetary authority

However, these considerations by no means suggest complete abandonment of monetary policy. The facts that techniques of monetary policy are more flexible and quickly adaptable, increased monetisation takes place as an economy grows and problems of narrowness and fragmentation of money markets are alleviated over time providing rationale for adoption of monetary policy in a judicious manner to promote growth and control inflation along with other instruments.


The author is a former Adviser to the Caretaker Government, Ministries of Finance and Planning and presently a visiting Professor in BRAC University. maislam@bracu.ac.bd [This write-up is based on the Second AKN Ahmed Memorial Lecture sponsored by Bangladesh Institute of Bank Management.] 

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