US monetary policy & Bangladesh economy

During my February visit to Bangladesh, I had the privilege of joining a Federal Reserve's (FED) Monetary Policy discussion session organised by the Chief Economist's Unit of the Bangladesh Bank (BB). The session was attended by senior economists, moderated by Chief Economist Dr Habibur Rahman. My commitment to participate in the discussion session was initiated by Dr Sayera Younus, Director of BB's research  department. The session topics and questions were open to participants' interests encompassing all aspects of US monetary policy vis-à-vis the global economy.  

The next day, February 12, I had a brief meeting with the BB Governor Abdur Rouf Talukder. We had a focused discussion about the state of the macro economy of Bangladesh. Our discussion converged to a consensus observation that Bangladesh exports need to be more diversified so that foreign exchange earnings are enhanced beyond the country's current dependency on finished garments and foreign remittances. We also agreed that there are some inescapable adverse and unfavourable outcomes on the broader macro-economy of Bangladesh -- mostly channelling through international trade, travel, foreign exchange reserves and so on.

The monetary policy session participants, already well versed in Federal Reserve's Traditional Monetary Policy (TMP) tools, wanted my perspectives on non-tradition monetary policy (NTMP) activisms in use since the financial crisis that lead the global economy to the Great Recession of 2008. 

The TMP tools include open market operations (OMOs), Statutory Required Reserves on demand deposits and Discount Wind Borrowing at the Fed's discount interest rate. The NTMP include Quantitative Easing (QE) and Forward Guidance.  

The QE policy involves the Fed's large-scale purchases of long maturities Treasuries, corporate bonds and mortgage backed securities to inject liquidity so as to keep the banking system solvent and operational. The purchase of long maturity securities was intended to lower the long-term interest rate. In contrast, the OMO was designed to lower short-term market interest rate. 

When the Fed had already achieved its funds rate to near-zero during the Great Recession, the traditional OMOs are not workable to lower the interest rate further. The Fed innovated the QE that increased the money and credit circulation in the economy, lowered long-term interest rates. The lower cost of long term borrowing spurred investment demand, economic growth, decreased unemployment and steered the economy on track past the Great Recession. 

Another NTMP adopted by the Federal Reserve after the Financial Crisis gained wide popularity is called Forward Guidance. This guidance provides policy narratives of the future course of monetary policy to the public. The idea behind it is to minimise future policy surprises and uncertainties so that individuals and businesses can make prudent spending and investments decisions.

There is a popular saying in the Wall Street that states, "When the Fed Chairman talks the rest of the global central bankers listens". The reason obviously is that Fed's policy of inter-state rate changes has global implications on financial markets, economic growth, and inflation.

The US has trade relations with over 200 countries, territories and regional associates across the world. Therefore, actions taken by the Federal Reserve influences economic orders and settings to the rest of the global economy, which in turn manifestly spill back on the U.S. economy requiring resetting policy parameters and mitigating actions. Therefore, the Fed policy makers pay close attention to developments sprouting outside the US. 

The transparency of US financial markets has greatly helped withstand and absorb vulnerability to disruptions in foreign economies and markets. However, the domestic economy is not immune to vulnerabilities originating from the home front. For example, the recent failure of two US banks - the Silicon Valley Bank (SVB) and the Signature Bank (SB) were victims of such vulnerabilities. 

The failure of the SVB is largely ascribed to the Federal Reserve's aggressive interest rate hikes to combat inflation. The SB failed for different reasons - excessive risk taking. It is a much smaller bank with only about $110 billion in assets vs $209 billion in assets held by SVB. The SVB failure may have some lessons to learn for the Bangladesh Banking industry in terms of risk management and customers' safety.  

Unlike most commercial banks, SVB was uniquely concentrated in providing banking services to nearly 50 per cent venture capital firms. For year after year SVB was drawing large sums of cash from about 2500 high-flying venture capital firms and start-ups.  The bank maintained a small cash reserves against deposits and invested the rest in long-term U.S. Treasuries which promised steady, modest returns during low interest rate regimes which now on hind side appears to be a short-sighted investment measure.

It is short-sighted, because the bank's executives were oblivious to the pandemic-wrought economic environment, potential adverse effects of government's large pandemic stimulus spending and the post-pandemic economic expansion that led to fast rising inflation.  The bank got trapped in low interest earning long-term Treasuries with their prices dropping precipitously while new issues of Treasuries offering higher return became more attractive as the Fed spearheaded its inflation combating policy raising its benchmark interest rate from near zero to 5 per cent in a year's time. To raise funds to pay its depositors the cash, the bank started selling its long-term assets at substantial losses. 

The Signature Bank provided lending services to law firms and real estate companies. Among its clients were people from corrupt business organisations of Donald Trump. Besides, its risk taking venture that began in 2018, involved taking deposits of crypto assets - proved to be an ill-fated decision with the demise of the Bahamas-based crypto currency exchange FTX in November 2022.  

Like SVB, most clients of SB had well over $250,000 in their accounts. The Federal Deposit Insurance Corporation insures deposits only up to $250,000.  Nearly 90 per cent of SB's close to $88 billion in deposits were uninsured at the end of 2022.  On March 10 the bank experienced a rush withdrawal of cash, words were out in the open and the bank's stock took a sharp nose down. 

One may wonder what effects the US monetary policy may have for the Bangladesh economy? A 2018 study (Ref: https://www.federalreserve.ovg/econres/feds/files/2019039pap.pdf) that focused on the effects of the Fed's contractionary monetary policy found significant increases in probability of bank crisis for countries that have direct trade linkages with the US. The estimated marginal effects show that "a 1 per cent tightening in monetary policy increases the probability of crises by 0.998-6.825 per cent for a given level of direct exposure to the U.S." This is not implausible given that when the Fed raises the interest rate to control credit and inflation, for example, trading partner countries which also enjoy exposure to US capital market could experience capital outflows, forcing an adjustment in external accounts and domestic vulnerabilities. For example, capital outflows drive the exchange value of the US Dollar  higher as foreign investors demand for USD to invest in US Treasury bonds and other USD denominated financial assets increases. Their domestic currencies take a beating against the USD, leading to higher import costs of industrial materials and machineries while concomitantly their foreign exchange reserves dwindle. Would that be wrong to say that Bangladesh economy, among the other US trading partners, is a victim of US aggressive interest rate policy? 

The 2018 study further found that countries having little or no direct exposure to the US economy and financial market, the impacts of Fed's monetary policy was ambiguous. These countries may have gained from diversification and openness of their economies from outflow of funds from countries which have direct exposure to the U.S. This implication is consistent with BB Governor and my observations that Bangladesh will have to diversify its exports sector to absorb potential adverse external shocks.

Dr. Abdullah A. Dewan, formerly physicist and nuclear engineer at Bangladesh Atomic Energy Commission, is Professor of Economics at Eastern Michigan University, USA.
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