The governor’s dilemma

Published : 26 July 2010, 03:13 PM
Updated : 26 July 2010, 03:13 PM

The governor of Bangladesh Bank has just announced the monetary policy for the second half of 2010. He could not possibly have been very comfortable with the script; it forced a marked shift in his usual populist stance that has endeared him to the people. He quite correctly articulated the need for "due vigil against inflationary pressures", but he has to pit this against the equally pressing need "to support government's policies and programs in pursuit of faster inclusive economic growth and poverty reduction".

However, these objectives may be difficult to achieve in the emerging macroeconomic environment of the global economy that is coming out of a deep recession. As it recovers, international commodity prices are again showing signs of upward movement. Falling prices of essential commodities since mid-2008, especially of fuel oil and cereals, underwrote the reduction in the domestic inflation rate of Bangladesh during 2008-09. With these international price trends reversing with the economic recovery, the inflation rate has started increasing since mid-2009.

By February 2010, the point-to-point inflation rate exceeded 9 percent, and by April 2010, the average yearly inflation rate (6.51 percent) overshot the BB target of 6.50 percent for FY 2010. It is most likely that by the end of June the average inflation rate will approach 7 percent.

This is not an overly alarming outcome on inflation, but BB is well advised to be cautious. With many countries trying to stimulate their economies through various fiscal and monetary measures, the emerging economies growing strongly and the domestic wages and utility prices set to rise, the outlook on inflation does not appear reassuring.

Bangladesh Bank has decided to put on monetary brakes to "neutralise likely inflationary pressure from this growth supportive monetary and credit policies". It has programmed to reduce money supply from 22.9 percent (May 2010) to 15.2 percent by June 2011 and reserve money from 25.2 to 13.0 percent.

That a reduction in money supply is essential for taming inflation is well known, but how this reduction is achieved gives an indication regarding the central bank's priorities. In the new monetary policy, the principal burden of the reduction will be borne by the private sector; private credit growth will be reduced from 22.3 percent (May 2010) to 16.0 percent by the end of FY 2011. The money supply is projected to contract to 15.2 percent.

Since the governor has already declared that agricultural credit will remain buoyant, the industrial and service sectors will bear the consequences of this monetary contraction. Since both these sectors are bigger and more dynamic than agriculture, any reduction in their growth rates will be difficult to offset with agricultural growth, which is typically modest.

In contrast to private credit, credit to the government and the public sector will sharply rise from -5.9 percent (May 2010) to 25.3 percent in June 2011. Bangladesh Bank is apparently making provisions for cushioning the impact of the fiscal expansion that the government has promised to embark upon. In doing so, it has brought to the fore the fact that the public sector crowds out the private sector when it goes for large fiscal expansion, something that will not come as a surprise to students of economics.

A necessary consequence of the credit squeeze is an increase in the interest rate. The Monetary Policy Statement has cleverly skirted the issue by simply saying: "… the interest rate structure is an outcome of complex interplays of conflicting interests of savers and entrepreneurs … interventions … will impair effectiveness of monetary policies". If BB achieves the objectives of restraining money and credit, there is no doubt that the interest rates will rise; indeed this is how the crowding out will eventuate.

It is also interesting to note that BB no longer regards the interest spread to be unusual or high: "the margins in Bangladesh are not outliers relative to other comparator economies". It says further that: "Intermediation margins are quite low in state owned banks, and modest also in some private sector banks." BB held just the opposite view only 2-3 years ago, and exhorted the commercial banks to reduce the margins although the spread then were not much greater than what they are now.

The business community of the country is a vibrant and politically powerful class. They may not agree with BB's assessment of the economy. On the contrary, they may act aggressively to counteract the restrictive monetary policy measures in order to execute their investment plans. If the pressure becomes inexorable, BB will not be able to hold down the private credit growth. Indeed, during the last five years BB has not been able to contain credit growth below the target. If monetary expansion overshoots the BB programme rate by large margins, the inflation target is sure to breach. FY 2010-11 may turn out to be more turbulent than the previous year.

Ironically, Bangladesh Bank is earnestly hoping that remittance inflow will decline and import will increase this year. Both of these are usually regarded as bad outcomes in populist discourse. Indeed, the government is actively seeking to increase the remittance inflow through greater outflow of workers and reducing import through increasing domestic production, especially of agriculture. The governor has in the past also spoken of the need to raise agricultural production substantially to achieve food self-sufficiency, i.e. reduce food import.

The reason for the turnaround is that the greater the inflow of remittance and the lower the import bill, the greater is the surplus in the balance of payments. Such a surplus jeopardises BB's monetary contraction programme, and thereby puts its monetary policy at risk. Faced with a rapidly increasing stock of foreign assets in its portfolio, it is no wonder that BB is now hoping for outcomes that contradict immediate objectives of the government. Good monetary policy does not always build on populist government policies.

One gets the impression that Bangladesh Bank believes the non-convertibility of the capital account to be essential for the effectiveness of monetary policy. It states, "Monetary policies and programmes in Bangladesh adopt the same tools and techniques as in other developing economies maintaining restrictions in external capital account. Monetary aggregates based policies and programmes retain relevance in economies with restricted capital accounts."

The tools and techniques that BB employs are standard in both developed and developing countries with both restricted and unrestricted capital accounts (although developed countries would be reluctant to use the reserve ratio requirement). Monetary policy can be more effective in countries with unrestricted capital accounts. What reduces the potency of monetary policy is not the openness of the capital account, but rather the exchange rate regime. If BB is maintaining restrictions on the capital account in order to increase the effectiveness of its monetary policy then it is pursuing the correct policy for the wrong reason.

Bangladesh Bank and the government appear to have decided for greater government involvement in the economy. If true, this will be a significant departure from the economic policy of the last three decades, which promoted greater space for the private sector and the market.