Intervention, missing money and inflation

Bangladesh continued with the fixed exchange rate regime of the Pakistani era for more than three decades. During this period the country suffered from chronic balance of payments deficits and the consequent pressure on the domestic currency to depreciate. Bangladesh Bank devalued the taka many times starting from Tk7.28 per US$ in January 1972 to Tk57.90 in February 2002. Following persistent advice from donor agencies Bangladesh finally adopted flexible exchange rate regime in May 2003. The decision was perhaps made easy by the fact that the current account balance and the overall balance of the balance of payments were in modest surplus during the preceding years.

Since 2005-06 Bangladesh faced a situation that it had never experienced before: it ran large current account and overall account surpluses. This was due mainly to a sharp increase in remittances from migrant workers overseas.  By 2008-09 the current account surplus exceeded 2.5 percent of the GDP. The influx of remittances led to a sharp increase in the stock of international reserves. Initially there was a euphoric reaction from all sides including the policymakers, but soon the other aspects of such asset accumulation became evident, at least to the central bankers.

Bangladesh Bank had to mop up the excess foreign currencies from the market, especially since 2006. This was necessary to prevent the value of the taka rising sharply against the dollar. It was feared that in the absence of intervention the value of the taka could appreciate to about Tk60/US$. Bangladesh Bank suspected that such a large appreciation will be disastrous for the domestic industries, especially export industries such as apparels. Aggressive intervention by the Bank succeeded in preventing the taka from appreciating.

The chart below confirms that old habits die hard. The official declaration of switching to a flexible exchange rate was an expression of intent only. Except for a brief two year period 2005 and 2006 when the taka depreciated significantly, Bangladesh Bank never really let go; it intervened to prevent appreciation of the value of the taka. Indeed, there was less fluctuation in the taka/US$ value during the last four years of the officially floating rate regime than during the fixed exchange regime of the past when the official exchange rate was frequently adjusted. As the near-horizontal portion of the graph makes obvious, the value of the taka against the dollar was very stable around Tk69/US$ during the last four years despite the reserves rising very rapidly.

Chart: Taka-US dollar exchange rate

The monetary consequence of the repeated purchases of foreign currencies from the market was that it also increased the total money supply in the absence of commensurate sterilisation. The monetary program of Bangladesh Bank that envisaged a relatively modest money growth of 15.8 percent was breached. As the table below shows, Bangladesh Bank has never been successful in accurately predicting the growth in the demand for money, but the error margin during 2009-10 was the largest in recent years. Errors in forecasting by itself are not unusual, what is worrisome though is that the program money growth rates always fell short of the actual money growth rates, i.e. the Bank was making systematic errors in predicting the trend of its principal control variable.

The table further suggests that by and large Bangladesh Bank overstated the GDP growth rate and understated the CPI inflation rate, i.e. the errors were not random. This calls into question if dispassionate scientific analyses were the only basis of these forecasts.

Since the exchange market interventions increased the money supply beyond the program rate, Bangladesh Bank lost, at least partially, the control of monetary policy. The fodder needed to stoke the fire of inflation is now on hand. It remains to be seen what measures it resorts to for containing inflation.

Table: Program and actual growth rates

	2005*	2006	2007	2008	2009	2010	2011
Broad money growth Actual	16.8	19.5	17.6	17.6	19.2	22.4
Broad money growth Program	14.5	13.0	12.0	16.0	16.9	15.5	15.8
GDP growth, actual	6.0	6.6	6.4	6.2	5.7	6.0
GDP growth, program	5.5	6.5	6.8	6.5	6.5	7.0	6.7
CPI growth, program	7.5	6.5	6.0	7.5	7.5	6.5	6.1
CPI growth, average actual	6.5	7.2	7.2	9.9	6.7	7.3
CPI growth, point-to-point, actual	7.4	7.5	9.2	10.0	2.3	8.7

* refers to fiscal year

Source: Bangladesh Bank and Planning Commission.

It is no wonder that Bangladesh Bank failed to achieve the target monetary growth. Targeting monetary aggregates was the central plank of monetary policy of many developed countries only a few decades ago. Most of them failed to contain the aggregates within their target bands. Hence, they eventually abandoned monetary targeting. As a then central banker famously said, "we did not abandon monetary aggregates, they abandoned us".

The nominal exchange rate is only one of the several variables that determine the competitiveness of domestic industries. One of the most important variables is the productivity of the domestic industry, which is determined by the productivity of both the entrepreneurs and the workers. The bottom line is that the locally produced goods must be cheaper than the foreign goods (quality adjusted). A large number of factors such as infrastructure, financing, governance, etc. besides physical productivity go into the determination of the final prices of goods.

An important consideration in the determination of competitiveness is the domestic inflation rate relative to the foreign inflation rates. If domestic inflation rises at a faster rate than the international rate, domestic goods could become uncompetitive even when the local currency depreciates. Real exchange rate is widely used to indicate the relative competitiveness of the domestic goods. Bangladesh Bank data suggest that despite very large depreciation of the taka during the last seven years, the real exchange rate has remained virtually constant; i.e. relative inflation movements have over time offset the benefits of depreciation. The central bank may have some control over the exchange rate, but the real exchange rate is determined by market fundamentals.

Two questions may arise in respect of the current situation. First, why did Bangladesh Bank not take sterilising measures to rein in money supply in order to keep it close to the program rate? This question is implied by Ahsan Mansur's informative article in The Financial Express, 21st October 2010. However, a careful inspection of the components of the money supply suggests that Bangladesh Bank did make some attempts toward sterilisation.

The stock of domestic assets of Bangladesh Bank declined from Tk26,145 crore in 2008-09 to Tk19,954 crore in 2009-10, a reduction of nearly one-quarter. This was presumably an attempt to offset the large 41.5 percent increase in the holding of foreign assets. Bangladesh Bank did bring down the growth rate of reserve money from 31.4 percent to 17.2 percent. But the market reacted by raising the reserve multiplier such that the squeeze on the reserve growth did not succeed in containing the growth of broad money (if the multiplier had remained constant, the money growth rate would have been close to the program rate). This was probably unexpected since the multiplier fell every year for five years in a row.

Bangladesh Bank is under pressure from the private sector to reduce the interest rate. A greater volume of investment is necessary to move the economy out of its current sluggish state. This also requires a reduction in the interest rate. Bangladesh Bank has repeatedly urged the commercial banks to reduce the lending rate to a single digit in order to support greater economic activities. A tightening of the money market would raise the interest rate, which would be contrary to its exhortations. It is caught in a web of conflicting objectives.

The second question is more complex: why is the large increase in money growth during the last two years not reflected in greater inflation; with lower money growth in 2006-07 and 2007-08 and higher GDP growth, the inflation rates were higher. A large part of the incremental money stock seemed to have had little effect on the prices, or missing from the inflation equation.

One possible answer to the conundrum would be that the effect of a larger money stock on inflation shows up with a substantial lag. If this is the case, we may experience further increases in the inflation rate in the near future notwithstanding whatever measures are taken now.

Another plausible explanation of the missing money derives from the motives for holding money. Money is held for both transactions and speculative purposes. As long as there exists a stable relationship between various types of monetary transactions and GDP, it is reasonable to use GDP as a proxy of total transactions, and this is the normal practice in the estimation of the demand for money.

A part of the monetary transactions takes place in the capital market. Since the time systematic data on the capital market are available (1995-96) and until recently, the turnover in the capital market rarely exceeded six percent of the (broad) money supply or two percent of the nominal GDP. Since these ratios are quite small, it would be permissible to ignore capital market transactions in estimating the demand for money or the impact of money on the inflation rate.

However, these ratios changed abruptly after 2006-07. In a single year they jumped by more than four times. By 2009-10, the ratio of capital market turnover to money increased to 70.6 percent and the ratio of turnover to GDP rose to 37.2 percent. With the capital market turnover amounting to such a large and variable ratio of the total money supply or GDP, it would not be appropriate to ignore its impact on money demand or inflation.

Money spent in the share market does not raise the demand for ordinary goods; it raises the demand for shares and accordingly raises their prices. Thus, with a sharp rise in the share market turnover since 2007-08 the prices of shares also increased sharply as there was no commensurate increase in the stock of shares.

Share prices are not included in the consumer price index; hence, an increase in share prices does not influence the movement of CPI. Since the share market absorbed a large part of the money supply, the entire increase in the money supply did not impact on the price level. The irrational exuberance of the share market thus might have unexpectedly performed a useful role in dampening inflation. One can of course argue that by allowing excessive growth of money Bangladesh Bank supported or even encouraged the irrational exuberance of the share market.

Be that as it may, letting this state of affairs to continue much longer would put the health of the financial sector at risk. The regulatory authority of Bangladesh Bank does not extend to the capital market, but as the supervisor of the financial sector it should ensure that financial institutions are not overly exposed to the capital market risks. The economy is not strong enough to withstand a financial crisis.

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Professor M A Taslim is the CEO, Bangladesh Foreign Trade Institute