Off the mark: Monetary contraction at variance with growth target

After a few years of relatively easy monetary policy, Bangladesh Bank (BB) seems to have finally clamped down on monetary growth. The growth of broad money has been brought down sharply to 5.5 percent during July-November 2011 as against 8.7 percent during the corresponding period last year. If this rate could be maintained for the rest of the year, the monetary growth rate would be well below 14 percent, which is much lower than the 21.3 percent growth rate of the last fiscal year.

Previous attempts of BB at 'cautious' and 'accommodative' monetary policy ended up with overshooting of monetary targets. Especially, during the last three years monetary growth remained rather high. Such permissive monetary environment encouraged the embedding of increasingly larger inflation expectations and the manifestation of an actual inflationary price spiral. The CPI inflation steadily rose to double digits raising concerns about the macroeconomic health of the country.

The high and rising inflation brought in its wake a worsening of balance of payments. After several years of surpluses, the current account and the overall account of the balance of payments moved into deficits. The current account deficit during the first 5 months of this fiscal year is still very small, but the overall balance has reached an alarming deficit level of nearly a billion dollar (BB, Major Economic Indicators, December 2011). The obverse of this deficit is a depletion of the stock of international reserves, which has declined by more than $1.6 billion (18 percent) during this time. The reserves currently stand at less than three months import payment requirements. An inevitable consequence of this depletion has been the rapid depreciation of the external value of the taka. It is now trading at over Tk83/US$ – a depreciation of nearly 20 percent in just over a year.

The governor of BB recently said that he was forced into a monetary contraction in order to stem the free flow of imports. He also asked the commercial banks to be more discreet about issuing LCs. The LC margins have also been raised in order to make it more difficult to import. All these monetary and administrative measures have perhaps contributed to a deceleration of import growth, which has fallen to 21 percent during the first 5 months of 2011-12, a substantial drop compared to the 37 percent growth during the same period last year. However, even at this reduced rate import payments considerably outstrip export receipts such that the trade balance rose markedly to $5.2 billion compared to $4 billion last year. Measures to reduce imports do not necessarily improve the balance of payments.

The principal impetus for monetary contraction is the taming of the inflationary spiral; but it is unlikely to yield much result in the short term. The manner in which monetary policy affects the price level is complex and uncertain. To be effective monetary policy must be able to significantly influence aggregate demand, and this in general requires aggregate demand to be responsive to interest rate changes. There are several channels through which a monetary policy impulse is transmitted to the real economy, however, the credit channel is perhaps the most important in the case of an economy such as Bangladesh.

In order to effect a monetary contraction, BB has raised the repo rate. It had earlier increased the cash reserve ratio and asked banks to adhere to the SLR requirement. What these measures mean is that BB has made liquidity more scarce and expensive for the banks. They have raised their deposit rates in order to attract liquid funds. Consequently they have been also forced to raise the loan rate. The time deposit rate has already increased to 13-14 percent and the unrestricted loan rate to more than 17 percent. Such a high loan rate discourages business enterprises from taking loans and thereby reduces credit demand of the business sector. The private sector credit flow during the first 5 months of this fiscal has halved relative to the credit flow during the corresponding period last year (from 12 to 6 percent). Of course, it should be mentioned that the reduction is also due to a large extent to the excessive credit taken by the government from the banks, which has increased from 0.6 to 24 percent. Such excessive government borrowing has dried up funds for the private sector that has contributed to the increase in the interest rates. Total credit growth has declined by 1.3 percent during this 5-month period.

A reduction in bank credit reduces investment spending since most business enterprises in Bangladesh depend on bank credit to finance their operations.  A slow down in investment activities reduces aggregate demand and output (GDP), which eventually forces prices down. Given this circuitous route, the final impact of the monetary policy is neither quick nor quantitatively certain.

Opportunities for raising money from the stock market, another source for business investment, are usually restricted to the relatively large enterprises in the formal sector. Most enterprises, especially the SMEs, have to provide funds either from their own sources or by borrowing from banks. Any reduction in bank credit affects the SMEs disproportionately since the superior clout and reputation of the large firms usually ensure that they do not face any great difficulty in accessing bank credit.  The SMEs are the principal sufferers from a monetary contraction, and many of them may go out of business. Thus, the current monetary policy is unfortunately not congenial to promoting SMEs, which is another BB policy.

The governor has claimed that the economy would achieve the projected 7 percent growth rate this year contrary to the Finance Minister's caution that such a high growth rate might not be achievable given the multifarious adverse developments. If the governor's claim turns out to be correct, it would imply an acceleration in the growth rate. Such acceleration would require a substantial increase in the investment demand, which if were to occur, would also raise the aggregate demand in order to match the increased output.

However, reducing the investment demand, and thereby the aggregate demand, are the principal objectives of the monetary contraction initiated by the governor; his policy can be deemed a success to the extent it reduces the aggregate demand. Hence, the 7 percent growth target would appear to be inconsistent with the current stance of the monetary policy; the growth target can be attained apparently only if the monetary policy fails.

Why would the governor initiate a policy that could not possibly achieve the growth rate that he considers so important? One possible answer could be that he wants to convince the market of the seriousness of his intent to control inflation. If the market is convinced, it may revise inflation expectations downward. If so, even with a lower money supply a higher economic growth is achievable. There are, however, at least two problems with this strategy. First, even if the strategy works, it will take considerable time to yield the desired result, and hence, cannot be expected to accelerate the short term growth rate. Secondly, the seminal work of Lucas and others show that the market anticipates policy moves and takes counter measures to avoid possible losses. The governor cannot expect to significantly influence a real variable by tinkering with monetary variables.  The most he could hope for is an eventual reduction in the inflation rate, which is precisely the reason why economists (and the IMF) have advised a monetary slowdown.

—————————
M A Taslim is a professor of the Department of Economics, University of Dhaka.