Monetary policy and the economy
Notwithstanding how Bangladesh Bank (BB) chose to describe it — cautious, accommodative, etc. — there is little doubt that the monetary policy of the country was expansionary until about last one year. The latest bout of monetary expansion began toward the end of 2009 and continued until about the last quarter of 2011 as shown in Chart 1 below. Monetary growth (month over same month of the previous year) was well above 19 percent during this period. However, monetary growth during June 2010 to August 2011 was in excess of 21 percent. Such excessive monetary growth led to not only an increase in inflationary pressures, but also significantly contributed to asset price bubbles, especially that of real estate and shares. BB put on a monetary squeeze since the last quarter of 2011 bringing down the growth rate to 17-18 percent.
Such a monetary contraction was forced upon BB by some adverse outcomes on the economic front. Firstly, the consumer price index, after falling in the wake of the commodity market crash of 2008, had started rising steadily. It rose to double-digit figure by March 2011 and it climbed to nearly 12 percent in January 2012. Rising inflation became a major public concern and an embarrassment for the government.
The financial crisis in the West in 2007 and the subsequent global recession took their toll on the nationâ€™s export revenue. Exports had maintained a healthy average growth rate of about 17 percent during the previous 5 year period. But the growth rate of export revenue (in dollar terms) fell to 10 percent in 2007-08 and a meagre 4 percent in 2008-09. After a spike of 41 percent in 2009-10, it fell to less than 6 percent in 2011-12 and fell further during the first quarter of 2011-12 to a paltry 2.1 percent. It is expected to remain low in the current year.
However, during this period there was robust growth of remittances which prevented the current account from turning negative. The current account balance had improved steadily since 2000-01 and reached $3.7 billion in 2009-10. Â BBâ€™s stock of international reserves rose from only $1.3 billion in June 2000-01 to $10.7 billion in 2009-10. Although the current balance reduced in amount since then, it still remained positive due to continued strong growth of remittances and a sharp reduction in import growth. As a result BBâ€™s stock of international reserves rose further to a record US$12.3 billion in October 2012. However, it should be noted that despite the large increase, the reserves in 20011-12 were actually equivalent to only 3.5 months of the nationâ€™s import payments against 3.6 months in 2006-07 when reserves stood at only $5.1 billion.Â Appearances can be deceptive!
The reserves were low even in comparison with the Asian low income countries which held enough to cover at least four monthsâ€™ import payments (IMF). The market responded to the incipient deterioration of the reserve situation; the taka exchange rate started depreciating. It depreciated from Tk69.41/US$ to Tk84.44/US$ between July 2010 and January 2012 – a fall in the external value of the taka by 21.7 percent in only about one and half years. Since then it recovered to Tk81-82/US$ as the reserve situation improved.
The prospect of a balance of payments crisis seemed real toward the end of 2011 and the beginning of 2012, which forced the government to seek succour from the IMF. The Finance Minister wrote to the IMF on 27 March 2012 requesting balance of payments support through Extended Credit Facility (ECF). The IMF promptly suggested some harsh monetary (as well as fiscal) measures as preconditions for the release of ECF fund of about one billion dollar. The script of the next biannual monetary policy statement of BB was thus foreshadowed in a memorandum agreed between the IMF and the Bangladesh government.Â It did not leave much scope for an exercise of the imagination and innovativeness of the BB officials in autonomously designing the nationâ€™s monetary policy.
The memorandum had stipulated Quantitative Performance Criteria and Indicative Targets for some key variables such as net domestic assets of Bangladesh Bank, net credit to the government by the banking system, non-concessional external debt and suppliersâ€™ credit and reserve money. The government had to also agree to maintain net international reserves, tax revenues and social spending above suggested minimums. Taken together these required a tight monetary policy with the specific objective of taming inflation and improving the balance of payments. As a corollary these stipulations also set the limits of the next budget.
BBâ€™s monetary policy thus accorded well with the stipulations set out in the memorandum.Â As mentioned above, BB had already started reducing monetary growth since the last quarter of 2011, but it really tightened up since the beginning of 2012. The interest rate increased further in response. The monetary squeeze had the expected result in a globally conducive environment. With a short lag the inflation rate started declining and by September 2012 it had come down to 7.4 percent and is expected to fall further should international commodity price situation not worsen.
Imports started declining in response to the tight monetary policy. A large part of the decline was due no doubt to the sharp decline in exports. The growth rate of imports had declined to 5.5 percent in 2011-12; however, during the first quarter of 2012-13 imports actually registered a negative growth of -5.2 percent. As mentioned earlier, exports maintained a small positive growth. Inward remittances increased by a robust 19.5 percent.Â As a result the current account posted a surplus of $135 million during this quarter. Thus despite the downturn in export trade the exchange rate held up well and edged toward Tk81/US$.
The current monetary policy stance has succeeded in bringing down the inflation rate. It has also helped prevent a balance of payments crisis from developing by reducing imports. While the benefits of a reduction in the inflation rate are well-understood, the implications of the decline in imports are not always immediately evident. Unlike what is commonly believed, it is usually not a healthy development; it is suggestive of a weakening economy.
Only about one-tenth of the imports of the country are categorised (in BB publications) as consumer goods. The rest are industrial raw materials, capital machinery and petroleum products. These are all inputs in the production of goods and services. There have been significant reductions in the import of some of these producer goods during the first quarter of 2012-13 relative to the same period last year. This suggests a significant reduction in demand of the producers, and hence indicative of a slowdown in industrial activities. The large reduction in the import of capital machinery is noteworthy. It is consistent with the oft-repeated complaint of the business people that they have been forced to shelve their investment plans. Consequently industrial investment during this fiscal year could be modest.
It is customary in the macroeconomic literature to regard import as positively related to income such that a reduction in GDP would in general reduce total import of the economy. The deterioration in the nationâ€™s export performance is due precisely to this relationship. The ongoing recession in our major export markets has reduced their import demand, and therefore, reduced the demand for our exports. Import and GDP data (both in current US$) of
Table 1: Growth in LC settlement for imports (percent)
Bangladesh for the period 2000-01 to 2011-12 also corroborate this well-established macroeconomic hypothesis as should be evident from Chart 2. The simple correlation between the two variables is 0.46, which is suggestive of a positive relationship between the two variables. Hence the current slowdown in imports most likely portends a reduction in the GDP growth rate.
There is nothing surprising about such an outcome of a tight monetary policy. The principal aim of a monetary contraction is to reduce aggregate demand, which in turn dampens inflationary expectations and eventually the actual inflation. The effect of a monetary policy measure is transmitted to the real economy through several channels. For an economy such as Bangladesh the interest rate channel and the credit channel are probably the most important. When the central bank puts on a squeeze on the money supply, the interest rate is bid up as has happened in Bangladesh. The higher interest rate and the difficulty of procuring credit reduce the credit flow to the private sector, especially the small and medium enterprises. Such a reduction causes a deceleration in investment which reduces aggregate demand, and hence, output.Â The reduction in aggregate demand and output also help to reduce import demand, and thereby improve the balance of payments.
There is prima facie evidence in favour of the arguments above. Monetary growth and inflation in Bangladesh during this millennium have been positively related as shown in Chart 3 implying that a monetary expansion has been accompanied by rising inflation. Therefore, it follows that any serious effort to reduce inflation must entail a monetary contraction. BB does seem to be serious about reducing inflation, and the understanding with IMF requires this as a precondition for the release of the next tranche of the ECF fund.
What has not received much mention in official discourse is that inflation and growth are also positively related, at least in the short run. This is the insight from the famous eponymously named Phillips Curve.Â Inflation and output data of Bangladesh seem to be consistent with this view. Chart 4 strongly suggests a positive relationship between these two variables. The correlation coefficient between them is 0.78, which is quite high. Thus the success of BBâ€™s monetary contraction will be most likely accompanied by a reduction in output growth during the current year. Once the inflationary expectations are reined in and the actual inflation rate comes down, output could expand at a faster rate.
The discussion above highlights an ineluctable fact of economic life: a pleasant outcome is usually accompanied by an unpleasant one. The pleasant outcome is what one regards as a benefit, while the unpleasant one is a cost. To receive a benefit some cost has to be incurred. The severity of the cost defines whether the benefit is worth having.
Bangladesh Bank is not a profit-making enterprise, nor is it a political institution. It does not need to suppress or sugar-coat the adverse consequences of some of its policy measures. A misperception about the impact of a policy could lead economic actors to take incorrect countermeasures, and thereby compound the problems. A frank statement of both aspects of a policy, favourable and unfavourable, will prepare the public better to face them. This will improve the chances of success of the policy.
M. A. Taslim is a Professor of Economics of the Department of Economics, University of Dhaka. He is currently holding the charge of the Chairman of the Department. He was formerly the Chairman of Bangladesh Tariff Commission.