Monetary policy and the price of appeasement

Coming out of a meeting on the April Fool's Day Finance Minister AMA Muhith announced a reduction in the cash reserve ratio (CRR) from 6.5 to 5.5 percent. Shortly thereafter Bangladesh Bank reduced the repo interest rate from 6.75 percent to 6 percent. These were unmistakably indications of an easing of the monetary policy only two months after the January-June 2018 Monetary Policy Statement had wisely charted a relatively conservative course for the monetary sector. The finance minister had earlier promised bank owners that all public institutions would be instructed to put half of their deposits with private banks, notwithstanding the fact that it would jeopardise the safety of their deposits.

A chorus of protests and criticisms rang out after these changes were announced. Virtually all economists who spoke to the media expressed strong reservations against these arbitrary changes. There are good reasons for their sharp reaction. The decision to make these important policy changes was arrived at in an extraordinary manner and announced by the finance minister, who had no business meddling with monetary policy. The central bank governor was reportedly called in by the finance minister to attend a meeting at a local hotel with the directors of private banks some of whom are widely known to be a rather unsavoury lot. They have been aggressively lobbying the government for an easing of monetary policy and other concessions claiming a liquidity shortage. A shocked former Bangladesh Bank deputy governor said that it was most unethical to throw the governor among a pack of bank owners in such a meeting. It was never done previously, not even during the Pakistan days. A bemused former governor commented that "this certainly wasn't proper in any way to cut important tools of the economy like CRR and repo interest rate at a meeting in a hotel." Obviously both these eminent persons interpreted the event as a crude tactic to force the governor to reverse policy on the run.

To make matters more intriguing these bankers were then invited with their spouses to a party by the prime minister. Immediately before this meeting the Bangladesh Bank had announced a reduction in the repo rate. The star of the bank owners must have been shining brightly upon them.

The one percent reduction in the CRR translates into almost Tk 100 billion in additional funds for the commercial banks. Since this amount will be in the form of reserve money, the banks could expand their credit operation by more than Tk 500 billion and keep credit at the higher level as long as CRR remains at 5.5 percent. This alone could increase money supply by more than 5 percent, making a mockery of the last MPS. Furthermore, when the central bank lends money to these banks through its open market operations, they will make a saving of Tk 7,500 for every million taka they borrow. This may encourage them to borrow more and thereby further raise the money supply. With an additional 25 percent of public body deposits channelled to them (at the expense of the state owned banks) they will have additional funds to lend out from. All these amount to a very hefty pre-budget free gift to the richest people of the country – a courtesy of the finance minister and the governor. Only a few months ago the government was struggling to find even a small fraction of this amount to fund the relief operations for the millions of flood affected people!

The ordinary public will ultimately bear the risks of the deposits in some of these misgoverned banks. Any subsidy provided by the government, such as recapitalisation, will also be paid from the public exchequer. The implied encouragement given to the bank management by all these monetary and fiscal measures will almost certainly increase moral hazard in the banking sector, which could lead to a worse crisis in future.

What the bank owners have gained from these dubious measures is clear enough; but what was the stake of the government that it so quickly submitted to their demand? Was it just a ploy to secure their support for the next election or did it have additional objectives? Hopefully, informed people will look for an answer to this question.

Over many years, and several governors, the Bangladesh Bank had made a sustained effort to contain inflationary expectations and enhance its credibility by making advance commitments about future growth of important monetary variables. These commitments (or targets) were contained in the Monetary Policy Statement announced biannually. Although the central bank was not always successful in not breaching the targets, it seldom changed the targets during the tenure of the Statement, and its intentions were starting to appear credible. But in one fell swoop the governor, presumably goaded by the finance minister, seemed to have undone much of the good work done over all these years. The relevance of the Monetary Policy Statement would be in question and the Bangladesh Bank might see an erosion of its credibility in the coming years. Its calming influence on inflationary expectations will also dwindle. It could take years to restore confidence. Meanwhile the ability of the central bank to control inflation will become that much more difficult.