In their Monetary Policy Statement (MPS) for the first half of FY25, Bangladesh Bank (BB) has stuck to the policy stance already in place.  There is no further tightening, no specific measures to enhance liquidity management and transition to a flexible market-based exchange rate regime from the "crawling peg".  The MPS recognises the deep stress in the financial sector and provides a long list of legislative measures already passed and regulatory plans announced without committing to a timebound and results-oriented path of action.  

Let's begin with the central question to gauge what more this MPS could have done to increase the potency of monetary policy in restoring macro-financial stability.

WHY HAS STABILITY REMAINED ELUSIVE?

Inflation has remained stubbornly close to double digits; foreign exchange reserves are significantly lower than they were a year ago; and financial sector woes appear to be seeking new lows all the time. What explains these performance shortfalls despite monetary tightening, exchange rate reforms and apparently streamlined financial regulation? The short answer is results elude when measures remain less than fully baked.

For most of the monetary tightening cycle that started in May 2022, the transmission of contraction remained confined within the banking system. It could not spillover at the retail level until July 2023 because of the 9 percent cap on retail lending rates.  The SMART based retail rate policy subsequently allowed limited room for transmission.  The door for transmission opened fully in principle only since May 2024 with the abolishing of SMART. Yet there are perceptions of invisible ceilings.

The tightening lacked consistency. BB has been financing the fiscal deficit indirectly by providing liquidity to banks against their holdings of government bills and bonds. Fiscal austerity has been limited at best.  The large budget deficit counteracted monetary contraction by boosting aggregate demand. Tightening is also diluted by BB's so called "supply-side intervention policy" to enhance production and support employment generation.

BB has continued supporting cash starved insolvent banks, Islamic banks in particular, without requiring them to take immediate corrective actions. Given the significant size of Islamic Banks, such liquidity support on a continuous basis dilutes transmission of monetary tightening. Note that the 9 percent penalty rate charged for under fulfillment of CRR is lower than the 10 percent rate of the Standing Lending Facility, which does not make sense. CRR non-compliance penalty should be above the Standing Lending Facility (SLF) rate.

The foreign exchange constraint has not eased durably. Forex reserves have shown some signs of stabilizing recently at a precariously low level.  Dollar inflow from remittances have been robust at around $2 billion per month on average and some budget support from development partners disbursed. Forex market volatilities triggered often by policy mood swings during September 2022 to May 2024 nurtured foreign exchange shortage.  The pause in forex reserve decline is only recent and uncertain to last long enough to allow broad based easing of import compression measures.

Production disruptions and market manipulation exacerbated inflationary pressure. These include a decline in productivity due to gas rationing, loadshedding, and foreign exchange shortage leading to disrupted supply in markets for goods and services. Unbridled use of market power to reap excess profits through opportunistic behavior kept prices of essentials highly volatile around a rising trend. BB's "supply side measures" made little difference!

CONTINUATION OF THE CONTRACTIONARY STANCE IS A NECESSITY

BB could signal a resolute commitment to inflation reduction by increasing the policy rate further by at least 50 basis points. However, the bigger challenge, which this policy has not quite addressed, is the operationalization of interest rate targeting with the ultimate objective of switching to an inflation targeting framework. Recall that BB announced transition from a monetary targeting to an interest rate targeting framework in its July-December 2023 MPS. It introduced an Interest Rate Corridor; adopted the overnight call rate as the intermediate policy rate target; and, in May 2024, abolished ceiling on banks' retail lending rates that used to be indexed to the Six Months Moving Average Rate for T-bill (SMART).

BB has missed the opportunity to move monetary policy modernization forward. Multiple BB policy rates are a major source of confusion. Such a multiplicity of "official" rates complicates communications on the stance of monetary policy, thus undermining monetary policy transmission. There are several variants of the Repo Rate at which BB lends to banks under various liquidity support facilities and the call rate designated as the target policy rate under the new interest rate targeting regime. There is also the Bank Rate which BB applies to rediscount bills of exchange or other commercial paper eligible for purchase and to set the penalty rate for banks for under fulfillment of the CRR.

Access to the standing deposit and lending facilities is not automatic. Foreign-owned banks with substantial liquidity surplus keep involuntary excess reserves in their accounts with BB because of limitations to depositing funds at the Standing Deposit Facility. Access to these facilities is supposed to be automatic if the borrower has sufficient collateral. The MPS does not address this issue. These facilities are designed to fulfill the role of buffering interest rate volatility.

NO OSTENSIBLE URGENCY FOR FINANCIAL REFORMS

Higher for as long as inflation remains high must be the mantra.  BB must allow full transmission of rising money market rates to the retail level while keeping in mind rate hike is not a panacea. It must also stop unconditional liquidity support to cash starved and insolvent banks through accelerated implementation of the Risk Based Supervision and the Prompt Corrective Action framework. Monetary policy effectiveness is contingent on the health and governance of the banking system.

The roadmap to reduce NPLs lacks a careful sequencing of milestones. BB reintroduced the obligation to treat exposures as non-performing when they are more than 90 days past due in February and March 2024; reduced the time needed for a bank to write off bad loans from five to two years; and mandated the set-up of a "write-off debt recovery unit" in each bank.

Building on this progress, BB has provided a wish list of reforms in the MPS without committing to time-bound actions except reiterating the timelines already deemed to be too slow. For instance, the implementation of the Prompt Corrective Action framework will not start before March 2025 and unpaid installment will have to wait to be considered past due after 90 days till March 31, 2025. Conducting an asset quality review to accurately evaluate the state of banks' balance sheets before setting NPL targets is not even on the cards.

Words are not backed by concurrent actions.

EXCHANGE RATE REFORMS AT A STANDSTILL

Following the introduction of crawling peg, BB is expected to readjust the band to facilitate progress towards a flexible, market based, transparent exchange rate regime. It needed to widen the band gradually to allow for greater exchange rate flexibility. Restoring the proper functioning of the interbank foreign exchange market is critical to ensuring the success of the new exchange rate arrangement.

Except for ceasing swaps among banks and BB, none of these priorities have figured concretely in the MPS. Yet BB has projected a 17.8 percent growth in net foreign assets of the banking system by June 2025 on the back of a 17 percent decline in FY24 and a 23.4 percent decline in FY23. Such a turnaround would require a drastic reduction in the current account deficit coupled with a larger financial account surplus.  None of these looks plausible without greater exchange rate flexibility, lower inflation and faster structural reforms.

The MPS alludes to a draft "comprehensive foreign exchange intervention strategy to support the effective functioning of the newly introduced crawling peg exchange rate regime." Looks like BB is striving to reinvent a path to "smoother transitions and maintaining stability".  Do we really need such diversions? Widening the band around the Tk 117/USD exchange rate could pave the way for advancing towards a fully flexible market-based exchange rate. Stability could be ensured through enhanced transparency of the foreign exchange market by developing a system of rate disclosures in real-time.