A challenging time for monetary policy

Bangladesh has made substantial progress in achieving price and macroeconomic stability. It has succeeded in maintaining inflation in modest single digits range, while also achieving high growth, due in a significant part to sound macroeconomic management. Until recently, monetary policy gained traction due to its operational autonomy and reliance on market-based procedures. However, with modest inflation policymakers appear now to be focusing more closely on tradeoffs among inflation, growth, and exchange rate stability. They are doing this in a context where institutional constraints are increasingly straining financial intermediation and monetary policy autonomy. Monetary policy transmission mechanisms are hindered by weaknesses in the legal environment, underdeveloped financial markets and oligopolistic banking behaviour, notwithstanding an excessive number of banks.  Interbank markets are rudimentary. Even though policy rates are used, changes to these policy rates have only limited effect on other interest rates. The role of banking remains essential to determining how monetary policy is transmitted to the economy.

The Bangladesh Bank often follows objectives in addition to price stability. These range from attempting to support economic growth and to explicitly targeting credit growth and exchange rate stability. The primacy of the inflation objective is generally not well established despite having an explicit numerical band of inflation target. The policy horizon is very short, making it difficult to focus on underlying pressures and trends rather than just recent developments. Exchange rate management has an important role in the monetary policy framework. Traditional reserve and broad money targeting framework is implemented in a flexible manner, manifested by frequent deviations from monetary programme targets. The BB often intervenes in the foreign exchange market to smooth exchange rate fluctuations. Analysis based on BB's overall intervention data shows interbank exchange rate fluctuations cause BB's intervention, not vice-versa. This holds for both buying and selling behaviour of the BB.

The Bangladesh Bank is about to announce the Monetary Policy Statement for the first half of FY20.  The macroeconomic context could not be more challenging: rising non-food inflation; weak private sector credit growth; significantly expanded bank borrowing target in the FY20 budget; declining liquidity in a non-performing loan saddled the banking system faced with weak deposit growth; an administratively driven mandate to cap lending rates at no more than 9 percent and deposit rates at 6 percent while interest rates on the National Savings Certificates are maintained at double digits; an overvalued exchange rate supported by large and persistent interventions for more than two years now; falling foreign exchange reserves; and plummeting stock prices. Many of these challenges are interrelated implying it is impossible to address them all with just one policy instrument such as the monetary policy.

The Bangladesh Bank thus needs to make a few tough choices under some binding constraints such as the central government borrowing target, the need to maintain a minimum 4-5 months equivalent of foreign exchange reserves cover, and the lack of political will to align the NSC rates with the market. The recent rise in the use of BB financing by the government has created risks that did not exist earlier--the monetisation of the fiscal deficit that could result in large increases in money supply and hence increase inflation. If deficit is not monetised, large government borrowing from the banking system, necessitated inter alia by likely revenue shortfall relative to the FY20 budget target, can severely crowd out the supply of credit to the private sector. In addition, fiscal expansion envisaged in the FY20 budget may create aggregate demand pressures that require a countervailing monetary policy response. Forcing reductions in lending rates and facilitating credit growth further add to pressures on monetary policy. This has so far involved relatively benign directives that have not been adhered to and understandably so. However, persistent extra-market pressures to lower lending rates can result in dodgy lending and borrowing practices (shadow banking), out of reach of regulators and make the exercise of regulation more difficult. 

So, what should the BB do?  Clearly, it cannot make all ends meet.  Nor is there such a thing as a riskless policy stance. The BB must prioritise primary targets and demote the secondary ones to bring greater clarity to the policy stance. Taming non-food inflation is an obvious high priority, but this cannot be at the cost of suppressing private sector credit growth or excessively drawing down foreign exchange reserves.  There is hardly any room for further easing the monetary policy stance. The BB reduced banks' cash reserve ratio from 6.5 percent to 5.5 percent and the repo rate from 6.75 percent to 6 percent in April 2018. It also extended the deadline to September 30, 2019 to meet the reduced limits on the advance deposit ratio. These easing measures were motivated by tightening liquidity conditions from a weaker balance of payments and the increase in bank's deposit and lending rates. Unfortunately, it failed to turn the situation around beyond some temporary effects. 

With growth targeted at above 8 percent that could lead to overheating, the BB will have to be vigilant against a pick-up in inflation expectations drawing cues from already rising non-food inflation to 5.7 percent in June 2019. Fortunately, headline inflation has remained subdued across most advanced and emerging market economies. Oil prices are expected to moderate from their current highs and be lower on average in 2019 than in 2018, but metal and agriculture prices are likely to stage a partial recovery, picking up momentum in 2020, according to the World Bank's latest Commodity Price Outlook. These may anchor inflationary expectations at a modest level since import prices exert significant pressures on inflation in Bangladesh.

Under these circumstances, the BB has the option of taking an accommodative stance at best since output growth appears to be above potential and inflation expectations are unlikely to be revised down in the near-term.  Note that many developing countries are moving toward more flexible monetary policy frameworks and more forward-looking policies as both short- and long-term relationship between broad money growth and inflation has weakened over time, especially in low-inflation countries. However, money still "matters" for inflation in that an exogenous increase in the money supply is likely to be expansionary. However, with supply shocks still the dominant source of macroeconomic fluctuations and financial system not deep enough, nominal GDP growth outlook must continue to guide monetary targeting. 

Private sector credit growth target has drawn much attention in the run up to the forthcoming monetary policy. What will matter is not just the quantity, which can be in the 15 to 17 percent range, but more importantly the quality of private credit. Stronger supervision of weak banks and liquidity support conditional on improving collection of NPLs rather than a broad easing of private credit is better suited to addressing liquidity problems in individual banks and strengthening confidence. High NPLs and weak bank governance nurse potential financial stability risks from a recovery in private credit growth, requiring macroprudential measures to mitigate these risks.

Policy pragmatism requires the BB to allow increased exchange rate flexibility to preserve the level of reserves, buffer the economy against external shocks, and increase space for the autonomous conduct of monetary policy. The resulting exchange rate depreciation may elevate the inflation risk somewhat, which can be mitigated through appropriate fiscal response, including compensating adjustment of import duties and fiscal austerity. Macroprudential policies, which the forthcoming MPS must clarify, should ensure adequate capital and liquidity safeguards against disruptive shifts in economic conditions, minimise balance sheet maturity and currency mismatches and ensure that these vulnerabilities do not hinder the essential shock absorbing role of flexible exchange rates.

The author is an economist.