Monetary policy brandishing double-edged swords

The first monetary policy of 2017 will soon be unveiled. The central bank can take a bow for maintaining macro stability even as economic growth edges up. True, monetary policy has come a long way. The era of easy money that stoked double-digit inflation, burnt up foreign reserves and bloated stock prices some years ago was rightfully dislodged by a more cautious approach. Tighter monetary policy, salted with lower commodity prices and favourable domestic harvests, cooked up a healthier concoction of lower inflation and interest rates. While prodigious accumulation of US dollar reserves insured the economy from external shocks and swelled our Export Development Fund, which might even be joined by a historic Sovereign Wealth Fund.

Yet, there are fault lines. Regulators are pursuing policies that, for all their front-loaded benefits, build up substantial economic risks along the way. By pegging the exchange rate to the US dollar, imposing tight foreign exchange regulations and targeting not-so-moderate inflation rates, monetary policy looks to be wielding double-edged swords. 

Consider the state of monetary affairs. Dollars are gushing in through exports, remittances, foreign aid, foreign direct investment and private borrowings. The only major source of outflow is through imports, which remain lukewarm without the infrastructure impetus. Resident corporations cannot invest overseas and make productive use of their excess savings. While fears over a current account deficit appear overblown considering that it will easily be swallowed up by a much larger surplus in the financial account. So even with the recent decline in remittances, Bangladesh Bank (BB) will be left with a bulging surplus in its balance of payments (BOP). 

Sure enough, BB will devour excess dollars to hold the exchange rate steady. It will then have to sell bonds to soak up local currency that it injected into the system, a practice known as "sterilisation" in central banking parlance. Sounds like a foolproof plan, at least in theory, but financial markets have a way of defying text-book logic. Banks, for instance, might be unwilling to gulp down vast swathes of low-yield bonds that BB dishes out. Even more so if policy rates are cut. That BB's operating target for controlling liquidity and interest rates, known as reserve money, was overshot several times already this fiscal year shows the limits of sterilisation. So what becomes apparent is an imminent collision-course between the need to contain money growth and the need to secure exchange rate stability. Add to that the cost of paying for domestic bonds with reserves that hardly earn any interest, and the free lunch of a BOP surplus no longer appears "free"! 

Meanwhile, the slow decay in trade competitiveness is well under way. With the Taka tightly managed relative to the dollar, there will be no stopping the Real Effective Exchange Rate (REER). Not that it should be wildly surprising. The dollar is appreciating against other major currencies fuelled by hopes of greater fiscal stimulus and faster monetary tightening in America, taking the Taka along for the ride. While 5+ percent domestic inflation, though lower than before, adds fuel to the fire of real effective appreciation in an era where many advanced economies are barely outrunning deflation. Supply-siders will insist infrastructure investment, and consequent import boom, might weaken the currency but further REER appreciation looks the most immediate outcome. 

If REER stabilisation is a priority, policymakers might consider a basket, or trade-weighted average, of major currencies as benchmark for foreign exchange intervention. The added flexibility will absorb shocks from divergent monetary policies that are taking shape in developed countries (tightening in America and easing in Europe/Japan). It will also shore up remittance inflows from countries like the United Kingdom whose currency depreciated significantly against ours recently. 

To be sure, inflation target must be reduced as well, preferably to 4.5-5.0 with a medium-term vision of below 4.0 percent. Worries over choking off growth by being more careful with money supply are overdone. The seductive fragrance of higher money growth and strong real economic activity will not go together for long. All it will do is feed into inflation, disproportionately benefitting the asset-rich. Considering 7.2 percent real growth target, broad money does not really need to rise by more than 13.0-13.5 percent. Take India and China for instance. Both averaged 7+ percent growth with broad money expanding by 12.02 and 12.64 percent respectively, during 2013-2015 according to World Bank and IMF data. 

In the meantime, regulators face yet another conundrum: capital leaking out of the country through over-invoicing of imports. Though capital controls (official restrictions on capital flows) remain tightly screwed in place, the expansion of trade and consequent rise in manipulation of trade invoices provide an easy conduit for money to escape. And despite its best intentions, restricting access to foreign exchange ends up pushing people to pay a premium in the informal currency market (Hundi). By extension, remittance inflows get diverted by more attractive rates there. At the end of the day, there will always be some demand for capital transfer and perhaps even more so as income rises. Capital controls are easy but dangerous substitutes for what's really needed: supply-side reforms in institutions, infrastructure, business-regulations, governance and national security that build more confidence in the economy. 

On the other hand, institutional savings that are cooped up in low-yield bank deposits remain starved of more profitable avenues like direct investment abroad. So a more liberal foreign exchange regime needs to find its way into the agenda. Greater financial openness will also reduce the need for BB to make substantial and costly interventions to keep the exchange rate stable. 

Detractors can fret about instability and balance of payment difficulties, but make no mistake, such risks will remain contained if capital controls are relaxed gradually (following a medium-term plan) and political conditions remain, by and large, stable. In fact, some of the foundations that merit a more liberal foreign exchange regime are already in place: a large tank of reserves, low external debt with very little short-term obligations, prudent macroeconomic policies and stable growth rate. 

In an ideal world, there are two more preconditions. First, bring more flexibility into the exchange rate, which would come from a REER-based approach noted above. Second, shift gears from money-stock management to interest-rate targeting. Managing inflation with broad money target becomes futile once capital flows a bit more liberally across borders. And herein lies the need for a vibrant local currency bond market, a prerequisite for targeting interest rates. Sadly, a deep bond market characterised by long-term debt instruments remain far from seeing the light of the day. 

And so the end-game is clear. Some bold steps departing from established conventions are necessary. Things might seem harmless right now, but eventually double-edged swords could leave scars that will prove difficult to heal.

The writer currently works as a macroeconomic Research Analyst in Washington D.C. and is a Fellow at the Asian Centre for Development in Dhaka. E-mail: sharjilmuktafi.haque@gmail.com