Inflation roars on

The latest inflation data has surprised very few observers. Inflation in May rose to 9.9%, riding on momentum from both food and nonfood prices in urban and rural markets. There is little solace in the month-over-month decline in food inflation due to seasonal factors such as the post Ramadan cooling of demand for food and the boro rice harvest. All items under nonfood inflation have increased both relative to May last year and April this year. Inflation in housing, utilities, household furnishings, recreation and culture are double digits with health and miscellaneous goods and services not too far behind.

Unconventional policies

We seem to be witnessing runaway inflation driven primarily by supply side constraints that cannot be attributed to global factors any more. International commodity prices have declined sharply over the past six months, after posting record-high levels last year (World Bank Commodity Market Outlook April 2023). The dollar and energy constraints the economy has been weathering for nearly a year now owe their deep rooting to what Moody's recently described as "unconventional" policies.

The policymakers counted on demand side measures which worked, as intended, in reducing imports but precipitated supply disruptions that were no part of policy intent. The dollar market faced a policy regime founded on the assumption that fixing dollar purchase prices by differentiated capping of the rate offered to the exporters and remitters will have no effect on supply while limiting exchange rate depreciation. Bankers got together under the umbrella of Bangladesh Foreign Exchange Dealers Association (BAFEDA) to do what Bangladesh Bank urged them to. These rates never caught up to the informal market despite several adjustments.

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The consequent dollar shortage in the formal system exacerbated the inflationary pressures created by the 20% or so depreciation of exchange rate for imports in the last 12 months. BAFEDA periodically adjusted upwards the export rate. flipflopped on the remittance rate and kept unchanged the average buying rate plus Taka one method of calculating the rate for importers. The periodic adjustment of the export rate, by taka 1 each time, could have fuelled speculations about future rate increases, thus incentivizing delays in repatriation of payments received against decent levels of export shipments (nearly $48 billion in July-May).

The informal market attracted remittances offering premium exceeding the subsidy in the formal channels. Remittances through the banking system remained flat notwithstanding nearly 2 million addition to the stock of Bangladeshi migrant labour overseas in last two years. Exchange rate repression disallowed further market driven depreciation as well as forex supply response. The latter reinforced forex rationing, leading ultimately to less reliable electricity as coal and gas could not be imported and payment arrears to the players in the electricity supply chain, among others, accumulated.

Inflation hits decade-high at 9.94% in May

Not in sync with the state of the economy

The dollar and energy shortages are causing more disruption in production and supply chains than recognized at the policy level. A rude awakening has come from the load shedding of around 2,500 megawatts every day. Businesses, services, shops, and markets are having to close earlier than usual. A severe water crisis in cities has made bearing the atrocious heat all so painful for households and institutions such as hospitals and schools. Industry insiders believe industrial productivity across different sectors is down 50% due to energy shortage and its unpredictable availability. This is toxic salt to the otherwise bearable injuries from 50% petroleum, 16% electricity and 150% gas price hikes during the year so far.

Prioritizing the use of dollars from the depleting official foreign exchange reserves appears to have cracked somewhere. Yes, there is not enough foreign exchange to import gas and coal. However, financial mismanagement on the part of the public entities in the sector and oversight on the part of the foreign exchange reserve managers are equally culpable for exacerbating the problem. For instance, depleting stock of coal in the least cost power plant of the country, while arrears on coal payments are piling up, should have triggered emergency response actions. Beyond writing letters to each other, not much seem to have happened. Bangladesh Power Development Board is growing unpaid bills to power producers even when they are not feeding electricity to the national grid.

Macroeconomic policies have maintained a stance nourishing the inflationary momentum. BB dollar sales siphoned excess liquidity from the banking system while domestic credit expanded. The dollar sales dried idle taka liquidity in the banking system. Domestic credit injected active money into the rest of the economy by paying for government expenditures. BB's net foreign asset (largely dollar denominated financial claims) in March 2023 was Tk616 billion lower than in March 2022. On the other hand, BB's claim on the public sector (central government and the state-owned enterprises) was Tk1040 billion and on private sector (predominantly deposit money banks) Tk15 billion higher. There was a net injection of Tk439 billion, equivalent to 1.1% of the FY22 GDP, during the twelve months ending March 2023. The 9% cap on nominal lending rate supported maintaining double digit (11.2%) growth of credit in the private sector despite a large fall in import trade and apparently weak real industrial demand for credit.

Learn from thy neighbour

We need look no further than our largest neighbour to learn how to combat inflation and avoid dollar shortage in crunch times. The Reserve Bank of India has been tightening monetary policy consistently over the past fiscal year. They increased repo rates (the rates at which banks borrow from the central bank) in a flexible lending rate environment, increased the Cash Reserve Ratio and reduced the rate of interest on cash deposited by banks with RBI. Transmission of these monetary policy signals reduced the amount of bank credit disbursed. The RBI refrained from monetizing the fiscal deficit.

Market-based interest rates, exchange rates and fuel prices made policy transmission easier. The Indian Rupee has so far depreciated 11.5% against the US dollar since early January 2022. But fuel prices fell with decline in crude oil prices, helped by purchases at a large discount from Russia. The government cut excise tax on petrol and diesel and reduced import duty on some critical raw materials for production. Aided further by rising borrowing costs and restrained government consumption, headline inflation eased below 5% in April 2023 from its 8% plus peak in July-August 2022.

The India rupee has matured to a managed float. Despite being stressed as overseas investors started paring their exposure amid international uncertainty and worries over the Indian economy, the RBI did not cap the exchange rate. RBI intervenes directly in the foreign exchange market through purchases and sales in US dollars and euro in the spot and forward markets. RBI's indirect interventions use reserve requirements and interest rate flexibility to smoothen temporary supply-demand mismatches. India showed what works. Bangladesh's exit from similar interest rate and exchange rate regimes shows what doesn't.

Fading global headwinds unlikely to be enough for taming inflation

Going forward, the global inflation outlook is favourable. International commodity prices are declining, albeit amidst volatilities. The dollar appears to be well past its peak reached last year. Much of the projected 26% decline in the energy price index in 2023 has already taken place. Food, metals, and minerals prices are expected to fall by 8% in 2023 and 3% in 2024 if trade from the Black Sea region remain stable.

Whether decline in global inflation will pass through Bangladesh depends partly on government policies and partly on the exercise of market power by the significant players in domestic consumer markets. Administered price increases in response to global price increases need reversal to pass through global price decreases to domestic prices. If regulators fail to act even handedly to restrain anticompetitive behaviour, the pass through may be more to profits than consumer prices in case of commodities whose prices are not administered.

The FY24 budget may add to the inflationary momentum with its heavy reliance on indirect tax rate hikes and an increase in budget deficit that looks deceptively modest as a percentage of GDP (5.2). Considering BB's past measures and their faith that these would eventually pay off, a policy pivot in the new Monetary Policy Statement on June 18 may be a far cry. But a significant course correction is overdue. It is not a lofty ideal to resurrect the lending rate regime to what used to be before April 2020 and the exchange rate regime before September 2022. Those will constitute good strategic retreat from the unconventional policies to launch reforms directed at making the credit and foreign exchange markets function better.