Monetary expansion to fight the pandemic challenges

The already slowing economic activity before the pandemic spiked down further since February amid substantial uncertainty about the pandemic's trajectory. Businesses are producing fewer goods and services for each unit of labor time because of disruptions in workplaces and markets. The public's willingness to spend has declined as they avoid social interactions, travel and discretionary recurrent and capital expenditures.

Put jobs ahead of growth

The adverse productivity and demand shock have caused economic contraction in industry and services. Various surveys suggest large increases in unemployment and poverty. Earnings of low-income groups declined by 49 percent, according to a recent Right to Food survey. Simulations by the South Asia Network of Economic Modelling suggest employment losses ranging between 6 to 12 million. Reverse migration from urban to rural areas provide the most powerful evidence. A sharp increase in "To-Let" signs in Dhaka's residential areas indicate the impact on the urban middle class.

Recovery prospects remain uncertain globally and locally. With the easing of containment measures some recovery is natural. However, this process is likely to stumble if the virus spreads with growth in economic activity. There may emerge a transitory new normal as households and businesses get used to dealing with infection risks with masks, hygiene and social distancing. Restoration of economic activity to pre-Covid-19 level without flattening the virus spread curve is a pipe dream.

What should be the monetary policy stance when the economy is both demand and supply constrained? The pandemic has radically changed the economic priorities. Bangladesh Bank (BB) needs to forsake the supporting growth and maintaining price stability refrain. Monetary growth sensitive core inflation risk has declined. Growth per se has no sheen when activities are virus constrained. The usual assumption that employment will follow growth is no longer pertinent.

The imperative now is to focus on employment and let growth follow as a by-product. This risks ex-post inefficiency by supporting employment that would have died any way, thus obstructing creative destruction. However, the alternative is to risk destruction without creation inherent in allowing the pandemic to decide which jobs shall live or die. Monetary expansion needs to target employment.

Job protection and creation requires designing policies such that credit flows where jobs are most at risk and where job creation potential is high. BB must nudge commercial banks to lend to firms where the cash-flow process is disrupted. A series of new refinancing facilities, amounting to Tk73,750 crore, with low interest rates have been introduced for large, medium, small, cottage, and micro enterprises. The policy makers have revealed a preference for targeting employment in exports, mainly garments, allowing banks to collect only 2 percent service charge from the borrowing enterprises. The 4 percent interest subsidy to large enterprises under the Tk300 billion credit package should also be targeted to protect employment.

Credit support for micro, cottage and small enterprises, mostly in the informal economy, are deficient in size and design. Refinancing rates on schemes for small businesses need to be significantly lower than for large enterprises. The small business sector is likely to protect or create more employment per unit of credit disbursed. Enabling micro enterprises to restart their business with a low-cost risk-sharing loan facility are high priorities on this ground. BB can assist by expanding liquidity facilities to Microfinance (MFIs) and similar institutions in coordination with the Micro Credit Regulatory Authority. MFIs are economic front liners providing financial services to hard-to-reach groups.

Targeted monetary expansion is no cake walk

BB quickly responded to the downturn. It reduced cash reserve ratios (CRR) by 100 to 200 basis points for different types of banking; interest rate on loans provided to banks and financial institutions under repo facility by 75 basis points; and increased the advance-deposit ratio (ADR) of conventional scheduled banks and the investment-deposit ratio (IDR) of Islamic Shariah based banks by 200 basis points. BB added a 360 days term repo facility for banks and other financial institutions.

These measures augmented taka liquidity in the financial system. The stock of reserve money – BB's net foreign assets and claims on the government and the deposit money banks – was 19.2 percent higher at end-May relative to end-February. In June, taka liquidity was also augmented by significant purchases of foreign exchange by BB. Note that excess liquidity declined from Tk1 trillion at end-December 2019 to Tk899.1 billion at end-March 2020 after increasing all last year.

Increase in high-powered money translates into more money in the hands of businesses, households and the government through expansion of credit to the private and public sectors. Broad money grew by 16.2 percent by May relative to February, behind reserve money growth despite 75 percent increase in credit to the central government. Private credit picked up at a leisurely pace. Whether the stimulus packages will expand the money supply through the targeted sectors depends how much and how soon the latter are able to access the credit.

Large businesses need liquidity to tide over the crisis. They are willing to access the subsidized credit if these do not come with strings such as retaining employment. Frequently changing BB edicts and procedural complexities are delaying disbursements, except for garments who have quickly accessed the facilities offered to pay wages. Small businesses, facing existential threat, cannot access the Tk200 billion subsidized credit because of no pre-existing relationship with banks and the lack of credible guarantees. Consequently, this part of private credit expansion may take a long time to materialize despite good intentions.

Government borrowing will rise

Government's bank borrowing is most likely to rise well beyond the Tk824 billion budget target. The latter alone is equivalent to 6.1 percentage point broad money growth relative to its level at end-May. It can have powerful multiplier effects if a significant part of it is monetized either through BB uptake of the public debt issues or through seigniorage revenues by printing BB or treasury notes. Expanding BB holdings of public debt instruments is easier to reverse than printing notes.

Monetary expansion through the public sector could create stability risks especially when fiduciary controls on public expenditures are dysfunctional. Among the dangers are inflation resulting from the supply of taka liquidity to pay for massively overpriced government purchases and vanity projects. The persistence of the negative productivity shocks from Covid-19 elevates the risk further. Erosion of confidence in the currency can make financial markets misbehave in ways not easy to anticipate.

Additional liquidity injections may nevertheless be needed. Liquidity may tighten as deposit growth slides, loan recovery rates falter, the demand for cash stays elevated, shortages emerge in the foreign exchange market and public borrowings increase. A part of the projected external financing gap is expected to be met by drawing down official reserves. This will increase the need for injecting taka liquidity even further. Allowing greater exchange rate flexibility can reduce soaking taka liquidity from the banking system.

BB has extended the trading of government securities held by banks in excess of the required 13.5 percent minimum SLRs in the repo market. This has freed a significant amount of securities for use in BB's open market operations. The SLR can be reduced from the current 13.5 percent by even 5 to 10 percentage points if needed to ease liquidity further. BB power to ensure commercial banks maintain adequate cash reserves hedges the consequent liquidity management risk.

Dismantle controls to enable liquidity supply response

The complexity created by excessive controls undermines the speed of liquidity supply response. The limits on the aggregate Advance to Deposit Ratio (ADR) makes little sense in the presence of CRR and SLR. Combined with the ceiling on lending rates, the financial sector is facing repression on both price and volume. BB's autonomy in the conduct of monetary policy cannot be more constrained.

The interbank money market trades are tightly controlled as well. In the primary market the auction committee often devolves securities to the authorized dealers when the prices quoted by the bidders are deemed unacceptable. There is no transparent trading platform for buying and selling government securities between commercial banks and no functioning secondary market allowing resale of securities. Banks are unable to freely adjust their liquidity positions. Lending rate in the interbank market is largely BB administered.

The conduct of monetary policy will benefit immensely if the regime of financial repression is dismantled. A growing appetite on the part of the government to borrow at rates ranging between 6 to 8 percent is antithetical to the objective of expanding private sector access to credit with the lending rate administered not to exceed 9 percent. It is not pragmatic to expect one (read banks) to swim out of troubled waters with both hands and legs tied.

At the end of the day what will matter under the exigencies created by the pandemic is whether monetary policy can stop job destruction by fattening the mortality rate of small businesses. This will require BB to help the financial intermediaries help small businesses through liquidity and regulatory easing not just for the conventional banks but also for institutions with a demonstrated capacity to provide and recover loans not backed by conventional collaterals.