Getting the policy mix right
The Monetary Policy Statement announced by the Bangladesh Bank (BB) for the second half of 2023 makes timid use of the instruments available to tighten money, notwithstanding the apparently "contractionary" stance, to combat spiraling inflation head on and stem, if not repair, the deepening dollar shortage. Earlier, on June 1, the government unveiled an expansionary fiscal policy relying heavily on borrowing from the banking system. A coordinated policy stance is important to make sure the two policies do not pull in directions counterproductive for stabilization, growth, and poverty reduction.
A shift to two disparate interest rate corridors
BB used to set monetary growth targets operationalized through exchange of short-term government debt with the authorized dealer banks. Under the new Interest Rate Corridor (IRC) system, BB will target the interbank call money rate to keep it close to the "policy rate" (repo), increased from 6% to 6.5%, within 200 basis points plus minus the target. The upper 8.5% bound will be supported by a Standing Lending Facility (SLF) meaning banks can borrow from BB if the call money rate exceeds 8.5%. The lower 4.5% bound (currently reverse repo) is supported by a Standing Deposit Facility (SDF) meaning the bank can deposit money with BB at this rate. SLF borrowing will add cash to the banks' reserve accounts while deposit with SDF will take it away. Reserve money will increase or decrease accordingly.
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This is a welcome step towards interest rate targeting. The correlation between money and prices is harder to gauge than it once was. Many central banks, including the Reserve Bank of India, have switched to inflation targeting with an implicit goal for growth. Inflation targeting starts with targeting interest rates rather than a specific amount or rate of growth of reserve and broad money. The desired interest rates of course have to be achieved through rates at the interface of the banking system and the rest of the economy. MPS has stumbled on this part.
There are different corridors of varying width for the lending rates. The vehicle BB has decided to use for influencing the bank lending rates is abbreviated SMART (Six Month Moving Average Rate of Treasury). The lending rate from July 1 will be the SMART rate (the reference rate) plus a maximum 3% spread for all commercial bank borrowers except CMSMEs and consumers for whom it can be 4%. The NBFIs are allowed a spread of 5%. BB will post the reference rate at the beginning of every month for the banks to set their lending rates accordingly.
There is no obvious link between the SMART and policy rate. Changes in the "policy rate" cannot automatically feed through to all the other interest rates that are relevant in the economy. The feed can happen under this regime only if the reference rate or the spread change, both decided by BB without necessarily factoring money market conditions. At the current SMART rate of around 7%, the 9% cap will most likely approach 10% for corporate and noncorporate business borrowers, the cap on CMSMEs will rise from 9% to 11%, and the cap on consumer loans will fall from 12% to 11%. These rates can inch up or down from month to month with changes in SMART rate. Since last April, this rate has hardly moved from around 7%.
One step forward on exchange rate unification
BB will unify its own buying and selling rates with interbank exchange rates from July 1. There will be no BB rate in the foreign exchange market. Bangladesh Foreign Exchange Dealers Association (BAFEDA) and the Association of Bangladesh Bankers (ABB) will continue to set the exchange rates for exports and remittances. The formula for setting the selling rates for imports remains unchanged as the bank specific weighted average of export and remittance rate plus 1.
The prevailing foreign exchange shortage is neither recognized as a consequence of the multiple rates nor a "cause" of rising inflation. There is in fact no mention of the phrase "foreign exchange shortage" in the entire MPS. BB narrative on inflation attributes it primarily to "disruptions" on the supply chain" and cost push from prices of imported items in the global market, exchange rate depreciation, energy price increases, and lack of a competitive environment "along with market syndication".
The faith in the policy model used to manage the growing external pressure, epitomized by declining official reserves by $1 billion every month on average this year, remains indelible. BB believes it has helped bring the different rates within the 2% variation. It is not clear what makes this 2% variation rule so sacrosanct. BB hopes to achieve a "market-based floating, flexible, and unified regime" within the third quarter of 2023.
BB considers the current level of the various exchange rates "market condition reflexive, requiring no major depreciation of the BDT at this moment." If indeed the current rates are fully aligned with market conditions, why not switch to a fuller unification to close the gap between the formal and informal rates sooner than later? What are we waiting for?
With caps on formal buying rates in place, the exchange rate channel of monetary policy transmission, given leaky capital account, will continue to take the form of local currency chasing foreign currency in the informal markets when money supply is expanding and vice versa. This means a perpetuation of financial account deficit as confidence erodes with domestic borrowers struggling to settle external payments against letters of credit and several other short-term borrowings.
The likely extent of monetary contraction
Policy contraction in a growing economy is judged based on monetary growth, the direction of policy of policy rates and their passthrough to downstream interest rates. The projected 10% broad money growth looks contractionary when compared with the projected 13.5% nominal GDP growth but not quite so compared with the 9.5% monetary growth estimated for FY23. What matters perhaps more for inflation is growth in domestic credit, projected to decline to 15.3% in FY24 from 16.9% this year. Credit to the public sector, the projected driver of decline in domestic credit growth, is subject to fiscal dominance.
The extent of policy contraction is therefore conditional on the fiscal deficit outcome and the impact of the rate hikes. The prima facie contractionary rate hikes are stunted by patchy passthrough. The monetary policy transmission mechanisms remain generally as constricted as they were. The 50-basis point policy rate increase can at most nudge the lending rates toward their ceilings. The borrowing cost channel remains limited to 10-11%.
The increase in caps could have effects some of which reinforce while others counteract each other. A one percentage point increase in the cost of credit to the business sector may decrease their demand for credit somewhat. How much only time will tell, but with real interest rates still near zero, the mileage cannot be too great. A 2-percentage point increase in lending rate to the CMSMEs could increase the volume of credit they receive by enabling reaching those rationed on cost considerations at the 9% rate. The demand creation effect of this increase may be outweighed by the efficiency gains in credit allocation and output response.
The policy rate hike makes banks less profitable in general and thus perhaps less willing to lend but this is counterweighed by enhanced interest in BB's subsidized lending through the refinancing facilities. Another significant offset to contraction could be the one percentage point reduction in the cap on consumer loans. Consumer credit growth rose to 22% in March, according to the MPS, with interest rate at 12%. The decline in the ceiling to 11% will stimulate their demand which banks will find more attractive relative to loans where the rate cannot exceed 10%.
On balance, the extent of monetary contraction from the measures does not appear to promise much. In other words, the policy is not tight enough considering the magnitude of targeted disinflation from the current 10% to 6% in FY24. The 100-200 basis points rise in the ceiling on commercial lending rate is well short of the 425 basis points increase in the inflation rate since the 9% cap came into effect in April 2020.
The emerging monetary-fiscal mix
In a high inflation environment, fiscal policy needs to focus on protecting the most vulnerable households and foster potential growth through structural reforms. The liquidity constrained low-income households have less room to buffer sharp increases in their cost of living while facing significantly higher effective inflation rates than high-income households because of relative energy and food price increases. Even tighter monetary policy, leading to lower headline inflation, would not prevent such uneven effects across households.
So far, the government has focused mainly on a combination of loosely targeted measures, fossil fuel subsidies and transfers to soothe the damages inflicted by price increases. Only a small share of the fiscal response targets low-income households. Many popular fiscal measures, such as price caps, broad-based subsidies, and development projects risk fueling inflation through deficit expansion.
The price pressures are unlikely to dissipate quickly. Fiscal policy is at risk of contributing to inflation at a time when price pressures remain unabated. The MPS commits to accommodate the planned government borrowing from the banking system in the FY24 budget. Real rates are negative for all tenors of treasury bills and bonds, implying policy is too accommodative. This raises the risks of eventually translating first round price rises into second round effects.
Prioritize macroeconomic stability
Stabilization means leaning against the direction in which the economy is headed. The current monetary-fiscal stance is not adequate for a return of inflation to 6% in FY24 without any transformative help from global forces. The government must address the underlying sources of the supply-side shocks affecting the structure of the economy more persistently, including shunning rigid adherence to policy models that may have aggravated the original supply shocks. At present, the largest risk for BB is an underestimation of inflation persistence.
