A refreshing departure from business as usual

A departure from conventional monetary policy was a need of the hour.  The Bangladesh Bank (BB) deserves high marks for coming remarkably close to meeting this need by announcing the continuation of an expansionary monetary policy stance since the immediate aftermath of the Covid-19 shock to the Bangladesh economy. Interestingly, the Monetary Policy Statement (MPS) also describes the stance as "accommodative".  

One may wonder how a policy can be both expansionary and accommodative at the same time. The answer is simple. It is expansionary because the projected 15.6 percent broad money growth exceeds the sum of the projected 13.6 percent nominal GDP growth and the decline in the rate at which money changes hands (income velocity). It is accommodative because the projected growth in credit to the public sector is fully in line with the bank borrowing target in the FY21 budget approved by the parliament at the end of June.

The articulation of the policy objectives is commendably noteworthy. The BB resisted the temptation to follow the path of least resistance. This would be to say that the objective of the policy is to attain 8.2 percent growth while keeping inflation within 5.4 percent. Instead, the MPS says the prime objective of the monetary policy and the monetary programme "are the recovery of the economy from the adversity of Covid-19 pandemic and the rehabilitation of the productive capacity of the economy….along with maintaining the dual goals of price stability and quality growth." The 8.2 percent growth fantasy makes its appearance later as part of the details which is understandable.  

Liquidity support is credibly assured

The signal that the BB is ready to provide whatever liquidity is needed to support economic recovery is loud and clear. Recall that the BB quickly eased liquidity in response to disruptions caused by the virus. The cash reserve ratios (CRR) were reduced by 100 to 200 basis points for different types of banking.  Interest rate on loans provided to banks and financial institutions under repo facility was reduced by 75 basis points. A 360-day term repo facility for banks and other financial institutions was added. The advance-deposit ratio (ADR) of conventional scheduled banks and the investment-deposit ratio (IDR) of Islamic Shariah based banks were increased by 2 percentage points. 

These measures together with weak private demand for credit, strong remittances, and purchase of dollars from the foreign exchange market has flushed the banking system with excess liquidity. However, the current excess liquidity can quickly disappear if deposit growth weakens, loan recovery rates continue to falter, the demand for cash stays elevated, shortages emerge in the foreign exchange market and public borrowings increase. 

The BB has made it clear that should such a situation arise; they will not hesitate to meet the gap between demand and supply. The announcement to reduce the repo, reverse repo and the bank rate without specifying the date from which these rates will be effective is perhaps intended to give credibility to their stated readiness to provide whatever liquidity is needed to face the economic adversities.

The key challenge will be to ensure the quality of credit

The best the BB can do to support quality growth is to ensure the quality of credit to the private sector. Achieving the 14.8 percent private credit growth target will be exceedingly difficult, given the uncertainties in external demand and the domestic economy. With the spread of the virus remaining out of control, private demand for credit will falter as investment, trade, and commerce stumble forward and backward.  Ensuring that credit goes to sectors such as agriculture, CMSMEs, manufacturing and so on, as identified in the MPS, will be critical for protecting employment and keeping the productive institutions afloat. Credit quality also suffers when it goes to hands already dirtied by habitually willful defaults. Adherence to prudential norms in the treatment of non-performing loans is crucial. 

The MPS recognises that NPLs will most likely increase. This possibility has been exacerbated by the recent BB decision to further increase forbearance in classifying loans given to CMSMEs.  While the intent is laudable, it sends the wrong signals and could be seriously abused. Most large private banks have capital and cash conservation covers to remain resilient down the road. The risk of a worrisome outcome, with the Covid-19 shock and fresh loan defaults joining forces, is higher if one considers the high levels of pre-existing distressed assets in the banking system.  Note that the BB's 2019 Financial Stability Report provides no data updates on distressed assets as if non-reporting will make the problem go away.

Stemming asset quality deterioration will be the most critical challenge. The MPS provides no indication of the measures the BB intends to take to address the current poor loan recovery rates resulting partly from the moratorium on loan classification till September 30 and the indulgences provided to the defaulters in the past.

Macro and micro prudential measures preserve financial stability amidst increases in loan defaults. Using them forthrightly against willful and habitual defaulters can reinforce the otherwise insufficient impact of purely monetary techniques. This is by no means easy as financial stability depends heavily on factors beyond BB. The pandemic has redefined the criticality of policy coordination between fiscal, structural, financial, and monetary policies. 

Erosion of external price competitiveness remains neglected

There is no indication about correcting the real exchange rate overvaluation. The MPS provides data showing that Bangladesh's Real Effective Exchange Rate is 12.6 percent appreciated relative to its level in 2015/16. Competing countries have nominally depreciated their currencies more than Bangladesh and their inflation rates have been lower. The nominal exchange rate depreciation and the inflation rate are the two changes that determine changes in a country's external price competitiveness.  

Bangladesh has fallen behind on both counts. This has adversely affected the international competitiveness of both our exports and import substitutes while missing out on the opportunity to encourage remittances without imposing any direct burden on the budget. With excess dollar liquidity currently in the market, the BB has the perfect opportunity to engineer a significant exchange rate depreciation while at the same time accumulating precious foreign exchange reserves. 

The 5.6 percent growth target in net foreign assets does not suggest any major shift in BB's stance to maintain the nominal exchange rate near about where it already is and making sure it does not appreciate in nominal terms relative to the US dollar. This strategy has failed to prevent the erosion of Bangladesh's external price competitiveness in recent years.