Walking down the contrarian lane

Contrarian policies are making headlines these days. In good times they may appear harmless because they don't bind. When incomes are growing and so are prices, a few percentages of monetary or fiscal expansion draws little notice. When incomes are down and prices up, going contrarian risk going further down on incomes and up on prices making it perilous to not notice.

In our monetary policy arena, the contrarian lane starts right from the projections. The Bangladesh Bank announced a mildly expansionary monetary stance in June. The reserve and broad money growth targets for FY23 exceed their realised FY22 growth rates. The assumed 7.5% GDP growth in the FY23 Monetary Policy Statement is higher than the provisional 7.25% BBS estimate for FY22. The MPS alludes to an inflation "ceiling" for FY23, presumably the 5.6% mentioned in the FY23 Budget Speech, lower than the 6.1% headline inflation in FY22.

A touch with reality feels GDP growth decelerating and inflation accelerating. Hard to find evidence to the contrary – locally and globally. The policy stance appears unconcerned about the economy being on a trajectory opposite to the one assumed. There is no indication of any policy adjustment other than the 25 basis point increase in the repo rate on Thursday.

The role of the bank lending rate in the transmission of monetary policy is in a deep freeze. The 75 basis point increase in the policy rate so far has less than 200 basis point room to move the lending rates industry wide. Meanwhile, the differential between the rates on safe assets and the lending rate cap has shrunk massively.

The options at play

BB tightens or loosens the stock of money through direct interventions on the supply side by increasing or retiring its lending to the government and the domestic financial institutions. A key tradeoff BB influences is between lending to the private sector versus lending to the government. BB purchase of government bills and bonds create reserve money. Purchase of bills and bonds by the primary dealer banks has no such effect. BB controls the auction of bills and bonds. When concerned about the private credit crowding out effect, BB may choose to devolve the issues to itself, prioritising growth over inflation control.

T bills and bonds are currently a very attractive class of assets for the bankers. Safety and profitability induces banks to embrace them readily under uncertain economic conditions. The risk of default is zero. The interest rates range between a little less than 6 to a little over 8.5% depending on the maturities. The average cost of finance in the banking system is probably poised to rise beyond the 4-5% range with increases in BB repo rate. The most banks can charge risky borrowers is 9%.

When margins are on a diet, why not sleep better? The preferred portfolio choice is a no brainer. Banks' excess reserves naturally flock to safe assets, thus drying out the supply of funds for lending to the private sector. BB's refinancing schemes prove handy in these circumstances when they come with spreads higher than other risky lending alternatives.

The elephant in the room is BB's intervention in the foreign exchange markets. BB's foreign currency assets constituted 82.5% of reserve money at end June 2022. The ups and downs in reserve money in recent years have reflected movements in the stock of FC assets targeted to keep the exchange rate pegged within a tiny band.

Direct interventions in the domestic taka and dollar markets have monetary effects. BB provides liquidity support to dealer banks and financial institutions in the repo market with tenures as short as 24 hours to three consecutive months. Dollar purchases reduce taka liquidity while sales increase it. Shortage of taka liquidity, when demand for credit is high because of near zero real lending rate, makes efficient credit rationing no more than a happenstance. Augmenting supply of cheap credit, rather than rate correction, in an inflationary environment is to live dangerously if not playing with fire.

Developments to date

Budget deficit fully monetised. Net government borrowing from the banking system (1 July-20 September) amounted to Tk2,861 crores while net borrowing from BB amounted to Tk8,845 crores. Part of the borrowing from BB was used to retire government debt to the banks. The excess of bids offered over bids accepted in the auctions at current yields indicates the devolvement of the new issues of government bills and bonds to the BB was not because of the lack of demand from the dealer banks.

Rising private credit growth. It reached 14.1% in August from 13.95% in July, 13.66% in June and 12.94% in May. The boost came from demand for trade financing and loan disbursement from the low-cost refinancing schemes. BB set up a revolving fund in July amounting to Tk25,000 crore for cottage, micro, small and medium entrepreneurs. Corporate entities switched to local currency loans because of the rise in interest rates abroad. Private credit growth is on course to exceed the 14.1% monetary policy target for the year.

Money on call is pricier. Sales of dollars, mostly to the state-owned banks, mopped up their taka liquidity reducing their capacity to lend in the interbank call money market. Over Tk32,729 crores flowed back to the BB through this mechanism in the first quarter of FY23. Call money rates have recently been hovering around 5.5%, compared with less than 2% a year ago.

Effect of dollar sales being sterilised. BB refrained from providing any taka liquidity support for almost all of FY21. This started changing in relatively small measures in FY22, making a pivot in the first quarter of the current fiscal year. The graphs on BB's daily local and foreign exchange liquidity management operations in recent months look like mirror images of each other.

Back to the past in the foreign exchange market, with a twist. Dealer banks are in a historically unique position to individually set the selling rate at cost plus and collectively set differentiated ceilings on the buying rates paying less where their bargaining power is high (export dollars) and more where their bargaining power is low (exchange house dollars). The dealers' associations claim they are merely carrying out the will of the regulator, suggesting a reverse regulatory capture.

Going contrarian is no free lunch

BB is by no means the only one walking down the contrarian lane. Turkey, China, and Japan are among the exceptions leaning in a direction opposite to their key foreign counterparts. Monetary and fiscal policies in the UK are currently on a collision course.

The Central Bank of the Republic of Turkey has lowered its policy rate by 500 basis points since August 2021 even though inflation has graduated to the hyper territory, making the real interest rate deeply negative. As of August, Turkey's official annual inflation rate rose to 80% from 17% in April. The lira has been the third-worst performing currency so far in 2022. CBRT embraced the unorthodox view that high interest rates cause inflation.

Inflation in China increased from 0.4% in December 2021 to 2.5% in August 2022 when the Renminbi reached a two-year low and the Chinese policymakers unexpectedly cut two key interest rates. China's policymakers believe deflation, not inflation, is the main risk faced by China at this stage because of zero-Covid policy which supports production but saps demand. However, Chinese consumers apparently are worried about job security, ability to pay rent or mortgage, groceries, and essential goods due to inflation and lockdowns.

The Bank of Japan has pursued an ultra loose monetary policy setting a short-term interest rate at minus 0.1% and purchasing Japanese government debt to defend the 0.25% cap for 10-year government bond yields. The expanding policy divergence between the BOJ and other central banks pushed yen down 25% this year. Consumer prices, in the land of falling prices, jumped 2.8% year-on-year, breaching BOJ's 2% inflation target. Consumers are feeling the pinch of unaccustomed price hikes without salary increases.

Fiscal and monetary policies acting at cross-purposes have rocked financial markets in the UK. The new government's mini budget announced unfunded tax cuts and huge increases in government borrowing just a day after the Bank of England hiked interest rates. Investors immediately dumped government and pension fund bonds, with the cost of borrowing over five years seeing its biggest one-day rise since 1991. The pound plunged against the dollar to levels last seen 37 years ago. Contrarian fiscal policy scared creditors who wasted no time to exit.

Revisiting the stance

Lessons learnt from all of the above is what not to do. BB revises the monetary program at the end of the first half of the fiscal year. Total liquidity injections through purchase of bills and bonds from the government, refinancing facilities and repo operations is still less than the total taka liquidity mopped through foreign exchange sales.

The stock of reserve money has been flirting around the backloaded monetary programme. The path next three quarters may need some de-escalation in the light of the inflationary trends in the first quarter. September inflation data is technically due next week although BBS is yet to release the August data.

Zahid Hussain is former lead economist of World Bank Dhaka office.