Time for a macro policy change?

A few days ago, one of our friends injured his left ankle. The doctor recommended a four-week plaster of Paris bandage which my friend got rid of within a few days citing "discomfort". With heavy pain, he started to put his body weight mostly on the right leg. He ended up with an even worse right knee injury. Now, with severe injury in both legs, my friend was forced to cut back on his normal life and then undergo a lengthier, more complicated rehabilitation plan. 

His case resembles our country's economic condition today. In this case, the ailment is a combination of extremely high commodity prices, high freight prices, supply chain bottlenecks and a rising US dollar. The result has been a massive trade and current account deficit coupled with sharply increasing inflation.

This sort of environment has two common policy solutions:

1) Increase interest rates to put pressure on discretionary import demand, and

2) Let the forex market find its new equilibrium with "some" support from our international reserve.

Just to give an example, someone bringing a luxurious item with a price tag of $1,000 from abroad might be discouraged if the interest rate on his/her "Consumer Loan" had changed from 9% to say 15% by his/ her bank or if the exchange rate for taka shot up by 10%.

In both cases, the subject person would find the ultimate cost for the imported item going up significantly and likely to cancel the purchase anyway. When thousands of such consumers would end up doing the same thing, total import demand and subsequently trade-gap of the country would also go down automatically. Fiscal policies such as raising import tax or tariff for selective items or increasing LC margin are unlikely to drive such outcomes on time.

However, in Bangladesh, we are yet to embrace either of the two solutions properly. Firstly, since April 2020 we are in a regime with a lending rate cap of 9%. This pretty much means Bangladesh Bank's policy rate has become ineffective as a policy tool.

With interest rates fixed, the entire pressure thus comes on the exchange rate. The initial response was to defend the currency by using up our reserves. Foreign exchange reserves fell from US$48bn to around US$41bn. As reserves started coming down, Bangladesh Bank took the prudent decision of letting the currency depreciate. BDT moved from 87 to 93 against the US$ while the kerb market exchange rate stands at around 98 (after hitting a high of 103). We are still behind the curve on depreciation.

Policy objectives in a country like Bangladesh must focus on the well-being of the lower-income group people in general. The 9% lending rate cap actually benefited big industrialists (higher income group population) disproportionately – mostly at the expense of the interest of the lower-income groups (i.e. the savers).

The industrialists managed to keep their interest expenses low due to the interest rate cap. But for this, banks started offering very low-interest rates on deposits. Even with the regulatory interventions, depositors, mostly coming from the lower-income group, lost their purchasing power due to the combination of high inflation and low deposit rates.

Lending rate caps also make the case for SMEs difficult as economics does not work for banks and FIs to prioritise lending to vulnerable small businesses at a maximum of 9% in the current economic conditions. 

While some depreciation of taka is inevitable, choosing a policy to only let taka depreciate instead of raising interest rates for businesses and consumers, favours the higher income group and penalises the lower income group people.

This is because a depreciation of the domestic currency means higher revenue for export-oriented businesses such as RMG - the same set of beneficiaries of the 9% lending rate policy. On the contrary, lower-income groups are now more vulnerable to depreciation-led inflationary pressures. Hence, the lending rate cap has also been driving inequality.

The world faces an extremely difficult situation right now and Bangladesh is no exception. Such situations warrant using solutions which can lead to short-term pain for long-term benefit.

A glance at the majority of the countries around the world indicates that they are using both the tools (interest rates as well as exchange rates) to deal with the present situation.

We need to act soon to stay competitive and committed to the spirit of the market economy. We need to reconsider policies related to interest rates and foreign exchange markets immediately. Bangladesh has a long history of maintaining prudent economic policies – now we are in yet another test.

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.