Vol. 5 Num 994 Sun. March 18, 2007  

Monetary contraction and growth

Quite contrary to what most people would assume to be the case, the central bank of Bangladesh has actually followed a policy of restraining the growth rate of the economy. It is almost two years now that Bangladesh Bank made the decision (or the decision was made for it) to switch to a contractionary monetary policy. The CEOs of all commercial banks were instructed to raise the interest rates only weeks after they had been publicly rebuked by the then Finance Minister for charging too high interest rates on loans. Having made the (according to many, wrong) decision, Bangladesh Bank did the only right thing it could do. It stuck by its new policy. Monetary policy should not be tinkered with every now and then as its effects might take more than a year to eventuate.

The ostensible purpose of the monetary contraction was to reduce (or at least not increase) the supposed inflationary impulse, which was running at 6.2 percent at the time. The Bank felt that the rising inflation was due to excessive demand and hence needed monetary discipline. Although the inflationary tendency at the time was not due primarily to demand pressures, the policy did yield the anticipated result; it contained inflation. The latest inflation figures suggest that it has not risen much more than half a percentage point over the level it had attained in April 2005. On a point-to-point basis the inflation rate has actually declined. It was a reasonably good achievement on the inflation front, but the important question is: what did it cost the economy?

A well-known tool of short term macroeconomic analysis, "Phillips Curve," says that a reduction in inflation can be achieved only at the expense of lower output (growth). Inflation, being a monetary phenomenon, can be always brought down, given sufficient time, by a monetary squeeze. Such a squeeze that manifests itself in rising interest rates increases cost of funds and thereby reduces aggregated expenditure, particularly investment expenditure. This helps to cool off the economy; investment and output (growth) fall. Employment also declines or does not increase as much. This is the principal real cost of monetary contraction. Much of the lost output and employment would have accrued to the poorer section of the community; they are particularly hard hit by a monetary contraction.

Bangladesh Bank is a bit reluctant about admitting that it has instituted a monetary contraction; it favours the term "cautious" to describe its monetary policy. It points out that there has been no contraction in money or credit supply. Monetary data show that there has been indeed no reduction in the growth of private sector credit, and hence Bangladesh Bank is entitled to claim that it has not squeezed credit supply.

However, credit supply is not a true indicator of money market conditions or the monetary stance of the central bank, since it ignores the demand side entirely. The money market would be slack with a credit growth of 19 percent (the actual growth in 2005-06) if the demand growth was only 15 percent, but it would be tight if the demand growth were 25 percent. In the former case, Bangladesh Bank would be executing an expansionary monetary policy resulting in a reduction in the interest rates, whereas in the latter case it would be executing a tight monetary policy with rising interest rates.

Hence, a more reliable indicator of the money market condition is the interest rate. Most central banks these days use the interest rate as the target variable of monetary policy as money or credit has been found to be quite unreliable. When they want to tighten the money market they attempt to raise the interest rate. This is the principal transmission channel of monetary policy.

The intent of Bangladesh Bank's monetary policy is very clearly reflected in a range of interest rates such as the rates on treasury bills and government bonds of various maturities, repo and reverse repo rates and rates on bank advances. These rates have all risen steadily since March 2005. The 28-day Treasury bill rate has risen by 2.62 per cent while the reverse repo rate (1-2 days) has risen by 2 per cent between March 2005 and December 2006. The rate on bank advances has risen by 1.67 per cent between March 2005 and September 2006. These are very substantial increases in the interest rates and doubtless indicate a steady tightening of the money market. This policy-induced monetary contraction has no doubt helped in keeping a lead on the inflation rate, but it has also dampened business enthusiasm to invest.

Monetary brakes were activated when the economy was palpably on the threshold of a 7 percent plus economic growth. Business confidence was high and private investment was booming. Even major foreign investors were keen to invest in the country despite all the adverse publicity regarding corruption and political bickering. The monetary contraction must have sent a clear message to private business about the central bank's intent regarding the future course of the economy. This must have cooled off their enthusiasm and thereby reduced business activities. The economy, thanks to a buoyant private sector, attained a growth rate of 6.7 percent (2005-06) when it should have achieved well over 7 percent.

The effects of monetary contraction have been now further accentuated by the unfavourable circumstances of the last several months. Although the Bangladesh Bank governor has boldly predicted a growth rate of 7 percent or higher for the fiscal year 2006-07, it is doubtful that the economy can maintain the growth momentum already achieved. The latest indications regarding the volume of exports, imports, and investment are not very encouraging. Unless the government takes some urgent measures to improve the situation we shall have a rather ordinary year ahead. This will make poverty alleviation that much harder to achieve; many poor people will have to wait longer for a remission of their misfortune.

The author is Professor of Economics and Chairman of Bureau of Economic Research, University of Dhaka.