How To Get More Of It

Economic policymaking paradoxes

Masihur Rahman

The economy started showing signs of weakness in 2004-05 amidst claims of macroeconomic balance. The divide between macro and micro economy is much too thin; if the microeconomy is not doing well, the macroeconomic stability cracks up. The numerous agents run the microeconomy; the policymakers risk the health of the economy if they want to fine-tune it too much. That is the bane of our economic policy.

In a bid to get the concessional funds of the World Bank and IMF, the government adopted floating exchange rate policy. There were apprehensions that the initial adjustment would entail deep depreciation of taka and that the Government lacked institutional capacity for managing floating exchange rate. The first apprehension proved false; if the misalignment were large, the shock of the initial adjustment would be deeper. The second apprehension institutional incompetence was not unfounded, whence the unintended consequences.

Not the only repository of statistics

The floating exchange rate regime leaves the determination of the exchange rate to the market, relieving thereby Government of a task which is professionally complex and politically difficult. However, Government did not adapt the method of foreign exchange management to the new policy regime and used its control over the NCBs to maintain exchange rate at a given level. The NCBs sold dollar cheaper than PCBs and FCBs up to Tk. 2.00 per dollar. The result was a stronger demand for dollar and consequent shortage in the market. The Bangladesh Bank had to sell some amount of dollar, which depleted the official reserve. Government's intervention through NCBs amounts virtually to a managed and multiple exchange rate regime, countenanced by the central bank to boot.

There has been a partial correction of the flawed management method of late. The difference between the exchange rates applied by NCBs on the one hand and PCBs and FCBs on the other has narrowed but still persists. Recently, the press reported that letters of credit could be opened at Tk. 67.00 to a dollar which again is an atavism of the managed exchange rate. It is necessary that government adopts exchange rate management method appropriate to the exchange rate policy regime: more specifically, allow the market to operate and find its own equilibrium; punish those who try to corner or manipulate the foreign exchange market.

The government attempted to dampen the import surge by imposing variable margin on LCs, particularly low margin for import of essential commodities. It was helpful to the extent that the cost of import of essentials such as food, edible oil, salt could be contained. However, at the aggregate level, the benefit was partially offset by the lowered tariff on certain 'luxury items' for example, high grade automobiles like Mercedes, BMW, Volvo which absorbed a substantial amount of import outlay. In addition, according to the media, the supply was controlled by cartels which extracted premium on scarcity of goods and under-valued dollar (the mirror image of which is over-valued taka). It is to the credit of Government that it avoided raising tariff across the board to contain import, which would have reversed the policy of liberalization.

Government embarked on an expansionary monetary policy stance in order to make cheap loan (i.e. at lower interest) to the borrowers. For all banks, lending rate fell by one percentage point from 12.78% in June 2003 to 10.79% in March 2005. NCBs effected the deepest cut (2.2 percentage point), followed closely by PCBs (2 percentage point), and FCBs (0.8 percentage point). Lending rates have started rising again which reached 10.92% in June 2005. Incidentally, FCBs reached their lowest lending rate in June 2005 when the lending rates in general had gone up. (Bangladesh Bank Quarterly April-June 2005, Vol. II, No. 4)

Deposit rate for all banks fell by 0.74 percentage point from 6.30% in June 2003 to 5.56% the lowest in December 2004. Again, NCBs effected the deepest cut (1.16 percentage point), followed by PCBs (0.72 percentage point). FCBs followed a different and more calculated path: between June and December 2004, they raised deposit rate (0.29 percentage point) and then reduced it (0.74-0.78 percentage point); their deposit rate remains the lowest (3.75% in June 2005). Deposit rates have started rising again which would improve intermediation which had suffered owing to the faulty policy to force down interest rate. (BBQ, April-June 2005, Vol. II, No. 4)

The burden of the reduced lending rate was borne mostly by the savers via lower deposit rate and partly by the banks via reduced spread between deposit rate and lending rate. The burden on the banks, however, was much lighter. Between June 2003 and June 2005, the average spread fell by over one percentage point (1.2 point). The fall of spread of the different categories of banks was dispersed widely: NCBs remained the closest to the average (1 point) while PCBs experienced a much larger decline (1.8 percentage point); FCB's did not experience a decline of spread worth mentioning (0.07 percentage point). (BBQ, April-June 2005, Vol. II, No. 4)

The differential adjustments to the interest regime are reflected in the profitability of the different categories of banks. In 2004 for which the latest data are available, NCBs incurred loss on assets (-0.14) as well as equity (-5.75); both had been positive during 2001-03. PCBs improved return on assets (0.69% in 2003 to 1.24% in 2004) as well as return on equity (11.37% to 19.53%). FCBs also raised return on assets (2.55% to 3.15%) and equity (20.39% to 22.47%). The capital-asset ratio of NCBs (4.1%) is dismally low relative to the international standard as well as PCBs (13.3%) and FCBs (24.3%). On the whole, government policy of cheap loan has made NCBs weaker than PCBs and FCBs. When the service sectors open up, FCBs will have a head start, which is not what Government intended. These are the wages of folly or sin! (BBQ, April-June 2005, Vol. II, No. 4)

The low interest rate policy was intended to stimulate industrial investment, which could not be achieved on a sustained basis. Industrial loan (excluding working capital) declined by 3.9% in 2003 which wiped out the modest growth at 3.5% in the previous year. However, it rose by 15% in 2004 but decelerated to 8% the next year. Industrial loan (excluding working capital) has been highly volatile in 2005, falling by 11% and 7% in the first and third quarters and rising by 24.5% and 3.5% in second and fourth quarters. (BBQ, April-June 2005, Vol. II, No. 4)

In a perverse way, increase of long term investment loan was accompanied by a corrective reduction of working capital loan which had grown at more than 50% until 2003 but decelerated to 26% and 36% in 2004 and 2005 respectively. This indicates low capacity utilization curiously coupled with additional capacity creation. Further, industrial loan (including capital investment and working capital) increased phenomenally (68%) in FY 04 only and has since been falling. The see-saw policy costs credibility of government. However, fortune has been bestowed on those who could get loan in 2004 at low interest rate! (BBQ, April-June 2005, Vol. II, No. 4)

The arguments for cheap loan were flawed. The low interest India, Pakistan and Sri Lanka could not be a sensible argument for low interest rate in Bangladesh. The capital markets of these countries are impermeably segmented and protected. Low interest does not stimulate investment if the investment climate shorthand for investors' confidence is unfavorable. Entrepreneurs' confidence depends on several factors such as a credible system of rule of rule of law, stable economic policies, and infrastructures. Low lending rate requires low deposit rate which hurts savings and is most probably militates against long term growth and autonomy of national economic policy (not autarchy). Injection of reserve money can drive down interest rate but generates inflationary pressures; such a strategy has limited application in terms of time and magnitude. Finally, the notion of high or low interest rate is misleading; there can be only equilibrium interest rate which matches loanable fund supply and demand. Government rushed into the cheap money policy without thinking through the economic logic or implications.

Inflationary pressure has been building up as a result of the expansionary monetary policy stance and deficit budgetary expenditure, exacerbated by crop failure and the current high petroleum prices. Measured average inflation rose from 1.9% in FY 01 to 6.5% in FY 05. The corresponding measure on a point-to-point basis is rise from 1.7% to 7.3%. Measured annualized inflation in September is 6.8% (7.0% on point-to-point basis). While the high import cost of petroleum has raised the inflation rate, the effect of high food price on inflation is much stronger than any other factor. During July-September when inflation softened a bit, food price inflation remained over 8% while the non-food price inflation never exceeded 5%. There is skepticism about government's claim for lower inflation because of high food price and there is some substance in the public discontent about rising prices.

Currently, inflation is measured as the changes of the prices of a consumption basket on a point-to-point basis.

While such a measure captures the consumers' unhappiness, it is not satisfactory for choosing corrective policies. Further, since disbursement of development aid is linked with inflation rate, it is necessary to chose better measures e.g. core inflation excluding the volatile elements and more reliable computation by a stronger National Statistical Agency. Government and donors have neglected both.

The Government plans to reduce domestic borrowing to about 2% of GDP and raising foreign assistance mostly concessional loan to about 2.4% of GDP. Actual disbursement of foreign aid has been lower than planned, which is adjusted by reduced development outlay and larger domestic borrowing. Net aid disbursement during July-August this year has been dismal: there has been a net repayment of US $ 18 million compared with net receipt of US $ 279 million during July-August last fiscal. There is a wide scope and strong justification to cut unproductive expenditure especially in the current budget which, however, requires deep adjustment of government structure as well as priorities.

While contractionary policy is recommended for reining in inflation, it appears that both monetary and fiscal policies continue to have an expansionary stance. During July-September 2005, domestic credit rose by 4.13% compared with 1.28% during the corresponding period last fiscal. Credit to the private sector grew by 3.43% only while that to the public sector grew by 6.25%. Credit to the public sector other than the government proper rose at a higher rate (15.0%) than to the government (2.4%). Government borrowing from the banking sector has accelerated to 18% from 30th June 2005 to 1st December. The provisional estimates show that Government borrowed Tk. 4303 crores over end-June 2005 when it stood at Tk. 23582 crores. Growth of bank borrowing at this rate is unsustainable.

According to reports from government sources, revenue collection during July-October 2006 has exceeded the budget target for the period by more than 53 percent. Development expenditure has been disquietingly dismal. On that account, the high rate of government borrowing appears unnecessary, far less justified. That is the cause of concern: borrowing from bank while revenue is commendably satisfactory indicates run-away expenditure.

The full implications of substituting foreign financing for domestic financing do not seem to have been adequately examined. Over FY02-05, foreign financing is projected to increase from 43% to 56% while domestic financing will fall to 44% of overall deficit. The strategy increases external debt and external dependence; debt repayment and servicing entail outflow of income and foreign exchange. Domestic financing does not entail leakage of income from the economy; it only transfers purchasing power from government to the private debt-holder. Government bond including saving certificate is an investment by the households, the small savers particularly. The economic cost of domestic debt is rather low. The deficit financing strategy has been overly influenced by consideration of the impact on the budget. However, Government has recently raised the return on saving certificates which will help mobilise small savings.

Government's economic policy suffers serious weaknesses on account of deficient analysis, inefficient coordination, and weak data. Efficiency of economic management requires substantial improvement in all these areas of governance. Unfortunately, the trend has been decline of institutional capacity, which is beyond the scope of the present article and could be another script another day.

..............................................................................
Dr. Masihur Rahman, retired Secretary, writes on economic and public policy issues; currently, he is Managing Director & Economic Adviser to the Credit Rating Agency of Bangladesh.