Priorities to bring back the economy on the right track

A retail store in the capital. File photo: TBS

The expectations are high on the interim government led by Professor Yunus. Among the many priorities, the students and mass people place a high hope that the government will tackle economic woes, or at least bring the economy on the right track.

The crucial issues include the containment of spiralling inflation, managing the exchange rate, and establishing a viable current account through establishing confidence among businesses, improving foreign exchange reserves, establishing discipline in the financial sector, making decisions about ongoing public projects, improving tax revenue, etc. Both monetary and fiscal policy reforms—short- to medium-term—are needed to be spelled out to address these issues.

Inflation Management

Inflation rates have been spiralling over a long-term period, mainly due to both external factors and internal monetary and economic mismanagement. The food inflation rate was as high as over 14% in July, and the overall inflation rate was over 11%, which is, at any rate, creating difficulties in maintaining the livelihoods of the people. Interest rate policy, though liberalised a few months ago, did not make any positive impact yet.

Last month's students' movements disrupted supply chains and created uncertainties, which also contributed to high food inflation. Restoring the supply chain, prudent monetary policy, and fiscal policy support are combinedly needed to tackle inflation. Technically, there is a tendency among countries to adopt a more rigid exchange rate regime in the face of high inflation, that is, to use the exchange rate as a nominal anchor.

Under the managed floating regime, some pragmatic policies on inflation targeting are required to smooth out the pace of depreciation/appreciation with frequent and small adjustments in the level of the nominal exchange rates. 

Simultaneously, in the face of high inflation, the policies to stabilise the nominal effective exchange rates (NEER) could produce better results than the stabilisation of the real effective exchange rates. These policies should be backed up by appropriate monetary policies through the channels of interest rate and credit disbursement policies, because rising interest rates to stem currency depreciation and credit flows can lead to a reduction in inflation. 

Exchange Rate Volatility

At the moment, the so-called crawling peg exchange rate system is being pursued by the Bangladesh Bank. It is not clear to me what the modalities of the crawling peg system are. There has been a significant gap between the official and unofficial market rates. Real exchange rate volatility is important when deciding on a flexible exchange rate regime.

Although the effect of real exchange rate volatility on trade and investments is not straightforward, it provides a signal to the management of the exchange rate. The simple approach of identifying the equilibrium exchange rate that provides a viable balance of payment would not be the right approach for a country like Bangladesh.

The reason, again, is the weaknesses of the financial system that embarks on speculative behaviour, over-and-under invoicing, etc. Rather, it may be better to follow the behavioural equilibrium exchange rate (BEER) in managing the exchange rate volatility. 

Excessive exchange rate volatility could contribute to "liability dollarisation"—when a sharp depreciation of the domestic currency increases the burden of external debt, which is very relevant for Bangladesh, as the country has been implementing many mega infrastructure projects with huge foreign loans.

This warrants the stabilisation of exchange rates. A managed float can cope with excessive exchange rate volatility at least in three channels: (i) by letting the domestic interest rate react to exchange rate movements; (ii) by limited foreign exchange rate market intervention using international reserves; and (iii) the creation of varying degrees of capital account restrictions (financial account also), which is already in place to some extent in Bangladesh.

Forex Reserve 

One of the priorities of the current government is to maintain a better foreign exchange reserve, at least contain the free fall of reserves, as was seen in the recent past. The positive relationship between exchange rate regime flexibility and international reserve accumulation can be explained from the perspective of crisis management.

For the purpose of managing floats through extensive intervention in the foreign exchange market, a country needs to accumulate a sufficiently large stock of reserves. In the presence of currency mismatches (balance sheet effect), protecting against a speculative attack, in theory, depends on the accumulation of a large stock of international reserves, which is not the case here now, and therefore, we are in a vulnerable situation.

Exchange rate stabilisation policies, thus, should be based on frequent and small adjustments rather than rare and large ones. A few words of caution are in order for the accumulation/use of reserves. Reserve accumulation or depletion should be handled with great caution, keeping in mind the inflationary pressure, external repayment of borrowing, debt sustainability, sterilisation activities, export and remittance flows, etc. Though these are mainly medium-to-long-term policies, the interim government may at least start the process with timely and prudent policies.

Financial Sector

The financial sector is now in the most disastrous situation. Banks are lacking liquidity, prudent governance is absent, NPL is skyrocketing, etc., making the sector vulnerable. While financial sector development could be an important determinant of proper implementation of monetary policy and currency management, one potential difficulty is that reforms in the financial sector cannot be achieved overnight as financial development involves the creation of institutions, market deepening, and product innovations.

Financial liberalisation generally modifies the domestic interest rate and alters intertemporal decisions of firms and individuals, and possibly of the public sector. Various reforms should be on the agenda, including the merger and acquisition of some distressed banks and the improvement of corporate governance of certain banks, particularly the Islami Shariah-based banks; application of banking rules and regulations; and stern action against the people who are behind wilful defaulters and involved with money laundering.

The current liquidity and interest rate structure, which is a constraint for independent persuasion of the monetary policy with weak monetary transmission channels, handicapped Bangladesh Bank from applying all of its monetary policy instruments at its disposal. Therefore, it is imperative for Bangladesh Bank to gain its authority to work on interest rate policy for viable credit channels for effective management of monetary and exchange rate policy. 

Finally, other fiscal objectives, such as increasing tax revenue, prudent public expenditure management, and containing corruption in both the financial and public sectors with appropriate legal measures, should be on the card to be implemented immediately.

Dr Monzur Hossain is the Research Director of BIDS. He can be reached at monzur@bids.org.bd

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.