Time to change macro policy?
Most countries in the world use both interest rates and exchange rates to stabilize the economy, while Bangladesh has capped interest rates at 9%.
A few days ago, a friend of ours injured his left ankle. The doctor recommended a four week cast of Paris dressing which my friend got rid of within days citing “discomfort”. With severe pain, he began to put his body weight primarily on his right leg. He ended up with an even worse right knee injury. Now, with a serious injury to both legs, my friend has been forced to cut back on his normal life and follow a longer and more complicated rehabilitation plan.
His case resembles the economic situation of our country today. In this case, the disease is a combination of extremely high commodity prices, high freight prices, supply chain bottlenecks and a rising US dollar. The result was a huge trade and current account deficit coupled with soaring inflation.
This type of environment has two common policy solutions:
1) Raise interest rates to put pressure on discretionary import demand, and
2) Let the foreign exchange market find its new equilibrium with “a” support from our international reserve.
Just to give an example, someone bringing in a luxury item with a price tag of $1,000 from abroad might be discouraged if the interest rate on their “consumer loan” had changed from 9% 15% by his bank or if the taka exchange rate jumped 10%.
In either case, the person concerned would find that the final cost of the imported item would increase significantly and would likely cancel the purchase anyway. When thousands of these consumers would end up doing the same, the total import demand and therefore the country’s trade gap would also automatically decrease. Tax policies such as increasing import tax or tariff for certain items or increasing LC margin are unlikely to bring such results in time.
However, in Bangladesh, we have not yet properly adopted either of the two solutions. First, since April 2020, we have been in a regime with a loan rate cap of 9%. This roughly means that the Bangladesh Bank policy rate has become ineffective as a policy tool.
With fixed interest rates, therefore, all the pressure is on the exchange rate. The first response was to defend the currency by drawing on our reserves. Foreign exchange reserves fell from US$48 billion to around US$41 billion. As reserves began to fall, the Bangladesh Bank made the cautious decision to let the currency depreciate. BDT moved from 87 to 93 against the US Dollar while the empty market exchange rate is around 98 (after hitting a high of 103). We are still behind the depreciation curve.
Policy goals in a country like Bangladesh must focus on the welfare of people in the low-income group in general. Capping the lending rate at 9% actually disproportionately benefited large industrialists (population of high-income groups) – mostly at the expense of the interests of lower-income groups (i.e. savers).
Manufacturers have succeeded in keeping their interest charges low thanks to the capping of interest rates. But for this, banks began to offer very low interest rates on deposits. Even with the regulatory interventions, depositors, mainly 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 it difficult to defend SMEs, as the economy does not allow banks and FIs to prioritize lending to vulnerable small businesses at a maximum of 9% under current economic conditions.
Although some depreciation of the taka is inevitable, the policy choice of only letting the taka depreciate instead of raising interest rates for businesses and consumers, favors the high-income group and penalizes low-income people.
Indeed, a depreciation of the national currency means higher revenues for export-oriented companies such as RMG – the same group of beneficiaries of the 9% loan rate policy. On the contrary, low-income groups are now more vulnerable to depreciation-induced inflationary pressures. Consequently, the ceiling on lending rates has also fueled inequality.
The world is currently facing an extremely difficult situation and Bangladesh is no exception. Such situations warrant the use of solutions that may result in short-term pain for long-term benefit.
A look at the majority of countries around the world indicates that they are using both tools (interest rate and exchange rate) to deal with the current situation.
We must act quickly to remain competitive and committed to the spirit of the market economy. We must immediately reconsider policies related to interest rates and foreign exchange markets. Bangladesh has a long history of maintaining prudent economic policies – we are now in another test.