Bangladesh Bank has been pursuing a contractionary monetary policy since December 2010. Initially, it was intended to avert a bubble in the country's capital market and to limit inflation at a reasonable level. The disclosure of the policy statement triggered a slump in the stock market and, since then, an increasing liquidity crunch ensued in the banking sector.

The exchange rate between Taka and the US dollar experienced a nominal devaluation by about 20 per cent in the last 12 months. Foreign exchange reserves plummeted. In January 2012, the reserve were found to be insufficient to support three-month import bills. Point-to-point CPI inflation continued to rise and hit a maximum 12 per cent in September 2011.

A rising inflation combined with an excessive government borrowing from the banking system has further aggravated liquidity position of the banking sector. Leading entrepreneurs of the country feared that the excessive public borrowing would crowd out private sector investment and slow down the economic growth.

Bangladesh Bank on January 26, 2012 thus unveiled its monetary policy statement (MPS) for the second half of 2011-12. The policy statement identified price stability and adjustment in the current account balance as major objectives. An intense debate is undergoing if the recent monetary and exchange rate policies would bring about the needed macroeconomic adjustment.

Before we focus on the effectiveness of recent monetary and exchange rate policies, it is better to reflect on how Bangladesh economy evolved into this present uncertainty. As we all know, our economy has grown three times bigger than the level it was in 1991.

The per capita GDP has more than doubled. Even the growth rate of per capita GDP accelerated from less than 2.2 per cent to more than 4.9 per cent during this time. Both saving and investment in relation to GDP also saw a persistent growth. Trade gap and as such saving-investment gap though widened, it did not cause any serious imbalance in our external account.

An increasing flow of inward remittances helped to meet this gap. This was a remarkable development. Goldman Sachs thus labelled Bangladesh as one of the New 11 (N-11) emerging economies that would drive the future growth of the world economy. But a big question is what went wrong that the economy got into a crisis scenario.

The rising economic growth was not all good. It is argued that it was more driven by rising aggregate demand than the expansion of productive capacity. This happened in the context of increasing exports and remittance earnings and a persistently rising broad money supply in the domestic economy. In fact, M2 to GDP ratio, which is a measure of broad money supply, increased from 31.5 per cent in 2000 to about 56.6 per cent in 2011. This monetary expansion was even more pronounced in recent times rising from 45.6 per cent of GDP in 2008 to 56.6 per cent in 2011.

An external factor indeed played a complimentary role to this monetary growth. It is that the central bank maintained a de facto pegged exchange rate with the US dollar and that, since August 2008, the dollar devalued by 25-40 per cent against some major currencies including the Japanese yen and euro. Note that the regime classification of exchange rate by Bangladesh Bank is managed floating not pegged to the dollar and it is known as de jure classification in the literature.

The fact that the taka-dollar exchange rate remained stable at around Tk 69/US dollar from 2007 to 2011 implies that the monetary policy in Bangladesh was somewhat tied with that of the United States. Since the Fed followed a hugely expansionary monetary policy to stimulate the US economy after the collapse of Lehman Brothers in 2008, Bangladesh monetary policy became automatically further expansionary as the central bank continued to peg its currency to the US dollar. It was also then a policy response to an uncertainty that our apparel exports would possibly suffer from a loss of demand in the US and Euro-area markets.

Excess liquidity in the financial sector was an obvious outcome and the private sector credit became cheaper. Both the deposit and lending rates decreased significantly. Investment by firms and consumption by households jumped up during the period. Economic growth accelerated largely because of rising aggregate demand and the soaring private sector credit fuelled it. Banks and financial institutions being flooded with money further found ways to prop up certain asset markets.

Given that the country is endowed with limited land and its share market is too small, both the markets observed bubbles in recent times. Bubble in the share market has in fact busted as the central bank began monetary tightening in the December of 2010. The timing of this policy intervention was too late to arrest emerging macroeconomic imbalances.

It is recognised in macroeconomics that prices do not respond to monetary expansion in the short-run. But as the real economy evolves to its long-run potential, excess money will only translate into rising price level. In fact, the consumer price index began to move up in the July of 2010. Point-to-point CPI inflation jumped up from 7.0 per cent in July 2010 to a double-digit 12 per cent in January 2012.

A persistently rising domestic price level has caused real effective exchange rate to appreciate and the trade deficit to widen. Trade deficit to GDP ratio increased from 6.6 per cent 8.8 per cent between 2010 and 2011 fiscal years. The taka value of aggregate imports increased by 46 per cent.

Imports of certain primary commodities, including rice, wheat, crude oil and other petroleum products, increased by about 85 per cent between the years. Current account balance deteriorated though remittance flow remained buoyant.

The central began tried to support initially its pegged exchange rate possibly to limit rise in local price of imported commodities. But the policy proved unsustainable as the foreign exchange reserves declined below US$10 billion in December 2011 and proved insufficient to cover even three-month import bills.

Bangladesh Bank thus let the taka-dollar exchange rate to depreciate by more than 20 per cent between July 2010 and January 2012. In fact, a large part of the devaluation happened in the last six-month period starting from July 2011.

Two further problems on the fiscal front compounded the problem. One is that the government failed to obtain its planned long-term external financing from the multilateral agencies to embark on some mega development projects, including Padma Bridge. The other is that the rising volume of imports of fuel and petroleum products forced the government to heavily borrow from the domestic banking system. An increased public borrowing resulted into a severe liquidity crunch in the banking system.

It is notable the liquidity crisis in the banking sector began when the central bank increased the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR) for the private commercial banks in the middle of December 2010. The liquidity problem since then only aggravated as the capital market crisis further worsened.

The big question is now if the recent MPS would bring about needed macroeconomic adjustments and, if yes, how long it will take to happen. The answer crucially depends on how fiscal policies will be coordinated with the monetary and exchange rate policies. One immediate policy goal should be a significant cut in the planned government spending. And it must accompany substantial reforms in fiscal management.

A nominal depreciation of taka/dollar exchange rate by more than 20 per cent would surely increase price competitiveness of our exports. As local prices of imported goods would rise substantially, the devaluation would significantly reduce growth rate of aggregate imports. An increasing flow of remittances will follow too.

The adjustment phase will likely be longer than the MPS perhaps expected it to be. Unless the fiscal management improves and government spending becomes restrained, the monetary policy objectives will remain unmet. For a government facing a general election in two years, it is politically costly though.

Financial Express/Bangladesh/ 15th Feb 2012