New government must set aright challenge of political economy 

Illustration:TBSa

When the crisis in the economy started a year and a half ago, if we had taken forceful corrective measures, then the situation would not have been like this; that I can firmly say. 

But we did not do that. At the very beginning, some narratives were being provided by the government that it was because of various external factors, which would unwind and return to normal. So nothing had to be done. Supply side would respond accordingly once the war was over. 

To some extent, it happened — commodity prices have stabilised, with crude prices even running lower than pre-war level. Food items like wheat, sugar also fell from their peaks, if we see the average commodity price index of the World Bank and the IMF. 

But the price situation has not changed in Bangladesh. Because we did not take the policy measures which were necessary for us at the time. Problems are largely internal, which have been aggravated by external factors. 

We never got this realisation, this narrative from the government, as the political government, as usual, chooses to be defensive always, telling all the problems were caused by global problems, they are not at fault.    

Of late, the government seems to have started to shift from the previous position and realised that the situation will not improve, and might rather turn worse if we do not act right now. 

We can list some of the problems we created for ourselves. One is the 9% lending and 6% deposit rate caps. It was politically decided that interest rates will be capped at 9% and 6%, and we will keep it up — an economic policy you will see nowhere in the world. From day one, we were saying it is impractical and that it will have its cost. 

There was not much problem at the beginning, because the global interest rate was much lower and US dollar loans were available at 0.5% to 0.75% interest rates. Rates in other currencies were also similar to that, and our interest rate cap was somewhat compatible to that trend.

But soon, global rates shot up to 7% from 0.5%, still we stuck to 6%. We did not adjust our policies to the global trend, although all other countries did. What was the consequence? In 2020-21, we had $13 billion in our financial account, $14 billion in 2021-22, which started to deplete due to capital flight, for two reasons — investors started to withdraw their capital to invest elsewhere or decided not to make fresh investments due to lower interest rates here. 

On top of it, the private sector, whose borrowing from external sources reached $26 billion, faced a loss of Tk1 lakh crore because of currency rate depreciation alone. That was a huge burden of liabilities on their balance sheet. 

Since external loans became costlier due to global rate hikes associated with locally-imposed taxes, the private sector re-paid more than they borrowed from foreign sources. Repayment put further pressure on the already depleting dollar reserves. 

When dollars were in short supply, then repayment surged, meaning that the financial account turned to negative $4 billion between July and October last year. This is a huge depletion. There must be some policy failures here. 

Another point is that because of the 9-6 cap put in place, the Bangladesh Bank's monetary policy could not bring much change. Keeping rates fixed at 9% and 6%, they did not have any other tool (to effectively intervene in the money market). What more could they have done other than hiking interest rates to tighten money flow? But the Bangladesh Bank had its hands tied. 

What the Bangladesh Bank could have done, what central banks all over the world did, was to hike interest rates. The US raised interest rates, The EU, the Bank of England, Reserve Bank of India — all did so. We did not increase rates, although we had higher inflation than them. 

Then what did we do to fight inflation? Nothing at all. We stuck to the 9-6 cap, the cost of which was huge. Sorry to say, it was not done under professional guidance, it was guided by business interests. Borrowers enjoyed the privilege of an interest rate lower than the inflation. These were loans almost free of cost. 

When the US Federal Reserve hikes rates to fight inflation, do they ask Wall Street if the rates should be hiked? Wall Street will never want the rates to go up, because it is against their business interest. Yet, the Fed will hike the rates for the greater interest of the country, of the citizens.

What was their statement? "Don't know where we are heading for. We will continue to hike rates so long as it is needed, until inflation comes down close to the desired level." 

Still they are saying, "We have not stopped yet, just paused." The US Fed is keeping its eyes fixed on both the trend of inflation and job data. The US is now having its all-time low unemployment, only 3.5%. The measurement is not as fictitious as ours. They are watching the labour market to see when wage pressure eases to keep inflation low. They are also watching the consumer price movement. Both the indices are slowing down. 

We lacked that level of determination. Our central bank has been guided solely by political economy, not by professional judgement. The central bank has not even utilised its own experiences and expertise. They waited for signals from the businesses, who got the signal from politicians, leading to today's situation.

However, the mode is changing now, as rational policy making is making a comeback. There must be political pressure to put the economy back on track. 

The macroeconomic stability built over the years has not turned fragile in just one year and a half. Our tax-GDP ratio is between 7% and 8%, which is not acceptable. It once reached 11%. Late finance minister AMA Muhith dreamt of expanding the annual budget to 20% of GDP, which he could not due to poor tax-GDP ratio. This was not a new problem, it was long-drawn. 

But what did we do to overcome it? No fundamental changes were done. New VAT law was put into effect, which lost its way under pressure from the business community. The political firmness, which was required to make it effective, was missing. So it was compromised. The discretion of VAT officials has been curtailed in the new law, but it was brought back along with many such provisions of the 2012 VAT law, making the new law largely ineffective. Single rate has been turned into multiple rates, input tax provision has been removed. 

I think we have not advanced on the revenue front, rather we have stepped backward.

We can see why our banking sector turned so bad. We need to ask why so many banks were given approval. Who are they? They did not have the merit to get those, only political decisions mattered here.

A rising trend has been noticed in giving loans without exercising due diligence. One after another loan scandal surfaced. 

And we did not learn any lesson from those scandals. No one was punished, no assets recovered. 

If patrons behind such scams are not exposed and punished, such incidents will repeat. This is what is happening now. We see unheard of people taking out takas in thousand crores from banks. 

These are preventable. But these misdeeds were rather encouraged through bad governance. While putting the blame on the political system, we have to hold the Bangladesh Bank responsible too as this institution is the regulator or watchdog of the financial sector. 

Another wrong policy was to keep the exchange rate almost fixed for 12 years or so. What signal did it give to the private sector? It signalled if $1 is Tk82, it would continue to be the same rate in future too. That prompted private sector borrowers from foreign sources to assume the exchange rate risks at 'zero' in calculations. In fact, the risk was not zero — it was big. 

It was the Bangladesh Bank that gave the borrowers the signal that the exchange rate will remain unchanged, so they can take foreign currency loans without hedging the exchange rate risks. The private sector is under pressure to repay around $10 billion or so in the next one year. 

At the same time, interest rates fell in the international market, which encouraged the private sector to enhance their external borrowing. From a business point of view, they found it beneficial to borrow at 3%-4% from abroad while the lending rate at home was 9%. 

Here also, the signal from the central bank to the private sector was wrong.

Today, the central bank's signals to private sector borrowers proved wrong. It is also a lesson for the private sector not to rely solely on such signals, they also need to behave prudently. 

Usually, it does not happen so, for instance during the Asian financial crisis. 

I was then at the IMF when the Asian crisis was unfolding. Countries like Thailand, Indonesia, South Korea, Malaysia were virtually fixed exchange rate regimes, like the one we followed for long. 

This is known as "carry exchange rate", an investment strategy that facilitates an investor to borrow low-cost funds in foreign currency and invest in another currency without hedging the exchange rate risk. It works well in periods of low forex market volatility and becomes risky when forex volatility rises, as it happened to Asian borrowers.

For example, Thai borrowers took yen loans from Japan, where interest rate was 1-1.5%, and happily invested the money at home. Indonesian or Korean investors did the same, borrowed low-cost loans in yen or dollar, and invested at home. Thus private sectors in those Southeast Asian nations borrowed heavily in foreign currencies, such as our private sector did in recent years, though not as much as those countries. 

When the financial shock hit, they were under pressure to repay foreign loans and central banks faced severe foreign exchange shortage — a situation we are now facing. 

The financial regulator needed to assess the consequences of keeping exchange rates fixed for so long, which they did not do. Fixed exchange rate and fixed interest rate are two main culprits behind the existing financial crisis. Because of the fixed interest rate, we could not fight inflation. And, if interest rate was raised, foreign loans at carry exchange rate would have been lower (putting less pressure on dollar reserves).

We needed to have our exchange rate adjusted to the inflation differential and real effective exchange rate (REER, which is weighted average rate in relation to other major currencies in the basket). Our inflation was always higher than that of major trading partners. US inflation was not big in the recent past and Japan did not have inflation for more than two decades. 

Also, take India into consideration, exchange rates of taka and the Indian rupee came too close to each other, only a Tk8-10 difference per dollar. But the purchasing rate in India is much higher than ours, the rupee buys much more than our taka. 

We brought the exchange rate closer, artificially. That gave us a short-lived chance to see our per capita income exceeding that of India, which was possible only because our exchange rate was appreciated (artificially). That is why we have fallen behind again.

In view of relative purchasing power, we must take into account the inflation differential and adjust it to REER, which would have supported us in two ways — promoting export and containing imports. Otherwise, allowing the market to decide the exchange rate will not be the right approach.

Our net export is around $25-$30 billion, which will be affected if our currency appreciates too much. Our exchange rate should be decided proactively, and in no way should it be over-appreciated, which will cause erosion in export competitiveness. It will not be wise to leave the exchange rate to the market in the current unstable situation. 

The new government should emphasise economic management and form a strong team, which will be politically empowered, not staffed with bureaucrats. Because it is more of a challenge of the political economy than any other issue. They have to set the policies and environment right.

Illustration: TBS

Dr Mansur is an economist and Executive Director of the Policy Research Institute of Bangladesh (PRI). This write-up is based on a conversation at TBS Economy on 17 December 2023.