Thoughts for Bangladesh Bank
The debate on creating an optimal monetary policy is continuously evolving. Over the years, various stakeholders and experts have proposed insightful initiatives to steer Bangladesh Bank in that direction. Yet, key issues that optimise the monetary policy, as proven in the international literature, are largely unaddressed in Bangladesh's context.
Three key considerations for BB could optimise its monetary framework.
INCORPORATING A GLOBAL-MACRO INDEX
The monetary policy in Bangladesh is based on a commendable framework that considers the interplay between economic growth, exchange rate, inflation, interest rate and money growth. But Bangladesh is not a closed-economy. International trade constitutes more than half of the GDP. Further integration with global financial markets is also on the cards.
Consider some examples -- India and China are two of the country's largest importing partners. Sudden changes in local demand-supply conditions due to exogenous changes in trade, labour, fiscal or monetary policy stances in these countries might affect prices of Bangladesh's imports from these destinations.
Or how about commodity price shocks, like the recent oil price crash (which improved our terms of trade) or the cotton price hike of 2011? Careful analysis from relevant sources (BB & Bloomberg) shows that inflation in Bangladesh moved somewhat in tandem with cotton and oil prices for the last few years.
Going beyond raw data, a simple correlation test will show the reader that cotton prices in international markets and inflation in Bangladesh had a correlation of 0.51 from July 2010 to December 2014. The figure stood at 0.38 for oil price and inflation. These numbers are definitely not small enough to be taken lightly and need further analysis to identify potential causality.
This reasoning indicates that it may be prudent to incorporate global macro variables into the monetary framework for more informed decisions. BB can consider creating a weighted-average index, composed of relevant external economic variables. Weighing can be assigned based on a factor's significance to Bangladesh's current account and macroeconomic developments. Incorporating such a measure into the existing decision-making process ensures that monetary policy formulation in Bangladesh has a quantifiable link with external economic conditions.
ADDRESSING THE DEPRECIATION DILEMMA
The central bank has been quite successful in the last couple of years in pegging the exchange rate to around Tk 78 against the dollar by proper management of the foreign currency supply in the market. Over the years, there has also been ongoing debate on whether to allow small depreciations of the exchange rate to improve trade balance.
With Bangladesh back to a widening current account deficit, the idea of currency devaluation could be explored again. However, there is one major question regarding this strategy. Will the increase in export receipts be greater than the increase in the cost of imports?
A look through BB publications shows that the trade deficit has not improved during either of the two major devaluation episodes of Bangladesh's exchange rate -- 2005 and 2011. Rather, the deficit worsened, especially during 2011.
A look at the real effective exchange rate shows a large depreciation in 2011, which coincided with worsening trade balance from 2010 to 2011. This indicates that depreciation does not improve trade balance in Bangladesh.
This tension between higher exports and an offsetting rise in imports needs to be resolved through careful analysis of the Marshall-Lerner (M-L) condition.
Finally, given that the M-L analysis is sensitive to the product composition of exports and imports, the central bank will need to carefully monitor composition of major commodities in trade - especially in imports, since exports are mostly dominated by RMG. The rationale is that even if the M-L condition holds today, there is no guarantee that it will hold a few years down the road. So the analysis will need to be repeated before any major devaluation policies are implemented.
DEPOLITICISATION OF MONETARY POLICY
The final point addresses the issue of the central bank's independence. International experience and empirical research prove, without any doubt, that an independent central bank is more successful in curbing inflation compared to one which is even partially governed by fiscal or political authorities.
This is because fiscal or political officials generally value short-run economic expansion, while disregarding long-run inflationary consequences of expansionary (and often unproductive) monetary policy.
The latest monetary policy statement in Bangladesh mentioned that there will be continued fiscal-monetary coordination among senior policy-makers to ensure that macro-adversities such as 'crowding out' does not take place.
But what are the implications of the statement which says that the government announced an inflation target of 5 percent by 2017?
Furthermore, the national budget states 'an investment-friendly monetary policy will be maintained ensuring uninterrupted credit flows to the productive sectors'. The budget speech of 2014-15, as all readers are aware, goes on to say that the finance ministry has been quite successful in containing inflation -- the core objective of the central bank.
Do these statements suggest that the central bank is independent from the government? The BB governor and other senior officials need to devise strategies to significantly reduce government influence in its macro-economic policy decisions.
A phase-by-phase approach can be considered. This process should start with reforms to ensure goal independence and management independence. But the process needs to be capped off with reforms which create legal independence. Only when central bank independence is translated to a national law, can this process be irreversible.
Reviewing these issues can help optimise the monetary framework in Bangladesh. Otherwise achieving the 5 percent inflation target within the envisaged 2017, while supporting economic growth, might not be feasible.
The writer is a graduate student from the department of international economics at Johns Hopkins University, Washington DC.