Dichotomy of inflation and credit expansion
COMBATING inflationary spirals while pursuing credit expansion in tandem for achieving poverty reduction through growth is often a mutually exclusive stance -- a dichotomy most macroeconomists would consider at odds, especially when an economy, such as Bangladesh, is projected to grow at 6.5% with a 9% inflation target.
When Bangladesh Bank (BB) Governor Salehuddin Ahmed announced that BB would follow an expansionary monetary policy, rebuffing IMF's prescription for a tighter policy, I heard about outpouring of praise from our economists and business circles. I wasn't sure if the favourable reaction was for real or for BB's courage in defying the IMF.
Prior to defying directives from foreign aid agencies, the policy makers must examine both short and long-term perspectives, weighing the potential risks and gains.
What's the risk involved in BB's expansionary policy stance? That is proficiently argued by The Daily Star's July 25 editorial, which says (rephrased): What is the guarantee that BB would succeed in directing the flow of credit to the productive sectors of the economy to replenish the supply side (investing in factors of production)? Since the current domestic inflation is mostly driven by external factors such as surging oil and food prices worldwide -- the episode of international transmission of inflation -- failure to make up for any shortfall in business expansion through investment in machinery and equipment, including those in the agricultural sector, would only add fuel to the inflationary fire.
The editorial's concern over the decline in the growth of the industrial sector from a hefty 10% (2006-07) to 6.87 % in recent months is compelling, but this nose-dive may not have simply been driven by credit crunch -- if there is one at all.
What BB is essentially asking for is investment targeted credit expansion, and for private banks to play an unstinting role to that end. A similar call is also echoed in the editorial, asking "the banks to channel funds from high profit earning trading and other activities to the real productive sectors."
Another expectation of BB from the banking sector is narrowing of the spread between deposit rate and lending rate. My May 19 piece, "Lending rate and deposit rate," has already argued why such a demand is ineffectual. Many of the same arguments also explain why banks may not accommodate any sermons for scaling back loans on high profit earning ventures and shifting to risky and uncertain investment loans.
Don't forget that banks, like any other businesses, operate to maximise profit while minimising risks of losses. This is in line with a fundamental tenet in economics, which states that resources are always attracted to activities that promise the highest returns.
"Inflation is the major threat to Asian countries," said Jong-Wha Lee, head of the Asian Development Bank's regional economic integration office. For example, India, China and Vietnam have recently been experiencing inflation rates of 7 %, 9%, and 19.4 % respectively.
The causes of inflation could be traced to the private sector and government deficit spending, or to shortfalls in output. Whatever triggered the initial inflation dynamics, it couldn't persist unless accompanied by sustained increase in money supply.
Aside from soaring costs of oil, food, and industrial raw materials, inflation in many Asian countries is partly fueled by the falling US dollar, particularly in countries that have let their currencies rise -- even if minimally -- against the dollar in an effort to hold on to export markets.
Justin Mott of the New York Times (April 8) reports that, in March, Vietnam's central bank had ordered the country's commercial banks to resume mopping up dollars within the narrow range of exchange rates set by the government.
Inflation in Taiwan has started to sneak up partly because the government waited until this year to let its currency -- the New Taiwan dollar -- appreciate. Taiwan's slim currency strengthening has started to hold down gasoline prices at the pump.
Persistent high inflation accompanies high costs. Its menacing effects not only disrupt the operation of a nation's financial institutions and markets, they also frustrate their integration with the global markets.
Inflation breeds uncertainty about future prices, interest rates, and exchange rates, and this, in turn, breeds risks among potential trade partners, discouraging trade. For commercial banking, it erodes the purchasing power of depositor's savings as well as that of bank loans. These well-known fallouts associated with inflation increase the risk associated with investment and production activities of firms and markets.
The effects of high inflation on a portfolio of financial assets depend on the type of stocks and bonds one holds. In general, inflation can discourage investors by reducing their confidence in long-maturity financial papers. The main problem with share prices and inflation is that a company's returns can be overstated -- one that portrays its earnings growth as overly impressive -- when, in fact, inflation is the reason behind the growth.
Inflation affects capital investment both directly and indirectly. It increases transactions and information costs, which directly hinders economic development. For example, when inflation makes real return uncertain, investment and planning become difficult -- and may often get postponed -- hindering growth.
In the presence of unpredictable inflation, relative prices become uncertain -- both lenders and borrowers become reluctant to enter into long-term contracts, a prerequisite for capital investment. Inflation, thus, inhibits growth through scaling down investment in productive activities.
What's the solution then? The government -- not commercial banks -- must create a favourable credit expansion environment, which will stimulate the business of banking across the country. That environment is facilitated by low inflation growth objective.
China and India are reported to have blunted the full impact of inflation so far through a combination of price controls and subsidies, and more countries are joining them. Vietnam has imposed price controls on transportation and gasoline, for instance.
It should be underscored that high inflation is often associated with financial repression as governments take actions to protect certain sectors of the economy. For example, interest rate ceilings are common in high inflation environments. Such controls lead to inefficient allocations of capital that inhibit economic growth.
The BB policy has not resorted to any financial repression -- at least not yet -- and there are no signs of that happening, although we see some moral suasion and indirect pressure on lending institutions to narrow the gap between deposit rates and lending rates.
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