Bangladesh’s currency conundrum: What role can interest rates play?
Bangladesh Bank, under the guidance of Prime Minister Sheikh Hasina, had set the goal of a single-digit interest rate regime for all loans and borrowings in 2019. A low interest rate regime means lower borrowing costs and enhanced demand for investments by households and private sector businesses. The Bank's goal was definitely pro-poor and intended to unlock access to capital at lower costs for a large number of borrowers. Incidentally, Bangladesh has also observed a surging flow of inward remittances since then. The inflow of current account receipts further accelerated as the pandemic significantly curtailed economic activity and slowed down investment demands. The country accumulated a record USD 48 billion of foreign exchange reserves by the end of August 2021. It was also a period when the central bank lowered the repo rate by 125 basis points and injected a massive volume of liquidity into the financial system. It was done primarily to ensure that households and businesses can access credit at low costs and stay afloat.
As the pandemic subsided and the economy reopened by mid-2021, the public policy of single-digit interest rate led to a resurgent growth in private sector credit. It fuelled the domestic demand for imports, and trade account and current account deficits soared to USD 37 billion and USD 18.7 billion respectively in 2021-22. Bangladesh Bank initially tried to defend an overvalued exchange rate of the taka against the US dollar, but a fast depletion of foreign exchange reserves forced the central bank to quit the exchange rate peg. As a result, the taka has devalued by more than 40 percent in the kerb market since January 1, 2022.
Now, a critical policy question is how the central bank can credibly defend its currency against further devaluation risks with a cap on interest rates in place. An interest rate cap implies that a central bank will have perfect foresight to bring about equilibrium between demand for and supply of real money balance. This job is practically impossible since the central bank controls neither prices of goods and services, nor the supply of real money balance for a small open economy like Bangladesh's.
Even nominal money supply is not static for many reasons. For example, if the central bank sells foreign exchange reserves to support the home currency against speculative attacks, the nominal money supply contracts. The supply of real money balance will contract further if aggregate price levels keep rising. For a given demand for real money balance, the interest rate will have to rise in order to clear the money market. A policy to cap interest rates below nine percent will either require printing new money or cause a disequilibrium in the money market. If the central bank keeps printing money, the inevitable happens: uncontrolled inflation, or hyperinflation.
On the other hand, if the central bank chooses to cap interest rates, disregarding money market equilibrium, a liquidity crisis will ensue and de facto credit rationing will begin in the financial system. The very goal of equity in access to capital would be lost. It may also push weaker banks and financial institutions into man-made insolvencies. This is because a predetermined interest rate will reduce net interest margins for banks and financial institutions. In an environment of weak regulatory oversight, the policy may further worsen problems of adverse selection and moral hazards in credit markets. That is why central banks shouldn't target interest rates. It can better target inflation rate or growth in monetary aggregate for financial sector stability.
An important question for Bangladesh Bank now is how an interest rate cap will affect current account deficits of the country, and so the resultant volatility in the foreign exchange market. In all likelihood, a continued low interest rate regime will cause a resurgent credit growth in the private sector and so in the demand for imports. Under the current circumstances, it must avert a persistently large trade account deficit and hence, a current account deficit. Any meaningful defence of the taka against further devaluation and exchange rate volatility must be based on substantial slowdown of imports. A monetary contraction and rising interest rate will help slow down import demand, thus improving the external account imbalance.
How does a market-determined interest rate help resolve external account imbalance? It works through a variety of channels.
First, a rising interest rate will depress credit demand across borrowers and demand for new investments by firms. It will encourage households and the government to redefine their respective budgets and keep their spending within limits. Now consider the aggregate volume of imports. Imports are everywhere in the sense that they constitute parts of household consumption, government spending and private sector investment. Each of these variables is critically dependent on interest rates. A low interest rate will stimulate aggregate demand, and so imports. If a central bank really wants to reign in imports, it must increase interest rates, pursue an equilibrium exchange rate, and make borrowing costlier. Both interest rates and exchange rates are powerful determinants of current account deficits.
Second, an artificially managed low interest rate will cause illicit capital mobility across borders. Local financial instruments, including shares, corporate bonds, bank deposits and others, are mostly denominated in taka, as are the returns on them. A currency devaluation makes all taka-denominated financial instruments to be less valuable in terms of their international purchasing power. In other words, the dollar rate of return on taka-denominated financial instruments will decrease as the taka depreciates. As households and firms read into the ability of a central bank to defend the home currency, the risk of devaluation will prompt them to find other ways to convert their taka assets into foreign currency-denominated assets, such as through the so-called hundi. Note that such speculative behaviour arises from a fear of devaluation. Sri Lanka, Pakistan and Turkey have all suffered from this crisis. At the heart of it is low interest rates in the presence of an unsustainable external account imbalance.
Thirdly, the fear of devaluation will also encourage non-resident Bangladeshis and local exporters to either cancel or defer transfer of their foreign exchange earnings to the home country. Attempts to under-invoice exports or over-invoice imports will also mushroom if the taka has a volatile exchange rate.
Fourth, international capital flows, in the private and public sector, will critically depend on future sustainability of balance of payments and stability of the national currency. Either a persistent current account deficit or a national currency susceptible to devaluation, or both, will diminish the prospect of international capital flows into the economy.
Finally, the current account deficit is equal to the excess of gross domestic investments over gross domestic savings. Does the government or the private sector have ample space to bring in foreign capital to finance their excess of investments over savings? The answer is "very unlikely" in the current state of the world economy. It therefore implies that a persistent current account deficit will cause further depletion of foreign exchange reserves or a problem of debt sustainability. The volume of foreign exchange reserves is now below USD 40 billion. If one takes into account rapidly rising external indebtedness of the private sector, the pressure on dwindling foreign exchange reserves will likely persist, leading to high risks of further taka devaluation. In this situation, Bangladesh Bank can better fix the currency turmoil by freeing both interest rate and exchange rate to adjust over time.
Dr Mizanur Rahman is a Commissioner of Bangladesh Securities and Exchange Commission. Views are his own and not of the institution's. He can be reached at [email protected]