Bangladesh’s Currency Conundrum: What Role Can Interest Rates Play?

Visual: Kazi Tahsin Agaz Apurbo

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Visual: Kazi Tahsin Agaz Apurbo

Bangladesh Bank, under the leadership of Prime Minister Sheikh Hasina, had set a target of a single-digit interest rate regime for all lending and borrowing in 2019. A low interest rate regime means lower borrowing costs and increased demand for investment by households and individuals. companies in the sector. The Bank’s objective was firmly pro-poor and aimed at unlocking access to capital at lower cost for a large number of borrowers. Incidentally, Bangladesh has also seen an increasing flow of inward remittances since then. The inflow of current account receipts accelerated further as the pandemic significantly reduced economic activity and slowed investment demands. The country accumulated a record $48 billion in foreign exchange reserves at the end of August 2021. It was also a period when the central bank cut 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 low-cost credit and stay afloat.

As the pandemic subsided and the economy reopened in mid-2021, the government’s single-digit interest rate policy led to a resumption of credit growth to the private sector. It fueled domestic demand for imports, and trade and current account deficits soared to USD 37 billion and USD 18.7 billion respectively in 2021-22. The Bangladesh Bank initially tried to defend an overvalued taka exchange rate against the US dollar, but a rapid depletion of foreign exchange reserves forced the central bank to abandon the exchange rate peg. As a result, the taka has devalued by more than 40% in the curbside market since January 1, 2022.

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Now, a crucial 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 ceiling implies that a central bank will have perfect foresight to ensure the balance between demand and supply of the real monetary balance. This work is practically impossible since the central bank does not control the prices of goods and services, nor the supply of real monetary balance for a small open economy like that of Bangladesh.

Even the nominal money supply is not static for many reasons. For example, if the central bank sells foreign exchange reserves to support the national currency against speculative attacks, the nominal money supply contracts. The real monetary balance supply will contract further if the overall price levels continue to rise. For a given demand for real money balance, the interest rate will have to rise in order to clear the money market. A policy aimed at capping interest rates below 9% will either require printing new money or causing an imbalance in the money market. If the central bank continues to print money, the inevitable happens: runaway inflation or hyperinflation.

On the other hand, if the central bank chooses to cap interest rates, disregarding the equilibrium of the money market, a liquidity crisis will ensue and a de facto credit rationing will begin in the financial system. The very objective of equity in access to capital would be lost. It can also push weaker banks and financial institutions into man-made insolvencies. Indeed, a predetermined interest rate will reduce the net interest margins of banks and financial institutions. In an environment of weak regulatory oversight, politics can further aggravate problems of adverse selection and moral hazard in credit markets. This is why central banks should not target interest rates. It can better target the inflation rate or the growth of the monetary aggregate for the stability of the financial sector.

An important question for Bangladesh Bank now is how an interest rate cap will affect the country’s current account deficits, and hence the resulting volatility in the foreign exchange market. In all likelihood, maintaining a low interest rate regime will lead to a recovery in private sector credit growth and hence import demand. Under the current circumstances, it must avoid a persistent trade account deficit and therefore a current account deficit. Any meaningful defense of the taka against further devaluation and exchange rate volatility must be based on a substantial slowdown in imports. A monetary contraction and a rise in interest rates will contribute to slowing the demand for imports, thus improving the imbalance in the external account.

How does a market-determined interest rate help resolve the external account imbalance? It works through a variety of channels.

First, a rise in interest rates will reduce borrowers’ demand for credit and businesses’ demand for new investment. It will encourage households and the government to redefine their respective budgets and limit their spending. Now consider the overall volume of imports. Imports are everywhere in the sense that they constitute elements of household consumption, public expenditure and private sector investment. Each of these variables essentially depends on interest rates. A low interest rate will stimulate aggregate demand, and therefore imports. If a central bank really wants to control imports, it must raise interest rates, seek an equilibrium exchange rate, and make borrowing more expensive. Interest rates and exchange rates are powerful determinants of current account deficits.

Second, an artificially managed low interest rate will lead to illicit capital mobility across borders. Local financial instruments, including stocks, corporate bonds, bank deposits and others, are mostly denominated in taka, as are their yields. A currency devaluation makes all taka-denominated financial instruments less valuable in terms of 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 businesses assess a central bank’s ability to defend the national currency, the risk of devaluation will prompt them to find other ways to convert their taka assets into foreign currency-denominated assets, for example via the so-called hundi. Note that such speculative behavior stems from a fear of devaluation. Sri Lanka, Pakistan and Turkey have all suffered from this crisis. At the heart of this are low interest rates in the presence of an unsustainable imbalance in the external account.

Third, the fear of devaluation will also encourage non-resident Bangladeshis and local exporters to cancel or postpone the transfer of their foreign exchange earnings to the country of origin. Attempts to under-invoice exports or over-invoice imports will also multiply if the taka has a volatile exchange rate.

Fourth, international capital flows, in the private and public sectors, will critically depend on the future viability of the balance of payments and the stability of the national currency. Either a persistent current account deficit, or a national currency susceptible to devaluation, or both, will reduce the prospect of international capital flows into the economy.

Finally, the current account deficit is equal to the excess of gross domestic investment over gross domestic savings. Does the government or private sector have enough leeway to attract foreign capital to finance their excess investment over savings? The answer is “highly unlikely” given the current state of the global economy. This therefore implies that a persistent current account deficit will lead to a further depletion of foreign exchange reserves or a problem of debt sustainability. The volume of foreign exchange reserves is now less than 40 billion dollars. Taking into account the rapid increase in external indebtedness of the private sector, the pressure on the reduction of foreign exchange reserves is likely to persist, leading to high risks of further devaluation of the taka. In this situation, the Bangladesh Bank can better resolve the currency turmoil by releasing both the interest rate and the exchange rate to adjust over time.

Dr Mizanur Rahman is Commissioner of the Bangladesh Securities and Exchange Commission. The opinions are his own and not those of the institution. He can be contacted at [email protected]

Leslie M. Gill