Blogs

Monetary policy - where things went wrong in last cycle

By Waseem Khan, CFA

Head of Research

EDGE Research & Consulting

Posted on: 25 Jun, 2023

It is no secret that the last few quarters have been difficult from a macro perspective. While there are many underlying reasons for this, some in our control and some out, the decision making on the monetary policy side has been a key aspect underlying all this. The new monetary policy has seen considerable discourse in public forums, however, I think the key points (lending rate cap/controlled FX rates) of our previous monetary policy deserve further attention to properly understand what really went wrong.

Lending rate cap

The official reasoning supporting the policy was to (i) make borrowing cheaper for industries, and (ii) limit cost push inflation by limiting cost of borrowing.

Despite many countries trying this from time to time (Turkey most recently), I am not aware of a single instance globally where low interest rates have led to lower inflation, so point (ii) is moot to begin with (the opposite is true). Coming to point (i), capped interest rates make borrowing cheaper, but this also forcefully reduces deposit rates to well below inflation rates. The problem here is that borrowers are generally large ticket while depositors are small ticket, i.e. middle-class saves while upper class borrows. Long story short, lending rate cap has unfortunately benefitted the few at the expense of the many.

Controlled FX rates

The official reasoning for this was to primarily control inflation (higher USD rates = higher import costs). When adopting this policy, many people commented that many export-led Asian countries in general have benefitted from controlled/managed FX rates. What they forgot to mention is that most of these central banks were controlling FX rates to ensure the domestic currency does not appreciate; in cases where central banks intervene to ensure the currency does not depreciate, this invariably results in a steep FX reserve bleed (Pakistan/Sri Lanka are recent examples).

This is because not allowing the currency to depreciate means fixing the USD (to BDT) at a rate lower than free market value; commercial banks won’t be able to attract dollars at that rate so the only source of dollars for settling imports becomes the central bank. This is generally called “defending the currency”. In the last 2 years, the central bank burnt through ~USD19bn of FX reserves defending the currency (from ~USD48bn peak to ~USD29bn bottom), which eventually led to a series of import restrictions. Ironically, these import restrictions led to supply shortages in the economy which fueled inflation; so it ended up as a proper lose-lose because we lost both FX reserves and inflation went out of control. Given inflation hits fixed-wage earners hardest, once again middle/lower income segments have had to foot the bill mostly.

Where things become even more complicated is that Balance of Payments (BoP) deficits are usually remedied by a combination of currency devaluation and higher interest rates. Both work to make things more expensive so that people/companies consume less (reduce aggregate demand), which reduces import demand and improves BoP. If our policy stance was to allow either of the two (lending rate/FX rate) to move freely, this might have worked, but fixing both essentially guarantees FX reserve bleed due to an overheating economy. In my view, this period of monetary decision making was a policy misstep. With the new monetary policy in place, the best we can do is hope the lessons from this faulty episode will be remembered.