Monetary policy geared to post-pandemic financial stability
Mustafa K. Mujeri | July 10, 2020 00:00:00
Within a period of less than four months of the outbreak of Covid-19 pandemic in Bangladesh, the economy has seriously been affected by a sharp decline in external demand, shocks in supply due to disruptions in global and domestic value chains, impact of lockdown and large scale job losses on domestic demand, stress on consumer and business environments, and deepening inequality and high incidence of economic and social uncertainties. So far, the impact has been all-encompassing and unprecedented, but its degree is still uncertain since the intensity of the pandemic is yet to be fully felt in the country.
The impact of the Covid-19 pandemic is felt not just by the national economy, but by the household economy of millions of Bangladeshis, especially the low income ones. Daily wage earners and informal workers have already been badly hit; many have nothing to live on now and are unable to buy adequate food for their families. Hunger, malnutrition, and other problems that have always plagued Bangladesh in the past are poised to intensify as a result of the pandemic.
The economic impact has mainly been felt through three major channels: (i) sharp decline in domestic economic activity after the shutdown announced on March 26, 2020 which is now gradually being lifted; (ii) unprecedented decline in exports of RMGs, which represent more than 80.0 per cent of Bangladesh’s exports; and (iii) rapid fall (from US$ 1.64 billion in January 2020 to USD 1.09 billion in April2020) in remittances from Bangladeshis working mostly in the Middle East who are affected not by the pandemic alone but also by the decline in oil prices.
Within a few weeks of the outbreak of Covid-19, Bangladesh instituted stringent measures to limit its spread through imposing a national lockdown in which air, bus, and train travel was suspended. As a result of these measures and Covid-19 related impacts, supply chains especially of essential commodities were disrupted and access to food staples became limited. Meanwhile, Bangladesh is still under limited lockdown and has launched the largest social welfare efforts in its history.
The government reacted promptly and allocated about US$29.0 million to the Ministry of Health and Family Welfare to fund the Covid-19 preparedness and response plan. To start with, a stimulus package of $588.0 million for export-oriented industries was announced. So far, the government has announced a total of 19 stimulus packages amounting to Tk 1,031.17 billion (3.70 per cent of GDP) to support the country’s economic recovery.
It appears that if recovery is fast (the so-called V-shaped recovery), economic activities may start to rebound by the end of 2020. However, the critical factor is the recovery of the domestic economy in all its dimensions which is still shrouded in many uncertainties with regard to both timing and the precision of the recovery’s speed or the extent.
Against this background, the country’s monetary policy needs to target the recovery of the economy from the disaster of Covid-19 and rehabilitation of the production capacity of the economy as its major goals along with restoration of the livelihoods of the people especially of the vulnerable groups who are the most severely affected by the pandemic.
We must also recognise that empirical evidence shows that the relationship between the monetary policy aggregates (e.g. money supply) and inflation (price level) is becoming increasingly ineffective in Bangladesh so that price stability as the dominant strategic target of Bangladesh Bank’s monetary policy is losing its credibility and guidance. The impact of money supply on inflation is becoming increasingly non-linear and asymmetric with long and variable lags; while globalisation, technological change and frequent supply shocks cause structural changes in the behaviour of inflation. This will probably be more so during Covid-19 pandemic and its aftermath in Bangladesh. As such, Bangladesh needs to explicitly consider these changes and formulate the monetary policy accordingly.
KEY ASPECTS OF TWO-PHASED MONETARY POLICY: The key consideration for the country’s monetary policy would be to adopt a medium to long term anti-Covid-19 strategy that goes beyond the already adopted one-shot policy measures by the Bangladesh Bank (e.g. changes in CRR; changes in interest rate on loans provided by Bangladesh Bank to scheduled banks and financial institutions under REPO facility; changes in ADR and IDR; new refinancing facilities with low interest rates to facilitate the implementation of incentive packages and support important sectors like agriculture, export-oriented industries and CMSMEs; etc.) to overcome the adverse effects of Covid-19 on the Bangladesh economy.
The strategy, moreover, should take note of past lessons, avoid past mistakes, minimise risks to financial instability, and facilitate the rapid movement to a ‘new normalcy’ through fixing the Covid-19 damages. Obviously, the focus should be on Covid-19 crisis management.
The above monetary policy strategy could be implemented within a phased approach. For the initial period (e.g. next six months), efforts could be devoted more towards further strengthening and consolidating (and adopting new measures as necessary for deeply affected sectors/enterprises)the immediate measures taken by Bangladesh Bank for meeting the Covid-19 shock; while starting to implement the medium to long term measures of the second phase adopting right sequencing.
In both phases, the anti-COVID-19 monetary policies should take into account the main reasons behind adopting the monetary strategies to address the challenges. The reasons could be multiple, but preparing a comprehensive list could help prioritise the policies and identify their short and medium term implications and synergies. One key aspect would be to introduce a system of regular monitoring to conduct strategic reviews and redesign the policy framework based on changing realities.
The main task of the monetary policy, especially during the next six months, will be to ensure adequate liquidity in the economy; which has been affected by a sudden and unexpected supply shock – large-scale disruption in all production sectors caused by health precautions and lockdown. This has also triggered a severe demand shock which has interrupted cash flows and the payments system. In order to revive the enterprises and restore employment, Bangladesh Bank should further push the commercial banks to especially lend to the enterprises where the cash-flow process is more disrupted.
This would require, for the Bangladesh Bank, to provide the framework of monetary measures, including interest rate incentives for the banks, to further expand the credit support especially to the CMSMEs. There should also be coordination with prudential measures and fiscal policy decisions. Special provision should be made on prudential ground regarding the treatment of bad loans that is probably inevitable (to a certain extent)in the case of these loans. Fiscal policy support should also be soughtfrom the government to guarantee a part of these loans. Bangladesh Bank should also be prepared to undertake purchases of bonds and commercial papers as necessary to ensure liquidity in the financial market needed for controlling COVID-19 consequences and avoiding financial meltdown.
Moreover, Bangladesh Bank should remain aware that wrong and/or inadequate action during this period would lengthen/deepen the short term crisis, trigger/escalate the crisis, and make the follow-up phase of recovery more complex and difficult. The Covid-19 shock has not only affected the already bad health of the financial (including the banking) sector of the country but also all aspects of the real and other sectors of the economy. The risk of a disastrous outcome from the combined impact of this all-encompassing crisis is therefore real; moreover, Bangladesh also faces a more unfavourable global economy with disrupted trade and capital flows.
At the end of the first phase, the expectation is that the health crisis of the pandemic will be substantially controlled; production and trade will start to resume normal speed; and the financial sector will come to terms, at least partially, with the deep scars of the crisis. However, the serious wounds will continue to persist in both the real and financial sector of the economy-high uncertainties will continue to affect investments (particularly private investment); aggregate consumption will remain depressed due to loss in employment/income; and overall economic activities and growth prospects will remain below their normal trajectories.
The medium and longer term measures will sequentially start, depending on the realities in the second half of the time frame, to cure the wounds, ensure sustained recovery, and re-launch normal economic activities and growth. As expected, some measures may be long term in nature and may have to be extended to a longer time horizon. One key aspect of these policies will be to ensure a close coordination between monetary and fiscal policies where fiscal policies will play the lead role while monetary policy will take the supportive role. Bangladesh Bank will have to ensure the coordination with fiscal authorities and provide technical and financial support as feasible to policy implementation. Relying on monetary expansion alone to fix the problems would more likely to be ineffective and unsustainable. Excessive money and credit supply along with fiscal expansion and the continuing negative supply shocks from Covid-19 could fuel inflationary pressures.
The fiscal policies of the medium phase would have to cover both redistributive measures and increased public expenditures, transfers and tax reliefs for individuals/enterprises which are more likely to be debt-financed. However, one must also realise that the quality of the fiscal measures and their implementation is probably more important than their size. The resulting increase in public debt would partly substitute unsustainable private debts helping enterprises and households to regenerate their capital destroyed by Covid-19 and its economic impacts.
The role of the monetary policy will be to effectively structure the newly accumulated public debt, monitor the liquidity situation of the banks, keep the interest rates low, and address any destructive speculative developments and contain interest rate spreads within limits. This is necessary to avoid any undesirable changes in risk premium that would limit the financial sector’s efficiency in resource allocation. A major concern of the monetary policy framework should be to ensure financial stability and its sustainability especially in the post-Covid-19 period when there will be rapid increases in public debt and widespread restructuring of private enterprises and their financial portfolio.
For the external sector, the policies should favour stable exchange rates. The policies should recognise that, although Covid-19 shocks may be similar, their economic consequences have been highly asymmetric across countries in terms of timing, nature of socioeconomic impact, reactions and combating strategy for health and economic impacts, and, above all, their financial and structural weaknesses and capacities to combat the crisis. Moreover, global spill over effects will continue for long creating differential effects on individual countries including Bangladesh.
For Bangladesh, monetary and prudential policies will have to act together where the main preoccupation will be restoring normalcy in the economy without jeopardising financial stability. The policies should also remain cautious of the fact that the degree of indebtedness of the economy will significantly increase as a result of the policies for addressing Covid-19 challenges. Financial fragilities may gradually emerge as a dominant theme in the financial sector. Bangladesh Bank should therefore adopt a work plan and announce the framework well in advance in coordination with fiscal and other macro policies. This will help anchor expectations and reassure all stakeholders on the existence of a coordinating procedure to cope with the Covid-19 crisis. In the post-Covid period, the Bangladesh Bank should consider widening the mandate of monetary policy to cover macro-financial stability, not price stability alone, along with economic growth.
A key concern would be to act quickly and decisively to provide liquidity to prevent financial instability from leading to further deterioration of the real economy. Along with this, for ensuring long-run growth necessary to restore economic well-being, Bangladesh Bank would have to adapt to new realities for using financial markets to ensure required liquidity, not through manipulating interest rates to finance government deficit and providing cheap credit to CMSMEs and other priority activities.
For the medium term, Bangladesh Bank should also step up providing credit for green investment and employment stimulus, as the lockdown measures are gradually relaxed and withdrawn. What matters most is the enhanced role of monetary policy to create employment and reconnect the supply chains and assist in the transition to higher growth and sustainability.
Dr Mustafa K. Mujeri is Executive Director, Institute for Inclusive Finance and Development (InM).