Macroeconomy Amid Trade War

Clashes of the titans in trade May prolong the struggling state.

Bangladesh Bureau of Statistics (BBS) divulged that inflation again increased to 9.87% in May. It is highly likely to see another round of hike in policy rate in the next monetary policy statement. A 1% increase will make the policy rate 9.5%,narrowing the gap between current inflation rate and policy rate. Fitch ratings downgrade of Bangladesh's credit rating will make foreign credit harder for the public and private sector. Bangladesh Finance Minister is optimistic about getting the third instalment of IMF credit package. IMF in its last board meeting in May cleared credit package for Ecuador.

Things turn out to be difficult for the government. Revenue shortfall,dependence on domestic borrowing from banks,lack of foreign credit and FDI will cause further depreciation of taka against US dollar. Central bank's stated policy of containing the inflation rate to 7.5% may be prolonged and face serious hurdle in the wake of trade war between China and USA.

So far US federal fund rate is being stuck at 5.33%. Federal Reserve System has no intention to lower it as it sees inflation will take time to ease. Moreover, lowering the interest rate will raise the US treasury bond price,facilitating the process of ditching US treasury assets by govts not happy with US policies. Meanwhile Chinese policy rate is now 3.45% and it may go down further. It will make Chinese goods even cheaper. Let's draw a rough sketch on how the macroeconomic situation will prevail in the country given different policy rates in USA and China and trade tensions between the two countries.

Fed funds rate:5.33%
Chinese policy rate: 3.45%
If the current policy rates prevail and the countries engage in tariff and trade war, then Bangladesh has to further depreciate the currency since value addition condition to US-bound goods will also get tougher. However, special treatment to US cotton made garments may give some favor. But to meet the extra cost emanating from trade restrictions, Bangladesh has to depreciate its currency further to give the exporters some kind of favor. On the other hand, Bangladesh has to continue its contractionary policy for a longer period to mitigate the inflationary pressure.

Fed funds rate: More than 5.33%
Chinese policy rate: Less than 3.45%
It will be hard to get foreign credit and assistance in US dollar. Dollar-based investment and return will be lucrative in the West and few will be reluctant to invest here where timely repatriation of profit is under scanner. Meanwhile, Chinese credit will be cheaper. Both the government and private sector will hinge on Chinese Yuan,easing the pressure on US dollar. Weakening of Yuan may increase Chinese share of EU export market, putting pressure on Bangladesh's export to EU. EU will unlikely to get tougher on China in the wake of a trade war in a bid to neutralize it against Russia. In this situation, taka has to be depreciated more than the previous scenario against the stronger US dollar and to stall the dollar flight. Amid tight monetary policy, the central bank may resort to money supplying measures,further worsening the inflation. More rise in policy rate and delay in stabilizing the macroeconomy. More reliance on Chinese credit and deepening trade ties between China and Bangladesh.

Fed funds rate: Less than 5.33%
Chinese policy rate: Less than 3.45%
It will help Bangladesh getting foreign credit in US dollar. Less pressure on forex reserve and taka. Ongoing monetary policy may go as usual and goals may be attained in the anticipated time. No large depreciation of taka is needed to make the goods more competitive. Easing of import restrictions on capital machinery may increase economic activity. Cheaper foreign goods/ingredients may ease inflationary pressure. Economic recovery will be early. This is an ideal case for Bangladesh as both the Yuan and US dollar credit will be available at an affordable rate in the wake of a trade war. Bangladesh may have to convert a significant amount of its US dollar assets into other IMF SDR currency or to procure gold if there is further unease in the relations between Bangladesh and USA.

Since access to foreign credit gets tougher for Bangladesh, Bangladesh has to prolong its austerity measures. In all three cases ,we see that Bangladesh has to continue raising policy rate and depreciating its currency. Likelihood of the occurrences of the cases would further depict a grimmer picture . Most optimistic scenario/case(the last one) for Bangladesh is less likely to happen. In a heated trade war,US will not lower the policy rate. The second one (worst for Bangladesh) will have a better chance to emerge than the first one. We have to further tighten our belt.

More Policy Changes Are Coming

Some are concerned about the policy of gradualism, Adjustment must go on in the face of criticism.

Recently, a group of businessmen and representatives of bankers met with Bangladesh Bank governor to raise their concerns over ensuing issues after the policy rate hike and depreciation of Taka. They are worried because frequent policy rate hike and depreciation of taka raise their costs. Some news reports even claimed that governor assured them that policy rate would not cross 14%. It is true that interest rate hike and depreciation to some extent raise the cost. However, taka 7 depreciation also opens the door for making gains. Last one year, selling dollars was one of the means for banks to make profits. In that light, this and future depreciation make rooms for the businesses to make profits and covering the costs originated from the high interest rate. Those borrowed money from foreign commercial institutions will suffer. But as many houses preferred to retain their dollar earnings abroad ,which is the rational and smart thing right now given the domestic situations, they likely to gain more in the long run in the face of further depreciation. Keeping money abroad is not a matter of ethics or morality,but is a matter of survivability/staying fit for the business group. At home, the group has to procure dollar at higher rates plus the availability of the foreign currency is not guaranteed in times of need. In addition, interest rate below inflation rate,political uncertainty and subsidized exchange rate will weaken the financial position of the company. And in the long run govt may have to bail it out by providing public money. Keeping money abroad means its wealth stays secure as its dollar investment is earning interest/profit in dollars and it will gain later from depreciation of domestic currency. Plus it can ink long term debt deal, reducing risk on interest rate. It also has access to relatively cheap credit. It stays strong as a business group if it perks its wealth abroad. Those operate their business abroad using same business identity should not be subject to harassment. There is no worry as they will repatriate the money at a convenient time. But those channelled out the fund through shell companies or tax havens may have dubious intentions.

To get rid of foreign currency crisis, we need further policy adjustment. Pakistani rupee is depreciated 89% in the span of 5 years. Vietnamese dong is depreciated 10% in the same period. While Bangladeshi taka is depreciated only 40% in the last two years.Prior to 2022,policy rate was 6% in Pakistan. And now it has become 22.5%. But price levels are coming down and rupee is appreciating. In Vietnam, policy rate was 6.3% prior to 2019. Now it is 4.5%. One of the good thing about dong is it appreciated when interest rate was high and depreciated when interest rate was low. Currency responded to the market accordingly. In Bangladesh, policy rate was 6% prior to 2020. From 2021 to 2023 ,it was kept at 4.5%. And now it becomes 8.5%,which is likely to rise further. Both Vietnam and Pakistan are strong competitors of Bangladesh in the RMG sector. Pakistan and Vietnam's garments export to the US market grew in recent months. Meanwhile, Bangladesh's export saw a negative growth in the US in the last three months of 2023. That means we need more depreciation of taka to make our apparel items competitive in the US market.

Policy rate hike is a must to give investors a signal that policy rate is aligned with the inflation rate. Back in October last year,in a piece titled "Slow Alignment Costs Investment"(for more read https://hoquestake.blogspot.com/2023/10/slow-alignment-costs-investment.html?m=1 ),I highlighted how slow policy adjustment has a negative effect on Internal Rate of Return based investment decision and political impasse affects payback period of the investment. In another piece titled "Could Bangladesh Get The Second IMF Credit Pack?" in September last year(for more read https://hoquestake.blogspot.com/2023/09/could-bangladesh-get-second-credit-pack.html?m=0),I argued how slow policy adjustment holds back investment.When interest rate is sufficiently high,above the inflation rate, investors anticipate that future interest rate may be lower with the ease of inflation. So they embark upon taking investment project.

Continuing the policy rate hike is a must in the wake of Fed's decision to raise the interest rate further. While inflation is coming down, Fed's decision is to make dollar stronger than other currencies. Central banks,corporations hold US treasury bonds. In case of heightened geopolitical tension,many govts and corporations owned by rich individuals may ditch these bonds ,reading political stand taken by their governments. Higher policy rates will keep the treasury bond price low and will inflict heavy loss to the owner of the bonds if he intends to sell it. Many Chinese companies hold huge amounts of treasury bonds and they cannot sell their US bonds so easily if hostility between the two countries takes a virulent form. This situation is very likely to emerge after the US election. For a foreseeable future, Fed's rate will rise even if inflation eases in the USA. And to make taka stronger and avoid further capital flight we have to keep raising the policy rate.

I think the central bank should stay on its current trajectory. And giving any kind of assurance is like giving a wrong signal to the market because we still do not know with certainty what economic reality will be three months down the line.

Fed's Policy Rate Hike And Its Consequences

Fed's policy rate hike Hurts investment and job alike. Addressing deficit and inflation May lead to pick unapproved coalition.

The Federal Reserve System’s decision to hike policy rate further is a great cause of concern for Bangladesh. It is likely to depreciate Taka's value against dollar.Bangladesh is already under IMF prescription and has taken a credit of $4.7 billion to address budget deficit. Sloppy economic management, fuel price hike due to war in Ukraine and US policy rate hike have made a dent into the economy.

In addition, as the country is heading for next general election, clandestine capital flight under the disguise of genuine trade flow continues unabated. Huge demand of dollars has already reflected in continuous fall of Taka.

In 1990-91,rate of taka was Tk 35.67/USD . In 1991-92,it was Tk 38.14/USD.In 1996-97, it was Tk 42.70/USD. In 1997-98,it was Tk 45.46/USD. In 2000-2001,it became Tk 53.95/USD. In 2001-02,it was Tk 57.43/USD. In 2005-06, it was Tk 67.07/USD. In 2007-08,it became Tk 68.60/USD.Biggest depreciation came this year. Now in the open market Taka is being sold at Tk 107/USD.In general,big depreciation of Taka against US dollar is observed before and after election year.

When Fed's policy rate rises,investment from rest of the world goes to the USA. It is because return on investment is higher in the USA than anywhere else.Deposits at American banks pays more. However,bonds and stocks' prices go down*.At the same time,cost on investment also increases as the lending rate rises in response to policy rate hike. So we see more job cuts,fewer expansion of businesses and tightening of wallet by household. At one hand,consumption of foreign goods fall ,on the other hand,foreigners bring their dollars to the US legitimately and illegitimately. Often this kind of capital flight pushes up the property prices in the USA.

Last year,Bangladesh became the second largest exporter of RMG items to Europe. It is unclear whether Europe’s policy to discourage Chinese export or its slow response to Fed's policy rate hike played the key role in Bangladesh’s export success. But many exporters do not bring their export proceeds in time. It is reflected at the end of each fiscal year.Mismatch ranges between few millions to a billion US dollar. IMF has already stressed to maintain unitary exchange rate regime by the end of this fiscal year. In addition, it also suggested to raise Tax-GDP ratio significantly. Though depreciation of Taka is an incentive to exporter ,increasing business cost,deteriorating law and order and higher return abroad may drive further capital flight.

Rising cost of Dollar may also aggravate import of essential commodities. Government is running a rationing program of providing essential commodities at affordable prices to 10 million poor families. As most of the commodities are importable, strong dollar is likely to increase the cost of such program. Moreover, higher prices of utility has also increased household's expenditure. To subsidize agricultural inputs in order to ensure food security,govt has to raise subsidy amid IMF's insistence on downsizing subsidy. Earlier govt printed money to dole out to the problematic banks. Govt may further print money to subsidize its programs. This will evidently push the price levels up.

“Greenfield investment in Bangladesh was declined by 59% in 2022.”

--UNCTAD

Both the inflation and Fed policy rate hike may prompt the Bangladesh Bank to raise the policy rate further at home. This means lesser investment at home in future as cost of doing business and cost of investment are likely to rise in Bangladesh. According to a report by UNCTAD, investment on relocating factories from Occidental countries to Bangladesh was declined by 59% in 2022¹**. The latest development may further erode the investment prospect in Bangladesh. Growing deficit may lead Bangladesh to solicit Middle Eastern countries for more recruitment and special arrangement on fertilizer production.

In brief,US policy rate hike has already cast a shadow over Bangladesh economy that has been bleeding from mismanagement and corruption for quite some time. Strong dollar may further weaken Taka and rising fuel cost and inflationary pressure may push Bangladesh embracing further strategic ties that are not endorsed by the Parliament.

Notes And References

1. "Bangladesh Investment Flow Declines Sharply In 2022:UNCTAD",The Business Standard, March 08,2023.For more read at https://www.tbsnews.net/economy/bangladeshs-investment-flows-decline-sharply-2022-unctad-596462

[Update:This piece has been updated twice on March 14,2023 by me:
*First update,7:58 Bangladesh Standard Time,includes a correction on the relationship between bonds and interest rate.
**Second one,at 14:50 Bandladesh Standard Time,is the reference to UNCTAD report.]