Mizanur Rahman:

Liquidity crunch has been one of the myriad issues our banks and financial institutions have been facing for a while. The emerging problem is fundamentally economic, but the role of weak regulatory oversight is also insurmountable in this scenario. Policymakers are nevertheless in denial, which is no prudential macroeconomic management. A persistent liquidity problem may not only translate into solvency problems for many, but it may also create fear in the minds of economic agents and produce contagion risks in the overall financial market.

Bangladesh Bank has been selling foreign exchange reserves since September 2021 in order to finance persistent current account deficits, and hence unfavourable balance of payments (BOP). The volume of gross forex reserves declined from the record USD 48 billion in August 2021 to less than USD 35 billion in October 2022. This fast depletion is occurring amid a worsening disequilibrium in the money market and multiple exchange rates in the forex market. In other words, the central bank is targeting interest rate and nominal exchange rate(s) in an environment of too many uncertainties. We see twin unsustainable outcomes as a consequence.

First, a liquidity crunch is deepening in our financial system because the taka liquidity is mopped up by the central bank whenever it is selling forex reserves in the open market. As the nominal exchange rate of the taka against the US dollar is still considered to be overvalued, the excess demand for forex reserves is increasing, which calls for further depletion of the central bank’s reserves, which will in turn cause further liquidity crunch. The government is putting disproportionate focus on controlling its expenditures, but that’s only one source of demand for forex. The other drivers are household consumption and investments by firms, both of which are functions of interest rates, among others. With interest rates still capped, the only way to control the larger part of import demand, and so the demand for forex, is to place border barriers (quota and tariff, for example) and other administrative guidance. It is a self-defeating strategy, in my opinion, and it doesn’t work in times of crisis.

Second, the aggregate price level has been rising fast since July 2021, mostly because of global supply chain breakdowns, rising prices of energy and other primary commodities (fuelled by the Russian invasion of Ukraine), and resurgent aggregate demand as the economy reopened after the pandemic. Now, a rising price level means more demand for nominal money balance in order to transact into even the same volume of goods and services. This means that the supply of real money balance has contracted faster over the past 12 months.

These two unintended outcomes are causing the liquidity crunch in our financial sector. The role of weak regulatory oversight and lack of governance are possibly the other major reasons. We have long observed that the asset quality of banks and financial institutions has deteriorated over the years. The rising volume of non-performing loans (NPLs) implies declining operating cash flows for the banks and financial institutions.

So how can the Bangladesh Bank resolve this liquidity crunch?

Firstly, the central bank shall be required to inject new liquidity, primarily through the repo market, into the financial system. If this class of assets turn out to be short of supply, the central bank may consider buying the next best class of financial instruments, such as bank bonds and of course at fair prices. A downside risk of this is that inflation will further accelerate, but the short-term priority is to avert a worsening liquidity crisis.

Secondly, in the parlance of money market equilibrium, the double decline of real money balance will demand a rapidly rising interest rate in order to clear the market. Here comes the destabilising role of fixed interest rates. Note that the Bangladesh Bank kept lending rates fixed at nine percent, when the equilibrium interest rate would be anything in the double-digit. So the policy solution is that the central bank lets interest rates be freely determined in the money market. That will work like a bypass surgery for a man under cardiac arrest. The reset of interest rates will allow banks and financial institutions to fairly price loans and credits and slow down demand for private sector credit. The money market will settle into fundamental equilibrium. This leads to the foreign exchange market.

The money market is intertwined with the forex market. An equilibrium in the money market, and so rising interest rates, will depress credit demand throughout the economy and so improve current account deficits. The BOP imbalance will also likely improve unless unsustainable payment obligations emerge on account of external indebtedness of private sector corporations. Private sector corporations which have borrowed from foreign lenders without hedging may also be forced to restructure their payment terms. But the best way to discipline the unscrupulous private sector borrowers of foreign currency loans is to subject them to fair-valued, not artificially overvalued, exchange rates of the taka. The biggest roadblock to external account stability is that the central bank is still living with an overvalued taka. The fact that the taka has depreciated 25 percent against the US dollar is no guarantee that the taka is fairly valued.

The IMF’s BOP support will also ease the burden in the short to medium terms. I am sure that the government will explore new long-term loans from bilateral and multilateral development partners. Note that the aggregate external indebtedness is still below 25 percent of the latest measure of GDP. But the acid test for the government as well as the central bank is to crack down on trade-based money laundering.

In this complex scenario, restoring equilibrium in both money market and forex market should be the central bank’s singular goal. The only way to achieve that is to allow interest rates and exchange rates to freely adjust until market equilibrium is reached. It will stabilise forex reserves via changes in the supply and demand for foreign exchanges in the immediate term.

(Dr Mizanur Rahman is a commissioner of Bangladesh Securities and Exchange Commission (BSEC). Views expressed in this article are those of the author and not of the commission.)