Monetary policy and investment

Mr Faruk has reviewed some broad issues in trade reforms and financial liberalisation in developing countries, including Bangladesh. As he has indicated, there is vast literature on these topics, including many empirical studies for Bangladesh. In a general sense, financial liberalisation encompasses the deregulation of interest rates, the floatation of the exchange rates, the privatisation of banks and other financial institutions, and the liberalisation of capital accounts in the balance of payments. It is not only the IMF and the World Bank but also most economists who argue for financial liberalisation in developing countries. The main aim of financial deregulation and reforms is to create an efficient financial system that raises economic efficiency and promotes economic growth. Although empirical evidence on this proposition is mixed, the alternative could be a repressed financial system that has been found extremely inefficient in most developing countries, including Bangladesh. There is plenty of evidence that financial repression creates a shallow financial system and retards economic growth. The financial system in Bangladesh that existed in the 1970s and early 1980s was shallow, inefficient and ridden with corruption. Over the past decade or so the financial system has developed significantly partly due to financial deregulation and reforms and is now playing an increasingly important role in the private-sector led growing economy.

On the trade front, most economists also argue that trade reforms are good for developing countries, as they raise efficiency and economic growth and lower the likelihood of a balance-of-payments crisis, especially under a flexible exchange rate system. There is, however, little doubt that trade reforms may adversely affect domestic industries, which are often protected under tariff-and non-tariff barriers, and raise the level of unemployment. Available evidence suggests that such problems are temporary but not insignificant. Trade reforms ultimately create a more efficient manufacturing sector, as well as a trade regime that can better absorb both domestic and external shocks, especially under a floating exchange rate system.

Although the debate on both trade and financial reforms has subsided, the issue remains as to whether a floating exchange rate system is appropriate for a developing country like Bangladesh. There is no easy answer to this because the appropriate exchange rate system ultimately depends on a host of characteristic features of the economy concerned, such as the size of the economy, the level of development, the nature of domestic and external shocks, the degree of capital mobility, the depth of money and capital markets, and the integration of the economy with the rest of the world. Nevertheless, as the Bangladesh experience suggests, a floatation of the exchange rate does not necessarily lead to extreme exchange rate volatility even when the country's money and capital markets remain underdeveloped. Apparently, for Bangladesh, the relative stability of the exchange rate (or the smooth depreciation of the currency) was due to controls over capital outflows. Another major reason for it was the continuation of relatively disciplined monetary and fiscal policies under the Poverty Reduction and Growth Facility Programme of the IMF. Furthermore, substantial inflows of foreign capital in the forms of aid, loans and remittances allowed the country to accumulate and maintain a respectable level of foreign exchange reserves.

Although I am not sure what Mr Faruk means by 'currency management liberalisation', it is presumably linked to the conduct of monetary policy for price stability in a deregulated financial environment. It is widely accepted that the conduct of independent monetary policy under a flexible exchange rate system remains at the discretion of a central bank. The government generally does not interfere in the conduct of monetary policy if there is an agreement between the government and the central bank that the central bank should undertake the delegated responsibility to maintain price stability (meaning low and stable inflation). Having gained such autonomy, the central bank can use whatever indirect monetary policy instruments at its disposal for monetary management within a pre-specified monetary policy framework. In the same spirit, the Bangladesh Bank has lately adopted monetary targeting as a strategy of monetary policy to control inflation. Therefore, there is nothing wrong in the monetary authorities' use of policy instruments to control any monetary aggregates or interest rates. In fact this is the key function of a central bank under a deregulated financial environment where inflation becomes the policy variable that underwrites the interest rates and exchange rates and therefore any lack of central bank's control over inflation, and for that matter, unsustainable monetary and fiscal policies, may lead to financial crises.

This is the reason why the IMF and the World Bank suggest that a developing country like Bangladesh should conduct its monetary and fiscal policies in a disciplined manner (arguably better under well-defined monetary and fiscal rules) so that they do not create macroeconomic imbalances, meaning high inflation and unsustainable current account imbalances. It is believed that in the absence of structural or policy-induced economic uncertainties, real economic forces would induce higher saving, investment (including foreign investment) and economic growth. As in a non-inflationary economy there is limited scope or need for speculative or inflation-hedging activities, it may create an environment for technological adaptation and innovations that would raise productivity and promote long-term economic growth. Any external sector imbalance (such as current account deficit) in such an environment would primarily represent a gap between private saving and investment and this would be financed through autonomous capital inflows.

Although the IMF used to argue for capital account liberalisation, it has accepted since the Asian currency crisis, that any premature liberalisation of capital accounts in developing countries may lead to currency crisis, especially under a pegged exchange rate system and when the domestic financial system remains weak and therefore cannot process large-scale inflows of foreign capital efficiently. This does not mean that there are no potential benefits from capital account liberalisation. While Indonesia made significant economic progress until the currency crisis under open capital accounts, other countries such as China and India have maintained control over capital accounts and still their economies have grown rapidly during the past decade or so.

In the past, Japan and South Korea also had closed capital accounts and particularly discouraged foreign investment. For Bangladesh, there are valid arguments for and against capital account liberalisation. Capital account liberalisation can encourage foreign investment (portfolio and direct), which in turn may act as an external constraint on domestic monetary and fiscal policies. After all, under a floating exchange rate system, any monetary and fiscal policies that appear unsustainable to investors (domestic or foreign) may trigger capital flight and create such a panic that no political authorities can afford to ignore.

Still there are unresolved issues in the sequencing of capital account liberalisation and the factors that trigger capital flight or currency crisis in developing countries. It is the fixed or pegged exchange rate system that remains vulnerable to currency crisis, although there is always 'fear of floating' because it may lead to excessive depreciation of the currency. Nevertheless, it is accepted that a mere floatation of the exchange rate, or even a liberalised capital account, does not necessarily lead to a large-scale depreciation of the currency. Whether a domestic currency will depreciate or appreciate under a floating exchange rate system depends on the country's underlying inflation relative to that of its trading partners. Under a floating exchange rate system, inflation is a policy variable that depends on the growth of the money supply relative to the growth of the economy. Therefore, it is not clear why a floating exchange rate system per se, and for that matter, an open capital account, would 'ruin investment and increase import; and subsequently, balance of payment may collapse'. This could be a perception but the macroeconomic outcomes under both a floating exchange rate system and open capital accounts vary from country to country and from time to time.

Therefore, no economist or organisation can prescribe a policy package (given imperfect information and knowledge and inherent uncertainties) that does not have some known or unknown consequences of one form or another. There are non-economic factors that may determine the effectiveness of economic policies. In Indonesia, rightly or wrongly, corruption was considered a factor that aggravated the currency crisis although its economic fundamentals were better than those of other countries in the region. In Bangladesh, it appears that the major constraint on foreign investment is politics-driven uncertainties that cannot be removed unless the politicians are forced to operate under some strict 'political rules'. Therefore, under the present circumstances, capital account liberalisation is unlikely to bring economic dividends but can only make the economy more vulnerable to 'politics-driven' financial crisis. This is despite the fact that there are valid economic arguments for capital account liberalisation at the present stage of the country's development. Therefore, until the intractable political issues are resolved, capital account liberalisation should remain only in the policy agenda of the government for future consideration and implementation.

Akhtar Hossain teaches Economics at the University of Newcastle, Australia.