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A potent mix for pernicious inflation

The intention of the above discussion is to sensitise the monetary and the fiscal authorities about the possibility of price implosion through interaction of high reserve and high liquidity. It will be apposite to take precautionary measures so that the situation does not go out of control at a later stage.

Saadat Husain
TRT foreign exchange reserve of Bangladesh crossed $9 billion before ACU payment. It stood at $8.6 after ACU payment. Soon, it is likely to cross $9 billion again. Such a high reserve was incredible only a few years back. When we used to negotiate with the donor countries or organisations in the Economic Relations Division (ERD) we were haunted by the umbra of foreign exchange shortage.
It was a fantasy for us to see our foreign exchange reserve reach a level that would place us in a respectable position at the bargaining table. A figure of $7-8 billion would be tolerable, $10 billion should be considered satisfactory. We are not far away from it; most probably we will reach that stage very soon. For ERD officials this is a happy moment, they can negotiate from a position of strength.
Banks are loaded with excess liquidity. Investors are shy. They are not borrowing enough to drain out the excess money parked in the banks. Statically, the situation is anti- inflationary. The dynamic implications may be different. It needs to be examined whether high deposits in the banks, in effect an augmented asset bast, will spur spending on consumption items. One has also to observe how this phenomenon interacts with drastic reduction of interest rate on deposits.
It cannot be ruled out that some depositors will draw their cash balance in the bank to spend it on consumer durables or consumption items.
The impact of high reserve on consumer prices depends on the transmission mechanism of foreign exchange accumulation and distribution of foreign exchange. Remittance driven foreign exchange reserve finds its way to millions of consumers in the form of enhanced money supply.
The dimension of increase is staggering, thanks to the operation of money multiplier. Money multiplier in Bangladesh being about 4.3, inflow of $10 foreign exchange soars to about Tk.3000 increase in money supply. The increased supply goes mostly to rural people with a high propensity to consume. This stokes price spiral in the market.
Increased export earnings from the RMG sector do not impact on the consumer prices in the same way because about 70% of the earnings are used to import raw materials for export items and because exporters' propensity to consume is low, particularly in the local market. They are likely to spend a part of their earnings on capital machinery and intermediate goods for non-RMG production as well.
If the monetary authority cannot effectively accomplish a sterilisation -process, runaway inflation may ensue in increased flow of remittance. Sterilisation is not an easy task; one needs to study hard to ascertain how far the central bank has been successful in carrying out the sterilisation operation. Normally, the central bank uses some stylised instruments like open market operation, Reverse REPO etc. to carryout the process.
Recently, Bangladesh Bank decided to use NOP (Net Open Position) to keep the foreign exchange market stable, which indirectly helped the sterilisation operation. The NOP limit has been re-fixed for 45 commercial banks out of 48. This will help the banks to settle large amounts of foreign exchange transactions without converting and reconverting them in the currency market.
Coming to excess liquidity, one sees the potential danger of increased money supply if it finds its way to innumerable consumers through some apparently improbable channel. It is like some blocked water body. Once it finds some leakage the deluge will create havoc. It
has, therefore, to be channelised in a controlled manner so that common citizens can benefit from the resource without being adversely affected by the gush.
Textbook items for spending the increased foreign exchange are investment goods, intermediate goods and strategic consumer goods in short supply. If investment is shy, and intermediate goods are not in high demand import of scarce but strategic consumer goods may be encouraged.
Consumer goods by themselves should not be considered as taboo when the country has a comfortable foreign exchange reserve. In case of inflation targeting it is expedient to increase the net supply of consumer goods in the country.
One way is to increase domestic production at a comparatively low cost; the other way is to import from the cheapest source. Since domestic production may be time consuming and may be costly at times, it is advisable to import strategically important consumer goods from the cheapest source to arrest inflationary tendency.
The intention of the above discussion is to sensitise the monetary and the fiscal authorities about the possibility of price implosion through interaction of high reserve and high liquidity'. It will be apposite to take precautionary measures so that the situation does not go out of control at a later stage.
Dr. Saadat Husain is Chairman. Public Service Commission.