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Wednesday, March 23, 2016

US monetary tightening: Implications for Bangladesh

Sharjil Haque

US Federal Reserve Chair Janet Yellen suggested earlier this month that central bank policy rates should be hiked as early as December, 2015. This will end a seven-year episode of near-zero interest rates, and have significant cross-country implications for macroeconomic management. Much of the debate over international impact on US monetary tightening focuses on global capital flows. Simply put, investors reallocate their portfolio from risky assets (for instance, assets in emerging economies) to safer assets offering improved returns (US assets after interest rates rise). This channel of international financial transmission is negligible for Bangladesh given that the country has a closed capital account. For instance, Bangladeshi residents are not allowed to invest abroad in bonds or foreign money markets (restricting capital outflow), while foreign investors are not allowed to invest in money market in Bangladesh (restricting capital inflow).

Notwithstanding a relatively closed capital account, Bangladesh is still connected with international markets through alternate channels. To recognise the importance of these channels, we need to look at broader contexts and take a forward-looking perspective. This note argues that Bangladesh's banking sector, the dominant player in the financial system as well as Bangladesh Bank (BB) could gain from higher US interest rates. On the other hand, real sector (non-financial) corporates stand to lose and/or face greater risk.

FROM FEDERAL FUNDS RATE TO LIBOR: IS THERE A CONNECTION? An important aspect of this analysis is that the focus is not on a 25 basis point increase in US short-term rates, resulting from the first hike. Rather, it takes into account the Federal Reserve's forward-expectations on short-term interest rates in the next 2-3 years. The Federal Open Market Committee, which decides US monetary policy direction, is targeting to increase policy rate (known as the Federal Funds rate) to about 2.5-3.0 per cent by 2017 through a series of interest rate spikes. As Chart 1 shows, policy rates could be increased to around 1.4 per cent in 2016, and around 2.6 per cent in 2017.

An increase in US interest rate is expected to be reflected in global financial markets. For instance, as Chart 2 shows, the London Interbank Offered Rate (LIBOR) moves almost perfectly in tandem with U.S. short-term interest rates of similar maturity. Before the global financial crisis, US treasury rate (6 month maturity) had reached about 5.0 per cent before tumbling down to zero 6-month LIBOR exhibited similar movement. When the Federal Reserve increases policy rates, the interest rate channel of monetary policy transmission should ensure that US treasuries increase accordingly. This will have the knock-on effect on increasing LIBOR by similar amounts plus a marginal markup. What are the implications of a 2-3 per cent increase in LIBOR by the next couple of years?

Respite for banks

An increase in LIBOR could be a welcome relief for domestic banks in Bangladesh. Banks have come under tremendous pressure in the last couple of years as major non-financial corporates in Bangladesh have increasingly availed foreign loans. Due to an interest rate differential with foreign lenders of about 6-plus per cent, banks have experienced significant drop in credit demand and profitability. But this interest rate differential is expected to go down markedly in the next couple of years as US increases interest rates and if domestic banks continue their current trend of lowering lending rates. Admittedly, domestic banks cannot bring lending rates below 10 per cent in the near term without a significant lowering of inflation and reduction in non-performing loans.

Given such constraints, if we assume domestic lending rates of about 10-11 per cent by the next two years, the interest rate differential with foreign lenders is expected to fall to around 3-4 per cent (based on an expectation of higher foreign lending rate of 7-8 per cent, due to an increase in LIBOR by 2-3 per cent). Lower interest rate differential will make domestic financial institutions more attractive to real sector firms, given that foreign loans also have added disincentives of exchange rate risks and stricter pre-conditions for loan disbursement.

EARN LOW, PAY HIGH: MISMATCH POINT : An increase in US interest rates is also expected to benefit the BB. The central bank has been under tremendous pressure in preventing an appreciation of the exchange rate to protect exports and remittance. The massive buildup of foreign reserves in the last three years could have appreciated the exchange rate to around BDT 70/USD if BB had not relentlessly removed excess dollars from the foreign exchange market. Yet, buying foreign currency resulted in injection of local currency into the economy, which directly contradicted with the central bank's price stability targets (given that higher money supply can lead to inflation). To resolve this issue, BB had to sterilise excess liquidity by selling BB bills and bonds. This cumbersome task results in massive financial challenge for the central bank given that what they earn on their assets (foreign reserves) is far less than what they pay for their liabilities (bills and bonds). Foreign reserves are generally invested in "safe haven" assets like U.S. treasuries (earning less than 1 per cent) while BB pays 5.25 per cent on its liabilities from sterilisation operations. Depending on BB's portfolio concentration in US risk-free assets, this interest rate mismatch is expected to fall considerably as US tightens monetary policy over the next couple of years and, by extension, US assets yield higher returns. This will allow BB to step up sterilisation operations when needed, while incurring significantly lower financial challenges.

POTENTIAL REDUCTION IN "CARRY-TRADE": Another aspect which BB can gain from is through potential reduction in "carry-trade". This is an age-old investment strategy where a trader borrows cheaply in a low-interest rate currency, and invests the proceeds in a high-interest rate currency. China, India, Sri Lanka, Indonesia and South Africa are few examples of countries where traders have benefitted from this strategy. Given a guaranteed stable exchange rate and high interest rate differential, the motivation for this strategy is certainly present in Bangladesh. Industry experts believe that Bangladeshi expatriates who own apartments in US, mortgage those and use the money to purchase high yielding assets like National Savings Schemes in Bangladesh.

It goes without saying, BB's foreign reserve management gets complicated due to such ad-hoc arbitrage. Carry-trade adds to rapid foreign currency inflow, contributing to exchange rate appreciation pressures. While monetary programming can reasonably foresee current account or FDI-related foreign currency inflow, "carry-trade" induced dollar inflow is certainly not forecastable - distorting BB's monetary policy forecasts. In such a scenario, US interest rate increase may actually be a blessing in disguise. The resultant fall in interest rate differential is expected to reduce motivation for utilising this arbitrage strategy, though not entirely since certain degree of interest rate differential will still persist. Nevertheless, investors would want to rebalance their portfolio with higher amounts of US assets (which are considered very safe) once its' returns improve.

WHAT FINANCIAL SECTOR GAINS, REAL SECTOR LOSES: While financial institutions stand to gain from higher global interest rates, the real sector faces a minor loss. Many non-financial corporates had been availing foreign loans at 5.0 per cent rate, allowing them to lower interest expense and improve profitability. Procedures on accessing foreign loans were eased further this year, implying greater number of firms will avail this relatively new channel. Yet these corporates may not receive loans at such low rates once US monetary policy tightens, due to factors outlined above.

A study conducted by BB dated March 2014 showed that around 200 companies had availed foreign loans since access was liberalised in 2008. These are highly reputed firms which have strong impact on economic activity in Bangladesh. It is safe to assume that the number of such reputable companies availing foreign loans has increased since then. The study also revealed that most companies received loans at LIBOR plus a 3 to 4.5 per cent spread. This is a variable rate foreign-liability which is subject to change if global interest rates rise. Clearly, as LIBOR increases, these firms could face significant interest rate risk which will pose unplanned pressure on their cash flows. Some large local corporates, for instance in the cement sector, have utilised financial derivatives to hedge interest rate risk. But financial sector officials suggest that relatively smaller firms have not hedged their variable-rate foreign liability, owing to added cost and general lack of experience with these instruments. Unprecedented expense due to higher interest rates could impede such firms' near-term investment plans, decrease profitability and reduce industry competitiveness.

DEPRECIATION OF EMERGING MARKET CURRENCIES AND RISKS FOR BANGLADESH EXPORTERS: A less visible threat lies with exporting corporations. Local non-financial corporates have been voicing their concerns over eroding export competitiveness and have urged the BB to depreciate the currency. While a small depreciation was observed this month (November, 2015), this trend is quite temporary and without a sustained pickup in imports, appreciating tendency could return quite soon. At the same time, if exchange rates of other emerging market economies depreciate with respect to the US dollar, Bangladeshi exporting firms will face tremendous competitive disadvantage in the international market. Is there a possibility for further depreciation of emerging market currencies, following the rout in August?

As mentioned earlier, global capital flow is the dominant channel for international transmission of US monetary policy changes. Unlike Bangladesh, emerging markets like India, China, Vietnam, Indonesia, Malaysia, and Cambodia have significantly more open capital accounts. This suggests that an increase in US interest rates will drive capital out of these countries and into the US. Subject to the level of central bank intervention, capital outflow will depreciate their currencies against the dollar. Depreciation will make their exports more competitive in the international market relative to their Bangladeshi counterparts. To tackle this scenario, the BB would have to "administer" an equivalent depreciation of Taka, which as discussed above entails massive financial costs. This is a highly worrisome issue for the real sector, given its heavy reliance on export-led growth.

FINAL REMARKS: Given multiple macroeconomic factors and their interconnectedness, more in-depth examination of a global interest rate shock is necessary. This is essential now as Bangladesh increases integration with international financial markets through easier access to foreign currency loans, gradual opening of capital account (still in very early stage) and issuance of sovereign bonds in addition to existing trade channels. In this context, this note ends by outlining the following questions, which appear important for much deeper understanding by all stakeholders concerned:

1. Should nominal exchange rate policy be revisited if emerging market currencies depreciate due to capital outflow?

2. What are the implications for Bangladesh's real effective exchange rate as US price levels change due to tighter monetary policy?

3. What steps need to be taken to ensure that domestic lending rates come down, sustainably, to at least 10 per cent to ensure a lower interest rate differential with the rest of the world?

4. What are the implications for capital account liberalisation in a global environment where investors might prefer US assets as their returns improve over the next 2-3 years?

5. How should Bangladesh pace its liberalisation of foreign currency borrowing given significant possibility of interest rate risk?

6. Finally, how can risks faced by real sector corporations, due to foreign currency loans, spillover to the domestic financial sector?

Sharjil Haque completed graduate studies in International Economics from Johns Hopkins University, and currently works as a Macroeconomic Analyst for an organization in Washington D.C. He is a Fellow

at the Asian Center for Development in Dhaka.

Source:  The Financial Express, 18 November 2015