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Bangladesh Bank has issued its Monetary Policy Statement July - December 2010 (MPS). In fact theforecasts cover the economy for the entire financial year July 2010 - June 2011 and none of thequantitative forecasts correspond to the six months period. As usual this statement is well presentedbut conveys the usual obscure objective of trying to square the circle, reduce inflation and increase thegrowth rate at the same time. The basic relationship, if there is one, between unemployment [i.e.

economic growth in the short run] and inflation controls central bank behaviour. Some central bankshave their objective as limiting the level of inflation. They take appropriate action without concern foremployment or growth. Other central banks like Bangladesh Bank and the US Federal Reserve arehanded a statutory objective of trying to achieve both. The best we know if you reduce inflation youslow growth and if you raise growth you raise inflation. This trade off is clearly present in Bangladeshbut no one wants to deal with its implications. The latest MPS continues to proclaim that one canachieve both. However, there is little convincing argument to tell us how the central bank willaccomplish this overall objective. In fairness to Bangladesh Bank one should separate the words fromthe deeds and the central bank has committed itself to an inflation reducing course.The mechanism for the trade off between growth and inflation works in many ways but the dominantchannel in Bangladesh is through the exchange rate: If the exchange rate is depreciated exports willincrease and imports will decrease leading to more domestic output using underemployed labour andcapital in Bangladesh. But if the Taka is weaker prices are higher. Bangladesh food prices are particularlyvulnerable to changes in the Taka-Indian rupee exchange rate due to the proximity of the markets. Insetting monetary policy one has to choose where on the growth-inflation trade off one wants to be.[This is a short run choice and has little to do with long term growth]. The MPS could take a stand tosupport rapid growth [6.7 per cent is rapid] and to force the Taka to depreciate to achieve such anoutcome; or the MPS could aim at a 4-5 per cent inflation rate and forcing a slow down of the growth of the private sector. The choice that has been made is the second of these-allowing the balance of payments to weaken while limiting the growth of the money supply to contain inflation.We cover three points:- What does the MPS tell us that BB expects of the economy?- What changes in money and credit, exchange rate and interest rates are expected?- Are the monetary policy instruments able to accomplish the changes?What does the MPS tell us that BB expects of the economy?The outcome of the economy in 2010/11 will depend on external factors, agriculture, fiscal policy andmonetary policy. The outcome is measured by GDP growth and inflation. The logic of the MonetaryPolicy Statement presentation is all tangled up. I try to untangle these ideas. The actions of the centralbank are in principle independent of the Government; this independence has strengthened in the pastfew years and this financial year will provide an interesting test. The MPS will soon fly in the face of theGovernment's wish for more expansionary monetary policy and we shall see if the central bank sticks toits objectives.The key elements driving the economy from the external sector are: Exports, remittances, foreign directinvestment and foreign aid. The central bank expects the nominal exchange rate with the dollar to besteady. Bangladesh Bank manages the exchange rate to keep it from appreciation which it wouldwithout BB's regular intervention. The central bank is silent on the real exchange rate, i.e. the nominalexchange rate corrected for the different rates of inflation. As the expected inflation rate is greater than

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that of the major traders and the Euro may depreciate we have a probable appreciation of the Taka inreal terms. If this is the correct view of the real exchange rate then this is consistent with the idea thatBB is probably leaning towards reduced inflation and slower growth although nowhere is this admitted.The behaviour of the real exchange rate is one critical indicator of the choice between inflation andgrowth.

For exports BB expects an increase of 10.4 per cent to $17.8 billion over $16.1 billion in 2009/10. This isa perfectly good if it is a conservative forecast. There are some ideas presented relevant to long rungrowth of exports with wishful thinking about new trading partners and international agreements; theseare good things to aim for but are distant. There are many things that will increase in the short run butBB does not focus on these. There are several potential downside risks in the export forecast:A. The world economy may not recover strongly; in particular the European countries may show weakergrowth and the Euro may depreciate with respect to the dollar. These will slow export growth. In mid2010 the world economy seems to be doing quite well, but most observers claim that there is somechance of a weaker performance.B. The labour conflicts and energy shortages may result in reduced apparel production and consequentlyexports. The export forecast presented by BB does not provide the commodity details but the impliedforecast performance of the garment sector should be 8-10 per cent. The MPS does state an opinion onthe question of the minimum wage taking the side of the workers in the critical garment sector. Theremarks on wages and the garment sector surprisingly show no recognition at all of the cost structure of the industry, the pricing of garment exports and the implications of a generous wage award. If BB iscorrect that rural wages have risen above garment sector wages then the stagnation of wages in thegarment sector indicates that the labour provided to the garment sector should shrink and labourshould shift to agriculture. This is one of many examples of the MPS where markets are ignored andreplaced with nave ideas about social justice. However, if this view of the relative wages is correct thenthe wage rates in the garment sector will rise on their own and the industry will shrink in output. Thenexus of rural and urban wages and the labour supply is an important issue that deserves much morework by the central bank. Indeed this statement in the MPS is probably the most important indicator of how the economy is evolving. Bangladesh is it seems moving into a condition of labour shortage.C. Another downside factor arises for shrimp exports which face problems arising from quality issues,labour disputes in the processing plants and environmental disputes at the farm level. These disputes goon and on without resolution. Everyone has suffered in this sector due to an inability to untangle andenforce the quality standards. Government after Government has failed to put in place the facilities thatwould enable this sector to grow rapidly. During the next year the ability of the industry andgovernment to manage these quality issues could cause a significant increase in shrimp exports or morelikely a sharp reduction.D. The final downside risk in the garment sector is found in the leather and leather products industries.This sector continues to stagnate unable to resolve the extremely serious environmental issues. Thetremendous potential of this sector is not being achieved. While it is not the BB's job to deal with thisproblem one should recognize that export growth could be greatly increased with a real effort byGovernment to resolve issues that have dragged on for years. Equally the sector may do less well thanexpected as the environmental problems mount with no resolution.Even admitting these downside risks I believe the BB export forecast is on the conservative side. The

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trend growth for exports is about 12 per cent; the past financial year showed a very low growth of about3 per cent over the previous financial year. We would expect, as the world economy is recovering,export growth would be much faster, rising above the trend. This is what is happening in othercountries. Hence export growth of 15-16 per cent seems to me more likely. The MPS might havemanaged to criticize the Government for the lack of interest in serious efforts to diversity and accelerate

export growth. The budgets efforts in this regard were at best modest. The stronger performance of exports suggested here would increase exports by another billion dollars.Remittance growth is projected to increase by 16 per cent to $12.9 billion from $11.1 billion in 2009/10.This is again a reasonable forecast; there are the well known downside risks of fewer workers beingaccepted in the Gulf States. But these are probably exaggerated and if true will have long run ratherthan short run effects.Foreign direct investment is projected to stay more or less the same at $700 million, so BB sees noimprovement in the FDI inflow. The general stance of the Government has been to discourage foreigninvestment. In the energy sector there is no actual progress in increasing foreign investment in the gasor the electricity generating sectors. In telecommunications the recent legislation will in the view of theindustry seriously discourage foreign investment. The new economic zones legislation will confuseeveryone with respect to the position and role of the export processing zones. Altogether the signals tothe potential foreign investors are not positive. Despite all of these negative ideas the prospects for theBangladesh are good, the commitment to democracy positive, and the growing economic ties with Indiaare factors that impress foreign investors. One can be more optimistic about the inflows of foreigninvestment.Foreign aid is projected at $2.8 billion gross compared to $2.3 billion in 2009/10. The donor communityis supportive of the government but finds it slow and difficult to deal with the Ministries. There is asurprising distrust between Government and donors. Bangladesh one of the poorest countries in theworld with massive poverty receives little foreign assistance on a per capita basis, only $17. BB iscertainly correct that this is not going to change much. Indeed past Governments have seen foreign aidas a displacement of private sector activity; these inflows have enabled the Government to expand whatthey are doing in many instances displacing the private sector.We can examine the impact of expected exports and remittances on growth: The increase of exportsforecast by BB is $1.7 billion of which half is imported components; combining this with the increase of remittances of $1.8 billion, weighted by estimated multipliers we have an expansion of $6.1 billionincluding in the estimated multipliers an estimated deficit of 2 per cent of GDP financed domestically.This corresponds to an expansion of GDP of 6.5-7.0 per cent consistent with the Budget forecast. Usingthe more realistic estimates of exports and imports the economy should grow 7.0-7.5 per cent. Mostcommentators have found the growth target ambitious; but I think it is rather modest. Bangladesh Bankhas correctly found the Budget target growth rate consistent with their picture of the economy.Bangladesh Bank through its lending programme is supporting more rapid growth in agriculture thoughmajor increases in availability of bank finance in rural areas. This programme is both potentiallysuccessful and also dangerous. It is successful if it raises output and increases wages in step withproductivity increases. But the increase in rural credit is one factor contributing to the higher wages inrural areas and hence putting pressure on the garment sector. This increase in agricultural credit is agood idea if the agricultural loans have an impact on production, raising labour productivity; but it is a

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very bad idea if there is no consequent increase in labour productivity, resulting in poor loan recovery.This is a very risky policy as it may not help farm labour productivity, but will harm the competitivenessof the garment sector. I do not think BB appreciates how risky this policy really is. To make it successfulthe farmers must improve their technologies using better quality seeds, improving agronomic practices,and improving the fertilizer mix. The ultimate test will be the real level of loan recovery. The rules for

determining NPLs in the agricultural sector are not as rigorous as for other loans in trading andmanufacturing, so the real loan recovery situation is likely to be less than transparent. There is aconsiderable improvement in the rural sector and rising rural wages seem to be a real phenomena but itis dangerous to throw kerosene on this fire with loans that do not lead to higher labour productivitythan would otherwise have been achieved.The Government expenditure programme as reflected in the 2010/11 budget is ambitious and thedeficit is expected to be around 5 per cent of GDP; although a large part of this will be financed throughforeign assistance there will be a significant increase in borrowing from the banking sector! This greaterdeficit in 2010/11 will be an expansionary factor unlike 2009/10 when the low deficit was almostneutral.All of these growth driven factors, BB believes, will validate the forecast increase in GDP of 6.7 per centforecast in the Budget presentation or even higher. Will such expansion cause inflation? Can BB controlinflation with such an increase of output? That is the key question before the monetary authorities.The result of the greater GDP growth rate, BB believes, will be a sharp increase in imports which areprojected to increase 18 per cent compared to 2.5 - 3 per cent for 2009/10. This forecast is very high.Past import increases have reached such rates only when commodity prices are rising. BB does not tellus in the MPS what is assumed. But this rate of import increase is probably too high.The current account surplus is projected to drop to $1 billion from $3.2 billion in 2009/10. Theinternational financial transactions come out according to BB with almost no change of a net outflow.However, including errors and omissions the out flow of capital will increase from about $400 million to$700 million. To be clear Bangladesh Bank projects the current account will be in surplus but the capitaland financial accounts will be in deficit resulting from a net outflow of capital to the rest of the world.Hence Bangladesh Bank projects the balance of payments surplus will decline to $358 million from$2.779 billion in 2009/10. In a nutshell faster economic growth will result in greater imports and sharplyreduce the balance of payments surplus.There is little discussion in the MPS of changes in domestic private investment. The linkage to monetarypolicy is discussed below. The level of private investment is not discussed in the MPS.The impetus to growth is expected to come from the agricultural sector and the industrial sector. On thedemand side one assumes that BB believes that the expected increases in Government expenditures willmore than offset the decline of the current account surplus. q