In a stunning departure from its usual preference for incremental reforms that are implemented cautiously, Bangladesh Bank on Wednesday (May 8) came out with all guns blazing, announcing at least two major policy changes which would directly impact the rate of lending (interest rate) in the country, and the local currency's exchange rate against the US dollar.

While it is true that the reform measures had been sounded out for a number of months now, and the Bangladesh Bank Governor had been speaking on them with greater urgency this week, nobody expected the two separate circulars issued by Shapla Chattor on Wednesday, that gave the reform initiatives official effect.

Un-smarting interest rates

In what is being described as possibly the most important move, Bangladesh Bank scrapped the SMART formula linked to treasury bills that it had been working with in order to make interest rates in the banking system fully market-based.

Now the interest rate will be fixed based on the bank-client relationships and the demand of loans and the supply of loanable funds in the banking sector, the central bank said in a notice. The decision comes into effect immediately, it said.

In July last year, the central bank withdrew the 9 percent lending rate cap it had imposed earlier and introduced the Six-months Moving Average Rate of Treasury bills (SMART).

The ending of the SMART is in line with the prescription of the International Monetary Fund (IMF) that has proposed a market-based rate-setting system. The suspension of the rate-setting formula coincided with the last day of an IMF mission visiting Dhaka to discuss the progress of the $4.7 billion loan programme.

The SMART formula has been put in place since higher consumer prices showed no sign of cooling despite the unprecedented spike in the policy rate. This largely happened because of the cheaper funds owing to the interest rate ceiling and market mismanagement.

Banks were allowed to add as high as 3.75 percentage points to the SMART rate as the margin for lending. Local experts and the IMF think an interest rate cap still exists owing to the SMART, said a senior official of the central bank. According to experts, the interest rates of both Treasury bills and bonds are controlled by the central bank.

In other words, the IMF had rejected the SMART formula as unfit to achieve the country's objectives. A BB official said the IMF suggested the BB let the market determine the lending rate since the SMART was not a market-based interest rate.

After the SMART was launched, the World Bank also said the introduction of a benchmark lending rate or reference rate for commercial banks could provide a transition path from rate caps toward market-determined rates.

On the other hand, there is fear among the business community that the rising interest rate could negatively impact the economy and businesses.

Since the rollout of the benchmark rate, loans indeed have become costlier.

The SMART rate for March stood at 10.55 percent. Since banks can add 3.75 percent as margin, the highest lending rate stood at 14.3 percent in April. The SMART rate was at 7.13 percent.

The notice said banks will announce sector-based interest rates and the interest rates will vary 1 percentage points depending on the credit risks of clients.

Whether the interest rate is fixed or variable has to be cited in the loan sanction letter. In the case of the floating rate, it should cite the number of times the lending rate could be increased and the range of the spike.

Banks will be able to levy up to 1.5 percent penalty interest on the outstanding amount of the overdue demand loans/working capital loans and the unpaid instalments of term loans.

They can't impose any other charges other than the announced interest rate, the BB said.

The interest rate of the stimulus packages, special funds, and refinancing funds unveiled by the central bank and the government would be fixed as per the guidelines formulated for the schemes, the BB said.

In a separate but related move, the monetary authority also raised the overnight repurchase agreement rate, a form of short-term borrowing cost for banks, by 50 basis points to 8.5 percent, to set the new interest rate regime on its way.

Exchange Rate: Crawling Peg introduced

The second major reform item saw Bangladesh Bank introduce the crawling peg exchange rate system and allowed banks to buy and sell US dollars freely at around Tk 117.

"It has been decided to introduce a crawling peg exchange rate system for spot purchases and sales of US dollars," the central bank said in a separate notice on the same day as the change to the interest rate regime was announced.

Under this system, a Crawling Peg Mid Rate (CPMR) has been set at Tk 117 per US dollar with an immediate effect. The central bank devalued the local currency by Tk 7 to Tk 117, the steepest slide in a day against the mighty dollar.

"Scheduled banks may purchase and sell US dollars freely around the CPMR with their customers and in interbank deals," the BB said.

The crawling peg, a system of exchange rate adjustments, falls between two extremes: the fixed rate and the floating or market-based rate. The key difference is that a crawling peg allows for limited fluctuations within a predefined range, while a fixed exchange rate has almost no flexibility.

Since September 2022, the exchange rate had been determined through a mechanism Bangladesh Bank came up with to arrive at a more market-based rate of the US dollar, in a deal with the Association of Bankers, Bangladesh and BAFEDA, the association of foreign exchange dealers. Economists have expressed their reservations about this on two fronts: that in the guise of switching to a market-based rate, we have handed over this determination to a cartel in the form of ABB and BAFEDA. And secondly, a market-based rate for the dollar would require a market-based interest rate as well.

Since mid-2022, the taka has been depreciating against the dollar, a trend primarily attributed to a balance of payments deficit leading to a significant reduction in reserves. The weakening of the taka has fuelled domestic inflation as the cost of imports has risen.

The move was announced as an IMF mission team led by Chris Papageorgiou concluded its 15-day visit to Bangladesh on Wednesday. During the visit, it discussed economic and financial policies in the context of the second review of the programme.

Papageorgiou issued a late statement acknowledging the reform initiatives, describing them as 'bold'. There has been some suggestion that announcing the reforms had become necessary to secure the staff-level agreement with the visiting delegation for release of the third loan tranche in the programme.

"We welcome Bangladesh Bank's bold actions to realign the exchange rate and simultaneously adopt a crawling peg regime with a band as a transitional step toward greater exchange rate flexibility to restore external resilience," said Papageorgiou in a statement.

He said the reserves have been declining for a real confluence of external shocks such as the Ukraine war, hike in interest rates globally and higher commodity prices. The higher prices have trickled down to the economy more quickly than other economies, raising inflation to a decade-high, he said.

The authorities have taken bold action and introduced a package of real reforms to deal with the current situation, he noted. The introduction of a new flexible exchange rate and the elimination of SMART could help create more flexibility, he hoped.

Short term pain for long term results?

Ahsan H Mansur, executive director of the Policy Research Institute, said the spike in interest rates may slow the economy further. "But it is necessary to overcome the challenges."

He said the introduction of the crawling peg would stabilise the taka-dollar exchange rate and improve foreign exchange reserves.

"The taka may depreciate further," he said, urging the government to discontinue the subsidy on remittances.

Asked whether the measures will bring back stability to the economy, the former economist of the IMF, said, "These are necessary steps, but not sufficient. However, without these steps, it will not be possible to help the economy overcome the crisis."

Zahid Hussain, a former lead economist at the World Bank's Dhaka office, said that of all the steps, the abolition of the SMART system was the most significant.

"The market-based interest rate is nothing new for us. Bangladesh has been following it since the economic liberalisation in the 1990s. Therefore, there is nothing to be worried about, and banks and other financial institutions are well-experienced in running operations under such a system."

The former WB official thinks the spike in the policy rate is appropriate, and it has to be kept at an elevated level until inflation comes down. He also said he was confused about the crawling peg system.

He said the central bank has narrowed the gap between the official exchange rate and the prevailing market rate by setting the dollar rate at Tk 117.

IMF's third tranche secured

Bangladesh is getting US$1.152 billion, more than double the amount scheduled, as the third tranche of an IMF loan meant to prop up falling forex reserves.

The all-clear came as the IMF announced on Wednesday that it had reached a staff-level agreement with the Bangladesh authorities on the policies needed to complete the second review of the ongoing loan programme.

Once approved by the executive board in the coming weeks, the IMF will make available about a total of US$1.152 billion to Bangladesh, says an IMF release.

Of the total sum, $932 million will come as Extended Credit Facility (ECF)/ Extended Fund Facility (EFF) while $220 million will come as Resilience and Sustainability Facility (RSF).

Bangladesh was supposed to get $668 million after the completion of the third review but the IMF staff team agreed to raise the dollop to $1.15 billion on request by the government, suggesting the government is badly in need of cash.

"Bangladesh authorities adopted some critical, reforms to address macroeconomic imbalances, including the realignment of the exchange rate, adoption of a crawling peg regime, and the full liberalisation of retail interest rates. It is imperative to sustain the reform momentum and ongoing efforts towards macroeconomic stabilisation," the lender of last resort said.

It also said the authorities' reform program supported by the IMF will continue to help Bangladesh navigate a difficult external environment and "preserve macroeconomic stability, while accelerating economic reforms and delivering on their climate agenda to achieve sustainable, inclusive, green growth."