contemporary macroeconomic issues--challenges and...
TRANSCRIPT
Contemporary Macroeconomic Issues--Challenges and
Opportunities
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Ahsan H. MansurExecutive Director
Policy Research Institute (PRI) of Bangladesh
10/17/2015
Purpose of the Presentation Bangladesh economy has been facing several macro-financial developments, some of which arepositive or virtuous and others are not so favorable, over the last fiscal year (FY15), namely:
The foreign exchange reserve hit a record high of US$25 Billon in FY15 and still growing.
The main source of the inflow is through increased activity in the financial account while theexternal current account balance has turned to a deficit after several years of sizable surpluses.
FDI has been lackluster, which together with private domestic sector sluggishinvestment, has contributed to the virtual stagnation of investment in relation to GDP. GDPgrowth rates while hovering around 6-6.5% rate officially, although there are reasons to castdoubt about these estimates given all other macroeconomic indicators like lackluster exportperformance, static private sector investment, private sector credit demand etc.
Erosion of export competitiveness through appreciation of Taka in real effective terms andloss of export market shares in the US and EU markets are matters of concern.
Against this background, today I would like to present a possible strategy for translating theprevailing macroeconomic stability and high level of reserves for boosting investment andaccelerating real economic growth.
10/17/2015 2
Foreign Currency Reserves have Hit Record High Levels
Foreign currency reserves have increased bymore than 120% during FY11 to FY15, reachinga record high of USD 25 Billion (Figure 1).
Owing to the deceleration in export growthand remittances the contribution to thereserve from the current account declinedsubstantially during FY14-FY15.
However, the financial account of thebalance of payments, which is often the leastunderstood part of the BOP in Bangladesh andin many other countries was the major driverof reserve accumulation (Figure 2).
Although historically financial accountbalance in Bangladesh was generally negativeor insignificant, from a deficit of more than $2billion in FY11, it turned to a small surplus inFY12 and thereafter steadily increased to arecord surplus of $5.2 billion in FY15.
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Figure 2: Account Balances - Current, Capital and Financial
Current Account Capital Account Financial Account
Source: Bangladesh Bank
Source: Bangladesh Bank, the World Bank, and Ministry of Finance.*FY15 includes data from July-2014 to May-2015 only.
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Figure 1: Month-on-Month Reserves (USD Billions) and Growth (%)
Month on Month Growth Reserves (billion US$)
10/17/2015
There has been a Major Shift in the Key Components of the BOP with Major Policy Implications
Historically, developments in Bangladesh Bank reserves were dictated by developments In thecurrent account: reserves grew when there was surplus in the current account and the fell whenthe current account was in deficit. This historical relationship is no longer applicable with theemerging dominance of the financial account. The current account balance declined turnedsignificantly negative in FY15, but the level of foreign reserves continued to increased sharply (by16.05% in FY15). The financial account turned around by $6.7 billion--from a deficit of $1.6 billion to a surplus of$5.2 billion—during FY11 to FY15.In contrast, the capital account balance deteriorated by more than 18% over the same 5-yearperiod (FY11-FY15). Therefore, it is obvious that the financial account has been a propelling force in theaccumulation of the foreign exchange reserve.
Source: Bangladesh Bank
Table 1: Balance of Payment Flows and Percentage Change
Capital Account balance Financial Account balance Current Account Balance(mil US$) Growth(%)
(mil US$) Growth(%)
(mil US$) Growth(%)
FY11 600 -1584 995FY12 482 -19.7 1436 -190.7 -447 -144.9FY13 629 30.5 2863 99.4 2388 -634.2FY14 598 -4.9 2813 -1.7 1406 -41.1FY15 491 -17.9 5150 83.1 -1645 -217.0
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Export Loss has Exacerbated (contd.)
The Real Effective Exchange Rate(REER) isat its highest point in recent years as itappreciated by more than 19% during FY11-14 undermining the competitiveness ofdomestic exporters. It has appreciatedfurther in FY15.
The rapid appreciation of the REER inrecent years can be attributable primarilyto:
(i) the higher inflation in Bangladeshrelative to its trading partners; and
(ii) the depreciation of all major currenciesagainst the US dollar while Taka hasremained virtually fixed against thedollar.
Source: Bangladesh Bank
Source: Bangladesh Bank
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Figure 4: Effective Exchange Rates - Nominal vs. Real
NER REER Index10/17/2015 5
Export Loss has Exacerbated , Especially in FY15 Q4
This puts Bangladeshi exporters at a tremendous competitive disadvantage, especiallyin the European markets as the Euro has depreciated substantially against the dollar inrecent times and is expected to remain weak in the foreseeable future. Since Bangladesh’sexports are priced in US dollar the unit value of exports in Euro have gone up sharply inrecent months with a negative impact on export growth.Relative to competing countries like India, the relative shift in the REER index forBangladesh is also noticeable. The story is not much different when compared withcurrencies of other competing countries.
Source: Bangladesh Bank and Reserve Bank of India
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Figure 5: REER Index Comparison Between BDT and Indian Rupee
BDT Indian Rs.
10/17/2015 6
Policy Dilemma for Bangladesh Bank Resulting from the Reserve Buildup?
The developments described produce a tricky situation for BB:
On one hand, in order to depreciate the value of Taka in nominal terms, BB hasto buy foreign exchange from the interbank market at a much faster pace.
On the other hand, the resultant excess liquidity may mandate sterilizationoperations in order to curb inflationary pressures which would undermine thenominal depreciation through a corresponding real effective appreciation of theTaka.
Bangladesh Bank is already undertaking sterilization measures by issuing BB T-bills, and pace of such operations/interventions would need to be accelerated.
This rapid growth in the financial account balance is a relatively new phenomenonand needs to better understood in terms of sustainability and policy implications.
10/17/2015 7
What Factors are Contributing to the Reserve Buildup? The wide interest rate differential between the Taka and dollar denominated assets—in anenvironment of stable exchange rate outlook--have created opportunities for arbitrage for financialmarket players. It is attractive for foreign and domestic investors with higher risk appetite toinvestment in Taka denominated assets leading to a surge in capital inflows in the form of variousforms of finance account transactions:
Domestic firms—in order to strengthen their balance sheet and profitability--are increasinglymore interested to borrowing in foreign exchange and from abroad taking advantage of lowerinterest rates on foreign currency denominated loans. Such borrowing, with approval by the HardLoan Committee is increasingly rapidly.
Foreign investors are investing in short-term Bangladesh Government Treasury Bills and makingquite easy and respectable returns.
Some market players may also be engaged in informal “carry trade” by borrowing abroad atlower interest rates and lending in Taka at higher interest rates at home.
Inflows through other formal channels like portfolio investment have also contributed to thereserve buildup.
Close monitoring on these known and unknown channels is absolutely essential. If theGovernment is not aware of these developments, with the growing importance of these inflowsany sudden reversal of the inflows could potentially harm stability of the financial markets.
10/17/2015 8
What Benefits Generally Result from High Level of Reserves?
High levels of foreign exchange reserves act as a self-insurance policy at times of balanceof payment crises. This is important for a small open economy like Bangladesh where currentaccount balances are often vulnerable to terms of trade fluctuations.
The example of East Asian countries, which rapidly built up foreign exchange reserves torecord high levels in the post-Asian Crisis period is worth mentioning in this regard.
A large foreign currency reserve is also likely to improve the credit rating of the country asthe likelihood of repayment is greatly increased.
This has a knock on effect on the country’s external borrowing costs as interest ratespreads for both sovereign and private borrowers over the London Interbank OfferedRate (LIBOR) would decrease.
With the decline in country risk, there will be increasing interest from foreign investors inmaking FDI in labor intensive industrial and IT related sectors in Bangladesh.
High level of reserves will also improve government’s capacity to finance largeinfrastructure projects like Padma Bridge, elevated express ways, and major power projectscurrently planned for. We will revisit this issue later in this presentation.
10/17/2015 9
What Kind of Policy Challenges May Result from the Rapid Accumulation of Reserves?
Accelerated inflow of foreign assets also creates a number of policy challengesincluding market pressures for exchange rate appreciation and complications formonetary management.
Bangladesh Bank needs to incessantly buy dollars to prevent a nominalappreciation of the exchange rate of Taka against the dollar.
However, buying dollars from the interbank exchange market has the side-effectof increasing money supply beyond the target level, undermining the inflationtarget.
Any sizable sterilization operation – which BB had to do in recent years due toexchange market interventions – to contain monetary growth within the intendedlimit entails quasi-fiscal costs and consequent reduction in the profitability of BBand transfer of profits to the budget.
10/17/2015 10
Lower Inflation is Key to Exchange Rate Stability and Competitiveness
Minimizing Inflation Differential with Trade Partners is Important for ExchangeRate Stability and Competitiveness. The inflation rate in Bangladesh is generally much higher than its tradingpartners contributing to loss of competition in a stable exchange rate environment.
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The Bangladesh Bank and Government should take notice of the fact that inflation ratesnot much above the levels of trading partners is a prerequisite for sustaining stability in theexchange rate and lower interest rate over the medium and long term.Policy makers should set lower inflation target compared with the 6-7% rate which hasbeen aimed at in recent years.
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Figure 7: Country-comparison of Inflation Rate (%)
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Interest Rates on NSS Instruments Must Move in Line with Market Developments
While the NSS rates have declined, it must go down further to address these issues. The wide interest rate differential between bank savings rates and the NSS rates alsonegatively impacted the deposit growth rate. In FY15 deposit growth was only 12%, as asignificant part of household savings were diverted to purchase NSS instruments.If deposit growth remains so low in FY16 and beyond, the scope for expanding privatesector credit growth (by 15%-16%) will be seriously constrained.
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Figure 8: Month-on-month Growth in Deposits
Interest rates on NSS must come down significantly so as to allow for gradual shift towardssingle-digit interest rates. Such a move would also help contain the rapid growth in interest payments on domesticdebt, prevent destruction of the T-bill market, and help development of the broader bondmarket.
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Figure 9: Month-on-Month Growth in Private Credit (%)
The Political Economy and NSS Interest Structure The National Saving Scheme should be seen as one of many financialinstruments available for people and a borrowing tool for the government.Historically, it was introduced in the British period when banking system was notwell developed and most households and localities were not covered by thebanking network.
However, over the intervening years, the system has become well entrenchedand pressure groups have developed making it a politically sensitive issue which itshould not be allowed to become. This is not the instrument to be used for socio-economic development like providing income support for the pensioners andwidows.Under the current circumstances it is being considered as a political instrumentwithout any understanding of its fiscal costs, and other economic implications suchas creating serious distortions for the financial market operations.
This practice must stop, and if needed for social and political imperatives, thegovernment should use its own fiscal resources for carrying out such activitiesrather than burdening the financial system of the country.
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How Would BB Try to Engineer a Depreciation of the Taka if it so Decides?
Depreciation of the currency will not be easy since the exchange rate is broadlymarket based.
Operationally this will entail Bangladesh Bank actively buying more from theinterbank foreign exchange market. The already high level of reserves will growfurther and at a faster pace.
This will have ramifications for the financial market since the money supply willincrease which will in turn jeopardize inflation targets. Sterilization measures willbe needed to curb inflationary pressures which will create other problemsdiscussed earlier.
In parallel, BB should also start implementing reforms to create greater demandfor foreign exchange by the private sector through further liberalization of foreignexchange regime, which is still most restrictive even among the South Asiancountries.
10/17/2015 14
What can BB do with this Higher Levels of Reserve?
Reserve management/slowing down the reserve build up- measures need to be taken tostem the reserve growth through market mechanism.
The financial and capital accounts should be liberalized further, which will createadditional demand for foreign exchange.
Export retention can be increased in steps and may ultimately go up to 100% (as inIndia and China). This will force commercial banks to manage foreign currencydenominated assets and develop more products for their clients in consultation withBB. Commercial banks will be flushed with dollars and will be in a position to offerforeign currency denominated domestic lending.
There could be further liberalization of the current account transactions like the levelof foreign exchange allowed for foreign travels, internet transactions for hotel bookingsand purchased from abroad etc.
10/17/2015 15
Stemming Reserve Growth and Boosting Investment Through Lowering of Interest Rates
Reserve growth can be stemmed through reduction in deposit and lending rates. Related measure and rationale hasalready been discussed.
For single digit lending rate the proportion of non-performing loans must come down. This will require bettergovernance of state owned banks and stronger supervision of private commercial banks.
The government has reduced the corporate tax rate for banks, however the tax should be reduced further. Inaddition, there is need for improving efficiency in operating costs, which can be achieved through consolidation andtechnical improvements.
Merger and acquisition of weaker banks by stronger ones should be encouraged so as to promote formation oflarger banks with larger capital base. Such banks and their capital base would attract more foreign counterparts andenable them to facilitate external lending- a service which at present is primarily limited to foreign banks.
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State Owned Commercial Banks Overall Banking Sector Private Commercial BanksSource: BB
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What should the Strategy be for the Best Utilization of the Opportunities Created by the High Level of Foreign Inflows
and Continued Reserve Buildup?
A number of options – all of which aimed at boosting domesticinvestment, sustainable economic development, further liberalization of theforeign exchange regime, and at the same time helping management of foreigncapital inflows – maybe considered in this respect.
First, Bangladesh Bank is already very active in a number of areas with totalcommitted resources in the range of US$2.5-3 billion. The amounts can certainlybe increased in line with growth in demand and accumulation of external reservesby BB. The specific areas where funding could be increased include discountfacilities like: Export Development Fund (EDF) for exporters; Green Financing Facility for environmentally sustainable investment promotion; Funds for Cleaner Textiles and Leather Processing Industries.
These facilities are already in operation or are going to be in operation very soon.
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Strategies for Utilization of the Opportunities Created by the High Level of
Foreign Inflows and Continued Reserve Buildup (Contd.) Second, foreign currency reserves of BB, if equivalent to more than six months ofimports, can also be used to create a Sovereign Wealth Fund (SWF). BB Governor hasalready announced the formation of a $2 billion “Sovereign Fund” for infrastructureinvestment in Bangladesh. Operational modalities for running such a fund should becarefully thought through.
SWFs as established globally are investment funds owned by the state and may beinvested either locally or internationally or both. In the case of Bangladesh, however, thefocus of the proposed SWF should be on investing and catalyzing investment in domesticinfrastructure projects which are suffering from funding constraints due to longer gestationand payback periods for such investment.
Until long term domestic funding sources like pension and gratuity funds in the public andprivate sector are widely available and the insurance sector is more developed, theproposed SWF can play a major role in Bangladesh’s infrastructure financing.
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Strategies for Best Utilization of the Opportunities Created by the High Level of Foreign Inflows and Continued Reserve Buildup (Contd.)
Third, the Ministry of Finance in consultation with the relevant lineministries/agencies should formulate an “Infrastructure Development Program” foraccelerating implementation of nationally important major infrastructure projects.The projects could include transforming all national highways to four laneswithin a 3-5-year period; construction of a freeway between Dhaka andChittagong, construction of a number of major bridges and tunnels and elevatedexpress ways, further expansion of Dhaka Mass Transit System (including new linesfor elevated or underground mass transit routes); and co-financing of some PPPprojects including Power Generation and Distribution Projects.The initial starting fund size could be US$2 billion and increasing over time toUS$10 billion or more. Availability of these funds will also help mobilize donorfinancing and PPP sponsors for infrastructure projects.The fiscal deficit may have to be increased by 1-2 percentage points in relation toGDP on a time-bound basis in order to accommodate such spending.
After taking into account the additional growth, the net increase in debt/GDPratio will still not exceed 43% of GDP.
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Inflation Could be a Limiting Factor in Managing the Build-up in Foreign Exchange Reserves
Although BB has attempted to maintain a stable nominal exchangerate vis-à-vis the US dollar, the real exchange rate has appreciatedsharply because Bangladesh has higher inflation compared to mostof its trading partners.
The adopted mitigation policies must ensure that there aremeasures to bring down current inflation rates of 6-7% closer to therates prevalent in Bangladesh’s trading partners.
There needs to be specific “inflation targets” to achieve the feat oflowering Bangladesh’s inflation further, which would ultimately lowerthe domestic interest rate structure and the inflation and interestrate differentials with trading partners.
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Concluding Remarks
The challenges posed by a burgeoning foreign exchange reserves have tobe mitigated using market-based instruments.
The mitigation instruments have to be carefully chosen, and should beprudent and strategic in nature. Only then can Bangladesh’s flourishingforeign exchange reserves can open up many opportunities.
The opportunities, if exploited adequately and on time, would boostBangladesh’s growth performance through lower interest rates, higherinvestment, greater price stability, faster employment generation, andstrengthened macroeconomic stability.
If implemented properly and effectively, the strategy will surely helpBangladesh break the “6% growth trap” and shift to an 8% growthtrajectory.
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Some Questions Related to Effects of Monetary Policies on Inflation and Capital Market Performance
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What are the key objectives of monetary policy (for an effective macroeconomic management)?
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Key Objectives of Monetary Policy
• Monetary policy is the process by which the monetary authority of a country controlsthe supply of money, often targeting an inflation rate or interest rate to ensure price stabilityand general trust in the currency.
• Further goals of a monetary policy are usually to contribute to economic growth andstability, to lower unemployment, and to maintain predictable exchange rates with othercurrencies.
• Broadly, there are two types of monetary policy:-Expansionary; and-Contractionary
Expansionary monetary policy increases the money supply in order to lowerunemployment, boost private-sector borrowing and consumer spending, and stimulate economicgrowth.Often referred to as "easy money policy," this description applies to many central banks sincethe 2008 financial crisis, as interest rates have been lowered and in many cases to levels near zero.Contractionary monetary policy slows the rate of growth in the money supply or outrightdecreases the money supply in order to contain inflation.While sometimes necessary, contractionary monetary policy—by containing credit expansion andspending by consumers and businesses--can in the short-run constrain economic growth andincrease unemployment.10/17/2015 24
Key Objectives of Monetary Policy in the U.S & the U.K
• In the U.S, Congress established the statutory objectives formonetary policy—(i) maximum employment, (ii) stableprices, and (iii) moderate long-term interest rates--in theFederal Reserve Act.
• The Federal Open Market Committee (FOMC) is firmlycommitted to fulfilling this statutory mandate. In pursuingthese objectives, the FOMC seeks to explain its monetarypolicy decisions to the public as clearly as possible.
• Clarity in policy communications facilitates well-informeddecision-making by households and businesses, reduceseconomic and financial uncertainty, increases the effectivenessof monetary policy, and enhances transparency andaccountability, which are essential in a democratic society.
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Key Objectives of Monetary Policy in the U.S & the U.K
• The Bank of England’s monetary policy objective is to deliver pricestability – low inflation – and, subject to that, to support the Government’seconomic objectives including those for growth and employment.
• Price stability is defined by the Government’s inflation target of 2%. Theremit recognizes the role of price stability in achieving macroeconomicstability more generally, and in providing the right conditions forsustainable growth in output and employment.
• The Government's inflation target is announced each year by theChancellor of the Exchequer in the annual Budget statement.
• The 1998 Bank of England Act made the Bank independent to set interestrates. The Bank is accountable to parliament and the wider public.
• The legislation provides that if, in extreme circumstances, the nationalinterest demands it, the Government has the power to give instructions tothe Bank on interest rates for a limited period.
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How do changes in monetary aggregates influence interest rates, and inflation credit growth in asset
markets (including stock markets notably)?
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Inflation and Monetary Policy Recent Bangladesh Experience
• Easy monetary policy stance, adopted by the BB since FY10, led todouble digit inflation, stock market bubble formation and its bursting inthe FY11, and sharp increases in land and property prices. The shift inmonetary policy stance since FY13 has helped restore price stability asinflation has been brought down to less than 6.5% and led to correctionsin asset prices in general, both in nominal and real terms.
• Bangladesh’s current level of inflation is at 6.4 percent . Thegovernment’s 6.2 percent target for the FY16 implies that we need to gofor further reduction by slightly pressing the brake on the price level.
• General inflation has fallen from 6.87 percent in January 2015 to 6.40percent in June, but core inflation that counts nonfood and nonfuelinflation is on the rise. It has inched up from 6.08 percent in January2015 to 6.74 percent in June of the same year, warranting a cautiousstance right now.
• Although BB's current monetary policy aims at supporting 7.0% growthand an inflation target of 6.2%.
Graph 4: General and Core Inflation
Source: Bangladesh Bank
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Target Actual
Monetary Policy Targets Vs Actual, in Recent Years
How does interest rate changes affect returns and prices of financial securities?
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Relationship between Price of Bonds and Interest Rates
• To explain the relationship between bond prices and bond yields, let’s use an example.• Assume you’ve just purchased a bond with a maturity of five years, a coupon of 5.0%, and you bought it at
par (i.e.; 100%), investing $1,000. At this point, your bond is worth exactly what you paid for it, no moreand no less.
• Also, you will receive annual interest of $50 ($1,000 x 5.0% = $50), plus the return of your principal atmaturity.
• However, the market value of your bond will fluctuate after your purchase as interest rates rise or fall.Let’s assume that interest rates rise.
• Lets assume interest rates rise to 7.0%. Because new bonds are now being issued with a 7.0% coupon, yourbond, which has a 5.0% coupon, is not worth as much as it was when you bought it. Why?
– If investors can invest the same $1,000 and purchase a bond that pays ahigher interest rate, why would they pay $1,000 for your lower-interest bond?In this case, the value of your bond would be less than $1,000.
– Hence, your bond would be trading at a discount.• Conversely, if interest rates were to fall after your purchase, the value of your bond would rise because
investors cannot buy a new issue bond with a coupon as high as yours. In this case, your bond would beworth more than $1,000. Hence, it would trade at a premium. The bottom line is this. The market value of abond will fluctuate as interest rates rise and fall.
• This example clearly shows the inverse relationship between Price of bonds and interest rates.
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Interest Rate Changes Affecting Required Rate of Returns
For Bond Holders:
• The market value of a bond fluctuates as interest rates rise and fall.• For instance, if a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at
maturity in one year), the bond's rate of return at the present time is approximately 5.26%((1000-950) / 950 = 5.26%).
• A zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in oneyear).
• The bond's rate of return at the present time should be approximately 5.26% ((1000-950) / 950= 5.26%).
• But bond investors, like all investors, typically try to get the best return possible. So, if currentinterest rates rise, giving newly issued bonds a yield of 10%, then the zero-coupon bondyielding 5.26% would not only be less attractive, it wouldn't be in demand at all.
• To attract demand, the price of the pre-existing zero-coupon bond would have to decreaseenough to match the same return yielded by prevailing interest rates. In this instance, thebond's price would have to drop from $950 (which gives a 5.26% yield) to at least $909 toyield a 10% return.
• Conversely, if interest rates were to fall , the value of the bond would rise.
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Interest Rate Changes Affecting Required Rate of Returns(cont.)
For Stock/Share holders:•
In a rising interest rate environment, all financial assets face headwinds as a result of the effect of higherdiscount rates upon their respective cash flows. In other words, the present value of future cash receiptswill be less when discounted at a higher rate.
• Rising interest rates raise the cost of debt capital. This in turn will negatively impact the profitability andreturn on investment for the businesses, which will be negatively reflected in the stock prices and futureearnings.
• Fixed-income securities will be particularly challenged.• The key to successful investing in this environment is finding assets with growth rates faster than the rate
of change in interest rate levels.• If the investor's required rate of return increases, such as from 7% to 9%, he will no longer be willing to
invest in a T-bill with a return of 7% and will have to invest in something else, like a bond with a return of9%.
• The required rate of return therefore adjusts the price that an investor is willing to pay for a given security.• This example just looks at the actions of a single investor. What would happen to stock prices if all
investors changed their required rates of return?• A market-wide change in the required rate of return would spark changes in the price of a security. If all
investors in a market reduced their required rate of return, they would be willing to pay more for a securitythan before. In such a scenario, security prices would be driven upward until the price becomes too highfor the remaining investors to purchase the security.
• Should the required rate of return increase instead of decrease, the opposite would hold true.
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Impact of Interest Rate changes on Levered vs Unlevered Firms
• Financial leverage arises when a firm decides to finance a majority of itsassets by taking on debt.
• Firms do this when they are unable to raise enough capital by issuing shares inthe market to meet their business needs.
• When a firm takes on debt, it becomes a liability on which it must payinterest. A company will only take on significant amounts of debt when itbelieves that return on assets (ROA) will be higher than the interest on theloan.
• A firm which has a high leverage is using debt as form of financing ratherthan equity. Since they have to pay interest on these debt instruments, theiroperations are more vulnerable to shifts in interest rate.
• Decline in interest rate will reduce their cost of borrowing and thereforeincrease profitability. However, an increase in interest rates will have thereverse effect and will reduce the firm’s profitability and its stock price.
• Firms which are high levered are usually considered riskier than low leveredfirms mainly due to their susceptibility to interest rate fluctuations.
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Interest Rate Changes and the Effect on Stock Prices
• When the interest rate increases, it does not have an immediate impact onthe stock market
• The first indirect effect of an increased interest rate is that banks increasethe rates that they charge their customers to borrow money. Individuals areaffected through increases to credit card and mortgage interestrates, especially if they carry a variable interest rate. This has the effect ofdecreasing the amount of money consumers can spend and hence theirdisposable income. This means that people will spend less discretionarymoney, which will affect businesses‘ revenues and profits.
• But businesses are affected in a more direct way as well. Companies borrowfunds from the banking system to fund their operations as well as forcapital. For either reasons, increased interest rates will increase either thecost of operations or the cost of capital for businesses. This in turn willnegatively impact the profitability and return on investment for thebusinesses, which will be reflected in the stock prices of the same.
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Bonds and ‘The Fear Trade’
• During periods of fear, many investors sell risky assets and invest them in safer investments.Government Treasury securities are one such option.
• Something serious must happen to cause fear. This could be a negative political or economicevent, a natural disaster, a terrorist attack (or the threat of one), etc. This prompts investors whoown risky assets, such as stocks, to sell.
• Many times investments are directed toward Government Treasuries which are considered tobe one of the safest investments on the planet. Because a large amount of money flows intothese securities, it drives their price up.
• It’s simple supply and demand. When demand exceeds supply, prices tend to rise.
• When it comes to bonds, prices and yields move in the opposite direction. When bond pricesrise, yields fall, and vice versa. Hence, when fear rises and money flows into bonds, it pushesprices higher and yields lower.
• Conversely, when interest rates rise, bond prices fall, and bond investors will feel some degreeof pain.
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Why Policymakers or Governments Might Care about Stock Market Bubbles
• The stock market’s ups and downs can have very real, if not direct, effectson the macro-economy. Stock market bubbles are a case in point. Theinevitable crash that follows a bubble has the potential to causerecessions—the Great Depression being the worst case example of thatconnection to date.
• Wealth Effects: One reason that fluctuations in stock prices may affect the macro-economy
is that individuals who hold stocks, either directly or indirectly (forexample, through mutual funds or pension plans), feel poorer when thestock market crashes.
This wealth effect causes people to cut back on their consumption, a majorcomponent of aggregate demand.
• This effect has given a potential rationale for policymakers or governmentsto monitor the stock market.
• However, it is only when there is a bubble—when stock prices deviatefrom their fundamental values—that trouble can arise. During abubble, firms including financial institutions are undertaking investmentsthat they “shouldn’t.” When the bubble pops and stock market prices returnto their fundamental prices, we can expect a long period of lowinvestment, and likely recession.
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How do changes in fiscal policy (such as changes in corporate tax rates, individual income and capital gain tax rates) affect
after-tax cash flows to investors and what will be their implication for securities prices?
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Corporate Taxation Amongst Listed Companies in Bangladesh
• Increase in the corporate tax rate generally reduce after tax profit anddividends of the listed companies thereby reducing their stock prices. Thecorporate tax rate for Publicly traded companies has been reduced in theFY16 budget from 27.5% to 25%, in order to encourage more companies toget listed in the stock exchange.
• This is in response to the policy objective of the government and SEC toimprove the supply of stocks and also to bring forth transparency incorporate practices.
• While corporate taxes for all publicly listed companies has eitherdecreased or remains unchanged in FY16, the tax rate for publicly tradedcigarette companies has been increased from 40% to 45%. This in linewith the concerted effort of the government to control tobacco consumptionthrough the use of taxes.
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Relationship between Fiscal Policy and Stock Market
• The main channel for fiscal policy to impact stock markets is throughtaxation of listed companies and capital gains taxes on investors.
• In Bangladesh, as discussed, the government has reduced taxes on publiclytraded companies to encourage greater participation in the secondarymarket.
• In terms of capital gain taxes, while before the stock market crash thegovernment did impose capital gains taxes, this measure was removed afterthe crash in order to provide some relief to the retail investors who werehard hit.
• While this move did encourage many investors to enter the marketagain, the government should consider re-introducing the measure inkeeping with standard international practice.
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