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Should Bangladesh Bank prop up the share market?

economy-dhaka-stock-exchange-1-1024x701The share market of the country, variously called the stock market, the capital market or the bourse, has been in the doldrums ever since billions of taka was siphoned off from the market in 2010 by scammers through fraudulent means. The elaborate scam encouraged a hype that led to very sharp increases in the share prices from about mid-2009. The bubble eventually burst at the end of 2010 with a spectacular crash of share prices. Although a probe committee was constituted and a report was filed no one was brought to justice. Confidence of the stakeholders in the market was severely shaken. Investment in the share market dried up: the daily turnover that had risen to Tk 325 billion toward the end of 2010 fell to Tk 38 billion during the last month (April 2015). To put it in a sharper perspective, the daily turnover at the end of 2010 was 0.43 percent of the country’s gross national income, but in 2015 it fell precipitously to 0.03 percent.

Disgruntled investors after record fall in the stock market (2011).
Disgruntled investors after record fall in the stock market (2011).
The DGEN index fell from an average of well over 8300 in December 2010 to only 4500 during July 2013. Dhaka Stock Exchange introduced a new index styled DSEX index in January 2013 and discontinued the estimation of DGEN index after July 2013. The new index shows that there has been very little increase in the index from February 2013 to April 2015. The downward movement of the stock market index was halted by April 2013, but it did not gain much traction since then.

The current state of the stock market is a good example of the role of business confidence or expectations on business performance. The 2010 stock market crash no doubt severely eroded confidence of the investors in the stock market, but the regulators or the government did very little to restore it. Consequently business expectations remained gloomy and the stock market stagnated.

A myth about the share market perpetrated in ordinary discourse with some success is that it is an important source of funds for investment (in macroeconomic sense). Facts, however, speak otherwise.

Professor F. Mishkin has provided evidence that the share market of USA accounted for only 2.1 percent of total external financing of the American business enterprises as late as 1970-85. The bourses of Germany and Japan show a similar trend. It should be borne in mind that the daily transactions in the share market, which the share market participants term ‘investment’, are trades in pre-existing capital and reflect only changes of ownership of capital. Such trades may be ‘investment’ to individuals, but they do not constitute investment in macroeconomic sense. Only the initial public offerings (IPOs) and perhaps bonus shares may be regarded as investment funds used for expansion of the capital base of business enterprises. The record of IPOs shows that they are an insignificant contributor to the total investment of Bangladesh (Tk 3.9 trillion in 2013-14). Data on bonus shares are not readily available, but they are not likely to be significant either.

It is, therefore, a bit surprising that the Chief Economist (CE) of Bangladesh Bank (BB) should call for the improvement in the performance of the share market an objective of a substantial change in interest rates on National Saving Directorate (NSD) saving instruments and time deposit rates. His statement made in a keynote speech of a seminar attracted the banner headline of this newspaper (27 April), which reported: “He expressed his frustration over the present state of the capital market and urged the government to take immediate measures to lower rates on saving instruments and term deposits with banks.”

The CE was worried that money was flowing from bourses to time deposits and national saving certificates because of the high interest rates on these saving instruments. Given his high position, it is likely that his publicly stated views may be in sync with the thoughts of BB senior management and even the Ministry of Finance. The fact that the Ministry of Finance indicated soon after that it would reduce the NSD rates strengthens such a belief. It is, therefore, pertinent to sound a caution about the simplistic solution to what is a complex problem.

The CE might have been unduly influenced by share market participants in assuming that investment would be significantly influenced by the stock market. The discussion above should dispel this view. The suggestion to reduce interest rates on saving instruments to raise stock demand and hence stock prices has a similar implication as slapping tariffs on imported textile in order to raise the demand for, and hence the price of, domestic textile and reduce the demand for foreign textile. This rewards the domestic textile industry at the expense of both foreign textile industry and domestic consumers. A reduction in the interest rates on savings will reward some stock market players at the expense of millions of depositors, but it is unlikely to do much good to the real economy.

Is it a fact that money was flowing out of the bourses and into the saving instruments in recent times? A look at the daily turnover of Dhaka Stock Exchange in Chart 1 below shows that after a very large rise in 2009 and 2010 and the equally large fall at the beginning of 2011 the turnover appears to have fallen to a lower level (but considerably higher than the pre-scam level) with occasional blips up and down. There is no discernible upward or downward trend in the turnover. Thus, it is not so much the case that money has moved out of the stock market, but rather that it has not attracted sufficient additional funds during the last four years as would be normally expected of a vibrant capital market of an economy growing at six percent plus rate.

Source: Dhaka Stock Exchange (website).
Source: Dhaka Stock Exchange (website).
The trend of time deposit shows rather clearly that its growth has slowed down quite markedly since 2011-12. This should not be surprising since time deposit comprises more than three-quarters of the money supply. BB had reined in money supply after the share market crash, consequently its growth rate declined. This caused a similar decline in the growth rate of time deposits.

Investment in NSD saving instruments on the other hand increased quite sharply during the last two years. The large interest differential between time deposit rates and the NSD saving rates obviously had a large role in encouraging investors to move into NSD saving certificates. It is a mystery why the Ministry of Finance had maintained the large differential for such a long time. It had substantial budgetary cost. If the NSD scheme were restricted to retirees and low income groups the differential could be justified.

It is not clear why a movement of funds from stock market to deposits and saving certificates, if it had occurred at all, should have reduced investment. Money invested in saving certificates is available to the government to fund its investment projects. Time deposit money are lent out by banks to their business clients to fund working and fixed capital needs. The decision to save and the decision to invest are independent decisions taken by different sets of people for different reasons, and the motivation of one does not necessarily impinge on the motivation of the other. A large number of surveys have been conducted by domestic and international organisations on investment issues in recent years, and none of them have found the state of the share market as an important impediment to business investment decision. The very bullish share market of 2007-2010 did not help raise the gross domestic investment ratio of the country, indeed it declined marginally. In contrast, the 2010 crash was followed by a very significant increase in the investment ratio. Physical and social infrastructure, domestic and world demand, policies, skill and business expectations play a dominant role in determining the volume of investment.

The rates on NSD saving certificates are set arbitrarily by the Ministry of Finance, but the rates on time deposits are determined largely by market forces. There are a large number of private banks in the country and it is unlikely that there is collusion among them to set the rate at a high or low level. However, BB can influence the market interest rate through an appropriate deployment of monetary policy instruments in accordance with its objectives. It is, therefore, confusing who the CE of BB was urging to reduce the deposit rates.

Interest rates are determined by the monetary policy of the country. The monetary policy stance has been set for the first half of 2015 by the Monetary Policy Statement of BB declared in January. Was the exhortation to reduce rates meant to be a signal to the market of a significant loosening of monetary policy during the next half of the year? The domestic inflation rate has been creeping up since the beginning of the year despite significant reductions in the international food and fuel prices. Is an expansionary monetary policy in this situation advisable?

The financial crises in the western world caused by asset market bubbles have spawned a lively debate regarding whether the central bank should take countermeasures when a bubble is forming. The discussion is understandably difficult and without a consensus. It is interesting that while economists are more liberal in suggesting that the central banks should intervene in the assets markets in order for bubbles being prevented from forming or growing too large, the central bankers by and large are more circumspect about intervention. They advise that central banks should not indulge in bubble-pricking for a number of reasons.

First, the central bank has only one instrument at its disposal, i.e. the interest rate or the reserve money supply. This is deployed to attain its inflation target. Any additional objective, such as asset prices, can be addressed without sacrificing the inflation target only fortuitously. When both objectives cannot be achieved simultaneously the central bank should not be so burdened since it may then fail to attain any of the targets, which will dent its credibility.

Second, there are many assets in the economy. If all asset prices are fortuitously moving in the same direction, the policy choice is less problematic. But if they are moving in opposite directions, what should be the target of policy? If a housing market bubble occurs at a time when the foreign exchange rate is depreciating and export industries are facing difficulties, is bubble-pricking by an increase in the interest rate desirable?

Third, any feasible interest rate increase may be insufficient in dousing the enthusiasm of asset market participants expecting much higher returns in a bubble-driven market.

Fourth, such interventions lead to moral hazard problems. Last, but not the least, is the Greenspan doctrine which warn that it is very difficult to identify a bubble, and it is very easy to mistake a genuine market correction as a bubble. It is also possible that asset prices reflecting market fundamentals could be mistaken as indicators of a depressed market. The cost of corrective measures based on incorrect diagnosis could be very high.

The strength of this cautious approach should be evident if the CE was incorrect in assuming that the stock market was in a depressed state. It is possible that the market has undergone some major downward market corrections and the DSEX index is now at about the value that correctly reflects the underlying fundamentals. If the latter happens to be the case, and BB were to intervene by reducing the interest rates, a bubble will be in the making. It may gain momentum to become a full-blown bubble in future. The very forces that persuaded BB to reduce interest rates arguing that the market was depressed ought to be able to also persuade it not to hike rates when the market is buoyant. The bubble will eventually burst with all the attendant problems, and BB will be held culpable. Many experts still hold the view that BB had in effect assisted in creating the 2010 stock market bubble by sharply increasing money supply in 2009-10 and 2010-11 (or reducing the interest rates), and permitting banks to deal in shares. Does it want to tread the same path again?

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