FROM USD 9 billion only four years ago, foreign exchange (forex) reserves have risen exponentially and ended 2015 at USD 27 billion. With this level of reserves, Bangladesh can now finance around seven months of imports – far higher than the minimum three-month requirement. This commendable development was initially brought about by exports and remittance outpacing imports (current account creating balance of payments surplus). More recently, the reserve buildup is attributable to increased foreign currency loans availed by private sector, foreign aid disbursement, foreign direct investment and financial inflows attracted by higher yield on taka-denominated assets (financial account creating balance of payments surplus).
This large stock of forex reserve provides an important source of self-insurance against potential balance of payments crisis and strengthens sovereign credit outlook. The latter attracts higher foreign investment, lowers country-risk premium charged on foreign borrowing and expands potential investor base for any sovereign bond Bangladesh decides to issue in the future. These benefits notwithstanding, rising foreign exchange reserve creates challenges for the central bank in terms of exchange rate management, containing inflation, maintaining profitability and productively allocating public resources.
EARNING LOW, PAYING HIGH
Since 2012, rapid reserve accumulation compelled Bangladesh Bank (BB) to relentlessly purchase excess dollars from the foreign exchange market to prevent taka appreciation (to protect exports and remittance). However, purchasing foreign currency injected local currency into the economy which undermined money supply and inflation targets. To meet monetary programme objectives, BB had to sterilise excess money supply incurring massive costs as the interest paid on sterilisation operations greatly exceeded that received on foreign exchange reserve holdings. Reserves are generally invested in safe and liquid (easily convertible to cash) foreign government securities which earn less than 1 percent, while BB pays more than 5 percent interest rate on its liabilities from sterilisation operations
INCREASING RISK TO CENTRAL BANK BALANCE SHEET
The rapid expansion of BB's balance sheet due to forex intervention raises risks associated with unfavourable exchange rate movement. An appreciation of the local currency can result in sizeable valuation losses on forex reserve holdings. As seen in Fiscal Year 2012-13, BB incurred foreign currency revaluation loss due to taka appreciation, which reduced its profitability and equity base (Source: BB Annual Report). Further episodes of taka appreciation could seriously weaken BB's financial health and further reduce its independence, ability to meet monetary targets and efficiency of forex reserve management.
ESCALATING OPPORTUNITY COSTS
It is also worth mentioning that foreign exchange intervention entails high opportunity costs since resources used could have been directed towards productive ventures. For instance, authorities could have used these resources to finance much needed infrastructure projects. As forex reserves continue to build, the overall opportunity cost of these low returns (compared to returns on alternative projects) will rise.
WAY FORWARD: FOREX RESERVE MANAGEMENT OPTIONS
Given these growing challenges, existing forex management policy cannot be a sustainable medium-term solution – especially if the pace of foreign currency inflow rises (for instance, due to rebound in exports and remittance). Authorities need to implement a dynamic reserve management strategy which carefully balances liquidity requirements, safety of capital and return on investment while supporting economic development and growth. Given multiple objectives, authorities need to establish how much reserves, above three-month import cover, should be held as buffer against external shocks (precautionary reserves). The remaining portion is excess reserves. Investment using precautionary reserves should be in highly liquid instruments, while excess reserves can be deployed in longer-term - and potentially less liquid - projects. A number of strategies, incorporating these considerations, are outlined below.
First, authorities need to strengthen exposure in U.S. fixed-income securities, given that the Federal Reserve Board is expected to steadily increase interest rates over the next two to three years. Using precautionary reserves, higher investment in U.S. treasuries and highly liquid corporate bonds could be considered. Investment in exchange-traded funds (ETF), with stable historical returns, can also be explored. ETF is an investment fund which generally tracks an index of financial assets and is traded in stock exchanges like most other equities. It is now increasingly utilised by central banks around the world to diversify and improve returns from forex reserves.
Second, BB should utilise excess reserves to expand its ongoing Selective Easing programme. In this regard, the fund-size of the following projects could be increased: Green initiatives, export promotion activities, environmentally responsible investments, promoting women entrepreneurship, skill-building ventures and supporting small and medium enterprises. Excess reserves can also be used to create a low-cost foreign currency fund for private sector manufacturing firms to accelerate productive imports. This strategy will serve the dual-purpose of encouraging new investments and generating improved returns on forex reserves for BB.
Finally, authorities could create an Energy Sector Fund to finance nationally-important power projects and a “Transport Sector Development Programme” - both using excess reserves. Depending on the initial fund size and future buildup of excess reserves, authorities may need to prioritise which of the following transport sector projects it can finance: construction of major bridges, elevated or underground rail-based mass transit system, bus rapid transit, stronger port connectivity and rural road network.
It goes without saying that channeling reserves in new directions will not be easy. Strong governance, separation from politically-motivated decisions and rigorous monitoring and evaluation are prerequisites for Bangladesh to reap the benefits of rising forex reserves. The options outlined, if utilised effectively, are expected to increase financial feasibility of forex management, stimulate private sector investment, create jobs and help Bangladesh achieve higher growth in a more inclusive manner. Will our policymakers capitalise on this underlying potential?
The writer currently works as a Macroeconomic Analyst for an organisation in Washington D.C. He is a Fellow at the Asian Center for Development in Dhaka.