Managing exchange rate regime: any cause for panic?
The pressure on the foreign exchange market is expected to taper off and the cooling effects of higher exports and remittances are likely to contribute towards stabilisation of the exchange rate
Exchange rate management has become a frontline issue in Bangladesh in recent times. The sharp rise in the price of the dollar and the significant decline in the foreign exchange reserves within a short span of time have sent shock waves across the economy.
In the backdrop of the recent Sri Lankan economic crisis, apprehensions have been expressed that Bangladesh may be on its way to facing a similar eventuality. With the preparation of the upcoming national budget for FY23 in its final stage, intense discussions are also taking place regarding appropriate budgetary measures that will be needed to counter the inflationary impact of the depreciation of the local currency.
We observe that inflation is rising, so is the gap in the current account balance, while remittance flow is sluggish and foreign exchange reserves are going down.
As part of its exchange rate management, the Bangladesh Bank (BB) is depreciating it to contain the import surge and guard against the downfall of the reserves. However, the central bank is following a strategy of gradual depreciation of the taka to smooth out the potential inflationary impact of such depreciation on the economy.
The Ministry of Finance approved raising the incentive for foreign remittance from 2 per cent to 2.5 per cent. LC margins have been raised to discourage imports of non-essential and luxury items. Restrictions have also been imposed on official foreign visits to reduce pressure on the foreign exchange market.
The BB's policy of gradual depreciation of the exchange rate has been criticised by many to be inadequate to contain import surges and reserves retention. They are suggesting a drastic depreciation so that the BB's rate matches the rate at which it is sold in the market.
There has been huge criticism of the BB's "failure" in dousing the gap between these exchange rates. The dilemma is that a massive exchange rate depreciation would fuel the current inflation while the slow pace comprises the risk of further depletion of the reserves.
To assess the efficacy of these measures we need to closely examine the nature of the difficulties we are currently facing in the foreign exchange market. From a policy perspective, these problems can be grouped under three categories: short term, medium-term, and long term.
The short-term problem arises from the fact that there has been a sudden surge in imports due to the release of pent-up import demand on investment, BMRE (Balancing, Modernisation, Rehabilitation and Expansion) and expansion in production capacities in one go. These were held up for two years due to the pandemic.
With the improvement in the Covid situation, the move toward economic recovery advanced at a rapid pace partly facilitated by the impressive growth in export demand and partly in the anticipation of a further rise in the prices of imported investment goods in the coming days.
There was a sudden escalation in foreign exchange demand also due to the rapid rise in foreign travels by Bangladeshis for medical, pilgrimage, education and recreation purposes as entry restrictions in the destination countries were relaxed significantly.
We need to understand that the sudden spike in foreign exchange demand due to this reason is likely to be transitory, and so it does not call for immediate corrections in the exchange rate. In that case, the enhanced demand for foreign currency will have to be met by drawing down the reserves, which the BB has, in fact, been doing during the current fiscal year.
The resulting decline in the foreign exchange reserves has been interpreted by some as the ominous indication of Bangladesh eventually landing on to a Sri Lanka type crisis. This view completely overlooks the fact that the purpose of building up foreign exchange reserves, in the first place, is to provide contingency support in the event of a sudden mismatch between inflow and outflow of foreign currency.
One also needs to take into account: the transitional nature of part of the enhanced import demand; the likely negative impact on import demand due to the successive depreciation of the local currency and other policy measures taken up to curtail foreign exchange demand; and the expected positive impact on export and remittance inflow due to the depreciation of the taka and the enhanced incentive for remittance.
The medium-term problem in the foreign exchange market arises out of the weakening of major world currencies against the US dollar. If we fail to adjust our currency at a commensurate rate it would imply an erosion of the competitiveness of our products against those of our competitors.
However, the extent to which Bangladesh needs to carry out this adjustment will depend on the current state of our exports and the outlook for export growth in the medium term. Against that consideration, Bangladesh seems to be in a fairly comfortable situation as the post-pandemic export levels have been quite impressive and with more than 30 per cent growth achieved in the current fiscal year, the export prospects in the medium term seem quite optimistic. In that context, the trade-off between additional export growth and the unavoidable inflationary impact of further depreciation of the local currency may not prove to be worthwhile.
It may be prudent to postpone the required exchange rate adjustments on this count as long as the robust export growth persists. Thus the gradual depreciation of the exchange rate by the BB appears to be the right strategy for the time being.
There is one important concern, however, that needs the attention of the policymakers: remittance. If the expatriate Bangladeshis do not get adequate conversion value for their hard-earned foreign currency due to the misalignment of the taka with the dollar, there will be a greater tendency to send remittance through the illegal channel, hundi.
To address this issue, the government has raised the incentive for remittance by half a percentage point. The incentive rate may be adjusted further in light of the emerging gap between the official and the open market price of the dollar.
The long-term difficulty that the external sector of our economy now faces is the sharp rise in the commodity prices and the shipment costs in the international market following the supply-chain disruptions caused by the Covid-19 pandemic, followed by the negative global economic impacts of the Russia-Ukraine war.
Unfortunately for Bangladesh, there has not been any commensurate increase in the export price index or in the wages of expatriate Bangladeshis. This means that in order to buy the same amounts of the same goods, Bangladesh needs more foreign currencies although there is no such increase in the foreign exchange supply due to export prices or foreign wage increases. Given that this new demand-supply gap of foreign currencies is likely to persist in the medium term, it naturally calls for exchange rate adjustments.
The BB can choose its own pace of adjustment but there is no escape from the need for price correction of the local currency.
The non-adherence of the banks to the BB's guideline of BC buying and selling rates and the resulting chaos in the foreign exchange market lead to the worst of both worlds: a depletion in foreign exchange reserves due to dollar sales by the BB and a rise in inflation due to the import LCs opened at a much higher rate than the BC selling rate. This is a regulatory failure and needs to be addressed by the regulator. The Bangladesh Foreign Exchange Dealers' Association has already met on this issue and has given the necessary instructions to its members.
As a developing country, we do face a persistent negative trade balance, as our import needs exceed our export capabilities. But remittance inflow has been our lifeline, often bridging the trade deficit and rendering a positive current account balance (CAB).
However, one needs to note that even in the years when Bangladesh experienced a negative CAB in the past, the impact on the foreign exchange reserves was none or marginal due to the healthy net capital inflow.
The recent adverse balance of payment situation has been somewhat unprecedented as there has been a culmination of several factors simultaneously. The supply shocks created through the Covid-19 pandemic and the Russia-Ukraine war have been exacerbated by the sudden surge in import demand. But as we cross the peak of the wave, the pressure on the foreign exchange market is expected to taper off and the cooling effects of higher exports and remittances supported by a gradual depreciation of the taka and higher remittance incentives are likely to contribute towards stabilisation of the exchange rate.
The resilience of Bangladesh's economy has been vindicated time and again. We need to pin our confidence on that and avoid unnecessary panicking.
The author is an economist