The bold move to a flexible exchange rate regime
The Bangladesh Bank (BB) has recently announced a shift to a flexible exchange rate system after a long period of a managed exchange rate system. Although this decision is primarily driven by conditions from the International Monetary Fund (IMF) for the disbursement of loans, it has been a widely discussed issue in the country. Bangladesh is currently under an IMF programme for a $4.7 billion loan, but the IMF did not disburse the fourth instalment in January 2025 as Bangladesh was reluctant to adopt a market-based exchange rate. Now, with the central bank agreeing to go for a flexible exchange rate, the IMF will disburse the fourth and fifth instalments in June this year.
This is a significant policy move that follows years of concern by Bangladesh Bank (BB) about the risks of currency depreciation and volatility. In early May 2024, BB introduced a crawling peg system as part of the IMF loan programme's conditions, aiming to stabilise the foreign exchange market when pressures on reserves arose due to remittance fluctuations and trade imbalances. Adopting the crawling peg, a system where a currency is allowed to change within a set range, was a transitional mechanism since a sudden move to a free float could lead to excessive depreciation and worsen inflation.
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The flexible exchange rate shift has been made because of a stable foreign exchange reserves at present. The foreign exchange reserve improved after the payments in December 2024 and robust exports and increases in remittances halted the declining trend of foreign exchange reserves. Additionally, the decline in illicit capital outflow has contributed to building up reserves.
The tight monetary policy is expected to reduce the inflation rate in the coming months, although the rate of decline is still slow as per official data. The central bank has refrained from selling dollars to the market and has been building foreign exchange reserves over recent months by buying dollars.
This policy shift of moving to a flexible exchange rate is expected to offer several economic benefits. It will enable BB to focus more on domestic issues, such as controlling inflation and managing interest rates, without the burden of constantly maintaining a fixed exchange rate.
Another benefit of a flexible exchange rate is that it enables the economy to adjust automatically when external factors change. For example, when global prices fluctuate or a trade imbalance occurs, the exchange rate can adjust independently to maintain stability, allowing the economy to handle external challenges more smoothly, with minimal interference. Consequently, this reduces the strain on foreign exchange reserves and makes the system more stable in the long run.
Additionally, a flexible exchange rate can make the country's exports cheaper and more competitive in international markets. This can encourage foreign investment, especially in industries that focus on exports, leading to a stronger export sector and contributing to overall economic growth.
Moreover, a market-based exchange rate would eliminate the scope for arbitrary interventions by BB that artificially favour certain groups or create a misleading picture of economic strength for political gain. In the past, BB interfered with the currency market to keep the taka value unrealistically high to benefit a select group, such as importers and to signal a strong economy to the public. During the previous regime, the BB governor kept the value of the taka artificially high through interventions, for example, selling dollars from reserves in the market to prop up the taka. This led to the loss of competitiveness of Bangladeshi exporters, as all competitor countries devalued their currencies. Eventually, economic reality forced BB to devalue the taka. But by then, the adjustment was swift and steep instead of gradual. As a result, imports became too costly.
Of course, BB will have to be prepared to face the associated challenges with a flexible exchange rate regime. One of the primary concerns with a flexible exchange rate is the potential for increased volatility, which could undermine investor confidence, disrupt trade, and complicate long-term business planning. While a flexible exchange rate allows the currency to adjust naturally to market conditions, it can also result in sudden and unpredictable fluctuations that could destabilise the economy. This is particularly worrisome for a low-income country like Bangladesh, which is vulnerable to external shocks.
Another challenge associated with a flexible exchange rate is the pass-through effect on inflation. When the value of the taka depreciates, the cost of imports rises, which can lead to higher prices for goods and services and increased inflation. Since Bangladesh is an import-dependent economy, this could result in higher costs, especially for essential commodities such as fuel, food, and raw materials.
BB can utilise its monetary policy tools to control inflation in case of exchange rate fluctuations. For instance, by adjusting interest rates, the central bank can work to keep inflation at a moderate level. However, this will require coordination with fiscal policies to ensure that higher expenditures do not drive inflation too high and economic stability is not undermined.
Therefore, navigating the challenges of a flexible exchange rate will require careful management and ongoing strategic interventions. BB has announced a mechanism to stabilise the currency market by establishing a $500 million fund to sell dollars in the market as needed. This measure aims to mitigate sudden fluctuations in the exchange rate and reduce the risk of extreme depreciation. However, effective management of this fund will require close monitoring of both domestic and global economic conditions.
The transition to a flexible exchange rate may initially raise concerns among both domestic and foreign investors. Investors generally prefer stable exchange rates, as volatility can increase the risks associated with cross-border trade and investment. The fear of sudden devaluation could lead to capital flight or a reduction in foreign direct investment (FDI).
Transparent communication will be crucial for BB in managing investor expectations. Clear and consistent messaging about the central bank's policies, including the mechanism for market interventions and strategies to maintain stability, will help reduce investor uncertainty.
The decision by BB to adopt a flexible exchange rate is a bold step in aligning Bangladesh's economy with global market dynamics. While the shift presents several challenges, such as increased volatility, inflationary pressures, and the need to build investor confidence, the opportunities it offers, particularly in terms of economic resilience, adaptability, and competitiveness, are significant. Only prudent macroeconomic management backed by appropriate policies and political stability can help achieve the benefits of a flexible exchange rate system.
Dr Fahmida Khatun is the executive director at the Centre for Policy Dialogue.
Views expressed in this article are the author's own.
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