Not exactly what the forex market needed

The forward exchange rate suddenly emerged as a buzz of the town last week. The Bangladesh Bank decided to put a ceiling on the taka dollar forward rate by setting the forward sale premium for contracts 90 days or less in duration. BB appears worried about forward deals serving as a route to bypass the administered spot rates it committed to let go by end-September in the FY24 Monetary Policy Statement. 

There are many takes on what motivated the move. Banks are allegedly charging different rates causing unhealthy competition among businesses. The playing field is tilted. Compliance is uneven. A ceiling on the premium will seal opportunism, bring rate convergence, and reduce volatility. BB is providing insurance to the forward sellers allowing a maximum 3.035% premium on the declared spot rate on a 90-day forward sale contract. Some even believe BB is indirectly increasing the taka dollar rate. 

Assertion of control

There is no evidence of unusual price divergences. The foreign exchange forward market is so thin that it finds no place in any reporting on market turnovers and rates. The rates posted by a couple of large domestic private banks show the 90-day forward rate was Tk112.925 on 24 September rising to Tk113.8537 on 27 September in one case and from Tk112.5135 to Tk113.8537 in the other. These data points suggest the interbank rate differences before the BB intervention were in ranges you would observe in any competitive foreign exchange market. The intervention led to convergence of the "posted" rates; a change not material enough to explain two consecutive circulars from BB within 48 hours. 

The price volatility argument doesn't fly either. One thing you do not see in the data on exchange rates since September 2022 is volatility in the official rates. They have all moved in one direction – up: Initially from Tk99 per $ for exports and Tk108 per $ for remittances to the currently unified buying (Tk110 per $) and selling rate (Tk110.5 per $) ceilings. There is no reliable series on rates in the parallel market, but these are outside BB's regulatory ambit anyway. They could arguably become more volatile due to the butterfly effects of this unanticipated intervention. Markets do not usually like such surprises.

BB has extended the radius of control to encompass the forward rate to keep the spot rate within the officially mandated zone. Many banks were perceived as trading US dollars forward to bypass the Bangladesh Foreign Exchange Dealers Association (Bafeda) and the Association of Bankers, Bangladesh (ABB) rates. BB wants to constrain such dealings by putting a ceiling on forward premium. Another case of ceilings breeding ceilings.

Market calculation of the forward premium uses the covered interest parity heuristic which adds a spread to the spot rate to compute the forward rate. Forward currency contracts tend to be quoted in forward points derived by using the predominant interest rates of both the local and foreign currencies considering the contract length and the current spot rate. The forward points can be positive (premium) or negative (discount), depending on the difference between the relevant domestic and foreign interest rates. This was hitherto not capped by BB.

Now it has by making forward points solely a function of the quarterly equivalent of the Six Month Average Rate on Treasury (SMART) rate plus 5%. BB sets the rates on 182-day treasury bills that go into the calculation of SMART, the spread over SMART, and the spot rate. This establishes full BB control over the maximum 90-day forward rate, thus narrowing the corridor bypassing ceilings on spot rates.

Unfit for purpose

A nagging shortage of foreign exchange is the Achilles heel of the economy currently. The net foreign exchange assets held by the BB is on a secular decline. The banking system's net open position has gone through waves of negatives and positives in the last twelve months (Figure-1). The volume of trade in the interbank market is limited largely to BB sales. This is a market where daily trade used to range between $400 to $600 million until BB started imposing rates in early 2022.

Inflows of foreign exchange have shifted down remarkably. Remittance growth plummeted from a monthly average of around 26.9% during July 2021-Sept 2022 to a negative 5.1% during October 2022 to September 2023. Remittance growth turned negative despite 13.1% growth in the number of workers employed overseas in the last 19 months ending July 2023. The remittance growth rates became more volatile on the downside (Figure-2) while net trade credit moved sharply into the negative territory (Figure-3) in the latter period, distinguished by a complicated system of multiple exchange rates.

These reflect a platter of dynamic responses from players on the receiving side of the exchange rate ceilings. BB continued to make Bafeda and ABB periodically (every 30 days on average) adjust rates by Tk1 for exports while keeping it stickier in case of remittances. Occasional arm twisting and raids by BB conflicted with their signal to "manage". The consequent unpredictability of BB stance cannibalised overground foreign exchange trades, only to reappear somewhere else in an adapted form, leading to a cat and mouse game of forex liquidity supply and demand.

Restricting the forwards points on top of repressed spot rates does nothing to address the shortage. The exchange rate regime exhibits properties similar to the Newton's First Law of Motion, also known as the Law of Inertia – the rate ceilings remain in motion, resistant to rubbing (friction) by the Authorised Dealers (ADs) and the reserve related Quantitative Performance Criteria (gravity) of the IMF program. How long it can stay in motion depends on the strength of the centrifugal forces keeping it away from market clearing.

Risks infant market mortality

The lesson drawn from recent experience appears to be that the solution to ineffective controls is more controls. Consider the difference the policy has made to the market behaviour parameters. ADs can sell dollars 90 or fewer days forward at a maximum rate of Tk113.85 per $. BB's clarification that the prescribed forward premium shall only be applied in forward sale for import payments not exceeding three months is ambiguous on whether the longer than 90-day duration forward sale contracts can be based on market determined premium or are not allowed.

Be that as it may, how many ADs can do 90-day forward sales at the BB set rate when the parallel market spot rates are around Tk118-120 per $ if they can "manage" and there is almost no prospect of an appreciation in the foreseeable future? Forward buying rates are automatically restricted except for those in dire need to manage meeting prior commitments. 

Central banks do not regulate forward market exchange rate premiums by setting ceilings. The size of the forward premium or discount mainly depends on the current expectation of future events. Traders consider the interest rate differentials between the two currencies and gauge market dynamics of particular currency pairs to determine the forward points. The currency with a higher yield is discounted and the currency with a lower yield tends to have a premium, other things being equal.

The social return from the forward exchange contract comes from providing firms exposed to foreign exchange risks with a hedging tool. New hedging instruments such as currency swaps, futures, and options have entered markets. The volume of swap transactions largely dominated the interbank (local) foreign exchange market with 93.1% share followed by spot transactions with 6.5% share in 2022 (BB, Financial Stability Report 2022, p. 100). Forward volume was a tiny 0.4%. 

Currency swaps and forward contracts serve different purposes and have distinct characteristics. Both can be used to manage currency risk or abused for speculation or even fraud. Regulatory reforms are needed to enhance the trading platforms, contract structuring, standards, flexibilities, settlement rules, counterparty risk sharing, default resolution, and access. Setting ceilings on premiums in an already thin market could increase the infant market mortality rate going forward.

Provides a convoluted policy signal

In an inflationary and money financed government expenditures environment in FY23, the official exchange rates remained overvalued despite upward adjustments. The parallel market premium presumably stayed high (judging from remittance data) and the volume of transactions conducted in the formal market gyrated. Quantity volatilities is an inevitable part of the fixed rate game. Ceilings on forward points is at best another paracetamol addressing only the symptoms while may be even worsening the disease. 

Drawing down foreign exchange reserves by on average $1 billion per month in the past 12 months did not mitigate the effect of expansionary policies on prices. The increase in prices and the reduction in real wages normally associated with a devaluation most probably has already taken place through a taka depreciation in the parallel market, in addition to devaluation of formal import rates. Domestic credit expansion under a fixed nominal lending rate and fixed nominal exchange rate are feasible, not to speak of being desirable, only when foreign exchange reserves are not tanking. 

Usable reserves are now less than three months of imports of goods and services. Supply of energy and domestic production are increasingly contingent on the adequacy of foreign exchange. Short term external debt is over 80% of reserves, close to the 100% red flag. External debt service burden is rising. Exports are facing headwinds. BB's explicit policy commitment, under these circumstances, has rightly been to rebuild reserve buffers and reset towards a market based exchange rate regime sooner than later. The ceiling on the forward premium is not signalling movement in that direction.

Zahid Hussain is a former lead economist of the World Bank, Dhaka office