Time to make dollar price flexible

Exchange rate is the most important price in any economy because of its pervasive macroeconomic effects. In most countries, exchange rate policy is prominent in policy debates. How is Bangladesh doing on the exchange rate front currently?  The International Monetary Fund (IMF), considered to be the global authority on exchange rate management, is very cautious on this question.  Here is what they say in their latest Article IV report dated August 7, 2019:

"The authorities should continue efforts to gradually increase exchange rate flexibility."

You can find this line in all recent Article IV reports on Bangladesh.  One does not have to be a rocket economist to figure that the IMF believes the exchange rate in Bangladesh has not been flexible enough or else why would they repeat the same line year after year?

Bangladesh Bank (BB) in theory maintains a flexible exchange rate regime.  In practice, BB intervenes by buying and selling US dollars (USD) and using "moral suasion". BB has in last two years used monetary policy to actually target the nominal exchange rate against the USD.  It sold over $4.6 billion in FY18 and FY19 and another $89 million in FY20 so far.  Coupled with a de-facto ceiling on the selling rate charged by the authorized foreign exchange dealers, administered through moral suasion, this resulted in keeping the inter-bank exchange rate within a rather narrow Tk 82-84 per USD band. It almost eliminated the difference between the interbank and the informal market exchange rates until recently when the differences have re-surfaced.  BB interventions have also reduced the level of foreign exchange reserves.

The stability in the nominal taka-USD rate has come at a price. It has damaged Bangladesh's price competitiveness.  The best way to gauge how much collectively is to look at the trends in the Real Effective Exchange Rate (REER)--a measure of the value of a currency against a weighted average of currencies of main trading partners divided by a price deflator. An increase in REER implies that exports become more expensive and imports cheaper. 

The Real Effective Exchange Rate (REER) appreciated by 5.6 percent in FY19 relative to its level in June 2018, more than reversing the 2.5 percent REER depreciation in FY18. The taka in real effective terms was 36 percent higher in June 2019 relative to its level in June 2013.  The real appreciation of the taka is attributable to faster domestic inflation relative to inflation in Bangladesh's key trading partners as well as the nominal appreciation of the taka against other major trading partners' currencies.

BB held the taka stable against the USD.  However, as shown in the table below, the exchange rate of our top four sources, accounting for over 50 percent of total imports, depreciated against USD by 1.2--4 percent in July-September this year relative to its average in 2018, implying nominal depreciation against Bangladesh taka as well since taka depreciated by only 0.7 percent against the USD during the same period.  Depreciation of currencies of Bangladesh's top export markets, accounting for over 65 percent of exports, ranged from 2.5--6 percent during the same period, implying even higher nominal depreciation against Bangladesh taka.  With USD strengthening in the international markets and Bangladesh's key export and import partners allowing their nominal exchange rate to depreciate against the US dollar, taka has appreciated against the Euro, the Pound, the Indian Rupee and the Chinese Yuan, among others.

BB's stance to keep exchange rate stable against the USD is often justified on inflation grounds. Exchange rate depreciation increase the local currency price of imported goods, other things equal.  The increase in the price of imported goods increases domestic price since these goods are either goods for consumption or intermediate goods. The increase in the foreign exchange rate also leads to cheaper domestic goods for foreign consumers, possibly resulting in increased exports, and more income in local currency for remittance recipient families, possibly resulting in higher remittances. The consequent increase in demand for domestic goods, coupled with increased cost of imported inputs, can also increase prices.

Empirical studies show the degree to which domestic prices adjust to exchange rate movements (described often as the exchange rate pass-through) varies considerably across countries and over time depending on the underlying causes of currency movements. Countries combining flexible exchange rate regimes and credible inflation targets tend to have lower pass-through ratios. Bangladesh's inflation trends juxtaposed against exchange rate movements suggests the fear of exchange rate induced inflation is exaggerated if not unfounded.

BB must decide whether it prefers to hang on to a relatively appreciated currency. In theory, there exists a tradeoff between competitiveness and purchasing power. A real depreciation can reduce purchasing power but improve competitiveness by lowering the price of domestically produced and increasing the price of foreign produced tradable goods.  However, the risk of the latter is minimal when the authority is faced with correcting the problem of over-valuation rather than engineering under-valuation.

There is no clear economic guideline as to the appropriate level of the exchange rate. The level of the exchange rate always has distributive consequences domestically, implying a role for interest group politics.

Capturing an industry's sensitivity to exchange rate changes involves measuring the extent to which it sells products to foreign markets, uses foreign-made inputs, and competes with foreign manufacturers on the basis of price.

Interest group activity on the level of the exchange rate faces substantial collective action problems as well. Exchange rate policy is only one of a number of potential policy instruments of relevance to affected groups. The returns to influencing trade and fiscal policy are appropriated by the lobbying industry entirely.  Lobbying for exchange rate adjustment, however, can benefit others with similar interests even if they do not, themselves, contribute to the lobbying effort. 

For example, traded goods industries have the option of lobbying for industry-specific trade policies when the currency appreciates. Currency policy and trade policy are close substitutes: a 5 percent real depreciation is equivalent to a 5 percent import tax plus a 5 percent export subsidy. Hence, the tradable sector can organize on an industry-by industry basis to seek trade barriers or export subsidies, thus mitigating the free rider problem.

It is therefore no surprise to see industry leaders in exports and import substitution sectors to seek enhanced "policy support" more than exchange rate adjustments. If better macroeconomic management, say by avoiding overvalued real effective exchange rate, can produce the same industry specific result as a direct cash subsidy and import tariff, it would make sense to opt for the former than latter simply to avoid the transaction costs and rent seeking risks associated with the latter.  Do not expect the industry to agree with this statement, because it is in their self-interest to get both.  However, they would insist more on the latter because they have to compete with all others to benefit from sound macroeconomic management whereas the targeted subsidy and import tariff are almost like a lock-in for the insiders.

An export subsidy, once in place, will stay irrespective of whether exports are up or down.  No such guarantee in a flexible exchange rate regime. If all exports do well, exchange rate may appreciate, negating partially the gains to the exporters and vice-versa. The subsidy per dollar, on the other hand, remains unchanged irrespective of the level of export earnings.  It protects the export industry insiders much more than a flexible currency.  Depreciation can induce entry into existing or new exports whereas accessing the subsidy would require the entrants to navigate through the process of subsidy administration.  Import tariffs require no such thing.  Yet it may be preferred to exchange rate depreciation by the insiders because it is independent of the level of demand-supply balance in the foreign exchange market and hence more predictable and durable.     

REER appreciation together with relatively low productivity levels has put Bangladesh at a competitive disadvantage. The adverse impact of this growing disadvantage on exports was partly alleviated by trade diversion spillovers from China in FY19.  But it has begun to catch up of late as reflected in a 2.9 percent decline in merchandise exports in the first quarter of FY20 relative to the same period last year. Exports of woven garments, knitwear, home textiles, frozen food, other manufactures, leather and agricultural products declined in almost all markets. 

BB intervention in the foreign exchange market has also exacerbated liquidity tightening in the money markets, thus contributing to weaker growth in credit to the private sector. The reduction in foreign exchange reserves has eroded the economy's resilience to internal and external shocks.

The private sector has been struggling to cope with the low quality of institutions and infrastructure.  Bangladesh slipped relatively on institutions, infrastructure and the macroeconomic environment in the Global Competitiveness Index 2019. There is not much BB can do on the structural front.  It can only help maintain a competitive exchange rate and adequate taka liquidity to support growth of credit for investment, production and trade.  Allowing greater exchange rate flexibility will enable market forces to correct the overvaluation.  This is now a practical necessity.

The author is an economist.