A unique exchange rate regime

Questions on exchange rate management have resurfaced because of the behaviour of exchange rate in the foreign exchange market in recent months. The debate is more about how, than whether, to manage the exchange rate. Regulating exchange rates for imports, limiting contestability for export dollars, and allowing free float for remittances, cash purchase and sales has transformed the foreign exchange regime into a mixture of pegs and floats where exchange rate uniformity, interbank trade in dollars, and foreign exchange availability have become casualties.

International practice

All countries currently manage their exchange rates, some more than others. The most powerful evidence on this is the large accumulation and decumulation of foreign exchange reserves by central banks even after the adoption of a flexible exchange rate system in the '70s. Policymakers have sweated over balancing the advantages of flexible exchange rate as a shock absorber and using exchange rate strategically to increase their share of the gains from international trade. Huge swings in global capital flows eroded the popularity of clean float leading countries to follow market-based management of the exchange rate, labelled as "dirty" float by free marketeers.

The "gold standard" is one in which monetary authorities engage in trading foreign exchange to prevent "excess" volatility of exchange rates. Exchange rates can go up and down in value depending upon the strength of the economies involved. Fluctuations not accounted for by changes in their fundamental determinants (such as interest rates, inflation, GDP growth, exports, remittances, imports) are considered "excess" volatility. In addition to using policy interest rates, monetary authorities buy and sell foreign exchange to prevent large currency swings. The ability to do the latter as needed depends on their "inventory" of internationally convertible currencies and gold, known as foreign reserves.

The "fear of floating" is widespread in emerging economies cutting across regions and levels of development. Depreciation is dreaded for fuelling inflation and making foreign currency denominated liabilities more burdensome. Appreciations are feared because of the Dutch Disease (negative consequences arising from large increases in the value of a country's currency) and valuation losses in foreign asset holdings. These two opposing considerations provoke interventions directed at moderating exchange rate volatility, deemed undesirable because of its association with increasing risks in international trade. Countries allegedly known as "currency manipulators" tend to undervalue their currency for as long as they can get away with this zero-sum game globally.

Changing rules of the game

Considered over a long haul since the Bangladesh Bank relinquished exchange rate pegging in 2003, the BB has engaged in moderating the volatilities. In the past decade, it has been erring on the side of overvaluation. Recently, as the external current account deficit surged, the BB sold more reserves to defend the taka against depreciation than the amount it acquired earlier to prevent appreciation. Shortfall in financing the current account deficit created excess demand for the globally rising dollar. The persistence of excess demand has caused some turbulence in BB's "stabilised" exchange rate regime, as classified by the IMF since February 2020.

The BB on 2 June announced verbally it will allow the taka to float against the US dollar. Market forces would set exchange rates. Had this been given a chance (it was not), the market would have found a set of rates where supply and demand clears after catching up with pent up depreciation. Arbitrage ensures convergence of rates at which the authorised dealers (banks) buy dollars from the exporters, individual remitters, and exchange houses. Call it x. There would be a similar convergence of rates at which banks sell dollars to importers, travellers, and outward remitters. Call it z. Sustainable foreign exchange intermediation requires the selling rate to exceed the buying rate (z>x). The interbank rate at which banks trade with each other for a very short period would be somewhere in between. Call it y. Rates in the informal market, call it w, tend to have a positive risk premium over the formal market selling rates. In equilibrium, the relation x < y < z < w must prevail. It can be violated on any given day but not day after day in the absence of frictions such as imperfect contestability and market policing by the regulators.

The BB focused on fixing the interbank rate and the rate offered by banks to importers. Banks are told verbally to follow BB's interbank rate for paying import bills. Banks can compete freely with buying rates offered to the overseas exchange houses engaged in remitting money. BB added some glue to supply of export dollars to make it stick with the designated bank. All export proceeds must be converted with the bank handling and negotiating the export documents. However, exporters can still negotiate rates using future export trade as levers. Rates on export dollars remain contestable, albeit imperfectly.

The market response

The price of dollar for import payments against LCs has been increasing even though all ADs report BB announced interbank rate as BC rate. On 4 August, banks reportedly charged importers up to Tk110 per dollar, compared to Tk105 the week before. The buying rate from the exchange houses increased to Tk111-112, compared with Tk 100 in the second half of July. Banks are competing to buy dollars from the exchange houses to meet large payments. The rates paid to exporters increased from Tk95 on 13 July to Tk102 on 4 August.

The BB limited dollar liquidity support to state banks at the interbank exchange rate for essential imports. Its interbank rate continues to be less than the buying rate from the exporters, individual remitters, and the exchange houses despite crawling up more than two handful times in the last three months.

The formal market response looks chaotic. Concerned, the BB rolled out on-site inspection of private commercial banks suspected of bypassing the interbank rate in Bills for Collection (import payments) and Telegraphic Transfer clean (purchase from individual remitters) transactions. BB teams also check the rates to the overseas exchange houses and poaching of other banks' clients.

The kerb market has moved in tandem provoking increased policing. The money changers bought the dollar at Tk106-107 and sold at Tk107-108 last week after peaking at Tk112 on 26 July. Amid the BB's increased raids, the number of dollar sellers declined despite plenty of customers willing to transact at the higher rate. Fear gripped the market making many money changers refrain from trading.

A divergence of rates between the exporters and remitters, with the latter getting the better side of the deal, reflects asymmetric contestability between banks in dealing with the exporters and exchange houses. Most banks are facing dollar deficiency in their foreign accounts. Although the rate they are charging importers looks lower than the rate they are paying the exchange houses, the margin from the rate paid to the exporters is fully or partially mitigating the losses. Free trade between banks in the interbank market is strangled by the BB's interbank rate being the lowest of all. Except BB, no one is willing to sell at this rate. Considered together, the observed rates relation seen of late cannot persist. Something, including reserves, has to give.

On 4 August, the BB Governor called a spade a spade on intervening in setting the exchange rate. Taka will float when the market becomes stable, he assured. The BB seems to be counting on significant easing of international commodity prices, declining import volume due to the policy measures, remittances edging up and exports averting major impact from expenditure slowdown in advanced economies as early as the next couple of months.

Test of the pudding is in the eating

Global experience shows market interventions of any kind cannot stop the fundamentally driven trends. The BB's analytical work using data for the period Q1 FY14 to Q2 FY19 found that the movement of nominal exchange rate was negatively associated with current account balance. The current account deficit in FY22 was 309% higher relative to FY21. The BB's interventions have led to a reserve loss of over $9 billion in the last 13 months. Yet the exchange rates have spiked with increased volatility leading the BB to play catch up by adjusting the interbank rate every now and then.

The BB's recent strategies contrast rather starkly with other central banks who could afford large scale interventions but chose not to. Japan had $1.3 trillion reserves in June 2022, yet it allowed 21.8% depreciation of the Yen in the last 12 months. Over the same period, South Korea allowed 12.7% deprecation despite having $438 billion in reserves. The Indian rupee has depreciated more than 7% in 2022 with the RBI still holding $572 billion. Taiwan's reserves in 2022 have been about 280% of their GDP while the Taiwanese dollar depreciated more than 7.5%. All stayed away from rate repression. They used the exchange rate as a shock absorber while protecting reserve buffers.

The BB is seeking similar results using its own unique model. Maintaining reserves at a minimum of 4-5 months equivalent of goods and services imports, restoring order in rates relation, and getting the interbank market back to functionality sooner than later is all that matters for market stabilisation. Only time will tell whether these will ultimately result from this unique experiment mixing elements of crawling peg (interbank rate), soft peg (BC rate), clean float (buying rate from exchange houses), moral suasion, market policing and targeted liquidity support.

Is it messy? Yes. Will it do more good than harm or vice-versa if BB's optimism about the economic outlook goes awry? No one can tell with any certainty. There is hardly any close prototype in our own past or other countries' practices.