Why rebuilding reserves proves so tough

A 17-month endeavour to rebuild the country's foreign exchange reserves, which plummeted to $23 billion from $38 billion, proved unfruitful, with a flawed exchange rate mechanism diverting dollar inflow towards informal channels, playing a significant role in the depletion of reserves.

Furthermore, the lending rate mechanism, which kept money cheap, fuelled import demand, and rising interest rates in the global market following the Russia-Ukraine war resulted in decreased private sector borrowing from foreign sources, thereby obstructing the rebuilding of reserves.

On the other hand, an extensive deficit in the financial account and downgrades in ratings by global agencies Moody's and S&P corroded the confidence of foreign investors, leading to a reduction in foreign fund inflow into the private sector and causing an erosion of forex reserves.

Despite the fact that the trigger for the dollar crisis was the Ukraine war that began in February 2022, poor handling of dollar pricing and a cap on lending rates exacerbated the situation, causing the reserves to keep shrinking.

The country's forex reserves had been declining from their peak of $48 billion in August 2021 but had remained above $38 billion until the onset of the Ukraine war.

But, there was no improvement in the reserve position until May this year. In June, the reserves experienced a slight increase due to budgetary support from multilateral donors, but they began to decline again the following month, reaching $23.16 billion on 23 August, according to data from the central bank.

More overseas loan repayments by businesses than receipts, lack of fresh foreign capital inflow and a surge in outflow of foreign portfolio are among the factors for reserves not being refilled as expected, financial analysts have said.

Exchange rate distortion also acted as a disincentive for repatriation of export proceeds and inward remittance through banking channels – two key sources of foreign exchange reserves, they believe.

Although the Bangladesh Bank announced the implementation of a unified exchange rate in July, putting an end to the multiple exchange rate regime introduced in the previous September, the gap between the selling rate of the dollar from reserves and the import rate continued to widen, reaching a maximum of Tk10.

The selling rate of the dollar from reserves was set at Tk109.5, intended as the sole exchange rate. However, certain banks are selling dollars to importers for as high as Tk120 in certain cases. The cash dollar rate in the kerb market is Tk117.50, indicating the actual dollar value.

The Bangladesh Bank announced the unified exchange rate to comply with a condition of the International Monetary Fund (IMF) as part of its $4.7 billion loan package but the rate is still managed by the central bank.    

The objective of introducing a unified exchange rate was aimed at easing pressure on foreign exchange reserves, but it has not yielded the desired results.

The wide gap between the officially declared rate and the market rate forced the Bangladesh Bank to sell dollars from its foreign exchange reserves despite a historic high devaluation of the Taka, where the dollar's price was raised by Tk2.85 in a single day on 3 July, indicating that the implementation of a unified exchange rate is still dictated.

Due to the elevated dollar rate in the market, the Bangladesh Bank had to sell $1.14 billion to banks from its reserves in July to cover the import expenses of government organisations.

Because the official rate falls significantly below market demand, remitters resorted to informal channels to access higher rates.

As per the Bangladesh Bank's financial stability report for 2022, the proportion of the trade deficit covered by remittances has significantly declined over the past two years, dropping to 71.3% in 2022 from 130% in 2020. This shift indicates that the remittance coverage, which had previously exceeded the trade deficit, is now insufficient.

The rate gap also prompted exporters to delay the repatriation of export proceeds, thereby exerting pressure on the foreign exchange reserve.

Central bank data reveal that a whopping $12 billion from Bangladesh's total exports last fiscal year did not come home.

Although the value of export shipments stood at $55.6 billion in fiscal 2022-23, the received export value was $43 billion. The significant disparity between shipment and realised export value highlights why the reserves have not been replenished despite the increase in exports.

Conversely, although imports experienced a decline of 15.76% last fiscal year, banks still grappled with the backlog payment of a record-high $89 billion in imports in the previous year.

While imports decreased by $14 billion to $75 billion in FY23 due to Bangladesh Bank-imposed restrictions during the dollar crisis, imports surged by $23.5 billion in FY22 when borrowing was inexpensive due to a lending rate cap.

Even though imports seemingly decreased in FY23, their volume remained insufficient in comparison to the previous year's growth, according to a senior executive of the Bangladesh Bank. As a result, the decline in imports did not significantly alleviate the dollar crisis, the executive noted.

The executive further explained that the heightened global interest rates curtailed private sector borrowing, a form of foreign borrowing that aids in rebuilding reserves.

In FY23, the private sector's net short-term borrowing amounted to a negative $1.9 billion, signifying loan repayment rather than new borrowing. In contrast, FY22 saw net short-term borrowing amounting to $3.3 billion.

The outstanding short-term private sector loans declined by $2.3 billion in just three months to $14 billion this March from December last year as loan payment was higher than borrowing, central bank data show.

Foreign borrowing became expensive due to the rise in interest rates. Currently, the Secured Overnight Financing Rate (SOFR) is over 5% and up to 3.5% additional interest adds to this for international loans, which means that borrowers are now subject to pay the highest 8.5% interest on their short-term foreign loans.

The reduction in foreign fund inflow turned the financial account to a deficit of $2 billion in FY23 from a surplus of $15.45 billion in FY22, central bank data show.

The central bank should engage in negotiations with foreign investors to formalise overdue credit, aiming to boost the inflow of fresh loans.

Ahsan H Mansur Executive Director, Policy Research Institute

What experts say

Dr Ahsan H Mansur, executive director of the Policy Research Institute (PRI), said there are huge payment obligations due against short-term loans. On the other hand, the dollar supply is not increasing as no fresh foreign direct investments are coming. Foreign portfolio investors are selling more than buying, he added.

He said exchange rate distortion is a reason for demand-supply imbalance. Moreover, money laundering could not be stopped, which also pushed up the dollar price.

Moreover, there is uncertainty ahead of the forthcoming national election which also impacts investors' confidence.

The impending national election has introduced an element of uncertainty that is impacting investor confidence, Mansur observed.

This lack of confidence is further compounded by the growing gap between government expenditures and revenue earnings. As government spending rises without a corresponding increase in revenue, it introduces instability into the economy.

Mansur believes that economic stability would have a positive impact on the forex market.

He has proposed that the central bank should engage in negotiations with foreign investors to formalise overdue credit, aiming to boost the inflow of fresh loans.

Zahid Hussain, former lead economist at the World Bank's Dhaka office, noted that despite efforts to restrict imports to preserve the forex reserve, this approach has not been effective. The root cause of this issue lies in the fact that the supply of dollars has not kept pace with the growing demand.

He also pointed out that exchange rate distortions have hindered the inflow of remittances. Additionally, the repatriation of export proceeds has fallen short of the value of shipments. This discrepancy has transformed trade credit into a significant negative factor, leading to a deficit in the financial account.

Data from the Bangladesh Bank illustrates that trade credit had a negative value of $6.5 billion in FY23, a significant increase from the $438 million reported in FY22.

The confidence of foreign investors has been impacted by various factors, including the downgrade of Bangladesh's country rating by Moody's Investors Service. This downgrade has resulted in a preference for paying back short-term credit rather than seeking renewal or new credit.

In May this year, Moody's Investors Service downgraded Bangladesh's ratings for the first time, placing it at "B1" from the "Ba3" category, but it kept the country's long-term outlook stable.

Another rating agency, S&P in July lowered the long-term rating outlook for Bangladesh to negative from stable, citing risks that the country's external liquidity position could deteriorate in the next year, while foreign exchange reserves remain under pressure.

However, Bangladesh Bank Governor Abdur Rouf Talukder in an event over the Monetary Policy announcement for the current fiscal year commented on Moody's downgrade geopolitical saying that the rating does not hold much significance for Bangladesh.

In a recent meeting with bankers, the governor asked for increasing remittance inflows, encouraging exports more than imports, and rebuilding the foreign exchange reserves.