Challenges and opportunities of growing forex reserves

In fiscal Year 2014/15 (FY15), Bangladesh's foreign exchange (forex) reserves crossed the US$25 billion mark, setting a new record for the emerging South Asian nation. With current level of reserves, Bangladesh will be able to afford seven months of imports.

The foreign currency reserve hit this record in FY15 despite a slowdown in exports and workers' remittances growth (Chart 1), a sharp rise in money being laundered out of the country, and the resulting widening of the external current account deficit (Chart 2). Given the weaknesses in the key external sector indicators, this reserve buildup is a surprising yet welcome development for Bangladesh which has been grappling with intense political unrest earlier in 2015 for almost one quarter.

What is behind this extraordinary growth in foreign exchange reserves in Bangladesh? As can be seen from Chart 2, the current account balance has been on a steady rise since 2011 despite prior undulations. However, the current account balance in FY15 registered the largest decline in 2015 since FY06.

Bangladesh's capital account has been more or less stagnant between 2006 and 2015. In contrast, the financial account balance was negative until FY 2011, after which it has been growing rapidly, recording a surplus of US$5 billion in FY15. This surge in the financial account balance is attributable to a number of factors contributing to inflow of funds into Bangladesh from abroad, including Bangladesh Bank's (BB) easing of restrictions on private sector's dollar denominated borrowing from abroad.

 This rapid growth in the financial account balance is a relatively new phenomenon and would require careful understanding of why it is happening, from what sources it is happening, and stability of such flows over the medium term.

In the remainder of this note we briefly cover the following issues: What benefits generally result from high level of reserves? What kind of policy challenges may result from the rapid accumulation of reserves? What kind of mitigating strategies may be adopted by BB and Government to manage the exchange rate without undermining export competitiveness and helping boost domestic investment?

High levels of foreign exchange reserves act as a self-insurance policy at times of balance of payment crises. This is important for a small open economy like Bangladesh where current account balances are often vulnerable to terms of trade fluctuations. The example of East Asian countries, which rapidly built up foreign exchange reserves to record high levels in the post-Asian Crisis period is worth mentioning in this regard.

[Continued on Page 4. The writers, Dr. Ahsan H. Mansur, Executive Director, Policy Research Institute (PRI) ([email protected]) and Muhammad Shafiullah, a Senior Economist at PRI ([email protected]), have jointly prepared the article for The Financial Express (FE)-PRI Economic Analysis Unit (EAU).]