Buying dollars cannot protect exports forever

Global foreign exchange markets just took a hammering from Britain's shock exit from the EU. In our own neck of the woods, the exchange rate does not float freely to fall prey to such volatility. But that does not mean it is any less important for one of our fundamental economic drivers - exports.
Export growth of 9.0 per cent this year is credited - at least in part - to a stable exchange rate which refused to budge from its 77-78 territory. In the interest of exporters, the central bank continued to buy large amounts of dollars from the foreign exchange market to stabilise the nominal exchange rate. If anyone is keeping count, it is now four years on the trot that annual foreign exchange purchases exceeded USD 3.5 billion. Small wonder that our foreign reserve just clocked USD 30 billion. One would think buying dollars is the best hedge for export growth.
Not quite. Going beyond sterilisation costs associated with massive foreign exchange intervention, fixing the Taka firmly to the nominal Dollar rate cannot prevent appreciation of the real effective exchange rate (REER). This is because Bangladesh's inflation-differential with the Euro Area, United States and China rose from 3.7, 4.1 and 3.6 per cent respectively in 2012 to 6.4, 6.3 and 5.0 per cent respectively in 2015. (Source: IMF WEO, author's calculations).
That Bangladesh's high inflation-differential with major trade partners has contributed to real effective appreciation is already well-known. The other less publicised - but equally important - factor which contributed to REER appreciation is the Taka's bilateral strengthening against a number of major currencies. By definition, REER reflects both inflation-differential and nominal exchange rate movements with trade partners (in trade-weighted terms). As it turns out, since the US dollar was strengthening and the taka-USD rate was kept stable, the taka appreciated significantly against other currencies from 2013 to 2015. Some notable ones include the Euro, British Pound, Malaysian Ringgit, Chinese Renminbi, Indian Rupee and Singapore dollar.
Proponents of the long-standing U.S. dollar-centric exchange rate policy may argue that we are yet to see any clear (adverse) impact on exports due to REER appreciation. Why worry about this now? Such scepticism typically overlooks a non-linear relationship. Prolonged REER appreciation could eventually wipe out Bangladesh's relative cost advantage, giving other developing countries a slice of Bangladesh's export pie. Slowdown in exports has undeniable implications for other aspects of the economy: employment, tax collection, bank asset quality and gross domestic product (GDP) growth, to name a few.
So what scenarios can lead to further dollar- and by extension, Taka- appreciation against other currencies? If for instance, the U.S. Federal Reserve continues on a tighter monetary policy path next year, subsequent capital inflow (say, from Europe, Japan or China) will lead to dollar appreciation against these countries' currencies. Further compounding this issue is Europe's adoption of extremely loose monetary policy and China's economic slowdown and recent devaluation.
Or take Brexit, for example. UK's unprecedented exit resulted in sharp depreciations of the pound (reached lows not seen since 1985) and the euro against the U.S. dollar. So the Taka has further appreciated against these currencies given its peg to the dollar. While we can continue spinning out different exchange rate-related scenarios, one fact becomes clear; stable taka-USD objective does not let Bangladesh adjust to exchange rate and monetary policy shocks in large open economies.
Given these external risks, identifying a strategy, which prevents REER appreciation, is the order of the day. One way is through a reduction in inflation-differentials with major trade partner countries. To be fair, this is a tough ask; the Euro Area, Japan and Singapore are grappling with deflation. China's inflation is falling due to slowing demand, property downturn and lower commodity prices. And let us not forget that India tugged down its inflation much faster than Bangladesh has in the last two years. On the other hand, Bangladesh Bank can hardly tighten monetary policy (to lower inflation) at a time when private sector credit demand is finally picking up.
In this context, the best way forward for Bangladesh would be to increase productive imports to take advantage of falling prices in trade partner countries and give the central bank a more realistic chance of depreciating the nominal (dollar) exchange rate. Admittedly, this is a lot easier said than done. Higher imports would require greater private investment, which, in turn, needs quality public spending on infrastructure, lower trade protection and efficient financial markets.
That leaves us with one last option. Bangladesh can follow in China's footsteps and adopt a currency-basket as reference for foreign exchange intervention. In December 2015, China moved away from its dollar-peg towards a currency basket to revive trade competitiveness and make the Renminbi more market-based. Bangladesh can consider a similar approach to protect competitiveness in the European market and also better synchronise exchange rate policy with monetary policy.
True, the matter is not so simple. Authorities would need to determine which currencies to use in the basket (apart from obvious candidates like the dollar, euro, pound etc.), what their respective weights should be, how to adjust those weights over time and how to be transparent about such a process. Nevertheless, if we agree that buying dollars cannot protect exports forever, prompt and decisive action is essential.
The writer currently works as a macroeconomic Research Analyst for an organisation in Washington D.C. He is a Fellow for the Asian Center for Development in Dhaka.  
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