Depreciation challenge amid monetary programme targets

The recent depreciation of emerging market currencies across Asia has sparked considerable debate in Bangladesh on whether or not to weaken the Taka. The general consensus among economists and the corporate sector is that Bangladesh should indeed depreciate to revive competitiveness of exports. In its latest monetary policy statement (MPS), Bangladesh Bank (BB) has also stated that it is considering depreciation for the same reason. In this context, this note briefly covers the following issues.
How has the central bank prevented misalignment between exchange rate and monetary programme targets when intervening in the foreign exchange market? What challenges will depreciation, and in particular sterilisation, create for the authorities? What strategies can be undertaken to counter these challenges?
BUILDUP OF FOREIGN RESERVES: The need for depreciation was fuelled by rapid foreign reserve accumulation. At the end of FY 2014-15, Bangladesh's foreign reserves crossed the USD 25 billion mark, covering seven months of imports. Exports, remittance, increased external borrowing by the private sector and lower import bills for food and oil created this welcome development. This massive buildup of foreign reserves, from less than USD 10 billion only three years ago, has continuously exerted pressure on the exchange rate to appreciate. Owing to growing price-differentials between Bangladesh and its major trade partners, BB could not prevent an appreciation of the real effective exchange rate (REER). But BB's heavy intervention in the interbank exchange market has kept the nominal exchange rate quite stable. As Figure 1 shows, BB's policy of mopping up USD 4-5 billion annually has kept the nominal exchange rate at around BDT 77/USD for the last three years.
However, this policy of keeping the exchange rate stable by removing excess dollars from the exchange market flooded the economy with local currency - increasing money supply. This created a tension between exchange rate and monetary programme targets which BB resolved by undertaking sterilisation operations. Sterilisation, generally speaking, is a strategy utilised by central banks to offset changes in domestic money supply due to changes in foreign currency inflow. BB conducts sterilisation via reverse repo operations by selling BB bills and bonds which soak up excess money supply from the economy. Figure 2 shows actual against programmed growth rates of major monetary indicators since 2013. BB's influence over net domestic assets (through sterilisation) has ensured that broad money did not exceed targets despite net foreign assets (generally foreign reserves) drastically exceeding programmed targets the last few years.
Despite this success, a potential depreciation and associated sterilisation raise several challenges and policy dilemma for the authorities. These are outlined below starting with immediate implications of depreciation, moving onto operational implications of foreign exchange intervention and ending with medium-term issues.
A critical assumption in BB's latest monetary policy projections is a sizeable pickup in imports. BB's projection for net foreign assets and by extension, reserve money, largely relies on the assumption of imports outpacing exports this fiscal year by 8.5 per cent. However, a sizeable depreciation of 5.0 (or more) per cent will complicate these forecasts as imports become more expensive. If we assume low import price elasticity (low responsiveness of import demand to changes in price) then BB's current import targets might understate what might happen in reality. If we assume a high import price elasticity (demand for imports would fall), then current targets might exceed actual values. Whichever may be the outcome, depreciating the currency could complicate BB's monetary programme projections and by extension, macroeconomic management.
The other challenge of orchestrating a depreciation - the responsibility of sterilising excess liquidity from the economy - will amplify growing quasi-fiscal costs for BB. This is attributable to the high interest rate differential between the rate the authorities pay on BB-bills/bonds and the low return they receive on foreign reserves (usually invested in U.S treasury securities). A rough idea of this cost can be obtained by utilising interest rate differential between one-year U.S. treasury securities and Bangladesh's 364-day treasury-bill. Currently this differential is around 6.0 per cent. If we assume Bangladesh is holding approximately USD 15 billion of reserves in excess of the minimum required (three months' import payments), then cost of holding reserves is roughly USD 0.9 billion. This figure is still on the lower side, since rapid reserve accumulation started from 2013, when the interest rate differential was much higher.
A DILEMMA FOR THE AUTHORITIES: From an operational standpoint of sterilisation, the maturity structure of securities issued poses a dilemma for the authorities. Sterilisation securities in most emerging market central banks tend to be short-term bills of less than one-year's maturity. Similarly, Bangladesh Bank has often focused on short-term bills. This can be attributed to better liquidity, lower borrowing costs and operational flexibility with these instruments. However, huge amounts of short-term liabilities exposes the central bank to rollover risk. Evidence from China (2007) and Indonesia (2011) suggests that shifting to securities with longer-term maturity also enhances monetary autonomy. These countries experienced improved performance in meeting broad money and inflation objectives in years when they shifted toward sterilisation securities with longer maturities. What should be the optimal mix of maturities of BB bills/bonds to ensure interest rates and inflation are not adversely affected when sterilisation unwinds?
These issues notwithstanding, the international literature in this area documents that it is extremely challenging to fully sterilise excess liquidity in developing economies owing to illiquidity in domestic bond markets. BB's own analysis showed that until 2013, the extent of its sterilisation was much lower than that of other Asian countries (Source: Reserve Accumulation and Sterilised Intervention in the Foreign Exchange Market in Bangladesh: An Empirical analysis, 2014). To its credit, BB has stepped up sterilisation operations since then. But if we assume that turning around the appreciating direction of Taka might require intervention amounts higher than what was needed just to keep it stable, then the challenge of fully sterilising excess liquidity will escalate for the authorities.
Assuming a heavy exchange-market intervention does depreciate the exchange rate, we can expect to see a revival in export competitiveness and remittance inflow. But, in the medium-term if we assume stronger and sustained inflow of foreign currency (through higher exports, remittance and external borrowing), the exchange rate will return to an appreciating trend. This would revive the same dilemma of eroding competitiveness that Bangladesh is in now and the authorities would have to resume its relentless dollar-purchase policy. How long can the authorities sustain this cumbersome dual-role of foreign exchange intervention and matching sterilisation? In addition to potentially undermining monetary objectives and imposing massive costs to the central bank, prolonged sterilised intervention can adversely affect financial sector development through interest rate distortion.  
POSSIBLE STRATEGIES: Now, what can the authorities do to counter these issues? Starting with the short-term and moving onto the medium-term, possible strategies are outlined below.
First, the authorities could consider incorporating the effects of a possible depreciation of around 5.0 per cent on its upcoming monetary programme projections. This could be approached as part of an alternate scenario where the exchange rate is weaker compared to a baseline scenario where the exchange rate remains at current levels. This is particularly relevant now given that international oil and food price, and by extension, Bangladesh's import prices have fallen. Meaning, existing estimates of price elasticity of imports may no longer be reliable and the effect of a depreciation on imports may be different from what it was a few years ago. In this regard, readers of BB's monetary policy statement would like to know the effect on imports, current account (or equivalently the change in net foreign assets) and Balance of Payments brought about by an exogenous shock to the exchange rate.
Second, the authorities could time its intervention so that it is fighting less against the appreciating wind. One approach would be to aggressively purchase dollars from the market when an Asian Clearing Unit payment intersects with lower inflow of exports and/or remittance. This is expected to create the shortage of foreign currency necessary to trigger a depreciation. Compared to intervening when net foreign currency inflow is following its regular trend, this strategy is expected to reduce the absolute value of intervention necessary to implement a depreciation. By extension, it means lower associated sterilisation costs.
Third, in the event that authorities are not able to fully sterilise excess liquidity with sterilisation bills/bonds and this results in persisting inflation, they would need to utilise additional tools. If inadequate sterilisation results in a widening gap between broad money growth and private sector credit growth (currently the difference is around 2.0 per cent) the authorities could utilise reserve requirements to drain part of the excess liquidity. However, the authorities should not hesitate to re-adjust reserve requirements when credit demand picks up.
Fourth, a cross-country scan shows that sterilisation securities in China and Korea, on average, have maturities of more than one year while Indonesia's is around nine months. Similarly, the authorities in Bangladesh could explore a moderately longer-maturity structure. If market appetite can be developed, a small share of securities (as percentage of total central bank securities outstanding) with maturities of around 1-3 years could be sold. This would reduce risk of frequent rollovers. It also spreads out the maturity mix of the central bank's liabilities and prevents massive amounts of local currency from re-entering the economy at any one point of time. This implies better control over both inflation and interest rates.
Fifth, with regards to the issue of low-yielding reserves and higher resultant sterilisation cost, BB Governor as well as industry experts have voiced the idea of creating a sovereign wealth fund (SWF). The SWF, to be created from reserves in excess of six months' imports, is intended to focus on domestic infrastructure projects - a much needed area of development in the country. But at the same time, the authorities need to be open to investing a small share of the SWF in international financial markets. The experience of SWFs from emerging economies like China, Indonesia and Brunei, who have profitably invested in diverse financial assets in the international market, suggests that this is an additional channel the authorities could explore. Apart from generating healthy returns, this strategy would deepen Bangladesh's weak presence in the international capital market.
Finally, we need to accept that sterilised intervention to revive external competitiveness cannot be a sustainable strategy to align exchange rate and monetary policy objectives. In the medium-term, export-competitiveness should be brought about by lower inflation-differentials with trading partners. Lower domestic inflation would allow for lower interest rates in the financial sector, encouraging investments and productive imports. Sustained imports will prevent appreciation pressures allowing the REER to stay close to its fair value.
The road to depreciation is a tricky one for the authorities. The challenges need to be countered utilising a carefully designed time-bound plan which ensures monetary and exchange rate policy synchronisation. Will our policy-makers rise up to tackle this urgent issue?
The author is currently working as a Macroeconomic analyst in Washington D.C. and previously worked in Dhaka in a similar role. He completed his master's in International Economics from Johns Hopkins University where Professor Jaime Marquez of the Federal Reserve Board,
USA supervised his thesis.