It is in general the case that the value of the domestic currency appreciates (may be with a lag) when there is a marked increase in the overall balance. Conversely, it depreciates when there is a fall in the overall balance. The balance of payments data of Bangladesh is roughly consistent with this theory keeping in mind that Bangladesh Bank might have taken offsetting measures.
Balance of payments data are available till June 2015. There has been a very large spurt in the overall balance surplus since 2011-12 (see Table). As a result, international reserves shot up nearly 2.5 times within the next three years from 10 to 25 billion dollars. Such a large surplus in foreign exchange receipts put pressure on the taka to appreciate. However, Bangladesh Bank (BB) was unwilling to let the taka appreciate substantially fearing an adverse impact on the export sector. It bought very substantial quantities of dollar from the market at an inflated rate to prevent the dollar value from falling. A similar situation also existed in fiscal years (FY), 2008-09 and 2009-10. The senior management of BB believed that without its intervention the dollar price (in terms of taka) could very well fall in excess of 10 per cent. The consequences of such a large appreciation on the external sector were not difficult to visualise.
Given that the country is still running a very large surplus in the overall balance, what could BB do to depreciate an undervalued taka? An immediate policy could be to substantially increase the purchase of dollars so that an artificial shortage of dollar is created in the market. A reduction in foreign borrowing will also trim the surplus. This will push up the exchange rate of dollar, thus depreciating the taka.
A consequence of such purchase is that the stock of international reserves will increase substantially. At the end of 2014-15, the stock was equivalent to about 7.4 months' import payments of the country. It is greater than what is required by any of the standard rules of optimal holding of international reserves such as import cover ratio, Greenspan-Guidotti rule, reserves to foreign debt ratio, etc.
In holding the stock of reserves, a major consideration is that it is costly to hold. Nonetheless, it is held because it offers some protection against the risks of fluctuations in the external environment. Reserves are usually invested in low productivity assets such as US treasury bills and bonds, when these could be put to higher yielding productive investment. Accumulating more reserves implies an escalation in the net costs. Assuming a spread of 6.0 per cent between reserve earnings and returns from alternative investment of reserves in excess of three months' import payments, a rough estimate of the loss in holding the current level of reserves is 0.84 billion dollars. (There are other measures of costs).
The accumulation of reserves for preventing currency appreciation is the least difficult strategy of exchange rate management since no major economic changes are required and the loss is little understood. It is relatively certain and can be implemented quickly. The other strategy would be to switch to an expansionary monetary policy with a substantial reduction in the interest rate and an increase in the supply of credit. To the extent it succeeds, investment will pick up and aggregate demand will rise. Gross domestic product (GDP) growth will accelerate and this will increase import demand. This in turn will worsen the overall balance of the balance of payments leading to taka depreciation.
There are at least two problems with this strategy. First, the transmission of monetary policy impulse to the real economy is not certain and the import demand may not pick up quickly. Second, the expansionary policy will almost certainly stoke up inflation both directly because of quick import price pass-through to domestic prices and indirectly, because of the increase in aggregate demand. The consequent price increase could undo much of the good work done by BB in containing inflation during the last two to three years. It seems unlikely that BB would opt for such a strategy especially when it has to negotiate with International Monetary Fund (IMF) for funds.
Until the large surplus in the overall balance of the balance of payments is corrected autonomously, there will be pressure on the taka to appreciate. The mopping up of the surplus not only prevents an appreciation of the taka, it also builds up the stock of reserves which tends to strengthen the credibility of taka as a stable currency. The undervaluation of the currency favours the export sector whose output rises above the optimal level. Economic growth can be sustained at a high level for a fairly long time without worrying about domestic demand. The loss of income due to holding excessive reserves is viewed by many as an acceptable cost for the gains.
The writer is Professor, Department of Economics, University of Dhaka.
 m_a_taslim@yahoo.com
To depreciate or not
writes M. A. Taslim in continuation of a front-page economic analysis on this theme | Published: September 10, 2015 00:00:00 | Updated: November 30, 2024 06:01:00
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