Matiur Rahman

Mysteries and consequences of sharp exchange rate changes:  A labyrinth?

May 3, 2012

exchange_rateSimply put, as in Economics 100, a bilateral exchange rate involves exchanges of one national (home) currency for another national (foreign) currency.  This is about exchanges of two different national monies. Functionally, definition of money is obvious.  But it is conceptually mysterious.  “It is a good servant, but a bad master.”  So is exchange rate.  Very seldom, the exchange ratio between different national currencies is one-to-one.  However, all national currencies are not tradable in the global currency market.  Only a handful of key national currencies are freely traded internationally on a daily basis during business hours at selected locations of industrial and advanced countries.  An internationally non-traded currency like Bangladesh Taka usually remains linked to one of the key internationally traded currencies depending on trade relation with the country concerned and the global reserve as well as vehicle status of its currency.  For good reasons, Bangladesh Taka is currently linked to US dollar.  The Taka-Dollar exchange rate is not fixed and rates with other currencies are computed via cross rates.  There are daily fluctuations in the rates conditional upon changes in Bangladesh demand for and supply of US dollar.

The determination of exchange rate and its forecasting are very complex and slippery, to say the least.  The volumes of theoretical and empirical academic publications on exchange rates are anecdotal and evolving.  At a particular point of time, what really determine exchange rate are not clearly observed and quantified.  Interactive and gyration of macroeconomic, financial, political, and psychological factors create a state of confusion in the efforts for determining and forecasting exchange rates.  Despite the confusion, efforts are relentless and continuous because exchange rate is very vital to international trade, foreign investment, business (domestic and international) and consumption.  In short, exchange rate changes affect the well-being of businesspersons, investors, foreign borrowers and lenders (corporations and government) and above all consumers directly or indirectly.  No economic agents are immune to these unpredictable changes.  So is the overall health of the economy in terms of economic growth, employment, price stability and capital market performance including the health of the overall financial infrastructure of a country.  However, the effects of daily exchange rate fluctuations are uneven across the above wide spectrum.

2008-10-28__front04For consumers, the effects depend on the composition of their consumption baskets consisting of purely domestic and foreign goods.  In domestic goods, the input mix also matters for cost-push inflation consequent upon depreciation of Taka.  X% depreciation of Taka does not mean X% rise in overall inflation rate.  The magnitude depends on the extent of exchange rate pass-through that hinges on input-mix (domestic and imported inputs) in unit production of goods and the percentage share of import-related goods in the overall consumption basket.  In my calculation, the extent of exchange rate pass-through is around 20% of X% depreciation of Taka in the inflation caused by the import-related items in the consumption basket.  Eventual reflection in the overall inflation is conditional upon % share of the import-related items in the basket.  In Bangladesh, domestically produced food items have the majority % share in the consumption basket.  Thus, a tendency to blame depreciation of Taka alone for acceleration in inflation rate is misplaced.  In fact, excessive monetary easing, supply chain disruptions, rent-seeking, and transportation bottlenecks are the primary reasons.

The Taka-Dollar daily exchange rate fluctuates as a result of imbalances between daily demand for and supply of US dollar in Bangladesh.  Excess demand for US dollar drives the rate up meaning depreciation/weakening of Taka against US dollar.  Excess supply of US dollar pushes the rate down meaning appreciation/strengthening of Taka against US dollar.  Although one currency’s depreciation implies appreciation of its counterpart and vice versa, the percentage depreciation of home currency (Taka) is not exactly equal to percentage appreciation of US dollar and vice versa as the formulas to calculate them are not identical.  However, they come within close proximity.

Taka being too strong or too weak against US dollar is not good for Bangladesh.  Stable Taka-Dollar exchange rate with fluctuations within a comfortable margin is conductive to foreign trade, investment, price stability, economic growth, employment, capital market, etc.  Too much volatility in daily exchange rate is detrimental.  Moreover, it is an indicator of gross market inefficiency.  Although nominal and real exchange rates are highly positively correlated, fluctuations in the latter unleash greater influences on reallocations of real global resources, corporate profitability with foreign exposure, foreign debt servicing and repayment obligations, cost of living, etc.  Thus, closer attention should be devoted to understand the causes and consequences of unpredictable fluctuations in real exchange rate.  Accordingly, pre-emptive monetary and fiscal adjustments are to be made as a part of macroprudential policy.

exchange-rate-vector-4088With a general readership in mind, the goal of this write-up is not to engage in serious academic and technical discussions.  The contents are kept limited to simple demand and supply analyses in conformity with the law of demand for and the law of supply of US dollar (foreign currency) as a normal good.  Among numerous factors, the dollar-demand generating variables for Bangladesh primarily include import payment settlement in dollar, dollar denominated foreign debt repayment and servicing obligations, capital flight, foreign investment, financing of smuggling, etc.  Likewise, the dollar-supply generating factors include export earnings, inflows of expatriates’ remittances, availability of foreign loans and foreign aid, foreign direct investment, etc.  Inflows of foreign currencies build foreign exchange reserve with the Bangladesh Bank.  This is maintained in several key currencies and are presumably invested in highly liquid and safe short-term foreign assets.  Changes in foreign exchange reserve below or above a critical level (i.e., 3 months’ import bill) may indicate directions for exchange rate movements.  A vast majority of this reserve is maintained in US dollar because of its global reserve currency status.  Unless an increase in foreign exchange reserve is offset by a corresponding reduction in domestic credit, money supply in Bangladesh will rise, accordingly.

More precisely, the credit entries in the balance of payment relate to supply of foreign currencies while debit entries relate to demand for foreign currencies.  Excess demand for a foreign currency is equal to its overall net outflow and excess supply equals its overall net inflow.  Both lead to exchange rate changes as depreciation and appreciation of Taka, respectively.  Taka-Dollar exchange rate changes are thus the results of demand-supply imbalances in US dollar term, as stated earlier.

Rising political uncertainty also plays a negative role in influencing Taka-Dollar exchange rate.  It undermines confidence in safety of capital at home thus triggering further capital outflows.  Political uncertainty clouds business environment and discourages business expansion.  Steep depreciation of Taka against US dollar raises import costs reducing the imports of intermediate goods, machinery, equipment, oil, etc., that vastly dominate the list of import items.  This is an ominous sign for future economic growth and employment.  This is the current situation in Bangladesh.

To stabilize exchange rate, domestic monetary and fiscal policies lose some effectiveness due to economic and financial globalization unless they are properly aligned with the major policy changes in key trading partner nations.  In Bangladesh, export base is narrow and less diversified, hindering overall export growth excepting RMGs.  Following depreciation of Taka against US dollar, export earnings in Taka-term rise with no doubt.  But not so necessarily in dollar term depending on price elasticities of domestic export supply and foreign import demand.  The recent global recession helped improve exports of low-end RMGs as foreign customers switched away from high-end RMGs to low-end RMGs following downswings in foreign disposable income.

To recapitulate, prior to independence the exchange rate was Pakistani Rupee 4.76 per US dollar.  Immediately after independence, the rate was somewhat arbitrarily re-fixed at Taka 8 per US dollar to make it at par with Indian Rupee-US Dollar rate.  Since then, Taka has been depreciating steadily amid fluctuations.  The exchange rate uncertainty reached a new height during second half of December 2011 through January, 2012 when the rate temporarily rose sharply to Taka 86 per US dollar from Taka 70 per US dollar.  Double digit inflation, inadequate inflow of foreign financial assistance, high oil price, downtrend in remittances, and exorbitantly high cost for oil-based energy-generating rental power plants contributed to this situation.  The rate, however, improved mildly to Taka 82 per US dollar.  The availability of near-$1 billion from the IMF under ECF with attached strings, $855 million syndicated loan from the International Islamic Trade Finance Corporation for energy sector, and recent uptrend in remittances will likely further improve the Taka-Dollar exchange rate.  Hopefully, such improvement may exert some positive influences on imports of intermediate and capital goods.  However, financial repression and economic mismanagement will produce results, otherwise.

The exchange rate is one of six major puzzles in international economics.  The exchange rate puzzle is about why exchange rates are so volatile and why they are disconnected from fundamentals.  Despite all the above, Bangladesh economy is less in dire shape than the selected official numbers show.  Some silent forces (small business, farmers, expatriates, rural microcredit receiving women) are at work to grease the wheels of the economy.  Only evolving political wastelands may lead to possible economic wastelands.  They, in turn, will throw exchange rates in uncharted territories to the detriments of all involved.  Dark clouds are in the horizon in the absence of political understanding and sound economic management.

——————————
Matiur Rahman is the MBA Director and JP Morgan Chase Endowed Professor of finance at McNeese State University, USA.

Tags: , , ,

WARNING: Any unauthorised use or reproduction of bdnews24.com content for commercial purposes is strictly prohibited and constitutes copyright infringement liable to legal action.
| | More
----------------------------------------------------------------------
(The opinions expressed below are those of the writer's and do not necessarily reflect that of bdnews24.com. bdnews24.com accepts no responsibility, legal or otherwise, for the accuracy or content of member comments.)
----------------------------------------------------------------------

8 Responses to “ Mysteries and consequences of sharp exchange rate changes:  A labyrinth? ”

  1. Mohammad A. Kalam on May 10, 2012 at 4:07 pm

    I fully agree with the reply posted by the esteemed author. In fact, the target readership was clearly mentioned at the beginning of paragraph 6.

    In general, it’s not prudent to come up with sweeping remark solely based one’s own perspective of knowledge and background.

  2. Shamsur Rahman on May 5, 2012 at 6:19 pm

    Good analysis. What is central bank and our policymakers planning to do about it?

  3. hasib on May 5, 2012 at 6:18 pm

    A well written piece. Hope Bangladesh Bank looks into the matter before it gets uglier.

  4. Golam Arshad on May 5, 2012 at 3:21 pm

    This is your punch line, and I quote, “Dark clouds are in the horizon in the absence of political understanding and sound economic management” harness revenue, control spending, be transparent and accountable, the rest will fall into place. Our economy will tend to its growth of 7.5 per cent, provided we maintain the check and balance in our economy.

  5. Shahidul Islam on May 4, 2012 at 10:56 pm

    A article of poor standard. It’s all about some basic theories. No analysis and no insight at all.

  6. shofi on May 4, 2012 at 9:44 pm

    I think BD central bank needs to focus on the matter. If they bother not to pay attention, I won’t be surprised if the rate reaches @100.xx within 2015. Bangladesh central bank monetary policy needs to be more prudent.

  7. Syed Basher on May 4, 2012 at 12:27 pm

    Very average piece of analysis. Most is what you say is well-known and you wrote a long piece just to make the point that taka-dollar exchange rate is affected by demand supply imbalance, surprise! Perhaps I expected much from you.

    • Matiur Rahman on May 5, 2012 at 1:56 am

      You are missing my point. The goal in this write-up is to promote financial literacy on exchange rate issues targeting general readers. Perhaps, it was not meant for you. I shall write another piece for you in the future.

      Thanks for your observation.

Leave a Reply

Get Adobe Flash playerPlugin by wpburn.com wordpress themes

 

May 2012
S S M T W T F
« Apr   Jun »
 1234
567891011
12131415161718
19202122232425
262728293031