Off the mark: To depreciate or not to depreciate

Published : 11 Sept 2015, 10:43 AM
Updated : 11 Sept 2015, 10:43 AM

The sudden devaluation of the Chinese yuan against the dollar last month jolted the global foreign exchange market. Despite the fact that the devaluation was not very large, around 5 percent, the foreign exchange markets around the world reacted almost immediately underscoring the sensitivity of the world economy to economic and financial developments in China. The currencies of a large number of countries including virtually all South-East Asian countries depreciated almost immediately.

One glaring exception to this trend was Bangladeshi taka. The value of the US dollar, the principal currency used by Bangladesh for trade and international finance, remained rock still when the world currencies were in turmoil. Indeed, the dollar exchange rate of taka has remained constant at 77.80 for the last six months, and moved very little during the last two and half years. Since China is the largest trading partner of Bangladesh and also the most formidable competitor in the global export market, especially that of apparel, footwear and shrimp, it is surprising that taka did not respond to the yuan devaluation. Incidentally the currencies of the fellow SAARC countries, India, Pakistan and Sri Lanka, all went through downward adjustments. This will most likely appreciate the real exchange rate of taka against these currencies.

This possibility has alarmed some people including the exporters of the country. The speakers in a recent seminar spoke strongly in favour of a depreciation of the domestic currency in order to offset the negative effects of the yuan devaluation. The major export of Bangladesh, apparel, competes in the global market against apparel from such countries as China, Vietnam, India, Mexico, Turkey, Indonesia and Cambodia. All these countries went through some depreciation of their currencies. Since the competitive margins in this market are razor thin, even a small price advantage could translate into a significant change in market share. The concern about the constancy of the taka exchange rate is understandable especially when export growth of the country has virtually stalled.

The value of a currency against another currency depends on the relative demand and supply of the two currencies. If the demand for and the supply of the currencies match each other, the exchange rate between the two will be in equilibrium with no tendency to change. However, if there is excess demand for the foreign currency, which is the same as an excess supply of the local currency, the value of the foreign currency in terms of the domestic currency tends to rise. Conversely, in the case of an excess supply of foreign currency its value tends to fall. Expectations also play an important role in the determination of the exchange rate in the short term.

A convenient measure of the state of excess supply of or demand for foreign currency is the overall balance of the balance of payments. Since most foreign transactions of Bangladesh are conducted in US dollar, it is the relevant foreign currency for the country and the balance of payments is estimated in US dollar. The exchange rate usually means taka-US dollar exchange rate. The overall balance shows the net result of all international transactions, both current and capital account transactions, undertaken by the private residents and the government of the country. When the overall balance is positive it suggests an excess supply of dollar at the current exchange rate and conversely. The surplus has to be bought off by the central bank to keep the balance of payments in balance at the current exchange rate. The amount bought is added to the stock of international reserves. When the overall balance is in deficit, the central bank has to sell foreign exchange from its reserves to keep the exchange market in equilibrium.

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 3 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 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 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 percent. 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 percent 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. 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 2-3 years. It seems unlikely that BB would opt for such a strategy especially when it has to negotiate with 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.

Table: Selected Indicators

Fiscal Year

Overall Balance (million US$)

International Reserves (million US$)

Exchange Rate (Tk/US$)

Inflation Rate  (percent)

2001-02

408

1,583

57.43

2.79

2002-03

815

2,470

57.9

4.38

2003-04

171

2,705

58.94

5.83

2004-05

67

2,930

61.39

6.48

2005-06

338

3483.8

67.08

7.16

2006-07

1493

5077.2

69.03

7.20

2007-08

331

6148.8

68.6

9.94

2008-09

2058

7470.9

68.8

6.66

2009-10

2865

10749.7

69.18

7.31

2010-11

-656

10911.6

71.17

8.80

2011-12

494

10364.4

79.1

10.62

2012-13

5128

15315.2

79.93

6.78

2013-14

5483

21508.0

77.72

7.35

2014-15

4373

25020.5

77.67

6.40

Source: Bangladesh Bank

Dr. M A Taslim is a Professor of the Department of Economic, University of Dhaka.