Bangladesh is one of the few countries which can brag about growing its foreign reserves. At the close of 2015, the accumulated foreign currency reserves hit a record high of $27.49 billion – sufficient to cover seven months of imports.

It is a tremendous confidence booster for a country which was described pejoratively as a “basket case”, meaning hopeless within a few years of its birth as an independent nation. It was a cruel remark from the world’s most powerful nation that opposed Bangladesh’s independence. It was not only unfair, but also insulting for a nation struggling to overcome the trauma of a bloody liberation war and trying to rebuild a devastated economy in the midst of the worst global economic environment since the Great Depression.

Nevertheless, some who appreciated the challenge saw Bangladesh as a “test case”, meaning “If development can succeed in Bangladesh, it can succeed anywhere else.” And it did; from the testing ground of development, Bangladesh has become a centre in the whirlpool of development in less than three decades!

Should we be resting on our laurel of success that both defied the “doom-sayers” and surprised the “sympathisers”? No, instead, reserve accumulation should be an integral part of the country’s development strategy. We should not only attract more foreign currencies, but also manage the reserve skillfully.

 

Reserve accumulation as self-insurance

In recent years, especially after the 1997-98 Asian financial crisis, countries have been accumulating reserves as “self-insurance” against potential external shocks often due to sudden outflows of capital or/and export slums.

Precautionary accumulation of foreign reserves for self-insurance purposes demonstrates lack of trust in the international financial architecture, led by the IMF. The global financial safety-net for countries experiencing sudden balance of payments crisis is found to be inadequate.

However, such reserve accumulation is not cost-less; it has opportunity cost. That is, reserves could have been used in a better way for development, especially in the social sector and infrastructure. The accumulated foreign reserves are normally kept in low-yielding US treasury bonds or in overseas bank account.

Thus, Bangladesh’s reserves are in fact financing advanced countries!

But this is only part of the story. The build-up of reserves may also help to support countries’ export-oriented development strategy.

 

Reserve accumulation as development strategy

More than their domestic resources, the lack of foreign exchange in sufficient quantity can be a binding constraint for many developing countries in their pursuit of development. This idea was formalised in the early 1960s as a “two-gap” model by Harvard Economist (later of the World Bank) Hollis Chenery and his associates. The lack of foreign exchange prevents importation of essential raw materials, technology and machinery to fully utilise domestic resources. This argument was used to justify foreign aid.

Later in the 1970s A.P. Thirlwall extended the idea that “in the long run, no country can grow faster than that rate consistent with balance of payments equilibrium on current account unless it can finance ever-growing deficits which, in general, it cannot”. This provided the theoretical foundation for an export-led development strategy.

It seems Japan and East Asian countries have understood this quite well. Unlike many countries that used import licensing to overcome the balance of payments constraint, Japan, Republic of Korea and lately China chose export oriented development models.

Reserves accumulation allows countries to not only better manage and smooth capital flow cycles, but also maintain an undervalued currency through interventions in the currency market. Undervalued exchange rates can increase the competitiveness of export. The growth of exports, in turn, stimulates the economy, creating a virtuous circle of high saving and investment rates.

The use of an undervalued exchange rate to boost export oriented industries is better than the policy of sector- or firm-specific subsidies or interventions (e.g. licensing), which not only requires extra-ordinary bureaucratic ability to “pick the winners”, but also is prone to rent-seeking. Consequently, reserve accumulations can have positive externalities on the production and industrial development, and can thus be a feature of a country’s development model.

 

Reserve accumulation and faster growth

As shown in Figure 1, the relationship between the current account surplus and growth rates has been positive. All fast growing countries that were revelry called “miracle economies”, from Botswana to China, had a considerably positive current account. Before the slowdown of growth since the mid-1980s, Japan looked very much like Botswana, Malaysia and Singapore – current account of over 2 % of GDP annually and growth of GDP per capita of over 4% a year in the 1950s-70s.

 

Figure 1: Average annual growth rates of GDP per capita and average current account balance, 1970-2013

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Source: UN-DESA calculations based on World Bank World Development Indicators, IMF Balance of Payments; provided by Vladimir Popov.

 

Central banks intervene in the foreign exchange market, keeping exchange rates from appreciating through building international reserves. China is the most often cited case, but a number of countries witnessed this phenomenon in some years, though only four large developing countries (with population of more than 50 million) – China, Bangladesh, Thailand and Myanmar – did so over a 15 year period (see Figure 2).

 

Figure 2: Average current account balance and capital flows to large developing countries (% GDP 2000-2014)

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Source: IMF Balance of Payments; various years; provided by Vladimir Popov.

 

Countries in the upper left-hand quadrant of Figure 2 display the typical text-book phenomenon – current account deficits matched by capital account surplus. Countries (Nigeria and Russia) in the lower right-hand quadrant are suffering from resource curse; they have capital account deficits that are financed by current account surplus. When the current account surplus is not enough to finance capital outflows, forced devaluation of the currency occurs, often in the form of currency crises. The periodic overvaluation of their currencies caused by large foreign capital inflows associated with their resource sector, a typical case of “Dutch disease”, implies the loss of competitiveness of their tradable sector.

 

Challenges of reserve accumulation

Although reserve accumulation and the use of an undervalued exchange rate is better than sector- or firm-specific export-oriented industry policy, it demands skill-full monetary policy management, supported by the fiscal authority. Otherwise, it can become self-defeating.

The accumulation of foreign reserves means an increase in the central bank’s asset which has to be either matched by increasing in its liabilities or offset by reducing other asset items in a double entry book-keeping system.

One main liability item of the central bank is the currency in circulation. If that goes up as a result of foreign reserve accumulation, it will create inflationary pressure, which will offset the impact of exchange rate on exports.

The central bank, on the other hand, can reduce some of its asset items to offset the increase in foreign reserves. That is, it can off-load or sell some of the government bonds (debt) that it holds. This would lower the price of government bond and hence increase interest rates which can tackle inflationary pressure.

But higher interest rates will adversely affect domestic investment, including in the tradable sector. Higher interest rates may also attract more short-term foreign capital which may destabilise the domestic financial sector and create upward pressure on the exchange rate (i.e. taka may become stronger vis-à-vis dollar).

How to prevent the policy of reserve accumulation from becoming self-defeating? First, the central bank has to have sound capital flows management strategies to prevent both sudden surge of capital flows and capital flights out of the country. Many developing countries exercise control over capital flows (China and India would be prime examples).

Second, the foreign reserve accumulation strategy has to be supported by the fiscal authority. In practice, as the statistics shows, the accumulation of foreign exchange is financed through government budget surplus and debt accumulation by non-bank public. Therefore, it is highly important for the fiscal authority to enhance its revenue mobilisation capacity and efficiency. It must not borrow from the banking sector, especially the central bank. If it has to borrow, it must be from the non-bank public by making government savings certificate more attractive to the public using various non-interest fiscal measures. Most countries that accumulated reserves rapidly exhibited low inflation, and low budget deficit (or budget surplus), but increasing holdings of government bonds by the public.

4 Responses to “Accumulation of foreign reserves: What good is it?”

  1. Anis Chowdhury

    Thanks, Mr. Chaudhury for your interest in this issue. Let me address your queries. Queries 1 & 2 are not directly relevant for the point that I was trying to make, i.e. the accumulation of FX should be a deliberate policy that helps keep exchange rate undervalued to support export-oriented industrialisation.

    Qurey # 3, re: budget deficit/surplus. I am not strcitly arguing for budget surplus. In a country like BD with huge development needs, budget deficit is unavoidable; so is inflation.

    The issue is not budget deficit or surplus, but where the money is spent. If the borrowed money (budget deficit) is for development projects, e.g. the Padma bridge then there should not be much problem, of course assuming it is spent well and not eaten up in corruption. This kind of expenditure is in fact an investment that adds to productive capacity and should “crowds in” private investment instead of “crowding out”. Imagine the expansion of market and reduction of transport cost that will happen with the Padma bridge and the profitability of private investment arising from it.

    The problem is when the borrowed money is for government recurrent expenditure or wage bills. This will contribute mostly to inflation. In this context, it would be important to find out whether the upward revsion of cost estimate is due to capital expenditure or due to inflated salary & consultancy fees or due to system loss/corruption.

    Again, we have to keep in mind that some inflation arising from development expenditure is unavoidable; and sometimes inflation is also needed to accelerate structural transformation of the economy. But this unavoiadable inflation should not be made intolerable by adding fuel to it through bloated recurrent government expenditure or incompetence or system loss.

    The issue of borrowing from banks and non-bank public is also important. Borrowing from banks, especially from the central bank, has implications for money supply and hence on inflation. On the other hand, borrowing from non-bank public is just shifting of purchasing power from public to the government and channeling savings to desired investment. That is why it is important to develop market, especially secondary market, for government bonds. In the case of Bangladesh, goverment should find non-interest rate incentives to make savings certificates more attractive. It can also consider strengthening compulsory retirement savings plan as in Singapore or Malaysia to give it non-market access to a large pool of savings to be used for development purposes.

    When the government borrows from the central bank, monetary policy no longer remains an independent policy instrument; it becomes subservient to fiscal policy. This is a point pertinent for your query # 4.

    My final point is that the use of FX accumulation as a deliberate policy tool is not without challenge. It requires a skilled central bank as well as support from the fiscal authority.

    • Mo Chaudhury

      Thanks Mr. A. Chowdhury for your response.

      PB and such infrastructure projects that are expected to significantly augment economic activity/productivity are desirable when suitably funded and built on a cost-effective basis. [Due to agency and governance/corruption problems, cost overrun can be common, as you mention. As you know, the Rooppur Nuke Plant cost estimate has gone up from $3b to $12b even before construction work started].

      With respect to crowding out, could it be a question of whether the lost investment/production by the private sector using the currently available loanable funds is expected to be lower or higher than the private production boost later by the infrastructure projects? As the Gov can/is actually forcibly obtaining the funds from the state owned banks at a lower rate, private sector is clearly at a disadvantage in obtaining the same funds.

      In my humble opinion, it might be better to obtain the large infrastructure project funds externally, if available at concessional rates. That should minimize the domestic crowding out effect as well as the upward pressure on domestic interest rate. The risks of course are the possibility of large depreciation of BDT or sudden shortage of FX, but these risks do not appear material now.

      Thanks again for a very nice commentary. Regards. — MC

      • Anis Chowdhury

        Yours are all valid concerns. The available research evidence from elsewhere shows overall significant positive impact of debt-financed large infrastructure investment on productivity and growth. This has been reported recently in the IMF’s World Economic Outlook. The key of course is efficient and effective implementation with minimum system loss. That’s what we should be demanding, not worry too much about issues like “crowding out” or debt & deficits.

  2. Mo Chaudhury

    Very informative and educational write-up.

    Few queries:

    1. In the case of BD, can the sharp rise in FX Reserve (FXR) in recent times be really seen in a positive sense? Isn’t the rise in the magnitude (not percent) of net remittance inflow an important driver? This component is not sensitive to FX rate, rather this excess supply of FX perhaps led to overvaluation of BDT, as investments and required imports might have been badly lagging in recent periods.

    2. Lower and falling international oil prices also should have contributed to the build up of FXR.

    3. Unfortunately BD has budget deficit, not surplus, and importantly the deficit is financed in a significant manner by loans to the Government by the state owned banks (via direct loan or purchase of Government securities). The bank capital situation of these banks are so bad now that many foreign banks reject Letter of Credit from these banks.

    Meantime, the increased government borrowing from the banks is sucking out loanable funds and crowding out private business borrowers for investment purposes.

    This problem became worse as the Government decided to finance the Padma Bridge internally and the estimated expense just went up by 40%.

    4. It might be useful to emphasize the FXR at Bangladesh Bank (BB) are not owned by the Government. BB mainly accumulates FXR when remittance inflow and export FX receipts are converted to BDT by the public and exporters through the banks. [The author does mention that BDT money supply liability increases with FXR accumulation (if other BB assets are not liquidated)].

    The FXR ownership by BB should be seen purely as an equivalent asset (BDT deposits) owned by the public and businesses and international investors. BB, acting as an independent institution, should aim at stabilizing prices (including FX rate) rather than acting as a fiscal agent of the Government, the latter’s preferences and needs are often driven by narrow political self interest.

    Sincere apologies in advance for any incorrect or unwarranted statements. Will be glad to stand corrected.

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