The current account and depreciation

When the current account is in the news it is unlikely to be good news. It usually attracts the attention of the media when it is in a large deficit. This is what is lately happening to the current account of Bangladesh. A surge in import in 2017-18 blew it out to a deficit of nearly $10 billion. This is more than seven times the deficit of the previous fiscal year.  The current account deficit is likely to be lower in 2018-19 financial year, but still substantial at about $8 billion. The deficits are not about to go away soon.

The current account deficit represents the magnitude of the spread between the domestic supply of and demand for foreign exchange, that is, the excess of demand for foreign exchange in current transactions. If the deficit is not completely offset by voluntary capital account transactions, it may push the foreign currency price, commonly known as the foreign exchange rate, up.

A depreciation of the domestic currency, which implies an increase in the price of the foreign currency, helps reduce the demand for the foreign currency as well as increase its supply, thereby raising the current account deficit. Hence, the occurrence of high current account deficits is frequently followed by suggestions for depreciation to reduce the deficits.

However, this relationship is neither immediate nor certain as an immediate result of depreciation is frequently a worsening deficit. Trade transactions of a country like Bangladesh are made in foreign currency, mostly US dollar. These cannot be changed until the existing contracts expire. It means the domestic businesses end up paying more in domestic currency for the imports, inducing a reduction in imports, but only with a time lag.

On the other hand, exporters receive higher prices for their products. But export volume is much less than the volume of imports in Bangladesh. Consequently, the higher receipts for exports do not compensate for the higher payments for imports. Deficit may widen initially in this way. After a while, when imports tend to decline and exports increase, the trade balance improves. The worsening of the trade balance after a depreciation of the domestic currency and its gradual improvement thereafter is stylised as the J-curve effect in trade economics.

A large credit entry in our balance of payments is secondary income which comprises mostly remittances from migrant workers. There does not seem to be a stable relationship between remittances and the exchange rate, but it seems to be related more to the number of people working overseas and the amount of money they earn individually.

Thus the impact of depreciation on the current account will be determined largely by its impact on the trade balance, which may be a factor in the J-curve effect.

Nearly nine-tenths of our imports comprise producer goods such as raw materials, intermediate goods and capital machinery. Thus an increase in costs of these imported goods in terms of taka immediately raises the production costs of almost all goods and services. Furthermore, Bangladesh being a small open economy has domestic prices of all tradable goods linked to international prices through the Law of One Price. Any depreciation will lead to a proportionate increase in the prices of tradable goods quickly because of this link. Having some of their inputs imported, the prices of non-tradable goods will also respond to the increase in costs of production. So, there seems to be little doubt that prices will rise soon after a depreciation of taka.

The development aspirations of a developing country like Bangladesh often imply that its import needs far exceed export earnings and other receipts. Since most of the imports comprise essential goods like food, oil and inputs in production, it is difficult to reduce usage greatly when their prices rise after depreciation of taka. Countries like Bangladesh produce a very limited range of goods that can be exported, and their productive capacity is also limited. Thus, depreciation may not increase the volume of exports greatly.

Domestic producers often operate through buying houses which have disproportionate market power over them. The benefits of depreciation do not always accrue fully to them as the buying houses may reduce the foreign exchange prices of the goods after depreciation. Depreciation has limited power to substantially improve the current account for these reasons.  Often it worsens the situation.

This can be illustrated with the history of the exchange rate and the current account of the country. Since most of the foreign transactions are done through US dollar, the taka-dollar exchange rate can be regarded as the appropriate exchange rate. Between 1973-74 and 1989-90, the taka-dollar exchange rate depreciated more than 400 percent, and yet the balance of payments worsened nearly 1,000 percent. Between 1995-96 and 2000-01, the exchange rate declined by 32 percent, but the deficit widened by 53 percent. The only period when the expected relationship held was 2001-02 to 2015-16. The currency depreciated gradually by 34 percent and the current account surplus increased. However, the depreciation of taka over the last two years saw the largest deficit ever. The numbers suggest that the influence of exchange rate on the current account is weak, and depreciation alone cannot be trusted to improve the current account. Perhaps, one can say that things could be worse without the depreciation.

SAVING AND INVESTMENT IDENTITY

The national income account identity points to the macro factors that directly determine the current account. One representation of it is: Current Account Balance is identically equal to National Saving minus Domestic Investment. This identity asserts that no matter what, the current account balance will be in surplus if national saving is greater than domestic investment. Therefore, it is useful to examine the profile of saving and investment to understand the current account.

Bangladesh Bank data show that the saving-to-GDP ratio from 2001-02 to 2015-16 exceeded the investment-to-GDP ratio every year except one, implying that the country had a balance of payments surplus all these years (See chart). These surpluses helped build up a large stock of international reserves over this period. The saving ratio peaked to 30.5 percent in 2012-13 and thenceforth gradually declined to 27.4 percent in 2017-18. The investment ratio on the other hand sustained its slow increase and eventually exceeded the saving ratio by 0.9 percent in 2016-17. The gap increased further to 3.8 percent in 2017-18. These were also the magnitudes of the current account deficits as suggested by the identity above though because of errors of measurement the relationship has not been shown exactly. These deficits, which show the extent of the excess demand for foreign exchange, put pressure on the exchange rate to depreciate. But the depreciation obviously did not always reduce the deficits.

There are no estimates of private saving ratios. However, the large reduction in the private consumption ratio might suggest an increase in the private saving ratio over the time assuming that private income relative to national income did not fall. The government consumption ratio on the other hand rose considerably, but its revenues did not increase much. This suggests its saving ratio fell. A large source of national saving – remittance – also declined; the remittance-to-GDP ratio declined steadily from 9.5 percent in 2009-10 to only 5.5 percent in 2017-18.  It seems reasonable to assume that the country's saving ratio declined mainly because of the decline in the government saving ratio and remittances. None of these respond much to depreciation.

Private investment ratio remained fairly stable during the past decade, but government investment ratio steadily increased from 4.3 percent to 7.3 percent. Hence, the increase in the country's investment ratio could be attributed largely to the increase in government investment. The contribution of the private sector was small.

The excess of the country's investment over saving, that is, the current account deficit, was then caused mainly by both an increase in government investment and a fall in saving as well as a slump in remittances. An improvement in the deficit could be achieved by either a reduction in government investment or an increase in saving. The same objective could also be achieved by a reduction in private investment, through perhaps crowding out, or an increase in private saving. An increase in remittances will also prevent the necessity to reduce government or private spending in order to improve the current account balance.

Could a depreciation of taka nudge the government to reduce its investment, which would require a reduction in spending on its much hyped mega projects, or to raise its saving effort that would inevitably involve raising taxes?

These are unlikely since the government investment projects were well thought out and it is committed to their full implementation, while its efforts to raise taxes hardly bore fruit in recent years. The government borrowed overseas to finance many of these projects in order to avoid, at least temporarily, higher interest rates and crowding out of the private sector. Depreciation could therefore work only by reducing private spending for both consumption and investment through price inflation. The crowding out of private absorption would release resources, which, if adequate to offset the higher spending of the government, could improve the current account balance.

However, if this were to transpire, the private sector would be much aggrieved as it would bear the burden of the government expansion. This might be an inconvenient political move for the government. A very large depreciation would be necessary for achieving such adjustment like blowing out the deficits. It is doubtful that the government will have the stomach for a large depreciation that would release the inflation genie and destabilise the economy. It is more likely that the government would consider it more judicious to defer the administration of any bitter antidote to reduce the deficit, especially when it can keep a lid on the current difficulties with overseas loans to finance the deficits.