Bangladesh Bank’s exchange rate problem
Governor Atiur Rahman has an exchange rate problem in his hand. The Bangladesh Bank’s de facto policy of pegging the taka against the dollar means it is depreciating against the Indian rupee, which in turn is fuelling inflationary pressures.
And yet, the solution is not obvious. Letting the taka freely float might not be a good idea because it’s not clear that Bangladesh Bank has the credibility to operate without a nominal anchor. Pegging against the rupee is a terrible idea. And letting taka appreciate a little might hurt exports.
Is anyone at the Bank thinking about this?
Let’s work through the logic with a set of charts.
The chart on the left shows taka’s exchange rate against the dollar, euro, and pound sterling. From Nov 2006, 1 dollar has bought about 69 taka. The IMF classifies Bangladesh Bank as pursuing a ‘conventional fixed peg arrangement’ against the US dollar (see the link above). Over this period, however, sterling and euro had not remained fixed against the dollar — dollar depreciated steadily against most floating currencies until September 2008, when a flight-to-safety effect during the worst of the global financial crisis saw dollar appreciate, and then since March 2009, dollar resumed its depreciating trajectory. The chart on the left also shows that taka’s exchange rate against the euro and the sterling follow this steady depreciation, sudden appreciation, further depreciation trajectory.
Now look at the chart on the right, which shows taka/rupee rate following a similar trajectory.
The snag is, taka’s depreciation against euro or sterling can be a good thing for Bangladeshi exports (more below), but depreciation against rupee is by and large a bad outcome for prices. I’ve made the argument before, citing formal econometric studies. Here let me show another chart.
This one shows price of one kg boiled rice in Dhaka (smoothed by 3-month-moving-average) against the taka-rupee rate from Dec 1995 to Dec 2008 (I don’t have more recent price data). There seems to be a pretty good relationship — taka depreciates against the rupee today, and rice prices in Dhaka rise a year or so later.
Since March 2009, taka has depreciated by over 7% against the rupee. And lo and behold, high rice prices are back in the newspaper headline.
So what should the Bangladesh Bank do?
First thing to note is that the current exchange rate policy is not without merit. Given large current account and budget deficits, the medium term expectation for the dollar is to depreciate. Fixing taka against the dollar then means depreciation against other major western currencies. This can help our export — indeed, this may well be a major factor behind our strong export performance. And our major export competitors like China or Vietnam (but crucially, not India) maintain some form of peg against the dollar. Therefore, letting taka appreciate would probably hurt our exports.
I say probably because our industry depends on imported raw material and machinery, and appreciation will help them. Also, it’s not clear how important the exchange rate is vis-a-vis other factors (such as the much touted Wal-Mart effect) for our exports. And finally, for exports, what matters is real (that is, inflation-adjusted), not nominal, exchange rate — if an undervalued taka leads to inflation in Bangladesh, then taka will have an effective real appreciation, which will hurt exports just as badly as if taka were allowed to appreciate.
I am not aware of any well specified exports equation that studies the importance of exchange rate for our exports, and would highly appreciate if anyone can cite one. Such a study would help ascertain the cost of letting taka appreciate.
Meanwhile, it’s very important to realise that the Bank should not even contemplate pegging taka against the rupee. There are many paranoid people in Bangladesh who fear ‘becoming like Nepal or Bhutan’ every time a dog barks. Well, pegging taka against rupee would make Bangladesh like Nepal or Bhutan (see the IMF link in first para).
Emotional nationalistic jingoism aside, there are sound macroeconomic reasons why we should not become like Nepal or Bhutan in this regards. Since the 1960s, macroeconomists have been aware of the impossible trinity which holds that a country can, at once, achieve only two and never three of the following: fixed exchange rate, capital mobility, monetary policy independence.
If taka was fixed against the rupee, this would mean our authorities would have to choose either capital mobility between the two countries, or monetary policy independence. Given the porous border and weak institutions, it would be practically impossible to restrict capital mobility. This means, we will have to cede monetary policy to the Reserve Bank of India.
This won’t involve any elaborate state protocol involving horses and other state paraphernalia. Most paranoid Indophobes in Dhaka wouldn’t probably even notice it. But it would mean everytime RBI changes monetary policy, we would have to match it, even if it means slowing our economy or allowing inflation to rise. If the RBI was was tightening monetary policy, and we didn’t want to because of weak domestic conditions, there would be capital flight and we could be threatened with a currency crisis. Alternatively, if the RBI loosened monetary policy, but we had inflation worries, there would be hot money flowing in, and the inflation problem would worsen.
This would be a much bigger encroachment to our sovereignty than any security or transit agreement.
So a rupee peg is clearly out, but a dollar peg has clear problems. What should the Governor do? What analysis is guiding his thinking?
(Data source: CEIC Asia, IMF).