Bangladesh Bank’s exchange rate problem

Posted in economics by jrahman on January 8, 2010

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).

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5 Responses

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  1. M Haque said, on January 10, 2010 at 12:54 am

    Without knowing much of the technicality on monetary policies and its possible and probable implications on the daily economic transactions, little knowledge on Malaysian Ringit pegging (lifted recently)and China’s defiant continuation of the fixed rate and its enormous impact on financial and economic safeguard found well inhibited in those economies. And both nations ripped the benefits. that is pegging their currencies not only saved them from the mony market sharks and manipulators but helped develop their exports as well as import for quite many years.

    Pegging against Rupees to contain rice or onion price does not seem viable or even technically sound to me.

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  4. Farida Khan said, on March 8, 2010 at 8:38 am

    Bangladeshi exports fell by much less than other countries in the last year and a half: this is a good time to examine the pattern and composition of those exports in order to formulate an export strategy in the short run: the question would be did Bangladesh’s exports to Europe and other destinations rise or did Bangladesh’s exports to the US rise? This question is important because if Bangladesh’s exports are seen as “inferior goods”, i.e. a Walmart brand that people switch to when they have less income, then devaluation should not make much difference – rather recessions will help Bangladesh’s exports, the income effect overpowering any substitution effects. What about during expansions? Devaluations are unlikely to yield much result and product quality improvements would be more important as would building brand reputation.

    Also, not being familiar with the nature of foreign portfolio investment into Bangladesh, I would be suspicious of the concept of high capital mobility between India and Bangladesh. If indeed, by raising interest rates Bangladesh can attract capital from India or by lowering it, have capital flight to India, the proposition of the impossible trinity would hold. However, is this the case? What is the nature of portfolio capital flows across these borders? It would seem that labor flows are just as relevant and if labor can flow, the trinity becomes possible as the goods markets can adjust with productivity and wage changes.

    Finally, a peg against a few major currencies/ major trade partners – renminbi, dollar, euro, and rupee does make sense but it is not clear to me that the Pound should be included among these. Jyoti Rahman is rightly pointing out the structuralist argument that intermediate goods and consumer goods cost more as the taka depreciates. This can hurt the trade balance more than the anticipated export increases can help. He also gives us good arguments against a float. Perhaps pegging against various currencies will take the attention off the rupee.

    • jrahman said, on March 8, 2010 at 12:41 pm

      Farida apa, agree that this is a good time to explore the composition of exports. I don’t have the data readily available now, but will write on it as soon as I get it.

      On the point about the capital flow to and from India, my understanding is that much of it (and the labour flow) between the two countries take place in an informal manner which is not captured in the official data, but whose effects can be felt in the measured economy nonetheless. Take your point about the trinity becoming possible with labour mobility as this makes goods market adjustment through productivity and wage changes possible. I didn’t think about that linkage before. Thanks for pointing it out.

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