Perils of the peg

Posted in economics by jrahman on December 9, 2010

I have been writing about the inflationary impact of the Bangladesh Bank’s de facto taka-dollar peg for years now.  My basic story is this:

  • taka has a de facto peg against the dollar, and as dollar has depreciated against other major currencies, so has taka;
  • depreciation against the Indian rupee is particularly important for inflation in Bangladesh — the rice markets in the two countries are highly (perhaps completely) integrated and there is a clear pattern of a depreciation against the rupee raising rice prices in Dhaka with a few months’ lag. 

I first publicly wrote about it here, and reprised the argument more recently here.  Privately, I’ve been telling people about it for a while longer.  When I first started telling this story, I heard three kinds of replies. 

First, taka was a floating currency — people simply wouldn’t believe that the Bangladesh Bank was actively intervening in the currency market: Saifur Rahman floated taka, so it was floating. 

Second, even if taka was pegged against the dollar, it was a good thing because an undervalued taka helped our exports.  When I pointed out that for exports, what matters is real exchange rate and economic growth of the buying countries, I was met with condescending comments about ‘not understanding the market’.

Third, that kind of ‘not understanding the market’ reached fever pitch when people discussed inflation — it had nothing to do with all this chartwaving about exchange rate and monetary policy, inflation was high because of Tarique Rahman and Hawa Bhaban (to be replaced by Moeen and the army, to be replaced by conspiracies to foil war crimes trial). 

It’s therefore very pleasing to see people with more impressive credentials than this lowly blogger taking the perils of the peg seriously.  Over the fold, I summarise three articles on the matter. 

I agree with all three.  Of course, whether Ahsan Mansur or M Tasnim shares my concerns ultimately don’t matter unless the Bangladesh Bank takes this seriously.  The Bank’s next monetary policy statement is due in January.  Here is hoping that they let go of the peg.

The first article is by PRI’s Ahsan Mansur, which appeared in the Financial Express on 21 October.

Mansur ackowledges the taka-dollar peg:

In recent months Bangladesh Bank has been actively buying in the interbank foreign exchange market to ensure that the taka exchange rate remains pegged against the dollar. By intervening in the exchange market in this manner to keep the value of the taka unchanged against the dollar, Bangladesh Bank has essentially kept the value of taka at a depreciated level.

He notes how it can seem to help the exporters.  But then he goes on to say:

For competitiveness of Bangladeshi exports, what really matters is the real effective exchange rate (REER), not the nominal exchange rate. …. REER has appreciated by 11.6 per cent since FY 06, entailing a corresponding erosion of competitiveness, despite the Bangladesh Bank’s policy of a fixed exchange rate regime. … It happened because Bangladesh has a much higher inflation rate compared to its trading partners.

His transmission mechanism, however, is not the food price via the taka-rupee rate.  Rather, he pins the blame directly on money supply.  In 2009-10, broad money expanded by 22.5%, well ahead of the Bank’s target of 15.5%.  He says:

The Bangladesh Bank has de facto lost control on money supply or liquidity expansion in the economy. …  While achieving exchange rate stability, Bangladesh Bank lost control on its money supply, and in the process, its control over inflation. This is the real dilemma that the Bangladesh Bank is facing today. It needs to choose between its exchange rate or inflation objectives. It will not be possible to achieve both with one single instrument called monetary policy.

The real exchange rate appreciation, and thus the futility of pegging the taka against dollar, has been explicitly mentioned by the World Bank in its latest report on Bangladesh:

The BB has regularly intervened in the foreign exchange market to maintain the competitiveness of the exchange rate, curbing tendencies for excessive volatility. …  However, Bangladesh’s relatively high inflation compared with its trading partners and the BB’s de facto policy of pegging the exchange rate to the US$ has contributed to an appreciation of the taka in real effective terms… .


 The report also says: Prices in Bangladesh are affected by price developments in the international market, especially food prices in India.

MA Taslim of Bangladesh Foreign Trade Institute echoes Mansur in BDnews24 on 12 November.  He claims that absent intervention, the taka might have risen to 60 per dollar.  He shows that broad money growth exceeded the Bank’s target for every year since 2004-05.  He also notes the rise in real exchange rate, and adds another dimension to the Bank’s multiple objectives:

Bangladesh Bank is under pressure from the private sector to reduce the interest rate. A greater volume of investment is necessary to move the economy out of its current sluggish state. This also requires a reduction in the interest rate. Bangladesh Bank has repeatedly urged the commercial banks to reduce the lending rate to a single digit in order to support greater economic activities. A tightening of the money market would raise the interest rate, which would be contrary to its exhortations. It is caught in a web of conflicting objectives.

Then he says asks something quite intriguing: given the current expansion of broad money, why is inflation not higher?  Where has all the money been going?  His answer: the share market.

Money spent in the share market does not raise the demand for ordinary goods; it raises the demand for shares and accordingly raises their prices. Thus, with a sharp rise in the share market turnover since 2007-08 the prices of shares also increased sharply as there was no commensurate increase in the stock of shares.

Share prices are not included in the consumer price index; hence, an increase in share prices does not influence the movement of CPI. Since the share market absorbed a large part of the money supply, the entire increase in the money supply did not impact on the price level. The irrational exuberance of the share market thus might have unexpectedly performed a useful role in dampening inflation. One can of course argue that by allowing excessive growth of money Bangladesh Bank supported or even encouraged the irrational exuberance of the share market.

Let’s summarise then:

  • taka is pegged to the dollar, ostensibly to help exports, which it fails to do because of the real appreciation through higher inflation;
  • inflation is the result of the peg, both through the taka-rupee channel as I’ve been arguing, but also through the direct result of excess liquidity growth that comes from the peg; and
  • the excess liquidity is not only causing inflation, it’s also causing the share market bubble which may be about to burst — in fact, if not for the bubble, inflation might have been higher.

Is the Bank listening?


2 Responses

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  1. Diganta said, on December 28, 2010 at 1:48 pm

    It’s a tough cat and mouse game for Bangladesh Bank. Very often the industrial lobby influences the Govt to shift fiscal policy as per their level of comfort. In South Asian countries few people understand things as complex as pegging currency. So, Govt policy lacks transparency. And lack of transparency raises lobbyists. Nice article by the way …

    • jrahman said, on December 29, 2010 at 3:26 am

      Thanks. Yes, few people understand the complexity and subtleties of the issue, but I would have thought people in the profession should.

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