Difference between official and market exchange rates: A few policy issues

Currently, the difference between the official exchange rate and the market exchange rate in Bangladesh exceeds the acceptable spread of transaction costs with a higher mark-up in both the inter-bank exchange rate and the government-approved money exchangers. The foreign exchange market is highly volatile as a result of a mismatch between demand and supply of foreign currency vis a vis the demand and supply of local currency, the taka. The supply lags behind the demand as surging import payments preempt the inflow of USD augmented through the remittance flow and the inflow from previous export shipments.

The trade deficit reached an all-time high of $25 billion in the first nine months of the current fiscal year, with the import payment of $61 billion. The current account, which records the net payment in invisibilities with the trade balance, reached $14 billion. Bangladesh Bank intervened in the market by selling over USD 5 billion to keep the foreign exchange market stable, causing a fall in international reserves of USD 48 billion in August 2021 to around USD 43 billion in May 2022. This is worth about six months of import payments against the norm of a minimum requirement of three months of import payments. The foreign exchange reserves depletion is entangled in the recovery of the post-Covid-19 phase with an increase in prices of all essential commodities, raw materials, and capital equipment and the rising fuel cost in the aftermath of the Russia-Ukraine war.

However, the foreign exchange reserve is still fairly satisfactory now.

For the last two weeks, jitters in the foreign exchange market accentuated through the increased demand of USD for higher import payments. It happened on account of the foreign tours and medical treatment tantamount to the prevalence of multiple exchange rates. A practice we experienced a long time back e,g., wage earners exchange rate or exchange rate in case of essential commodities and luxurious items. The margin in many cases is between Tk.10-15. On May 16, 2022, the central bank succumbed to a further devaluation of the taka, raising the exchange rate of the USD to Tk. 87.5 from Tk 86.7, causing an increase of Tk. 2.7 in the inter-bank transaction in the past nine months since August 2021.

The current situation may be explained through several theoretical facets. First, the exchange rate needs to be adjusted with the status of the overall balance of payments through managed floating. The overvalued currency hurts the remittance flow, exports appear to be more competitive, and often encourage unnecessary imports. The introduction of a 2 percent income incentive, which was then revised to 2.5 percent, manifests the margin of taka's overvaluation. An intelligent option could be to add this 2.5 percent incentive in USD value which could minimize lots of administrative requirements. Countries experiencing continuous balance of payments deficit should periodically review the exchange rate realignment with currency depreciation. The overvalued currency, taka, could be marginally adjusted during the next fiscal to avoid the present swooping fall.

Secondly, the volume of the forward-market hedging to circumvent the risk of exchange rate variation may be a factor in the hiking of the exchange rate. Thirdly, the policy change on the interest rates by the major players in the foreign exchange market could destabilize the parities among the world's different currencies. Recently, we observed an aggressive interest rate hike by the Fed [Federal Reserve] and a policy in the offing for the ECB [European Central Bank]. The Fed raised interest rates for the first time on May 9, 2022, after 2018, to contain the economic risks of excessive inflation and the war in Ukraine. "Most policymakers now see the federal funds rate rising to a range between 1.75 per cent and 2 per cent by the end of 2022, the equivalent of a quarter-percentage-point rate increase at each of the Fed's six remaining policy meetings this year" with a projection to reach 2.8 per cent next year - above the 2.4 per cent.

An increase in the interest rate of any hard currency could result in the depreciation of currencies pegged to the USD. An interest rate hike is a preferred policy for an economy experiencing inflation and safeguarding the currency's value. However, inflation is expected to remain above the Fed's 2 per cent target through 2024, and the Fed may be more aggressive in raising rates if they do not see improvement. The ECB is also contemplating hiking interest rates by as many as three times; 0.25 percentage points each to contain inflation. If this were to happen by December, it would have the effect that by 2023 the deposit rates for banks, which are now minus 0.5 percent, would be in positive territory. With a rate hike in July, ECB policymakers are becoming more vocal about normalizing monetary policy more quickly than previously expected. Indeed, Fed policy to raise rates by half a percentage point appreciated the USD value against the Euro; the value slumped to a five-year low at nearly USD 1.03. The Euro itself is not an attractive currency at the moment. Hedge funds are already betting on it. In the past month alone, they've piled on USD 7 billion in notional value into options wagers on parity, making it the most popular trade among those looking for a further drop in the common currency.

Another theoretical premise on the rapid depreciation of the currency may be explained through the Overshooting Model by R. Dornbush. Dornbush's assertion on the flexibility of the exchange rate is more pronounced than the change in the price level with a permanent increase in the money supply. The increased money supply causes the worldwide inflationary trend to address the emerging needs of the Covid-19 and the Russia-Ukraine war. Only the exchange adjusts immediately and absorbs the full impact of a change in money supply, causing it to overshoot. Wages and prices are rather sticky in the short run.

The divergence between the official exchange rate and the market rate creeps in owing to the multiple dubious transactions in the foreign exchange market fueled by syndication and anticipation of further depreciation of the taka. The mismatch between demand and supply may be reduced through gradual realignment of exchange rate and ensuring discipline in inter-bank and kerb market transactions, a cap on the anticipated mark-up. The proper alignment of currency value, neither overvalued nor undervalued, may help the remittance flow and the export earnings to tie with the import payments ensuring equity in the demand and supply in the market. The government took the bold initiative to curtail foreign tours such as exposure visits, study tours, workshops, and seminars abroad that could have a salutary effect on the foreign exchange reserve. BB and related agencies should be more cautious in scrutinising the documents related to the outflow of foreign currency on various heads, such as medical expenditures and educational expenses.

The writer is the Treasurer and a Professor at the School of Business and Economics, United International University. He may be contacted at obaidur@ eco.uiu.ac.bd