Home ›› 26 Feb 2023 ›› Editorial
The exchange rate is one of the crucial variables in ensuring a safe level of inflation and growth-- a realistic exchange rate contributes to the balance of payments equilibrium. The gyration of exchange rate influences the domestic price of imports which could lead to higher producer prices and subsequently to higher consumer prices. An open economy with over 40 percent of trade intensity is vulnerable to inflation due to exchange rate fluctuation—the greater the degree of openness, the greater the elasticity of the Exchange Rate-Pass Through [ERPT].
The current worldwide inflationary syndrome questions the superiority and adaptability of the flexible exchange rate over the fixed exchange rate in the mid-seventies. The dynamics of the inflationary spiral are now evident in the aftermath of COVID-19 and the uncertainty hidden in the Russia- Ukraine war.
Inflation is now a global concern accentuated by the unprecedented appreciation of the United States dollar. The domestic price level, i.e., the Consumer Price index [CPI], is highly susceptible to inflationary syndrome through the exchange rate channel. The appreciation of a vehicle currency due to a higher interest rate causes havoc on the CPI in many import-dependent countries through the high elasticity of ERPT. In many instances, domestic currency depreciation increases the import cost expressed in domestic currency and is transmitted to inflated domestic prices, reducing the profit margin. The degree of pass-through, however, falls within a wide range, starting from zero to complete pass-through. The degree of pass-through is determined according to the firms’ behavior; firms usually choose between keeping the markups unchanged and preserving the sales price level, otherwise balancing both alternatives. There is mixed empirical observation on the ERPT. During the 1990s, domestic inflation had weak effects, even with a considerable exchange rate variation in a few small open economies. The presence of other factors, such as an increase in domestic production, could have a beneficial effect on the importable. Again, small open economies are price takers in the international commodity market, and thus the initial price could be above the average level.
The magnitude of exchange rate variations transmitted to domestic prices is vital in monetary policy. The extent and speed of the ERPT are critical in the central bank's design and conduct of monetary policy, with price stability as the principal goal. The depreciation of the currency could help to reduce the trade deficit given the highly elastic demand for export and inelastic demand for imports, as illustrated in the Marshall - Learner condition. Empirical studies attempt to discover the relationship between the exchange rate and the traded goods’ price. A study using the panel data of a few disaggregated export items of Bangladesh revealed one-to-one correspondence between the changes in the exchange rate and export prices. However, the such relationship does not hold for readymade garment (RMG) exports. The prominent strategy is the perception of destination markets' demand patterns and, consequently, the pricing-to-market (PTM). The minimal volume expansion due to local currency depreciation could be the Multi-fiber Arrangement (MFA) regime that constrained the competitive behavior of different suppliers in some selected export items. The degree of pass-through falls within a wide range, from zero to complete pass-through. The degree of pass-through is determined according to the firms’ behavior regarding the changes in the exchange rate. Firms usually choose between keeping the markups unchanged and preserving the sales price level, otherwise balancing both alternatives. Moreover, internal market structure and external shocks may be associated with different pass-through exposure. The use of the exchange rate as a buffer against external shocks .and the independence of the central bank in foreign exchange reserve management plays a vital role in this transmission mechanism.
Bangladesh’s economy survived the ordeal of COVID-19 with enviable growth in comparison to global standards. However, the growth momentum slowed in the continuation of the Russia- Ukraine war, and the uncertainty clouded the future growth prospect. The high global commodity price and supply chain disruption still fuel global inflation. The global inflation was very high, close to above 50 percent [ base 2016 = 100] from March 2021 to June 2022, and still at a high level in the neighborhood of 30 percent. The effects of global commodity price hikes ultimately caused significant increases in import costs since the first quarter of 2021. Consecutive four quarters of 2021 experienced 32.3, 72.9, 47.6, and 60.5 percent import growth, which created huge pressure on the exchange rate of Bangladeshi taka against the United States dollar. The onslaught could have been averted initially with an overvalued exchange rate and a satisfactory level of reserves. Still, with the burgeoning trade deficit, the exchange rate through several phases is now over Taka 106. The nominal exchange rate was BDT 86.20 per USD in March, BDT 93.45 in June, BDT 101.70 in September, and BDT 104.35 in October 2022.
The import-dependent nature of many essentials such as fuel, edible oil, food, wheat, sugar, intermediate goods, and raw materials continues to witness higher prices in Bangladesh. The country may experience another price spiral during the coming Ramadan. An example is the date price; on the pretext of lower imports, the traders hike the price by about 50 percent from the previous year’s level. The recent price hike of soybean oil and sugar are two examples. The price hike put financial strains on fixed-income groups. The middle and the poor are the worst sufferers. The local currency depreciation and inadequate opening of L/C due to the foreign currency crisis may not be the sole reason for this high ERPT. It is important to review the various routes of market imperfections through which price hikes exceed the margin of nominal depreciation. Market syndication is one obvious example.
The writer teaches at BRAC University and BIDS as an adjunct Faculty in the Master's Program in Economics. He can be contacted at mirobaidurr7@gmail.com
