Slippery exchange rate: A benign diagnosis

First-year students of economics are often intrigued by the phrase movement along the demand or the supply curve or shift of either the demand or the supply curve and its consequences on the equilibrium price or quantity.

When it is the movement along the curves, fine-tuning the demand and supply helps convergence in the equilibrium level without significant gyrations in the variables-- a simple exercise of manipulating demand and supply. However, the shift of either the demand or the supply curve, the frequency of changes, the endogeneity, and the world economic environment constitutes a severe challenge for policy planners, especially in the monetary aspect.

When the government pursues pragmatic monetary, fiscal, and exchange rate policies in either the expansionary or contractionary phase of the business cycle, the government can use the automatic stabilizer to sustain the growth process. However, when the shift in the curves is due to external forces, it is difficult to reach a comfortable level conducive to many stakeholders in the economy.

The equilibrium exchange rate is determined by the interaction of the demand and supply of local currency vis a vis the demand and supply of any hard currency, say USD.

With the scarcity of USD and abundant supply of Bangladeshi Taka, the Taka loses its internal value; and you need to spend relatively more Taka to buy one unit of foreign currency. The demand for foreign currency is a derived demand that fulfills the market for many other commodities or services, such as imports and to pay for investment in the foreign country. Maintaining a stable exchange rate fosters exports and imports, a healthy balance of payments status, and a beneficial effect on domestic inflation and interest rate.

The Bangladeshi currency Taka has been experiencing a slippery exchange rate since January 2022. The historical exchange rate from January 2019 to January 2022 was smooth; the average exchange rate was hovering from 84 to 86 Taka to one USD. The weaknesses start in June 2022 and reached Taka One hundred six in February 2023 with the current rate of June 2023, taka one hundred eight. Indeed, the record level of reserves of USD 48 billion in August 2021 gave the buoyancy and steadiness of the exchange rate during the period.

The currency’s strength or weakness is linked to the level of reserves; a higher reserve keeps the currency robust and fungible. The reserves were USD 40 billion, USD 36 Billion, USD 32 billion, and USD 30 billion, in July 2022, October 2022, January 2023, and April 2023, respectively. The currency is losing its value with dwindling reserves.

The current account with trade balance, services, and secondary income is crucial to the exchange rate alignment. The trade deficit weakens the exchange rate as demand for foreign currency cause a slide in the local currency value against the hard currency. However, the lion’s share of the trade deficit is compensated by the secondary income that includes private transfers of workers’ remittances; over 80 percent of the trade deficit could be salvaged by the worker’s remittances in Bangladesh. The perennial trade deficit is a concern for the economy. A cautious outlook on the nature of imports and the scrutiny of the importable could be soothing for reducing the gap.

The financial accounts of the balance of payments are another criterion to examine currency alignment status. Bangladesh enjoyed a surplus in the financial account. The deficit of over USD 2 billion is now a concern and requires scrutiny. FDI net inflows and MLT amortization payments; the deficit may be higher for amortization payments. A negative financial account indicates leakage and may constitute an attack on the currency.

The switching to a floating exchange rate on May 31, 2003, and the transition from a fixed exchange rate was frictionless. The flow of remittances and the export growth with a narrow base keep the currency value competitive with many neighboring countries. The real effective exchange rate index asserts that Bangladesh’s currency was overvalued. The overvalued currency helps an economy in two ways; a higher value of GDP and per capita income, and secondly, boosts the manufacturing sector through low cost of import. The current trend of exchange may be overshooting of the exchange rate hidden in insipid overvaluation. Exchange rate overshooting is often amplified by a relatively shallow and inefficient domestic foreign exchange market.

Many factors caused the demand curve for foreign currency to shift rightwards and the supply curve to shift leftwards. The Covid-2019 pandemic and Russia - Ukraine war are the two apparent reasons for this shift. The uncertainty of the war and environmental degradation could drastically curtail the growth tempo in many developed and developing countries.

Exchange rate policy is an integral part of an overall monetary and macroprudential policy with price stability and economic growth. The interest rate policy plays a complementary role in the whole process because inflation targeting is an essential element in the floating exchange regime.

The writer teaches at BRAC University and BIDS as an adjunct Faculty in the Master’s Programme in Economics. He can be contacted at [email protected]