Home ›› 24 Jul 2022 ›› Editorial
A question is raised by the ordinary people regarding the optimum level of reserves in the background of the economic crisis in Sri Lanka; the level of reserves a country should maintain in facing an impending crisis. It is also essential to know why and how the stocks of international reserves are depleted. Many economies in the world are now crippled due to the adoption of wrong policies such as investment in mega projects with loans and without any adequate provision of servicing the debt compounded by both wrong domestic policies and a harsh international environment. The mismatch between the import payments and export earnings and thus the deficit in the current account may be one of the prime reasons for international reserves depletion. Another reason is the flight of capital.
The first theoretical edifice on the optimum theory of international reserve was expounded in the late 1960s by Professor Fritz Machlup. Professor Machlup was an Austrian economist who taught at many distinguished universities such as Harvard, Stanford, and Cornell. His theory on the optimum level of reserves tagged Fritz Machlup's yearning for new clothes on prestige issues and was not thus backed by any economic criterion. The level of reserves held by the central bank of a country was considered to be a whimsical issue. Thus, Machlup Wardrobe’s theory of international reserves could not provide conclusive evidence on the rationale for optimum reserves. The justification of Machlup’s theory is embedded on two counts. Holding of International reserves was not a dominating factor in the late 1960s during the fixed exchange rate regime characterized by strict guidelines on the alignment of currency per value by the International Monetary Fund [IMF]. Again, the total volume of world trade was below 25 per cent in terms of the total world GDP in 1970 as compared to over 55 per cent in 2020.
Bangladesh's economy is now showing certain weaknesses in macroeconomic management. The clamour towards holding an adequate level of international reserves and ongoing vulnerability to certain external shocks renders an unstable value of the Bangladeshi taka that necessitated interventions by the Bangladesh Bank, the central bank. On several occasions, Bangladesh Bank sold US dollars to banks to meet the huge import demand for the domestic market and stabilize the exchange rate of the Bangladeshi taka. These weaknesses and continuous depreciation of the currency value is now a slur on the sound macroeconomic management of the monetary authority in Bangladesh. The recent visit by the IMF team and the request by the finance division for budget support of USD 4.5 billion manifest a debilitating situation on the holding of foreign exchange reserves. The government officials held talks with the representatives of the International Monetary Fund (IMF) on borrowing international reserves in narrowing the budget deficit. The foreign exchange reserves stood at USD 39.77 billion on July 13, 2022, which is USD 6 billion less in comparison to the previous year. The drop has been attributed to Bangladesh Bank's import payments of $1.99 billion to the Asian Clearing Union (ACU). There are a few specific pieces of advice from the IMF in addressing the ongoing volatility in foreign exchange rates owing to dwindling Bangladeshi exports in the wake of global economic slowdowns in major destinations points in the United States and Europe and the anticipation of lean flow of remittance in the event of recession in Middle Eastern countries. There are reservations also about the capping of the existing interest rate of 6 per cent on deposits and 9 per cent on loans when the official inflation rate hovers around 8 per cent.
An effective way to protect and augment foreign exchange reserves is to curtail unnecessary imports and expedite the inflow by reducing the lead time between the export shipments and money transfers through the banking channel.
An effective way to augment foreign exchange reserves is to curtail unnecessary imports and expedite the inflow by reducing the lead time between the export shipments and money transfers through the banking channel. The reserves witnessed a dive as import payments increased to USD 78 billion in FY 21 but export earnings and remittances could fetch only USD 73 billion. The caveat here is that the flow of remittance has witnessed a decline of USD 3.74 billion. The export earnings crossed the USD50 billion mark. There are several initiatives in discouraging imports of non-essential commodities yet the impact on the trade balance is not perceptible, import growth slowed to 15 per cent last May but the average import growth came down to 38 per cent as compared to 45 per cent in the previous ten months.
However, choking domestic demand due to spiraling inflation may curtail imports and the budget support of USD 4.5 billion could have a positive impact on the current account, at the optimum level of reserves, and thus on the exchange rate. The basic norm upholding the holding of reserves is adequate provision of three months of the import bill. A reserve of around USD40 billion, equivalent to eight months of import payments indicates a reasonably sound situation for Bangladesh.
However, the margin requirement is the payments of import bills for three months. Bangladesh's foreign exchange reserves soared to a record amount of $46.15 billion in December 2021. This analysis displays that the leverage in the optimum level of reserves hinges fundamentally on two factors; inward remittances and diversification of export baskets to bolster export earnings. There must be concerted efforts in increasing exports of light engineering, leather and leather goods, and processed agricultural products.
Bangladesh also needs to work out alternatives to compensate for the losses due to graduation in 2026 when the country may lose certain incentives related to trade facilitation measures. However, a further decline in export earnings and a lean flow of remittance could be a challenge for Bangladesh in macroeconomic management.
Unfortunately, Ukraine-Russia war is making a dent in the level of reserve accentuated by the high fuel and fertilizer import costs creating jitters in the foreign exchange market. Power generation through coal instead of expensive LNG in many developed countries may cause an increase in the price of coal. It could be a severe blow both to the degradation of environment as well as to the level of international reserves.
A pragmatic policy to tame surging imports is to insulate depreciation in exchange rate management. The dollar has appreciated with reference to the other major hard currencies of the world, such as the British Pound and the Euro. The Bangladesh Bank may follow a strategy of gradual depreciation of the taka to get a salutary effect on the potential inflationary impact of such depreciation.
The writer is the Treasurer and a Professor at the School of Business and Economics, United International University. He can be contacted at obaidur@ eco.uiu.ac.bd
