The behavioural linkages between the balance of payments and exchange rates have long been recognised as far back as the fourteenth century, when secondary markets had emerged for the bills of exchange issued by different European banking centres. However, since the middle of the twentieth century the rapid expansion of international capital movements relative to the growth of international movement of goods and services has given a new perspective on the relationships between the two.
In an open economy the balance of payments (BoP) and the exchange rate are very important concepts to gain a deeper insight into the working of the global economy. Bangladesh Bank is responsible for compiling the BoP statistics in Bangladesh, and these are also regularly published by international agencies like the International Monetary Fund (IMF) and the World Bank (WB). It is the international balance sheet of the country that records all international transactions made by its residents, businesses and government with the rest of the world over the course of a year.
Since a country like Bangladesh's economic relationship is not entirely based on the trade in goods and services, the BoP also includes transactions involving assets both financial (money, stocks and bond) and physical (investment in companies and real estates), otherwise know as capital. In summary, the BOP records all international transactions in goods, services and assets.
The BoP data is not a simple set of numerical accounting figures but is the consolidation of a number of key economic indicators and an encapsulation of powerful economic forces. Trends in the BoP data can have a large impact on a country's economic activity placing constraints on the rate at which an economy can grow as well as indicating the level of income and employment a country can be expected to sustain.
Therefore, in practical terms, a starting point for any analysis of a country's broad economic characteristics and important economic features is its BoP. The BoP data provides a precise representation of the country's comparative advantage.
A country's BoP for a single year is of limited value. But when studied over a number of years provide an insight into the identification of structural shifts taking place in the economy, thereby indicating the likely trends that may be in the future.
More importantly, a change in a country's BoP can cause fluctuations in the exchange rate. The reverse is also equally true when a fluctuation in relative currency strength can alter the BoP.
For the purposes of balance of payments accounting, international transactions are commonly broken down into three important sub-components for Bangladesh: the current account balance(CA), the capital account balance (KA) and the financial account balance (FA). BoP=CA+KA+FA.
At the transaction level, separate import, export or money transfer transactions enter into the BoP using a double entry bookkeeping system. The sum of all entries in the three sub accounts (CA, KA & FA) must equal to zero since for every credit entry, there must be a debit entry.
However, given the enormity of the task in collecting all data for the BoP, it is not unusual that the BoP rarely, if ever balances. Also, there are other reasons, especially for a country like Bangladesh where trade channels are used to transfer money overseas using such methods as under-invoicing and sales contract. The payments for services that can be adjusted for transferring money overseas or to suit clients' tax purposes or both and also business or citizens underreporting their income abroad. There are always illegal international transactions such as hundi, smuggling, drugs etc, which may throw off the double entry balance.
Therefore, if a discrepancy arises, that is adjusted through an entry made in the errors and omissions (E&O) account-- also called the statistical discrepancy (SD) to reach the zero balance. The E&O is defined as the sum of all the BoP items with their sign reversed i.e., E&O= - (CA+KA+FA). The balance of payments data for Bangladesh in 2020 recorded an amount of US$ -526.773 million as E&O. The E&O for Bangladesh averaged US$ -87.342 from 1976 to 2020. A negative sign of E&O indicates under-recording of debits such as capital outflows or current account debits. According to the IMF's Balance of Payments Manual, the BoP identity is summarised as: CA+KA+FA+E&O=0
Therefore, it is not necessary that each of the account which comprises the entire BoP must individually balance. The BoP is made up of a series of balances, each of which can be in surplus or in deficit resulting in the overall balance of each of the major accounts.
Between 1980 and 2020, Bangladesh achieved a current account surplus for 14 years and a deficit for 27 years. Usually, a country recording a current account surplus indicates its dependence on exports revenue, with high savings and weak domestic demand. On the other hand, a country recording a current account deficit is indicative of its dependence on imports, low savings and high personal consumption rates as a percentage of disposable income.
The current account balance of Bangladesh as a percentage of GDP provides an indication on the level of international competitiveness. Between 1997-98 and 2019-20, the average value of current account balance as percentage of GDP for Bangladesh stood at 0.6 per cent. This figure reached an all time high of 3.3 per cent in 2009-10 and a record low of -3.7 per cent in 2017-18. The data clearly indicates Bangladesh's lack of international competitiveness.
If the current account deficit within the accounting period is not exactly matched by a capital account surplus, the monetary authority i.e., Bangladesh Bank closes the gap either running down the official reserves or an accounting entry is made through the E&O account to compensate for unidentified capital flows thereby offsetting the difference between the current account and the capital account.
The capital account measures the capital expenditure and overall income of a country while the financial account measures the changes in international ownership assets. Positive capital and financial accounts indicate a country as net debtor to the world, while negative accounts make the country a net creditor. The capital and financial accounts are intertwined because they both record international capital flows.
The relationship between the BoP and exchange rates under a floating exchange rate regime will be driven by the supply and demand for the country's currency and all transactions taking place with other countries. Now a days, all these transactions are automated through an intermediary so individual buyers need not enter the Forex market to obtain goods or services.
Once transactions are completed, they appear in the current account section of the BoP. The same also holds true for investment, loans or other capital flows. All capital flows between countries show up in the capital account section of the BoP.
Therefore, under a floating exchange rate regime, as more Bangladesh currency Taka (BDT) is demanded to satisfy the needs of foreign consumers and investors, an upward pressure is placed on the price of BDT. To put it another way, it costs relatively more to exchange for BDT in terms of foreign currencies.
However, the exchange rate of BDT may not rise if other factors are concurrently weighing it down, for example an expansionary monetary policy might increase the supply of BDT and decrease its value relative to other currencies.
The above relationship between the BoP and exchange rates exists only in an open economy with a freely floating exchange rate regime. But that is not the case in Bangladesh.
The exchange rate regime that is in place now in Bangladesh can be described as a managed floating exchange rate regime where the BDT is pegged to the US Dollar (USD). The capital account is not fully convertible either in Bangladesh. Also, BDT convertibility into foreign currencies is very strictly regulated.
Therefore, Bangladesh Bank has to intervene as and when necessary in the foreign exchange market to keep the BDT/USD exchange rate at the pegged rate. According to Bangladesh Bank it does so by largely relying on inter-bank exchange rates. Bangladesh Bank also intervenes by providing foreign exchange liquidity support to the commercial banks to settle their trade related transactions. According to the Bangladesh Bank, the cross rates of BDT with other currencies are based on New York and Dhaka closing exchange rates.
In effect, Bangladesh Bank must intervene to defend the peg under the managed exchange rate system. If the exchange rate is under downward pressure, Bangladesh Bank must intervene to sell foreign currency and buy BDT. Such an intervention will be reflected in a decrease in official international reserve holdings. The opposite is true if BDT experiences upward pressure. This currency peg will work only so long as Bangladesh Bank has sufficient international reserves to keep defending it, if not, the peg will collapse.
However, it is generally considered that the BDT remains overvalued when viewed in terms of the real effective exchange rate (REER) despite the fact that BDT has been depreciating in recent times. As volumes of imports and exports are sensitive to REER, the overvalued BDT makes Bangladeshi exports relatively more expensive and imports relatively cheaper. Therefore, an artificially high currency peg contributes to overconsumption of imports which can not be sustained in the long run, and often causes inflation.
The conclusion is that under the managed exchange rate system official intervention in the foreign exchange market alters Bangladesh Bank's assets and liabilities in ways that change not only its holding of official international reserve assets but also country's money supply-- unless Bangladesh Bank does something to neutralise that.