Exchange rate misalignment in Bangladesh
Md Nur-E-Alom Siddique and Md Abir Hossain
Exchange rate misalignment influences the economic performance of a country especially when it comes to developing countries like Bangladesh. The impact of exchange rate misalignment on growth is more relevant in developing countries than in developed countries. According to D. Rodrik, periods of rapid growth are associated with currency undervaluation for most countries. He argues that an increase in undervaluation boosts economic growth as powerfully as a decrease in overvaluation, and that this holds only for the developing countries and the effect disappears in the case of developed countries.
Exchange rate misalignment is defined as the deviation of the real exchange rate from its equilibrium level. Significant and persistent misalignment disturbs the balance of the economy and is regarded as one of the early warning indicators of economic vulnerability. Persistent overvaluation of the real exchange rate reflects unstable macroeconomic conditions making the countries vulnerable to speculative attack and leads to currency crisis. On the other hand, an undervalued exchange rate makes overheating economy which creates inflationary pressure and misallocates the resources between tradable and non-tradable sectors. The Washington Consensus views that real exchange rate misalignment implies macroeconomic imbalances that can be disastrous for growth. Maintaining of real exchange rate close to equilibrium level is good for an economy from both its internal and external positions, though equilibrium real exchange rate is an unobservable variable. It mostly depends on a number of macroeconomic fundamentals, many of which are endogenously determined within the economy.
International Monetary Fund (IMF) often encourages developing and emerging economies to keep the actual Real Effective Exchange rate (REER) close to the equilibrium real exchange rate. REER is a weighted average of a country's currency in relation to an index or basket of other major currencies which plays a significant role in the broad allocation of resources and pattern of spending behavior in the economy. REER is mostly used to determine the currency value of one country relative to other major trade countries' currencies. It is as a measure of competitiveness which also determines and influences the performance of the export sector. It reflects the currency's position in terms of purchasing power with respect to other currencies and indicates whether a currency has appreciated or depreciated relative to the trade partners. Exchange rate misalignment can arise in any regime of exchange rate such as fixed exchange rate, floating exchange rate or manage floating exchange rate regimes.
Bangladesh adopted a floating exchange rate regime on May 30, 2003. While the advantages of a freely floating regime are well known, it is still debated whether this regime is suitable for the developing countries. Bangladesh regularly intervenes in the foreign exchange market to stabilise exchange rate. However, intervention in the managed floating regime causes the misalignment of exchange rate: either overvalued or undervalued. Therefore, in the context of Bangladesh, it is important to conduct study for the examination of real exchange rate behaviour and possible exchange rate misalignment using updated data covering flexible exchange rate regime. This paper estimates real exchange rate misalignment for Bangladesh using time series techniques including Dynamic OLS (DOLS). In this paper, the equilibrium exchange rate is derived based on the BEER approach introduced by Clark and MacDonald (1998). The approach gives an equilibrium exchange rate estimating from the relationship between real exchange rate and a set of fundamental determinants where only permanent changes of these fundamentals drive the equilibrium exchange rate. Therefore, firstly, this paper calculates equilibrium REER for Bangladesh using updated annual data: REER from Bruegel [who calculates REER which is consumer price index-based real effective exchange rate considering a large number of trading partners as weights] and other data from World Development Indicators (WDI). [Data for the year 2021 is estimated, not actual]. Secondly, it presents both the direction (Overvalued/Undervalued) and the magnitude of currency misalignment, if any, for Bangladesh.
BEHAVIOR OF NOMINAL EXCHANGE RATE, REER AND NEER IN BANGLADESH: Figure-2 shows the movement of both the REER and the NEER in Bangladesh for the period of FY93 to FY21. Bangladeshi taka (BDT) against US Dollar (USD) (period average) stood at 84.81 in FY21 from 38.15 in FY92. The trend in the nominal bilateral exchange was somewhat volatile but it was upward indicating deprecation of the exchange rate for the period of FY92-FY21 except some periodic appreciation. Depreciation rate was highest in FY12 at 11 per cent. Thereafter, depreciation level decreased and hovered within 4 per cent except FY14 and FY15, when BDT appreciated somewhat against Dollar in FY14 and FY15.
Over the time, NEER is declining steadily from 146.90 in 1993 to 98.40 in 2021 which showed a decline of around 33 percent, on average. On the other hand, REER observed an upward trend from 1993 to 2000 (Figure-2). After that REER observed a declining trend till 2006 and after that it observed an appreciation from 100 in 2006 to 179 in 2021, reflected the domestic price level pressure in Bangladesh compared to its trading partner countries (figure-3).
EXCHANGE RATE (REER) MISALIGNMENT: Figure-4 depicts the misalignment of REER during 1992 to 2021.The positive value of misalignment implies the overvaluation of REER where the negative value of REER implies the undervaluation of REER. The REER was overvalued most of the time except from 1992 to 1994 and from 2003 to 2005. Since 2002 REER started to become undervalued due to the continued lower inflation and occasional devaluations. Then Bangladesh adopted floating Exchange rate regime in mid of 2003. However, during the initial stage of the floating regime (2004-2006), the taka remained competitive due to high depreciation of taka and US high domestic inflation. The REER misalignment followed zigzag trend and continued overvaluation after 2003 and reached highest in 2019. However, in the last couple of years, currency misalignment became narrowed indicates that actual REER is closer to equilibrium REER (EREER) which is calculated based on economic fundamentals. [Whereas REER reflects the currency's value in terms of purchasing power with respect to other currencies and indicates whether a currency has appreciated or depreciated relative to the trade partners. It does not consider the economic fundamentals of the countries]. The study finds that in 2020, REER overvaluation was around 5 per cent and in 2021 it was 7 per cent. Although actual REER is continuously appreciating and stood at 115.76 in December 2021, the study finds that considering economic fundamentals Bangladeshi taka is slightly overvalued. Overvaluation in REER was somewhat compensated by the improvement in economic fundamentals such as productivity differential of Bangladesh during the pandemic. For instance, Bangladesh experience positive economic growth during the Covid-19 pandemic while most of countries in the world experienced negative growth, leads to higher the relative productivity slightly.
CONCLUSION AND POLICY RECOMMENDATIONS: The concept of real exchange rate misalignment is ambiguous because there is no universal consensus on equilibrium of exchange rates. Therefore, different assumptions, methodology and datasets provide different results in the investigation of equilibrium exchange rate and calculating misalignment. This policy note measures equilibrium real effective exchange rate and exchange rate misalignment for Bangladesh. The equilibrium exchange rate is derived based on the BEER approach, which gives an exchange rate at a level that is consistent with the medium- and long-term economic fundamentals. Then, exchange rate misalignment is measured as the deviation of the actual real exchange rate from equilibrium level.
The note finds REER misalignment followed an unstable fashion over the period considered (1992-2021) and the REER was overvalued most of the time except from 1992 to 1994 and from 2003 to 2005. Since 2002, REER started to become undervalued due to the continued lower inflation and occasional devaluations. However, during the initial stage of the floating regime (2004-2006), the taka remained competitive due to high depreciation of taka and US high domestic inflation. The REER overvaluation reached highest in 2019. However, in the last couple of years, currency misalignment became narrowed indicates that actual REER is closer to equilibrium REER (EREER) which is calculated based on economic fundamentals. In 2020, REER overvaluation was around 5 per cent and in 2021 it was 7 per cent. Although actual REER is continuously appreciating and stood at 115.76 in December 2021, the study finds that considering economic fundamentals Bangladeshi taka is slightly overvalued. Overvaluation in REER was somewhat compensated by the improvement in economic fundamentals such as productivity differential of Bangladesh during the pandemic.
This policy note may provide some insight for the policy makers. Since misalignment in case of both overvaluation and undervaluation is considered as harmful for economic performances, appropriate exchange rate policy should be maintained which can reduce the REER misalignment. To reduce the magnitude of REER over valuation, Bangladesh either may allow some depreciation in nominal exchange rate or may take necessary measure to reduce domestic inflation. Maintenance of Purchasing Power Parity (PPP) is quite useful for maintaining trade competitiveness. This policy can help to prevent overvaluation of the currency too. Regular calculation of exchange rate misalignment may help to know the actual level of misalignment and take appropriate policy to maintain REER close to equilibrium level. A study on the impact of exchange rate misalignment on economic performance, for instance, export, economic growth should also be initiated to know the extent to which policy makers should response to currency misalignment.
Md. Nur-E-Alom Siddique is Joint Director, and Md Abir Hossain is Assistant Director, of Chief Economist's Unit (CEU), Bangladesh Bank.
[The article is abridged version of policy note titled Analysis of Equilibrium Exchange Rate and Exchange Rate Misalignment in Bangladesh. Full paper including econometric exercise regarding equilibrium REER and REER misalignment is available at:www.bb.org.bd/en/index.php/publication/policynotes]