For a small open economy, exchange rate stability is vital for promoting trade and welfare. In Bangladesh, sustained stability of its exchange rate has been a cornerstone of the government's prudent management initiatives for the last two years. There has been virtually no change in the nominal exchange rate (NER) of Bangladesh Taka (BDT) relative to the US dollar ($) until the end of 2015, remaining stable at Tk. 77.8 for one US dollar.
In the years leading up to 2015, the accumulation of foreign exchange reserves continues to put appreciation pressures on BDT. During the same time, Bangladesh Bank (BB) continued its prudent interventions in the foreign exchange market by buying foreign currency (mostly US dollars) in order to counter Taka's nominal appreciation, in a commitment to its objective of maintaining exchange rate stability.
Foreign exchange reserves underwent rapid growth in the past few years, from some US$ 15 billion in fiscal year (FY) 2013 to more than US$ 28 billion in FY2016 (Figure 1). Although the central bank's intervention (i.e., its purchase of foreign currency) is crucial in maintaining exchange rate stability, it leads to an increase in the money supply that needs to be sterilized, to prevent aggravating the inflation rate beyond BB's target level.
However, an improvement in the performance of imports relative to exports offers some hope. If this current trend of imports outpacing exports persists, it will help bring about a slowdown in the accumulation of foreign reserves. This will ease appreciation pressures on BDT, putting Bangladesh Bank in a comfortable position to manage the monetary sector.
Despite a slowdown in the accumulation of foreign reserves, the Taka continues to face appreciation pressures in real terms. Bangladesh's real effective exchange rate (REER) -- a measure that adjusts the nominal exchange rate for differences in domestic inflation and those of the country's main trading partners -- has been trending upwards since FY2011 (Figure 2). The REER fell somewhat in FY2015, but continues to trend high compared to that of FY2011. The REER trend often reflects export competitiveness; with an appreciation in the REER indicating deteriorating export competitiveness and vice-versa.
The sharp appreciation of the REER is mainly due to higher inflation in Bangladesh relative to its trading partners, such as the US, European Union (EU), China, India and Japan. A comparison of inflation in these countries with that of Bangladesh reveals a substantial difference (Figure 3). The inflation rate differential with the major trading partners currently stands at four (4) percentage points. Despite the low inflation target set by Bangladesh Bank (BB), the differential is expected to remain wide over the next few years.
Figure 4 plots Bangladesh's exports performance and its REER for the period between FY2000 and FY2015. We can see that exports have been on a constant upward trend during this period, with some minor fluctuations. Export growth can be seen to be slightly stymied in the last few fiscal years. The REER, on the other hand, can been seen to decline slowly until the late 2000s. Since then, the REER is found to be on an upward trajectory. From the late 2000s, Bangladesh's exports and the REER can be observed to move somewhat in opposite directions; signifying the linkage between the REER and export competitiveness.
An appreciation in the REER is likely to result in an erosion of competitiveness of Bangladesh's exports, especially in the European markets as the euro has depreciated substantially against the US dollar in recent times and is expected to remain low in the foreseeable future. Bangladesh's exports, mainly ready-made garments, are usually priced in US dollar. As such, the price of such exports went up sharply in recent times, hurting export competitiveness and growth. The slump in export growth in FY2015 is a manifestation of this problem. This lackluster performance of exports in recent times should provide an impetus to the argument in favour of further depreciation of the exchange rate.
This presents a very tricky situation for BB: it has to buy more foreign currency from the market to engineer a nominal depreciation of BDT; at the same time it has to counter excess liquidity brought about by this intervention, which culminates in higher inflation and a corresponding real effective appreciation of the Taka. Fortunately, it can arrest the trend of an appreciating REER through other measures as well instead of only the NER and thereby resolve the dilemma presented by an effort to bring about a depreciation of the NER through reserve buildup. The two other important measures are to reduce the rate of inflation and to lower the trade protection. Lower inflation rate will directly address the appreciation of the REER. Reduced trade protection will boost imports and also avoid the anti-export bias of trade policy.
In conclusion, real exchange rate management should be an important area of contemporary policy intervention by BB as it has the potential to significantly affect the country's export competitiveness and economic development. However, this should be combined with efforts to further reduce inflation and to lower trade protection. This combined policy package will be a more effective way for managing an appreciation of the REER than the focus on only the NER.
[Dr. Muhammad Shafiullah is a Senior Economist at Policy Research Institute of Bangladesh and can be reached at [email protected] Zarif Iftekhar Rasul was a former Economic Consultant at PRI and can be reached at [email protected]]