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The Financial Express

Depreciation and inflation

M. A. Taslim | Published: May 07, 2017 21:27:05 | Updated: October 17, 2017 13:03:31


Depreciation and inflation

The exporters of the country, especially ready-made garments exporters, have been urging Bangladesh Bank for a depreciation of the external value of the domestic currency taka for some time now. They argued that such a step was essential to maintain the competitive edge of export in the world market in view of the depreciation of the currencies of competing countries. The recent falling trend of export and a ballooning trade deficit give some credence to the demand (Table below).
Some economists also lent support to their demand. They advanced an additional and a bit more subtle argument that the inflation rate of Bangladesh was well above the inflation rates of its trading partners. This should have normally caused a depreciation of the taka. The failure to let the external exchange value of taka adjust to the inflation differential led to the worsening of the real exchange rate. This reduced the competitive strength of the exporters, which did not bode well for the future. Depreciation was necessary to reverse the situation.  
However, it should be understood that the proximate cause of currency depreciation is not the inflation differential. A currency depreciates in the foreign exchange market only when the demand for foreign exchange exceeds the supply. Since most of the external transactions in Bangladesh are done with the US dollar, it may be regarded as a proxy for foreign exchange. Hence, the exchange rate of the US dollar in terms of taka (Tk/US$) will increase, i.e. taka will depreciate, only if the demand for dollar is less than the supply. 
The net supply-demand balance of the dollar can be deduced from the balance of payments account of the country. If the overall balance in this account is positive it reflects an excess of dollar in the market, and when it is negative the dollar is in short supply. 
Unless the central bank overrides the market outcome through exchange market intervention, a shortage of the dollar should depreciate the taka, while a positive overall balance should appreciate the taka in terms of dollar. The central bank can offset limited imbalances in the balance of payments with reserve management to keep the currency stable or move it in a desired manner. 
It so happens that the overall balance of the balance of payments has been positive for the last six years (Fiscal Year or FY 2011-12 to FY 2016-17). This obviously implies the dollar was in excess supply in recent years. All these years, Bangladesh Bank purchased the excess dollar in order to keep the foreign exchange market stable. If it had not intervened to mop up the excess supply of dollar, the taka would have certainly appreciated. A collateral benefit of the intervention has been the build-up of the stock of international reserves of the country. The reserves increased from US dollars ($) 10.4 billion to more than $32 billion during this period, but the taka did not appreciate noticeably (Table above). 
If the exchange market were really free, the taka would have appreciated considerably notwithstanding the depreciation of other currencies and the inflation differential between Bangladesh and its trading partners. This is in sharp contrast to what the economists had assumed. 
Does this mean that the economic theory that suggests that the rate of change of the exchange rate is aligned to the interest differential is wrong? Not quite! What is to be understood is that this alignment between the rate of change of the exchange rate and the inflation differential actually takes place over a notoriously long time, sometimes several years, to complete; and it will happen only if the market is free to adjust. 
In the situation we are currently in, the surplus in the balance of payments would have, if the markets were free to adjust and the central bank did not intervene, led to an appreciation of the taka initially. This would have reduced the competitive strength of the exporters and raised the attractiveness of imported goods and services, which would have in the course of time reduced the trade balance. The reduction in export and increase in import would have slowed down gross domestic product (GDP), which would have also helped to reduce aggregate demand. This would have reduced the inflationary pressure in the economy and thereby reduce the inflation differential with trading partners. The reduced trade balance would have reversed the exchange rate movement, and ultimately the situation predicted by the theory would have been established.  
Obviously Bangladesh Bank has no appetite for such long drawn and uncertain market adjustments. It intervenes frequently to move the exchange rate in a manner of its choosing. The exporters are evidently not happy with the level of intervention (or their profit margin); they want more. 
But the remit of Bangladesh Bank is much wider than the interest of the exporters. It has to carefully consider the consequences of exchange rate movements on all sectors of the economy and on the welfare of the people. The exporters may not always get what they want.
The major contributor to the problem of appreciation is the inflow of remittances. Until recently the total amount of foreign exchange received from our workers overseas is believed to have exceeded the net foreign exchange earnings from export. Such a large inflow must have exerted a very considerable pressure on the exchange rate of taka to appreciate. This was strengthened further by the inflow of foreign loans which increased substantially since FY 2010-11. Without the countervailing foreign exchange market interventions by Bangladesh Bank the economy would have suffered from the Dutch Disease Syndrome that would have caused a considerable slowdown of export growth. 
Bad news can be good news, at least occasionally and for some. The inflow of remittances has slowed down very sharply opening up a large current account deficit for the first time in five years. This could force a depreciation of the taka especially if the market expects a further worsening of the current account. The signs of this happening have already emerged and it could strengthen in the next few months.  If it goes too far, Bangladesh Bank could be forced to intervene in the reverse direction. 
e-mail: m_a_taslim@yahoo.com  
 

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