The fair value of the taka

What is the importance of exchange rate policy in an economy? Let us look at the oil market. Amid the rage of the coronavirus pandemic, we have also witnessed a price war between Russia and Saudi Arabia, the two top producers of crude oil. This oil price war was different for Russia than previous episodes for two reasons. After years of relative isolation, Russia had amassed a foreign exchange reserve over $500 billion that rivals Saudi's sovereign wealth fund. Russia has another macro weapon that the Saudis lack; the flexibility of the ruble to adjust to external shocks. Unlike Saudi Arabia's decades-old riyal-dollar exchange rate peg, since 2015 the value of the ruble is determined by market demand-supply forces.

So, when the price of crude oil fell by nearly 50.0 per cent in a span of three weeks in March 2020, the Russian ruble has lost nearly 20.0 per cent of its value against the U.S. dollar, the invoicing currency of oil. The flexibility of the ruble gave Russia an upper hand in the oil price war. Last year, the lifting cost of oil in Russia averaged $3.10 per barrel versus $2.80 per barrel in Saudi Arabia. Thanks to the ruble's flexibility, Russia's lifting costs have now fallen to $2.50 per barrel, below Saudis. In other words, the dollar cost of Russian oil is now cheaper than Saudi Arabia's oil.

Similar examples of the insulation flexible exchange rates abound in developed and emerging countries. The moral of the story is simply this: flexible exchange rates cushion an economy from external shocks. In response to the coronavirus outbreak, most emerging market currencies have fallen against the U.S. dollar. Since the beginning of March 2020, the Indian rupee has fallen by over 5.0 per cent, the Indonesian rupiah by over 7.0 per cent, the Mexican peso and South African rand by nearly 20.0 per cent, and the Vietnamese dong by over 1.0 per cent. By contrast, the Bangladeshi taka has barely changed (0.1 per cent) after coronavirus spread rapidly around the world. Clearly, Bangladesh's competitors learned the right lesson from the current oil price war.

Crisis analysis is sometimes easier since a crisis singles out dominating factors. During crises, the U.S. dollar tends to appreciate against emerging market currencies as the dollar is considered the only 'safe' currency. In normal times, however, the policy to devalue a currency cannot be assessed without an analytical framework, because an ad hoc approach to currency value has serious ramifications on the health of a country's trade and national output.

In recent research, we have used a number of models of exchange rate determination to quantify the equilibrium exchange rate of the taka vis-à-vis the U.S. dollar. We focused on the dollar because Bangladesh Bank practices a 'managed float' approach, which allows the taka to move against the dollar within a narrow range, while the taka is allowed to vary flexibly against all other currencies.

The basic idea behind exchange rate determination models is that currencies have an equilibrium level to which they will eventually return. The main challenge is to pin down the factors that determine the equilibrium level(s). The oldest theory of exchange rate determination is 'purchasing power parity' (PPP), which predicts that if Bangladesh's price level is higher than that of its trading partners, taka should depreciate.

Using data over the years 1980-2019, the purchasing power parity (PPP) model yields an estimate of $1 = Tk 110 in 2019, against the actual rate of Tk 84 per dollar. This suggests that taka is misaligned by over 20.0 per cent from its equilibrium level or that Bangladesh has a taka overvaluation problem. In fact, the estimated average overvaluation rate over the past five years (2015-2019) was 18.0 per cent.

The PPP model provides a good guidance for taka in the long run, but its short-run performance is not satisfactory. Short-run decisions regarding exchange rate policy have to be taken as they come, and the recent oil price war provides a crucial lesson. In the second model, we consider an 'external balance model' which uses net foreign assets as a share of Gross Domestic Product (GDP), interest rate and GDP differentials between Bangladesh and the United States (US). A positive net foreign asset means that a country is a creditor and, generally speaking, positive interest rate and GDP differentials relative to the foreign country are expected to appreciate the home country.

According to the results of the external balance model, in 2019, the estimated equilibrium value of taka is $1 = Tk 80, against the actual value of $1 = Tk 84.45. In other words, the external balance model suggests that in 2019 taka was undervalued by roughly 5.50 per cent. It may seem surprising, but the average value of the actual exchange rate of Tk 80.95 per dollar in the past five years (2015-2019) comes very close to the estimated equilibrium value of Tk 81.17 over the same period. It is tempting to conclude that Bangladesh Bank's exchange rate policy can be mimicked in a textbook-type model.

Besides these two models, we have also utilised other models of exchange rate determination that incorporate terms or trade and productivity differential, among other variables. We obtained mixed results - some showing an overvalued taka, while others suggesting an undervalued taka.

 Another way to gauge the extent of currency misalignment is using the real exchange rate, which is adjusted to reflect the different inflation rates. An increase in the real exchange rate means real appreciation of taka which is considered bad for the country's export competitiveness. Between 2004 (when Bangladesh Bank adopted a managed float) and 2019, a span of 15 years, the taka-dollar real exchange rate appreciated by nearly 46.0 per cent .Whereas during the same period the nominal depreciation of taka against the dollar was almost 42.0 per cent. When we consider a broader, trade-weighted basket, the real effective exchange rate of taka vis-à-vis 171 trading partner currencies had appreciated by 51.0 per cent over 2004-2019. In comparison, the nominal effective exchange rate of taka versus 171 trading partner currencies depreciated by only 21.0 per cent.

 What these numbers tell us is that in a world with the US as the only trading partner, the taka has depreciated to a reasonable extent. But, in the real world with many competing trading partners, taka has room for further depreciation as seen from the wedge between nominal and real effective exchange rates of taka.

 Many Asian countries -- China being a prime example -- actively engineered undervaluation to boost growth. On the other hand, many African economies shunned depreciation because they depend on imported capital to finance infrastructure projects as well as to keep the cost of other imported goods under check. Trade experts in Bangladesh often stressed taka devaluation, among other suggestions, to increase our export competitiveness.

In conclusion, the tendency to keep the currency strong or weak must essentially be guided by the structure of the economy. More rigorous knowledge and understanding is thus needed to enlighten decisions and policies.

Syed Basher and Md. Atikul Islam Sadi are respectively, professor of economics at East West University and senior research associate at New Vision Solutions Limited.
[email protected], [email protected]

[This article is bases on a research which is part of a wider research project under Sustainable Finance Department, Bangladesh Bank. The views expressed here are authors' own.]