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Currency depreciation and balance of payments

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Bangladesh's balance of payments (BoP) captures the transactions between Bangladeshi residents and the rest of the world in a given period of time. Residents are defined broadly to include people who live in Bangladesh, engaged in businesses and other organisations that operate in Bangladesh.  

Balance of payments divides transactions into two broad accounts: current account (CA) and combined capital and financial account (CFA). In essence, the current account captures the net flow of money that results from Bangladeshis engaged in international trade, while the combined capital and financial accounts capture Bangladesh's net change in ownership of assets and liabilities. These broad accounts are often referred to as the two sides  or two sub accounts of the balance of payments.

To put it simply, current account records the flow of goods and services in and out of a country (imports and exports). Current account also includes net income such as interest and dividends and current transfers from abroad such as foreign aid and remittances which can be a very substantial part of the total for Bangladesh. The capital and financial account measures the capital transfers between Bangladesh residents and foreign residents. The capital and  financial account reflects increases or decreases in the country's ownership of international assets. 

Balance of payments are put together according to international standards set out by the International Monetary Fund (IMF) and the United Nations (UN) that make Bangladesh's balance of payments comparable with those of other countries.

At the transaction level, separate import, export or money transfer transactions enter into the BoP using a double entry book keeping system. It is not necessary that each of the accounts 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. 

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 also used to transfer money overseas using such methods as under-invoicing and sales contract. The payments for services can be adjusted for transferring money overseas or to suit clients' tax purposes or both and also  businesses or citizens underreporting their income abroad. There are always illegal international transactions such as hundi, smuggling etc.  which may throw off the double entry balance. The current account is the central focus of  attention to have a grasp of  any country's external economic relations  and also an important metric for any country because it measures current trade activities, direct investments incomes, unrequited transfers and the performance of assets held by residents of the country. 

The exchange rate exerts a significant influence on the trade balance, and by extension, on the current account. Theoretically it can be argued that an overvalued currency makes imports cheaper and exports less competitive, thereby widening the current account deficit or narrowing the surplus. An undervalued currency, on the other hand, boosts exports and makes imports more expensive, thus increasing the current account surplus or narrowing the deficit. 

Between1980-81 and 2021-22, Bangladesh achieved a current account surplus for 14 years and a deficit for 28 years indicating two thirds of the mentioned period the country experienced outflows exceeding inflows in the current account. The corollary of this is that the level of national savings has been less than investment. Therefore, a current account deficit may  be a reflection that saving is less than investment and investment being financed by capital inflows from abroad resulting in Bangladesh becoming a net importer of capital.

However, there was a significant deterioration in the current account balance during  2021-22 reaching US$18.69 billion rising from US$4.57 billion the previous year. The trend continued during the first two months of the current financial year (2022-23). Bangladesh's current account deficit accounted for 3.8 per cent of the country's nominal GDP in June 2022, compared with a 0.9 per cent of the same in the previous year. 

The trend in deteriorating current account balance in Bangladesh is largely a reflection of increasingly widening deficits in the trade balance. Bangladesh's trade deficit hiked up to US$33.22 billion in 2021-22. According to the credit rating agency S&P Global "High commodity prices, surging domestic demand, and tighter monetary policy are exerting pressure on Bangladesh's external profile".

Since the middle of this year the Bangladesh currency taka has been depreciating rapidly raising concerns about its impact on the deteriorating current account balance. While the direct effect of a currency depreciation is to increase the price of imports relative to exports, which tends to decrease the value of net exports (exports-imports) and widens current account deficit, the indirect effects of a currency depreciation increase the volume of exports and reduce volume of imports. This has an offsetting effect and tends to increase net exports and reduce the current account deficit. 

The two effects differ in their response time to the currency depreciation. The direct effect of a currency depreciation occurs immediately but the indirect effect of the same on exports and imports occur with a time lag. Therefore, in the short run, a currency depreciation is likely to increase the current account deficit.

A current account deficit can only be sustained if there are capital inflows to match it, unless the country can drawdown its reserves. Many countries also seek balance of payment support from outside sources including the International Monetary Fund (IMF) to facilitate the adjustment process as Bangladesh has done recently. 

Currency depreciation can also be a part of this adjustment  process but fraught with controversy, especially it has been argued that devaluation has most often been proved to be ineffective. It can contribute to rising inflation without sufficiently improving the external payments positions with negative consequences for growth and employment.

A floating  exchange regime was instituted in June 2003, but the exchange rate regime that is in place now in Bangladesh can be described as a managed floating exchange rate regime where the Bangladesh taka (BDT) is pegged to the US Dollar (USD). But in very recent times Bangladesh appears to have moved to a multiple exchange rates regime. 

The capital and financial account is not fully convertible in Bangladesh as such  Bangladesh's currency is not yet fully convertible. Convertibility is the ease with which a country's currency can be converted into another currency through global exchanges. Bangladesh's taka is a partially convertible currency where convertibility into foreign currencies is very strictly regulated.

With the adoption of the floating exchange regime in 2003, the value of Bangladesh currency taka (BDT) has  been depreciating against  the US dollar (USD), even during the periods when  the US dollar itself has been losing value. 

Keeping in view the state of the global economy at the time of writing this article, it is clearly evident that we are in a  global economic slowdown and fears of recession are looming. The head of the World Trade Organisation (WTO) recently (September 27) said that the world was sliding into a recession due to multiple overlapping crises.  She further added that the repercussions on emerging markets and developing countries would be quite severe. 

A recession may also cause a depreciation in the exchange rate because interest rates usually fall, but this is not always the case. In fact, currencies of emerging markets and developing  economies quite often fall even when interest rates go up. Some of the leading causes for such a depreciation usually include rising inflation, lower export revenues, a surge in imports, central bank intervention, and traders and speculators selling currencies on the market.

As the taka depreciates, one would expect that exports from Bangladesh would become more price competitive stimulating  export growth. But imports would become more expensive and most exports from Bangladesh require imported inputs. Therefore, the gains from price competitiveness, in the face of depreciating taka against the dollar might be offset by increasing imported input costs. 

The depreciating taka could also cause a potential loss of confidence in the Bangladesh economy. Exchange rates are an important way of measuring a country's economic health and a way to assess the suitability of an economy for business expansion. This is why the exchange rate markets are closely watched.

The taka recently devaluated steeply against the US dollar as soaring import payments have created an acute shortage of the dollar in Bangladesh's banking system. 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 floating  exchange rate system. If the exchange rate is under downward pressure, Bangladesh Bank must intervene by selling USD 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 so long as Bangladesh Bank has sufficient international reserves to keep defending it; if not, the peg will collapse. 

It is generally considered that  the BDT still  remains overvalued when viewed in terms of the real effective exchange rate  (REER) despite the fact that BDT has been depreciating in recent times in nominal terms. As volumes of imports and exports are sensitive to the 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.

It is clearly evident that Bangladesh has an underlying structural current account deficit problem caused by high marginal propensity to consume and declining comparative advantage as reflected in the country's deteriorating terms of trade (ToT). More than two thirds of Bangladesh's economic growth come from household consumption (e.g. 69.5 per cent in 2020). This persistently high share of household consumption restricts growth in savings and gross fixed capital formation (GFCF). In fact, a consumer-led economic growth will cause a deterioration in the current account. Higher consumer spending will lead to higher spending on imports.  

Also, now as the US dollar is appreciating leading to the depreciation of the taka likely to lead to have a contractionary effect on the real economy through its negative impact on firms'  investment spending including firms producing non-tradable goods. The depreciating taka will also contribute to higher  inflation as the prices of imported goods and services rise.

Relative changes in export and import prices arising from the depreciation of taka mainly influence demand for tradable goods and services, but it has also implications for non-tradables and import substitutes. The resulting decrease in imports will contribute to increased demand for non-tradables and import substitutes. 

Meanwhile in the face of deteriorating trade balance, the Bangladesh government has introduced measures to restrict imports and also actively intervened in the foreign exchange market by introducing multiple exchange rates such as special exchange rates for expatriates for remittances, imports etc.  

While these measures are likely to reduce trade deficit temporarily, they do not stimulate exports. With rising inflation (9.5 per cent in September relative to 7.48 per cent in July this year), exports have become less competitive. To further compound the problem, as these measure are unlikely to have any impact on underlying inflation, production will shift to more profitable import substitutes as they now benefit from higher domestic prices due to import controls and the economy will become more inward-looking. 

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