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As a growing economy, Bangladesh is actively involved in international trade and foreign direct investment (FDI). As such, the exchange rate greatly matters to the Bangladesh economy because of its influence on trade and financial flows between Bangladesh and the rest of the world, thus making it an important economic variable.
In a more precise way, changes in the exchange rate affect economic activity and inflation through changes in the relative prices of goods and services produced domestically and overseas, impacting decisions about production and consumption. It also affects the prices of goods and services produced within Bangladesh relative to those produced overseas, thus impacting the balance of payments. Both of these impacts have very far-reaching consequences for the macroeconomic performance of the Bangladesh economy.
An exchange rate is a rate at which one currency is exchanged for another currency (or a group of currencies). The exchange rate of the Bangladesh taka (BDT) against the US dollar (USD) has been depreciating since the last quarter of 2021. A decrease in the value of the BDT is known as depreciation. Currency depreciation can take place for a variety of reasons. Countries with weak economic fundamentals, such as chronic current account deficits and high inflation rates, usually lead to depreciating currencies.
In mid-January this year, Bangladesh Bank (BB) raised the benchmark interest rate by 25 basis points to 6 per cent from 5.75 per cent to contain inflation, but that did not work in the short run as inflation resurged again in the following month, and now in April 2023 it stood at 9.24 per cent (FE, May 4). So to contain inflation BB may push its benchmark rate further up.
Bangladesh Bank is now also overhauling its interest rate policy for commercial banks in line with the IMF recommendation, which will entail the removal of the cap on commercial banks' lending rates.
There are a few factors behind the rising trend of inflation in Bangladesh. They include the price rise of essential consumer items, particularly food and fuel, slow growth in agriculture, rise in world prices, and the sharp depreciation of the taka against the US dollar. In addition, the Russia-Ukraine military conflict has also exacerbated the recent inflationary surge. Also, supply chain disruptions caused by geo-economics fragmentation further added to the problem.
An IMF Blog (April 5) also noted that global economic and financial fragmentation intensified geopolitical tensions. It added that such fragmentations affect global financial stability by affecting cross-border investment, international payment systems and asset prices.
For many households in Bangladesh, rising inflation poses a significant challenge. Rising inflation can erode the value of real wages and savings, making families poorer, thus creating a cost-of-living crisis. To mitigate the cost of living shock, the government's plan to stimulate growth has further added to the depreciation of the taka. Such a plan will also likely raise underlying inflationary pressure and increase public debt. Such a policy is more likely to benefit higher-income households than the overwhelming majority of lower-income households, which are most vulnerable to the inflationary effects as prices of essential goods continue to rise.
The world has experienced significant spikes in food and fuel prices over the last couple of years with severe consequences for Bangladesh, a net food and fuel importing country. In addition, changes in international prices and exchange rates have an impact on food and fuel import prices.
The USD is the main currency that is used in international trade transactions and has been soaring, now up by 15 per cent over the last year, devaluing currencies around the world, including BDT creating an unsettled outlook for the global economy. About 90 per cent of all global foreign exchange transactions, which include trade invoicing, international deposits and loans, are conducted in the USD. However, the principal factor that contributes to the dominance of the UDS in the global economy is the strength of its economy (24 per cent of global GDP) and the depth of its capital markets. Such a rapid appreciation of the USD has been caused by the US Federal Reserve's (the Fed) tightening of its monetary policy to combat rising inflation in the US.
The Fed will likely continue to aggressively pursue its tight monetary policy despite the current banking crisis in the country for the remainder of 2023. Despite the banking crisis over the last two months, Federal Reserve Chairman Jerome Powell again announced another rate hike by 25 basis points on May 3 to rein in inflation. Now the rate hike puts the federal funds rate, the borrowing rate for commercial banks, between 5 per cent to 5.25 per cent, the highest since September 2007.
This tightening of monetary policy by the Fed will continue to cause depreciation of currencies of developing countries like Bangladesh as these countries, including Bangladesh, face capital outflows and rising balance of payments difficulties.
Furthermore, the USD also has been and continues to benefit from its status as a safe-haven currency. The rising fears of a global economic slowdown this year (2023) and a recession in Europe further strengthened its status. Also, many veteran observers of the US economy have commented that this is one of the most uncertain times for the US economy that they have ever seen. Furthermore, a recent statement by the Fed said, "Recent developments (i.e. banking turmoil) are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring and inflation".
A paper published by the Fed in 2021 indicates multiple instances when rising US interest rates have been shown to increase debt burdens, trigger capital outflows and generally cause tightening financial conditions that can lead to financial crises in developing countries.
Bangladesh's currency has been facing downward pressure from the USD since the last quarter of 2021 and has depreciated quite substantially to the tune of 25 per cent since then. The currency has been depreciating at a time when the country also has been experiencing declining foreign exchange reserves and remittances. Despite the depreciation of BDT, there has been no significant improvement in export revenue as expected. Also, high import dependency and a more significant share of dollar-invoiced imports further added to Bangladesh's current economic woes.
Some researchers have pointed out that as the USD appreciates, trading by developing countries becomes more expensive, leading to a decline in their trade volume. This, in turn, more than offset the export-boosting effect of a depreciating currency. According to the Financial Express (May 4), Bangladesh's merchandise exports fell by 16.52 per cent in April this year, largely due to a fall in demand for RMG.
In fact, during the FY 2021-22, Bangladesh recorded a record current account deficit of US$17 billion. Also. the country's trade deficit jumped to a record level of over US$33 billion in the same year due to rising imports. Rising imports and a widening trade deficit also contribute to the depreciation of the BDT.
In the face of deteriorating foreign exchange reserves, Bangladesh sought funds from the IMF amounting to US$4.5 billion. An initial agreement for the loans was reached in November last year.
Declining foreign exchange reserves and shortages of the USD in the open market have made food and fuel imports very difficult for the country, further exacerbating the inflationary pressure. The depreciation of the BDT has already created a severe cost of living crisis for the vast majority of people in the country as prices of daily essentials are rising sharply. The currency's depreciation is now posing Bangladesh's most severe economic challenge. As such, managing the exchange rate regime to help stabilise the BDT is the most urgent task facing the government, along with stabilising the market for daily essentials.
While Bangladesh adopted a floating exchange regime in 2003, it follows a managed floating exchange rate regime. As a result, multiple exchange rates prevail now in the country, such as one for imports, another for exports and another for remittances.
Under such circumstances, the exchange rate is not allowed to adjust. Also, jacking up interest rates by Bangladesh Bank to fight inflation has become less effective, as reflected in resurging inflation in the country, nor has it helped stabilise the BDT. This is simply because exchange rates impact domestic inflation through their effect on tradable prices.
Bangladesh Bank also resorted to restrictions on imports and foreign exchange interventions. Such interventions in the foreign exchange market alter Bangladesh Banks' assets and liabilities in a way that changes its holding of official international reserve assets and the country's money supply unless Bangladesh Bank does something else to neutralise that, i.e., sterilises the impact of its interventions.
But such interventions are no substitute for much wider needed macroeconomic policy adjustments if sustainable macroeconomic stability is to be achieved with the implications for the exchange rate. Therefore, the appropriate policy response under the current circumstances would be to allow the exchange rate to adjust under a freely floating exchange rate regime while using monetary policy instruments to keep inflation at the target range.