The need for depreciation was fueled by rapid foreign reserve accumulation. As of September 2015, Bangladesh’s foreign reserves stand at USD 26 billion from less than USD 10 billion only three years ago. Such rapid reserve accumulation would have appreciated the nominal exchange rate if BB had not relentlessly mopped up excess foreign currency from the interbank exchange market.
However, this policy of keeping the exchange rate stable by removing excess dollars from the market, injects equivalent local currency into the domestic economy. This creates a conflict between exchange rate and price stability targets which BB resolved by undertaking sterilisation operations. BB conducts sterilisation via reverse repo operations by selling BB bills and bonds, which removes the excess money supply. This strategy has ensured that broad money did not exceed monetary programme targets, despite net foreign assets (foreign reserves) drastically exceeding monetary programmed targets the last few years. Notwithstanding this success, a potential depreciation and associated sterilisation raises several challenges for the authorities.
In the latest monetary policy statement, BB’s projection for net foreign assets and by extension, broad money, largely relies on the assumption of import growth outpacing export growth by 8.5 percent – a rate similar to last year’s. However, a depreciation will affect these forecasts as imports become more expensive. Owing to pre-existing trade contracts, it is quite likely that the volume of import will not adjust immediately while the benefits to exporters will appear with a substantial lag. The implication is that trade deficit could worsen in the short-run before improving eventually– this is popularly known as the J-curve effect. In such a scenario, both trade and the current account deficit could exceed the authorities’ monetary policy projections for FY 16, complicating its current financial programming exercise, and by extension monetary management.
The other aspect of foreign exchange intervention – sterilising excess liquidity – poses a major challenge for BB. Due to the high interest rate differential between the rate authorities pay on BB-bills/bonds and the low return they receive on foreign reserves (usually invested in U.S treasury securities), the central bank incurs massive quasi-fiscal costs. Assuming 5-6 percent interest rate differential and that Bangladesh is holding approximately USD 15 billion of reserves in excess of three months’ import payment, cost of holding excess reserves is USD 0.75-0.90 billion (note there are other ways also of calculating this cost). This figure is still on the lower side since rapid reserve accumulation started from 2013, when the interest rate differential was much higher. An artificially orchestrated depreciation will only add to this cost.
Even if we assume that the cost is not substantial, there is always an underlying risk of incomplete sterilisation. Given that BB purchased roughly USD 1.6 billion this fiscal year till September 20, just to keep the exchange rate stable, the absolute amount of intervention necessary to fully turn around an appreciating currency could well be higher than previous years’ USD 4-5 billion dollars. This means the challenge of sterilising excess liquidity escalates for the authorities. Any slowdown in sterilisation activities will translate to widening gap between broad money and private sector credit growth, potentially leading to higher inflation or even asset market bubbles.
Looking at the medium-term, if we assume a sustained pickup in exports, remittance or external borrowing from the private sector, speed of foreign currency inflow could rise. How long can authorities sustain this stance of artificially stabilising the exchange rate while maintaining price stability objectives?
Now, what can authorities do to counter these issues?
First, authorities could consider incorporating the effects of a possible depreciation of around 5 percent on its upcoming monetary programme projections. This is particularly relevant now given that international oil and food price, and by extension, Bangladesh’s import prices have fallen. Meaning, existing estimates of price elasticity of imports may no longer be reliable and the effect of a depreciation on imports may be different from what it was a few years ago. In this regard, readers of BB’s monetary policy statement would like to know the effect on imports, current account and ultimately Balance of Payments brought about by an exogenous shock to the exchange rate. Additionally, it would be interesting to see if there is a J-curve effect with major trading partners given a change in exchange rate.
Second, authorities could time its intervention so that it is fighting less against the appreciating wind. One approach would be to aggressively purchase dollars from the market when an Asian Clearing Union payment intersects with lower inflow of exports and/or remittance. This is expected to create the shortage of foreign currency necessary to trigger a depreciation. Compared to intervening when net foreign currency inflow is following its regular trend, this strategy is expected to reduce the absolute value of intervention necessary to implement a depreciation. By extension, it means lower associated sterilisation costs.
Third, in the event that BB is not able to fully sterilise foreign exchange intervention with sterilisation bills/bonds and this results in persisting inflation or greater levels of excess liquidity in the banking sector, authorities would need to utilize additional tools. Based on the experience of China, India and several other emerging Asian countries in this context, authorities could utilise reserve requirements to soak up excess money supply. However, authorities should not hesitate to re-adjust reserve requirements when credit demand picks up.
While in the short-term, depreciation seems to be the best strategy to revive exports, in the medium term, authorities will need to tackle eroding competitiveness by reducing the inflation differential with major trade partners. Apart from reducing the real effective exchange rate, lower inflation will allow for lower lending rates, encouraging investments and productive imports. Sustained imports will prevent massive appreciation pressures and reduce BB’s cumbersome dual-role of foreign exchange intervention and matching sterilisation.
The writer is currently working as a macroeconomic analyst in Washington D.C.
Source: The Daily Star
