Buy or sell dollars: what should we do?
The US Dollar has now breached the 100 Tk mark and Bangladesh Bank is taking contradictory action to deal with the situation. Earlier, it sold $7.62 billion of reserves to protect the taka’s value. More recently, the government requested $4.5 billion from the International Monetary Fund (IMF) and $1 billion from the World Bank to replenish foreign currency reserves. Similarly, after failing to shore up the taka even by selling reserve dollars, the central bank apparently decided to let the dollar rate be set by the market. However, according to news reports, he again tried to stop the devaluation of the taka by fixing the rate at which banks can buy or sell dollars.
The sudden appreciation of the dollar can certainly be disconcerting. However, much of its cause is rooted in past failures to adjust the taka’s exchange value in a timely manner. For a long time, Bangladesh let the taka be overvalued. The average annual inflation rate in the United States and Bangladesh during the decade 2012-2021 was 1.88% and 6.05%, respectively, implying a difference of 4.17 percentage points. Yet the dollar exchange rate has fallen from Tk 79.1 in 2012 to just Tk 84.8 in 2021, suggesting an average annual increase of less than 0.7%. Although relative movements in the prices of tradable goods and services may provide a more accurate anchor, it is clear that the adjustment in the value of the taka has remained well below what was needed. It can be noted that neighboring India has devalued its currency several times over the past decade. The strong growth in remittances and exports during these years helped Bangladesh ignore the need for this adjustment. However, the combination of a sharp increase in the import bill and a drop in remittances has now highlighted the accumulated adverse consequences of an overvalued taka.
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One has the impression that the devaluation of a country’s currency reflects the deterioration of its economy. This is not necessarily the case. The exchange rate mainly depends on the inflation rates in the economies in question, and a country can do well even if it has a relatively higher inflation rate. Moreover, the absolute value of the currency does not reflect the strength of a country’s economy. For example, on July 12, 2022, one dollar was equivalent to 137 Japanese yen and 1,934 Italian lira. This does not mean that the Japanese and Italian economies are worse than that of Bangladesh. What is important is to ensure that the exchange rate reflects the price levels in the countries in question.
Generally speaking, the overvalued taka was expected to dampen exports and boost imports. The intriguing political-economic question is why exporters did not exert enough pressure to correct the overvaluation. Government policy of offering cash incentives to exporters could be one answer. RMG exporters still account for around 80% of Bangladesh’s total exports, and they have been receiving cash incentives since their emergence. They also benefit from lower corporate tax rates. Given this generous support, RMG exporters probably had little to fault the overvalued currency. In prosperous East Asian countries, privileges granted to export-oriented industries were always time-limited and usually expired after a decade. In contrast, the privileges enjoyed by the RMG sector in Bangladesh have become a permanent feature of the landscape.
The other social group that was affected by the overvalued taka were the remittance senders. Unlike RMG exporters, they are a diffuse group, with a relatively small per capita gain from the overvaluation correction, and therefore have not been able to mount collective action. However, they expressed their displeasure by sending more money through informal channels. The government tried to counteract this trend, again, with a cash incentive policy, this time directed at remittance senders.
However, targeted cash incentive policies are generally ineffective compared to the universal policy of correct currency valuation. Targeted policies often create distortions and lead to unwarranted behavior. For example, it is widely believed that cash incentives given for remittances have led to the recycling of dollars (sent via hundi, to be brought back through official channels) to collect the cash incentives. Similarly, cash incentives on exports appear to have given rise to a perpetual reliance on government largesse, rent seeking, and an inability to argue for a higher exchange rate policy. rational.
The policy of targeted monetary incentives is harmful for at least three other reasons. First, it is discriminatory, as not all exporters benefit from cash incentive programs, and an overvalued currency makes it more difficult for potential new exporters to proliferate. Second, cash incentive programs create an additional burden on the budget. Third, the overvalued currency creates unreasonable pressure on imports.
Of course, the forced and somewhat sudden correction of the overvalued taka, as is happening now, creates the problem of imported inflation. However, artificially trying to protect the high taka value is not the answer. The earlier sale of $7.62 billion of reserves was a misguided move and proved futile. Similarly, the idea of borrowing from the IMF and the World Bank to replenish reserves is also not justified. Taking additional loans is not the solution.
In the short term, the first task is to allow a correction of the overvaluation to occur. This correction needs to be sustained, rather than a one-off affair. Second, it is necessary to recognize the potential benefits of forced devaluation. This can boost exports and remittances and curb imports – which are needed now. Instead of cash incentives which create a fiscal burden and can be misused, other creative measures should be devised to encourage remittances through formal channels. The government has already taken administrative measures to contain imports. These must be implemented effectively. Third, there is a need to consider removing or relaxing the interest rate cap to curb import demand. Fourth, taxes and duties on imports must be revised to maintain the importation of essential inputs. Fifthly, subsidies must be granted to offset the imported inflation of particular products and for the most deserving categories of the population.
In the medium term, sector management must be improved. This is particularly the case of the energy sector, which has become the main applicant for foreign exchange and subsidies, to such an extent that it now threatens our balance of payments and our macroeconomic stability. Similarly, once the overvaluation is corrected, it should be possible to phase out cash incentives for the RMG sector and ease the fiscal burden. So, with a little creativity, the current crisis can also be used to better balance the economy.
Dr S Nazrul Islam is a visiting professor at the Asian Growth Research Institute (AGI) in Japan.