Time to exit the failed experiment

Bangladesh's experiment in exchange rate management since September last carries a classic textbook lesson for students of macroeconomic management in an open economy. Flirting with heterodox exchange rate policies when reserves are woefully inadequate, access to financing is limited and the informal channels are agile can cause tremendous disruptions to foreign exchange availability and hence the economy. 

Theories aside, the choice essentially is a "managed" or "fixed" float. Exchange rate in a managed float is determined by market forces subject to central bank forward guidance backed up by foreign exchange reserves to engage in forex buying and selling. A designated authority sets and adjusts the exchange rate from time to time in a fixed float as has been the case in Bangladesh since mid-September 2022.

A mess we did not need

BB could not maintain a certain exchange rate level or even influence the exchange rate movements when push came to shove last year. So it devised the so called beyond the textbook model by making the Bangladesh Association of Foreign Exchange Dealers (BAFEDA) and the Association of Bankers Bangladesh (ABB) jointly set widely different buying rate ceilings for exports and remittances well below market. As diversion to informal channels flourished, BB ramped up interventions right, left and center. BAFEDA-ABB rates crawled up and the difference between the export rate and the remittance rate narrowed as shortages emerged in the formal system. 

BB wanted to tame inflation by curbing deprecations pressures. But the unintended consequences overwhelmed its noble aspirations. Forex shortages deepened, disrupting the economy in all spheres. While reluctant to admit the failed experiment, BB aspires to switch back to a market-based regime from the third quarter of 2023, starting with the unification of the BB rate with the interbank rate from 1 July. 

This has been misunderstood by many, including Bloomberg, as free float. Not even close. The move towards a full unification of rates will hopefully transpire by end-September as BB instructs BAFEDA-ABB to further narrow the arbitrary differential between the export and remittance rates. The extent to which it will let the rates float is something even the IMF does not appear to have any clue despite having a program. 

As the recent Bangladesh experience shows, rate volatility that always hit headlines is one side of the foreign exchange coin. The other side is volatility in forex trade volume resulting from fixing the rates arbitrarily. This other side has become painfully vivid more than ever before in the last twelve months. Yet there is the fear that letting the caps go will lead to chaotic and manipulated market rates. The volatility in quantity is attributed to external conditions, not arbitrary rate fixing! 

The downsides to rate volatility are contingent on the quantities supplied and demanded clearing over time at the fixed rate. That does not happen with misaligned administered rates and segmented markets with porous lines of formality. When formal market rates are overvalued, quantities shift to the informal, thus cramping international transactions through the formal channels.

Let the record speak

Excessive rate volatility has been rare in Bangladesh's history of a managed float. Exchange rate fluctuations across periods is a good heuristic to gauge volatility. There is hardly any period in the history of weekly and monthly averages of the interbank exchange rate since May 2003 (when BB ended fixing exchange rate) that stands out as an "excessively" volatile period. 

Market determination of exchange rates weathered political instability in 2006, natural disasters in 2009, the global financial crisis followed by food and energy price hikes in 2008-09, political instability again in 2013-15, and the pandemic in 2021. The exchange rate stood its ground with reserves accumulating from $10.3 billion in FY12 to over $46 billion at the end of FY21 helped by over a decade of sustained current account surplus until FY17 and growing financial account surplus from FY18 onwards. The exchange rate appreciated from Tk79.2/USD in FY12 to Tk77.7 in FY15 before depreciating to Tk84.8 by FY21. 

All hell broke loose ever since. Fearing volatility, BB stuck to the other extreme of "excessive smoothing". The US Dollar Index increased from a low of 96.3 in mid-January 2022 to a 20 year high of 114 in late September 2022. The dollar appreciated 18%. This was a year when the dollar strengthened against nearly every other major currency to levels not seen in decades. The taka-US dollar rate during the same period depreciated 15.2%, notably below the 18% catch-up rate. In 2020 and 2021 the exchange rate remained flat at around Tk84.8.

The unraveling of a slippery slope

The seeds of stress began unraveling slowly but surely from FY18. The current account deficit spiked to over $9.5 billion in FY18 following a deficit of $1.3 billion the previous year. After declining to $4.5 billion in FY19, the current account deficit peaked to an all-time high of $18.9 billion in FY22, a year in which the overall balance of payment deficit ballooned to $5.3 billion. 

As pressures on reserves mounted with BB relentlessly defending throughout FY22, the interbank average jumped from Tk87.1/$ in May to Tk95 in August. BB stumbled between imposing interbank market rate, market policing, firing several treasury officials of dealer banks before getting the authorized dealers preannounce differentiated rates. This public private partnership repressed the forex market deep down from which it is yet to recover.

Meanwhile, the financial account turned into deficit for the first time since FY11 but never over $2 billion as during July-April FY23. The size of the unaccounted outflows reached an all-time high of $3.1 billion in July-April this fiscal year, compared with $1.9 billion outflow during the same period last year. Both of these topped the previous high of $1.5 billion in July-January FY12. The rise in financial account deficit and unaccounted outflows led to the highest ever $8.8 billion overall BOP deficit in July-April FY23. 

The institutional weakness revealed in the process of handling the crisis and payment deferrals eroded confidence leading to difficulties in rolling over short term debt already hamstrung by regulatory caps on all-in costs of borrowing offshore. The underpricing of export dollars boosted deferral of export earnings repatriation. The "errors and omissions" spike in the negative zone has been sharp and persistent since December 2022, unlike ever before. 

The challenge of a fixed float in the presence of large security seeking and speculative capital flows is evident from this experience. BB dictations created a false sense of security and encouraged, albeit unintentionally, speculative one-sided bets. The expectation that more increases are on cards found self-fulfillment. 

Protecting reserves and capping the exchange rate when BOP deficits are persistent is an impossible duality. Parallel exchange markets feast on caps not supported by the supply of foreign exchange to meet demand for current account transactions. The digitized and word-of-mouth informal exchanges are beyond the regulatory ambit. The ones the regulator can reach – the kerb market – flee when BB inspectors raid.

The manipulability of forex markets

The apprehension that allowing the market to have the decisive influence on the setting of exchange rates risks oscillations and overshooting due to market manipulation is more popular than the reality warrants. The inherently global foreign exchange markets, made up of many different currency pair markets, are the largest and most liquid of all the financial markets. Participants in these markets buy, sell, exchange, and speculate 24/7. Beyond trade and investment requirements, foreign exchange is bought and sold for risk management, arbitrage, and speculative gain. Financial flows are a key determinant of exchange rates in the short run. Interest rate differentials move yield-driven capital but there may be many other drivers over space and time. 

Currency markets are vulnerable to speculation, herd behavior, sticky dollar prices (due to dollar invoicing) and irrational mood swings. But they are not easy to manipulate. Traders can of course change the value of a currency to profit from confidential information about something about to happen that could change prices. Collusion can be "active", with traders speaking to each other, or "implicit" where traders are aware of what other people in the market are itching to do. Such happenings are rare. 

It is easier to move prices if several market participants work together. The price movements arising from the manipulation are empirically small. The biggest losers are companies found guilty of manipulation when regulators do not come to rescue them. Without regulatory connections, the manipulators find it hard to survive in markets with near instantaneous contestability. Market manipulation of the kind reported in rice, wheat, onion, edible oil, sugar for instance have no parallels in currency markets.

Recognizing reality

In fact, the currency markets are often held to be an ongoing referendum on government policy decisions and the health of the economy. Markets vote with their feet and exit a currency when they feel uncomfortable with the policy. 

The price levels in the economy typically reflect the substantial and sustained spread between the official and parallel rates. Allowing market participants in such circumstances to use a market clearing rate benefits economic activity without necessarily leading to more inflation if fiscal and monetary policies are supportive (IMF, Recognizing Reality, 2021). 

Policymakers must adjust early and quickly, especially in smaller countries that "aren't anchors of the international system". This advice from Stanley Fischer, a former IMF Chief Economist and the US Federal Reserve Vice Chairman, is like a lighthouse that can guide policy makers, especially central bankers, through the stormy seas.

Zahid Hussain, former lead economist, World Bank's Dhaka office.