Cenbank signals more flexible exchange rate, monetary policy tightening

The central bank hinted that it would go for further flexibility of exchange rate after introducing the crawling peg system in May this year, a move that will allow the value of the taka to fluctuate more freely in response to market forces, such as supply and demand, rather than being tightly controlled or pegged to another currency.

Bangladesh assured this to the managing director of the International Monetary Fund (IMF) through a letter signed by Finance Minister Abdul Hassan Mahmood Ali and Bangladesh Bank Governor Abdur Rouf Talukder on 4 June. The IMF attached the letter to its second review report under the Extended Credit Facility arrangement disclosed on 25 June.

In the letter, Bangladesh said it would gradually expand the band to increase exchange rate flexibility and prevent excessive depletion of foreign exchange reserves.

Bangladesh also pledged to tighten monetary policy further to address persistent inflationary pressures.

On 24 June, despite missing the net international reserves ceiling and revenue target, the IMF approved releasing $1.15 billion as the third tranche of Bangladesh's $4.7 billion loan package. The funds are expected to be disbursed within two days.

On 8 May, the Bangladesh Bank introduced the crawling peg exchange rate system, marking the largest single-day devaluation of the taka, raising the dollar price from Tk110 to Tk117.

The mid-rate for the crawling peg was fixed at Tk117 initially and has remained unchanged despite the current average market rate of the dollar being above Tk118.

The governor's commitment suggests that further devaluation of the taka could be expected in the coming period.

In its review report, the IMF said the Bangladesh Bank was given a waiver for maintaining the net reserve target set for December 2023 based on the two corrective actions – the appropriate realignment of the exchange rate and operationalisation of the new exchange rate arrangement; and the authorities' commitment to a tighter policy mix to counter inflation.

The Bangladesh Bank failed to meet the net reserve target of $17.7 billion set for December when the actual net reserve was $16.7 billion, according to the IMF report.

The IMF also revised down the net reserve ceiling for June this year to $14.78 billion from an earlier target of $20.1 billion.

In April this year, net reserves fell to $12.8 billion, down from $19.6 billion at the end of June 2023, according to the IMF review report.

"Reserve coverage is currently below the threshold of 3 months of prospective imports, but it is expected to stabilise around four months of coverage in the medium term," said IMF.

"Despite this difficult environment, our program implementation has been broadly on track. We have successfully met all quantitative targets, except for the performance criteria (PC) on net international reserves (NIR)," said the governor in the letter.

"The underperformance in NIR reflects challenging external conditions, including continued global monetary tightening and larger-than-expected spillovers into Bangladesh, and heightened economic uncertainties," he said.

"To address elevated inflation and falling FX reserves, we have realigned the exchange rate to the market-clearing level and simultaneously adopted a crawling peg with a band system as a transitional step toward greater exchange rate flexibility in line with the IMF recommendations," said the governor.

"We have also prepared measures to further safeguard FX reserves buffer with the IMF assistance. We have also adopted a mechanism of readjusting (shifting) the band to allow for additional exchange rate flexibility and to prevent excessive loss of FX reserves. In addition, we are committed to further tightening the monetary policy stance and recalibrating fiscal policy to support monetary tightening," according to the letter.

The IMF in its report said that exchange rate policy should focus on ensuring the smooth functioning of the new exchange rate regime. Restoring the proper functioning of the interbank FX market is critical to ensure the success of the new exchange rate arrangement. 

In the near term, the Bangladesh Bank should also steadfastly adhere to the mechanism of readjusting (shifting) the band to avoid excessive depletion of FX reserves, according to the IMF. 

Over time, the parameters of the new regime should be periodically reviewed to ensure that the rate of the crawl is consistent with the monetary policy settings and the band is gradually widened to allow for greater exchange rate flexibility. The impact of the recent exchange rate reform on the banking sector is anticipated to be minimal, said the IMF in its report.

Banks' balance sheets are relatively protected from fluctuations in exchange rates as the Bangladesh Bank regulation mandates banks to maintain their net open position (NOP) at a maximum of 15% of their regulatory capital.

At the end of September 2023, the aggregate NOPs amounted to 9% of the aggregate regulatory capital, and among the 61 banks, only 13 exhibited small negative NOPs.

Recent stress tests conducted by the central bank indicate that a depreciation of the taka by 10% would not cause any banks to fall short of the regulatory capital requirements, according to the IMF report.

IMF estimates a peak policy rate of 9%

Monetary policy should continue to focus on addressing internal imbalances. Still elevated inflation and inflation expectations will require continued monetary policy tightening until inflation consistently slows down to the Bangladesh Bank's medium-term target range of 5-6%, according to the IMF report.

According to IMF estimates, the policy rate may need to increase to a peak of 9% from the current 8.5% currently by mid-FY25 to tame inflation to 7% by end-FY25 and bring it close to 5.5 by end-FY26. The elimination of the SMART benchmark rate for retail interest rates will enhance the effectiveness of monetary policy transmission