Exchange rate management in the Covid-19 era

Exchange rate policy in the context of the Covid-19 crisis draws attention to countries that are excessively dependent on the export of a few goods – such as ready-made garments (RMG) in Bangladesh or energy – and countries that have excessive external debt.

Exchange rate pressure is a signal of underlying economic distress in many countries. With a recent plunge in oil prices – due to low demand for energy products during lockdown measures worldwide – exchange rates of net oil exporting countries, such as Indonesia, Brazil, Australia etc. have depreciated to a great extent. 

These countries as well as those are in dire need of debt service in the months of covid pandemic face extra pressure for foreign exchanges that led to a pressure of depreciation.. On the other hand, the US dollar and Japanese yen appear to be gaining slightly – mainly because of fall in prices of commodity and energy products plus a decrease in demand for investments.

It is now time to see whether the G-3 countries opt to intervene in the market to stabilise the foreign exchange market. Otherwise, this might contribute to a volatile foreign exchange market worldwide in the coming days.

The Covid-19 crisis might have created depreciating pressure on the exchange rate in Bangladesh, too, in the context of sharp decline in exports of RMG products – exports fell by 83 percent year-on-year in April 2020 – to a great extent and drop of remittances to some extent. This might have led to the appreciation of the real effective exchange rate (REER) because of non-adjustment of nominal rates.

Though officially Bangladesh's exchange rate system is freely floating, in reality it maintains almost a fixed rate with a little sporadic movement. The changes in exchange rates of Bangladeshi taka against the US dollar for a three-month moving average was Tk. 0.20 for the last year (July 2019 to June 2020) and was Tk. 0.03 for the last six months (January to June 2020) indicating a very stable currency.

Notwithstanding, the stability in exchange rates has been achieved with active intervention in the Forex market—either by buying or selling dollars or by imposing restrictions on "open positions" of the banks.

Intervention in the foreign exchange market has so far led more to the  'fear of appreciation' than the 'fear of depreciation' – which is mostly related to a mercantilist motive to keep the currency undervalued and foster the competitiveness of exports.

 This policy, however, makes a good balance between exporters' demands and countries' macroeconomic stability. Yet, continuing such a dogmatic policy for quite a long time might lead to the appreciation of the REER and consequent loss of international price competitiveness as is seen in the figure below.

In particular, from January 2019, the appreciation of the REER appeared to be higher than before and warranted more corrections than what had been done.

The context of exchange rate management has now changed due to the Covid-19 crisis. The crisis put a hold on the flow of foreign currency from export sectors and foreign remittances. Though Bangladeshi remitters sent a considerably good amount of remittances during the last quarter (March-June 2020) in the face of risks of losing jobs, particularly in the Middle-east, this phenomenon is thought to be temporary. Overall, these developments might exert depreciating pressure on the Bangladeshi taka.

Bangladesh also received some amount of foreign aid from multilateral donors to support budget deficits and public health measures – which preserves some slack on the external front. The debt-to GDP ratio was 36 percent in 2019 and the IMF projected it to be 41 percent this year due to pandemic expenditures – which is still considered sustainable. However, a good foreign reserve of over $33 billion might act as a cushion against a currency crisis.

There is a high possibility of competitive devaluations globally, especially among our trading partners in the post-Covid-19 recovery phase. The economies globally have used, and will continue to use a combination of interest-rate cuts and extraordinary monetary stimulus to rejuvenate their economy – which will further weaken their currencies.

The move of China and India to weaken their currencies was due amid slowing economic growth, weak consumer prices, and anemic exports. The impact of the devaluation is likely to result in further pressure in many nations for interest-rate cuts and beggar-thy-neighbor devaluations. China and India have made unusually large devaluations to their currencies in the last year and a similar pattern will likely continue to tackle the Covid-19 crisis. As China and India are our important trade partners, we must keep eye on their currency movement.

In the context of apparent competitive devaluations in the coming days, Bangladesh will not have better alternatives than to join the race of competitive devaluations to provide further respite to exporters and cushion for reserves.

The question that remains, how much devaluation will Bangladesh be able to afford? The value addition of RMG products is still not more than 60 percent – implying that drastic depreciation will not bring much benefit to the economy, rather it might generate inflationary pass through effect to domestic prices.

Definitely a free fall is not the right option for Bangladesh, and therefore a certain level of intervention would be necessary. However, at the same time, a judicious sterilisation should be on the cards keeping in mind that various competing risks might propel the economy in the post-Covid-19 period.

In the recovery stage, there is a risk of creating macroeconomic symptoms of irrational exuberance, like accelerating growth coupled with accelerating inflation, a higher budget deficit and gradual overvaluation of the taka. In that upheaval it would be challenging to maintain international competitiveness and domestic macroeconomic stability simultaneously.

A discretionary market intervention policy would be needed not only to handle competitiveness but also to contain domestic inflation and depletion of reserves. The guiding principle of such discretionary policy would be to keep one's eyes on the REER and gradually hit the bulls-eye rather than to wait for a large shock.

While it may not be a good idea for a developing country like Bangladesh to let everything onto the market, it is also not good to keep the exchange rate almost fixed for a long time. There must be reconciliation between these two extremes and alternative policy options must be spelled-out. 

Similarly, more international reserves do not necessarily mean they are better, and a large stockpile should not be mistaken as a sign of economic resilience leaving some room for active interventions. This is given the fact that the volatile growth of remittances, as well as international reserves, in the post-covid era may pose policy challenges for macroeconomic stability.

The current level of reserves, which may cover imports of about six months in normal times, may not be deemed sufficient in the recovery phase. Any thought on the use of international reserves for public investments of any form, that is now at the discussion table, would be counterproductive by fueling inflation and posing risks for managing any currency crisis in the post-covid recovery phase. So, save them for rainy days coming ahead.

This again calls for some pragmatic policies in managing the exchange rate through continuous monitoring of relevant indicators such as the REER and the nominal effective exchange rate (NEER). The rule of thumb for exchange rate stabilisation policies is to make frequent but small adjustments. A decline in global commodity and energy prices might provide a room for moderate depreciation of the taka.

Moderate depreciation will help lean away future big shocks and obviously is expected to provide incentives to exporters and remitters. The bottom line is that considering favorable inflation situations with sluggish investment or aggregate demand, Bangladesh Bank might consider depreciating the taka at a moderate level to adjust a part of the REER appreciation.

To avoid further pressure on exchange rates, the government should try to borrow more in foreign currencies from international financial institutions to service foreign debts. Finally, gradual but small adjustments of exchange rates, in line with the REER and NEER movements, would be the pragmatic way to manage any future currency crisis.

Dr. Monzur Hossain is a Senior Research Fellow of BIDS. He is the editor of the book "Bangladesh's Macroeconomic Policy," published by Palgrave Macmillan in February 2020. He can be reached at [email protected]