Moving sideways on reforming exchange rate management
Another multiple exchange rate system is emerging after months of deliberations between the Bangladesh Foreign Exchange Dealers Association (Bafeda), the Association of Bankers, Bangladesh (ABB), and the Bangladesh Bank. It is dominated by discriminatory exchange rate ceilings set at levels closer to reality. The new arrangement can work in good times, but boomerang in stressed times such as the present.
Dealer Associations batting for the regulator
Bafeda and the ABB have set maximum buying rates and prescribed a formula for maximum selling rates. The regulatory arrangement looks like a foreign exchange dealers' cartel organised at the behest of the BB. "The central bank instructed us to determine the exchange rate for the banking sector after reviewing the overall forex market. We have made the decision accordingly," said the ABB president.
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The role of these organisations has transformed. Originally, their goals were to create awareness and recognition of forex dealers and their views on enforcement of regulation in the industry. The ABB, a platform of bankers, generally performs an ideation and communication role. Development of an orderly inter-bank foreign exchange market was the raison d'être creating Bafeda. The interbank market has been in a coma for months.
The ABB and Bafeda are on a call of collective duty to revive the interbank market. Treasury heads of banks have started reporting their weighted average cost to Bafeda daily which, in turn, has started posting it on their website along with the industry average that will be the reference rate for revaluation purposes.
Endowing dealers with cartel-like market power has to do a lot more with the failures of recent BB attempts to repress the exchange rates through jawboning and policing. The price setting function appropriated from competitive market forces is delegated to a platform representing the corporate management of the dealer banks.
A plethora of ceilings
Exporters and remitters sending money directly to banks can get a maximum Tk99 per USD. Authorised dealer banks cannot offer more than Tk108 for remittances through exchange houses, including banks' own. The rate charged for selling USD is a weighted average of the maximum rates and the rate on dollars bought from the interbank market, calculated on a rolling five-day period, plus Tk1.
Each bank faces a different ceiling. Banks with a higher share of export dollars face a lower selling rate ceiling than banks with a lower share. There are as many selling rate ceilings as the 56 authorised dealers with presumably wider variation than used to be the case before the recent tremor. On 14 September, the lowest average buying cost was reported at Tk99 and the highest at Tk111.49. The lower and upper bounds should soon converge towards Tk99 and Tk108 respectively.
The five-day rolling average would behave like a creeping float when the ceilings are binding. Unlike clean floats where no ceilings or pricing formula dictates market rates, this one will only reflect changing shares of export and remittances in daily supply of foreign exchange and variations within the Tk1 spread. The structure of the exchange rates is anchored on three policy parameters: the maximum export rate, the maximum exchange house rate, and a spread with limited variability.
The ceilings on exports and exchange houses are currently binding which imply binding ceilings on the import rates. During 13-15 September, the industry average cost ranged between Tk103.14 and Tk103.35. These translate to an average LC ceiling ranging approximately between Tk104.14 and Tk104.35. LC settlement rates were above Tk105 in recent months.
Expected behaviour of the exchange rates
The market is bifurcated into export, exchange house and import segments, each with its own exchange rate that can float below the prescribed maximum.
The industry average import rate will vary directly with the share of remittance and inversely with the share of exports in the total foreign exchange supply within the Tk100 to Tk109 range. Any excess demand at the ceiling rate structure will require non-price rationing while any excess supply will be corrected by the downward flexibility of the buying rates.
Interbank rate will be determined by supply and demand in the interbank market absent any BB intervention. The market seems to have started to breathe a little with the BB refraining from imposing its rate on trade between banks since 12 September. At what rate is the convergence between supply and demand likely in the interbank market?
This must be the rate where banks are indifferent between buying and selling. If the gain from buying at the prevailing interbank rate exceeds the gains from selling, excess demand will push the rate up. Conversely, if the gain from selling exceeds the gains from buying, excess supply will push the rate down. The equilibrium must therefore be at the rate where the gain from buying equals the gain from selling.
Let x equal the exchange house (the highest cost) rate, y equal the export (the lowest cost) rate and z equal the interbank rate. You gain by buying from the interbank market if the interbank rate is lower than the exchange house rate (x > z or x - z > 0). You gain from selling in the interbank market if the interbank rate is higher than the export rate plus the spread (s) you could get by selling the export dollar to the importers (z > y + s or z - y - s > 0).
To be indifferent, the gains from buying must equal the gains from selling i.e. x - z = z - y - s. Since the x, y and s are given by policy, the only unknown in this equation is z which equals (x + y + s)/2; essentially a constant. With x = 108, y = 99, and s = 1, the competitive equilibrium interbank rate is Tk104.
This is the proximate rate around which the interbank rate is likely to gravitate when it fully recovers from months of inactivity and contestability. Any other rate implies the existence of unrealised gains from trade – a hallmark of market inefficiency. Unless the policy parameters change, the equilibrium interbank rate will move only decimally as long as the aggregate availability of foreign exchange remains tight.
Likely consequences under stressed conditions
Assuming the new arrangement survives, economic reasoning suggests different consequences depending on whether the market is in a good state or a bad state such as the present. In a good state, meaning an excess supply of foreign exchange, downward flexibility in all rates will allow the incentive distorting rate divergences to diminish as the dependence on exchange house dollars declines. The problem is in bad times when the ceilings are binding, and the USD is on steroids.
These problems have little to do with the dampening of GDP measured in USD due to a higher BB rate. GDP is what it is. The higher reference rate has no implications for inflation either because inflation depends on the rates at which transactions involving foreign exchange are settled, not the BB rate.
The excess of import over the export rate increases the pre-existing anti-export bias. For instance, with a maximum Tk99 per USD on exports and, let's say, Tk105 for imports on average, domestic producers will prefer selling in the export market only if the export price is 6.1% higher than the domestic price, other things equal. The rate of this tax on exports varies directly with the remittance intensity of foreign exchange supply up to a maximum 10.1% implied by the Tk109 implicit import rate ceiling.
The higher import rate hits the pockets of the non-privileged exporters on the cost side as well. Exporters without access to the back-to-back Letter of Credit or the Export Development Fund will have to pay the import rate of their bank. The effective rate of "tax" on these exporters varies directly with the import share of their own exports in addition to the remittance intensity of their banks.
The returns from under invoicing exports and over invoicing imports are stronger. Repatriating export proceeds as remittances through the exchange houses yields a hefty Tk11.7 per USD (including the 2.5% subsidy on remittances). This is large enough to even justify forgoing cash subsidies, particularly where subsidies are low. There may also be roundtripping of money by over-invoicing imports financed at below industry average exchange rate of export intensive banks.
Effective enforcement of a ceiling on the rate offered to the exchange houses could reduce their markups. However, the exchange houses could pass back the incidence of the ceiling to the remitters who then may turn more towards informal channels.
All of the above effects could deepen the foreign exchange shortage. In addition, the government may lose revenue from the source tax on exports and pay higher subsidies on remittances boosted by under invoiced export earnings repatriation and roundtripping of over-invoiced import dollars. The adage "when in a hole, do not dig further" is very relevant here.
Can't avoid the unavoidable
The upward rigidity in the buying and selling rates will be tested going forward. Large current account deficits may not moderate enough, foreign correspondent banks are tightening financing terms and offers, the 3% cap on all-in cost for short-term permissible trade finance in foreign exchange is likely to bite and the outstanding $19.2 billion short-term foreign currency debt (as on end-March 2022) could face rollover difficulties.
An initially more painful but eventually more efficient mechanism for dealing with such pressures is to float without encumbrance. When you have already used $10.5 billion reserves in the last 14 months to defend the Tk95 rate, it is difficult to convince market players there is a defendable path. The volatility accompanying floating is predominantly a manifestation of the incompatibility of the interest rate and fiscal policies, apart from the lack of credibility of de jure exchange rate policy which encourages self-fulfilling speculation.
Zahid Hussain is former lead economist of World Bank Dhaka office.
