Will the crawling peg exchange rate work for Bangladesh?
Countries with forex volatility and economic instability may use this model, between the two extremes of fixed and floating rates, to minimise the effects of economic dislocation, manage inflation expectations, and prevent uncontrolled currency devaluation. But a crawling peg comes with its own set of drawbacks
The Bangladesh Bank (BB) announced a new monetary policy on 15 January 2024 and is set to adopt a crawling peg exchange rate for foreign exchange. Until 2022, the central bank maintained a controlled exchange rate mechanism, allowing currency appreciation and depreciation on a limited scale.
Then, in September 2022, the Bangladesh Bank introduced a multiple exchange rate mechanism instructing the Bangladesh Association of Banks to set different export, import, and remittance rates to control the rapid increase in dollar prices.
This mechanism failed to stabilise the forex market and instead intensified reserve erosion as the dollar selling rate from the reserve was the lowest of the rates. As a result, all commercial banks came to the Bangladesh Bank to buy the dollar from the reserve instead of purchasing from the market, depleting forex reserves faster. On the other hand, the expatriates opted for the secondary market to send their currency, facilitating the illegal transfer of money to other countries.
Amid this situation, the central bank announced the adoption of a market-driven exchange rate regime to promote stability in the foreign exchange market, especially to satisfy the IMF team while negotiating the loans. But they have changed their mind. On 9 December 2023, the Bangladesh Bank governor ruled out the possibility of adopting a floating exchange rate and suggested the potential introduction of a new mechanism — crawling peg.
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A crawling peg allows the currency to fluctuate between an upper and lower band. Under the new policy, there will be a narrow band corridor where the real effective exchange rate (REER) stands in the middle. The corridor will have an upper ceiling and floor rate, and the exchange rate will move within the bounds.
A crawling peg involves a central bank undertaking a public obligation to maintain its country's exchange rate within a comprehensive, publicly announced band around a parity that is periodically adjusted in relatively small steps in a way intended to keep the band in line with the fundamentals. The authorities believe that the system will reduce the forex-market volatility and bring stability to the exchange rate, ensuring transparency.
A crawling peg exchange rate belongs to a fixed exchange rate mechanism but allows the selected domestic currency to fluctuate between controlled upper and lower bands. Countries with forex volatility and economic instability may use this combination of a fixed and floating rate model to minimise the effects of economic dislocation, manage inflation expectations, and prevent uncontrolled currency devaluation. It is challenging for the bureaucratic-led Bangladesh Bank to make quick and effective decisions on time.
The International Monetary Fund (IMF) has agreed to support the system. However, the Bangladesh authorities promised on several occasions to introduce a market-based floating system but over and again, changed that decision. A technical team of the IMF will be visiting Dhaka soon for capacity development to implement the crawling peg-based exchange regime.
After a central bank establishes a par value for the currency peg, it computes an upper and lower band, allowing its currency to fluctuate in a controlled environment. The central bank may adjust the par value and currency bands to reflect changing economic or market conditions.
Two types of crawling pegs exist in practice, active and passive, depending on what central banks use a crawling peg to achieve. In an active crawling peg, the central bank will announce its upper and lower bands and maintain the peg via buying and selling in the forex market in small steps, attempting to manipulate inflation expectations. With a passive crawling peg, each adjustment remains coincidental, usually tied to inflation rate changes, announced monthly or bi-monthly in some countries. The primary goal is to preserve foreign currency reserves.
The crawling peg system has many risks such as: creating artificial exchange rates; increasing the risk of speculators, forex traders, and market forces, which may crush the mechanism to prevent destabilisation of currencies; and draining foreign exchange reserves amid central bank interventions and manipulations through active crawling pegs.
Only Nicaragua and Vietnam employ the crawling peg system, while China has adopted a variation, often termed a 'delayed peg'. In the past, countries like Botswana, Argentina, Ecuador, Uruguay, and Costa Rica experimented with crawling pegs but later abandoned them.
The experience of other countries is alarming. The currencies of East Asian countries were more or less pegged to the US dollar in the mid-1990s. When the dollar collapsed in 1995, their effective exchange rates depreciated, and they became hyper-competitive on world markets, sparking an export boom despite the Chinese devaluation of the preceding year.
But when the dollar recovered in the summer of 1995 and continued to strengthen after that, they suddenly found that their competitive position was eroding, export growth slowed accordingly, and within two years, their seemingly impregnable economies had gone into crisis due to the underlying weaknesses in their banking systems that were exposed by the crisis.
It seems clear that the actual policy of de facto pegging to the dollar was a contributory cause of the East Asian meltdown of 1997. For example, the failed peg harmed economies in 1997, when Thailand used all its currency reserves to defend the Thai Baht, resulting in an unpegging to the US Dollar, leading up to the Asian Financial Crisis of 1997 amid contagion that forced currency devaluations across Southeast Asia and a global financial market sell-off.
An adequately introduced crawling peg reduces excessive forex rate fluctuations, enabling better planning for businesses and investors. It provides a tool for managing inflation expectations, contributing to price stability and economic growth if the pegged currency remains stable. Developing and emerging economies will peg their domestic currency to a foreign one, usually the US Dollar or the Euro.
But a crawling peg remains vulnerable to speculation as it presents an artificial exchange rate and depends on central bank currency manipulation and management. In comparison, it may provide a temporary solution to a problem.
The crawling peg may be preliminary before transitioning into a floating exchange rate mechanism. We would welcome the upcoming crawling peg to move towards a market-centric rating aimed at reducing volatility on the forex market if the Bangladesh Bank courts IMF-recommended reforms for open market policy.
M S Siddiqui is a Non-Government Adviser at the Bangladesh Competition Commission.
Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.
