Flexible exchange rate can resolve the ongoing reserves crisis

Md. Tawhidul Islam & Kazi Nazifa Dilruba :

Bangladesh Bank has been struggling to maintain a healthy US dollar reserve for quite some time now.

As of November, the reserve stands at somewhere between 19 to 24 billion dollars according to reports from Bangladesh Bank.

Governor Abdur Rouf Talukder describes the current situation to be rock bottom for the country and adds the country has not been in a worse economic condition in the past 36 years. Several critical measures are being taken to improve our reserve.

Import restrictions are being implemented due to the shortage of dollars in Bangladesh Bank. The rigid exchange rate policy is one of the main reasons responsible for the current reserve crisis.

Adopting a more flexible exchange rate as suggested by the IMF can help to deal with the current crisis.

The perfect time to make the transition from fixed to flexible is when the economy is in good condition, which for Bangladesh was during the Covid-19 period. When the world was hit with a global pandemic, the country had reserves up to 48 billion dollars.

The reserve counted for 40 billion dollars without the EDF fund. More was being exported than imported and dollar inflow through remittance was at its peak.

Unfortunately, not much was done to bring about the required transition in the exchange rate regime when the time was appropriate.

The reserve crisis we are facing today is a result of several policies, practices and world events coinciding.

The rigid exchange rate policy followed by Bangladesh Bank artificially appreciating taka against dollar triggered the practice of transferring money through hundi.

Remittance sent through hundi has made the situation worse as individuals find it more beneficial to send money through informal agencies than through official banking channels.

Moreover, the malpractice of over invoicing and under invoicing in trade has led to a deficit in the US dollar reserve.

Following the approval of the second installment of a US$681 million loan, the IMF has revised its target. According to the new conditions, the minimum net International reserve (NIR) in the central bank has to be US$17.78 by December.

By March, the reserve is expected to rise to US$19.26 billion. Given the current reserve amount in the Bangladesh Bank, it might be challenging to achieve these targets. However, with proper implementation of policies, these newly set NIR targets can be met.

Bringing flexibility in exchange rate towards the open market rate is the key to combat the current reserve crisis. It would lower the amount of remittance money transacted through hundi and increase the US Dollar reserve in Bangladesh Bank.

However, given the current economic condition, it would be very difficult for the Bangladesh economy to make the transition as it is not well prepared to absorb the hit from the sudden spike in dollar rate against taka. Regardless, the transition has to be made soon even if the cost is high in order to save the country from a worse situation.

While the transition might worsen the economic condition of Bangladesh in the short run, the policy makers should aim to make smooth the transition process to ensure having to bear a minimum cost for this change. The country can proceed towards flexibility in the exchange rate either rapidly or gradually.

Given the current economic condition, rapid transition is not an ideal solution for the country. It risks coming with a high level of cost, especially in terms of inflation through the depreciation of taka. A robust economy would be able to absorb such shock and make the transition with lesser repercussions.

A gradual, step-by-step change might be the more suitable option for us and have less of a toll on our economy. First, the central bank can set one or two nominal anchors to specify the objective. Given securing the desired amount of dollar reserve is the first priority, setting the exchange rate as the primary target and inflation rate as the secondary target can be a reasonable strategy moving forward. Inflation is also likely to come down when a stable market based exchange rate is established.

It is important to keep in mind that before the gradual approach is implemented, preparation must be taken to deal with the possible consequences in the future. Autonomy of the central bank, forecasting the inflation rate and ensuring transparency are some of the important considerations that are going to make the transition easier.

Gradual approach prevents the authorities from taking drastic measures. In this approach, a fixed range can be set under which the currency can float freely and then slowly and gradually broaden the range based on the condition of the economy.

In order to minimize the risk, a basket of currency can be pegged to taka to reduce the exposure from external shocks. Additionally, disclosing information with regards to changes in the exchange rate policy is vital for restoring confidence in the economy. It will allow people to make informed decisions by reducing the uncertainty.

Md. Tawhidul Islam and Kazi Nazifa Dilruba are students of economics at East West University.