Adopt market-driven US dollar exchange rate

Following the advice of the International Monetary Fund (IMF), the Bangladesh Bank has taken the initiative to set the exchange rate of the US dollar based on market principles. However, the Bangladesh Bank is not yet fully leaving the determination of the exchange rate of the US dollar to the market. It is still retaining some control over the exchange rate. Through a notification issued by the Bangladesh Bank, the new system for determining the exchange rate of the US dollar is being implemented starting this January. This new method for setting the exchange rate of the US dollar can be described as a advanced step towards the currently prevalent 'crawling peg' system. Under the crawling peg system, a reference rate would be set for the exchange rates of the US dollar and other foreign currencies. Scheduled banks and authorized institutions engaged in foreign exchange transactions would then set the exchange rate by adding or subtracting one taka from the rate set by the Bangladesh Bank. For example, if the exchange rate for one US dollar is set at 117 taka, the market would follow that base rate with minor adjustments.

Scheduled banks and institutions engaged in foreign exchange transactions would add one taka to the set rate of 117 taka for each US dollar, making it 118 taka, or deduct one taka, selling the dollar at 116 taka. The new system for foreign exchange transactions that has been introduced is similar to the crawling peg system. However, the difference is that under the crawling peg system, once the exchange rate for foreign currencies was set, it would remain in effect for a period of time. The Bangladesh Bank’s set rate would be followed until further instructions were given. In contrast, under the new system being implemented, the Bangladesh Bank will determine the exchange rate for foreign currency every working day by noon, based on the rates received from various scheduled banks and foreign exchange institutions. A reference value will be set, and transactions will be advised accordingly. If any scheduled bank or institution involved in foreign exchange transactions buys or sells foreign currency at a rate higher than the rate determined by the Bangladesh Bank, the institution will face penalties. These penalties can range from one million taka to 5 per cent of the total transaction amount.

Under the new rules, the reference rate or middle rate for one US dollar will be 119 taka. Institutions purchasing US dollars earned through remittances or export earnings can buy them at 121.50 taka, which is 2.5 taka above the reference value of 119 taka. They will be allowed to sell the US dollar at a price one taka higher than the rate at which they purchased it. The authorities at the Bangladesh Bank believe that this new system will help reduce the instability in the currency market. It is worth noting that the foreign exchange market, particularly the exchange rate for the US dollar, has experienced instability over the last two and a half years. During this period, the exchange rate for one US dollar has increased from 85 taka to 120 taka. With the new system, the reference value determined daily by the Bangladesh Bank will reflect the market demand and supply, making the reference value for the next day more market-driven.

If the exchange rate for the US dollar were fully liberalized at this moment and determined based entirely on the market, there could be extreme instability in the currency market. In such a scenario, managing the situation would become very challenging. Therefore, the Bangladesh Bank has adopted a "slow and steady" approach. It is worth noting that just a few months ago, the exchange rate for one US dollar was set at 110 taka. At that time, the exchange rate in the kerb market was around 122/123 taka for one US dollar. Under normal circumstances, the exchange rate in the kerb market would differ by 1 or 2 taka from the banking channel’s rate, but a difference of 10/12 taka was not indicative of a normal situation. The artificial setting of the exchange rate for the US dollar had caused various economic disruptions. When the crawling peg system was introduced, the value of the US dollar increased from 110 taka to 117 taka within just one day. This means that the Bangladesh Bank had been artificially preventing the depreciation of the local currency, the taka, against the US dollar.

The question then arises: Why did the Bangladesh Bank try to keep the exchange rate of the US dollar fixed? It is generally believed that by preventing the depreciation of the local currency, the cost of imports becomes relatively cheaper. However, if the local currency were to depreciate for some reason, importers could buy the same amount of US dollars without spending more local currency. As a result, import costs become relatively more affordable. Typically, the artificial appreciation of the local currency is done to control high inflation. For example, if previously 100 US dollars were needed to import a product, but if the local currency depreciates against the US dollar, then the same quantity of goods would require more local currency. On the other hand, if the local currency is artificially kept overvalued against foreign currencies, it could lead to a decline in export earnings and remittance inflows.

In a free-market economy, relying on artificial measures is never beneficial. The idea that an increase in the exchange rate of the US dollar automatically leads to an increase in import-related costs, and thereby causes inflation in domestic markets, is not entirely true. This is because only about 25 per cent of the goods consumed in Bangladesh are imported, while the remaining 75 per cent are locally produced. So, why are the prices of all goods increasing? Even during harvest seasons, when the prices of various products drop significantly at the producer level, the consumer-level prices do not reflect this change substantially. This is because our market management system is not functioning satisfactorily. Therefore, solely blaming the exchange rate of the US dollar for inflation does not bring any real benefit.

Recently, the government decided to double the tariff rates on 43 products. Many people argue that this decision was made based on the advice of the IMF. On one hand, the government talks about reducing inflation, but on the other hand, it has increased the value-added tax (VAT) on these 43 products. Previously, these products were subjected to a 7.5 per cent VAT. These products are certainly essential, which is why the tax rate was lowered despite knowing that the collection would be relatively low. Now, the prices of these products are set to rise. Undoubtedly, the price of these items will increase. Although the finance adviser claims that the tax hike will not put any pressure on inflation, can we really trust this statement? Without controlling the politically supported and powerful business syndicates in the market, controlling the prices of goods will be impossible.

According to news reports, in Bogura, cauliflower is being sold at only 2 taka per kilogram. Can we buy cauliflower at such a low price in the capital? In the current market system, producers at the grassroots level are deprived of receiving a fair price for their produce. On the other hand, consumers are forced to buy goods at prices higher than the fair value. In between, middlemen are reaping the benefits. Business syndicates are always sheltered and protected by political governments. They not only ensure the satisfaction of leaders from the ruling party but also try to please leaders from opposition parties. As a result, when the opposition comes to power, they also fail to take any action against the syndicates.

The damage being done to the country's economy by artificially keeping the exchange rate of foreign currency, especially the US dollar, low is often overlooked. A healthy foreign currency reserve is crucial for the economy of any country. If a country’s foreign currency reserve decreases, it faces a range of problems. Generally, foreign currency can be earned in three ways: through goods exports, labor exports, and foreign loans or financial aid. Among these, foreign currency earned from labor exports and foreign financial assistance is typically debt-free. However, the foreign currency earned through loans needs to be repaid later, along with interest. A significant portion of foreign currency earned from goods exports is spent on importing raw materials, capital machinery, and intermediate goods.

In Bangladesh's economy, the largest source of foreign currency is still the goods export sector. Every year, a substantial amount of foreign currency is earned from this sector, and about 35 to 40 percent of this is spent on importing various industrial materials. As a result, this sector contributes only about 60 to 65 percent to the national economy. Exporters always hope for a significant depreciation of the local currency, the taka, against the US dollar. When the local currency depreciates, they receive more taka for the same amount of export earnings without any additional costs.

For example, if an exporter earns 1 US dollar from exporting a product, and the exchange rate is 100 taka per dollar, the exporter will receive 100 taka for that dollar. If the exchange rate of the US dollar increases by 10 percent, or if the local currency depreciates by 10 percent, the exporter will now receive 110 taka for the same 1 dollar, which is 10 taka more than before. This increase comes without any additional cost to the exporter.

Since the exchange rate of the local currency is artificially maintained and is not allowed to fluctuate with demand and supply, exporters often do not bring their entire export earnings into the country. Instead, they engage in under-invoicing, where the actual value of the exported goods is understated. For example, an exporter might export goods worth 150 US dollars but agree with the importer to declare only 100 US dollars as the value of the export. The 100 US dollars will be brought into the country through legal channels, while the remaining 50 US dollars will stay abroad and be handed over to the exporter. The exporter can then bring this 50 US dollars back into the country via informal methods like hundi or use it abroad for other purposes. This method also allows the exporter to avoid tax-related complications.

On the other hand, those who earn foreign currency through labor exports often find that sending money through informal channels, like hundi, results in a much higher exchange rate compared to sending money through formal channels. If they receive 6 or 7 taka more per US dollar through hundi, why would anyone want to send their earnings through legal channels? It is often said that it is difficult to expect ethical behavior from someone who is hungry for a long time.

If the exchange rate for foreign currency is made market-based and if remittance collection from expatriate workers is facilitated, remittance flows could increase significantly. Therefore, there is no valid reason to keep the exchange rate for foreign currency artificially fixed under the pretext of increasing import costs.

MA Khaleque: Retired banker and writer on economic issues.