Bangladesh
Selected Issues
Author: International Monetary Fund
Publication Date:
15 Oct 2008
eISBN:
9781451804270
Language:
English
Keywords:
ISCR; CR; Bangladesh; export; investment; VAT; market intervention; equilibrium current account; nominal exchange rate; market code of conduct; hundi market; Current account balance; Currency markets; ERER approach
Download PDF (455.7 KB)

This Selected Issues paper on Bangladesh reviews institutional developments in the foreign exchange market since 2002. In 2002, there have been several aspects of the financial system and exchange market in Bangladesh that posed impediments to a floating exchange rate system. The financial system has been dominated by state-owned commercial banks with assets amounting to about 24 percent of GDP and accounting for some 46 percent of industry net assets. Market interventions have been largely confined to building foreign exchange reserves and to countering rare disorderly market conditions.

Abstract

This Selected Issues paper on Bangladesh reviews institutional developments in the foreign exchange market since 2002. In 2002, there have been several aspects of the financial system and exchange market in Bangladesh that posed impediments to a floating exchange rate system. The financial system has been dominated by state-owned commercial banks with assets amounting to about 24 percent of GDP and accounting for some 46 percent of industry net assets. Market interventions have been largely confined to building foreign exchange reserves and to countering rare disorderly market conditions.

I. Exchange Rate Assessment and Market Development

I.1. Assessment of the Real Effective Exchange Rate1

A. Introduction

1. This section documents the estimation of the equilibrium real effective exchange rate (REER) for Bangladesh. The three CGER methodologies were employed to assess the Bangladeshi taka: a “macroeconomic balance” approach, a reduced-form “equilibrium real exchange rate” approach, and an “external sustainability” approach.2 These assessments were complicated by the lack of long-time series data and the unavailability of suitable panel data to undertake a full dynamic analysis of the equilibrium real exchange rate. Instead, the three methodologies were used with a single country estimation to generate an assessment. The results from the three tests indicate that the taka is close to its estimated equilibrium level.

B. Macroeconomic Balance (MB) Approach

2. The MB approach calculates the difference between an estimated equilibrium current account balance (norm) and its projected value. The exchange rate adjustment that would eliminate the difference between this estimated norm and projected current account over the medium term at prevailing exchange rates is then obtained using country-specific elasticities of the current account with respect to the real exchange rate.

3. The current account norm is estimated using the following fundamental variables for the sample period of 1981–2007. Annual data are used because of the lack of a long time series of quarterly data. A single-country estimation method is used because of the unavailability of suitable panel data.

  • Fiscal balance: A higher government budget balance raises national saving and thereby increases the current account balance. The measure of the fiscal balance used was the ratio of the central government budget balance to GDP, relative to the weighted-average budget balance of trading partners.3

  • Economic Growth: Economies that are in the early stages of economic development have a greater need for investment and are likely to finance investment through external borrowing. As they develop and their income levels increase, the current account balances should improve. The deviation of the real per-capita GDP growth rate from its trading-partners’ weighted average is used to capture relative economic growth.

  • Net Foreign Assets: Standard literature suggests two opposite effects of net foreign assets (NFA) on the current account. Countries with relatively high NFA can afford to run trade deficits and still remain solvent, potentially leading to an inverse relation between the two variables. On the other hand, higher net foreign income flows from high NFA can create a positive correlation. The previous year’s NFA to GDP ratio was used to avoid a reverse link from the current account balance to NFA.4

  • Private Transfers: In addition to official transfers to low income countries, higher private transfers from abroad increases the current account balance of labor-exporting countries. To capture the importance of remittances as a source of foreign exchange and investment in Bangladesh, the ratio of private transfers to GDP was included as an additional fundamental variable.5

4. Fiscal balance, economic growth, and private transfers are estimated to be positively associated with the current account while initial NFA is negatively associated. We employ an ordinary least square method to estimate the model; all variables are statistically significant at the 5 percent or 1 percent confidence level (Table I.1).

Table I.1.

Bangladesh: Macroeconomic Balance Regression Estimates

Dependent Variable: CA/GDP

article image
Estimation vis OLS regression is reported.

  • The coefficient on the fiscal balance is 0.169, implying that a 1 percentage point of GDP increase in the government budget balance (relative to trading partners) leads to around a 0.2 percentage-point increase in the current account balance in percent of GDP.

  • The coefficient of 0.386 on output growth implies that, ceteris paribus, a 1 percentage-point higher growth rate of real GDP per capita (relative to the trading partners) improves the current account balance (relative to GDP) by around 0.4 percentage-points.

  • The negative coefficient on initial NFA implies that an improvement in the net external position enables a smaller current account balance to be consistent with solvency.

  • The coefficient of 0.444 on private transfer confirms that workers’ remittances have contributed significantly in improving the current account balance.

5. Current account norms are calculated by applying the coefficient estimates to the historical values of the regressors for 1981–2007 and the projections for 2008–13. The medium-term projection values for fiscal balance, output growth, and private transfers are based on the World Economic Outlook database, and initial NFA is derived from the recent trend of Bangladesh’s net external position. Figure I.1 illustrates the current account norm together with the projected medium-term current account.

Figure I.1.
Figure I.1.

Bangladesh: Equilibrium Current Account

(percent of GDP)

Citation: IMF Staff Country Reports 2008, 335; 10.5089/9781451804270.002.A001

6. The elasticity of the current account to the real exchange rate is calculated using the volume elasticities of exports and imports. This elasticity is required to determine the exchange rate adjustment needed to close the gap between the projected current account and current account norm and is calculated by the following formula:

∂(CA/GDP)/(∂RER/RER) = ηX(XGS/GDP) – (ηM – 1)(MGS/GDP)

where ηX and ηM are the volume elasticities of exports and imports, respectively, and XGS/GDP and MGS/GDP are the ratios of exports and imports to GDP, respectively. Export and import elasticities of –0.71 and 0.92, respectively, were used based on the background study summarized in Isard et. al (2001).

7. The equilibrium current account is estimated to remain broadly in balance over the medium term (Figure I.1). The current account norm is affected by a projected deterioration of the fiscal balance (relative to trading partners) and an improvement in the net external position, as well as higher economic growth and larger expected inflows of private transfers from abroad. The projected underlying medium-term current account for Bangladesh remains close to its estimated equilibrium level requiring only small movements in the real exchange rate to close the gap between the norm and the projected current account (Table I.2).

Table I. 2.

Bangladesh: Exchange Rate Assessment based on MB Approach

(All figures in percent, except for elasticity)

article image
Source: Staff extimates.

C. Equilibrium Real Exchange Rate (ERER) Approach

8. The reduced-form ERER approach directly estimates an equilibrium real exchange rate for each country as a function of medium-term fundamentals. The exchange rate adjustment needed to restore equilibrium over the medium term is then calculated as the difference between the estimated equilibrium real exchange rate and its current value. The following fundamental variables are considered over the sample period of 1990–2007, with projections based on the World Economic Outlook database:

  • Real Effective Exchange Rate: From the IMF INS database.

  • Net Foreign Assets: The previous year’s NFA scaled by the sum of exports and imports were used to avoid reverse causality from the current account to the contemporaneous NFA.

  • Productivity Differential: The Balassa-Samuelson effect is captured in the productivity differential series, which is the difference in output per worker in tradables and nontradables production, relative to the weighted-average productivity differentials of trading partners.

  • Commodity Terms of Trade: Higher commodity terms of trade should appreciate the real exchange rate through real income or wealth effects.

  • Government Consumption: Higher government consumption is likely to appreciate the real exchange rate to the extent that such consumption falls more on nontradables than tradables, thereby raising the relative price of the former. The variable used here is the ratio of government consumption (purchases of goods and services plus government wages) to GDP.

9. The ERER was estimated by Vector Error Correction Model (VECM) as:

Δxt=η+Σi=1pΦiΔxt−i+Πxt−1+εt

where Δ denotes the first difference operator, xt is a (n × 1) vector of variables described below at time t, η is a (n × 1) vector of deterministic variables, Φi is a (n × n) coefficient matrix, Π is a (n × n) matrix whose rank determines the number of cointegration vectors, and εt is a (n × 1) vector of white noise disturbances at time t.

10. Table I.3 reports the estimated equilibrium long-run (cointegrating) relationship between the real exchange rate and the set of explanatory variables. The coefficient sign of the productivity differential (long-run equilibrium) in the cointegration equation confirms the Balassa-Samuelson effect. The results imply that an improvement in the net external position, improvement in the terms of trade, and increases in government consumption are associated with a depreciation of the REER. That the signs of these three variables are different from what we expect in theory or what can be found in advanced countries, underscores the fact that for a country like Bangladesh at an early stage of economic development there are many country-specific factors affecting the movement of the real exchange rate, which may not be well captured in standard economic variables

Table I.3.

Bangladesh: Equilibrium Real Exchange Rate Approach VECM Estimates

article image

11. The ERER approach also suggests that the taka is close to its estimated equilibrium level. As shown in Figure I.2, as of end-2007, the taka was estimated to be within 3 percent of its equilibrium level. The change in Bangladesh’s estimated medium-term ERER is mainly driven by more rapid increases in productivity of nontradable good sectors than trading partners and a projected improvement in the net external position.

Figure I.2.
Figure I.2.

Bangladesh: Equilibrium Real Exchange Rate

(in natural logarithm)

Citation: IMF Staff Country Reports 2008, 335; 10.5089/9781451804270.002.A001

D. External Sustainability (ES) Approach

12. The ES approach calculates the difference between the actual current account balance and the balance that would stabilize the NFA position of the country at some benchmark level. Using the same elasticities as in the MB approach, this difference is translated into the real exchange rate adjustment that would bring the current account balance in line with its NFA-stabilizing level. Unlike the other two methodologies, this approach requires no econometric estimation and relies on minimal assumptions regarding the economy’s potential growth rate and inflation rate.

13. Given the benchmark NFA/GDP ratio (nfas), the NFA-stabilizing current account/GDP ratio (cas) is calculated by:

cas≈g+π1+g+πnfas

where g is the growth rate of real GDP and π is the inflation rate. The end-2006 level of NFA/GDP was used as the benchmark.6 Then, the required exchange rate adjustment needed to close the gap between the projected current account and the NFA-stabilizing current account is calculated using the same elasticities as in the MB approach.

14. For Bangladesh, this approach suggests that a larger current account deficit than currently projected would be consistent with a stable NFA position. To stabilize net foreign assets at the current level (around -26 percent of GDP), and assuming growth in real GDP of 7 percent and inflation of 4 percent, Bangladesh could run a current account deficit of around 2½ percent of GDP, compared to a projected current account surplus of ½ percent of GDP. By applying a calculated 0.14 elasticity of the current account to the real exchange rate, this would imply that a taka appreciation in real terms by about 16 percent over the medium term would be consistent with meeting the estimated current account deficit that would stabilize NFA at its current level (Table I.4).

Table I.4.

Bangladesh: Exchange Rate Assessment based on ES Approach

(all figures in percent, except for elasticity)

article image

E. Conclusion

15. The current account is broadly in balance and the exchange rate level is assessed to be appropriate across a range of measures. Both the macroeconomic balance approach and the ERER approach imply that the current level of the taka is very close to its estimated equilibrium level. Though the external sustainability approach implies that the projected external current account (and the real exchange rate) are different than the levels that would stabilize NFA, we believe that is because the benchmark level of NFA/GDP ratio is not an appropriate level for Bangladesh to target since the economy is in the midst of a transition toward the next stage of economic development and the net external position is expected to continue to improve.

I.2. Institutional Issues and Experience with Implementation of the Floating Exchange Rate Regime7

A. Introduction

16. Bangladesh’s key economic and social indicators had shown steady improvement throughout the 1990s, but the economy became increasingly fragile in the early 2000s as a result of a prolonged period of political strife that resulted in a slowing of structural reforms and an erosion of financial discipline. Expansive fiscal policy was accompanied by accommodating monetary policy as credit to the government from the banking system grew on the order of 30 percent in 2001.

17. Under the fixed exchange rate regime at that time, ad hoc adjustments in the taka/dollar rate were implemented after extensive deliberations amid much public speculation, which resulted in persistent uncertainty.8 During 2000 and 2002 the taka was allowed to depreciate by about 12 percent vis-à-vis the dollar with a concurrent depreciation of the real effective exchange rate of only about 7 percent—a relatively modest adjustment given the expansive financial policies.

18. The resulting control of inflation was achieved at the cost of a steady erosion of international reserves, thereby exacerbating the country’s vulnerability to external shocks. The authorities’ reluctance to allow the exchange rate to move more freely resulted in the imposition of a series of administrative measures aimed at restraining foreign exchange demand and encouraging exports. For example, direct export subsidies and subsidized credit facilities for exports were employed and high margin requirements on opening new letters of credit for imports were imposed.

19. The policy discussions at the time, therefore, centered on the merits of moving to a flexible exchange rate system (Figure I.3). It was argued that such a move would, among other things, depoliticize the determination of the exchange rate, ensure quick adjustments of the exchange rate to market developments (thereby stemming the loss of international reserves), and enhance the authorities’ ability to address external shocks in a timely manner (such as the removal of preferential access to industrialized markets for ready-made garment exports, which was planned for end-2004).

Figure 1.3.
Figure 1.3.

Bangladesh: Exchange Rates (2000-02)

(January 2000=100)

Citation: IMF Staff Country Reports 2008, 335; 10.5089/9781451804270.002.A001

20. The paper reviews institutional developments in the foreign exchange market since 2002. The main conclusions of the paper are that the change to a more flexible regime was implemented smoothly and has allowed the exchange rate to adjust to external shocks. Limited short-term movement in the nominal exchange rate, however, and sluggish growth in trading activity point to the need for more to be done to nurture the development of the market.

B. Institutional Changes in the Exchange Rate Regime 9

21. In 2002, there were several aspects of the financial system and exchange market in Bangladesh that posed impediments to a floating exchange rate system. The financial system was dominated by state-owned commercial banks (nationalized commercial banks or NCBs) with assets amounting to about 24 percent of GDP and accounting for some 46 percent of industry net assets. The banking system was also characterized by a high level of nonperforming loans, low capital, inefficiency, weak governance, and poor risk management. Consequently, resolution of financial sector issues was a major element of the government’s medium-term reform program. Particular attention was given to reform of the NCBs, which played a dominant role in the foreign exchange market. The two largest NCBs were the main source of foreign exchange at the time and thus the modernization of their foreign exchange operations was a key ingredient in implementing a floating exchange rate system.

22. The foreign exchange market consisted of a number of tiers. The taka was pegged to a basket of currencies from which a trading band against the U.S. dollar was determined. The band was adjusted in an ad hoc manner, partly with a view to maintain the value of the real exchange rate. Banks were required to submit their requests for dollars to Bangladesh Bank (BB) in the morning and were notified in the afternoon if they had been successful. The criteria for deciding on a request were: (i) proper documentation of the underlying commercial transaction; (ii) the lack of surplus liquidity elsewhere in the interbank market; (iii) that the bank not have a long net open dollar position; and (4) that the request be to settle a current payment due. Banks were free to deal at rates outside the band, but there were not significant divergences because BB exerted moral suasion on banks that withheld dollar liquidity from the market. There were also parallel markets, in which BB-authorized money changers exchanged mainly with travelers. Prices were slightly less favorable than in the interbank market. Finally, the hundi market was a major conduit for remittances, although there were no reliable estimates of the magnitude of these flows at the time.

23. In the preparation to move to a floating system, specific measures were targeted to strengthen BB’s capacity in foreign exchange and monetary operations, including: (i) granting BB the authority to intervene in the exchange market; (ii) establishing an effective system of interaction between BB and the interbank market; (iii) improving operational reporting arrangements in BB; (iv) announcing a timetable for the elimination of restrictions on current payments and transfers; (v) liberalizing treasury bill auctions; (vi) strengthening liquidity forecasting; (vii) introducing repurchase operations to strengthen short-term monetary management; and (viii) improving BB’s ability to collect and analyze information on banks’ exposure to interest rate risk.

24. A number of important actions were also adopted within a few months of floating to deepen and reinforce those taken in the preparatory stage. These actions were aimed at giving BB greater operational independence and refining monetary and foreign exchange management through adjustments in the mix of policy instruments. Revisions were made to the legislative framework and statistical monitoring of foreign exchange operations. Emphasis was also given to strengthening prudential regulations and supervision of the banking system. The measures in this area included: (i) modifying the cash reserve requirement to exclude foreign currency balances; (ii) upgrading accounting arrangements at BB; (iii) modernizing the market code of conduct; (iv) establishing a Lombard facility to assist banks with temporary liquidity problems; and (v) closing the BB window with an open-ended option to purchase banks’ treasury bills. A few additional medium-term reforms such as gradually reducing and eventually eliminating the statutory liquidity ratio, and establishing a primary dealer system for government securities were expected to take longer to implement. The primary dealer system was finally established in 2007.

25. The transition to the floating regime in May 2003 was accomplished smoothly. Nearly all of the planned actions were completed. Favorable market conditions during the first 18 months of the float allowed the external position to strengthen. Market interventions were largely confined to building foreign exchange reserves and to countering rare disorderly market conditions such as a large jump in demand for foreign exchange from importers. The taka/dollar rate, however, was surprisingly stable during this initial period showing only 4 percent depreciation, although there was significantly more depreciation of the nominal effective rate given the depreciation of the dollar vis-à-vis the euro. The result was a real effective depreciation on the order of 10 percent (Figure I.4).

Figure 1.4.
Figure 1.4.

Bangladesh: Exchange Rates (2000-06)

(January 2000=100)

Citation: IMF Staff Country Reports 2008, 335; 10.5089/9781451804270.002.A001

C. Recent Developments

26. While the initial transition to the new institutional structure was generally seen as a success, there is more that needs to be done to improve the functioning of the floating rate system. In general, the system that was put in place in May 2003 needs to be developed further to improve the efficiency of the foreign exchange market and allow for the better integration of exchange rate and monetary policy.

27. The taka/dollar rate depreciated by about 13 percent during 2005–06, but has been virtually constant during 2007 and the first half of 2008 (Figure I.5). During the most recent period, the stability of the dollar rate has coincided with a nominal effective depreciation on the order of 6 percent, but given the increase in prices relative to trading partners, a 2 percent real appreciation. Changes in the underlying market conditions have been reflected more in changes in central bank net purchases from the market than in changes in the nominal rate. While strong remittances and exports led to significant central bank purchases in late 2006 and early 2007, this situation subsequently reversed with the central bank demonstrating a clear pattern of selling dollars starting in late 2007 (Figure 1.6).

Figure I.5
Figure I.5

Bangladesh: Exchange Rates (2006-08)

January 2006=100

Citation: IMF Staff Country Reports 2008, 335; 10.5089/9781451804270.002.A001

Figure 1.6.
Figure 1.6.

Bangladesh: Central Bank intervention and Nominal Exchange Rate Movements (2006-08)

Citation: IMF Staff Country Reports 2008, 335; 10.5089/9781451804270.002.A001

28. In addition, there has been little development of the foreign exchange market as evidenced by the lack of increase in volumes transacted (Figure 1.7), which have only increased from an average of about $US8 million in 2006 to about $US11 million in 2008 despite large increases in trade and financial flows.

Figure 1.7.
Figure 1.7.

Bangladesh: Daily Foreign Exchange Spot Trading Volume

($US Millions)

Citation: IMF Staff Country Reports 2008, 335; 10.5089/9781451804270.002.A001

29. The limited movement in the nominal exchange rate under such market conditions and the lack of deepening of the foreign exchange market highlight the need for further market development. In this regard, it appears that even though key elements of a flexible rate system were put in place starting in mid-2003, there is more that needs to be done to complete the reform.

D. Recommendations

30. Measures that might help make the exchange system more responsive to changing market conditions and deepen the foreign exchange market:

  • Provide more latitude for the dealing room to make transactions without relying on BB management. This would speed up response time to banks’ bids and thus reduce uncertainty.

  • Further liberalize rules on forward trading to allow banks to manage their foreign exchange more efficiently. Banks are currently limited by the requirement to have 50 percent cover from their own customers’ export receipts. Without the ability to trade forward freely, those with excess foreign exchange will be less likely to release it into the market for those with a current need.

  • Enforce the net open position limits (NOP). This would encourage banks to satisfy their foreign exchange demand in the interbank market.

  • Stop the practice of allowing frequent overdrafts by banks on their foreign clearing accounts held at BB as a way for banks to manage foreign exchange. This diminishes the incentive to deal in the interbank market.

  • Allow more movement in the taka/dollar rate from day to day to encourage active interbank trading.

  • Allow and encourage banks to make two way quotes and trade currency just like any other asset.

  • Establish a joint steering committee for BB treasury staff and banks’ treasurers (excluding CEOs, MDs, or BB senior management) so that they can exchange information and discuss issues and challenges arising in the market.

References

  • Dalton, John, 2006. “From Fixed to Float in Bangladesh,” Chapter 10 in Building Monetary and Financial Systems, Case Studies in Technical Assistance, edited by Charles Enoch, Karl Habermeier, and Marta Castello-Branco, (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • International Monetary Fund, 2002 Bangladesh Selected Issues and Statistical Appendix, IMF Staff Country Report No. 02/114 (Washington).

    • Search Google Scholar
    • Export Citation

  • International Monetary Fund, 2007, Bangladesh: Selected Issues, IMF Staff Country Report No. 07/230 (Washington).

  • Isard, Peter, H. Faruqee, G. R. Kincaid, and M. Featherston, 2001, Methodology for Current Account and Exchange Rate Assessment, IMF Occasional Paper No. 209 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Lane, Philip and G. M. Milesi-Ferretti, 2006, “The External Wealth of Nations Mark II: Revised and Extended Estimates of External Assets and Liabilities, 1970–2004,” IMF Working Paper No. 06/69 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Lee, J., G. M. Milesi-Ferretti, J. Ostry, A. Prati, and L. A. Ricci, 2008, Exchange Rate Assessments: CGER Methodologies, IMF Occasional Paper No. 261 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
1

Prepared by Joong Shik Kang (APD).

2

The IMF Consultative Group on Exchange Rates (CGER) has provided exchange rate assessments for a number of advanced economies from a multilateral perspective since the mid-1990s and expanded the coverage to emerging market economies in the mid-2000s. Bangladesh is not part of the CGER exercise and is not included in the sample of 54 countries on which the models are estimated. More details on the methodology can be found in IMF (2006).

3

The weights used in calculating the REER in the IMF’s IFS database are used for trading partners. The central government budget balance is used because of the lack of data on the general government.

4

The NFA variable in all three approaches uses the net external position series in the revised database on external assets and liabilities of Lane and Milesi-Ferretti (2006).

5

Workers remittances now constitute the largest source of foreign exchange after exports. See Chapter VI of the Selected Issues paper for the 2007 Article IV consultation (IMF Country Report No. 07/230).

6

The end-2006 data are the latest available from the dataset developed by Lane and Milesi-Ferretti in The External Wealth of Nations (2006). It is available at: http://www.imf.org/external/pubs/ft/wp/2006/data/wp0669.zip.

7

Prepared by Perry Perone (PDR).

8

Selected Issues Paper (IMF Country Report No. 02/114).

9

This section draws from Dalton (2006).

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Bangladesh: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2008: Issue 335
Publisher:
International Monetary Fund
ISBN:
9781451804270
ISSN:
1934-7685
Pages:
46
DOI:
https://doi.org/10.5089/9781451804270.002

Bangladesh: Equilibrium Current Account

(percent of GDP)

Bangladesh: Equilibrium Real Exchange Rate

(in natural logarithm)

Bangladesh: Exchange Rates (2000-02)

(January 2000=100)

Bangladesh: Exchange Rates (2000-06)

(January 2000=100)

Bangladesh: Exchange Rates (2006-08)

January 2006=100

Bangladesh: Central Bank intervention and Nominal Exchange Rate Movements (2006-08)

Bangladesh: Daily Foreign Exchange Spot Trading Volume

($US Millions)