Abstract
Multiple external shocks and suboptimal domestic policy responses have led to sustained foreign exchange (FX) pressures in Bangladesh. These developments have highlighted the need for a more flexible exchange rate regime to rebuild external resilience as well as to prepare Bangladesh to successfully integrate into the global financial system post LDC graduation. While the authorities have appropriately accelerated reforms to allow greater exchange rate flexibility, managing transition risks remains crucial. Policy actions to restore external resilience need to be well calibrated and carefully sequenced to facilitate a non-disruptive transition toward greater exchange rate flexibility.
Bangladesh: Toward Greater Exchange Rate Flexibility1
Multiple external shocks and suboptimal domestic policy responses have led to sustained foreign exchange (FX) pressures in Bangladesh. These developments have highlighted the need for a more flexible exchange rate regime to rebuild external resilience as well as to prepare Bangladesh to successfully integrate into the global financial system post LDC graduation. While the authorities have appropriately accelerated reforms to allow greater exchange rate flexibility, managing transition risks remains crucial. Policy actions to restore external resilience need to be well calibrated and carefully sequenced to facilitate a non-disruptive transition toward greater exchange rate flexibility.
A. Recent Pressures in the FX Market
1. Bangladesh has faced a challenging external environment in recent years, amidst Russia’s war in Ukraine and global monetary tightening. Led by worsening terms of trade including from rising global commodity prices and a strong post-pandemic rebound in imports, the CA deficit widened substantially in FY22. This resulted in sharp decline in FX reserves and depreciation of the Taka against the U.S. dollar. The authorities responded to adverse external developments by tightening monetary conditions and implementing demand management measures, including restrictions on non-essential imports by requiring higher margin on letters of credit (LC), and sought a Fund-supported program.
2. To further arrest currency pressures, Bangladesh Bank (BB) accelerated several reforms to allow greater exchange rate flexibility in line with its commitments under the Fund-supported program. BB discontinued the use of official exchange rate for transactions on behalf of the government by replacing it with the prevailing daily interbank exchange rate, announced by the Bangladesh Foreign Exchange Dealers’ Association (BAFEDA) as a reference rate, thus eliminating multiple currency practice subject to Fund jurisdiction under Article VIII. BB also published gross official reserves as per BPM6 definition by excluding foreign currency assets which are claims on residents or not readily available. BB further scaled back non-monetary use of FX reserves, including foreign currency lending, by about US$2 billion in FY23.
Current Account (CA) Adjustments during FY22 and FY 23
(In percent of GDP)
Citation: IMF Staff Country Reports 2023, 410; 10.5089/9798400260728.002.A002
Sources: Bangladesh Bank; and IMF Staff Calculations.Financing of CA Deficit during FY22 and FY23
(In percent of GDP)
Citation: IMF Staff Country Reports 2023, 410; 10.5089/9798400260728.002.A002
Sources: Bangladesh Bank; and IMF Staff Calculations.3. The CA deficit narrowed considerably but overall BOP balance deteriorated in FY23. FX shortages and LC margin requirements on the payments by bank deposits to curb non-essential imports (aimed at managing import demands) have led to a sharp contraction in imports by 16 percent y-o-y in FY23. Exports remained resilient, despite slow growth in major trading partners. The CA balance improved significantly. Nevertheless, the financial account experienced an outflow of 0.5 percent of GDP (US$2.1 billion) in FY23, compared to inflows historically averaging about 2.5 percent of GDP, signaling capital flight. While export shipments (i.e., total shipment value of exports from Export Promotion Bureau recorded under BOP) grew by 6.3 percent y-o-y in FY23, export proceeds (i.e., the export receipts recorded by BB based on FX deposits at commercial banks) increased marginally relative to FY22. Consequently, unrealized export proceeds—the difference between export shipments and realized export proceeds—increased to US$9.6 billion amounting to 2.1 percent of GDP in FY23.2 This reflected delayed repatriation and repayment of export proceeds, turning short-term trade credit sharply negative. High global inflation and continued supply disruptions have increased import costs for externally financed investment projects, resulting in delayed project execution, and consequently reducing corresponding external project finance disbursements. An unprecedented reversal in the financial account led to a continued decline in FX reserves, despite the improvement of the above-the-line current account.
Gap Between Export Shipments and Receipts
(In percent of GDP)
Citation: IMF Staff Country Reports 2023, 410; 10.5089/9798400260728.002.A002
Sources: Bangladesh Bank; Bangladesh Export Promotion Bureau; and IMF Staff Calculations.Exchange Rate, Policy Rate and Inflation Gaps Between Bangladesh and the United States
(In percent and Taka/USD, respectively)
Citation: IMF Staff Country Reports 2023, 410; 10.5089/9798400260728.002.A002
Sources: Bangladesh Bank; Federal Reserve Board; Haver Analytics; and IMF Staff Calculations.4. Faster-than-anticipated global monetary policy tightening, inadequate domestic policy response, and expectation of further currency depreciation have contributed to financial outflows. The policy rate gap between Bangladesh and the U.S. declined from 4.9 percent at the start of the pandemic to 1.2 percent by end-June 2023. At the same time, inflation in Bangladesh remains elevated leading to a widening inflation gap with the U.S. As Bangladeshi firms reduced foreign borrowing, private external credit inflows declined sharply. Net short-term private loan inflows of US$3.1 billion in FY22 reversed to an outflow of US$1.9 billion in FY23, as repayments outpaced new loans due to higher global financing costs. In addition, frequent changes to exchange rate policy setting, uncertainty surrounding the FX management framework and expectation of further currency depreciation have added to significant delays in export repatriation. To address these repatriation delays, BB in March 2023 mandated that export receipts will be converted at the exchange rate prevailing on the market on the date when the proceeds should have been realized.
B. Transitioning to a More Flexible Exchange Rate
5. Given recent developments and continued challenging external environment, Bangladesh would benefit from greater exchange rate flexibility. The benefits for Bangladesh at the current juncture, include: (1) stemming losses of FX reserves and relieving ongoing depreciation pressures triggered initially by the worsening terms of trade in FY22 and later by the reversal in financial account in FY23, (2) enhancing resilience and adaptability to external shocks, especially as Bangladesh graduates from the LDC category and becomes more closely integrated into the global financial system, and (3) supporting the move to a more modernized and forward-looking monetary policy framework and enhancing BB independence. In this regard, policy actions and reform measures should be well-calibrated and carefully sequenced to facilitate the transition toward a more flexible exchange rate system, while minimizing adjustment costs to the economy.
Near-Term Policy Priorities
6. To restore external resilience, near-term corrective policy actions would require reducing the reliance on the exchange rate as primary nominal anchor for monetary policy, further tightening the monetary policy stance, and maintaining fiscal discipline. Country experiences suggest that when supported by appropriate macroeconomic policies a move to a market-clearing exchange rate level could be accomplished in a less disruptive manner and with lower macroeconomic costs even in the absence of ideal pre-conditions for gradual transition (Ötker-Robe et al., 2007). Building on such country experiences, the near-term policy priorities for Bangladesh could include:
Reducing the reliance on the exchange rate as the primary nominal anchor for monetary policy and allowing market forces to determine the exchange rate to better buffer external shocks. While broad money (M2), GDP growth forecast, and projected inflation all serve as the stated intermediate targets in BB’s updated monetary policy framework and the policy interest rate has de-jure become the operational target, both the authorities and market participants still view the exchange rate as a de-facto nominal anchor. This is signaled by the significant efforts which both BAFEDA and BB put into maintaining the exchange rate at desired levels—the former, by mandating a specific price of Taka per dollar for forex transactions, and the latter, by extensive unsterilized FX interventions. Since the recent shift in terms of trade and reversal of the financial flows, the demand for FX increased notably and authorities had to step up efforts to keep the exchange rate from falling, resulting in depletion of FX reserves. To offset these pressures the authorities should continue to de-emphasize the role of the exchange rate as a nominal anchor while working on establishing an alternative forward-looking nominal anchor (e.g., a credible inflation target). During this process, reporting ex-post open-high-low-close exchange rates would enhance transparency and better support price discovery. FX interventions should be limited to smoothen volatility and should not counter persistent trends.
Further tightening monetary policy stance and liberalizing market lending rates to improve monetary transmission. Monetary policy under the alternative nominal anchor arrangement described above should aim at responding to expected inflationary pressures, while limiting imbalances in the money and foreign exchange markets. The current macroeconomic conditions in Bangladesh are characterized by persistently high inflation and seemingly unanchored inflation expectations, coupled with global financial tightening. To this end, raising the policy rate, while allowing this rate hike to transmit more freely through the entire yield curve, would help restore macroeconomic stability in a swifter and more effective manner.
Maintaining fiscal prudence to complement the monetary authorities’ efforts. Monetary financing, direct or indirect, often generates excess domestic liquidity that puts pressure on the exchange rate while at the same time weakening the central bank’s financial position and its ability to sterilize the excess at the appropriate level of interest rate (IMF, 2023). Country experiences suggest that central bank deficit financing is associated with exchange rate depreciation and higher inflation (Hooley, et al., 2021), rendering monetary policy ineffective. For Bangladesh, phasing out and eliminating devolvement of government securities on BB at below market-clearing interest rates would increase central bank independence, enhance the monetary transmission, and reduce pressures on the exchange rate.
Government T-Bill and T-Bond Rates
(In percent)
Citation: IMF Staff Country Reports 2023, 410; 10.5089/9798400260728.002.A002
Source: Bangladesh Bank.Medium-Term Reform Measures
7. Looking ahead, the transitional exchange rate arrangement over the medium term could gradually shift from a single reference currency peg to a basket of currencies with a narrow band corridor in a first phase, and a gradual widening of the exchange rate bands in a second phase. Successful transitions have typically implemented a peg to a currency basket or a crawling arrangement with a gradual widening of the exchange rate bands (Text Figure 1). In an exchange rate band arrangement, the exchange rate is allowed to freely fluctuate within an announced percentage deviation from a midpoint rate, and the central bank intervenes to prevent the exchange rate from crossing the band barriers. The midpoint of the band corridor could be determined in different ways but should not be allowed to persistently deviate from the underlying fundamental trend which is defined by the equilibrium/long-run dynamics of the real effective exchange rate adjusted by inflation differential with the trading partners.
Stylized Transitional Exchange Rate Arrangements
Citation: IMF Staff Country Reports 2023, 410; 10.5089/9798400260728.002.A002
Source: IMF staff and El Hamiani Khatat, Buessing-Loercks, and Fleuriet (2020).8. Country experiences show that an exchange rate band could provide greater exchange rate flexibility and monetary policy independence. Introducing a sufficiently wide band around the existing (central) parity or by adjusting the midpoint level would allow balancing the costs of exchange rate volatility and the benefits of monetary policy independence. Persistent upward or downward trends might require adjusting the midpoint level to ensure that the flexibility provided by the bandwidth is not quickly exhausted by a potential misalignment. The width of the band will reflect the trade-off between the costs of exchange rate volatility and the benefits of monetary policy independence, and over the medium term could be informed by historical norms in the exchange rate volatility (e.g., nominal effective exchange rate and real effective exchange rate).
9. Modernizing the monetary policy framework in tandem would assist the transition to greater exchange rate flexibility. The current episode in Bangladesh have demonstrated that exchange rate as a nominal anchor is very costly to maintain in the face of significant adverse external shocks. Broad money as a nominal anchor has two concerns: first, central banks have limited control over it due to unstable multipliers, and second, the relationship between broad money and inflation/inflation expectations has been weak and unstable due to volatile money velocity (IMF, 2015). This leaves inflation target as the optimal choice for a nominal anchor that will operationalize the price stability mandate of BB. A credible inflation target would help BB better anchor inflation expectations while providing room to support its growth objective without destabilizing inflation. It would also help to better absorb external shocks by letting the exchange rate to adjust more freely, which in turn would allow BB to focus instead on domestic price stability. Country experiences also show that successful transitions to a free-floating exchange rate regime were often accompanied by the adoption of explicit inflation target (Ötker-Robe and others, 2007).
10. Infrastructure development and deepening of the interbank FX market is essential to support price formation in FX markets. Importers and exporters in Bangladesh largely lack appropriate risk management practices, often creating uneven demand and supply conditions. This situation reflects many factors including BB interventions as de facto exchange rate insurance (IMF, 2018). Transitioning to greater exchange rate flexibility in a sustainable manner, however, will require developing deep and liquid FX markets. Developing derivatives markets would be critical for market participants to manage foreign exchange risk better, allowing BB to reduce its role as a market maker and FX insurance provider. BB should foster market development by removing obstacles to market activity and upgrading necessary infrastructure.
C. Managing Transition Risks: Some Considerations
11. Transitioning to greater exchange rate flexibility could incur adjustment costs. Even in well-managed transitions three specific frictions might induce adjustment costs and require considerations—net impact on budget, unhedged private sector FX exposures, and passthrough to inflation. Moreover, disorderly transitions could result in sharp depreciations or exchange rate overshooting as in the cases of Brazil (1999), Czech Republic (1996–97), and Uruguay (2002) if not accompanied by appropriate monetary and fiscal policy stance (Ötker-Robe and others, 2007). Lack of developed FX markets, appropriate intervention policy, technical capacity to adopt an alternate nominal anchor, and monetary policy independence have resulted in short-lived but ultimately unsustainable attempts to adopt flexible exchange rate regimes as in the cases of Ecuador, Pakistan, and Uzbekistan (Ötker-Robe and others, 2007).
12. Quantifying these adjustment costs remains challenging in Bangladesh. First, net negative impact on budget stemming from increased external debt servicing costs and higher implied fiscal subsidies for imported essentials (including food, energy, and other commodities) could be substantial. External debt service, which stood at around 1 percent of GDP for FY23, and fiscal subsidies for natural gas, electricity, fertilizers, and food, which amounted to 1.4 percent of GDP (or around 12 percent of total spending) in FY23, would rise further with depreciation, the latter especially given the absence of automatic domestic price adjustment mechanism. Second, the passthrough from depreciation could contribute to increase in prices, in which the short-run exchange rate passthrough ratio for Bangladesh is estimated to be at 0.25.3 Finally, FX exposures in the private sector4 (i.e., through banks and corporates) might adversely expose some private entities to any large movements in exchange rates, particularly for those with large unhedged FX liabilities.
13. A gradual transition, supported by appropriate macroeconomic policies, could mitigate many of the associated adjustment costs. Country experiences suggest that developing a credible alternative nominal anchor is a slow process, with an interim arrangement often characterized by a crawling band while policymakers shift to another nominal anchor. Notably, Chile, Hungary, Israel, and Poland have transitioned successfully using crawling bands that were widened over time in response to increases in capital inflows (Duttagupta, Karacadag, & Fernandez, 2006). On the other hand, countries which adopted flexible exchange rates under market pressure, with little preparation, and lack of supporting institutions and policies, faced higher upfront macroeconomic costs. Persistent FX market pressures and the prevailing macroeconomic imbalances, as well as current financial and institutional conditions, might require an expedited transition schedule in Bangladesh.
D. Conclusions
14. A more flexible exchange rate regime is essential for Bangladesh to rebuild external resilience and successfully integrate into the global financial system post LDC graduation. Near-term policy actions should adopt a tight monetary stance and maintain fiscal discipline to support a move toward greater exchange rate flexibility. BB should adopt a transitional exchange rate arrangement, reducing the reliance on the exchange rate as primary nominal anchor, and gradually moving to a credible inflation target as a sole nominal anchor for monetary policy. The transitional exchange rate arrangement could involve a gradual shift from a single reference currency peg to a basket of currencies with a narrow band corridor. Gradually increasing flexibility through wider exchange rate bands would develop better awareness of FX risks among market participants. BB should establish necessary technical platforms for interbank foreign exchange transactions, and with time deepen the interbank foreign exchange market to support price formation and develop derivatives markets to help manage foreign exchange risk.
References
Duttagupta, R., Karacadag, C., and G. C. Fernandez, 2006, “Moving to a Flexible Exchange Rate: How, When, and How Fast?”, In Moving to a Flexible Exchange Rate. International Monetary Fund.
El Hamiani Khatat, M., Buessings-Loercks, M., and V. Fleuriet, 2020, “Monetary Policy Under an Exchange Rate Anchor”, International Monetary Fund, Working Paper No. 2020/180.
Gray, M. S. T., 2021, “Recognizing Reality—Unification of Official and Parallel Market Exchange Rates”, International Monetary Fund, Working Paper No. 2021/025.
Hooley, J., Nguyen, L., Saito, M., and S. Nikaein Towfighian, 2021, “Fiscal Dominance in Sub-Saharan Africa Revisited”.
International Monetary Fund, 2015, “Evolving Monetary Policy Frameworks in Low-Income and Other Developing Countries”, IMF Staff Report.
International Monetary Fund, 2018, “Bangladesh: Monetary Policy Modernization at Bangladesh Bank Challenges, Next Steps and SARTTAC Support”, Technical Assistance Report, November 2018.
International Monetary Fund, 2023, “Islamic Republic of Mauritania: Selected Issues”, IMF Country Report No. 2023/074.
Ötker-Robe, M. I., D. Vavra, and a Team of Economists, 2007, “Moving to Greater Exchange Rate Flexibility: Operational Aspects Based on Lessons from Detailed Country Experiences”, International Monetary Fund, Occasional Papers.
Prepared by Richard Varghese (SPR) and Yaroslav Hul (ICD).
While some share of this gap can be attributed to “local exports” (shipments from export processing zones to domestic market mistakenly attributed to exports) and export payment cancellations due to quality control issues and vendor bankruptcies, historically high unrealized export proceeds signal capital flight. Uncertainty around general elections could also be another near-term contributing factor to high levels of unrealized export proceeds, as exporters reportedly choose to withhold bringing their proceeds back into the country until the elections results are finalized.
See 2023 Bangladesh: Selected Issues paper “Taming Inflation: Policy Options and Trade-offs.”
Private sector external debt was 5 percent of GDP in FY23, declining marginally from FY22.
