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Two decades of floating exchange system

Published : Thursday, 6 October, 2022 at 12:00 AM  Count : 1282

On May in 2003, central bank issued a circular declaring floating exchange rate system. The circular stated that exchange rates for spot purchase and sale transactions of US dollar by central bank with authorized dealer banks would be decided on a case to case basis, but without reference to any pre-announced band. Central bank would undertake purchase or sale transactions in US dollar to maintain orderly market conditions, the circular noted.

Open economy macroeconomics contains a concept introduced by Mundell-Fleming. The concept states that a country may simultaneously choose any two, but not all, of the three goals - monetary policy independence, exchange rate stability, and financial market openness to the full extent.

The Breton Woods system, which existed from 1944 to 1971, allowed its member states to impose capital controls. During this period, financial market was open with control over monetary policy and exchange rate. But after 1971, policy advocacy by non-state organizations was to regulate monetary policy with open up of financial market and floating exchange rate. The opening of financial market leads to convertibility of capital account. Bangladesh economy adopts monetary policy independence and exchange rate flexibility, with restrictions for transactions under capital accounts.

After 1970 with the collapse of Breton Woods system, floating exchange rate system was adopted de jure worldwide. But floating exchange rate is de facto managed, commonly known as dirty floating. Exchange rate is managed by central bank through market intervention by way of purchases and sales of foreign currency from and to market at a set exchange rate. This set rate automatically plays roles in interbank transactions.

There is a tug of war in pricing of local currency with regards to overvalue and undervalue. Overvalue is a cost to foreign currency earners and benefits to foreign currency remitters, and vice versa in case of undervalue. It is not so easy to make equilibrium if there prevails imbalance between inflows and outflows.

Intervention of foreign exchange market is to keep price at suppressed level for supports of import needs. But it does not work at all times. The situation is costly since it facilitates foul players. In this situation, central bank tries to set rates for interbank transactions and import payments. But huge imports at higher costs automatically increase price level. Banks stop interbank dealings which lead to destroy wholesale markets. In absence of whole sales market, market becomes non-operational.

Under the circumstances, banks advise importers to arrange foreign currency from other banks which sell at higher rates. The situation evaporates wholesale market, without which retail trade cannot run in a proper way. Consequently, intervention in the way of exchange rate dictation does not work properly; fair price prevails in the long run defeating such intervention.

In absence of wholesale market, consumers produce goods for consumption - subsistent living. This way of living cannot upgrade the standard of human beings. In the same way, foreign exchange market cannot be deep unless wholesale market is operational.

Under de facto exchange rate system, exchange rate is directed by central bank in different ways. During the tenure of two decades, the dictated rates work well in Bangladesh, except few situations. But rate imposed administratively does not work well in the situation of market manipulation which requires disciplinary actions.
 
Directed exchange rate cannot work where there is a mismatch between supply and demand of foreign currency. Mismatched position results in noncompliance of what central bank asks for. Under this situation, every transaction is arranged by bilateral negotiations between banks and customers, giving favour to powerful customers but customers having 'no say' face deprives.

Bangladesh being a country of import-dependence needs huge imports. The currency at overvalued level encourages unnecessary imports like luxuries. Simple solution is to depreciate local currency which will set to improve inflows of foreign currency. It is true but fundamental concept will work and lead to increase import prices. As a result, currency depreciation fuels inflation.

It is not easy to come out of dirty floating rate system. During the passage of two decades in Bangladesh, no alternative way was found to go for full fledged floating rate regime. During the Covid-19, the world was in lockdown leading to disruption of production. Invasion of Russia on Ukraine leads the world to a further miserable position. It results in enhancement of commodities price globally. Bangladesh needs import of commodities at that price leading to a gulf of trade gap which is not manageable by other external sources of current incomes and transfer receipts. Consequently, current account balance goes to negative territory at a new height.

A trade-off is needed between costs and benefits. Challenges prevail to bring the situation. Where is the solution? During the two decades, current account balance was found in reasonable level. But the abnormality during the current year indicates a gulf of difference between inflows and outflows, as noted earlier. In this situation, dictation of price of foreign currency at administrative way does not work much. The solution lies in different tools - reduction of outflows by cutting unnecessary imports of goods and services, or adjustment of currency price at new level, or both.

To protect unnecessary imports, the Government issued an order already imposing regulatory duties. Central bank imposed margin requirement while on opening import letters of credit, including monitoring of high value import letters of credit. Despite, market is not found at desired level. As such, other alternative needs to be applied. Of late, it is reported that central bank will not dictate interbank exchange rate. Foreign exchange dealers associations are allowed to determine exchange rate.

Exchange rate benefits need to go to exporters. Business insiders indicate that the rate for export proceeds is lower compared to wage remittances. On the other hand, exporters are to sell export receipts with banks designated for the transactions as per directive from central bank. This instruction seems locking exchange rate for exporters without competition. The way-out through associations may result in non-market phenomenon which warrants revisit.

Recent decision regarding interbank exchange rate based on weighted average buying rate with a markup may revitalize interbank market. If so, importers will not be compelled to buy foreign currency at higher rates from other banks in the name of 'corporate deals'.

Joseph E. Stiglitz in a recent paper stated quoting Adam Smith; capitalism is not a self-sustaining system, because there is a natural tendency toward monopoly. It is true. Despite, fair value needs to be allowed. Otherwise, illegitimate pays will continue at the cost of many. As such, rate adjustment at workable upward level in foreign exchange market will encourage inward remittances, and discourage unnecessary imports. However, recent depreciation in exchange rate for Taka leads inflation into domestic price level. So nothing is worrisome in respect of inflation.

Twentieth birth anniversary of de jure floating exchange system is going on. Let operators play at their own ways within the regulatory framework. During this anniversary, administrative attention is required when operators deviate from the compliance of rule-book. Otherwise, indiscipline in the market may lead the market to volatility, the result of which will be a mismatch with regards to demand and supply.
The writer is a contributor












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