'Food inflation is an unavoidable consequence of currency devaluation'

Three months into the Russian invasion of Ukraine, Bangladesh has begun to contemplate the cost of the conflict as skyrocketing global prices are depleting its foreign reserves. 

In the first nine months of the current fiscal year, Bangladesh's import payments had risen by 44% year-on-year to $61.5 billion, while the trade deficit rose to $25 billion. For context, during the same period, exports grew only 33% to $36.6 billion.

Bangladesh Bank's foreign exchange reserves – which peaked last August at $48 billion – fell to below $41.8 billion. The current level of the reserve can cover 4.8 months of import payments.

While most economists agree that Bangladesh is unlikely to fall victim to similar catastrophes as Sri Lanka or Pakistan, constant calls for devaluing the currency have become a mainstay of national discourse.

However, the central banks' weary and rather sluggish adjustments to the foreign exchange rates saw the official exchange rate increase by only Tk0.8 on 17 May to Tk87.5 while a dollar was being sold in the kerb market at over Tk100.

On the other hand, drastically devaluing the currency would further increase the cost of essential imports such as gas, oil, fertilisers, edible oil, wheat, etc., potentially pushing the price levels beyond the reach of ordinary citizens.

Given such complex circumstances, The Business Standard spoke to Dr MA Razzaque, Chairman of Research and Policy Integration for Development (Rapid), to explore the implication of currency devaluation for trade competitiveness as well as food security.

In a recent article published in a leading English daily, Birupakkha Pal, former Chief Economist of Bangladesh Bank, wrote that devaluing the currency has become essential and should have been done earlier. Would you agree with the statement?

The way the exchange rate has been managed in Bangladesh has been creating problems for quite some time. Although on paper, Bangladesh has a floating exchange rate regime, in reality, it is more of a managed floating exchange rate. And under this managed float system, the currency has remained overvalued for a long time while Bangladesh's export competitors, such as Cambodia, Vietnam, etc., have adjusted their currency subject to evolving market conditions.

Consequently, economists and exporters – under the threat of Bangladesh's export competitiveness being eroded – continually urged the authorities to adjust the currency accordingly.

That is, even though the discourse surrounding currency devaluation came to the forefront during the twin crises of post-pandemic external adjustment challenges and most recently, the Russian invasion of Ukraine, the concerns regarding export competitiveness always lingered.

The problem is while we focus on the nominal exchange rate only, it is the real exchange rate – measured by the nominal exchange rate times the relative price of goods at home with respect to prices in foreign countries – is a more important indicator for external competitiveness. Given the accumulated unadjusted for price differentials, our external competitiveness has been under pressure for several years now.

The current situation needs a delicate balancing act. If no currency adjustments are taken, the much higher dollar prices in the kerb market could lead to more remittances being channelled through the informal market, further weakening the reserves situation. On the other hand, a sizable devaluation would feed inflation.

Despite the considerable discrepancy between the kerb market and the official rate, BB devalued the local currency by only Tk0.25 on 9 May and then another Tk0.8 on 16 May. The gap between the formal and informal market is still about Tk8 to Tk9 per USD. Why is it taking so much time for the central bank to devalue the currency?

Policymakers like to see the growth in Gross Domestic Product (GDP) and per capita GDP as indicators of success in Bangladesh. This means devaluation has not been a major consideration when growth was mainly driven by domestic production rather than exports. Since growth has mainly come from domestic production, maintaining the taka value of dollars at a low level has helped our per capita GDP (in current USD) to rise fast. 

However, if the currency is devalued and the nominal exchange rate rises, it would also result in a decrease in per capita GDP (Current USD). Hence, a potential reduction in per capita GDP serves as a disincentive to the policymakers to devalue the currency.

What are the implications of such a decision for the rising trade deficit and export competitiveness?

Bangladesh is largely a price taker economy. So, devaluing the currency would lead to inflation. Import prices have already increased. Further devaluing the currency would further increase import prices. On top of that, the rising import prices will then be subjected to customs duty, supplementary duties and finally, Value-Added Tax (VAT), which will further cause prices to rise in the domestic market.

That being said, Bangladesh Bank's foreign exchange reserves currently stand at $41 billion – a considerably depleted number compared to its peak value of $48 billion in August 2021. The current reserve would cover import payments for another 4.8 months. Given the unsettled world markets, I think we are reaching a point fast when we need to prevent our reserves from falling below the current level.

Drastically devaluing the currency would further increase the cost of essential imports. Photo: Noor-a-Alam

Under ordinary circumstances, most economists recommend that the reserve should cover at least three to five months of import payments. However, against the backdrop of the twin crises, it would be easier to handle market volatilities if the foreign reserves were larger.

On the one hand, devaluing the currency will give rise to inflationary pressure. On the other hand, it should increase the export competitiveness of Bangladeshi products and encourage increased remittance inflow through legal channels, which will ease the pressure on the foreign reserve. From this perspective, it is a trade-off worth considering.

Moreover, during market volatilities, the government should consider negotiating and materialising soft loan debts with low-interest rates that consist of grant-like conditions and components. Doing so would also release the pressure on the foreign reserve.

Recently, we have observed Pakistan and especially Sri Lanka struggling with their foreign exchange reserves. While some may argue that it will severely affect their ability to export, eventually, they will become competitive by devaluing their currency. Bangladesh, therefore, should also devalue its currency to remain competitive in global trade.

There is a considerable discrepancy between the kerb value and the official exchange rate. How far should Tk be devalued to bridge this gap between these markets?

There is no ideal magnitude of the discrepancy that should be maintained between the kerb and official rates. The kerb market essentially reflects the demand for US dollars in the informal market. For instance, many Bangladeshi students study in Indian colleges while many others visit the country for health and tourism purposes and most of the need for foreign currencies are met through informal channels.

But for about two years during the Covid-19 pandemic, nobody could travel abroad because of restrictions. As most countries gradually began relaxing restrictions, more and more Bangladesh started to travel abroad for various purposes which have contributed to higher demand for dollars in the kerb market and subsequent rise in the exchange rate.

Just yesterday, the value of the greenback jumped to Tk102 in the kerb market. The central bank cannot continue to allow the gap between the kerb and formal market to rise unchecked and should devalue the currency accordingly.

In determining the ideal exchange rate, the central bank can pursue a 'creeping currency devaluation' where the central bank gradually adjusts the currency as abruptly increasing the exchange rate may adversely affect the market.

Many blame the high exchange rate for Taka in informal markets like Hundi for low remittance inflow through legal channels. Will devaluing the currency be enough to restore confidence in the legal channels? Should other policies be considered?

When the demand in the informal market is strong, remittances through legal channels can be affected. Unfortunately, it is extremely difficult to understand the kerb market. For example, many migrants send remittances during the holidays like Eid, even when they have not earned enough to remit back home.

In such cases, they borrow money from lenders in the host country (where the migrants work). Since most of these migrants cannot borrow from formal channels in the host country, they have to rely on informal channels.

Again, as long as there is high demand for informal channels, official exchange rate management will be difficult. Along with the demand for informal trade settlements (including those associated with education, health, and tourism purposes), outright illegal activities can heat up the kerb market.

To effectively control the informal market, we need to first understand how it works. However, we do not have enough information on the kerb market. For instance, India and Bangkok are two of the most visited destinations for Bangladeshi travellers. Visitors often visit these countries under the pretence of tourism even though they often have health or business concerns to attend to.

To limit their expenses abroad and the flight of foreign currency, the formal market limits the highest amount of dollars that can be exchanged. But since the regulators have no control over the informal market, the consumers can simply buy more dollars there and spend it abroad.

In many instances, policy options are sought while facing a crisis. However, for Bangladesh it is high time to pragmatically consider what should be a sound exchange rate management system given the rise in income and the need for boosting external competitiveness.

Devaluing the currency would increase the cost of all imports, not only luxurious ones. Given India's restriction on exporting wheat, Indonesia's restriction on exporting edible oil, etc., how would that affect domestic inflation and food security?

Food inflation is an unavoidable consequence of currency devaluation as it would become costlier to import food grains and raw materials such as fertilisers. However, there are other domestic policy instruments that can be employed to counteract inflationary pressure.

For instance, the government can increase agricultural subsidies on fertiliser or provide the right kind of price support to the farmers. Under social protection interventions, the government has laudably operated large open market sale of certain food items at subsidised prices targeting the urban poor.

This scheme should be enhanced given the unprecedented circumstances. The government also runs a scheme called Food-friendly Programme under which millions of rural families are benefited. Therefore, certain tested systems are already in place and those should now be strengthened by expanding coverage.

That being said, this is a policy challenge, and there is no magic solution. The historical low-tax GDP ratio of Bangladesh means the fiscal space is severely contracted.

Given the inflationary pressure of currency devaluation, what other policies could be pursued to ease the pressure of import payments on the foreign reserve?

Whenever there is inflationary pressure in developed economies like the US or the UK, the first thing their central bank does is raise the interest rate. Unfortunately, Bangladesh Bank has cut off its monetary arms by fixing the interest rate spread between 6% to 9%. Given the current inflation rate, many people would argue that real interest rates are either close to zero or negative. This can cause non-productive use of scarce capital resources and/or effectively subsidised spending by certain consumers.

Another challenge is that the inflationary crisis is being driven by shortage of supplies (e.g., potentially for wheat) and price hikes of primary commodities in the world market. In these areas, the room for improving domestic supply-side capacities is limited. But, I do think that global supplies will eventually respond positively to these rising prices and if further global supply chain shocks are not arising, eventually some of the pressures will die down. The Western developed countries have started employing anti-inflationary measures while China has slowed down significantly due to heightened Covid-related measures. This can help cool off certain primary product markets.