How to manage exchange rate in a crisis

The Covid-19 pandemic and subsequent recovery process of the economies led to huge pressure on foreign currency reserves in developing countries leading to a potential crisis in exchange rate management for these countries. 

Later the Ukraine-Russia war and subsequent economic and other sanctions imposed by the USA and European countries deteriorated the situation further and made recovery difficult for these countries. A sharp depreciation of currencies against the US dollar, high inflation, and depletion of international reserves pose threats to macroeconomic stability in these countries.

The two crises — the Covid-19 pandemic and the Ukraine-Russia war — have led to twin economic crises — the balance of payment (currency) and the banking crisis in developing countries. Along with this, the probability of a debt crisis is increasing. In this critical situation, governments are struggling to find a solution to the problem. Bangladesh is not an exception.

What lesson can we learn from the Southeast Asian and other currency crises in the 1990s? The optimal choice of exchange rate regime has been the main focus of discussion after the Southeast Asian crisis in 1997-98. The causes of the crisis and its management by Southeast Asian (SEA) countries have provided lessons for emerging developing countries. Before the crisis, Southeast Asian economies adopted a variety of intermediate exchange rate regimes (band, crawling peg, baskets etc.). At the advent of the crisis, most SEA countries adopted floating regimes by abandoning intermediate ones. Only Malaysia adopted a fixed regime.

The pre-crisis (before 1997) exchange rate rigidity with high capital mobility is believed to be one of the main reasons for the crisis in Southeast Asia. Despite the suggestion to maintain a corner (either fixed or freely floating) regime, most of these SEA floaters have reverted to a de facto-managed floating system after the crisis. It appears that SEA countries moved from an intermediate regime to a cornered regime to resolve the crisis and returned to another intermediate regime when the situation became normal. Note that one standard guideline is that while nominal shocks raise the likelihood of a fixed regime, real shocks call for flexibility.

However, a combination of both nominal and real shocks calls for a middle-ground managed floating exchange rate. Recent trends in regime transition due to shocks lead to only a temporary transition to an alternative regime and countries often revert to the previous regime after the crisis. SEA countries are notable examples of this trend. However, shocks appear to occur in countries having weak financial institutions. These countries often intervene in the market to shield their fledgling banking industries in the face of large exchange rate movements.

Exchange rate management came to the fore after the Covid-19 pandemic when countries started recovering, which created massive pressure on foreign currencies to finance external trade. The Ukraine-Russia war further jeopardises the situation by creating supply-side constraints on food and fuels. As a result, spiralling inflation with the sharp depreciation of the dollar exchange rate created extra pressure on international reserves in developing countries like Bangladesh.

Containing the depletion of reserves led these countries to depreciate their currencies, again aggravating inflation in these countries.  Which exchange rate system is better suited to developing countries? 

In such a situation, countries may adopt a currency basket system to maintain exchange rate stability and flexibility. However, considering the macroeconomic situation of Bangladesh, with high inflationary pressure and depleting reserves, a managed floating regime is the most reasonable choice.

The experiences of the currency crises in Asia, Latin America, Africa and the Middle East during 1973–1996 suggest that economic fundamentals, shocks, and financial and political institutional variables can be instrumental for exchange rate regime choices. However, various shocks lead financially underdeveloped countries to diverge from the de jure intermediate (fixed) or floating regime. It was observed that during the period of divergence, countries undertook necessary financial reforms. That is, financial reforms may shield economies from the shocks arising from a particular currency regime.

Political institutions also play an essential role in the choice of a regime, but it varies with the level of financial development. These examples establish the fact that the development of the financial system is crucial for the sustainable choice of a fixed or a floating exchange rate regime. In this context, I beg to differ from those suggesting adopting a market-based, freely floating regime in Bangladesh.

If a freely floating rate is adopted, in my view, the crisis will further be aggravated due to our less developed and less efficient financial system. The speculative behaviour of the banks already created turmoil in the early days of the crisis a few months back, which was evident from Bangladesh Bank's action against some commercial banks.

In favour of my argument for a managed floating regime with exchange rate movement in small steps is based on two stylised facts, which suggest that while a lower level of economic development, financial liberalisation and high inflation call for a fixed exchange rate, a high degree of trade openness, capital mobility, real exchange rate volatility and fiscal performance increase the likelihood of a more flexible regime. Therefore, to contain inflation (mostly imported) and maintain trade with a less developed financial system. This is what Bangladesh Bank is currently doing.

I appreciate their approach; however, they need to find a unified rate with a sustainable exchange rate management approach. The objective of their exchange rate policy should be to maintain short-term stability and long-term flexibility. I would say that the situation would not be that critical if Bangladesh Bank had followed this approach in the last few years.

Though in recent days, with several rates for exporters, importers and remitters, the exchange rate market is largely stabilised, it's time to move for a unified exchange rate to avoid distortions in the economy.  While managing the exchange rate in this crisis period, a few issues need to be monitored constantly.

Real exchange rate volatility

Real exchange rate volatility is important when deciding on a flexible exchange rate regime. Although the effect of real exchange rate volatility on trade and investments is not straightforward, it provides a signal to the management of the exchange rate. The simple approach of identifying the equilibrium exchange rate that provides a viable balance of payment would not be the right approach for a country like Bangladesh.

Again, the reason is the weaknesses of the financial system that embarks on speculative behaviour, over-and-under invoicing, etc. I would suggest following the behavioural equilibrium exchange rate (BEER) to manage the exchange rate volatility.

As excessive exchange rate volatility could contribute to "liability dollarisation" — when a sharp depreciation of the domestic currency increases the burden of external debt, which is very much relevant for Bangladesh as the country has been implementing many mega infrastructure projects with huge foreign loans, this warrants the stabilisation of exchange rates.

A managed float can cope with excessive exchange rate volatility at least in three channels: (i) by letting the domestic interest rate react to exchange rate movements, (ii) by limited foreign exchange rate market intervention using international reserves, and (iii) the creation of varying degrees of capital account restrictions, which is already in place in Bangladesh.

Inflation rate

There is a tendency among countries to adopt a more rigid regime in the face of high inflation, that is, to use the exchange rate as a nominal anchor. Under the managed floating regime, some pragmatic policies on inflation targeting are required to smooth out the pace of depreciation/appreciation with frequent and small adjustments in the level of the nominal exchange rates. Simultaneously, in the face of high inflation, the policies to stabilise the nominal effective exchange rates (NEER) could produce better results than stabilising the real effective exchange rates.

Appropriate monetary policies should back up these policies through the channels of interest rate policies because rising interest rates to stem currency depreciation can lead to a reduction in inflation. The current cap on interest rates needs to be revised upward to achieve better results on both inflation and exchange rate volatility.

Reserve accumulation

The positive relationship between exchange rate regime flexibility and international reserve accumulation can be explained from the perspective of crisis management. For the purpose of managing floats through extensive intervention in the foreign exchange market, a country needs to accumulate a sufficiently large stock of reserves. In the presence of currency mismatches (balance sheet effect), protecting a country against a successful speculative attack, in theory, depends on the accumulation of a large stock of international reserves.  

The maintenance of large stocks of reserves is a costly activity; exchange rate stabilisation policies should be based on frequent and minor adjustments rather than rare and large ones. A few words of caution are for the accumulation/use of reserves. Reserve accumulation or depletion should be handled with great caution, keeping in mind the inflationary pressure, external borrowing repayment, debt sustainability, sterilisation activities, etc.

Financial structure

While it is argued that financial sector development could be a critical determinant of a currency regime choice, one potential difficulty is that reforms in the financial sector cannot be achieved overnight as financial development involves the creation of institutions, market deepening, and product innovations.

Financial liberalisation generally modifies the domestic interest rate and alters the intertemporal decisions of firms, individuals, and possibly the public sector. With financial liberalisation and capital account liberalisation, a country is expected to deploy a complementary exchange rate policy as suggested by the impossible trinity doctrine. This doctrine states that the choice of exchange rate regime cannot be made independently of the choices regarding the degree of international financial integration and the desired level of monetary autonomy.

The current interest rate cap, a constraint for independent persuasion of the monetary policy, handicapped the Bangladesh Bank from applying all of its monetary policy instruments at its disposal. Therefore, the Bangladesh Bank must gain its authority to work on interest rate policy to manage monetary and exchange rate policy effectively.

Dr Monzur Hossain is the Research Director of the Bangladesh Institute of Development Studies (BIDS). He can be reached at monzur@bids.org.bd