Exchange Ratc-lVlanagcme~t/underFloating Regime in Bangladesh*~

I I 2 --.---:'" t)Monzur Hossain and Mansur Ahmed ~ 0

Executive Suinmary (;~ " bv ,SJeL;i-I Exchange rate management i" ene of the central issues of macroeconomic policies. This has

I received wide attention among policy makers and researchers, particularly from the time when

Bangladesh adopted the floating exchange rate system. In this context, this study attempts to

I analyze exchange rate policies in Bangladesh for the period 2000-2008 covering pre- and post­

floating regimes and provides a discussion on alternative policy options. It takes into account the

I behavior of the nominal exchange rate and the real exchange rate, as well as exchange rate

misalignments.

I Exchange Rate Systems in Bangladesh

I Historically, Bangladesh had been maintaining various pegged exchange rate regimes, such as

I pegged to Pound Sterling (1972-1979), pegged to a basket of major trading partners' currencies

with £ as the intervening currency (1980-1982), pegged to a basket of major trading partners'

I currencies with US$ as the intervening currency (1983-1999), and an adjustable pegged system

(2000-2003). In May 31, 2003, Bangladesh switched to floating exchange rate system by

abandoning the adjustable pegged system.

I Floating Exchange Rate Regime in Bangladesh

The transition to a floating regime on May 31, 2003 was peaceful and the first ten months can be

I viewed as a "honeymoon period" for Bangladesh because the exchange rate remained fairly

stable experiencing a depreciation of less than 1 percent from June 2003 to April 2004. Exchange I

rate kept on rising gradually from mid-2004 and it reached its peak at Tk. 70lUSD in 2006 from

Tk. 58/USD, accounting for 20 percent depreciation. Since then (2007-2009), it remained fairly

stable and has been fluctuating between Taka 68 and 70. Therefore, the floating regime is

characterized by both volatility and stability. To this end, it is of interest to know now

I Bangladesh bank manages the exchange rate.

I I This study' was carried out under the BIDS Policy Resource Program (BIDS-PRP) with the sponsorship of the

Manusher Jonno Foundation. : Research Fellow, Bangladesh Institute of Development Studies (BIDS). - Research Associate, Bangladesh Institute of Development Studies (BIDS).

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I Exchange Rate Management in Bangladesh: De jure vs. De facto

Officially (de jure) Bangladesh maintains a floating exchange rate system. Floating exchange

I rates are characterized by little intervention in the exchange rate markets together with unlimited

volatility of the nominal exchange rate. In a floating regime, since little or ho intervention is

I required, reserves exhibit relatively low volatility. However, our estimates of relative volatilities

of the exchange rate, reserves and interest rates are found to be very low for the period 2006:5 ­

I 2008:6, indicating an active intervention activities in the foreign exchange market particularly

after March 2006. This has lead the nominal exchange rate to remain almost fixed or to move

I within a very narrow range for the period. In this context, we assess the de facto exchange rate

regime of Bangladesh for the period 2000-2008 following the method developed by Levy-Yeyati

I and Sturzenegger (2002).

I We find that the de facto exchange rate regime of Bangladesh had never been the freely floating

rate regime, rather, Bangladesh has been pursuing a managed floating rate system in practice,

from the very beginning of its transition to the floating regime. ­I

Why Bangladesh intervenes in the foreign exchange market?

I Two issues are investigated that may justify intervention in the foreign exchange market. One is

the exchange market pressure and the other is ~xchange rate pass-through. We find that the

I exchange rate pass-through effect is high and statistically significant for Bangladesh-87

percent for international price, 95 percent for Indian price. This indicates that a change in

I international or Indian prices will, in the long run, almost completely translate into a change in

domestic prices. Therefore, any depreciation of taka will lead to increased inflation In

I Bangladesh. This partly justifies the intervention activities in the foreign exchange market.

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We also find that exchange market pressure (EMP) is positive in Bangladesh during 2005-2D07

and such pressure sometimes emerged as shock in the foreign exchange market. We find a

positive link between domestic credit growth (or reserve depletion) and exchange rate market .~

I pressure. This indicates that any sterilized intervention would lead to the exchange rate market

pressure. On the other hand, incomplete sterilization will lead to increased inflation. Therefore,

I to smooth out the pressure, proper monetary policy stance wOuld be warranted, particularly

through interest rate channel.

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I I The important policy question in this regard is, therefore, whether the current exchange rate

management is good or bad for the economy. To answer this question, we look into the behavior

I of the real exchange rates and exchange rate misalignment.

Behavior of the Real Effective Exchaligc Rate (REER)

I I An estimate of the real effective exchange rate (REER) and its equilibrium position will help us

recognize whether the exchange rate is overvalued or undervalued. We have estimated the REER

following the methods that Bangladesh bank uses considering eight major trading partners with--------, -------~

I due weights. Our finding suggests that the REER has depreciated around 20 percent from the

year 2000 in an unstable fashion before it started appreciating from September 2008. Is this a '-----------------­

I good policy for Bangladesh to let real exchange rate depreciate around 20 percent in an unstable

I fashion, given that the export basket is not very diversified? The real Euro was also unstable,

which appears to contribute to the overall instability in the REER as it moves in tandem with the

REER.

I The estimated equilibrium REER suggests that the REER has been overvalued on average by 3 ~

I percent from the second quarter of 2004. This finding suggests that there was a scope for around

2-3 percent depreciation of the nominal exchange rate. Moreover, net foreign assets are found to

I have significant effect on the REER appreciation while terms of trade, real interest rate

differential and government budget deficits are found to be significant to the REER depreciation.

Export Performance and Exchange Rate

I Exporters often demand depreciation of the exchange rate to gain international pnce

competitiveness. Therefore, we make an attempt to examine the effect of real exchange rate

volatility on exports. We have estimated several long-run export demand functions considering

foreign income, international price (terms of trade) and REER volatility as the primary ,.

I determinants. Overall export from Bangladesh is found to be inversely related to international

price, and the relationship is statistically significant implying price support is crucial for the

export se.ctor. However, although REER volatility has significantly positive effect on Qverall

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exports, the impact is very low. The low magnitude of the coefficient of volatility indicates that

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the less the REER volatility, the more will be the positive impact on overall exports. This finding

calls for the stabilization of the REER.

Export of Knitwear and Woven gannents ccnstitute 60 percent of our total exports, of which 70

I percent are exported to the US (23 percent) and EU market (47 percent). However, estimating

demand functions for knitwear and woven garments in the US and EU market, we find

I significant impact of price and income on woven and knitwear exports respectively. As a result,

woven exports have experienced sharper decline than knitwear in these markets in the later half

I of 2008 in the face of global economic recession (16 percent vs. 9 percent in August 2008).

These results indicate that there was a scope for giving a boost to the export sector through the

I exchange rate channel, which was absent. Consequently, our exports to the EU market are facing

big hurdles during the later half of 2008-one of the reasons could be the instability of the real

I euro.

I Although Income is also found to be significant for export demand of the USA and EU for

kni twear and woven, exports of these items are expected to be less affected by the current global

recession due to low income elasticity. Therefore, price support to exports through exchange rate

I I management might be very useful. However, maintaining overall stability of the REER see~j to

be crucial to bring more gain in international price competitiveness.

Concluding Remarks

I The contemporary policies of exchange rate management in Bangladesh, e.g. to keep nom-i,nal

exchange rate almost fixed or to allow the REER to depreciate in an unstable fashion, cann9! be

I regar-ded as optimum. Our analysis indicates that the central bank authority keeps exchange rates

fixed, perhaps to controll imported inflation and to contain exchange rate pressure. However, ,.

during the latter half of the year 2008, Forex market pressure was very low, and a declining trend

of global and domestic inflation was observed. At that time our exports were facing a downturn

I as well. In this context, keeping the exchange rate fixed at a certain level for a long time

contributed to the appreciation of the REER and hurt the export sector in particular, and possibly

I ~ . GDP growth too. In general, Bangladesh Bank could not reap the advantages of fleXIble

exchange rate system. Therefore, Bangladesh Bank should pursue some pragmatic policies in

I managing the exchange rate throu..,gh continuous monitoring of relevant indicators such as the

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I REER, NEER, Export, Import, Inflation, Exchange Market Pressure, net foreign assets and

I domestic assets.

I Policy Options

I In the absence of a solid consensus on the proper target of exchange rate management, we

propose to adopt the following pragmatic policies:

I • A managed floating exchange rate system with a policy of short-tenn stability and long­

I tenn flexibility might be appropriate for Bangladesh. Exchange rate should be allowed to

move along the market trend to a certain extent and intervention should be done only to

smooth out the pace of depreciation/appreciation.I ­

• The management of the nominal exchange rate should not be ad-hoc. The target of

I exchange rate management s~uld be the REER stabilization.

• The REER index should be properly constmcted and constantly monitored. Since

I Bangladesh's trade is dollar-denominated, we propose to create a REER basket of four

~ currencies (instead of eight currencies in the current system) including the US

I dollar, the Euro, the UK pound sterling and the Japanese yen with proper weights.

I • In order to stabilize the REER, the bilateral real exchange rate of Euro must be stabilized

following its movements against the US dollar.

I • For managing floats, an active intervention in the foreign exchange market requires the

accumulation of a sufficiently large stock of reserves. Therefore, exchange rate

stabilization policies should be based on frequent and small adjustments.

• A triggered mechanism needs to be adopted for additional adjustments in the face,.of a

real shock which cannot be absorbed by gradual adjustments in domestic prices and

wages.

I • In ·the face of a crisis, it is better to stabilize the NEER instead of the REER when other -I trading partner currencies are fluctuating against each other.

• Finally, Bangladesh should work toward financial development with greater emphasis

I given to financial liberalization in order to sustain the managed floating regime.

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I IMPROVING REMITTANCE SERVICES: APPROACHES ADOPTED BY BANGLADESH IN LOWERING COSTS, EXPANDING ACCESS AND PROVIDING INFORMATION

I @emittances from migrant workers constitute a major element supporting the balance of

payments positions of low income developing economies. ~~aRgladesh;-th&-'FemiHilnee

receipts _uLUS03::84iLbillion .(&-+percent .of-GDP)..in..f.Y.OS.(July 'O~JUlle-oS} y.je re more- than~·/ t-im:96-l.he_Offl.ci.aLO~elopmeni.AssjstanGe-{QDA}-f€ceiJ1t-5. Nearly doubling from the FY2000 level I

/ of USD 1.949 billion, the remittance receipts in FY06 approached @ percent of exports in

absolute size and have substantially cushioned the economy from the severity of the oil price

I shock. Consumption and investment would have been curtailed much m'ore drastically because of

the high import cost of oil, but for the continued healthy growth in remittances

I Given this importance for the economy, Bangladesh authorities have accorded high priority to

improving remittance services for migrant workers, with initiatives towards:

I expanding access, bringing the services closer to their work places in host countries and

closer to the recipients in rural Bangladesh;

I lowering costs for the remittance services;

ensuring competitive exchange rate and providing convenient saving and investment

options both in foreign and domestic currencies,

I providing infonmation about the remittance services and the savings and investment

options with sufficient details to enable migrant workers to choose the best suited, least

I cost options.

~ Expanding access to remittance services

I To enable migrant workers to remit funds through intermediaries as close to their workplaces as

I possible, Bangladesh <1uthorities have supported and encouraged establishment and continual

€X9c.nsion of ,drawing arrangements between banks in Bangladesh and remittance

int~ ...mediaries in the source countries including banks and duly licensed and supervised

I money tra;:::;'-::"or~/ exchange houses. Banks in the source countries usually have only limited

interest in handling small remittances of migrant workers without other more remunerative

banking relationships; exchange houses/money transferors have therefore assumed a more

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prominent role than banks in handling workers remittances.

Besides the numerous drawing arrangements (exceeding 400), banks in Bangladesh have also

set up subsidiaries/branches in the major host countries of Bangladeshi mjgr~t workers

(UK, USA, UAE, Kuwait, Qatar, Singapore, Italy etc.) for mobilizing remittanc~J rwo bank~ from Bangladesh have posted personnel ir. Saudi Arabia specifically to facilitate remittances, this

being the single largest source country with 39.2 percent of total remittance receipts in FY05

The government's post office department also has some role in handling remittances in the form

I of international money orders from their counterparts in the host countries of Bangladeshi migrant

workers.

At the receiving end in Bangladesh, more than 6300 bank branches spread all over the country

I are active in delivering remittances to recipients. The authorities have set 48 hour and 72 hour

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I delivery time standards respectively for urban and rural areas; but the 72 hour delivery time

standard for rural areas is oftener breached than complied with. To improve matters, banks are

cooperating towards faster deliveries, using the services of each other's branch networks,

I Further, some banks have usefully engaged the extensive branch networks of

microfinance NGOs in delivery of remittances to recipients in the remoter rural locations, .

_~LOWering costs of remittance services

I Only about five percent of migrant workers from Bangladesh are well paid professionals, the large

majority are low wage unskilled and semiskilled workers who send small amounts out of their

I earning at regular intervals for subsistence of their families in Bangladesh. The flat fees charged

by banks and money transferors for these small sized remittances tend t.o be high relative

to the amounts remitted (m remitting from..the 11\:i', tho flat fcc of £25 charged for t,a,lsfe,s tJp-+o

I £500 ccmes lO-1D percent for a ty~ieally median sized rem+t~ The paying bank at

I the delivery leg in Bangladesh has also its delivery costs to recoup, with little or no interest float to

be earned for the brief intervening period in prompt deliveries. The high costs involved in

transfers through the formal system result in significant volumes of remittances of migrant

I workers being siphoned off by illegal informal channels ('hundi' or 'hawala' operators&Lowering

the costs of remittance services is therefore seen as important for benefiting the migrant workers

I and their families in Bangladesh, and for drawing the illegal informal transfers into the legal formal

channels.

The main approach in efforts for lowering of remittance costs facing the migrant workers

I has been to increase competition amongst intermediaries in collecting the remittances in

the host countries. The number of drcwing arrangements of banks in Bangladesh with banks

and I:cellsed money transferors/exchange houses in host countries of migrant workers are

continuaily being expanded, and information on all the available remittance options are being

dissAminated amongst the migrant workers and the remittance recipients in Bangladesh. )

I At the Bangladesh end, banks are being encouraged and prompted to adopt upgraded IT

systems and more efficient procedural arrangements towards reducing the costs of

remittance delivery; they are also being motivated to extend to the rural remittance

I recipients a broader menu of deposit, payment and lending services instead of mere

I remittan,s;e delivery, with manifold increase in earning prospects from these additional

servicePe 'challenge fund' in the recently undertaken 'RemittcHice and Payments Partnership

(RPP) between the government of Bangladesh and the British DFID will provide grant support to

banks and other remittance intermediaries for financing part of !heir implementation costs of

innovative initiatives for improving delivery of remittances and other financial services t.o the

unserved/underserved population segments in rural areas. Automation of cheque clearing and

modernization of the payment settlement arrangements to be implemented under the RPP project

I will also contribute substantially towards higher efficiency and lower costs in remittance delivery.

I , ~ Competitive exchange rate and convenient savings and investment options for ~\t:J) migrant workers

Migrant Bangladeshi workers abroad are free to maintain non resident accounts with banks in

I Bangladesh in US dollar, Pound Sterling, Euro or Yen; balances in these accounts can earn

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interest and are freely transferable abroad. Savings options at attractive interest rates are

available for them in 3 year US dollar bonds, in 5 year Taka wage earner development bonds and

in 5 and 10 year Taka treasury bonds issued by the government, with free repatriability of

principal; interest earned is also freely repatriable abroad on all these bonds except the wage

I earner development bond. Migrant workers abroad may also make portfolio investments through

stock ~vchanges in Bangladesh, using non resident investor's Taka accounts maintained with

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banks'! Quotas Ci,~ reserved for migrant workers abroad in allotments of .p:imary issues of eqUity

in tm{ stock exchanges, and in allotment of plots in residential estates developed by public

authorities. These savings and investment avenues in Bangladesh have been attracting the

surplus earnings of the better off segm;nts of migrant workers, underpinning sustained

I healthy growth ()f remittance inflows;,(;he transition from May 2003 to market based

floating exchange rate for Taka has further facilitated remittance growth,protecting the

I remittance inflows from the adversity of inappropriate overvaluation of domestic currency.

~ Providing information to the migrant worker diasporas about the available\:!.-J remittance, savings and investment options

I Effective dissemination and continual updating of information about the available remittance,

savings and investment options for the migrant workers in the host countries is important in

I enabling them to make informed choices about the best suited, least cost options. The

information and communication channels employed include:

I pre-departure briefings for migrant workers by the government's Bureau of Manpower

Employment and Training (BMET);

I migrant worker diaspora briefings in social events and meetings in host countries,

supported by the labor wings of embassies of Bangladesh;

I bulletins/press releases/advertisements in print and electronic media channels popular

with the migrant worker diasporas in host countries, and also in Bangladesh for

information of families/beneficiaries of migrant workers;

I information booklets/brochures/pamphlets in hard copy made available through banks in

Bangladesh and their drawing arrangement counterparts abroad;

I websites of the government, central bank, commercial banks and embassies abroad.

Satisfactory institutional arrangements are yet to be in place for regular updating of the

information materials with accurate, dependable information on changes in practices, regutatory

arrangements and costs relating to remittances in the host countries of migrant workers. The RPP

project undertaken by the government with support from British DFID will, interalia, attend to

I capacity building on this aspect. This appears to be a possible area for useful support and

attention also from the UN agencies concerned with labor migration issues.

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