The management of the exchange rate in Bangladesh has been rather odd.
There is a posted spot rate [CB rate] supposedly a market determined rate but actually announced by the central bank.
This is conveyed to the banks by telephone calls and there is no actual formal official notification.
This rate is given by the central bank from time to time.
It does not really respond to market forces as Bangladesh Bank does not seem to have any reason for setting the rate at the level given.
Until recently there was hardly any change: From end July 2019 until end August 2021 the difference between the maximum and the minimum was less than 1% of the mean of the maximum and minimum.
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A true floating rate would never have such characteristics.
The best explanation available is that the central bank wants to present a picture that the Taka is not depreciating.
Why they would want to do that when everyone in the foreign exchange market knows the actual situation, one cannot explain.
But the common opinion expressed in the media is that the exchange rate is stable but has suddenly started to move a bit (about 2%).
There is much discussion of small changes.
Ignoring the central bank’s fixing of the exchange rate, the real foreign exchange market operated by the banks establishes a price [exchange rate] usually based on a three-day forward rate that the central bank has allowed to serve as the actual rate used in most transactions.[1]
The length of the forward used may vary from L/C to L/C.
Contrary to common belief the foreign exchange rate in Bangladesh is market determined and floats.
Each commercial bank holds some foreign exchange to enable it to handle import payments and it may hold dollars from settling export earnings.
The bank can also buy or sell foreign exchange to another bank.
The holdings of the commercial banks are large enough to manage foreign exchange transactions most of the time.
Occasionally the central bank may intervene to buy or sell foreign exchange.
Over the past few years the banks have adopted the forward rate for transactions and these rates were not far from the official rate.
The market for foreign exchange has gotten out of control in recent months, as the gap between supply and demand of dollars increased.
The large increase in the current account deficit has left a substantial gap between the supply and demand of dollars that has not been closed by central bank sales of dollars.
In 2020/21, with the onset of the pandemic Bangladesh ran a $10 billion surplus.
The central bank had to buy dollars to prevent the appreciation of the Taka.
In 2021-22 the situation reversed and a large shortage of dollars emerged.
The gap was very large due to tremendous increase of imports and Bangladesh Bank failed to supply enough dollars, hence the transaction's exchange rate (3 days forward rate) depreciated more than 10%.
Both import and export bills are settled at the forward rate and not at the official spot rate.
Bangladesh Bank knows very well that you cannot have a price that fails to clear the market.
If one really tried to impose such a rate what would happen?
What happens if there is a greater demand for dollars than is available in the market?
A black market of some type will arise; if company A gets dollars and company B does not then company A may offer to sell some to company B at a higher exchange rate.
The funds flowing through the hundi market would be a way to get around the official exchange rate.
For example, under invoicing the L/Cs for imports do not represent the true price of the import.
Funds from the hundi market where Taka are purchased at a depreciated rate cover the difference.
This is in effect a depreciation of the Taka for this import.
Over the past year the central bank has managed the situation through two actions: First, allowing most foreign exchange transactions to pass through the forward market; the forward market adjusts according to supply and demand.
Second, when market conditions became very stressed due to a shortage of dollars, Bangladesh Bank released dollars from reserves.
Over the past nine months up to March 31, 2022 the central bank has released at least $3 billion net from reserves [the deficit in the balance of payments] and the forward exchange rate has depreciated about 10%.
The official rate has depreciated a little but it does not really matter as few transactions take place at that rate.
Most observers seem to have not realized that there was a depreciation of the Taka.
In fact there are many calls for a depreciation of the Taka.
This depreciation has already happened.
All should be clear: there is a market clearing exchange rate whose value is based on supply and demand.
How could the foreign exchange market work? In my view there are two objectives: (1) The exchange rate should adjust according to supply and demand. (2) Government intervention may be justified for two reasons.
The first reason is to limit sharp changes in the exchange rate that may cause difficulties for persons not related to a large transaction disturbing the market.
Second, the government might decide as a matter of high-level growth policy to depreciate the Taka a substantial amount to raise the competitiveness of exports.
Many Asian countries have done exactly that.
The simplest way is to establish a central rate, announced by the central bank or the Ministry of Finance [who should determine the system for fixing the exchange rate is a political decision].
All transactions are to be in a band of plus/minus 2% of the announced rate.
If the rate is pushing against one boundary, dollars are either purchased or sold by Bangladesh Bank.
But the central rate is then adjusted to keep the market rate in the middle of the band.
This is effectively a floating rate but there is a delay to limit excessive rapid change in the exchange rate.
The floating Taka would bring about short term adjustments. Depreciation discourages imports and encourages exports.
The adjustments in the exchange rate would move the market towards equilibrium.
The present management of the exchange rate is confusing to many.
It is not transparent.
Bangladesh Bank should move to an immediate transparent system with a truly floating rate.
It would be fairer, it would reduce discrimination among customers, and it would reduce the costs of operating the ackward, expensive system now in place.
Forrest Cookson is an economist who has served as the first president of AmCham and has been a consultant for the Bangladesh Bureau of Statistics
[1] Three day forward rate: The exchange rate that will apply in three days. One rate for buying FX and one for selling FX.