If you don’t know the underlying economics of an issue or subject then it’s going to be easy enough to be confused by what happens surrounding that economic issue or subject. And so it is with the Taka against the US dollar exchange rate.
The rate has been declining over time -- good, it should be. That isn’t quite how most think of it but that’s just because most haven’t grasped those little subtleties of what is going on.
Short-term versus long-term
What happens to a financial market price in the immediate short-term is regarded as a random walk.
This little bit of jargon means just what we think it would: It’s as if we’re watching a drunk looking for his keys, lurching first this way then that. There’s no predicting which way he’s going to go next -- although we’d bet flat on his back at some point.
Financial market prices are held to work the same way. We cannot tell whether the next price change in a share, a currency rate, the gold price, is going to be up or down -- it’s random. But that is only in that very short and immediate term.
Once we start looking at medium to long-term then we can, and do, say that there are more fundamental drivers of price changes. The most basic of those being the interplay of supply and demand and we could just stick there.
But we’ve also had a few centuries of looking at how those interplay in specific financial markets. Share prices tend to fall when the company announces lousy results. The gold price tends to rise in times of fear and worry -- it’s a “safe haven” in the jargon.
And currency rates, the price of one money expressed in units of some other money, will move according to the difference in inflation rates in those two currencies.
The inflation factor
The foreign exchange market is by far the largest in the world. Turnover is some $5 trillion a day. Yes, that’s trillions, a day.
Almost all of this is speculation, certainly 90% is, perhaps even 99.9%. And what people are really speculating upon is that dividing line between random walk and moving to match inflation rates.
All market participants, and the theorists, will agree that the price next second is not predictable, but that the price next decade is, at least to some extent. Somewhere in the middle there is the point where unpredictable turns to possible-to-forecast.
But note what is being said again -- in the medium to long-term we expect exchange rates to move according to the difference in inflation rates.
The inflation rate in Bangladesh, in Tk, is some 5.8 % or so. The inflation rate in America, in US $, is around 2.6%. Let’s just pretend that’s 2.8% for the ease of arithmetic.
We would therefore expect the Tk to decline 3% a year against the US $. That’s just what our basic understanding of exchange rates tells us. It won’t happen exactly and we’re not quite sure when but that’s generally, over time, what we expect.
Price-fixing is unsustainable
All of this seems to come as something of a surprise to some complainin here in Dhaka, who worry that manipulation is going on in the foreign exchange market.
The central bank is operating normally, there’s no great problem with reserves of foreign currency.
Income from exports is looking good, both from remittances -- the export of labour -- and goods. There are limits on how much foreign currency is allowed to buy imports.
There really shouldn’t be any great pressure of the Tk/$ exchange rate. And yet it declines. Why?
The answer isn’t because the central bank isn’t doing its work. Well, it could be, of course, because a bureaucracy doesn’t always gets it right. And it’s not machination in speculation either -- well, of course, again, it could be.
We could speculate again upon those who would damage the country; there’s a near infinite list of people who could be doing who knows what things. But all of those are going to be short-term issues and price influences. They’re going to influence our random walk part of the pricing process, not that longer term.
A pretty basic insistence within economics is that we can cheat or manipulate the price system, sure we can, but the longer we attempt to do so the more effort it takes and eventually there’s no one left with the ability to do it.
This is true even of governments. It’s entirely possible to insist that the price of rice on Wednesday will be some fixed, say, Tk10 per kg. The further that is away from the real, free market, price then the more effort needs to be made to make it so. But more than that, the longer the period of time we try to fix the price the more effort we’ve got to expend.
Depending upon what we’re talking about we might be successful for a few hours, a few months, but eventually economic reality breaks through and the price of something will revert to being just what the price of that something is.
So it is with our foreign exchange rate, the price of money.
Whether we have private actors trying to manipulate the price for profit, or the government trying to manipulate it for better reasons, it’s always going to be true that unless we devote truly massive resources to it, our price-fixing is only going to last for the short-term. In the long-term, exchange rates move according to the relative inflation rates.
So, why is the Tk/$ exchange rate falling? Because inflation is higher in Bangladesh than in America.
All other stories are only talking about the short-term; in the long-run relative inflation is the only one that matters.
Tim Worstall is a Senior Fellow at the Adam Smith Institute in London. He also writes for the Continental Telegraph