The serious depletion in foreign exchange reserves in recent months has brought to the forefront the issue of exchange rate management. Even before reserves had started falling, economists in Bangladesh had called for a devaluation of the exchange rate.
They had argued that the value of the Taka was being kept artificially high -- and this was hurting exports. Their views were echoed by many in the garment industry.
These voices got louder in recent months as the gap between the official exchange rate and the market rate became unsustainably large. Economists and many market players have suggested that the exchange rate be made flexible and allowed to respond to the forces of demand and supply.
The government is hesitant. At the core of this reluctance is fear; fear about how things will unfold if the exchange rate is allowed to be market-determined.
Such behaviour is not unusual in governments. Policy reforms involve risks -- and governments are usually risk averse. But inaction can also be costly.
So, the answer is to manage the risks, not to shy away from them. Fortunately, we do not need to look far across our borders for examples of such prudent behaviour. Let us dig a bit into our own history.
Lessons from history
Bangladesh experienced a somewhat similar situation exactly two decades ago. After rising steadily in the first half of the 1990s, foreign exchange reserves peaked at $3.07 billion at the end of 1994/95.
At this time, these were equivalent to 6.85 months of imports, one of the highest levels achieved in Bangladesh. Reserves then started falling. By the end of June 2002, these reached $1.58bn, equivalent to just six weeks of imports.
Within a span of seven years, this important number had dropped from one of its highest levels in the history of Bangladesh to one of its lowest.
The IMF was concerned. In its 2002 country report on Bangladesh, the IMF devoted a chapter to the exchange rate regime. The chapter started with the following caution: “In recent years, Bangladesh has maintained a fixed yet adjustable exchange rate regime in the face of an expansionary fiscal policy, rapid growth of domestic credit, and unanticipated adverse external conditions. Although inflation has remained low, this policy has led to a steady erosion of the international reserve position, exacerbating the country's vulnerability to external shocks.”
The Bangladesh government could have adopted tight fiscal and monetary policies to stop this loss of reserves. Instead, it tried to restrain foreign exchange demand through various controls while also trying to encourage exports and remittance flows through various measures.
It could have also devalued the Taka but steps in this direction were hesitant. No wonder people aware of this episode in our economic history get a feeling of déjà vu when they observe recent policy behaviour.
Based on this assessment in 2002, the IMF came out strongly for a change in the exchange rate regime. The report stated: “Given the overall policy environment and external vulnerabilities, the usefulness of the fixed exchange rate system has run its course. Greater exchange rate flexibility is needed to ensure that the exchange rate sends appropriate market signals and to enhance authorities' ability to address more effectively and timely both domestic imbalances and external real shocks arising from a rapidly changing global environment.”
The then Governor of the Bangladesh Bank, Dr Fakhruddin Ahmed, was sympathetic to the proposal but was acutely aware of the risks involved. His main concern was that if the exchange rate regime was made flexible, there could be speculative attacks on the Taka.
In other words, market players with considerable liquid funds would aggressively enter the foreign exchange market to buy or sell dollars. Their speculative actions would make the Taka volatile and perhaps lead to significant depreciation in its value.
But Dr Ahmed was not going to be unduly deterred by the risks. He understood the costs of holding on to a rigid exchange rate regime and realized that the answer lies in managing the risks, not in shying away from those.
But not everyone agreed. The IMF proposal to go for a flexible exchange rate regime faced opposition in the country. One critic was the economist Mirza Azizul Islam, then Chairman of the Securities and Exchange Commission. Incidentally, he was a close friend of Fakhruddin Ahmed.
These top regulators of Bangladesh's financial sector knew each other from their days as batch-mates in the Economics Department of Dhaka University and in the elite civil service of the country. Both had a PhD in economics, and both had subsequently left the domestic civil service to become international civil servants -- Ahmed in the World Bank and Islam in the United Nations.
Then, after retirement, both had returned home and became head of financial regulatory bodies at the same time. Despite all these similarities, Ahmed and Islam found themselves pitted against each other in the debate.
In early 2003, I happened to be present at a seminar organized by the Centre for Policy Dialogue (CPD) in Dhaka on this very subject. Mirza Azizul Islam had just prepared a paper for the CPD which he presented in the seminar. Fakhruddin Ahmed was on the panel of discussants.
In his paper, Islam laid out two major arguments. First, he argued that the economic and institutional prerequisites of a floating exchange rate regime, such as sophisticated financial institutions and broad and deep markets for foreign exchange, were not met in Bangladesh.
Islam knew about the experience of other countries where such a move had generated significant volatility in exchange rates. He feared the same for Bangladesh. There were already many problems in the investment climate of the country. If exchange rate volatility was added to these, it would deter much-needed investment.
His second main argument was that the existing exchange rate system has worked well. Islam wrote: “The present exchange rate regime in Bangladesh has served the country quite well. No major misalignment with equilibrium exchange rate has occurred and real effective exchange rate has not been allowed to appreciate. There has been satisfactory performance in terms of certain key macro-economic indicators such as export growth, current account deficit, inflation, and remittance by non-resident Bangladeshis.” So, if the current exchange regime is working well, let it remain as it is. “If it ain't broke, don't fix it,” I remember Islam saying, as he summarized his position against the proposed move to flexible exchange rates.
Despite such opposition, the Bangladesh Bank went for a freely floating regime. The big decision came on May 30, 2003. The IMF, which had not been alerted about this important move, was pleasantly surprised.
What about the volatility fears? Did these come true?
Six years after the policy decision, two economists at the Bangladesh Institute of Development Studies, Monzur Hossain and Mansur Ahmed, published an article that provided the answer. Hossain and Ahmed wrote: “The transition to the floating regime was smooth and the first [10] months can be viewed as the “honeymoon period” for Bangladesh because the exchange rate remained stable, experiencing depreciation of less than 1[%] from June 2003 to April 2004.”
The exchange rate then depreciated by about 20% by 2006 to reach Tk70 per $ before stabilizing around that level.
The two economists also calculated an index of the volatility of the exchange rate. This index increased from 2.65 in the pre-floating regime (January 2000-March 2003) to 3.03 in the three-year following the regime switch (June 2003 to February 2006) but went down considerably to 0.71 during the March 2006-June 2008 period.
Thus, contrary to the fears of many, the move to a freely floating exchange rate system did not lead to much volatility in the exchange rate or a fast depreciation of the Taka. Why was this so?
Prudent actions
The answer lies in some prudent actions of the Bangladesh Bank. Governor Fakhruddin Ahmed had decided that before he floated the exchange rate, he was going to build capacity in the Bangladesh Bank to manage market liquidity so that speculative attacks on the Taka could be minimized.
The central bank needed tools to both assess excess liquidity in the market and to mop it up when needed. The officers in the Bangladesh Bank had to be trained in such tools.
Ahmed asked for help from both the IMF and other central banks in the region. The help came promptly, and it was only after adequate capacity had been built to manage liquidity that the momentous decision was taken in May 2003.
This policy episode has important lessons for economic management in Bangladesh. The government is often reluctant to go for policy reforms, especially bold ones, because it is unsure of what these would lead to.
Policy makers are allergic to volatility, whether in exchange rates, foreign exchange reserves, inflation, exports, production or employment. And they have good reasons to be so.
But volatility can be addressed. Risks can be assessed and managed.
Policy reforms involve risks -- but that's not an excuse for inaction. What is required is the vision and patience to build risk management capacities.
This was the approach taken by a Bangladesh Bank governor two decades ago. The present governor may take note.
Syed Akhtar Mahmood is an economist, previously with an international development agency.
