Exchange rate is the price of foreign currency in terms of local currency. Transactions with the external world are executed in a few currencies like US dollar, euro, etc. Countries like ours depend on greenbacks for most of the transactions with external sectors. The exchange rate of Bangladesh is de jure floating, but it is de facto managed.
Presently, each greenback is priced at more than Tk110. What is to happen if each greenback is equivalent to each Taka? It has impacts on both respects, negative and positive. Taka equivalent to major currency means that it is overvalued. It encourages imports of goods and services.
Nothing is bad if raw materials are imported for producing outputs locally. But cheap foreign currency leads to import finished goods. As a result, domestic industries face challenges with foreign goods. Cheap foreign currency facilitates capital movements through unofficial paths or in disguise of trade. On the other hand, overvalued currency discourages export trades and remittances earnings.
There are four aspects with regards to external sectors: Trade balance, current account balance, financial account balance, and net international investment position. The trade balance of an economy measures the value of goods and services it exports less than the value of goods and services that it imports. An economy exporting more than it imports is in trade surplus. On the other hand, an economy importing more than it exports is in a trade deficit.
Current account balance is a measure which considers trade balance and other items like investment income between nations, cash transfers between home and host countries. An economy with current account surplus brings inflows into it. On the other hand, an economy with a current account deficit needs to send money abroad out of it.
Financial account balance is the opposite side of a current account balance. It represents the change in ownership of assets. A country with a current account deficit ends up with a financial account surplus of equivalent amount. It means that host countries own more financial assets of their home countries. A country with a current account surplus ends up with a financial account deficit of the same amount, which means that they own more financial assets abroad.
An economy can own financial assets of other countries -- like corporate shares, bonds, and so on. The net international investment position on an economy represents the accumulation of current account and financial account imbalances. In simple sense, it can be said that it quantifies the total amount of foreign assets of an economy less the total amount of domestic assets owned by foreign economies.
Countries that produce more than they consume over a long period of time generate trade surpluses and current account surpluses. This results in a positive position of net international investment. As a result, they accumulate assets abroad. When a country runs a large and persistent trade deficit, it means that the country lives beyond its means. The situation needs to be supported by foreign investment and borrowing from external sources.
Under the gold-backed monetary system, “country A” exports consumer goods to “country B” which exports industrial goods. They start with a new ledger: None owns assets with each other. In this example, they establish a trade relation, and country B exports more goods and services to country A, and all transactions are paid for with gold. So, country B runs a trade surplus with country A. Settlement of payments against goods and services from country B with gold means that gold is flowing from country A to country B. Country A is accumulating goods and services that depreciate in their value over time, while country B is accumulating gold transferred from country A, which lasts forever and represents savings.
There may be a time in the future where country B begins importing more than it exports. It can happen in the situation when commodities become globally undersupplied and expensive, then country B as a resource-constraint country may end up paying a lot of money for its commodity imports. Country B will not face problems because of having a lot of gold savings from its prior productive period of running trade surpluses. Country A, as a nation that exports consumer goods, might therefore be able to get a lot of that gold back during a period of high commodity prices.
In the present situation of the world, the trading between two countries is to be done with a variety of different currencies, such as their own fiat currencies, or US dollar, or debt and equity arrangements. As an example, country A pays its own currency for its individual imports from country B, and the producers of country B take the currency of country A and immediately buy assets in country A.
Instead of losing its gold to country B in this scenario, country A is losing some of its ownership of domestic assets. Country B is acquiring a larger stake in country A, either as an equity holder or as a credit lender. Entities of country A in aggregate are over-consuming and are paying for current consumption out of their future expected income flows. While entities of country B in aggregate are allowing entities of country A to over-consume. In the process, country B is acquiring shares of future income streams of country A.
It is inevitable to face temporary trade deficits by an economy. To continue with our example, industrial imports support the development of infrastructures. Country A needs to surrender its assets to country B in the process as propositioned in the above discussion. Country A can use these imports productively to earn lots from external sectors by exports. It can then build up foreign assets over time. The above proposition makes country A to be trade surplus in the long run. It could be possible provided that this country has an abundance of input contents. It would need infrastructure to level the playing field for international trade.
But all countries are not as capable as country A. Ours is a country with a huge population, but it lacks natural resources as input. The population makes the country a market for manufactured goods. The economy is growing at a sound pace leading up to the graduation from LDC status. The economy opens up to global transactions through trading of readymade garments. Input imports are executed to produce garment outputs, leaving a portion of foreign income as value addition. On the other hand, inflows on account of transfer income from wage earners make the current account a good position.
But the balance is not sufficient to support manufacturing activities. Policy support in this context would support a lot -- supply chain finance, buyer’s credit, UPAS (usance payment at sight) LC. The situation and cheap import finance from external sources encourages the development of manufacturing industries. But dependency on imports for running the manufacturing sector is not so easy. They require payment support at a reasonable exchange rate. External import finance cannot last long unless the economy generates income from foreign sources.
It is reportedly said that foreign exchange market of the country is under pressure due to huge payment pressures. Different proposals are reported to have been prescribed. One of them is to set the exchange rate free. This will improve exports and wage remittances, as per different advocacies.
Perhaps that is true. But export trade is not so sensitive to depreciation of local currencies. Inside information indicates that different policy supports such as cheap financing, incentives, and currency depreciation are considered by foreign buyers to calculate the price of their imports. As such, exporters are not so much benefited by currency depreciation.
On the other hand, encouragement of wage remittances by currency depreciation indicates that there exists a shadow market for executing cross border payments. The market can be used for capital flight and other regular payments in case of tight regulations. Until otherwise the shadow market can be kept suppressed, this market will operate at a higher exchange rate. The prescription cannot bring fruitful results in the existence of the shadow market. On the other hand, there is a direct correlation between local currency depreciation and changes in price level.
Depreciation in local currency hits the economy hard, without increasing income levels to all at a reasonable proportion. Dependency on external sectors needs to be continued. It is inevitable. But depreciation of local currency cannot balance the external sector as touted. It needs to be retained at a level in which both parties: Foreign currency earners and payers are in a win-win situation.
Focus needs to be given to increase income from external sources by driving manufacturing products to go abroad and making the country a “destination for services” to the external world. Without looking into text book solutions, practical problems need to be identified for promotion in export of goods and services.
Mehdi Rahman works in the development sector.
