The case of compensated depreciation

Countering Potential Inflationary Impacts in Bangladesh

The exchange rate is once again on the economic policy radar. The other day at the second annual economic conference sponsored by the daily Bonik Barta, the current and former governors of the Bangladesh Bank (BB) took turns highlighting how the BB has led the economy of Bangladesh and paved the way. to reach the heights it reaches 50 years of independence. In particular, former governor Dr Farashuddin, in his impressive video remarks, addressed the issue of the exchange rate and made a strong case for depreciation in light of emerging global challenges and opportunities and as a strategy for superior export performance in the post-war period. recovery in the event of a pandemic. BB acted and slightly depreciated the exchange rate by 1.41% on January 10, 2022. As stated, the strategy is to gradually depreciate the exchange rate in phases. The fear of inflation, we are told, is what prevents a sharp depreciation.

To put it simply, the nominal exchange rate (eg Taka 86 = US $ 1.0) is the exchange price. This price increases and decreases with changes in the demand and supply of foreign currency. The demand for foreign exchange is a derived demand, arising from the demand for the importation of goods and services. Likewise, the currency supply is generated by the export of goods and services. Lately, with the strong economic recovery underway, there has been an unusually strong recovery in import demand that could reach a record $ 75 billion in fiscal year 2022, up from $ 60 billion in fiscal year 2022. Fiscal year 2021. As might be expected, this puts great pressure on the exchange rate, which would have automatically depreciated under a floating exchange rate regime. But as we know ours is a managed float regime and the BB had to withdraw some $ 2.5 billion from its reserves to prevent the exchange rate from depreciating significantly and causing market instability. If the exchange rate could be determined by market forces, an increase in the import bill greater than the export supply would have caused the rate to depreciate, leading to lower import demand and preventing a decline. official reserves. In a controlled float regime, one is reluctant to let the exchange rate depreciate too quickly for fear of causing imported inflation.

On the other hand, although supply has also recovered thanks to a recovery in exports, the latter (exports) have historically lagged behind imports, leaving excess demand in the market. But the supply of foreign exchange generated by exports must include remittances (export of factor services). Projections from the Policy Research Institute of Bangladesh (PRI) indicate that exports will exceed US $ 46 billion, supplemented by an additional US $ 22 to 23 billion in remittances. Note that remittances have declined this year after a record jump of 36% last year; however, it will exceed the US $ 1.0 billion figure for fiscal 2019 by more than 20%. Pressure on exchange rates could be further alleviated by the influx of foreign aid money. On this point, there are optimistic expectations of net inflows (aid minus debt service) of around $ 5 billion based, among other things, on new budget support commitments from the World Bank and others. multilateral organizations. Exports, remittances and aid could bring in up to $ 75 billion, almost the equivalent of the import bill of $ 75 billion. The balance of payments (BOP) could still be broadly balanced at the end of the year or slightly in deficit (estimated at 2.6% of GDP).

Either way, one can imagine growing pressure on the exchange rate to depreciate in the short term (signaled by the excess of the policy rate over the bank / official rate), unless exports and flows help did not materialize as expected. Imports could also decline by year-end for a variety of reasons. Leaving the exchange rate unadjusted would lead to an appreciation of the real effective exchange rate (REER) which compromises the competitiveness of exports.

Economists focus on the real effective exchange rate as an indicator of the competitiveness of exports. The latest trends in the REER (the REER is the nominal exchange rate adjusted to account for the differences in inflation between Bangladesh and its main trading partners) estimated by BB seem to suggest an appreciating trend until FY2020. before falling moderately as the nominal exchange rate hovered around Tk 85 / US $. Overall, the trend of the REER over the recent past has not been good news for our exporters (Fig. 1) as the appreciation of the REER harms the competitiveness of exports and has a deterrent effect. Even a slight depreciation of the nominal exchange rate could reverse this trend and provide relief to exporters.

Export growth can be stimulated by various policies, of which good exchange rate management is crucial. Without arguing for an undervalued real exchange rate, there is no justification for allowing the REER to appreciate for a while.

THE POLITICAL DILEMMA: Exporters would like to see the nominal exchange rate depreciate significantly (i.e. bring in more Taka per dollar of exports) to compensate for sluggish export prices or higher prices. cost of imported inputs. But the Bangladesh Bank has avoided slipping the exchange rate too much for fear of fueling inflation. With comfortable foreign exchange reserves, the $ 2.5 billion sale might not be a problem, but as pressure mounts from surging imports, this approach would be untenable. is there an exit?

One solution is: compensated damping. A policy of “compensated depreciation” could be an option for decision makers to consider. This is an exchange rate depreciation that is offset by downward tariff adjustments. Such a measure could be:

(a) an incentive to all exporters,

(b) maintain a level of protection for import substitution producers,

(c) have a neutral effect on the price level, and

(d) be revenue neutral.

Here is how it works. In principle, a 5% depreciation of the exchange rate (say, from Tk 86 per dollar to Tk 90) is equivalent to a 5% subsidy on all exports, a 5% increase in tariffs as well as an increase percent of effective protection on import substitutes (because a 5 percent increase in the value of imports is equivalent to a 5 percent increase in all tariffs, on production and on equal parts inputs ). By increasing the Taka value of imports by 5 percent, this could generate additional income. But it would also push the prices of imports and import substitutes up 5 percent, raising fears of currency depreciation fueling inflation. This is where the principle of compensation comes into play. If tariffs are then reduced by 5 percent, the price effect of currency depreciation would be neutralized. The net result is a uniform (ie, non-discriminatory) incentive of 5 percent for all exports (thereby eliminating some anti-export bias) while all other impacts are neutralized. Effective protection and income will remain unchanged.

To summarize the steps:

(a) 5 percent depreciation is equivalent to 5 percent export subsidy (not from the treasury);

(b) a 5 percent depreciation is equivalent to a 5 percent increase in tariffs resulting from a 5 percent increase in the value of imports, thus potentially fueling inflation;

(c) Reducing existing tariffs by 5 percent will offset the effect of (b) leaving exports with a 5 percent subsidy, which will boost exports.

This example uses a hypothetical depreciation of 5 percent to explain the principle of compensated depreciation in the context of Bangladesh. The actual applicable rate will have to be determined after careful simulation of exports, imports and income impacts, which was done as part of the PRI research.

Better export performance is an absolute imperative if the 8th Five Year Plan (8FYP) targets on industrial growth and GDP are to be met and post-pandemic recovery is to be sustained. While cash subsidies on exports can create fiscal pressure and risk violating World Trade Organization (WTO) rules, a depreciation under a floating exchange rate regime would be a WTO-compliant trade measure. which could boost exports for an economy that is a price-entrepreneur in the world market and, theoretically speaking, faces unlimited markets for its exports, if it can produce competitively. This explains the fact that the global ready-to-wear market is still open and that Bangladesh’s share could be much higher than the 6.2% it currently holds.

IMPLEMENTATION PROBLEMS: Regarding the compensated tariff reduction, in principle it is possible to uniformly reduce 5% of all tariffs. Simply removing the 3 percent regulatory charge (RD) all at once could do the trick – neutralize the inflationary effects of a 5 percent exchange rate depreciation, leaving no income effect or protection. The elimination of R&D reduces the current average nominal tariff from 26.4 percent in fiscal year 21 to 25 percent, a reduction of 5 percent.

Expert advice is available locally on how to rationalize the tariff structure to offset any rate of depreciation without harming customs revenues or the current rate of effective tariff protection. Our proposal is somewhat radical in its approach, but we believe that the principle of “compensated depreciation” should take the breath away of any protectionist opposition.

CONCLUDING REMARKS: Economists agree that good management of the exchange rate is essential to ensure the competitiveness of exports and superior export performance. In an economy where exports are a key engine of growth, an exchange rate misalignment could have a deleterious effect on economic growth. The nominal exchange rate is what everyone notices and talks about. But economists are more concerned with trends in the real exchange rate which takes into account the relative changes in inflation rates between trade economies. If the real exchange rate is overvalued, it is a major drag on exports by stifling profits. Maintaining the nominal exchange rate during periods of import surges would lead to an appreciation of the real exchange rate detrimental to exports. Indeed, international data reveals that economies that have been successful in promoting export-oriented growth policies have not only avoided real appreciation, but have instead pursued policies of undervaluing their exchange rates at some point in time. to another. According to Dani Rodrik of Harvard University, China is the most recent example of an economy that has undervalued its currency for several decades to reap the rewards of accelerated export and GDP growth. As a policy, the least the Bangladesh Bank can do is never allow the exchange rate to become overvalued.

Dr Zaidi Sattar is President of the Policy Research Institute of Bangladesh (PRI). He can be contacted at [email protected]

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