September 17, 2022, 12:00

Last modification: September 17, 2022, 1:56 p.m.

Illustration: TBS

“>

Illustration: TBS

Another multiple exchange rate system is emerging after months of deliberations between the Bangladesh Stockbrokers Association (Bafeda), the Bangladesh Bankers Association (BBA) and the Bangladesh Bank. It is dominated by discriminatory exchange rate caps set at levels closer to reality. The new arrangement may work in good times, but boomerang in tough times like the present.

Dealer associations fight for the regulator

The Bafeda and the ABB have set maximum buy rates and prescribed a formula for the maximum sell rates. The regulatory system resembles a cartel of currency traders organized at the request of the BB. “The central bank asked us to determine the exchange rate for the banking sector after looking at the whole foreign exchange market. We took the decision accordingly,” said the ABB chairman.

The role of these organizations has changed. Originally, their goals were to raise awareness and recognition of forex brokers and their views on regulatory enforcement in the industry. The ABB, a platform of bankers, generally assumes a role of ideation and communication. The development of an orderly interbank foreign exchange market was the raison d’être for the creation of Bafeda. The interbank market has been in a coma for months.

The ABB and the Bafeda are on a call of collective duty to revive the interbank market. Bank treasury officials have started reporting their weighted average cost daily to Bafeda which in turn has started publishing it on its website along with the industry average which will be the benchmark rate for repricing purposes.

Giving dealers cartel-like market power has to do much more with the failures of recent BB attempts to suppress exchange rates through jaws and police. The function of setting prices resulting from competitive market forces is delegated to a platform representing the general management of the concessionary banks.

A multitude of ceilings

Exporters and senders who send money directly to banks can get a maximum of 99 Tk per USD. Licensed dealer banks cannot offer more than Tk 108 for remittances through exchange houses, including own banks. The rate charged for the sale of USD is a weighted average of the maximum rates and the rate of dollars bought on the interbank market, calculated over a period of five rolling days, plus Tk1.

Each bank faces a different cap. Banks with a higher share of export dollars face a lower sell rate cap than banks with a lower share. There are as many sell rate caps as the 56 authorized dealers with likely more variation than before the recent shake-up. On September 14, the lowest average purchase cost was reported at 99 Tk and the highest at 111.49 Tk. The lower and upper bounds should soon converge to Tk99 and Tk108 respectively.

The five-day moving average would behave like a creeping float when the ceilings are binding. Unlike clean floats where no cap or pricing formula dictates market rates, this one will only reflect changes in the shares of exports and remittances in the daily currency supply and variations within the market. Tk1 gap. The exchange rate structure is anchored on three policy parameters: the maximum export rate, the maximum real estate exchange rate and a limited variability spread.

Caps on exports and exchange offices are currently binding, implying binding caps on import rates. From September 13 to 15, the industry average cost ranged between Tk 103.14 and Tk 103.35. These translate to an average LC ceiling of approximately between Tk104.14 and Tk104.35. LC settlement rates were above Tk105 in recent months.

Expected behavior of exchange rates

The market is divided into export, exchange and import segments, each with its own exchange rate which can float below the prescribed maximum.

The industry average import rate will vary directly with the share of remittances and inversely with the share of exports in total currency supply within the range of 100-109 Tk. Any excess demand at the cap rate structure will require non-tariff rationing, while any excess supply will be corrected by the downward flexibility of purchase rates.

The interbank rate will be determined by supply and demand in the interbank market in the absence of any intervention by the BB. The market seems to have started to breathe a little, the BB having refrained from imposing its rate on exchanges between banks since September 12th. How fast is convergence between supply and demand likely on the interbank market?

This must be the rate at which banks are indifferent between buying and selling. If the gain from buying at the prevailing interbank rate exceeds the gain from selling, excess demand will drive the rate up. Conversely, if the gain from selling exceeds the gain from buying, the excess supply will drive the rate down. The equilibrium must therefore be at the rate where the gain from the purchase is equal to the gain from the sale.

Let x equal the exchange rate (the highest cost), y equal the export rate (the lowest cost), and z equal the interbank rate. You win by buying on the interbank market if the interbank rate is lower than the house exchange rate (x > z or x – z > 0). You win selling in the interbank market if the interbank rate is above the export rate plus the spread(s) you could get from selling the export dollar to importers (z > y + s or z – y – s > 0).

To be indifferent, the gains from the purchase must be equal to the gains from the sale, i.e. x – z = z – y – s. Since x, y and s are given by policy, the only unknown in this equation is z which is equal to (x + y + s)/2; essentially a constant. With x = 108, y = 99 and s = 1, the competitive equilibrium interbank rate is Tk104.

This is the approximate rate around which the interbank rate is likely to gravitate when it fully recovers from months of inactivity and contestability. Any other rate implies the existence of unrealized trading gains – a hallmark of market inefficiency. Unless the political parameters change, the equilibrium interbank rate will move only decimals as long as the global availability of foreign exchange remains limited.

Photo: Noor-A-Alam

“>
Photo: Noor-A-Alam

Photo: Noor-A-Alam

Likely consequences under stressful conditions

Assuming the new arrangement survives, economic reasoning suggests different consequences depending on whether the market is in a good state or a bad state like the present. In a good state, i.e. an oversupply of currencies, downward flexibility in all rates will allow incentive-distorting rate discrepancies to diminish as dependence on exchange dollars decreases. The problem is in tough times, when the caps are tight and the USD is on steroids.

These problems have little to do with the weakening of GDP measured in USD due to a higher BB rate. GDP is what it is. The higher benchmark rate also has no impact on inflation, as inflation depends on the rates at which transactions involving foreign currencies are settled, not the BB rate.

The excess of the import rate over the export rate increases the pre-existing anti-export bias. For example, with a maximum of 99 Tk per USD on exports and, say, 105 Tk for imports on average, domestic producers will prefer to sell in the export market only if the export price is 6 .1% at the domestic price, all other things being equal. The rate of this tax on exports varies directly with the remittance intensity of the currency supply up to a maximum of 10.1% implied by the cap on the implicit import rate Tk109.

The higher import rate also hits the pockets of non-preferred exporters on the cost side. Exporters who do not have access to the back-to-back letter of credit or the Export Development Fund will have to pay their bank’s import rate. The effective rate of “tax” on these exporters varies directly with the share of imports in their own exports, in addition to the remittance intensity of their banks.

The returns from under-invoiced exports and over-invoiced imports are higher. Repatriation of export earnings in the form of remittances through exchange houses yields Tk 11.7 per USD (including the 2.5% subsidy on remittances). This is significant enough to even justify foregoing cash grants, especially when grants are low. There can also be money back and forth by overpricing imports financed at an exchange rate below the industry average of export-intensive banks.

The effective application of a ceiling on the rate offered to exchange houses could reduce their margins. However, exchange houses could pass on the impact of the cap to senders who could then turn more to informal channels.

All of the above effects could aggravate the currency shortage. In addition, the government may lose revenue from the withholding tax on exports and pay higher subsidies on remittances, stimulated by the repatriation of under-invoiced export earnings and the round trip of overcharged import dollars. The adage “when you’re in a hole, don’t dig any further” is very relevant here.

I can’t avoid the inevitable

The upward rigidity of buying and selling rates will be tested in the future. Large current account deficits may not be moderate enough, foreign correspondent banks are tightening funding terms and offers, the 3% cap on the overall cost for permitted short-term foreign exchange trade finance is likely to bite and the outstanding $19.2 billion in short-term foreign currency debt (as at end-March 2022) could face refinancing difficulties.

An initially more painful but ultimately more effective mechanism for coping with such pressures is to float unhindered. When you’ve already used $10.5 billion in reserves over the past 14 months to defend the Tk95 rate, it’s hard to convince market participants that there is a defensible path. The volatility that accompanies floating is mainly a manifestation of the incompatibility of interest rate and fiscal policies, besides the lack of credibility of de jure exchange rate policy which encourages self-fulfilling speculation.


Illustration: TBS

“>
Illustration: TBS

Illustration: TBS

Zahid Hussein is the former chief economist of the Dhaka office of the World Bank.