Exchange Rate Policy, Reserve Management and Its Implications on the Economy

8/6/2019 Exchange Rate Policy, Reserve Management and Its Implications on the Economy

1/13

qwertyuiopasdfghjklzxcvbnmqwerty

opasdfghjklzxcvbnmqwertyuiopasdfg

klzxcvbnmqwertyuiopasdfghjklzxcvbnmqwertyuiopasdfghjklzxcvbnmqwe

yuiopasdfghjklzxcvbnmqwertyuiopa

dfghjklzxcvbnmqwertyuiopasdfghjklz

vbnmqwertyuiopasdfghjklzxcvbnmq

wertyuiopasdfghjklzxcvbnmqwertyu

pasdfghjklzxcvbnmqwertyuiopasdfgh

klzxcvbnmqwertyuiopasdfghjklzxcvb

mqwertyuiopasdfghjklzxcvbnmqwer

uiopasdfghjklzxcvbnmqwertyuiopasd

ghjklzxcvbnmqwertyuiopasdfghjklzx

vbnmqwertyuiopasdfghjklzxcvbnmrt

uiopasdfghjklzxcvbnmqwertyuiopasd

ghjklzxcvbnmqwertyuiopasdfghjklzx

Exchange Rate Policy,

Reserve Management

and its implications on

the Economy

Macroeconomics Term Paper

5/26/2010

Submitted to:

Dr. Mohammed Farashuddin

Visiting Professor

Submitted by:

Rashed Al Ahmad Tarique

ZR 61

BBA 16th

Batch

IBA, DU.


2/13

1

Contents

Introduction...................................................................................................................................... 2

The Policy Maker and Implementer.............................................................................................. 2

Forex Reserve Trends in the Decade........................................................................................... 3

Determinants of the Foreign Exchange Regime ............................. ............................. ........................ 4

Transition to a Floating System ..................................................................................................... 5

Diversification of Reserves .......................... ................................ ...................... ................................ . 6

Buildup of Foreign Exchange Reserves ............................ ................................ ...................... ............. 6

Foreign Exchange Reserve Management for Long-term Growth ........................................................ 8

List of References ............................................................................................................................ 11


3/13

2

Introduction

Bangladesh is a very small player on the international market when it comes to international

trade. Its trade volumes are minuscule compared to global players. So concentrating much

effort on managing its foreign reserves may seem quite irrelevant as it matters little on a

global scale. However, as people of Bangladesh it means the exact opposite for us. This is

because unlike the United States or the Eurozone, a large number of giant economies would

not place their significant weight behind propping it up. We as a country must see that our

reserve levels are maintained so that we can display a clean bill of health to the global

economy and grow at a sustainable rate by tapping into the global market.

In this paper, we will look at who controls the foreign exchange policy, the foreign exchange

reserves, how it is managed, what the optimal level of reserves ought to be and steps to be

implemented in enabling sustainable growth in the economy through foreign exchange

reserve maintenance.

The Policy Maker and Implementer

In Bangladesh, the Bangladesh Bank is in charge of formulating and implementing

exchange rate policies and the official foreign exchange reserve holder. Towards

liberalization of foreign exchange transactions, a number of measures were adopted since

1990s. Bangladeshi currency, the Taka, was declared convertible on current account

transactions (as on 24 March 1994), in terms of Article VIII of IMF Article of Agreement

(1994). As Taka is not convertible in capital account, resident owned capital is not freely

transferable abroad. Bangladesh adopted Floating Exchange Rate regime since 31 May

2003. Under the regime, BB does not interfere in the determination of exchange rate, but

operates the monetary policy prudently for minimizing extreme swings in exchange rate to

avoid adverse repercussion on the domestic economy. In the forex market banks are free to

buy and sale foreign currency in the spot and also in the forward markets. Bangladesh Bank


4/13

3

(BB) is empowered by section 7A of Bangladesh Bank Order, 1972 (Presidents Order No.

127 of 1972) to hold and manage the official foreign exchange reserve of Bangladesh. It

maintains its foreign exchange reserve in different currencies to minimize the risk emerging

from widespread fluctuation in exchange rate of major currencies and very irregular

movement in interest rates in the global money market. BB has established Nostro account

arrangements with different Central Banks. Funds accumulated in these accounts are

invested in Treasury bills, repos and other government papers in the respective currencies.

It also makes investment in the form of short term deposits with different high rated and

reputed commercial banks and purchase of high rated sovereign/supranational/corporate

bonds. Forex Reserve & Treasury Management Department of BB performs the operational

functions regarding investment which is guided by investment policy set by the BBs

Investment Committee headed by a Deputy Governor. The funds are invested to earn

maximum returns at minimum risk.

Forex Reserve Trends in the Decade

The following table shows the levels of foreign exchange reserves over the fiscal years

2000-2001 to 2009-2010 (up to March 2010):

Fiscal Year In million US $

2009-2010 10142.00

2008-2009 7470.90

2007-2008 6148.80

2006-2007 5077.20

2005-2006 3483.80

2004-2005 2930.00

2003-2004 2705.00

2002-2003 2469.60

2001-2002 1582.90

2000-2001 1306.70


5/13

4

As observed from the above table, the foreign exchange reserves have grown almost ten-

fold over the last decade, considered by many as a remarkable achievement. Political

governments have even gone towards great lengths in taking credit for the buildup of these

reserves. They have labeled the foreign exchange reserve growth as a mark of core

strength of the economy.

While the Bank may have been benefited from strong remittance inflows from wage earning

expatriate incomes that have managed to steam ahead at a break-neck pace and a

government whose priorities were entrenched in building up a strong reserve (for political

purposes or otherwise), the massive increases in the reserves allowed the Bank to play a

much stronger role in the free-flowing floating market to maintain stable exchange rates,

which certainly facilitated international trade to a great degree.

Determinants of the Foreign Exchange Regime

A number of factors affect the choice of foreign exchange policy by the central bank.

Empirical results show that economic fundamentals, shocks, financial and political

institutional variables provide relevant guidance for de jure whatever countries report to

the IMF, despite reality - regime choices. However, various shocks lead countries to diverge

from the de jure, fixed or floating regime, if they do not have strong financial institutions.

During the period of divergence, countries undertake necessary financial reforms that help

them converge to the de jure regime. This suggests that financial development is crucial for

the sustainable choice of a fixed or a floating exchange rate regime. For example, countries

with high unhedged foreign currency denominated debt or high exchange rate risk exposure

have an incentive to peg even if they are officially floating. Inability to hedge, in turn, usually

reflects the inability of these countries to borrow abroad in their own currency, also known

as the original sin hypothesis. On the other hand, some countries are experiencing fear of

pegginga fear that pegging would invite speculative attacks as a result of destabilizing

misalignment. Liberalization of credit control, interest rate, entry barriers and privatization

process, are highly significant to the choice of a flexible regime. The liberalization of

domestic financial sector leads to a better allocation of resources and makes the country


6/13

5

more attractive to both domestic and foreign investors. Thus, intuitively, a more flexible

regime is desirable in a more liberalized economy. But capital and current account

liberalization has not been found significant to the regime choice. This result can be

explained from two angles. First, this is possibly because, capital account liberalization and

reversals become more likely with speculative attacks brought about by liberalizing capital

restrictions. Second, the fact is that capital liberalization is possible under both fixed and

floating regime. Among economic structural variables, while trade openness increases the

chance for fixing exchange rate, per capita GDP growth, a proxy for economic development,

calls for flexible exchange rate regime. The IMF programs often set some conditionality to

reform domestic financial sector that the borrowing country must obey. Hence, the

relationship between

IMF programs and the choice of a flexible regime are consistent from financial liberalization

perspective. From a political perspective, the more unpredictable the results of a general

election, the more effect it has on the exchange rate and hence the greater the incentive for

the central bank to influence the exchange rate and abide by the de jure policy.

Transition to a Floating System

Bangladesh stepped into the floating exchange rate regime at the end of May 2003 with the

objectives of increasing the effectiveness of monetary policy on one hand and to avoid crisis

associated with the fixed exchange rate regime on the other. Output growth in Bangladesh

performed well in the intermediate and floating exchange rate regimes. Inflation is lower in

the intermediate regime despite higher money supply and exchange rate depreciation.

There is also evidence that currency depreciation boosted exports growth in the floating

regime, though not in the prior contexts.

After the float, Bangladesh Bank occasionally intervened directly in the foreign exchange

market through sale and purchase of foreign exchange to maintain market stability. BB

could also influence the market exchange rate of Taka by tightening or loosening the money

market through the auctions of T-bills, repo and reverse repo transactions. During May 2003

(just before the float) the BDT-USD exchange rate was 57.4. After the transition on May 31,

the exchange rate moved up to 58.4 in June and the weighted average exchange rate


7/13

6

remained below 58.7 for the rest of the calendar year. From June 03 to April 04, the

BDT/USD exchange rate remained fairly stable experiencing a depreciation of less than one

percent. Therefore volatility in the exchange market was effectively contained. The notable

success of Bangladesh in keeping the volatility low immediately after the transition to

floating exchange rate is striking, especially as it has been widely reported that exchange

rate suffers significant increases in volatilities when adopting the floating regime. One

possible explanation could be that Bangladeshs financial system lacks the features that

usually cause exchange rate volatility in an industrialized economy like significant level of

speculation or heterogeneity mainly due to a relatively small number of participants and low

volume of transactions. Furthermore, to avoid any undue fluctuation in the foreign exchange

market due to speculation, Bangladesh Bank withdrew necessary amount of liquidity from

the money market using reverse repo immediately before moving toward the floating regime.

Hence, the money market absorbed the pressure of the transition, with the call money rate

shooting up briefly from the pre transition single digit levels to levels exceeding forty percent.

The call money rate came back to single digit levels by the second week as the pressure on

liquidity was eased with the exchange rate remaining stable. Therefore, the central bank did

not need to run down its reserves; rather it could build up its reserve position through buying

USD regularly from the market.

Diversification of Reserves

In order to avoid putting all its eggs in one basket, the central banks around the world tend

to diversify their portfolio of foreign exchange reserves in a number of major currencies.

These factors are based primarily on the exchange rate of the foreign currencies, financial

and commercial links with the reserve currency countries. However, this process is gradual

and the composition is constantly changing over the course of time, despite some experts

suggesting a massive global change in the currency compositions.

Buildup of Foreign Exchange Reserves

Central banks in developing countries, wanting to devalue the domestic currency, to

promote export, usually intervene in the foreign exchange market by buying up foreign

currency using domestic moneyoften backing this up with sterilization to counter

inflationary pressures. Such interventions are usually effective in devaluing the currency but


8/13

7

lead to a buildup of foreign exchange reserves beyond what the central bank may need.

Here bigger is not always better because the funds trapped in the reserve may have been

put to some better use somewhere else in the economy. So a different strategy is proposed

in a study by Kaushik Basu called Strategic Price Intervention.

The BB would could call a public-sector bank and offer the bank X Takas for every dollar,

where the X here is the same u that the large forex dealers earn as revenue from each

dollar that they acquire. In other words, the central bank puts a public sector bank on par

with a forex dealer. What this simply means is that the forex market functions exactly like

before but with n + 1 strategic agents the n dealers and 1 bank which now plays like a

dealer. It follows from standard industrial organization theory that this will raise the price, i.e.

the exchange rate without building up the reserves excessively.

The following strategies have been suggested in literature:

o Reserves equal to short-term external debt: Countries that may be vulnerable to a

capital account crisis can benefit from holding reserves sufficient to cover all debt

obligations falling due within the coming year. This benchmark, known as the

Greenspan-Guidotti rule, is the most widely preferred benchmark for measuring

vulnerability to capital account crisis, and its relevance to currency crisis prevention

has the strongest empirical support.

o Reserves equal to roughly 5-20 percent of M2: Economies that need to shore upconfidence in the value of local currency and reduce the risk of capital flight may find

this benchmark useful. Less flexible exchange rates necessitate higher reserves

relative to M2.

o Reserves equal to three or four months of imports: This benchmark is especially

relevant to low-income countries exposed to current account shocks and without

significant access to capital markets.

Holding reserves beyond the recommended benchmarks will, other things equal, probably

reduce an economys vulnerability to financial crisis. But it will do so with diminishing

marginal benefit and rising marginal costs. Though difficult to quantify, the costs associated

with holding reserves include:


9/13

8

o Sterilization costs: Sterilization neutralizes the inflationary monetary impact of

reserve accumulation, typically by domestic debt issuance to offset the associated

increase in money supply. If the interest rate for domestic borrowing exceeds the

interest rate on reserves, the direct fiscal costs may be significant. In addition, the

economy may incur indirect systemic costs because sterilization allows a central

bank to influence the real exchange rate and hence disrupt appropriate current

account adjustment.

o Opportunity costs: Alternative uses for foreign exchange reserves may yield greater

returns examples include prepaying external debt and undertaking public

investment projects. If reserves exceeding the level or ratio indicated by adequacy

benchmarks were put to alternative uses with returns only three percent higher than

current risk-free reserve assets, benefits could be as much as one percent of GDP

each year.

o Balance sheet risks: If the local currency appreciates, the local value of

international reserves decreases. Although some monetary authorities may average

these losses out over time, other central banks may realize significant balance sheet

losses. Even if the central bank is able to recapitalize from retained profits and is

not directly affected by losses, those retained profits represent revenue forgone by

the treasury. Reserves in most of these countries are several times central bank

capital and more than ten percent of GDP, so the magnitudes of potential losses are

significant.o Other costs: If reserves create a false sense of security, the incentive to tackle

difficult reforms may be reduced. Rapid reserve accumulation may also complicate

the formulation of monetary policy under flexible exchange rates.

In light of the potential cost of holding reserves, in situations where reserves far exceed

commonly accepted adequacy levels, questions can arise about the necessity and wisdom

of adding further reserves to existing stocks.

Foreign Exchange Reserve Management for Long-term Growth

Studies suggest that the accumulation of foreign exchange reserves (FER) contributes to

economic growth of a developing economy by increasing both the domestic and foreign


10/13

9

direct investment/GDP ratios as well as the share of exports in GDP. Permanent FER

accumulation influences economic growth through two different mechanisms, each of them

dominates at different stages of development. After the early stage of industrialization is

finished and the manufacturing sector is ready to compete in the world market, FER

accumulation causes real exchange rate undervaluation that allows full advantages of

export externality and triggers export-led growth. Export expansion facilitates knowledge

transfer and creates incentives for improvements of production quality. At the same time,

real depreciations result in a substitution of imports by domestic production that may be

advantageous due to learning by doing externality, if the country dependence on imports is

weak. At the later stage, FER build up attracts foreign direct investment because it

increases the credibility of the government of a recipient country and lowers the dollar price

of real assets. If the net inflow of FDI is larger than the increase in FER, or if the FDI

externality is strong enough, then growth acceleration may be reached inspite of

overvaluation of the real exchange rate.

Whereas it is widely recognized that devaluation can increase output in the short run, bringing

actual output above the potential level, it is generally assumed that in the long-term growth rates of

output do not depend on the exchange rate. On the contrary, the exchange rate itself in the long

run is considered as an endogenous variable determined by the growth rates of prices and outputs

in trading countries. Nevertheless, there is strong empirical evidence that the accumulation of

foreign exchange reserves may lead to lower exchange rates, which in turn stimulate export-led

growth. Countries with rapidly growing FER/GDP ratios, other things being equal, exhibit higher

investment/GDP ratios, higher trade GDP/ratios, higher capital productivity and higher rates of

economic growth.

First, accumulation of foreign exchange reserves has the conventional short-term expansionary

effect relative prices of tradables increase with respect to prices of non-tradables and wages. In

the long run this effect disappears as increased profits are invested and lead to increased demand

for non-tradables and labor. But if there are subsequent unexpected rounds of FER build up, the

long-term growth rates may increase. Second, undervaluation of the currency stimulates the

increase in exports. This increase in exports raises accumulated knowledge due to learning from

external trade and therefore economic productivity as well. The rate of growth rises and this

outweighs the potential gain from spending reserves for current needs. Third, undervaluation

lowers foreign currency prices of domestic real assets and thus attracts foreign direct investment.


11/13

1 0

Besides, continuing FER build up (especially in periods of trade deterioration) gives a powerful signal

to investors that the government is in full control of the situation and can afford costs for the sake

of pursuing a consistent policy. Even if FER accumulation outweighs the FDI flow, FDI externalities

may be strong enough to accelerate growth. For obvious reasons technologically backward

countries have much more to gain from export externality and from the inflow of foreign direct

investment. That is why the benefits of reserve accumulation should be especially promising for

developing countries.


12/13

1 1

List of References

www.bangladesh-bank.org/

Bangladesh Bank Information and Public Relations Division

Institutional Development and the Choice of Exchange Rate Regime: A Cross-Country

Analysis - Monzur Hossain

An Analysis of Bangladeshs Transition to Flexible Exchange Rate Regime - Sayera

Younus, and Mainul Islam Chowdhury

Are High Foreign Exchange Reserves in Emerging Markets a Blessing or a Burden?

Russell Green and Tom Torgerson

Capital flows and financial assets in emerging markets: determinants, consequences and

challenges for central banks - Muhammad Al-Jasser and Ahmed Banafe

The Mechanics of Central BankIntervention in Foreign Exchange Markets - Kaushik Basu

Recent Monetary Policy Statement of Bangladesh Bank (July 2009): An Analytical

Commentary- Debapriya Bhattacharya and Towfiqul Islam Khan

Foreign Exchange Reserves, Exchange Rate Regimes, and Monetary Policy: Issues in Asia

-Akiko Terada-Hagiwara

Foreign Exchange Reserves andInfIation: an Empirical Study of Five East Asian Economies

- Mei-Yin Lin and Jue-Shyan Wang

Accumulation of Foreign Exchange Reserves and Long-Term Growth - Victor Polterovich

and Vladimir Popov

FX reserve management trends and challenges - Claudio Borio, Gabriele Galati and

Alexandra Heath

The fuss about foreign exchange reserves accumulation - Charles Wyplosz

Foreign exchange reserves - how much is enough? - Marion V Williams

Are Developing Asias Foreign Exchange Reserves Excessive? An Empirical Examination -Donghyun Park and Gemma B. Estrada

The Currency Composition of Foreign Exchange Reserves: Retrospect and Prospect

Barry Eichengreen and Donald J. Mathiesen

The Social Cost of Foreign Exchange Reserves- Dani Rodrik


13/13

1 2

Documents

Exchange Rate Policy, Reserve Management and Its Implications on the Economy