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Our problematic macroeconomic duo

Dollar shortage and inflation were the topic of the past week. Understandably so because of the noise around exchange rates at which banks executed foreign exchange trades. This problematic macroeconomic duo is driven by global conditions and domestic demand. None of the policy options are costless while some can make things worse.

Reality check

The external current account deficit increased to $14.1 billion in July-March, compared to $555 million during the same period last year. External financing was not large enough to prevent a rise in the overall balance of payments deficit from $2 billion to $3 billion.

This understates the foreign exchange supply demand imbalance. The Bangladesh Bank has sold $5.3 billion so far this year. It adjusted the official buying and selling rates several notches in a short time. We saw a whole variety of rates last couple of weeks, including centuries.

Inflation increased to 6.3% year-on-year in April 2022, compared with 5.6% in April 2021. Both food and non-food inflation have risen. Rural inflation is higher than urban inflation. The increase in inflation cannot yet be attributed significantly to stronger dollar. The rate of taka depreciation was a tiny 1.7% in July-April.

This problem is not just in Bangladesh. South Asia’s current account deficits are widening. East Asia’s current account surpluses are shrinking. Inflation is projected at 5.7% in advanced and 8.7% in developing economies in 2022.

Same drivers

How has the duo emerged in Bangladesh? In short, increase in international prices, including a pricier dollar, and domestic demand underpinned divergence between supply and demand in the forex market and rise in inflation.

Merchandise import payments increased faster than rise in export receipts. Deficit in the services account expanded. The Global Supply Shortages Index and Price Pressure Index reached a 17-year high in 2021-22, pointing to persistent and elevated supply issues and price pressures on commodities. Declining remittances dried what was a booming source of forex supply during most of the pandemic.

Not all the deficit in the current account was due to international price hikes. The Bangladesh Bureau of Statistics has projected real import growth in FY22 at 45% and real export growth at 23.2%. Import price growth (7%) exceeds export price growth (6.2%), implying a 0.8 percentage point adverse shift in Bangladesh’s terms of trade. This pales in comparison to the 21.8 percentage point excess growth of real import relative to exports. These imply that growth in real domestic demand outpaced growth in real income. Total consumption to GDP ratio increased from 73% in FY20 to 78.4% in FY22.

Inflation is broad based. Of the 422 items in the urban consumption basket, prices of 225 items increased more than 6% in March 2022 relative to March last year. Prices of 25 items decreased or stayed the same. Of the 367 items in the rural consumption basket, prices of 211 items increased more than 6% and prices of 47 items either decreased or stayed the same. Inflation cut across locally produced and importable as well as tradable and non-tradable, suggesting a role of domestic demand in pulling inflation.

Inflation in rural areas came not from rice but from wheat, vegetables, edible oil, locally produced food items (readymade tea), tobacco products, clothing and fabrics, infant wear, footwear, household repairing, public transport (bus, rickshaw fares), and some luxury blades and detergents.

Rice shows up more prominently in urban inflation along with fish, eggs, edible oil, sugar, tobacco, men’s clothing (buttons, tailoring charge, pants, ganjees), lady’s clothing (saree, scarf, blouse), infant wear (nipple feeders), kitchen utensils (locally produced plates, glass and tablespoons), household articles (mosquito coil), public transport (bus, rickshaw, launch fares), motor diesel, toilet soaps and deodorants.

These facts together suggest global market conditions cannot be the whole story. A surge in demand for both domestic and foreign goods happened particularly at the middle- and upper-income level. The surge favoured importable as evident from the rise in import-GDP ratio from 15.8% in FY20 to 23.1% in FY22.

Drivers of domestic demand

Lifting of restrictions on mobility and vaccination unlocked expenditures postponed due to the pandemic. This pent-up demand theory implies a rise in domestic saving in the pandemic ridden FY20-21, followed by a fall. Domestic saving did rise from 26.9% in FY19 to 27.1% in FY20 but fell to 25.3% in FY21, when lockdowns induced by the second Covid wave were less stringent, and subsequently to 21.6% in the lockdown-free FY22. Faster progress in the implementation of stimulus packages contributed as well.

Expenditure switching towards importable resulted from overvalued taka. This is apparent from Bangladesh Bank data on the rate which keeps Bangladesh’s real effective exchange rate constant at the FY15/16 level. Excess of the REER based rate relative to the actual indicates overvaluation. This excess increased from Tk9.6 per dollar on 30 June 2021 to Tk16.7 on 8 May 2022. Overvalued taka means imports are cheaper than it would have been if there were no (or narrowing) difference between the REER based- and the actual nominal exchange rate.

Unlike global conditions, exchange rate management and domestic demand are not beyond our policymakers’ jurisdictions. An orderly correction of the exchange rate is needed for external balance. Macroeconomic policies can facilitate adaptation to global conditions by shaving off some excess domestic demand.

Orderly course correction

When the de facto exchange rate regime is murky, market behaviour can become disorderly. The BB pressures the authorised dealers (ADs) to buy and sell foreign exchange from each other at the official rates. When push comes to shove, the ADs opt out of the market. The interbank market last week looked like the edible oil market – little on the shelves for trade! Asymmetries between exchange rates offered by dealers emerged from choking off interbank transactions. The BB’s buying and selling rates have lost relevance for all practical purposes, notwithstanding recent adjustments.

The BB’s job is to facilitate market adaptation to changing underlying conditions. The foreign exchange market is not nascent. It knows how to discover the same price for the bulk of their clients. The market makers can plan their positions with reasonable accuracy when there is fair play. Repression of practices used by traders to arbitrage away pricing inefficiencies catapult the exchange rate into a non-equilibrium state; even gate round-tripping from the foul playing banks to the curb market.

If the shock to external balance were temporary, the shortage could be largely assuaged without exchange rate depreciation by digging deeper into the reserves. Deficit decline and resurgent financing when the shock fades could be counted on to build reserves…

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