Bangladesh should avoid the mistakes that doomed Sri Lanka

Given the current incineration of the Sri Lankan economy, good economic advice would include: “Do not do things the Sri Lankan way”. This is advice that the Bangladeshi government is either not heeding or has not received.

Yes, it is only in a small way but this is one of those areas where it is not true that a little of what you fancy does you good. It is a bad idea right from the start.

Back when I did discuss those Sri Lankan ways I said: “ You can only have a foreign exchange shortage if you are trying to fix the price of that foreign exchange.” This is exactly where the current Bangladeshi policy is failing.

The correct policy to have over the foreign exchange rate is not to have one – a policy that is, not a foreign exchange rate. This is not, to put it mildly, what is currently happening. As can be seen by the varied discussions that are going on. The kerb market rate is 97.50 Bangladeshi taka, the inter-bank rate is 87.90 Bangladeshi taka. Furthermore, the banks have been instructed not to deviate from the “official” rate which will be announced to them.

The kerb rate is close to the free market rate, although it is influenced higher by the restrictions on that inter-bank rate. A true free market rate would be somewhere between the two.

Exchange rate policy

The fact that Bangladesh has two rates and that what the banks are allowed to quote is managed suggests that the country has a policy of trying to fix the exchange rate.

This is why the country’s central bank has a problem with the number of dollars available. Because you can only have a shortage of foreign exchange if you are trying to manipulate the price of that foreign exchange.

It is particularly silly that the “official” rate is higher than the free market one would be.

This makes imports cheaper and means that exports are producing less domestic revenue. And why would anyone want to do that? What makes it much worse is that only a certain select few get allocated that scarce foreign exchange at the preferential rate.

Yes, we might think that a benevolent government will allocate according to national needs but that is not what actually happens.

Everyone and their grandmother start lobbying to gain access to those dollars at the preferential rate. There is free money in those foreign exchange rates – and there is a lot of competition for that free money.

Such lobbying is pure waste in an economic system. It is actually a standard finding that the waste of resources devoted to politics to gain subsidies or distortions is actually far worse than the subsidies or distortions themselves.

We also get lots of clever plans to inject liquidity into the market, all of which are entirely unnecessary – they exist only because of the attempt to manipulate the currency itself. As Forrest Cookson has been detailing there are interesting things to be done to curb excessive volatility. But curbing the speed at which prices change is different from trying to curb the price changes themselves.

The basic problem behind all of this seems to be official ignorance of two important points about exchange rates. One is very basic – the foreign exchange rate of the Taka should decline over time. The long term determinant of an exchange rate is the relative inflation rates between the two economies/currencies.

A country which is developing quickly will have higher inflation. This is just how it works out – development is, by definition, that wages are rising.

Fixation on dollar

This causes considerable changes in the prices of goods relative to those of services – because the cost of services is largely wages, which are changing relative to the prices of goods of course. So, speedily developing economies have inflation in them. This means that the foreign exchange rate will decline during periods of speedy development. That is just the way it works.

The second is a seeming fixation on the US dollar foreign exchange rate – the dollar to Taka one. It is not, in fact, that the Taka is declining in value so much as that the dollar is rising.

Over the past year, the US dollar has risen 12% or 13% against the euro, about the same against the pound sterling and around 15% against the Yen.

It is the dollar going up, not the Taka going down.

Trying to maintain the Taka rate against the dollar is therefore not the management of the foreign exchange rate at all, it is the importation of American economic policy into Bangladesh.

Policy and interest rates determine foreign exchange in the medium term, but that inflation rate differential tends to dominate in the long term. So what we have got is the authorities trying to manage the exchange rate, when they should not be, at cost to the wider society. Obviously, they should stop doing so. Just have a free market in foreign exchange and be done with it.

Tim Worstall is a senior fellow at the Adam Smith Institute in London.

This article first appeared in Dhaka Tribune.