Exchange market intervention may backfire

Dhaka, Dec 9 (bdprem.com)—An idea that has been floating around in public discourse for some time is that an appreciation of the domestic currency could reduce inflation. This suggestion seems to have attracted the imagination of the policymakers who are at their wit's end about the accelerating inflation. Any plausible-sounding intervention that promises to rein in the galloping inflation is welcome, more so if it is easy to implement. The appreciation theory is as simple and attractive a theory as that of syndicates and hoarding that were so popular only a few months ago, and formed the basis of the recent government interventions. The results of these interventions are all too well known to bear repeating. Your Ad Here The relationship between an appreciation of the local currency and a reduction in prices is firmly rooted in the purchasing power parity theory which says that the domestic price of an imported good (or a tradable good) will be equal to the import cost of the good. Since the import cost is equal to the exchange rate times the international price (plus taxes and transaction costs), it follows that an appreciation of the local currency will reduce the domestic price if the international price remains constant. Apparently convinced of the merit of this theory, Bangladesh Bank (BB) engaged in limited exchanged market interventions beginning 29th October. Within four weeks it sold 181.5 million dollars in several tranches from its foreign exchange reserves. The dollar depreciated by ten paisa by 19th November and remained steady thereafter. Some high officials of BB expect the depreciation to be of the order of 20 paisa eventually. It is not certain if BB has done a rigorous background study before engaging in the intervention. Since exchange market intervention is a not a frequently used monetary policy tool, one would have expected BB to do a thorough econometric study to establish the direction and magnitude of the likely consequences on the exchange rate, prices and other variables both in the short and the long term. Such a study was also necessary to decide on the magnitude of the intervention itself. BB is fortunate to have one of the largest economics research departments in the country, and additionally, it is also the purveyor of most of the information needed for such a study. Recently BB had added to its considerable research facility by creating a Policy Analysis Unit at a very high cost. But unfortunately all these enviable research resources remain underutilised. There seems to be some reluctance in BB, just as there is in other government departments, to encourage research. Such an antipathy toward research cannot be helpful in reducing its reliance on external advice for policy making. Although the purchasing power parity theory predicts that a one percent appreciation of the taka reduces prices by one per cent, in practice it is not always so at least in the short term. Import prices are not always passed through fully and there is the possibility of overshooting. Hence, domestic prices may either not decline as much as the rate of appreciation or it may decline even more. A feel about the elasticity magnitudes is important since outcomes could vary widely. If the pass through is less than, say, one-half, a two per cent appreciation of the taka will reduce prices by less than one percent. The benefits of such a small reduction in inflation may not outweigh the possible losses incurred because of the appreciation. Even with a large pass-through the taka has to appreciate significantly, say by at least 2 per cent, to have a noticeable impact on prices. A two per cent appreciation would mean that the taka value of the dollar has to fall from Tk68.71 (as on the day before the intervention) to Tk67.34, i.e. by Tk1.37. BB's exchange market intervention to the tune of 181.5 million dollars has appreciated the taka by only 10 paisa. If the amount of dollar sold and appreciation were linearly related (it is usually not) and assuming that the entire appreciation was due only to the intervention, BB would need to sell about 2.5 billion dollars to bring down the value of dollar to the desired level. The required intervention would be even larger if part of the appreciation was due to other factors. If we agree with the forecast that the appreciation will be eventually 20 paisa, the required intervention would be 1.25 billion dollars, still a very large amount. Could BB engage in such a massive intervention, and even if it did, could the appreciation be anything more than a transient phenomenon? The answer is probably no considering the consequences of a large intervention. If taka were to eventually appreciate by 20 paisa, this would represent an appreciation of the taka by less than three-tenths of one per cent. Such a tiny appreciation cannot possibly have any impact on the prices. In other words, the overt rationale for the exchange market intervention is not tenable with such small interventions. BB has to massively increase the magnitude of the interventions to have a noticeable impact on the prices. Even though the microscopic appreciation achieved so far does little to reduce prices, it could have a significant adverse effect on a very important sector, viz. ready made garments, which is entirely export-oriented. The average profit earned by an RMG entrepreneur is estimated to be about seven per cent of the value of the output. Hence, for every dollar (at Tk68.71) of output the entrepreneurs earn on average a profit of about Tk4.81. If the dollar depreciates by twenty paisa, the profit margin could decline to Tk4.61 since other costs are not likely to be much affected by the dollar depreciation. Hence, the appreciation would mean a 4.2 per cent reduction in the profit margin. If the dollar were to depreciate by 50 paisa - still too small an amount to affect the prices much - the average profit margin of the RMG entrepreneurs could decline by more than ten per cent. Such a reduction in the profit margin will no doubt have a significant negative impact on the leading sector of the economy, and many marginal entrepreneurs will have to exit from the industry. The appreciation will also take a toll on other export industries as their international competitiveness will decline. The effort to reduce inflation might end up reducing exports. The principal problem with appreciation through exchange market interventions is not that it will have an insignificant impact on inflation but that it is a largely self-defeating measure in a country that has only very limited reserves. A casual inspection of data will reveal that there is a positive relationship between the level of the reserves and taka appreciation. The domestic currency is stronger when the level of reserves is high and conversely. The sale of dollar increases the immediate market supply of dollar and thereby depreciates the dollar (or appreciates the taka). But it also simultaneously reduces the level of reserves. The appreciation obviously encourages a higher level of imports, which together with the slow down in exports widens the trade deficit. All these set in motion opposite forces that reverse the original appreciation in due course. Thus the impact appreciation could be maintained only for a limited time which might very well be insufficient to allow the market to reduce prices. BB has neglected to highlight a very important consequence of the exchange market intervention: it leads to a monetary contraction unless offset by other operations. Hence, by engaging in exchange market intervention BB has effectively acted in line with the IMF advice of a contractionary monetary policy that it has publicly vowed not to follow under intense civil society, business and media pressure. Although this puts BB in an awkward position of having to renege on its vow (something it should not have made in the first place), this collateral effect of the intervention could work toward a reduction in inflation through the monetary channel. Assuming the money multiplier to be 4.7, a 181.5 million dollar unsterilised intervention reduces the money supply by more than 5,800 crore taka. This translates into a reduction in money supply of about 2.7 per cent. Such a monetary contraction will no doubt reduce aggregate demand and also help in cooling down inflationary expectations. The intervention could thus eventually have some moderating influence on inflation, but not through the exchange rate channel as some people are claiming. Inflation being a monetary phenomenon will be ultimately determined by monetary factors. The implications of exchange market interventions are neither straightforward nor easily understood. The processes involved are complex and the final outcome is contingent on several factors as well as the magnitudes of the relevant elasticities. Since monetary policy works with a substantial lag and unleashes forces that can have far-reaching consequences for the economy, it should be wielded with due diligence and care. Adequate research should precede any such policy measure to ensure that the actual outcome is close to what was desired.