Recently, there has been a surge of both applause and concerns regarding the record foreign exchange reserves announced by the Bangladesh Bank (BB). Suggestions are coming from different corners to ensure the proper utilisation of the reserves so that its bad effect on the economy is minimised.
In this regard, Biru Paksha Paul, a professor of Economics at State University System of New York, Cortland, has offered two suggestions in an article titled "High Foreign Reserves: Asset or Liability" which was published in a Dhaka daily. The suggestions are: (1) Bangladesh Bank should take the initiative of further import liberalisation so that funds are easily available for importing capital machinery and intermediate goods. (2) Bangladesh government should speed up its public projects work to stimulate the spirit of the private investors. That means Prof Paul has suggested a Keynesian intervention in the economy to stimulate investment.
First of all, the question arises: on what basis should the BB take the initiative of further import liberalisation? If the argument, as it is in Prof Paul's view, is that record reserves will create currency appreciation effect which is in fact detrimental to export, a counter argument can be offered that such outcome is natural and the BB should not proceed on this justification only.
Secondly, the Keynesian intervention is not tenable given the source of woes and misery that the country is suffering from. If one analyses the source of sluggish economic performance, one can't support such Keynesian perspective to boost the economy. We should seek a permanent cure of the wound rather than temporary cures from time to time.
ROLE OF THE CENTRAL BANK: If one accepts the statement that political factors are responsible for sluggish investment and import growth that has given rise to a record surge of foreign exchange reserves, then how can one suggest that the BB should make an active intervention to offset the possible bad effects stemming from the record foreign exchange reserves? Certainly, it is not a task of the BB, the central bank.
It has become a habit to think that the central bank is such an omnipotent organisation that it should take action whatever the circumstances are. But prudence dictates that the BB should respond to what the economic trend indicates and not determine what the economic trend should be. Again, if the current flood of foreign reserves has partly been caused by political factors, then how much justification is there to claim that BB is responsible to offset the effect of high foreign exchange reserves? It should not be a concern of the BB.
The traditional thinking in academic and professional circle is that an economic crisis, whatever may be its source, should be cured by economic measures taken either by the government or by its allied organisations such as the central bank. To cite Prof. Paul's suggestion, let's say that the central bank has adopted the import liberalisation measure to offset the ballooning currency appreciation effect. And also assume that by such measure, the BB has escaped the currency appreciation effect. From a very simple point of view, we should welcome such a decision since the danger of export contraction would be avoided by overcoming the currency appreciation dilemma. This is true but this is not the spirit of the use of economic measures by the central bank. Why should the central bank be burdened with a responsibility to cure an infection that is created by unruly politics? This may be justified given the exigency of the circumstances. But the question remains: how much desirable is such a solution? We fear that this import liberalisation policy by the BB will not pass this desirability test at all. The desirability test is that economic policies should not be used as an instrument to ward off crises that are generated completely out of the ecnomic model; to rephrase, if we describe the model as an economy and we describe such a model by setting and postulating some definite relationship among different variables, then any disturbance that is generated within the model should be warded off by economic measures or policies.
To cite a historical example from Keynes' General Theory, if the marginal efficiency of capital is depressed by the lack of confidence of investors which is due to some unwanted behavioural mess such as animal spirits, we can justify the intervention to bring an economy back to the track. But, the recent bulge of foreign exchange reserves is not generated within the model but completely by some factors outside the model, for example, by political mess. If this is the case, then we recommend that central bank should refrain itself from taking any initiative to prevent a hazard that is contributed by political instability. Doing so would be indulging the political parties to do the same harm in the same manner in the future and keeping them as safe as before. Let economic forces teach them a lesson and this is more desirable because if they take some lesson, they would think twice in future to inflict any harm on the economy.
Coming back to the central issue, we argue that the BB should allow Taka to appreciate against the dollar to the same extent as reserves inflated by the sluggish investment and import growth due to political instability. To present this in a precise way:
In the above figure, foreign exchange reserves (R) is measured off on the horizontal axis and exchange rate (ER) on the vertical axis. The graph shows that as the amount of foreign exchange reserves increase, domestic currency against dollar appreciates or exchange rate increases. It shows that normal exchange rate at the normal exchange reserves (Rs*) is ER*. But when the level of exchange reserves increases, exchange rate increases and for the reserves increase to the amount (Rsa - Rs*) exchange rate increases to the amount (ERa - ER*). As pointed in the above graph, both reserves bulge (Rsa - Rs*) exchange rate appreciation (ERa - ER*) are outside the model; that means they are not generated primarily by any shocks to any variables inside the model where the model is the entire economy.
By this reasoning, we argue that increased reserves measured by (Rsa - Rs*) is not a desirable reserves and the exchange rate appreciation measured by (ERa - ER*) is not also desirable. Now the question is: how to overcome the currency appreciation effect from such an unwanted reserve bulge? We may try two solutions: The first solution can be import liberalisation as suggested by Prof. Paul. The second solution can be decreasing the unwanted reserves by allowing the currency to appreciate. If we take import liberalisation step, then we will be able to keep exchange rate at ER* since such import liberalisation will reduce the foreign exchange reserves from the unwanted level Rsa to the desirable level Rs*. On the other hand, if we take the second step, same outcome will emerge with the exchange rate ER* and reserves Rs* decreasing the level of reserves from Rsa to Rs*. But this symmetricity is not a sign of symmetricity at all. Why is this so? Let us see.
For this reason that, without replacing economic instability due to political instability by corrective economic policy such as import liberalisation step, we make political chaos a function of economic instability which is in this case soaring exchange rate. Therefore:
In the above figure, change in the exchange rate (re) is measured off on the horizontal axis and political chaos (pc) or instability on the vertical axis. The graph shows a downward sloping straight line depicting a negative relation between political chaos and the change in exchange rate that as the magnitude of the change in exchange rate increases political chaos decreases and vice-versa. This downward sloping straight line is derived from the function J. From the graph, we see that at the re* change in the exchange rate, political chaos is pc0. But as the value of re increases to re1, political chaos decreases to pc*. But our desired value of the change in exchange rate and political chaos or instability are re* and pc* respectively.
Now, the question is: how to achieve this combination of both values? The function J which embodies the negative relationship between political chaos and the change in exchange rate gives the answer. It implies that as the value of re approaches re1, the value of pc approaches pc*. But the value of re1 is not the real value associated with pc* rather it is compatible with re*. Therefore, value of re1 for re can't exist when the value of pc is pc*. So, the line TT makes a leftward shift and the value of re also reduces to re* from re1. This illustration is built on the notion that the central bank allows Taka to appreciate against dollar due to reserves bulge instead of taking other steps just to offset the appreciation effect. Now, assume instead that the central bank has taken the other route to prevent currency appreciation effect and has allowed import liberalisation as per Prof Paul's suggestion. The spirit of such measure is captured by the function J1 which shows that whatever the value of the change in exchange rate, political chaos is always fixed at pc0. Let's say by import liberalisation, the central bank has achieved somehow the value re* and so political chaos should be pc*. But the function J1 indicates that political chaos is pc0, and the difference (Pc0 - pc*) is the measure of the existence of political instability to create further problems in the future. At this point a question arises: is it possible that the value of re stays at re* with the value pc0? The answer is no. Sooner or later re will be moving to re1 with still Pc0. This means that the central bank will not be able to stabilise the exchange rate rather it will aggravate the situation with frequent ups and downs in the exchange rate. This shows why the two measures - allowing Taka to appreciate and allowing import liberalisation to neutralise the effect of bulging foreign exchange reserves on currency - are not symmetric at all though both measures bring the change in the exchange rate to re*. The import liberalisation step will do so for a very short period and the central bank will not able to sustain the value re* by such steps. But by allowing the currency to appreciate following the negative relationship embodied in J function, the central bank will able to stabilise the value of re at re* and once this is achieved, the value of re will not anyway move from re* unless something other
The above illustrative discourse indicates why Keynesian intervention can't be justified in this circumstance as well. This point can be analysed more clearly going back to the J and J1functions respectively. If we allow the variables to adjust by setting a relationship as embodied in J, we don't need the Keynesian intervention. But if we allow the economy to adjust by setting a relationship as embodied in J1, we need the Keynesian intervention.
As mentioned above, the matter is not whether we need the Keynesian intervention or not but rather whether it is justified or not given the source and origin of the problem. For the same reasons outlined above, Keynesian measure can't be justified at all because such a measure will be able to solve the problem for a very short time but will leave a permanent infliction on the economy exactly like the unstable exchange rate.
The contributor writes from the University of Denver, USA.