Balance of payments and exchange rate
Muhammad Mahmood |
Sept. 25, 2021, 8:55 p.m.
Behavioral links between balance of payments and exchange rates have long been recognized as early as the 14th century, when secondary markets emerged for bills of exchange issued by various European banking centers. However, since the mid-twentieth century, the rapid expansion of international capital movements relative to the growth of internal movements of goods and services has given a new perspective on the relationship between the two.
In an open economy, the balance of payments (BoP) and the exchange rate are very important concepts to better understand how the world economy works. The Bangladesh Bank is responsible for compiling BoP statistics in Bangladesh, and these are also regularly published by international agencies such as the International Monetary Fund (IMF) and the World Bank (WB). It is the country’s international balance sheet that records all the international transactions made by its residents, businesses and government with the rest of the world over the course of a year.
As the economic relationship of a country like Bangladesh is not entirely based on trade in goods and services, the BoP also includes transactions involving both financial assets (money, stocks and bonds) and physical (investment in businesses and real estate), i.e. capital. In summary, the BOP records all international transactions of goods, services and assets.
BoP data is not a simple set of digital accounting figures, but the consolidation of a number of key economic indicators and an encapsulation of powerful economic forces. Trends in BoP data can have a big impact on a country’s economic activity, imposing constraints on an economy’s growth rate and indicating the level of income and employment that a country can expect to maintain.
Therefore, in practical terms, a starting point for any analysis of a country’s general economic characteristics and important economic characteristics is its BoP. BoP data provides an accurate representation of the country’s comparative advantage.
A country’s BoP for a single year is of limited value. But when studied over a number of years, they provide insight into the identification of structural changes underway in the economy, thus indicating likely trends that may occur in the future.
More importantly, a change in a country’s BoP can cause the exchange rate to fluctuate. The reverse is also true when a fluctuation in the relative strength of the currency can change the BoP.
For the purposes of balance of payments accounting, international transactions are generally divided into three important sub-components for Bangladesh: current account balance (AC), capital account balance (KA) and account balance. financial (FA). BoP = CA + KA + FA.
At the transaction level, separate import, export or money transfer transactions enter the BoP using a double-entry accounting system. The sum of all postings in the three sub-accounts (CA, KA and FA) must be zero because for each credit entry there must be a debit entry.
However, given the enormity of the task in collecting all the data for the BoP, it is not unusual for the BoP to rarely, if ever, balance. Besides, there are other reasons, especially for a country like Bangladesh where trade channels are used to transfer money overseas using methods like underbilling and contract of sale. Payments for services that can be adjusted for transferring money abroad or to meet the tax needs of clients or both, as well as businesses or citizens underreporting their income abroad. There are always illegal international transactions such as hundi, smuggling, drugs etc. which can disrupt the double entry balance.
Therefore, if a deviation occurs, it is adjusted by an entry made in the errors and omissions (E&O) account – also known as the statistical deviation (SD) to reach the zero balance. E&O is defined as the sum of all the elements of the BoP with their sign reversed, i.e. E&O = – (CA + KA + FA). Bangladesh’s balance of payments data in 2020 recorded an amount of -526.773 million US dollars as E&O. The E&O for Bangladesh averaged -87.342 USD from 1976 to 2020. A negative E&O sign indicates an under-recording of debits such as outflows or current account debits. According to the IMF Balance of Payments Manual, the identity of the BoP is summarized as follows: CA + KA + FA + E & O = 0
Therefore, it is not necessary that each of the accounts that includes the entire BoP must balance each other individually. The BoP is made up of a series of balances, each of which may be in surplus or in deficit, which results in the overall balance of each of the major accounts.
Between 1980 and 2020, Bangladesh recorded a current account surplus for 14 years and a deficit for 27 years. Usually, a country with a current account surplus indicates its dependence on export earnings, with high savings and low domestic demand. On the other hand, a country with a current account deficit is indicative of its dependence on imports, low savings, and high personal consumption rates as a percentage of disposable income.
Bangladesh’s current account balance as a percentage of GDP gives an indication of the level of international competitiveness. Between 1997-98 and 2019-20, the average value of the current account balance as a percentage of GDP in Bangladesh was 0.6%. This figure reached a record high of 3.3% in 2009-10 and a record low of -3.7% in 2017-18. The data clearly indicates Bangladesh’s lack of international competitiveness.
If the current account deficit during the accounting period is not exactly offset by a capital account surplus, the monetary authority, i.e.Bangladesh Bank, closes the gap either by reducing official reserves, or by making an accounting entry via the E&O account to compensate for unidentified capital. thus compensating for the difference between the current account and the capital account.
The capital account measures the capital expenditure and aggregate income of a country, while the financial account measures changes in internationally owned assets. Positive capital and financial accounts indicate a country as a net debtor to the world, while negative accounts make the country a net creditor. The capital and financial accounts are closely linked as they both record international capital flows.
The relationship between the BoP and exchange rates under a floating exchange rate regime will be determined by the supply and demand of the country’s currency and all transactions taking place with other countries. Nowadays, all of these transactions are automated through an intermediary, so that individual buyers do not need to enter the Forex market to obtain goods or services.
Once the transactions are completed, they appear in the current account section of the BoP. The same goes for investments, loans or other capital flows. All capital flows between countries appear in the capital account section of the BoP.
Therefore, in a floating exchange rate regime, as more Bangladeshi currency Taka (BDT) is demanded to meet the needs of consumers and foreign investors, there is upward pressure on the price of BDT. To put it another way, it costs relatively more to trade BDT in terms of foreign currency.
However, the exchange rate of BDT may not increase if other factors weigh on it simultaneously, for example an expansionary monetary policy could increase the supply of BDT and decrease its value against other currencies.
The above relationship between the BoP and exchange rates only exists in an open economy with a freely floating exchange rate regime. But this is not the case in Bangladesh.
The exchange rate regime currently in place in Bangladesh can be described as a managed floating exchange rate regime where the BDT is pegged to the United States dollar (USD). The capital account is also not fully convertible in Bangladesh. In addition, the convertibility of BDT into foreign currencies is very strictly regulated.
Therefore, the Bangladesh Bank should intervene as necessary in the foreign exchange market to keep the BDT / USD exchange rate at the fixed rate. According to the Bangladesh Bank, it does so by relying heavily on interbank exchange rates. The Bangladesh Bank also intervenes by providing liquidity support in foreign currency to commercial banks to settle their commercial transactions. According to the Bangladesh Bank, the cross rates of BDT with other currencies are based on the closing exchange rates of New York and Dhaka.
Indeed, the Bangladesh Bank must intervene to defend the anchoring in the controlled exchange rate system. If the exchange rate is under downward pressure, the Bangladesh Bank must step in to sell foreign currency and buy BDT. Such an intervention will result in a decrease in official international reserves. The reverse is true if the BDT is under upward pressure. This currency parity will only work as long as the Bangladesh Bank has sufficient international reserves to continue to defend it, otherwise the currency parity will collapse.
However, it is generally considered that the BDT remains overvalued in terms of the real effective exchange rate (REER) despite the fact that the BDT has depreciated in recent times. As import and export volumes are REER sensitive, the overvalued BDT makes Bangladeshi exports relatively more expensive and imports relatively cheaper. Therefore, an artificially high currency parity contributes to overconsumption of imports that cannot be sustained in the long run, and often causes inflation.
The conclusion is that under the controlled exchange rate system, official intervention in the foreign exchange market changes the assets and liabilities of the Bangladesh Bank so as to change not only its holding of official international reserve assets. , but also the country’s money supply – unless the Bangladesh Bank does something to neutralize this.