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Foreign exchange reserve of BB cannot be used to meet local currency needs of development without affecting macroeconomic balance
Nazneen Ahmed, Ph.D is a senior research fellow at the Bangladesh Institute of Development Studies (BIDS).
In recent months, Bangladesh has experienced a sharp rise in its foreign exchange reserve. There has been a welcome increase in the inflow of remittances supported by the 2% incentive bonus introduced by the government.
This has been accompanied by favourable movement in trade balance, as imports – both private and public remained sluggish against the decelerating exports. While use of foreign aid remained at a low level due to economic slowdown, there has been additional inflow of foreign aid to combat Covid-19 related crisis, which further contributed to the rise in reserve.
Bangladesh's foreign exchange reserve reached USD39 billion mark in August 2020. The reserve fluctuated between USD32 billion to USD33 billion for almost a year up until May 2020. It has been on the rise since then and mounted by about 6 billion to USD39 billion in August.
There has been a flurry of suggestions in recent times regarding possible use of the foreign exchange reserve of Bangladesh Bank for accelerated development of the country. Some enthusiastic experts have suggested using the reserve to train-up and financially support returnee migrants from abroad.
l misperceptions seem to underlie these suggestions. The misconceptions include the following amongst others.
Functions and use of foreign exchange reserve
Foreign exchange reserve is an asset of the central bank, in our case, the Bangladesh Bank (BB). Section 7A of Bangladesh Bank Order, 1972 (President's Order No. 127 of 1972), has empowered BB to hold and manage the official foreign exchange reserve of Bangladesh.
BB holds a good part of its foreign exchange reserve in Nostro Accounts, which are accounts that are held in foreign banks including foreign central banks in the currency of the country where the funds are held.
The global money market experiences significant fluctuations in the exchange rate of major currencies and very irregular movement in interest rates.
Therefore, it is risky to keep all foreign exchange reserves in one currency and BB maintains its foreign exchange reserves in different currencies. BB has established Nostro account arrangements with different Central Banks. Funds accumulated in these accounts are invested in Treasury bills, repos and other government papers in the respective currencies.
BB also invests in short term deposits with different high rated and reputed foreign commercial banks and also purchases high rated sovereign/supranational/corporate bonds. To diversify the portfolio and reap possible capital gains, BB also uses part of the foreign exchange reserve to hold gold.
Foreign exchange reserve maintained by BB serves two primary purposes. First, it provides the back up reserve to meet all foreign exchange claims on the country in the event of an adverse balance of payments situation.
Second, it signals the financial strength of the economy to meet foreign obligations. Rise in foreign exchange reserve enhances the capacity of the country to make import payments, service foreign debt and facilitate repatriation of earnings of foreign investors, and hence, is a reflection of its credentials to attract foreign investment, have better credit rating and maintain stable exchange rate.
From that perspective, the liquidity of the foreign exchange reserve held by BB is an important consideration, and hence BB makes investment decisions pertaining to the reserve carefully to ensure optimum short term returns with minimum market risks. So, the perception that the foreign exchange reserve with BB sits idle is a totally incorrect one.
Counterpart liability and access of government functionaries
When any foreign exchange enters BB reserve by way of foreign remittance, export earning, foreign investment, foreign aid etc. BB's asset rises and at the same time a counterpart liability is immediately created.
In most cases, the liability is in the form of Taka printed by BB, which is known as the High-Powered money or the Reserve money. The Reserve money, which forms the cash base of the economy, exists in either of the following four forms:
(i) currency in circulation outside the banking system,
(ii) commercial bank's balance with BB,
(iii) currency in the bank vault, and
(iv) deposits with BB of institutions other than commercial banks. Depending on the size of the money multiplier, the Reserve money generates a higher level of Broad money, and thus, causes an increase in the money supply.
The other form in which BB creates counterpart liability is by crediting foreign currency account of the beneficiary to the extent of foreign exchange inflow. In this case, there is no impact on money supply.
Clearly, the foreign exchange reserve of the BB is not without a claim tag and hence it would be totally inappropriate to consider it as a freely available resource. Moreover, being a balance sheet item of the BB, there is no automatic access of government functionaries to this resource.
Conversion into Taka
The suggestion that foreign exchange reserve of BB can be used to meet local currency needs of development is also misplaced. Since liabilities have already been created against the reserve, fresh printing of Taka against the reserve would create a balance sheet mismatch for BB with liabilities exceeding the assets. Moreover, Taka printing as explained earlier, influences money supply with concomitant impact on exchange rate and inflation.
Use of foreign exchange reserve to finance import
Imports are executed by opening Letter of Credit (LC) through commercial banks. The bank makes available the foreign exchange from its holding against equivalent Taka payment by the importer, which means that the importer purchases the foreign exchange to make the import.
In most cases, such imports are based on borrowing of Taka by the importer. In some cases, specially in the case of import financed through Off-Shore Banking Units (OBUs), the borrowing is in the form of foreign currency and hence repayment also has to be made in foreign currency.
In the former case (imports based on borrowing of Taka), import gets executed by reduction in foreign exchange reserve and corresponding reduction in Taka liability of BB with consequent impact on money supply. In the latter case (imports financed through OBUs), there is no change in the asset position of BB nor in its Taka liability thus keeping money supply unaffected.
This process of import applies to both private and public sector imports, except in the case of foreign funded projects, where import is financed by drawing down the foreign currency account of the importer.
For the government to draw upon the foreign exchange reserve of BB to finance its import, it will have to follow one of these alternative routes. The options are (i) to draw down foreign currency account, (ii) to purchase foreign currency with Taka out of budgetary resource, (iii) to borrow Taka from the banking system to pay for the foreign exchange, and (iv) to borrow foreign currency under arrangement for repayment in foreign currency.
Except for buying or borrowing foreign exchange in one of the above methods, the government cannot use the reserve of BB to finance its imports. If it compels BB to provide foreign exchange without appropriate repayment arrangement, it will, once again, create a balance sheet mismatch for BB with liabilities exceeding assets. This will also have implications for the exchange rate and the inflation situation.
So, the broad conclusion is that there is no free lunch. Foreign exchange reserve of BB cannot be used to meet local currency needs of development without affecting macroeconomic balance. Using the reserve to finance government imports will also have to follow the standard routes of either purchase or borrowing following standard regulations.
Source
Nazneen Ahmed, Ph.D is a senior research fellow at the Bangladesh Institute of Development Studies (BIDS).
In recent months, Bangladesh has experienced a sharp rise in its foreign exchange reserve. There has been a welcome increase in the inflow of remittances supported by the 2% incentive bonus introduced by the government.
This has been accompanied by favourable movement in trade balance, as imports – both private and public remained sluggish against the decelerating exports. While use of foreign aid remained at a low level due to economic slowdown, there has been additional inflow of foreign aid to combat Covid-19 related crisis, which further contributed to the rise in reserve.
Bangladesh's foreign exchange reserve reached USD39 billion mark in August 2020. The reserve fluctuated between USD32 billion to USD33 billion for almost a year up until May 2020. It has been on the rise since then and mounted by about 6 billion to USD39 billion in August.
There has been a flurry of suggestions in recent times regarding possible use of the foreign exchange reserve of Bangladesh Bank for accelerated development of the country. Some enthusiastic experts have suggested using the reserve to train-up and financially support returnee migrants from abroad.
l misperceptions seem to underlie these suggestions. The misconceptions include the following amongst others.
- The reserve sits idle earning no benefits;
- There are no counterpart liabilities to these assets and therefore this free resource can be easily drawn upon to meet developmental needs;
- The Ministry of Finance and other government functionaries have a natural claim on this resource;
- The foreign exchange can be freely converted into Taka to meet local currency needs of development; and
- Import needs of the government can be easily financed from the reserve without any disruptive imbalance in the macro economy.
Functions and use of foreign exchange reserve
Foreign exchange reserve is an asset of the central bank, in our case, the Bangladesh Bank (BB). Section 7A of Bangladesh Bank Order, 1972 (President's Order No. 127 of 1972), has empowered BB to hold and manage the official foreign exchange reserve of Bangladesh.
BB holds a good part of its foreign exchange reserve in Nostro Accounts, which are accounts that are held in foreign banks including foreign central banks in the currency of the country where the funds are held.
The global money market experiences significant fluctuations in the exchange rate of major currencies and very irregular movement in interest rates.
Therefore, it is risky to keep all foreign exchange reserves in one currency and BB maintains its foreign exchange reserves in different currencies. BB has established Nostro account arrangements with different Central Banks. Funds accumulated in these accounts are invested in Treasury bills, repos and other government papers in the respective currencies.
BB also invests in short term deposits with different high rated and reputed foreign commercial banks and also purchases high rated sovereign/supranational/corporate bonds. To diversify the portfolio and reap possible capital gains, BB also uses part of the foreign exchange reserve to hold gold.
Foreign exchange reserve maintained by BB serves two primary purposes. First, it provides the back up reserve to meet all foreign exchange claims on the country in the event of an adverse balance of payments situation.
Second, it signals the financial strength of the economy to meet foreign obligations. Rise in foreign exchange reserve enhances the capacity of the country to make import payments, service foreign debt and facilitate repatriation of earnings of foreign investors, and hence, is a reflection of its credentials to attract foreign investment, have better credit rating and maintain stable exchange rate.
From that perspective, the liquidity of the foreign exchange reserve held by BB is an important consideration, and hence BB makes investment decisions pertaining to the reserve carefully to ensure optimum short term returns with minimum market risks. So, the perception that the foreign exchange reserve with BB sits idle is a totally incorrect one.
Counterpart liability and access of government functionaries
When any foreign exchange enters BB reserve by way of foreign remittance, export earning, foreign investment, foreign aid etc. BB's asset rises and at the same time a counterpart liability is immediately created.
In most cases, the liability is in the form of Taka printed by BB, which is known as the High-Powered money or the Reserve money. The Reserve money, which forms the cash base of the economy, exists in either of the following four forms:
(i) currency in circulation outside the banking system,
(ii) commercial bank's balance with BB,
(iii) currency in the bank vault, and
(iv) deposits with BB of institutions other than commercial banks. Depending on the size of the money multiplier, the Reserve money generates a higher level of Broad money, and thus, causes an increase in the money supply.
The other form in which BB creates counterpart liability is by crediting foreign currency account of the beneficiary to the extent of foreign exchange inflow. In this case, there is no impact on money supply.
Clearly, the foreign exchange reserve of the BB is not without a claim tag and hence it would be totally inappropriate to consider it as a freely available resource. Moreover, being a balance sheet item of the BB, there is no automatic access of government functionaries to this resource.
Conversion into Taka
The suggestion that foreign exchange reserve of BB can be used to meet local currency needs of development is also misplaced. Since liabilities have already been created against the reserve, fresh printing of Taka against the reserve would create a balance sheet mismatch for BB with liabilities exceeding the assets. Moreover, Taka printing as explained earlier, influences money supply with concomitant impact on exchange rate and inflation.
Use of foreign exchange reserve to finance import
Imports are executed by opening Letter of Credit (LC) through commercial banks. The bank makes available the foreign exchange from its holding against equivalent Taka payment by the importer, which means that the importer purchases the foreign exchange to make the import.
In most cases, such imports are based on borrowing of Taka by the importer. In some cases, specially in the case of import financed through Off-Shore Banking Units (OBUs), the borrowing is in the form of foreign currency and hence repayment also has to be made in foreign currency.
In the former case (imports based on borrowing of Taka), import gets executed by reduction in foreign exchange reserve and corresponding reduction in Taka liability of BB with consequent impact on money supply. In the latter case (imports financed through OBUs), there is no change in the asset position of BB nor in its Taka liability thus keeping money supply unaffected.
This process of import applies to both private and public sector imports, except in the case of foreign funded projects, where import is financed by drawing down the foreign currency account of the importer.
For the government to draw upon the foreign exchange reserve of BB to finance its import, it will have to follow one of these alternative routes. The options are (i) to draw down foreign currency account, (ii) to purchase foreign currency with Taka out of budgetary resource, (iii) to borrow Taka from the banking system to pay for the foreign exchange, and (iv) to borrow foreign currency under arrangement for repayment in foreign currency.
Except for buying or borrowing foreign exchange in one of the above methods, the government cannot use the reserve of BB to finance its imports. If it compels BB to provide foreign exchange without appropriate repayment arrangement, it will, once again, create a balance sheet mismatch for BB with liabilities exceeding assets. This will also have implications for the exchange rate and the inflation situation.
So, the broad conclusion is that there is no free lunch. Foreign exchange reserve of BB cannot be used to meet local currency needs of development without affecting macroeconomic balance. Using the reserve to finance government imports will also have to follow the standard routes of either purchase or borrowing following standard regulations.
Source
