THE external exchange rale of a country's currency vis-a-vis other currencies la an economic variable, which from the beginning of this century upto Die present time has been set or influenced by governments as a conscious policy decision. It can either be tightly con trolled and fixed by government decree or allowed to float" to market forces freely or within a "desired’ or desirable" range, with many other approaches in between An efficient, competitive and growing economy with low in nation would tend to have a stronger currency over the long term. Looked at another way. the purchasing power of a currency in its home country would determine Its external value over the longer term The more rapid the deterioration of real purchasing power the more rapid is the decrease in external value or exchange rate of that currency

Devaluation occurs when a government deliberately ad justs downwards the exchange rale of its currency, while a currency is said to have depre elated In external value when its exchange rate goes down In a freely floating currency market without government intervention

The word "devalue” is loa ded and comes with a negative connotation which is somewhat unwarranted In the curr ency context. As a sirnpll flcation. assume that all our foreign currency needs are met from export revenues A devaluation or depreciation simply increases the Taka cost for the user of foreign cur rency (let us say dollars) not the dollar cost for the country, and Increases the Taka amount to the earner of dollars (i.e the exporter) It Is therefore an in tra country transfer only, and does not involve a transfer of wealth or Income to foreigners as sometimes thought In that sense, a downward adjust ment of the exchange rate4 is a more suitable term than devaluation or depreciation, since the intrinsic "value" of the currency tn Its domestic context remains unchanged, (i.e. the same amount of money still chases the same national output of goods and services)

It is important to be clear about the cause and effect re lationshlp the weaker the economy, the weaker will be the intrinsic value of the currency and not vice versa. That is. a devaluation or currency depreciation is a reflection of an already debilitated economy: it is not that the devalua-tion/dep. leads to a weakening of the economy. On the con-trary. It is often the required adjustment to reality, which enables tire economy to once again return to a healthy and balanced position.

In fact, while there is considerable research, literature and evidence on the economic ill effects of an ’overvalued’ currency (i.e. a currency whose Intrinsic value is lower than the exchange rate maintained by the government directly or Indirectly), there is not much to be found on undervaluation. I suspect that undervaluing a currency may. in fact, be beneficial on the whole to the concerned economy (the Japanese and Korean currencies were arguably undervalued for long periods of time), and is simply one of those options which everyone cannot start availing at the same time since competitive devaluations would simply cancel each other out. (Wiuiess the recent grumblings within the European Union about the UK's devaluations.)

Increasingly, people are becoming accustomed to the idea of currency devaluation and many are now pushing for a suitable downward adjustment of the Taka from its current level. Until very recently, devaluation was a dirty word in Bangladesh and there was hardly any support (with the

notable exception of the WBI for a weaker Taka. Now that the mental block regarding this negative sounding word has been removed, I believe we can address the Issues more constructively.

For Bangladesh, the appropriate question Is -- what is the optimal exchange rate policy and what should the rate be today under that policy to achieve the best economic results? Unfortunately, the ex change rate Issue is not being approached in this way. On the contrary, our exchange rate determination is currently quite passive This may be con trasted with the obvious policy being followed by Pakistan for decades, where the Pakistani Rupee very closely follows the Indian Rupee. Given Bangladesh s border situation, huge legal imports, and main competitor status with India, a policy of linkage with the Indian Rupee makes even more sense for us based on maintaining purchasing power parity between the two currencies.

What Bangladesh actually does Is maintain a stable Rea) Effective Exchange Rate, or REER. vis-a-vis the (urrencies of Bangladesh s major trading partners II e countries from whom we import and to whom we export) Starting with some base year as 100 or starting Ent (a year in which BOP the ance of payments, was In "equilibrium"), the Bangladesh Bank keeps adjusting the Taka

value to compensate for the difference between domestic Inflation and Inflation In the trading-partner countries, so that purchasing power of the Taka vis a vis the currencies of the major trading partners is reflected In the exchange rate The underlying assump tlon Is that maintaining a stable REER would also main tain enough competitiveness of tradeables to ensure a healthy balance of payments equilibrium In the medium to long term.

The major problems here are straightaway, that the base year is quite arbitrary, while the usefulness of keeping up with the major trading partners ts not well established The base year exchange rate is assumed to reflect an equllib-'num position, i.e. the inflows and outflows of foreign currencies are balanced and sustainable at that rate. This assumption may be quite unwarranted and the base year exchange rate may in fact be way out of line It makes more sense to keep up with major competing countries, as opposed to major trading partners, as suggested earlier.

The REER system is also often found to be inconsistent with BOP equilibrium, as both Pakistan and India have shown. For example, since 1985. India's REER has had to come down to around 56. (while Pakistan's is down to 68). to achieve BOP equilibrium. The more pertinent question Is. why follow such an apparently passive approach to exchange rate setting? Why not consider exchange rate setting as an important instrument of economic policy and use it more aggressively to promote the country's long term economic interest, fitting it into the complete package of policy measures?

One approach is to work on the premise that the best exchange rate is the one that will be determined by the free play of demand and supply forces in an open foreign currency market. since the exchange rate would keep going up and down to restore any BOP disequilibrium. While’ developed (and many progressive developing) countries follow this approach.

It usually complements virtually free trade with nominal import tariffs, so that both the currency buying and selling and the underlying goods and services transactions are open and unrestricted. The problem with Bangladesh Is tnat exports are open, unrestricted and relatively tax free (at the Bangladesh end. and largely at the destination end as well) while Imports are still relatively heavily taxed (at the Bangladesh end) Therefore imports are relatively suppressed. so that demand for foreign currency Is relatively suppressed, and the exchange rate of Taka In a free currency market In Bangladesh would tend to be artificially high (thereby resulting In an anti export bias)

A more subtle problem, perhaps unique to Bangladesh (though apparently Israel and Egypt also suffer the same problem), is that foreign aid flows at close to 9 2b comprise tor meet up a substantial por tlon of our total foreign cur rency needs of about 8 6 billion (the balance 8 4 billion coming from our remittances and export earnings) If the GOB did not meet Its annual budget shortfall (ADP) largely from externa) aid flows, but raised It domestically through higher taxes or national debt borrowing and we assume away this S 2b foreign cur rency inflow a huge hole

would arise In the foreign cur rency market which would necessitate a similarly huge devaluation or depreciation Io reslore demand supply equilibrium. This aid-induced dis tortion in essence therefore sustains a substantial overvalua tlon of the Taka with reference to a long term equilibrium ex change rate which would equate demand/supply in the foreign exchange rate The obvious corollary is that long term orientation towards exports and export growth Is being held back due to the ad verse price signals (through an overvalued exchange rate) as a result of this significant aid In duced distortion, another anti-export bias

Given this aid-induced distortion and significant Import barriers, even a completely free currency market would therefore still "overvalue" the Taka vis-a-vis the rate consistent with long term BOP equi librium with freer trade and reduced aid. Nevertheless, the GOB shied away from an earlier commitment to fully float the Taka by November 1995. due to a rapid deterioration of the current account, the reserves position, and inflation. It was feared that there would tie a rapid depreciation of the Taka. Introducing volatility and cost-push inflation (through Imports).

While there are many valid counter arguments, let us assume simply that the GOB Is erring on the side of caution. But surelv. If all indicators point to the need for a substantia! downward adjustment of the Taka (including substantial slides in the external value of the currencies of our neighbours and main competitors — India. Pakistan. Sri Lanka), the GOB must start devaluing the Taka in an orderly fashion, having ruled out the depreciation option as being potentially volatile and disruptive. Instead, inappropriate measures to curtail imports have been taken, such as 'credit squeezes on import related finance. These are completely contrary to the norms of an efficient and open markei economy and start Introducing unnecessary distortions. Meanwhile. Bangladeshi exporters continue to face a persistent

and debilitating anti-export bias due to the inappropriate exchange rate policy, despite a rhetorical commitment to export growth

There are compelling reasons to remove at least one source of anti-export bias identified earlier. Import taxes (while the aid-Induced distortion is expected to gradually reduce with the current climate of aid reduction) 1 ) The theoretical arguments support Ing free trade, and the observed success of free trading nations. 2) Virtual free trade with India along the borders. I.e. close to zero import taxes (except for the usual transaction" costs. 3) The progress of SAPTA. with the ultimate objective of free trade (SAFTA) with our neighbours 4) Our commitments under GATT/WTO to reduce Import taxes. 5) Our No 1 Import Item by far fabrics for the RMG Industry. Is Imported tax free under the bonded warehouse system The textile sector Is also the largest employer In Bangladesh, comprising the RMG industry, the handloom sector, and all other kinds of textile units.

All talk of ’protection" and effective protection’’ Is quite meaningless In this context, where the Government is actu ally not In a position to provide any protection even If It wanted to (there being strong arguments for not providing

any protection In any case) We must keep In mind that, after all. our exporters are surviving without any protection, in fact, may tie even "negative" protec tlon Therefore there Is noth ing Inconceivable about the idea of not affording any "protection" to anyone In this context, tt Is worth nothing that the Srl Lankan Government has already given notice to its business community that import taxes will shortly be made uniform (I.e a single rate for all Uema), and that rate would be under 19%. Anyone can work out. with a bit of thought, that the only import tax structure which completely removes "tariff anomalies'" (I.e. where a higher tax rate Is paid on Imported raw materials than on the imported finished goods made out of that material) Is a single tax rate for all items, particularly when rates are compressed (to under 30% for example)

Furthermore, the economj-dhfly most efficient import tax rate in theory is the lowest possible, i.e. zero, with greater efficiency In an economy being achieved the lower the import tax rates. We need to become accustomed to the idea of a zero or near zero uniform import tax rate, which would in fact be consistent with : 1.) Eradication of all tariff anomalies. expansion of trade and economic growth, reduction of anti-export bias, greater competitiveness and efficiency of the economy. 2.) Dwindling away of the illegal unrecorded border imports since "transaction" costs and other inefficiencies involved with "border" trade would be higher than In zero tax imports through the usual legal channels. 3.) SAPTA rapidly moving towards SAFTA. 4.) Bangladesh rapidly achieving GATT/WTO objectives. 5.) The reality of duty free textile imports by the' RMG industry.

This reality would be explicitly recognized, generalized. and taken into account into the overall situation of the textile industry. Fabrics would remain tax free, but grey fabrics. yarns, dyes and chemicals and raw cotton/polyester would also become tax free, so that local textile manufacturers trying to be competitive with tax free imported fabrics would have a much better

chance. The entire textile sector would in fact become more globally competitive and effi-' cient. The elusive "backward

linkage" could begin In earnest.

If at this point there is a feeling that something is a miss in the above arguments, there is. A substantial devaluation /depreciation should accompany the above measures. Suppose, for example, that the average import tax rate today is 30 per cent. This could be reduced at one stroke to 20 per cent while the Taka is devalued 10 per cent simultaneously With some simplifying assumptions, there is thus no cost-push inflation, nor any unjustified decrease in protection or increase tn import demand Repeated decreases (and compression) of import taxes, accompanied by matching devaluations, could bring us closer to the "dream" of zero import tax — constrained only by the need to raise Government revenues, which should in fact be increasingly through VAT This would reduce consumption overall and raise savings and Investment another pressing need in a trade neutral fashion. But what a boost this .would provide to external competitiveness of our exports and potential exports! No amount of energy, credit, tax and other less direct forms of Incentives/subsidies can match up to the impact of a straightfor ward devaluation/depreciation

of the Taka. Our entire tradeables (exports and prod-ucts/industrles competing with imports) sector Is reeling under the weight of the price bias Introduced through an overvalued Taka

Looking at the larger picture. we are not an India or China so that our rapid growth prospects have been rightly Identified as being dependent

on external forces — foreign trade and direct private investment from abroad. In our case (unlike the huge and irresistible Chinese and Indian economies).- both these de-pend to a large extent on the openness, transparency, competitiveness and efficiency of the economy, including the currency market. The foreign parties potentially wishing to do business with and in Bangladesh are those with over a century's experience in

They can understand and analyse the behaviour of unhampered market forces anywhere in the would, but certainly cannot feel comfortable with highly regulated systems whose change patterns are not always rational from their perspective

The direction of economic policy for Bangladesh is therefore clear — free and functioning markets to achieve efficiency. competitiveness and global integration (leading to investment and burgeoning trade). Any intervention has to be carefully justified in terms of market failure. Import taxes need to be reduced to a uniform and low level, the foreign currency market needs to be completely deregulated, and the Taka floated to find its (depreciated) value. If the GOB is still afraid to let go because of presumed volatility. R should Immediately devalue substantially as a pro-active measure, before events overtake and overwhelm, and it ends up being too little too late. There Is no doubt that non-private flows (aid. soft loans, etc.) will start drying up alongside the export slowdown and rapid import growth, and our exchange rate targets to achieve BOP equilibrium should re-adjust accordingly in the short-term, while the longer term approach to exchange rate policy should be re-thought along the lines suggested above.

The writer is Associate Professor. Institute of Business Administration. Dhaka University.