BANGLADESH Bank has been very active in exchange rate interventions. The Daily Star recently reported that the central bank bought a record $5.14 billion from the market in the just-concluded fiscal year to stabilise the exchange rate, in particular to halt appreciation.

The move was aggressive because the amount was only $157 million in fiscal 2011-12 and $316.50 million the previous year. BB's efforts helped raise the country's foreign exchange reserve to more than $15 billion.

Exchange rate intervention in Bangladesh, the flipside of reserve accumulation, has been attributed more to the 'fear of appreciation' than that of depreciation, which is related to a mercantilist attempt to keep the currency undervalued (either to foster the competitiveness of exports or to detract from the competitiveness of imports). Ultimately, it contributes to a current account surplus, both allows the accumulation of foreign assets and preserves some slack on the external front.

What are the reasons behind the appreciating trend of the exchange rate? Excessive liquid dollar asset in the market is mainly due to a decline in imports and increase in remittances. This ultimately triggers a slack in domestic demand or ineffective domestic demand management.

This also points to inconsistencies in monetary policies. On the one hand, the BB has been pursuing contractionary monetary policy in order to keep inflation low. On the other hand, it has been injecting money into the market by buying dollars, although it claims that part of the injected money was sterilised through issuing bonds.

Partial sterilisation may not help keep inflationary pressure in control. As a result of contractionary monetary policy, domestic demand gets squeezed, which was reflected in lower import demand. Excess liquid taka in the banking sector also supports this claim.

Another aspect of buying dollar from the market is to strengthen the reserve position. How does it help the economy?

International reserves are basically used to finance international transactions, to serve as a buffer against unexpected payment difficulties and to allow implementation of monetary and foreign exchange rate policies.

Recently, international reserves in Bangladesh exceeded the $15 billion mark. Such high reserves have been welcomed at all levels with great satisfaction, thanks to remitters as well as active intervention. The reserve accumulation has happened in Bangladesh mainly due to record high remittance growth, constant purchase of dollar from the local currency market and low imports as a result of sluggish investment demand.

The pertinent questions are: Is accumulation of international reserve a case of 'more is better'? Will the current level of reserve sustain in the future? What are the costs and benefits of such reserve accumulation?

Generally, a country should maintain international reserve at a level with which it can meet import payments for at least three months. With $15 billion in reserves, Bangladesh can meet import payments for six to seven months.

In this context, this is a case of satisfaction. Having international reserve more than the standard level (equivalent to nine-month import payments) could work as a safeguard against any currency crisis.

However, there is no such sign of crisis that may occur in the near future for which a healthy reserve would be needed. This is rather a cause of concern for many reasons.

For example, an accumulation of reserves over time may entail risks and costs like inflationary pressure, overinvestment, asset bubbles and complications in the management of monetary policy. Persistent reserve accumulation suggests a strong external sector with significant current account surpluses, which is certainly true for Bangladesh. It has consistently been registering current account surpluses for the last few years. While a persistent current account surplus can be interpreted as a sign of high remittance growth without any clear implication to rising productivity or falling costs, it can be interpreted as a sign of an inherently weak domestic economy.

According to the absorption approach to interpreting balance of payments statistics, the current account balance is the difference between national income and domestic absorption, where absorption is defined as the sum of private consumption expenditure, investment and government expenditure. A current account surplus, thus, suggests there is a weak domestic demand, and that there is a glut of domestic savings. As such, more international

reserves do not necessarily mean better, and a large stockpile should not be mistaken as a sign of economic resilience. Besides, an accumulation of reserves entails risks and costs.

The persistent growth of remittances as well as international reserves may pose policy challenges for macroeconomic management, exchange rate policy and financial sector supervision, if it is not managed properly. Capital inflows could accelerate the growth of domestic credit, create economic overheating, including inflation, and cause the real exchange rate to appreciate, thus affecting macroeconomic performance in a way not consistent or compatible with domestic policy objectives, such as sustainable economic growth with price stability.

Unsterilised intervention partly contributes to liquidity overhang in the money market, and possibly to a surge in inflation too. Increase in remittances and net foreign assets could lead to a stock price boom and a bubbly sentiment in the stockmarket.

Another concern for high international reserve is that it may create a problem like the 'Dutch Disease'. This is a combination of factors, such as overvaluation of taka, loss of competitiveness and shrinkage of the manufacturing sector due to persistent large capital inflows. The phenomenon of de-industrialisation in the presence of rich natural resources, which happened in the Netherlands in the 1960s, is called the Dutch Disease. In Bangladesh, the impact of remittance inflows can lead to such a problem.

Therefore, international reserves can act as a double-edged sword for an economy. While a low level of reserve is not good for an economy, it is also not good for an economy to have a high level of reserve. Although there is no credible estimate on the optimal level of reserve for Bangladesh, it still appears not to be a cause of serious concern.

Finally, exchange rate management should not be against the wind without making proper assessment in the light of real effective exchange rate movement.

The writer is a research fellow at Bangladesh Institute of Development Studies (BIDS). He can be reached at monzur@bids.org.bd.