Dilemmas of foreign currency reserves

While addressing the questions the lawmaker raised, this article also touches on why a country needs to hold forex reserves and how to manage them.

As I see it, Bangladesh's foreign exchange (forex) earnings is a function of essentially seven factors: (a) export of goods and expert services; (b) remittances from temporary workers abroad, (c) foreign direct investments, (d) remittances from immigrants and their recurrent visits to Bangladesh, (e) foreigners investing in domestic capital markets, (f) popularity of BIMAN on international routes, and (g) inflow of foreign tourists.

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These sources of forex reserves, in turn, depend on a country's international image which itself depends on leadership and political stability, absence of political corruption, ease of investment, industrial harmony, road communications, sea and air port facilities, and so on.

Nearly 90 percent of our exports constitute finished garments, jute and finished jute products, frozen fish, seafood, pharmaceuticals, leather, and ceramic products. However, the recent wage disputes culminating in violent disturbances in garments factories will have major setbacks which the LGRD Minister Mannan Bhuiyan summed up by saying that the incidents damaged Bangladesh's image abroad and the foreign buyers left the country with a bad impression (DS May 24). Unless the underlying problems are resolved soon, such incidents are waiting to erupt thus discouraging the already dwindling FDI.

Our FDI is a meagre $2.5 billion in 5 years (Viet Nam attracted $2.4 in just first five months of 2006) and foreign investment in the capital market is almost non-existent. BIMAN, a losing enterprise, is in shambles. Foreigners have little or no attraction to tour Bangladesh, more so because of the terrorist menace and the recent withdrawal of Peace Corps for safety concerns.

By far the most important factors deterring inflow of FDI are political corruption, political instability, labour unrest, and the rise of religious fanaticism.

Using Corruption Perception Index (CPI), economists estimated that a country with a CPI score of 7 is 10 times more favourable to attract a dollar of FDI per capita than a country with a CPI score of 6. For example, India with a CPI score of 2.8 is nearly 13 times more likely to succeed in attracting a dollar of FDI per capita than Bangladesh (with a CPI score of 1.5); Malaysia or Tunisia with a CPI score of 5.0 are nearly 36 times more likely than Bangladesh to attract a dollar of FDI per capita.

In a recent study Joshua Aizenman and Nancy Marion have shown that political instability and political corruption significantly reduce a country's foreign exchange reserves (FER). As a proxy for political instability the authors used a measure of the probability that the government would change by constitutional means and for political corruption they used CPI measure. Both political corruption and political instability thwart the inflows of a country's sources of FER because they frustrate forex earning activities (Ref: International Reserve Holdings with Sovereign Risk and Costly Tax Collection, NBER Working Paper 9154, September, 2002).

An examination of the FER of selected Asian countries reveals that since the 1997-1998 South East Asian (SEA) financial crises, monetary authorities in these markets have been stockpiling FER to ward off another crisis. Bangladesh with a desperately low level of FER (which is approximately 16.24 percent of external debt based on 2005 estimates) and with its all enveloping poor governance and failed leadership, is dangerously poised to plunge from its current weak state status to a failing state image.

Countries hold large amount of FER for various reasons such as averting a financial crisis. A sharp devaluation of domestic currency raises a country's costs of the paying back of foreign debt as well as the costs of imported goods that in turn raise the specter of inflation. By having its own ammunition to defend its currency in a crisis, a country also avoids concerns that the government or the private sector will default on foreign debt payments.

Traditionally, the adequacy of FER is determined by months of import cover with 3-4 months regarded as adequate. This implicitly assumes a time frame to successfully overcome a short-term shock in external payments. Since the 1997-98 financial crisis in the SEA countries lasted for a lengthy period, many changes in international financial markets brought new measures of adequate reserves. The most prominent of these is the Guidotti rule, which stresses that liquid reserves be maintained in sufficient quantity to meet external obligations for about a year without any external assistance.

Managing FER efficiently is another intricate issue. Depending on the level of FER, a country should set a limit on reserves for investment in foreign treasury bonds and deposits in foreign banks to meet the needs of debt repayment and imports. Reserves in excess of that limit should be channeled to purchase strategic resources such as imports of energy, stabilize raw material prices, and hedge against price fluctuations on the international market. Some funds could be invested in holdings of major raw material producers so that domestic enterprises have access to stable imports of the much needed raw materials. Unfortunately, because of low FER these risk averting options are not open to Bangladesh.

With only $3 billion current FER, which is alarmingly low as a percent of external debt, Bangladesh is exposed to a high risk and very low credit worthiness globally. If the expatriates working in the Middle East are told, "we don't need you any more", the country may be thrown into a calamitous financial crisis.

Professors Aizenman and Nancy concluded that "countries whose policy makers care less about the future, countries that are politically unstable, and countries suffering from political corruption find it desirable to hold smaller precautionary forex reserve balances". No, the authors didn't use Bangladesh data. The corroboration of their results by the prevailing conditions in Bangladesh simply underscores the credibility of the predictions of their model as being steadfast.

Dr. Abdullah A. Dewan is Professor of Economics at Eastern Michigan University.