To devalue or not to devalue?
WHETHER or not Bangladesh should devalue its currency is a question that has assumed some prominence. For some time now exporters have been pressing for devaluation, primarily on the ground that the currencies of some competitor countries have depreciated considerably over the past few months. The president of Knitwear Manufacturers and Exporters Association opposed devaluation and asked for higher export subsidy. I was also confronted with the demand for devaluation. My response was that the decision on this matter required a thorough examination of the economy-wide impact of devaluation. According to media reports, the present finance minister hinted that the taka might be devalued; subsequently he stated that there would be no tinkering with the current regime and market forces would determine the exchange rate. To me, the question of intervention in the foreign exchange market is not an ideological one. In most countries with floating exchange rate regimes, central banks do intervene in the foreign exchange market in order to achieve broader macro-economic goals. Bangladesh has been no exception to this widespread practice. Is there any compelling economic logic that warrants devaluation? The objective of this article is to clarify the analytical underpinnings of the case for and against devaluation. The case for devaluation rests on the ground that if exporters are facing hardship due to developments in the global economy they need to be compensated, and devaluation would be an effective tool for providing such compensation. It should be noted that devaluation does not change the price of export in terms of foreign currency, but raises it in terms of domestic currency. As a consequence, domestic consumption of the export commodity is reduced, also the producers are enabled to move up along the supply curve. The combined result is to increase the volume of exports. The exporters earn greater revenue, proportionate to the increase in the volume of exports and the magnitude of devaluation. The above analytical result can be realised only if certain conditions are met. First, devaluation-induced domestic price increase causes a fall in the domestic consumption of the export commodity. In the case of garments exports, this is likely to be the case in Bangladesh. With low per capita income, the demand for garments may be fairly price elastic. The second condition is that for the full realisation of the beneficial impact of devaluation, the supply curve has to remain unchanged. This is a most unlikely scenario in Bangladesh. The garments industry is substantially dependent on imported inputs, and devaluation would cause an increase in their domestic price. As a result, the supply curve would shift to the left, undermining the increase in export volume relative to what would be the case if the supply curve remained unchanged. Furthermore, labour engaged in the garment industry may demand higher wages more forcefully, leading to a further shift of supply curve to the left. The third condition is that the prices of garments remain unchanged in terms of foreign currency and that Bangladesh satisfies small country assumption, meaning that the country can sell any volume at the existing international price. This condition is also most unlikely to be met in the present circumstances. Some garments exporters said that they were facing pressure from the foreign buyers to reduce prices in terms of foreign currency. Devaluation might add fuel to such pressure and, if our exporters have to yield, a significant portion of the potential benefit of devaluation would be appropriated by foreigners. The above analysis suggests that the beneficial impact of devaluation on garments exporters is at best uncertain. Those who clamour for devaluation pitch their argument primarily on devaluation of the currencies of competitor countries. It is worth mentioning that between 2003 and 2007, the taka depreciated by 19%. As against this, currencies of several competitor countries appreciated: China 8%, India 13%, Laos 8% and Nepal 9%. Some countries, of course, experienced depreciation, but much less than Bangladesh: Cambodia 2%, Pakistan 4%, Vietnam 4%, and Sri Lanka 14%. However, during the second half 2008, some of these countries experienced substantial devaluation (though Chinese yuan continued to appreciate). To see whether greater devaluation of the currencies of some competitor countries has cut into exports of Bangladesh, we need to examine whether export volumes of those countries have increased by a greater extent than those of Bangladesh. It appears legitimate to conclude that exports of competitor countries have increased, if at all, but at no expense to Bangladesh. During July to December of 2008, export of woven garments in dollar value terms registered a growth of 21%, and knitwear a rate of 27%, despite downward slip in October and December (DS Feb 4). Most of the increase in export has been generated by increase in volume, rather than price. It is doubtful if any of our competitor countries has witnessed such high growth, devaluation notwithstanding. This is because labour cost in Bangladesh is much lower than in most of the competitor countries, outweighing their supposed advantage attributable to devaluation. Furthermore, there may have been a switch in demand from high-end to low-end products which Bangladesh exports. If the demand for the latter producers also shrinks, it is likely to become price-inelastic. So even a reduction in foreign currency price may not stimulate exports. Another argument often advanced in favour of devaluation is the likely increase of remittance. Here it should be noted that during July 2008 to January 2009, remittances increased by a spectacular 30% over the corresponding period of the preceding fiscal year (DS Feb 10). There is, thus, no evidence that the present exchange rate has discouraged remittances. If the global meltdown leads to loss of employment abroad, or slower rate of recruitment, there is no rational basis to assume that devaluation would cure the malady. Let me state a couple of the undesirable consequences of devaluation. Devaluation increases the domestic price of most goods (including those which are exported and the domestically produced import-competing products). Therefore, the benign trend in inflation, which started from October 2008 (point to point inflation fell to 7.3% in October 2008 and 6.1% in November 2008 from 11.2% in November 2007), would run the risk of being reversed. Devaluation would also have an adverse impact on government finances. The subsidy requirements for food, fuel, and fertiliser would go up if the present price level is to be maintained. Furthermore, taka cost of external debt service will also increase. Devaluation is a macro-economic policy tool, which a country may need to deploy when it suffers from persistent imbalance in external accounts and the deficit cannot be financed within the limits of sustainable external debt service. With a still healthy growth of exports and remittances, that is not the situation in Bangladesh right now. In considering devaluation, the government and the Central Bank should carefully weigh: (i) the likelihood of increasing exports and remittances in the present global climate through devaluation, (ii) the impact on inflation, and (iii) consequences for the government budget.
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