Press Release – The Exchange Rate and Economic Growth: An Empirical Assessment on Bangladesh

In Bangladesh, real exchange rate depreciation appears to have led to higher economic growth. However, policymakers need to be careful when considering managing the exchange rate as a development policy.

The research, presented by Bazlul H. Khondker (University of Dhaka) at the International Growth Centre’s South Asia Growth Conference 2013 argues that real exchange rate depreciations can be beneficial for growth when properly managed.

Khondker and co-authors find that, in Bangladesh, exchange rate depreciations have had economic effects beyond simple inflationary ones. Indeed, the researchers conclude that exchange rate depreciations actually appear to have had a long-term expansionary effect and therefore led to higher economic growth. They also find the size of this effect to be economically significant: in the long run a 10% depreciation of the real exchange rate is associated with a 3.2% rise in aggregate output.

While this result is overall encouraging, the researchers also find that depreciations lead to short-run contractionary movements, and to the rise of consumer prices. This, and the need to harmonise the exchange rate policy with fiscal and monetary policy, makes it difficult for policymakers to rely on exchange rate depreciations as an economic development strategy.

Background

Despite putting in place a supposed-to-be market based mechanism in 2003, Bangladesh’s exchange rate regime continues to be characterised by widespread interventions. The management of the exchange rate is considered to be a major policy objective in Bangladesh, and the news of taka depreciation is mostly greeted with scepticism about macroeconomic soundness of the economy.

The issue is controversial: exporters often demand depreciations in order to become more competitive in international markets; on the other hand, consumers who rely on imported goods for consumption are against it as it leads to higher price levels. While the issue of nominal depreciations attracts a lot of attention in Bangladesh, discussions surrounding it mainly focus on inflation and are generally without any reference to overall economic activity.

Key findings

  • Despite a steady rise in the nominal exchange rate, Bangladesh’s real exchange rate has hardly changed since the 1980s.
  •  Real depreciations are found to have a long-term expansionary effect. Indeed, in the long run a 10% depreciation of the real exchange rate is associated with a 3.2% rise in aggregate output.
  • However, in the short-run, real depreciation is found to be contractionary; a 10% depreciation would lead to a half a per cent decline in GDP.
  • There is evidence of very high degree of exchange rate pass-through, meaning that exchange rate depreciation leads to substantial price increases for consumers.

Policy implications

Real exchange rate depreciations, by enhancing the external competitiveness, can help expand output of the export sector. They can also improve the competitiveness of the import-competing sector, supporting its growth. However, their appeal as a development strategy is dubious. First, a policy based on supporting exchange rate depreciations would need to be combined with a strategy tackling inflation. Second, the effectiveness of this strategy would largely depend on depend on the nature of accompanying monetary and fiscal policies, as well as other factors influencing the relative prices of tradable goods.

The researchers propose that a policy allowing creeping depreciations that would avoid any significant contractionary effect in the short run while allowing for improved competitiveness and output growth in the long-run might be more pragmatic and feasible in Bangladesh.

Research aim

This research aims to understand the effects of exchange rate changes on economic growth in Bangladesh.

Research methods

The researchers make use of a Keynesian analytical framework to derive an empirical specification. They then carefully construct a real exchange rate series, and employ cointegration techniques to determine the impact of taka depreciation on economic output.

Researchers

Bazul H. Khondker is a Professor of Economics at the University of Dhaka, Bangladesh. He specializes in the area of distributional consequences of macroeconomic policies.

Mahammad A. Razzaque is an Economic Advisor at the Commonwealth Secretariat, London, UK.

Sayema H. Bidisha is an Assistant Professor at the University of Dhaka, Bangladesh.

 

This statement was issued at the South Asia Growth Conference 2013, held in New Delhi, India.