Dragging Peg: The Promise of a Stable Dollar Market Ahead

In response to market pressure or advice from the International Monetary Fund, the central bank introduced the floating exchange rate mechanism on May 8.

The drag pin system is new to Bangladesh. Generally, in this process, a middle rate is established to determine the exchange rate, along with upper and lower limits that form a band within which the rate can fluctuate. The market adjusts by adjusting this average rate and band as needed.

In the two weeks since its implementation, the trailing peg appears to have yielded positive results for the country’s dollar market. Banks are exercising more freedom in trading and there are indications of an easing of dollar liquidity.

Now is a good time to analyze how the system has achieved this and its potential for a balanced forex market in the coming months.

With the introduction of the mechanism, the central bank set the Average Drag Rate (CPMR) at Tk 117. This caused a Tk7 increase in the official dollar rate, marking the highest one-day increase in the country’s history. Banks were allowed to trade dollars around the CPMR without an official band, but were verbally advised to keep transactions within Tk116-118.

No need to hide fee information

In terms of dollar remittances, signals from central banks play a crucial role in global currency markets.

Consequently, the remittance dollar rate rose by Tk1-1.5 a day after the Bangladesh Bank announced the protracted tightening, while remittance inflows also picked up.

Previously, with a fixed exchange rate, banks collected remittances at higher rates and sold those dollars to importers at even higher rates. However, banks tend to hide these high rates in various ways.

Since the introduction of the trailing peg, banks’ information hiding has been reduced significantly and they are now providing the central bank with accurate information on dollar transactions.

Effect on the inflow of remittances

Although the dollar rate for remittances has been increased from Tk 115-116 to Tk 118-119 under the new system, there was no alternative considering the circumstances.

However, the increase in remittance rates has also benefited the banking sector. Central bank data shows $1.38 billion in remittances arrived in the first 17 days of May.

Bankers expect that if this pace continues, Bangladesh could receive close to $2.5 billion in remittances by the end of the month.

In the first 10 months of the current fiscal year, remittances averaged less than $2 billion. Hence, with the introduction of the peg, remittances are likely to increase by an additional $500 million in May.

Interbank transactions in dollars

After two years, the sliding peg system has enabled the resumption of interbank transactions in dollars.

State-owned and private banks had stopped such trading since September 2022 due to the fixed dollar rates by the Bankers Association, Bangladesh and the Bangladesh Foreign Exchange Dealers Association.

Banks were forced to buy dollars at inflated rates but could not detect it. With interbank trading, banks had to accept the central bank’s announced rate, leading to losses during dollar crises.

The drag pin has simplified this process. Earlier, inter-bank sales were limited to Tk 110, but now banks can sell up to Tk 118, narrowing the gap with the market rate and facilitating inter-bank transactions.

Stakeholders believe that if the system works smoothly, interbank transactions will gradually resume. Many banks hold excess dollars and selling them at market prices would increase the dollar supply.

They also say that banks with high demand for dollars can then buy from the interbank, reducing competition for sent dollars. With less competition, dollar prices of remittances are less likely to rise unexpectedly in the market.

Benefits for exporters

Earlier, exporters were getting a maximum rate of Tk 109.50 per dollar. After the introduction of the drag pin system, they get a maximum rate of Tk118.

This means that exporters from Bangladesh are getting about 8% more and have gained a ground in competition with exporters from other countries.

The banking sector has already begun to receive the result of the increase in the dollar rate of export earnings.

Managing directors of several banks told The Business Standard that exporters are now bringing home larger amounts of export earnings. They are making efforts to collect payments which is improving access to dollars and liquidity in banks.

In addition, due to exporters’ access to more liquidity, their ability to set workers’ wages by taking into account the country’s inflation will increase.

Moving forward

Bankers said a trailing peg is not a market-based dollar rate, but a step toward it. They warn that it will not solve all the issues in the dollar market or keep the dollar rate low. Proper implementation of the drag pin is essential, with adjustments informed by market feedback.

First, they suggested that the central bank formally set a clear band, perhaps Tk2-Tk3 or 2%-3%. The current “about CPMR” guidance is not providing any clear direction to the market.

Explaining the matter, they said that the demand for dollars in the country is now much higher than the supply as the rate is around Tk 118 in the market. This creates upward pressure on the rate despite the rising dollar price. Therefore, the market should be allowed to operate according to its own rules to avoid further depletion of forex reserves.

The country’s gross reserves are currently $18.61 billion, at least $5 billion less than usable reserves. Gross reserves at the beginning of the current fiscal year were $23.75 billion. That is, the reserves have fallen by about 22% in a period of about 11 months.

The main reason for this decline was the sale of dollars from reserves to state banks to pay for government imports.

State-owned banks must raise dollars from the market at their own demand to prevent a fall in reserves. This will be possible only when the interbank dollar market is fully operational, bankers said.

Second, the trailing peg is only effective if the average rate is flexible. The central bank has currently fixed the mid-rate at Tk 117, but it needs to be updated regularly based on the dollar’s daily weighted average (WMD) rate, which was Tk 117.77 last Thursday.

Bankers suggested using WAR as the average rate for the next day’s trading band to provide better guidance and market observation.

Third, the dollar exchange rate depends on the money supply. If banks and merchants have plenty of cash, the dollar rate will rise. To control the exchange rate of the dollar and reduce inflation, the money supply must be reduced.

A banking expert noted that the central bank has successfully reduced the money supply in the past to control inflation. This tested method should be used again in the current situation. While the central bank is already trying to reduce the money supply, these efforts must be intensified.

In addition, banks should reduce lending through tools such as repos and guaranteed liquidity support facility (ALSF), he said. A reduced money supply will create liquidity stress, leaving banks with little choice but to raise money by selling excess dollars or borrowing through currency swaps. This will reduce the demand for dollars.

Although this approach may not favor investment growth, the central bank may need to take such tough decisions to resolve the crisis, he added. “In general, the central bank should use the peg and other tools to stabilize the dollar rate and market, allowing the dollar market to run its course.”