In January, Bangladesh Bank said it was evaluating a plan to introduce a crawling peg system for the local currency to keep it stable, which would be a step toward a flexible exchange-rate regime. Following the announcement, Moody's Investor Services, one of the world's leading credit rating agencies, said the taka could trade at around 115 per dollar by the end of June, compared with 110 on January 28.

"The introduction of the crawling peg would allow greater stability and predictability of the exchange rate, while further reflecting prevailing market forces compared to the current rate-fixing mechanism," said Marcus Yiu, analyst at Moody's in Singapore at the time.

Since mid-2022, the taka has been depreciating against the dollar, a trend primarily attributed to a balance of payments deficit leading to a significant reduction in reserves. The weakening of the taka has fuelled domestic inflation as the cost of imports has risen. In response to these challenges, Bangladesh Bank charted a gradual shift towards a market-based exchange rate system. The crawling peg was said to be part of a transition to a more flexible exchange rate and a way to prevent further depletion of foreign exchange reserves.

The crawling peg, it was said, would go some way toward rebuilding resilience and adaptability to external shocks, especially as Bangladesh graduates from the LDC category in 2026 and becomes more closely integrated into the global financial system. That means Bangladesh is on course to adopt a "more modernised and forward-looking monetary policy framework." It would also augment the central bank's freedom in monetary policy.

"While the authorities have appropriately accelerated reforms to allow greater exchange rate flexibility, managing transition risks remains crucial. Policy actions to restore external resilience need to be well-calibrated and carefully sequenced to facilitate a non-disruptive transition toward greater exchange rate flexibility," the IMF said in a report in December 2023.

The crawling peg system would be linked to a carefully selected set of currencies and operate within a predefined exchange rate band. This strategy is aimed at tempering unusual fluctuations in the currency's value.

"The central bank would establish a stable benchmark while retaining the flexibility to intervene in the market as necessary to maintain the currency within the designated boundaries," Bangladesh Bank said in January.

According to an IMF assessment, the exchange rate not being market-based was the reason behind the deficit in the financial account, which widened to $8.36 billion in the July-February period from $2.32 billion a year earlier. As a result, much of the export proceeds did not return home to Bangladesh, while remittances were still flowing through unofficial channels.

In September 2022, the central bank had said it was moving towards a more market-based rate, forming a rate-setting committee comprising members of the two leading private sector forex dealers' associations, the Bangladesh Foreign Exchange Dealers' Association (BAFEDA) and the Association of Bankers, Bangladesh (ABB). In reality however the exchange rate was fixed by the Bangladesh Foreign Exchange Dealers' Association and the Association of Bankers on unofficial instructions from the central bank, in an arrangement likened to a cartel by some economists.

Sleeping with the enemy

The reference to a cartel may have had more than simply economic significance, where it describes an agreement between a group of producers of a good or service to control the supply or to regulate or manipulate prices, with an aim to increase its members' profits. But Bangladesh Bank had also formed this committee with members from banks that it had recently prosecuted, and indeed it was still prosecuting, on grounds of manipulating the dollar price.

In August 2022, just a month prior to setting up the rate-setting committee, the central bank had ordered the removal of six banks' treasury chiefs after finding evidence of increasing dollar rates by storing the greenback beyond allowed limits against them. Of these, five were domestic and one was a foreign bank.

Later on, five of the removed treasury chiefs were permitted to return to their previous positions. The managing directors (MD) of the banks concerned were also acquitted of the charges brought against them.

But that was not the end of the problem. In July 2023, the central bank was forced to launch field-level operations to keep banks from selling dollars at higher prices than the rate set by the committee formed by ABB-Bafeda members. The regulator formed six teams to directly monitor the situation, according to sources at the Bangladesh Bank.

The move came after the central bank received complaints against 13 banks about selling the greenback at exorbitant rates. They included both foreign and local banks. Bangladesh Bank was in possession of preliminary evidence against the banks for buying and selling dollars at higher prices than the rate set by ABB-Bafeda.

"The Bangladesh Bank has started an investigation on the banks involved in dollar manipulation. Details will be available once the investigation is completed. Action will be taken against those involved," Mezbahul Haque, executive director and spokesperson of the regulatory body, said at the time.

The names of the 13 banks allegedly manipulating the dollar price came out in the preliminary investigation. For legal reasons we cannot name them since Bangladesh Bank has not completed its investigation or made the report public, but among these were several banks that were previously accused of manipulating the dollar price, according to officials familiar with the matter.

Officials of the Bangladesh Bank alleged that amid a dollar supply crisis, some banks began making extra profits by hoarding the greenback beyond the allowed limits. By keeping those dollars out of the market, those banks artificially hiked the price of the US currency, they said.

Later in October Bangladesh Bank fined the treasury heads of 10 banks Tk1 lakh each due to trading of dollars at higher prices. Bangladesh Bank officials said that these banks had deviated from trading dollars at prescribed rates set by Bafeda-ABB amid the ongoing dollar crisis.

The treasury heads of the banks cannot avoid responsibility for trading dollars at high prices, they added. The banks are Social Islami, Al-Arafah Islami, Mercantile, Modhumoti, Midland, Brac, Exim, Premier, Shahjalal Islami and Trust.

Before imposing the fine, the Bangladesh Bank had sought explanations from the 10 banks over allegations of buying and selling dollars at higher prices than the set price.Sources at the central bank said that although the maximum exchange rate for imports was fixed at Tk109.50 per dollar (at the time), some banks charged as much as Tk117 for a dollar, while selling it at Tk116.

Needless to say, the fines imposed were miniscule compared to the damage done to the economy by such activity, and anyway the banks escaped any institutional culpability. Later in March of this year, we learned that the central bank had waived the fines imposed on the heads of the treasury departments of 10 banks who were penalised Tk1 lakh each for trading dollars above the regulated price.

However, "strict warnings" were apparently issued to them, with the condition that they refrain from such actions in the future.

The decision was made during the 433rd meeting of the Bangladesh Bank's Board of Directors, chaired by Governor Abdur Rouf Talukder.

Getting worse before it gets better

Given all that we know, it should come as no surprise that according to the latest assessment by Moody's Ratings, released this week, the taka is likely to fall deeper into record-low territory as the central bank loosens its grip on the currency with the shift to the crawling peg. It will probably weaken another 2% to about Tk 120 per dollar by the end of the year, said Young Kim, an analyst at the rating firm in Singapore. The currency has hit a series of record lows in recent days.

However, the recently introduced crawling peg system will allow the taka to move closer in value to the rate it trades in the unofficial market, he said. That is a key point of the change in regime, although this may not necessarily hold true if unethical traders in the unofficial market want to continue to make higher profits.

A more flexible foreign-exchange regime is part of a package of policies recommended by the International Monetary Fund, which handed the nation a $4.7 billion bailout program last year. The policy shift may help Bangladesh avoid a further deterioration in its FX reserves, which Fitch Ratings cited as a key reason for downgrading the nation's credit score deeper into junk in May.

"Most of the pressure for Bangladesh is external and was around the fixed-exchange rate that created distortion between the market and the official exchange rate," said Kim, "That's why they devalued taka quite significantly. Reducing that gap helps reduce some of the imbalances."

But what if the unethical traders in the market want to continue making Tk 7-8 off each dollar? That is when the decision to not punish those found of unethical trading in the market may come back to haunt the central bank.

The central bank introduced the crawling peg exchange rate system and set the mid rate at Tk 117 per dollar in May, prompting a nearly 8% slide in the currency this quarter. It weakened 0.3% to 117.7 against the greenback on Tuesday (June 11) to close at a new low.

Bangladesh is also slashing spending and raising taxes as it seeks to narrow the budget deficit and shore up revenues amid a steady erosion of foreign reserves. The central bank has also made interest rates market-based to curb inflationary pressure as the nation grappled with the fastest pace of price rises in seven months in May.

The crawling peg is a system of exchange rate adjustments that falls between two extremes: the fixed rate and the floating or market-based rate. The key difference is that a crawling peg allows for limited fluctuations within a predefined range, while a fixed exchange rate has almost no flexibility.

The new system is primed to bring more flexibility to the exchange rate regime by loosening the central bank's grip on the taka, a key prescription from the International Monetary Fund. The key question, according to economists, is this: will the central bank bring the new exchange corridor closer to the informal market rate to curb opaque currency flows?

"The crawling peg is just a formula. If the dollar-taka exchange rate based on the crawling peg comes close to the informal market rate, it may yield some benefits because that will discourage dollar flows into the informal market," said Zahid Hussain, former lead economist of the World Bank's Dhaka office.

The main advantages of a crawling peg are that it avoids economic instability as a result of infrequent and discrete adjustments (fixed exchange rate), and it minimises the rate of uncertainty and volatility since the fluctuation in the exchange rate is kept minimal (floating exchange regime).

For example, Mexico used a crawling peg to address inflation in the peso crisis. It transitioned from a fixed exchange rate in the 1990s without the instability of rapid devaluation.

In practice, the system may not be an "ideal system" under certain scenarios. For instance, if there are substantial currency flows that may affect the exchange rate, monetary authorities may be "forced" to accelerate currency realignment, leading to substantial unsystematic costs to market players. In practice, only a few countries have adopted crawling pegs.

Currently, only three countries -- Botswana, Honduras, and Nicaragua - use a crawling peg, according to the International Monetary Fund. In 2022, some 13.4 percent of the IMF members used the hard peg, 46.9 percent the soft peg, which includes the countries using the crawling peg, and 34 percent floating exchange rates.

Crawling pegs are often used to control currency moves when there is a threat of devaluation due to factors such as inflation or economic instability, said the IMF.

At the end of the day, the regime chosen to determine a country's exchange rate is less important than the fundamentals underlying its economy. A country with a high demand for its goods tends to export more than it imports, increasing demand for its currency. A country that imports more than it exports will see less demand for its currency. It is well-known that Bangladesh since 2022 has seen a spike in imports that officials are now trying to rein in. At the same time, the country has become newly dependant on greater imports of imported energy, particularly LNG. Unless these trends are managed, taka's slide against the dollar may continue to be a feature of the economy in coming years.