Demand in Shadow Market for Foreign Currencies Suppresses Remittance Flows Through Official Channels

 

In the pursuit of macroeconomic stability, foreign exchange reserves and remittance inflows remain the cornerstone of many developing economies, especially in remittance-dependent countries like Bangladesh. However, a growing dissonance has emerged between official remittance figures and the reality of cross-border money movements. This divergence can be attributed in large part to the emergence and growing influence of the shadow market - or more precisely, the hundi system - that creates a parallel channel for foreign exchange transactions. This informal market, driven by demand from capital flight, under-invoicing in trade, and a widening gap between official and market-determined exchange rates, has become a powerful suppressor of remittance flows through legitimate banking channels.

At the core of this problem is a fundamental market mismatch: the official exchange rate fails to reflect the real value of the local currency vis-à-vis global currencies, particularly the US dollar. When the central bank maintains a pegged or semi-managed rate that undervalues the dollar relative to market demand, an incentive arises for informal transactions. For remitters - especially low-income workers in the Middle East, Malaysia, or Europe - the differential of even Tk 3–5 per dollar can mean a significant difference in the total value received by their families. Given the economic hardships of both senders and recipients, it is not irrational for them to seek out more profitable exchange routes, even if unofficial.

The demand for foreign currency in the informal market arises from several channels: illicit capital outflows, under-invoicing in import trade, over-invoicing in export transactions, and even narcotics or gold smuggling. These transactions often require foreign currency liquidity in cash or overseas accounts - transactions the formal market cannot legally fulfill or match in rate or speed. As a result, the informal market creates a premium for US dollar, which then drives intermediaries to seek foreign currency from migrant workers abroad, bypassing the official remittance channels.

A remitter, instead of sending money through a bank or MTO (money transfer operator), may simply hand over dollars to a hundi agent abroad. The agent, connected to a network in Bangladesh, delivers equivalent Taka - at a better rate - to the recipient’s door. This process involves no paperwork, no tax scrutiny, and no banking delays. But it does involve a significant leakage from the central bank’s monitoring framework and weakens the country’s balance of payments position by lowering visible remittance flows. In fact, when the hundi rate exceeds the formal banking rate by a significant margin, even patriotic appeals or remittance incentives struggle to shift behavior.

Bangladesh, like several South Asian countries, has long battled with the parallel currency market. However, the pressure has intensified in recent years as reserves have dwindled, current account deficits widened, and the demand for informal dollar access surged. The result is an unsustainable two-tiered exchange regime: one that tries to preserve formal stability and another that reflects real, market-driven dynamics. This duality creates arbitrage opportunities, encourages malpractices, and ultimately distorts macroeconomic indicators.

The most immediate impact of the shadow market is visible in monthly remittance figures. When incentives were increased, such as the government’s 2.5% cash rebate on remittances through formal channels, there was a temporary rise in official flows. But as the exchange rate gap widened due to dollar scarcity, the growth flattened or declined. The rebate proved insufficient in offsetting the advantage of hundi rates. Moreover, remittance behavior is responsive not just to price signals but also to trust in banking systems, perceived liquidity risks, and procedural simplicity. The hundi system, though informal and illegal, offers frictionless service and instant disbursement - advantages the formal banking system has yet to match.

There is also a structural problem in how the exchange rate policy is managed. By trying to micromanage the taka-dollar rate rather than allowing it to be more flexible and responsive to demand and supply, the central bank inadvertently fuels the black market. When official reserves shrink, import restrictions are imposed, and dollar liquidity dries up in the banking system, businesses and individuals turn to alternative markets. Importers needing to pay suppliers or students paying overseas tuition fees often find the informal market more ‘reliable’ in terms of availability - despite higher rates.

Furthermore, the mismatch between financial sector regulations and real economic behavior has aggravated the situation. Controls on outward remittances, difficulty in opening foreign currency accounts, and bureaucratic delays create a perception that the official channel is rigid and inaccessible. At the same time, lax monitoring of cross-border mobile money, cryptocurrency-based transfers, and third-party apps has allowed informal networks to thrive.

This is not merely a law enforcement issue - it is a market failure. The informal market only exists because it serves a demand that the formal system cannot meet under existing constraints. Policymakers must therefore go beyond regulation and focus on aligning market incentives. A market-clearing exchange rate is the first necessary reform. The more competitive and realistic the official rate becomes, the less incentive there will be to engage with the hundi system. In fact, several countries that floated their exchange rates saw a subsequent rise in formal remittance flows. Egypt and Nigeria offer lessons - albeit with caveats - about how devaluation, when accompanied by banking reforms, can help rechannel remittances through official platforms.

The second reform must involve improving the efficiency and reach of remittance services. Reducing transaction costs, enabling mobile and digital channels, and removing bureaucratic steps can make formal transfers as easy as hundi. In rural Bangladesh, where banking penetration is still low, access to microfinance institutions, agent banking, and mobile financial services can provide a viable formal alternative. Trust in the banking system must also be restored by ensuring faster service, better exchange rates, and reliable disbursement, especially in crisis periods.

Another issue is the quality and enforcement of anti-money laundering and counter-terrorism financing frameworks. A weak enforcement regime allows informal operators to function with minimal risk. Greater coordination among law enforcement, the central bank, and cross-border financial intelligence units is needed to dismantle underground networks and penalize repeat offenders. However, without plugging the market gaps, crackdowns alone will only displace the problem rather than resolve it.

Bangladesh’s remittance sustainability cannot be ensured by moral persuasion alone. Migrant workers face harsh conditions abroad and expect maximum value for their hard-earned money. To redirect their remittances through banks and MTOs, the financial ecosystem must become more responsive to their needs. That means higher returns, lower costs, better service, and easier access. And above all, it means acknowledging that shadow markets are not mere criminal deviations - they are economic signals pointing to systemic flaws.

Additionally, the current regulatory architecture must be reviewed. Excessive approval requirements for remittance-related products, or rigid ceilings on permissible outward transfers, often end up encouraging informal alternatives. Instead, adopting a rules-based, transparent system with automatic entitlements can reduce discretion and thereby limit the growth of shadow demand. The longer a dual exchange rate persists, the stronger the incentive for illicit transfers becomes. Therefore, convergence towards a unified, market-clearing rate will help re-anchor expectations.

Finally, data transparency and public communication are crucial. When people see monthly remittance data fluctuating without clear policy explanations, they assume policy confusion or hidden risks. The central bank must proactively communicate its exchange rate stance, reserve adequacy, and remittance strategies. Clear signaling can shape behavior and reduce uncertainty-driven decisions.

In the end, the fight to protect remittance flows must be waged on multiple fronts: pricing, policy, technology, enforcement, and trust. If the informal market continues to offer a better deal - both financially and logistically - than the formal system, no amount of patriotism or incentive will sustainably reverse the tide. Bangladesh has an opportunity to act now, before the shadow market becomes the mainstream one.
 

Mehdi Rahman works in the
development sector. He also
writes on foreign trade 
and monetary issues.