Assignment on Determinants of Exchange Rate in Bangladesh: Overview and Trend Submitted to: Dr. Juthathip Jongwanich Assistant Professor Submitted by: Group No : 3 Group Members: Mohammad Akhlasuddin Shah Zia-ul Haque Mohammad Atiq Mohammad Rayhan Miah Jigme Chogyel Dorji Wangchuk Sonam Tobgay 1
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
Assignment on
Determinants of Exchange Rate in Bangladesh:
Overview and Trend
Submitted to:
Dr. Juthathip JongwanichAssistant Professor
Submitted by: Group No : 3
Group Members:
Mohammad AkhlasuddinShah Zia-ul HaqueMohammad Atiq
Mohammad Rayhan MiahJigme ChogyelDorji WangchukSonam Tobgay
1
ContentsSL No. Particulars Page No.
1.0 Introduction 3
1.1 Scope of the Study 4
1.2 Limitations of the Study 4
1.3 Further Scope of the Study 4
2.0 Exchange Rate 5
2.1 Definition 5
2.2 Exchange Rate Regime 5
3.0 Exchange Rate Regime of Bangladesh 9
3.1 Reasons for changing of Exchange rate regime 11
3.2 Performance during Fixed Rate Regime 12
3.3 Performance after the Regime Change 13
3.4 Current Exchange Rate System of Bangladesh 14
3.5 Nominal and Real Exchange Rates 16
3.6 Behavior NEER and REER in Bangladesh 17
4.0 Determinants of the Exchange Rate 19
5.0 Conclusions 30
References 31
List of Tables
Table-1 Principle objectives of countries for choosing different exchange rate policies. 6
Table-2 Evolution of de jure exchange rate regimes in emerging Asian economies 8
Table-3 Chronology of Bangladesh Exchange Rate 10
Table-4 All regimes and respective number of followers of the regimes 10
List of Figures
Figure-1 Current situation of Taka against US Dollar 15
Figure-2 Behavior of REER and NEER in Bangladesh 18
Figure-3 Recent movement of NEER and REER in Bangladesh. 18
Figure-4 Movement of Exchange Rate against Trade Deficit and Current Account Balance 19
Figure-5 Movement of Exchange Rate due to Demand and Supply change 20
Figure-6 Impact of Foreign Exchange Reserve over Exchange Rate 21
Figure-7 Impact of Remittances on Exchange Rate 22
Figure-8 Movement of Exchange Rate due to inflation 24
Figure-9 Impact on the exchange rate when interest rates are raised 26
2
Abstract:
The objective of this paper is to analyze determinants of exchange rate practices in
Bangladesh placing special emphasis on macroeconomic explanations. In the process, the
paper also tries to identify nominal exchange rate, real exchange rate and the variables that
play important roles in determining the exchange rate of BDT (ISO symbol of
Bangladeshi currency-Taka). In order to provide context; the trend of exchange rate
system in Bangladesh – its past and present have been briefly discussed.
1.0 Introduction
[Whereas, it is necessary to establish a central bank in Bangladesh to manage the
monetary and credit system of Bangladesh with a view to stabilizing domestic monetary
value and maintaining a competitive external par value of the Bangladesh Taka towards
fostering growth and development of country’s productive resources in the best national
interest;]- the preamble of Bangladesh Bank Order 1972.
The exchange rate is one of the most important policy variables, which determines the
trade flows, capital flows & FDI, inflation, international reserve and remittance of an
economy. Besides, exchange rates of currencies lie at the heart of international trade. So,
exchange rate management is one of the central issues of macroeconomic policies.
The currency of Bangladesh is Bangladesh Taka (BDT), which was created to replace the
Pakistan Rupee in January 1972. Before 1983, the Taka was linked to Pound Sterling. The
exchange rates for currencies other than Sterling are based on the London market rates for
the currencies concerned. Started from January 1983, however, its intervention currency
was changed to the U.S. Dollar. Started from 1979, the Bangladesh Bank followed a semi-
flexible exchange rate policy, revaluing the Taka on the basis of a trade-weighted basket
of currencies, with fluctuation margins of 2.5% on either side. Exchange rate of
Bangladesh has received wide attention among all concerned from end-May, 2003 when
Bangladesh adopted the floating exchange rate system. The exchange rate management
has, of late, received renewed attention with the emergence of global financial crisis and
its likely impact on trade, investment and overall gross domestic product (GDP) growth in
2007-08.
3
The paper consists of two parts. In the first part, we present a brief theoretical framework
discussing different exchange rate systems, a historical overview of the exchange rate
system of Bangladesh, the probable reasons for the regime change and a brief discussion
of the performance of the two regimes. After that, we move on to the second part i.e. the
determinants of exchange rate in Bangladesh.
1.1 Scope of the Study:
The study focuses the various foreign exchange regime of Bangladesh; try to find the
determinants and behavioral change of foreign exchange of Bangladesh. To analyze REER
and NEER Data have been collected from 2004-2006. For the rest of the study , data have
been collected from 1998-99 to 2010-11.
1.2 Limitations of the Study:
Every research work needs high degree of involvement regarding collection of
information, creation of database, review of literature and analysis of the data. In this
study, utmost endeavor has been put to collect, organize, analyze, and interpret the related
data and finally to attain the optimum outcome of the study. However, this study has
suffered from certain constraints noted below:
Primary and unpublished data have not considered for the study.
The depth of the analysis has been limited to the extent of information collected
from different sources.
No regression model is used to find out the correlation between various
determinants. Rather the study focused on the impact of various determinants on
the exchange rate in a positive or negative way, but not about the exact change of
foreign exchange to every determinant.
Last of all, this study has been conducted within a very limited time. So, time
constraint has played a key role for the whole study.
1.3 Further Scope of Study:
Further study may be conducted to measure and analyze effect of individual determinants
on exchange rate as well as aggregate effect of all the determinants’ to exchange rate.
4
2.0 Exchange Rate:
2.1 Definition
The exchange rate is defined as the price of one unit of currency in terms of another
currency. If one USD costs 82.50 BDT then 1 BDT costs 1/82.50=0.012 USD. If the
exchange rate is stated in terms of the USD (for example, 82.50 BDT/USD) then the USD
is called the base currency or the unit currency and BDT is called the quoted currency.
In most countries, the exchange rate is expressed using the foreign currency as the base
currency. For example, in Bangladesh, the USD exchange rate would be expressed as
82.50 BDT per USD while, in the U.S., the same exchange rate would be would be
expressed as 0.012 USD/BDT. This way of specifying the exchange rate is called the
direct method as you can immediately figure out how much you have to pay for one unit
of foreign currency.
In some countries, the exchange rate is expressed using the home currency as the base
currency. In the UK for example, the Danish exchange rate would be expressed as 9.2
DKK/GBP. Thus, you have to invert the exchange rate if you want to figure out how much
one unit of foreign currency costs in the UK. This method is called the indirect method of
specifying the exchange rate and the notation is sometimes called British notation.
2.2 Exchange Rate Regimes:
The choice of exchange rate regime has always been one of the most important subjects in
international macroeconomics. Since the publication of Robert Mundell’s “A Theory of
Optimum Currency Area”, we have seen a large amount of literature trying to tackle this
crucial issue to identify how countries choose their exchange rate regimes. According to
the theory of optimum currency areas, this choice is made on the basis of some structural
and macroeconomic factors such as the size, the degree of openness or the level of
economic development of a particular country. Another set of literature emphasizes
political and institutional factors such as political instability, central bank independence or
the government temptation to inflate as important criteria influencing the choice of
exchange rate regime.
5
Table-1: Principle objectives of countries for choosing different exchange rate policies.
Monetary Policy Framework No. of Countries
Exchange rate anchor 96
Monetary aggregate target 31*
Inflation targeting framework 24
IMF-supported or other monetary program 08
Other 35
Source: IMF Annual Report 2006
Note: *according to IMF Annual Report 2006, Bangladesh belongs to this group, where the
monetary authority takes the exchange rate policy to achieve the targets of international reserve,
narrow money(M1), Broad Money (M2) etc.
The most important characteristics of exchange rate system are to what degree the country
is trying to control the exchange rate.
i. Completely Fixed Exchange Rate Regime
ii. Completely Floating (Flexible) Exchange Rate Regime
iii. Intermediate Exchange Rate Regime
iv. Monetary union
i. Completely Fixed Exchange Rate: In a fixed exchange rate system, exchange rates are
either held constant or allowed to fluctuate only within very narrow boundaries. If an
exchange rate begins to move too much, governments intervene to maintain it within the
boundaries. In some situations, a government will devalue its currency while in other
situations it will revalue its currency against other currencies.
ii. Floating Exchange Rate: In a freely floating exchange rate system, also known as a
clean float, exchange rate values are determined by market forces without intervention by
the governments. A major advantage of this system is the insulation of a country from the
inflation or unemployment problems in other countries. An additional advantage of this
system is that a central bank is not required to constantly maintain exchange rate within
specified boundaries. A country’s economic problems can sometimes be compounded by
freely floating exchange rate.
6
iii. Intermediate Exchange Rate Regime
a) Pegged Exchange Rate: Under such a system, the value of the home currency is
pegged to a foreign currency. The pegged currency moves in line with that currency
to which it is fixed against other currencies. Some currencies such as the Bhutanese
Ngultrum is pegged with Indian Rupee while Argentine Peso or the Chinese Yuan
are pegged against a single currency (US Dollar) while some others are pegged
against a composite of currencies such as the composite of European currencies. If a
country conducts most of its trade with another country then pegged system yields
benefit to both these countries as it virtually eliminated the exchange rate risk. The
risk associated with depreciation of that currency to which it is pegged.
b) Managed float exchange rate system: Also known as a dirty float. It is similar to a
freely floating system in that exchange rates are allowed to fluctuate on a daily basis
and there are no official boundaries. It is similar to a fixed rate system in that
governments can and sometimes do intervene to prevent their currencies from a sharp
fall. It prevents a crash in the value of the currency, should it happens. Some criticize
such a policy as it seeks to protect the home currency at the expense of others.
iv. Monetary Union: A country may also be a part of a monetary union where all the
countries in the union share the same currency. There is then no exchange rate between the
countries in the union. The union must itself select an exchange rate system vis-a-vis other
currencies. The largest monetary union is the EMU, the European Monetary Union with
its currency the Euro. The euro is flexible against other currencies (except those that are
pegged to the Euro).
7
Table-2: Evolution of de jure exchange rate regimes in emerging Asian economies
Economy Period Exchange Rate Regime
China, People’s Rep. of 1990-1998
1999-June 2005
July 2005-Present
Managed floatingConvertible pegged arrangementManaged floating exchange rates with reference to a currency basket
Hong Kong, China 1983-present Currency board arrangement
India 1990-present Managed floating with no predetermined path of exchange rate
Korea, Rep. of 1990-1997
1998-present
Managed Floating
Independently floating
Indonesia 1990-July 1997
Aug 1997-June 2001
July 2001-present
Managed floating
Independently floating
Managed floating with no predetermined path for exchange rate
Malaysia 1991-August 1998
September 1998-2005
2006-present
Managed floating
Conventional pegged arrangement
Managed floating with no predetermined path for exchange rate
Philippines 1990-presnt Independent floating
Singapore 1990-present Managed floating exchange rates with reference to a currency basket
Taipei, China 1990-present Independent floating
Thailand 1990-June 1997
July 1997-2001
Pegged to a composite of currencies
Managed floating with no predetermined path for the exchange rate
Bangladesh 1972-May 2003
June 2003-present
Pegged to GBP and USD
Managed floatingSource: 1975 to 1998: International Monetary Fund, Annual Report on Exchange Arrangements
and Exchange restrictions, various years until 1998; 1998 to present: central bank websites
8
3.0 Exchange Rate regime of Bangladesh
Two distinctively different exchange rate regimes have been in place in Bangladesh –
i. A fixed exchange rate regime from January 1972 – May 2003 and
ii. A floating exchange rate regime since June 2003.
i. Fixed exchange rate regime:
Bangladesh, the focus of this paper, had a fixed exchange rate system in place since
January, 1972, virtually since the birth of the Nation (Bangladesh won its war of
Independence on December 16, 1971).
Exchange rate regime of Bangladesh can be characterized mostly as a fixed rate system
imposed and influenced by the government. Given an existing nominal exchange rate, the
corresponding real effective exchange rate was estimated. If the real effective exchange
rate (REER) as estimated on the basis of current par value significantly diverged from the
desired REER, corrective response was initiated by changing the nominal exchange rate.
The exchange rate policy decisions, though notified in all cases by the Bangladesh Bank,
were made on behalf of and in close consultation with the Ministry of Finance.
Bangladesh Bank did not have the sole authority over determining the exchange rate
policy. Up to 24th May 2001, Bangladesh Bank used to announce specified buying and
selling rates. From 3rd December 2000 Bangladesh Bank adopted the practice of declaring
a 50 paisa (0.50 Taka) band within which buying and selling transactions were to be
undertaken; this band was widened to Taka 1.00 from 25th May 2001. Even during the
fixed regime, as mentioned earlier, Bangladesh pursued an active exchange rate policy.
This activism is reflected in the frequency of nominal exchange rate changes announced
by the Central Bank. From 1983 onwards, there have been as many as 89 adjustments in
the exchange rate of which 83 were downwards and only six were upward.
ii. Floating exchange rate regime:
After more than 31 years, Bangladesh adopted a freely floating regime on May 30, 2003
by abandoning the adjustable pegged system. The transition to the floating regime was
smooth and the first ten months can be viewed as the “honeymoon period” for Bangladesh
because the exchange rate remained stable, experiencing a depreciation of less than 1
percent from June 2003 to April 2004. Exchange rate kept on depreciating gradually from
9
mid-2004 and it reached its peak at Tk. 70/USD in 2006 from Tk. 58/USD, accounting for
a 20 percent depreciation. Since then (2007-2009), it remained fairly stable and has been
fluctuating between Taka 68 and 69. Again in September 2011, USD/BDT rate reached to
83.50 due to high import pressure but now hovering at around Tk.81.50. The floating
regime is thus characterized by both volatility and stability.
Table-3: Chronology of Bangladesh Exchange Rate
Period Chronology of Bangladesh Exchange Rate
1972-1979 Pegged to the British Pound Sterling
1980-1982 Pegged to a basket of major trading partners’ currencies with pound sterling as the intervening currency
1983-1999 Pegged to a basket of major trading partners’ currencies with US Dollar as the intervening currency
2000-2003 An adjustable pegged system
June 2003-present Floating exchange rate systemSource: Bangladesh Bank
Table-4: All regimes and respective number of followers of the regimes
Exchange Rate Regimes No. of Countries
Exchange arrangements with no separate legal tender 41
Currency board arrangements 7
Conventional fixed peg arrangements 49
Pegged exchange rates within horizontal bands 6
Crawling pegs 5
Exchange rates within crawling bands **
Managed floating with no predetermined path for the exchange rate 53*
Independently floating 26
Source: IMF Annual Report 2006
Note: *according to IMF annual Report 2006, Bangladesh belongs to this exchange rate system, in
which the monetary authority tries to influence the exchange rate without taking a precise
exchange rate target. Authority intervenes directly or indirectly. However, intervention takes place
considering the parallel market status, balance of payment position, international reserve situations
etc. **none.
10
3.1 Reasons for Changing the Fixed Rate System to Floating
Some of the reasons the exchange rate regime was changed are discussed below:
a. Balance of Payments disequilibrium can automatically be restored to equilibrium.
When the economy experiences a balance of payments deficit, there is excess demand
for the foreign currency and the exchange rate of the local currency depreciates. This
may have the effect of automatically restoring equilibrium. In such case, the value of
local commodities falls from foreigners’ perspective making them more attractive
abroad hence increasing export and value of foreign goods increases from domestic
perspective making them less attractive locally. Both could lead to an improvement in
the balance of payments situation.
b. May decrease inflationary pressures and improve international competitiveness. A
floating exchange rate can reduce the level of inflation in LDCs like Bangladesh.
Allowing the exchange rate to float freely should ensure that exports do not become
uncompetitive. The basic idea comes from the Purchasing Power Parity theory. A
competitive high rate of inflation tends to make the exports uncompetitive.
c. To keep pace with the other markets in South Asia where India (in1998), Pakistan (in
2000) and Sri Lanka (in 2001) have already introduced the floating rate system.
(Islam, 2003)
d. Donors had also been putting pressure on Bangladesh to go for the floating exchange
rate system and reportedly, obtaining foreign assistance from them also depended
somewhat on introducing the new floating exchange rate system. Hence, it can be
argued that pressure from the IMF and the World Bank was an important factor behind
the regime change.
e. Involvement of the government would stop under the new system where market forces
determine the actual price of Taka rather than the finance ministry or the central bank.
11
3.2 Performance during Fixed Rate Regime
Let’s take a look at the performance of Bangladesh in terms of certain key objectives that
an exchange rate regime is expected to promote and how it fared during the fixed rate
regime. The relevant objectives are:
(a) the prevention of any major misalignment of exchange rate and, in particular, the
prevention of appreciation of the real effective exchange rate which can hurt exports; (b)
the promotion of exports and containment of current account deficit;
(c) moderation of inflation; and
(d) enhancement of remittances.
(a) Misalignment of exchange rate: The prevention of misalignment implies that the
actual exchange rate should correspond to the estimate of equilibrium exchange rate. A
recent study undertaken by ADB concluded that the misalignment between the actual and
equilibrium exchange rate for the period 1997 to 2001 was small and progressively
narrowed since 1998. During 2001, the misalignment was only 2.2 per cent. Also, the
exchange rate policy succeeded in preventing appreciation of the real effective exchange
rate throughout the 1990s. It can thus be concluded that the fixed exchange rate regime has
avoided any major misalignment in the exchange rate.
(b) Exports and Current Account Balance:
Bangladesh’s achievement in terms of containing Current Account deficit was not
unsatisfactory. It has done consistently better than Sri Lanka, and better than Pakistan in
all the recent years except in 2001. The only country with which Bangladesh compares
somewhat unfavorably is India, but that should not come as a surprise even to a casual
observer in view of India’s high savings rate and level of industrialization.
(c) Inflation:
The discussion of inflation in the context of exchange rate regime becomes relevant
because of two major considerations. First, a change in the exchange rate is almost certain
to cause a change in the domestic prices of tradable goods. Second, the prices of non-
tradable goods are also likely to be affected because the non-tradable goods often use
tradable inputs and the demand switch generated by initial change in the exchange rate
may not extract corresponding supply response from the non-tradable sector to leave
12
prices unchanged. Bangladesh did reasonably well in terms of inflation criterion. During
the past decade, its inflation rate never reached double-digit level. In every year except
1999, the inflation rates in Bangladesh have been similar to or lower than the South Asian
average.
(d) Remittances: Remittances by Bangladeshi workers employed abroad play an
important role in moderating the country’s trade deficit. The country’s performance in
respect of remittances in Dollar terms has maintained an uninterrupted upward trend.
There was only a minor blip in 2001. The performance of Bangladesh in terms of certain
key objectives that an exchange rate regime is expected to promote has been quite
satisfactory. So it is arguable that the fixed exchange rate regime of Bangladesh had
served the country reasonably well.
3.3 Performance after the Regime Change
It was feared by some that the introduction of the freely floating system may immediately
adversely affect the value of the Taka as it did when this change took place in the
neighboring country. There had been a dip in the value of the weaker currency right after
floatation. But this did not happen for the Taka, which initially remained strong after the
flotation.
Contrary to a lot of speculation about a possible drastic fall in the value of Taka it actually
fared well initially. It also contradicted the historical experience of the other Asian
countries. We can see it by looking at the following exchange rates between Taka and the
USD. Exchange rate of BDT against USD on May 22, 2003 (a week before the regime
change): Tk 57.80/ USD (The Daily Star, May 23, 2003) Exchange rate of BDT against
USD on August 18, 2003 (about one and a half month after the regime change): Tk 57.82/
USD (The Daily Star, August 19, 2003)
It’s obvious here that Taka had not depreciated much against the USD in the early days
after the regime change. It actually gained initially and then remained steady as Dollar
showed signs of weakening against the Euro. Other economic indicators also did not hint
any significant deviations after the introduction of the freely floating system. For example,
the flow of remittances maintained its upward trend as it did during the fixed rate regime.
Also, offering of Dollar denominated bonds increased the reserve of Dollars. The rate of
13
inflation was 5.98% in March 2003, which is higher than 4.58% in the fiscal year of 2000-
2001. The current account deficit was 15,809 Crores BDT ($ 2.72 billion). GDP growth
was approximately 5.5% in 2003 – 2004 (Data source: Official Website of Bangladesh
Bureau of Statistics: http://www.bbs.gov.bd/) Thus, we can conclude that immediately
after the exchange rate system regime change, performance had been reasonable compared
to the performance during the fixed rate regime. In comparison, the BDT had fared more
or less the same in the competitive environment.
However, since then, value of Taka has fallen drastically against Dollar. In February 2007,
BDT against USD was Tk 69.00/USD. Many have attributed this fall in Taka value to the
floating exchange rate regime.
Some of the other note-worthy factors that may influence the change in exchange rate of
Taka are changes in net exports or trade deficits, changes in foreign currency reserves,
changes in real interest rate and change in the rate of inflation. In the next part of the
paper, significance of these factors on value of Bangladesh currency has been analyzed
thoroughly.
3.4 Current Exchange Rate System of Bangladesh
Officially (de jure) Bangladesh maintains floating exchange rate system. Empirical
evidence and theory suggests that floating exchange rates are characterized by little
intervention in the exchange rate markets together with unlimited volatility of the nominal
exchange rate. In a floating regime, since little or no intervention is required, reserves
exhibits relatively low volatility. However, it is observed that relative volatilities of the
exchange rate, reserves and interest rates are very low for the period 2007- 2009,
indicating an active intervention in the foreign exchange market. This observation is
correct because Bangladesh Bank purchased US$1.48 billion from the inter-bank market
in 2008-09, most of which remained unsterilized (MPS, July 2009). Such foreign
exchange intervention activities have led to a situation where the nominal exchange rate
has remained almost fixed or has moved within a very narrow range for the aforesaid
period.
Therefore, the de facto exchange rate regime of Bangladesh has not been in the purview of
the freely floating rate regime. Generally speaking, Bangladesh practices a managed