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

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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

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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.

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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.

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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.

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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.

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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).

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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

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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

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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.

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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.

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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

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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

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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

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floating rate system from the very beginning of its transition to floating regime. More

precisely, the recent exchange rate behavior indicates a fixed exchange rate system is in

place (from 2007 onward).

Fig.1:- Current situation of Taka against US Dollar

Depreciation of currency entails several types of effects on the economy. First,

depreciation directly affects the rate of inflation through the level of the pass-through.

Many studies including a recent one by the Bangladesh Institute of Development Studies

(BIDS) found a high pass-through effect of depreciation of Taka in Bangladesh. Since

Bangladesh is an import dependent country, any change in prices in the international

market will eventually transmit to domestic prices. Second, depreciation also affects

output growth through different channels including the balance sheet channel. Third,

usually a larger depreciation entails a smaller increase in interest rates and this has effect

on the credit channel. Therefore, the overall impact of depreciation depends on the trade-

off between these effects.

Caught in this dilemma, the monetary authorities perhaps have chosen to keep the

exchange rate nominally fixed or almost fixed for last two years, by intervening in the

foreign exchange market. However, to manage floats or to maintain a long-term value of

the currency, Bangladesh Bank must have to acquire a good stock of international

reserves. Recent increasing trends of remittance and net foreign assets give us an

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indication of bright prospects of acquiring large stock of international reserves, which is

now stood at around $10.5 billion by which Bangladesh can meet up three to four months

import cost. In the face of current account surplus with increasing remittance with low

import demand, the Taka is likely to face constant market pressure to appreciate. Market

analysis also reveals the fact that the Taka is now under the pressure of appreciation, but

Bangladesh Bank maintains an undervalued Taka through huge purchase of US Dollars

from the market to maintain export competitiveness.

Occasional intervention in the foreign exchange market brings some positive benefits,

particularly for developing countries like Bangladesh if the intervention is targeted to

achieve some economic objectives such as stable inflation or trade competitiveness. A

word of caution is in order if nominal exchange rate moves along a continuum for long

time-it may create distortions in the market, such as macroeconomic symptoms of

irrational exuberance, which include strong growth, accelerating inflation, rising

international reserves, and gradual overvaluation (the loss of international price

competitiveness). This is a troublesome situation and if it continues for long time, there

might have the risk of possibility of crisis.

3.5 Nominal and Real Exchange Rates

The nominal exchange rate is the relative price of the currencies of two countries. For

example, if the exchange rate between the U.S. Dollar and the Bangladeshi Taka is 80 per

Dollar, then you can exchange one Dollar for 80 Taka in world market for foreign

currency. A Bangladeshi who wants to obtain Dollars would pay 80 Taka for each Dollar

he bought. An American who wants to obtain Taka would get 80 Taka for each Dollar he

paid. When people refer to “the exchange rate” between two countries, they usually mean

the nominal exchange rate.

The real exchange rate is the relative price of the goods of two countries. That is, the real

exchange tells us the rate at which we can trade the goods of one country for goods of

another. The real exchange rate is sometimes called the terms of trade. The real effective

exchange rate (REER) is the inflation-adjusted and trade-weighted exchange rate, which is

used as a popular index of international trade competitiveness of a country. On the other

hand, nominal effective exchange rate (NEER) is a trade-weighted index, which is also

used to represent trade competitiveness.

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3.6 Behavior of NEER and REER in Bangladesh

In May 2003, the government announced the full free floating exchange rate system in

Bangladesh. It was a historic move towards application of market mechanism in

macroeconomic management. It was anticipated that the shift from a managed floating

system to a free floating would have an impact on the foreign exchange market and the

market distortion which prevailed in the exchange rate would be corrected. Before the

floating exchange rate system Bangladesh Bank regularly calculated real effective

exchange rate (REER) using a basket pegging formula with USD as a lead currency.

Based on the REER and other macroeconomic considerations Bangladesh Bank

announced a buying and selling rate for the foreign currencies. The lower and higher

limits of buying and selling rates were mandatory for the dealers. Since the announcement

of switching to the free-floating system a dealer can offer buying and selling rates based

on their own market analysis. However, Bangladesh Bank continues to calculate the

REER to monitor the market trends for necessary intervention.

The estimation of NEER and REER reveals very important behavior of foreign exchange

market in Bangladesh. The NEER index since July 2004 shows that there is a cyclical

trend in the index, which is interpreted as market correction only for demand-supply

mismatch which took place in the exchange rate behavior in Bangladesh market. The

REER based exchange rate, in Bangladesh, increased to Tk. 71.74 per USD at the end of

September 2011 from Tk. 68.85 per USD at the end of September, 2010, indicating that

the country has lost some of its external trade competitiveness during Q1FY12 compared

to the same quarter of previous fiscal year.

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Fig.2:- Behavior of NEER and REER in Bangladesh

Fig.3: - Recent movement of NEER and REER in Bangladesh.

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4.0 Determinants of the Exchange Rate

The next section presents some determinants of the exchange rate. These determinants

could lead to changes of a floating exchange rate or put pressure on a fixed exchange rate.

1. Current Account Balance and Trade Balance:

Exports, imports and the trade balance can influence the demand of currency aimed at real

transactions. An increasing trade surplus will increase the demand for country's currency

by foreigners (e.g. if the United States is running a trade surplus, there will be demand

from overseas for the USD to pay for these goods), so that there should be a pressure for

appreciation. A trade deficit should lead to the currency weakening.

If exports and imports largely determined by price competitiveness and the exchange rate

truly sensitive to trade imbalances, then any deficit would imply a depreciation followed

by booming exports and falling imports. Thus, the initial deficit would be quickly

reversed. Trade balances would almost always be zero.

Fig.4:- Movement of Exchange Rate against Trade Deficit and Current Account Balance

In Bangladesh, the foreign exchange market experienced some depreciation pressures on

the Tk. since last few years. This was due to demand pressure for high import payments

especially high fuel import costs in the context of a decline in external financing inflows.

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Following the higher demand for foreign currencies, the Tk. depreciated by 1.46 percent

against the US Dollar during Q1FY12.

2. Changes in Demand-Supply:

A change in demand-supply plays a key role in determining exchange rate of a currency in

a flexible exchange rate regime. Importers and investors are the major buyer of foreign

currency while exporters are the major supplier of foreign currency.

Fig.5:- Movement of Exchange Rate due to Demand and Supply change

3. Foreign Exchange Reserve

Bangladesh has been experiencing huge trade deficit and its condition is gradually

deteriorating as a whole as Bangladesh is a net importer country. But so far Bangladesh

has been able to manage this deficit with huge inflow of workers’ remittance from abroad

to make its current account positive. As Bangladesh does not allow Capital account

convertibility and gets fair amount of foreign loans and grants and with current account

surplus there should be surplus supply of foreign exchange into the country’s reserve and

thus make its currency appreciate. But in reality, Bangladesh is experiencing huge

pressure in its reserve and exchange rate depreciation. Consequently, Central Bank of

Bangladesh is intervening in the FX market time to time to keep the currency from free

falling. The question, why this is happening despite positive current account balance and

capital control.

Bangladesh Government adopts fiscal policy of deficit budgeting for its capital

expenditure in infrastructure, health, education etc. This deficit is mainly financed by

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foreign loans and grants from donor countries, IMF, World Bank, Asian Development

Bank etc. There has been a declining trend in foreign loans and grants due to global

economic crisis. Also, huge subsidy is being provided in food import and fuel import

which creates huge pressure in its FX reserve. So, overall Bangladesh is experiencing

pressure in FX reserve and currency depreciation.

Fig.6:- Impact of Foreign Exchange Reserve over Exchange Rate

4. Foreign Remittance

Workers’ remittances have an ever important role as one of the major sources of foreign

exchange earnings for the Bangladesh economy. It accounts for over 12 per cent of GDP

in 2010 and having colossal socio economic implications for the country. The relationship

between remittances flow and REER is ambiguous since increased flow of remittances

may impact differently on the REER through consumption, savings and investment

choices by the recipient families on the economy. Inflow of remittances may increase the

consumption by the recipient families on the non tradables sector, or reduce their work

leisure choice, which may increase the relative price of nontradables to tradables and

appreciate the real exchange rate of the country. On the other hand, the flow of

remittances may increase the saving and investment efforts by recipient families, lowers

the resource gap and raises investment in education, health and small business. This in

turn will lower the relative price of nontradables to tradables and improves the

international competitiveness of the country. However, government expenditure, openness

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in goods and capital markets are facilitating the improvement of international

competitiveness as they depreciate the real exchange rate of the country in the long run.

Fig.7:- Impact of Remittances on Exchange Rate

5. Relative Price Changes/Inflation

The inflation rate is also considered to be a determinant of the exchange rate. A high

inflation rate should be accompanied by depreciation of the exchange rate. The more so if

other countries enjoy lower inflation rates, since it should be the difference between

domestic and foreign inflation rates to determine the direction and the scale of exchange

rate movements.

One popular debate concerns the role of nominal exchange rate in managing inflation.

There are quite a few policymakers, researchers and businesspeople who believe that the

depreciation of the exchange rate is the primary culprit underlying rapid inflation in

Bangladesh. This group believes that the government should basically pursue a fixed

nominal exchange rate policy. The underlying logic is the standard cost-push argument for

inflation. Exchange rate raises the Taka price of imported inputs that pushes up the cost of

production and that in turn fuels inflation.

If the exchange rate is to be used as a policy variable to anchor inflation, then it must be

supported by adequate reserves and an appropriate monetary policy that limits the rate of

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inflation to the rate prevailing in the reserve currency country on a long-term basis (a near

impossible target for Bangladesh). This will also imply that fiscal policy cannot rely on

borrowings from the BB as presently. A fixed exchange rate regime imposes huge

discipline on monetary and fiscal policies in the absence of which the exchange rate will

become over-valued in real terms leading to balance of payments problems.

A much better policy regime for Bangladesh is to continue with the present flexible

exchange rate management but support a stable (but not fixed) nominal exchange rate

outcome by pursuing prudent fiscal and monetary policies. Prudent monetary and fiscal

policies will keep inflation under control over the longer-term (although short-term

inflationary episodes might result from international oil price or food price hikes) thereby

moderating the pressure on the nominal exchange rate.

Thus, the core objective of monetary policy should be to target a relatively low rate of

inflation over the longer term and not allow substantial deviations from this long-term

rate. For example, a 5 percent rate of inflation may appear to be a reasonable long-term

target for monetary policy. With the US inflation rate in the 2-3 percent range, this will

imply a 2-3 percent annual average rate depreciation of the nominal exchange rate over the

longer term.

The exchange rate of Bangladesh was virtually fixed for four years during July 2006 to

July 2010. The rate of inflation started climbing from July 2009 owing primarily to

expansionary monetary policy (during 2009 to 2011). This increased the demand for

imports, which put pressure on the balance of payments. Bangladesh was fortunate to have

substantial balance of payments surpluses in 2006-2010 owing to large inflow of

remittances that allowed the Bangladesh Bank to build up substantial reserves. So, when

the demand for imports soared (import growth accelerated to 40 percent in 2011), the BB

was able to protect the exchange rate for a while and instead take the pressure on reserves.

Between April 2011 and November 2011, the central bank lost as much as $2 billion of

foreign reserves.

Faced with this unsustainable pressure on the reserves, the BB let the exchange rate

depreciate. Even with that rapid depreciation, the current account balance that recorded a

surplus of $3.7 billion in FY2010 is now expected to become a deficit in FY2012. If the

exchange rate was not allowed to be adjusted to the demand pressure, there would have

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been a substantial further run on the reserves. The other adverse effect of a fixed exchange

rate regime in the face of rapid inflation is a substantial appreciation of the Bangladesh

currency in real terms. The continued over-valuation of the real exchange rate would hurt

exports. Carried over the longer- term, the trade gap would widen rapidly and destabilise

the balance of payments that could fuel a major economic crisis.

The basic message is that a fixed exchange rate regime is inconsistent with an

expansionary monetary policy. If the exchange rate is to be used as a policy variable to

anchor inflation, then it must be supported by adequate reserves and an appropriate

monetary policy that limits the rate of inflation to the rate prevailing in the reserve

currency country on a long-term basis (a near impossible target for Bangladesh). This will

also imply that fiscal policy cannot rely on borrowings from the BB as presently.

Fig.8:- Movement of Exchange Rate due to inflation

6. Relative Purchasing Power Parity

Another form of real determination of exchange rate is offered by the "one price law" or

the “purchasing power parity”, according to which any freely good or service has the same

price worldwide, after taking into account nominal exchange rates. But in order to

equalize the price of several goods, more than one exchange rate may turn out to be

necessary, or an exchange rate that represents a tradable basket of goods and services. The

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purchasing power parity exchange rate (PPP) between a foreign currency and the U.S.

Dollar can be defined as:

PPP = (Cost of a Market Basket of Goods and Services at Foreign Prices) / (Cost of the

Same Market Basket of Goods and Services at U.S. Prices)

This gives us the exchange rate in terms of the units of foreign currency per Dollar. The

Dollars per unit of foreign currency is just the reciprocal.

The exchange rate between countries, therefore, should be such that the currencies have

equivalent purchasing power. For e.g. if a hamburger costs 3 US Dollars in the United

States and 100 yen in Japan, then the exchange rate must be 100 yen per Dollar. The

foreign exchange market would adjust, over the long term, to permit the functioning of the

"one price law", because the purchasing power of one currency increases (or decreases)

relative to another currency.

7. Relative Interest Rates

Interest rates on treasury bonds will influence the decision of foreigners to purchase

domestic currency in order to buy these treasury bonds. Higher interest rates will attract

capital from abroad, thereby increasing demand for the currency, and therefore the

currency will appreciate. Note, what is important is difference between domestic and

foreign interest rates, thus a reduction in foreign interest rates would have a similar effect.

Accordingly, an increase of domestic interest rates by the central bank could be considered

a way to defend the currency.

But, it may be the case that foreigners rather buy shares instead of treasury bonds. If this

were the strongest component of currency demand, then an increase of interest rate may

even lead to the opposite results, since an increase of interest rate quite often depresses the

stock market, leading to share sales by foreigners. A restrictive monetary policy

(increasing interest rates) usually also depresses the growth perspective of the economy. If

foreign direct investment are mainly attracted by future growth prospects and they

constitute a large component of capital flows, then this FDI inflow might stop and the

currency could weaken. Therefore, interest rates do have an important impact on exchange

rate but one has to be careful to check additional conditions.

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Fig.9:- Impact on the exchange rate when interest rates are raised

8. Speculators, Traders and Financial Instruments

Past and expected values of the exchange rate itself may impact on current values of it.

The activities of foreign exchange traders, speculators and investors may turn out to be

extremely relevant to the determination of the market exchange rate. Financial instruments

like futures and forwards may also play an important role on the determination of

exchange rates.

A foreign exchange speculator who expects the spot rate of a foreign currency to be higher

in three months can purchase the currency in the spot market today at today's spot rate,

hold it for three months, and then resell it for the domestic currency in the spot market

after three months. If he is right, he will make a profit; otherwise, he will break even or

incur a loss. On the other hand, a foreign exchange speculator who expects the spot rate of

a foreign currency to be lower in three months can borrow the foreign currency and

exchange it for the national currency at today's spot rate. After three months, if the spot

rate on the foreign currency is sufficiently lower, he can earn a profit by being able to

repurchase the foreign currency (to repay the foreign exchange loan) at the lower spot rate.

It is important to note that foreign exchange speculation usually takes place in the forward

market because it is simpler and, at the same time, involves no borrowing of the foreign

currency or tying up of the speculator's funds. Actions in foreign exchange options

markets can also influence exchange rates, especially in the short-term. To understand the

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dynamics between spot rates, interest rates and forward rates it is interesting to understand

the mechanics behind covered interest arbitrage.

George Soros is most famous for his single-day gain of US$1 billion on Sept 6, 1992, which he

made by short selling the British pound. At the time, England was part of the European Exchange

Rate Mechanism, a fixed exchange-rate system which included other European countries. The

other countries were pressuring England to devalue its currency in relation to the other countries in

the system or to leave the system. England resisted the devaluation, but with continued pressure

from the fixed system and speculators in the currency market, England floated its currency and the

value of the pound suffered. By leveraging the value of his fund, Soros was able to take a $10

billion short position on the pound which made him US$1 billion. This trade is considered one of

the greatest trades of all time.

8.1. Interest Rate Parity

Interest rate parity is a relationship that must hold between the spot interest rates of two

currencies if there are to be no arbitrage opportunities. The relationship depends upon spot

and forward exchange rates between the currencies. It is:

s is the spot exchange rate, expressed as the price in currency a of a unit

of currency b

f is the corresponding forward exchange rate

ra and rb are the interest rates for the respective currencies

m is the common maturity in years for the forward rate and the two

interest rates.

The interest rate parity (covered interest arbitrage) plays a fundamental role in foreign

exchange markets, enforcing an essential link between short-term interest rates, spot

exchange rates and forward exchange rates.

8.2. Influence of the FX Options Market on Short-Term Exchange Expectations

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Implied volatility is one of the key variables used to calculate the price of an FX option. It

is often interpreted as the market’s measure about possible future movements in spot

(related to the standard deviation of returns over a sample period). In the FX options

market, the preference of calls (right to buy a currency) over puts (right to sell a currency)

is measured by an asset class called risk reversal skew (RR) which is mathematically

defined as:

D delta Risk Reversal Skew = Implied Volatility of a D Delta Call – Implied Volatility of

a D Delta Put

The FX market closely watches these risk reversals. A positive RR, for example, indicates

preference for calls over puts, a signal often perceived as bullish by the market, leading to

overbought positions in the underlying currency, that further exacerbate the RR. This is a

par excellence example of a self-fulfilling prophecy. A defining example of this

phenomenon was the trend up in EUR from the lows in 2002 that saw the risk reversal

continually favoring EUR calls. FX Option positions also give rise to a phenomenon

referred to as strike gravity. As the FX option trader deals in the spot market to hedge a

significant FX option position against counterparty that is not an active market participant,

the spot gravitates towards the strike of the option as the trade approaches maturity. This

effect is more pronounced when the said position is an exotic option with a digital payout

and both the participants have access to liquidity in the cash market to actively manage the

exotic option. These FX flows arising from aggressive hedging by the FX Option market

players often dictate short-term currency moves.

9. Political and Psychological Factors/TOT

Political or psychological factors are also believed to have an influence on exchange rates.

Many currencies have a tradition of behaving in a particular way such as Swiss francs

which are known as a refuge or safe haven currency while the Dollar moves (either up or

down) whenever there is a political crisis anywhere in the world. Exchange rates can also

fluctuate if there is a change in government. A few years back, India’s foreign exchange

rating was downgraded because of political instability and consequently, the external

value of the rupee fell. Wars and other external factors also affect the exchange rate. For

example, when Bill Clinton was impeached, the US Dollar weakened. During the Indo-

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Pak war the rupee weakened. After the 1999 coup in Pakistan (October/November 1999),

the Pakistani rupee weakened.

5.0 Conclusion

To conclude, the exchange rate management in Bangladesh can be rated as good, as it has

not faced any crisis yet. However, still there are scopes to improve the exchange rate

management by taking timely decision/correction. For which, the capacity for exchange

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rate management needs to be improved to reap the maximum benefits of a managed

floating system. It is to be noted that Bangladesh has not yet been tested for its capacity of

managing exchange rate in a crisis or difficult situation. However, the management

capacity would be tested with more capital movements, introduction of currency

derivatives, increase of financial depth etc., if the economy embarks on middle-income

growth path. Proper co-ordination and care should be taken before declaring the fiscal

policy. Government and central bank need to work together and find the right procedure of

inter-action between monetary and fiscal policy without hampering the competitiveness of

the country in international trade and to ensure the growth and development of country.

Even exchange market pressure in Bangladesh is likely to increase soon if the global

economy starts recovering in a full swing. In that case, it would not be easy to keep the

exchange rate fixed without proper monetary stance to maintain low or stable inflation.

Therefore, for better management of exchange rate under a managed floating regime,

Bangladesh Bank should work more on institutional development, bringing efficiency in

the foreign exchange market and financial sector along with its own capacity building.

References

Bangladesh Bank, 2012(May), Economic Trends, Statistics Department, of Bangladesh,

Bank, Dhaka. (Website: http://www.bb.org.bd/pub/index.php).

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Goswami, G., G., and Sarker, M,. M., I., “Nominal and Real effective Exchange Rates

for Bangladesh: 1972:07-2008:12”, Journal of Economics and

Behavioral Studies, Vol.2, No. 6, pp. 263-274, June 2011.

Hossain, M., and Ahmed, M., “An assessment of Exchange Rate policy under Floating

Rate Regime in Bangladesh”, The Bangladesh Development Studies,

Vol.XXXII, December 2009, No.4.

Jochumzen, P., (2010), “Essentials of Macroeconomics” Peter Jochumzen & Ventus

Publishing ApS, Page No. 19-21.

Mankiw, N., G.,(2010), “Intermediate Macroeconomics” Worth Palgrave Macmillan

Publishers Limited, Seventh Edition (International Edition),

Page No.135-147.

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