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Effect of Inflation and Exchange Rate on Foreign Direct Investment

(FDI) Decision in Furniture Industry (Processed wood) in Bangladesh

Submitted by

Name: Ahmed Zaheer

Roll: 22

Batch: 44E

Name: Krisnendu Roy

Roll: 29

Batch: 44E

Submitted To

Melita Mehjabeen, Lecturer, Institute of Business Administration,

University of Dhaka

In partial fulfillment of requirement for course work of International

Finance (F603)

Date: 14.01.13

Course No: F603

Course Title: International Finance

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Declaration

This is to declare that work content of this term paper is prepared by Ahmed Zaheer (22,44E)

and Kisnendu Roy (29,44E) under supervision of Mrs. Melita Mehjabeen, Lecturer Institute

of Business Administration, University of Dhaka

Submitted by

Ahmed Zaheer Krisnendu Roy

Roll-22, Batch 44E Roll-29, Batch 44E

ii

Acknowledgment

We would like to express a sincere and special thank to our course teacher Mrs. Melita

Mehjabeen, Lecturer Institute of Business Administration (IBA-DU) for her affectionate and

careful supervision, sympathetic co-operation, her continuous support, guidance, thorough

correction and efforts in doing this paper. Without her encouragement and valuable

suggestions it would be impossible to bring this paper work to success.

We would also like to acknowledge Otobi Ltd management for the support and timely

cooperation.

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Abstract

Foreign direct investment (FDI) plays a significant role in economic growth of a country like

Bangladesh. Along with sectors such as RMG, Leather, Pharmaceuticals furniture industry of

Bangladesh is growing rapidly. Impact of exchange rate and inflation on FDI inflow in

Bangladesh was evaluated in this paper. Correlation coefficient between exchange rate and

FDI inflow indicated a strong positive relationship of FDI inflow and weakening currency of

the host country. Inflation had a negative impact on FDI inflow especially in labor intensive

industry such as furniture because inflation tends to push labor cost upward. Linear

regression was utilized to predict future exchange rate and inflation in Bangladesh. These

relationships were used to identify advantages and disadvantages of FDI on furniture industry

of Bangladesh. Exchange rate and inflation in Bangladesh is favorable to make FDI in

furniture industry considering there are other positive factors such as huge unexploited local

market, export opportunity, cheap labor etc are present in this sector.

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Table Of Contents

1. Introduction ........................................................................................................................ 1

2. Literature Review ............................................................................................................... 2

2.1. Exchange Rate and FDI............................................................................................... 2

2.2. Inflation and FDI ......................................................................................................... 3

3. Objective ............................................................................................................................. 4

4. Methodology ....................................................................................................................... 5

5. Effect of Exchange rate and Inflation on FDI in Bangladesh............................................. 5

5.1. Exchange rate and FDI inflows In Bangladesh ........................................................... 5

5.2. Inflation rate and FDI inflows in Bangladesh ............................................................. 7

6. FDI in Furniture industry in Bangladesh ............................................................................ 8

6.1. Overview of furniture Industry in Bangladesh ............................................................ 8

6.2. Prospects of Furniture Industry in Bangladesh ........................................................... 9

6.3. Advantages of FDI in furniture industry in Bangladesh ............................................. 9

6.4. Disadvantages of FDI in furniture industry in Bangladesh ......................................... 9

7. Result ................................................................................................................................ 10

8. Conclusion ........................................................................................................................ 10

Reference ................................................................................................................................. 11

Table of Figures

Figure 1: Exchange rate of USD against BDT........................................................................... 5

Figure 2: Yearly FDI inflow ...................................................................................................... 6

Figure 3: FDI inflow against Exchange Rate ............................................................................. 6

Figure 4: Yearly inflation (%).................................................................................................... 7

Figure 5: Yearly FDI inflow ...................................................................................................... 7

Figure 6: Market share in furniture industry in Bangladesh ...................................................... 8

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1. Introduction

Bangladesh is a densely populated, low income country which has huge potential for foreign

direct investment particularly in labor intensive industries such as garments, leather and

furniture industry. Bangladesh has a huge local market of furniture and also has all the

ingredients to become a noteworthy exporter of furniture. In this paper we analyze the effect

of inflation and exchange rate on foreign direct investment decision with our focus directed

towards furniture industry.

In most developing countries there is the dearth of capital for investment which has affected

the economic situation of these nations. In order to ameliorate the situation various

governments of these nations has now focused much attention on investment especially

foreign direct investment which will not only guarantee employment but will also impact

positively on economic growth and development. FDI is needed to reduce the difference

between the desired gross domestic investment and domestic savings.

According to Adegbite and Ayadi (2010) FDI helps fill the domestic revenue generation gap

in a developing economy, given that most developing countries’ governments do not seem to

be able to generate sufficient revenue to meet their expenditure needs. Other benefits are in

the form of externalities and the adoption of foreign technology. Externalities here can be in

the form of licensing, imitation, employee training and the introduction of new processes by

the foreign firms (Alfaro, Chanda, Kalemli, Ozean and Sayek 2006).

Foreign direct investment consists of external resources including technology, managerial

and marketing expertise and capital. All these generate a considerable impact on host nation’s

productive capabilities.

McAleese (2004) states that, “FDI embodies a package of potential growth enhancing

attributes such as technology and access to international market.” But the host country must

satisfy certain preconditions in order to absorb and retain these benefits, and not all emerging

markets possess such qualities (Borensztein, De Gregorio and Lee, 1997; Collier and Dollar,

2001; Seetanah and Khadaroo, 2007)

Monetary policy can shape the economic environment that is conducive in attracting FDI into

host countries. However the characteristics of monetary policy presents the “impossible

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trinity” – a trilemma problem where trade-offs must be done in order to maintain economic

stability. Two of these anchors are inflation autonomy and exchange rate variability. These

trade-offs can impact on the host country’s attractiveness on FDI inflow (Lahrèche-Révil and

Bénassy- Quéré, 2002; Gelb, 2005; Umezaki, 2006).

Given the Bangladesh economy resource base, the country’s foreign investment policy should

move towards attracting and encouraging more inflow of foreign capital. The need for foreign

direct investment (FDI) is born out of the under developed nature of the country’s economy

that essentially hindered the pace of her economic development. Furniture sector of

Bangladesh is very encouraging for foreign investors because Bangladesh already has a

skilled manpower in this sector.

2. Literature Review

2.1. Exchange Rate and FDI

In the past, economists believed that there is no advantage to be gained by purchasing foreign

capital and/or assets. As the economic system works in a long-term equilibrium, any firm

purchasing foreign assets at a “bargain”, in the hope of taking advantage of stronger currency

in their home country against the targeted country, can be equalized by price adjustment of

the assets in the long run (Froot and Stein, 1989). Froot and Stein (1989) argue that the

economy is distorted by “informational imperfection” (p. 4), and opportunities are not equal

across borders. There are merits in holding foreign assets. The difference in cultures, work

ethics and way of life can have markedly different efficiency outcome.

Today, there exists a “common wisdom” regarding the relationship between FDI and

exchange rate. When a country’s currency devalues, it is viewed as an opportunity for foreign

investors to purchase assets at a reduced cost. This is especially true when foreign firms have

identified specific assets in their targeted markets (Blonigen, 1997).

Barrell and Pain (1996) find that investors tend to postpone their investment when the

currency in the targeted market strengthens. This occurs when investors are speculating the

currency to depreciate in the future and thus maximize the profit of their investment at a later

stage. Because of this reactionary nature of investors’ behavior, they have also noted that

there is a significant time lag between exchange rate changes and FDI movement.

3

Ahn et al. (1998) note mixed sentiment toward increasing FDI competitiveness by

devaluating currency. However, they find that empirical research generally shows a positive

impact.

Erramilli and D’Souza (1995) find that exchange rate volatility is one of the contributors

toward external uncertainty in an economy that have a major effect on FDI inflow. Campa

(1993) notes that lack of information in a volatile environment would deter investment, and

unlike portfolio flows, FDI offers investors very few instruments to hedge against such risk

(Bénassy-Quéré, Fontagné and Lahrèche-Révil, 2001).

In a study in Ghana, Kyereboah-Coleman and Agyire-Tettey (2008) find that volatility in

exchange rate has a significantly negative impact on FDI inflow and that inappropriate

macroeconomic policy can result in overvaluing the currency; therefore, discouraging FDI.

Similar to the findings from Barrell and Pain, they also note that the lag in FDI is highly

significant.

However, high exchange rate volatility does not always imply a negative effect on FDI

Inflow. Qin (2002) finds that if a low differential in purchasing power parity exists between

trading countries, two-way FDI can occur. And FDI would become an instrument for local

producers to hedge their risk in a volatile exchange rate environment.

2.2. Inflation and FDI

A host country’s economic instability can be a major deterrent to FDI inflow. As briefly

discussed in previous sections, any form of instability introduce a form of uncertainty that

distort investors’ perception on the future profitability in the country (Erramilli and D’Souza,

1995).

Akinboade, Siebrits and Roussot (2006, p. 190-191) state that “low inflation is taken to be a

sign of internal economic stability in the host country. High inflation indicates the inability of

the government to balance its budget and the failure of the central bank to conduct

appropriate monetary policy.” In other words, inflation can be used as an indicator of the

economic and political condition of the host country, but the differences between “high”

inflation and “low” inflation is not distinct (Ahn, Adji and Willett, 1998).

4

A few literatures offer some distinctions on the level of inflation. Rogoff and Reinhart (2002)

find that high inflation does not happened in the absence of other macroeconomic problems.

The cost of inflation can have prominent effect on the economy’s growth. This hindrance is

more prominent at an inflation rate at 40% and higher, but they also note that a country with

higher inflation rate, especially below the 40% level, is worse off than a country with slightly

lower inflation. The comparative figure they quoted was 10% compare to 5% (p. 30).

Lipsey and Chrystal (2006, p. 578) offer a definition for hyperinflation. They state it as

“Inflation so rapid that money ceases to be useful as a medium of exchange and a store of

value.” But they also concede that countries with inflation rate higher than 50%, to some

200% plus, have proven to be manageable as the population adjusts in “real term”. These

literatures have highlighted that inflation destroys the value of currency. The impact on

growth is negative, and in turn, a negative impact on FDI.

Glaister and Atanasova (1998) mention the effect of high inflation had on employment in

Bulgaria. Although they did not draw direct inferences to the relationship between FDI and

inflation, they seem to suggest that high inflation can cause various problems within the

country to reduce its attractiveness to foreign investors.

Coskun (2001, p. 225) suggests that lower inflation and interest rate coupled with other

factors such as “full membership with the EU” and high economic growth can attract foreign

investors and increase the FDI inflow into Turkey.

Wint and Williams (2002) show that a stable economy attracts more FDI, thus a low inflation

environment is desired in countries that promote FDI as a source of capital flow.

3. Objective

1. To observe impact of inflation and exchange rate on foreign direct investment

decisions.

2. To evaluate comparative advantages and disadvantages of foreign direct investment

in Bangladesh in furniture manufacturing on the basis of inflation and exchange rate.

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4. Methodology

Information was obtained from both primary and secondary sources. Primary data was

collected by interviewing strategic business development team of Otobi Ltd. Secondary data

was collected from Bangladesh Bank, BOI, ADB, WB websites, published academic papers

and research institution’s reports.

5. Effect of Exchange rate and Inflation on FDI in Bangladesh

5.1. Exchange rate and FDI inflows In Bangladesh

Currency of Bangladesh has weakened steadily against US dollar from 1996 to 2012 as

shown in the Chart 1. We also observe that there is substantial growth in FDI inflow in this

period most notably from 2004 onward (Shown in Figure 1 and 2). This suggests that

weakening currency of the host country has a positive impact on foreign investment as

mentioned in earlier chapter of the paper.

(Source: Bangladesh Bank website)

Figure 1: Exchange rate of USD against BDT

0

10

20

30

40

50

60

70

80

90

BD

T

Exchange Rate (USD)

6

(Source: Bangladesh Bank website)

Figure 2: Yearly FDI inflow

(Source: Bangladesh Bank website)

Figure 3: FDI inflow against Exchange Rate

Correlation between FDI inflow and exchange rate from 1196-97 to 2011-12 was calculated

and correlation coefficient was measured to be 0.81 indicating a strong positive relationship

between FDI inflow and exchange rate (Shown in figure 3). This occurs because investors see

weak local currency as an opportunity to acquire asset at a reduced cost.

Linear regression of exchange rate indicates BDT will further weaken against USD and may

play a major part to attract FDI in the future.

0

200

400

600

800

1,000

1,200

1,400

Mil

lio

n (

$)

FDI Inflow

R² = 0.652

0

200

400

600

800

1,000

1,200

1,400

30 40 50 60 70 80 90

FD

I In

flo

w (

Mil

lio

n $

)

Exchange Rate of USD (Bdt)

FDI Inflow VS Exchange Rate

7

5.2. Inflation rate and FDI inflows in Bangladesh

Inflation has increased from 1996 to 2012 but as shown in the chart had volatile changes in

the period between 1996 and 2004. FDI in flow in this period had a decreasing trend

supporting that inflation rate volatility has a negative impact on foreign investment because it

indicates an unstable economic condition.

(Source: Bangladesh Bank website)

Figure 4: Yearly inflation (%)

(Source: Bangladesh Bank website)

Figure 5: Yearly FDI inflow

0%

2%

4%

6%

8%

10%

12%

%

Inflation (%)

0

200

400

600

800

1,000

1,200

1,400

Mil

lio

n (

$)

FDI Inflow

8

Although inflation is increasing in Bangladesh from 2002 onward it was always under 12%.

Linear regression of the past data indicates it will be around 10% in next few years (Shown in

figure 4 and 5). This level of inflation is not unfavorable to FDI as mentioned in earlier

chapter of the paper and FDI inflows in this period also reflect this as there is an increasing

trend of FDI inflow in this period.

6. FDI in Furniture industry in Bangladesh

6.1. Overview of furniture Industry in Bangladesh

Furniture industry is one of the fastest growing industries of Bangladesh and has the potential

to be next economic booster. The total furniture market size as well as demand is estimated to

be approximately BDT 80,000 million per year in Bangladesh. The whole market can be

divided into two major categories which are organized and unorganized sector.

Approximately 18% of the whole market can be defined as organized as this portion has

standard manufacturing, distribution and marketing facility. (Maksudul Haque

Chowdhury,Nazib Haider Chowdhury Farahnaz Zarrin,October 2012) This sector is divided

into some major companies namely Otobi, Partex, Hatil etc. Market share of these companies

is reflected in figure 6.

Figure 6: Market share in furniture industry in Bangladesh

Organized

17.76%

Unorganiz

ed

82.24%

Otobi

34%

Navana

11%Partex

10%

Hatil

10%

Studio45

7%

Akhter

9%

Others

19%

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6.2. Prospects of Furniture Industry in Bangladesh

With the industrial growth in various industries like RMG, textiles and ship building, there is

a huge demand for industrial furniture in these sectors, which are currently being met through

import. In a recent assessment, it is seen that on an average 1.5%-2% of the ship building cost

is spent on furniture and the existing market is over USD 9-12 million. Furthermore there is a

potential deemed export market of around USD 48 million annually by 2014. Moreover some

international furnishing suppliers for ships source products from different countries based on

their product requirement and quality standards. As the overall quality of furniture in

Bangladesh is considerably high, there is a chance to enter this market. (Maksudul Haque

Chowdhury,Nazib Haider Chowdhury Farahnaz Zarrin,October 2012)

Furniture industry of Bangladesh is a lucrative sector for FDI considering the facts that there

is a huge unexploited local market, potential for exporting, cheap and available labor.

6.3. Advantages of FDI in furniture industry in Bangladesh

Several advantages can be identified in support of making FDI in furniture industry in

Bangladesh. Namely

Huge unexploited local market.

Scope of export

Cheap and available skilled labor

Favorable exchange rate trend

To keep accordance with the scope of this paper we will focus our attention towards effect of

exchange rate and FDI in furniture industry in Bangladesh. There is a strong positive

correlation between exchange rate and FDI inflow suggesting that weakening of local

currency is favorable for FDI. Linear trend of exchange rate in Bangladesh indicates that

Bangladesh currency will weaken in future. All these information indicates that currently

furniture industry of Bangladesh is a lucrative sector for making FDI as far as exchange rate

is concerned. FDI decision can be further enhanced due to above mentioned advantages

besides favorable exchange rate.

6.4. Disadvantages of FDI in furniture industry in Bangladesh

FDI flow in furniture industry in Bangladesh can be hindered by some factors such as

Lack of infrastructure

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Power crisis

Political situation

Inflation rate

We will limit our discussion within the effect of inflation rate to maintain the focus of this

paper. Increasing inflation usually indicates a volatile economy which deters investors to

make any venture especially in labor intensive sectors such as furniture industry. Increasing

inflation will increase cost of living triggering escalating labor cost. If labor cost is not

adjusted with inflation then it will lead to labor unrest resulting even worse circumstances.

Inflation in Bangladesh has an increasing trend but in recent year the trend shows less

volatility. Linear regression suggests that it will be about 10% in next few years. Although an

increasing inflation trend is not favorable for investment there is substantial evidence that it

will be within acceptable limits in near future.

7. Result

1. There is a positive relationship between FDI inflow and weakening currency of the

host country.

2. Inflation has a negative impact on FDI inflow in a country.

3. Exchange rate and inflation trend in Bangladesh is favorable for making FDI in

furniture industry considering this sector is very potential with huge unexploited local

market, export opportunity, cheap labor etc

8. Conclusion

FDI plays a major part in the economic growth of a country especially of a developing

country like Bangladesh. Exchange rate and inflation have substantial effect on FDI inflow of

a country. Till now furniture industry of Bangladesh didn’t attract any significant amount of

FDI though there is huge potential of this sector both as a local market and export oriented

industry. Favorable exchange rate and inflation trend will help to attract FDI in furniture

manufacturing sector along with other sectors such as RMG, Pharmaceuticals and Leather;

therefore will positively contribute to the economic growth of Bangladesh.

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