Floating of Taka- An Impact Analysis

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Acknowledgement

At the beginning I would like to thank the Almighty Allah for my completing the report

in as safe and sound manner.

I would like to express my humble gratitude to my supervisor, Md. Mohiuddin Ahmed,

Associate Professor, IBA for helping me in preparing in every aspect of my report. As the

topic was a bit complicated one and requires an understanding of macroeconomic

situation of Bangladesh, Sir was always been cooperative with me in explaining the

situation.

Next I would like to express my gratitude to my organizational supervisor Mr.

Mohammod Ahmed Ali, Deputy General Manager, Foreign Exchange Policy

Department, Bangladesh Bank to become my super visor. His cooperation was very

essential so long as the data collection is concerns

I also want to convey my gratitude to all of my colleague and friends to help me

completing this report.


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July 7, 2007

Professor G. M. Chowdhury

ChairmanInternship and Placement Programme

Institute of Business Administration

Sub: Submission of internship report.

Sir:

I am submitting the report titled Floating of TAKA: An impact analysis, which I was

assigned to prepare as a partial requirement of my MBA course. The report title wasselected in accordance with my internship supervisor Mr. Mohiuddin Ahmed and my

organizational supervisor at Bangladesh Bank. In general the report deals with thechanging foreign exchange regime of Bangladesh.

I am thanking you to give me am opportunity to select the topic as well selecting my

supervisor.

Yours sincerely.

Syed Golam Shahjarul ALamMBA 40 (D)

Roll: 09


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References

1. Engel, Robert and Graner. Cointegration and error correction: Representation,

Estimation and Testing.

2. Richard. The Foreign exchange Market Theory and Econometric Evidence

3. Eitmen at el. Multinational Business Finance

4. Policy Analysis Unit (PAU) of Bangladesh Bank. Policy notes: An analysis of

Bangladeshs Transition to Flexible Exchange Rate Regime.

5. Abdur Razzaque and Mahbubur Rahman.Paper on the econometric modeling of

Bangladesh perspective.

6. Bangladesh Bank (2006b), Monetary Policy Review, Vol 2, Policy Analysis

Unit (PAU), Research Department.

7. IMF (2005), Annual reports on Exchange Arrangement and Exchange

Restrictions.

8. Bangladesh Bank Bulletin, 2006, 2007

9. Economic trends, 2005-2007(Up to April)

10. Bangladesh Bank Quarterly (October-December)

11. Export receipt 2005-2006

12. Import receipt 2005-200613. Export receipt 2006-2007

14. Import receipt 2006-2007


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Floating of TAKA: An impact analysis

Prepared for:

Mohiuddin AhmedAssociate Professor

Prepared By:

Syed Golam Shahjarul AlamMBA ProgramRoll#09(40D)

INSTITUTEOF BUSINESS ADMINISTRATION

UNIVERSITY OF DHAKA

JULY 07, 2009


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TABLE OF CONTENTS

EXECUTIVE SUMMARYviii

CHAPTER 1....................................................................................................................................................1

INTRODUCTION..........................................................................................................................................1

1.1 BACKGROUND OF THE STUDY......................................................................................................1

1.2 OBJECTIVES OF THE STUDY...........................................................................................................3

1.3 METHODOLOGY................................................................................................................................3

1.3.1 Data collection...............................................................................................................................31.3.2 The Model used..............................................................................................................................4

1.3.3 Software used.................................................................................................................................5

1.4 LIMITATIONS......................................................................................................................................51.5 ORGANIZATION OF THE REPORT..................................................................................................6

CHAPTER 2....................................................................................................................................................7

BANGLADESH BANK AND THE FINANCIAL SYSTEM......................................................................7

2.0 BANGLADESH BANK AND THE FINANCIAL SYSTEM .............................................................7

2.1 BANGLADESH BANK........................................................................................................................7

2.1.1 Introduction ..................................................................................................................................7

2.1.2Organizational level of decision making........................................................................................8

2.2 THE REGULATORY ATMOSPHERE................................................................................................8

2.2.1 Central Bank and its policies.........................................................................................................92.2.2 Bank Licensing ..............................................................................................................................9

2.2.3 Interest Rate Policy......................................................................................................................10

2.2.4 Capital Adequacy.........................................................................................................................102.2.5 Loan Classification and Provisioning.........................................................................................10

2.2.6 Commercial Banks ......................................................................................................................11

2.2.7 Specialized Banks .......................................................................................................................11

2.2.8 Financial Institutions (FIs)..........................................................................................................11

2.2.9 Microfinance Institutions (MFIs) ...............................................................................................122.3 PARTICIPANTS IN THE CAPITAL MARKET................................................................................14

2.3.1 Capital Market ...........................................................................................................................14

2.3.2 Stock Exchanges..........................................................................................................................14

2.3.3 Investment Corporation of Bangladesh (ICB).............................................................................15

2.3.4 Insurance ....................................................................................................................................15

2.4 FOREIGN EXCHANGE SYSTEM ...................................................................................................15

2.4.1 Exchange Rate Policy .................................................................................................................16

CHAPTER-3.................................................................................................................................................17

LITERATURE REVIEW............................................................................................................................17

3.1 THE HISTORY OF BANGLADESH CURRENCY REGIME .........................................................17

3.1.1 Fixed Exchange Rate Era (1972-1975).......................................................................................17

3.1.2 Pegged Exchange Rate Era (1975-2003)....................................................................................193.1.3 Adopting Floating Exchange Rate (2003-onward)......................................................................20

3.1.4 Central bank intervention............................................................................................................21

3.2 THE DETERMINATION OF EXCHANGE RATES.........................................................................22


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3.2.2 Long Term Equilibrium...............................................................................................................25

3.3 FACTORS AFFECTING EXCHANGE RATE..................................................................................27

3.3.1 Purchasing power parity............................................................................................................27

3.3.2 Interest rate parity.......................................................................................................................28

3.3.3 Relative income differential.........................................................................................................293.3.4 Government controls...................................................................................................................29

3.3.5 Expectations.................................................................................................................................303.3.6 Interaction of factors ..................................................................................................................30

3.4 ARGUMENTS FOR FLOATING EXCHANGE RATES .................................................................30

3.4.1 Monetary policy autonomy..........................................................................................................31

3.5.2 Exchange rates as automatic stabilizer.......................................................................................31

3.5 ARGUMENTS AGAINST FLOATING EXCHANGE RATES .......................................................32

3.5.1 Discipline.....................................................................................................................................333.5.2 Destabilizing speculation and money market disturbances ........................................................33

3.5.3 Injury to international trade and investment ..............................................................................33

3.5.4 Uncoordinated economic policies...............................................................................................33

3.5.5 The illusion of greater autonomy ................................................................................................33

EXPERIENCES FROM DEVELOPING COUNTRIES..........................................................................34

4.1 CURRENCY FLOAT- THE SOUTH ASIAN EXPERIENCE...........................................................344.1.1 Experience of Sri Lanka with Floating Exchange rate Regime...................................................35

4.1.2 Indias with Floating (managed) Exchange Rate .......................................................................35

4.1.3 Experience of Pakistan with Floating Exchange rate Regime....................................................37

4.2 EXPERIENCESOTHERCOUNTRIES ........................................................................................................38

4.2.1 Chinas Pegged Exchange Rate and Global Imbalances............................................................38

4.2.2 Convertibility in developing countries.........................................................................................41

CHAPTER 5..................................................................................................................................................43

IMPACT OF FLOATING............................................................................................................................43

5.1 INTRODUCTION.....................................................................................................................................43

5.2THEDATASET.......................................................................................................................................45

5.2.1 Exchange rate..............................................................................................................................47

5.2.2 Export..........................................................................................................................................485.2.3 Import..........................................................................................................................................48

5.2.4 Remittance...................................................................................................................................49

5.2.5 Current Account Balance (CAB).................................................................................................50

5.2.6 Inflation .......................................................................................................................................51

5.3 THE MODEL..........................................................................................................................................51

5.3.1 Model specification......................................................................................................................51

5.3.2 Model testing...............................................................................................................................52

5.3.3 Forecasting..................................................................................................................................585.3.4 Trend analysis..............................................................................................................................61

5.3.5Correlation matrix .......................................................................................................................64

5.3.6 Regression line of the variables...................................................................................................65

5.3.7 Findings from the model..............................................................................................................68

CHAPTER 6..................................................................................................................................................69

FOREIGN EXCHANGE RISK MANAGEMENT....................................................................................69

6.1 THE POLICY.....................................................................................................................................69

6.1.1 Credit risk ...................................................................................................................................70

6.1.2 Market Risk..................................................................................................................................70

6.1.3 Market Factors............................................................................................................................70

6.1.4 Value-at-Risk (VAR) ...................................................................................................................70

6.2 ORGANIZATIONAL STRUCTURE.................................................................................................70


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6.2.1 Centralized Foreign Exchange and Money Market Activities.....................................................71

6.2.2 Separate Trading and Risk Management Units...........................................................................71

6.2.3 Organization Chart......................................................................................................................72

6.3.4 Treasury.......................................................................................................................................72

6.3.5 Treasury Back-Office...................................................................................................................726.2.5 Restrictions..................................................................................................................................73

6.3 THE PROCESS...................................................................................................................................736.3.1 Dealing Room..............................................................................................................................74

6.3.2 Taped Conversations...................................................................................................................74

6.3.3 Deal Recording............................................................................................................................74

6.3.4 Deal-Delay...................................................................................................................................75

6.3.5 Counterparty Limits.....................................................................................................................76

6.3.6 Triggers........................................................................................................................................776.3.7 Stop Loss Orders..........................................................................................................................77

6.3.8 Appropriateness of Dealing.........................................................................................................77

6.3.9 Deals Outstanding Limit..............................................................................................................78

6.3.10 Daily Treasury Risk Report.......................................................................................................78

6.3.11 Code of Conduct........................................................................................................................79

6.3.12 Conversation Language.............................................................................................................79

CHAPTER 7..................................................................................................................................................81

CONCLUSION AND FINDINGS ..............................................................................................................81


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Chapter 1

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

Exchange rate is an important economic indicator and a key policy variable.

The choice of an exchange rate policy has a considerable impact on a countrys

well being. Sometimes issues related to exchange rates are highly debated.

The search for a suitable exchange rate policy partly depends on the goals that

policy makers attempt to achieve. There are some factors that may influence

the choice of an exchange rate regime such as conditions in the world

economy, the domestic business cycle, imperfections in the workings of

internal markets, political economy aspects and even academic trends.

Recently a number of countries have moved towards more flexible exchange

rate regimes. Historically, Bangladesh adopted diverse exchange rate regimes

since her independence in December 1971 in order to allow effective

management of foreign exchange and achieve a tolerable level of inflation with

desired level of economic growth. In January 1972, the exchange rate of

Bangladeshs currency Taka was fixed with the British Pound Sterling. As thePound Sterling was floated with dollar - later in 1972 - Taka was also floated

with Dollar via Pound Sterling. In 1979 Taka was pegged to a basket of

currencies of Bangladeshs major trading partners, with Pound Sterling as the

intervention currency which was later replaced by US Dollar in 1983. This

exchange rate arrangement continued till May 2003. Finally, Bangladesh

adopted a floating exchange rate system.

The cross border movement of currencies was also regulated by the centralBank. Bangladesh Bank used to publish a daily foreign exchange rate sheet

that had two sets of rates; one being the rates for commercial banks to

transact with their customers and the other being rates for the commercial

banks to transact with Bangladesh Bank. In the year of 1993 we have seen a

significant shift in the countrys foreign exchange regulatory policies where the

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Bangladesh Taka (BDT) was declared convertible in the current account. Most

restrictions related to current account activities were relaxed where

commercial banks were given the responsibility to ascertain genuineness of the

transactions and the central banks prior approval requirements in these

regards were withdrawn. The responsibility of exchange rate quotation was left

to the commercial banks where Bangladesh Bank only committed support to

the commercial banks to plug any net foreign currency gaps in the market at

their pre-specified buying and selling rates. Many circulars and guidelines were

issued at that time to communicate the changes as well as to guide the market

participants.

The Bangladesh Government has for the first time switched on to the floating

exchange rate system from the pegged system since May 31, 2003. The

Bangladesh Taka exchange rate was declared floating and the band of the

central banks US Dollar buying selling rate were withdrawn. Going to floating

exchange rate arrangement definitely have an influence on the overall trade

and economy of the country. In the new system taka was allowed to float

independently, that means market forces of demand and supply of foreign

currencies will play key role in determining the exchange rate of taka. The

introduction of floating exchange rate system entailed a lot of advantages overthe other systems. From the macro point of view where the stability of the

entire world is concerned, a free-floating system could be preferable to the

other systems. Another additional advantage of floating rates is that Central

Bank is not required to constantly maintain exchange rates within specific

boundaries. Therefore, it is not forced to implement an intervention policy that

may have an unfavorable effect on the economy just to control exchange rates.

Furthermore, the govt. can implement policies without concern as to whether

policies will be maintained the exchange rates within specific boundaries.

Finally, if exchange rates were not allowed to float, investors would invest

funds in whatever country had the highest interest rate. This would cause the

govt. in countries with low interest rates to restrict investors funds from

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leaving the country. Thus there will be more capital flow restrictions, and

financial market efficiency would be reduced.

1.2 OBJECTIVES OF THE STUDY

The study mainly focuses on the impacts of Floating Exchange Rate

Arrangementon different macro-economic variables. This study also shows the

change in foreign exchange market trading in our financial system after

floating. The specific objectives of the study are:

o To evaluate the market responsiveness after introducing the floating

o To identify and evaluate the major changes of the macro variables after

the currency floating

o To evaluate the impact of adopting floating exchange rate on the

financial system

o To understand the risk and ways of risk minimization in floating exchange

era

o To prepare an econometric modeling based on the data input

1.3 METHODOLOGY

1.3.1Data collection

Mostly the data are collected from the secondary sources of different

publications. Among the different sources are ADB, WB and IMF journals,

Economic Trends published by Bangladesh Bank, publications, periodicals,

journals, daily newspaper, web-sites etc. Internet was a good help in searching

international development in foreign exchange crises over the past two

decades. The data set is designed in quarterly basis. It is very difficult to find

out the quarterly data for all the area of study. So, different sources are to

examine to come up with a relevant data set. Again data varies significantly

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from source to source. As for example the export and import data for

Bangladesh Bureau of Statistics (BBS) Bangladesh Bank are very much

different in terms of real proceeds. Bangladesh Bank documents only when the

payment is received. But BBS always do their calculation on the basis of

invoice.

1.3.2The Model used

The model is tested by ADF test for the stationary of the variables of the time

series data. After that the cointegration test is performed by Engle-Graner

method.

Long run model

ext= 1+ 2ert+ ut..(1)

The model is used to find out the long run relationship between the dependent

variable exports (ex) with the independent variable Exchange Rate(er). It was

expected that the relationship is to be positive in long run. The error term Utto

find out the consistency of the relationship.

Hypothesis

H0: 2 0H1: 2 = 0

I expect the value of2 is positive.

It is well understood that the export and exchange rate has a liner relationship

in the long run. So my objective is to prove that there is really a relationship

and the relationship is positive. So the null hypotheses for the model is that 2

0 that is the regression line has a positive slop. However, I will now try to

prove the alternative hypotheses that 2 = 0.

Short run model

ext= 1 + 2ert+ 3ut-1 + t..(2)

I expect the value of2 is positive and3 negative.

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The short run model is different in that due to some other variation the

relationship between export and exchange rate may not be as linear as we

stated in the long run model. Here we will find that an additional parameter 3

is added with an error term of the previous period. Now if the error is

subtracted from the equation the short run model can be fitted to our

assumption that there is a linear relationship between the two variables.

1.3.3Software used

Use of software becomes inevitable in testing econometric modeling. In this

respect the following software are used for both analysis and graphical

representation.

o Microfit

o SPSS

1.4 LIMITATIONS

Despite high degree of precaution is taken to have authentic data that really

reflect the empirical situation there are some limitations in term of reliability of

source. As for example the export and import data from Bureau of Statistics are

far more different than the data process by the Statistics Department of

Bangladesh Bank. This is due to the fact that BBS collected the data when an

LC in opened with the bank or an LC is received by a bank. However,

Bangladesh Bank collects the data of export-import based on the payment. In

this case the data of Bangladesh Bank is more reliable as this is truly the net

amount of export. Another limitation is in getting data in month wise. This is

why I use here quarterly basis data.

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1.5 ORGANIZATION OF THE REPORT

Chapter one is the introductory part of this report consists of background of

the study, objectives, methodology, limitations and organization of the report.

Chapter two provides an overview of financial sector of Bangladesh. Chapter

three provides the literature review on exchange rate arrangement. Chapter

four discusses the experience of floating of exchange rate in different

developing countries and elaborates some incidences of global crises in last

two decades. Chapter five introduce the econometric modeling to find out the

relationship among exchange rate with other variables. This chapter also

elaborates the impact of floating of exchange rate. Chapter six introduces the

risk management of foreign exchange in the floating ear and provide with some

guide lines to manage modern dealing room. Chapter seven concludes thereport with findings.

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Chapter 2

BANGLADESH BANK AND THE FINANCIAL SYSTEM

2.0 BANGLADESH BANK AND THE FINANCIAL SYSTEM

The financial system of Bangladesh consists of Bangladesh Bank (BB)

as the central bank, 4 nationalized commercial banks (NCB), 5

Government owned specialized banks, 30 domestic private banks, 10

foreign banks and 28 non-bank financial institutions. The financial

system also embraces insurance companies, stock exchanges and co-

operative banks.

2.1 BANGLADESH BANK

2.1.1Introduction

Bangladesh Bank was established by Bangladesh Bank Order 1972 by

president order. By this order Bangladesh Bank became the central

bank of Bangladesh. This gives Bangladesh Bank the exclusive right to

formulate monetary policy and oversee the total financial sector of the

country. In general Bangladesh Bank has to perform the following

duties.

Formulating the monetary policy

Stabilizing the price level

Controlling the financial environment

To perform these duties a number of other duties are to be

accomplished by this organization. To bring confidence on the banking

sector Bangladesh Bank acts as a lender of the last resort for the

commercial banks. Again BB works as the banker or the Government.

So different kind of debt instruments are to service by Bangladesh

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Bank as the budget deficit has to finance by the central bank or the

commercial banks from private borrowing.

2.1.2Organizational level of decision making

Virtually Bangladesh Bank is an autonomous organization and takes

most of the decisions independently. However there are some

interventions from the Government part in some macro-economic

decision making.

Head Office

Board of Director (BOD)Executive Committee

Governor

Deputy Governor

Executive Director

Department/ Branch Office

General Manager

Deputy General Manager

Joint Director

Deputy Director

Assistant Director

2.2 THE REGULATORY ATMOSPHERE

The regulatory players of Bangladesh are generally the central bank

the security and exchange commission and the ministry of finance.These three organizations work closely to keep the financial market in

control.

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2.2.1Central Bank and its policies

Bangladesh Bank (BB), as the central bank, has legal authority to

supervise and regulate all the banks. It performs the traditional central

banking roles of note issuance and of being banker to the governmentand banks. It formulates and implements monetary policy, manages

foreign exchange reserves and supervises banks and non-bank

financial institutions. Its prudential regulations include: minimum

capital requirements, limits on loan concentration and insider

borrowing and guidelines for asset classification and income

recognition. BB has the power to impose penalties for non-compliance

and also to intervene in the management of a bank if serious problems

arise. It also has the delegated authority of issuing policy guidelines

and directives regarding the foreign exchange regime.

2.2.2Bank Licensing

Bank Company Act, 1991, empowers BB to issue licenses to carry out

banking business in Bangladesh. Pursuant to section 31 of the Act,

before granting a license, BB needs to be satisfied that the following

conditions are fulfilled:

"that the company is or will be in a position to pay its present or future

depositors in full as their claims accrue;

that the affairs of the company are not being or are not likely to be

conducted in a manner detrimental to the interest of its present and

future depositors;

that, in the case of a company incorporated outside Bangladesh, the

Government or law of the country in which it is incorporated provides

the same facilities to banking companies registered in Bangladesh as

the Government or law of Bangladesh grants to banking companies

incorporated outside Bangladesh and that the company complies with

all applicable provisions of Bank Companies Act, 1991."

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Licenses may be cancelled if the bank fails to comply with above

provisions or ceases to carry on banking business in Bangladesh.

2.2.3Interest Rate Policy

Under the new interest rate policy, which became effective in January

1990, in mid 90s it was under some band and at the end of 90s all

deposit (Bank/Financial Institutes) rates are decontrolled. Lending

(Bank/Financial Institutes) rates are also freely determined by the

market, except for exports.

2.2.4Capital Adequacy

In January 1996, BB announced a new policy on Capital Adequacyalong the lines recommended by the Basle Committee on banking

supervision, which has been revised by the bank. The Revised policy

on capital adequacy requires scheduled banks to maintain 100 crore or

at least 9% risk weighted asset (of off-balance sheet risk and risk in

different types of assets) as capital whichever is higher.

2.2.5Loan Classification and Provisioning

Bangladesh Bank introduced new accounting policies with respect to

loan classification, provisioning and interest suspense in 1989 with a

view to attaining international standards over a period of time. A

Revised policy for loan classification and provisioning was introduced

from January 1, 1999. The Revised policy calls for an independent

assessment of each loan on the basis of qualitative factors and

objective criteria. Each loan is branded with the worst level of

classification resulting from these independent assessments.

Under the existing system scheduled banks are required to maintain

provisions against unclassified and substandard loans in addition to

doubtful and loss loans. They are allowed to book interest against

classified loans only on cash basis.

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Whether a credit is classified or not under the objective criteria, it is

subjected to classification under qualitative judgment if any doubt

arises regarding repayment of loan.

2.2.6Commercial Banks

The commercial banking system dominates Bangladesh's financial

sector with limited role of Non-Bank Financial Institutions and the

capital market. The Banking sector alone accounts for a substantial

share of assets of the financial system. The banking system is

dominated by the 4 Nationalized Commercial Banks , which together

controlled more than 40% of deposits where PCB has 46% as of

December 31, 2005.

2.2.7Specialized Banks

Out of the 5 specialized banks, two (Bangladesh Krishi Bank and

Rajshahi Krishi Unnayan Bank) were created to meet the credit needs

of the agricultural sector while the other two ( Bangladesh Shilpa Bank

(BSB) & Bangladesh Shilpa Rin Sangtha (BSRS) ) are for extending

term loans to the industrial sector.

2.2.8Financial Institutions (FIs)

Bangladesh Bank exercises powers under the Financial Institutions Act

1993 and regulates institutions engaged in financing activities

including leasing companies and venture capital companies.

Twenty-eight financial institutions are now operating in Bangladesh. Of

these institutions, 1(one) is govt. owned, 15 (fifteen) are local (private)

and the other 12(twelve) are established under joint venture with

foreign participation. The total amount of loan & lease of these

institutions is Tk.29,729 million as on 30 April, 2003. Bangladesh Bank

has introduced a policy for loan & lease classification and provisioning

for FIs from December 2000 on half-yearly basis. To enable the

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financial institutions to mobilize medium and long-term resources,

Government of Bangladesh (GOB) signed a project loan with IDA, and a

project known as ``Financial Institutions Development Project (FIDP)``

has started its operation from February 2000. Bangladesh Bank is

administering the project. The project has established ``Credit, Bridge

and Standby Facility (CBSF)`` to implement the financing program with

a cost of US$ 57.00 million.

2.2.9Microfinance Institutions (MFIs)

The member-based Micro-finance Institutions (MFIs) constitute a

rapidly growing segment of the Rural Financial Market (RFM) in

Bangladesh. At present, Grameen Bank is the only formal financial

institution among them, established in 1983 under a special law with

the initial support from Bangladesh Bank. The poor borrowers of

Grameen bank who are mostly women own the bank and it is the

pioneer organization of this type. Besides Grameen Bank there are

more than 1000 semi-formal institutions operating mostly in the rural

sector of the country; BRAC, ASA, and PROSHIKA are being considered

three big NGO-MFIs. These institutions have an explicit social agendato cater to the needs of the poorer sections of population, and have a

focus towards women clients.

Till June 2005 the total coverage of micro-finance programs in

Bangladesh is more than 13 million households. Four big institutions

including Grameen Bank dominate the micro-finance market of

Bangladesh. Grameen Bank, BRAC, ASA, and PROSHIKA account for

60% of the total amount of outstanding loans made by all MFIs, and itis widely believed that top 20% institutions account for 80% of the

total market. The Grameen Bank alone provides about one-third of the

total amount of outstanding micro-loans. There is no cap or spread on

interest rate offered for deposit and loan in case of NGO-MFIs.

However, in practice on average NGO-MFIs offer mostly 5-7% interest

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on deposits to the members and charge 15% interest on loan in flat

method.

At present NGO-MFIs are not regulated or supervised or monitored by

any single authority in Bangladesh; they are under the system of off-site supervision by the authorities that provide them registration as

non-government organizations (NGOs). However, the regulatory issue

has come to the forefront because MFIs are providing financial services

and products to the poor, outside the formal banking system.

Considering the need to develop an appropriate regulatory and

supervisory system for this sector the Government of Bangladesh has

established a Unit named "Microfinance Research and Reference

Unit (MRRU)" in Bangladesh Bank. A high power national Steering

Committee under the leadership of Governor of the bank looks after

the various functions of the unit. The Committee is also responsible for

formulating a uniform guideline and the legal framework of a

regulatory body for this rapidly growing financial sector.

The unit has already published an operational guideline for these NGO-

MFIs with the help of the committee and has been collecting quarterly

information since January 2004 on governance, savings, credit, receipt

and payment from them. The unit is also providing training to these

institutions on the operational guideline supplied to them. Recently the

committee has submitted a draft law to the Government, hence it is

expected that after the promulgation of the law this sector will be

under formal financial system in near future. All these programs

mentioned above (guideline, training and information collection) going

on under the unit are being considered as the background work

towards the formulation of a full-fledged regulatory framework for the

micro-finance sector in Bangladesh.

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2.3 PARTICIPANTS IN THE CAPITAL MARKET

2.3.1 Capital Market

The Capital market, an important ingredient of the financial system,

plays a significant role in the economy of the country. The Securities

and Exchange Commission exercises powers under the Securities and

Exchange Commission Act 1993. It regulates institutions engaged in

capital market activities. The SEC has issued licenses to 31 institutions

to act in the capital market. Of these, 21 institutions are Merchant

Banker & Portfolio Manager while 9 are Issue Managers and 1(one) acts

as Issue Manager and Underwriter.

2.3.2Stock Exchanges

There are two stock exchanges (the Dhaka Stock Exchange (DSE) and the Chittagong

Stock Exchange (CSE) which deal in the secondary capital market. DSE was established

as a public Limited Company in April 1954 while CSE in April 1995. As of June 2009

the total number of enlisted securities with DSE is 2901. The total market capitalisation of

the countrys prime bourse DSE whopped to Tk 931.03 billion on June 30, 2008 as

against Tk. 475.86 billion of 30th June 2007,showing a 95.66 per cent increase. Turnover

in DSE Crossed the Landmark of Tk. 8.00 Billion by June 2009. DSE continued its

efforts to develop the market through taking various reforms and programmes throughout

the year. Since the inception of the DSE Training Academy on September 10, 2007,

many training programmes for investors, authorised representatives, seminar on

Derivatives, Financial Options and Futures for DSE officials and professionals took place

during the period. Apart from DSE head office, many brokers and institutional investors

are arranging awareness programmes in the newly opened Training Academy. Removing

the prevailing weakness in fixed IPO Shares Pricing Method, DSE has been closely

working with SEC to introduce Book-Building, alternative method of share price

1 DSE Annual Report 2007-08

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valuation. It is assumed that after the introduction of proposed Book Building Method

profitable and fundamentally sound companies will come forward to the capital market.

Direct listing of Jamuna Oil Company, Meghna Petroleum Ltd, Titas Gas Transmission

and Distribution Co. Ltd, ACI Formulations and Shinepukur Ceramics fulfilled the

investors demand in the securities market. Of them, ACI Formulations and Shinepukur

Ceramics were the first private companies to get direct listing.

2.3.3Investment Corporation of Bangladesh (ICB)

The Investment Corporation of Bangladesh was established in 1976

with the objective of encouraging and broadening the base of industrial

investment. ICB underwrites issues of securities, provides substantial

bridge financing programs, and maintains investment accounts, floats

and manages closed-end & open-end mutual funds & closed-end unit

funds to ensure supply of securities as well as generate demand for

securities. ICB also operates in the DSE and CSE as dealers.

2.3.4 Insurance

The insurance Sector is regulated by the Insurance Act, 1938 with

regulatory oversight provided by the controller of Insurance on

authority under the ministry of commerce. The General insurance

services are provided by 44 companies and the life insurance services

are provided by 18 companies. The industry is dominated by the two

large, state-owned companiesSBC(Sadharon Bima Corporation) for

general insurance and JBC(Jibon Bima Corporation) for life insurance--

which together command most of the total assets of the insurance

sector.

2.4 FOREIGN EXCHANGE SYSTEM

On March 24, 1994 Bangladesh Taka (domestic currency) was declared

convertible for current transactions in terms of Article VIII of the IMF

Articles of Agreement but BB actually declared it on October 20, 1993.

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Consequent to this, current external settlements for trade in goods and

services and for amortization payments on foreign borrowings can be

made through banks authorized to deal in foreign exchange, without

prior central bank authorization. However, because resident owned

capital is not freely transferable abroad (Taka is not yet convertible on

capital account), some current settlements beyond certain indicative

limits are subject to bonafide checks.

Direct investments of non-residents in the industrial sector and

portfolio investments of non-residents through stock exchanges are re-

patriable abroad, as also are capital gains and profits/dividends

thereon. Investment abroad of resident-owned capital is subject to

prior Bangladesh Bank approval, which is allowed only sparingly.

2.4.1Exchange Rate Policy

The exchange rate policy of Bangladesh Bank aims at maintaining the

competitiveness of Bangladeshi products in the international markets,

encouraging inflow of wage earners' remittances, maintaining internal

price stability, and maintaining a viable external account position. Prior

to the inception of floating exchange rate regime, adjustments in

exchange rates were made while keeping in view the trends of Real

Effective Exchange Rate (REER) index based on a trade weighted

basket of currencies of major trading partners of Bangladesh and the

trends of other important internal and external sector indicators. Under

the existing floating exchange rate regime, the inter-bank foreign

exchange market sets the exchange rates for customer transactions

and inter-bank transactions based on demand-supply interplay; whilethe exchange rates for the Bangladesh Bank's spot purchase and sales

transactions of US Dollars with ADs is decided on a case to case basis.

Bangladesh Bank does not undertake any forward transaction with

ADs. The ADs are free to quote their own spot and forward exchange

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rates for inter-bank transactions and for transactions with non-bank

customers.

Chapter-3

LITERATURE REVIEW

3.1 THE HISTORY OF BANGLADESH CURRENCY REGIME

The history of Bangladeshi currency regime is somewhat evolutionary

in terms of liberalization of the domestic currency with foreign

currency. At the beginning, the currency regime was rigidly fixed with

an intervention currency and with the advent of problems with the

fixed regime Bangladesh has to abandon that regime to adapt a new

system for new situation. Later Bangladesh went for peg system and at

one stage it was found to be insufficient to confront new financial

system globally. Finally, Bangladesh started with the most ambitious

plan to float the taka to fight in open market with other international

currencies.

3.1.1Fixed Exchange Rate Era (1972-1975)

During the liberation war, the whole economy was shattered.

Therefore, immediately after the liberation, Bangladesh Bank

confronted with two massive tasks-

(i) Reconstruction of banking system,

(ii) Selection of an intervention currency and the fixation ofexchange rate against that currency for conducting the

international trade.

In 1972, Bangladesh Bank decided that Pound Sterling (PS) would be

the intervening currency, when throughout the world it was the

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window of floating exchange rate. Bangladesh Bank decided to adopt

fixed exchange rate and fixed exchange rate 1PS=Tk.18.9677 from

January 1972 which was Pakistan Rupees 13.43 before liberation.

Therefore, while fixing exchange rate Bangladesh devalued her Tk. by

around 29%. At the time of declaration of exchange rate Bangladesh

Bank withdrew dual exchange rate prevailing during Pakistan regime in

the form of Export Bonus Scheme and Home Remittance Bonus

Scheme.

The introduction of single exchange rate did not last long. From July

1972, Bangladesh Bank introduced Premium Scheme for Home

Remittance under which for aboard, exchange rate was fixed at Tk.

30per Pound Sterling.

Afterward, from July 1973, Bangladesh Bank introduced cash subsidy

Scheme (30% of FOB value of export) for all export except jute and

jute goods in terms of domestic currency for export from Bangladesh.

During the time Bangladesh Govt. was spending a huge amount of

money for reconstruction of the war savaged by borrowing from

banking system. At that time PS was becoming weaker and weaker day

by day against Dollar. For the above reasons, in 1974-75, country

experienced an unusual inflation of 67%. Because of continuous

weakening of PS and substantial increase in petroleum price (that was

creating a huge pressure on foreign exchange reserve), Bangladesh

Bank taken two major decisions- (i) Demonstration of 100 Tk. note and

(ii) substantial devaluation of Tk. by 37%, effective from May, 1975

fixed at 1PS= Tk.30. Simultaneously, Premium Scheme for Home

Remittance and cash subsidy Scheme were withdrawn and at the time

of early 1975-76, two new schemes were introduced (i) Wage Earners

Scheme (ii) Export performance License Scheme.

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3.1.2Pegged Exchange Rate Era (1975-2003)

In order to give the support to the exporters and bring a change in the

exchange rate system, Bangladesh Bank adopted a Flexible Exchange

Rate system in 1975, which continued till June 1979 and by this timeexchange rate was adjusted 15 times to finally stand at 1 =Tk. 33.

From late 1979, a trade weighted currency basket method was

introduced keeping PS as intervening currency and this arrangement

continued till the end of Dec. 1982 when exchange rate stood at 1 =

Tk.38.82.

Because of continuous weakening position of PS, it was decided to take

Dollar as intervening currency rather than PS from January 1983 and

exchange rate was fixed as $1=Tk.24.56. For fixing exchange rate,

trade weighted currency method continued till 1984-85. By this time

exchange rate was depreciated 13 times at the end of June 1985 stood

at $1=Tk.28. In order to bring stability and dynamism in the exchange

rate policy NEER and REER system was introduced in 1985-86. The

above system was continued up to May 30, 2003. Bangladeshi Taka

(BDT) has been annually devalued almost 6% since 1987 and haddevalued the currency by 827% since 1974.

However, a pegged arrangement too is not without its deficiencies. The

main benefit that a pegged exchange rate may bring in an extremely

high inflationary country is through its use as a nominal anchor. In

Bangladesh, inflation rate has not been so high by developing country

standards. Hence, the exchange rate peg did not play such a role.

Exchange rate peg also helps to align inflation of the country with that

of the anchor.

However, this is true for a small open economy, where there is a

greater convergence of domestic inflation with the anchor country. The

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inflation rate in a large open economy with a dominant non-tradable

goods sector, like Bangladesh, can deviate significantly from inflation

in the anchor country. Moreover, independent monetary policy plays

an important role in a country where there is a non-tradable goods

sector, which explains the appropriateness of the floating exchange

rate system.

In addition, Bangladesh experiences frequent domestic and external

real shocks, such as drought and floods and the terms of trade. Such

shocks can be deflected or absorbed better through a floating

exchange rate system. Finally, currency devaluation remains a

politically sensitive issue in most countries including Bangladesh. In

general, it is politically costly to adjust a pegged exchange rate than to

allow the exchange rate to move by a corresponding amount under a

floating system. The former is visible and involves an explicit govt.

decision but the latter is less of an event and can be attributed to

markets.

3.1.3Adopting Floating Exchange Rate (2003-onward)

From 31 May 2003, Bangladesh Bank was abandoned the fixation of

exchange rate through NEER/REER and entered into the new exchange

rate system called Floating Exchange Rate system. Under this

system, the market itself is determining exchange rate. Normally, No

intervention of Bangladesh Bank under this system is desired. But in

case of any disaster they should intervene.

Under Floating Exchange Rate system, the exchange rate between the

local currency and a foreign currency is determined when the demand

for and available supply of foreign currency is the same. When an

economy is experiencing a balance of payments deficit and there is

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excess demand of foreign currency, the exchange rate of the local

currency falls and depreciates and restores the equilibrium

automatically. In such a situation, the foreign currency value of exports

falls making them more attractive abroad and local value of imports

increases making them less attractive locally, thereby BOPs situation

improves. On the other hand when BOPs surplus and excess supply of

foreign currency exists, the value of local currency goes up, again

restoring a balance in the foreign exchange market and the BOP.

Bangladesh has been practicing floating exchange rate system for past

few years. Before introducing the floating exchange rate officially

effective from 31st May 2003, Bangladesh Bank used to undertake spot

purchase and sell of US $ with authorized dealers at the pre-

announced rate. Under this system Bangladesh Bank used to

undertake buying and selling transaction under a band with authorized

dealers only. The last band was announced in the month of January

2002 whereby buying and selling band were fixed at TK.57.40 to 58.40

respectively per US dollar. On the other hand, authorized dealers in the

foreign exchange market set the exchange rate themselves for their

customers and inter-bank transactions. However inter-bank

transactions particularly spot purchase and sell of foreign currencies

are conducted over the telephone and the dealers themselves finalize

deals over telephone. Now with the effect from 31st May 2003,

Bangladesh Bank exchange rates for spot purchase and sell

transactions of US $ with authorized dealers will be fixed on case to

case basis, but without reference to any pre-announced band.

3.1.4Central bank intervention

For a developing country like Bangladesh, the arguments in favor and

against the float are many. One of the prerequisites of a floating

exchange rate regime is the presence of an alternative nominal anchor

for the conduct of monetary as well as fiscal policies. Since the floating

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exchange rate does not provide such an anchor. The alternative

anchor, most often suggested is inflation targeting. Monetary and fiscal

policies should be tuned to ensure that the target is not violated. The

regime therefore, requires an independent and competent Central

Bank.

For Bangladesh, even this condition is satisfied, problem could still

crop up, as inflation is often the result of supply shocks from natural

calamities. This complicates the task of predicting the behavior of

inflation and also of controlling it through monetary policy instruments.

The other important requirement for currency float is the presence of a

deep and efficient foreign exchange market, as thin markets result ingreater volatility. In Bangladesh, the market for spot transactions is

pretty thin and in the absence of organized markets for currency

futures and options, there is little scope to hedge exchange rate risks.

A well-regulated and well-supervised and financially sound banking

system is also a crucial requirement, especially if the long-term

objective is to open the capital account.

Finally, the requirement of high international reserves is of no lessrelevance to the floating rate regime as it is for a pegged rate regime.

Authorities cannot remain idle when the exchange rate fluctuates

widely. This requirement is especially relevant to Bangladesh as its

thin foreign exchange market implies greater currency fluctuations.

3.2 THE DETERMINATION OF EXCHANGE RATES

From the mid-1970s through the late 1990s, exchange rates among

the major currenciesthe U.S. dollar, the Japanese Yen, and the

deutsche markexhibited substantially greater volatility than existed

under the Bretton Woods system that prevailed from 1945 to 1971.

Wide swings such as the 1980-85 appreciation of the U.S. dollar and

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the 1990-95 appreciation of the yen have generated a vast literature,

dedicated to understanding (and potentially mitigating) this increase in

exchange rate volatility.

3.2.1 Short Term Supply Demand

If a country prefers not to intervene to stabilize (or moderate the

movement of) its exchange rate, the exchange rate will be market-

determined. When the determination of an exchange rate is left to

market forces, it is considered a free floating rate. Thus, free

floating exchange rates are determined by the demand for and supply

of currencies by private individuals, banks and non-bank firms, and

non-central bank government agencies. Figure 1 shows how the forces

of supply and demand determine the equilibrium exchange rate.

Figure 3.1: Exchange Rate Determination in A Free Market

From the viewpoint of the Bangladesh

PFX

Taka SFX

Depreciation Tk.70.0

Tk.65.0

TakaAppreciation Tk.60.0

DFX

QFX

1 2 3 4 5 6

23

Tak

a per

Doll

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(Billions of Dollars)

The supply schedule reflects the quantity of foreign exchange that will

be offered at various exchange rates, ceteris paribus, while the

demand schedule depicts the quantity of foreign exchange that will be

demanded at alternative exchange rates, ceteris paribus. As Figure 1

shows, the equilibrium exchange rate of Tk.65 per dollars is

established where the quantity of foreign exchange supplied and the

quantity demanded are equal.

The balance-of-payments approach to exchange rate determination

emphasizes the connection between a nations balance of payments

and its foreign exchange rate. The idea is that the demand for foreign

exchange corresponds to the debit items on a nations balance of

payments statement, while the supply of foreign exchange

corresponds to the credit items. Thus, the U.S. demand for Taka

reflects their desire to purchase goods and services from Bangladesh,

make investments in Bangladesh, repay debts to Bangladeshi lenders,

or send transfer payments to residents of Bangladesh. Similarly,Bangladeshs demand for dollars is a function of its desire to purchase

goods and services from the United States, invest in U.S. assets (real

or financial), repay loans to American lenders, or make transfer

payments to U.S. citizens. In the event that there is a discrepancy

between the desires of Americans and Bangladeshi citizens, market

forces will generate movements in the exchange rate until the quantity

supplied and quantity demanded are brought into equality.

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3.2.2Long Term Equilibrium

Exchange rates are thought to respond to a variety of stimuli, including

long-term structural, medium-term cyclical, and short-term speculative

forces. Thus, the standard framework for the determination of freely

floating exchange rates posits:ERS = ([rD rW], (6.1)

ERM = g(

1tt

uu ) (6.2)

ERL = h( clpYp

e,,,,

) (6.3)

Here, ERS is the short-term exchange rate, ERM is the medium-term rate

and ERL is the long-term rate, rD is the real domestic interest rate, rW is

a measure of real interest rates in the rest of the world, ERe is the

expected exchange rate,

u is the unemployment rate in the current

time period,1

tuis the unemployment rate in the previous period,

p is

the rate of inflation, e is a measure of profit expectations, pY is real

income, l is labor productivity, and c is a measure of consumer

preferences. Figure- 5 sums up this approach graphically.

Figure 3.2: Exchange Rate Movements under A Free Float

Currencys

(Trade-weighted)

Exchange Value Equilibrium

Path

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Long-run equilibrium

path, driven by Short-

run Overshooting

fundamentals

Time Medium-run cyclical path, driven by fundamentals

Thus, even though short- term influences (e.g. movements in

exchange rates and changing expectations) can cause a countrys

exchange rate to move away from its long-run equilibrium path,longer-run structural forces and medium-term cyclical forces are

eventually supposed to push the value of the currency back toward its

fundamental equilibrium path.

The exchange rate, which is a price, is often considered the most

important price in the economy. As explained above, the Agreement

of the International Monetary Fund gives nations the right to choose

the manner in which they want the price of their currency determined.If a nation decides to leave the determination of its currencys value to

market forces, then, depending upon the structure of the relevant

markets, exchange rate movements will affect the ability of domestic

producers to compete with foreign-produced goods and services.

Some economists believe that these movements will impose significant

costs on both consumers and firms, as resources are reallocated in

response to changes in the exchange rate. To avoid, or at least

mitigate, these costs, it is often argued that currency prices should be

fixed, managed, or targeted rather than left to float freely. The

intermediate methods intermediate in the sense that neither

perfectly flexible nor rigidly fixed extremes are adopted for the

determination of a nations exchange rate.

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3.3 FACTORS AFFECTING EXCHANGE RATE

Under Floating Exchange Rate Arrangements Exchange Rate is

primarily determined by demand for foreign currency and Supply of

foreign currency where demand and supply of foreign currency is also

affected some other sensitive factors.

Theoretically demand for foreign currency is determined by several

factors-

a) Import payments

b) Service payments which includes income payments

c) Debt service payments

d) Foreign Aids (outward)e) Foreign Investments (outward)

Supply of foreign currency is composite of-

a) Export Receipts

b) Service Receipts which includes income Receipts

c) Debt service Receipts

d) Foreign Aids (inward)

e) Foreign Investments (inward).

Besides the above, the following factors affects the Exchange Rate

movements

a) Relative Inflation Rate

b) Relative Interest Rate

c) Relative Income Level

d) Government Controlse) Expectations

3.3.1 Purchasing power parity

The parchasing power parity theory attempts to quantify the

relationship between inflatiion and exchange rate that argues that

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differences ihn inflation rate between aountries will lled to changes in

the spot exchange rate. Changes in relative inflation rates can affect

international trade activity which influences the demand for and supply

of currencies and therefore influences spot exchange rates.If US

inflation increases substantially while the British inflation remains the

same, the US demand for the British goodwill increase. so the US

demand fir British pound will increase that will result the appreciation

of British currency.

on the other hand the British people will be less willing to buy US

goods, so supply of pound will decrease. Because of inflation the new

equilibrium will be set at 1.57 and earlier it was 1.55 dollar per pound.

3.3.2Interest rate parity

Changes in relative interest rate affect investment in foreign securities,

which influences the demand and supply of currencies and therefore

influence exchange rates. If the US interest rate rises relative to British

interest rate,the US investors is likely to reduce their demand for

pound.

On the other hand the supply of pound will rise, that will cause the

depreciation of British pound from 1.55 to 1.50 dollar per pound.

Real interest rate although a relatively high interest rate attract foreign

inflows, the relatively high interest rate may reflect expectations of

relatively high inflation.

Real interest rate= Nominal interest rate- Inflation rate.

So , as an investor one should consider the real rate of interest to

make the investment decision.

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3.3.3Relative income differential

Relative income level is the third factor effecting exchange rate.

Because income can affect the amount of import demanded, it can

affect exchange rate. If the income level in USA rises substantiallywhere the British income level ,that will affect the following factors-

0 the demand schedule for pound.

1 the supply schedule for pound.

2 the equilibrium exchange rate

the demand for pound will be up rocket as a result of the increasing

demand for British goods and the pound will appreciate relative todollar.

3.3.4Government controls

The government of foreign countries can affect exchange rate in many

ways, including-

(1) Imposing foreign exchange barriers,

(2) Imposing foreign trade barriers,

(3) Intervening foreign exchange market

(4) Affecting macro variables such as inflation

,interest rates, income levels.

If the US interest rate rises and the British interest rate remains the

same the British supply of pound will increase to obtain more US dollar.

If the British government imposes heavy tax on interest income from

foreign investment, this could discourage the exchanger of pound for

dollar.

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3.3.5Expectations

The fifth factor affecting exchange rate is the market expectation of

future exchange rates. Like other market foreign exchange markets

react to any news that may have future effect. News of a potentialsurge in US inflation may cause currency traders to sell dollars,

anticipating a future decline in the dollars value. such type of

response places immediate downward pressure on the dollar.

The transactions within the exchange markets facilitate either trade or

financial flows. The tare related foreign exchange transactions are

generally less responsive to news. Financial flow transactions are very

responsive to news, however, because decisions to hold securitiesdenomination particular currency are often dependent on anticipated

changes in currency values. To the extent that news affects

anticipated currency movements, it affects the demand for currencies

and the supply of currencies for sale. Because of such speculative

transactions, foreign exchange rates can be very volatile.

3.3.6Interaction of factors

Trade related factors and financial factors sometimes interact.

Exchange rate movement may be simultaneously affected by these

factors. An increase in income levels sometimes causes expectations

of higher interest rates. So even though a higher income level can

result in more imports, it may also indirectly more financial inflows.

Because the favorable financial flows may overwhelm the unfavorable

trade flows, an increase in income levels is frequently expected to

strengthen the local currency.1

3.4 ARGUMENTS FOR FLOATING EXCHANGE RATES

As international currency crises of increasing scope and frequency

erupted in the late 1960s, most economists began advocating greater

flexibility of exchange rates. Many argued that a system of floating

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exchange rates would not only automatically ensure exchange rate

flexibility but would also produce several other benefits for the world

economy. The case for floating exchange rates rested on three major

claims:

3.4.1Monetary policy autonomy

If Central Banks were no longer obliged to intervene in currency

markets to fix exchange rates, govt. would be able to use monetary

policy to reach internal and external balance. Furthermore, no country

would be forced to import inflation (or deflation) from aboard.

3.5.2Exchange rates as automatic stabilizer

Even in the absence of an active monetary policy, the swift adjustment

of market-determined exchange rates would help countries maintain

internal and external balance in the face of changes in aggregate

demand. The long and agonizing periods of speculation preceding

exchange rate realignments under the Bretton Woods rules would not

occur under floating.

Balance of Payment (BOP). Balance of Payments on current account

disequilibria will automatically be restored to equilibrium. A balance of

payments deficit caused by a decrease in the demand for Bangladesh

exports would lead to a shortage of foreign currency as the amount of

foreign currency available falls - shown by a shift to the left of the

supply curve for foreign currency. This would push up its price and

hence lead to a depreciation of the Taka.

The fall in the value of Taka causes the price of Bangladesh exports to

decrease and the price of foreign imports to increase. Consequently

the demand for Bangladesh exports increases and the demand for

foreign imports decreases. The deficit shrinks and the balance of

payments returns to equilibrium assuming the Marshall Lerner

Condition is satisfactorily met.

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Thus, in theory, governments need not worry about having to manage

their balance of payments situation. If the exchange rate is allowed to

fluctuate freely any disequilibria will automatically be restored to

equilibrium. The need to resort to overseas borrowing to finance

balance of payments deficits (adding to the burden of Bangladesh's

existing debt) is therefore less. The attention of government can then

be focused on achieving other government objectives such as inflation,

unemployment, and economic growth and poverty reduction.

Reduction in inflationary pressures. One argument is that a

floating exchange rate will reduce the level of inflation. Bangladesh

has suffered from high levels of inflation. Allowing the exchange rate to

float freely should ensure that Bangladesh exports do not become

uncompetitive. This is embodied in the Purchasing Power Parity theory.

A high rate of inflation in Bangladesh would tend to make Bangladesh

exports uncompetitive. Their demand would fall and the foreign

exchange flowing into the country would also fall. The supply curve of

available foreign currency would in turn shift to the left causing its

value to increase and the corresponding value of the Taka todepreciate. This would, assuming the Marshall Lerner condition was

met, lower the price of Bangladesh exports making them more

competitive.

3.5 ARGUMENTS AGAINST FLOATING EXCHANGE RATES

The experience with floating exchange rates between the world wars

had left many doubts about how they would function in practice if the

Bretton Woods rules were scrapped. Some economists were skeptical

of the claims advanced by the advocates of floating and predicted

instead that floating exchange rates would have adverse

consequences for the world economy. The case against floating rates

rested on five main arguments:

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3.5.1Discipline

Central Banks freed from the obligation to fix their exchange rates

might embark on inflationary policies. In other words, the discipline

imposed on individual countries by a fixed rate would be lost.

3.5.2Destabilizing speculation and money market disturbances

Speculation on changes in exchange rates could lead to instability in

foreign exchange markets and this instability, in turn, might have

negative effects on countries internal and external balances. Further,

disturbances to the home money market could be more disruptive

under floating than under a fixed rate.

3.5.3Injury to international trade and investment

Floating rates would make relative international prices more

unpredictable and thus injured international trade and investment.

3.5.4Uncoordinated economic policies

If the Bretton Woods rules on exchange rate adjustment were

abandoned, the door would be opened to competitive currency

practices harmful to the world economy. As happened during the

interwar years, countries might adopt policies without considering their

possible beggar-thy-neighbor aspects. All countries would suffer as a

result.

3.5.5The illusion of greater autonomy

Floating exchange rates would not really give countries more policy

autonomy. Changes in exchange rates would have such pervasive

macroeconomic effects that central banks would feel compelled to

intervene heavily in foreign exchange markets even without a formal

commitment to peg. Thus, floating would increase the uncertainty in

the economy without really giving macroeconomic policy greater

freedom.

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3.5.6The Marshall Lerner Condition is not necessarily met

The problem for countries such as Bangladesh and many other LDCs is

that the link between the exchange rate adjustment and the balance of

payments improvement is not as straightforward as the above would

suggest. Some economists would argue with the idea that balance of

payments deficits would automatically be returned to equilibrium

under a floating exchange rate system. They argue that the Marshall

Lerner conditions are not met.

3.5.7Cost Push Inflationary Pressures

A depreciating currency will help a country's exporting sector.

However, the cost of imports will invariably rise leading to cost push

inflationary pressures. Those people whose livelihoods rely on the

consumption of goods with high import content will experience

hardship.

Chapter 4

EXPERIENCES FROM DEVELOPING COUNTRIES

4.1 CURRENCY FLOAT- THE SOUTH ASIAN EXPERIENCE

The experiences of Asian countries that have switched to a floating

exchange rate have been mixed. South East Asian countries

(Indonesia, Philippines, Korea, and Thailand) that adopted floating

exchange rate regime following the Asian crisis experienced much

greater volatility compared to the pre-crisis period. However, Indias

switch to the floating exchange rate in 1993 was relatively smooth.

Pakistans currency experienced considerable volatility after the

country abandoned the peg and in Sri Lanka too adoption of the float

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resulted in considerable volatility. In both these countries, the

respective central banks had to actively support their currencies.

4.1.1Experience of Sri Lanka with Floating Exchange rate

Regime

Sri Lanka adopted a free float on 23 January 2001. Immediately after

the float, there arose considerable volatility. The currency fell

drastically in two days following the float to as low as Rupee 98/$

compared to Rs.79/$ in November 2000. This forced the authorities to

intervene in support of the currency and induce stringent control

measures so as to restore the currency to Rs.87/$ by about March

2001. As of November 2001, the rupee depreciated to Rs.93/$.

The volatility and the sharp depreciation in Sri Lanka occurred in spite

of putting in place precautionary foreign exchange regulations in

conjunction with the float. These regulations, inter alia, imposed limits

on banks daily net foreign exchange exposure; enjoined banks to

ensure settlement of export credit by using export proceeds within 90

days (later extended to 120 days) and to impose penalties for overdue

settlements; introduced restrictions and deposit requirements forbanks forward sales of foreign exchange and prohibited prepayment

of import bills. The country also has set of detailed guidelines for

dealing in foreign exchange market and the conduct of intervention by

the central bank.

4.1.2Indias with Floating (managed) Exchange Rate

India adopted a unified exchange rate system in March 1993 in which

the exchange rate is determined by the supply and demand condition

in the inter-bank foreign exchange market. The subsequent to the

liberalization of the financial sector in 1993, the inflows of capital seem

to have had a positive influence on the changes in the real effective

exchange rate. Specifically, capital flows Granger cause the changes in

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the real effective exchange rate. The lagged net capital inflows after

September 1993 have had a smoothing effect on the volatility of REER.

The countrys exchange rates remained fairly stable till August 1995,

but then there was a sharp depreciation against the dollar by 12% by

the end of 1995. There was again a sharp depreciation by about 15%

between September 1997 and July 1988. By November 2001, there

was a further depreciation by about 13% and Rupee/Dollar exchange

rate was 48.0.

The adoption of floating/flexible regime has not freed the Reserve bank

of India (RBI), the central bank of India, from intervening in the foreign

exchange market as well as some large of fact that the thinness of the

foreign exchange market as well as some large transactions can cause

excessive volatility, RBI pursues an explicit policy of intervention in the

spot market and also undertakes both forward and swap transactions

in support of its exchange rate objectives.

In the case of India, the process of liberalization is still very far from

complete. For this reason, judgments about whether the liberalization

of capital flows has been a success or a failure are necessarily

premature. At present India has a partially open capital account, which

allows foreign institutional investors to invest in India (stocks, bonds,

bills) and repatriate in dollars. Domestic residents and companies are

prohibited from investing in assets abroad. India has had significant

controls on both inflows and outflows. These controls have applied to

broad spectrum of assets and liabilities, applying to debt, equity and

currency. These capital management techniques have involved strict

regulation of financial institutions, as well as controls of externaltransactions. Although the Indian economy has moved towards a

progressively freer capital market, this has been an extremely gradual

process.

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Developing countries like India face significant risk from a quick

reversal of foreign institutional inflows. In case the foreign institutional

inflows are decided only by external factors that could be destabilizing.

The rapidly changing global liquidity conditions may trigger foreign

institutional outflows from India, which through a signaling role has the

potential to create panic among local investors. We would like to model

the determinants of net foreign institutional investment to India by

including global and local factors.

4.1.3Experience of Pakistan with Floating Exchange rate

Regime

Pakistan can be considered to have adopted a sort of floatingexchange rate policy since July 2000 when the exchange rate band

was abandoned. But the experience of Pakistan after introducing

floating exchange rate was not good. So the State Bank of Pakistan

also intervenes in foreign exchange market. The interventions take the

form of outright sales/purchase of foreign exchange; swap transactions

and provision of foreign exchange to banks to cover certain bulky

imports.

The market-based unified exchange rate system that was introduced

on May 19, 1999 was replaced with free floating of Pak-rupee against

US dollar from July 21, 2000. As expected, foreign exchange

market came under pressure initially. Pak-rupee/ US dollar inter-bank

floating exchange rate for the month of July, 2000 averaged Rs.52.5 as

against Rs.55.1 prevailing in the open market, showing a premium of

Rs.2.6 per Us Dollar or 5.0 percent. The pressure on rupee continues tomount due largely to heavy demand for US dollar to clear up foreign

repayment obligations and POL import bills. Consequently, the rupee/$

parity in the inter-bank market increased to an average of Rs.61.1

during April 2001 vis--vis Rs.63.8 prevailed in the open market. This

reflects a premium of Rs.2.7/$ or 4.4 Percent. The premium almost

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remained stable during the current fiscal year because of

corresponding rise of rupee/$ exchange rate in both the inter-bank and

open market. Since the beginning of the current fiscal year, Pak-rupee

against US dollar has depreciated by 14.1% till April 2001.

Foreign Exchange reserves have widely fluctuated in the decade of the

1990s. These were as low as $ 529 million on end June, 1990 but with

a built up of $ 2208 million, the foreign exchange reserves peaked at $

2737 million by the end June, 1995 mainly on account of one time sale

of Pakistan Telecommunication voucher amounting to $ 862 million.

Since then the reserves have exhibited a declining trend and declined

to $ 930 million (end June, 1998) in the aftermath of economic

sanctions. As a result of macroeconomic stability attained through

effective management, the reserve position improved and aggregated

at $ 1352 million on end June 2000. The reserves on end April 2001

amounted to $ 1123 million, showing a fall of 16.9 percent over the

level of end June 2000.

4.2 EXPERIENCES OTHER COUNTRIES

4.2.1Chinas Pegged Exchange Rate and Global Imbalances

Since 1995, the Peoples Republic of China (PRC) pegged its currency,

the renminbi, to the U.S. dollar at the rate of $1 equals 8.28 yuan. If

the foreign exchange value of the renminbi begins to increase (i.e., $1

becomes less than 8.28 yuan), the PRCs central bank must purchase

U.S. dollars with yuan. Such U.S. dollar purchases increase the supply

of yuan and reduce the renminbis foreign exchange value until it

again equals the pegged exchange rate. Simultaneously, the PRCs

central bank buys U.S. Treasury and U.S. Agency debt securities with

Floating of Taka- An Impact Analysis

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