Assignment on

Determinants of Exchange Rate in Bangladesh: Overview and Trend

Submitted to: Dr. Juthathip Jongwanich Assistant Professor

Submitted by: Group No : 3 Group Members: Mohammad Akhlasuddin Shah Zia-ul Haque Mohammad Atiq Mohammad Rayhan Miah Jigme Chogyel Dorji Wangchuk Sonam Tobgay

Contents
SL No. 1.0 1.1 1.2 1.3 2.0 2.1 2.2 3.0 3.1 3.2 3.3 3.4 3.5 3.6 4.0 5.0 Particulars Introduction Scope of the Study Limitations of the Study Further Scope of the Study Exchange Rate Definition Exchange Rate Regime Exchange Rate Regime of Bangladesh Reasons for changing of Exchange rate regime Performance during Fixed Rate Regime Performance after the Regime Change Current Exchange Rate System of Bangladesh Nominal and Real Exchange Rates Behavior NEER and REER in Bangladesh Determinants of the Exchange Rate Conclusions References List of Tables Table-1 Table-2 Table-3 Table-4 Principle objectives of countries for choosing different exchange rate policies. Evolution of de jure exchange rate regimes in emerging Asian economies Chronology of Bangladesh Exchange Rate All regimes and respective number of followers of the regimes List of Figures Figure-1 Figure-2 Figure-3 Figure-4 Figure-5 Figure-6 Figure-7 Figure-8 Figure-9 Current situation of Taka against US Dollar Behavior of REER and NEER in Bangladesh Recent movement of NEER and REER in Bangladesh. Movement of Exchange Rate against Trade Deficit and Current Account Balance Movement of Exchange Rate due to Demand and Supply change Impact of Foreign Exchange Reserve over Exchange Rate Impact of Remittances on Exchange Rate Movement of Exchange Rate due to inflation Impact on the exchange rate when interest rates are raised 15 18 18 19 20 21 22 24 26 6 8 10 10 Page No. 3 4 4 4 5 5 5 9 11 12 13 14 16 17 19 30 31

Abstract:
The objective of this paper is to analyze determinants of exchange rate practices in Bangladesh placing special emphasis on macroeconomic explanations. In the process, the paper also tries to identify nominal exchange rate, real exchange rate and the variables that play important roles in determining the exchange rate of BDT (ISO symbol of Bangladeshi currency-Taka). In order to provide context; the trend of exchange rate system in Bangladesh its past and present have been briefly discussed.

1.0 Introduction
[Whereas, it is necessary to establish a central bank in Bangladesh to manage the monetary and credit system of Bangladesh with a view to stabilizing domestic monetary value and maintaining a competitive external par value of the Bangladesh Taka towards fostering growth and development of countrys productive resources in the best national interest;]- the preamble of Bangladesh Bank Order 1972. The exchange rate is one of the most important policy variables, which determines the trade flows, capital flows & FDI, inflation, international reserve and remittance of an economy. Besides, exchange rates of currencies lie at the heart of international trade. So, exchange rate management is one of the central issues of macroeconomic policies. The currency of Bangladesh is Bangladesh Taka (BDT), which was created to replace the Pakistan Rupee in January 1972. Before 1983, the Taka was linked to Pound Sterling. The exchange rates for currencies other than Sterling are based on the London market rates for the currencies concerned. Started from January 1983, however, its intervention currency was changed to the U.S. Dollar. Started from 1979, the Bangladesh Bank followed a semiflexible exchange rate policy, revaluing the Taka on the basis of a trade-weighted basket of currencies, with fluctuation margins of 2.5% on either side. Exchange rate of Bangladesh has received wide attention among all concerned from end-May, 2003 when Bangladesh adopted the floating exchange rate system. The exchange rate management has, of late, received renewed attention with the emergence of global financial crisis and its likely impact on trade, investment and overall gross domestic product (GDP) growth in 2007-08. The paper consists of two parts. In the first part, we present a brief theoretical framework discussing different exchange rate systems, a historical overview of the exchange rate
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system of Bangladesh, the probable reasons for the regime change and a brief discussion of the performance of the two regimes. After that, we move on to the second part i.e. the determinants of exchange rate in Bangladesh.

1.1

Scope of the Study:

The study focuses the various foreign exchange regime of Bangladesh; try to find the determinants and behavioral change of foreign exchange of Bangladesh. To analyze REER and NEER Data have been collected from 2004-2006. For the rest of the study, data have been collected from 1998-99 to 2010-11.

1.2

Limitations of the Study:

Every research work needs high degree of involvement regarding collection of information, creation of database, review of literature and analysis of the data. In this study, utmost endeavor has been put to collect, organize, analyze, and interpret the related data and finally to attain the optimum outcome of the study. However, this study has suffered from certain constraints noted below: Primary and unpublished data have not considered for the study. The depth of the analysis has been limited to the extent of information collected from different sources. No regression model is used to find out the correlation between various determinants. Rather the study focused on the impact of various determinants on the exchange rate in a positive or negative way, but not about the exact change of foreign exchange to every determinant. Last of all, this study has been conducted within a very limited time. So, time constraint has played a key role for the whole study.

1.3

Further Scope of Study:

Further study may be conducted to measure and analyze effect of individual determinants on exchange rate as well as aggregate effect of all the determinants to exchange rate.

2.0 Exchange Rate:

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2.1 Definition
The exchange rate is defined as the price of one unit of currency in terms of another currency. If one USD costs 82.50 BDT then 1 BDT costs 1/82.50=0.012 USD. If the exchange rate is stated in terms of the USD (for example, 82.50 BDT/USD) then the USD is called the base currency or the unit currency and BDT is called the quoted currency. In most countries, the exchange rate is expressed using the foreign currency as the base currency. For example, in Bangladesh, the USD exchange rate would be expressed as 82.50 BDT per USD while, in the U.S., the same exchange rate would be would be expressed as 0.012 USD/BDT. This way of specifying the exchange rate is called the direct method as you can immediately figure out how much you have to pay for one unit of foreign currency. In some countries, the exchange rate is expressed using the home currency as the base currency. In the UK for example, the Danish exchange rate would be expressed as 9.2 DKK/GBP. Thus, you have to invert the exchange rate if you want to figure out how much one unit of foreign currency costs in the UK. This method is called the indirect method of specifying the exchange rate and the notation is sometimes called British notation.

2.2 Exchange Rate Regimes:

The choice of exchange rate regime has always been one of the most important subjects in international macroeconomics. Since the publication of Robert Mundells A Theory of Optimum Currency Area, we have seen a large amount of literature trying to tackle this crucial issue to identify how countries choose their exchange rate regimes. According to the theory of optimum currency areas, this choice is made on the basis of some structural and macroeconomic factors such as the size, the degree of openness or the level of economic development of a particular country. Another set of literature emphasizes political and institutional factors such as political instability, central bank independence or the government temptation to inflate as important criteria influencing the choice of exchange rate regime.

Table-1: Principle objectives of countries for choosing different exchange rate policies. Monetary Policy Framework
No. of Countries
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Exchange rate anchor Monetary aggregate target Inflation targeting framework IMF-supported or other monetary program Other
Source: IMF Annual Report 2006

96 31* 24 08 35

Note: *according to IMF Annual Report 2006, Bangladesh belongs to this group, where the monetary authority takes the exchange rate policy to achieve the targets of international reserve, narrow money(M1), Broad Money (M2) etc.

The most important characteristics of exchange rate system are to what degree the country is trying to control the exchange rate.
i.

Completely Fixed Exchange Rate Regime Completely Floating (Flexible) Exchange Rate Regime Intermediate Exchange Rate Regime Monetary union

ii.
iii. iv.

i. Completely Fixed Exchange Rate: In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries. If an exchange rate begins to move too much, governments intervene to maintain it within the boundaries. In some situations, a government will devalue its currency while in other situations it will revalue its currency against other currencies. ii. Floating Exchange Rate: In a freely floating exchange rate system, also known as a clean float, exchange rate values are determined by market forces without intervention by the governments. A major advantage of this system is the insulation of a country from the inflation or unemployment problems in other countries. An additional advantage of this system is that a central bank is not required to constantly maintain exchange rate within specified boundaries. A countrys economic problems can sometimes be compounded by freely floating exchange rate.

iii. Intermediate Exchange Rate Regime

a) Pegged Exchange Rate: Under such a system, the value of the home currency is

pegged to a foreign currency. The pegged currency moves in line with that currency to which it is fixed against other currencies. Some currencies such as the Bhutanese Ngultrum is pegged with Indian Rupee while Argentine Peso or the Chinese Yuan are pegged against a single currency (US Dollar) while some others are pegged against a composite of currencies such as the composite of European currencies. If a country conducts most of its trade with another country then pegged system yields benefit to both these countries as it virtually eliminated the exchange rate risk. The risk associated with depreciation of that currency to which it is pegged.
b) Managed float exchange rate system: Also known as a dirty float. It is similar to a

freely floating system in that exchange rates are allowed to fluctuate on a daily basis and there are no official boundaries. It is similar to a fixed rate system in that governments can and sometimes do intervene to prevent their currencies from a sharp fall. It prevents a crash in the value of the currency, should it happens. Some criticize such a policy as it seeks to protect the home currency at the expense of others. iv. Monetary Union: A country may also be a part of a monetary union where all the countries in the union share the same currency. There is then no exchange rate between the countries in the union. The union must itself select an exchange rate system vis-a-vis other currencies. The largest monetary union is the EMU, the European Monetary Union with its currency the Euro. The euro is flexible against other currencies (except those that are pegged to the Euro).

Table-2: Evolution of de jure exchange rate regimes in emerging Asian economies

Economy China, Peoples Rep. of Period 1990-1998 1999-June 2005 July 2005-Present Hong Kong, China India Korea, Rep. of 1983-present 1990-present 1990-1997 1998-present Indonesia 1990-July 1997 Aug 1997-June 2001 July 2001-present Malaysia 1991-August 1998 September 1998-2005 2006-present Philippines Singapore Taipei, China Thailand 1990-presnt 1990-present 1990-present 1990-June 1997 July 1997-2001 Exchange Rate Regime Managed floating Convertible pegged arrangement Managed floating exchange rates with reference to a currency basket Currency board arrangement Managed floating with no predetermined path of exchange rate Managed Floating Independently floating Managed floating Independently floating Managed floating with no predetermined path for exchange rate Managed floating Conventional pegged arrangement Managed floating with no predetermined path for exchange rate Independent floating Managed floating exchange rates with reference to a currency basket Independent floating Pegged to a composite of currencies Managed floating with no predetermined path for the exchange rate Pegged to GBP and USD

Bangladesh

1972-May 2003

June 2003-present Managed floating Source: 1975 to 1998: International Monetary Fund, Annual Report on Exchange Arrangements and Exchange restrictions, various years until 1998; 1998 to present: central bank websites

3.0 Exchange Rate regime of Bangladesh

Two distinctively different exchange rate regimes have been in place in Bangladesh i. ii. i. A fixed exchange rate regime from January 1972 May 2003 and A floating exchange rate regime since June 2003. Fixed exchange rate regime:

Bangladesh, the focus of this paper, had a fixed exchange rate system in place since January, 1972, virtually since the birth of the Nation (Bangladesh won its war of Independence on December 16, 1971). Exchange rate regime of Bangladesh can be characterized mostly as a fixed rate system imposed and influenced by the government. Given an existing nominal exchange rate, the corresponding real effective exchange rate was estimated. If the real effective exchange rate (REER) as estimated on the basis of current par value significantly diverged from the desired REER, corrective response was initiated by changing the nominal exchange rate. The exchange rate policy decisions, though notified in all cases by the Bangladesh Bank, were made on behalf of and in close consultation with the Ministry of Finance. Bangladesh Bank did not have the sole authority over determining the exchange rate policy. Up to 24th May 2001, Bangladesh Bank used to announce specified buying and selling rates. From 3rd December 2000 Bangladesh Bank adopted the practice of declaring a 50 paisa (0.50 Taka) band within which buying and selling transactions were to be undertaken; this band was widened to Taka 1.00 from 25th May 2001. Even during the fixed regime, as mentioned earlier, Bangladesh pursued an active exchange rate policy. This activism is reflected in the frequency of nominal exchange rate changes announced by the Central Bank. From 1983 onwards, there have been as many as 89 adjustments in the exchange rate of which 83 were downwards and only six were upward. ii. Floating exchange rate regime:

After more than 31 years, Bangladesh adopted a freely floating regime on May 30, 2003 by abandoning the adjustable pegged system. The transition to the floating regime was smooth and the first ten months can be viewed as the honeymoon period for Bangladesh because the exchange rate remained stable, experiencing a depreciation of less than 1 percent from June 2003 to April 2004. Exchange rate kept on depreciating gradually from mid-2004 and
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it reached its peak at Tk. 70/USD in 2006 from Tk. 58/USD, accounting for a 20 percent depreciation. Since then (2007-2009), it remained fairly stable and has been fluctuating between Taka 68 and 69. Again in September 2011, USD/BDT rate reached to 83.50 due to high import pressure but now hovering at around Tk.81.50. The floating regime is thus characterized by both volatility and stability. Table-3: Chronology of Bangladesh Exchange Rate
Period 1972-1979 1980-1982 Chronology of Bangladesh Exchange Rate Pegged to the British Pound Sterling Pegged to a basket of major trading partners currencies with pound sterling as the intervening currency Pegged to a basket of major trading partners currencies with US Dollar as the intervening currency An adjustable pegged system

1983-1999

2000-2003

June 2003-present Floating exchange rate system Source: Bangladesh Bank

Table-4: All regimes and respective number of followers of the regimes

Exchange Rate Regimes Exchange arrangements with no separate legal tender Currency board arrangements Conventional fixed peg arrangements Pegged exchange rates within horizontal bands Crawling pegs Exchange rates within crawling bands Managed floating with no predetermined path for the exchange rate Independently floating Source: IMF Annual Report 2006 Note: *according to IMF annual Report 2006, Bangladesh belongs to this exchange rate system, in which the monetary authority tries to influence the exchange rate without taking a precise exchange rate target. Authority intervenes directly or indirectly. However, intervention takes place considering the parallel market status, balance of payment position, international reserve situations etc. **none. No. of Countries 41 7 49 6 5 ** 53* 26

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3.1 Reasons for Changing the Fixed Rate System to Floating

Some of the reasons the exchange rate regime was changed are discussed below: a. Balance of Payments disequilibrium can automatically be restored to equilibrium. When the economy experiences a balance of payments deficit, there is excess demand for the foreign currency and the exchange rate of the local currency depreciates. This may have the effect of automatically restoring equilibrium. In such case, the value of local commodities falls from foreigners perspective making them more attractive abroad hence increasing export and value of foreign goods increases from domestic perspective making them less attractive locally. Both could lead to an improvement in the balance of payments situation.
b. May decrease inflationary pressures and improve international competitiveness. A

floating exchange rate can reduce the level of inflation in LDCs like Bangladesh. Allowing the exchange rate to float freely should ensure that exports do not become uncompetitive. The basic idea comes from the Purchasing Power Parity theory. A competitive high rate of inflation tends to make the exports uncompetitive. c. To keep pace with the other markets in South Asia where India (in1998), Pakistan (in 2000) and Sri Lanka (in 2001) have already introduced the floating rate system. (Islam, 2003)
d. Donors had also been putting pressure on Bangladesh to go for the floating exchange

rate system and reportedly, obtaining foreign assistance from them also depended somewhat on introducing the new floating exchange rate system. Hence, it can be argued that pressure from the IMF and the World Bank was an important factor behind the regime change.
e. Involvement of the government would stop under the new system where market forces

determine the actual price of Taka rather than the finance ministry or the central bank.

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3.2 Performance during Fixed Rate Regime

Lets take a look at the performance of Bangladesh in terms of certain key objectives that an exchange rate regime is expected to promote and how it fared during the fixed rate regime. The relevant objectives are: (a) the prevention of any major misalignment of exchange rate and, in particular, the prevention of appreciation of the real effective exchange rate which can hurt exports; (b) the promotion of exports and containment of current account deficit; (c) moderation of inflation; and (d) enhancement of remittances. (a) Misalignment of exchange rate: The prevention of misalignment implies that the actual exchange rate should correspond to the estimate of equilibrium exchange rate. A recent study undertaken by ADB concluded that the misalignment between the actual and equilibrium exchange rate for the period 1997 to 2001 was small and progressively narrowed since 1998. During 2001, the misalignment was only 2.2 per cent. Also, the exchange rate policy succeeded in preventing appreciation of the real effective exchange rate throughout the 1990s. It can thus be concluded that the fixed exchange rate regime has avoided any major misalignment in the exchange rate. (b) Exports and Current Account Balance: Bangladeshs achievement in terms of containing Current Account deficit was not unsatisfactory. It has done consistently better than Sri Lanka, and better than Pakistan in all the recent years except in 2001. The only country with which Bangladesh compares somewhat unfavorably is India, but that should not come as a surprise even to a casual observer in view of Indias high savings rate and level of industrialization. (c) Inflation: The discussion of inflation in the context of exchange rate regime becomes relevant because of two major considerations. First, a change in the exchange rate is almost certain to cause a change in the domestic prices of tradable goods. Second, the prices of non-tradable goods are also likely to be affected because the non-tradable goods often use tradable inputs and
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the demand switch generated by initial change in the exchange rate may not extract corresponding supply response from the non-tradable sector to leave prices unchanged. Bangladesh did reasonably well in terms of inflation criterion. During the past decade, its inflation rate never reached double-digit level. In every year except 1999, the inflation rates in Bangladesh have been similar to or lower than the South Asian average. (d) Remittances: Remittances by Bangladeshi workers employed abroad play an important role in moderating the countrys trade deficit. The countrys performance in respect of remittances in Dollar terms has maintained an uninterrupted upward trend. There was only a minor blip in 2001. The performance of Bangladesh in terms of certain key objectives that an exchange rate regime is expected to promote has been quite satisfactory. So it is arguable that the fixed exchange rate regime of Bangladesh had served the country reasonably well.

3.3 Performance after the Regime Change

It was feared by some that the introduction of the freely floating system may immediately adversely affect the value of the Taka as it did when this change took place in the neighboring country. There had been a dip in the value of the weaker currency right after floatation. But this did not happen for the Taka, which initially remained strong after the flotation. Contrary to a lot of speculation about a possible drastic fall in the value of Taka it actually fared well initially. It also contradicted the historical experience of the other Asian countries. We can see it by looking at the following exchange rates between Taka and the USD. Exchange rate of BDT against USD on May 22, 2003 (a week before the regime change): Tk 57.80/ USD (The Daily Star, May 23, 2003) Exchange rate of BDT against USD on August 18, 2003 (about one and a half month after the regime change): Tk 57.82/ USD (The Daily Star, August 19, 2003) Its obvious here that Taka had not depreciated much against the USD in the early days after the regime change. It actually gained initially and then remained steady as Dollar showed signs of weakening against the Euro. Other economic indicators also did not hint any significant deviations after the introduction of the freely floating system. For example, the flow of remittances maintained its upward trend as it did during the fixed rate regime. Also, offering of Dollar denominated bonds increased the reserve of Dollars. The rate of inflation

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was 5.98% in March 2003, which is higher than 4.58% in the fiscal year of 2000-2001. The current account deficit was 15,809 Crores BDT ($ 2.72 billion). GDP growth was approximately 5.5% in 2003 2004 (Data source: Official Website of Bangladesh Bureau of Statistics: http://www.bbs.gov.bd/) Thus, we can conclude that immediately after the exchange rate system regime change, performance had been reasonable compared to the performance during the fixed rate regime. In comparison, the BDT had fared more or less the same in the competitive environment. However, since then, value of Taka has fallen drastically against Dollar. In February 2007, BDT against USD was Tk 69.00/USD. Many have attributed this fall in Taka value to the floating exchange rate regime. Some of the other note-worthy factors that may influence the change in exchange rate of Taka are changes in net exports or trade deficits, changes in foreign currency reserves, changes in real interest rate and change in the rate of inflation. In the next part of the paper, significance of these factors on value of Bangladesh currency has been analyzed thoroughly.

3.4 Current Exchange Rate System of Bangladesh

Officially (de jure) Bangladesh maintains floating exchange rate system. Empirical evidence and theory suggests that floating exchange rates are characterized by little intervention in the exchange rate markets together with unlimited volatility of the nominal exchange rate. In a floating regime, since little or no intervention is required, reserves exhibits relatively low volatility. However, it is observed that relative volatilities of the exchange rate, reserves and interest rates are very low for the period 2007- 2009, indicating an active intervention in the foreign exchange market. This observation is correct because Bangladesh Bank purchased US$1.48 billion from the inter-bank market in 2008-09, most of which remained unsterilized (MPS, July 2009). Such foreign exchange intervention activities have led to a situation where the nominal exchange rate has remained almost fixed or has moved within a very narrow range for the aforesaid period. Therefore, the de facto exchange rate regime of Bangladesh has not been in the purview of the freely floating rate regime. Generally speaking, Bangladesh practices a managed floating rate system from the very beginning of its transition to floating regime. More precisely, the

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recent exchange rate behavior indicates a fixed exchange rate system is in place (from 2007 onward).

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

Depreciation of currency entails several types of effects on the economy. First, depreciation directly affects the rate of inflation through the level of the pass-through. Many studies including a recent one by the Bangladesh Institute of Development Studies (BIDS) found a high pass-through effect of depreciation of Taka in Bangladesh. Since Bangladesh is an import dependent country, any change in prices in the international market will eventually transmit to domestic prices. Second, depreciation also affects output growth through different channels including the balance sheet channel. Third, usually a larger depreciation entails a smaller increase in interest rates and this has effect on the credit channel. Therefore, the overall impact of depreciation depends on the trade-off between these effects. Caught in this dilemma, the monetary authorities perhaps have chosen to keep the exchange rate nominally fixed or almost fixed for last two years, by intervening in the foreign exchange market. However, to manage floats or to maintain a long-term value of the currency, Bangladesh Bank must have to acquire a good stock of international reserves. Recent increasing trends of remittance and net foreign assets give us an indication of bright prospects of acquiring large stock of international reserves, which is now stood at around $10.5 billion by which Bangladesh can meet up three to four months import cost. In the face
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of current account surplus with increasing remittance with low import demand, the Taka is likely to face constant market pressure to appreciate. Market analysis also reveals the fact that the Taka is now under the pressure of appreciation, but Bangladesh Bank maintains an undervalued Taka through huge purchase of US Dollars from the market to maintain export competitiveness. Occasional intervention in the foreign exchange market brings some positive benefits, particularly for developing countries like Bangladesh if the intervention is targeted to achieve some economic objectives such as stable inflation or trade competitiveness. A word of caution is in order if nominal exchange rate moves along a continuum for long time-it may create distortions in the market, such as macroeconomic symptoms of irrational exuberance, which include strong growth, accelerating inflation, rising international reserves, and gradual overvaluation (the loss of international price competitiveness). This is a troublesome situation and if it continues for long time, there might have the risk of possibility of crisis.

3.5 Nominal and Real Exchange Rates

The nominal exchange rate is the relative price of the currencies of two countries. For example, if the exchange rate between the U.S. Dollar and the Bangladeshi Taka is 80 per Dollar, then you can exchange one Dollar for 80 Taka in world market for foreign currency. A Bangladeshi who wants to obtain Dollars would pay 80 Taka for each Dollar he bought. An American who wants to obtain Taka would get 80 Taka for each Dollar he paid. When people refer to the exchange rate between two countries, they usually mean the nominal exchange rate. The real exchange rate is the relative price of the goods of two countries. That is, the real exchange tells us the rate at which we can trade the goods of one country for goods of another. The real exchange rate is sometimes called the terms of trade. The real effective exchange rate (REER) is the inflation-adjusted and trade-weighted exchange rate, which is used as a popular index of international trade competitiveness of a country. On the other hand, nominal effective exchange rate (NEER) is a trade-weighted index, which is also used to represent trade competitiveness.

3.6 Behavior of NEER and REER in Bangladesh

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In May 2003, the government announced the full free floating exchange rate system in Bangladesh. It was a historic move towards application of market mechanism in macroeconomic management. It was anticipated that the shift from a managed floating system to a free floating would have an impact on the foreign exchange market and the market distortion which prevailed in the exchange rate would be corrected. Before the floating exchange rate system Bangladesh Bank regularly calculated real effective exchange rate (REER) using a basket pegging formula with USD as a lead currency. Based on the REER and other macroeconomic considerations Bangladesh Bank announced a buying and selling rate for the foreign currencies. The lower and higher limits of buying and selling rates were mandatory for the dealers. Since the announcement of switching to the freefloating system a dealer can offer buying and selling rates based on their own market analysis. However, Bangladesh Bank continues to calculate the REER to monitor the market trends for necessary intervention. The estimation of NEER and REER reveals very important behavior of foreign exchange market in Bangladesh. The NEER index since July 2004 shows that there is a cyclical trend in the index, which is interpreted as market correction only for demand-supply mismatch which took place in the exchange rate behavior in Bangladesh market. The REER based exchange rate, in Bangladesh, increased to Tk. 71.74 per USD at the end of September 2011 from Tk. 68.85 per USD at the end of September, 2010, indicating that the country has lost some of its external trade competitiveness during Q1FY12 compared to the same quarter of previous fiscal year.

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

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

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4.0 Determinants of the Exchange Rate

The next section presents some determinants of the exchange rate. These determinants could lead to changes of a floating exchange rate or put pressure on a fixed exchange rate. 1. Current Account Balance and Trade Balance: Exports, imports and the trade balance can influence the demand of currency aimed at real transactions. An increasing trade surplus will increase the demand for country's currency by foreigners (e.g. if the United States is running a trade surplus, there will be demand from overseas for the USD to pay for these goods), so that there should be a pressure for appreciation. A trade deficit should lead to the currency weakening. If exports and imports largely determined by price competitiveness and the exchange rate truly sensitive to trade imbalances, then any deficit would imply a depreciation followed by booming exports and falling imports. Thus, the initial deficit would be quickly reversed. Trade balances would almost always be zero.

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

In Bangladesh, the foreign exchange market experienced some depreciation pressures on the Tk. since last few years. This was due to demand pressure for high import payments especially high fuel import costs in the context of a decline in external financing inflows.

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Following the higher demand for foreign currencies, the Tk. depreciated by 1.46 percent against the US Dollar during Q1FY12. 2. Changes in Demand-Supply: A change in demand-supply plays a key role in determining exchange rate of a currency in a flexible exchange rate regime. Importers and investors are the major buyer of foreign currency while exporters are the major supplier of foreign currency.

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

3. Foreign Exchange Reserve Bangladesh has been experiencing huge trade deficit and its condition is gradually deteriorating as a whole as Bangladesh is a net importer country. But so far Bangladesh has been able to manage this deficit with huge inflow of workers remittance from abroad to make its current account positive. As Bangladesh does not allow Capital account convertibility and gets fair amount of foreign loans and grants and with current account surplus there should be surplus supply of foreign exchange into the countrys reserve and thus make its currency appreciate. But in reality, Bangladesh is experiencing huge pressure in its reserve and exchange rate depreciation. Consequently, Central Bank of Bangladesh is intervening in the FX market time to time to keep the currency from free falling. The question, why this is happening despite positive current account balance and capital control. Bangladesh Government adopts fiscal policy of deficit budgeting for its capital expenditure in infrastructure, health, education etc. This deficit is mainly financed by foreign loans and grants from donor countries, IMF, World Bank, Asian Development Bank etc. There has
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been a declining trend in foreign loans and grants due to global economic crisis. Also, huge subsidy is being provided in food import and fuel import which creates huge pressure in its FX reserve. So, overall Bangladesh is experiencing pressure in FX reserve and currency depreciation.

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

4. Foreign Remittance Workers remittances have an ever important role as one of the major sources of foreign exchange earnings for the Bangladesh economy. It accounts for over 12 per cent of GDP in 2010 and having colossal socio economic implications for the country. The relationship between remittances flow and REER is ambiguous since increased flow of remittances may impact differently on the REER through consumption, savings and investment choices by the recipient families on the economy. Inflow of remittances may increase the consumption by the recipient families on the non tradables sector, or reduce their work leisure choice, which may increase the relative price of nontradables to tradables and appreciate the real exchange rate of the country. On the other hand, the flow of remittances may increase the saving and investment efforts by recipient families, lowers the resource gap and raises investment in education, health and small business. This in turn will lower the relative price of nontradables to tradables and improves the international competitiveness of the country. However, government expenditure, openness in goods and capital markets are facilitating the improvement of international competitiveness as they depreciate the real exchange rate of the country in the long run.

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Fig.7:- Impact of Remittances on Exchange Rate

5. Relative Price Changes/Inflation The inflation rate is also considered to be a determinant of the exchange rate. A high inflation rate should be accompanied by depreciation of the exchange rate. The more so if other countries enjoy lower inflation rates, since it should be the difference between domestic and foreign inflation rates to determine the direction and the scale of exchange rate movements. One popular debate concerns the role of nominal exchange rate in managing inflation. There are quite a few policymakers, researchers and businesspeople who believe that the depreciation of the exchange rate is the primary culprit underlying rapid inflation in Bangladesh. This group believes that the government should basically pursue a fixed nominal exchange rate policy. The underlying logic is the standard cost-push argument for inflation. Exchange rate raises the Taka price of imported inputs that pushes up the cost of production and that in turn fuels inflation. If the exchange rate is to be used as a policy variable to anchor inflation, then it must be supported by adequate reserves and an appropriate monetary policy that limits the rate of inflation to the rate prevailing in the reserve currency country on a long-term basis (a near impossible target for Bangladesh). This will also imply that fiscal policy cannot rely on borrowings from the BB as presently. A fixed exchange rate regime imposes huge discipline
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on monetary and fiscal policies in the absence of which the exchange rate will become overvalued in real terms leading to balance of payments problems. A much better policy regime for Bangladesh is to continue with the present flexible exchange rate management but support a stable (but not fixed) nominal exchange rate outcome by pursuing prudent fiscal and monetary policies. Prudent monetary and fiscal policies will keep inflation under control over the longer-term (although short-term inflationary episodes might result from international oil price or food price hikes) thereby moderating the pressure on the nominal exchange rate. Thus, the core objective of monetary policy should be to target a relatively low rate of inflation over the longer term and not allow substantial deviations from this long-term rate. For example, a 5 percent rate of inflation may appear to be a reasonable long-term target for monetary policy. With the US inflation rate in the 2-3 percent range, this will imply a 2-3 percent annual average rate depreciation of the nominal exchange rate over the longer term. The exchange rate of Bangladesh was virtually fixed for four years during July 2006 to July 2010. The rate of inflation started climbing from July 2009 owing primarily to expansionary monetary policy (during 2009 to 2011). This increased the demand for imports, which put pressure on the balance of payments. Bangladesh was fortunate to have substantial balance of payments surpluses in 2006-2010 owing to large inflow of remittances that allowed the Bangladesh Bank to build up substantial reserves. So, when the demand for imports soared (import growth accelerated to 40 percent in 2011), the BB was able to protect the exchange rate for a while and instead take the pressure on reserves. Between April 2011 and November 2011, the central bank lost as much as $2 billion of foreign reserves. Faced with this unsustainable pressure on the reserves, the BB let the exchange rate depreciate. Even with that rapid depreciation, the current account balance that recorded a surplus of $3.7 billion in FY2010 is now expected to become a deficit in FY2012. If the exchange rate was not allowed to be adjusted to the demand pressure, there would have been a substantial further run on the reserves. The other adverse effect of a fixed exchange rate regime in the face of rapid inflation is a substantial appreciation of the Bangladesh currency in real terms. The continued over-valuation of the real exchange rate would hurt exports. Carried over the longer- term, the trade gap would widen rapidly and destabilise the balance of payments that could fuel a major economic crisis.
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The basic message is that a fixed exchange rate regime is inconsistent with an expansionary monetary policy. If the exchange rate is to be used as a policy variable to anchor inflation, then it must be supported by adequate reserves and an appropriate monetary policy that limits the rate of inflation to the rate prevailing in the reserve currency country on a longterm basis (a near impossible target for Bangladesh). This will also imply that fiscal policy cannot rely on borrowings from the BB as presently.

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

6. Relative Purchasing Power Parity Another form of real determination of exchange rate is offered by the "one price law" or the purchasing power parity, according to which any freely good or service has the same price worldwide, after taking into account nominal exchange rates. But in order to equalize the price of several goods, more than one exchange rate may turn out to be necessary, or an exchange rate that represents a tradable basket of goods and services. The purchasing power parity exchange rate (PPP) between a foreign currency and the U.S. Dollar can be defined as: PPP = (Cost of a Market Basket of Goods and Services at Foreign Prices) / (Cost of the Same Market Basket of Goods and Services at U.S. Prices)

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This gives us the exchange rate in terms of the units of foreign currency per Dollar. The Dollars per unit of foreign currency is just the reciprocal. The exchange rate between countries, therefore, should be such that the currencies have equivalent purchasing power. For e.g. if a hamburger costs 3 US Dollars in the United States and 100 yen in Japan, then the exchange rate must be 100 yen per Dollar. The foreign exchange market would adjust, over the long term, to permit the functioning of the "one price law", because the purchasing power of one currency increases (or decreases) relative to another currency. 7. Relative Interest Rates Interest rates on treasury bonds will influence the decision of foreigners to purchase domestic currency in order to buy these treasury bonds. Higher interest rates will attract capital from abroad, thereby increasing demand for the currency, and therefore the currency will appreciate. Note, what is important is difference between domestic and foreign interest rates, thus a reduction in foreign interest rates would have a similar effect. Accordingly, an increase of domestic interest rates by the central bank could be considered a way to defend the currency. But, it may be the case that foreigners rather buy shares instead of treasury bonds. If this were the strongest component of currency demand, then an increase of interest rate may even lead to the opposite results, since an increase of interest rate quite often depresses the stock market, leading to share sales by foreigners. A restrictive monetary policy (increasing interest rates) usually also depresses the growth perspective of the economy. If foreign direct investment are mainly attracted by future growth prospects and they constitute a large component of capital flows, then this FDI inflow might stop and the currency could weaken. Therefore, interest rates do have an important impact on exchange rate but one has to be careful to check additional conditions.

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Fig.9:-

Impact on the exchange rate when interest rates are raised

8. Speculators, Traders and Financial Instruments Past and expected values of the exchange rate itself may impact on current values of it. The activities of foreign exchange traders, speculators and investors may turn out to be extremely relevant to the determination of the market exchange rate. Financial instruments like futures and forwards may also play an important role on the determination of exchange rates. A foreign exchange speculator who expects the spot rate of a foreign currency to be higher in three months can purchase the currency in the spot market today at today's spot rate, hold it for three months, and then resell it for the domestic currency in the spot market after three months. If he is right, he will make a profit; otherwise, he will break even or incur a loss. On the other hand, a foreign exchange speculator who expects the spot rate of a foreign currency to be lower in three months can borrow the foreign currency and exchange it for the national currency at today's spot rate. After three months, if the spot rate on the foreign currency is sufficiently lower, he can earn a profit by being able to repurchase the foreign currency (to repay the foreign exchange loan) at the lower spot rate. It is important to note that foreign exchange speculation usually takes place in the forward market because it is simpler and, at the same time, involves no borrowing of the foreign currency or tying up of the speculator's funds. Actions in foreign exchange options markets can also influence exchange rates, especially in the short-term. To understand the dynamics

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between spot rates, interest rates and forward rates it is interesting to understand the mechanics behind covered interest arbitrage.
George Soros is most famous for his single-day gain of US$1 billion on Sept 6, 1992, which he made by short selling the British pound. At the time, England was part of the European Exchange Rate Mechanism, a fixed exchange-rate system which included other European countries. The other countries were pressuring England to devalue its currency in relation to the other countries in the system or to leave the system. England resisted the devaluation, but with continued pressure from the fixed system and speculators in the currency market, England floated its currency and the value of the pound suffered. By leveraging the value of his fund, Soros was able to take a $10 billion short position on the pound which made him US$1 billion. This trade is considered one of the greatest trades of all time.

8.1. Interest Rate Parity Interest rate parity is a relationship that must hold between the spot interest rates of two currencies if there are to be no arbitrage opportunities. The relationship depends upon spot and forward exchange rates between the currencies. It is:

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

f is the corresponding forward exchange rate ra and rb are the interest rates for the respective currencies m is the common maturity in years for the forward rate and the two interest rates.

The interest rate parity (covered interest arbitrage) plays a fundamental role in foreign exchange markets, enforcing an essential link between short-term interest rates, spot exchange rates and forward exchange rates. 8.2. Influence of the FX Options Market on Short-Term Exchange Expectations
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Implied volatility is one of the key variables used to calculate the price of an FX option. It is often interpreted as the markets measure about possible future movements in spot (related to the standard deviation of returns over a sample period). In the FX options market, the preference of calls (right to buy a currency) over puts (right to sell a currency) is measured by an asset class called risk reversal skew (RR) which is mathematically defined as: D delta Risk Reversal Skew = Implied Volatility of a D Delta Call Implied Volatility of a D Delta Put The FX market closely watches these risk reversals. A positive RR, for example, indicates preference for calls over puts, a signal often perceived as bullish by the market, leading to overbought positions in the underlying currency, that further exacerbate the RR. This is a par excellence example of a self-fulfilling prophecy. A defining example of this phenomenon was the trend up in EUR from the lows in 2002 that saw the risk reversal continually favoring EUR calls. FX Option positions also give rise to a phenomenon referred to as strike gravity. As the FX option trader deals in the spot market to hedge a significant FX option position against counterparty that is not an active market participant, the spot gravitates towards the strike of the option as the trade approaches maturity. This effect is more pronounced when the said position is an exotic option with a digital payout and both the participants have access to liquidity in the cash market to actively manage the exotic option. These FX flows arising from aggressive hedging by the FX Option market players often dictate short-term currency moves. 9. Political and Psychological Factors/TOT Political or psychological factors are also believed to have an influence on exchange rates. Many currencies have a tradition of behaving in a particular way such as Swiss francs which are known as a refuge or safe haven currency while the Dollar moves (either up or down) whenever there is a political crisis anywhere in the world. Exchange rates can also fluctuate if there is a change in government. A few years back, Indias foreign exchange rating was downgraded because of political instability and consequently, the external value of the rupee fell. Wars and other external factors also affect the exchange rate. For example, when Bill Clinton was impeached, the US Dollar weakened. During the Indo-Pak war the rupee weakened. After the 1999 coup in Pakistan (October/November 1999), the Pakistani rupee weakened.
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5.0 Conclusion
To conclude, the exchange rate management in Bangladesh can be rated as good, as it has not faced any crisis yet. However, still there are scopes to improve the exchange rate management by taking timely decision/correction. For which, the capacity for exchange rate management needs to be improved to reap the maximum benefits of a managed floating system. It is to be noted that Bangladesh has not yet been tested for its capacity of managing
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exchange rate in a crisis or difficult situation. However, the management capacity would be tested with more capital movements, introduction of currency derivatives, increase of financial depth etc., if the economy embarks on middle-income growth path. Proper coordination and care should be taken before declaring the fiscal policy. Government and central bank need to work together and find the right procedure of inter-action between monetary and fiscal policy without hampering the competitiveness of the country in international trade and to ensure the growth and development of country. Even exchange market pressure in Bangladesh is likely to increase soon if the global economy starts recovering in a full swing. In that case, it would not be easy to keep the exchange rate fixed without proper monetary stance to maintain low or stable inflation. Therefore, for better management of exchange rate under a managed floating regime, Bangladesh Bank should work more on institutional development, bringing efficiency in the foreign exchange market and financial sector along with its own capacity building.

References
Bangladesh Bank, 2012(May), Economic Trends, Statistics Department, of Bangladesh, Bank, Dhaka. (Website: http://www.bb.org.bd/pub/index.php). Goswami, G., G., and Sarker, M,. M., I., Nominal and Real effective Exchange Rates for Bangladesh: 1972:07-2008:12, Journal of Economics and
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Behavioral Studies, Vol.2, No. 6, pp. 263-274, June 2011. Hossain, M., and Ahmed, M., An assessment of Exchange Rate policy under Floating Rate Regime in Bangladesh, The Bangladesh Development Studies, Vol.XXXII, December 2009, No.4. Jochumzen, P., (2010), Essentials of Macroeconomics Peter Jochumzen & Ventus Publishing ApS, Page No. 19-21. Mankiw, N., G.,(2010), Intermediate Macroeconomics Worth Palgrave Macmillan Publishers Limited, Seventh Edition (International Edition), Page No.135-147. ----------------------

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