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Effect of Inflation and Exchange Rate on Foreign Direct Investment (FDI) Decision in Furniture Industry (Processed wood) in Bangladesh

Course No: F603 Course Title: International Finance

Submitted To Melita Mehjabeen, Lecturer, Institute of Business Administration, University of Dhaka In partial fulfillment of requirement for course work of International Finance (F603) Date: 14.01.13

Submitted by Name: Ahmed Zaheer Roll: 22 Batch: 44E Name: Krisnendu Roy Roll: 29 Batch: 44E

i Declaration

This is to declare that work content of this term paper is prepared by Ahmed Zaheer (22,44E) and Kisnendu Roy (29,44E) under supervision of Mrs. Melita Mehjabeen, Lecturer Institute of Business Administration, University of Dhaka

Submitted by

Ahmed Zaheer Roll-22, Batch 44E

Krisnendu Roy Roll-29, Batch 44E

ii Acknowledgment We would like to express a sincere and special thank to our course teacher Mrs. Melita Mehjabeen, Lecturer Institute of Business Administration (IBA-DU) for her affectionate and careful supervision, sympathetic co-operation, her continuous support, guidance, thorough correction and efforts in doing this paper. Without her encouragement and valuable suggestions it would be impossible to bring this paper work to success. We would also like to acknowledge Otobi Ltd management for the support and timely cooperation.

iii Abstract Foreign direct investment (FDI) plays a significant role in economic growth of a country like Bangladesh. Along with sectors such as RMG, Leather, Pharmaceuticals furniture industry of Bangladesh is growing rapidly. Impact of exchange rate and inflation on FDI inflow in Bangladesh was evaluated in this paper. Correlation coefficient between exchange rate and FDI inflow indicated a strong positive relationship of FDI inflow and weakening currency of the host country. Inflation had a negative impact on FDI inflow especially in labor intensive industry such as furniture because inflation tends to push labor cost upward. Linear regression was utilized to predict future exchange rate and inflation in Bangladesh. These relationships were used to identify advantages and disadvantages of FDI on furniture industry of Bangladesh. Exchange rate and inflation in Bangladesh is favorable to make FDI in furniture industry considering there are other positive factors such as huge unexploited local market, export opportunity, cheap labor etc are present in this sector.

iv Table Of Contents 1. 2. Introduction ........................................................................................................................ 1 Literature Review ............................................................................................................... 2 2.1. 2.2. 3. 4. 5. Exchange Rate and FDI............................................................................................... 2 Inflation and FDI ......................................................................................................... 3

Objective............................................................................................................................. 4 Methodology....................................................................................................................... 5 Effect of Exchange rate and Inflation on FDI in Bangladesh............................................. 5 5.1. 5.2. Exchange rate and FDI inflows In Bangladesh ........................................................... 5 Inflation rate and FDI inflows in Bangladesh ............................................................. 7

6.

FDI in Furniture industry in Bangladesh ............................................................................ 8 6.1. 6.2. 6.3. 6.4. Overview of furniture Industry in Bangladesh ............................................................ 8 Prospects of Furniture Industry in Bangladesh ........................................................... 9 Advantages of FDI in furniture industry in Bangladesh ............................................. 9 Disadvantages of FDI in furniture industry in Bangladesh ......................................... 9

7. 8.

Result ................................................................................................................................ 10 Conclusion ........................................................................................................................ 10

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

Table of Figures Figure 1: Exchange rate of USD against BDT........................................................................... 5 Figure 2: Yearly FDI inflow ...................................................................................................... 6 Figure 3: FDI inflow against Exchange Rate ............................................................................. 6 Figure 4: Yearly inflation (%).................................................................................................... 7 Figure 5: Yearly FDI inflow ...................................................................................................... 7 Figure 6: Market share in furniture industry in Bangladesh ...................................................... 8

1. Introduction Bangladesh is a densely populated, low income country which has huge potential for foreign direct investment particularly in labor intensive industries such as garments, leather and furniture industry. Bangladesh has a huge local market of furniture and also has all the ingredients to become a noteworthy exporter of furniture. In this paper we analyze the effect of inflation and exchange rate on foreign direct investment decision with our focus directed towards furniture industry. In most developing countries there is the dearth of capital for investment which has affected the economic situation of these nations. In order to ameliorate the situation various governments of these nations has now focused much attention on investment especially foreign direct investment which will not only guarantee employment but will also impact positively on economic growth and development. FDI is needed to reduce the difference between the desired gross domestic investment and domestic savings. According to Adegbite and Ayadi (2010) FDI helps fill the domestic revenue generation gap in a developing economy, given that most developing countries governments do not seem to be able to generate sufficient revenue to meet their expenditure needs. Other benefits are in the form of externalities and the adoption of foreign technology. Externalities here can be in the form of licensing, imitation, employee training and the introduction of new processes by the foreign firms (Alfaro, Chanda, Kalemli, Ozean and Sayek 2006). Foreign direct investment consists of external resources including technology, managerial and marketing expertise and capital. All these generate a considerable impact on host nations productive capabilities. McAleese (2004) states that, FDI embodies a package of potential growth enhancing attributes such as technology and access to international market. But the host country must satisfy certain preconditions in order to absorb and retain these benefits, and not all emerging markets possess such qualities (Borensztein, De Gregorio and Lee, 1997; Collier and Dollar, 2001; Seetanah and Khadaroo, 2007) Monetary policy can shape the economic environment that is conducive in attracting FDI into host countries. However the characteristics of monetary policy presents the impossible

2 trinity a trilemma problem where trade-offs must be done in order to maintain economic stability. Two of these anchors are inflation autonomy and exchange rate variability. These trade-offs can impact on the host countrys attractiveness on FDI inflow (Lahrche-Rvil and Bnassy- Qur, 2002; Gelb, 2005; Umezaki, 2006). Given the Bangladesh economy resource base, the countrys foreign investment policy should move towards attracting and encouraging more inflow of foreign capital. The need for foreign direct investment (FDI) is born out of the under developed nature of the countrys economy that essentially hindered the pace of her economic development. Furniture sector of Bangladesh is very encouraging for foreign investors because Bangladesh already has a skilled manpower in this sector. 2. Literature Review

2.1. Exchange Rate and FDI In the past, economists believed that there is no advantage to be gained by purchasing foreign capital and/or assets. As the economic system works in a long-term equilibrium, any firm purchasing foreign assets at a bargain, in the hope of taking advantage of stronger currency in their home country against the targeted country, can be equalized by price adjustment of the assets in the long run (Froot and Stein, 1989). Froot and Stein (1989) argue that the economy is distorted by informational imperfection (p. 4), and opportunities are not equal across borders. There are merits in holding foreign assets. The difference in cultures, work ethics and way of life can have markedly different efficiency outcome. Today, there exists a common wisdom regarding the relationship between FDI and exchange rate. When a countrys currency devalues, it is viewed as an opportunity for foreign investors to purchase assets at a reduced cost. This is especially true when foreign firms have identified specific assets in their targeted markets (Blonigen, 1997). Barrell and Pain (1996) find that investors tend to postpone their investment when the currency in the targeted market strengthens. This occurs when investors are speculating the currency to depreciate in the future and thus maximize the profit of their investment at a later stage. Because of this reactionary nature of investors behavior, they have also noted that there is a significant time lag between exchange rate changes and FDI movement.

3 Ahn et al. (1998) note mixed sentiment toward increasing FDI competitiveness by devaluating currency. However, they find that empirical research generally shows a positive impact. Erramilli and DSouza (1995) find that exchange rate volatility is one of the contributors toward external uncertainty in an economy that have a major effect on FDI inflow. Campa (1993) notes that lack of information in a volatile environment would deter investment, and unlike portfolio flows, FDI offers investors very few instruments to hedge against such risk (Bnassy-Qur, Fontagn and Lahrche-Rvil, 2001). In a study in Ghana, Kyereboah-Coleman and Agyire-Tettey (2008) find that volatility in exchange rate has a significantly negative impact on FDI inflow and that inappropriate macroeconomic policy can result in overvaluing the currency; therefore, discouraging FDI. Similar to the findings from Barrell and Pain, they also note that the lag in FDI is highly significant. However, high exchange rate volatility does not always imply a negative effect on FDI Inflow. Qin (2002) finds that if a low differential in purchasing power parity exists between trading countries, two-way FDI can occur. And FDI would become an instrument for local producers to hedge their risk in a volatile exchange rate environment.

2.2. Inflation and FDI A host countrys economic instability can be a major deterrent to FDI inflow. As briefly discussed in previous sections, any form of instability introduce a form of uncertainty that distort investors perception on the future profitability in the country (Erramilli and DSouza, 1995). Akinboade, Siebrits and Roussot (2006, p. 190-191) state that low inflation is taken to be a sign of internal economic stability in the host country. High inflation indicates the inability of the government to balance its budget and the failure of the central bank to conduct appropriate monetary policy. In other words, inflation can be used as an indicator of the economic and political condition of the host country, but the differences between high inflation and low inflation is not distinct (Ahn, Adji and Willett, 1998).

4 A few literatures offer some distinctions on the level of inflation. Rogoff and Reinhart (2002) find that high inflation does not happened in the absence of other macroeconomic problems. The cost of inflation can have prominent effect on the economys growth. This hindrance is more prominent at an inflation rate at 40% and higher, but they also note that a country with higher inflation rate, especially below the 40% level, is worse off than a country with slightly lower inflation. The comparative figure they quoted was 10% compare to 5% (p. 30). Lipsey and Chrystal (2006, p. 578) offer a definition for hyperinflation. They state it as Inflation so rapid that money ceases to be useful as a medium of exchange and a store of value. But they also concede that countries with inflation rate higher than 50%, to some 200% plus, have proven to be manageable as the population adjusts in real term. These literatures have highlighted that inflation destroys the value of currency. The impact on growth is negative, and in turn, a negative impact on FDI. Glaister and Atanasova (1998) mention the effect of high inflation had on employment in Bulgaria. Although they did not draw direct inferences to the relationship between FDI and inflation, they seem to suggest that high inflation can cause various problems within the country to reduce its attractiveness to foreign investors. Coskun (2001, p. 225) suggests that lower inflation and interest rate coupled with other factors such as full membership with the EU and high economic growth can attract foreign investors and increase the FDI inflow into Turkey. Wint and Williams (2002) show that a stable economy attracts more FDI, thus a low inflation environment is desired in countries that promote FDI as a source of capital flow. 3. Objective 1. To observe impact of inflation and exchange rate on foreign direct investment decisions. 2. To evaluate comparative advantages and disadvantages of foreign direct investment in Bangladesh in furniture manufacturing on the basis of inflation and exchange rate.

5 4. Methodology Information was obtained from both primary and secondary sources. Primary data was collected by interviewing strategic business development team of Otobi Ltd. Secondary data was collected from Bangladesh Bank, BOI, ADB, WB websites, published academic papers and research institutions reports. 5. Effect of Exchange rate and Inflation on FDI in Bangladesh

5.1. Exchange rate and FDI inflows In Bangladesh Currency of Bangladesh has weakened steadily against US dollar from 1996 to 2012 as shown in the Chart 1. We also observe that there is substantial growth in FDI inflow in this period most notably from 2004 onward (Shown in Figure 1 and 2). This suggests that weakening currency of the host country has a positive impact on foreign investment as mentioned in earlier chapter of the paper.

Exchange Rate (USD)

90 80 70 60 50 40 30 20 10 0

BDT

(Source: Bangladesh Bank website)

Figure 1: Exchange rate of USD against BDT

FDI Inflow
1,400 1,200 Million ($)

1,000
800 600 400 200

(Source: Bangladesh Bank website)

Figure 2: Yearly FDI inflow

FDI Inflow VS Exchange Rate

FDI Inflow (Million $) 1,400 1,200

1,000
800 600 400 200 0 30 40 50 60

R = 0.652

70

80

90

Exchange Rate of USD (Bdt) (Source: Bangladesh Bank website)

Figure 3: FDI inflow against Exchange Rate Correlation between FDI inflow and exchange rate from 1196-97 to 2011-12 was calculated and correlation coefficient was measured to be 0.81 indicating a strong positive relationship between FDI inflow and exchange rate (Shown in figure 3). This occurs because investors see weak local currency as an opportunity to acquire asset at a reduced cost.

Linear regression of exchange rate indicates BDT will further weaken against USD and may play a major part to attract FDI in the future.

7 5.2. Inflation rate and FDI inflows in Bangladesh Inflation has increased from 1996 to 2012 but as shown in the chart had volatile changes in the period between 1996 and 2004. FDI in flow in this period had a decreasing trend supporting that inflation rate volatility has a negative impact on foreign investment because it indicates an unstable economic condition.

Inflation (%)
12% 10% 8% % 6% 4% 2% 0%

(Source: Bangladesh Bank website)

Figure 4: Yearly inflation (%)

FDI Inflow
1,400

1,200
Million ($) 1,000 800 600 400 200 0

(Source: Bangladesh Bank website)

Figure 5: Yearly FDI inflow

8 Although inflation is increasing in Bangladesh from 2002 onward it was always under 12%. Linear regression of the past data indicates it will be around 10% in next few years (Shown in figure 4 and 5). This level of inflation is not unfavorable to FDI as mentioned in earlier chapter of the paper and FDI inflows in this period also reflect this as there is an increasing trend of FDI inflow in this period.

6. FDI in Furniture industry in Bangladesh

6.1. Overview of furniture Industry in Bangladesh Furniture industry is one of the fastest growing industries of Bangladesh and has the potential to be next economic booster. The total furniture market size as well as demand is estimated to be approximately BDT 80,000 million per year in Bangladesh. The whole market can be divided into two major categories which are organized and unorganized sector. Approximately 18% of the whole market can be defined as organized as this portion has standard manufacturing, distribution and marketing facility. (Maksudul Haque

Chowdhury,Nazib Haider Chowdhury Farahnaz Zarrin,October 2012) This sector is divided into some major companies namely Otobi, Partex, Hatil etc. Market share of these companies is reflected in figure 6.

Organized 17.76%

Others 19% Otobi 34% Akhter 9% Studio45 7% Hatil 10% Navana 11%

Unorganiz ed 82.24%

Partex 10%

Figure 6: Market share in furniture industry in Bangladesh

9 6.2. Prospects of Furniture Industry in Bangladesh With the industrial growth in various industries like RMG, textiles and ship building, there is a huge demand for industrial furniture in these sectors, which are currently being met through import. In a recent assessment, it is seen that on an average 1.5%-2% of the ship building cost is spent on furniture and the existing market is over USD 9-12 million. Furthermore there is a potential deemed export market of around USD 48 million annually by 2014. Moreover some international furnishing suppliers for ships source products from different countries based on their product requirement and quality standards. As the overall quality of furniture in Bangladesh is considerably high, there is a chance to enter this market. (Maksudul Haque Chowdhury,Nazib Haider Chowdhury Farahnaz Zarrin,October 2012) Furniture industry of Bangladesh is a lucrative sector for FDI considering the facts that there is a huge unexploited local market, potential for exporting, cheap and available labor.

6.3. Advantages of FDI in furniture industry in Bangladesh Several advantages can be identified in support of making FDI in furniture industry in Bangladesh. Namely Huge unexploited local market. Scope of export Cheap and available skilled labor Favorable exchange rate trend To keep accordance with the scope of this paper we will focus our attention towards effect of exchange rate and FDI in furniture industry in Bangladesh. There is a strong positive correlation between exchange rate and FDI inflow suggesting that weakening of local currency is favorable for FDI. Linear trend of exchange rate in Bangladesh indicates that Bangladesh currency will weaken in future. All these information indicates that currently furniture industry of Bangladesh is a lucrative sector for making FDI as far as exchange rate is concerned. FDI decision can be further enhanced due to above mentioned advantages besides favorable exchange rate.

6.4. Disadvantages of FDI in furniture industry in Bangladesh FDI flow in furniture industry in Bangladesh can be hindered by some factors such as Lack of infrastructure

10 Power crisis Political situation Inflation rate We will limit our discussion within the effect of inflation rate to maintain the focus of this paper. Increasing inflation usually indicates a volatile economy which deters investors to make any venture especially in labor intensive sectors such as furniture industry. Increasing inflation will increase cost of living triggering escalating labor cost. If labor cost is not adjusted with inflation then it will lead to labor unrest resulting even worse circumstances.

Inflation in Bangladesh has an increasing trend but in recent year the trend shows less volatility. Linear regression suggests that it will be about 10% in next few years. Although an increasing inflation trend is not favorable for investment there is substantial evidence that it will be within acceptable limits in near future.

7. Result 1. There is a positive relationship between FDI inflow and weakening currency of the host country. 2. Inflation has a negative impact on FDI inflow in a country. 3. Exchange rate and inflation trend in Bangladesh is favorable for making FDI in furniture industry considering this sector is very potential with huge unexploited local market, export opportunity, cheap labor etc 8. Conclusion FDI plays a major part in the economic growth of a country especially of a developing country like Bangladesh. Exchange rate and inflation have substantial effect on FDI inflow of a country. Till now furniture industry of Bangladesh didnt attract any significant amount of FDI though there is huge potential of this sector both as a local market and export oriented industry. Favorable exchange rate and inflation trend will help to attract FDI in furniture manufacturing sector along with other sectors such as RMG, Pharmaceuticals and Leather; therefore will positively contribute to the economic growth of Bangladesh.

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