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.

July 7, 2007 Professor G. M. Chowdhury Chairman Internship 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 was selected in accordance with my internship supervisor Mr. Mohiuddin Ahmed and my organizational supervisor at Bangladesh Bank. In general the report deals with the changing 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 ALam MBA 40 (D) Roll: 09

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 2005-2006 13. Export receipt 2006-2007 14. Import receipt 2006-2007

Floating of TAKA: An impact analysis

Prepared for:

Mohiuddin Ahmed Associate Professor

Prepared By:

Syed Golam Shahjarul Alam MBA Program Roll#09(40D)

INSTITUTE OF BUSINESS ADMINISTRATION UNIVERSITY OF DHAKA

JULY 07, 2009

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...............................................................................................................................3 1.3.2 The Model used..............................................................................................................................4 1.3.3 Software used.................................................................................................................................5 1.4 LIMITATIONS......................................................................................................................................5 1.5 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.........................................................................................................9 2.2.2 Bank Licensing ..............................................................................................................................9 2.2.3 Interest Rate Policy......................................................................................................................10 2.2.4 Capital Adequacy.........................................................................................................................10 2.2.5 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) ...............................................................................................12 2.3 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)....................................................................................19 3.1.3 Adopting Floating Exchange Rate (2003-onward)......................................................................20 3.1.4 Central bank intervention............................................................................................................21 3.2 THE DETERMINATION OF EXCHANGE RATES.........................................................................22

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.........................................................................................................29 3.3.4 Government controls...................................................................................................................29 3.3.5 Expectations.................................................................................................................................30 3.3.6 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.....................................................................................................................................33 3.5.2 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...........................................................34 4.1.1 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 EXPERIENCES OTHER COUNTRIES ........................................................................................................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 5.2THE DATA SET.......................................................................................................................................45 5.2.1 Exchange rate..............................................................................................................................47 5.2.2 Export..........................................................................................................................................48 5.2.3 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..................................................................................................................................58 5.3.4 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

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...................................................................................................................72 6.2.5 Restrictions..................................................................................................................................73 6.3 THE PROCESS...................................................................................................................................73 6.3.1 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........................................................................................................................................77 6.3.7 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

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 the Pound 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 central Bank. 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 1

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 over the 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

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 Arrangement on 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 1.3.1 Data 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 3

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. 1.3.2 The 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 Ut to find out the consistency of the relationship. Hypothesis H0: 2 0 H1: 2 = 0 I expect the value of 2 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 of 2 is positive and 3 negative. 4

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. 1.3.3 Software 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.

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 the report with findings.

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 cooperative banks.

2.1 BANGLADESH BANK 2.1.1 Introduction 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

Bank as the budget deficit has to finance by the central bank or the commercial banks from private borrowing.

2.1.2 Organizational 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.

2.2.1 Central 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 government and 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, and limits on for loan asset concentration classification and and insider income borrowing guidelines

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. 2.2.2 Bank 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." 9

Licenses may be cancelled if the bank fails to comply with above provisions or ceases to carry on banking business in Bangladesh. 2.2.3 Interest 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. 2.2.4 Capital Adequacy In January 1996, BB announced a new policy on Capital Adequacy along 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. 2.2.5 Loan 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. 10

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. 2.2.6 Commercial 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. 2.2.7 Specialized 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 term loans to the industrial sector. 2.2.8 Financial 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 11 (BSRS) ) are for extending

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. 2.2.9 Microfinance 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 agenda to 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 it is 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 12

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 offsite 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 NGOMFIs 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.

2.3.2 Stock 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. 2.3.3 Investment 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.

15

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 repatriable 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. 2.4.1 Exchange 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; while the 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

16

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. 3.1.1 Fixed 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) (ii) Reconstruction of banking system, Selection of an intervention currency and the fixation of exchange 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

17

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.

18

3.1.2 Pegged 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 time exchange 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 had devalued 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

19

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.

3.1.3 Adopting 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 20

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 preannounced 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 31 st 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. 3.1.4 Central 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 21

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 in greater 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 less relevance 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

22

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 marketdetermined. When the determination of an exchange rate is left to Thus, free market forces, it is considered a free floating rate.

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 Depreciation

Tak a per Doll ar

SFX Tk.70.0 Tk.65.0

Taka Appreciation Tk.60.0 DFX QFX 1 2 3 4 5 6

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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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3.2.2 Long 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], ERM = g( u t u t 1 ) ERL = h( p, e , Y p , l , c )

(6.1) (6.2) (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, ER e is the expected exchange rate, u is the unemployment rate in the current time period, u t is the unemployment rate in the previous period, 1

is

the rate of inflation, e is a measure of profit expectations, Y p 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

25

Long-run equilibrium path, driven by run Overshooting fundamentals Short-

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. 26

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 factorsa) 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 ofa) 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 Controls e) 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 27

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. 3.3.2 Interest 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.

28

3.3.3 Relative 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 substantially where the British income level ,that will affect the following factors0 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 to dollar. 3.3.4 Government 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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3.3.5 Expectations 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 potential surge 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 securities denomination 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. 3.3.6 Interaction 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

30

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: 3.4.1 Monetary 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. 3.5.2 Exchange 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.

31

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 to depreciate. 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: 32

3.5.1 Discipline 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. 3.5.2 Destabilizing 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. 3.5.3 Injury to international trade and investment Floating rates would make relative international prices more

unpredictable and thus injured international trade and investment. 3.5.4 Uncoordinated 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. 3.5.5 The 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. 33

3.5.6 The 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.

3.5.7 Cost 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

34

resulted in considerable volatility. In both these countries, the respective central banks had to actively support their currencies. 4.1.1 Experience 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 for banks 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. 4.1.2 Indias 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

35

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 external transactions. Although the Indian economy has moved towards a progressively freer capital market, this has been an extremely gradual process.

36

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. 4.1.3 Experience of Pakistan with Floating Exchange rate Regime Pakistan can be considered to have adopted a sort of floating exchange 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 to mount 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 37

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 4.2.1 Chinas 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 the U.S. dollars that it acquires. This increases the PRCs foreign exchange reserves. If the foreign exchange value of the renminbi

38

begins to decline (i.e., $1 becomes more than 8.28 yuan), this process is reversed. Determined to retain power after the events of 1989, the Chinese leaders sought to redefine the Communist Party as the provider of economic growth and improving living standards for the Chinese people. The leaders devised an export-led, inward foreign direct investment-dependent development strategy that could deliver rapid economic growth given the PRCs serious interrelated structural problems of its domestic economy. An undervalued pegged exchange rate is integral to this strategy. Economists estimate that the renminbi is now undervalued by between 15 percent and 40 percent. An undervalued renminbi reduces the real wages of Chinese workers and lowers production costs in the PRC. Thus, an undervalued renminbi encourages foreign multinational irms to invest in the PRC and shift production to their Chinese affiliates. The PRCs development strategy has been successful. From 1990 to 2004, the PRCs average real GDP growth was 9.3 percent. The PRCs share of the worlds goods exports has expanded dramatically. From 1994 to 2004, the PRCs average net foreign direct investment inflow was equal to 4.1 percent of GDP. To run large current account surpluses and large investment inflows simultaneously, the PRC must accumulate U.S. dollars and dollar denominated assets to maintain its undervalued pegged exchange rate. By December 31, 2004, the PRC had acquired $610 billion in foreign exchange reserves. Under the pegged exchange rate policy, the real value of the renminbi has generally tracked the real value of the U.S. dollar. Since 2002, the real values of the U.S. dollar and the renminbi have trended down together. Because of these decreases, governments in other major Asian economies feared that their domestic firms and their domestic affiliates of foreign multinational firms would lose export market share in Europe and North America to Chinese firms and Chinese affiliates of foreign multinational firms. Consequently, central banks in these other major Asian economies 39

increased their aggregate foreign exchange reserves to $1.8 trillion on December 31, 2004. This limited the increase in the real values of their currencies against the real values of U.S. dollar and the renminbi. The foreign exchange reserves of the PRC and other major Asian economies are excessive by any standard. The PRCs foreign exchange reserves were equal to 37.0 percent of its GDP on December 31, 2004. Similarly, the aggregate foreign exchange reserves of the other major Asian economies were equal to 24.5 percent of their aggregate GDP on December 31, 2004. In contrast, the foreign exchange reserves of the United States were equal to a mere 0.4 percent of GDP on December 31, 2004. Through massive interventions in foreign exchange markets, other major Asian economies were generally successful in thwarting significant appreciations in the real value of their currencies. Without such massive interventions, the real value of the currencies of most major economies in the rest of the world increased significantly. Beginning in 2002, Asian central banks accumulated foreign exchange reserves at a historically unprecedented rate. One result was a net inflow of $717 billion into the United States between 2002 and 2004. This inflow slowed the decline in the real value of the U.S. dollar. The U.S. Treasury recently concluded, Chinas fixed exchange rate is now an impediment to the transmission of price signals and international adjustments, and imposes a risk to its economy, Chinas trading partners, and global economic growth. Because of the PRCs policy, the United States is running somewhat larger current account deficits than it would run based solely on the private decisions of individuals and firms around the world. Moreover, the PRCs pegged exchange rate policy is distorting expectations about future global prices and rates of return on investments. Thus, the PRCs pegged exchange rate policy is causing underinvestment in some sectors and overinvestment and malinvestment in other sectors in countries around the world. The artificially high real value of the U.S. dollar is shifting investments from 40

the tradable goods sector toward the non-tradable goods and services sectors. As Federal Reserve Governor Ben S. Bernanke observed, much of the recent capital inflow has shown up in higher rates of home construction and in higher housing prices while the growth in export-oriented sectors such as manufacturing has been restrained. This distortion extends beyond the United States to other countries that have not intervened massively in foreign exchange markets. Overinvestment and malinvestment may be occurring in the PRCs tradable goods sector. To lesser extent, similar distortions may be occurring in other major Asian economies. Unless the PRC changes its undervalued pegged exchange rate policy, these global imbalances will fester. Their inevitable correction will become more costly to the PRC, the United States, and the rest of the world in terms of lost employment production, and wealth. 4.2.2 Convertibility in developing countries The debate on Capital Account Convertibility (CAC) has intensified in light of the recent currency crises in Europe (1992-3), Mexico (1995), and Asia (1997). These events have brought into sharper focus the costs and benefits associated with capital account convertibility. Economists are divided on this issue, and policymakers are often wary given the perceived costs. Until recently, the IMF has always exhorted developing countries to embark on capital account convertibility, but after the Asian crisis even the IMF has shown some ambivalence toward capital account policies. Most developing countries have explicitly liberalized international trade and, accordingly, they have relaxed the currency restrictions for current account transactions. However, most developing countries continue to impose controls on capital account transactions, the socalled capital flows.

41

Historically, the Bretton Woods system recognized a role for capital controls to enable countries defend their pegged exchange rates. But, following the breakdown of the Bretton Woods system in 1973, the de facto acceptance of floating exchange rates and the globalization of financial markets led to the amendment of Article IV of the IMF Articles of Agreement. Today, the IMF no longer has formal jurisdictional responsibilities over capital controls. By the early 1990s, just twenty years after the advent of the floating exchange rate system, the industrialized countries had abandoned virtually all controls on international capital movements. Developing countries have also started liberalizing their capital account transactions, often as part of comprehensive economic reform programs. But, such liberalization has been partial in most cases. Some countries liberalized capital flows while maintaining a fixed exchange rate. Many developing countries maintain controls on foreign capital inflows but are less stringent when it comes to outflows of domestic capital. In short, the process of financial liberalization has been only partial in most of process. the developing world. Financial liberalization, and its consequences, must be judged in the context of an incomplete

42

Chapter 5 IMPACT OF FLOATING

5.1 INTRODUCTION The impact of the floating is not that much of a prevalent in our foreign exchange market as central bank always took necessary action to keep the foreign exchange market in stable position. To keep in control Bangladesh Bank normally takes the following three actions. a. Participate in foreign exchange market b. Excess liquidity management (money market operation) c. Open mouth operation Just before the floating of taka in May 31, 2003 Bangladesh Bank swept all the excess liquidity in the money market. As a result the banks had to manage their domestic currency liquidity and the call money rate is shot up. However, the good effect of this operation is that the foreign exchange traders could not get an opportunity to speculate because of the shortage of liquidity. This whole thing has been done by the new system of reveres-repo. Money market operation is not always harmless for the financial system. This instrument can be used to tackle any shock or adverse situation. Recently the participation in foreign exchange market by the central bank becomes a common phenomenon. This becomes possible due to the fact that Bangladesh Bank has a reserve of more than $ 4 Billion. So the volatility can be maintained effectively with buying and selling operation of the foreign exchange in the domestic market. Open mouth operation or moral suasion was always been a very effective central bank tool. In foreign exchange trading the commercial

43

bank most of the time abides by any advice for them to keep the market less volatile.

44

5.2

THE DATA SET Table 5.1: The consolidated data set of all the variables

Year 1997 1998

Quarter Q3 Q4 Q1 Q2 Q3

ER 44.333 45.23 46.3 46.3 47.1 48.5 48.5 48.5 49.5 51 51 51 54 54 54 57 57 57 57.9 57.9 57.9 57.9 57.9 57.9 57.9 57.9 58.42 58.44 58.94 59.84 59.52 59.97 62.8 63.59 65.06 65.87 68.07 69.74 69.09 69.1

Export 68101 66162 62967 73712 70083 72716 68959 82481 80037 79284 81643 95336 103195 101261 86740 101055 109650 93746 103615 120228 109650 93756 103615 120228 127360 117661 123086 146831 129569 116709 127399 133638 128015 113594 137985 155036 178766 240114 246098 233143

Import 86086 98500 91808 98149 91522 101278 106351 121670 104118 118962 105535 143208 134232 137842 140434 152137 123698 142431 160285 176807 123698 142431 160285 176807 152342 161949 164569 214191 177577 189989 222643 218739 219613 230123 251331 290233 274577 292419 316639 336378

Remittance 16731 17358 17713 17593 18591 21141 19920 22404 20834 24994 24423 27885 24305 25245 24344 28641 30923 32566 44218 43649 42112 42386 45424 47128 42880 49243 54451 51896 49536 58208 65557 65138 71829 74259 86914 88954 91827 92544 91889 105792

CAB 2849 -10406 -4363 191 663 1999 -11002 -10486 -24081 -4409 -4064 -10710 -3152 -5351 -24134 -10920 4212 -2779 5976 6572 -3854 -4680 7476 8121 30634 -4766 -6795 -7641 17957 4275 -26458 -338 9010 7372 16990 14529 27863 23781 28188 11816

Inflation 4.0 4.0 8.7 8.7 8.7 8.7 7.1 7.1 7.1 7.1 2.1 2.1 2.1 2.1 1.9 1.9 1.9 2.2 3.19 3.58 4.14 3.84 5.04 5.03 5.58 6.5 5.94 5.64 7.35 5.5 6.72 7.35 7.01 7.07 6.17 7.54 6.89 7.08 7.1 7.15

GDP 5.4 5.4 5.2 5.2 5.2 5.2 4.9 4.9 4.9 4.9 5.9 5.9 5.9 5.9 5.30 5.30 5.30 5.30 4.40 4.40 4.40 4.40 5.30 5.30 5.30 5.30 6.27 6.27 6.27 6.27 5.96 5.96 5.96 5.96 6.71 6.71 6.71 6.71 6.05 6.05

1999

Q4 Q1 Q2 Q3

2000

Q4 Q1 Q2 Q3

2001

Q4 Q1 Q2 Q3

2002

Q4 Q1 Q2 Q3

2003

Q4 Q1 Q2 Q3

2004

Q4 Q1 Q2 Q3

2005

Q4 Q1 Q2 Q3

2006

Q4 Q1 Q2 Q3

2007

Q4 Q1 Q2

Sources: Bangladesh Bank Bulletin 2006, 2007, 2008, Export receipt 2005-2008 Economic trends, 2005-2008(Up to April), 2005-2008 45 Import receipt

Bangladesh Bank Quarterly (October-December)

The data are collected from different secondary sources such as different publications of Bangladesh Bank. All the data are arranged as 46

squarely

basis

to

have

closer

look

at

the

change

in

the

macroeconomic variables with the change of the exchange rate. But the problem with time series data is that some of them do not have change over the period of time. Again there is some time-lag for getting the desire effect of a change in one variable to another. So to build up a model with the data close attention has to give so that the normal trend does not interfere with the analysis. Before going to the analysis part we need to have an idea about the change of the variables with time. 5.2.1 Exchange rate Before the change of the exchange rate regime the in May 31, 2003 the exchange rate used to be fixed by the Bangladesh Bank authority and the market has to take that rate whatever is the demand and supply. This peg system of exchange rate is for the stabilization of our foreign exchange market which is very important for the external traded especially for export and remittance. However this fixed exchange rate regime used to create imbalance with our overall economy which was thought to be an imperfect market situation for a country. So with the advice of IMF Bangladesh hast to float her currency and here the market would determine the perfect rate of the exchange rate. The exchange rate date is taken in quietly basis although in the time of fixed era the exchange rate used to be fixed for a certain period. The exchange rate of that period was taken as the previous times rate. Figure 5.1: Change in exchange rate over time.

47

ER 80 70 60 50 ER 40 30 20 10 0
Q 3 Q 1 Q 3 Q 3 Q 1 Q 3 Q 1 Q 3 Q 1 19 97 19 98 19 98 20 00 20 01 20 01 20 04 20 04 20 05 20 07 19 99 19 99 20 00 20 02 20 02 20 03 20 03 20 05 20 06 20 06 Q 1 Q 1 Q 3 Q 1 Q 1 Q 3 Q 1 Q 3 Q 3 Q 1 Q 3

Period

5.2.2 Export Most of the time the taka has been devaluated due to the fact that our export sector will get an incentive as the exporter would get more local currency in exchange of foreign currency. This is true that our export sector has got a huge momentum during the past two decades. Now question arises that whether this increase in the export is due to the devaluation or not. One more important thing for export is that the product has been diversified in different area and at the same time the value addition in export has been reduced substantially for last few years so long as one-third of our export basket is consist of RMG. This is because of the fact that we could not create a sustainable backward linkage for the RMG sector. Even the forward linkage for the RMG is not our own build. The buying house and other marketing organizations for the RMG is the evidence of the situation. As a result the contribution of this particular sector insignificant compare to what we think by the volume of export. 5.2.3 Import Bangladesh has been generally import base country from the liberalization of the country. Among the major import items the food grain, capital machinery, vehicles and other luxury items. The import

48

was always been costly for Bangladeshi business people as the dollars were always been costly for the importer. However, the import is strongly correlated with the export as the import of the raw materials is essential for RMG export. Figure 5.2: Export and import relationship (Quarterly)
Export 400000 350000 300000 Million taka 250000 200000 150000 100000 50000 0
Q 1 Q 1 Q 3 Q 3 Q 3 Q 3 Q 3 Q 1 Q 3 Q 1 Q 3 Q 1 Q 3 Q 1 Q 3 Q 1 Q 1 Q 1 Q 3 19 98 19 98 19 99 20 02 20 03 20 04 20 05 19 97 19 99 20 00 20 00 20 01 20 01 20 02 20 03 20 04 20 05 20 06 20 06 20 07 Q 1

Import

Period

The above graph shows a very interesting relationship between export and import as a whole. It is being seen from the graphs that the export and import are highly correlated (.94). The fact is that most import is for the purpose either for raw materials or capital machineries for the processing of the exportable product. 5.2.4 Remittance The foreign exchange from export and import are mostly offset each other and some times the importer hat to get extra payment from the remittance earning. This is the only sustainable source of income from the expatriate Bangladeshi worker especially working in the MiddleEast. In fact, the whole foreign exchange reserve of the country comes from the remittance. A close study of the graph shows that the incoming remittance has been increasing significantly from 2005Q1 and onward. At the same time the CAB shows to be positive as the time goes on. This is because of the fact that the official channel of sending 49

remittance has improved due to several facilitating factors taken by the Government which encourages the wage earners to send the money through banking system instead of hundy or hawala system. Figure 5.3: Current Account Balance (CAB) and remittance

Remmittance 120000 100000 80000 60000 40000 20000 0

Q 1 Q 1

CAB

Million taka

Q 3

Q 3

Q 3

Q 3

Q 3

Q 1

Q 3

Q 1

Q 3

Q 1

Q 3

Q 1

Q 3

Q 1

Q 1

Q 1

Q 3

19 98

19 98

19 99

20 02

20 03

20 04

20 05

19 97

19 99

20 00

20 00

20 01

20 01

20 02

20 03

20 04

20 05

20 06

20 06

-40000 Period

5.2.5 Current Account Balance (CAB) Historically Bangladesh has been a negative current account as the Balance of Trade (BOT) was always been negative. However our income surplus started to increase enormously after the mid 90s contributing to the CAB to become positive. So the imbalance in BOT is supported by the incoming remittance.

50

20 07

-20000

Q 1

5.2.6 Inflation Inflation is a problem for any developing country. One hand Government has to keep proper employment level to both political and social reason and check the price level on the other hand. It is true that our monetary policy always accommodate a tolerable level of inflation to our economy. The inflation is partly contributed by the incoming remittance as the increase of foreign exchange has to increase domestic money supply. The Government did not allow the taka to become strong due to the fact that our incoming remittance will reduce for devaluation of dollar. So there is always a pressure of inflation in our economy. According to the graph the level of inflation was its minimal level during the period of 1999 and 2000 where the growth of exchange rate was much more then the inflation. During this period the total reserve of Bangladesh was also very lower level as the resave of the current account surplus was spent to import different food grin by the government and the import become comparatively cheaper.

5.3 THE MODEL

This econometric model is built on the assumption that exchange rate is an independent variable and all other macro-economic variables are dependent on the exchange rate (er). I took three other macro-economic indicators such as export (ex), import (im), remittance (rem).

5.3.1 Model specification

Long run model 1. ext = 1 + 2 ert + u t ex and er both are I(1); ut is I(1)in ADF test but ut is stationary from auto corrrelation function and correlogram. As we know that autocorrelation function and correlogram give more appropriate result for small longitude of data. From autocorrelation function we get no trend of ut. So ex and er is cointegrated.

51

Hypothesis H0: 2 = 0 H1: 2 0 I expect the value of 2 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 2. ext = 1 + 2 ert + 3u t 1 + t I expect the value of 2 is positive and 3 negative. 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.

5.3.2 Model testing

ADF test for stationary of the independent variable exchange rate (er)
Unit root tests for variable ER The Dickey-Fuller regressions include an intercept but not a trend ******************************************************************************* 35 observations used in the estimation of all ADF regressions. Sample period from 1998Q4 to 2007Q2 ******************************************************************************* Test Statistic DF ADF(1) ADF(2) ADF(3) ADF(4) -.24483 -.20453 .15882 -.44283 -.48393 LL -47.6918 -47.6632 -46.7446 -42.0985 -41.8946 AIC -49.6918 -50.6632 -50.7446 -47.0985 -47.8946 SBC -51.2472 -52.9962 -53.8553 -50.9868 -52.5607 HQC -50.2287 -51.4685 -51.8184 -48.4407 -49.5053 -2.9472

******************************************************************************* 95% critical value for the augmented Dickey-Fuller statistic = LL = Maximized log-likelihood SBC = Schwarz Bayesian Criterion HQC = Hannan-Quinn Criterion AIC = Akaike Information Criterion

52

Unit root tests for variable ER The Dickey-Fuller regressions include an intercept and a linear trend ******************************************************************************* 35 observations used in the estimation of all ADF regressions. Sample period from 1998Q4 to 2007Q2 ******************************************************************************* Test Statistic DF ADF(1) ADF(2) ADF(3) ADF(4) -1.5715 -1.5387 -1.0671 -2.5353 -3.2318 LL -46.4006 -46.3723 -45.9918 -38.6964 -36.4723 AIC -49.4006 -50.3723 -50.9918 -44.6964 -43.4723 SBC -51.7336 -53.4830 -54.8801 -49.3624 -48.9160 HQC -50.2060 -51.4461 -52.3340 -46.3071 -45.3514 -3.5426

******************************************************************************* 95% critical value for the augmented Dickey-Fuller statistic = LL = Maximized log-likelihood SBC = Schwarz Bayesian Criterion HQC = Hannan-Quinn Criterion AIC = Akaike Information Criterion

53

ADF test for stationary of the independent variable export (ex)

Unit root tests for variable EXPORT The Dickey-Fuller regressions include an intercept but not a trend ******************************************************************************* 35 observations used in the estimation of all ADF regressions. Sample period from 1998Q4 to 2007Q2 ******************************************************************************* Test Statistic DF ADF(1) ADF(2) ADF(3) ADF(4) .25471 -.22529 1.4021 .76875 .76287 LL -387.6685 -387.3432 -384.1094 -383.4075 -383.3940 AIC -389.6685 -390.3432 -388.1094 -388.4075 -389.3940 SBC -391.2239 -392.6762 -391.2201 -392.2959 -394.0601 HQC -390.2054 -391.1486 -389.1832 -389.7498 -391.0047 -2.9472

******************************************************************************* 95% critical value for the augmented Dickey-Fuller statistic = LL = Maximized log-likelihood SBC = Schwarz Bayesian Criterion HQC = Hannan-Quinn Criterion AIC = Akaike Information Criterion

Unit root tests for variable EXPORT The Dickey-Fuller regressions include an intercept and a linear trend ******************************************************************************* 35 observations used in the estimation of all ADF regressions. Sample period from 1998Q4 to 2007Q2 ******************************************************************************* Test Statistic DF ADF(1) ADF(2) ADF(3) ADF(4) -1.3043 -2.0315 -.15819 -1.5105 -2.5278 LL -386.0564 -384.6540 -383.7398 -381.3735 -379.1014 AIC -389.0564 -388.6540 -388.7398 -387.3735 -386.1014 SBC -391.3894 -391.7647 -392.6282 -392.0396 -391.5451 HQC -389.8618 -389.7278 -390.0821 -388.9842 -387.9806 -3.5426

******************************************************************************* 95% critical value for the augmented Dickey-Fuller statistic = LL = Maximized log-likelihood SBC = Schwarz Bayesian Criterion HQC = Hannan-Quinn Criterion AIC = Akaike Information Criterion

54

Result of Long run model

Ordinary Least Squares Estimation ******************************************************************************* Dependent variable is EXPORT 40 observations used for estimation from 1997Q3 to 2007Q2 ******************************************************************************* Regressor C ER R-Squared S.E. of Regression Mean of Dependent Variable Residual Sum of Squares Akaike Info. Criterion DW-statistic Coefficient -209146.3 5733.7 .78767 20835.4 115080.6 1.65E+10 -455.5080 .51459 Standard Error 27505.7 482.9133 R-Bar-Squared F-stat. F( 1, 38) S.D. of Dependent Variable Equation Log-likelihood Schwarz Bayesian Criterion T-Ratio[Prob] -7.6037[.000] 11.8731[.000] .78209 140.9705[.000] 44633.4 -453.5080 -457.1969

*******************************************************************************

*******************************************************************************

Diagnostic Tests ******************************************************************************* * * * * B:Functional Form * * C:Normality * Test Statistics * * 4)= 1)= 2)= 1)= * *CHSQ( * *CHSQ( * LM Version * * 25.4153[.000]*F( * 17.6796[.000]*F( * 7.4316[.024]* * 16.9164[.000]*F( 1, 38)= Not applicable 1, 37)= 4, 34)= F Version * * 14.8121[.000]* * 29.3071[.000]* * * * 27.8477[.000]* ******************************************************************************* * A:Serial Correlation*CHSQ(

* D:Heteroscedasticity*CHSQ(

******************************************************************************* A:Lagrange multiplier test of residual serial correlation B:Ramsey's RESET test using the square of the fitted values C:Based on a test of skewness and kurtosis of residuals D:Based on the regression of squared residuals on squared fitted values

55

Pattern of the residual Figure 5.4: Correlogram of residual of long run model
0.60 -0.40 0 Autocorrelations of res -0.20 0.00 0.20 0.40

10 Lag

15

20

Bartlett's formula for MA(q) 95% confidence bands

Result for short run model

Ordinary Least Squares Estimation ******************************************************************************* Dependent variable is DEXPORT 39 observations used for estimation from 1997Q4 to 2007Q2 ******************************************************************************* Regressor C DER RES(-1) R-Squared S.E. of Regression Mean of Dependent Variable Residual Sum of Squares Akaike Info. Criterion DW-statistic Coefficient 1931.7 3154.4 -.25120 .15154 14382.8 4231.8 7.45E+09 -430.1554 1.5197 Standard Error 2812.5 2554.8 .12082 R-Bar-Squared F-stat. F( 2, 36) S.D. of Dependent Variable Equation Log-likelihood Schwarz Bayesian Criterion T-Ratio[Prob] .68684[.497] 1.2347[.225] -2.0792[.045] .10440 3.2149[.052] 15198.0 -427.1554 -432.6507

*******************************************************************************

*******************************************************************************

56

Diagnostic Tests ******************************************************************************* * * * * B:Functional Form * * C:Normality * Test Statistics * * 4)= 1)= 2)= 1)= * *CHSQ( * *CHSQ( * LM Version * * 12.0528[.017]*F( * 1.2071[.272]*F( * 33.0208[.000]* * .011869[.913]*F( 1, 37)= Not applicable 1, 35)= 4, 32)= F Version * * 3.5782[.016]* * 1.1179[.298]* * * * .011264[.916]* ******************************************************************************* * A:Serial Correlation*CHSQ(

* D:Heteroscedasticity*CHSQ(

******************************************************************************* A:Lagrange multiplier test of residual serial correlation B:Ramsey's RESET test using the square of the fitted values C:Based on a test of skewness and kurtosis of residuals D:Based on the regression of squared residuals on squared fitted values

The short run changes in exchange rate have a positive impact on short-run changes in export. So here I can interpret 3154.4 as the short run marginal effect of exchange rate on export; the ling run marginal effect is 5733.7 - estimated by (static) equilibrium model(1).

57

5.3.3 Forecasting
The forecasting from the model shows a very encouraging development in the export, remittance and import sector. All the variables have increased substantially after the floating exchange rate has been implemented. The following figures will show how the forecasted variables have supersedes the actual data from 2003:Q3 when floating has been implemented. Figure 5.5: Actual and forecasted export

Plot of Actual and Single Equation Static 250000 200000 150000 100000 50000 0 1997Q3 2000Q1 2002Q3 2005Q1

Quarters

58

Figure 5.6: Actual and forecasted import

Plot of Actual and Single Equation Static Fo 400000 300000 200000 100000 0 1997Q3

2000Q1

2002Q3

2005Q1

Quarters

Figure 5.7: Actual and forecasted remittance

59

Plot of Actual and Single Equation Static F 110000 90000 70000 50000 30000 10000 1997Q3 2000Q1 2002Q3 2005Q1

Quarters

60

5.3.4 Trend analysis

Trend of the variables and the change in the difference of the change has been shown in the following figures. The significant aspect trend is that they do not show a particular pattern over time. That is the change of exchange rate and export is stationary in the first differences. Figure 5.8: The trend of exchange rate (er)

70 65 60 55 50
Figure 5.9: The trend of difference in change in exchange rate (der)

45 40 1997Q3

3.0 2.5 2.0 1.5 1.0 0.5 0.0

1998Q4

2000Q1

2001Q2

2002Q3 Quarters

2003Q4

61

Figure 5.10: The trend of difference in change in exchange rate (der)

250000

200000

150000

100000

50000

0 80000 1997Q3
60000

1998Q4

2000Q1

2001Q2 Quarters

2002Q3

2003Q4

200

40000

20000
62

Figure 5.11: The trend of difference in change in exchange rate (der)

63

5.3.5 Correlation matrix

Exchange rate (er) vs. other variables The matrix shows the correlation of exchange rate (er) with export (ex), import (im), remittance (rem), inflation (inf) and gdp. From the table it is found that the correlation exchange rate is very high with the other variables. Table 5.2: Correlation of exchange rate (ER) with other macro-economic variables Er Ex Im Rem Inf Gdp Er 1 0.8875 0.9304 0.9430 0.0931 0.6119 Ex 1 0.9253 0.8913 0.2036 0.6851 Im 1 0.9724 0.2563 0.7371 Rem Inf gdp

1 0.3139 0.7060

1 0.2215

Difference in exchange rate (er) vs. difference in other variables The matrix shows the correlation of difference in exchange rate (der) with other variables difference in export (dex), difference in import (dim), difference in remittance (drem), difference in inflation (dinf) and difference in (dgdp). This correlation of differences is much more convencing as this system eliminate the normal tendency of growth in both the variables.

D.er D.im D.ex D.rem D.inf D.gdp

Table 5.3: Correlation of difference in exchange rate (D.ER) D.er D.im D.ex D.rem D.inf 1 -0.1128 1 0.2228 0.3175 1 0.1490 0.3670 0.0004 1 0.0099 0.0028 -0.0198 -0.0371 1 -0.0112 -0.0560 0.1359 0.0322 -0.3918

D.gdp

64

5.3.6 Regression line of the variables

Figure 5.12: Regression line of Export (ex)

Export

250000

Observed Linear

200000

150000

100000

50000 40.000 45.000 50.000 55.000 60.000 65.000 70.000

ER

Figure 5.13: Regression line of change indifference in export (dexport)

dexport

Observed Linear 60000.00

40000.00

20000.00

0.00

-20000.00 -1.00 0.00 1.00 2.00 3.00

der

65

Figure 5.14: Regression line of Import (im)

Import

350000

Observed Linear

300000

250000

200000

150000

100000

50000 40.000 45.000 50.000 55.000 60.000 65.000 70.000

ER

Figure 5.15: Regression line of change in difference in import (dimport)

dimport

60000.00

Observed Linear

40000.00

20000.00

0.00

-20000.00

-40000.00

-60000.00 -1.00 0.00 1.00 2.00 3.00

der

66

Figure 5.16: Regression line Remittance (erm)

Remmittance

150000

Observed Linear

120000

90000

60000

30000

0 40.000 45.000 50.000 55.000 60.000 65.000 70.000

ER

Figure 5.17: Regression line of change in difference of remittance (drem)

dremiittance
Observed Linear

15000.00

10000.00

5000.00

0.00

-5000.00 -1.00 0.00 1.00 2.00 3.00

der

67

The problem with the correlation of the time series data is that most of the time it will provide a misleading picture about the relationship between the variables. If we take the example of export and exchange rate we will find the correlation of this two variables are nearly 90%. So, can we say that just devaluating taka by 10% we can achieve a boost in export earning by 9%? Actually this never can be a situation. In fact, the increase in export is due to the fact that the exportable items are diversified substantially along with the specialization of the exporter in production and marketing. The same things go with the remittance and import. In reality remittance should be positively correlated and import should be negatively correlated with the exchange rate. However, we found in the graph that both remittance and import are positively correlated. So the conclusion is that normal correlation between variables is not a good indicator for showing a relationship. For time series data if we can track the difference of the variables the relationship will be more authentic. This difference will indicate that how much of one variables change has affected the change of other variables. So if we compare the result of the correlations of difference we find that export and remittance are positively correlated whereas import is negatively correlated with exchange rate.

5.3.7 Findings from the model

There is no cointegration relationship between export and exchange rate by using ADF unit root test of residual of long run model. But if we use autocorrelation function we find residual of long run model is stationary. Thus the export and exchange rate is conintegrated. In the short run model we use error correction mechanism (ECM) to reconcile the short run behavior of economic variables (export, exchange rate) with its long run behavior. If any disequilibrium does arise in the short run model it will eventually corrected through the long run model. There is a structural break in 2003 Q3 when the exchanger rate is floated. It is found that the export has shoot up to its higher level compare to the forecasted export trend.

68

Chapter 6 FOREIGN EXCHANGE RISK MANAGEMENT 6.1 THE POLICY

From 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. To adapt to the changed environment, many banks established dealing rooms and some centralized their foreign exchange and money market activities under a single functional area which is still in its rudimentary stage. Bangladesh Bank, in order to take the local market further ahead, decided to form a focus group to prepare a strategy paper to address the major risk elements involved in the foreign exchange activities. All financial activities involve a certain degree of risk and particularly, the financial institutions of the modern era are engaged in various complex financial activities requiring them to put proper attention to every detail. The success of the trading business depends on the ability to manage effectively the various risks encountered in the trading environment, and the organizations policies and processes require development over time to ensure that this is done in a controlled way. The key risk areas of a financial institution can be broadly categorized into: o Credit risk o Market risk and o Operational risk In view of the significance of the market risk and in order to aggregate all such risks at a single department and to bring expertise in such functions, the concept of Treasury has evolved. Todays financial institutions engage in activities starting from import, export and remittance to complex derivatives involving basic foreign exchange and money market to complex structured products. All these require high degree of expertise that is difficult to achieve in the transaction originating departments and as such the expertise is housed in a separate department i.e. treasury.

69

6.1.1 Credit risk

Credit risk arises from an obligors failure to perform as agreed. o Interest rate risk o Liquidity risk o Price risk o Compliance risk o Reputation risk

6.1.2 Market Risk

Market risk is defined as the potential change in the current economic value of a position (i.e., its market value) due to changes in the associated underlying market risk factors. Trading positions are subject to mark-to-market accounting, i.e., positions are revalued based on current market values and, for on-balance sheet positions, reflected as such on the balance sheet; the impact of realized and unrealized gains and losses is included in the income statement.

6.1.3 Market Factors

A market factor is defined as a variable (i.e., a market price or rate, such as a spot FX rate or an interest rate) that can impact the economic valuation of a contractual position. All relevant market factors must be identified and taken into consideration in the establishment of the independent market risk limit frameworks. They also must be specified at a sufficient level of detail so that distinct types of market risks to which a risk taking unit is exposed are separately identified. It is a part of the market risk management activity to identify and specify all relevant market factors for each risk-taking unit and to take them into consideration in the establishment of the independent market risk limit frameworks.

6.1.4 Value-at-Risk (VAR)

VAR is intended to estimate the potential decline in the value of a position or a portfolio, under normal market conditions, within a defined confidence level, and over a specific time period.

6.2 ORGANIZATIONAL STRUCTURE

In performing all the above -listed functions in an appropriate manner and depending on the nature of business of the financial organization and its size, an organization would best determine the appropriate organization structure for its treasury and treasury back-office functions. However, irrespective of the size, nature of business, all treasury functions require to have clear demarcation between the direct dealing and all settlement and support functions i.e. the treasury that would be 70

involved only in dealing activities and the treasury support unit (commonly known as the treasury back-office) that would be responsible for all related support functions. This is required for control reasons meaning that different persons/ department should be responsible for the dealing and the settlement, measurement, reporting etc.

6.2.1 Centralized Foreign Exchange and Money Market Activities

A financial organizations balance sheet is formed from its core activities. However, as perfection in the balance sheet is almost impossible, organizations require access to the wholesale market to plug in gaps and mismatches (though, wholesale activities are primarily for managing gaps and mismatches, this is also done for proprietary trading and arbitrage purposes). As the two types of wholesale activities i.e. foreign exchange and money market are heavily interdependent, these are required to be housed in the same area. This means that an organizations foreign exchange and money market activities are to be unified in the same department for efficiency.

6.2.2 Separate Trading and Risk Management Units

The traders are required to operate within prescribed risk limit framework where a different group of people known as the market risk managers, have responsibilities of identifying the risk areas and their appropriate limits. The roles and responsibilities of these two departments in term of controlling and managing risk are:

Traders/ Risk-Taking Units o Maintain compliance with the market risk limit policies and remain within their approved independent market risk limit framework at all times o Ensure no limit breaches and arrange for pre-approval of any higher limit requirements o Inform the market risk management unit of any shifts in strategy or product mix that may necessitate a change in the market risk limit framework o Seek approval from the market risk management unit prior to engaging in trading in any new product o

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Market Risk Management o Review policy at least annually and update as required Independently identify all relevant market risk factors for each risk taking unit o Develop proposals for the independent market risk limits/ triggers, in conjunction with the risktaking units o Ensure that limits/ triggers are appropriately established o Independently monitor compliance with established market risk limits/ triggers

6.2.3 Organization Chart

Considering the above and in relation to the local market, an appropriate organization chart has been drawn. The proposed structure has been drawn bearing in mind all possible roles and functions that are currently applicable to our market. In organizations where it does not justify employment of full time employees for each of the functions, a single employee or department can be used for more than one function. The proposed organization Chart has been detailed on annexure IV. From the organization structures shown on annexure III, it is evident that the reporting lines for the officers managing the treasury and the treasury back office are different. This is an ideal structure that needs to be in place for control reasons. In our domestic market, organizations according to their existing structure/ policy, would best determine in which of their departments the treasury would report and in which the treasury back office would.

6.3.4 Treasury
o Head of Treasury o Cross Currency Dealer o USD/BDT Dealer o Securities and Statutory Management Dealer o Lcy & Fcy Money Market Dealer o Balance Sheet Manager

6.3.5 Treasury Back-Office

o Manager Local Currency Nostro Reconciliation o Manager Foreign Currency Nostro Reconciliation o Manager Foreign Currency Position Reconciliation o Manager Local Currency Position Reconciliation 72

6.2.5 Restrictions
It is important to not e that there are certain activities that are restricted by traders and back-office staff. Treasury Traders Are Restricted from Deal processing o Accounting entries o Sending/ receiving deal confirmations o Issuing/ receiving Bangladesh Bank cheques o Sending settlement instructions i.e. swift messages/ telexes o Generating revaluation rates Treasury back-office is restricted from dealing activities o Decide on exchange rates/ quoting prices o Striking deals with counterparties o Raising deal slips o Altering deal details o Updating position blotters o Deciding on nostro funding o Approving counterparty credit limits o Approving market risk limits

6.3 THE PROCESS

In a proper treasury setup, a dealer strikes a deal in the market and maintains his/ her own record for monitoring the exchange position. Within a reasonable time, s/he passes on the detailed information of the deal to the treasury back office. The back office arranges for the deal confirmation with the counterparty, arranges settlement, reconciles exchange positions and advises to treasury and runs the valuation on a periodic basis. The dealing function requires the dealers to make very quick decisions either for taking advantages of any market movements or for unwinding an unfavorable position. Also, the treasury dealing is a wholesale function that involves large lots. These together make the job of a dealer requiring a number of supporting systems. o Proper information sources e.g. Reuters Money 2000, Bloomberg, financial TV channels etc. o Adequate and dedicated communication tools e.g. Reuters Dealing System, telephone, fax, telex etc. o Specially designed dealing desks to appropriately accommodate the various information and communication tools 73

o High level of dealing skills o Quick decision making authority o Independent decision making authority o Specific task allocations

6.3.1 Dealing Room

Since the dealers have access to global live prices of various products through their various communication tools, their desks are required to be access restricted. As a result, dealers are typically housed inside a covered room known as the dealing room where the access is generally restricted only to the dealers and the related personnel.

6.3.2 Taped Conversations

In many occasions, the dealers conclude deals over the phone. This is particularly applicable where deals are done on the local market where dealers are mostly known to each other and they feel comfortable dealing by talking to other dealers over phone. Such deals over the phone do not have any hard evidence and in a fast dealing environment, there is risk of mistakes (of rates, amounts or value dates etc.) As a result, all telephonic conversations taking place in the dealing room are required to be taped. Taped conversations can assist in resolution of any disputes that may arise. As such, all telephone lines of the dealing rooms, may it be a direct line or a connection through the PABX, must be taped. This means that dealing over the mobile phones must be restricted.

6.3.3 Deal Recording

The job nature of a dealer is highly demanding and the environment of a dealing room is very active. In such an environment when a dealer continues to deal, his/ her focus remains on the market. As such there is a risk of a dealer completely forgetting about a deal or part of a deal or making mistake in recording that deal. To eliminate this risk, a dealer must record the deal immediately after it is concluded with the counterparty. The deal recording needs to be done in two ways. Position Blotter. Immediately after a deal is done, the dealer should record the deal on the position blotter and update his position. It is of utmost importance to a dealer to remain aware of his/ her position at all times. This is required to capture any immediate opportunity or to be in a position to immediately react to any adverse situation. 74

Deal Slip. A dealer must, at the earliest possible time, record the details of the deal on a slip or memo which is known as the deal slip or deal ticket. In some organizations, the deal slips are electronic and are through inputs into their automated systems. A typical deal slip would contain details such as, payment instruction, value date, currencies, amounts etc. The deal slip should be passed on to the treasury back-office at the earliest for their further processing of the deal. Ideally, all deal slips should be pre-numbered for control reasons and the treasury back-office must monitor for any breakage in sequence. Where pre-numbered deal slips are in place, any cancelled deal slips must also be forwarded to treasury back office for appropriate record keeping/ filling.

6.3.4 Deal-Delay
All deals done by dealers are required to be processed by the treasury back-office for which they need to be informed of the details of the deals within a certain time. In this process dealers raise deal tickets that need to be sent across to the treasury back-office within shortest possible time. The timeliness of raising deal slips/ inputting into the automated system as well as passing them on to the back-office is not only sound business practice but also critical for monitoring of credit risk, price risk and regulatory compliance. Table 6.1: Deal capture standers Product Deal-slip raising/ Deal-slip to reach backSystem Input Time office 10 min. 25 min. 10 min. 22 min. 15 min. 30 min. 10 min. 25 min. 10 min. 25 min. 10 min. 25 min. By 10.30 am on payment Within 30 minutes day By 12.30 pm Within 30 minutes By 12.00 pm Within 30 minutes

Products Spot FX Forward FX FX Swaps Call/Notice Money Money Market Term FC Deposits TB Purchase Repo Reverse Repo

The guidelines as per the above table may slightly vary depending on the distance of the physical locations of the treasury and the treasury back office and degree of system automation within the treasury organization. However, if the deviation from the above mentioned times is in excess of 10 minutes, the concept of the deal delay process would be defeated. For monitoring of the proper functioning of this process, treasuries where manual deal-slips are raised, should use time stamping on 75

deal tickets. In environments where treasury automated systems are used, the time stamping may not be required since the system should automatically take care of this.

6.3.5 Counterparty Limits

The issue of counterparty limits arises from the risk that a customer with whom an organization had a reciprocal agreement defaults. Credit risk is the risk that the counterparty to a financial transaction here a foreign exchange contract, may become unable to per form as per its obligation. The extent of risk depends on whether the other party's inability to pay is established before the value date or is on the same value date of the foreign exchange contract. Settlement risk. The risk on the settlement day that one counterparty pays funds or delivers a security to fulfill its side of the contractual agreement, but the other counterparty fails on its side to pay or deliver. This occurs when items of agreed upon original equal values are not simultaneously exchanged between counterparties; and/or when an organizations funds are released without knowledge that the counter value items have been received. Typically the duration is overnight/ over weekend, or in some cases even longer i.e., until the organization receives the confirmation of receipt of funds. The risk is that the organization delivers but does not receive delivery. In this situation 100% of the principal amount is at risk. The risk may be greater than 100% if in addition there was an adverse price fluctuation between the contract price and the market price. Pre-settlement risk. The risk that a client defaults on its agreement with the organization before the settlement day. Whilst the organization has not paid away any funds, it still has to replace the contract at the current market rates, which might have moved against it. In this case the organization is exposed to possible adverse price fluctuations between the contract price and the market price on the date of default or final liquidation. The organizations loss would then be the difference between the original contract price and the current market price on the date of default. All banking organizations must have appropriate counterparty limits in place for their treasuries. The limit structure will depend on each organizations credit risk appetite based on their credit risk policies as well as target market criteria. All such credit risk limits should be set by the organizations credit risk approving unit, which is independent of the treasury dealing function.

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6.3.6 Triggers
A trigger is a level of a position at which an organization decides that the management should be made aware of. This may be in terms of a market value of a position or an unusual trading volume etc. This is a predetermined level given by the management. When a trigger is hit, the management needs to be informed of the same. Upon advised of a trigger, the management usually decides on closer monitoring of the particular situation. In cases of a loss trigger, the amount is generally set at a lower level than the stop loss limit (at which the position has to be un winded).

6.3.7 Stop Loss Orders

A stop loss limit for a product is generally a certain percentage of the organizations prior year profit from that product. For example if an organizations FX trading revenue for the year 2002 was USD A, the management/ market risk management unit may decide to accept a maximum of 10% loss of that during the current year. In that case the stop loss limit for that organization for 2003 would be A X 10%. In managing the business within the stop loss limit, treasuries running overnight positions (within their overnight limits) must leave appropriate overnight watch orders.

6.3.8 Appropriateness of Dealing

While transacting with a client, a dealer should be aware of the counterpartys dealing style & product mix and assess (prior to concluding a deal) whether the customer is dealing in an appropriate manner. A dealer should have the responsibility to ensure that the volumes of activity and types of products transacted by a client are appropriate for that particular client and the risks of these transactions are clearly understood by them. Prior to conclusion of a deal, a dealer needs to assure that the counterparty is authorized to enter into such transaction (both from counterpartys internal and regulatory perspective).To address the appropriateness issue, it might be a good idea for the organization to get a standard agreement signed by all its counterparties. For our case, such an agreement can be drafted by BAFEDA and can be made mandatory for all members to sign. This exercise is carried out by the treasury back-office to check for whether all deals have been dealt at market rates. Any deals done at off market rates must be raised to the respective dealer for a satisfactory explanation bringing this to the notice of the chief dealer. In case of a non-acceptable justification provided by the dealer, the organization may decide to engage in further investigation. This monitoring process needs to be in place to guard against application of any inappropriate rates.

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Treasury front office primarily uses Reuters for pricing of its products and treasury operations should also collect most of the data for their independent verification process from the same source. Following is a guide that can be followed in the process of independent verification of prices for various products/ instruments: All bank treasuries publish a rate sheet for retail FX transactions for various types of customer related transactions in various currencies. Buy and sell rates for all currencies for all types of transactions that are covered in the rate sheet is based on sufficient spreads taken from the bid/ offer of central bank's quote on USD/BDT for the day as well as spreads on cross currencies available from Reuters. It is primarily designed to cover retail and small corporate FX transactions. Correctness in preparation of rates for these transactions must be covered through maker-checker control (as well as the automated banking system through defined bands in the system). However, for certain customers, transaction rates might differ from the published rates. In these instances there should either be standing instruction issued by the head of treasury or the relevant rate exception signed by a treasury personnel. On customer FX, the rate bands are higher to accommodate higher spreads. However, since all customer transactions are based on a principle of a positive spread, negative spreads for such transactions must be highlighted as exceptions for explanations and approvals.

6.3.9 Deals Outstanding Limit

It is a good practice to monitor the total deals outstanding of the treasury. This exercise requires to be carried out by the treasury back office to check against any unusual volumes of activity. Each treasury would have its own volume trend and the treasury back office should monitor whether all activities are being carried out within usual trend. The management may decide to set a limit for all outstanding FX contracts at any given point of time. For example, in a fast dealing environment, a dealer may make a mistake and execute a deal with an additional zero that would make the dealt amount much higher than intended. If a deal outstanding monitoring (by an independent unit) process is in place, this would be highlighted and brought to the attention of the senior management for any appropriate action.

6.3.10 Daily Treasury Risk Report

The treasury back-office is required to summarize all daily positions particularly the end-of-day positions on a report format for the information of the senior management. Such report should ideally contain information about outstanding open position against limit, different currency-wise outstanding 78

exchange position (against limits if applicable), outstanding foreign exchange forward gaps in different tenors, tenor-wise MCO report, interest rate exposures of the balance sheet, counterparty credit limits usage, days P&L against trigger & stop loss limit etc. A sample format of a daily treasury report for the senior management has been drawn in annexure VIII.

6.3.11 Code of Conduct

Due to the special nature of job that dealers engage in, they are expected to act in a professional and ethical manner. The principles constituting the ethical conducts for dealers are detailed in annexure IX.

6.3.12 Conversation Language

All dealing related conversations taking place in the treasury must be in an acceptable language for operational clarity. To elaborate, all conversations on the Reuters Dealing System must be in English and all conversions over telephone must be restricted to either in Bengali or in English.

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Chapter 7 CONCLUSION AND FINDINGS

To asses the impact of floating on the overall economy is a very sophisticated task as there are always several other macro-economic variables are affecting the exchanger rate and the export, import and remittance. The model used in this report to find out the relation ship between export and import is a very simple one. In this model I tried to find out if the change of export has a relationship with the exchange rate. In other word I tried to find out the export performance in the floating ear of Bangladesh foreign exchange. The summary of the whole basements are as following. The exchanger change of exchange rate revile the similar pattern pre and post floating There is a good association between exchange rate and export The current account balance (CAB) has shown a upward trend after floating The import has a negative correlation with the exchange rate The remittance has shown significant improvement in free floating era Bangladesh Bank can have more control over the forex market because huge reserve Floating era triggers the change in dealing in foreign exchange market The risk element has increase as the free floating era Most macroeconomic variables did well compare to the forecasted trends

To sum up, it is obvious that the translation of Bangladesh currency regime from peg to free floating was not very problematic as we have seen in the case of Latin American and other developing countries. Therefore it is not far for Bangladesh to go for full convertibly soon.

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