[Type text]

Prepared for:
Fin
444
Mirza M. Ferdous(MzF)
Assignment 2

Jubayer Rahman
600-030
Muhammad Moinuddin
0995 030

081091

Abid Mustafizur Rahman

-428-030

073

Asma Quadry Deepa

-294-030

072

Fhamida Iqbal
303-030

071-

Definitions:
Government Intervention in Foreign Exchange Market
Foreign exchange intervention is defined generally as foreign exchange transactions
conducted by the monetary authorities (Central Bank) with the aim of influencing exchange
rates. It is the process by which the monetary authorities attempt to influence market
conditions and/or the value of the home currency on the foreign exchange market.
Intervention usually aims to promote stability by opposing disorderly markets, or in response
to special circumstances. Central Banks engage in international transactions by buying
foreign denominated assets and selling their currency or by selling foreign assets (from their
international reserves) and purchasing the domestic currency. These activities affect the
exchange rate of the home currency with respected currencies.

Interest Rate Parity (IRP)

This theory quantifies the relationship between interest rate differential and forward rate
(discount or premium). This theory says that when the difference between the interest rates of
two countries and the difference between the forward and spot rates of those countries is
same, then interest rate parity holds. Market forces cause the forward rate to differ from the
spot rate by an amount that is sufficient to offset the interest rate differential between the two
currencies. Then, covered interest arbitrage is no longer feasible, and the equilibrium state
achieved is referred to as interest rate parity (IRP).
When IRP exists, the rate of return achieved from covered interest arbitrage should equal the
rate of return available in the home country.

Purchasing Power Parity (PPP)

This theory tries to quantify the relationship between inflation and exchange rates. When one
countrys inflation rate rises relative to that of another country, decreased exports and
increased imports depress the countrys currency.

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There are two types of PPP:

1

Absolute form of PPP: The absolute form of PPP, or the law of one price, suggests
that similar products in different countries should be equally priced when measured in

the same currency.

Relative form of PPP: The relative form of PPP accounts for market imperfections
like transportation costs, tariffs, and quotas. It states that the rate of price changes
should be similar.

International Fisher Effect (IFE)

International Fisher Effect (IFE) Theory states that the currency of a nation with a
comparatively higher interest rate will depreciate in value in comparison to the currency of a
nation with a comparatively lower interest rate. It further implies that the extent of
depreciation will be equal to the difference in interest rates in those two nations. It is based on
the observation that the level of real interest rate in an economy is closely linked to the level
of local inflation rate and is independent of a government's monetary policies. Thus, in
general, the higher the inflation rate, the lower the value of currency. According to IFE if the
interest rate in foreign country increases, then the currency of that country will depreciate as
increase in nominal interest rates reflect expected inflation.

BDT against USD

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The Bangladeshi Taka (BDT) exchange rate depreciated 8.35 % against the US Dollar (USD)
during the last 12 months, considering from the very start of the year 2010. Historically, from
1994 until 2011 the USD and BDT exchange averaged 72.05 reaching an historical high of
78.60 in November of 2011 and a record low of 40.10 in June of 1995. The Bangladeshi Taka
spot exchange rate specifies how much one currency, the USD, is currently worth in terms of
the other, the BDT.

As we can see in the graph above that from the year 2007 till the end of 2009 the exchange
rate between BDT and USD was pretty much stable with little unnoticeable fluctuations
around 68 Taka per Dollar to 69 Taka per Dollar. But, from the beginning of the year 2010 the
exchange rate of BDT with USD was towards an increasing trend, starting from 68.80 Taka
per Dollar to being 78.60 Taka per Dollar as of Today November 25, 2011.
Exchange rate management is one of the central issues and Exchange rate of Bangladesh has
received wide attention among all concerned from end-May, 2003 when Bangladesh adopted
the floating exchange rate system. Traditionally, Bangladesh had been maintaining various
pegged exchange rate regimes, such as pegged to the British pound sterling (1972-1979),
pegged to a basket of major trading partners' currencies with pound sterling as the intervening
currency (1980-1982), pegged to a basket of major trading partners' currencies with US dollar
as the intervening currency (1983-1999), and an adjustable pegged system (2000-2003). On
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May 31, 2003, Bangladesh switched to floating exchange rate system by abandoning the
adjustable pegged system.
Bangladesh maintains a floating exchange rate system from the year 2003 and empirical
evidence and theory suggests that floating exchange rates are characterized by little
intervention in the exchange rate markets together with unlimited volatility of the nominal
exchange rate. In a floating system, since little or no intervention is required, reserves
exhibits relatively low volatility. However, it is observed that relative volatilities of the
exchange rate, reserves and interest rates are very low for the period 2007 - 2009, indicating
an active intervention in the foreign exchange market by the Government of Bangladesh. This
observation is correct because Bangladesh Bank purchased US $1.48 billion from the interbank market in 2008 2009. Such foreign exchange intervention activities have led to a
situation where the nominal exchange rate has remained almost fixed or has moved within a
very narrow range for the aforesaid period.
Therefore, the exchange rate system of Bangladesh has not been in the pure state of the freely
floating rate system. All in all, Bangladesh practices a managed floating rate system from the
very beginning of its transition to floating system as the government of Bangladesh
intervenes when the currency in moving more of one side. However, to manage floats or to
maintain a long-term value of the currency, Bangladesh Bank must have to acquire a good
stock of international reserves.
In addition to all these, the recent exchange rate hike (2010 Jan to now Nov 2011) of USD
against BDT is the main concern for Bangladesh and the Finance Minister of Bangladesh,
Abul Maal Abdul Muhith states that the reason for this is because the Bangladesh Bank tried
to lock the price of USD at Taka 69, which was wrong and therefore the price of dollar has
been steadily rising against the taka. As a result, the reserve is under pressure in line with the
importing cost and also the other reason is the Hajj as because those who went to perform
Hajj, they had to take dollars with them which worsened the exchange rate as the demand
for USD increased against BDT.
Over the longer term, the most important policy for preserving the value of the Bangladeshi
currency is to keep inflation under control. If the inflation rate in Bangladesh continues to be
substantially higher than the US inflation rate, demand for dollar will continue to exceed its
supply and the price of the dollar in taka terms will continue to rise over the long term.

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Interest and Inflation Rates in Bangladesh

for the past 5 Years

Interest Rate
Year
2006
2007
2008
2009
2010

Lending rate
11.06%
12.28%
12.63%
13.36%
12.75%

Deposit rate
5.77%
6.51%
7.23%
7.97%
7.34%

Year

Rate %

Real GDP %

2005

7%

6.4%

2006

7.2%

6.65

2007

9.1%

6.3%

2008

8.9%

4.9%

2009

5.4%

4.7%

2010

8.1%

6%

Inflation Rate

By looking at the tables above we can say that the interest rates and inflations rates in
Bangladesh have fluctuated a lot over the past five years. In the year 2006 the lending rate
and the deposit rate were low compared to that of the other 4 years. The lending rate and
deposit rate increased on 2007, this might have been because of changes in policies made by
government as these policies of government effect interest rates and that in turn affects the
inflation rates. In 2006, there was an increase in money supply and because of which general
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public were holding more money. Government might have wanted to control this situation
and might have wanted to control the money supply of Bangladesh and so might have
implemented contradictory monetary policy. By this policy, government of Bangladesh
decreased the money supply, though there was high demand for money. As a result of this
mismatch the interest rates have increased in 2007. Lending rate increased to 12.28% and
deposit rate increased to 6.51%. This indicates that in 2007, investors were discouraged to
invest due to increase in lending rates and on the other hand, depositors were encouraged to
deposit which was also due to increase in deposit rates. As investors were discouraged to
invest, investments in that year decreased which affected the income levels of the people of
the country. Income levels decreased as investments decreased, decreasing production and
increasing unemployment. This all lead to increase in price level, and that increased the
inflation rate in 2007 by a large amount, it rose to 9.1% which is a lot compared to the last
years. As inflation rate rose by a huge amount, this increased the general price level of
commodities in Bangladesh, which affected the international trading as well. Increase in
prices decreased exports, increased imports. People were buying imported goods as those
were cheaper compared to local goods. All these had combined effect in the GDP of our
country; it decreased to 6.3% from 6.65% in the last year. In the year 2008, the lending rate
and the deposit rates increased further which again decreased investments and increased
savings. As investments decreased this decreased the income levels as well, though inflation
decreased but it did not decrease by a significant amount, as a result GDP continued to
decrease and became 4.9% which indicates a significant amount of drop from 6.3% in 2007.
In 2009, the interest rates increased the most; lending rate became 13.36% and deposit rate
increased to 7.97% again indicating decrease in investments and increase in savings. Again in
this year inflation decreased but that did not lead to an increase in our GDP. This decrease in
GDP indicated that people were becoming more and more dependent on imported
commodities rather than domestic commodities. In 2010, some changes took place again, a
decrease in interest rates were seen. This might have been the result of changes in the policies
of government. This time maybe the government of Bangladesh wanted to increase the
money supply, which will increase investments and that might bring up the GDP rate. As the
GDP was continuously decreasing, government might have wanted to improve the overall
situation of the country. This time government might have implemented expansionary
monetary policy which increases money supply and decreases interest rates. So in 2010,
lending rate decreased to 12.75% and deposit rate decreased to 7.34%, this shows that people
then wanted to invest as the interest rates decreased a little bit and as the deposit rates
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decreased depositors were discouraged to save money. They wanted to invest rather than save
as that would have earned them more return. As investments increased, production increased,
employment opportunities were created as a result unemployment reduced increasing
employment rate. This all had an effect in the level of income, as investments were being
made, employment increased, so level of income also increased. Though in 2010, inflation
also increased to 8.1%, but this did not affect the GDP of Bangladesh that much as it
increased to 6% which was quite good compared to the last years. This might have happen
because of increase in investments, increase in consumptions, decrease in savings, increase in
income level, and decrease in dependence on foreign commodities, decrease in imports. So
from the above data, we can conclude that, government policies affect interest rates as
interest rates depend heavily on government policies and these interest rates make an impact
on inflation rates, income level and to the GDP of a country.

IRP, PPP, and IFE in context of BDT against

USD

Interest Rate Parity (IRP)

Derivation of IRP:

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End-value of a $1 investment in covered interest arbitrage = (1/S) (1+i ) F

F
= (1/S) (1+i ) [S (1+p)]
F
= (1+i ) (1+p)
F
In which, p is considered as the forward premium.

End-value of a $1 investment in the home country = 1 + i

Equating the two and rearranging terms:

p = (1+iH)

-1

(1+iF)

Forward = (1 + home interest rate) - 1

Premium

(1 + foreign interest rate)

When IRP is calculated certain factors are taken into considerations. They are:
1

Political Risks: Governments might bring some changes in terms of exchange in

currencies.
Different tax laws: Different countries have different laws, when laws vary, after tax
returns should be considered rather than before tax returns.

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Purchasing Power Parity (PPP)

Derivation of PPP:
Assumehome countrys price index (P ) = foreign countrys price index (P )
h
f
When inflation occurs, the exchange rate will adjust to maintain PPP:
P (1 + I ) (1 + e ) = P (1 + I )
f
f
f
h
h
Where,

I
h
I

inflation rate in the home country

inflation rate in the foreign country

% change in the value of the foreign currency

Since P = P and solving for e gives:

h
f
f
f (1 + Ih)

e=

(1 + If)
If I >I ,e > 0 (foreign currency appreciates)
h f f
If I <I ,e < 0 (foreign currency depreciates)
h f f

When the inflation differential is small, the PPP relationship can be simplified as
e I - I
f h
f

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Usually it has been seen that PPP does not occur. There are two possible reasons why PPP
does not occur. They are:
1

Confounding effects: This means not only interest rate differentials have effect on
exchange rates, but government policies, income levels also affect exchange rates. All
these variables together have a combined effect on exchange rate.

Lack of substitutes for traded goods: For example, there are no substitutes for oil,
so even if the price of oil increases people cannot stop buying it.

International Fisher Effect (IFE)

Derivation of IFE

Setting r = r : (1 + i ) (1 + e ) 1 = i
f h
f
f
h
Solving for e : f (1 + i ) _
h
f e=
1

(1 + if)

If i >i ,e > 0 (foreign currency appreciates)

h f f
If i <i ,e < 0 (foreign currency depreciates)
h f f

When the interest rate differential is small, the IFE relationship can be simplified as

e ~i - i
f h
f

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Since the IFE is based on PPP, it will not hold when PPP does not hold.
For example, if there are factors other than inflation that affect exchange rates, the rates
will not adjust in accordance with the inflation differential.

Effects of IRP, PPP, and IFE on BDT against

USD
Effects of PPP
Inflation rates from 2005 to 2010 in Bangladesh and U.S:
Year
2005
2006
2007
2008
2009
2010

Average Inflation in
U.S
3.4%
3.2%
2.8%
3.8%
-0.4%
1.6%

Year
2005
2006
2007
2008
2009
2010

Inflation in
Bangladesh
7%
7.2%
9.1%
8.9%
5.4%
8.1%

If two countries produce products that are substitutes for each other, the demand for the
products should adjust as inflation rate differ. From the table above of inflation rates of the
two countries we can see that the inflation rates of the U.S has been on the lower side
compared to Bangladesh inflation rates.
Now to explain the impact of PPP theory on both the countries lets look into the table. We
can see that, the inflation rates in U.S have decreased from 3.2% in 2006 to 2.8% in 2007,
decreasing by 0.4% whereas, in Bangladesh the inflation rates have increased from 7.2% in
2006 to 9.1% in 2007, increasing by 1.9% (we took the year 2007 as at that time Bangladesh
experienced the highest rate of inflation).
Under these conditions PPP theory suggests that the U.S dollars should appreciate by
approximately 6.3% (the difference in the inflation rates). Thus, the exchange rate should
adjust to offset the differential in the inflation rates of the two countries. If this occurs, the
prices of goods in the two countries should appear similar to consumers. That is, the relative
purchasing power when buying products in one country is similar to when buying products in
the other country.
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Year
2006
2007
2008
2009
2010

Lending rate
11.06%
12.28%
12.63%
13.36%
12.75%

Deposit rate
5.77%
6.51%
7.23%
7.97%
7.34%

Effects of IRP
Interest rates from 2005 to 2010 in Bangladesh and U.S
Rates in Bangladesh and U.S:

From the table and graph above we can see that in 2010, Bangladeshi taka exhibits an interest
rate on of 7.34% ( a 6 month interest rate) while, the U.S dollar exhibits an interest rate on
of 0.3% ( a 6 month interest rate). From a U.S investors perspective, the U.S dollar is the

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home currency. According to IRP theory, the forward rate premium of the taka with respect to
U.S dollar should be:
p=

[(1 + 0.003) / (1 + 0.0734)] -1

= - 0.065 or 6.5%
Thus, the taka should exhibit a forward discount of 6.5%. this implies that U.S. investors
would receive 6.5% less when selling taka 6 months from now (based on a forward sale) than
the price they pay for taka today at spot rate. Such a discount would offset the interest rate
advantage of the taka. If the takas spot rate is $.10, then a forward discount of 6.5% means
that the 6 month forward rates is as follows:
F = S (1+p)
= $.10 (1 0.065)
= $ 0.0935.

Effects of IFE
For showing the effects of IFE on Bangladesh and U.S we assume that:
The nominal interest rate is 8% in the U.S. investors in U.S. expect a 6% rate of inflation,
which means that they expect to earn return of 2% over one year. The nominal interest rate in
Bangladesh is 13% and the investors here also require a real return of 2%, the expected
inflation rate in Bangladesh must be 11%. According to PPP theory the Bangladeshi taka is
expected to depreciate by approximately 5% against the U.S. dollars ( as the Bangladesh
inflation rate is 5% higher). Therefore, U.S. investors would not benefit from investing in
Bangladesh because the 5% interest rate differential would be offset by investing in a
currency that is expected to be worth 5% less by the end of the investment period. U.S
investors would earn 8% on the Bangladeshi investment, which is the same as they could earn
in United States.

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Bangladesh Foreign Currency

Transfers/Remittances
Foreign investors are free to make investments in Bangladesh in the industrial enterprises
except for a few reserved sectors such as Arms and Ammunition, etc. An industrial venture
may be set up in collaboration with local investors or may even be wholly owned by the
foreign investors. Similarly, there is no restriction under the Foreign Exchange Regulations
Act on the import of securities into Bangladesh. However, no securities can be exported or
taken out of Bangladesh without general or special permission from Bangladesh Bank (the
central bank).
Bangladesh has seen a positive trend in foreign direct investment (FDI). A number of private
sector multinational corporations and local big business houses made major investments.
Private enterprises flourish when public policies, institutions, and activities provide an
attractive and equitable environment for private activities. All too often in the region,
however, the private sector is able to grow in spite of, rather than because of, the national
business climate. Thus, promoting private sector development requires finding a good
balance between the complementary functions of the state and the private sector.
In comparison with other developing nations, Bangladesh lags far behind in many key
indicators. There are wide allegations by the business forums regarding the bar on foreign
investment with capital outflow. They tend to pointing out the Foreign Exchange Regulation
Act, 1947 (FERA-1947) where local investors' foreign investment matter is not clear. The bar
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appears to be mainly to secure the foreign currency reserves in the country. Many developing
countries, however, allow local investors foreign investment with strict rules to ensure return
of the foreign currency in a given time.
Some of these regulations and facilitation from the FERA 1947 are as below:
Opening of Bank Account by a Foreign Investor
1

A non-resident may open with any Authorized Dealer (AD) branch of a bank Foreign
Currency (FC) accounts and Non-resident Foreign Currency Deposit (NFCD)
accounts with foreign exchange brought in from outside. Balances of these accounts

are freely transferable abroad.

A foreign investor may also open a Taka account freely with any bank while he is

resident.
A non- resident can open a Non-Resident Investors Taka Account (NITA) with any
AD in Bangladesh with foreign exchange remitted from abroad through normal
banking channel or by transfer of funds from the non-resident investors foreign
currency account for portfolio investment in Bangladesh.

Bringing in Cash from Abroad by a Foreign Investor

1
2

A foreigner can bring in foreign exchange in any form including cash without limit.
For amounts, in excess of US$ 5,000 a declaration on FMJ form is required to be

made to the Customs Authorities at the time of entry.

Amounts brought in may also be taken out freely, subject to production of declaration
where applicable.

Transfer of Capital and Capital Gains

1

The repatriation of sale proceeds (including capital gains) of shares of companies

listed in a Stock Exchange in Bangladesh may be made through an AD if such

investment takes place through NITA operation.

Remittance of sales proceeds of shares of companies not listed in a Stock Exchange
requires prior BB permission, which is accorded to for amounts not exceeding the net

asset value of the shares.

Transfer of shares and securities from one non-resident to another non-resident
requires no prior BB approval.

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Remittance of Royalty, Technical Know

1

Industrial enterprises may enter into agreements for royalty, technical knowhow,/technical assistance fees abroad if the total fees and other expenses connected

2
3

with technology transfer do not exceed:

a 6% of the previous years sales of the enterprise as declared in their tax return.
b Or 6% of the cost of the imported machinery in case of new project.
These agreements need however be registered with BOI.
Agreements not in conformity with these general guidelines require prior permission

of BOI.
Authorized Dealers may remit royalty, technical know-how/technical assistance fees
payable as per agreements subject to approval of Board of Investment.

Transfer of Profit and Dividend Accruing to a Foreign Investor

Profits:
Branches of foreign firms/companies including foreign banks, insurance companies and
financial institutions are to remit their post-tax profits to their head offices through ADs.
Dividends:
Remittance of dividend income to non-resident in respect of their investments in Bangladesh
may be made through an AD.
Local Borrowing
1

Bank may extend working capital loan or term loans in local currency to foreign
controlled or foreign owned firms/companies (manufacturing or non-manufacturing)

operating in Bangladesh on the basis of normal banker-customer relationship.

Banks are free to grant local currency loans to joint venture industries in EPZ up to
the amount of short-term foreign currency loans obtained from abroad.

Borrowing from abroad

1
2

Borrowing from abroad in foreign currency requires prior BOI approval.

Repayment of principal and interest of approved foreign currency borrowing may be

made through ADs as per agreed terms.

100% foreign owned and joint venture units in EPZs may, however, obtain foreign
currency loans from overseas banks and financial institutions without prior BOI or BB
approval.
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Joint ventures in EPZ cannot, however, create change on their assets favoring nonresidents.

Prior approval of Bangladesh Bank is no longer required for:

Remittance of profits to the head office of foreign investors.

Issuance of share to non-residents against investment in industrial setup in

Bangladesh.
Remittance of dividends on such shares to the non-resident investors.
Portfolio investment by non-residents including foreign individuals/enterprises in

shares and securities through stock exchanges on Bangladesh.

Remittance of dividend on portfolio investment by non-residents through stock

exchanges of Bangladesh.
Remittance of sale proceeds including capital gains.
Remittance of principal and interest installments on loan/suppliers credit obtained by

industrial
units from foreign lenders with approval of BOI.
Remittance in repayment of principal and payment of interest on such loans.
Remittance of royalty, technical know-how and technical assistance fees in

conformity to the BOI guidelines.

Remittance of savings of expatriate personnel, out of salary and benefits stated in BOI
approved contract, at the time of their leaving Bangladesh.

Export Encouragement Measures

Annual foreign exchange retention quota from exporter has been re-fixed at 40% of

FOB export earnings.

Retention quota for high import content exporters is 7.5% of FOB export earnings.
Exporters are allowed to keep foreign exchange retention quota in foreign currency

accounts in a bank in Bangladesh dealing with foreign currency.

Usage of funds of the retention quota of exporters in setting up offices abroad and
bonafide business expenses such as visit abroad, participation in export fair &
seminars, import of raw materials, machineries and spares etc. are allowed keeping
the bank informed.

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Bangladeshs Government Regulations on

power sector
Bangladesh's energy infrastructure is quite small, insufficient and poorly managed. The per
capita energy consumption in Bangladesh is one of the lowest (136 kWH) in the world.
According to a government assessment in 2006, the country's expected demand of power will
be 6,066 MW in 2009, 9,786 MW in 2015 and 13,993 MW in 2020.
Electricity is the major source of power for country's most of the economic activities.
Bangladesh's installed electric generation capacity was 4.7 GW in 2009; only three-fourth of
which is considered to be available. Only 40% of the population has access to electricity
with a per capita availability of 136 kWh per annum. Overall, the country's generation plants
have been unable to meet system demand over the past decade.
Present society demands electricity as its basic need in every moment. Future electric energy
demand data is an essential requirement for the expansion analysis of all sectors of a power
system.
Bangladesh faces one of the worst power crises of the world. The total demand for electricity
in the country is in fact less than the demand of a medium sized city in Europe. Power
Development Board (PDB) sources said while the official power demand was just 5000MW,
the unofficial demand was hovering around 6000 MW. The officially estimated power
demand is 5000 MW against a generation of around 3500 MW. Around 1500 MW power
could not be generated due to short supply of gas to many power plants.
A PDB official said the real power situation was worse than the official picture. The Rural
Electrification Board (REB) needs 2500 MW, but is given less than half of that. Dhaka
Electricity Supply Authority (DESA) and Dhaka Electric Supply Company (DESCO) need
more than 2000 MW power and the PDB needs another 2000 MW
This entire problem in power supply is created because of

Huge demand
Need big investment
Need technological expertise
Less manpower

If any MNC invest in power sector they could get more benefited rather than investing in
RMG.
Because to invest any RMG they have to have some portfolio could be very problematic for
any MNC. To understand a new culture and also to maintain a lots of portfolio could not be
easy for any new MNC. If they invest power sector there is a high possibility that our
electricity problem could solve, because they can invest a big amount, if they want can use
their own employee so they dont have to waste on manpower. They can also get some

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facilities which Bangladeshi governments are giving to any MNC company to invest
Bangladesh.
There are number of facilities and incentives would be provided to the foreign investors.
Some of them as follow:
Tax exemption on royalties, technical know-how and technical assistance fees, and
facilities for their repatriation.
Tax exemption on interest on foreign loans.
Tax exemption on capital gains from transfer of shares by the investing company.
Avoidance of double taxation case of foreign investors on the basis of bilateral
agreements.
Exemption of income tax for up to three years for the expatriate personnel employed
under the approved industry.
Remittance of up to 50% of salary of the foreigners employed in Bangladesh and
facilities for repatriation of their savings and retirement benefits at the time of their
return.
No restrictions on issuance of work permits to project related foreign nationals and
employees.
Facilities for repatriation of invested capital, profits and dividends

So we suggest MNC should invest in Power generate sector in Bangladesh. It can be

observed from the above discussions that there are some potentialities in doing business with
Bangladesh. Despite the negligible problems we think there is an ample scope for the MNC
to start Power generates business in Bangladesh. Present globalization process as well as the
favorable government policy will be helpful to the MNC in this regard.

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