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Submitted to: Dr. Mohammed Farashuddin Visiting Professor Submitted by: Rashed Al Ahmad Tarique ZR 61

BBA 16 Batch IBA, DU.

Introduction...................................................................................................................................... 2 The Policy Maker and Implementer .............................................................................................. 2 Forex Reserve Trends in the Decade ........................................................................................... 3 Determinants of the Foreign Exchange Regime.................................................................................. 4 Transition to a Floating System ..................................................................................................... 5 Diversification of Reserves................................................................................................................. 6 Buildup of Foreign Exchange Reserves ............................................................................................... 6 Foreign Exchange Reserve Management for Long-term Growth ........................................................ 8 List of References ............................................................................................................................ 11


Bangladesh is a very small player on the international market when it comes to international trade. Its trade volumes are minuscule compared to global players. So concentrating much effort on managing its foreign reserves may seem quite irrelevant as it matters little on a global scale. However, as people of Bangladesh it means the exact opposite for us. This is because unlike the United States or the Eurozone, a large number of giant economies would not place their significant weight behind propping it up. We as a country must see that our reserve levels are maintained so that we can display a clean bill of health to the global economy and grow at a sustainable rate by tapping into the global market. In this paper, we will look at who controls the foreign exchange policy, the foreign exchange reserves, how it is managed, what the optimal level of reserves ought to be and steps to be implemented in enabling sustainable growth in the economy through foreign exchange reserve maintenance.

The Policy Maker and Implementer

In Bangladesh, the Bangladesh Bank is in charge of formulating and implementing exchange rate policies and the official foreign exchange reserve holder. Towards liberalization of foreign exchange transactions, a number of measures were adopted since 1990s. Bangladeshi currency, the Taka, was declared convertible on current account transactions (as on 24 March 1994), in terms of Article VIII of IMF Article of Agreement (1994). As Taka is not convertible in capital account, resident owned capital is not freely transferable abroad. Bangladesh adopted Floating Exchange Rate regime since 31 May 2003. Under the regime, BB does not interfere in the determination of exchange rate, but operates the monetary policy prudently for minimizing extreme swings in exchange rate to buy and sale foreign currency in the spot and also in the forward markets. Bangladesh Bank Page avoid adverse repercussion on the domestic economy. In the forex market banks are free to

(BB) is empowered by section 7A of Bangladesh Bank Order, 1972 (Presidents Order No. 127 of 1972) to hold and manage the official foreign exchange reserve of Bangladesh. It maintains its foreign exchange reserve in different currencies to minimize the risk emerging from widespread fluctuation in exchange rate of major currencies and very irregular movement in interest rates in the global money market. BB has established Nostro account arrangements with different Central Banks. Funds accumulated in these accounts are invested in Treasury bills, repos and other government papers in the respective currencies. It also makes investment in the form of short term deposits with different high rated and reputed commercial banks and purchase of high rated sovereign/supranational/corporate bonds. Forex Reserve & Treasury Management Department of BB performs the operational functions regarding investment which is guided by investment policy set by the BBs Investment Committee headed by a Deputy Governor. The funds are invested to earn maximum returns at minimum risk.

Forex Reserve Trends in the Decade

The following table shows the levels of foreign exchange reserves over the fiscal years 2000-2001 to 2009-2010 (up to March 2010):
Fiscal Year 2009-2010 2008-2009 2007-2008 2006-2007 2005-2006 2004-2005 2003-2004 2002-2003 2001-2002 2000-2001 In million US $ 10142.00 7470.90 6148.80 5077.20 3483.80 2930.00 2705.00 2469.60 1582.90 1306.70


As observed from the above table, the foreign exchange reserves have grown almost tenfold over the last decade, considered by many as a remarkable achievement. Political governments have even gone towards great lengths in taking credit for the buildup of these reserves. They have labeled the foreign exchange reserve growth as a mark of core strength of the economy. While the Bank may have been benefited from strong remittance inflows from wage earning expatriate incomes that have managed to steam ahead at a break-neck pace and a government whose priorities were entrenched in building up a strong reserve (for political purposes or otherwise), the massive increases in the reserves allowed the Bank to play a much stronger role in the free-flowing floating market to maintain stable exchange rates, which certainly facilitated international trade to a great degree.

Determinants of the Foreign Exchange Regime

A number of factors affect the choice of foreign exchange policy by the central bank. Empirical results show that economic fundamentals, shocks, financial and political institutional variables provide relevant guidance for de jure whatever countries report to the IMF, despite reality - regime choices. However, various shocks lead countries to diverge from the de jure, fixed or floating regime, if they do not have strong financial institutions. During the period of divergence, countries undertake necessary financial reforms that help them converge to the de jure regime. This suggests that financial development is crucial for the sustainable choice of a fixed or a floating exchange rate regime. For example, countries with high unhedged foreign currency denominated debt or high exchange rate risk exposure have an incentive to peg even if they are officially floating. Inability to hedge, in turn, usually reflects the inability of these countries to borrow abroad in their own currency, also known as the original sin hypothesis. On the other hand, some countries are experiencing fear of pegginga fear that pegging would invite speculative attacks as a result of destabilizing misalignment. Liberalization of credit control, interest rate, entry barriers and privatization domestic financial sector leads to a better allocation of resources and makes the country Page process, are highly significant to the choice of a flexible regime. The liberalization of

more attractive to both domestic and foreign investors. Thus, intuitively, a more flexible regime is desirable in a more liberalized economy. But capital and current account liberalization has not been found significant to the regime choice. This result can be explained from two angles. First, this is possibly because, capital account liberalization and reversals become more likely with speculative attacks brought about by liberalizing capital restrictions. Second, the fact is that capital liberalization is possible under both fixed and floating regime. Among economic structural variables, while trade openness increases the chance for fixing exchange rate, per capita GDP growth, a proxy for economic development, calls for flexible exchange rate regime. The IMF programs often set some conditionality to reform domestic financial sector that the borrowing country must obey. Hence, the relationship between IMF programs and the choice of a flexible regime are consistent from financial liberalization perspective. From a political perspective, the more unpredictable the results of a general election, the more effect it has on the exchange rate and hence the greater the incentive for the central bank to influence the exchange rate and abide by the de jure policy.

Transition to a Floating System

Bangladesh stepped into the floating exchange rate regime at the end of May 2003 with the objectives of increasing the effectiveness of monetary policy on one hand and to avoid crisis associated with the fixed exchange rate regime on the other. Output growth in Bangladesh performed well in the intermediate and floating exchange rate regimes. Inflation is lower in the intermediate regime despite higher money supply and exchange rate depreciation. There is also evidence that currency depreciation boosted exports growth in the floating regime, though not in the prior contexts. After the float, Bangladesh Bank occasionally intervened directly in the foreign exchange market through sale and purchase of foreign exchange to maintain market stability. BB could also influence the market exchange rate of Taka by tightening or loosening the money market through the auctions of T-bills, repo and reverse repo transactions. During May 2003 the exchange rate moved up to 58.4 in June and the weighted average exchange rate Page (just before the float) the BDT-USD exchange rate was 57.4. After the transition on May 31,

remained below 58.7 for the rest of the calendar year. From June 03 to April 04, the BDT/USD exchange rate remained fairly stable experiencing a depreciation of less than one percent. Therefore volatility in the exchange market was effectively contained. The notable success of Bangladesh in keeping the volatility low immediately after the transition to floating exchange rate is striking, especially as it has been widely reported that exchange rate suffers significant increases in volatilities when adopting the floating regime. One possible explanation could be that Bangladeshs financial system lacks the features that usually cause exchange rate volatility in an industrialized economy like significant level of speculation or heterogeneity mainly due to a relatively small number of participants and low volume of transactions. Furthermore, to avoid any undue fluctuation in the foreign exchange market due to speculation, Bangladesh Bank withdrew necessary amount of liquidity from the money market using reverse repo immediately before moving toward the floating regime. Hence, the money market absorbed the pressure of the transition, with the call money rate shooting up briefly from the pre transition single digit levels to levels exceeding forty percent. The call money rate came back to single digit levels by the second week as the pressure on liquidity was eased with the exchange rate remaining stable. Therefore, the central bank did not need to run down its reserves; rather it could build up its reserve position through buying USD regularly from the market.

Diversification of Reserves
In order to avoid putting all its eggs in one basket, the central banks around the world tend to diversify their portfolio of foreign exchange reserves in a number of major currencies. These factors are based primarily on the exchange rate of the foreign currencies, financial and commercial links with the reserve currency countries. However, this process is gradual and the composition is constantly changing over the course of time, despite some experts suggesting a massive global change in the currency compositions.

Buildup of Foreign Exchange Reserves

Central banks in developing countries, wanting to devalue the domestic currency, to promote export, usually intervene in the foreign exchange market by buying up foreign inflationary pressures. Such interventions are usually effective in devaluing the currency but Page currency using domestic moneyoften backing this up with sterilization to counter

lead to a buildup of foreign exchange reserves beyond what the central bank may need. Here bigger is not always better because the funds trapped in the reserve may have been put to some better use somewhere else in the economy. So a different strategy is proposed in a study by Kaushik Basu called Strategic Price Intervention. The BB would could call a public-sector bank and offer the bank X Takas for every dollar, where the X here is the same u that the large forex dealers earn as revenue from each dollar that they acquire. In other words, the central bank puts a public sector bank on par with a forex dealer. What this simply means is that the forex market functions exactly like before but with n + 1 strategic agents the n dealers and 1 bank which now plays like a dealer. It follows from standard industrial organization theory that this will raise the price, i.e. the exchange rate without building up the reserves excessively. The following strategies have been suggested in literature: o Reserves equal to short-term external debt: Countries that may be vulnerable to a capital account crisis can benefit from holding reserves sufficient to cover all debt obligations falling due within the coming year. This benchmark, known as the Greenspan-Guidotti rule, is the most widely preferred benchmark for measuring vulnerability to capital account crisis, and its relevance to currency crisis prevention has the strongest empirical support. o Reserves equal to roughly 5-20 percent of M2: Economies that need to shore up confidence in the value of local currency and reduce the risk of capital flight may find this benchmark useful. Less flexible exchange rates necessitate higher reserves relative to M2. o Reserves equal to three or four months of imports: This benchmark is especially relevant to low-income countries exposed to current account shocks and without significant access to capital markets.

Holding reserves beyond the recommended benchmarks will, other things equal, probably reduce an economys vulnerability to financial crisis. with holding reserves include: But it will do so with diminishing marginal benefit and rising marginal costs. Though difficult to quantify, the costs associated Page

Sterilization costs:

Sterilization neutralizes the inflationary monetary impact of

reserve accumulation, typically by domestic debt issuance to offset the associated increase in money supply. If the interest rate for domestic borrowing exceeds the interest rate on reserves, the direct fiscal costs may be significant. In addition, the economy may incur indirect systemic costs because sterilization allows a central bank to influence the real exchange rate and hence disrupt appropriate current account adjustment. o Opportunity costs: Alternative uses for foreign exchange reserves may yield greater returns examples include prepaying external debt and undertaking public investment projects. If reserves exceeding the level or ratio indicated by adequacy benchmarks were put to alternative uses with returns only three percent higher than current risk-free reserve assets, benefits could be as much as one percent of GDP each year. o Balance sheet risks: If the local currency appreciates, the local value of international reserves decreases. Although some monetary authorities may average these losses out over time, other central banks may realize significant balance sheet losses. Even if the central bank is able to recapitalize from retained profits and is not directly affected by losses, those retained profits represent revenue forgone by the treasury. Reserves in most of these countries are several times central bank capital and more than ten percent of GDP, so the magnitudes of potential losses are significant. o Other costs: If reserves create a false sense of security, the incentive to tackle difficult reforms may be reduced. Rapid reserve accumulation may also complicate the formulation of monetary policy under flexible exchange rates. In light of the potential cost of holding reserves, in situations where reserves far exceed commonly accepted adequacy levels, questions can arise about the necessity and wisdom of adding further reserves to existing stocks.

Foreign Exchange Reserve Management for Long-term Growth

Page Studies suggest that the accumulation of foreign exchange reserves (FER) contributes to economic growth of a developing economy by increasing both the domestic and foreign

direct investment/GDP ratios as well as the share of exports in GDP. Permanent FER accumulation influences economic growth through two different mechanisms, each of them dominates at different stages of development. After the early stage of industrialization is finished and the manufacturing sector is ready to compete in the world market, FER accumulation causes real exchange rate undervaluation that allows full advantages of export externality and triggers export-led growth. Export expansion facilitates knowledge transfer and creates incentives for improvements of production quality. At the same time, real depreciations result in a substitution of imports by domestic production that may be advantageous due to learning by doing externality, if the country dependence on imports is weak. At the later stage, FER build up attracts foreign direct investment because it increases the credibility of the government of a recipient country and lowers the dollar price of real assets. If the net inflow of FDI is larger than the increase in FER, or if the FDI externality is strong enough, then growth acceleration may be reached inspite of overvaluation of the real exchange rate. Whereas it is widely recognized that devaluation can increase output in the short run, bringing actual output above the potential level, it is generally assumed that in the long-term growth rates of output do not depend on the exchange rate. On the contrary, the exchange rate itself in the long run is considered as an endogenous variable determined by the growth rates of prices and outputs in trading countries. Nevertheless, there is strong empirical evidence that the accumulation of foreign exchange reserves may lead to lower exchange rates, which in turn stimulate export-led growth. Countries with rapidly growing FER/GDP ratios, other things being equal, exhibit higher investment/GDP ratios, higher trade GDP/ratios, higher capital productivity and higher rates of economic growth. First, accumulation of foreign exchange reserves has the conventional short-term expansionary effect relative prices of tradables increase with respect to prices of non-tradables and wages. In

the long run this effect disappears as increased profits are invested and lead to increased demand for non-tradables and labor. But if there are subsequent unexpected rounds of FER build up, the long-term growth rates may increase. Second, undervaluation of the currency stimulates the increase in exports. This increase in exports raises accumulated knowledge due to learning from external trade and therefore economic productivity as well. The rate of growth rises and this Page outweighs the potential gain from spending reserves for current needs. Third, undervaluation lowers foreign currency prices of domestic real assets and thus attracts foreign direct investment.

Besides, continuing FER build up (especially in periods of trade deterioration) gives a powerful signal to investors that the government is in full control of the situation and can afford costs for the sake of pursuing a consistent policy. Even if FER accumulation outweighs the FDI flow, FDI externalities may be strong enough to accelerate growth. For obvious reasons technologically backward countries have much more to gain from export externality and from the inflow of foreign direct investment. That is why the benefits of reserve accumulation should be especially promising for developing countries.



List of References Bangladesh Bank Information and Public Relations Division Institutional Development and the Choice of Exchange Rate Regime: A Cross-Country Analysis - Monzur Hossain An Analysis of Bangladeshs Transition to Flexible Exchange Rate Regime - Sayera Younus, and Mainul Islam Chowdhury Are High Foreign Exchange Reserves in Emerging Markets a Blessing or a Burden? Russell Green and Tom Torgerson Capital flows and financial assets in emerging markets: determinants, consequences and challenges for central banks - Muhammad Al-Jasser and Ahmed Banafe The Mechanics of Central Bank Intervention in Foreign Exchange Markets - Kaushik Basu Recent Monetary Policy Statement of Bangladesh Bank (July 2009): An Analytical Commentary - Debapriya Bhattacharya and Towfiqul Islam Khan Foreign Exchange Reserves, Exchange Rate Regimes, and Monetary Policy: Issues in Asia - Akiko Terada-Hagiwara Foreign Exchange Reserves and InfIation: an Empirical Study of Five East Asian Economies - Mei-Yin Lin and Jue-Shyan Wang Accumulation of Foreign Exchange Reserves and Long-Term Growth - Victor Polterovich and Vladimir Popov FX reserve management trends and challenges - Claudio Borio, Gabriele Galati and Alexandra Heath The fuss about foreign exchange reserves accumulation - Charles Wyplosz Foreign exchange reserves - how much is enough? - Marion V Williams Are Developing Asias Foreign Exchange Reserves Excessive? An Empirical Examination Donghyun Park and Gemma B. Estrada The Currency Composition of Foreign Exchange Reserves: Retrospect and Prospect Barry Eichengreen and Donald J. Mathiesen The Social Cost of Foreign Exchange Reserves- Dani Rodrik