CHAPTER 9

BALANCE OF PAYMENTS
“Unsustainable situations usually go on longer than most economists think possible. But they
always end, and when they do, it’s often painful.”- Paul Krugman.
Chapter learning Objectives:
 To discuss the structure of Balance of Payments (BOP) with a main focus on current account.
 To discuss how Balance of Payments behave under different exchange rate system.
 To understand the pros and cons of having Balance of Payments deficit or surplus.
 To know the historical trends of Balance of Payments of Bangladesh.
 To know about the real accounting method and format used to calculate the Balance of
Payments in Bangladesh.
 To gain an in-depth knowledge about how different accounts are recorded, calculated and
what are their impact in the overall Balance of Payments.
 To gain knowledge practically through analysis of the year to year up and down of the
Balance of Payments.
 To understand the policies required to implement in order to improve balance of payments.
Concepts and Definition:
Definition: The balance of payments in Bangladesh is defined in "Annual Balance of Payments"
as a statistical statement for a given period showing: (a) transactions in goods, services, and
income between the Bangladesh economy and the rest of the world; (b) changes in the economy's
monetary gold, Special Drawing Rights (SDRs), and claims on and liabilities to the rest of the
world; and (c) transfers and counterpart entries that are needed to balance, in the accounting
sense, any entry for the foregoing transactions and changes that are not mutually offsetting.
Balance of payments data are compiled and disseminated on a monthly, quarterly, and annual
basis by the Bangladesh Bank (BB) in accordance with the principles and methodology
recommended in the fifth edition of the IMF "Balance of Payments Manual" (BPM5). So,
Balance of Payments is a record of official estimates of all transactions between a country with
the rest of the world during a given year. It shows the sum total of all external transactions
arising from export and import of goods and services and transfers, such as remittances and
capital inflows and outflows (transactions on capital account).
STRUCTURE OF BALANCE OF PAYMENTS
The IMF classifies balance of payments transactions into five major groups:
A: Current Account
B: Capital Account
C: Financial Account
D: Net Errors and Omissions
E: Reserves and Related Items
A. Current Account consists of:
 Goods (exports and imports).
 Services (earning and expenditures for invisible trade item).
 Income (on investments).
 Current Transfers like workers remittance.
B. Capital Account consists of:
 Capital transfers (transfer of title, fixed assets, etc.)
 Acquisition or disposal of non-produced, non-financial assets, sale or purchase of non-
produced assets (rights to natural resources, patents, copyrights, trademarks, and leases).
C. Financial Account consists of:
 Foreign direct investments (FDIs).
 Foreign portfolio investments.
 Other investments.
D. Net Errors and Omissions:
 This is a plug item designed to keep the balance-of-payments accounts in balance.
E. Reserves and Related Items: Group E, Consists of:
 Official reserve assets
 Use of IMF credits and loans
 Exceptional financing
Since Balance of Payments will always balance that means all five major groups will sum up to
zero.
Current account + capital account + financial account + net errors and omissions +
reserves and related items = 0 or equation wise;
CuA + CaA + FiA + NEO + RR = 0.
Balance of Payments history of Bangladesh
The Bangladesh Bank prepares balance of payments positions (BOP) of the country following
the IMF Balance of Payments Manual. The data are derived from various sources such as
foreign exchange transaction records of authorized dealers, documents of the Ministry of Food
on import of food grain by the government, documents of Ministry of Finance on imports
financed through foreign loans and grants, and custom records for the preparation of BOP. The
deficit in the current account of balance of payment in 1972-73 was $370 million. It rose to a
record level at $1,003 million in 1974-75 or 7.08% of GDP.
Bangladesh received a substantial amount of assistance under various facilities of the
International Monetary Fund to correct her balance of payment disequilibrium position. The
amount drawn by Bangladesh from IMF under a stand-by arrangement in June 1974 and July
1975 stood at SDR 93.75 million. Bangladesh received SDR 62.50 million under Compensatory
Financing Facility for export shortfall in December 1972. This stand-by programme was
attributed to declines in the current account deficit of $881 million or 12.33% of the GDP in
1975-76, to $439 million or 6.42% of the GDP in 1976-77.
Devaluation of Bangladesh currency in terms of US dollar by 61% in May 1975 and further, by
10% and 11% within June to December 1975, and January to December, 1976, had a positive
impact on the balance of payments situation of the country. Bangladesh also undertook other
internal corrective measures during that period like adoption of restrictive monetary and fiscal
policies. These were reflected in the raising of bank rate from 5% to 8%, reduction of subsidies,
and upward adjustment of prices of some public utilities. Along with these measures, policies
for export promotion and import substitution were undertaken by the government to correct
imbalances in payments situation.
The current account deficit of BOP of Bangladesh reached $1,436 million or 11.23% of the GDP
in 1979-80, but gradually declined to $1,055 million or 6.85% of the GDP in 1985-86, and
further to $981 million, or 4.19% of the GDP in 1990-91. Bangladesh's drawings from the IMF
continued to increase. These drawings during the period from 1976 to 1982 amounted to SDR
689.39 million under various facilities viz., Compensatory Financing Facilities, Oil Facilities,
Trust Fund Facilities, Stand-by Arrangements and Extended Fund Facilities. The adjustment
policies that Bangladesh pursued under various facilities of the IMF brought about some positive
changes in the economy. The aggregate demand management policies initiated by IMF through
streamlining fiscal and monetary systems proved largely successful. The exchange rate and
interest rate policies of Bangladesh brought about positive results. The Fund's arrangements for
high conditional loans also worked as a 'seal of approval' for enhanced foreign assistance to
Bangladesh. Bangladesh entered into Structural Adjustment Facility with IMF in February 1987
and into Enhanced Structural Adjustment Facility in August 1990 to improve her balance of
payments position. Bangladesh also received emergency assistance from IMF in November
1998.
The current account deficit during the 1990s did not pose a serious problem for Bangladesh. The
deficit in the current account declined from $981 million, or 4.19% of the GDP in 1990-91, to
$664 million, or 2.28% of the GDP in 1994-95, but rose to $1,291 million, or 4.05% of the GDP
in 1995-96. Thereafter, this deficit continued to decline till 1999-2000. Notable developments
that have taken place in Bangladesh during the 1990s include a continued trade liberalization
policy and implementation of the Financial Sector Reforms Programme. A liberal Import Policy
Order for 1995-97 was put into effect to remove quantitative restrictions on imports. A fairly
liberal five-yearly trade policy became effective from July 1998. Average nominal tariff rate
declined from 57% in 1991-92 to 20% in 1997-98 and further, to 16% in 1999-2000. The highest
decline in tariff rate was from 90% in 1991-92 to 37.5% in 2000-2001.
Despite liberalization of import trade of the country, improvements in current account deficit
continued during the late 1990s due mainly to increase in export receipts, decline in deficits in
services account, and increase in wage earners remittances. The net position under services'
account became positive in 1996-97 and continued to be so till 1999-2000. The wage earners
remittances recorded increase from $555 million in 1985-86 to $764 million in 1990-91, to
$1,217 million in 1995-96, and further to $1,947 million in 1999-2000.
Items 1974-75 1980-81 1985-86 1995-96 1998-99
Import 1232 2687 2364 6947 8018
Export   353 820 909 3884 5324
Trade Balance   -879 -1867 -1455 -3063 -2694
Current Account Balance   -1003 -1428 -1055 -1291 -394
IMF Account (Net) -28 -66 27
a) SDR Purchase   92 138
b) SDR Repurchase 120 66 111
Source: Bangladesh Bank
Table 9.1: Balance of Payments of Bangladesh (in million US dollar)
CURRENT ACCOUNT BALANCE
In economics, the current account is one of the two primary components of the balance of
payments, the other being the capital account. The current account is the sum of the balance of
trade (exports minus imports of goods and services), net factor income (such as interest and
dividends) and net transfer payments (such as foreign aid). One may refer to the  list of countries
by current account balance.
It can also be said “A record of a country's earnings from the sale of visible and invisible items
minus its expenditure on visible and invisible items from abroad”.
Current account balance (% GDP) for the last 20 years of Bangladesh are given below
Year Current Account Balance
1990 -3.1
1991 -1.1
1992 0.4
1993 0.4
1994 -0.9
1995 -2.3
1996 -2.4
1997 -1.534
1998 -1.05
1999 -0.875
2000 -1.44
2001 -0.912
2002 0.336
2003 0.323
2004 -0.322
2005 0.012
2006 1.172
2007 1.121
2008 1.915
2009 2.86
2010 0.46
2011 -0.91
Balance of payments data are based upon the methodology of the 5th edition of the International
Monetary Fund's Balance of Payments Manual (1993).
Source: (1) Economy Watch
(http://www.economywatch.com/economic-statistics/country/Bangladesh/)
(2) Bangladesh Bank
Bangladesh balance of payments after 2001 was positive except in 2004 when it has
experienced a negligible deficit. From July 2009-June 2010, the overall balance of payments
surplus was approximately $2.87 billion but things got changed very quickly after that fiscal
year, given a higher trade gap between export and import bills (due to rise in petroleum prices,
soya beans, cotton and rise in capital machinery prices), lower growth in inflow remittances,
less FDI inflow and larger outflow of portfolio investments. Even though Bangladesh escaped
the deficit narrowly in July 2010-June 2011 fiscal year but it is expected this current fiscal year
of July 2011-June 2012, Bangladesh will experience a balance of payments deficit.
Factors responsible for deficit in BOP of Bangladesh
Here are few reasons behind the balance of Payments deficit in Bangladesh:
 Industrial backwardness
 Lack of export growth
 Excessive import of luxury goods
 Lack of diversification on export products
 Too much concentration on EU and USA market
 Deteriorations in the terms of trade
 Mounting debt problem
 Higher inflation
 Poor infrastructure
 Low workers’ productivity
 Dependency on importation of wheat, soya-beans etc.
 Lack of natural resources like petrol, iron etc.
Problem 9.1: Find out the balance of trade and balance of current account, if we have: inflow on
account of services: $10,000 m; outflow on an account of services: $8000 m; outflow of dividend
royalty, etc. $11,000 m; inflow of dividend, etc. $5,600 m; exports of goods: $100,000 m;
imports of goods: 120,000 m; net remittance: 12,000 m.
Solution: $ in millions
Imports - 120,000
Exports 100,000
Balance of trade - 20,000
Services (net) {$10,000-$8,000} 2,000
Investment income (net) {$5600-$11,000} -5,400
Remittance (net) 12,000
Balance of current account - 11,400
So, we have a current account deficit of $11,400 m.
Problem 9.2: Find out the balance of capital account, if: inflow of loans: $12000 m; repayments
of loan: $13,150 m; FDI inflows: $7,000 m: FDI outflow: $1,500 m; short term movement of
funds: -$1200 m.
Solution: $ in millions
Loan (net) {12000-13150} -1150
FDI (net) {7000-1500} 5500
Short term funds -1200
Balance of capital account $3150 m
Problem 9.3: Find out the amount of foreign reserves in Bangladesh on 30.06.2011, if:
Foreign exchange reserves on 30.06.2010: $10.4 billion
Balance of current account during 2010-2011: -$2.1 billion
Balance of capital account during 2010-2011: $800 million
Balance of financial account during 2010-2011: $300 million
Statistical discrepancy during 2010-2011: -$600 million
Solution:
$10.4 billion + (-$2.1 billion) + 0.8 billion + 0.3 billion + (-$.6 billion) = $8.8 billion.
Balance of payments under fixed and floating Exchange rate system
Under the fixed exchange rate system it is difficult to pursue an effective monetary policy
because any changes in interest rates or money supply will lead to inflows or outflows of
currency and increase pressure on the currency either devalue or revalue it. If the government
tries to keep the value of the currency unchanged then have to change the money supply
accordingly which will affect the interest rates. So under the fixed exchange rate monetary policy
is quite ineffective. But a fiscal policy is more effective. If the country is facing current account
deficit, to discourage imports, the government could deflate the economy through higher taxes
and less government spending. This will eventually reduce aggregate demand and lead to lower
demand for money and lower interest rates. So import will fall and thus current account balance
will improve.
Under the floating exchange rate system monetary policies are more effective. If a country is
facing a current account deficit the monetary policy makers (normally the central bank authority)
will follow a contractionary monetary policy. A contractionary monetary policy either increases
interest rates or cutting the money supply or a combination of both will lead to lower
consumption (foreign goods as well) and investment and thus lower aggregate demand. A lower
value of the currency will help to export more and import less and thus improves the balance of
payments. On the other hand, fiscal policy under the floating exchange rate system is less
effective. When a country faces a current account deficit the government may raise the taxes or
cut the government expenditures to reduce the aggregate demand but a depreciated currency may
already caused a higher inflation which will force the interest rates to jump up high. So it may be
difficult for the government to reduce spending or raise taxes.
Pros and Cons of deficit and surplus on the current account:
When a country is spending more on foreign goods and services than earning from them
(including remittance) we say the country is facing a current account deficit that means more
money is leaving the country than entering in the economy.
If a country experiences current account deficit for longer period of time then it may create
problems with the competitiveness of that country’s industries. In this world, United States is
facing the highest current account deficit which is almost a trillion dollar. As we know a current
account deficit is usually offset by the surplus of capital and financial account. But when we look
at exchange rate regime it is believed a continuous current account deficit is only possible under
the fixed exchange rate system. Because when a country fixed her currency against another
currency obviously so many other variables change over time which will either undervalue or
overvalue the currency but it cannot correct the market equilibrium value due to rigidity in fixing
the value. But under a floating exchange rate mechanism if a country is facing a current account
deficit, this deficit may be offset by inflows on the capital and financial account or the
government may have to intervene to buy up excess currency. So under the floating exchange
rate system the external value of the currency will fall making export competitive again and
import less attractive. So when U.S was having a huge trade deficit with Japan it was expected
the Japanese yen will appreciate against the USD and thus American made products became
cheaper in international market and made in Japan products more expensive. So Americans will
buy less Japanese goods whereas Japanese will buy more American goods and thus trade gap
between U.S and Japan will narrow and exactly this is what we have observed over the past 20
years where the value of Japanese Yen against US$ has continuously appreciated. But when it
comes to China who has a pegged exchange rate mechanism against US$ that means Chinese
Yuan won’t appreciate against US$ since it is pegged and fully managed by the Chinese
government. That’s why we see American politicians always scream by blaming China that it
has intentionally kept her currency value underpriced since China doesn’t follow a floating
exchange rate system.
As we know now U.S.A is the largest borrower (debtor) and China is now the largest lender
(creditor) the question arises whether a current account deficit or surplus is all good or bad.
A current account deficit (i.e. USA) is a problem for the following reasons:
1. If a country runs a current account deficit then it must have to make sure it is capable of
financing it by having a capital and financial account surplus. For U.S.A, so far it has not
been a problem yet to finance the current account deficit since U.S Treasury bonds are still
very attractive for foreign investors but the question is how long can the attraction last?
2. Under the floating exchange rate mechanism, a country cannot run current account deficit
forever since a deficit will translate the depreciation of that country’s currency as we have
seen in the case of Japan where US$ has steadily depreciated against Japanese Yen and thus
Americans cut the demand for made in Japan’s products and services. But under the
fixed/pegged exchange rate system like China it is not that simple.
3. If a country is spending more on foreign goods and services than earning then it will
experience a lower employment at home since the goods purchased from China will create
jobs in China; not in USA.
4. From the analysis of past financial crisis it has been noted that running a deficit for longer
period of time is like inviting financial trouble. It is at first will force the country to devalue
or depreciate their currency to make export more attractive but once the country enters that
path of devaluation or depreciation it may cause a self-fulfilled prophecy which will cause
more reduction in the value of their currency and thus a cut of their purchasing power of their
residents and lower standard of living.
A current account surplus (i.e. China) is a problem for the following reasons:
1. One country’s surplus (China) is another country’s deficit (USA) and thus the country with
the deficit (USA) may introduce methods of protectionism to discourage imports.
2. An increase in the demand for products of a country leads to an increase in the value of
currency under floating exchange rate thus making the country uncompetitive in the world
market.
3. Under the fixed exchange rate or pegged exchange rate like China, a current account surplus
will increase the domestic money supply, which may lead to high inflation since the country
is not appreciating the value of their currency. For example, if China appreciates her currency
Yuan 10% then Chinese residents could get foreign goods 10% cheaper and thus will help to
lower domestic inflation.
4. Since current account surplus means capital and financial account deficit that means capital
will outflow from China and Chinese foreign reserves will increase which must be kept either
in US$, gold, Euro, Pound or Special Drawing Rights (SDR). So this huge Chinese reserves
of U.S treasury bonds pose a real threat to the capability of U.S government to pay it and for
that we have seen U.S sovereign credit rating has been cut from AAA to AA+ by Standard
 and Poor’s and Chinese authority is not quite sure how to safeguard their hard earned foreign
currency now.
Policies to improve the Balance of Payments
How to Reduce a Trade Deficit: There are ways for a country to reduce her trade deficit. It may
take some short term measures to mid and long term policies to improve the BOP. For example,
Deflate the Economy
A tight monetary and fiscal policy will reduce inflation and income. This leads to increased
exports and reduced imports, which, in turn, improve the trade balance. In action, this means the
country should control government budget deficits, reduce the growth of the money supply, and
institute price and wage controls.
Devalue the Domestic Currency
A devalued currency against the currencies of major trading partners will reduce a trade deficit.
This is because currency devaluation will make imported goods more expensive and exported
goods less expensive. But this will not work if:
1. There is no strong foreign demand for discounted priced exports.
2. If domestic companies do not have the spare capacity to produce more exports.
3. If other competing countries also devalue their currency.
4. If domestic residents buy imports, even at higher prices.
5. If middlemen do not pass the price changes to customers.
Establish Public Control
There are two types of public controls: foreign exchange controls and trade controls.
1. Under foreign exchange controls, a country forces its exporters and other recipients to sell
their foreign exchange to the government. This foreign exchange is then allocated to various
domestic users.
a. This restricts the country’s imports to a certain amount of foreign exchange earned by the
country’s exports.
b. This lowers the amount of imports.
2. Under trade controls, exports and imports are manipulated through tariffs, quotas, and
subsidies.
a. These measures can be used to lower the level of imports.
b. On the other hand, these measures may also lead to increased inflation, eroded purchasing
power, and a lower standard of living and also invite a trade war with other trading partners.
J-Curve
The J-curve is an economics term that describes the relationship between the trade balance and
currency devaluation. The J-curve shows that a country’s currency depreciation causes its trade
balance to deteriorate for a short time, followed by a flattening out period, and then ending with
a significant improvement in the long run. The typical time lag is 18 months, and empirical study
finds the J-curve effect in about 40% of cases.
The J-curve depicts the lag between the currency depreciation of a country and the improvement
in its trade balance. According to J-curve, when a country’s currency depreciates trade balance
worsens at first because the cost of previously ordered imports rises, while the home currency
price of previously ordered exports remains the same but gradually trade balance starts to
improve as lower cost of exports stimulate foreign demand while the demand for imports
declines due to higher prices of foreign made goods. For example, our currency in the beginning
of 2011 was around 70 BDT per USD what has depreciated to around 78 in the month of
November of 2011. So for us we have to pay the higher prices for the imported goods like what
we bought for $1 now importers will pay 78 TK instead 70 whereas the exporter will earn $1. So,
a higher import bill but unchanged export earnings will worsen the trade balance but as time
progress foreigners will find our 70 TK product not $1 anymore but only around $0.875 so they
are getting around 12.5% discount and thus a sharp rise in export order whereas our citizens will
find the same foreign products which was only 70 TK now it is 78 TK which will force some of
them to substitute foreign made goods to home made goods and thus a lower demand for foreign
imports. In the long run, we will see the trade balance improves gradually but we must keep in
mind whether only our currency has depreciated or our competitors did the same thing as well.
For example, if Pakistani Rupee depreciates 20% against USD at the same time then J- Curve
won’t be applicable for us to that situation since 20% discounted Pakistani products would be
preferred by foreigners more than 12.5% discount on Bangladeshi products.
Change in Trade balance
+ J-curve

Trade balance
eventually improves

Currency devaluation

0 Time

Trade balance initially deteriorates

--
Diagram 9.1

Marshall Lerner condition

Marshall Lerner condition is the minimum necessary condition in order for a country to devalue
her currency to improve her balance of payments. It is the sum of price elasticity of exports and
price elasticity of imports which must be greater than one to have a net positive effect on BOP.
The bigger the sums of these two are, the bigger the improvement of the balance of payments
account. For example, if Bangladesh wants to lower the value of Taka we must calculate the sum
of price elasticity of exports and imports and then if it comes more than one only then it could be
justified since balance of payments will improve. A devaluation of taka means a reduction in the
price of exports, quantity demanded for these will increase and at the same time, price of imports
will rise and their quantity demanded will diminish. The net effect on the trade balance will
depend on if goods exported are elastic to price means more sensitive to price changes to demand
increases for example, a 10% discounted products has increased a 20% rise in demand then total
export will rise. Similarly, if goods imported are elastic to price translates that a 10% rise in
foreign imports have caused 20% drop in demand of foreign made goods then in both cases it
will help improve the trade balance. If they are not price elastic then a 10% cut in prices will
cause only say 5% rise in quantity demanded and taka’s devaluation won’t be a wise decision in
that situation. Besides most of the products that we purchase from international market like
petrol, soya beans, wheat, cotton etc. are price inelastic which means even the price of these
commodities rises we have no other alternative but to import since we are totally dependent on
imports. So a rise in prices of these commodities won’t cut the demand as much and so a
stronger currency could well help us to get it cheaper. But for a country like China who has a
trade surplus a weaker currency give them a competitive edge in the global trade which makes
their products even more cheaper and thus raise their trade surplus further.
Importance of Remittance for Bangladesh
In general Remittance means a payment of money sent to a person in another place. In another
sense Money (or its representative, as a bill of exchange or draft or other order for money)
forwarded from one place to another is known as remittance; also, the act of forwarding it is
remittance.
It can also be said as Funds forwarded from one person to another. But in economics and
finance, remittance means when a citizen who lives in a foreign country sends money to his
motherland. In Bangladesh, inward remittance plays a vital role in financing the huge trade
deficit since the amount is more than $12 billion in 2011-2012 fiscal year. As from the data
below, we can see a healthy growth rate in remittance inflow until 2010 but currently it has
shown a steady rise again and in the first quarter of 2012-2013 fiscal year it has jumped more
than 20% which has helped the foreign reserve to cross the $12 billion mark but due to global
financial state and middle-east unrest it hasn’t grown as much in 2011 and some of the major
manpower exporting countries like Malaysia, Saudi Arabia, UAE and Kuwait has stopped taking
our nationals to work in these countries. It should be our government’s one of the highest priority
to open up these economies for our citizens since remittance play a crucial role in financing our
huge trade deficit and help us to build a healthy foreign reserve to absorb any negative impact
our economy may face in near future.
Since we have more than $8 billion dollar trade deficit which means we import that amount more
than export which requires financing and the handsome amount of remittance has helped us to
finance this huge trade deficit without resorting to finance externally like IMF. So, remittance
played a vital role in stabilizing the value of our currency along with helping Bangladesh Bank to
manage currency valuation to pursue other economic objectives more effectively. Government
and other concerned authority must take necessary effort to stop illegal money transfer like
‘Hundi’ and inspire expatriates to remit their hard foreign currency through the proper banking
channels to be included in the balance of payments of Bangladesh.
Twenty two years Remittance of Bangladesh is given below:

Year Remittance Year Remittance

(US$ million) (US$ million)

1990 781.54 2001 2,104.50
1991 769.3 2002 2897.76
1992 901.97 2003 3226.18
1993 1009.09 2004 3517.76
1994 1153.54 2005 4178.82
1995 1201.57 2006 5425.98
1996 1355.34 2007 6570.96
1997 1525.03 2008 9258.6
1998 1599.24 2009 10104.96
1999 1705.74 2010 10987.4
2000 1949.32 2011 12843.4
Source: Bangladesh Bank
Trends of Remittance in US$(million)

Balance of Trade:
The difference between the value of goods and services exported out of a country and the value
of goods and services imported into the country. The balance of trade is the official term for net
exports that makes up the balance of payments. The balance of trade can be a surplus which
translates export amount is bigger than import amount and is considered favourable whereas an
unfavourable trade balance is trade deficit where export amount is less than import bills. The
official balance of trade is separated into the balance of merchandise trade for tangible goods and
the balance of services.
Balance of trade = Dollar price of exports X Quantity of Exports – Dollar price of Imports X
Quantity of Imports
Financing the Current Account Deficit:
A country running a current account deficit automatically implies running a capital account and
financial account surplus. The larger the current account deficit, the larger the capital and
financial account surplus. So a country like USA who has got a huge current account deficit
automatically translates they must run almost the same size capital and financial account surplus.
Otherwise, it won’t be possible for them to finance the trade. Now if still after that a country is in
deficit balance then they have to use their foreign reserve or sale of foreign assets to finance the
deficit. For a third world country like Bangladesh when it runs current account deficit most of
the time it seeks IMF’s help to stabilize the balance of payments. Bangladesh Bank has recently
secured almost $1 billion dollar IMF soft loan to negate any immediate impact on our balance of
payments. The other thing a country can do is to use her foreign currency reserve as we have
done it over the last few quarters and that’s why our foreign reserve has dwindled from over $11
billion to now below $10 billion (Jan 2012). Another way is to attract more FDI and portfolio
investments which will help stabilize the balance of payments along with inspiring Bangladeshi
expatriates to send more money to Bangladesh. One of the last resorts is to find a friendly
country that may be willing to lend us soft loan.
Sovereign Rating: It is a rating given to a country by an international rating agency (Moody or
Standard and Poor). The rating captures a country’s credit risk. The rating agency looks at the
overall economic position along with the forecasted balance of payments situation before grading
a country. Currently, Bangladesh is graded to a BB- rating in 2011 from S&P and Ba3 from
moody’s whereas USA has been downgraded from AAA to AA+ by S&P whereas Moody’s kept
it unchanged with Aaa rating which means the highest rating. The higher the grading, the better
the chances for a country to finance her trade deficit by issuing bonds and to attract more FDI
and portfolio investments. Since USA Sovereign Rating is very high that’s why U.S Treasury
bills yield is so low whereas Bangladesh would have to raise the yield much higher due to lower
rating compare to USA.
Long term solution to the deficit problem:
A government must think long term solution to trade deficit since those short term measure will
still make the country susceptible to financial crisis. The country must take measures which will
improve the international competitiveness. Here are few measures which will address some long
term solution to the deficit problem.
 Lower the taxes to promote investment.
 Lower the interest rates to make cost of borrowing cheaper.
 Ensure gas and power along with roads and highways and sea ports.
 Spend more on research and development to promote quality and competition.
 Maintain a stable currency along with stable political atmosphere.
 Make the cost of doing business cheaper by improving workers productivity.
 Help entrepreneurs to start up a business by cutting red tape and corruption.
 Above all, increase the country brand just like ‘Made in Japan’ is a prime brand.
Food for thought: Is being a net debtor nation good or bad? In the 19 th Century, the U.S.
was a net debtor nation and U.K. was a net creditor nation, helping finance the expansion
of a former, minor British colony into the largest economy in the world. From WWI-1985,
the U.S. was a net creditor nation, with a net outflow of capital to the rest of the world.
Since 1985, the U.S. has been a net debtor nation until now.
SUMMARY:
Balance of payment is a record of all the flows of money into, and out of a country (i.e.
Bangladesh) over a given time period (usually a year). It is split into two principal accounts: the
Current Account (exports and imports of goods and services) and the Capital Account (flows
of money for investment plus government reserves of foreign currencies).
Balance of payment deficit is a term that is often used that doesn't actually mean anything
because the balance of payments should always balance. The term is mistakenly used to refer to
disequilibrium in the balance of payments. In other words, the current account is in deficit or
surplus.
Balancing item is the old name for net errors and omissions which helps the book to balance.
The term net errors and omissions is much more sensible because this item is included in the
balance of payments simply to reflect the mistakes that are made in the collection of the data.
Since our independence we always had trade deficit but in the past 10 years except 2004 we have
had current account surplus mainly due to healthy inflow of remittance. Our FDI inflow is not
satisfactory and the economy is very much dependent on some inelastic import goods which
makes the aggregate economy quite susceptible to external shock and due to sharp rise in oil and
other commodity prices which caused a sharp rise in import bills for the current account into
deficit in 2010-2011 and the foreign reserve dwindled quite sharply from over $11 billion to
below $9 billion which forced the government to ask for emergency fund from IMF and let the
taka value fall from 71 to above 81 against USD to discourage imports and encourage the exports
and also it has encouraged expatriates to remit more dollar to Bangladesh. Running a trade
deficit or current account deficit is not a problem under certain conditions. For example, if we
import more capital machineries which will help the country to industrialize in coming days or if
the imported goods help the country to reduce inflation and improve the living standards of
Bangladeshi residents then it is not that bad to run a deficit. But we must do keep in mind about
how to finance the current account deficit. In the western countries it is simply translate the
surplus in capital account since foreign reserve is not that important for them. But in Bangladesh
our capital account is quite negligible and so we are more dependent on our foreign reserves to
make up for the current account deficit.
CASE STUDY 1: Bangladesh sees balance of payments move into deficit in decade.
DHAKA, Aug. 25 (Xinhua) -- Bangladesh's balance of payments after a decade swung into a
deficit of 635 million U.S. dollars in the last 2010-11 fiscal year concluded in June, an official
said Thursday.
The Bangladesh Bank (BB) official, who preferred to be unnamed, told Xinhua that the country's
overall balance of payments entered the negative territory after a decade because of a widening
trade gap, lower growth in inflow remittances and a deficit of 1.58 billion U.S. dollars in the
financial account in the last 2010-11 fiscal year (July 2010-June 2011).
During the same period of the previous 2009-10 (July 2009-June 2010) fiscal year, the BB data
showed, the overall balance of payments surplus of the South Asian country was 2.87 billion
U.S. dollars.
The central bank statistics showed Bangladesh's overall Bop registered a deficit of 281 million
U.S. dollars in 2000-01 (July 2000-June 2001) fiscal year.
As the import bill rose sharply due to price-hike of commodities in the global market, the BB
official said Bangladesh’s trade deficit swelled by over 42 percent year-on-year to 7.33 billion
U.S. dollars in the last 2010-11 fiscal year.
Over the last years, he said, robust growth in inflow of remittances from millions of expatriate
Bangladeshis helped offset the impact of the trade shortfall and kept the overall balance of
payments in surplus.
The deficit in Bop started in November last year and continued until June 2011 as growth in
inflow of remittances dipped, he added.
The amount of remittances from nearly 7 million Bangladeshis, living and working abroad, in the
last fiscal year 2010-11 stood at 11,649.59 million U.S. dollars, 6.03 percent higher than the
same period a year ago, the BB data showed.
Over the last few years until 2009-10 fiscal (July 2009-June 2010), the BB official said the
country's remittance growth hovered around 15-30 percent. With over 22 percent growth in
2008- 2009 and 32 percent growth in 2007-08 fiscal years, the expatriate incomes hit 9.69 billion
U.S. dollars and 7.91 billion U.S. dollars respectively.
The booming growth rate of remittances suffered first blow in 2010 as overseas jobs plummeted
against the backdrop of the global economic recession.
"The pressure on external sector may continue in the near future following widening trade gap
and lower inflow of remittances," Mustafa K Mujeri, Director General of the Bangladesh
Institute of Development Studies (BIDS), was quoted by local English newspaper the Financial
Express as saying in a report recently.
Mujeri, a former chief economist of the central bank, also said the country's current account
balance will improve if the flow of inward remittance and export earnings increase this fiscal.
The current account balance in the last 2010-11 fiscal year decreased by over 73 percent to 995
million U.S. dollars from 3. 724 billion U.S.dollars of the previous 2009-10 fiscal year, showed
the BB data.
Following the deficit in overall balance of payments, however, the central bank's foreign
exchange reserves dipped to 10.38 billion U.S. dollars at the end of July from nearly 11 billion
U.S. dollars logged at the end of June.
Editor: Wang Guanqun

Question 1: Why do you think suddenly Bangladesh experienced a Current account deficit?
Question 2: What steps Bangladesh Bank should undertake to go back to Current account
surplus again in next fiscal year?
Question 3: What has to happen for Bangladesh internationally which will help her to be a
Current account surplus country again?
Question 4: Why cutting the imports not always a smart way of improving balance of payments?
CASE STUDY 2:
Surprise jump in U.S. trade deficit worries economists.
July 14, 2010| By Don Lee, Los Angeles Times
Reporting from Washington — In a sign that Americans are persisting in the risky habit of
buying more than they sell in the global economy, the U.S. trade deficit jumped unexpectedly in
May to the highest level since November 2008.
That prompted some analysts to cut back their forecasts of how much the economy would grow
in the second quarter and to warn that the underlying imbalance posed a threat to the nation's
long-term prosperity and economic strength.
"Definitely the weakness in trade through May suggests less momentum in the economy," said
Shawn DuBravac, chief economist for the Consumer Electronics Assn.
After Tuesday's report, Macroeconomic Advisers, a major forecasting firm based in St. Louis,
slashed its estimate of gross domestic product growth in the second quarter by 0.8 of a
percentage point to a weak 2.4% annual rate. GDP, a measure of total economic output, grew by
2.7% in the first quarter.
Some economists were even more pessimistic.
"Now, a rising trade deficit and continued weakness among regional banks threaten to derail the
recovery," wrote Peter Morici, a University of Maryland professor and former chief economist at
the U.S. International Trade Commission.
Longer term, analysts worry that the U.S. seems to be returning to a pattern of buying more than
it can afford with financing from overseas while export-powered economies such as China
continue to rack up surpluses. Many economists blamed at least part of the 2008-09 recessions
on such global economic imbalances.
The Commerce Department said Tuesday that the trade gap rose to $42.3 billion in May, up
nearly 5% from April's $40.3 billion. Economists had expected the May deficit to decline to
about $39 billion because oil prices were lower and retail sales fell that month.
But American purchases of foreign-made computers, cars and consumer goods increased
considerably in May. The deficit with China, which had eased during the recession and the early
part of the recovery, is rising again and was a major factor in the higher trade gap in May.
For the first five months of the year, the trade deficit totaled $197.8 billion — a 38% increase
from the January-to-May period of 2009. In manufactured goods, China accounted for more than
70% of the shortfall.
U.S. manufacturers have long complained that China deliberately undervalues its currency, the
Yuan, giving its exporters a low-cost advantage over foreign competitors. Beijing said last month
it would allow a more flexible exchange rate. But the Yuan has yet to strengthen significantly.
"The best answer is for China to move faster on its currency [appreciation] and … make their
market easier for the U.S. to sell into," said Frank Vargo, vice president for international
economic affairs at the National Assn. of Manufacturers.
Analysts were surprised at the strength of imports in May, given that U.S. consumers remain
skittish about spending and that many manufacturers have largely finished rebuilding their
inventory of goods after slashing them during the recession.
Question 1: Why did Economists expect a lower trade deficit? Why did it go up?
Question 2: How Chinese Yuan’s appreciation will help reduce the U.S trade deficit?
Question 3: Can U.S. continuously run a current account deficit? What are the risks involved?
CASE STUDY 3: Latest BOP of Bangladesh (2010-2011)
Balance of payments of Bangladesh over the past two fiscal years is given below:
Balance of payments [Annual Data]
(In million US$)
Items 2009-10 2010-11 %
July-June July- Changes
 June 3 over 2
1 2 3 4
  Trade balance -5155 -7328
   Export f.o.b.(including EPZ) 16233 23008 41.74
    Of which : Readymade garments(RMG) 12497 17914 43.35
   Import f.o.b (including EPZ) -21388 -30336 41.84
  Services -1233 -2398
   Receipts 2478 2570 3.71
   Payments -3711 -4968 33.87
  Income -1484 -1354
   Receipts 52 119
   Payments -1536 -1473
    Of which : Official interest payments -215 -220
  Current transfers 11596 12075
   Official transfers 127 127
   Private transfers 11469 11948 4.18
    Of which : Workers' remittances 10987 11650 6.03
  Current Account Balance 3724 995
  Capital account 512 600
   Capital transfers 512 600
  Financial account -651 -1584
   Foreign direct investment (net) 913 768
   Portfolio investment (net) -117 -28
   Other investment -1447 -2324
    MLT loans (excludes suppliers credit) 1589 1051
    MLT amortization payments -687 -739
    Other long term loans (net) -151 -101
    Other short term loans (net) 62 531
    Trade credit (net) -1043 -1895
    DMBs and NBDCs -315 -160
     Assets -410 -902
     Assets -452 -1011
     Liabilities 95 292
  Errors and omissions -720 -646
  Overall Balance 2865 -635
  Reserve Assets -2865 635
    Assets* -3616 481
    Liabilities 751 154
    Bangladesh Bank -2865 635
  Memorandum Items :
 Gross reserves (before valuation 11087 10538
adjustments)
  Valuation Adjustment During the
-337 374
Period**
  Gross reserves (after valuation
10750 10912
adjustments)
  In months of imports of goods and
5.1 3.7
services
-
  ODs to ADs and Reserve held at OBUs -269
123456789
Source: Statistics Department Bangladesh Bank.
* Estimated for the current year
Question 1: Evaluate the trade performance of Bangladesh from July 2009- June 2010 with the
July 2010- June 2011.
Question 2: Current Account balance of 2010-2011 is given here. Can you do the math to
confirm the number?
Question 3: What could be the possible reasons behind the sudden drop of overall balance from
a surplus of $2865 million in 2010 to a deficit of $635 million in 2011?
Question 4: Calculate how many months import bills could have been paid with the foreign
reserve in 2010 and 2011 fiscal year? (Hint: Divide the total imports by 12 to get the monthly
import bills).
CASE STUDY 4: Country’s trade deficit widens, (Monday, July 30 2012)
Jasim Uddin Haroon (The Financial Express)
The trade deficit in Bangladesh widened further in fiscal year (FY) 2012 to US$10.43 billion
from around $9.0 billion in the previous one, mainly because of a declining trend about export
growth particularly since March last, central bank sources said.
The gap which was expected to be higher than what it was, has been contained mainly due to
adoption of contractionary monetary policy, the country’s economists said.
Bangladesh imported goods worth US$34.72 billion in FY 12 compared with $31.95 billion in
2011.
Bangladesh fetched export earnings worth US$24.28 billion in FY 2012 as against $22.92 in the
previous fiscal.
Ahsan H Mansur, executive director of Policy Research Institute (PRI), Bangladesh, a private
think-tank, said: "Export receipts in fiscal 2012 were slightly higher than those of the previous
year."
He said tight monetary policy helped stabilise the macroeconomic situation. Otherwise, he
added, the country's reserve would have come under more severe pressure.
The tightening of the monetary policy discouraged substantially the imports of luxury and
unnecessary goods, he said, adding: "This policy was essential to restore the large imbalance and
insulate the balance of payment from a severe pressure."
He said the government's switching of the expenditure policy not only restrained the import but it
also promoted the export earnings, following depreciation of the local currency against the
greenback.
He said the gap would have been wider if the unmet demands for petroleum products, capital
machinery, intermediate goods and other industrial raw materials were catered to.
"If the petroleum products were allowed to be imported as per the demand, the gap would have
been much higher," he added.
He, however, said food grain import fell substantially in the year leading to lower import
payments.
The opening of fresh LCs for import of rice came down to an almost zero level recently because
of the availability of adequate stocks of the main food item.
The country's overall import orders entered into a negative territory in the just ended fiscal,
mainly due to lower import of food grains and luxurious items, officials said.
The opening of letters of credit (LCs) against imports, generally known as import orders,
registered a negative growth of 4.29 per cent in the July-June period of the FY 2011-12 against a
stellar growth of 34.04 per cent growth in FY `11, according to the central bank statistics.
On the other hand, the settlement of LCs, generally known as actual imports, grew by nearly 9.0
per cent in the FY `12 from that of 38 per cent in the previous fiscal.

Question 1: What are the main reasons behind a widening of trade gap in Bangladesh?
Question 2: How the adaptation of a contractionary monetary policy helped the country to avoid
a further widening of trade gap?
Question 3: What are the drawbacks of adopting the contractionary monetary policy on the
aggregate economy?
Question 4: How a depreciated BDT helped our economy to reduce the trade gap which would
have widened further if the exchange rate was at previous rate of around 70 BDT per dollar?
CASE STUDY 5: IMF clears loan, finally
Thursday, April 12, 2012
Sheikh Shahriar Zaman (Senior Economics Correspondent)
Dhaka, Apr 12 (bdnews24.com) –Cash-strapped Bangladesh will get about $1 billion in extended
credit facility from IMF after swallowing a not-so-sweet reform prescription from the global
lender.
The IMF executive board approved the three-year ECF of SDR 639.96 million (about $987
million) and it would immediately disburse $141 million, says a media statement of the IMF
Thursday.
In an instant reaction the central bank governor Atiur Rahman described IMF's credit approval as
a welcome development for Bangladesh.
"Other donors will now show positive attitude towards Bangladesh after IMF's credit approval.
As a result, it will have a positive impact on foreign investment," Bangladesh Bank governor
Atiur Rahman said.
"Using the loan, the balance of payment problem can be handled, which would advance
Bangladesh in international credit rating, and promote country's image in the international
arena."
Bangladesh has been negotiating with IMF for over a year to get the loan under the ECF
arrangement to cope with the on-going balance of payments problem that stood at negative $978
million in Jul-Nov period of the current fiscal.
It was negative $584 million at the same period of the last fiscal.
Even after a series of power price hikes as prescribed by it, the IMF sounded far from happy over
the pace of such action.
"Prolonged delays in adjusting fuel, electricity, and fertilizer prices and unanticipated increases
in import-related costs could exert additional pressure on the fiscal and external positions," the
IMF said.
The ECF arrangement is designed to helping efforts to "restore macroeconomic stability,
strengthen the external position, and engender higher, more inclusive growth".
After the board's discussion of Bangladesh, Naoyuki Shinohara, Deputy Managing Director and
acting Chair, said: "Macroeconomic pressures have intensified in Bangladesh since late 2010 due
to a negative terms-of-trade shock, rising oil and infrastructure-related imports, and
accommodative policies."
"During the programme period," the IMF statement said, "Bangladesh is committed to taking
actions to create fiscal space, reinvigorate the financial sector, and catalyse additional resources,
in order to boost social- and development-related spending, tackle power shortages and the
infrastructure deficit, and stimulate export-oriented investment and job growth.
"Bangladesh will undertake reform programmes in four major areas to ensure macroeconomic
stability, external viability, and sustained growth.
"The reform areas are fiscal policy, monetary and exchange rate policy, financial sector and trade
and investment."
Bangladesh, according to the IMF, has been facing macroeconomic pressures over the past 18
months when balance of payments went into a deficit in the last fiscal and reserves declined
significantly owing mainly to increased demand for oil imports.
The IMF projected that GDP growth is expected to slow to 5.5 percent in the current fiscal.
"Fiscal strains have emerged due to rising subsidy costs, mainly on account of higher fuel
consumption while headline inflation, while moderating recently, remains at an elevated level,
with nonfood inflation the main driver."
Growth rebound expected
The IMF projected that from the next fiscal, growth is likely to rebound, assuming stable
domestic economic conditions; more effective resource usage, notably development partner
support; and improved global economic conditions.
It, however, said the near- to medium-term outlook "hinges on timely progress on policy
adjustments and structural reforms envisaged under the government's programme".
"Inflation is expected to decline to single digits by end 2012 through appropriately restrained
fiscal and monetary policies and, over time, by a further easing of supply constraints."
"The overall BOP is projected to return to a surplus in FY13 through a combination of policy
tightening measures, exchange rate flexibility, and more supportive global conditions.
"Reserves are programmed to rise, reaching nearly three months of import cover by FY15.
Risks
While the delays in "adjusting" the utility prices and "unanticipated increases in import costs"
put pressure on the fiscal and external positions, the IMF sees better days ahead.
"Bangladesh's medium-term prospects are broadly favorable, but still subject to risks. Policy
buffers are limited in the event of adverse real shocks, given heightened inflation and reserve
losses," it said.
Adjustments and reforms also require strengthened implementation capacity, it added.
Naoyuki Shinohara said more recently, a weakening in external demand and a surge in oil prices
have further weakened Bangladesh's balance of payments and added to fiscal and inflationary
pressures.
Bangladesh is focusing on policy adjustments and structural reforms aimed at restoring
macroeconomic stability, strengthening the external position, and promoting higher, more
inclusive growth.
"The authorities are committed to these objectives and stand ready to take additional measures,
as appropriate, to ensure the success of the programme."
Bangladesh earlier took US$590 million under poverty reduction growth facility approved in
2003.
Question 1: "Other donors will now show positive attitude towards Bangladesh after IMF's
credit approval. As a result, it will have a positive impact on foreign investment," – justify the
statement.
Question 2: Why did IMF impose conditions to cut subsidy before approving the loan?
Question 3: What were the main reasons behind designing the extended credit facility?
Question 4: What kind of reforms Bangladesh would have to undertake in four major areas?
Critically evaluate whether these reforms will bring a positive change in our economy.
Question 5: According to IMF – What are the some short and medium term challenges
Bangladesh economy is likely to face in coming years?
TRUE/FALSE
1. Balance of payments is the all financial inflow and outflow between two countries.
2. Bangladesh always had experienced trade surplus since independence.
3. Due to sharp rise in remittance we were capable of financing our trade deficit.
4. Balance of payments should always balance since net errors and omissions are included just
to make sure it does balance.
5. Under a floating exchange rate system, a country having current account deficit must have a
capital and financial account surplus.
6. Balance of trade = Dollar price of exports x Quantity of Exports – Dollar price of Imports x
Quantity of Imports.
7. Bangladesh is graded to a BB+ rating in 2011 from S&P and Ba2 from moody.
8. Remittance is accounted under capital account in BOP accounting.
MULTIPLE CHOICE QUESTIONS:
1. The accounting statement that summarizes all the economic transactions between a
country's residents and foreign residents is called the balance of .
a) trade b)current account c) capital account d) payments
2. The balance of payments identify states that the combined balance of current account,
capital account, financial account, net errors and omissions, and reserves and related items
must be .
a) greater than 1 b) less than 1 c) equal to zero (0) d) between -1 and +1
3. An increase in the current account deficit will place _______ pressure on the home
currency value, other things equal.
a) upward b) downward c) upward or downward d) unknown
4. Which of the following would likely have the least direct influence on a country’s
current account?
a) inflation b) national income c) exchange rates d) tariffs
5. The J-curve effect holds that a country's currency depreciation causes its trade balance
to ____.
a) deteriorate for a short time
b) flatten out after an initial deterioration
c) significantly improve in the long run
d) all of the above
6. To reduce its trade deficit, a country should do all of the following but ____.
a) deflate the economy
b) devalue the currency
c) adopt foreign exchange controls
d) increase money supply
7. A country incurs a surplus in its balance of payments when ___.
a) credit transactions exceed debit transactions
b) it earns more abroad than it spends
c) autonomous receipts exceed autonomous payments
d) all of the above
8. The primary component of the current account is the:
a) balance of trade. c) balance of capital market flows.
b) balance of money market flows. d) unilateral transfers.
9. ------------- is (are) income received by investors on foreign investments in financial assets
(securities).
a) Portfolio income c) Unilateral transfers
b) Foreign direct income d) Factor income.
10. The financial account in the balance of payments does not include the following __ .
a) FDI b) gold c) foreign bank loans d) portfolio investment
11. Which of the following is not one of the major groups that make up the balance of
payments?
a) current account b) capital account c) financial account d) net errors and omissions
12. In a freely floating exchange rate system, a current account deficit should produce a
financial account .
a) surplus b) deficit c) balance d) both a and b
13. As the real value of the yen rises, the balance on Japan's current account is likely to ---.
a) stay the same b) improve c) deteriorate d) cannot tell
14. If a country imposes tariffs on imported goods, then that country's balance of payments
will very likely .
a) improve b) deteriorate c) stay the same d) cannot tell
15. Holding other things constant, an increase in the current account deficit of a country's
balance of payments will most likely .
a) weaken the value of its currency b) increase the value of its currency
c) not affect the value of its currency d) all of the above
16. The current account includes .
a) merchandise exports and imports b) earnings from invisible trade
c) unilateral transfer items d) a and b
17. A country incurs a surplus in its balance of payments when ------.
a) credit transactions exceed debit transactions
b) it earns more abroad than it spends
c) autonomous receipts exceed autonomous payments
d) all of the above
18. Which of the following is true about Bangladesh’s balance of payments?
a) Since independence, we never had trade surplus.
b) We have some years trade deficits and some years trade surplus.
c) Our FDI inflow was always positive.
d) all of the above.
SHORT ANSWER QUESTIONS:
1. What is balance of payments? Distinguish between current account and capital account?
2. Why do you think balance of payments should always be in a balance? Is it really?
3. What is the danger of running a continuous trade deficit?
4. How can a country gain international competitiveness?
5. What is Marshall Lerner condition?
6. What is Sovereign Rating?
LONG ANSWER QUESTIONS:
1. To what extent you would justify Bangladesh to run a trade deficit and what is the impact of
it on our national economy?
2. What are the policies Bangladesh could adopt in the short-term and long-term to improve
her current account?
3. What are the potential drawbacks of running a current account deficit and surplus for a
country?
4. What is J- Curve? What should a country consider before devaluing her currency? Explain it
by drawing a J-Curve.
5. What options do we have to finance our current account deficit? Why did we face a threat
of running a current account deficit in 2011?
6. What is the importance of remittance for Bangladesh? How does it to stabilize the balance
of payments of Bangladesh?
7. What short, mid, and long-term strategies should be adopted to improve our balance of
payments? What could be done by Bangladesh Bank in this regard?
 CHAPTER 10
FOREIGN DIRECT INVESTMENT
“The social object of skilled investment should be to defeat the dark forces of time and
ignorance which envelope our future.”- John Maynard Keynes.
Chapter Learning Objectives
 To understand the differences between FDI and portfolio investment
 To understand the motives behind foreign direct investment.
 To understand various ways of entering into a foreign market.
 To evaluate the costs and benefits of foreign direct investment.
 To describe various strategies to attract foreign direct investment.
 To understand the factors that discourages foreign direct investment inflow.
 To understand the importance of currency stability to attract FDI.
Definitions and types of FDI:
Foreign direct investment (FDI) is also called "direct foreign investment (DFI)", "direct
investment", or "foreign investment." It is an activity where foreigners come to another country
to set up and/or run a factory, hotel, farms, or other business enterprises. More precisely, here are
some definitions of FDI:
Definition #1: "Direct investment refers to investment that is made to acquire a lasting interest
in an enterprise operating in an economy other than that of the investor, the investor's purpose
being to have an effective voice in the management of the enterprise." [IMF Balance of Payments
Manual, 4th edition, 1977, p.136]
Definition #2: "The balance-of-payments accounts define direct investment as that part of
capital flows that represents a direct financial flow from a parent company to an overseas firm
that it controls." [E.M. Graham and P.R. Krugman, "The Surge in FDI in the 1980s"]
So we can say, Foreign Direct Investment (FDI) is the category of international investment
made by an entity resident in one economy (direct investor) to acquire a lasting interest in an
enterprise operating in another economy (direct investment enterprise). The lasting interest is
deemed to exist if the direct investor acquires at least 10% of the voting power of the direct
investment enterprise.
FDI statistics record separately:
1) Inward FDI (or FDI in the reporting economy), namely investment by foreigners in
enterprises resident in the reporting economy.
2) Outward FDI (or FDI abroad), namely investment by residents entities in affiliated
enterprises abroad.
FDI statistics record both the initial investment and all subsequent investment made by the direct
investor, in the form of equity capital, or in the form of loans, or in the form of reinvesting
earnings. Investment made through other affiliated enterprises of the same group of the direct
investor should also be recorded according to the international methodology.
FDI is contrasted to "portfolio investment" where there is no intention or interest to control an
enterprise. The purpose of portfolio investment is basically to get a good financial return as in
the case of investing in stocks, bonds, gold, art objects, etc.
COMPONENTS OF FDI:
 Equity capital: Direct investor's purchase of shares of an enterprise in another country.
 Intra company loans: Debt transactions between parent enterprises and affiliates.
 Reinvested earnings: Part of an affiliate’s earnings accruing to the foreign investor that is
reinvested in that enterprise.
WAYS TO ENTER INTO A FOREIGN MARKET:
There are basically six different ways to enter a foreign market. Each of these entry strategies is
discussed below:
1. Exporting: Most manufacturing firms begin their global expansion as exporters and only later
switch to another mode for servicing a foreign market.
Advantages of exporting: Exporting avoids the often substantial cost of establishing
manufacturing operations in the host country. Exporting may help a firm achieve experience
curve location economies. Besides, the size of some economies could be not big enough to enter
in another form other than direct exporting.
Disadvantages of exporting: Exporting from the firm's home base may not be appropriate if
there are lower-cost locations for manufacturing the product abroad. High transport costs and tax
on import (tariff) barriers can make exporting uneconomical. Agents in a foreign country may
not act in exporter’s best interest.
2. Turnkey Project: In a turnkey project, the contractor agrees to handle every detail of the
project for a foreign client, including the training of operating personnel. At completion of the
contract, the foreign client is handed the "key" to a plant that is ready for full operation - hence
the term turnkey. This is actually a means of exporting process technology to another country.
Advantages of turnkey project: The main advantage of a turnkey project is that it is a way of
earning great economic returns from the know-how required to assemble and run a
technologically complex process. Turnkey project may also make sense in a country where the
political and economic environment is such that a longer-term investment might expose the firm
to unacceptable political and/or economic risk.
Disadvantages of turkey project: First, by definition, the firm that enters into a turnkey deal will
have no long-term interest in the foreign country. Second, the firm that enters into a turnkey
project may create a competitor. If the firm's process technology is a source of competitive
advantage, then selling this technology through a turnkey project is also selling competitive
advantage to potential and/or actual competitors.
3. Licensing: A licensing agreement is an arrangement whereby a licensor grants the rights to
intangible property to another entity (the licensee) for a specified time period, and in return, the
licensor receives a royalty fee from the licensee. Intangible property includes patents, inventions,
formulas, processes, designs, copyrights, and trademarks.
Advantages of Licensing Agreement: In the typical international licensing deal, the licensee puts
up most of the capital necessary to get the overseas operations going. Thus, a primary advantage
of licensing is that the firm does not have to bear the development costs and risks associated with
opening a foreign market. Licensing is often used when a firm wishes to participate in a foreign
market, but is prohibited from doing so by barriers to investment. Licensing is frequently used
when a firm possesses some intangible property that might have business applications, but does
not want to develop those applications itself.
Disadvantages of Licensing Agreement: First, licensing does not give a firm the tight control
over manufacturing, marketing, and strategy that is required for realizing experience curve and
location economies. Second, competing in a global market may require a firm to coordinate
strategic moves across countries by using profits earned in one country to support competitive
attacks in another. Licensing severely limits a firm's ability to do this. A third problem involves
the potential loss of proprietary (or intangible) technology or property. One way of reducing the
risk of losing proprietary trade secrets is through the use of cross-licensing agreements. Under
a cross-licensing agreement, a firm might license some valuable intangible property to a foreign
partner, but in addition to a royalty payment, the firm might also request that the foreign partner
license some of its valuable know-how to the firm.
4. Franchising: Franchising is basically a specialized form of licensing in which the franchisor
not only sells intangible property to the franchisee, but also insists that the franchisee agree to
abide by strict rules as to how it does business.
Advantages of Franchising: The advantages of franchising as an entry mode are very similar to
those of licensing. Specifically the firm is relieved of many costs and risks of opening up a
foreign market.
Disadvantages of Franchising: Franchising may inhibit the firm's ability to take profits out of
one country to support competitive attacks in another. A more significant disadvantage of
franchising is quality control. The geographic distance of the firm from its foreign franchisees
can make poor quality difficult for the franchisor to detect.
5. Joint-Ventures: A joint venture entails establishment of a firm that is jointly owned by two
or more otherwise independent firms. For example, GrameenPhone was set up as a joint venture
between Norwegian telecom giant Telenor and Grameen telecom.
Advantages of Joint Ventures: A firm can benefit from a local partner's knowledge of the host
country's competitive conditions, culture, language, political systems, and business systems.
Second, when the development costs and/or risks of opening a foreign market are high, a firm
might gain by sharing these costs and/or risks with a local partner. In many countries, political
considerations make joint ventures the only feasible entry mode.
Disadvantages of Joint Ventures: First, just as with licensing, a firm that enters into a joint
venture risks giving control of its technology to its partner. Second, a joint venture does not give
a firm the tight control over subsidiaries that it might need to realize experience curve or location
economies. Third, shared ownership arrangements can lead to conflicts and battles for control
between the investing firms if their goals and objectives change over time, or if they take
different views as to what the venture's strategy should be.
6. Wholly Owned Subsidiaries: In a wholly owned subsidiary, the firm owns 100 percent of
the stock. Establishing a wholly owned subsidiary in a foreign market can be done two ways.
The firm can either set up a new operation in that country or it can acquire an established firm or
use that firm to promote its products in the country's market.
Advantages of a Wholly Owned Subsidiary: First, when a firm's competitive advantage is based
on technological competence, a wholly owned subsidiary will often be the preferred entry mode,
since it reduces the risk of losing control over that competence. Second, a wholly owned
subsidiary gives a firm the tight control over operations in different countries that are necessary
for engaging in global strategic coordination (i.e., using profits from one country to support
competitive attacks in another). Third, a wholly owned subsidiary maybe required if a firm is
trying to realize location and experience curve economies.
Disadvantages of a Wholly Owned Subsidiary: Establishing a wholly owned subsidiary is
generally the most costly method of serving a foreign market. Firms doing this must bear full
costs and risks of setting up overseas operations.
TYPES OF FDI:
According to Chryssochoidis, Millar & Clegg, 1997 there are five different types of foreign direct
investment (FDI).
The first type of FDI is taken to gain access to specific factors of production, e.g. resources,
technical knowledge, material know-how, patent or brand names, owned by a company in the
host country. If such factors of production are not available in the home economy of the foreign
company, and are not easy to transfer, then the foreign firm must invest locally in order to
secure access.
The second type of FDI is developed by Raymond Vernon in his product cycle hypothesis.
According to this model the company shall invest in order to gain access to cheaper factors of
production, e.g. low-cost labour. The government of the host country may encourage this type
of FDI if it is pursuing an export-oriented development strategy. Since it may provide some form
of investment incentive to the foreign company, in form of subsidies, grants and tax
concessions. If the government is using an import-substitution policy instead, foreign
companies may only be allowed to participate in the host economy if they possess technical or
managerial know-how that is not available to domestic industry. Such know-how may be
transferred through licensing. It can also result in a joint venture with a local partner.
The third type of FDI involves international competitors undertaking mutual investment in one
another, e.g. through cross-shareholdings or through establishment of joint venture, in order to
gain access to each other's product ranges. As a result of increased competition among similar
products and R&D-induced specialisation this type of FDI emerged. Both companies often find it
difficult to compete in each other's home market or in third-country markets for each other's
products. If none of the products gain the dominant advantage, the two companies can invest
in each other's area of knowledge and promote sub-product specialisation in production.
The fourth type of FDI concerns the access to customers in the host country market. In this type
of FDI there are not observed any underlying shift in comparative advantage either to or from
the host country. Export from the companies' home base may be impossible, e.g. certain
services, or the capability to request immediate design modifications. The limited tradability of
many services has been an important factor explaining the growth of FDI in these sectors.
The fifth type of FDI relates to the trade diversionary aspect of regional integration. This type
occurs when there are location advantages for foreign companies in their home country but the
existence of tariffs or other barriers of trade prevent the companies from exporting to the host
country. The foreign companies therefore jump the barriers by establishing a local presence
within the host economy in order to gain access to the local market. The local manufacturing
presence need only be sufficient to circumvent the trade barriers, since the foreign company
wants to maintain as much of the value-added in its home economy.
MODES OF FDI
 Greenfield FDI entails establishment of new production facilities and movement of
intangible capital (in services) contributing to capital formation and employment generation.
 Cross-border M& As end up transferring production assets to foreign investors and does not
increase capital stock.
 Round-tripped investments involve channeling of local investor's funds abroad and
subsequent return to local economy in the form of direct investment.
 Trans-shipped investment or investment mainly intended for FDI in some other country
which does not increase capital stock.
Difficulty in measurement:
While the theoretical definition of FDI is clear, in reality, there are serious measurement
problems. For example,
1) Whether a foreign investor has an intention to control or participate in the management is not
directly observable. In the Japanese and US balance-of-payments statistics, investment is
considered FDI if the foreign share is 10% or more; otherwise, it is classified as portfolio
investment.
2) While a loan from the parent company is counted as FDI, a bank loan guaranteed by the
parent company is not. Again, this is an arbitrary distinction since the two loans which would
have virtually the same economic effect.
3) Whether the value of foreign investment is recorded at book value or at market value makes a
difference. The latter changes due to inflation/deflation and capital gain/loss.
4) Statistics for commitment (approval or promise to invest) is easier to collect, but actual
implementation is more difficult to know. There was always a discrepancy between the
registered FDI data and actual investment amount in Bangladesh.
NEED FOR FOREIGN CAPITAL:
Foreign direct investment (FDI) is a potent weapon of economic development, especially in the
current global context. It enables a capital-poor country like Bangladesh to build up physical
capital, create employment opportunities, develop productive capacity, enhance skills of local
labor through transfer of technology and managerial know-how, and help integrate the domestic
economy with the global economy.
The need for foreign capital in Bangladesh arises on account of the following:
1. Inadequacy of Domestic Capital: In view of the inadequacy of domestic capital, foreign
capital is needed to meet the huge requirements of development projects in the path of rapid
economic development and industrialization of Bangladesh. Our GDP per capita is very low and
thus very low savings which is not enough to invest and create employment and attain much
desired 8% GDP growth.
2. The Technology Gap: As compared to the advanced countries there is a lot of technology
gap which necessitates import of foreign technology. Such technology usually comes along with
foreign capital in the form of private foreign investment or foreign collaborations. Thus, there is
utmost need of foreign capital. In Bangladesh we didn’t have much of MOBILE WIRELESS
communication technology fifteen years ago. That’s why Grameen Phone, Robi, Banglalink,
Airtel and other mobile operators helped Bangladesh to abridge the technology gap with the
developed world.
3. The Initial Risk: Due to lack of experience, expertise and heavy initial risk, there is always
a lack of flow of domestic capital into lines of production. The foreign capital taking initial risk
stimulates the flow of domestic capital and stock entrepreneurship. For example, deep sea off-
shore oil and gas exploration is a risky investment since no guarantee of findings. That’s one of
the reasons behind signing deep sea oil and gas exploration contract with the U.S oil giant
ConocoPhillips.
4. Development of Basic Infrastructure: There is also a lack of basic infrastructure which is
very essential for the economic development of Bangladesh. Foreign capital helps in the
development of infrastructural facilities such as transport, communication, power etc.
5. Balance of Payment Support: During the process of economic development, the
underdeveloped countries usually face a crisis of balance of payments due to heavy imports of
capital goods, technical know-how, spare parts and even industrial raw materials. Thus, foreign
direct investment inflow helps the country to get the much needed foreign currency.
6. Employment generation: A developing country like Bangladesh which is overly populated
has serious unemployment problem due to lack of capital investment. Foreign capital can create
employment and thus can help in reducing unemployment problem in Bangladesh.
THEORIES OF FDI
Theoretically, there are three possible explanations why FDI occurs and production sites move
from one country to another in this fashion.
The first is the factor proportion hypothesis. In conformity with the standard Heckscher- Ohlin
trade model, this hypothesis says that the capital-labor ratio of a country determines what it
produces. Low income countries with less capital and more labor (i.e., the K/L ratio is low)
produces labor-intensive products while high income countries with more capital and less labor
(i.e., the K/L ratio is high) produces capital-intensive products. According to this theory, as a
labor abundant country accumulates capital through investment, its product mix will also shift.
The second is the technology ladder hypothesis. This says that production pattern is determined
not so much by the simple capital-labor ratio, but whether a country can acquire necessary skills
and technology to produce more complicated goods. For this, learning is very important.
Learning must also be supported by appropriate education and training, ample supply of good
managers and engineers, R&D, IT infrastructure, etc. According to this theory which emphasizes
quality rather than quantity, countries with a lot of investment but no capacity improvement will
waste resources and may not be able to establish new industries.
The third is the FDI dynamics hypothesis (or industrial cluster hypothesis). This view says that
industrialization begins with an accumulation of a critical mass of FDI. Capital accumulation or
technical mastery of the host country is not essential at the initial stage. Instead, what is crucial is
whether or not the government can offer attractive FDI environment, especially free business
environment and the low cost of doing business (which includes not only labor but also
electricity, water, transportation, communication, housing, etc). At first, only cheap labor is
utilized for simple assembly. But if assemblers successfully accumulate, parts suppliers
gradually emerge (or come from abroad) and domestic procurement of parts and materials
becomes possible. Once a virtuous circle between assemblers and parts suppliers is established,
more and more investors (both assemblers and parts suppliers) will come. This is the situation
now observed in the coastal areas of China (Guangdong and Shanghai areas). Capital
accumulation and improvement of domestic capability will occur as a result of this process; they
are not the cause of development.
Each of these theories has a different implication for policy makers. The first hypothesis says:
invest. The second says: improve domestic capability. The third says: invite as much FDI as
possible. At present, economists cannot say for sure which explanation is most convincing in the
present context of the global economy.
In the second and third hypotheses, the role of supporting industries is particularly important.
Supporting industries (also called parts industries, ancillary industries, etc) are upstream
industries that supply intermediate inputs to the final producer. Final assembly is usually easy
but producing high-quality parts with high-quality materials is much more difficult. The value of
the product is mostly determined by the quality of the upstream industries. Developing countries
usually start with final assembly, and try to develop supporting industries later. But very few
have succeeded so far. Thailand has accumulated automobile parts industries (Japan is the key
investor) and Southern China has an accumulation of electronics parts industries (Taiwan
is the major investor). Even in these cases, the host countries remain highly dependent on
foreign technology, marketing and management. Key parts and materials often continue to be
imported. The development of supporting industries is a big challenge for developing countries
opting for FDI-driven growth. A country like Bangladesh may not be an expert in building a
new car but it can start producing quality auto parts and gradually shift from small parts
to auto body to auto engine and thus build a new auto factory.
Economic Determinants of FDI
From an economic perspective, determinants of FDI can be grouped into resource-oriented and
market-oriented determinants. The resource-oriented determinants include availability of raw
materials, low-cost skilled/unskilled labour, technology-created or innovation-created assets and
physical infrastructure. Market-oriented determinants for FDI inflows from the host country’s
perspective generally refer to the market size and marketability of the field products for which
FDI is sought. Projects that depend on a resource (e.g. oil and gas and mineral processing
projects) often have to compete for capital funds with similar projects proposed elsewhere to
investors. Proponents of non-resource-based projects seek the lowest cost/highest return location
for their investments.
Other economic factors such as liberal industrial policy reforms, liberalization of policies related
to FDI, investment treaties with other countries for promotion and protection of investment,
incentive packages, etc. come after consideration of the factors mentioned earlier.
Factors affecting the flow of foreign capital:
The followings are some of the factors that may affect the flow of capital into any country.
1. The expected rates of return or rates of interest on investments;
2. Attitude of investors for investment in overseas capital market;
3. The credit standing of the country where the investment is to be made;
4. The internal economic, social and political stability of a country;
5. The relative stability in rates of exchange of currencies of the two countries;
6. The business cycle phase whether passing through depression or boom of a country.
7. The gap between savings and investment resulting in current account gaps of the country.
8. The policies of globalization, liberalization and that of international integration adopted by
the country;
9. Flexible legal and institutional structure of the country which can be easily understood by the
investors; and
10. Availability of innovative financial products in the financial markets etc.
COSTS AND BENEFITS OF FDI INFLOW FOR BANGLADESH
FDI is not free of cost. Foreigners come to a new country with the intention of maximizing
profit. So, as long as they receive what they have come for, there is nothing to worry about but
unfortunately, this is not always the case. Here are some of the costs of attracting FDI:
 If an MNC finds another lucrative market then they may shift their business from Bangladesh
and it exposes the risk of losing one business and thus higher unemployment.
 Shifting the business also means converting their invested money back to foreign currency
and thus it may reduce our foreign reserve significantly.
 Sometimes MNCs have better management and cost cutting tools and technologies which
give them better hand in competing against local Bangladeshi owned firms and so, as a
result, some domestic firms may go out of business.
 Sometimes excess fiscal incentives for the foreign direct investment could jeopardize local
Bangladeshi investment. For example, Sahara’s recent proposed real estate investment offer
in Bangladesh.
 Sometimes MNCs tend to interfere in domestic politics to pave away for attaining their
desired demand and thus can even try to change the government as we had a bitter experience
of “East India Company” which was a British multinational company with the intention of
promoting trade and investment in our part of the world.
 Whatever profit an MNC makes, the firm can remit the profit back to the originated company
and thus a pressure on foreign reserve. For example, the profit Grameenphone makes, 54% of
it could be remitted by Telenor which owns that portion of the company.
Of course, there are lots of benefits of attracting FDI in Bangladesh. Here are some of the
benefits of attracting FDI:
 A country like Bangladesh where there is a need for capital badly since capital per worker in
Bangladesh is one of the lowest in the world. So foreign capital will help the country to
develop economically and thus meet the higher demand of capital from foreigners.
 A country like Bangladesh where unemployment rate is very high and thus wasting huge
amount of human capital due to lack of employment. But more inflow of FDI would give
those unemployed citizens a chance to get jobs and thus could reduce the unemployment
problem gradually.
 FDI brings foreign currency and thus help the country to improve the foreign reserve and
bring stability in Balance of Payments.
 Foreign investment not only creates jobs but those locals along with foreign workers do also
pay income taxes along with value addition taxes and city taxes which is much needed for the
 government of Bangladesh to finance her budget deficit. For example, the tax our
government collects from grameenphone and British American Tobacco Company is one of
the largest amounts in Bangladesh.
 FDI helps fast transfer of technology and managerial skills that increase labour productivity
and contribute to innovations. For example, deep sea oil and gas drilling technology is not
available in Bangladesh but Conoco-Phillips investment in this regard would help some
Bangladeshi engineers to get a first hand in this technology and gain experience.
 FDI creates competition in the domestic market and thus higher competition normally
translates better quality products at a cheaper rate with greater consumer choice.
 FDI also helps a country to develop her tourism sectors since foreigners would like to spend
money on getting to know the country as well and they would be the ideal candidate to
promote “Beautiful Bangladesh” to the outside world.
 Due to FDI, government sometimes is forced to improve the infrastructure of roads and
highway along with some independent institutions like Anti-corruption commission and
independent judicial system. Sometimes the presence of big MNC may help a country to
protect the democracy since most MNCs prefer to operate under calm and quiet stable
democratic political system.
Strategy to attract more FDI (FDI promotion)
For a least developed country like Bangladesh, we need to follow some strategies by
implementing sound policies which are required in a global arena to attract more FDI.
First, we must understand FDI dynamics from the viewpoint of foreign investors. Too many
officials who promote FDI in Bangladesh think in terms of domestically set goals and
requirements, and scare away potential foreign investors. National goals and social concerns are
certainly important, but they must be realized in a way that is consistent with FDI inflows.
Second, we should not change rules after foreigners have already invested. Policy changes are
fine, sometimes, especially for better. But for those who came earlier, the old rules should
continue to apply so that they will not suddenly face an unfavorable situation. Some foreign
investors termed Policy uncertainty is one of the biggest problem in Bangladesh.
Third, do not promote always to have a vertically integrated industry, from raw materials to
final assembly. In the age of globalization, no country can do that, not even developed ones.
Target where our dynamic comparative advantage is, and concentrate our effort on it.
Fourth, do not force to use domestically available natural resources unless they are highest
quality and lowest cost (or nearly so) in the world. From the viewpoint of competitiveness, it is
better to import best raw materials from the most efficient producers in the world.
Fifth, building supporting industries and technical transfer will take time. They must be done in
proper speed and sequence. Hasty requirement of local contents not only violates WTO but also
drives away foreign investors.
Six, accumulate assembly-type FDI first, without selectivity, even though domestic value- added
is low. Next, as assemblers naturally desire to procure inputs domestically, promote or invite
domestic and foreign parts suppliers. If successful, a virtuous circle between assembly and parts
will emerge. Technology transfer will come after this, not before.
Seven, work cooperatively with foreign investors. Listen to their needs carefully (we don't have
to accept all of their complaints; sometimes they are selfish). We must set agreed goals for
technical transfer, domestic procurement, etc. and design consistent supporting policies. Work
with foreign investors toward these goals, and also solve any problems with them.
Eight, simple external opening (free trade and investment) is not enough. We must use targeted
policies to create superior locational advantages and lower the costs of doing business in our
country. This requires, among other things, improving domestic skills (production management,
marketing, engineering--not just primary education), infrastructure, supporting institutions,
efficient government services, good management of industrial and export processing zones, and
so on.
Nine, export-oriented FDI should be welcomed most, while domestically oriented FDI is a
different story and must be treated differently. Do not attract them with high import protection. If
they are already here with high protection, show them a tariff reduction schedule and give them
incentive to lower costs. The final outcome (survive or exit) should be determined by global
competition and efforts of individual enterprises. This is the same for protected local enterprises
as well.
How to Promote FDI?
International evidence has shown that foreign investors are attracted to a country by three basic
factors:
 The “product” or the country itself is an investment site. Some aspects of the product such as
location, existence of natural resources, and market size are generally beyond the ability of
the government to change. Other factors such as macroeconomic stability, investment
regime, and physical and social infrastructure are more under the influence of government
policy.
 The “price”, or the cost to the investor of locating and operating within the investment site.
This includes the cost of accessing land, infrastructure and utilities, the effective cost of taxes
and subsidies, and the administrative cost of various regulatory procedures. A broad-based,
transparent, non-discriminatory, and predictable regulatory framework is a very powerful
attraction for a country seeking foreign investments.
 The “promotion”, or activities that disseminate information about or attempt to create an
image of the investment site and provide services for the prospective investor. Typically,
promotional activities aim to capitalize on a country’s product and price advantages.
It is often argued that only when the “product” and “price” are right can a country truly benefit
from a successful promotion effort.
The government of Bangladesh has earmarked foreign direct investment as the prime vehicle for
economic growth and expansion. Towards this end, a number of agencies have been created with
specific promotional roles. These are as follows:
 Bangladesh Export Processing Zones Authority (BEPZA)
 Board of Investment (BOI).
We also have Export Promotion Bureau (EPB) who helps to bring more FDI in Bangladesh.
Bangladesh Export Processing Zones Authority (BEPZA)
The Bangladesh Export Processing Zones Authority (BEPZA) was established to setup and
operate export processing zones in Bangladesh under the Bangladesh Export Processing Zones
Authority Act, 1980. To begin with, it was decided that the country would have three export
processing zones in phases, one each of the port cities of Chittagong and Khulna and one air
transportation based zone near Hazrat Shah Jalal International Airport at Dhaka.
BEPZA develops and services special areas where potential investors would find a congenial
investment climate free from procedural complications. The policy making body of the
Bangladesh Export Processing Zones Authority is its Board of Governors chaired by the Head of
the Government. The Board consists of Ministers and Secretaries of several relevant Ministries
and Divisions. Any decision taken by the Board of Governors is deemed to be the decision of the
government. For carrying out the day to day functions including implementation of the Board's
decisions, there is an Executive Board of BEPZA consisting of an Executive Chairman and three
members.
Objectives of BEPZA:
 Promotion of foreign (FDI) & local investment
 Diversification of export
 Development of backward & forward linkages
 Generation of employment
 Transfer of technology
 Up-gradation of skill
 Development of management.
Bangladeshi EPZ's at a glance
1. EPZ-Chittagong, 2. Dhaka, 3. Mongla, 4. Ishwardi, 5. Comilla, 6. Uttara, 7. Adamjee
and 8. Karnaphuli.

Board of Investment (BOI)

The Government of Bangladesh established the Board of lnvestment (BOI) for accelerating
private investment both from domestic and overseas sources with a view to improve the socio-
economic conditions of our country. The Board is headed by the Prime Minister. Other members
are Ministers and Secretaries of concerned ministries. It is vested with necessary powers to take
decisions for speedy implementation of new industrial projects and provide operational support
services to the existing ones. The BOI is a high-powered government apex body for promotion
and development of foreign and local private investment in the country. The major functions of
the Board are as follows:
 Promotion of investment
 Providing all kinds of facilities for capital investment and rapid industrialization.
 Registration of industrial projects.
 Creation of infrastructural facilities for industries.
 Issuance of work permits to expatriate personnel.
 Providing import facilities to industrial units.
 Approval of the terms and conditions for foreign private loans and supplier credits beyond
the prescribed limit.
 Approval of payment of technology transfer fees (royalty, technical know-how and technical
assistance fee) beyond the prescribed limits to foreign nationals/organizations.
 Recommendation for allotment of land in the industrial areas/estates for industrial purpose.
In addition, the BOI assists investors in obtaining the following services expeditiously:
 Electricity, gas, water, sewerage and telecommunication connections, custom clearance for
imported machinery, spare parts and raw materials.
 Clearance regarding environment pollution.
 All other facilities and services that may be required for speedy setting up of an industry.
The Executive Council of the BOI consists of an Executive Chairman and Members and is
responsible for carrying out the day to day functions and decisions of the Board which are
deemed to be the decisions of the government.
General features of FDI
Here are some general features of global FDI flows:
1) FDI is less volatile than portfolio investment or bank loans. In the 1997-98 Asian crises,
capital inflows in the form of short-term bank loans suddenly reversed, but FDI did not leave the
affected countries. In fact, FDI in the form of mergers and acquisitions (M&A) rose sharply after
the crisis, as foreigners bought up local firms at low cost (i.e., at greatly depreciated exchange
rates).
2) Generally speaking, FDI among developed countries is much greater than FDI from developed
to developing countries. FDI among developing countries is very small. The only notable
exception to this rule is China's huge absorption of FDI in recent years.
3) Total FDI data includes mergers & acquisitions (M&A), setting up branch offices, service
FDI, energy and mineral extraction, and so on. Greenfield-type manufacturing FDI, most desired
by developing countries, is only a small part of FDI flows.
4) Over time, popular destinations of FDI shift. From the viewpoint of Japan as a source country,
the most popular FDI destination in the 1970s was Hong Kong, Singapore, Korea, and Taiwan.
In the late 1980s it was ASEAN4 (especially Thailand and Malaysia). Since the 1990s to present,
China has emerged as the most popular FDI destination in the entire developing world.
FDI trends in Bangladesh
Board of Investment of Bangladesh is the principal investment promotion agency engaged
mainly in investment promotion, facilitation, and policy advocacy support for the policy makers.
According to an UNCTAD report, FDI to Bangladesh averaged only $17 million annually from
1990-1995, but increased to over $200 million in 1996, primarily due to foreign investment in
Bangladesh’s energy sector. In 1997 and 1998, there was a sharp rise of almost $600 million
before falling almost half in 1999. Since 2005 FDI averaged around $800 million except in 2008
where it crossed the $1 billion mark according to UNCTAD report. We are still lagging behind
economies like Vietnam who has attracted more than 5 times FDI compare to us.
Bangladesh has, very often sent trade delegations abroad to explore trade opportunities as well as
highlight opportunities for investing in Bangladesh. A number of foreign business delegations
have visited Bangladesh to explore trade and investment opportunities, including from India,
France, Turkey, Malaysia, Taiwan China, and Korea.
With so much efforts have been made to attract the foreign direct investment but very little
success have been achieved so far since the FDI in 1997 and 2011 is not much different to
address. A detailed planning and one stop service for the foreign investors as well as creating a
stable political will in this regard is a must to improve the existing situation. Besides, we must
ask ourselves what Vietnam is doing right which brought them five times more FDI than us.
Further research is needed to conduct in this regard since in the past sixty years most of the
developing countries then like Japan, South Korea, Malaysia got out of developing tag and
became a developed country by virtue of attracting more foreign capital and use that capital to
industrialize and create jobs and help the economy grow at a higher rate by exporting to foreign
destinations. A very recent example is China who is now a major recipient of FDI inflow which
helped them to industrialize so quickly that some finance experts term the event as ‘Chinese
miracle’. We can also achieve this miracle by attracting more FDI in labor intensive sectors
which will create jobs and reduce unemployment and help the country to get out of least
developed country tag.
FDI inflow in Bangladesh since 1996
Millions in US$

(Source: World Investment Report, UNCTAD)

FDI Policy Framework & Incentives in Bangladesh:
Facilities and incentives for foreign investors:
 Tax exemption on royalties, technical know how and technical assistance fees and facilities
for their repatriation.
 Tax exemption on interests on foreign loans.
 Tax exemptions on capital gains from transfer of shares by the investing company.
 Remittances of up to 50% of salaries 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.
 Provision of transfer of shares held by foreign share holders to local investors.
 'Taka' the Bangladesh currency would be convertible for international payments for the
foreign investors.
 Reinvestment of remittable dividends would be treated as new investment.
 Level playing field: foreign owned companies duly registered in Bangladesh will be on the
same footing as locally owned ones.
 Foreign investment in Bangladesh is secure and highly profitable.
 According to available records no foreign investors have ever lost money in Bangladesh.

The Package of incentives is listed below:

Fiscal incentives for industries:
 Corporate tax holiday of 5 to 7 years for selected sectors
 Reduced tariff on import of raw materials capital machinery
 Bonded warehousing
 Accelerated depreciation on cost of machinery is admissible for new industrial undertaking
(50% in the first year of commercial production, 30% in the second year, and 20% in the
third year)
 Tax exemption on capital gains from the transfer of shares of public limited companies listed
with a stock exchange
 Reduced Corporate Tax for 5 to 7 years in lieu of tax holding.
Financial incentives for export oriented industries:
 Cash incentives and export subsidies ranging from 5% to 20% granted on the FOB value of
the selected products
 90% loans against letters of credit (by banks)
 Funds for export promotion
 Export credit guarantee scheme
 Permission for domestic market sales of up to 20% of export-oriented companies outside
EPZ (relevant duties apply)
Additional facilities/incentives:
 100% foreign equity allowed
 Unrestricted exit policy
 Remittance of royalty, technical know-how and technical assistance fees
 Full repatriation facilities of dividends and capital at exit
 Citizenship by investing a minimum of US$ 5,00,000
 Permanent resident permits on investing US$ 75,000
 An investor can wind up investment either through a decision of the AGM or EGM. He or
she can
 repatriate the sales proceeds after securing proper authorization from Bangladesh Bank
Why Bangladesh?
Bangladesh is a winning combination with its competitive market, business-friendly environment
and cost structure that can give you the best returns.
Industrious low-cost workforce
Bangladesh offers a well-educated, highly adaptive and industrious workforce with the lowest
wages and salaries in the region. 57.3% of the population is under 25, providing a youthful group
for recruitment. The country has consistently developed a skilled workforce catering to investors
needs. English is widely spoken, making communication easy.
Strategic location, regional connectivity and worldwide access
Bangladesh is strategically located next to India, China and ASEAN markets. As the South Asian
Free Trade Area (SAFTA) comes into force, investors in Bangladesh will enjoy duty-free access
to India and other member countries.
Strong local market and growth
Bangladesh has proved to be an attractive investment location with its over 146.6 million
population and consistent economic growth leading to strong and growing domestic demand.
Low cost of energy
Energy prices in Bangladesh are the most competitive in the region. Transportation on green
compressed natural gas is less than 20% of the diesel price.
Proven export competitiveness
Bangladesh enjoys tariff-free access to the European Union, Canada, Australia and Japan. In
Europe, Bangladesh enjoys 60% of the market share and is the top manufacturing exporter
amongst 50 least developed countries.
Stable Currency and healthy foreign reserve
The exchange rate between US Dollar and Bangladeshi taka is quite stable from 2006 to 2010.
We have more than $12 billion foreign reserve which is quite good enough to finance three
months of our import bills.
Competitive incentives
Bangladesh offers the most liberal FDI regime in South Asia, allowing 100% foreign equity with
unrestricted exit policy, easy remittance of royalty, and repatriation of profits and incomes.
Export processing zones
Bangladesh offers export-oriented industrial enclaves with infrastructural facilities and logistical
support for foreign investors. The country is also developing its core infrastructures, including
roads, highways, surface transport like expressway and port facilities for a better business
environment.
Positive climate
A largely homogeneous society with people living in harmony irrespective of race and religion,
Bangladesh is a democratic country enjoying broad bi-partisan political support for private
investment. The legal and policy framework for business is conducive to foreign investment.
FDI Magazine of The Financial Times in March 2010 conducted a competition under the head
“Global Ranking Competition of Economics Zones” based on the following nine categories of
ranking:
Best Overall Global Special Economic Zone
Best Economic Potential
Best Cost Effectiveness
Best Facilities
Best Transportation Link
Best Incentives
Best Promotion
Best Airport
Best Port
In the competition out of 700 Economic Zones globally 200 participated in the competition. All
the zones were evaluated on a 10 point scale on the basis of some set criteria. Among the top 10
of the two categories Chittagong Export Processing Zone, Bangladesh scored 3rd position in the
“Best Cost Effectiveness” and also 4th position in the “Best Economic Potential” for 2010-2011.
Source: FDI Magazine
Comparative Advantages of Bangladesh for Investment purposes:
Bangladesh has the following comparative advantages for foreign investment over other
competing Asian countries:
1. Low cost and easily trainable labour is abundantly available in Bangladesh. Out of the total
population of 147 million, the labour force comprises more than 60 million. According to U.S
consultancy group Jassin-O’Rourke, Bangladeshi workers average wage is $0.22 per hour
compare to China’s $0.86 and $0.51 of India.
2. Bangladesh is one of the three Asian countries (the other two being Sri Lanka and China) who
offers unconditional 100 percent foreign equity or ownership in industrial investments.
3. Inflation rate is still one the lowest (10.1 percent) among some of the Asian countries.
4. There is no restriction on issuing work permit to a foreign national.
5. Bangladesh is most liberal in granting permanent resident ship and citizenship to foreigners.
Reportable investment of only US$ 75.000 in an industrial project is the only condition of
granting permanent resident ship and a minimum investment of US$ 500,000 or transferring
US$ 1,000,000 to any recognized financing institution which should be non-repatriable is the
only condition for getting Bangladeshi citizenship.
6. Tax holiday allowed for new investment in Bangladesh is the minimum, 5 to 9 years in most
of the areas on some conditions, and 12 years in special economic zones (in the Chittagong
Hill Tracts).
7. Bangladesh enjoys Most Favoured Nation (MFN) status from a number of countries including
the U.S.A., with whom bilateral treaty of trade and investment has been signed. The countries
with which Bangladesh so far signed bilateral investment treaties are U.S.A., U.K. Germany,
Romania, Belgium, South Korea, Thailand, Turkey, France and Italy.
8. As one of the least developed countries, Bangladesh enjoys Generalized System of Preference
(G.S.P.) facilities for favourable export to the U.S.A.
9. Avoidance of double taxation agreements have been signed with Japan, U.K., Italy, Canada,
Sweden, Malaysia, Singapore, and the Republic of Korea.
10. Legal protection to all foreign investments in Bangladesh is provided by an Act of Parliament
passed in 1980 against nationalization and expropriation. Non-commercial risks of investment
in Bangladesh are also insured by the Multilateral Investment Guarantee Agency.
11. Foreign Exchange regulations have been relaxed to the maximum limit by the recent
introduction of free convertibility of Taka, the Bangladesh currency. This has accelerated the
free flow of international business transactions.
12. Repatriation of foreign capital investment along with profits/dividends has been made easy
and simplified. Now no prior permission of any authority is required for their repatriation.
13. Cost of land and energy prices are one of the lowest in the region. There is a huge proven and
recoverable deposit (about 11 trillion cubic feet) of natural gas in Bangladesh. A potential
reserve of 50-70 trillion cubic feet is known.
14. Bangladesh has two seaports with modern facilities, internal transport and communication
system has vastly improved over the years.
15. Most importantly Bangladeshi people are hospitable, friendly and resilient and greatly value
the role of foreign investment in their country.
Factors that played a positive role so far to attract FDIs in Bangladesh
The following factors could be attributed for the flow of foreign direct investments in
Bangladesh:
1. Bangladesh has a well developed network of banking and financial institutions and an
organized capital market open to foreign institutional investors that attracts them to undertake
investments.
2. Bangladesh has vast potential of young entrepreneurs in the private sector. Their skills could
be utilized by the foreign investors by forming joint venture and their competence can be used as
a base for carrying out production activities and export to foreign destinations.
3. For the last few years there has been political stability in the country and a stable currency.
4. Bangladesh enjoys good reputation among other countries as to honouring of its commitments
about repayment obligations, remittance of dividends etc.
5. Bangladesh has vast potential of unskilled labour available at cheap rates as compared to
other countries, and vast natural resources that attract foreign investors.
6. Bangladeshi made most products receive duty free entrance to EU and other countries except
USA.
7. Bangladesh is lucky to be located in such an attracted geographical location where half the
world population lives. It is bordering with India and only 240 kilo meters away from China
along with ASEAN nations and not very far from all of the Middle Eastern countries.
685
Factors that Discouraged FDIs inflow in Bangladesh
Factors that have played a role to discourage foreign investors to undertake investments in
Bangladesh include:
1. High rates of taxation;
2. Lack of infrastructure facilities (no new connection of gas, electricity and poor roads);
3. Favoritism in the selection of investment;
4. Complicated legal framework of rules, regulations procedures hampers foreign direct
investments into Bangladesh;
5. Lack of transparency and rampant corruption;
6. Lack of skilled manpower;
7. Very low workers productivity;
8. Recent currency volatility and political instability along with labor unrest.
9. Lack of financing options in Bangladesh.
Don't discourage FDI
FDI tends to be by far the most stable form of external finance and is often accompanied by
transfers of foreign managerial skills and technology. And, hopefully, not foreign holdings of
equities, which provide great benefits in terms of risk sharing. True, sudden reversals by foreign
investors can be a problem for countries with rigidly fixed exchange rates, but that says more
about fixed rates than it does about cross-border holding of equities.
The real debate is about portfolio investment especially in the form of debt instruments – both
short-term flows and certain types of long-term flows. Debt does not have the desirable risk-
sharing properties of FDI and equity, and it makes countries susceptible to reversals of sentiment
and insolvency problems. It is unwise to think that all debts are bad but the onus lies on the
shoulder of the government or the private sector to make sure that they are capable of servicing
the debts and it simply means the cost of borrowing foreign capital must not be higher than the
investment return from that capital. Recently Bangladesh government has shown a keen interest
to attract portfolio investment in the capital market especially in the stock market by giving them
10% tax rebate to revive the bearish trend and is under the impression that foreign investors will
make the market more efficient. But instead of making the share market stable; they may
exacerbate the situation since our stock market is quite prone to rumor and spreading rumor is
not that difficult to rip off the ignorant investors in this part of the world.
FDI’s impact on Balance of payments
The economic impact of FDI on the level of economic activity has been widely investigated in
recent years across different countries. Some results suggest that the inflow of FDI can ‘crowd
in’ or ‘crowd out’ domestic investment depending on specific circumstances. Overall, FDI has a
positive impact on economic growth but the magnitude of the effect depends on the availability
of complementary resources, especially on the domestic stock of human capital.
In Bangladesh, FDI inflows are reported under the capital and financial account of the country’s
Balance of Payments (BOP) statement which provides the direct effect on the BOP. Thus the
inflow of FDI plays an important role in determining the surplus/deficit in the capital and
financial account of the BOP statement. From the above, it can be said that the initial impact of
an inflow of FDI on Bangladesh’s BOP is positive but the medium term effect could become
either positive or negative as the investors increase their imports of intermediate goods and
services, and begin to repatriate profit.
After setting up capital machineries, the FDI-financed companies begin to export their products
as most of these companies are export-oriented. Usually, FDI inflow tends to have a greater
positive impact through augmenting exports than creating a negative impact through increasing
imports. It is found that FDI-financed firms tend to export a greater proportion of their output
than their local counterparts as these firms usually tend to have a comparative advantage in their
knowledge of international markets, efficiency of distribution channels, and their ability to adjust
and respond to the changing pattern and dynamics of international markets.
An open mind but not a blind eye
As we come to find out lots of benefits derived out of FDI inflow but do need to keep in mind
that it comes with a cost. Even where some limited form of capital control is warranted on
economic grounds, actual implementation is all too often dominated by political considerations,
and the results are not pretty. A few powerful political stakeholders benefit but only at a high
cost to other citizens. And no country that has made substantial progress in capital account
liberalization has been inclined to reverse that progress in any long-term sense—not even
countries that have suffered crises like Thailand. Countries that have opened up their capital
accounts seem to believe that whatever problems they faced in liberalizing, the benefits will
exceed the costs going forward.
Hard work remains to be done on capital account liberalization and its sequencing with other
policies to find the point at which the benefits to further capital market integration stop
exceeding the costs. An analytical study in a recent issue of the IMF's World Economic Outlook
(WEO) stressed the importance of making sure that financial market liberalization does not get
too far ahead of trade liberalization. Another WEO study suggested that, to some extent, exact
sequencing may be less important than making sure that macroeconomic and regulatory policy
are strong prior to liberalization.
In the meantime, there seems to be a good case for keeping an open mind on the issue of capital
controls and debt– especially when debating ways to better immunize the global financial system
against financial crises in the twenty-first century.
FOOD FOR THOUGHT: Why do most Finance graduates want to work for multi-national
companies?
SUMMARY:
There is ample evidence that FDI is a key ingredient to sustainable economic growth. However,
FDI does not come without pre-conditions, nor can host countries reap all the benefits of FDI
automatically. Just like any other business people, foreign investors are driven by profits. An
enabling environment for FDI has several components.
First of all, political and macroeconomic stabilities are an absolute pre-requisite for any kind of
private investment, including FDI. Numerous studies have amply demonstrated that political and
economic stabilities, along with the prospect of growth, are the most important determinants for
FDI. Only in extreme cases, such as the existence of crucial natural resources, would a foreign
investor go to a war zone or where there is rampant inflation.
Secondly, a sound policy and regulatory framework and efficient supporting institutions to
enforce the relevant laws and regulations are imperative for FDI to enter and thrive. Especially in
a globalized competitive market, the difference between countries in how conducive their
investment climate may be, including how an investor is received, how many administrative and
regulatory obstacles an investor has to overcome to enter and operate, and how commercial
disputes are handled through the judiciary system have a huge impact on where the investor will
go and how much contribution the investment will make to the host economy.
Finally, an adequate physical and social infrastructure complements a good policy and regulatory
framework to create the necessary environment for attracting FDI. These include the quantity
and quality of roads and communication systems, skilled labor, as well as the efficiency with
which public services are delivered. They are also important if the full potential benefits of FDI
presence are to be realized.
At the country level, a new World Bank study found that administrative procedures, and the
costs and delays associated with them, can significantly influence the location of multinational
firms and productivity in Bangladesh. Other studies, often via surveys, tend to confirm such
conclusions. Therefore, rather than being a means to address market failures and to promote
investment, the existing regulatory framework in a large number of developing countries is being
perceived by many as an administrative obstacle. These administrative barriers can be
particularly negative for foreign investors who are not politically connected, who operate under
strict internal corporate guidelines, or who do not have local partners to take care of a multitude
of procedural obstacles and associated payments. Accordingly, countries may lose the “good”
foreign investors they precisely attempt to attract in the first place.
Weak infrastructures, lack of enabling environment, political instability, bureaucratic bottle-
necks and absence of proper legal framework reportedly are the major factors which investors
see as impediments to FDI in developing countries like Bangladesh.
Moody's Investors' service has rated Bangladesh BA3, which implies sound macroeconomic
fundamentals and better credit worthiness. This ranking is similar to that of BB- assigned by
Standard and Poor's recently. In South Asia, which is amongst the least economically integrated
regions of the world; Bangladesh ranks number 2, just after India. This rating broadly
incorporates financial and balance of payments robustness, continued economic stability and
sustained growth at around 6 per cent per annum over the last one decade. Stable prices,
exchange rates, high foreign currency reserves and growing home remittances from overseas
Bengali workers contribute a lot to this perception. Policy consistency along with steady progress
in trade openness has helped steady economic growth averaging over 6% per annum.
For Bangladesh to be successful in attracting more FDI some recommendations are made here:
- Quality of bureaucracy and governance need to improve
- Improvement of law and order situation
- Development of infrastructure and human resources
- Improvement of port services
- Privatization and further reforms
- Modernization of business law
- Setting up of industrial parks
- Setting up of new EPZs
- Improving the country’s image abroad
- Policies regarding macroeconomic stability
- Economic and commercial diplomacy.
CASY STUDY 1: Resolving security concerns, political uncertainty to woo FDI stressed.
FE Report. (11 December, 2011)
Economists and trade experts Saturday stressed the need for removal of security concerns,
further liberalization of trade-related policies and resolving political uncertainty to woo foreign
direct investments (FDIs) for sustainable economic growth.
The inward flow of FDI is awfully low in Bangladesh compared to other countries having similar
status as one of the least developed countries (LDCs), they said.
Country's eminent economists and researchers were speaking at a three-day seminar titled,
"Bangladesh at 40: Changes and Challenges." organized by faculty of Business Studies of
Jahangirnagar University (JU). Professor Abul Bayes of JU chaired the session.
Addressing the seminar, noted economist Dr Wahiduddin Mahmud said lack of favourable
investment climate is also reflected by the fact that in spite of very liberal policies, Bangladesh is
yet to become a favourite destination for FDI.
The country needs to tackle several growth-related factors like poor governance, large scale tax-
evasion, extremely high population density and the associated scarcity of land and natural
resources to ensure sustainable growth, said the former adviser to the caretaker government.
The country will also have to address low-skilled labour force and its vulnerability to natural
disasters including the prospect of being one of the victims of climate change, he said.
Dr Mahmud was delivering Martyr Memorial Lecture on "Bangladesh's Development Surprise:
“A Test Case or Showcase.” At JU seminar.
"After four decades of its independence it has now become a major issue of research as to how
could the progress achieved so far have been possible given the country's desperate initial
conditions and allegedly poor record in governance," Dr Mahmud said.
"After three elected governments having completed their tenures and the fourth one being
midway in its tenure, the country still remains a 'test case' of whether economic development and
democracy promotion can proceed hand in hand in such a low income country," he said.
Focusing on country's export trend, Professor Mahmud said, "While most low-income countries
depend largely on the export of primary or resource based products, Bangladesh has made a
transition from being primarily a jute- exporting country to a RMG exporting one."
The transition has been dictated by the country's resource endowment characterized by extreme
Land scarcity and very high intensive manufacturers, he said.
"Manufactured exports currently account for more than 90 per cent of the country's export
earnings - a unique feature among countries at a similar stage of development," said Mr.
Mahmud.
Having low wage costs can hardly compensate for its relative disadvantage in marketing skills
and infrastructure, he said.
Executive Director of Centre for Policy Dialogue (CPD) Mustafizur Rahman in his presentation
on "Bangladesh and Regional Cooperation in South Asia: Evaluation, Prospects and
Challenges," said that the country is located in strategically important place being nearer to two
important power houses- India and China.
Both India and China are the rising stars, which will dominate overall growth in the 21st century.
"We are fortunate to be located near the rising stars of the century," he said. The location itself
brings us immense possibilities for growth, he said."It is upon us, to decide whether we will be
able to accelerate our growth or lag behind," said the CPD top brass.
"If we do not respond properly others will take the opportunity," he said.
Professor Rahman, who is the member of an official delegation to the forthcoming World Trade
Organization (WTO) conference in Geneva, also pointed out that attaining duty and quota-free
access of Bangladeshi products into US market will be one of the key targets of the country.
Professor Selim Rahman of Dhaka University said the country should move forward to have a
good chunk of regional trades through necessary changes in policy measures and governance
system.
"We did liberalise our policies on ad-hoc basis, which in turn failed to attract FDIs as there are
Contradictions in policies,” said Mr. Rahman."We are at once reducing customs duty but raising
Para-tariff on the other hand," he said. The country requires developing its competitiveness and
diversification of export baskets to sustain export growth dominated by readymade garment
(RMG) sector, he added.
CPD's Senior Research Fellow KG Muazzem said country's total inward stock of FDI until 2010
was only US$6.1 billion which is accounted for only 6.1 per cent of gross domestic product
(GDP) and mere 0.03 per cent of total global stock of FDI worth US$19.1 trillion. Although
Bangladesh is in leading position among the LDCs, the country's FDI flow is only 3.5 per cent of
the total FDI inflow to LDCs, he said in his presentation titled, 'Foreign Direct Investment.'
The neighbouring India attracted $24 billion in last year alone, said Mr. Muazzem.
Despite having provision for full repatriation of profit and liquidated investment, fiscal
incentives and other benefits, national treatment at post-establishment phase, protecting foreign
investment under the bilateral investment treaty with 29 countries and provide opportunity to
avoid double taxation under the double taxation treaty with 28 countries, country's FDI is
awefully low, he lamented.
The trend of inward flow of FDI was not consistent in Bangladesh, he said.
It was almost absent in 1970s and was even negative in some years in 1980s perhaps because of
adverse impact of a number of economic and political factors including weak macroeconomic
condition, predominance of public sector enterprises, small domestic market, early phase of rise
of export oriented RMG industry and political instability, he said.
Since mid-1990s, FDI flow has started to rise mainly in energy and power and RMG sector.
In 2000s, major surge in FDIs were in telecommunication, banking and lately in RMG and
Textile sectors. There is a huge difference between the projects registered for FDI and those
which were finally in operation.
"If all the registered projects at the Board of Investment (BOI) were realised since 1970s, FDI
stock would as high as US$17 billion at the end of 2010," said Mr. Muazzem.
Dr Ismail Hossain of JU in his presentation titled, " External Sector of Bangladesh:
Developments, Policy Reforms & Outlook for the Future," said one of the successes of
Bangladesh in the post independence period is sustained high rate of growth of exports
exceeding that of imports resulting in reduced trade deficit as a proportion of GDP.
"Trade performance was, however, low in the seventies and the eighties when export was small
and marked by annual fluctuations and financed about one third of imports," he said.
"Sustained annual increase in export began in the later half of the eighties and in fiscal year (FY)
2010-11 it financed more than 75 per cent of imports," he said.
Bangladesh underwent a shift in the trade regime from inward-looking to an outward-looking
one resulting in higher integration of the economy in the global economy, he said.
The external sector thus faces both opportunities and challenges from an increasingly globalized
world. In this context, it is important to see how trade will evolve in the next 40 years, he added.
The forecast is based on two different models which are currently in use.

Question 1: Why do you think inward FDI is awfully low in Bangladesh compare to other Asian
nations?
Question 2: Why is there a huge difference between the projects registered for FDI and those
which were finally in operation?
Question 3: What does the statement mean "If we do not respond properly others will take the
opportunity?"
Question 4: Why integrating our economy with the rest of the world poses both opportunities
and challenges financially?
CASE STUDY 2: Can the government of India stay firm on retail FDI?
November 29, 2011 3:09 pm by Neil Munshi.
It was, many said, one of the most revolutionary fiscal reforms India had instituted in years. But
perhaps Indians aren’t quite ready for a revolution. At least not this kind.
Opposition parties – and even some members of the ruling coalition government – halted
proceedings in parliament again on Tuesday in the wake of last week’s decision to open up
India’s lucrative retail market to foreign investment. The lawmakers say it threatens millions of
small businesses.
With the opposition gaining momentum, there is every chance that FDI reform could go the route
of the US President Barack Obama’s healthcare reform bill – delivering a watered-down version
of reform that pleases neither side.
India’s cabinet passed the FDI reform on Thursday – it doesn’t have to be approved by
parliament – in the middle of what have now been six days of paralysis and chaos in the lower
house.
By Friday, an opposition leader declared she would “personally set afire the showroom [of a
foreign retailer] when it opens anywhere in the country and I am ready to be arrested for the act.”
Protests followed across the country. Reports of a Carrefour being torched in Jaipur turned out to
be untrue, though a few effigies of foreign retailers and Manmohan Singh, the prime minister,
did go up in flames.
Members of all the major political parties met the finance minister on Tuesday. They emerged
with no consensus other than an agreement that opposition views should be brought to the prime
minister and the cabinet. (Though those could be gathered just by turning on the television.)
The announcement of the reform late on Thursday night came as a shock to many Indians who
had written off Singh’s scandal-plagued government as unable to pass meaningful reform – it
was as if the ruling Congress party were saying: “See, we can still do big things!”
But the reform may simply be too big for a politically weak government to pull off.
The opposition says unless the reform is rolled back it will not allow the lower house to function
– this during a crucial winter session in which legislators were meant to consider 54 important
bills but have not, with just 15 days remaining, managed to discuss let alone pass a single one.
Even members of the Congress party are decrying the decision because it will hurt the poor, and
comes at a bad time given upcoming elections. At the same time, backers of the anti-corruption
bill that was supposed to be the centerpiece of the session are nipping at Singh’s heels.
The government claims to be standing firm. Will it bow to pressure in the end? As the days of
policy inaction and protests stretch into weeks and maybe months, and with key regional
elections looming next year and federal elections in 2014, it may just realize that India wasn’t
ready for a revolution after all.
Question 1: Why do some politicians oppose FDI in India’s retail sector?
Question 2: Why a weak government may not be capable of conducting meaningful reform in
financial sector?
Question 3: Write down the importance of this reform bill for India and what will it cost if India
fails to pass the bill?
Question 4: Why do some politicians always oppose FDI? Critically evaluate their views.
TRUE/FALSE
1. When a firm exports to a foreign country, foreign direct investment occurs. 
2. Under the free market view, countries should specialize in the production of those goods and
services that they can produce most efficiently. 
3. Greenfield investment involves the establishment of a new operation in a foreign country. 
4. FDI takes on two forms: green-field investments and licensing. 
5. Executives see FDI as a way of circumventing future trade barriers
6. FDI has grown significantly slower than world trade and world output. 
7. Most FDI has been directed at the developed nations of the world as firms based in advanced
countries invested in the others' markets. 
8. Licensing is an attractive option because the firm has valuable know-how that can be
adequately protected by a licensing contract. 
9. The only two alternatives that firms have besides FDI are licensing and franchising. 
10. Because of the problems associated with doing business in a different culture where the
"rules of the game" may be very different, FDI is risky. 
11. Even though developed nations still account for the largest share of FDI inflows, FDI into
developing nations has increased significantly over the years. 

MULTIPLE CHOICE QUESTIONS:

1. Although Gillette is an American company, it has invested substantial business
resources in activities outside the United States. This practice is referred to as: 
a) Foreign direct income
b) Multinational investment income
c) Foreign international trade
d) Foreign direct investment
2. The big advantage of establishing a(n) _____ in a foreign country is that it gives the
firm a much greater ability to build the kind of subsidiary company that it wants. 
a) joint venture b) partnership c) franchise d) Greenfield venture
3. Which one is not a component of FDI?
a) Equity capital b) Intra company loan c) Reinvested earnings d) Capital budgeting
4. Which one is not one of the three basic factors that foreign investors are attracted to?
a) Product b) promotion c) distribution d) price
5. Which of the following is a disadvantage of joint ventures? 
a) The shared ownership arrangement can lead to conflicts and battles for control between the
investing firms.
b) It gives a firm the tight control over subsidiaries that it might not need to realize experience
curve or location economies.
c) A firm that enters a joint venture risks giving control of its technology to its competitors.
d) When the development costs and/or risks of opening foreign markets are low, a firm might
gain by sharing these costs and/or risks with a foreign partner.
6. FDI is an acronym that stands for
a) foreign direct investor b) foreign direct investment
c) foreign direct institute d) Foreign direct investor.
7. The United States is one of the most favorite destinations of FDI because of all of the
following except:
a) it has a large and wealthy domestic market.
b) it is quite hostile to foreign direct investment.
c) it has a stable political and social environment.
d) it is an open economy which is open to FDI.
8. Which of the following involves granting a foreign entity the right to produce and sell the
firm's product in return for a royalty fee on every unit sold? 
a) Licensing b) Franchising c) Exporting d) Renting
9. The _____ view argues that international production should be distributed among
countries according to the theory of comparative advantage. 
a) Free market b) Liberal c) Conservative d) Radical
10. Although it normally involves much longer-term commitments, franchising is
essentially the service industry version of: 
a) Exporting b) Licensing c) Renting d) Franchising
11. _____ has the following advantages: firms benefit from a local partner's knowledge of
the host country's competitive conditions, a firm shares development costs with a local
partner, and in many countries political considerations necessitate this form of entry.
a) A joint venture b) Partnership c) Subsidy d) Franchise
SHORT ANSWER QUESTIONS:
1. What is meant by the term foreign direct investment?
2. What is portfolio investment?
3. What are the components of FDI?
4. What are the six ways of entering into a foreign market?
5. What is Greenfield FDI?
6. Why is it so difficult to measure FDI inflow?
7. What are the few comparative advantages Bangladesh possesses to attract more FDI?
8. What are the objectives of BEPZA?
9. What are the major functions of Board of Investment of Bangladesh?
LONG ANSWER QUESTIONS:
1. What are the costs and benefits of attracting FDI in Bangladesh?
2. Why do we need foreign capital badly in Bangladesh?
3. What are the factors affecting the flow of foreign capital in Bangladesh?
4. What are the advantages and disadvantages of Licensing?
5. What are the advantages and disadvantages of Franchising?
6. What is a Joint Venture? Why do you think it is one of the best way of attracting FDI in
Bangladesh?
7. What are the some strategies we can take to attract more FDI in Bangladesh?
8. What is the impact of FDI on balance of payments?
9. What considerations must be taken before attracting FDI inflows to get the highest benefit in
Bangladesh? Why portfolio investment should not be encouraged in the same manner like
FDI?
10. Why do you think Bangladesh has failed to attract a substantial amount of FDI compare to
other developing countries over the past 20 years?
 CHAPTER 11
THE INTERNATIONAL MONETARY SYSTEM
“The trade of the petty usurer is hated with most reason: it makes a profit from currency itself,
instead of making it from the process which currency was meant to serve.”- Aristotle.

Chapter Learning Objectives:

 To present a history of the International Monetary System.
 To understand the Bretton Woods agreement and its’ impact on International Monetary
System.
 To discuss the International Monetary Fund and the World Bank and their objectives.
 To explain the system of Special Drawing Rights (SDRs) and their uses.
 To describe the purposes, operations, and consequences of the European Monetary System.
 To outline recent proposals for international monetary reform.
Financial transactions between the country citizens and among different countries require an
established arrangement that is intended to facilitate settlement of payments. These arrangements
form the subject matter of the International Monetary System. The international monetary system
that we observe today has gone through various evolutions to come at this stage. This chapter
will take us to the past when trade payments were settled through barter to the use of commodity
currencies to now fiat money which is well known as paper money. This chapter will also
provide us an insight as to why we failed to create a well established uniform international
monetary system and what the future lies ahead.

INTERNATIONAL MONETARY SYSTEM:

The International Monetary System consists of laws, rules, institutions, instruments, and
procedures, all of which are involved in the international transfers of money. The elements above
affect foreign exchange rates, international trade and capital flows, and balance-of-payments
adjustments. The international monetary system plays a critical role in the financial management
of multinational businesses and the economic policies of individual countries.
Institutional framework within which international monetary system attributes:
1. International payments are made.
2. Movements of capital are accommodated.
3. Exchange rates are determined.
An international monetary system is required to facilitate international trade, business, travel,
investment, foreign aid, etc. To understand the flow of international capital/currency we study
the International Monetary System which is a complex system of international arrangements,
rules, institutions, policies in regard to exchange rates, international payments, capital flows.
International Monetary System has evolved over time as international trade, finance, and
business have changed, as technology has improved, as political dynamics change, etc.
Example: evolution of the European Union and the Euro currency impacts the International
Monetary System.

SPECIE COMMODITY STANDARD (The past)

Primitive peoples extracted from nature what they needed or fashioned it into things they could
use. When they produced more than they needed, they bartered the excess for what they could
not produce themselves. There is another group of people who needed that excess goods and
have the excess of what the first group is looking for. It's called trading. Commodities are traded
for commodities, and over time some commodities became medium of exchange, the most
prevalent of which are precious metals that are converted into specie (coin). But this system
works only when the commodities traded have equal value. When they don't, trade becomes a
form of theft, which leads to unfairness and conflict. Since trading through barter faced many
inconveniences and metal coin or commodity currency established itself for settling payments
which gave birth to the specie commodity standard. The coin (mostly gold and silver) had the
stamp of the sovereign on the basis of weight and fineness and were full-bodied coins meaning
that their value was equal to the value of metal contained therein. When it was gaining popularity
some coin makers started to mix lower value metal with it and thus the real value of metal came
to be lower than the face value of the coin.
The Coinage Act or the Mint Act, passed by the United States Congress on April 2, 1792,
established the United States Mint and regulated the coinage of the United States. The long title
of the legislation is an act establishing a mint, and regulating the Coins of the United States.
This act established the silver dollar as the unit of money in the United States, declared it to be
lawful tender, and created a decimal system for U.S. currency.
On May 8, 1792 An Act to Provide For a Copper Coinage was signed into law by President
George Washington. This legislation resulted in the birth of the copper cent, from which
descends today's one cent piece in the U.S. The Act also stipulated that "the director of the mint
be authorized to contract for and purchase a quantity of copper, not exceeding one hundred and
fifty tons to be coined at the mint into cents and half-cents and be paid into the treasury of the
United States, thence to issue into circulation." Furthermore, "no copper coins or pieces
whatsoever except the said cents and half-cents, shall pass current as money, or shall be paid, or
offered to be paid or received in payment for any debt, demand, claims, matter or thing
whatsoever."
Let us take a longer view of the international monetary system, dividing it up into its phases. The
period from 1815 to 1873 was a period of bimetallism, for which gold and silver were the basic
reserve assets and the main countries were France and the United States. During the civil war,
the United States suspended convertibility, leaving France alone among major powers, on
bimetallism. Remember that in a world economy, as long as one country fixes the price of both
silver and gold, then that fixes the relative prices of both gold and silver in the world. For 1815
until 1873, the relative price ratio of gold and silver varied only between 15:1 and 16:1. This
bimetallic system gave the world a monetary unity, providing countries that were on the silver
standard with a fixed exchange with countries on the gold standard. Support for the bimetallic
monetary system dwindled a bit when the United States dropped its commodity standard and
incurred inflation from 1862 until 1879.
But what happened in the 1870s? France went to war with Germany and had to suspend
convertibility. Then nobody was on bimetallism, except for a few countries like Belgium and
Switzerland that were in the Latin Monetary Union, but with American production of silver
going up and Germany dumping silver as the new German Empire shifted to gold, France
realized it would have to buy up all excess silver in the world on its own. Silver would have
displaced all gold currency. So France did not go back to bimetallism and that system therefore
became a dead letter. The world economy now split into an international gold standard on one
hand and an international silver standard on the other. Silver's monetary role was diminishing
and the gold brigade was beginning to encompass the mainstream of the world economy.
Over the period from 1873 to 1896, the price level was falling. This was the period of populist
revolts in the Midwest USA. The populists hated the fact that farmers had to pay back debts with
an appreciated currency. In 1896, William Jennings Bryan's electrified his audience with his
Drexel Avenue speech in Chicago in which he charted that the American farmer was being
"crucified on a cross of gold." There was deflation in the gold countries in this period because
when countries shifted from bimetallism to the gold standard, the movement created an excess
demand for gold-tight money-and as a result, deflation. Also in 1873, Prussia and the
Scandinavian countries abandoned the silver standard, depressing silver and creating inflation in
countries sticking to silver So there were two worlds during that time period: an inflationary
silver world and a deflationary gold world until 1896, when, finally, soaring gold supplies from
South Africa, where gold had been discovered in the Witswatersrand in 1886, combined with the
introduction of the cyanide process to bring huge amounts of gold into the system.
GRESHAM’S LAW:
Gresham's Law states that overvalued money will drive undervalued money out of the market.
Or more simply, "bad money drives out good money out of the market".
Gresham's Law comes into play, when several types of money have a conversion ratio specified
by legal tender laws, different from their market price. For example, let's say the law sets the
ratio at 20 ounces of silver for one ounce of gold; but the market price is 15. Any contract or debt
in silver can be now paid in gold. So, instead of spending 20 silver, the debtor will buy an ounce
of gold for 15. As a result, no one will be willing to enter a contract quoted in silver.
The undervalued money will vanish from the market, bringing down prices quoted in it. Those
still using it will likely find themselves in trouble, because they made debts and investments
under the old price level and expected their incomes to be correspondingly higher. The 'good
money' will be held by the users of money, or sold into other countries, where the local laws do
not apply. This exchange of currencies takes time, while the supply of money shrinks. This
produces a temporary deflationary effect.
The Law is a special case of the usual effects of price controls by government: in this case, the
government’s artificial fixing of an exchange rate between two or more moneys creates a
shortage of the artificially under-valued money and a surplus of the over-valued money.
THE CLASSICAL GOLD STANDARD (1875-WWI)
For about 40 years most of the world was on an international gold standard, ended with First
World War (WWI) when most countries went off gold standard. London was the financial center
of the world, most advanced economy with the most international trade. Classical Gold Standard
is a monetary system in which a country's government allows its currency unit to be freely
converted into fixed amounts of gold and vice versa. The exchange rate under the gold standard
monetary system is determined by the economic difference for an ounce of gold between two
currencies.
The gold standard was mainly used from 1875 to 1914 and also during the interwar years. Gold
Standard exists when most countries:
1. Use gold coins as the primary medium of exchange.
2. Have a fixed exchange rate between ounce of gold and currency.
3. Allow unrestricted gold flows - gold can be exported/imported freely.
4. Banknotes had to be backed with gold to assure full convertibility to gold.
5. Domestic money stock had to rise and fall with gold flows.
Rules of the game under the gold standard for participating countries:
1. Fix an official gold price and allow free convertibility between domestic money and gold at
this official rate (i.e. US$20.67/ounce of gold, £4.2474/ ounce of gold).
2. Impose no restriction on the import and export if gold is used for international transactions.
3. Issue national currency only with gold backing.
4. In the event of a short – run liquidity crisis associated with gold outflows, the central bank
should lend to domestic banks at higher interest rates.
5. If first Rules temporarily suspended, restore convertibility at the original rate as soon as
practical.
The gold standard worked until World War I. The war disrupted trade flows and the free
movement of gold.
Example of the Gold Standard:
Consider a world with two countries denoted A and B and suppose that Country A runs a balance
of trade surplus, i.e. its exports exceed its imports. Country A exports goods and imports gold. Its
money supply increases, which increases the price of its goods and services. The reverse occurs
in B. The increase in A’s prices and the decrease B’s prices will eventually correct the trade
imbalance. In 1914, European countries went off gold, by and large, to finance deficit spending.
This sent gold to the United States in return for munitions and other war supplies. Gold flooded
into the United States and the newly-created Federal Reserve monetized it, causing the price
level to double. As always happens when countries shift onto or off of the gold standard, gold
became unstable in 1914.
From 1914 to 1924, America had anchored dollar standard because it was the only major
currency on gold and other countries started to base their currencies more on the dollar than on
gold. Then in 1924, Germany went back to gold in its stabilization plan to stop its hyperinflation.
In 1925, Britain, not wanting to be left behind by Germany, went back to gold. In 1926, France
went back to gold more or less because Britain and Germany had gone back to gold; and it went
back at a rate that left the franc undervalued. So the world went back to a gold standard, and
what do you think happened? Just as in 1914, when countries went off the gold standard creating
inflation, when they went back to gold this created an excess demand for gold, causing deflation.
The deflation of the 1930s, which was a major contributing factor to the depression, was a direct
consequence of the movement back to gold at a price level in the 1920s that was above the
equilibrium price level for equilibrium under the gold standard. Of course, other factors were
involved in the Depression, including the immediate impact of the Smoot-Hawley tariff, but the
major factor was the deflation inaugurated by the restoration of the internal gold standard with
gold undervalued.
Britain went off gold in 1931 and America in 1933. America then went back to gold after
devaluing the dollar in 1934. France was still on gold, but in 1936, France had to devalue and
was the last country to leave the Reformed Gold Standard of the post war period. 1936 was also
the year of the Tripartite Monetary Agreement which established a new kind of international
monetary system, a dollar standard where the dollar was the only currency anchored to gold. All
of the other countries in that system kept their respective currencies pegged to the dollar. That
system lasted from 1936 to 1971.
The creation of the gold standard monetary system in 1875 marks one of the most important
events in the history of the foreign exchange market. Before the gold standard was implemented
countries would commonly use gold and silver as means of international payment as explained
earlier.
Although the gold standard would make a small comeback during the inter-war years, most
countries had dropped it again by the onset of World War II. However, gold never ceased being
the ultimate form of monetary value.
Advantages of Gold Standard:
1. Ultimate hedge against inflation. Because of its fixed supply, gold standard creates price
level stability, eliminates abuse by central bank/hyperinflation.
2. Automatic adjustment in Balance of Payments due to price-specie-flow mechanism.
Disadvantages of Gold Standard:
1. Possible deflationary pressure. With a fixed supply of gold (fixed money supply), output
growth would lead to deflation.
2. An international gold standard has no commitment mechanism, or enforcement mechanism,
to keep countries on the gold standard if they decide to abandon gold.
GOLD AND MONEY
A question could rise why gold is needed at all for the design of the International Monetary
system since it is a metal that is basically no use other than ornaments. Why can't a wise central
bank (or a group of them) manage money supply without any reference to gold? In fact, this was
exactly the question raised by the famous economist John Maynard Keynes.
Perhaps the most fundamental answer is: central bankers are (were) not so wise. If you tie the
value of money to gold, it may fluctuate due to the shifting demand and supply conditions of
gold. But that would be much better than hyperinflation or deep devaluation caused by a huge
budget deficit or irresponsible monetary policy. Gold is needed to discipline the monetary and
fiscal authorities. Even though macroeconomics has advanced, we cannot trust every central
banker, even to this date.
But at the same time, there are problems associated with the rigid gold-money linkage.
First, short-term price fluctuation is unavoidable. In the 19th century, when a new gold mine
was discovered in California or Alaska, the supply of gold increased greatly and the world had
inflation. But when there was no such big gold discovery, there was a deflation. No one could
ensure that the speed of gold discovery matched the increase in global money demand.
Second, the more serious problem is long-term shortage of monetary gold. Over the years, the
growth of the rapidly industrializing world economy was faster than the pace of gold discovery.
In order to supply the needed money, the gold standard was gradually transformed so that a small
amount of gold could back a much greater amount of money.
The gold standard evolved in the following steps:
1) Gold coin standard: Only gold coins circulate as money, and no paper money or bank deposits
are used. The amount of monetary gold is equal to money supply. All money has intrinsic value.
2) Gold bullion standard: As the banking system creates deposit money, people begin to carry
paper notes for convenience. But paper money can be exchanged for gold at any time. Most
monetary gold is accumulated at bank vaults in the form of gold bullions (gold bars). Through
the money multiplier process, money supply is much greater than the amount of gold held by
banks.
3) Gold exchange standard: if gold shortage persists, further saving of gold becomes necessary.
Gold can be held only by the center country (US Federal Reserves) while other central banks
hold dollar reserves, not gold. Their dollar holdings are guaranteed to be converted to gold by the
United States of America.

The Collapse of the Gold Standard:

The main problem with the gold standard was that if a country was not competitive in the world
marketplace, it would lose more and more gold as more goods were imported and less exported.
With less gold in stock, the country would have to contract the money supply, which would hurt
the country's economy. Less money in circulation reduces employment, income, and output;
more money increases employment, income, and output. This is the basis of modern monetary
policy, which is implemented by central banks all over the world to stimulate a sluggish
economy by increasing the money supply or to reign in an overheating one by contracting the
money supply.
During the 1930's, the world was experiencing something that was very new to the classical
economists of the Great Depression. Countries started abandoning the gold standard by reducing
the amount of gold backing their currency so that they could increase the money supply to
stimulate their economies. This deliberate reduction of value is called a devaluation of currency.
When some of the countries abandoned the gold standard, then it just collapsed, for it was a
system that could not work unless all of the trading countries agreed to it.
Of course, at some point, something else would have to take its place; otherwise, there could be
no world trade–at least not in the quantities that were then occurring. As World War II was
coming to a close, it was obvious that another system would be needed to replace.
Bretton Woods and the IMF (1944-1973)
After World War II, the Bretton Woods system was established. In fact, the agreement to create
a new international monetary system was negotiated among the allied powers even before the
end of WWII, leading to the Bretton Woods Agreement in 1944. Bretton Woods is the name of a
small tourist spot in the mountains of New Hampshire, USA. There, the delegates gathered to
design a new global economic system. Their most important goal was to prevent each country
from pursuing selfish policies, such as competitive devaluation, protectionism and forming trade
blocks, which damaged the world economy in the 1930s.
The British delegation was headed by John M. Keynes, the famous economist, while Harry D.
White of the US Treasury Department represented the American side. The contents of the new
system were negotiated essentially by these two countries. As a dominant military and economic
power, the US took the leadership away from Britain, which was war torn and losing
international influence. The Keynes proposal was rejected and the US idea became the
foundation of the newly created International Monetary Fund (IMF).
IMF started with 30 countries but now has over 180 members. It has five objectives:
 To promote international monetary cooperation.
 To facilitate the balanced growth of international trade.
 To promote exchange stability.
 To eliminate exchange restrictions.
 To create standby reserves.
The rejected British proposal was to create a mighty settlement union for all countries. Each
country was to have an official account at this mechanism, and all balance of payments (BOP)
surpluses and deficits would be recorded and settled through these accounts. This would mean
that both surplus and deficit countries bear the responsibility for correcting the imbalance.
However, the U.S. plan, which was actually adopted, was a much weaker revolving fund. Each
country would contribute a certain amount ("quota") to this fund, and member countries with
BOP difficulties would borrow (or "purchase" hard currencies) from this fund. This meant that
only deficit countries would bear the responsibility for correcting the imbalance. (The UK was
expected to be a deficit country after the war, while the US was expected to be a surplus
country.) Later in the 1950s, borrowing countries were required to implement macroeconomic
policies to reduce the deficit ("conditionality").
The Bretton Woods Agreement also established the World Bank (International Bank for
Reconstruction and Development). The World Bank's initial purpose was to assist the recovery
of war-torn Europe and Japan. But in reality, Japan's recovery was assisted by US bilateral aid
and Europe's recovery was promoted by the Marshall Plan, a massive US aid program. The
World Bank subsequently became an organization to assist developing countries.
Although the World Bank does not play a direct role in monetary policy, it contributes to the
global monetary system by providing low interest loans to developing countries. These loans,
which are used for such things as public-sector projects (i.e. power stations, roads, etc.),
agricultural development, education, population control, and urban development, are intended to
promote economic development and increase the standard of living in developing countries. The
bank lends money under two schemes. Under the IBRD scheme, money is raised through bond
sales in the international capital market. Borrowers pay a market rate of interest—the bank's cost
of funds plus a margin for expenses. This "market" rate is lower than commercial banks' market
rate. Under the IBRD scheme, the bank offers low-interest loans to risky customers whose credit
rating is often poor. A second scheme is overseen by the International Development Association
(IDA), an arm of the bank created in 1960. Resources to fund IDA loans are raised through
subscriptions from wealthy members such as the United States, Japan, and Germany. IDA loans
go only to the poorest countries. Borrowers have 50 years to repay at an interest rate of 1 percent
a year. The world's poorest nations receive grants and noninterest loans.
The IMF and the World Bank were called the Bretton Woods sister organizations. One more
organization (International Trade Organization) was also planned but not created at that time.
Instead, the General Agreement on Tariffs and Trade (GATT), a non-organizational entity,
played the role of promoting free trade for four decades. GATT became institutionalized as
WTO in 1995. So we now have three sisters.

The IMF (left) and the World Bank today, in Washington, DC

Features of the Bretton Woods international dollar standard:
One of the main features of Bretton Woods is that the U.S. dollar replaced gold as the main
standard of convertibility for the world’s currencies; and furthermore, the U.S. dollar became the
only currency that would be backed by gold. (This turned out to be the primary reason that
Bretton Woods eventually failed.)
 A system of fixed exchange rates on the adjustable peg system was established. Exchange
rates were fixed against gold but since there were fixed dollars of gold (35 per ounce) the
fixed rates were expressed relative to the dollar. Between 1949 and 1967 sterling was pegged
at 2.80.Governments were obliged to intervene in foreign exchange markets to keep the
actual rate within 1% of the pegged rate.
 Governments were permitted by IMF rules to alter the pegged rate – in effect to devalue or
revalue the currency but only if the country was experiencing a balance of payments
deficit/surplus of a fundamental nature.
 The dollar became the principal international reserve asset. Only the USA undertook to
convert their currency into gold if required. In the 1950’s they held the largest gold stocks in
the world. Thus the dollar became “as good as gold” and countries were willing to use the
dollar as their principal. Initially the Bretton Woods system appeared to work well. World
trade grew at record rates in the 1950’s and the world experienced what has since been
described as the “golden age of capitalism”.

However in 1971 the system collapsed, clearly there were problems that had developed over the
previous two decades.
The collapse of the Bretton woods system:
Over the next 25 or so years after adopting the Bretton Woods system, the U.S. had to run a
series of balance of payment deficits in order to be the world’s reserved currency. By the early
1970s, U.S. gold reserves were so depleted that the U.S. treasury did not have enough gold to
cover all the U.S. dollars that foreign central banks had in reserve. Finally, on August 15, 1971,
U.S. President Richard Nixon closed the gold window, and the U.S. announced to the world that
it would no longer exchange gold for the U.S. dollars that were held in foreign reserves. This
event marked the end of Bretton Woods and most countries moved to some system of floating
exchange rates.
What caused the collapse of the system?
With such an excellent macroeconomic record, why did the Bretton Woods system collapse
eventually? Economists still debate on this question, but it is undeniable that there was a nominal
anchor problem. The collapse of the Classical Gold Standard was externally forced (i.e., by the
outbreak of WW1), but the collapse of the Bretton Woods system was due to internal
inconsistency. The American monetary discipline served as the nominal anchor for the Bretton
Woods system. But when the US started to inflate its economy, the international monetary
system based on the US dollar began to disintegrate.
The system relied on period revaluations/devaluations to ensure that exchange rates did not move
too far out of line with underlining competitive. However, countries were reluctant to alter their
pegged exchange rates since –
 Surplus countries were under no pressure to revalue since the accumulation of foreign
exchange reserves posed no real economic problems.
 Deficit countries regarded devaluation as an indicator of the failure of economic policy. The
UK resisted devaluation until 1967 – long after it had become dearly necessary.
Besides, financing of US war against Vietnam and an arms and space race against Soviet Union
along with increased social benefits to common Americans forced US to raise the money supply
which it couldn’t do under Bretton Woods agreement.
General floating begins
Since 1973 to present, the major currencies in North America, Europe and Japan have been
floating. During this period, exchange rate instability among major currencies was the norm.
While the US dollar continues to be the most popular international currency, there is no more
guarantee that the US will always play a positive role in stabilizing the international monetary
system. While the US remains economically dominant, its occasionally unilateral behavior has
become a major disturbing factor in the world economy. Meanwhile, EU and Japan (especially
the latter) are not powerful enough to overtake the dollar's dominant position.
The policy management of the floating rate system changed significantly before and after 1985.
Before 1985, currency fluctuation was considered generally desirable, although somewhat
unstable. After 1985, it was recognized that free floating sometimes became too volatile, and
joint intervention to stabilize the foreign exchange market was at times deemed necessary.
Managed float, 1973-1985
From the early 1970s to the early 1980s, the world economy suffered a serious "stagflation"
(coexistence of high inflation and output stagnation). Prices and interest rates rose and diverged
across countries. There were also two "oil shocks" in 1973-74 and 1979-80, both associated with
instabilities in the Middle East. The oil price increased greatly and major oil producers curtailed
its supply (including the oil embargo to unfriendly countries).
Many industrial countries experienced low (even negative) growth, productivity slowdown,
higher unemployment and fiscal crisis. The important thing was that these macroeconomic
shocks were common to all countries.
During this turbulent time, major exchange rates also showed great instability. Floating
currencies did not move smoothly in response to changing fundamentals. Rather, they exhibited
short-term volatility, medium-term misalignment and long-term drift. This meant that floating
rates did not necessarily provide an automatic adjusting mechanism (as the advocates of free
floating believed). Exchange rate instability itself became a serious shock to the world economy.
Economists began to wonder why.
After the breakdown of the Bretton Woods system in the early 1970s, the dollar depreciated
against other currencies. Then it stabilized a while. But it began to depreciate greatly in 1977-78
until an emergency dollar rescue package was implemented in November 1978. After that, the
dollar gradually appreciated until 1985, damaging the international competitiveness of US firms.
Gradually, the world began to move toward harnessing the excessive movement of the major
currencies. But returning to the fixed exchange regime remained out of question for a majority of
policy makers.
There was a hot debate regarding the cause of global economic slowdown in the 1970s-80s.
Many economists blamed the supply shocks (especially the oil shocks and wage rigidity) for
global slowdown. They considered it lucky that the world had made the transition to a floating
rate regime by the time of the oil shocks so that the negative impact could be absorbed more
smoothly. But some economists, including Ronald McKinnon and Robert Mundell, disagreed.
They emphasized the shift in monetary and exchange rate regime (i.e., the breakdown of the
Bretton Woods system) as the major cause of global inflation and recession. For them, the oil
shocks were the result of global monetary instability and not the cause.

The Plaza-Louvre regime, 1985 to present:

Since the 1970s, the design and revision of the international monetary system was handled by a
group of industrial countries bilaterally, regionally, or multilaterally. Their cooperation (or the
lack of it) has determined the evolution of exchange rates. By contrast, IMF has not shown much
interest or leadership in stabilizing or improving the international monetary system. In the late
1970s, IMF endorsed the floating rate regime as the most realistic solution, albeit imperfect.
In September 1985, the finance ministers of the G5 countries (US, Japan, Germany, France, UK)
gathered at Plaza Hotel in Manhattan, New York and decided to lower the dollar which was
clearly overvalued (the Plaza Agreement). The US government, which had so far been reluctant
to intervene in the currency market because of the free market philosophy, also agreed to
cooperate. The joint intervention of these countries was very effective, depreciating the dollar's
value from 240 yen to 140 yen and from 2.8 German DM to 1.8 DM within a year and half.
Some claim that the dollar's decline already began a few months before the Plaza Agreement.
But the announcement effect of the policy change on a global scale was undeniable.
However, the dollar continued to slide beyond the level which was comfortable for Japan and
Germany. In February 1987, the economic leaders of the G7 countries (G5 plus Italy and
Canada) met in Paris to stop the further fall of the dollar (the Louvre Accord). After that, the yen
stabilized in the 120-150 range against the dollar.
The Plaza-Louvre cooperation marked the new era of managing floating exchange rates.
Previously, free floating was considered ideal and the US was particularly unwilling to intervene.
But after these meetings, the major countries began to co-operate a bit more. And this regime
still continues today.
The Plaza-Louvre regime can be summarized as follows:
The Plaza-Louvre Regime: RULES OF THE GAME
1. Unannounced, soft, variable and broad target zones for the major
currencies (especially yen/dollar and euro/dollar) are imagined. Target
zones can be revised if economic fundamentals change.
2. During the normal time when the exchange rates lie within these zones,
let the market decide the currency levels.
3. Intervene jointly, but infrequently, if the actual rates are moving out of
these zones. Do not hide these interventions.
4. Not only Japan and EU, but also the US should participate in these
currency interventions in a symmetrical manner.
5. Interventions must be sterilized (i.e., do not permit the domestic money
supply to change because of currency interventions).
6. Capital mobility must be preserved (current-account and capital-account
convertibility).
7. Other than the above, each country should use macroeconomic policies
to pursue domestic goals.
In the summer of 1995, in the spirit of the Plaza-Louvre regime, the major countries jointly
intervened aggressively to support the collapsing dollar, which eventually turned around and
began to appreciate. Apart from this, smaller joint interventions have become more common,
although still infrequent.
The European Monetary System
After the collapse of the Bretton woods systems, several European countries started to move
towards a system in which there was increasing stability between their national currencies, even
though there might still be volatility in their exchange rates with currencies of non – member
states. This objective was eventually incorporated into the European monetary system (EMS) of
the European Union.
The EMS was established in 1979. As part of this system, there was an exchange rate mechanism
for achieving stability in the exchange rates of member currencies, by restricting exchange rate
movements within certain limits or “bands”.

The objectives of the EMS were: -

 Exchange rate stability – Members agreed to stabilize exchange rates within the narrow
bands of the exchange Rate Mechanism (ERM).
 To promote convergence – in economic performance in member states especially in terms of
inflation rates, interest rates and public borrowing. This is seen as necessary step in the move
to a single currency.
 A long-term aim of achieving a single European currency as part of a wider economic and
monetary Union.
The main features of the ERM were: -
 Each country had a central rate in the system expressed in terms of a composite currency, the
European currency unit (ECU).
 Currencies were only allowed to fluctuate within specified bands.
 Within these there were narrower limits, measured in ECU and acting as trigged for policy
action by governments to limit further exchange rate movement.
The first stage was to establish the ECU. This was the central currency of the EMS and was a
composite currency whose value was determined by a weighted basket of European currencies.
Use of the ECU was largely restricted to official transactions.
The central feature of the EMS, the operation of the exchange rate mechanism and the
experience of the UK illustrates the difficulties of achieving exchange rate stability within
Europe.
THE EURO
The EU’s new single currency, the euro, was duly launched on 1 st January 1999. 11 of the 15 EU
countries agreed to participate and Greece subsequently joined as a 12 th member. Three countries
(Denmark, Sweden and the UK) decided not to join. The euro and the national currencies existed
side-by-side for all countries in the euro-zone. Exchange rates for each national currency were
irrevocably locked in terms of Euros. The existing national currencies (such as the French franc
and Dutch mark) continued in circulation until 1st January 2002, when they were replaced by
euro notes and coins. The euro-zone is comparable in size to the US and the euro has become
one of the world’s major currencies.

Main Advantages of a single currency Euro (€):

1. Significant reduction in transaction costs for consumers, businesses, governments, etc.
(estimated to be .4% of European GDP, about $50B!) European Saying: If you travel through
all 15 countries and exchange money in each country but don't spend it, you end up with 1/2
of the original amount!
2. Elimination of currency risk, which will save companies hedging costs.
3. Promote corporate restructuring via M&A activity (mergers and acquisitions), encourage
optimal business location decisions.
Main Disadvantage of a single currency Euro (€) :
1. Loss of control over domestic monetary policy and exchange rate determination. Suppose
that our economy is not well-diversified, and is dependent on exports of ready-made
garments, it might be prone to "asymmetric shocks" to its economy. If there is a sudden drop
in world garment prices, our economy could go into recession or GDP growth could slow
down and thus unemployment could increase. If we have our own independent monetary
policy, we could use monetary stimulus to lower interest rates and lower the value of our
currency, to stimulate the domestic economy and increase exports. As part of a common
currency, we will no longer have those options; it will be under the control of the single
Central Bank, which will probably not adjust policy for us to accommodate Bangladesh's
concern. We may have a prolonged recession without taking any necessary recourse of action
by the monetary authority if it left under the control of a single authority who is not looking
 into our economic situation instead other different 30 countries concern. There are also limits
to the degree of fiscal stimulus through tax cuts, since budget deficits cannot exceed 3% of
GDP, a requirement to maintain membership in EMU (to discourage irresponsible fiscal
behavior).
2. If one of the Euro member state economy suffers serious economic contraction it may take
down the value of Euro along with the credibility just like it is now the case for Greece who
is reeling off one of the worst financial crisis in recent memory and the exchange value of
Euro is now one of the lowest point against some major currencies in the past three years.
The European Central bank (ECB)
The ECB began operations in May 1998 as the single body with the power to issue currency,
draft monetary policy and set interest rates in the euro-zone. It is based in Frankfurt and it is a
sole issuer of the euro.
Strategic implications of Economic and Monetary Union and the euro
For the member countries, Economic and Monetary Union (EMU) has created a single currency,
the euro, with a single interest rate and single monetary policy. The benefits of EMU
membership have included:-
 The elimination of foreign exchange risk from dealings in the form national currencies of the
euro-zone countries.
 Larger and more competitive capital markets.
 Greater transparency of competition within the euro-zone.

A Theory of Superpower Influence

Historically, whenever there has been a superpower in the world, the currency of the superpower
plays a central role in the international monetary system. This has been as true for the
Babylonian shekel, the Persian daric, the Greek tetradrachma, the Macedonian stater, the Roman
denarius, the Islamic dinar, the Italian ducat, the Spanish doubloon and the French livre as it has
for the more familiar pounds sterling of the 19th century and the present greenback U.S. dollar.
The superpower typically has a veto over the international monetary system and because it
benefits from the international use of its currency, its interest is usually in vetoing any kind of
global collaboration that would replace its own currency with an independent international
currency.
In the 1870s, the United States and France were campaigning for international monetary reform
in the sense of an international return to bimetallism and the development of a standard
international unit of account. Which country was saying no? It was Britain, the leading world
power in the 19th century. As top power, or at least "first among equals,’’ Britain always said no
to international monetary reform, no to an alternative to the pound as a unit of account and the
sterling bill as the most important means of payment. But when Britain faded in displaying her
superiority in economic might then America rose to that vacant position, the positions were
simply reversed, with Britain wanting international monetary reform now but the United States,
the new superpower, rejecting it.
At the world gold conference in 1933, France wanted international monetary reform. France
wanted the United States and Britain to go back to fixing of the price of gold. President
Roosevelt said no, and the dollar continued to float until, unilaterally, the U.S. devalued the
dollar, raising the price of gold from $20.67 per ounce to $35. The United States did not want to
move back to an international monetary system, except under terms that gave it leadership.
At Bretton Woods in 1944, President Roosevelt told Treasury Secretary Henry Morgenthau to
make plans for an international currency after the war. Economists remember that Harry Dexter
White and the staff at the US Treasury made a plan that involved the creation of a world
currency to be called the unitas. Keynes, in London, made a comparable plan for reform that
included a world currency called bancor. When the British delegation came over for the Bretton
Woods conference, it kept bringing up the question of a world currency, but the Americans now
had second thoughts and kept silent. Thus academic internationalist idealism fell prey to
economic national self-interest. As a result the enlightened superpower backed away not only
from Keynes' bancor plan, but from its own unitas plan. Bretton Woods did not create a new
international monetary system; it kept the system that had been in place since 1934.
“The conference at Bretton Woods, New Hampshire, in 1944 did not create a new international
monetary system. Rather, it created two new international institutions, the IMF and the World
Bank, were set up to manage international interdependence in the international financial system
and provide a chance to interfere in the decision making of another country for the anchored
dollar standard.
Reform on International Monetary System:
There is no point in talking about reform on international monetary system because from the past
history it is clear whoever is in power of controlling the global economy that country won’t ever
try to reform the international monetary system to keep in mind the welfare of the global
economy. Because of the bright prospect of the future of Euro, Europeans do not want to talk
about international monetary reform anymore. When the US starts to talk about international
monetary reform, Europeans would interpret it as an attempt on the part of the United States to
break up their play for sustainable and credible Euro. So the United States would not talk about
international monetary reform now anyway, because a superpower never pushes international
monetary reform unless it sees reform as a chance to break up a threat to its own supremacy. The
dollar liabilities of the United States have been rising every day. It is clear that the United States
is never going to suggest an alternative to its present system because it is already a system where
the United States maximizes its seigniorage which means it is making a handsome profit that
results from the difference in the cost of printing money and the face value of that money.
The Long Run Prospects
So much for the past and present: We now move to the 21st century. The dollar is the preeminent
currency of the world. Europe is struggling to maintain the credibility of Euro due to some
mismanagement of some member states macro economy. It is still believed that Europe will be
able to withstand the present financial crisis and will become more robust by establishing its’
credit to the international monetary system.
The European continent, as a country, has a GDP that is probably 10% to 15% larger than
the United States. The European Community uses a currency that is internationally
important since it is considered a good substitute of U.S dollar. Geographically, Europe is more
convenient to all of the former Soviet Union countries, Africa and the Middle East than is the
United States.
There will also be a role for gold. The total amount of gold mined since the days of Nefertiti is
about 3.5 billion ounces (120,000 tons). One billion ounces is in the central banks, more than
another billion ounces is in jewelry, and the rest is in speculative hoards. This last holding is why
ex. The Fed Chairman, Alan Greenspan says he looks at gold whenever he gets a chance. He
looked at three things for signs of inflation in the economy: First was at the money supply, the
second was at interest rates, and the last one was a look at gold. You can see this in the bond
market. If there is a nig outbreak in the price of gold, you know that there is an increase in
inflationary expectations and people will start to sell bonds, sending interest rates up. The stock
of gold in the world is going to maintain itself as a reserve asset for a long time to come.
Thinking ahead to the year 2030, we cannot ignore the fact that the yen is going to be a very
important player. Japan has a GDP in nominal terms 60% of the United States' GDP. China's
renminbi will also become an important currency. By the coming years, the Yuan will be a very
important force. However, we do not really know what the relationship is going to be between
the Euro, Yuan, GBP and yen with the dollar in the coming years.
FOOD FOR THOUGHT: One world, single currency! Can’t we have it?
SUMMARY:
Before there was currency, nations traded goods directly, paying for one good by exchanging it
for another. It was barter on a national scale. Because of its many advantages, money was
eventually created to facilitate trading. In the beginning, trading partners would use a common
form of money to conduct their business, which was usually gold or silver. Then eventually the
benefits of paper currency became evident, but since each country issued its own currency, it
wasn't very useful for international trading, since the purchasing power of each currency differed
considerably and could differ over time depending on how much currency the countries issued.
Gold is going to be a part of the structure of the international monetary system for the 21st
century, but not in the way it has been in the past. We can look upon the period of the gold
standard, the free coinage gold standard, as being a period that was unique in history, when there
was a balance among the major powers and no single super power dominated.
Bismarck once said that the most important event in the 19th century was that England and
America spoke the same language. In the same spirit, the most important event in the 20th
century was the creation of the Federal Reserve System, the vehicle for the spread of the dollar.
Without that, you would not have had the subsequent monetary events that took place. Let us
hope that the most important event of the 21Tst century will be that the dollar and the Euro learn
to live together and so also Yuan and Yen find a suitable place in this international monetary
system.
Hence, foreign exchange history can be viewed as a series of solutions that allowed countries to
issue their own currency and to conduct their own monetary policy while also allowing
international trade to be conducted by providing a means of exchanging one currency for another
according to the exchange rate between them, which was either agreed-upon or set by the
market.
INTERNATIONAL MONETARY FUND (IMF)
Created in 1944, its objectives are:
a. To promote international monetary cooperation.
b. To facilitate the balanced growth of world trade.
c. To promote exchange stability.
d. To eliminate exchange restrictions.
e. To create standby reserves
SPECIAL DRAWING RIGHTS (SDRs)
1. IMF created SDRs in 1969.
2. 1970-1974: SDR's value tied with the US dollar.
3. 1974-1981: SDR's value tied with a basket of 16 currencies.
4. Since 1999, SDR's value tied with the US dollar, Japanese yen, British pound, and euro.
5. IMF use SDRs in a variety of transactions and operations.
In addition, SDRs are used as means to determine a reference interest rate, an international
reserve asset, and a unit of account. The IMF has survived the demise of the Bretton Woods
system. Today it loans money to developing countries or to those in crisis, or transitional
economies like Communist countries changing over to capitalism. It can impose strict rules, if
necessary, over the economies of the loan recipients to help them repay their debt. Another
organization created by the Bretton Woods Agreement—the International Bank for
Reconstruction and Development (IBRD), or World Bank, has also survived. The World
Bank's original purpose was to finance the reconstruction of Europe and Asia after World War II.
Today, the World Bank loans money, mostly to developing countries, for commercial and
infrastructure projects, and the loans must be backed by the country receiving the loans. It does
not, however, compete with commercial banks.
CASE STUDY 1: Should we close down WB, IMF offices in Bangladesh?
Mamun Rashid, Financial Express. ( 6th December, 2011)
The World Bank (WB) and the International Monetary Fund (IMF) are being put on the dock at
frequent intervals in Bangladesh and possibly, in many other developing countries. Recently the
IMF has been strongly criticized by a section of our economists, for not releasing the extended
credit facility to the tune of USD 1.0 billion and, more importantly, attaching a lot of conditions
to the release of the said facility. The economists, interestingly, all of them belonging to one
specific school of thought’, were of the opinion that we should generate the equivalent amount, if
not more, to finance our important projects being imbued with the ‘spirit’ of the War of
Liberation’. They also felt that the IMF or WB growth prescriptions were always typical and
faulty; therefore we should stay away from them.
At this point in time, we possibly need to review the role of the World Bank and IMF in
Bangladesh and examine the validity of the allegations that are being made against these
institutions. As a nation, we have behaved in a self-defeating manner on numerous occasions in
the past including championing in corruption, political violence, social injustice and economic
mismanagement. It is extremely important to ensure that we are not committing a similar mistake
by implicating two institutions that are trying to assist a country that is being harmed more by a
segment of its own people, including corrupt political parties, dishonest business community,
‘playing to the gallery’ type leaders and, to some extent, by a section of ‘narrow—focused’
press. Bangladesh joined the World Bank in 1972, soon after Independence. Early projects
financed by the Bank built shelters in cyclone-affected areas and provided urgently needed
drinking water. The Bank also worked with others to revive the war-torn country’s economy.
Since 1972, the Bank concessional lending arm, the IDA, has financed around 200 projects with
loans of about USD 10 billion. In the 1970s, the Bank supported efforts to expand agricultural
production, which have helped Bangladesh achieve near self-sufficiency in food production,
food supply and develop population and family planning programmers that have dramatically
lowered the high fertility rates. From the mid- 1980s, the Bank expanded support for more
energy projects, particularly in the oil and gas sectors, to reduce the country’s dependence on
imported energy and speed up development of its own gas reserves. The Bank also supported the
government’s efforts to encourage private-sector development and to deal with distortions in
trade, pricing, credit allocation and interest rates. One of the World Bank’s flagship projects in
Bangladesh is Jamuna Bridge. The Bank’s private sector arm, the International Finance
Corporation (IFC), was instrumental in developing privates sector leasing, housing finance,
mobile phone, power plant and large manufacturing projects too. The Bank also helped
significant improvement in the country’s financial sector, through the changes brought in by
‘financial sector reform project’ or ‘strengthening the central bank’ project and so on.
There is nothing wrong for an economist or a policy analyst or for that matter, the WB or the
IMF, to suggest that interest rates should go up or down in demanding economic situations,
governance should improve, privatization of state-owned enterprises (SOE) should be expedited,
corruption should be eliminated, the poor should have access to credit, financial sector should be
more efficient and inclusive or their operating model to be more self sustaining, country should
be less reliant on subsidies and the private sector should be strengthened. It was deemed that our
economists in question gradually came to the realization that the country needed more reform,
market liberalization, accountability and transparency in execution of the development projects
and independence of the regulatory institutions responsible to drive the future of this nation. So,
why are the World Bank and the IMF being made the scapegoats? The reality of the matter is
that the concerned economists or at least some of them were deeply involved in and taking
credits for influencing the election manifesto or budgetary process of the present government.
However, when the prices of essentials have gone up with rising inflation, exports and
remittances started showing a downward trend, government bank borrowing is rising to and
abnormal level, the national budget is found to be not as effective as was told before, it is nothing
surprising that they (under the influence of opportunist group) found it east to pass the blame on
the World Bank and the IMF, the institutions that never enjoyed cheap popularity.
The World Bank is a vital source of financial and technical assistance to developing countries
around the world. The WB is not like a conventional a bank. It is made up of two unique
development institutions—the International Bank for Reconstruction and Development (IBRD)
and the International Development Association (IDA) owned by 185 member countries. Each
institution plays different but supportive role in its mission of global poverty reduction and the
improvement of living standards. The IBRD focuses on middle income and creditworthy poor
counties, while IDA focuses on the poorest countries in the world. Together they provide low-
infrastructure, communications and for many other purposes.
The IMF’s primary purpose is to ensure the stability of the international monetary system—the
system of exchange rates and international payments that enables countries to buy goods and
services from each other, To maintain stability and prevent crises in the international monetary
system, the IMF reviews national, regional, and global economic and financial developments. It
provides advice to its member countries, encouraging them to adopt policies that foster economic
stability, reduce their vulnerability to economic and financial crises, and raise living standards,
and serves as a forum where they can discuss the national, regional, and global consequences of
their policies. The IMF also makes financing temporarily available to member counties to help
them address balance of payments problems – that is, when they find themselves short of foreign
exchange because their payments to other countries exceed their foreign exchange earnings or at
least being challenged.
The Bank and the Fund have their own limitations, they also have track record of, not always
serving the interest of the member or borrowing countries, at times due to their ‘one-size-fits-all’
strategy or not being able to understand the ground realities. This is more applicable to the fund.
The Bank is more on the listening and learning road. However, both these institutions are
evolving and shifting from their ‘age old’ stances, with the changing realities in the member
countries. Therefore, it is now up to the member countries, why and how they would league with
the two institutions and ensure member’s interest is better served, rather than being dictated by
the institutions. Tying up the release of development support credit with reforms in a specific
segment of the economy has yielded very good result for the financial sector in Bangladesh, not
necessarily it will yield similar results in every sector. However, discipline brought in by various
exercises has helped the country to streamline its many project conception and implementation
process as well as brought in overall efficiency in economic management.
India or China, never thought of closing down the World Bank or the IMF offices, rather they
make sure, how they would make the best use of these global development institutions. They
negotiate well with them on their terms to get the best for their people. Why cannot Bangladesh
pursue the same goal?
Question 1: What are the main purposes of IMF and World Bank?
Question 2: Why did India or China never think of closing down the IMF or the World Bank?
Question 3: How would $1 billion loan from IMF help us in improving our Balance of
payments?
Question 4: What are some of the criticisms against IMF and World Bank? Do you think those
criticisms are justified?
CASE STUDY 2: Dollar's Reign as World's Main Reserve Currency Is Near an End - WSJ.com

MARCH 2, 2011, The Wall Street Journal by BARRY EICHENGREEN

The single most astonishing fact about foreign exchange is not the high volume of transactions,
as incredible as that growth has been. Nor is it the volatility of currency rates, as wild as the
markets are these days. Instead, it's the extent to which the market remains dollar-centric.
Consider this: When a South Korean wine wholesaler wants to import Chilean cabernet, the
Korean importer buys U.S. dollars, not pesos, with which to pay the Chilean exporter.
Indeed, the dollar is virtually the exclusive vehicle for foreign exchange transactions between
Chile and Korea, despite the fact that less than 20% of the merchandise trade of both countries is
with the U.S., Chile and Korea are hardly an anomaly: Fully 85% of foreign exchange
transactions world-wide are trades of other currencies for dollars. What's more, what is true of
foreign-exchange transactions is true of other international business. The Organization of
Petroleum Exporting Countries sets the price of oil in dollars. The dollar is the currency of
denomination of half of all international debt securities. More than 60% of the foreign reserves
of central banks and governments are in dollars.
The greenback, in other words, is not just America's currency. It's the world's. But as astonishing
as that is, what may be even more astonishing is this: The dollar's reign is coming to an end. I
believe that over the next 10 years, we're going to see a profound shift toward a world in which
several currencies compete for dominance.
The impact of such a shift will be equally profound, with implications for, among other things,
the stability of exchange rates, the stability of financial markets, the ease with which the U.S.
will be able to finance budget and current-account deficits, and whether the Fed can follow a
policy of benign neglect toward the dollar.
The Three Pillars
How could this be? How could the dollar's longtime most-favored-currency status be in
jeopardy?
To understand the dollar's future, it's important to understand the dollar's past—why the dollar
became so dominant in the first place. Let me offer three reasons.
First, its allure reflects the singular depth of markets in dollar denominated debt securities. The
sheer scale of those markets allows dealers to offer low bid-ask spreads. The availability of
derivative instruments with which to hedge dollar exchange-rate risk is unsurpassed. This makes
the dollar the most convenient currency in which to do business for corporations, central banks
and governments alike.
Second, there is the fact that the dollar is the world's safe haven. In crises, investors instinctively
flock to it, as they did following the 2008 failure of Lehman Brothers. This tendency reflects the
exceptional liquidity of markets in dollar instruments, liquidity being the most precious of all
commodities in a crisis. It is a product of the fact that U.S. Treasury securities, the single most
important asset bought and sold by international investors, have long had a reputation for
stability.
Finally, the dollar benefits from a dearth of alternatives. Other countries that have long enjoyed a
reputation for stability, such as Switzerland, or that have recently acquired one, like Australia,
are too small for their currencies to account for more than a tiny fraction of international
financial transactions.
What's Changing
But just because this has been true in the past doesn't guarantee that it will be true in the future.
In fact, all three pillars supporting the dollar's international dominance are eroding.
First, changes in technology are undermining the dollar's monopoly. Not so long ago, there may
have been room in the world for only one true international currency. Given the difficulty of
comparing prices in different currencies, it made sense for exporters, importers and bond issuers
all to quote their prices and invoice their transactions in dollars, if only to avoid confusing their
customers.
Now, however, nearly everyone carries hand-held devices that can be used to compare prices in
different currencies in real time. Just as we have learned that in a world of open networks there is
room for more than one operating system for personal computers, there is room in the global
economic and financial system for more than one international currency.
Second, the dollar is about to have real rivals in the international sphere for the first time in 50
years. There will soon be two viable alternatives, in the form of the euro and China's yuan.
Americans especially tend to discount the staying power of the euro, but it isn't going anywhere.
Contrary to some predictions, European governments have not abandoned it. Nor will they. They
will proceed with long-term deficit reduction, something about which they have shown more
resolve than the U.S. And they will issue "e-bonds"—bonds backed by the full faith and credit of
euro-area governments as a group—as a step in solving their crisis. This will lay the groundwork
for the kind of integrated European bond market needed to create an alternative to U.S.
Treasurys as a form in which to hold central-bank reserves.
China, meanwhile, is moving rapidly to internationalize the yuan, also known as the renminbi.
The last year has seen a quadrupling of the share of bank deposits in Hong Kong denominated in
yuan. Seventy thousand Chinese companies are now doing their cross-border settlements in
yuan. Dozens of foreign companies have issued yuan-denominated "dim sum" bonds in Hong
Kong. In January the Bank of China began offering yuan-deposit accounts in New York insured
by the Federal Deposit Insurance Corp.
Allowing Chinese companies to do cross-border settlements in yuan will free them from having
to undertake costly foreign-exchange transactions. They will no longer have to bear the
exchange-rate risk created by the fact that their revenues are in dollars but many of their costs are
in yuan. Allowing Chinese banks, for their part, to do international transactions in yuan will
allow them to grab a bigger slice of the global financial pie.
Admittedly, China has a long way to go in building liquid markets and making its financial
instruments attractive to international investors. But doing so is central to Beijing's economic
strategy. Chinese officials have set 2020 as the deadline for transforming Shanghai into a first-
class international financial center. We Westerners have underestimated China before. We
should not make the same mistake again.
Finally, there is the danger that the dollar's safe-haven status will be lost. Foreign investors—
private and official alike—hold dollars not simply because they are liquid but because they are
secure. The U.S. government has a history of honoring its obligations, and it has always had the
fiscal capacity to do so.
But now, mainly as a result of the financial crisis, federal debt is approaching 75% of U.S. gross
domestic product. Trillion-dollar deficits stretch as far as the eye can see. And as the burden of
debt service grows heavier, questions will be asked about whether the U.S. intends to maintain
the value of its debts or might resort to inflating them away. Foreign investors will be reluctant to
put all their eggs in the dollar basket. At a minimum, the dollar will have to share its safe-haven
status with other currencies.
A World More Complicated
How much differences will all this makes—to markets, to companies, to households, to
governments?
One obvious change will be to the foreign-exchange markets. There will no longer be an
automatic jump up in the value of the dollar, and corresponding decline in the value of other
major currencies, when financial volatility surges. With the dollar, euro and yuan all trading in
liquid markets and all seen as safe havens, there will be movement into all three of them in
periods of financial distress. No one currency will rise as strongly as did the dollar following the
failure of Lehman Bros. There will be no reason for the rates between them to move sharply,
something that would potentially upend investors.
But the impact will extend well beyond the markets. Clearly, the change will make life more
complicated for U.S. companies. Until now they have had the convenience of using the same
currency—dollars—whether they are paying their workers, importing parts and components, or
selling their products to foreign customers. They don't have to incur the cost of changing foreign
currency earnings into dollars. They don't have to purchase forward contracts and options to
protect against financial losses due to changes in the exchange rate. This will all change in the
brave new world that is coming.
American companies will have to cope with some of the same exchange-rate risks and exposures
as their foreign competitors.
Conversely, life will become easier for European and Chinese banks and companies, which will
be able to do more of their international business in their own currencies. The same will be true
of companies in other countries that do most of their business with China or Europe. It will be a
considerable convenience—and competitive advantage—for them to be able to do that business
in yuan or euros rather than having to go through the dollar.
U.S. Impact
In this new monetary world, moreover, the U.S. government will not be able to finance its budget
deficits so cheaply, since there will no longer be as big an appetite for U.S. Treasury securities
on the part of foreign central banks.
Nor will the U.S. be able to run such large trade and current account deficits, since financing
them will become more expensive. Narrowing the current-account deficit will require exporting
more, which will mean making U.S. goods more competitive on foreign markets. That in turn
means that the dollar will have to fall on foreign-exchange markets—helping U.S. exporters and
hurting those companies that export to the U.S.
My calculations suggest that the dollar will have to fall by roughly 20%. Because the prices of
imported goods will rise in the U.S., living standards will be reduced by about 1.5% of GDP—
$225 billion in today's dollars. That is the equivalent to a half-year of normal economic growth.
While this is not an economic disaster, Americans will definitely feel it in the wallet.
On the other hand, the next time the U.S. has a real-estate bubble, we won't have the Chinese
helping us blow it.
Question 1: Why does the author claim “dollar’s reign as world main currency is near an end”?
Question 2: Why did the dollar become so dominant as the world most favorite currency?
Question 3: What is changing gradually that could shift the dollar dominance in international
monetary system?
Question 4: How China’s Yuan is posing a direct threat against dollar’s dominance as global
currency?
Question 5: How does U.S benefit from the fact that its’ currency is the most favored currency
in the international monetary system?
CASE STUDY 3: China to create special currency test zone. (Financial Times by Simon
RABINOVITCH) ( 28th June 2012)
.COM (JUNE 29, 2012)
Beijing (Financial Times) -- China plans to create a special zone to experiment with currency
convertibility in Shenzhen, the city where it introduced key economic reforms three decades ago.
The measure will enable Hong Kong banks to lend renminbi directly to companies in Qianhai
Bay -- a new economic zone on a peninsula across the water from Hong Kong -- according to
Chinese state media.
Beijing will unveil the details on Friday as Hu Jintao, Chinese president, visits Hong Kong for
the 15th anniversary of the handover of the city from Britain.
Analysts say the experiment could prove as critical to eventually dismantling capital controls as
Deng Xiaoping's reforms were to opening China to the world.
The Qianhai experiment follows a series of steps taken by the Chinese government to move
towards making the renminbi a convertible currency that analysts believe could one day vie with
the US dollar for pre-eminence in global markets.
Over the past two years, Chinese companies have been allowed to settle most of their
international trade in renminbi. This has provided a conduit for the currency to flow abroad for
the first time in large volumes.
Foreign institutions have also been given a limited but growing array of investment options for
their renminbi holdings, such as Hong Kong's dim sum bond market and a programme for
buying Chinese equities.
But China has installed speed bumps to ensure the renminbi cannot travel freely across the
border for pure financial transactions. Beijing is aware that hasty capital account openings can
spark situations such as the 1997 Asian financial crisis.
Allowing Hong Kong banks to lend to Chinese companies on the mainland creates a new,
potentially wide channel for renminbi held overseas to flow back to China.
Banks in Hong Kong are currently allowed to lend to Chinese clients in Hong Kong, but not in
China. If the Chinese clients want to bring that money into China, they need to obtain approval
from the foreign exchange regulator. The new rules are expected to eliminate many of those
controls to make it possible for Hong Kong banks to directly lend to Chinese clients in
Shenzhen.
In selecting Shenzhen for the latest trial, China's planners are making a nod to the past. In 1980,
Shenzhen was designated the country's first special economic zone, bringing foreign investment
and free trade to China, and launching the country on its way to becoming the world's second-
largest economy.
Liu Ligang, an economist at ANZ, said the risks of the latest measure were greater than those
attached to the 1980s opening.
"Money is fungible. Like water, it flows to low levels. So if money can flow from Hong Kong to
Qianhai, the money will flow from Qianhai to other parts of China that can offer higher returns."
He said China had to ease its control of interest rates and deepen the domestic bond market
before opening the capital account to lessen the risk of speculative capital rushing in and local
companies accumulating dangerously big foreign debts.
Separately on Friday, the stock exchanges of Hong Kong, Shanghai and Shenzhen said they
would create a joint venture index company to give investors access to companies listed in all
three cities for the first time and boost their capital markets.
Charles Li, chief executive of the Hong Kong Exchange, said it would create its first cross-
border indices by the end of the year and launch derivative products and exchange traded funds
based on the indices and stocks next year.
Question 1: How creating a special currency test zone will liberalize the capital control in
China?
Question 2: How would China’s special currency test zone one day vie against the dominance of
U.S dollar?
Question 3: What are the pre-requisite before opening the capital account? What are the risks of
opening the capital account?
Question 4: How did the currency management of Yuan help China to become the second
largest economy in the world?
TRUE/FALSE
1. The international monetary system provides a means of exchanging currencies in
international business transactions.
2. The BOP can be useful in detecting signs of trouble that could lead to governmental trade
restrictions.
3. Ancient reliance on gold as a medium of international exchange led to the adoption of an
international monetary system known as the gold standard.
4. The gold standard effectively created a floating exchange rate system.
5. During the gold standard, the international monetary system was also called the dollar-based
gold standard.
6. Once the gold standard was suspended, it was never considered again for use in the
international monetary system.
7. The international monetary system refers to the institutional arrangements that govern trading
patterns among countries using currency as a medium of fluidity.
8. The Bretton Woods System established an international monetary regime between 1944 and
1973 to avoid the devaluation devastations of the 1930s and WWII.
9. The official name for the World Bank is the International Bank for Reconstruction and
Development
10. The Bretton Woods system was a system of floating exchange rates.
11. In 1995, WTO replaced GATT which seeks to reduce tariff and promote more global trade.
12. Devaluation of upto 10% were permitted under the Bretton Woods system.
13. Since 1973, exchange rates have been relatively stable thanks to the floating exchange rate
system.
14. The Plaza Accord, signed in 1985, suggested that it would be desirable for most major
currencies to fall against the US dollar.
MULTIPLE CHOICE QUESTIONS:
1. The objectives of the International Monetary Fund (IMF) are .
a) to promote international monetary cooperation
b) to promote exchange stability
c) to create standby reserves
d) all of the above
2. The Bretton Woods system was set up on the theory that
a) deficits were temporary and could be financed by international assistance.
b) exchange rates would be used to achieve equilibrium.
c) the gold standard would ultimately be restored.
d) balance-of-payments deficits should be related to decreases in a country’s money supply.
3. An international gold standard requires all of the following except that
a) each country set a price for its currency in terms of gold.
b) each country allow anyone to convert gold into its currency and vice versa.
c) the domestic money supply be tied to the domestic stock of monetary gold.
d) gold circulate within each country.
4. Under the current international monetary system,
a) each country can choose whether it wants a fixed or a floating exchange rate.
b) surveillance is conducted by the International Monetary Fund (IMF) over the exchange-rate
policies of its members.
c) there is joint floating by some countries.
d) All of the above.
5. Supporters of the current international monetary system argue that it
(a) allows monetary autonomy.
(b) eases balance-of-payments adjustment.
(c) recycles oil revenues easily.
(d) All of the above.
6. Critics of the current international monetary system charge that
a) it has poorly handled oil deficits.
b) the foreign-exchange market is inefficient.
c) it may encourage too much inflation.
d) it relies too much on the International Monetary Fund (IMF).
7. One reason the Bretton Woods system did not work well was that
a) floating exchange rates do not work.
b) speculators were in a no-lose situation in anticipating which countries would devalue their
currencies.
c) fixed exchange rates do not work.
d) America has too much gold.

8. The euro began public circulation in ____.

a) 1999 b) 2000 c) 2001 d) 2002

9. Which of the following is not directly related to the Bretton Woods system?
a) 1944
b) the fixed exchange rate system
c) the bank of England
d) the International Monetary Fund

10. Why is the international monetary system necessary for international business?
a) Because it is a historically significant institution.
b) Because it controls interest rates on international business loans.
c) Because it establishes the rules by which countries value and exchange currencies.
d) Because it sets the price of a given currency.

11. The _____ establishes the rules by which countries value and exchange their currencies.
a) international monetary system b) OECD c) IMF d) Central bank

12. The _____ provides a mechanism for correcting imbalances between a country’s
international payments and its receipts.
a) international accounting standards
b) internationally accepted standards of bookkeeping
c) international monetary system
d) IMF

13. What precious metal was used in ancient times as an international medium of
exchange?
a) platinum b) sterling silver c) steel d) gold

14. The _____ refers to an international monetary system in which countries agreed to buy
or sell their paper currencies in exchange for gold on the request of any individual or firm
and to allow the free export of gold.
a) free exchange system b) free market system
c) gold standard d) mercantilism
15. What was created by the gold standard?
a) a fixed exchange rate system b) a floating exchange rate system
c) an accounting system d) an export system
16. Of which system is the gold standard essentially the opposite?
a) mercantilism b) silver standard c) econometrics d) factor endowments
17. Why was the gold standard suspended during World War I?
a) It was no longer safe to transport gold.
b) Economic pressures of war caused countries to suspend pledges to buy and sell gold at their
currencies’ par values.
c) Countries were angry at opposing countries and refused to trade with them.
d) The Bank of England could not maintain the pound’s value.

18. What did the Bretton Woods conferees agree to do in 1944?

A. to end World War II
B. to renew the gold standard
C. to adhere to the sterling standard
D. to promote world peace

19. The Bretton Woods conference sought to do which of the following?

a) Create a postwar economic environment that would promote world peace.
b) Renew the gold standard.
c) Create the International Monetary Fund and IBRD.
d) All of the above.
20. The International Bank for Reconstruction and Development is also known as _____.
a) the World Bank b) the IMF c) WTO d) the Bretton Woods
21. The purpose of the _____ is to oversee the functioning of the international monetary
system.
a) World Bank b) IMF c) IDA d) WTO
22. Which agreement resulted in each country adopting its own exchange rate system?
a) Bretton Woods b) Smithsonian c) Jamaica d) Brussels
23. The _____ was created to manage currency relationships within the European Union.
a) European Monetary System b) International Monetary System
c) Louvre Accord d) Plaza Accord

SHORT ANSWER QUESTIONS:

1. What is the Coinage Act?
2. What are the five objectives of IMF?
3. What were the main features of Bretton Woods system?
4. Write down the three steps which helped gold standard to evolve?
5. Summarize the Plaza-Louvre regime.
6. What were to reasons behind creating single currency Euro by the ECB?
7. What were the main features of ERM?
8. What are the advantages and disadvantages of EURO?
9. What are the benefits of European Monetary Unit?

LONG ANSWER QUESTIONS:

1. What was the gold standard? Who participated in the system? What were the major
advantages and disadvantages of the gold standard system?
2. What was the Bretton Woods agreement? How was it different from the gold standard?
3. What two multinational institutions were established at the Bretton Woods agreement? What
are their roles in the International Monetary System?
4. Why did the Bretton Woods system fail? Could it last forever?
5. Discuss some criticism against IMF and World Bank. Critically evaluate whether those
criticisms are valid or not.
6. What are the problems of the current International Monetary System?
7. Why reforms on International Monetary System are so hard? What could you envision about
the long prospects of our current International Monetary System?
8. Why do you think superpowers always tried to impose their own currency to take the lead
role in International Monetary System?