international finance term paper roll 22 & 29 (44e)
DESCRIPTION
Relation between inflation, exchange rate and foreign investment in Bangladesh using linear regression analysis. Institute of Business administration (IBA) Dhaka University.Foreign direct investment (FDI) plays a significant role in economic growth of a country like Bangladesh. Along with sectors such as RMG, Leather, Pharmaceuticals furniture industry of Bangladesh is growing rapidly. Impact of exchange rate and inflation on FDI inflow in Bangladesh was evaluated in this paper. Correlation coefficient between exchange rate and FDI inflow indicated a strong positive relationship of FDI inflow and weakening currency of the host country. Inflation had a negative impact on FDI inflow especially in labor intensive industry such as furniture because inflation tends to push labor cost upward. Linear regression was utilized to predict future exchange rate and inflation in Bangladesh. These relationships were used to identify advantages and disadvantages of FDI on furniture industry of Bangladesh. Exchange rate and inflation in Bangladesh is favorable to make FDI in furniture industry considering there are other positive factors such as huge unexploited local market, export opportunity, cheap labor etc are present in this sector.TRANSCRIPT
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Effect of Inflation and Exchange Rate on Foreign Direct Investment
(FDI) Decision in Furniture Industry (Processed wood) in Bangladesh
Submitted by
Name: Ahmed Zaheer
Roll: 22
Batch: 44E
Name: Krisnendu Roy
Roll: 29
Batch: 44E
Submitted To
Melita Mehjabeen, Lecturer, Institute of Business Administration,
University of Dhaka
In partial fulfillment of requirement for course work of International
Finance (F603)
Date: 14.01.13
Course No: F603
Course Title: International Finance
i
Declaration
This is to declare that work content of this term paper is prepared by Ahmed Zaheer (22,44E)
and Kisnendu Roy (29,44E) under supervision of Mrs. Melita Mehjabeen, Lecturer Institute
of Business Administration, University of Dhaka
Submitted by
Ahmed Zaheer Krisnendu Roy
Roll-22, Batch 44E Roll-29, Batch 44E
ii
Acknowledgment
We would like to express a sincere and special thank to our course teacher Mrs. Melita
Mehjabeen, Lecturer Institute of Business Administration (IBA-DU) for her affectionate and
careful supervision, sympathetic co-operation, her continuous support, guidance, thorough
correction and efforts in doing this paper. Without her encouragement and valuable
suggestions it would be impossible to bring this paper work to success.
We would also like to acknowledge Otobi Ltd management for the support and timely
cooperation.
iii
Abstract
Foreign direct investment (FDI) plays a significant role in economic growth of a country like
Bangladesh. Along with sectors such as RMG, Leather, Pharmaceuticals furniture industry of
Bangladesh is growing rapidly. Impact of exchange rate and inflation on FDI inflow in
Bangladesh was evaluated in this paper. Correlation coefficient between exchange rate and
FDI inflow indicated a strong positive relationship of FDI inflow and weakening currency of
the host country. Inflation had a negative impact on FDI inflow especially in labor intensive
industry such as furniture because inflation tends to push labor cost upward. Linear
regression was utilized to predict future exchange rate and inflation in Bangladesh. These
relationships were used to identify advantages and disadvantages of FDI on furniture industry
of Bangladesh. Exchange rate and inflation in Bangladesh is favorable to make FDI in
furniture industry considering there are other positive factors such as huge unexploited local
market, export opportunity, cheap labor etc are present in this sector.
iv
Table Of Contents
1. Introduction ........................................................................................................................ 1
2. Literature Review ............................................................................................................... 2
2.1. Exchange Rate and FDI............................................................................................... 2
2.2. Inflation and FDI ......................................................................................................... 3
3. Objective ............................................................................................................................. 4
4. Methodology ....................................................................................................................... 5
5. Effect of Exchange rate and Inflation on FDI in Bangladesh............................................. 5
5.1. Exchange rate and FDI inflows In Bangladesh ........................................................... 5
5.2. Inflation rate and FDI inflows in Bangladesh ............................................................. 7
6. FDI in Furniture industry in Bangladesh ............................................................................ 8
6.1. Overview of furniture Industry in Bangladesh ............................................................ 8
6.2. Prospects of Furniture Industry in Bangladesh ........................................................... 9
6.3. Advantages of FDI in furniture industry in Bangladesh ............................................. 9
6.4. Disadvantages of FDI in furniture industry in Bangladesh ......................................... 9
7. Result ................................................................................................................................ 10
8. Conclusion ........................................................................................................................ 10
Reference ................................................................................................................................. 11
Table of Figures
Figure 1: Exchange rate of USD against BDT........................................................................... 5
Figure 2: Yearly FDI inflow ...................................................................................................... 6
Figure 3: FDI inflow against Exchange Rate ............................................................................. 6
Figure 4: Yearly inflation (%).................................................................................................... 7
Figure 5: Yearly FDI inflow ...................................................................................................... 7
Figure 6: Market share in furniture industry in Bangladesh ...................................................... 8
1
1. Introduction
Bangladesh is a densely populated, low income country which has huge potential for foreign
direct investment particularly in labor intensive industries such as garments, leather and
furniture industry. Bangladesh has a huge local market of furniture and also has all the
ingredients to become a noteworthy exporter of furniture. In this paper we analyze the effect
of inflation and exchange rate on foreign direct investment decision with our focus directed
towards furniture industry.
In most developing countries there is the dearth of capital for investment which has affected
the economic situation of these nations. In order to ameliorate the situation various
governments of these nations has now focused much attention on investment especially
foreign direct investment which will not only guarantee employment but will also impact
positively on economic growth and development. FDI is needed to reduce the difference
between the desired gross domestic investment and domestic savings.
According to Adegbite and Ayadi (2010) FDI helps fill the domestic revenue generation gap
in a developing economy, given that most developing countries’ governments do not seem to
be able to generate sufficient revenue to meet their expenditure needs. Other benefits are in
the form of externalities and the adoption of foreign technology. Externalities here can be in
the form of licensing, imitation, employee training and the introduction of new processes by
the foreign firms (Alfaro, Chanda, Kalemli, Ozean and Sayek 2006).
Foreign direct investment consists of external resources including technology, managerial
and marketing expertise and capital. All these generate a considerable impact on host nation’s
productive capabilities.
McAleese (2004) states that, “FDI embodies a package of potential growth enhancing
attributes such as technology and access to international market.” But the host country must
satisfy certain preconditions in order to absorb and retain these benefits, and not all emerging
markets possess such qualities (Borensztein, De Gregorio and Lee, 1997; Collier and Dollar,
2001; Seetanah and Khadaroo, 2007)
Monetary policy can shape the economic environment that is conducive in attracting FDI into
host countries. However the characteristics of monetary policy presents the “impossible
2
trinity” – a trilemma problem where trade-offs must be done in order to maintain economic
stability. Two of these anchors are inflation autonomy and exchange rate variability. These
trade-offs can impact on the host country’s attractiveness on FDI inflow (Lahrèche-Révil and
Bénassy- Quéré, 2002; Gelb, 2005; Umezaki, 2006).
Given the Bangladesh economy resource base, the country’s foreign investment policy should
move towards attracting and encouraging more inflow of foreign capital. The need for foreign
direct investment (FDI) is born out of the under developed nature of the country’s economy
that essentially hindered the pace of her economic development. Furniture sector of
Bangladesh is very encouraging for foreign investors because Bangladesh already has a
skilled manpower in this sector.
2. Literature Review
2.1. Exchange Rate and FDI
In the past, economists believed that there is no advantage to be gained by purchasing foreign
capital and/or assets. As the economic system works in a long-term equilibrium, any firm
purchasing foreign assets at a “bargain”, in the hope of taking advantage of stronger currency
in their home country against the targeted country, can be equalized by price adjustment of
the assets in the long run (Froot and Stein, 1989). Froot and Stein (1989) argue that the
economy is distorted by “informational imperfection” (p. 4), and opportunities are not equal
across borders. There are merits in holding foreign assets. The difference in cultures, work
ethics and way of life can have markedly different efficiency outcome.
Today, there exists a “common wisdom” regarding the relationship between FDI and
exchange rate. When a country’s currency devalues, it is viewed as an opportunity for foreign
investors to purchase assets at a reduced cost. This is especially true when foreign firms have
identified specific assets in their targeted markets (Blonigen, 1997).
Barrell and Pain (1996) find that investors tend to postpone their investment when the
currency in the targeted market strengthens. This occurs when investors are speculating the
currency to depreciate in the future and thus maximize the profit of their investment at a later
stage. Because of this reactionary nature of investors’ behavior, they have also noted that
there is a significant time lag between exchange rate changes and FDI movement.
3
Ahn et al. (1998) note mixed sentiment toward increasing FDI competitiveness by
devaluating currency. However, they find that empirical research generally shows a positive
impact.
Erramilli and D’Souza (1995) find that exchange rate volatility is one of the contributors
toward external uncertainty in an economy that have a major effect on FDI inflow. Campa
(1993) notes that lack of information in a volatile environment would deter investment, and
unlike portfolio flows, FDI offers investors very few instruments to hedge against such risk
(Bénassy-Quéré, Fontagné and Lahrèche-Révil, 2001).
In a study in Ghana, Kyereboah-Coleman and Agyire-Tettey (2008) find that volatility in
exchange rate has a significantly negative impact on FDI inflow and that inappropriate
macroeconomic policy can result in overvaluing the currency; therefore, discouraging FDI.
Similar to the findings from Barrell and Pain, they also note that the lag in FDI is highly
significant.
However, high exchange rate volatility does not always imply a negative effect on FDI
Inflow. Qin (2002) finds that if a low differential in purchasing power parity exists between
trading countries, two-way FDI can occur. And FDI would become an instrument for local
producers to hedge their risk in a volatile exchange rate environment.
2.2. Inflation and FDI
A host country’s economic instability can be a major deterrent to FDI inflow. As briefly
discussed in previous sections, any form of instability introduce a form of uncertainty that
distort investors’ perception on the future profitability in the country (Erramilli and D’Souza,
1995).
Akinboade, Siebrits and Roussot (2006, p. 190-191) state that “low inflation is taken to be a
sign of internal economic stability in the host country. High inflation indicates the inability of
the government to balance its budget and the failure of the central bank to conduct
appropriate monetary policy.” In other words, inflation can be used as an indicator of the
economic and political condition of the host country, but the differences between “high”
inflation and “low” inflation is not distinct (Ahn, Adji and Willett, 1998).
4
A few literatures offer some distinctions on the level of inflation. Rogoff and Reinhart (2002)
find that high inflation does not happened in the absence of other macroeconomic problems.
The cost of inflation can have prominent effect on the economy’s growth. This hindrance is
more prominent at an inflation rate at 40% and higher, but they also note that a country with
higher inflation rate, especially below the 40% level, is worse off than a country with slightly
lower inflation. The comparative figure they quoted was 10% compare to 5% (p. 30).
Lipsey and Chrystal (2006, p. 578) offer a definition for hyperinflation. They state it as
“Inflation so rapid that money ceases to be useful as a medium of exchange and a store of
value.” But they also concede that countries with inflation rate higher than 50%, to some
200% plus, have proven to be manageable as the population adjusts in “real term”. These
literatures have highlighted that inflation destroys the value of currency. The impact on
growth is negative, and in turn, a negative impact on FDI.
Glaister and Atanasova (1998) mention the effect of high inflation had on employment in
Bulgaria. Although they did not draw direct inferences to the relationship between FDI and
inflation, they seem to suggest that high inflation can cause various problems within the
country to reduce its attractiveness to foreign investors.
Coskun (2001, p. 225) suggests that lower inflation and interest rate coupled with other
factors such as “full membership with the EU” and high economic growth can attract foreign
investors and increase the FDI inflow into Turkey.
Wint and Williams (2002) show that a stable economy attracts more FDI, thus a low inflation
environment is desired in countries that promote FDI as a source of capital flow.
3. Objective
1. To observe impact of inflation and exchange rate on foreign direct investment
decisions.
2. To evaluate comparative advantages and disadvantages of foreign direct investment
in Bangladesh in furniture manufacturing on the basis of inflation and exchange rate.
5
4. Methodology
Information was obtained from both primary and secondary sources. Primary data was
collected by interviewing strategic business development team of Otobi Ltd. Secondary data
was collected from Bangladesh Bank, BOI, ADB, WB websites, published academic papers
and research institution’s reports.
5. Effect of Exchange rate and Inflation on FDI in Bangladesh
5.1. Exchange rate and FDI inflows In Bangladesh
Currency of Bangladesh has weakened steadily against US dollar from 1996 to 2012 as
shown in the Chart 1. We also observe that there is substantial growth in FDI inflow in this
period most notably from 2004 onward (Shown in Figure 1 and 2). This suggests that
weakening currency of the host country has a positive impact on foreign investment as
mentioned in earlier chapter of the paper.
(Source: Bangladesh Bank website)
Figure 1: Exchange rate of USD against BDT
0
10
20
30
40
50
60
70
80
90
BD
T
Exchange Rate (USD)
6
(Source: Bangladesh Bank website)
Figure 2: Yearly FDI inflow
(Source: Bangladesh Bank website)
Figure 3: FDI inflow against Exchange Rate
Correlation between FDI inflow and exchange rate from 1196-97 to 2011-12 was calculated
and correlation coefficient was measured to be 0.81 indicating a strong positive relationship
between FDI inflow and exchange rate (Shown in figure 3). This occurs because investors see
weak local currency as an opportunity to acquire asset at a reduced cost.
Linear regression of exchange rate indicates BDT will further weaken against USD and may
play a major part to attract FDI in the future.
0
200
400
600
800
1,000
1,200
1,400
Mil
lio
n (
$)
FDI Inflow
R² = 0.652
0
200
400
600
800
1,000
1,200
1,400
30 40 50 60 70 80 90
FD
I In
flo
w (
Mil
lio
n $
)
Exchange Rate of USD (Bdt)
FDI Inflow VS Exchange Rate
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5.2. Inflation rate and FDI inflows in Bangladesh
Inflation has increased from 1996 to 2012 but as shown in the chart had volatile changes in
the period between 1996 and 2004. FDI in flow in this period had a decreasing trend
supporting that inflation rate volatility has a negative impact on foreign investment because it
indicates an unstable economic condition.
(Source: Bangladesh Bank website)
Figure 4: Yearly inflation (%)
(Source: Bangladesh Bank website)
Figure 5: Yearly FDI inflow
0%
2%
4%
6%
8%
10%
12%
%
Inflation (%)
0
200
400
600
800
1,000
1,200
1,400
Mil
lio
n (
$)
FDI Inflow
8
Although inflation is increasing in Bangladesh from 2002 onward it was always under 12%.
Linear regression of the past data indicates it will be around 10% in next few years (Shown in
figure 4 and 5). This level of inflation is not unfavorable to FDI as mentioned in earlier
chapter of the paper and FDI inflows in this period also reflect this as there is an increasing
trend of FDI inflow in this period.
6. FDI in Furniture industry in Bangladesh
6.1. Overview of furniture Industry in Bangladesh
Furniture industry is one of the fastest growing industries of Bangladesh and has the potential
to be next economic booster. The total furniture market size as well as demand is estimated to
be approximately BDT 80,000 million per year in Bangladesh. The whole market can be
divided into two major categories which are organized and unorganized sector.
Approximately 18% of the whole market can be defined as organized as this portion has
standard manufacturing, distribution and marketing facility. (Maksudul Haque
Chowdhury,Nazib Haider Chowdhury Farahnaz Zarrin,October 2012) This sector is divided
into some major companies namely Otobi, Partex, Hatil etc. Market share of these companies
is reflected in figure 6.
Figure 6: Market share in furniture industry in Bangladesh
Organized
17.76%
Unorganiz
ed
82.24%
Otobi
34%
Navana
11%Partex
10%
Hatil
10%
Studio45
7%
Akhter
9%
Others
19%
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6.2. Prospects of Furniture Industry in Bangladesh
With the industrial growth in various industries like RMG, textiles and ship building, there is
a huge demand for industrial furniture in these sectors, which are currently being met through
import. In a recent assessment, it is seen that on an average 1.5%-2% of the ship building cost
is spent on furniture and the existing market is over USD 9-12 million. Furthermore there is a
potential deemed export market of around USD 48 million annually by 2014. Moreover some
international furnishing suppliers for ships source products from different countries based on
their product requirement and quality standards. As the overall quality of furniture in
Bangladesh is considerably high, there is a chance to enter this market. (Maksudul Haque
Chowdhury,Nazib Haider Chowdhury Farahnaz Zarrin,October 2012)
Furniture industry of Bangladesh is a lucrative sector for FDI considering the facts that there
is a huge unexploited local market, potential for exporting, cheap and available labor.
6.3. Advantages of FDI in furniture industry in Bangladesh
Several advantages can be identified in support of making FDI in furniture industry in
Bangladesh. Namely
Huge unexploited local market.
Scope of export
Cheap and available skilled labor
Favorable exchange rate trend
To keep accordance with the scope of this paper we will focus our attention towards effect of
exchange rate and FDI in furniture industry in Bangladesh. There is a strong positive
correlation between exchange rate and FDI inflow suggesting that weakening of local
currency is favorable for FDI. Linear trend of exchange rate in Bangladesh indicates that
Bangladesh currency will weaken in future. All these information indicates that currently
furniture industry of Bangladesh is a lucrative sector for making FDI as far as exchange rate
is concerned. FDI decision can be further enhanced due to above mentioned advantages
besides favorable exchange rate.
6.4. Disadvantages of FDI in furniture industry in Bangladesh
FDI flow in furniture industry in Bangladesh can be hindered by some factors such as
Lack of infrastructure
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Power crisis
Political situation
Inflation rate
We will limit our discussion within the effect of inflation rate to maintain the focus of this
paper. Increasing inflation usually indicates a volatile economy which deters investors to
make any venture especially in labor intensive sectors such as furniture industry. Increasing
inflation will increase cost of living triggering escalating labor cost. If labor cost is not
adjusted with inflation then it will lead to labor unrest resulting even worse circumstances.
Inflation in Bangladesh has an increasing trend but in recent year the trend shows less
volatility. Linear regression suggests that it will be about 10% in next few years. Although an
increasing inflation trend is not favorable for investment there is substantial evidence that it
will be within acceptable limits in near future.
7. Result
1. There is a positive relationship between FDI inflow and weakening currency of the
host country.
2. Inflation has a negative impact on FDI inflow in a country.
3. Exchange rate and inflation trend in Bangladesh is favorable for making FDI in
furniture industry considering this sector is very potential with huge unexploited local
market, export opportunity, cheap labor etc
8. Conclusion
FDI plays a major part in the economic growth of a country especially of a developing
country like Bangladesh. Exchange rate and inflation have substantial effect on FDI inflow of
a country. Till now furniture industry of Bangladesh didn’t attract any significant amount of
FDI though there is huge potential of this sector both as a local market and export oriented
industry. Favorable exchange rate and inflation trend will help to attract FDI in furniture
manufacturing sector along with other sectors such as RMG, Pharmaceuticals and Leather;
therefore will positively contribute to the economic growth of Bangladesh.
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