The Journal of Developing Areas

ABSTRACT:

Economists and policymakers often associate external competitiveness with the real exchange rate. This paper seeks to study Bangladesh’s external competitiveness by critically examining the determinants of the country’s real equilibrium exchange rate. While a number of studies have been done on Bangladesh in this area, no consensus has emerged on the determinants of real exchange rate. Few studies explicitly incorporate net foreign assets when modeling exchange rate change of Bangladesh. This paper plans to bridge this gap by developing a simple model in line with Musa (1984), Faruqee (1995), and Égert (2004). In this model, the current account in the long-run is driven by adjustment in the net foreign assets (NFA) towards a targeted level. Given a country’s long-run target for the stock of net foreign assets, the real equilibrium exchange rate then corresponds to a current account balance that is consistent with the income flows from this stock. The model is then tested by applying the autoregressive distributed lag (ARDL) bound testing approach by Pesaran et al. (2001) to the cointegration for the long-run and using the error correction model to examine the short-run dynamic relationship among real exchange rate, dual productivity differentials, net foreign assets, and real absorption. The empirical analysis is based on the annual data series from 1980 to 2014, collected electronically from the online databases of the IMF, the Penn World Table, and the World Bank. The empirical result show that, once shocked, real exchange rate convergence to equilibrium is quick with 64% of the adjustment occurring in the first year. The study finds that increased capital flow, greater real absorption, and faster productivity growth in the tradable sector relative to that of the non-tradable sector lead to real exchange rate appreciation. The estimated parameters are also stable. The paper then discusses policy implications and sheds some lights on the research limitations and future research considerations. For example, the paper recommends that Bangladesh should try to keep its currency relatively weak to protect domestic producers from foreign competition and strengthen their competitiveness to produce for and sell, particularly readymade garments, to world markets.