Weak US economic performance coupled with huge current account deficit (above USD 600 billion) mainly contributed to the below par performance of the US dollar. Nevertheless there were other reasons behind dollar's recent slide. Apprehension of rate cut by US Federal Reserve (currently 5.25 percent) vis-à-vis expectation of rate hike in other currencies like Sterling (5 percent) and euro (3.5 percent) may drive investments away from dollar due to the lower yield advantage. Adding to the pressure were indications from Bank of China that it might shift a portion of the USD 1 trillion foreign exchange reserve from dollar to other currencies. Analysts expect the weakness of USD to continue until the first quarter of 2007. However, a subsequent rate cut by the US Federal Reserve may give rise to more capital investment leading to a healthier economy and consequently a stronger currency later in 2007.

While the world is wondering whether the US currency is undergoing a benign adjustment or a precipitous plunge, how does this affect us here in Bangladesh? The dollar's weakness against major currencies has a direct bearing on various business sectors. The country has seen significant capital investment in the last few years. RMG, the largest export contributor in Bangladesh, registered considerable investment in backward linkage since 2005 resulting in heavy import of capital machineries. During this period, power, telecom and pharmaceuticals sectors among others have also put in huge investment. A large portion of the capital machinery required to support these investments have been imported from the Eurozone. In 2006 alone, the euro has appreciated by around 16 percent against BDT, mainly driven by the EUR/USD volatility in the international market. This rise in euro has caused import costs to escalate leading to project cost overruns and threatened to render projects unviable in some cases. Besides increased imports, the Bangladesh market has recently experienced a rise in commercial foreign currency borrowing among the large corporate. Since most of these loans are linked to some floating index, i.e. LIBOR, the customers are exposed not only to FX risk but also interest rate volatility.

The way to mitigate these risks faced by corporates in a volatile market scenario is to utilise different hedging products. Better cash flow management, improved cost forecast, better pricing are but a few benefits that hedging offers. However, it is best not to consider hedging as money making tool, rather as insurance against downside risk in adverse market scenario. The beauty of hedging tools is that it can be tailor-made according to the need of the customers. Currently the most common hedging tool is forward which involves fixing the exchange rate in advance. Some of the vanilla derivative products such as FX option, range forward, interest rate swap, interest rate cap etc are also generating interest among customers nowadays. Options, unlike forward, not only provide protection against downside but also offer flexibility to take advantage of favorable market movement. A range forward, a popular derivative structure, provides a range of rates instead of a single rate. Both options and range forward have pros and cons but they offer more flexibility over forward. An importer buying a forward for euro 2 million at USD 1.3 per EUR can save USD 40,000 if euro reaches 1.32 at the time of payment. However, unlike forward, options enable the customers to take advantage of availing the market rate if EUR/USD moves below 1.3. However, these are few blips in the vast world of derivatives, alternatively known as “Structured Products”, because thousands of products of varied complexity can be structured to match the exact need of the customer to hedge all kind of financial risks, starting from foreign exchange, interest rates to commodity. Recently, Bangladesh market experienced the first ever FX derivative transaction - a USD/JPY range forward, marking a positive sign towards market development.

Hedging tools which are quite common in developed markets have also become an integral part of the FX markets in neighboring countries of India and Pakistan. The financial markets of India and Pakistan, once very similar to Bangladesh, have seen phenomenal growth and increased depth after the introduction of risk hedging products. This gave foreign investors a boost in confidence since it provided them with the much needed tools for financial risk management. Even Sri Lanka has recently joined this league by derivatizing the fx market when the country's central bank opened up the Lankan Rupee Option market in December 2006.

With marked rise in volatility, the time is apt for Bangladesh market to explore and mobilise FX risk hedging solutions.

-The write-up is prepared by Standard Chartered Bank