Bangladesh -- 2008 Article IV Consultation: Concluding Statement
July 17, 2008
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
Despite global economic challenges and domestic natural disasters, economic performance in FY08 was resilient. Growth momentum was maintained and international reserves increased despite severe import pressures. The poor, who suffer the most from high inflation, have been hit particularly hard by high food prices. Looking forward, increasing inflationary pressures could threaten growth and further erode gains made in poverty reduction over recent years. Early monetary policy actions to counter these pressures would anchor inflation expectations and reduce the need for more drastic actions later. Keeping within the FY09 budget framework will be important to complement monetary policy-despite recent administered price increases, state-owned enterprise losses remain the main fiscal challenge. The medium term economic outlook remains bright but accelerated progress on structural reforms, particularly to further improve revenue collections and strengthen the financial sector, is required.
I. Recent Economic Developments
1. Macroeconomic performance has been remarkably resilient in a year of multiple natural disasters and elevated international food and fuel prices. Estimated growth of above 6 percent for FY08 reflects a strong pick-up in domestic economic activity in the second half of the year, assisted by rapid growth in garments exports and surging remittances. These, together with increased aid, allowed a steady external position despite the increased need for food imports and escalating international prices. Inflation rose as a result of these external shocks, averaging almost 10 percent in FY08.
2. Nevertheless, life has become more difficult for large segments of the population. The natural disasters and subsequent rapid food price increases of early 2008 put severe pressure on incomes, particularly of the urban and landless rural poor, reversing some of the recent reductions in poverty. Although food prices moderated somewhat near the end of FY08, allowing point-to-point inflation to drop to 7½ percent in May, the pass through of recent increases in fuel prices have seen food prices rise again and placed further pressure on the poor.
3. Impressive gains in revenue collections were instrumental in allowing the FY08 budget deficit to remain below the budget target. Improved taxpayer compliance and collection of arrears contributed to a 27 percent nominal increase in revenue in FY08, ½ percent of GDP over the budget target. As a result, the budget deficit is expected to be under 4 percent of GDP (excluding the BPC debt operation), despite spending on disaster relief and improved budget coverage of escalating fuel and fertilizer subsidies. Continued problems in implementing the ADP also contributed, and increased external disbursements allowed domestic financing to remain below 2 percent of GDP.
4. The dollar exchange rate remained stable but growth in monetary aggregates has started to increase. Money growth fell in mid-FY08 but picked up again, with broad and reserve money growth exceeding 17 percent in May 2008. Private sector credit growth remained strong throughout the year, in part due to the need to finance increased food imports, and reached 25 percent (point-to-point) in May. The nominal exchange rate remained stable in dollar terms in FY08, reflecting selling of reserves by Bangladesh Bank (BB) to counter mid-year pressures, but depreciated by 6½ percent in effective terms as the dollar's value decreased in international markets. Remittances and strong exports allowed international reserves to grow moderately; import coverage, however, remains relatively low by international standards at 2¾ months of prospective imports.
II. Economic outlook
5. Growth momentum should remain in the near-term but inflation is likely to increase. With credit growth and government spending fuelling demand, wage pressures emerging, international commodity prices continuing to increase and monetary policy remaining accommodative, inflation is likely to return to double digits in July and remain there throughout FY09. Growth will remain strong in the early part of the year but could begin to deteriorate if inflation begins to affect economic activity. The external position will continue to be supported by strong remittances, exports and external assistance. Sustained increases in commodity prices will lead to higher imports which would marginally reduce international reserve coverage to about 2½ months of imports.
6. Growth could remain relatively sluggish while current challenges are addressed, before moving up towards its potential over the medium term. Policy actions to bring inflation under control will be required and are likely to create some temporary headwinds to economic momentum. However, growth should increase to around 7 percent over the medium term as agriculture maintains its upward momentum, and domestic services and construction continue to expand as Bangladesh capitalizes on high regional growth. With the current account remaining broadly in balance, aid and gradually increasing capital inflows will underpin a steady increase in international reserve coverage.
7. Risks to this outlook are mainly on the downside. The external environment is particularly uncertain at present—a sustained increase in oil prices is not assumed in the staff team's baseline projections but is a distinct possibility. Such an increase would put the balance of payments and fiscal position under significant stress and further reduce near-term growth prospects. Other risks stem from the political environment—if uncertainty increases as the nation passes through local and national elections; delays in policy adjustments that contribute to higher inflation; declines in external demand, and; in the longer term, climate change. On the upside, good FY08 performance could indicate stronger underlying growth potential than assumed in the baseline projections.
8. External debt is projected to remain sustainable with low risk of distress. However, taking into account domestic debt, the risk of distress will remain moderate particularly because of the vulnerability of the debt ratios to slower growth. Contingent liabilities arising from state-owned enterprises and low revenue collections are additional sources of risk. Managing these risks requires strengthened debt management. The staff team therefore encourages the authorities to build on recent measures to strengthen debt management, including by developing a comprehensive external debt data base and centralizing the recording of all external aid flows.
III. Macroeconomic Policies
9. Policies should focus on leaving a sustainable macroeconomic position to the next administration. The recent increases in energy and fertilizer prices show that the caretaker government is willing to take difficult decisions when necessary. The main priority now is to keep control of inflation while accommodating public expenditure requirements, particularly those stemming from the natural disasters and food crisis. The medium-term growth path envisaged in the macroeconomic framework will require accelerated progress in structural reform areas, particularly in strengthening the fiscal and financial sectors, and deepening the foreign exchange market.
A. Monetary and Exchange Rate Policy
10. BB's monetary policy stance was broadly appropriate during most of FY08. Although inflation was in double digits for much of the year, it was mainly driven by first round supply shocks. With a slowdown in economic activity in the first half of FY08 and money growth slowing BB took an appropriately neutral position, keeping interest rates and market liquidity steady.
11. A shift in policy is now needed to counter increasing inflationary pressures. With stronger domestic demand and increasing wage pressures, the first round effects of the latest fuel price adjustments on CPI inflation are likely to be accompanied by second round effects that will increase the risk of entrenched inflation. The team understands BB's concern to ensure that credit continues to be available to growth-driving sectors but does not believe that it is possible for a selectively accommodative monetary policy to effectively counter inflationary pressures. A preemptive movement in interest rates in the short term would send a signal of the central bank's intention to fight inflation, rein in increasing inflation expectations and help prevent second round effects becoming entrenched. Delaying action could be more harmful to growth prospects as it would require larger and more aggressive policy responses in the future.
12. Some adjustment in monetary policy would also be consistent with BB's exchange rate objectives. The rigidity of the dollar rate has not yet seriously constrained macroeconomic performance, as the effective exchange rate depreciated in line with the dollar and the real exchange rate remained in line with its equilibrium level. These fortuitous circumstances cannot, however, be expected to continue. Greater exchange rate flexibility would provide an additional macroeconomic policy tool and also help deepen the foreign exchange market. In this context, a somewhat tighter monetary stance will support BB's preference to use the exchange rate to counter imported inflation while moderating the need to sell international reserves to protect the exchange rate.
B. Financial Sector Strengthening
13. Successful financial sector development is a keystone to securing the future growth potential of Bangladesh. Progress has been made in isolated areas including (but not limited to) strengthening the regulatory and prudential framework of BB, corporatizing and improving the management of the state banks, and initiating the development of a government securities market. However, the agenda is large and despite this progress Bangladesh is falling further behind other countries. Going forward, there will need to be a comprehensive vision for the financial sector and stronger support for market development, with Bangladesh Bank taking a prominent leadership role. As part of that effort, and to protect itself from potential vulnerabilities, BB needs to build on the reforms it has already made in its internal operations to ensure that they are in line with best international practice.
14. The banking sector is growing but the state-owned commercial banks (SCBs) still undermine the efficiency of the system. Private banks grew rapidly in FY08 and their financial soundness strengthened. However, the SCBs, which account for over 30 percent of total banking sector assets, remain mainly moribund, with negative capital and high (30 percent) NPL ratios. Accelerating progress on strengthening their financial position with a view to eventual divestment remains a high priority in financial sector development. While the progress made in some of the SCBs is encouraging, their increasing NPL ratios are a serious cause for concern. BB needs to continue to closely monitor credit quality across the entire banking system, particularly in the light of accelerating credit growth.
15. Financial sector deepening requires the development of an active secondary market in government paper, which will also assist in monetary policy implementation. The establishment of a system of primary dealers for government securities in FY08 was a significant achievement but its operation needs to be improved before an active secondary market can develop. The key constraining factor is the authorities' inflexibility on interest rates which undermines the auction process and results in substantial devolvement of securities onto the primary dealers at rates that frustrate trading and remove a tool for indirectly influencing the exchange rate. Yielding to market pressures for upward movement in rates would have beneficial impacts for financial sector deepening and would be consistent with shorter-term monetary policy requirements. Clarifying prudential regulations on mark-to-market and liquid reserves and establishing a delivery versus payment system would also encourage secondary market trading.
16. Reinvigorating the foreign exchange market would complement reforms in the government debt market. A vibrant foreign exchange market will not develop in the absence of greater movements in the exchange rate. Market development will also require BB to put in place measures to encourage trading, including stricter enforcement of open position limits, and allowing banks to engage in uncovered forward trades and two-way quotes on a more consistent basis.
C. Fiscal Policy
17. Adhering to the macroeconomic targets of the FY09 budget is important to prevent putting further pressure on inflation. In normal circumstances, it would have been preferable to have a less expansionary budget in the face of rising inflation. However, given the need to address the social impact of natural disasters and higher food prices while further improving budget coverage of SOE losses, the mission supports the budget's targets of an overall deficit of 5 percent and domestic financing of 2¾ percent of GDP. Budget policy measures eroded the tax base and increased the burden on improved enforcement to achieve the revenue target. Nevertheless, the mission believes that continued gains in tax compliance and the improvement in the base achieved in FY08 should at least allow the budget target for revenue to be met and perhaps even exceeded. Given the inflationary pressures, any excess should be used to reduce the overall deficit and domestic financing. Ensuring safety net programs, particularly the new 100 days employment generation program, are well-targeted and minimize leakages will be important to safeguard the quality of the expenditure expansion.
18. The substantial hike in fuel and fertilizer prices may not be sufficient to keep within the budget's provisions. Volatility in international commodity markets makes it unusually difficult to forecast the fiscal burden of administered prices for state-owned enterprises. Assuming no further domestic price increases, budget provisions for fuel subsidies will require international oil prices to return to around $110 a barrel; current projections of an average price of around $125 a barrel would imply a further Tk30 billion in subsidies to BPC. In addition, escalation in international fertilizer prices means that around Tk10 billion in additional transfers to BCIC would be required. If overruns remain at these levels the team supports the authorities' plans to cover them from within the expenditure envelope, including from block allocations, potential overlaps between safety net allocations, and the fact that ADP continues to suffer from implementation constraints. In this scenario, any revenue collections over budget estimates should be used to reduce the deficit rather than funding subsidy overruns. The need to deal with any additional SOE losses, should they arise, should be met, by further price increases so that other priority spending on key social and development programs are not compromised. In the medium term a more transparent and affordable approach to subsidies is essential. This requires the adoption of a framework that will allow prices to automatically adjust to full cost coverage, such as the approved, but never used, formula for petroleum pricing.
19. In the medium term, increased revenue is crucial to allow fiscal policy to return to a lower deficit path. The FY09 budget should be a temporary deviation from the restrained fiscal position—an overall deficit below 4 percent of GDP and domestic financing below 2 percent of GDP—that has served Bangladesh well in the recent past. The draft Public Resource and Budget Management Ordinance will be helpful in this regard. The staff team encourages the early adoption of the ordinance together with implementing regulations that clarify institutional responsibilities. Remaining well within the ordinance's targets (ceilings for annual domestic financing of 3 percent of GDP and total public debt of 60 percent of GDP) while at the same time increasing public expenditure will require substantial increases in revenue. Improvements in tax administration that are underway such as consolidating and extending the coverage of the two LTUs, separating policy from administration, and strengthening audit procedures can support further marginal increases in the revenue to GDP ratio. More substantial increases will, however, require a comprehensive revision of income tax and VAT legislation that will modernize the tax system and broaden the base.
20. Improving the quality of public expenditure is needed to accelerate poverty reduction. This will require reducing subsidies to provide fiscal space for increased and better-targeted social spending and public investment. The Medium-Term Budget Framework (MTBF) provides a good basis for re-orienting savings from subsidies towards higher priority objectives, including better quality ADP spending. In this context, the team welcomes the Ministry of Finance's plans to start reviewing the performance of line ministries against their own performance indicators in the MTBF. The priority should now be to roll out the initiative to all spending ministries within 2-3 years. Maintaining control over public sector wage increases, particularly in the context of the 2009 Public Wage Commission, will also be important in maintaining fiscal space and moderating the benchmark these increases could set for the private sector. Increases in pay scales will need to be phased in to make the fiscal burden manageable.
IV. Other Issues
21. The macroeconomic framework of the draft Poverty Reduction Strategy Paper (PRSP) is broadly in line with the team's projections and the medium-term budget framework. The team notes the substantial work that has gone into producing the comprehensive strategy in such a short period of time. The transitional nature of the current administration heightens the importance of broad consultation; however, the accelerated timetable has meant that consultation with the donor community and civil society has been limited.
22. Improving the quality and timeliness of economic statistics would improve policy making. Some improvements have been made, notably in streamlining public sector coverage in the fiscal accounts and on-going work on a new CPI consumption basket. Key priorities going forward are strengthening BoP statistics through improving the consistency of trade data and developing international investment statistics, improving the source data for national accounts statistics and introducing more frequent and timely dissemination practices, and moving towards GFSM2001 standards for fiscal statistics.
1 The staff team is grateful for the full cooperation and extensive hospitality provided by the Bangladesh authorities during the discussions held during July 2-15. The team also met with a broad cross section of the private sector, academics and civil society.