Bangladesh—2009 Article IV Consultation: Preliminary Conclusions of the IMF Mission
October 30, 2009
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.
Bangladesh’s economy has held up well, despite the global recession. Although the strength of the global recovery remains uncertain, Bangladesh’s medium-term prospects are good with a substantial upside which depends on the government’s vigor to implement structural reforms. The government and the Bangladesh Bank (BB) should continue their prudent macroeconomic policies and adopt an ambitious but realistic agenda of macroeconomic and structural reforms aimed at boosting medium-term growth and raising living standards. In this regard, the mission welcomes the authorities’ reform plans in the areas of tax policy, public expenditure management, and monetary and financial sector policy.
I. Recent Economic Developments
1. Bangladesh’s economy has held up remarkably well despite the global recession. Financial contagion was contained by low levels of financial integration. Growth, estimated at 5.9 percent for FY09, decelerated only modestly from the pace recorded in recent years and remained broad-based. The limited impact of the global downturn on Bangladesh’s growth partly reflects the relatively low overall trade openness, the limited openness to capital flows, the large share of basic textiles and garments in total exports, and robust remittance inflows.
2. The external position strengthened considerably in FY2009 and the first quarter of FY2010. Strong remittances, resilient exports and weak imports caused the current account of the balance of payments to record a surplus of almost 3 percent of GDP in FY09, up from less than 1 percent of GDP in FY08. With the capital and financial account of the balance of payments broadly in balance, the improvement in the current account caused a major rise in gross international reserves, from US$6.1 billion at the end of FY08 to US$7.5 billion by the end of FY09. Reflecting also an SDR allocation from the IMF (US$0.7 billion) and expected ADB disbursements (US$0.7 billion), gross international reserves are set to exceed US$10 billion. This is equivalent to 4.8 months of prospective imports, a 15-year high.
3. This has put pressure on BB’s monetary policy framework. The improvement in the current account put upward pressure on the taka which BB countered through unsterilized foreign exchange purchases. This caused reserve money growth to accelerate to 32 percent in June 2009; banks’ excess reserves rose sharply and short-term interest rates declined below 1 percent. Already certain financial institutions have increased their dependency on short-term funding, exposing themselves to the fluctuations of the money market. However, during the summer no reverse repo transactions were undertaken.
4. Inflation fell but price pressures are mounting. Declining international food and commodity prices resulted in a fall in inflation to 2.2 percent in June 2009. However, against the backdrop of resurgent international commodity prices and rising regional food prices, inflation rose to 4.7 percent in August. At the same time, accommodative monetary policy has contributed to a 35 percent rise in stock market prices since end-March and upward pressure on real estate prices.
5. The FY09 budget deficit remained below the budget target, despite revenue shortfalls, owing to continued problems in implementing the Annual Development Program (ADP). Held back by lower import prices, customs revenue fell short of the target. As a result, the ratio of NBR tax revenue to GDP declined by 0.2 percentage points to 8.2 percent, undershooting the original budget target by 0.7 percent of GDP. ADP spending fell short of the original budget by Tk 60 billion reflecting implementation bottlenecks. As a result, the overall fiscal deficit (including grants) amounted to 3 percent of GDP, almost 1 percentage point of GDP smaller than envisaged in the original budget. The counterpart to the lower deficit was mostly in lower than budgeted disbursements of foreign loans.
6. In the area of structural reforms, needed to unlock Bangladesh’s potential through private sector-led growth, progress was mixed. A comprehensive plan to address the power and gas shortages remains under discussion. Progress in Public Private Partnerships (PPP) has been very slow. The reintroduction of interest rate ceilings on important categories of bank lending was a setback to financial market development, and the recent appointments made at the Boards of Directors of three state-owned commercial banks (SCBs) were not fully in line with established regulations. The FY2010 budget’s extension of para-tariffs and the introduction of a regulatory duty to a large number of consumer goods raised nominal protection and is second-best to comprehensive tax policy reform.
II. Economic Outlook
7. Amid continued uncertainty about the strength of the global recovery, Bangladesh’s growth momentum is likely to remain somewhat subdued in the near term yet inflation seems set to increase. The staff team projects that growth may decelerate to 5 percent in FY2010 as economic activity is likely to be held back by weak imports, particularly of capital machinery, sluggish exports and private sector credit, and an ongoing slowdown in the hiring of Bangladeshi workers by employers abroad. The strong performance of the agricultural sector in FY09 will also be hard to exceed substantially. The ample availability of liquidity is likely to help drive up inflation throughout FY2010, possibly to double digits by the summer. The external position will remain strong and gross international reserves should remain above a relatively comfortable 4 months of prospective imports.
8. Over the medium term, as global growth and trade recover, Bangladesh’s growth should edge up as well, to around 6 percent per annum, building on increasing trade integration with countries in the region and the rest of the world, and growth momentum in the agriculture, services, and construction sectors. The current account can be expected to stay in surplus with the import coverage of reserves remaining robust.
9. There are both downside and upside risks to the baseline projections. A prolonged global slump could hold back exports and remittances. Continued shortage of energy supply may further discourage private-sector investment and FDI. On the other hand, private sector investment may jump, if the global recovery is deemed more robust than expected. Acceleration in structural reforms could also boost growth substantially.
III. Macroeconomic Policies
A. Fiscal Policy
10. Growth is held back by insufficient investment in infrastructure, especially in the energy and transportation sectors.
• The government should urgently address the root causes of chronic under-implementation of the ADP including the capacity constraints and governance issues.
• The government should accelerate its efforts to mobilize resources for infrastructure betterment, including by PPP and bond issuance. In this context, the mission is anxious to see the Ministry of Finance (MOF) plays a key role in pushing PPP initiatives forward.
11. The mission commends the government’s strong commitment to fundamental tax reforms.
• Bangladesh’s tax-to-GDP ratio (around 8.5 percent) is 4 percentage points lower than the average of the regional economies at a similar development stage, severely constraining the scope for higher spending in key fields.
• While Bangladesh’s external debt position does not pose immediate risk, escalating foreign borrowing, especially non-concessional loans, may weaken its external debt position. Besides, foreign donors may not be able to meet increasing borrowing demand from Bangladesh. In fact, despite the large budget support from the ADB, there may be a shortfall in net external financing in FY2010.
• On the domestic front, the government has tripled the net sales of National Savings Certificates (NSCs) during June-August 2009 compared to a year earlier, to benefit from investor appetite, but at higher than prevailing market rates. As it is expected that the demand for private sector credit will increase and inflation will rise, the government’s interest bill can be expected to rise rapidly in the coming year.
• Thus, tax reforms are vital to unleash Bangladesh’s potential, while maintaining fiscal prudence. The government should keep to its timetable for VAT reform and submit the new legislation to Parliament in the context of the FY2011 budget.
12. Energy and fertilizer subsidies look set to rise again.
• International oil prices have been rising in recent weeks and domestic prices for petroleum products and electricity are again below the levels needed to cover the costs of the BPC and the PDB.
• The mission recommends that the authorities opt for early and more frequent adjustment of retail energy prices, combined with targeted compensation for the poor. This would prevent the accumulation of large losses and an eventual large price adjustment, as was experienced in FY08.
• By reducing infrastructure bottlenecks, including oil-import facilities, the transportation and distribution costs can be substantially reduced, which would lessen the need to raise retail prices.
B. Monetary and Exchange Rate Policy
13. The mission commends BB’s initiative to reduce the excess liquidity in the financial system.
• Banks’ excess reserves have come down to Tk 55 billion, from Tk 100 billion at end-June, despite the continued strong net inflow of foreign exchange. BB aims to gradually bring excess reserves down further.
• However, the mission notes that most of the mopping up of liquidity has been achieved through the sale of government securities and NSCs. While robust remittance inflows are expected to continue, the investor sentiment may turn around quickly, which could raise inflationary pressure very rapidly. To forestall such a situation, BB needs to start issuing a sufficiently large amount of BB bills, so that excess liquidity is taken out even if the government starts to draw on its deposits with BB. Although this may inevitably lead to a rise in market interest rates, the alternative is unduly high inflation, which would inflict severe damage to the economy, especially the poor.
• Active reverse repo operations and the greater issuance of BB bills will increase the quasi-fiscal costs of monetary policy. In this context, the mission welcomes the assurance by the MOF to bear such costs, to fend off a worse outcome of higher inflation.
• In the long run, there is also scope to strengthen the monetary policy framework and stabilize systemic liquidity. To enhance the credibility and predictability of monetary policy BB should consider moving to a standing facility for repo and reverse repo operations and adopting an interest rate corridor once fully functional open market operations are in place. In addition, averaging reserve requirements on a two-week maintenance period would help control short-term volatility.
14. Greater exchange rate flexibility could help ease the burden on monetary policy and reduce the costs of managing liquidity for BB, while dampening inflationary pressures.
• The mission shares the authorities’ view that the taka is somewhat undervalued, though not far out of line. By allowing appreciation of the taka exchange rate, the build-up of the excess liquidity in the financial system would slow, easing the burden on monetary policy.
• While acknowledging the difficulty in changing the exchange rate policy at this juncture, the mission believes that greater exchange rate flexibility is in the long-term interest of the economy. As an interim step, adopting a narrow band for the U.S. dollar/taka exchange rate may be worth considering.
C. Financial Sector Reforms
15. The mission welcomes the progress made in financial sector reform and applauds BB’s willingness to pursue further reforms.
• Considerable progress has been made in strengthening the soundness and resilience of the financial sector since the 2003 FSAP. Building on this progress, since last August, BB has made steady progress in implementing many of the recommendations advanced by the 2010 FSAP update mission.
• Recent improvements include (i) preparing for the introduction of Basel II regulations effective January 1, 2010; (ii) raising the quality of banks’ capital; (iii) creating risk management units at all banks; (iv) strengthening BB’s in-house capacity for stress testing; and (v) requesting commercial banks to run their merchant banking business through separately formed subsidiary companies.
• The mission welcomes BB’s request for a resident advisor to assist with strengthening BB’s banking supervision capacity.
16. The weak state of the SCBs remains a key concern.
• Although the SCBs’ finances have improved, they remain much worse than the finances of the private banks.
• Strategic guidance and robust decisions --- based on business principles at the Board and management level --- remain critical to further promote SCBs’ soundness, especially in view of the recent relaxation of the cap on the loan portfolio growth from 5 to 10 percent. In this context, the jury is still out on whether all of the recently appointed directors and chairmen would live up to the expectations that they will be able to help further strengthen the SCBs.
• The mission urges BB to closely monitor the performance of the three corporatized SCBs using agreed verifiable indicators. In order to prevent an increase in non-performing loans in the medium term, and thereby protect the population from the costs of a potential bail-out, BB should use its supervisory powers to take corrective measures, as necessary, if there is evidence that these banks are not being run appropriately.
• On the other hand, it is vital that Rupali Bank should be brought under the same restructuring and monitoring program as the other SCBs as quickly as possible. It is critical that all four SCBs are run based only on commercial considerations.
17. There is also an urgent need to strengthen accounting practices, and to unify and broaden regulations.
• Weaknesses in the implementation of accounting standards by banks appear to cause an overestimation of the decline in the NPL ratio.
• Prudential and regulatory enforcement needs to be improved in order to ensure that all microcredit and non-bank financial institutions are brought fully within the regulatory perimeter.
18. Measures should be taken to increase efficiency in the financial markets.
• Non-prudential interventions, such as ceilings on lending rates for priority sectors, moral suasion, directed lending, and easing debt service for some sectors, are counterproductive in the long run. In light of this, the mission welcomes BB’s pronouncement that the ceilings on lending rates are temporary. In the mission’s view, they and other intervention instruments should be removed as soon as possible and in any case before market interest rates rise with higher inflation.
• The fixed interest rates on NSCs are a burden on the budget and distort the monetary policy transmission mechanism. Increased flexibility of interest rates would make the auction process for government securities more efficient and eliminate the devolvement of securities onto the primary dealers at rates that frustrate trading.
• An active secondary market in government paper helps financial sector deepening and monetary policy implementation, and ultimately reduces borrowing costs.
IV. Improving Statistics
19. Improving the quality and timeliness of economic statistics would strengthen policy making. The mission welcomes the progress that has been made in improving trade statistics. Adoption of a Statistics Act would clarify responsibilities in the compilation of statistics and provide needed autonomy to the Bangladesh Bureau of Statistics (BBS). Other key priorities include improving and updating the source data for national account statistics, moving towards Government Financial Statistics Manual 2001 standards for fiscal statistics, and ensuring that the BBS has sufficient staff and other resources to compile statistics.