final pri policy briefs july 2012

7/31/2019 Final PRI Policy Briefs July 2012

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PRI Quarterly Policy

Briefs on Bangladesh

June 2012

Policy Research Institute of Department for International


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PRI Quarterly Policy Briefs on Bangladesh Economy June 2012

Contents

Summary........................................................................................................................... iv

I. FY13Budget and Its Challenges ............................................................................ 1

Introduction........................................................................................................................1

Global economic outlook ....................................................................................................1

The New Budget ............................................................. .....................................................3

Key Recommendations .......................................................................................................7

II. Is Bangladesh Banks Monetary Policy Stance Working? .................................. 9

Background .......................................................................................................................9

Execution of Monetary Policy in Recent Years ............................................................9

Fiscal and Monetary Policy Coordination ...................................................................10

Are Monetary Developments Compatible with IMF Performance Criteria andBenchmarks? ..................................................................................................................11

Is the Tightened Monetary Policy Working? ...............................................................12

Future Challenges and Recommendations for Monetary Management ................12

III. Explaining Inflation in Bangladesh ..................................................................... 14

Background .....................................................................................................................14

The Policy Debate ..........................................................................................................14

Quantitative Analysis .....................................................................................................14

Summarizing the Key Empirical Results .....................................................................17

Implications for Policies .................................................................................................17 Agenda for Further Research .......................................................................................18

IV. Is Trade Policy Losing Direction? ....................................................................... 18

Background .....................................................................................................................18

Launch of DTIS and Impending Trade Policy Review ..............................................18

Global Economic Environment and Outlook for 2013 ...............................................18

Evolution of Trade Policy in Bangladesh ....................................................................19

Budget 2013 and Tariff Adjustments ...........................................................................20

Trade Policy Losing Direction .......................................................................................21

Summarizing the Key findings ......................................................................................22

Policy Recommendations..............................................................................................22


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List of Tables

Table 1.1: Overview of the World Economic Outlook Projections ............................... 1

Table 1.2: Fiscal Outturn (BDT in billions) ..................................................................... 2

Table 1.5: Sectoral Allocation of Government Expenditure ......................................... 7

Table 1.6: NBR Tax Revenue Performance .................................................................... 7

Table 2.1: Monetary Targets for End June 2012 .......................................................... 11

Table 4.1: Outlook of Global Output and Trade ........................................................... 18

Table 4.2: Progress in tariff rationalization FY01-13 ................................................... 20

Table 4.3: Average Nominal Protection Rate, Dispersion, Maximum and General .. 21

List of Figures

Figure 1.1: Remittance (Million USD) .............................................................................. 2

Figure 1.2: Foreign Aid Flows .......................................................................................... 2

Figure 1.3: Total subsidy and sectoral allocation ......................................................... 2

Figure 1.4: Export to EU; Growth .................................................................................... 4

Figure 1.5: Planned and Actual Public Investment ....................................................... 4

Figure 1.6: Trend in ADP Implementation ...................................................................... 4

Figure 1.7: SUBSIDY-GDP ratio ....................................................................................... 5

Figure 2.1: Monetary Policy Targets Vs Actual, in Recent Years ................................ 9

Figure 2.2: Advance to Deposit Ratio (%) ....................................................................... 9

Figure 2.3: Point to Point Inflation ................................................................................ 10

Figure 2.4: Exchange Rate ............................................................................................. 10

Figure 2.5: Repo Rate and CRR ..................................................................................... 10

Figure 2.6: Private and Public Sector Development .................................................... 11

Figure 2.7: Distribution of Domestic Credit Flow ........................................................ 11

Figure 2.8: Share of Public Sector Credit in Total Domestic Credit Stock ............... 11

Figure 2.9: Crude oil price in Dubai ($/bbl)................................................................... 12

Figure 2.10: Domestic Credit Development ................................................................. 12

Figure 3.1: Recent Bangladesh Inflation, point to point ............................................. 14

Figure 4.1: Average Nominal Protection Trends ......................................................... 20

Figure 4.2: NPR trends and emergence of para-tariffs ............................................... 21

Figure 4.3: Average NPR by Import Categories ........................................................... 21


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Summary

FY13 Budget and its Challenges

The budget for Fiscal year 2013 (FY13) has been announced against the backdrop ofmixed performance in the preceding year in terms of macroeconomic and fiscalmanagement.

In FY12, the global economy has been undergoing new and tougher challenges withthe unfolding Euro Zone Debt Crisis and the aftershocks of the Financial Crisis of2008-09. Bangladesh has been significantly impacted through the trade channel butoverall has fared reasonably well with real GDP growth at 6.3%.

A surge in subsidy payments (primarily for fuel, electricity and agriculture), a shortfallin aid utilization in the first half of FY12, fragile balance of payment situation, andexcessive borrowing by the government from the banking system complicated fiscalmanagement and contributed to stagnation of domestic investment. Healthyremittance inflows helped contain balance of payments (BOP) pressures and thestellar performance in terms of revenue collection helped fiscal management.

The growth target (7.2% in real terms) in Budget FY13 seems overly optimistic underthe current global economic environment and stagnant level of domestic investment.Its realization will require double-digits manufacturing sector growth, which is unlikelyto materialize given the depressed outlook for exports to the EU and the USA whichaccount for more than 80% of Bangladeshi exports.

Faster ADP utilization and limiting subsidies to the budgeted levels will remain asmajor challenges for fiscal management in Budget FY13. Price adjustments for fueland electricity, in the context of a comprehensive medium-term subsidy reductionstrategy and with extensive public discussion to build political consensus, will theappropriate way to proceed.

The revenue target is ambitious, but attainable, if efforts to broaden the tax netthrough modernization and strengthening of tax administration are sustained. Thethrust on VAT and income tax is appropriate and given Bangladeshs relatively lo w

VAT and income tax productivity, there is enormous scope for higher revenue growth.

On the expenditure side, Awami League governments traditional thrust on socialsectors and safety net programs for poverty alleviation has been maintained in FY13budget. The top three recipients of budgetary allocations are education, agriculture,and local government and rural development. Social security and welfare, power andenergy, and health sectors also received high priority.

Is Bangladesh Banks Monetary Policy Stance Working?

Bangladesh Bank (BB) generally recognizes the imperative for prudent monetarypolicy and accordingly establishes quantitative targets for key monetary aggregates.However, in recent years actual implementation fell short of the targets as monetary

policy was accommodative to meet the growing demand of various sectors. Mostmonetary targets were exceeded by wide margins every year leading to build up ofinflationary pressures, asset price bubbles and balance of payments pressures.

Taking these developments into account, BBs Monetary Policy Statement (MPS) ofJanuary 2012 stated to pursue a restrained monetary growth path consistent withcurbing inflationary and external sector pressures.. Monetary tightening measureswhich were initiated since March 2011 by BB through corrective measures likeincreasing the policy rates, removing the cap on lending rates, and allowing theexchange rate to be determined by market forces.

At a time when monetary policy started to become tighter due to BB measures,government borrowing from the banking system increased sharply, exceeding thefull-year borrowing target within 5 months after the beginning of the fiscal year. This

unsynchronized fiscal-monetary policy mix crowded out private sector credit up toNovember 2011 and led to tensions in the money market. The situation however


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changed markedly since December 2011, due to corrective measures on the fiscalside which helped restrain public sector borrowing from the banking system.

The tightening measures helped contain the expansion of monetary aggregates:growth of broad money decelerated to 17% by April 2012 from 21.3% in FY11;private sector credit growth declined to 18.2% over the same period compared with25.8% in FY11. As of end-April 2012, monetary developments were broadly in line

with BBs monetary targets for end-June 2012 as stated in MPS for January to June2012 and also with the monetary targets set under the IMF ECF program.

Tighter monetary policy has helped contain inflation and stabilize the exchange ratein the second half of FY12. Achieving the inflation target of 7.5% set in FY13 wouldbe challenging but attainable. It will require continued monetary restraint, andfavorable domestic and external supply/price developments. On its part, BB shouldfocus primarily on achieving the quantitative targets and not on policy instruments likeinterest rates. Maintaining the right mix between fiscal and monetary policies in thenew fiscal year and beyond will be important for the success of monetary policy.

Explaining inflation in Bangladesh

Bangladesh has experienced frequent inflationary episodes since independence.Most recently inflation has been increasing since June 2009, rising from an averageof 2.3% during 2008/09 to a peak of 12% in September 2011. The inflation ratedeclined to 9.9% in April 2012. The rapid rate of inflation has become a majoreconomic and social problem.

Quantitative time series analysis using data from 1981-2011 shows that the rate ofgrowth of money supply is a major determinant of inflation over the long term.

International food prices have short-term effects on inflation but are not a factor

underlying long-term inflation.

Quantitative results show that the inflation determines nominal exchange ratedepreciation and not the other way round. The causality from inflation to exchange

rate is a very powerful and fundamental result for policy making. The main messageis that if we want to have a stable exchange rate over the longer term, we need tokeep the rate of inflation low and closely aligned to international inflation.

GDP growth and inflation are negatively correlated over the longer term. So, there isno evidence that higher rate of GDP growth requires higher inflation (beyond athreshold level of 4-5%).

Fiscal policy will need to be consistent with the targets of prudent monetarymanagement. Accommodating sustained international price increases in fuel pricesthrough budgetary subsidies that is financed through borrowing from the BangladeshBank is inconsistent with sound monetary management and inflation control.

Is Trade Policy Losing Direction?

Trade liberalization is stalled; but no clear direction has emerged since the dawn ofthe new century. The structure of incentives underlying the trade regime favorsproduction of domestic import substitutes over exports, creating an inherent anti-export bias.

Although the RMG sector is free from the shackles of high tariffs on inputs or outputs,other exports or potential exports are not.

Tariff and para-tariff proposals in FY2013 budget signals continuation of the recenttrend of rising average nominal protection and wider dispersion of the tariff structure.While para-tariffs have been emerging as significant component of nominal tariffs, forthe first time, its share has exceeded average custom duty.

While nominal tariffs on inputs (basic raw materials and intermediate goods)continue to fall, those on final consumer goods trend upwards, thus widening the


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wedge between average tariffs on outputs and inputs, augmenting tariff escalation atthe last stage of processing.

articulation of the kind of trade policy needed to improve export performance andsupport the high growth needed to reach middle income status by 2021.

policy stance to support growth; (ii) putting back the trade liberalizationagenda/program back on track, which will entail reduction of both the averagenominal tariff rate and the dispersion of the tariff structure since tariff escalationbreeds inefficiency and undermine competitiveness of firms in the long run; (iii)scaling down of top tariff rates along with para-tariffs to give domestic customersrelief; and (iv) balancing the interests of both producers and consumers in tradepolicy formulation.


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I. FY13Budget and Its Challenges

Ahsan Mansur

Introduction

The budget for FY13 has been announced by theHonorable Finance Minister on June 7, 2012, against thebackdrop of mixed performance in the preceding year interms of macroeconomic and fiscal management. Globaleconomic outlook and Bangladeshs export prospectshave also deteriorated markedly because of furtherdeepening of the Euro-Zone Debt Crisis. The budgetwould be last full-year budget for the current governmentbefore facing elections and it has been unveiled in anenvironment of intensifying political uncertainty. Thebudget targets an acceleration of real GDP growth to7.2% and a sharp deceleration of inflation to 7.5%, whileconsolidating Governments efforts towards improved

macroeconomic stability and further alleviation ofpoverty.

This policy note analyzes the emerging challenges inimplementing the budget taking into account issues thatemerged in implementing the FY12 budget. Morespecifically, following a brief review of the backgroundagainst which the budget has been unveiled, it focuseson: whether the growth target will be achievable and itsimplications for fiscal management. This note is also anexercise in pointing out the major issues/factors thatmust be handled with vigilance in order to achieve thegoals that have been set out in the new budget. Issues

relating to the inflation target and the underlying policieshave been covered in the second policy brief.

Global economic outlook

Bangladesh has been somewhat sheltered from the fullbrunt of the global economic recession of 2008-09 dueits limited international financial integration. The EuroZone Debt Crisis however is growing grimmer and itsshockwaves are already being felt across the worldthrough various channels. The Industrial Worldthedestination of Bangladeshi exports--has entered into anextended phase of slow growth or recession induced bythe Euro Zone debt crisis.

Table 1.1: Overview of the World Economic OutlookProjections

IMF 2009 2010 2011 2012 2013 P

GDP at constant prices(% change)

World Output -0.6 5.2 3.9 3.5 4.1

Advanced Economics -3.6 3.2 1.6 1.4 2.0

Euro Zone -4.3 1.9 1.4 -0.32 0.9

Emerging andDeveloping Economics

2.8 7.5 6.2 5.7 6.1

Developing Asia 7.1 9.7 7.8 7.3 7.9

Continue....World Trade Volume(goods and services)

-10.5 12.9 5.8 4.0 5.6

Commodity Prices(USD) (% change)

Oil -36.3 27.9 31.6 10.3 -4.11

Nonfuel (CommodityNon-Fuel Price Index )

-15.7 26.3 17.8 -10.3 -2.1

Source: World Economic Outlook Database April 2012 Edition

Real GDP growth in most major regions of the world is

expected to be lower in 2012 in comparison to 2011, withthe Euro Zone expected to grow negatively. Theslowdown in GDP growth in Asia and the developingworld is being partly caused by mellowing of the growthspurt of large economies like China and India.

A review of Bangladeshs macroeconomic performancein FY12 shows that the estimated real GDP growth rateof 6.3%, although lower than the 7% target set earlier, isrespectable. The moderate slowdown in growthwhichis broadly in line with the predictions of professionalbodiesis attributable to the slowdown in exports andthe dampening of general investors sentiment which led

to a deceleration in the performance of themanufacturing and services sectors as well as privateinvestment. However, the effect was cushioned to acertain extent due domestic demand, supported bycontinued strong inflow of remittances which helpedsustain domestic economic activity and revenueperformance. There has also been a decline inagriculture performance which is a bit surprising, butperhaps owing to the decline in agricultural productsprices in the global market.

Even though Bangladesh did not perform as well as ithad set out to in terms of GDP growth, its performancehas been better than its Asian counterparts like India,China etc, who have experienced a more pronounceddecline in growth this year in comparison to the last.While Bangladesh has been affected primarily throughthe export channel, the comparator countries have beenaffected through trade as well as financial channels likeFDI and portfolio investment.

0

2

4

6

8

10

12

2009 2010 2011 2012

GDPGrowth(%)

China India Bangladesh Vietnam


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Figure 1.1: Remittance (Million USD)

Source: Bangladesh Bank

Remittance inflows provided the much neededsupport from the demand side: As previouslymentioned, inflow of workers remittances has been asaving grace for Bangladesh in FY12 with the countrypossibly recoding the highest growth in remittanceinflows in the world. Initial worries that there could be amassive reflow of Bangladeshis from abroad due to theArab Spring as well as global economic slowdown didnot materialize at all. It is expected that so long thecrude oil prices remain around $70-$80 per barrel, muchof the investment programs in the GCC region willcontinue to be implemented along with strong demandfor expatriate workers. The number of workers goingabroad has rebounded strongly in FY12 and the outlookremains favorable therefore providing a safety net for the

external current account and foreign exchange balancesin the upcoming fiscal year.

Figure 1.2: Foreign Aid Flows

The foreign aid flow has been on a declining trend whenwe compare the data for FY10 and FY11 (July-May). InFY12, especially based on data for July- November, itseemed like the declining trend would continue.However, aid utilization/disbursements improvedmarkedly since December 2011 and continued on anupward trend for the remainder of the fiscal year (Figure

1.2). Total and net aid disbursements in FY12 (July-May)

was 17.7% and 23.2% higher, respectively, over thecorresponding period in FY11.

This increase in fund inflows also helped containgovernment domestic borrowing from the bankingsystem over the corresponding period. Much better

utilization of foreign aid in the second half of FY12enabled the government to limit the level of bankfinancing well below the target set under the IMFprogram and the revised budget. The target for domesticborrowing from the banking system in FY13which hasbeen set at Tk. 230 billionwould only be attainable ifthe authorities once again succeed in utilizing externalfinancing along the lines targeted in the budget.

Table 1.2: Fiscal Outturn (BDT in billions)FY11 FY12 (B) FY12 (RB) FY13 (B)

Total Revenue 929.9 1183.85 1148.85 1396.7

NBR Tax 790.92 918 923.7 1122.59

Other Revenue 160.95 225.85 225.15 274.11

Total Expenditure 1283 1636 1612.13 1917.4

CurrentExpenditure 796 879 918.23 979.02

Of Which

Interest Payments 157 180 198 233.02

Subsidy 92.69 92.88 122.63 144.45

Transfer Payments 222.14 253.11 253.9 241.82

ADP Expenditure 390 460 410.8 550

OthersExpenditures(Including BlockAllocations)

97 297 283.1 15.94

Overall Balance -353.1 -452.15 -463.28 -520.7

(% of GDP) -4.20% -4.92% -5.06% -5.00%Source: Ministry of Finance

While Bangladesh Bank has averted a balance ofpayments crisis in FY11 by allowing the domesticlending rates and the exchange rate freelydetermined by market forces, the balance ofpayments situation continued to remain fragile inFY12. The external trade account deficit grew by 13%between July-March FY12 in comparison to thecorresponding period in the previous fiscal year. Despitethe buoyant inflow of remittances (by 13%), the currentaccount balance declined by 22% to US$ 456 millionduring the first 9 months of FY12. The level of foreignexchange reserves declined further by US$ 0.5 billion tobelow the psychologically important $10 billion level atthe moment.

Figure 1.3: Total subsidy and sectoral allocation

FY 09

FY 11

FY 12

0

200

400

600

800

1000

1200

1400

Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May

0

500

1000

1500

Jul-Nov

Dec-May

Jul-Nov

Dec-May

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Dec-May

FY10 FY11 FY12

$1,237

$675 $614

$846

$419

$1,300

$989

$302 $323$485

$79

$916

inmillionUS$

Total Aid Net Aid


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Source: Medium-term Budget Framework (MTBF)

Fiscal management got complicated by a surge insubsidy payments and a shortfall in aid utilization.The subsidy budget was exceeded by a substantialmargin owing to increased funds required for theagriculture, fuel (BPC) and electricity (PDB) sectors

which accounted for the over 70% of the total subsidy inthe revised budget. The rising price of fuel in theinternational market and a markedly higher volume ofimports associated with the liquid fuel based, togetherwith delays in adjusting domestic administered prices offuel and electricity, led to a surge in budgetary subsidiesin FY12. The resulting increase in government borrowingfrom the banking system exceeded the annual target byDecember 2011, created a liquidity crunch in the moneymarket by crowding out the private sector.

While the government faced problems in itsexpenditure management, its revenue performance

exceeded expectations and helped fiscalmanagement. The NBR revenue surplus is expected tobe about BDT 8.4 billion in FY12, despite a markedslowdown in non-oil imports and associated import stagetaxes. As is the case every year, actual ADPimplementation is expected to fall shy of its target inFY12 by about 10.87% of the original budget. Thisdevelopment together with better than budgeted revenueperformance, helped contain the overall fiscal deficitincluding grants to about 4% of GDP, below the originalbudget target. Some corrective measures to containsubsidy through several rounds of petroleum andelectricity prices adjustments played a crucial role in

improving fiscal management in the second half of FY12.As a result, government borrowing from the bankingsystem which surged to BDT [180] billion at end-November, remained stable at similar levels by end-April2012. This level of fiscal deficit and debt is consistentwith fiscal sustainability. However, the distribution offinancing still remains a problem, as external financing(net) has been stagnant or declined in dollar terms inrecent years due to governments inability to implementforeign funded ADP projects.

The New Budget

Budget FY13 is the fourth budget of present governmentand the penultimate one before it goes for re-election.This budget therefore not only has economic

ramifications for the country, the government also has alot riding on it to meet their political aspirations. Thisbudget is by far the biggest budget in the countryshistory in both absolute and relative terms, respectively,at BDT 1.9 trillion or 18.4% of GDP.

While many analysts have characterized the size of thebudget as politically driven, we believe that an 18%increase in spending may not be consideredexpansionary given that the nominal GDP growth ratewould be more than 15%. The deficit level of 4.5% ofGDP (including grants) is very much in line with pastbudgets and consistent with debt sustainability. At thiscrossroad with election ahead, the government had twobasic options: (i) to go for an election oriented populistbudget with much higher spending and overall deficit; or(ii) strive for maintaining macroeconomic stability througha prudent fiscal stance with fiscal deficit limited to 5% ofGDP. We believe that the authorities have opted for the

second option in order to restore macroeconomicstability by containing inflation, easing money markettensions by avoiding crowding out of the private sector,and achieving a respectable growth rate even if it maynot reach the ambitious target of 7.2%.

The budget deficit (including grants) for FY13 at 4.5%indicates that the fiscal stance will remain more or lessthe same as in most other years. Nevertheless, webelieve that the government will face enormouschallenges in implementing the budget and achieving themacroeconomic objectives in several areas includingachieving growth and inflation objectives; containing the

surging subsidy bill; implementing the donor-fundedprojects included in the ADP; achieving the ambitiousrevenue target; and alleviating poverty through bettermanagement and targeting of social spending.

FY10 FY11FY12(P)

FY13(SFYP)

Sectors Growth Rate (%)

Agriculture 5.2 5.1 2.5 4.4

Industry 6.5 8.2 9.5 9.9

of whichManufacturing 6.5 9.4 9.8

10.1

Services 6.5 6.2 6.1 7.1

GDP 6.1 6.7 6.3 7.2Share as % of GDP

Agriculture 20.5 20.3 20.0 19.3

Industry 29.9 29.9 30.4 31.3

of whichManufacturing 17.9 17.9 18.4 19.0

Services 49.7 49.8 49.6 49.4Source: Sixth Five-Year Plan (SFYP)

We consider the growth target as overly optimisticunder the current global economic environment andstagnant level of domestic investment. The budgetenvisages a strong rebound in economic growth to 7.2%despite significant downside risks and a sharp reduction

in inflation to 7.5% through better co-ordination in fiscaland monetary policy. It also aims to bring forth more

0

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200

300

400

FY 07 FY 08 FY 09 FY 10 FY 11 FY 12 FY

13B

Total Subsidy Fuel (BPC) Agriculture Electricity (PDB)


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equitable distribution in income and thus reduce povertylevel through more equitable growth and higher socialsector spending. In the remainder of this policy brief wepresent the challenges that the authorities will face inachieving the growth target and in implementing thebudget during the course of the year.

Double-digit manufacturing sector expansion is apre-requisite for higher growth. The analysispresented in the Sixth Five Year Plan (SFYP) indicatesthat even with a sharp rebound in agriculture output,achieving 7.2% real GDP growth will require themanufacturing sector to grow by more than 10%. Giventhat the manufacturing sector is heavily dependent onthe export sector which is facing a slowdown due to theEU debt crisis, such a strong performance in themanufacturing sector is unlikely to materialize.Furthermore, the investment level (both public andprivate sector) required for achieving or sustaining

growth rates in excess of 7% is unlikely to materialize inFY13, given the shortfall in investment experience inrecent years.

Figure 1.4: Export to EU; Growth

Despite resilience, Bangladesh cannot avoid a fall inexports to the industrial countries. The export sectorof the country has performed quite resiliently even in theface of the global recession of recent years. While theglobal trade in value terms declined by more than 30% atits bottom, Bangladeshs export decline was limited to11.7% at its worst. In line with the previous episode (FY08-09), currently there are signs of a significantslowdown in global and Bangladesh exports. Thissituation will probably deteriorate further in next fewmonths. Unlike the past episode (global economic crisis)this time the economic slump in the Euro Zone is likely tobe much more protracted. The recovery process thistime will probably be more prolonged taking the form ofU instead of the V shape as it was in 2008 -09. As theEuro Zone receives the largest amount of Bangladeshsexports slowdowns in that region could have quite anadverse effect on our exports.

Both public and private sector investment arerunning well below their desired/required levels.Investment- public and private- is usually supposed to bethe growth trigger for most economies and Bangladesh isno exception. Increasing the Investment/GDP ratio tomuch higher levels was always considered to be critically

important for achieving growth rates ranging from 7% to8% under the SFYP. After completion of 2 years underthe SFYP, the investment level still remains at about25%, where it has been hovering for many years,compared with the target of 29% of GDP by FY13 underthe SFYP.

Figure 1.5: Planned and Actual Public Investment

Source: Sixth Five-Year Plan (SFYP)

The implicit target for investment set out in the FY13budget seems even more unattainable for severalreasons like the current unstable political environment,labor unrests and shutdowns in the RMG export sector,

inadequate energy and infrastructural support to name afew. All these factors tend to act as a disincentive forinvestors and thereby will most probably lead to declinein investment flows. In FY12, actual public investment fellshort of the SFYP target for public investment. Thetargeted increase in public investment in FY13 also fallsshort of the SFYP target. The situation is much worsewith private sector investment. The shortfall in privateinvestment in FY12 was about 2% of GDP. Privatesector investment would need to reach 23% of GDP inFY13 from about 18% level in FY12. A formidable taskindeed!

Figure 1.6: Trend in ADP Implementation

1.9

20.7

-13.0

52.4

7.3

15.916.7

19.5

-13-5.5

-20.0

-10.0

0.0

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20.0

30.0

40.0

50.0

60.0

Jul-Sep

Oct-Dec

Jan-Mar

Apr-Jun

Jul-Sep

Oct-Dec

Jan-Mar

Apr-Jun

Jul-Sep

Oct-Dec

Jan-Mar

Apr-Jun

Jul-Sep

Oct-Dec

Jan-feb

FY 09 FY 10 FY 11 FY 12

Value In EUROS (million) Qnty_In_100KG

0

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4

6

8

FY10 FY11 FY12 FY13(e)

%

of

GDP

SFYP Public Investment Actual Public Investment

16

18

20

22

24

FY10 FY11 FY12 FY13(e)

%o

fGDP

SFYP Private Investment Actual Private Investment


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FY 11 BFY 11 RBFY 12

BFY 12

RBFY 13

B

No. of ADP projects 916 1185 1039 1228 1037

Increase/decrease 269 189

Original/Revised ADPbudget (BDT in billions)

356.8 338.08 460 410 550

Increase/decrease -18.72 -50

Source: Planning Commission and Ministry of Finance

ADP utilization has been a common shortcoming ofthe government in the past and therefore chances arehigh that the trend will continue in FY13 as well.However, significant gains have been made on twofronts. Because of the large size of the ADP allocation,despite the implementation shortfall, actual growth in

ADP spending has been respectable in recent years.The pace of utilization has increased significantly sinceFY10, compared to earlier years. The result of these twofavorable developments is a steady increase inimplemented ADP size in relation to GDP in recentyears. From the lowest level of close to 3% of GDP in FY09, the size of ADP is expected to increase by 1.5-2percentage points to about 5% of GDP in FY13.Nevertheless, there are other problems with the projectselection process.

There are too many projects under the ADP, constrainingadequate funding and thereby limiting the capacity to

complete the projects on time. Every year the size of theADP is reduced significantly through a mid-year reviewexercise. But a large number of new projects averagingabout 200 are added to the revised ADP. Furthermore,507 projects have been added in FY12 RB without anyfund allocation. These issues raise questions regardingboth the adequacy of the selection process and quality ofprojects under the ADP.

Figure 1.7: SUBSIDY-GDP ratio

Source: Medium-Term Budget Framework (MTBF)

In FY12, if we include the amount deferred to the nextyear, the amount of budgetary subsidy on an accrualbasis would amount to 4.5% of GDP.

The subsidy in the power sector has been particularlynoticeable as the figure has been revised up by aconsiderable amount over the budgeted figure:

Fiscal costs associated with the power sector

strategy far exceeded the original estimates;

If unchecked, costs will be much higher in the

coming years because more rental power plants

will be in operation; and

There will be longer than usual delays in

implementing the medium and large power

plants due to problem in securing finance.

The overall size of energy subsidies has grown rapidly inrecent years due to rising import costs and inadequatecost recovery, undermining the fiscal position and overallmacroeconomic stability. Notwithstanding significant fuel

and electricity prices adjustments over the past year,more upward adjustments in petroleum and electricityprices would be necessary in FY13, given the projectedimport costs and available budgetary financing.

To contain fuel subsidies, the government has plannedto move to an automatic adjustment formula byDecember 2012, which will ensure full pass-through ofchanges in international prices (an important IMFprogram benchmark). Implementation of such anautomatic adjustment mechanism, if adopted, would helpstabilize budgetary subsidy for fuel.

Subsidy reduction is a politically sensitive issue. Politicalconsensus and support from the people will be critical for

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

FY05

FY06

FY07

FY08

FY09

FY10

FY11

FY12RB

FY13B

(

%)

ADP/GDP ratio

0.00%

1.00%

2.00%

3.00%

4.00%

FY 09 FY 10 FY 11 FY 12B FY 12RB FY 13B

2.28%

3.30% 3.32%

0

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100

150

200

250

300

350

BDTinbillions

Total Subsidy Total Energy Subsidy (PDB & Fuel)


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sustainable reduction in subsidies. A carefully preparedsubsidy reduction strategy will help create awarenessabout this issue and engender political support for thecause.

It must also be recognized here that a power sector

generation plan based on larger gas and coal fired plantsis a must for the growth strategy and fiscal sustainability.Without plans for utilizing domestic coal, BOP and fiscalsector vulnerabilities would persist.


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Table 1.5: Sectoral Allocation of GovernmentExpenditure

Growth in Real terms (%) As % of Total Expenditure

FY10A

FY11A

FY12RB

FY13B

FY10A

FY11A

FY12RB

FY13B

LocalGovernment

and RuralDevelopment

15.7 15.6 7.4 10.1 9.6 10.1 9.5 9.6

DefenseService

37.9 14.9 1.5 -2 10.4 10.9 9.6 8.7

Education andTechnology

22 11.3 -9.2 9.9 18.4 18.6 14.8 14.9

Health 19.3 6.7 5.2 6.5 7.2 7 6.4 6.3

SocialSecurity andWelfare

-18.4 6.7 20.1 -1.1 8 7.8 8.1 7.4

Power andEnergy

32.6 92.1 2.8 11.5 4 7 6.3 6.4

Agriculture 6.1 6.7 4.2 -6.3 12.8 12.4 11.3 9.7

Others 22.6 -1.9 47.2 18.7 29.6 26.4 33.9 37

TotalProgramme

Expenditure

16.3 10.1 14.3 8.9 100 100 100 100

Source: Ministry of Finance

The thrust on social sectors and safety net programsfor poverty alleviation has been maintained. A broadreview of budgetary appropriations indicates that thethrust of the budget in FY13 is appropriately on the socialsector. The top three recipients of budgetary allocationsare for education, agriculture, local government and ruraldevelopment, social security and welfare, and health.The share of defense spending has been following adeclining trend, which is expected to continue in FY13.

Allocation to agriculture has declined both in relative andreal terms, perhaps due to the subsidy reduction

strategy. The power and energy sector is the highest interms of real growth in expenditure. Such social sectorand expenditures on power sector if conductedconsistently and properly could lead to substantialchanges in both sectors and improve standard of living ofthe people.

Table 1.6: NBR Tax Revenue Performance

FY10 FY11 FY12 FY13(Budget)

Growth Rate(As Percentage Change)

Total NBRRevenue

18.1 27.8 16.6 21.5

of Which:

Income Tax 23.2 32.2 24.2 25.8Value Added

Tax15.6 29.6 13.9 18.0

Custom Duty 9.8 15.3 6.6 15.0

(% of Total NBR Revenue)

Income Tax 26.4 27.6 28.5 31.4Value Added

Tax38.3 37.5 38.0 36.0

Custom Duty 17.8 16.6 15.0 12.9

Source: Ministry of Finance, Bangladesh

On the revenue side, the target is ambitious butattainable if efforts to broaden the tax net through

modernization and strengthening of taxadministration are sustained. The revenue target is

ambitious because, except for two years FY08 andFY11, NBR had never recorded such a high target inrecent years. Nevertheless, it is also true that NBR hasexceeded its budget targets for the 3

rdconsecutive year

through FY12, which gives some confidence to thisambitious target.

As in recent years, realization of the NBR revenue targetwould critically depend on success in maintaining themomentum in revenue generation from income tax andVAT:

On the income tax side, a number of important

revenue augmenting measures have been

adopted, including: higher minimum tax; keeping

the exemption level unchanged at Tk. 180,000,

despite its reduction in real terms through inflation;

broadening the scope of tax withholding, effective

operation of the alternative dispute

resolution(ADR) mechanism, higher tax rate for

exporters, etc.

The downside risks relating to the FY13 revenue

target primarily originate from the slower expected

GDP growth.

There is no major change in the VAT regime in

FY13. The thrust is primarily on strengthening and

modernization of tax administration to enhance

efficiency of the VAT system.

Given Bangladeshs relatively low VAT and income taxproductivity, there is potential scope for realizing thetarget if NBR modernization efforts are continued.

Key Recommendations

Overall, the FY13 budget is ambitious requiring vigilance

and perseverance for its effective implementation. Its

proper implementation will require focusing on the

following issues:

The targeted domestic borrowing from the banking

system at Tk. 230 billion is already very high, andany shortfall in revenue, domestic non-bank

financing through national savings

bonds/certificates, and external financing will

further increase recourse to bank financing and

thereby crowd out the private sector and/or

monetization of borrowing undermining growth and

inflation objectives.

On the expenditure side, limiting the subsidy bill to

the budgeted level would require firm actions in the

form of price adjustments for petroleum products

and electricity. The measures must not bedelayed, as was the case last year.


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8


The authorities should prepare a comprehensive

medium-term subsidy reduction strategy and hold

public discussions on the strategy to mobilize

public support for future cuts in subsidies.

Achieving the ambitious revenue target, in the face

of slower than projected real economic growth,

would entail strengthening tax administration and

sustaining the reform process initiated in the VAT

and direct tax fronts.

Accelerating the pace of foreign-funded project

implementation and releasing the counterpart

foreign financing would be keys to increasing ADP

utilization and reduce pressure on domestic bank

financing. Making the positions of Project Directors

more attractive by: giving them more authority in

implementation and release of funds; rewardingthem for good performance; and simultaneously

holding them accountable for speedy project

implementation. Linking disbursement of Taka

counterpart funds to utilization of foreign funds

more effectively would encourage project

management teams to focus on accelerating

disbursement of foreign resources.


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9


II. Is Bangladesh Banks Monetary

Policy Stance Working?

Ahsan Mansur

BackgroundIn order to tackle the growing inflationary pressure andincreased balance of payments vulnerability, BangladeshBank announced a shift in its monetary policy stance inJanuary 2012. By November 2011, the general inflationreached almost 12%, the highest level since 1998, andgovernment borrowing from the banking system tofinance budgetary operations already crossed theborrowing limit established in the budget for the wholeyear. Increased import payments associated with higherpetroleum prices and volume of imports, started to exertpressures on the exchange rate and the level of foreignexchange reserves.

Taking these developments into account, BangladeshBanks Monetary Policy Statement (MPS) of January2012, stated to pursue a restrained monetary growthpath consistent with curbing inflationary and externalsector pressures, while ensuring adequate private sectorcredit to stimulate inclusive growth. Followingsuccessive years of significant deviations between theannounced MPS stances and their implementation, inthe guise of so called accommodative monetary policy,there was a certain amount of skepticism aboutBangladesh Banks resolve in pursuing a restrainedmonetary policy in line with the quantitative monetarytargets. There is also widespread realization that BBsrecent inability to firmly adhere to its announced MPSquantitative targets have fueled inflation, created assetmarket bubbles, and weakened Bangladeshs BOPposition.

This policy brief aims to: determine whether BB is indeedseriously pursuing the intended policy stance announcedin the January 2012 MPS; examine the coordinationbetween monetary and fiscal policy to avoid crowding outof the private sector; compare the developments ofmonetary aggregates and appropriateness of the policystance with the commitments made under the IMFsupported ECF program; and assess the effectiveness ofthe policy stance in terms of containing inflation,stabilizing the exchange rate and BOP pressures.

Execution of Monetary Policy in Recent Years

BB generally recognized the imperative for prudentmonetary policy and accordingly established quantitativetargets for key monetary aggregates in each and everyMPS in recent years. However, actual implementationfell well short of the requirement. BB put a cap on thelending rate of commercial banks and did not respondforcefully when monetary aggregates exceeded the

intended levels by wide margins. BB characterized thispolicy stance as accommodative to meet the credit

needs of a growing economy. As a result, most monetarytargets were exceeded by wide margins every year.

Figure 2.1: Monetary Policy Targets Vs Actual, inRecent Years

This mismatch between announced policy and actualimplementation continued up to March 2011.

Although BB increased the Cash Reserve Ratio (CRR)for the first time in May 2010 and the Repo Rate in

August 2010, monetary tightening, as reflected throughmonetary aggregates did not take place due toinadequacy of the measures and lack of strongsurveillance on banks. In particular, at times the credit todeposits ratio of commercial banks exceeded the levelsconsidered prudent in part due to inadequate monitoringand surveillance.

Figure 2.2: Advance to Deposit Ratio (%)

The destabilizing impact of such monetaryexpansion was visible on both domestic and externalfronts. On the domestic front, a sharp rise in inflationand asset prices essentially resulted from excessliquidity in the economy. CPI inflation reached almost12% in September 2011 on a point-to-point basis whichwas highest since 1998.

15.5

16.7

15.2

16 1

716

22

.4

24.2

21.

3 25.8

17.2

18.2

Broad

money

(M2)

growth

Private

sector

credit

growth

Broad

money

(M2)

growth

Private

sector

credit

growth

Broad

money

(M2)

growth

Private

sector

credit

growth

FY 10 FY 11 FY 12

Target Actual

April2012

April2012

74

75

76

77

78

79

80

81

82

83

Jun-09

Oct-09

Feb-10

Jun-10

Oct-10

Feb-11

Jun-11

Oct-11

Feb-12

(%)


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10


Figure 2.3: Point to Point Inflation

The impact of monetary expansion on asset priceswas quite costly for the economy. The liquidityexpansion helped create a large bubble in the alreadyovervalued capital market. Real estate prices alsoexperienced an unprecedented surge. On the other

hand, significantly higher inflation than Bangladeshsmajor trading partners reduced competitiveness ofdomestic products and made imports cheaper in realterms. These developments, coupled with increaseddomestic demand due to monetary expansion abovereasonable level, widened the trade deficit. The resultingbalance of payments pressure contributed to a markeddepreciation of the Taka, following a long period ofrelative exchange rate stability.

Figure 2.4: Exchange Rate

Against this backdrop, the need for monetarytightening became pressing by end-February 2011.

Although somewhat late, BB took a series of monetarytightening measures and private sector credit growth

started declining beginning in the last quarter of FY11.

Figure 2.5: Repo Rate and CRR

Before March 2011 BB never looked like adhering to itsmonetary policy targets. As the BOP situation becomeunsustainable with imports growing by more than 40%and a large BOP financing gap was emerging, beginningMarch 2012, BB started to respond proactively bytightening monetary and demand management policies.

In particular:

The repo rate has been revised upward for 5times between March 2011 and January 2012.

The Cash Reserve Requirement (CRR) wasalso increased by 0.5 percentage point to 6% inNovember 2010.

BB was stricter in maintaining credit to depositratio of commercial banks within the permissiblelevel this time around and the cap oncommercial lending rates was removed except

for some strategic sectors.

The exchange rate of Taka was also allowed tobe freely determined by market forces to stemthe run on reserves.

These tightening measures helped contain theexpansion of monetary aggregates close to the monetarytargets of BB for end-June 2012. If monetary targets areachieved for FY12, which is a realistic possibility, this willbe for the first time after failures in achieving so in twoconsecutive years with accommodative monetarystance.

Fiscal and Monetary Policy Coordination

Right policy mix is a precondition for the success ofmacroeconomic management. Bangladesh has had along tradition of good fiscal and public debtmanagement. Fiscal deficit has generally been limited ator below 5% of GDP and external financing primarilylimited to concessional borrowing from multilateral andbilateral official sources. As noted in the Policy Brief onFY13 Budget, fiscal management in FY12 wascomplicated by two emerging problems associated with:a surge in subsidy payments in the first half of FY12 dueto delays in implementing necessary price adjustments;and a precipitous fall in foreign financing in part due toslower implementation of foreign funded projects andlower disbursement of program or budget financing.

At a time when monetary policy started to become tighterdue to BB measures described above, governmentborrowing from the banking system surged due to thecombined effect of the sharp increase in subsidypayments and the collapse of foreign financing (net). Atits worst points, more than 60% of domestic creditexpansion was diverted to budget financing in June2012, which further increased to 100% in July. Becauseof this lack of fiscal and monetary policy coordination, themonetary tightening measure contributed to a significantlevel of crowding out of the private sector in the first half

9.15

7.46

12.72

0

5

10

15

Jan-09

Mar-09

May-09

Jul-09

Sep-09

Nov-09

Jan-10

Mar-10

May-10

Jul-10

Sep-10

Nov-10

Jan-11

Mar-11

May-11

Jul-11

Sep-11

Nov-11

Jan-12

Mar-12

May-12

(%)General Food Non-Food

Source: BBS

83.581.9

60

65

70

75

80

85

FY08

FY09

FY10

FY11

Jul-11

Aug-11

Sep-11

Oct-11

Nov-11

Dec-11

Jan-12

Feb-12

Mar-12

Apr-12

ay-12

TakaperUSD

4.0

5.0

6.0

7.0

8.0

Jan-10

Mar-10

May-10

Jul-10

Sep-10

Nov-10

Jan-11

Mar-11

May-11

Jul-11

Sep-11

Nov-11

Jan-12

Mar-12

May-12

Repo Rate CRR

Tighter monetary target

implementation

Loose monetary target

implementation


17/28

11


of FY12 and created the perception that monetary policywas excessively tight. Increased public sector borrowingsharply reduced the space for private sector borrowing.Much of the private sector credit contraction wasbecause of increased public sector borrowing, while theslowdown in the overall domestic credit growth was

relatively modest.

Figure 2.6: Private and Public Sector Development

It is interesting to note that public sector borrowing wasalready on an upward trend since April 2010. However,initially this did not lead to crowding out because in initialmonths public sector borrowing was relatively modestand monetary tightening was yet to be taken. As totaldomestic credit kept on growing from about 13% inJanuary-April 2010 to the peak level of almost 30%March 2011, there was scope for accommodating bothprivate and public sector credit growth. Crowding out

particularly took place during April to November 2011.During this period 43% of domestic credit flow went tothe public sector, which is much higher than the usual20% share of this sector. This period can becharacterized as unsynchronized fiscal-monetary policymix.

Figure 2.7: Distribution of Domestic Credit Flow

The situation changed markedly since December2011, due to corrective measures on the fiscal side,primarily through containment of subsidies. During

December-April 2012--for a full 5-month period andmostly in the second half of the fiscal year whenborrowing requirement generally goes up--public sectorborrowing was marginally negative. The share of publicsector credit in total credit, which increased from lessthan 19% in December 2010 to 23.4% in November

2011, came down to 21.8% by April 2012. This indeedhas been a remarkable turnaround.

Figure 2.8: Share of Public Sector Credit in TotalDomestic Credit Stock

Are Monetary Developments Compatible withIMF Performance Criteria and Benchmarks?

On the backdrop of rising BOP pressures andmacroeconomic tensions, Bangladesh has adopted astabilization program which is being supported by theIMF under its Extended Credit Facilities (ECF). The ECFwill provide financial support in the amount of SDR 640

million over a three year period. First tranche under thisarrangement was disbursed in last April. Under thisprogram, Bangladesh Government has establishedcertain quantitative monetary targets, consistent with itsinflation and BOP objectives, some of which areperformance criteria and some are quantitativebenchmarks under the program. Further disbursementsare conditional upon achieving these targets.

Table 2.1: Monetary Targets for End June 2012ECFBenchmark/Performance Criteria MPS

Actual Apr-12

Reserve money (eop stock inbillions of Taka); BM 1014 1007 917NDA of BB (eop stock in billions ofTaka); PC 550 418*Net credit to the centralgovernment (NCCG) by thebanking system (ceiling,cumulative change from thebeginning of the fiscal year, inbillions of taka); PC

252 165.6

* Figure of end March. PC=Performance Criteria; and BM= Benchmark

Bangladesh is firmly on track towards achieving themonetary targets set under the IMF ECF program.Monetary targets stated in the MPS for January-June

2012 were also broadly in line with the ECF. The ECFarrangement has a ceiling on reserve money expansion(indicative target). By end June 2012 reserve money

21.04

54.39

32.38

18.22

-10

0

10

20

30

40

50

60

Jan-10

M

ar-10

M

ay-10

Jul-10

S

ep-10

N

ov-10

Jan-11

M

ar-11

M

ay-11

Jul-11

S

ep-11

N

ov-11

Jan-12

M

ar-12

Domestic Credit Public Sector Credit

Private Sector Credit

Dec-10, 18.7

Nov-11, 23.4

Apr-12, 21.8

18

20

22

24

26

28

30

Oct-06

Apr-07

Oct-07

Apr-08

Oct-08

Apr-09

Oct-09

Apr-10

Oct-10

Apr-11

Oct-11

Apr-12

(%)


18/28

12


must be kept under 13% on year-on-year basis. In lastApril actual growth rate was 10.17. In case ofgovernment borrowing from the banking sector, althoughin terms of growth rate up to April is higher than theceiling, borrowing can be kept under the ceiling given thegovernments recent success in limiting bank borrowing.

Government has cushion of around Tk. 86 billion in thisregard.

Is the Tightened Monetary Policy Working?

The objective of monetary tightening was to restore bothinternal and external imbalances by taming inflation andthereby also stabilizing the exchange rate. From theFigure 2.3 we can see that inflation is trending downwardand came down to 9.15% in May from the peak level of11.97% in last September. Growth in import paymentsdecelerated sharply despite much higher oil-relatedpayments. As shown in Figure 2.4, after a sharp

depreciation of the Taka, the exchange rate hasremained stable throughout the second half of FY12.

In FY13 budget, the government has set the inflationtarget at 7.5%. Like monetary targets, inflation targetsstated in FY10 and FY11 budgets were also notachieved. Thus questions have been raised aboutgovernments ability and seriousness in realizing theinflation target for FY13.

We are of the view that, if BB adheres to the monetarytargets stated in the MPS and the ECF arrangementwith the IMF, and maintains a similar policy stance

for FY13, bringing the inflation rate down to thetarget level of 7.5% will be challenging but doable.Continued prudent monetary tightening and favorableexternal environment would be preconditions for realizingthe inflation objective. Coincidentally, global economicslowdown has been pushing both fuel and non-fuelcommodity prices downward, from their recent peaklevels in April 2011. Crude oil price has come down bymore than 20% since March 2012 due to comfortableglobal inventory position and a slowdown in demandgrowth both from industrialized and emergingeconomies. Given the global economic outlook, theweakening process may continue in the coming months.

The terms-of-trade gains resulting from the decline inglobal prices will not only help stabilize domestic pricesbut also reduce pressure on the current account balance.

Figure 2.9: Crude oil price in Dubai ($/bbl)

Recent developments in India will also have a favorableimpact on domestic prices. Monetary tightening by RBIand lower domestic demand has reduced Indias inflationin 2012. After reaching a recent high level, food prices inIndia has come down significantly and remained ataround that level in recent months. Bumper harvests

have stabilized food prices in India and are expected toremain stable in coming months. Depreciation of Indiancurrency has also made Indian food/commodity pricescheaper in terms of BDT in recent months.

Above all, domestic supply situation of basiccommodities like rice, potato and vegetables havegenerally been very good with bumper outputs in mostproducts. Following the bumper boro crop rice priceshave declined significantly and are likely to remain stablein the coming months.

The favorable supply situation at home and abroad,

combined with prudent demand management throughmonetary and fiscal policies should help realize theinflation target.

Future Challenges and Recommendations forMonetary Management

Monetary development since last January has beenmoving in the right direction to achieve the MPS targetsand quantitative limits established under the ECF.

Achieving the end-June targets will require BB to firmlyadhere to its monetary targets.

Figure 2.10: Domestic Credit Development

Jul-08,

131.22

Dec-08,

41.00

Mar-12,

122.28

28-Jun,

92.00

0

20

40

60

80

100

120

140

Jan

-06

Jul

-06

Jan

-07

Jul

-07

Jan

-08

Jul

-08

Jan

-09

Jul

-09

Jan

-10

Jul

-10

Jan

-11

Jul

-11

Jan

-12

22.45

27.41

19.1

10

20

30

40Domestic Credit

FY 12 FY 11MPS Average FY06-FY10

34.4533.55

31.0

-5

5

15

25

35

45

55

65 Public Sector Credit

19.45

25.84

16.0

10

20

30

40

Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun

Private Sector Credit


19/28

13


The other challenge will be to maintain the rightpolicy mix by properly synchronizing fiscal policy withthe monetary stance. This issue of policy mix will beespecially important since the government isapproaching final year of its tenure. As other sources ofdeficit financing become more difficult to secure, the

government may become tempted to rely more heavilyon bank borrowing.

In its monetary policy operations BB should focusprimarily on the quantitative targets and not onpolicy instruments like interest rates. It is beyond thecapacity of any central bank to influence or target both,and BB is no exception.

Like most developing countries, transmission ofmonetary policy is considered inefficient in Bangladesh.Development of the treasury bills and bond marketwill be keys to enhance the transmission

mechanism.


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14


III. Explaining Inflation in Bangladesh1

Sadiq Ahmed

Background

Bangladesh has been experiencing a rapid growth in thegeneral price level in recent years. The rate of inflationhas crept up steadily since July 2009, rising from anaverage of 2.3% during 2008/09 to a peak of 12% inSeptember 2011 (Figure 3.1). The inflation rate declinedto 9.9% in April 2012. The rapid rate of inflation hasbecome a major economic and social problem. Unlessthis is tackled forcefully and with some urgency it couldbecome a substantial political debacle for theGovernment when it seeks re-election in the next 18months. It is also important that right policy choices aremade in the effort to control inflation based on soundanalysis.

Figure 3.1: Recent Bangladesh Inflation, point topoint

Source: Bangladesh Bank

The Policy Debate

There is much policy debate, often influenced by populistperceptions, about what factors cause inflation. Onepopular debate concerns the role of nominal exchange

rate in managing inflation. There are quite a few policymakers, researchers and business who believe that thedepreciation of the exchange rate is the primary culpritunderlying rapid inflation in Bangladesh. This groupbelieves that the government should basically pursue afixed nominal exchange rate policy. The underlying logicis the standard cost-push argument for inflation.Exchange rate raises the taka price of imported inputsthat pushes up the cost of production and that in turnfuels inflation.

1This policy note is based on a longer research paper in progress. The longer

paper provides all quantitative results and the database for the regression

results.

The other debate is the role of international commodityprices. The rising global food and fuel prices are seen asthe main culprit underlying inflation in Bangladesh. Inthis debate inflation is temporary and the governmenthas little control over inflation except to make efforts toinsulate domestic food and fuel prices from rising

through price controls and subsidies. The influence ofthis populist argument on policy making is large andillustrated by the rapidly growing subsidy bill of thegovernment that has now run into almost 4% of GDP,equivalent to over 35% of total tax revenue.

A third major policy debate is the perceived trade-offbetween growth and inflation. The argument here is thatdeveloping countries like Bangladesh have no choice butto tolerate significant inflation as a price for economicgrowth and development. This is a more substantiveargument based on quantitative research done by theBangladesh Bank that argues that there is a trade-off

between inflation and growth well upto 6-8% rate ofinflation. Efforts to reduce inflation below this thresholdlevel will have an adverse effect on growth.

The policy debate suggests that there is considerableconfusion and disagreement on the nature of inflation inBangladesh and factors that explain inflation. Giventhese issues it is important that policy analysis forinflation control must be based on a careful review of thedata and proper quantitative analysis.

Quantitative Analysis

Time series data and related analysis can be very helpfulin understanding macroeconomic developments, makingprojections for the future and developing policyresponses to tackle unhappy macroeconomic outcomes.The analysis of inflation is a good example of how propertime series analysis can help the government to controlinflation and stabilize the macroeconomy. We will like tostress the importance of proper time series analysisbecause in its absence we can easily reach erroneousconclusions that, if applied to policy making, can dosubstantial damage to the macroeconomy.

Stationarity and Causality Tests for Proper TimeSeries Analysis

A key requirement of this proper analysis is to first startwith a good theory about causality. Many things tend tomove together over time. Without a sound analysis ofhow developments are correlated and what is the causeand what is the effect there is either a risk of spuriouscorrelation or mis-specification of the relationship.Economic theory helps avoid the problem of spuriouscorrelation, but it sometimes does not help identify thecausality. This problem of establishing causality in timeseries data has received a great deal of attention inquantitative economic research and considerableprogress has been made in recent years to help identifyproper causality, thereby facilitating better policy makingand economic forecasting.

0

2

4

6

8

10

12

14

16

Nov-09

Dec-09

Jan-10

Feb-10

Mar-10

Apr-10

May-10

Jun-10

Jul-10

Aug-10

Sep-10

Oct-10

Nov-10

Dec-10

Jan-11

Feb-11

Mar-11

Apr-11

May-11

Jun-11

Jul-11

Aug-11

Sep-11

Oct-11

Nov-11

Dec-11

Jan-12

Feb-12

Mar-12

Apr-12

%General Food Non-Food


21/28

15


Working independently in different time periods, tworesearchers, Clive Granger of the University ofNottingham in England and Christopher Sims of thePrinceton University in USA, pioneered the quantitativemethods for establishing causality. Both received theNobel Prize in Economics; Granger in 2003

(unfortunately he died in 2009) and Sims in 2011. Thestatistical technique developed to establish causality isknown as the Granger-Sims test.

Good practice quantitative research using time seriesdata first needs to ensure that the data are stationary(to enable meaningful predictions) and that causality isestablished using the Granger-Sims test before decidingwhich variable is the cause (also called the independentor exogenous variable) and which variable is the effect(also known as the dependent variable or endogenousvariable).

Inflation and GDP Growth Models for Bangladesh

Turning to the Bangladesh situation, we need testablemodel to quantitatively determine the factors that explaininflation. Drawing from economic literature and the policydebate in Bangladesh, there are basically three modelsof inflation. The simplest model, which appeals most topopulists and is well understood in Bangladesh, is thecost-push model of inflation where the rate of inflation isdetermined by cost factors such as international foodand fuel prices, other sources of imported inflationreflected by world inflation, and the nominal exchangerate changes. The second model is the well-known

monetarist hypothesis popularized by Nobel LaureateMilton Friedman where inflation is determined by theexcess of monetary growth over the rate of growth ofGDP. In this model inflation is purely a monetaryphenomenon. The third and more widely acceptedmodel is one that combines both cost-push andmonetary factors. Which factor dominates at any point intime is determined on the basis of proper time seriesanalysis.

For this paper we develop a generalized inflation modelthat combines both cost-push and monetarist variables.The model is specified as follows:

INF= f (GM2, GGDP, DNER, GIFP),

Where:

INF= rate of inflation;

GM2= growth of broad money;

GGDP= rate of growth of GDP;

DNER= depreciation of the nominal exchangerate;

GIFP= rate of growth of international food prices.

The model basically says that inflation is determined bythe rate of growth of money supply (broadly defined), the

rate of growth of GDP, the nominal exchange rate, andthe rate of growth of international food prices. Other cost

factors such as international inflation could also beintroduced and will be considered as we go along.

Since there is a policy debate surrounding therelationship between inflation and rate of growth of GDP,we also estimate a model for GDP growth that allows for

feedback from inflation to GDP growth and money supplygrowth to GDP growth. A simple GDP growth model isspecified below.

GGDP= f (GM2, INF, INV/GDP, GLab, T/GDP),

Where:

GGDP= rate of growth of GDP;

INF= rate of inflation;

GM2= rate of growth of broad money;

INV/GDP= investment rate;

GLab= growth rate of labor force

T/GDP= trade to GDP ratioThe GDP growth model says that the growth of GDPdepends upon the rate of investment, the growth of laborforce, trade to GDP ratio (to allow for openness effect),the rate of inflation and the rate of growth of moneysupply.

Stationarity Test Results

The data we use is from 1981-2011, which gives a fairlylarge number of observations to estimate stable long-term relationships between the variables. Before weestimate these two equations, we need to test forstationarity and causality. The standard Dickey-Fuller

stationarity tests show that the data for GDP growth,Inflation, M2 growth, International food price inflation,Depreciation of the nominal exchange rate, and Laborforce growth are all zero order stationary. Theinvestment rate is not zero order stationary. However,the investment level (INV) is zero order stationary.Similarly, the trade to GDP ratio is not zero orderstationary but the change in the ratio (D T/GDP) isstationary.

Granger Causality Test Results

Mere evidence of correlation does not indicate causality.

Economic theory can help. Thus, there is little debateabout the causality of the following relationships: worldfood price inflation causes domestic inflation; labor forcegrowth causes GDP growth; investment rate causesGDP growth; and trade-openness causes GDP growth.However causality relationship between inflation andmoney supply growth; between GDP growth andinflation; between GDP and money supply growth; andbetween inflation and nominal exchange rate changesare debatable. So the data were checked for causalityusing the Granger causality test. The results are:

1) Inflation and GDP growth do not Granger cause each

other.


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16


2) M2 growth Granger causes Inflation but not the otherway round.

3) Inflation Granger causes Nominal exchange ratedepreciation but not the other way round

4) GDP and M2 growth Granger cause each other

The result that inflation causes exchange ratedepreciation rather than the other way round indicatesthat it cannot be used as a determinant of inflation. The

joint causality between GDP growth and M2 growthsuggests that M2 cannot be used on the right hand sideof GDP growth equation. Instead an instrumentalvariable (growth of private credit GPC) is used afterensuring its stationarity, Granger causality test andrelevance as an instrument.

Estimation Results for Inflation

The estimated regression result for inflation equation is

shown below:

INF= 8.28 (0.002) + 0.21(0.010) GM2+ 0.015 (0.66)GIFP- 0.99 (0.026) GGDP

R-squared=0.3183; Adj. R-squared= 0.2425; p values inbrackets

The results show that the growth of broad money (GM2)has a strong and positive effect on domestic inflation(INF), while GDP growth has a strong and negativeeffect on inflation. These results are consistent with thefindings of many other researches. International food

price inflation has the right sign but its coefficient is notsignificant, suggesting that while it may play a significantrole in the short-term it is not a significant factor for long-term inflation. Introduction of international inflationvariable did not show up as significant.

Estimation Results for GDP Growth

The estimated regression result for the GDP growthequation is shown below:

GGDP= 4.39 (0.00) + 0.0031 (0.00) INV + 0.172 (0.355)GPC -0.14 (0.056) INF+0.069 (0.218) D T/GDP -0.098(0.626) GLF

R-squared= 0.615; Adj R-squared= 0.61; p values inbracket

The results show that investment (INV) is a strong andpositive determinant of GDP growth. Inflation (INF) hasa strong and negative relationship with GDP growth.Growth of private credit (GPC) has the correct sign butits coefficient is insignificant. Trade liberalization

(D T/GDP) has a positive effect on GDP growth,although its coefficient has a relatively low significance.The labor force growth (GLF) variable comes up

insignificant and with the wrong sign. This could reflect ameasurement problem.

Is There Evidence of Growth-Inflation Trade-Off?

One contentious issue in Bangladesh is the presumedtrade-off between inflation and growth. In the results wepresent above, the relationship between GDP growthrate and inflation for Bangladesh is unambiguously

negative. This makes imminent economic sense. Highinflation distorts investor preferences as well asconsumer behavior that tend to hurt growth. In particularinflation tends to be associated with asset price bubblesthat cause resources to be diverted to real estate andunnecessary build-up of commodity stocks. It also tendsto hurt financial savings.

In the estimates reported in this paper, the relationshipbetween growth and inflation is assumed to be linear.The proponents of the trade-off argument base this on apresumed non-linear relationship. The argument here isthat the relationship between inflation and growth is

positive up to a certain thresh-hold level of inflation.Once the threshold level is crossed, the relationshipbecomes negative. Empirical research seeks to find thisthreshold level of inflation. Research done byBangladesh Bank has come up with results that suggestthat the threshold level of inflation is 6-8%. For India, thethreshold level was found to be between 4.5-5%.

It is reasonable to expect that a 4-5% rate of inflationmight be needed to provide the flexibility of resourcemobility for growth in a developing country likeBangladesh. But the 6-8% threshold range is too largeand further research is needed to come up with more

definite results. It is also important that data used forestimation is properly filtered to ensure stationaritybefore estimation is done. The research should alsoexplain why an 8% inflation rate is necessary to achievehigher growth and how significant, if at all, is the trade-off. As we explain below, in an environment of low globalinflation, especially in USA (2-3% inflation rate per year),targeting an inflation rate that is much in excess of theUS inflation will tend to depreciate the Bangladeshcurrency (since the Dollar serves as the reservecurrency) and conflict with the objective of exchange ratestability.

Causality Between Inflation and Exchange RateChanges

The Granger test for causality showed that inflationcauses exchange rate depreciation and not the otherway round. The economic rationale for this is that asinflation rate increases it tends to appreciate theBangladesh currency which increases imports andreduces exports. This exerts pressure on the nominalexchange rate, which then depreciates. The exchangerate is also influenced by the inflow of net foreign capital.The higher the net inflow, the higher the tendency of thenominal exchange rate to appreciate and vice versa.


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Accordingly, the rate of depreciation of the nominalexchange rate variable was empirically tested with thefollowing results:

DNER= 0.76 (0.02) (INF USINF) +0.35 (0.58)NCI

R-squared = 0.28; Adj R-squared= 0.23; p valuesin bracket

DNER= depreciation rate of taka vis-a-vis USdollar; INF= Bangladesh inflation rate; USINF =US inflation rate; NCI= net capital inflows.

All variables satisfy zero order stationarity condition.Since the net capital flow variable is insignificant andappears with the wrong sign, it was dropped. Therevised estimate is:

DNER= 0.85 (0.00) (INF-USINF)

R-squared= 0.27; Adj R-squared= 0.24; p valuesin bracket

Quantitative results show that the depreciation of thenominal exchange rate is strongly and positivelycorrelated with the inflation differential betweenBangladesh and USA (the country issuing the reservecurrency). On average a one percent increase in theinflation differential causes a 0.85 percent increase in therate of depreciation of the nominal exchange rate. So,contrary to populist perceptions, the depreciation in thenominal exchange rate is the result of domestic inflationrate that much exceeds the global inflation rate. The

absence of role of capital flows in influencing exchangerate is also an important result. Bangladesh, unlike othercountries, does not have an active foreign capitalmobilization strategy. As a result, net capital inflows havebeen like a random factor with little influence onexchange rate changes.

Summarizing the Key Empirical Results

The rate of growth of money supply is a majordeterminant of inflation over the long term.

International food prices affect inflation in the

short term but not in the long term

GDP growth and inflation are negativelycorrelated over the longer term. So, there is noevidence that higher rate of GDP growth requireshigher inflation.

The paper did not test for the threshold level ofinflation. The suggested range of 6-8% inflationthreshold emerging from the Bangladesh Bankresearch is highly debatable. In India it wasfound to be between 4.5-5%, which appearsmore reasonable. Whether even lower long-term

inflation rate (2-3%) is achievable without

sacrificing growth is an empirical question thatneeds further research.

Inflation causes exchange rate depreciationrather than the other way round. So, the stabilityof the nominal exchange rate can be ensured by

keeping inflation low.

There is no evidence that high rates of M2growth (beyond prudent levels) support highereconomic growth or investment.

Implications for Policies

There are strong and powerful implications for policies

that follow from these empirical results. These can besummarized as follows:

Over the long term sustained reduction in therate of inflation will require reduction in the rateof growth of money supply. This is consistentwith international good practice where monetarypolicy is the primary instrument of inflationcontrol.

A policy of keeping inflation rate low (4-5% peryear) is also good for supporting higher rates ofgrowth.

A policy of easy money does not support higher

investment or growth; instead high rates ofmonetary growth (beyond a level consistent withreal GDP growth and desired inflation rate) feedon inflation and negatively affect growth.

Higher rates of growth will require higherinvestment. Higher investment depends onfactors other than the rate of growth of moneysupply (beyond prudent levels).

Fiscal policy will need to be consistent with thetargets of prudent monetary management.

Accommodating sustained international priceincreases in fuel prices through budgetarysubsidies that is financed through borrowing

from the Bangladesh Bank is inconsistent withsound monetary management and inflationcontrol.

The causality from inflation to exchange rate is avery powerful and fundamental result for policymaking. The main message is that if we want tohave a stable exchange rate over the longerterm, we need to keep the rate of inflation lowand closely aligned to international inflation.

The other policy that could help stabilize theexchange rate is foreign capital inflows.Bangladesh does not have a strategy formobilizing foreign capital and as such is missing

out on one useful policy instrument for exchangerate management.


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Agenda for Further Research

There are a number of areas where further research willbe helpful.

Transmission mechanism between monetarypolicy and aggregate demand via interest rate.

The threshold level of inflation for growth-inflation trade-off based on sound time seriesanalysis.

Implications of monetary policy for managinginflation in light of the threshold level of inflation.

Role of international food prices in domesticinflation over the longer-term.

Determinants of investment and whethermonetary policy has any long-term effects on therate of investment.

IV. Is Trade Policy Losing Direction?

Zaidi Sattar

Background

Bangladesh aspires to become a middle income countryby 2021. That hope is predicated on raising its current 6-6.5 percent annual growth rate of GDP to 8 percent ormore on a sustainable basis for the next decade. Thereis no doubt that the nature of trade policy during thisperiod will play a supportive or restraining role inachieving the targeted rate of growth. Historical evidencearound the globe point to the fact that high performingeconomies (those growing at annual rates of 7-8 percent

for long periods) also have the most open trade regimes,particularly during the periods of high performance. Thisrelationship was validated in a seminal cross-countryresearch paper by David Dollar and Art Kraay (2001),which also concluded that growth was good for the poor.

In the late 1990s, Bangladesh was listed by analystsamong the most globalized developing economies onthe basis of its trade openness and progressiveintegration with the world economy. The expectation wasthat, in two decades or so, Bangladesh would be rankedamong the most open economies of the developingworld. That did not happen, as progress in trade

liberalization stalled after a decade of tariff rationalizationand removal of trade-related quantitative restrictions. Isthe current trade policy stance consistent withBangladeshs long-term growth and poverty reductiongoals?

Annual budgets in Bangladesh have a major role incarving out the trade policy stance following somemeasure of consultations with business chambers andother stakeholders. FY2013 budget is no different as thetariff and para-tariff adjustments proposed provide thedirection and contours of trade policy which will have animpact on the incentive regime that will affect decisions

of investors, producers, exporters, importers, andconsumers. Employment, growth, and poverty reduction

are the eventual outcome of these decisions. Thatmakes a critical review of budgetary proposals on tradetaxes important for policy.

Launch of DTIS and Impending Trade PolicyReview

The year 2012 is critical for trade policy. After aspectacular year in export performance, the sharpslowdown this year has raised concerns about thesustainability of export growth. The Government, incooperation with the World Bank, has launched thepreparation of a Diagnostic Trade Integration Study(DTIS), a study that seeks to identify hindrances togreater integration of Bangladesh into the multilateraltrading system. The DTIS will reflect the above concernson sustainability of export growth, and will build onexisting work and fill knowledge gaps where necessary.Later this year, the periodic Trade Policy Review on

Bangladesh is also expected to take place at the WTO.Thus, given the fact that Bangladesh aspires to becomea middle income country by 2021, which would definitelyrequire a trade policy orientation that is supportive ofhigh export performance and rapid GDP growth, it hasbecome a national imperative to review the state of playin trade policy and mould it in the right direction. TheBudget for FY2013 has been launched but no changes intrade policy directions are evident from the tariffproposals.

Global Economic Environment and Outlook for2013

Because of progressive integration of the Bangladesheconomy with global trade and finance, it cannot beimmune to external developments. The global economyhas been slowly trying to recover from the lasting effectsof the global financial crisis of 2008. A modest uptick wasnoticeable in the US economy as consumption andinventory investment picked up along with the credit andlabor markets. But recent events- especially those in theEuro area -- has imposed fresh uncertainties on theglobal economic outlook for 2012 (Table 1). IMFs latestGloba

final pri policy briefs july 2012

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