Public Information Notice No. 05/90

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Bangladesh

July 18, 2005

On June 29, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Bangladesh.¹

Background

Since the last Article IV consultation, Bangladesh's economy has continued to expand, supported by a stable macroeconomic environment and progress in implementing structural reforms, broadly in line with the recommendations made by the Executive Board. Real GDP growth is projected at 5¼ percent in FY05 (ending June 30), reflecting a slight deceleration from 5½ percent in FY04 due to the impact of devastating floods last July. The floods damaged major crops, particularly rice. This, together with an upswing in global oil and commodity prices, contributed to a surge in inflation in late 2004, which has since moderated and is projected at an annual average of 6½  percent in FY05.

As in the previous two years, the fiscal stance has been prudent, with the overall budget deficit estimated at 4.2 percent of GDP in FY05 (from 3.2 percent in FY04), reflecting in part flood relief efforts. Revenue is projected to increase by 16 percent in FY05 (compared to 9 percent in FY04). This outcome, however, falls short of the revenue effort of ½ percentage point of GDP in the FY05 budget, reflecting delays in the implementation of tax administrative reforms and lingering weaknesses in audit and collection enforcement. Total spending is projected to be 0.5 percent of GDP lower than in the revised budget, on account of lower-than-projected development expenditure. The structure of deficit financing remains sound, with domestic financing capped at 2 percent of GDP, whereas external financing continues to be on concessional terms.

The external position strengthened in 2003-04, but pressures emerged at the beginning of 2005. Export earnings have moderated since November 2004, reflecting mainly a sharp decline in prices associated with the elimination of the Multifiber Arrangement (MFA) quotas on January 1, 2005. Imports have grown rapidly due to higher oil and commodity prices, an increase in food imports, and stronger demand for investment goods. Oil imports are estimated to exceed forecast levels significantly. The external current account is projected to move to a deficit of US$1.1 billion (or 1.8 percent of GDP) in FY05, from near balance in FY04.

Since floating the exchange rate in May 2003, the taka has depreciated by 9 percent and 5 percent in nominal and real effective terms, which has helped boost the competitiveness of Bangladesh's export sector. The authorities have confined their interventions to building reserves and to countering disorderly market conditions during a period of generally favorable balance of payment conditions. To ease the pressure from multiple external shocks in early 2005, Bangladesh Bank (BB) sold some foreign exchange reserves in January while allowing the taka to depreciate by 5 percent against the U.S. dollar. Taking into account higher payments for oil imports, gross international reserves are projected at $2.7 billion at end-June 2005 (2.4 months of imports), after peaking at US$3.2 billion at end-2004.

Monetary policy has been supportive of growth, but an accommodative stance in early 2005 contributed to pressures on the exchange market. Reflecting in part lending to the agricultural sector for flood rehabilitation and strong demand for credit in a low interest rate environment, reserve money growth has accelerated since late 2004, while growth of private sector credit and broad money have also increased sharply. A decline in real interest rates led to a slowdown in the net sales of treasury securities by BB, with many banks holding treasury securities only up to the limit under the Statutory Liquidity Requirement.

Good progress has been made in strengthening the banking system. BB has raised minimum capital requirements, taken steps to reduce insider lending, and has improved the institutional framework for the prudential supervision of the financial system. As part of the reforms of the nationalized commercial banks (NCBs), the information memorandum for the divestment of Rupali Bank has been issued, management teams have been put in place for Sonali and Agrani, and the contract for Janata Bank was signed recently. Performance under the Memorandum of Understanding between BB and the NCBs has been satisfactory, although there is scope for further increasing cash recoveries from the largest defaulters.

Reform of tax administration has advanced, but has yet to translate into an acceleration of revenue growth. The institutional structures have been set up, including the Large Taxpayer Units for income tax and VAT and the Central Intelligence Cell, but enforcement, audit and collection efforts remain weak, reflecting capacity constraints and opposition from vested interests. Extensive court injunctions on tax cases have undermined the function of the National Board of Revenue. Two benches in the High Court have now been created to deal exclusively with tax cases and to expedite the clearing process.

Progress has been mixed in reforming the state-owned enterprises (SOEs) and their financial conditions remain weak. On the positive side, the government adjusted prices for energy products in December 2004 and January 2005, in line with pricing formulas agreed with the World Bank. This helped reduce the financial losses of energy sector SOEs and improve their viability. On the negative side, after initial success in the closure of manufacturing SOEs in FY03, further closure/downsizing of SOEs stalled due to difficult labor issues. But these loss-making units can no longer resort to bank financing or budgetary resources and have been encouraged to downsize through hiring freezes and a voluntary retirement scheme.

Significant headway was made on trade reform in FY05 through a reduction in the level and dispersion of duties and a streamlining of quantitative restrictions. The structure of customs duty rates was simplified to three slabs, with the top rate reduced by 5 percent to 25 percent, and supplementary duties were reduced. These measures have significantly lowered the dispersion of custom duties. Quantitative restrictions were streamlined, with a simplification of administrative procedures and a halving of the number of restricted products starting April 2005.

Executive Board Assessment

The Executive Directors commended the Bangladesh authorities' efforts in maintaining economic stability and in advancing the structural reform agenda, in spite of a difficult political environment and external shocks. Directors welcomed the buoyant economic growth, moderate inflation, and the rise in international reserves since July 2004. Looking forward, Directors underscored that Bangladesh faces the key challenges of accelerating growth and maintaining macroeconomic stability while overcoming the potentially significant impact of the MFA phaseout. They also noted that structural weaknesses—including the country's low revenue base, weak infrastructure, and inefficient public enterprises—continue to pose serious obstacles to private sector development. Directors therefore called for the continuation of core reforms in tax administration, banking, and the energy sector, as well as improved governance, to enhance the business environment, promote export diversification, and facilitate economic recovery and poverty alleviation.

Directors welcomed efforts to finalize Bangladesh's National Poverty Reduction Strategy Paper, which will serve as a roadmap for meeting the Millennium Development Goals. They concurred with the PRSP's focus on fiscal reforms and the development of anti-poverty programs within the context of a medium-term budgetary framework. However, they acknowledged that the elimination of the MFA quotas, the country's susceptibility to natural disasters, and a confrontational political environment pose risks towards achieving this goal.

Directors were encouraged by the authorities' resolve to improve revenue mobilization through strengthened tax administration and to support pro-poor expenditures while protecting fiscal sustainability. They stressed that effective implementation of tax administration measures and strict enforcement are vital to the revenue effort, and will require strong political support. Directors noted that modernizing the National Board of Revenue (NBR) along functional lines is also a critical step toward developing a more effective tax administration. They therefore welcomed the authorities' intention to implement the Strategic Reform Plan for the NBR with World Bank assistance. Directors also stressed that current expenditures need to be contained and the development budget strengthened through better project selection, improved procurement management, and timely compliance with policy conditions for project financing. Directors supported the government's intention to curtail and phase over three years the public sector wage increases while protecting pro-poor expenditures. The importance of aligning such increases with civil service reform was emphasized.

Directors expressed support for Bangladesh to maintain a flexible exchange rate system based on market principles. They stressed that the system should be allowed to operate as intended, especially during a time of market pressures. In view of an adverse external environment and exchange market pressures, Directors noted that this would be particularly important for preserving competitiveness. They supported the authorities' intention to continue to confine their interventions in the exchange market to countering disorderly conditions, to abandon the use of suasion, and further develop the operations of the exchange market.

Directors noted that a tight monetary stance is important to contain inflationary pressures. In this context, BB is encouraged to actively use open market operations to ensure adequate liquidity management and to allow interest rates to increase in order to ensure sufficient demand for treasury securities. Directors also encouraged BB to implement further improvements in the functioning of the interbank and treasury bill markets, as recommended by the recent Fund technical assistance mission. Reactivating the primary dealer system and deepening the secondary market for treasury securities are important steps in this regard.

Directors were encouraged by the progress achieved in reforming and divesting the NCBs. Taking Rupali Bank to the point of divestment is a significant demonstration of the authorities' commitment to bank reform. Directors added that recent efforts to improve the supervision and regulation of the banking system will reduce financial vulnerabilities and enhance the allocation of capital. They stressed the importance of ensuring that banks meet all prudential regulations, including on net open limits on foreign exchange transactions.

Directors welcomed the authorities' commitment to further trade reform, particularly in view of the competitive challenges in a post-MFA environment. The reduction and rationalization of trade taxes in FY05 have helped to enhance competitiveness and reduce anti-export bias. The streamlining of the supplementary duty system in the FY06 budget, together with a significant reduction in quantitative restrictions and the removal of restrictions on foreign direct investment in the ready-made-garment sector outside the export processing zones, are steps in the right direction. Directors noted that it would be desirable to further simplify the supplementary duty regime.

Directors encouraged the authorities to work with the World Bank and the Asian Development Bank toward implementing a restructuring plan to improve the operational and financial performance of the energy sector SOEs. Measures to reform the power sector distribution system, particularly those under Dhaka electric system authority's current network, are key to this strategy. This will require intensified efforts to reduce system losses through enhanced monitoring and improved bill collection.

Directors noted that, in light of rising global fuel prices and the weak financial position of energy sector SOEs, the adjustments on domestic fuel prices in the first half of 2005 are appropriate. However, they underscored that the authorities need to keep domestic fuel prices under close review and make further adjustments as needed. The impact of higher domestic fuel prices on the poor can be reduced by well-targeted and transparent transfers to them.

Directors welcomed the recent establishment of the Anti-Corruption Commission. Concerted follow-up actions are required to make the Commission function effectively so as to enhance its credibility. In this respect, developing an anti-corruption strategy with technical assistance from donors would be an important step to tackle governance issues and help improve the investment climate.