Public Information Notice No. 02/54

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Bangladesh

May 15, 2002

On April 29, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Bangladesh.¹

Background

Bangladesh's key economic and social indicators improved steadily in the 1990s, but poverty remained pervasive. Backed by prudent macroeconomic policies and an initial strong drive for structural reforms, Bangladesh recorded robust output and export growth, low single-digit inflation, improved literacy and heath indicators, food self-sufficiency, and lower population growth. Extreme poverty was reduced by 20 percent over the decade, although its level remained relatively high at one-third of the population.

Despite these achievements, the economy became progressively more fragile after the mid-1990s due to a persistent pursuit of expansionary fiscal and monetary policies along with slow progress on needed structural reforms, especially in the banking and state-owned enterprises (SOEs) sectors. Specifically, the central government deficit, which remained in the range of 4-4⅓ percent of GDP in FY95/96-FY97/98, climbed to the range of 5-6 percent in FY99/00-FY00/01. Rising credit demands of the government, the SOEs, and the private sector were readily accommodated by monetary policy; credit from the banking system to the central government grew at annual rates of 30-35 percent in the two years through end-FY00/01. Broad money increased at an annual rate of 17-19 percent during this period as the Bangladesh Bank interest rate was kept constant in nominal terms.

These growing domestic imbalances were reflected in pressures in the foreign exchange market and by a marked decline in international reserves. In response, the authorities opted for sporadic step adjustments in the nominal exchange rate and resorted to administrative controls to limit the growth of imports. Despite these controls, gross international reserves by mid-2001 had fallen to less than 1½ months of imports. This policy-induced fragility was exacerbated by the global slowdown that began in late 2000 and, with exports declining sharply, real GDP growth in Bangladesh is estimated to have slowed from 5 percent in FY00/01 to around 3¾ percent in FY01/02. To date the impact on the current account has been contained through the administrative controls on imports as well as ongoing strong worker remittances from abroad.

Against this background, the authorities introduced a number of measures late last year to counter the increased fragility. While some measures have been steps in the right direction-a broadening of tax bases, the reduction in the high interest rates offered on savings certificates-fiscal and monetary policies remained expansionary and there was little reform in the SOEs and banking sectors. To start to offset these imbalances, in February 2002 the Bangladesh Bank rescinded the right of banks to meet their reserve requirements in foreign exchange, lowered and removed some of the exchange restrictions that have been introduced, and the government has announced a cut in some development and recurrent expenditures. The authorities have also redoubled efforts to accelerate the preparation of an interim Poverty Reduction Strategy Paper that could provide a framework for a comprehensive medium-term poverty-reducing growth strategy.

Executive Board Assessment

Directors expressed concern that, following a strong performance until the mid-1990s, the Bangladesh economy has become increasingly fragile as a result of expansionary fiscal and monetary policies and a loss of momentum in structural reforms. As evidence of this growing fragility, Directors cited the projected slowdown in economic growth in fiscal year 2001/02, the compression of trade due to a sharp decline in exports and imports, and the declining level of international reserves. Given the deterioration in the external balance, the authorities now have limited room for maneuver in responding to external shocks.

Against this background, Directors urged the new government to embark decisively on a comprehensive medium-term economic program on the basis of a broad public consensus to address domestic imbalances, accelerate the rate of economic growth, and reduce poverty. They commended the government's efforts to address the immediate economic weaknesses, especially the steps taken to tighten budgetary discipline, improve the finances of SOE, and increase the effectiveness of monetary operations and policies. At the same time, Directors expressed concern about the authorities' resort to administrative measures to cope with underlying weaknesses, noting the intensification of exchange restrictions through margin requirements on letters of credit and increased import duties and surcharges in response to balance of payments pressures. They welcomed the authorities' timetable for eliminating all identified exchange restrictions on current international transactions, and urged them to reduce reliance on administrative controls on economic activity more generally.

Directors stressed that an immediate priority in Bangladesh is to limit the fiscal deficit consistent with the amount of concessional financing available. In this context, they welcomed the government's efforts to contain the deficit in fiscal year 2001/02, to carry out carefully selected expenditure cuts, to ensure only minimal carryover of expenditure into the next fiscal year, and to prevent arrears on government obligations. They agreed that, in the short run, expenditure restraint is the main available means of curtailing the deficit. The key challenge in the medium term will be to place the public finances on a sound footing. This will require determined efforts to strengthen revenue performance and the financial performance of SOEs, reprioritize public expenditure, and cut waste.

Directors welcomed the authorities' commitment to strengthen the effectiveness of monetary policy. They encouraged the authorities to progressively let the market determine yields in the treasury bill auctions, to further develop indirect instruments of monetary management, to remove remaining administered interest rates, and to link the interest rate on national savings certificates to a market-determined treasury bill yield.

Directors were encouraged by the authorities' willingness to move to a more market-oriented exchange rate system in order to help cushion the economy against external shocks and enhance the effectiveness of monetary policy. They recognized the authorities' concerns about a possible overshooting of the exchange rate but considered that the risks involved in the transition would be minimized by the implementation of strong supportive macroeconomic policies and structural reforms. In particular, they stressed the need to improve the fiscal situation, strengthen the financial sector, increase the central bank's independence, and develop more effective monetary policy instruments.

Directors agreed that, in the medium term, the main task will be to lift the rate of economic growth sufficiently to achieve a significant reduction in the prevailing high levels of poverty. In this regard, Directors welcomed progress in preparing an interim poverty reduction strategy paper, noting that this paper could be the first step toward an eventual request for an arrangement with the Fund under the Poverty Reduction and Growth Facility. They urged the authorities to translate the broad strategies into concrete public actions, with clearly identified budgetary costs set in a multi-year macroeconomic framework.

Directors noted that, apart from a stable macroeconomic environment, satisfactory progress on structural reform is required to underpin higher levels of economic growth over the medium term. One priority reform is to strengthen the banking system. To accomplish this, the Bangladesh Bank Order needs to be amended to ensure the central bank's independence and to extend its supervisory powers to cover nationalized commercial banks and development finance institutions. Directors also considered that a more lasting solution should involve addressing the incentives and governance problems of troubled institutions. Directors stressed the importance of reducing the current high level of nonperforming loans and strictly enforcing prudential standards. In this context, they welcomed the Financial Sector Assessment Program exercise scheduled for May 2002. Directors welcomed the recent passage of the Money Laundering Prevention Act.

Noting the financial burden posed by state-owned enterprises, Directors urged the authorities to develop a plan for stemming the losses of the largest enterprises, focusing on revenue-enhancing measures and hard budget constraints. They also urged the authorities to move ahead forcefully to strengthen and implement their plans for privatization and closure or restructuring of nonviable enterprises, and to put in place adequate social safety nets to protect those who will be adversely affected.

Directors noted that further exchange and trade liberalization, including elimination of existing export impediments, will ensure that appropriate price signals are transmitted to the economy and will increase external viability. In view of the authorities' commitment to eliminate all identified exchange restrictions by the time of the next Article IV consultation, Directors agreed to approve these restrictions on a temporary basis.

Directors welcomed the authorities' progress in producing more accurate and timely economic data, especially on the budget, as well as their decision to participate in a fiscal Report on Standards and Codes exercise. Directors noted the importance of technical assistance to fulfill the above agenda, and urged that the technical assistance provided to the authorities be effectively utilized.