Bangladesh
Selected Issues

This Selected Issues paper analyzes the reforms in the energy sector in Bangladesh. It assesses the fiscal position of Bangladesh and examines its fiscal sustainability using a simple measure based on the debt dynamics. It concludes that although Bangladesh has so far maintained its sustainability mainly owing to the large portion of foreign financing with highly concessional interest rates, the potential fiscal burdens related to the structural problems in the banking sector and state-owned enterprises might threaten sustainability.

Abstract

This Selected Issues paper analyzes the reforms in the energy sector in Bangladesh. It assesses the fiscal position of Bangladesh and examines its fiscal sustainability using a simple measure based on the debt dynamics. It concludes that although Bangladesh has so far maintained its sustainability mainly owing to the large portion of foreign financing with highly concessional interest rates, the potential fiscal burdens related to the structural problems in the banking sector and state-owned enterprises might threaten sustainability.

I. Recent Reforms in the Energy Sector in Bangladesh 1

A. Power Sector

Status

1. Power shortage has become one of the most important bottlenecks to economic development of Bangladesh. Per capita consumption of electric power in Bangladesh is extremely low compared to its neighbors. Power is available to only 15 percent of the total population of the country. The sector is also suffered considerably from low efficiency and huge system losses. In spite of the fact that installed generation capacity is about 30 percent greater than the peak demand, the Bangladesh Power Development Board (BPDB) cannot adequately maintain the power systems causing chronic load shedding due to serious financial constraints, high system losses and low efficiency. Through substantial progresses have been achieved in recent year, the combined systems losses and accounts receivable of BPDB and Dhaka Electric Supply Authority (DESA) remained as high as 33 percent and 9 months equivalent, respectively.

Reforms since 1994

2. In view of the poor performance, the government, with assistance from donors, had formulated comprehensive reforms in the power sector since 1994. New entities in generation and transmission, such as the Rural Power Company (RPC), the Power Grid Power Company of Bangladesh (PGCB), the Dhaka Electric Supply Company (DESC), the AES Haripur Power Company as well as the Meghnaghat Power Company (MPC) have been constituted. It is expected that over the next few years, these companies will own and operate a substantial part of the power sector’s assets.

3. The government has also taken concrete steps to involve the private sector. The private power generation policy was approved in October 1996. Potential has been created to add 1400 MW of capacity over the next five years by the private sector on BOO basis. This is 45 percent of the current installed capacity of 3100 MW and 68 percent of the currently available capacity of about 2000 MW. Several public/private and private sector entities have been licensed to construct and operate power generating facilities. One of these, the Rural Power Company has already started the construction and its first unit is expected to be in commercial operation by March 1999. Others are four barge-mounted power stations totaling to about 400 MW, the independent power producer stations at Meghnaghat (450 MW) and Haripur (360 MW) and the 100 MW expansion at Baghabari. However, till date, only the Mymensingh project and two barge-mounted power stations at Khulna and Baghabari have reached financial close and are expected to be commissioned shortly.

4. As a first step toward unbundling of BPDB, PGCB has been created to own and operate entire transmission system in Bangladesh. This will essentially segregate generation and distribution activities of BPDB, PGCB will start taking over of transmission assets related to Meghnaghat BOO project by September 1998 and complete taking over of all transmission assets by June 1998.

5. In the distribution sub-sector, there is a new mix of entities. In 1996, DESC was established to gradually take over the distribution system from DESA. In the rural areas, the Palli Bidyut Samities (PBSs) own and operate the distribution systems. Whereas the performance of BPDB and DESA has not been good, the performance of several PBSs has been excellent.

6. Rationalization of tariffs is an integral part of the power sector reforms. Until September 1996, the weighted average national retail tariff for electricity was only about 60 percent of the long-run marginal cost. To address this problem the government implemented tariff adjustments based on a formula to compensate for variations in fuel cost and foreign exchange fluctuations semiannually (March and September) each year.

7. Two issues arise out of the present situation. First, there seems to be an over commitment of base-load generation capacity. With a base load to peak load ratio of about 46 percent, continued addition of base load capacity will be detrimental to the system. Second, the government has guaranteed conversion of foreign exchange under the several implementation agreements that have been signed or committed to be signed. The amount under guarantee represents a large portion of the country’s total foreign exchange reserves.

Direction of new reforms

8. The following reforms in the power sector are needed in the near future:

(i) Functional segregation or “unbundling” of the sector into generation, transmission and distribution companies and establishing commercial relationships between such unbundled entities;

(ii) Establishment of an independent statutory regulatory authority to oversee licensing, tariffs, approval of long-range plans and regulatory functions. This will be done through a law amending the existing provisions for supply of electricity;

(iii) Continue private sector participation in the sector, in generation and distribution. In generation, care needs to be taken on the private sector participation based on a long-term least cost expansion program, and in consistence with the ability of the country to meet local and foreign currency commitment;

9. In distribution, there is a need to adopt a policy of corporatizing the successor distribution companies of BPDB and preparing one distribution company for areas other than Dhaka for structured, solicited privatization either folly or through transfer of management control to a strategic investor;

10. The government should ensure the independence of the management of newly created power sector entities. They should function in accordance with the Companies Act 1994;

11. It is recognized that in the transition process there may be a need for a de facto “single” buyer to facilitate the transition to a competitive pool and to protect consumer interests. BPDB should play this role.

B. Gas Sector

Status

12. Natural gas is an important resource for the economic development of Bangladesh. The share of natural gas in the commercial energy consumed has grown from 35 percent in 1980 to about 70 percent in 1998. Gas supply has, however, not kept pace with demand due to lack of investment in the sector. Investments have been mostly funded under concessional loans from multilateral and bilateral agencies. In 1993, however, the government introduced a new Petroleum Policy to encourage private sector participation in gas exploration and production under Production Sharing Contracts (PSCs). This policy has been generally successful and the flow of gas from the first round of PSCs is expected shortly. The current gas shortages are expected to be overcome by the end of 1998. The government is at present negotiating contract awards under the second round of PSCs.

Supply and demand situation

13. Total proven recoverable gas reserves in Bangladesh are estimated at about 13 trillion cubic feet (TCF). So far, about 2.7 TCF have already been consumed. The international Oil Companies (IOCs) are optimistic about discovering appreciable gas reserves in the near future. This has led to heightened interest in exploration activities in Bangladesh.

14. Preliminary estimation indicates that by the end of 1998 daily gas supply potential will be 30 percent higher than the demand. This gas supply surplus will be maintained up to the end of 2000, if there is no additional production capacity. Thereafter the surplus will gradually reduce over the next three years to zero by 2003. However, additional development gas wells in the public sector fields as well as the second round of PSCs may increase the supply substantially.

Major sector issues

15. Performance of the Public Sector Though the various public gas companies are incorporated under the Company Act and they are supposed to be independent, in reality they enjoy very limited operational or financial autonomy. Meanwhile, since they operate under the veil of state ownership and are insulated from real commercial or market risks, overall capacity in terms of management skills and financial viability remains weak. This situation is further aggravated by the high system losses and large outstanding receivables. Losses in the distribution system, for example, are as high as 26 percent. The high distribution losses are unsustainable and negatively impact the financial position of the public oil companies and overall revenue of the sector.

16. Gas Tariff. At present gas prices are set for different consumer groups and are kept uniform throughout the country despite variances in the costs of supply. The current average consumer price of Tk 54 per Mcf, set in 1994, is far below the long run marginal cost of Tk 73.8 per Mcf To attract private sector involvement, the cost of gas should be increasingly linked to the international fuel oil prices. The consumer prices need to be revised and restructured so that there is transparency of prices at different stages in the supply chain and to enable cost changes to be passed on to the consumers.

17. Gas Utilization and Conservation Policy. As a result of the private sector’s activity under the first round of PSCs, there are already indications that the country’s own needs will be met for the foreseeable future. The IOCs are generally upbeat about the prospects of discovering and establishing additional gas reserves that could justify gas exports. A clear picture of the gas reserves will emerge in the next three to four years after additional drillings in present concession areas and the new areas to be awarded under round two. The government therefore needs to develop a gas utilization and conservation policy that addresses the best economic use of this resource.

18. Foreign Exchange for Servicing Private Sector Investments. The repatriation of the IOCs’ entitlements, under the current and future PSCs for cost recovery and profit sharing, will create a huge demand on the foreign currency resources. While increase of gas availability could boost economic growth and exports, the demand on the foreign currency could be much earlier than the export earnings materialize. Concern has been expressed that the foreign currency required to service the private sector investment would create pressure on the foreign currency reserve of the country. Detailed assessment needs to be made on the foreign exchange impacts resulting from private sector investments in both gas and power sectors.

Direction of new reforms

19. The gas sector is poised to make a major contribution to the development of Bangladesh. There are real prospects that the gas reserves may become the driving force in the economic development of the country by closing the energy supply demand gap and by providing huge foreign exchange earnings. It also offers a unique opportunity for attracting foreign direct investment thus freeing scarce concessional and public sector funds for investment in social sectors and other sectors which cannot attract funds.

20. With deepening of reforms, the gas sector should be fully unbundled and the main entities will be a set of exploration/production companies largely in the private sector in the next few years. An integrated gas transport system—portions of which could be privately owned—and privatized gas distribution utilities will also be established. Distribution companies will be commercialized and privatized. The following major reforms need to be implemented:

(i) The Gas Law needs to be drafted and approved and second round PSCs need to be concluded;

(ii) Gas transmission should be flexible and be open to both public and private sectors and operate on all open access bases. Towards this end government should issue its policy on private sector participation;

(iii) The high distribution losses should be addressed by (1) immediate institution of administrative and legal actions to reduce losses and recover dues from the users and (2) bringing in private sector participation;

(iv) The gas tariff should be revised without any further delay by at least 30 percent on average with unbundling of well-head price, transmission charge and distribution margin. The structure of the tariff should be reconsidered based on the cost of supply to each consumer category independent of the ownership category of the consumers;

(v) In order to reduce the pressure on foreign currency required to service the private sector investment and to maximize the economic benefits of the gas reserves, the government needs to put in place a gas utilization policy and plan to enable the gas producers to sell their gas and make a reasonable return on their investment;

(vi) The import and distribution of LPG should be liberalized and deregulated. Private sector investors should be allowed to import bottles and distribute LPG without any restriction.

II. Fiscal Sustainability in Bangladesh1

A. Fiscal Situation in Bangladesh

21. Since the late 1980s, Bangladesh has shown modest improvements in its overall economic performance, although there have been ups and downs.2 Up to FY 1993/94, price inflation has declined to the low single-digit level and the external accounts have strengthened, although output growth rates were largely stagnant at 4 percent levels. These improvements were mainly owing to a reform program, supported by an ESAF arrangement. Prudent macroeconomic policies were pursued, and comprehensive reform measures in the area of financial, fiscal, and external sectors were taken. However, economic performance during the mid-1990s deteriorated, with stagnant growth, increased inflation and a widened external imbalance. No major reform efforts were made in this period, thereby inhibiting the economy from attaining its full growth potential. Economic performance has been somewhat encouraging in recent years, with higher growth and reduced external pressures. However, the macroeconomic situation remains fragile, including increased inflationary pressures and slow pace of structural reforms. Moreover, the current structural problems in areas of banking sector and state-owned enterprises (SOE) are likely to cast a large burden on the economy.

22. During the recent period, the fiscal position has been managed prudently.3 Higher revenues, which more than offset the increase in expenditures, made the fiscal improvement possible. While total expenditure has risen by 2 percent of GDP since FY 1989/90, total revenue has increased by about 3 percent of GDP, on the average.4 As a result, the overall deficit of the government was reduced from 6 percent in 1989/90 to 4.2 percent in 1997/98, except for a temporary deterioration in FY 1994/95, when fiscal policy was expansionary (Chart 1). The reduction of the budget deficit reduced the recourse to the domestic financing, helping underpin macroeconomic stability. The primary deficit, which excludes the interest payments and grants from the overall deficit, has been maintained at about 1.5 percent of GDP in recent years. The gap between the overall and primary deficit has also remained unchanged recently, since a decreasing trend in grants relative to GDP has been roughly offset by an increase in interest payments.

Chart 1.
Chart 1.

The Fiscal Situation in Bangladesh

(as a percentage of GDP)

Citation: IMF Staff Country Reports 1998, 130; 10.5089/9781451804058.002.A001

23. The revenue structure of Bangladesh has been weak, and characterized by high and uneven import tariffs, various excise taxes and narrowly-based corporate and personal income tax. Total revenue, until the late 1990s, was less than 6 percent of GDP, with half of the tax revenue accounted for by customs duties (Chart 2). The tax base was significantly eroded by numerous preferences and exemptions. The major revenue reforms took place in 1991, when the VAT was introduced. The VAT, initially applying to manufacturing and import stages, has expanded its coverage through removal of exemptions. Although several sectors, including power and textiles, are still out of its net, the introduction of VAT increased the revenue by about 2 percent of GDP, and, together with supplementary duties and excises, accounted for almost a half of the total tax revenue (about 7 percent of GDP). As regards customs duties, notwithstanding the continuous lowering of the tariff rates, such duties have remained at more than 2 percent of GDP. Income tax collections, however, have been stagnant at less than 1 percent of GDP, which reflected excessive tax holidays and a poorly structured system of depreciation allowances. Although the total revenue-to-GDP ratio had increased after the reform, it has been stagnant at the level of less than 10 percent since 1993/94, which put Bangladesh as one of the lowest revenue performance countries.

Chart 2.
Chart 2.

Revenue Performance

(as a percentage of GDP)

Citation: IMF Staff Country Reports 1998, 130; 10.5089/9781451804058.002.A001

24. Total expenditure of the central government has modestly increased from 12 percent of GDP in the late 1980s to 13.7 percent in FY 1997/98, except for FY 1994/95, when it reached more than 14 percent (Chart 3). Two major expenditure components are current expenditure and the Annual Development Program (ADP). Current expenditure averaged about 7 percent of GDP, although it has increased modestly in recent years due to the increase in pay and subsidies. Payments for goods and services including pay and allowances have accounted for about two-thirds of the total current spending. Interest rate payments have been small, reflecting the concessional nature of foreign loans, although they have increased recently due to higher nonbank financing and higher domestic interest rates. ADP expenditures, which are a major vehicle for public investment in Bangladesh, had increased in the early 1990s to 7 percent of GDP by FY 1994/95. However, it declined to 6 percent to GDP by FY 1997/98, due to implementation difficulties as well as prioritization of the investment projects. Foreign grants and concessional loans have continued to play a major role in financing ADP, while domestic financing has become also important in recent years. Other expenditures, including the food account deficit and non-ADP capital spending, took a small portion of expenditure, averaging about 0.5 percent of GDP.

Chart 3.
Chart 3.

Trend in Expenditure Composition

(as a percentage of GDP)

Citation: IMF Staff Country Reports 1998, 130; 10.5089/9781451804058.002.A001

25. Financing of the overall government deficit has been mostly through foreign grants (mainly food and commodity aid) and highly concessional foreign borrowing in the form of project aid. Foreign financing, which accounted for more than 80 percent of the total financing in the early 1990s, has shown a declining trend in recent years (Chart 4). On the other hand, domestic financing has increased recently, reaching 40 percent in 1997/98. Among domestic financing, the portion of nonbank financing has increased, reflecting issuance of high interest-bearing saving instruments. Bank financing, mostly borrowing from the Bangladesh Bank, has maintained at a quite low level, contributing to alleviate inflationary pressures.

Chart 4.
Chart 4.

Financing of the Fiscal Deficit

(as a percentage of GDP)

Citation: IMF Staff Country Reports 1998, 130; 10.5089/9781451804058.002.A001

26. The reduction of the budget deficit and a large portion of concessional foreign financing contributed to lower the government debt burden (foreign debts, on which real interest rates are negative, accounted for more than 70 percent of the total debt). The government debt-to-GDP ratio has fallen from 55 percent in the early 1990s to 50 percent in 1997/98. However, an increasing share of costly domestic financing and the potential budgetary cost, especially related to the structural problems in the banking sector and SOEs, are likely to put pressures on the debt burden.

27. International comparison confirms that the fiscal situation in Bangladesh is very weak, especially in revenue efforts, compared to neighboring and other developing countries (Chart 5). The revenue-to-GDP ratio of Bangladesh is lower than that of the non-OECD African and Asian countries as well as that in the neighboring countries. Such a low level of revenue mobilization puts a constraint on expenditures, which have also been low compared to other countries. In terms of revenue composition, the domestic indirect taxes including VAT account for a relatively large portion of the total revenue, while the portion accounted by income taxation remains small (Chart 6). The poor revenue performance of Bangladesh reflects extensive tax exemptions and generalized tax incentives, weak tax administration, and the sizable underground economy which erode the tax base. It needs to be tackled in order to finance the resource needs to attain a sustained growth and to alleviate poverty.

Chart 5.
Chart 5.

Revenue and Expenditure, International Comparison 1/

(as a percentage of GDP)

Citation: IMF Staff Country Reports 1998, 130; 10.5089/9781451804058.002.A001

Source: Data provided by the Bangladesh authorities, and IMF, the Government Finance Statistics1/ FY 1997/98 data are used for Bangladesh, while the average of the available data during 1990-95 is used for other countries.
Chart 6.
Chart 6.

Revenue Composition, International Comparison 1/

(as a share of total revenue)

Citation: IMF Staff Country Reports 1998, 130; 10.5089/9781451804058.002.A001

Source: Data provided by the Bangladesh authorities, and IMF, the Government Finance Statistics1/ FY 1997/98 data are used for Bangladesh, while the average of the available data during 1990-95 is used for other countries.

28. Notwithstanding the weak fiscal position of Bangladesh, the budget deficit has so far been financed without raising the debt burden significantly. As regards future prospects, however, whether Bangladesh could maintain the current fiscal stance while keeping it’s sustainability is uncertain. Regarding expenditure, the potential costs related to the structural problems in the banking sector and SOEs could increase the fiscal burden substantially. Budgetary outlays on infrastructure and social expenditures such as education also need to be increased in order to sustain growth and reduce the poverty, that still afflicts nearly a half of the population. Moreover, the declining trend in concessional foreign financing and the rising share of domestic financing with higher interest rates are more likely to aggravate the fiscal situation. Revenue performance would also remain at the current level without rigorous reform efforts, and might not be enough to meet the resource requirement. In this context, we need to assess the fiscal sustainability of Bangladesh under various scenarios, and examine how much fiscal reform is required to keep the fiscal stance sustainable.

B. How to Measure Fiscal Sustainability

29. The public sector deficit and the burden of the public debt have important macroeconomic implications. Besides crowding out private investment, the public sector deficit might result in persistent inflation through monetisation of the deficit and/or vicious spirals of debt and deficit. An important issue regarding fiscal policy is the sustainability of fiscal position, which attempts to answer the question of whether the current fiscal position is sustained without exploding or imploding debt.

30. Assessing the sustainability of the fiscal policy is a complex and judgemental exercise, depending critically on assumptions concerning the future path of a number of macroeconomic variables. Assessments of fiscal sustainability attempt to examine the magnitude of medium- or long-run inconsistencies in fiscal policy and to measure the size of the fiscal adjustment needed to achieve stabilization of the base year public sector debt to GDP ratio. Most measures of fiscal sustainability, based on the accounting approach to public sector solvency, are derived from the following intertemporal budget constraint.5

DpPy+i.DPy+i*.ED*Py=M˙Py+D˙Py+ED˙*Py(1)

where Dp is the primary deficit of the government (excluding grants); P is the GDP deflator; y is real GDP; i and i* are the domestic and foreign nominal interest rates; D and D* are the stock of domestic and foreign public debt; E is the nominal exchange rate (domestic currency units of foreign exchange); M is base money stock; and dots indicate time derivatives. The above budget constraint equates the above-the-line deficit (the sum of the primary deficit and interest payments) to below-the-line financing sources (the change in monetary and nonmonetary public debt holdings).

Simple manipulation of equation (1) permits derivation of the ratio of the primary deficit to GDP as:

dp=m˙+(π+g).m+d˙+d˙*+(gr*c).d*(2)

where the lowercase variables, dp, d, d*, and m are defined as the ratios of Dp, D, D*, and M to GDP at current prices; π is the domestic inflation rate; g is real GDP growth; r and r* are the domestic and foreign real interest rates; c is the rate of real exchange rate depreciation. Equation (2) states that the primary deficit of the public sector, as a share of GDP, is constrained not to exceed the sum of the following financing sources: (i) seigniorage revenue comprising the inflation tax on the monetary base and growth-induced increase in money demand; (ii) the excess of real GDP growth over the real interest rate (adjusted for real exchange rate depreciation for foreign interest rate) multiplied by both the domestic and foreign debt stock; and (iii) increases in the stock of domestic and foreign debt.

31. One widely used measure of fiscal sustainability is to compare actual primary deficits and sustainable primary deficit levels. The sustainable primary deficit (sdP) is computed by holding constant the ratios of public debt and money to output, which is given as follows:

sdp=s+(gr).d+(gr*c).d*(3)

where s is seigniorage revenue (s = (π+g)·m). That is, the sustainable deficit level is defined as the deficit level that could be financed without adding to the debt burden and without resorting to monetary financing. If actual primary deficits are greater than the sustainable levels, then debt to GDP ratio would continue to rise, resulting in unstable debt dynamics. This measure of fiscal sustainability, based on the accounting approach, has several shortcomings, including the arbitrariness of the initial debt level and ignorance of different macroeconomic effects of change in public expenditure composition and varying tax regimes.6 However, it not only allows a determination of the range of sustainable deficits under various scenarios of economic growth, inflation, and domestic and foreign interest rates, but it also provides a tractable framework for examining the consistency between macroeconomic policy objectives and the size of the public sector deficit.

32. Alternative fiscal sustainability measures, suggested in other studies, include constant net worth deficit, primary gap and medium-term tax gap. The constant networth deficit, suggested by Buiter (1985), is defined as the difference between the present discounted value of the primary fiscal balance and public sector net worth, both in terms of ratios to GDP. A fiscal position is considered as sustainable if the present discounted value of the primary deficit is smaller than public sector net worth. The primary gap, suggested by Blanchard (1990), is defined as the difference between the primary surplus that stabilizes the outstanding public debt to GDP ratio and the current primary balance.7 The medium-term tax gap, suggested also by Blanchard (1990), equals the difference between the tax ratio, consistent with a stabilized initial public debt to GDP, and the current tax ratio. It measures the required adjustment in the tax ratio needed to stabilize the outstanding public debt to GDP ratio. These measures have advantages in that they are relatively simple, model-free, and based on a restricted information set. While they provide a useful tool for cross-country comparisons, they inevitably ignore the interrelation of macro variables, and are very sensitive to changes in parameters such as interest rates.

33. In this analysis, we rely on the fiscal sustainability measure suggested in Equation (3), which is based on a larger information set regarding the prospects of macroeconomic variables.

C. Fiscal Sustainability in Bangladesh

Medium-term macroeconomic prospects

34. The analysis of fiscal sustainability is conducted under the two alternative scenarios, a no reform scenario and an adjustment (reform) scenario, which provide developments of the major macroeconomic parameters for the calculation of the fiscal sustainability measure.1 Before turning to description of each scenario, the following caveats have to be kept in mind.

35. The fiscal sustainability analysis, as mentioned above, is to see whether the underlying fiscal balance is sound enough to cover debt-service burdens without increasing debt-to-GDP ratio. In order to better reflect the future paths of the public sector deficit and its debt dynamics, the fiscal position of the public sector (rather than the central government) as well as potential fiscal costs needs to be incorporated. In the case of Bangladesh, however, information on the consolidated fiscal balance of the public sector is not available.2 In this study, we focus on the central government balance, while also attempting to take into account the potential fiscal costs related to the structural problems of the banking sector and SOEs.

36. As regards potential fiscal burdens which would fall on to the government, the following costs need to be considered. First, restructuring of the banking sector, including the potential costs of recapitalization and other possible costs such as purchases of nonperforming loans need to be considered. Nonperforming loans of Nationalized Commercial Banks (NCBs) as well as Private Domestic Banks (PDBs) are estimated at around 50 percent of the portfolio. Recapitalization of the banks to keep the capital adequacy ratio in line with the international standard alone would cost about 6 percent of GDP. Retrenchment of the workers would also add a further cost of 0.5 percent of GDP (World Bank estimates (1998)). Second, reform costs of the SOE sector, including potential debt assumption, writing-off of debt to the government, and the retrenchment of workers would increase the fiscal burdens. Assuming government absorption of about one-third of SOEs debt in the industrial sector (141 SOEs, denoted Category III)3, the fiscal cost could be 1.7 percent of GDP, and its retrenchment cost could add a further 0.5 percent of GDP. Inclusion of other SOEs (Category I and II) could add an additional cost of 1 to 2 percent of GDP. Third, in order to attain sustained growth and to reduce poverty, budgetary outlays in the physical infrastructure and social expenditures such as education and public health will need to be increased. The overall reform costs are difficult to estimate more precisely, as they will depend on the coverage, the speed and the modalities of the reforms. Aside from the budgetary outlays in infrastructure and education, the staffs rough estimates put the structural reform costs at 10 percent of GDP in total over the medium term.

37. An important issue to note is how to treat the reform costs in the sustainability analysis. It depends on many factors including the nature of expenditure and the way through such assistance is provided. For instance, in case where reform costs are of a once and for all nature, it is appropriate to consider only the interest component, which would better reflect the underlying fiscal position. On the other hand, when the fiscal burdens due to the reforms are more likely to continue, the reform cost itself needs to be reflected in the primary balance, since it affected the underlying fiscal balance. In the case of Bangladesh, the banking sector and SOE reform costs, which are estimated to be about 10 percent of GDP, are more of a temporary nature. However, other potential fiscal costs including investment in physical infrastructure and social spending, as illustrated above, are needed to increase in order to achieve high growth and to alleviate poverty. To better reflect the underlying fiscal balance, we spread out the banking sector and SOE reform costs over the next five years, and expect that a similar magnitude of expenditure continues after FY 2003/04.4

Table 1.

Budgetary Cost of the Banking Sector and SOE Reforms

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Figures in the left column are in billions of Taka and the right in percent of GDP. The banking sector cost is as of June 1997, and the cost for SOEs is as of June 1996. Figures in percent of GDP are calculated using the corresponding nominal GDP (the 1996/97 GDP for the banking sector and the 1995/96 GDP for the SOEs).

The number of the Category HI workers is assumed to be a half of the total SOE workers.

38. Returning the medium-term prospects, the adjustment scenario assumes that the comprehensive structural reforms, in such areas as in the banking sector and SOEs as well as on the revenue side, take place. The adjustment scenario envisages high growth under price stability. GDP growth rates are expected to rise from 5.6 percent in 1997/98 to 7 percent by 2002/03, while price inflation is stabilized into 4 percent levels. High growth is made possible due to a rapid increase in investment, together with broad efficiency gain which the structural reforms would bring. The reform costs to tackle the structural problems in the banking sector and SOEs are estimated to be 10 percent of GDP, as indicated above. Higher public saving, which is vital to meet the resource needs, is attained primarily through higher revenue. Revenue reform is assumed to bring a revenue gain of 2.5 percent of GDP over the medium term. The overall government deficit, including the reform costs, rises initially to 5.6 percent of GDP, but declines gradually to 4 percent levels as a higher revenue is attained. The foreign financing of the deficit is expected to decline from 2.6 percent in 1997/98 to 1.9 percent of GDP in FY 2002/03, while the share of domestic financing become larger (2.3 percent of GDP in FY 2002/03). Interest rates (on government bonds) are projected to remain at 11 percent, which are broadly in line with the nominal GDP growth. The rate of real exchange rate depreciation is expected to be zero.

39. Under no reform scenario, on the other hand, neither reforms in the banking sector and SOEs sector nor revenue reform takes place. The structural problems prevalent in the economy threaten macroeconomic stability, with adverse implications for investment and growth. Real GDP growth is expected to be lowered gradually to 4 percent levels over the medium term, while price inflation remains at 7 percent. As the potential cost of the banking sector and SOEs materializes without revenue reforms, the overall government deficit worsens into more than 6 percent of GDP in FY 2002/03, most of which is financed by domestic financing. Interest rates are expected to rise by about 2 percent to 13 percent level, reflecting inflationary pressures and inefficient financial intermediation. Medium-term macroeconomic prospects under each scenario are summarized in Table 2.

Table 2.

Medium-Term Macroeconomic Prospects Under Each Scenario

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In percent of GDP.

It represents interest rates for government bonds. It is more likely to be higher than the projected, considering the large issuance of government bonds.

Fiscal sustainability in Bangladesh5

40. The fiscal sustainability in Bangladesh is assessed by comparing the actual primary deficit and the sustainable primary deficit in Equation (3), which is as follows:

fs=dpsdp=dp(gr).d(gr*c).d*(4)

where fs is a sustainability measure, of which positive sign indicates that the primary deficit exceeds the sustainable level, resulting in increases in the debt-to-GDP ratio. Note that the seigniorage component (s) is absent in the equation, since most of the Bangladesh Bank’s profit is already reflected in the actual deficit (dp) by its transfer to the government.6

41. The fiscal sustainability measure has been calculated by plugging medium-term projection of key macroeconomic variables, shown in Table 2, into Equation (4). The results of the sustainability analysis are reported in Table 3. As shown in the table, the fiscal position of Bangladesh has been sustainable so far, owing to several factors. First, the interest rates on foreign financing have been very low due to the highly concessional nature. Second, foreign debt, with negative real interest rates, accounted for more than 70 percent of the total debt. These two factors made the effective interest rates on the government debt very low. Third, the fiscal improvement, although moderate, together with higher growth improved the fiscal sustainability.

Table 3.

Bangladesh: Summary of the Fiscal Sustainability Analysis

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The figures indicate fs in the Equation (4).

42. Fiscal sustainability over the medium term is found to depend critically on the scenario envisaged. Chart 7 compares the sustainability under various scenarios, in which the difference between the projected primary deficits and the sustainable levels, in percent of GDP, is plotted. Under the scenario that no reform takes place, the fiscal position is quite sustainable in the initial stage. However, as the potential burden of the banking sector and SOEs materializes, the fiscal position becomes unsustainable. By FY 2002/03, the actual primary deficit exceeds the sustainable level by about 1 percent of GDP, and the fiscal position is expected to deteriorate further after FY 2003/04. Low growth, increase of the fiscal burdens due to the structural problems, and greater domestic financing with higher interest rates are the underlying factors which aggravate the fiscal situation.

Chart 7:
Chart 7:

Fiscal sustainability in Bangladesh

(difference between the projected primary deficits and the sustainable deficits, in percent of GDP)

Citation: IMF Staff Country Reports 1998, 130; 10.5089/9781451804058.002.A001

43. On the other hand, under the adjustment scenario where the revenue reform as well as the banking sector and SOE reforms takes place, the fiscal stance turns out to be sustainable with a fair margin. For the initial stage of the reform where the revenue increase is small relative to the reform cost, the projected primary deficit exceeds the sustainable level. As the revenue efforts become stronger, however, the fiscal position begins to improve, and the sustainability is quite well maintained by a margin of 1 to 2 percent of GDP in FY 2002/03 when the reforms are to be finalized. The adjustment scenario without the revenue reform is also drawn in Chart 7 to see what would happen without the revenue reform. Despite the higher growth, the fiscal sustainability is threatened, as the projected primary deficit exceeds the sustainable level by 1 percent of GDP in FY 2002/03. It underscores the importance of the proposed revenue reforms to absorb the potential costs, without which the structural reforms could be constrained by a lack of fiscal resources.

Sensitivity analysis of the fiscal sustainability

44. The medium-term fiscal sustainability depends on the projected paths of major macroeconomic variables. However, the macroeconomic prospects are subject to change with, indeed even without, exogenous shocks to the economy. Considering the potential risks related to this kind of analysis, we assess fiscal sustainability under various assumptions on the macroeconomic variables, including a lower growth, a higher reform cost, further real depreciation of the exchange rate, lower aid, and higher interest rates.7 The results of the sensitivity analysis, conducted under the adjustment scenario, are reported in Table 3, and its cumulative effect is drawn in Chart 8.

Chart 8.
Chart 8.

Sensitivity of the sustainability

(same as in Chart 7)

Citation: IMF Staff Country Reports 1998, 130; 10.5089/9781451804058.002.A001

45. The sensitivity analysis shows that there remains a substantial risk while the sustainability margin (1 to 2 percent of GDP) under the adjustment scenario could absorb an individual shock. Under a lower growth assumption by one percentage point (6 percent growth over the medium term), the sustainability measure turned out to deteriorate by about 0.5 percent of GDP. A higher reform cost, by 1 percent of GDP each for the next five years, significantly threatened sustainability.8 Further real depreciation of the exchange rate by 2 percent,9 which raises the debt service burden, aggravated the sustainability measure by about 0.6 percent of GDP. Lower aid, which is assumed to be constant at the FY 1997/98 level in absolute terms, and a higher interest rate by 2 percentage points (changed from 11 percent to 13 percent) also aggravated the sustainability by 0.1 to 0.2 percent of GDP. The results, which are cumulatively drawn in Chart 8, indicate that how essential is the proposed revenue reform in order to keep the fiscal sustainability under various risks.

D. Conclusion

46. This paper assessed the fiscal position of Bangladesh and examined its fiscal sustainability using a simple measure based on the debt dynamics. While Bangladesh has so far maintained its sustainabilitiy mainly due to the large portion of foreign financing with highly concessional interest rates, the potential fiscal burdens related to the structural problems in the banking sector and SOEs might threaten the sustainability. Stronger revenue efforts, which would raise the revenue to GDP ratio by a total of 2½ percentage points of GDP over the medium term, are likely to be essential in absorbing the structural reform costs and also keeping the fiscal sustainability under possible downside risks.

47. The results of this analysis need to be interpreted with a caution. First, the sustainability measure, employed in the analysis, provides only one of several possible perspectives on the soundness of public finances. For example, it assesses the sustainability from the perspective of borrowers rather than creditors, and a fiscal position is sustainable only when the creditors are willing to finance it. Second, any sustainability measure critically relies on the status of the consolidated fiscal position and the potential fiscal burdens. In this context, significant improvements in government finance data are indispensable to better assess the fiscal position and its sustainability. Also, further studies regarding the magnitude of the structural reform costs related to the banking sector and SOEs would help improve the quality of the analysis.

III. Banking System Problems and Reform in Bangladesh1

48. The banking sector in Bangladesh has experienced severe problems for more than a decade. This chapter establishes the extent of bank soundness problems based on quantitative indicators of financial distress. In its analysis it regards the bank soundness problems as symptoms that reflect the underlying weaknesses in the banks and in their surrounding environment such as the regulatory framework and the legal and judiciary system. It analyzes these weaknesses and identifies key areas where reforms are needed. The chapter is structured as follows: Section A gives an overview of the financial system; Section B looks at financial indicators of bank soundness problems; Section C analyzes the underlying weaknesses that cause the financial problems; Section D discusses key issues related to severe banking distress; Section E gives an overview of recent reforms; and Section F suggests future reforms.

A. Background

Overview of the financial system

49. The banking sector dominates the financial system in Bangladesh, accounting at end-1997 for 96 percent of the system’s total assets. Overall, the size of the financial sector relative to GDP remains somewhat smaller than in other countries in the region (Table 1).

Table 1.

Regional comparison of indicators on financial sector, saving and investment.

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Source: WEO Reporting System, IMF.

50. The banking institutions in Bangladesh comprise the central bank—the Bangladesh Bank (BB)—four nationalized commercial banks (NCBs), four government-owned specialized development banks, 18 private domestic banks (PDBs), and 12 foreign banks. The NCBs dominate the commercial banking sector accounting for about two-third of its assets, although the share has been declining over the last decade reflecting the impact of some financial sector reforms, including the privatization of two NCBs. The specialized banks, created with special mandates to address the financial needs of clients in the agricultural and industrial sectors and used as a means of granting subsidies to these sectors, have been experiencing especially serious structural problems in recent years. While their deposit-taking is relatively small (5 percent of all bank deposits), they provide 17 percent of all bank advances, financed by large borrowings from the central bank. The foreign banks with a stable share of about 7 percent of bank assets in recent years are active principally in international transactions.

Macroeconomic environment for the financial sector in recent years

51. As seen in Table 2, the overall macro economy has on balance provided a relatively stable and favorable environment for financial sector development in recent years. Real GDP growth has been fairly high (average 5.2 percent) and rising over the period, and exports and workers’ remittances from abroad have grown rapidly. This has boosted banking sector liquidity through a steady increase in deposits which have grown faster than nominal GDP. Inflation has been relatively low and the exchange rate fairly stable. Fiscal deficits have been manageable, averaging 4½ percent of GDP, and in general prudence has limited the part of deficit financing coming from the banking system. So far the net impact on the Bangladeshi economy of the current Asian financial crisis has in fact been mildly positive.2

Table 2.

Bangladesh: Overview of the Macro-Financial System, 1993/94-1997/98

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Early problems of banking distress

52. Severe banking problems are not a recent phenomenon in Bangladesh, having prevailed for more than a decade in the state-owned banks but by the early 1990s, also in the private domestic banks. The need for overhaul in the banking sector was recognized in the late 1980s leading to implementation of the World Bank supported financial sector reform program (FSRP) from 1989 to 1995. Related policy measures for the financial sector were also important components of an ESAF supported program in the early 1990s. Key reform areas in the FSRP were: interest rate liberalization; abolition of sectorally directed lending; abolition of sectoral refinancing from the central bank; new private sector entry; improving financial management in the state banks; and strengthening banking supervision, supported by technical assistance. Considerable progress was made in moving away from the previous system of direct controls in the banking system as well as in revising loan classification and provisioning criteria, the legal provisions and procedures for enforcing loan recovery, and improving the availability of credit risk information. Notwithstanding this, the commercial banks have remained in severe distress.

B. Bank Soundness in Recent Years

53. An assessment of bank soundness looks at the banks’ solvency or capital adequacy, the quality of their assets or loan portfolio which is their revenue generating base and the banks’ liquidity. This section discusses these factors using selected quantitative indicators such as the share of overdue or nonperforming loans (NPLs) in total bank loans, the adequacy of provisioning against loan losses and capital adequacy.

54. It is shown that by most measures Bangladesh’s banking system is unsound and that there has been little improvement in the banking system in recent years. Bank capital and provisioning are highly inadequate in almost all domestic banks; asset quality is very poor and the management and operating environment is unsatisfactory. The high levels of classified loans necessarily adversely affect the banks’ earnings and cash flow, and raise concerns about liquidity if deposit growth were to slow down. However, so far liquidity appears sufficient. There has been no sign of withdrawal of funds that could have come from confidence loss. In light of the public knowledge of the distress in the PDBs, this leads one to conclude that the public is applying the assumption of government support for the NCBs also for the PDBs.

55. Given that the foreign banks are generally sound, the analysis focuses in particular on the domestic banks which account for 94 percent of the banking system and in which the problems are concentrated. The main focus is on the NCBs and PDBs and in general excludes the specialized banks whose main funding is not through deposit-taking but rather from government institutions. The empirical data are provided by the BB and are based on the authorities’ classification and prudential standards when not specifically indicated otherwise.

Nonperforming loans and provisioning shortfalls

56. The loan classification and loss provisioning criteria in Bangladesh are less rigorous than the international “best practice” standards. However, the gap in these standards as well as those for capital adequacy has been progressively narrowed since 1995 when a revised phased schedule for tightening the classification criteria reaching full international standards by January 1999, was introduced. In 1997, loans were classified as “substandard” when overdue for 9 to below 24 months (international standard: 4-6 months), “doubtful” for 24 to below 36 months (international standard: 7-12 months), and “bad” for 36 months or more (international standard: 13 months or more). The provisioning requirements were for unclassified loans: 1 percent; substandard: 10 percent; doubtful: 50 percent; and bad loans: 100 percent. Only the provision for substandard loans differed from international standards at 20 percent.

Table 3.

Bangladesh: Summary performance indicators in the banking system, 1994 -1997

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In percent of total loans.

In percent of classified loans.

Includes overdue agriculture short-term loans of 4.6 and 4.8 percent of all classified loans in 1994 and 1995, respectively.

Adjusted to exclude interest suspense and in percent of total loans excluding interest suspense.

Table 4.

Bangladesh: Commercial Bank Loan Classification and Provisioning, 1994-1997

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Excluding staff loans and including agriculture loans (both short-term and medium/long-term). Excludes specialized bank loans. Includes interest suspense, as per authorities’ reporting.

Includes BSB, BKB, RAKUB and BSRS, although BSRS data are incomplete. BASIC is classified here as a private commercial bank.

Including classified agriculture short-term loans.

Adjusted to exclude interest suspense.

For 1994 and 1995, excludes overdue agriculture short-term loans. Includes interest suspense, which is not allocated between categories, in official figures.

57. The share of nonperforming loans is very high and has been rising over the last two years. The classified loans ratio for domestic commercial banks increased from 34 to 35 percent in 1995-1997, reflecting a steady rise in the NPL ratio of NCBs to 37 percent whereas the PDBs reduced their NPL ratio to 31 percent (Table 3). These ratios as reported by the BB are very high by international comparison. Furthermore, they understate the NPL problem when measured by the more rigorous international standards. Based on June 1997 data (from local audits) and consistent with international classification standards, the World Bank has made preliminary estimates of NPL ratios in the range of 50 percent for all domestic commercial banks. Comparable data from other countries in Asia and Latin America with severe banking distress show average NPL ratios of 20 percent before a banking crisis with the highest NPL ratio being 35 percent. Preliminary NPL estimates from recent international audits of the four NCBs show similar magnitudes which are also expected for the PDBs. Furthermore, NPLs were particularly pervasive in the specialized development banks where the ratio as reported by BB exceeded 65 percent and was rising. Even after excluding the interest suspense, the classified loans ratio for all domestic commercial banks remained high by international comparison—at 25-25½ percent in 1995-1997—and worsened for the NCBs. However, to some extent the increase in the measured NPL ratios in the NCBs in 1995-1997 could reflect the gradual tightening of classification requirements. The sharp increase in loans classified as bad could also partly reflect this.

58. The concentration of defaulting individual borrowers is very high. At end-1997, 88 percent of the NPLs were to the private sector and within this group the NPLs were extremely concentrated. In the NCBs the top 20 private sector defaulters (1 percent of their borrowers) accounted for 21 percent of their NPLs in September 1997, and 95 percent of the loans of these defaulters were overdue. The NPLs of the PDBs were even more heavily concentrated: The banks’ top 20 private sector defaulters (3 percent of their borrowers) accounted for 47 percent of the NPLs, and 83 percent of their loans were overdue.

59. A very high proportion of the classified loans is bad with only a low likelihood of recovery. The expected loan losses are tentatively estimated at about 6 percent of GDP, assuming 80 percent loss on the NPLs. This reflects the large extent of bad loans.

60. Domestic banks are seriously deficient in loan loss provisions and their provisioning deficiency has been worsening. Their provisioning shortfalls rose in 1997 to 52½ percent of required provisions (Table 3). These data show that while in recent years the provisioning regulations have progressively approached and are now close to international standards, they are in practice not followed by domestic banks. Since the loan classification standards (which are the basis for calculating required provisions) are less stringent than international practice, estimates based on the latter would show larger provisioning shortfalls.

Capital adequacy

61. Domestic banks have effectively remained insolvent in recent years with continued deterioration in the NCBs but with modest improvement in the PDBs. The strained capital position of the NCBs has continued in spite of a substantial recapitalization by the government in the early 1990s (Tk 62 billion or 5 percent of GDP). This was done without fundamental restructuring and hence improvement of their operations.

Table 5.

Bangladesh: Capital Adequacy, 1994-1997

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In 1994 and 1995, capital adequacy was defined as 6 percent of bank demand and time deposits, with a minimum capital of Tk 200 million. Bank “assets” reported here are therefore equal to deposits and are lower than a normal definition of total assets (and liabilities) by excluding paid-up capital, reserves and retained earnings.

For 1994 and 1995, official data are not applicable as required capital was derived from a different base and methodology from 1996 onwards.

Table 6.

Bangladesh. Overdue Loans, 1995 - 1997 1/

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BB’s definition of overdue loans differs somewhat from its definition of classified loans. The amounts are somewhat higher under the definition of overdue but track each other closely under the two definitions.

Table 7.

Bangladesh: Outstanding and Overdue Loans By Economic Sector, 1994 - 1997 1/

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Defined by BB as a loan where a contractual debt service payment is at least one day overdue.

62. Since 1996, banks have been required to hold (core plus supplementary) capital equivalent to 8 percent of risk-weighted assets, with a minimum capital requirement of Tk 200 million; previously, banks were required to hold 6 percent of total demand and time liabilities (excluding interbank deposits) in paid-up capital and reserves. The current regulations are close to the Basle standard which also requires 8 percent of risk-weighted assets but more stringent weighting and classification of the various asset types. Estimates of domestic banks’ actual capital adjusted for provisioning shortfalls show that NCBs and PDBs effectively have remained insolvent (i.e., with negative adjusted capital) since 1995 (Table 3) and that their capital position adjusted for provisioning shortfalls has continued to deteriorate slowly. While these data as reported from BB clearly show the need for a substantial recapitalization of these banks, the true extent of the shortfalls is better estimated based on international standards given the less rigorous auditing and regulatory requirements used in Bangladesh. Such estimates have been made by the World Bank based on June 1997 data.

63. The potential recapitalization cost of the banks in order to bring capital adequacy and provisions to international standards is estimated at about 6 percent of GDP. The recapitalization cost was estimated by the World Bank at Tk 71 billion in the case of the NCBs and Tk 34 billion in the case of the PDBs. These estimates are made by measuring capital and provisions against the Basle standard. However, one should note that this standard was designed with the G-10 industrial countries in mind with far more developed financial systems than Bangladesh. In the case of the latter, prudence would advocate aiming over time at an even higher capital requirement in percent of risk weighted assets.

Bank liquidity

64. The steady growth in deposits, helped by a favorable macroeconomic environment, has provided sufficient liquidity for domestic banks in recent years. The banks have in general complied with the relatively stringent liquidity reserve requirements which are: five percent of deposits must be held as cash reserves with the central bank and the equivalent of a further 15 percent of deposits must be held as qualifying “secure” assets (either cash or government securities). Consequently, loans are limited to around three-quarters of bank deposits for most deposit money banks. Recourse to central bank credit increased in 1997 but was in general not necessary to meet the liquidity reserve requirements. However, liquidity of the NCBs as a group has at times been very close to the required minimum levels, possibly indicating more pressing liquidity needs for some individual banks.

C. Underlying Reasons for the Bank Soundness Problems

65. Having established the severity of banking distress in Bangladesh, this section identifies the factors that have caused the financial problems and points out areas where reform is needed.

66. The roots of the banking sector problems in Bangladesh go back several decades. Following independence in 1971, the banking sector was nationalized and remained largely government-owned and controlled until the mid-1980s when some liberalization began to occur. The high degree of direct state control in banking activities resulted in nationalized banks not maintaining truly commercial banking practices and skills as well as in inadequate banking supervision. Bank loans were disbursed mainly to the publicly-directed sectors without proper commercial consideration, the internal control and account systems of the banks were weak, and the quality of bank assets was not evaluated on strict accounting principles. In these circumstances, NPLs in the banking system rose dramatically.

67. The persistence of the banking soundness problems stems from the lack of political will so far to address squarely their root causes rather than the weaknesses in the regulatory and supervisory system which have been progressively reduced over time. The government seems to have been deterred by the perceived political and economic strength of key stakeholders (including major defaulters) and, if weak banks were closed, fear of possibly triggering a run on the banks and losing public support.

68. The factors behind the banking sector’s problems can be addressed in terms of the three key elements of a sound banking system: (a) the regulatory and supervisory system; (b) bank management and corporate governance; and (c) the legal and court system.

Problems and weaknesses in the regulatory and supervisory system

69. The central bank, Bangladesh Bank, is constrained by lack of authority and autonomy regarding enforcement of regulatory standards, automatic lending to government and directed lending to priority sectors. While a number of prudential regulations such as loan classification, provisioning requirements and capital adequacy are now coming close to international standards, the key problem is weak and inadequate enforcement of these regulations. This is illustrated by the emergence of severe banking soundness problems in the PDBs following their rapid entry and credit expansion. This took place without adequate and timely strengthening of bank supervision capacity, of the legal and regulatory framework and of the enforcement of prudential standards. Other areas of weakness are the lack of transparency, the accounting base as well as the prudential regulations on credit exposure to individual borrowers and their enforcement.

70. In reality almost two thirds of the banking system (the NCBs) are not fully under the regulatory oversight and hence the legal authority of the BB. While being monitored by the Ministry of Finance, the NCBs are subject to priorities set by the government that may differ from prudential concerns. Furthermore, the BB lacks functional focus, its financial conditions are weak and the staffs professional skills are inadequate. This partly reflects the effect of strong and militant unions interfering in personnel, recruitment and promotion decisions.

71. An additional problem area is the deposit insurance system which BB administers. This insurance system is grossly under funded compared to its legal obligation of coverage. This implies a substantial contingent fiscal liability or similarly, quasi fiscal costs associated with BB bailing out banks in the event of a liquidity crisis.

Problems and weaknesses in bank management

72. Common to all domestic commercial banks is weak corporate governance. There is a general lack of transparency and accountability and disclosure standards are inadequate. There has been no effective and transparent process for holding the incumbents responsible for their performance. The important role of independent bank auditors for good governance has been neglected, and the accounting base, wanting in transparency and credibility, is not fully adequate to ensure that the actual classification of loans reflects the true quality of the assets. Furthermore, concentration of NPLs on individual borrowers is very high, reflecting the banks’ lack of a prudent credit policy.

Nature of problems in the nationalized commercial banks (NCBs)

73. The government through the Ministry of Finance interferes implicitly and explicitly in the internal management and operational matters of the NCBs. Political interference is seen in the selection of Directors to their Boards; the composition of their management teams; and in their loan portfolios. The latter reflects political pressure for lending to SOEs—even long-time defaulting ones—or preferred sectors such as agriculture with extraordinarily high NPL ratios. As a result, these banks are vulnerable to their lending exposure in agriculture (Table 7). Nevertheless, a large share of the loan portfolio of poor quality is to the rest of the private sector. This partly reflects lack of competent bank staff which has led to poor assessment of credit risk, poor project selection and lack of assistance on corporate debt workouts. The banks’ professional competence and operational efficiency have been impaired by strong and militant unions who are increasingly politicized and who interfere in management and personnel decisions. The NCBs are over staffed and the number of branches is excessive as reflected in a number of branches running losses for many years. Another problem for these banks is that the government on several occasions has announced loan amnesties to various categories of private sector borrowers without reimbursement to the affected banks in a transparent manner. Beyond their direct impact on the banks these actions have also undermined the financial discipline in the banking sector.

Nature of problems in the private domestic banks (PDBs)

74. Weak governance and lack of firm supervision are key issues in the case of the PDBs. The financial strength of these banks has been severely weakened by insider lending, fraud and negligence, including involvement by directors, managers and owners. This has not been sufficiently deterred by the regulatory, supervisory and legal system although seven PDBs are now under enhanced monitoring by the BB. They have signed Memoranda of Undertaking with the BB which require certain corrective measures. However, there have been no punitive measures for non compliance. The NPLs to borrowers with genuine financial problems reflect to some extent the rapid credit expansion after deregulation.

75. The NPLs of the PDBs are excessively concentrated in a small number of big private borrowers; and the concentration has worsened in recent years. This reflects poor risk management and breach of regulations on individual lending limits.

76. Part of the current NPL problems of the PDBs is a carryover from the 1980s. Out of the currently 18 PDBs, three were previously NCBs that were partly or fully privatized in the 1980s without recapitalizing for the bad public sector debt, leaving a weak capital base.

Legal framework and court system

77. The third weak element in the banking system is the legislation affecting the financial system as well as the court system. The legal framework and the court system are not adequate to guarantee their disciplinary function; i.e., enforcing lenders’ recourse on borrowers including SOEs: (I) Effective measures cannot be implemented in a timely manner. The court process for default cases is long and protracted with opportunities for defaulters to take advantage of loopholes in the laws or to successfully block banks’ suits in court. As a result a very low share of cases under litigation is being settled, (ii) Over recent years, a number of laws have been identified as needing strengthening to enhance BB enforcement power as well as to close existing loopholes and strengthen the position of creditors. The authorities have been making progress in this area recently.

D. Issues Arising from the Weaknesses in the Banking System

Costs

78. As seen in many countries, severe banking sector distress has a negative impact on savings and investment. The lower investment levels translate into a cost to the economy in the sense of lost economic growth that comes from (i) reducing available resources in the financial system, and (ii) misallocation of existing resources. The impact on savings and investment is reflected in the relatively low degree of financial intermediation (measured as the ratio of deposits to GDP) compared to other countries in the region (Table 1).

(i) Both savings and lending volumes have been depressed due to the high spread between bank lending and deposit interest rates (over 7 percentage points) as a result of the very high incidence of NPLs. Real lending rates have remained high (9-12 percent since 1990). The severity and persistence of banking distress may also have dampened the growth in bank deposits by weakening the public’s confidence in the banking sector to some extent.

(ii) The quality of resource allocation is worse in a less efficient financial sector resulting in lower returns on investment. This aspect is reflected in the high NPL ratios, at least on defaulters with genuine economic problems. Regarding fraudulent defaulters, the loss to the Bangladeshi economy is somewhat less than that of the banks since some of the funds are invested in the domestic—probably mainly in the informal—economy or abroad.

79. The costs discussed here have already taken place but continue to accumulate in the absence of decisive reforms. The dampening effect of banking distress on investment and economic growth gives reason to question the authorities’ expectations of high and accelerating rates of economic growth if fundamental reforms were not to be undertaken.

80. The bank soundness problems have led to considerable contingent fiscal liabilities. The state owned part of the banking sector has been running a substantial quasifiscal deficit by accumulating large losses on NPLs, eroding the banks’ capital. To the extent that PDBs will not be allowed to fail, the government may have to support these banks as well in a liquidity crisis. In either case this implies the realization of considerable contingent fiscal liabilities since recapitalization will be necessary. Potential fiscal costs of a new round of recapitalization have kept increasing and they will continue to do so in the absence of decisive reforms addressing the root problems in the banking sector.

Stability of the system: liquidity risks

81. In light of the severity of banking sector problems in Bangladesh compared to other countries in the region where full blown financial sector crises have been triggered, it is natural to ask why this has not happened in Bangladesh. The answers are manifold.

82. As noted, over the last five years the macroeconomic environment has been favorable for the banking sector. Sustained and rapid increases in real GDP and exports have provided for a steady increase in deposits, absorbing fairly easily the liquidity drain from the NPLs.

83. Reflecting the closed capital account, foreign exchange exposure of banks and of corporate borrowers is much less than in the crisis affected countries. This gives more room for maneuver in a crisis since as a last resort, substantial liquidity injection to troubled banks would help to ride over the storm. Although this would affect inflation and the exchange rate, the exchange rate impact on corporations’ (and banks’) balance sheets would effectively be contained to a much larger extent than in the Asian crisis countries (Table 8). Also reflecting the relatively closed capital account, capital inflows and outflows have so far had limited impact on domestic asset prices with the exception of a short-lived boom and bust cycle on the stock exchange in 1996 driven by foreign portfolio investments. One has not seen the type of real estate asset price bubble as in the Asian crisis countries, reflecting the much lower bank lending to the real estate sector in Bangladesh (as a share of the total economy).

Table 8.

Bangladesh: Vulnerability Indicators, 1992/93 -1997/98

(in percent of GDP, unless otherwise indicated)

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Source: Data provided by the Bangladesh authorities; and staff estimates.

Measured at the authorities’ classification standards. Based on the more stringent international standards, nonperforming loan ratios would be higher.

The ratios do not take into account loan loss provisioning shortfalls. Prior to 1995/96 capital adequacy was not defined in terms of risk-weighted assets and hence the data are not comparable for the earlier years.

Based on quarterly survey of loans and advances of commercial banks.

Foreign currency liabilities as percent of foreign currency assets.