Bangladesh: Selected Issues and Statistical Appendix

This Selected Issues paper and Statistical Appendix examines Bangladesh’s nonfinancial state-owned enterprises. The paper argues that, given the overall policy environment and external vulnerabilities, the usefulness of the fixed exchange rate system in Bangladesh has run its course. Greater exchange rate flexibility is needed to ensure that the exchange rate sends appropriate market signals, and to enhance the authorities’ ability to address more effectively and timely both domestic imbalances and external real shocks arising from a rapidly changing global environment. The paper also outlines the structure and recent performance of the commercial banking sector.

Abstract

This Selected Issues paper and Statistical Appendix examines Bangladesh’s nonfinancial state-owned enterprises. The paper argues that, given the overall policy environment and external vulnerabilities, the usefulness of the fixed exchange rate system in Bangladesh has run its course. Greater exchange rate flexibility is needed to ensure that the exchange rate sends appropriate market signals, and to enhance the authorities’ ability to address more effectively and timely both domestic imbalances and external real shocks arising from a rapidly changing global environment. The paper also outlines the structure and recent performance of the commercial banking sector.

II. The Exchange Rate Regime in Bangladesh1

1. In recent years, Bangladesh has maintained a fixed yet adjustable exchange rate regime in the face of an expansionary fiscal policy, rapid growth of domestic credit, and unanticipated adverse external conditions. Although inflation has remained low, this policy has led to a steady erosion of the international reserve position, exacerbating the country’s vulnerability to external shocks.

2. Rather than tightening fiscal and monetary policies to stem the loss of foreign exchange reserves, the authorities took measures aimed at: (i) restraining the demand for foreign exchange through the imposition of exchange and trade restrictions and extension of foreign exchange guarantees for oil imports; (ii) encouraging exports through preferential credit facilities and subsidies, reducing the cost of workers remittances through the banking system by setting special transfer facilities, and securing the repatriation of foreign exchange by imposing a comprehensive export surrender requirement scheme; and (iii) strengthening the gross foreign reserve position by incurring on nonconcessional external borrowing and delaying some external payment obligations. The decision to adjust the exchange rate was usually preceded by extensive deliberations within the government over several months, amid much speculation in the media, resulting in persistent uncertainty and increased misalignment until corrective actions were finally taken.

3. This chapter argues that, given the overall policy environment and external vulnerabilities, the usefulness of the fixed exchange rate system has run its course. Greater exchange rate flexibility is needed to ensure that the exchange rate sends appropriate market signals, and to enhance the authorities’ ability to address more effectively and timely both domestic imbalances and external real shocks arising from a rapidly changing global environment.

A. Recent Exchange Rate Policies and Practices

4. The taka is currently pegged to a trade-weighted currency basket, but the reference currency in exchange rate management is the U.S. dollar. Although the Bangladesh Bank (BB) does not have the authority to conduct day-to-day exchange rate management,2 it announces daily a buy-sell band for the U.S. dollar against the taka and trades with authorized dealers in the U.S. dollar only. Effective December 4, 2000, BB discontinued selling and buying U.S. dollars from authorized dealers at the pre-announced rates and instead set buy-sell rates for each transaction separately within the announced band. The authorized dealers then set their own buying and selling rates for the U.S. dollar and other currencies based on cross rates in international exchange markets.

5. The taka exchange rate against the U.S. dollar is supposed to be adjusted when the authorities consider that its value is misaligned with the currency basket of major trading partners, and when external and internal developments require such an adjustment.3 In practice, the authorities have devalued the taka against the U.S. dollar once every few months, the most recent episodes being 2 percent in July 1999, 5.9 percent in August 2000, 5.5 percent in May 2001, and 1.5 percent in January 2002 (Figure II.1).

Figure II.1.
Figure II.1.

Bangladesh: Exchange Rate Adjustments, Jan. 1999 - Jan. 2002 1/

Citation: IMF Staff Country Reports 2002, 114; 10.5089/9781451804096.002.A002

1/ Downward movement indicates depreciation.

6. Having opted for sporadic devaluation, the authorities resorted to other means to relieve pressures on the foreign exchange market. In addition to maintaining several longstanding restrictions on making payments and transfers for current international transactions,4 in December 2000 the government introduced margin requirements (set at different rates) on letters of credit for most commercial imports.5 These rates were further increased from 50 percent to 100 percent in November 2001.6

7. The authorities have also tightened the trade regime in recent years aimed at compressing imports. In the early 1990s, Bangladesh made considerable progress in trade liberalization by rapidly eliminating quantitative restrictions and reducing the top import tariff rates. The maximum tariff rate was reduced from 350 percent in 1990–91 to 37½ percent in 1997–98, and the unweighted average tariff rate fell from 89 percent in 1990–91 to 17 percent in 1995–96. However, this trend has been somewhat reversed in recent years. The unweighted average tariff rate increased to 21 percent during 1999–01 while surcharges and duties on imports were introduced frequently (including the most recent one in December 2001), resulting in a combined average tariff rate of 25¾ percent in 2001. Following this increase, along with existing nontariff barriers, Bangladesh has become one of the most restrictive trade systems among Fund members in general, and the Asian region in particular.7

8. The authorities have also made efforts at securing the supply of foreign exchange. To this end, they have relied on a comprehensive foreign exchange surrender requirement system, which allows exporters to retain only 7½ percent of proceeds from ready-made garment exports and 40 percent from all other exports. The authorities have also used direct export subsidies and credit facilities for exports at the administered below-market interest rates to encourage exports. Administrative measures (including setting up official transfer points abroad at lower-than-commercial cost) have also been used to attract a higher level of workers’ remittances through the banking system and away from the informal market.

9. To strengthen gross foreign reserves, the authorities have occasionally incurred nonconcessional external borrowing and delayed payments to foreign energy companies under joint-venture agreements. They have also provided foreign exchange guarantees to ensure oil imports, the most recent such transaction amounting to $257 million.

10. Despite these measures, the taka has continued to go through prolonged cycles of overvaluation and the pressures on the balance of payments have remained unabated given the ongoing pursuit of expansionary financial policies. Net international reserves declined from $853 million at end-2000 to $479 million by end-January 2002.

B. Real Effective Exchange Rates, Cost of Doing Business, and International Competitiveness

11. While acknowledging the limitations of using traditional indicators of real effective exchange rates (REER) in assessing the external competitiveness of a country,8 the staff has estimated annual REER based on consumer price indices (CPI) and unit labor costs (ULC)9 for Bangladesh for the period 1989–01. Six such measures have been made using the weights provided by the Information Notice System (INS),10 and three new weights have been calculated to reflect recent emerging trade patterns since 1995–01. The new sets of weights were constructed based on the average export, import, and trade values.

12. Representative REER series (Figure II.2 and Figure II.3) indicate a U-shaped behavior in each of the measurements.11 In particular, the REER depreciated in the early 1990s, reflected in part in the improvement in Bangladesh’s external competitiveness through trade liberalization. The CPI-based REER appreciated in late 1990s, owing to higher inflation in Bangladesh during 1998-99 relative to its partner countries and marked depreciation of the neighboring countries.12

Figure II.2.
Figure II.2.

Bangladesh: Competitiveness Indicators, 1989-2001

Citation: IMF Staff Country Reports 2002, 114; 10.5089/9781451804096.002.A002

Figure II.3.
Figure II.3.

Bangladesh: REER based on Unit Labor Costs, 1989-2001

Citation: IMF Staff Country Reports 2002, 114; 10.5089/9781451804096.002.A002

13. Altogether these calculations do not suggest that the exchange rate in Bangladesh is grossly misaligned. However, the widening current account deficit (excluding capital grants) to GDP ratio, a weakening capital account, and declining net international reserves in the presence of increasing administrative measures all point to some erosion in competitiveness and business confidence since June 2000.

14. Moreover, indications are that the cost of doing business in Bangladesh, based on the 2001 Index of Economic Freedom,13 is high compared with most countries worldwide and has significantly impaired the competitiveness of firms.14

C. Policy Alternatives

15. The above discussion indicates that the authorities’ adherence to the current exchange rate regime represents a costly way to keep inflation low. With continued public sector deficits being financed by domestic borrowing, the achievements on inflation have come at the cost of a declining level of international reserves and increased recourse to administrative controls to support the regime. A lower reserve position has substantially reduced the authorities’ ability to defend the peg and render the country more vulnerable to external shocks.

16. In such an environment, adopting a more flexible exchange rate policy would seem to have a number of advantages. In particular it would: (i) depoliticize the determination of the exchange rate and ensure quick adjustment of the exchange rate to market developments; (ii) provide a role for monetary policy in macroeconomic management and enhance the ability of the authorities to address external shocks in a timely manner; (iii) provide appropriate signals for the generation and allocation of savings and the conduct of monetary policy; and (iv) stem the loss of international reserves, thereby reducing the need to rely on distortions to address balance of payments problems.

17. Bangladesh’s low export diversification also suggests advantages in shifting to greater flexibility in its exchange rate system. As exports are concentrated heavily on ready-made garments and a few primary commodities, such as cotton and jute, the country is vulnerable to terms-of-trade shocks in the context of a pegged exchange rate regime.15 Greater flexibility would also help Bangladesh face better the scheduled loss of preferential access of ready-made garment exports to the United States, Canada, and the European Union by end-2004 under the WTO agreements, and the expected heightened competition in textiles and clothing following the entry of China into the WTO.

18. There are several prerequisites to adopting a more flexible exchange rate system in order to fully reap the benefits of the new regime as a means to enhance macroeconomic management. To minimize exchange rate volatility, the move to a greater flexibility would have to be part of a comprehensive and credible stabilization effort—including, first and foremost, a tightening of fiscal policy and the imposition of hard budget constraints on enterprises. The vulnerability of financial intermediaries to large changes in the exchange rate would have to be reduced through measures to strengthen the banking sector, including limiting banks’ foreign exchange and external borrowing, establishing and enforcing prudential regulations to limit foreign exchange, interest rate, credit, and liquidity risks, and monitoring capital movements to avoid destabilizing short-term capital flows.

19. Greater flexibility would also require the following supporting changes in monetary management:

  • Strengthening BB’s liquidity forecasting framework to be able to adhere to a monetary program aimed at maintaining low inflation and restoring net international reserves to a comfortable level.

  • Enhancing BB’s ability to conduct open-market operations to control liquidity, while taking steps to develop the secondary market for securities as soon as possible. Open-market operations could be complemented by BB’s standing facilities.

  • Liberalizing all remaining administered domestic interest rates to complement a more flexible exchange rate regime. In this context, the interest rate structure of savings certificates would have to be linked to the interest rate obtained in the primary auctions of securities, and government intervention in the money market would have to be avoided. Primary auctions of government securities should be based on announced volumes on offer.

  • Phasing out the exchange restrictions in order to deepen the liquidity of the foreign exchange market.

  • Providing BB with independence to conduct of monetary and exchange rate policies free of political interferences.

D. Conclusions

20. In recent years, the sporadic adjustments in the exchange rate in the face of expansionary financial policies have resulted in a gradual, and persistent erosion of international reserves. To slow the reserve losses, the authorities resorted to exchange and trade restrictions and other distortionary measures. A move to a more flexible exchange rate arrangement would help mitigate pressures on the balance of payments and reduce external vulnerability. To support a new regime, the government will need to remove existing exchange and trade restrictions, adopt a tight fiscal and monetary program, and liberalize interest rates in a well-timed and sequenced approach, along with structural reforms in a number of key areas, including banking, SOEs, trade and export diversification.

1

The main contributors to this chapter were Mr. Raj Nallari (ext. 35881) and Ms. Yan Sun (ext. 35371).

2

Article 22 of the Bangladesh Bank Order of 1972 empowers BB to deal with authorized dealers at the buying and selling rates, but the responsibility for setting the exchange rates is with the Ministry of Finance.

3

A parallel market also exists; there has been a small premium since August 2000, which declined subsequently after recent devaluations.

4

Including: (i) requirement for advance payments for imports of certain goods and services; (ii) restrictions on convertibility and transferability of current proceeds from nonresident taka accounts; (iii) limits on travel, education, and medical expenses abroad; and (v) prohibition on payments for other invisibles.

5

In Bangladesh, the letters of credit are normal short-term facilities for import payments. As Bangladesh accepted the obligations under Article VIII, Sections 2, 3 and 4 in March 1994 to maintain full convertibility of the current account, this margin requirement constitutes a restriction under Article VII, Section 2(a) because it increases the price of making import payment (current transactions).

6

On February 1, 2002, in response to an increase in rice and wheat prices following a decline in grain production, the authorities reduced the margin requirements on letters of credit for imports of rice and wheat from 100 percent to 25 percent.

7

According to the Fund’s index of trade restrictiveness, Bangladesh is rated at 8 on a scale of 1 to 10, with 10 being the most restrictive. In a regional context, Bangladesh has the same trade restrictiveness as that of India, but it remains more restrictive than in Malaysia, Nepal, Pakistan, South Korea, Sri Lanka, and Thailand.

8

For discussions on advantages and disadvantages of various competitiveness indicators, see Maciejewski, Edouard B., “Real” Effective Exchange Rate Indices, IMF Staff Papers, Vol. 30,491–541 (September 1983); Marsh, Ian W., and Stephen P. Tokarick, Competitiveness Indicators: A Theoretical and Empirical Assessment, International Monetary Fund, Working Paper 29 (March 1994); and Zanello, Alessandro, and Dominique Desruelle, A Primer on the IMF’s Information Notice System, International Monetary Fund, Working Paper 71 (May 1997).

9

The ULC-based measures take into consideration the wage rates in the economy and in the manufacturing sector in particular, using both the simple average wage and weighted average wages in Bangladesh based on the share of each industry in total output.

10

The standard INS weights are based on: manufacturing trade (MT); primary commodity trade (PCT); bilateral manufacturing imports (BMI); bilateral manufacturing exports (BME); and third market competition (TMC).

11

The decrease (increase) of REER implies a depreciation (appreciation).

12

A11 Bangladesh’s competitors have adopted more flexible exchange rate regimes and have adjusted more quickly than Bangladesh to rapidly changing external developments.

13

Published by the Heritage Foundation, U.S.A.

14

The index, which takes into account the state of financial intermediation and infrastructure and governance problems, was calculated for 155 countries and Bangladesh ranked 132nd among these countries.

15

According to the Gini-Hirschman indices of export commodity diversification and export geographic diversification, the degree of export concentration in Bangladesh became the highest in the last decade among its major competitors (China, India, Indonesia, Pakistan, Sri Lanka, and Thailand).

Bangladesh: Selected Issues and Statistical Appendix
Author: International Monetary Fund