1st PRI Quarterly Policy Briefs

PRI Quarterly Policy Briefs on Bangladesh Economy
June 2012
Policy Research Institute of Bangladesh (PRI)
Department for International Development (DFID)
June 2012
Contents
Summary .................................................................................................................................. iv I. FY13 Budget and Its Challenges ................................................................................... 1 Introduction ..................................................................................................................1 Global economic outlook................................................................................................1 The New Budget.............................................................................................................3 Key Recommendations ...................................................................................................6 II. Is Bangladesh Banks Monetary Policy Stance Working? ............................................ 8 Background ...................................................................................................................8 Execution of Monetary Policy in Recent Years ...............................................................8 Fiscal and Monetary Policy Coordination.......................................................................9 Are Monetary Developments Compatible with IMF Performance Criteria and Benchmarks? ............................................................................................................... 10 Is the Tightened Monetary Policy Working?................................................................. 11 Future Challenges and Recommendations for Monetary Management....................... 11 III. Explaining Inflation in Bangladesh ............................................................................ 13 Background ................................................................................................................. 13 The Policy Debate........................................................................................................ 13 Quantitative Analysis................................................................................................... 13 Summarizing the Key Empirical Results ....................................................................... 16 Implications for Policies ............................................................................................... 16 Agenda for Further Research ....................................................................................... 16 IV. Is Trade Policy Losing Direction? ................................................................................ 17 Background ................................................................................................................. 17 Launch of DTIS and Impending Trade Policy Review ................................................... 17 Global Economic Environment and Outlook for 2013 .................................................. 17 Evolution of Trade Policy in Bangladesh ...................................................................... 18 Budget 2013 and Tariff Adjustments ........................................................................... 19 Trade Policy Losing Direction ...................................................................................... 20 Summarizing the Key findings ..................................................................................... 21 Policy Recommendations ............................................................................................ 21
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June 2012
List of Tables
Table 1.1: Overview of the World Economic Outlook Projections ........................................ 1 Table 1.2: Fiscal Outturn (BDT in billions) .............................................................................. 2 Table 1.5: Sectoral Allocation of Government Expenditure .................................................. 6 Table 1.6: NBR Tax Revenue Performance.............................................................................. 6 Table 2.1: Monetary Targets for End June 2012 ................................................................... 10 Table 4.1: Outlook of Global Output and Trade ................................................................... 17 Table 4.2: Progress in tariff rationalization FY01-13 ........................................................... 18 Table 4.3: Average Nominal Protection Rate, Dispersion, Maximum and General............ 19
List of Figures
Figure 1.1: Remittance (Million USD) ...................................................................................... 2 Figure 1.2: Foreign Aid Flows .................................................................................................. 2 Figure 1.3: Total subsidy and sectoral allocation................................................................... 2 Figure 1.4: Export to EU; Growth............................................................................................. 4 Figure 1.5: Planned and Actual Public Investment ................................................................ 4 Figure 1.6: Trend in ADP Implementation .............................................................................. 4 Figure 1.7: SUBSIDY-GDP ratio................................................................................................ 5 Figure 2.1: Monetary Policy Targets Vs Actual, in Recent Years ........................................... 8 Figure 2.2: Advance to Deposit Ratio (%) ............................................................................... 8 Figure 2.3: Point to Point Inflation.......................................................................................... 9 Figure 2.4: Exchange Rate ....................................................................................................... 9 Figure 2.5: Repo Rate and CRR ................................................................................................ 9 Figure 2.6: Private and Public Sector Development ............................................................ 10 Figure 2.7: Distribution of Domestic Credit Flow................................................................. 10 Figure 2.8: Share of Public Sector Credit in Total Domestic Credit Stock ........................... 10 Figure 2.9: Crude oil price in Dubai ($/bbl)........................................................................... 11 Figure 2.10: Domestic Credit Development ......................................................................... 11 Figure 3.1: Recent Bangladesh Inflation, point to point...................................................... 13 Figure 4.1: Average Nominal Protection Trends .................................................................. 19 Figure 4.2: NPR trends and emergence of para-tariffs ........................................................ 20 Figure 4.3: Average NPR by Import Categories .................................................................... 20
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June 2012
Summary
FY13 Budget and its Challenges
The budget for Fiscal year 2013 (FY13) has been announced against the backdrop of mixed performance in the preceding year in terms of macroeconomic and fiscal management. In FY12, the global economy has been undergoing new and tougher challenges with the unfolding Euro Zone Debt Crisis and the aftershocks of the Financial Crisis of 2008-09. Bangladesh has been significantly impacted through the trade channel but overall has fared reasonably well with real GDP growth at 6.3%. A surge in subsidy payments (primarily for fuel, electricity and agriculture), a shortfall in aid utilization in the first half of FY12, fragile balance of payment situation, and excessive borrowing by the government from the banking system complicated fiscal management and contributed to stagnation of domestic investment. Healthy remittance inflows helped contain balance of payments (BOP) pressures and the stellar performance in terms of revenue collection helped fiscal management. The growth target (7.2% in real terms) in Budget FY13 seems overly optimistic under the current global economic environment and stagnant level of domestic investment. Its realization will require double-digits manufacturing sector growth, which is unlikely to materialize given the depressed outlook for exports to the EU and the USA which account for more than 80% of Bangladeshi exports. Faster ADP utilization and limiting subsidies to the budgeted levels will remain as major challenges for fiscal management in Budget FY13. Price adjustments for fuel and electricity, in the context of a comprehensive medium-term subsidy reduction strategy and with extensive public discussion to build political consensus, will the appropriate way to proceed. The revenue target is ambitious, but attainable, if efforts to broaden the tax net through modernization and strengthening of tax administration are sustained. The thrust on VAT and income tax is appropriate and given Bangladeshs relatively low VAT and income tax productivity, there is enormous scope for higher revenue growth. On the expenditure side, Awami League governments traditional thrust on social sectors and safety net programs for poverty alleviation has been maintained in FY13 budget. The top three recipients of budgetary allocations are education, agriculture, and local government and rural development. Social security and welfare, power and energy, and health sectors also received high priority.
Is Bangladesh Banks Monetary Policy Stance Working?
Bangladesh Bank (BB) generally recognizes the imperative for prudent monetary policy and accordingly establishes quantitative targets for key monetary aggregates. However, in recent years actual implementation fell short of the targets as monetary policy was accommodative to meet the growing demand of various sectors. Most monetary targets were exceeded by wide margins every year leading to build up of inflationary pressures, asset price bubbles and balance of payments pressures. Taking these developments into account, BBs Monetary Policy Statement (MPS) of January 2012 stated to pursue a restrained monetary growth path consistent with curbing inflationary and external sector pressures.. Monetary tightening measures which were initiated since March 2011 by BB through corrective measures like increasing the policy rates, removing the cap on lending rates, and allowing the exchange rate to be determined by market forces. At a time when monetary policy started to become tighter due to BB measures, government borrowing from the banking system increased sharply, exceeding the fullyear borrowing target within 5 months after the beginning of the fiscal year. This unsynchronized fiscal-monetary policy mix crowded out private sector credit up to
iv
PRI Quarterly Policy Briefs on Bangladesh Economy November 2011 and led to tensions in the money market. The situation however changed markedly since December 2011, due to corrective measures on the fiscal side which helped restrain public sector borrowing from the banking system.
June 2012
The tightening measures helped contain the expansion of monetary aggregates: growth of broad money decelerated to 17% by April 2012 from 21.3% in FY11; private sector credit growth declined to 18.2% over the same period compared with 25.8% in FY11. As of endApril 2012, monetary developments were broadly in line with BBs monetary targets for end-June 2012 as stated in MPS for January to June 2012 and also with the monetary targets set under the IMF ECF program. Tighter monetary policy has helped contain inflation and stabilize the exchange rate in the second half of FY12. Achieving the inflation target of 7.5% set in FY13 would be challenging but attainable. It will require continued monetary restraint, and favorable domestic and external supply/price developments. On its part, BB should focus primarily on achieving the quantitative targets and not on policy instruments like interest rates. Maintaining the right mix between fiscal and monetary policies in the new fiscal year and beyond will be important for the success of monetary policy.
Explaining inflation in Bangladesh
Bangladesh has experienced frequent inflationary episodes since independence. Most recently inflation has been increasing since June 2009, rising from an average of 2.3% during 2008/09 to a peak of 12% in September 2011. The inflation rate declined to 9.9% in April 2012. The rapid rate of inflation has become a major economic and social problem. Quantitative time series analysis using data from 1981-2011 shows that the rate of growth of money supply is a major determinant of inflation over the long term. International food prices have short-term effects on inflation but are not a factor underlying long-term inflation. Quantitative results show that the inflation determines nominal exchange rate depreciation and not the other way round. The causality from inflation to exchange rate is a very powerful and fundamental result for policy making. The main message is that if we want to have a stable exchange rate over the longer term, we need to keep the rate of inflation low and closely aligned to international inflation. GDP growth and inflation are negatively correlated over the longer term. So, there is no evidence that higher rate of GDP growth requires higher inflation (beyond a threshold level of 4-5%). Fiscal policy will need to be consistent with the targets of prudent monetary management. Accommodating sustained international price increases in fuel prices through budgetary subsidies that is financed through borrowing from the Bangladesh Bank is inconsistent with sound monetary management and inflation control.
Is Trade Policy Losing Direction?
Trade liberalization is stalled; but no clear direction has emerged since the dawn of the new century. The structure of incentives underlying the trade regime favors production of domestic import substitutes over exports, creating an inherent anti-export bias. Although the RMG sector is free from the shackles of high tariffs on inputs or outputs, other exports or potential exports are not. Tariff and para-tariff proposals in FY2013 budget signals continuation of the recent trend of rising average nominal protection and wider dispersion of the tariff structure. While para-tariffs have been emerging as significant component of nominal tariffs, for the first time, its share has exceeded average custom duty. While nominal tariffs on inputs (basic raw materials and intermediate goods) continue to fall, those on final consumer goods trend upwards, thus widening the wedge between
PRI Quarterly Policy Briefs on Bangladesh Economy average tariffs on outputs and inputs, augmenting tariff escalation at the last stage of processing.
June 2012
FY2013 budget proposals on trade policy do not appear to be inconformity with the articulation of the kind of trade policy needed to improve export performance and support the high growth needed to reach middle income status by 2021. Policy recommendations made in the policy brief include: (i) changing the trade policy stance to support growth; (ii) putting back the trade liberalization agenda/program back on track, which will entail reduction of both the average nominal tariff rate and the dispersion of the tariff structure since tariff escalation breeds inefficiency and undermine competitiveness of firms in the long run; (iii) scaling down of top tariff rates along with para-tariffs to give domestic customers relief; and (iv) balancing the interests of both producers and consumers in trade policy formulation.
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June 2012
World Trade Volume (goods and services) Commodity Prices (USD) (% change) Oil Nonfuel (Commodity Non-Fuel Price Index )
I.
FY13 Budget and Its Challenges

Ahsan Mansur
-10.5
12.9
5.8
4.0
5.6
Introduction
The budget for FY13 has been announced by the Honorable Finance Minister on June 7, 2012, against the backdrop of mixed performance in the preceding year in terms of macroeconomic and fiscal management. Global economic outlook and Bangladeshs export prospects have also deteriorated markedly because of further deepening of the Euro-Zone Debt Crisis. The budget would be last full-year budget for the current government before facing elections and it has been unveiled in an environment of intensifying political uncertainty. The budget targets an acceleration of real GDP growth to 7.2% and a sharp deceleration of inflation to 7.5%, while consolidating Governments efforts towards improved macroeconomic stability and further alleviation of poverty. This policy note analyzes the emerging challenges in implementing the budget taking into account issues that emerged in implementing the FY12 budget. More specifically, following a brief review of the background against which the budget has been unveiled, it focuses on: whether the growth target will be achievable and its implications for fiscal management. This note is also an exercise in pointing out the major issues/factors that must be handled with vigilance in order to achieve the goals that have been set out in the new budget. Issues relating to the inflation target and the underlying policies have been covered in the second policy brief.
-36.3 -15.7
27.9 26.3
31.6 17.8
10.3 -10.3
-4.11 -2.1
12
GDP Growth (%)
China
India
Bangladesh
Vietnam
10 8 6 4 2 0 2009 2010 2011 2012
Source: World Economic Outlook Database April 2012 Edition
Real GDP growth in most major regions of the world is expected to be lower in 2012 in comparison to 2011, with the Euro Zone expected to grow negatively. The slowdown in GDP growth in Asia and the developing world is being partly caused by mellowing of the growth spurt of large economies like China and India. A review of Bangladeshs macroeconomic performance in FY12 shows that the estimated real GDP growth rate of 6.3%, although lower than the 7% target set earlier, is respectable. The moderate slowdown in growthwhich is broadly in line with the predictions of professional bodiesis attributable to the slowdown in exports and the dampening of general investors sentiment which led to a deceleration in the performance of the manufacturing and services sectors as well as private investment. However, the effect was cushioned to a certain extent due domestic demand, supported by continued strong inflow of remittances which helped sustain domestic economic activity and revenue performance. There has also been a decline in agriculture performance which is a bit surprising, but perhaps owing to the decline in agricultural products prices in the global market. Even though Bangladesh did not perform as well as it had set out to in terms of GDP growth, its performance has been better than its Asian counterparts like India, China etc, who have experienced a more pronounced decline in growth this year in comparison to the last. While Bangladesh has been affected primarily through the export channel, the comparator countries have been affected through trade as well as financial channels like FDI and portfolio investment.
Global economic outlook

Bangladesh has been somewhat sheltered from the full brunt of the global economic recession of 2008-09 due its limited international financial integration. The Euro Zone Debt Crisis however is growing grimmer and its shockwaves are already being felt across the world through various channels. The Industrial Worldthe destination of Bangladeshi exports--has entered into an extended phase of slow growth or recession induced by the Euro Zone debt crisis. Table 1.1: Overview of the World Economic Outlook Projections
IMF GDP at constant prices (% change) World Output Advanced Economics Euro Zone Emerging and Developing Economics Developing Asia Continue.... 2009 2010 2011 2012 2013 P
-0.6 -3.6 -4.3 2.8 7.1
5.2 3.2 1.9 7.5 9.7
3.9 1.6 1.4 6.2 7.8
3.5 1.4 -0.32 5.7 7.3
4.1 2.0 0.9 6.1 7.9
PRI Quarterly Policy Briefs on Bangladesh Economy Figure 1.1: Remittance (Million USD)
1400 1200 1000 800 600 400 200 0 Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May FY 12 FY 11 FY 09
June 2012 This increase in fund inflows also helped contain government domestic borrowing from the banking system over the corresponding period. Much better utilization of foreign aid in the second half of FY12 enabled the government to limit the level of bank financing well below the target set under the IMF program and the revised budget. The target for domestic borrowing from the banking system in FY13which has been set at Tk. 230 billion would only be attainable if the authorities once again succeed in utilizing external financing along the lines targeted in the budget. Table 1.2: Fiscal Outturn (BDT in billions)
Total Revenue NBR Tax Other Revenue Total Expenditure Current Expenditure Of Which Interest Payments Subsidy Transfer Payments ADP Expenditure Others Expenditures (Including Block Allocations) Overall Balance (% of GDP) FY11 929.9 790.92 160.95 1283 796 157 92.69 222.14 390 97 -353.1 -4.20% FY12 (B) 1183.85 918 225.85 1636 879 180 92.88 253.11 460 297 -452.15 -4.92% FY12 (RB) 1148.85 923.7 225.15 1612.13 918.23 198 122.63 253.9 410.8 283.1 -463.28 -5.06% FY13 (B) 1396.7 1122.59 274.11 1917.4 979.02 233.02 144.45 241.82 550 15.94 -520.7 -5.00%
Source: Bangladesh Bank
Remittance inflows provided the much needed support from the demand side: As previously mentioned, inflow of workers remittances has been a saving grace for Bangladesh in FY12 with the country possibly recoding the highest growth in remittance inflows in the world. Initial worries that there could be a massive reflow of Bangladeshis from abroad due to the Arab Spring as well as global economic slowdown did not materialize at all. It is expected that so long the crude oil prices remain around $70-$80 per barrel, much of the investment programs in the GCC region will continue to be implemented along with strong demand for expatriate workers. The number of workers going abroad has rebounded strongly in FY12 and the outlook remains favorable therefore providing a safety net for the external current account and foreign exchange balances in the upcoming fiscal year. Figure 1.2: Foreign Aid Flows
Total Aid 1500
$1,237 $989 $846 $675 $302 $614 $323 $485 $419 $79
Source: Ministry of Finance
Net Aid
$1,300 $916
in million US$
1000 500 0
Jul-Nov
While Bangladesh Bank has averted a balance of payments crisis in FY11 by allowing the domestic lending rates and the exchange rate freely determined by market forces, the balance of payments situation continued to remain fragile in FY12. The external trade account deficit grew by 13% between July-March FY12 in comparison to the corresponding period in the previous fiscal year. Despite the buoyant inflow of remittances (by 13%), the current account balance declined by 22% to US$ 456 million during the first 9 months of FY12. The level of foreign exchange reserves declined further by US$ 0.5 billion to below the psychologically important $10 billion level at the moment. Figure 1.3: Total subsidy and sectoral allocation
350 300 250 200 150 100 50 0 FY 07 FY 08 FY 09 FY 10 FY 11 FY 12 FY 13B
Total Subsidy Fuel (BPC) Agriculture Electricity (PDB)
Source: Medium-term Budget Framework (MTBF)
Jul-Nov
Dec-May
Dec-May
Jul-Nov
FY10
FY11
FY12
The foreign aid flow has been on a declining trend when we compare the data for FY10 and FY11 (July-May). In FY12, especially based on data for July- November, it seemed like the declining trend would continue. However, aid utilization/disbursements improved markedly since December 2011 and continued on an upward trend for the remainder of the fiscal year (Figure 1.2). Total and net aid disbursements in FY12 (July-May) was 17.7% and 23.2% higher, respectively, over the corresponding period in FY11.
Dec-May
PRI Quarterly Policy Briefs on Bangladesh Economy Fiscal management got complicated by a surge in subsidy payments and a shortfall in aid utilization. The subsidy budget was exceeded by a substantial margin owing to increased funds required for the agriculture, fuel (BPC) and electricity (PDB) sectors which accounted for the over 70% of the total subsidy in the revised budget. The rising price of fuel in the international market and a markedly higher volume of imports associated with the liquid fuel based, together with delays in adjusting domestic administered prices of fuel and electricity, led to a surge in budgetary subsidies in FY12. The resulting increase in government borrowing from the banking system exceeded the annual target by December 2011, created a liquidity crunch in the money market by crowding out the private sector. While the government faced problems in its expenditure management, its revenue performance exceeded expectations and helped fiscal management. The NBR revenue surplus is expected to be about BDT 8.4 billion in FY12, despite a marked slowdown in non-oil imports and associated import stage taxes. As is the case every year, actual ADP implementation is expected to fall shy of its target in FY12 by about 10.87% of the original budget. This development together with better than budgeted revenue performance, helped contain the overall fiscal deficit including grants to about 4% of GDP, below the original budget target. Some corrective measures to contain subsidy through several rounds of petroleum and electricity prices adjustments played a crucial role in improving fiscal management in the second half of FY12. As a result, government borrowing from the banking system which surged to BDT [180] billion at end-November, remained stable at similar levels by end-April 2012. This level of fiscal deficit and debt is consistent with fiscal sustainability. However, the distribution of financing still remains a problem, as external financing (net) has been stagnant or declined in dollar terms in recent years due to governments inability to implement foreign funded ADP projects.
June 2012 government had two basic options: (i) to go for an election oriented populist budget with much higher spending and overall deficit; or (ii) strive for maintaining macroeconomic stability through a prudent fiscal stance with fiscal deficit limited to 5% of GDP. We believe that the authorities have opted for the second option in order to restore macroeconomic stability by containing inflation, easing money market tensions by avoiding crowding out of the private sector, and achieving a respectable growth rate even if it may not reach the ambitious target of 7.2%. The budget deficit (including grants) for FY13 at 4.5% indicates that the fiscal stance will remain more or less the same as in most other years. Nevertheless, we believe that the government will face enormous challenges in implementing the budget and achieving the macroeconomic objectives in several areas including achieving growth and inflation objectives; containing the surging subsidy bill; implementing the donor-funded projects included in the ADP; achieving the ambitious revenue target; and alleviating poverty through better management and targeting of social spending.
FY10 Sectors Agriculture Industry of which Manufacturing Services GDP Agriculture Industry of which Manufacturing Services FY11 FY12 (P) FY13 (SFYP) 4.4 9.9 10.1 7.1 7.2 19.3 31.3 19.0 49.4
5.2 6.5 6.5 6.5 6.1 20.5 29.9 17.9 49.7
5.1 8.2
Growth Rate (%) 2.5 9.5
9.4 9.8 6.2 6.1 6.7 6.3 Share as % of GDP 20.3 20.0 29.9 30.4 17.9 49.8 18.4 49.6
Source: Sixth Five-Year Plan (SFYP)
The New Budget

Budget FY13 is the fourth budget of present government and the penultimate one before it goes for re-election. This budget therefore not only has economic ramifications for the country, the government also has a lot riding on it to meet their political aspirations. This budget is by far the biggest budget in the countrys history in both absolute and relative terms, respectively, at BDT 1.9 trillion or 18.4% of GDP. While many analysts have characterized the size of the budget as politically driven, we believe that an 18% increase in spending may not be considered expansionary given that the nominal GDP growth rate would be more than 15%. The deficit level of 4.5% of GDP (including grants) is very much in line with past budgets and consistent with debt sustainability. At this crossroad with election ahead, the
We consider the growth target as overly optimistic under the current global economic environment and stagnant level of domestic investment. The budget envisages a strong rebound in economic growth to 7.2% despite significant downside risks and a sharp reduction in inflation to 7.5% through better co-ordination in fiscal and monetary policy. It also aims to bring forth more equitable distribution in income and thus reduce poverty level through more equitable growth and higher social sector spending. In the remainder of this policy brief we present the challenges that the authorities will face in achieving the growth target and in implementing the budget during the course of the year. Double-digit manufacturing sector expansion is a prerequisite for higher growth. The analysis presented in the Sixth Five Year Plan (SFYP) indicates that even with a sharp rebound in agriculture output, achieving 7.2% real GDP growth will require the manufacturing sector to grow by more than 10%. Given that the manufacturing sector is
PRI Quarterly Policy Briefs on Bangladesh Economy heavily dependent on the export sector which is facing a slowdown due to the EU debt crisis, such a strong performance in the manufacturing sector is unlikely to materialize. Furthermore, the investment level (both public and private sector) required for achieving or sustaining growth rates in excess of 7% is unlikely to materialize in FY13, given the shortfall in investment experience in recent years. Figure 1.4: Export to EU; Growth
Value In EUROS (million) 60.0 50.0 40.0 30.0 20.0 10.0 0.0 -10.0 -20.0
Apr-Jun Jul-Sep Jul-Sep Jan-Mar Jan-Mar Oct- Dec Oct- Dec
June 2012 Figure 1.5: Planned and Actual Public Investment

8
% of GDP
6 4 2 0 FY10 SFYP Public Investment FY11 FY12 FY13(e)
Qnty_In_100KG 52.4
Actual Public Investment
24 20.7 16.7 19.5 1.9 -13.0

Apr-Jun Apr-Jun Jul-Sep Oct- Dec Jan-Mar
15.9 7.3 -5.5 -13

Oct- Dec Jan-feb Jul-Sep
% of GDP
22 20 18 16 FY10 SFYP Private Investment FY11 FY12 FY13(e)
Actual Private Investment
FY 09
FY 10
FY 11
FY 12
Source: Sixth Five-Year Plan (SFYP)
Despite resilience, Bangladesh cannot avoid a fall in exports to the industrial countries. The export sector of the country has performed quite resiliently even in the face of the global recession of recent years. While the global trade in value terms declined by more than 30% at its bottom, Bangladeshs export decline was limited to 11.7% at its worst. In line with the previous episode (FY 08-09), currently there are signs of a significant slowdown in global and Bangladesh exports. This situation will probably deteriorate further in next few months. Unlike the past episode (global economic crisis) this time the economic slump in the Euro Zone is likely to be much more protracted. The recovery process this time will probably be more prolonged taking the form of U instead of the V shape as it was in 2008-09. As the Euro Zone receives the largest amount of Bangladeshs exports slowdowns in that region could have quite an adverse effect on our exports. Both public and private sector investment are running well below their desired/required levels. Investmentpublic and private- is usually supposed to be the growth trigger for most economies and Bangladesh is no exception. Increasing the Investment/GDP ratio to much higher levels was always considered to be critically important for achieving growth rates ranging from 7% to 8% under the SFYP. After completion of 2 years under the SFYP, the investment level still remains at about 25%, where it has been hovering for many years, compared with the target of 29% of GDP by FY13 under the SFYP.
The implicit target for investment set out in the FY13 budget seems even more unattainable for several reasons like the current unstable political environment, labor unrests and shutdowns in the RMG export sector, inadequate energy and infrastructural support to name a few. All these factors tend to act as a disincentive for investors and thereby will most probably lead to decline in investment flows. In FY12, actual public investment fell short of the SFYP target for public investment. The targeted increase in public investment in FY13 also falls short of the SFYP target. The situation is much worse with private sector investment. The shortfall in private investment in FY12 was about 2% of GDP. Private sector investment would need to reach 23% of GDP in FY13 from about 18% level in FY12. A formidable task indeed! Figure 1.6: Trend in ADP Implementation
6.00% 5.00% 4.00%
ADP/GDP ratio
(%)
3.00% 2.00% 1.00% 0.00%
FY12 RB
FY13 B
FY05
FY06
FY07
FY08
FY09
FY10
FY11

FY 12 FY 13 B RB 1228 189 1037
Source: Medium-Term Budget Framework (MTBF)
June 2012
FY 11 B FY 11 RB FY 12 B No. of ADP projects Increase/decrease Original/Revised ADP budget (BDT in billions) Increase/decrease 916 269 1185 1039
In FY12, if we include the amount deferred to the next year, the amount of budgetary subsidy on an accrual basis would amount to 4.5% of GDP. The subsidy in the power sector has been particularly noticeable as the figure has been revised up by a considerable amount over the budgeted figure: Fiscal costs associated with the power sector strategy far exceeded the original estimates; If unchecked, costs will be much higher in the coming years because more rental power plants will be in operation; and There will be longer than usual delays in implementing the medium and large power plants due to problem in securing finance.
356.8
338.08
460
410
550
-18.72
-50
Source: Planning Commission and Ministry of Finance
ADP utilization has been a common shortcoming of the government in the past and therefore chances are high that the trend will continue in FY13 as well. However, significant gains have been made on two fronts. Because of the large size of the ADP allocation, despite the implementation shortfall, actual growth in ADP spending has been respectable in recent years. The pace of utilization has increased significantly since FY10, compared to earlier years. The result of these two favorable developments is a steady increase in implemented ADP size in relation to GDP in recent years. From the lowest level of close to 3% of GDP in FY 09, the size of ADP is expected to increase by 1.5-2 percentage points to about 5% of GDP in FY13. Nevertheless, there are other problems with the project selection process. There are too many projects under the ADP, constraining adequate funding and thereby limiting the capacity to complete the projects on time. Every year the size of the ADP is reduced significantly through a mid-year review exercise. But a large number of new projects averaging about 200 are added to the revised ADP. Furthermore, 507 projects have been added in FY12 RB without any fund allocation. These issues raise questions regarding both the adequacy of the selection process and quality of projects under the ADP. Figure 1.7: SUBSIDY-GDP ratio
4.00% 3.00% 2.00% 1.00% 0.00%
FY 09 FY 10 FY 11 FY 12B FY 12RB FY 13B
The overall size of energy subsidies has grown rapidly in recent years due to rising import costs and inadequate cost recovery, undermining the fiscal position and overall macroeconomic stability. Notwithstanding significant fuel and electricity prices adjustments over the past year, more upward adjustments in petroleum and electricity prices would be necessary in FY13, given the projected import costs and available budgetary financing. To contain fuel subsidies, the government has planned to move to an automatic adjustment formula by December 2012, which will ensure full pass-through of changes in international prices (an important IMF program benchmark). Implementation of such an automatic adjustment mechanism, if adopted, would help stabilize budgetary subsidy for fuel. Subsidy reduction is a politically sensitive issue. Political consensus and support from the people will be critical for sustainable reduction in subsidies. A carefully prepared subsidy reduction strategy will help create awareness about this issue and engender political support for the cause. It must also be recognized here that a power sector generation plan based on larger gas and coal fired plants is a must for the growth strategy and fiscal sustainability. Without plans for utilizing domestic coal, BOP and fiscal sector vulnerabilities would persist.
3.30% 3.32% 2.28%
350 300 250 200 150 100 50 0
BDT in billions
Total Subsidy
Total Energy Subsidy (PDB & Fuel)
PRI Quarterly Policy Briefs on Bangladesh Economy Table 1.5: Sectoral Allocation of Government Expenditure
Growth in Real terms (%) FY10A Local Government and Rural Development Defense Service Education and Technology Health Social Security and Welfare Power and Energy Agriculture Others FY11 A 15.6 FY12 RB 7.4 As % of Total Expenditure FY13B FY10A FY11A FY12RB FY13B
June 2012 consecutive year through FY12, which gives some confidence to this ambitious target. As in recent years, realization of the NBR revenue target would critically depend on success in maintaining the momentum in revenue generation from income tax and VAT: On the income tax side, a number of important revenue augmenting measures have been adopted, including: higher minimum tax; keeping the exemption level unchanged at Tk. 180,000, despite its reduction in real terms through inflation; broadening the scope of tax withholding, effective operation of the alternative dispute resolution(ADR) mechanism, higher tax rate for exporters, etc. The downside risks relating to the FY13 revenue target primarily originate from the slower expected GDP growth. There is no major change in the VAT regime in FY13. The thrust is primarily on strengthening and modernization of tax administration to enhance efficiency of the VAT system.
15.7
10.1
9.6
10.1
9.5
9.6
37.9 22 19.3 -18.4 32.6 6.1 22.6
14.9 11.3 6.7 6.7 92.1 6.7 -1.9
1.5 -9.2 5.2 20.1 2.8 4.2 47.2 14.3
-2 9.9 6.5 -1.1 11.5 -6.3 18.7 8.9
10.4 18.4 7.2 8 4 12.8 29.6 100
10.9 18.6 7 7.8 7 12.4 26.4 100
9.6 14.8 6.4 8.1 6.3 11.3 33.9 100
8.7 14.9 6.3 7.4 6.4 9.7 37 100
Total Programme 16.3 10.1 Expenditure Source: Ministry of Finance
The thrust on social sectors and safety net programs for poverty alleviation has been maintained. A broad review of budgetary appropriations indicates that the thrust of the budget in FY13 is appropriately on the social sector. The top three recipients of budgetary allocations are for education, agriculture, local government and rural development, social security and welfare, and health. The share of defense spending has been following a declining trend, which is expected to continue in FY13. Allocation to agriculture has declined both in relative and real terms, perhaps due to the subsidy reduction strategy. The power and energy sector is the highest in terms of real growth in expenditure. Such social sector and expenditures on power sector if conducted consistently and properly could lead to substantial changes in both sectors and improve standard of living of the people. Table 1.6: NBR Tax Revenue Performance
FY10 FY11 FY12 FY13(Budget) Growth Rate(As Percentage Change) Total NBR Revenue 18.1 27.8 16.6 21.5 of Which: Income Tax 23.2 32.2 24.2 25.8 Value Added Tax 15.6 29.6 13.9 18.0 Custom Duty 9.8 15.3 6.6 15.0 (% of Total NBR Revenue) 26.4 27.6 28.5 31.4 Income Tax Value Added Tax 38.3 37.5 38.0 36.0 Custom Duty 17.8 16.6 15.0 12.9 Source: Ministry of Finance, Bangladesh
Given Bangladeshs relatively low VAT and income tax productivity, there is potential scope for realizing the target if NBR modernization efforts are continued.
Key Recommendations
Overall, the FY13 budget is ambitious requiring vigilance and perseverance for its effective implementation. Its proper implementation will require focusing on the following issues: The targeted domestic borrowing from the banking system at Tk. 230 billion is already very high, and any shortfall in revenue, domestic non-bank financing through national savings bonds/certificates, and external financing will further increase recourse to bank financing and thereby crowd out the private sector and/or monetization of borrowing undermining growth and inflation objectives. On the expenditure side, limiting the subsidy bill to the budgeted level would require firm actions in the form of price adjustments for petroleum products and electricity. The measures must not be delayed, as was the case last year. The authorities should prepare a comprehensive medium-term subsidy reduction strategy and hold
On the revenue side, the target is ambitious but attainable if efforts to broaden the tax net through modernization and strengthening of tax administration are sustained. The revenue target is ambitious because, except for two years FY08 and FY11, NBR had never recorded such a high target in recent years. Nevertheless, it is also true that NBR has exceeded its budget targets for the 3rd
PRI Quarterly Policy Briefs on Bangladesh Economy public discussions on the strategy to mobilize public support for future cuts in subsidies. Achieving the ambitious revenue target, in the face of slower than projected real economic growth, would entail strengthening tax administration and sustaining the reform process initiated in the VAT and direct tax fronts. Accelerating the pace of foreign-funded project implementation and releasing the counterpart foreign financing would be keys to increasing ADP utilization and reduce pressure on domestic bank financing. Making the positions of Project Directors more attractive by: giving them more authority in implementation and release of funds; rewarding them for good performance; and simultaneously holding them accountable for speedy project implementation. Linking disbursement of Taka counterpart funds to utilization of foreign funds more effectively would encourage project management teams to focus on accelerating disbursement of foreign resources.
June 2012
June 2012 economy. As a result, most monetary targets were exceeded by wide margins every year. Figure 2.1: Monetary Policy Targets Vs Actual, in Recent Years
22.4 24.2 21.3 25.8 16 18.2
II.
Is Bangladesh Banks Monetary Policy Stance Working?

Ahsan Mansur
Background
15.5
16.7
15.2
In order to tackle the growing inflationary pressure and increased balance of payments vulnerability, Bangladesh Bank announced a shift in its monetary policy stance in January 2012. By November 2011, the general inflation reached almost 12%, the highest level since 1998, and government borrowing from the banking system to finance budgetary operations already crossed the borrowing limit established in the budget for the whole year. Increased import payments associated with higher petroleum prices and volume of imports, started to exert pressures on the exchange rate and the level of foreign exchange reserves. Taking these developments into account, Bangladesh Banks Monetary Policy Statement (MPS) of January 2012, stated to pursue a restrained monetary growth path consistent with curbing inflationary and external sector pressures, while ensuring adequate private sector credit to stimulate inclusive growth. Following successive years of significant deviations between the announced MPS stances and their implementation, in the guise of so called accommodative monetary policy, there was a certain amount of skepticism about Bangladesh Banks resolve in pursuing a restrained monetary policy in line with the quantitative monetary targets. There is also widespread realization that BBs recent inability to firmly adhere to its announced MPS quantitative targets have fueled inflation, created asset market bubbles, and weakened Bangladeshs BOP position. This policy brief aims to: determine whether BB is indeed seriously pursuing the intended policy stance announced in the January 2012 MPS; examine the coordination between monetary and fiscal policy to avoid crowding out of the private sector; compare the developments of monetary aggregates and appropriateness of the policy stance with the commitments made under the IMF supported ECF program; and assess the effectiveness of the policy stance in terms of containing inflation, stabilizing the exchange rate and BOP pressures.
16
17
April 2012
17.2
Broad money (M2) growth
Private sector credit growth
FY 10 Target
FY 11 Actual
FY 12
This mismatch between announced policy and actual implementation continued up to March 2011. Although BB increased the Cash Reserve Ratio (CRR) for the first time in May 2010 and the Repo Rate in August 2010, monetary tightening, as reflected through monetary aggregates did not take place due to inadequacy of the measures and lack of strong surveillance on banks. In particular, at times the credit to deposits ratio of commercial banks exceeded the levels considered prudent in part due to inadequate monitoring and surveillance. Figure 2.2: Advance to Deposit Ratio (%) (%)
83 82 81 80 79 78 77 76 75 74
Jun-09
Oct-09
Jun-10
Oct-10
Jun-11
Feb-10
Feb-11
Oct-11
Execution of Monetary Policy in Recent Years

BB generally recognized the imperative for prudent monetary policy and accordingly established quantitative targets for key monetary aggregates in each and every MPS in recent years. However, actual implementation fell well short of the requirement. BB put a cap on the lending rate of commercial banks and did not respond forcefully when monetary aggregates exceeded the intended levels by wide margins. BB characterized this policy stance as accommodative to meet the credit needs of a growing The destabilizing impact of such monetary expansion was visible on both domestic and external fronts. On the domestic front, a sharp rise in inflation and asset prices essentially resulted from excess liquidity in the economy. CPI inflation reached almost 12% in September 2011 on a pointto-point basis which was highest since 1998.
Feb-12
April 2012
PRI Quarterly Policy Briefs on Bangladesh Economy Figure 2.3: Point to Point Inflation (%)
15 10 5 0
Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12
June 2012 Before March 2011 BB never looked like adhering to its monetary policy targets. As the BOP situation become unsustainable with imports growing by more than 40% and a large BOP financing gap was emerging, beginning March 2012, BB started to respond proactively by tightening monetary and demand management policies. In particular: The repo rate has been revised upward for 5 times between March 2011 and January 2012. The Cash Reserve Requirement (CRR) was also increased by 0.5 percentage point to 6% in November 2010. BB was stricter in maintaining credit to deposit ratio of commercial banks within the permissible level this time around and the cap on commercial lending rates was removed except for some strategic sectors. The exchange rate of Taka was also allowed to be freely determined by market forces to stem the run on reserves.
General
Food
Non-Food
12.72 9.15 7.46
Source: BBS
The impact of monetary expansion on asset prices was quite costly for the economy. The liquidity expansion helped create a large bubble in the already overvalued capital market. Real estate prices also experienced an unprecedented surge. On the other hand, significantly higher inflation than Bangladeshs major trading partners reduced competitiveness of domestic products and made imports cheaper in real terms. These developments, coupled with increased domestic demand due to monetary expansion above reasonable level, widened the trade deficit. The resulting balance of payments pressure contributed to a marked depreciation of the Taka, following a long period of relative exchange rate stability. Figure 2.4: Exchange Rate
60
Taka per USD
These tightening measures helped contain the expansion of monetary aggregates close to the monetary targets of BB for end-June 2012. If monetary targets are achieved for FY12, which is a realistic possibility, this will be for the first time after failures in achieving so in two consecutive years with accommodative monetary stance.
65 70 75 80 85
Oct-11 FY 08 FY 09 FY 10 FY 11 Jul-11 Aug-11 Sep-11 Nov-11 Dec-11 Jan-12
Fiscal and Monetary Policy Coordination

81.9
May-12 May-12 Mar-12 Apr-12
83.5
Feb-12
Against this backdrop, the need for monetary tightening became pressing by end-February 2011. Although somewhat late, BB took a series of monetary tightening measures and private sector credit growth started declining beginning in the last quarter of FY11. Figure 2.5: Repo Rate and CRR
Repo Rate 8.0 7.0 6.0 5.0 4.0
Jan-10 Mar-10 May-10 Jul-10 Nov-10 Jan-11 Mar-11 Sep-10
Right policy mix is a precondition for the success of macroeconomic management. Bangladesh has had a long tradition of good fiscal and public debt management. Fiscal deficit has generally been limited at or below 5% of GDP and external financing primarily limited to concessional borrowing from multilateral and bilateral official sources. As noted in the Policy Brief on FY13 Budget, fiscal management in FY12 was complicated by two emerging problems associated with: a surge in subsidy payments in the first half of FY12 due to delays in implementing necessary price adjustments; and a precipitous fall in foreign financing in part due to slower implementation of foreign funded projects and lower disbursement of program or budget financing. At a time when monetary policy started to become tighter due to BB measures described above, government borrowing from the banking system surged due to the combined effect of the sharp increase in subsidy payments and the collapse of foreign financing (net). At its worst points, more than 60% of domestic credit expansion was diverted to budget financing in June 2012, which further increased to 100% in July. Because of this lack of fiscal and monetary policy coordination, the monetary tightening measure contributed to a significant level of crowding out of the private sector in the first half of FY12 and created the
CRR
Loose monetary target implementation
Tighter monetary target implementation

May-11 Jul-11 Nov-11 Jan-12 Mar-12 Sep-11
PRI Quarterly Policy Briefs on Bangladesh Economy perception that monetary policy was excessively tight. Increased public sector borrowing sharply reduced the space for private sector borrowing. Much of the private sector credit contraction was because of increased public sector borrowing, while the slowdown in the overall domestic credit growth was relatively modest. Figure 2.6: Private and Public Sector Development
60 50 40 30 20 10 0 -10
Jan-10 Mar-10 May-10 Jul-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Nov-11 Sep-10 Sep-11
June 2012 of the fiscal year when borrowing requirement generally goes up--public sector borrowing was marginally negative. The share of public sector credit in total credit, which increased from less than 19% in December 2010 to 23.4% in November 2011, came down to 21.8% by April 2012. This indeed has been a remarkable turnaround. Figure 2.8: Share of Public Sector Credit in Total Domestic Credit Stock (%)
30 28 26 24 22 20
Jan-12 Mar-12
54.39 32.38 21.04 18.22
Nov-11, 23.4 Apr-12, 21.8 Dec-10, 18.7

Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Oct-11 Apr-12
18
Domestic Credit Private Sector Credit
Public Sector Credit
It is interesting to note that public sector borrowing was already on an upward trend since April 2010. However, initially this did not lead to crowding out because in initial months public sector borrowing was relatively modest and monetary tightening was yet to be taken. As total domestic credit kept on growing from about 13% in January-April 2010 to the peak level of almost 30% March 2011, there was scope for accommodating both private and public sector credit growth. Crowding out particularly took place during April to November 2011. During this period 43% of domestic credit flow went to the public sector, which is much higher than the usual 20% share of this sector. This period can be characterized as unsynchronized fiscal-monetary policy mix. Figure 2.7: Distribution of Domestic Credit Flow
Are Monetary Developments Compatible with IMF Performance Criteria and Benchmarks?
On the backdrop of rising BOP pressures and macroeconomic tensions, Bangladesh has adopted a stabilization program which is being supported by the IMF under its Extended Credit Facilities (ECF). The ECF will provide financial support in the amount of SDR 640 million over a three year period. First tranche under this arrangement was disbursed in last April. Under this program, Bangladesh Government has established certain quantitative monetary targets, consistent with its inflation and BOP objectives, some of which are performance criteria and some are quantitative benchmarks under the program. Further disbursements are conditional upon achieving these targets. Table 2.1: Monetary Targets for End June 2012
ECF Benchmark/ Performance Criteria Reserve money (eop stock in billions of Taka); BM NDA of BB (eop stock in billions of Taka); PC Net credit to the central government (NCCG) by the banking system (ceiling, cumulative change from the beginning of the fiscal year, in billions of taka); PC 1014 550 Actual Apr12 917 418*
MPS 1007
252
165.6
* Figure of end March. PC=Performance Criteria; and BM= Benchmark
The situation changed markedly since December 2011, due to corrective measures on the fiscal side, primarily through containment of subsidies. During December-April 2012--for a full 5-month period and mostly in the second half
Bangladesh is firmly on track towards achieving the monetary targets set under the IMF ECF program. Monetary targets stated in the MPS for January-June 2012 were also broadly in line with the ECF. The ECF arrangement has a ceiling on reserve money expansion (indicative target). By end June 2012 reserve money must be kept under 13%
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PRI Quarterly Policy Briefs on Bangladesh Economy on year-on-year basis. In last April actual growth rate was 10.17. In case of government borrowing from the banking sector, although in terms of growth rate up to April is higher than the ceiling, borrowing can be kept under the ceiling given the governments recent success in limiting bank borrowing. Government has cushion of around Tk. 86 billion in this regard.
June 2012 Recent developments in India will also have a favorable impact on domestic prices. Monetary tightening by RBI and lower domestic demand has reduced Indias inflation in 2012. After reaching a recent high level, food prices in India has come down significantly and remained at around that level in recent months. Bumper harvests have stabilized food prices in India and are expected to remain stable in coming months. Depreciation of Indian currency has also made Indian food/commodity prices cheaper in terms of BDT in recent months. Above all, domestic supply situation of basic commodities like rice, potato and vegetables have generally been very good with bumper outputs in most products. Following the bumper boro crop rice prices have declined significantly and are likely to remain stable in the coming months. The favorable supply situation at home and abroad, combined with prudent demand management through monetary and fiscal policies should help realize the inflation target.
Is the Tightened Monetary Policy Working?

The objective of monetary tightening was to restore both internal and external imbalances by taming inflation and thereby also stabilizing the exchange rate. From the Figure 2.3 we can see that inflation is trending downward and came down to 9.15% in May from the peak level of 11.97% in last September. Growth in import payments decelerated sharply despite much higher oil-related payments. As shown in Figure 2.4, after a sharp depreciation of the Taka, the exchange rate has remained stable throughout the second half of FY12. In FY13 budget, the government has set the inflation target at 7.5%. Like monetary targets, inflation targets stated in FY10 and FY11 budgets were also not achieved. Thus questions have been raised about governments ability and seriousness in realizing the inflation target for FY13. We are of the view that, if BB adheres to the monetary targets stated in the MPS and the ECF arrangement with the IMF, and maintains a similar policy stance for FY13, bringing the inflation rate down to the target level of 7.5% will be challenging but doable. Continued prudent monetary tightening and favorable external environment would be preconditions for realizing the inflation objective. Coincidentally, global economic slowdown has been pushing both fuel and non-fuel commodity prices downward, from their recent peak levels in April 2011. Crude oil price has come down by more than 20% since March 2012 due to comfortable global inventory position and a slowdown in demand growth both from industrialized and emerging economies. Given the global economic outlook, the weakening process may continue in the coming months. The terms-of-trade gains resulting from the decline in global prices will not only help stabilize domestic prices but also reduce pressure on the current account balance. Figure 2.9: Crude oil price in Dubai ($/bbl)
140 120 100 80 60 40 20 0
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08
Future Challenges and Recommendations for Monetary Management

Monetary development since last January has been moving in the right direction to achieve the MPS targets and quantitative limits established under the ECF. Achieving the end-June targets will require BB to firmly adhere to its monetary targets. Figure 2.10: Domestic Credit Development
Domestic Credit 40 30 20 10 FY 12 MPS 65 55 45 35 25 15 5 -5 40 Public Sector Credit FY 11 Average FY06-FY10
27.41 22.45
19.1
34.45
33.55
31.0
Jul08, 131.22
Mar12, 122.28 28Jun, 92.00
Private Sector Credit
30
Dec08, 41.00
Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12
25.84
20
19.45
16.0
10 Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun
11
PRI Quarterly Policy Briefs on Bangladesh Economy The other challenge will be to maintain the right policy mix by properly synchronizing fiscal policy with the monetary stance. This issue of policy mix will be especially important since the government is approaching final year of its tenure. As other sources of deficit financing become more difficult to secure, the government may become tempted to rely more heavily on bank borrowing. In its monetary policy operations BB should focus primarily on the quantitative targets and not on policy instruments like interest rates. It is beyond the capacity of any central bank to influence or target both, and BB is no exception. Like most developing countries, transmission of monetary policy is considered inefficient in Bangladesh. Development of the treasury bills and bond market will be keys to enhance the transmission mechanism.
June 2012
12
June 2012 main culprit underlying inflation in Bangladesh. In this debate inflation is temporary and the government has little control over inflation except to make efforts to insulate domestic food and fuel prices from rising through price controls and subsidies. The influence of this populist argument on policy making is large and illustrated by the rapidly growing subsidy bill of the government that has now run into almost 4% of GDP, equivalent to over 35% of total tax revenue. A third major policy debate is the perceived trade-off between growth and inflation. The argument here is that developing countries like Bangladesh have no choice but to tolerate significant inflation as a price for economic growth and development. This is a more substantive argument based on quantitative research done by the Bangladesh Bank that argues that there is a trade-off between inflation and growth well upto 6-8% rate of inflation. Efforts to reduce inflation below this threshold level will have an adverse effect on growth. The policy debate suggests that there is considerable confusion and disagreement on the nature of inflation in Bangladesh and factors that explain inflation. Given these issues it is important that policy analysis for inflation control must be based on a careful review of the data and proper quantitative analysis.
III.
Explaining Inflation in Bangladesh1

Sadiq Ahmed
Background
Bangladesh has been experiencing a rapid growth in the general price level in recent years. The rate of inflation has crept up steadily since July 2009, rising from an average of 2.3% during 2008/09 to a peak of 12% in September 2011 (Figure 3.1). The inflation rate declined to 9.9% in April 2012. The rapid rate of inflation has become a major economic and social problem. Unless this is tackled forcefully and with some urgency it could become a substantial political debacle for the Government when it seeks re-election in the next 18 months. It is also important that right policy choices are made in the effort to control inflation based on sound analysis. Figure 3.1: Recent Bangladesh Inflation, point to point %
16 14 12 10 8 6 4 2 0
Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12
General
Food
Non-Food
Quantitative Analysis
Time series data and related analysis can be very helpful in understanding macroeconomic developments, making projections for the future and developing policy responses to tackle unhappy macroeconomic outcomes. The analysis of inflation is a good example of how proper time series analysis can help the government to control inflation and stabilize the macroeconomy. We will like to stress the importance of proper time series analysis because in its absence we can easily reach erroneous conclusions that, if applied to policy making, can do substantial damage to the macroeconomy. Stationarity and Causality Tests for Proper Time Series Analysis A key requirement of this proper analysis is to first start with a good theory about causality. Many things tend to move together over time. Without a sound analysis of how developments are correlated and what is the cause and what is the effect there is either a risk of spurious correlation or mis-specification of the relationship. Economic theory helps avoid the problem of spurious correlation, but it sometimes does not help identify the causality. This problem of establishing causality in time series data has received a great deal of attention in quantitative economic research and considerable progress has been made in recent years to help identify proper causality, thereby facilitating better policy making and economic forecasting.
Source: Bangladesh Bank
The Policy Debate

There is much policy debate, often influenced by populist perceptions, about what factors cause inflation. One popular debate concerns the role of nominal exchange rate in managing inflation. There are quite a few policy makers, researchers and business who believe that the depreciation of the exchange rate is the primary culprit underlying rapid inflation in Bangladesh. This group believes that the government should basically pursue a fixed nominal exchange rate policy. The underlying logic is the standard cost-push argument for inflation. Exchange rate raises the taka price of imported inputs that pushes up the cost of production and that in turn fuels inflation. The other debate is the role of international commodity prices. The rising global food and fuel prices are seen as the
1
This policy note is based on a longer research paper in progress. The longer paper provides all quantitative results and the database for the regression results.
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PRI Quarterly Policy Briefs on Bangladesh Economy Working independently in different time periods, two researchers, Clive Granger of the University of Nottingham in England and Christopher Sims of the Princeton University in USA, pioneered the quantitative methods for establishing causality. Both received the Nobel Prize in Economics; Granger in 2003 (unfortunately he died in 2009) and Sims in 2011. The statistical technique developed to establish causality is known as the Granger-Sims test. Good practice quantitative research using time series data first needs to ensure that the data are stationary (to enable meaningful predictions) and that causality is established using the Granger-Sims test before deciding which variable is the cause (also called the independent or exogenous variable) and which variable is the effect (also known as the dependent variable or endogenous variable). Inflation and GDP Growth Models for Bangladesh Turning to the Bangladesh situation, we need testable model to quantitatively determine the factors that explain inflation. Drawing from economic literature and the policy debate in Bangladesh, there are basically three models of inflation. The simplest model, which appeals most to populists and is well understood in Bangladesh, is the costpush model of inflation where the rate of inflation is determined by cost factors such as international food and fuel prices, other sources of imported inflation reflected by world inflation, and the nominal exchange rate changes. The second model is the well-known monetarist hypothesis popularized by Nobel Laureate Milton Friedman where inflation is determined by the excess of monetary growth over the rate of growth of GDP. In this model inflation is purely a monetary phenomenon. The third and more widely accepted model is one that combines both cost-push and monetary factors. Which factor dominates at any point in time is determined on the basis of proper time series analysis. For this paper we develop a generalized inflation model that combines both cost-push and monetarist variables. The model is specified as follows: INF= f (GM2, GGDP, DNER, GIFP), Where: INF= rate of inflation; GM2= growth of broad money; GGDP= rate of growth of GDP; DNER= depreciation of the nominal exchange rate; GIFP= rate of growth of international food prices. The model basically says that inflation is determined by the rate of growth of money supply (broadly defined), the rate of growth of GDP, the nominal exchange rate, and the rate of growth of international food prices. Other cost factors such as international inflation could also be introduced and will be considered as we go along.
June 2012 Since there is a policy debate surrounding the relationship between inflation and rate of growth of GDP, we also estimate a model for GDP growth that allows for feedback from inflation to GDP growth and money supply growth to GDP growth. A simple GDP growth model is specified below. GGDP= f (GM2, INF, INV/GDP, GLab, T/GDP), Where: GGDP= rate of growth of GDP; INF= rate of inflation; GM2= rate of growth of broad money; INV/GDP= investment rate; GLab= growth rate of labor force T/GDP= trade to GDP ratio The GDP growth model says that the growth of GDP depends upon the rate of investment, the growth of labor force, trade to GDP ratio (to allow for openness effect), the rate of inflation and the rate of growth of money supply. Stationarity Test Results The data we use is from 1981-2011, which gives a fairly large number of observations to estimate stable long-term relationships between the variables. Before we estimate these two equations, we need to test for stationarity and causality. The standard Dickey-Fuller stationarity tests show that the data for GDP growth, Inflation, M2 growth, International food price inflation, Depreciation of the nominal exchange rate, and Labor force growth are all zero order stationary. The investment rate is not zero order stationary. However, the investment level (INV) is zero order stationary. Similarly, the trade to GDP ratio is not zero order stationary but the change in the ratio (D T/GDP) is stationary. Granger Causality Test Results Mere evidence of correlation does not indicate causality. Economic theory can help. Thus, there is little debate about the causality of the following relationships: world food price inflation causes domestic inflation; labor force growth causes GDP growth; investment rate causes GDP growth; and trade-openness causes GDP growth. However causality relationship between inflation and money supply growth; between GDP growth and inflation; between GDP and money supply growth; and between inflation and nominal exchange rate changes are debatable. So the data were checked for causality using the Granger causality test. The results are: 1) Inflation and GDP growth do not Granger cause each other. 2) M2 growth Granger causes Inflation but not the other way round. 3) Inflation Granger causes Nominal exchange rate depreciation but not the other way round
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PRI Quarterly Policy Briefs on Bangladesh Economy 4) GDP and M2 growth Granger cause each other The result that inflation causes exchange rate depreciation rather than the other way round indicates that it cannot be used as a determinant of inflation. The joint causality between GDP growth and M2 growth suggests that M2 cannot be used on the right hand side of GDP growth equation. Instead an instrumental variable (growth of private credit GPC) is used after ensuring its stationarity, Granger causality test and relevance as an instrument. Estimation Results for Inflation The estimated regression result for inflation equation is shown below: INF= 8.28 (0.002) + 0.21(0.010) GM2+ 0.015 (0.66) GIFP- 0.99 (0.026) GGDP R-squared=0.3183; Adj. R-squared= 0.2425; p values in brackets The results show that the growth of broad money (GM2) has a strong and positive effect on domestic inflation (INF), while GDP growth has a strong and negative effect on inflation. These results are consistent with the findings of many other researches. International food price inflation has the right sign but its coefficient is not significant, suggesting that while it may play a significant role in the short-term it is not a significant factor for long-term inflation. Introduction of international inflation variable did not show up as significant. Estimation Results for GDP Growth The estimated regression result for the GDP growth equation is shown below: GGDP= 4.39 (0.00) + 0.0031 (0.00) INV + 0.172 (0.355) GPC -0.14 (0.056) INF+0.069 (0.218) D T/GDP -0.098 (0.626) GLF R-squared= 0.615; Adj R-squared= 0.61; p values in bracket The results show that investment (INV) is a strong and positive determinant of GDP growth. Inflation (INF) has a strong and negative relationship with GDP growth. Growth of private credit (GPC) has the correct sign but its coefficient is insignificant. Trade liberalization (D T/GDP) has a positive effect on GDP growth, although its coefficient has a relatively low significance. The labor force growth (GLF) variable comes up insignificant and with the wrong sign. This could reflect a measurement problem. Is There Evidence of Growth-Inflation Trade-Off? One contentious issue in Bangladesh is the presumed tradeoff between inflation and growth. In the results we present above, the relationship between GDP growth rate and inflation for Bangladesh is unambiguously negative. This makes imminent economic sense. High inflation distorts investor preferences as well as consumer behavior that tend
June 2012 to hurt growth. In particular inflation tends to be associated with asset price bubbles that cause resources to be diverted to real estate and unnecessary build-up of commodity stocks. It also tends to hurt financial savings. In the estimates reported in this paper, the relationship between growth and inflation is assumed to be linear. The proponents of the trade-off argument base this on a presumed non-linear relationship. The argument here is that the relationship between inflation and growth is positive up to a certain thresh-hold level of inflation. Once the threshold level is crossed, the relationship becomes negative. Empirical research seeks to find this threshold level of inflation. Research done by Bangladesh Bank has come up with results that suggest that the threshold level of inflation is 6-8%. For India, the threshold level was found to be between 4.5-5%. It is reasonable to expect that a 4-5% rate of inflation might be needed to provide the flexibility of resource mobility for growth in a developing country like Bangladesh. But the 68% threshold range is too large and further research is needed to come up with more definite results. It is also important that data used for estimation is properly filtered to ensure stationarity before estimation is done. The research should also explain why an 8% inflation rate is necessary to achieve higher growth and how significant, if at all, is the trade-off. As we explain below, in an environment of low global inflation, especially in USA (2-3% inflation rate per year), targeting an inflation rate that is much in excess of the US inflation will tend to depreciate the Bangladesh currency (since the Dollar serves as the reserve currency) and conflict with the objective of exchange rate stability. Causality Between Inflation and Exchange Rate Changes The Granger test for causality showed that inflation causes exchange rate depreciation and not the other way round. The economic rationale for this is that as inflation rate increases it tends to appreciate the Bangladesh currency which increases imports and reduces exports. This exerts pressure on the nominal exchange rate, which then depreciates. The exchange rate is also influenced by the inflow of net foreign capital. The higher the net inflow, the higher the tendency of the nominal exchange rate to appreciate and vice versa. Accordingly, the rate of depreciation of the nominal exchange rate variable was empirically tested with the following results: DNER= 0.76 (0.02) (INF USINF) +0.35 (0.58) NCI R-squared = 0.28; Adj R-squared= 0.23; p values in bracket DNER= depreciation rate of taka vis-a-vis US dollar; INF= Bangladesh inflation rate; USINF = US inflation rate; NCI= net capital inflows.
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PRI Quarterly Policy Briefs on Bangladesh Economy All variables satisfy zero order stationarity condition. Since the net capital flow variable is insignificant and appears with the wrong sign, it was dropped. The revised estimate is: DNER= 0.85 (0.00) (INF-USINF) R-squared= 0.27; Adj R-squared= 0.24; p values in bracket Quantitative results show that the depreciation of the nominal exchange rate is strongly and positively correlated with the inflation differential between Bangladesh and USA (the country issuing the reserve currency). On average a one percent increase in the inflation differential causes a 0.85 percent increase in the rate of depreciation of the nominal exchange rate. So, contrary to populist perceptions, the depreciation in the nominal exchange rate is the result of domestic inflation rate that much exceeds the global inflation rate. The absence of role of capital flows in influencing exchange rate is also an important result. Bangladesh, unlike other countries, does not have an active foreign capital mobilization strategy. As a result, net capital inflows have been like a random factor with little influence on exchange rate changes.
June 2012
Implications for Policies

There are strong and powerful implications for policies that follow from these empirical results. These can be summarized as follows: Over the long term sustained reduction in the rate of inflation will require reduction in the rate of growth of money supply. This is consistent with international good practice where monetary policy is the primary instrument of inflation control. A policy of keeping inflation rate low (4-5% per year) is also good for supporting higher rates of growth. A policy of easy money does not support higher investment or growth; instead high rates of monetary growth (beyond a level consistent with real GDP growth and desired inflation rate) feed on inflation and negatively affect growth. Higher rates of growth will require higher investment. Higher investment depends on factors other than the rate of growth of money supply (beyond prudent levels). Fiscal policy will need to be consistent with the targets of prudent monetary management. Accommodating sustained international price increases in fuel prices through budgetary subsidies that is financed through borrowing from the Bangladesh Bank is inconsistent with sound monetary management and inflation control. The causality from inflation to exchange rate is a very powerful and fundamental result for policy making. The main message is that if we want to have a stable exchange rate over the longer term, we need to keep the rate of inflation low and closely aligned to international inflation. The other policy that could help stabilize the exchange rate is foreign capital inflows. Bangladesh does not have a strategy for mobilizing foreign capital and as such is missing out on one useful policy instrument for exchange rate management.
Summarizing the Key Empirical Results

The rate of growth of money supply is a major determinant of inflation over the long term. International food prices affect inflation in the short term but not in the long term GDP growth and inflation are negatively correlated over the longer term. So, there is no evidence that higher rate of GDP growth requires higher inflation. The paper did not test for the threshold level of inflation. The suggested range of 6-8% inflation threshold emerging from the Bangladesh Bank research is highly debatable. In India it was found to be between 4.5-5%, which appears more reasonable. Whether even lower long-term inflation rate (2-3%) is achievable without sacrificing growth is an empirical question that needs further research. Inflation causes exchange rate depreciation rather than the other way round. So, the stability of the nominal exchange rate can be ensured by keeping inflation low. There is no evidence that high rates of M2 growth (beyond prudent levels) support higher economic growth or investment.
Agenda for Further Research

There are a number of areas where further research will be helpful. Transmission mechanism between monetary policy and aggregate demand via interest rate. The threshold level of inflation for growth- inflation trade-off based on sound time series analysis. Implications of monetary policy for managing inflation in light of the threshold level of inflation. Role of international food prices in domestic inflation over the longer-term. Determinants of investment and whether monetary policy has any long-term effects on the rate of investment.
16
June 2012 Later this year, the periodic Trade Policy Review on Bangladesh is also expected to take place at the WTO. Thus, given the fact that Bangladesh aspires to become a middle income country by 2021, which would definitely require a trade policy orientation that is supportive of high export performance and rapid GDP growth, it has become a national imperative to review the state of play in trade policy and mould it in the right direction. The Budget for FY2013 has been launched but no changes in trade policy directions are evident from the tariff proposals.
IV.
Is Trade Policy Losing Direction?

Zaidi Sattar
Background
Bangladesh aspires to become a middle income country by 2021. That hope is predicated on raising its current 6-6.5 percent annual growth rate of GDP to 8 percent or more on a sustainable basis for the next decade. There is no doubt that the nature of trade policy during this period will play a supportive or restraining role in achieving the targeted rate of growth. Historical evidence around the globe point to the fact that high performing economies (those growing at annual rates of 7-8 percent for long periods) also have the most open trade regimes, particularly during the periods of high performance. This relationship was validated in a seminal cross-country research paper by David Dollar and Art Kraay (2001), which also concluded that growth was good for the poor. In the late 1990s, Bangladesh was listed by analysts among the most globalized developing economies on the basis of its trade openness and progressive integration with the world economy. The expectation was that, in two decades or so, Bangladesh would be ranked among the most open economies of the developing world. That did not happen, as progress in trade liberalization stalled after a decade of tariff rationalization and removal of trade-related quantitative restrictions. Is the current trade policy stance consistent with Bangladeshs long-term growth and poverty reduction goals? Annual budgets in Bangladesh have a major role in carving out the trade policy stance following some measure of consultations with business chambers and other stakeholders. FY2013 budget is no different as the tariff and para-tariff adjustments proposed provide the direction and contours of trade policy which will have an impact on the incentive regime that will affect decisions of investors, producers, exporters, importers, and consumers. Employment, growth, and poverty reduction are the eventual outcome of these decisions. That makes a critical review of budgetary proposals on trade taxes important for policy.
Global Economic Environment and Outlook for 2013

Because of progressive integration of the Bangladesh economy with global trade and finance, it cannot be immune to external developments. The global economy has been slowly trying to recover from the lasting effects of the global financial crisis of 2008. A modest uptick was noticeable in the US economy as consumption and inventory investment picked up along with the credit and labor markets. But recent events- especially those in the Euro area -- has imposed fresh uncertainties on the global economic outlook for 2012 (Table 4.1). IMFs latest Global Economic Outlook projects world output and trade to slow in 2012 with a modest pick up in 2013. The future of the European Economic and Monetary Union has become increasingly uncertain with mounting sovereign debt causing significant increases in sovereign bond rates and unwillingness of a large fraction of the population of affected EU countries to Table 4.1: Outlook of Global Output and Trade
2009 GDP (% change) World Advanced economies Euro area Emerging and developing economies Developing Asia Trade Volume (% change) World Imports of goods and services World Exports of goods and services World -10.2 13.0 5.8 3.9 5.7
Source: IMF Global Economic Outlook April 2012 -0.6 -3.6 -4.3 2.8 7.1 5.3 3.2 1.9 7.5 9.7 3.9 1.6 1.4 6.2 7.8 3.5 1.4 -0.3 5.7 7.3 4.1 2.0 0.9 6.0 7.9
2010
2011
2012
2013P
-10.5
12.9
5.8
4.0
5.6
Launch of DTIS and Impending Trade Policy Review

The year 2012 is critical for trade policy. After a spectacular year in export performance, the sharp slowdown this year has raised concerns about the sustainability of export growth. The Government, in cooperation with the World Bank, has launched the preparation of a Diagnostic Trade Integration Study (DTIS), a study that seeks to identify hindrances to greater integration of Bangladesh into the multilateral trading system. The DTIS will reflect the above concerns on sustainability of export growth, and will build on existing work and fill knowledge gaps where necessary.
-10.9
12.7
5.8
4.2
5.6
accept austerity measures to ensure fiscal consolidation. The impact of the Euro zone crisis is being felt by the developing Asian nations through the export and financial channels
17
PRI Quarterly Policy Briefs on Bangladesh Economy leading to a softening of growth in developing and emerging Asian region. From the global trade perspective, 2012 is expected to see a decline in trade volume growth but a modest bounce back is expected in 2013. Given lower deficit in deficit economies like the United States and lower surpluses in surplus economies like Japan, the global trade-related imbalances are not expected to worsen. Besides this, the decline in consumption during the crisis in the U.S and Europe has not been met by increased domestic demand growth in surplus economies like China, consequently leading to a slowdown in global demand for global imports. Again, the decline in demand in the U.S and Europe has affected China and Developing Asia through export channels, which constitutes a huge portion of their income and GDP. The same is true for Bangladesh, whose current state of integration with the global economy, make its growth and export prospects over the short- to medium-term rather subdued in view of the sluggishness of global output and trade in the near-term.
June 2012 Tariff rationalization and reduction: During the 1990s, Bangladesh significantly reduced its tariff rates and rationalized the structure, progressively moving towards the goal of simplicity and transparency of the customs tariff. The top custom duty (CD) rate came down from 160 percent in 1990 to 25 percent today. The average (un-weighted) customs duty declined to 13.6% in FY12 as compared with 70.6% in FY92, and 100% in 1985 (Sattar 2012). Considerable rationalization of the tariff structure occurred and progress was made towards achieving a degree of uniformity and removing some tariff anomalies that existed due to higher tariffs on intermediates than final products. Two features stand out in the evolution of protective tariffs: (a) the sharp reductions which began in FY92 halted around FY96, and (b) the emergence of para-tariffs, additional levies such as supplementary duties, regulatory duties, and infrastructure development surcharge. Trade liberalization slowed down by the mid-1990s, and was even somewhat reversed during the last few years of the decade, on the popular notion that earlier reforms had been too much too fast. Resistance to liberalization from business and industry became strong enough at this time to forestall further reduction in protection. One reason could be that productivity improvements and efficiency adjustments were not fast enough for those industries that had gotten used to high protection. At the end, these groups exerted enough pressure to undermine political will to carry forward the liberalization agenda. At the turn of the century, it was all too evident that trade liberalization had slowed down, while some new external developments, particularly in the trade arena, had to be reckoned with. China and Vietnam joined the WTO and were subject to the rules of the multilateral trading system, most significant of which was the requirement to bring down their tariff rates, as a condition of membership. India, having been determined as having the most restrictive trade regime in South Asia, launched a major liberalization program, unilaterally, and under SAFTA, for the South Asian region. Within a few years, India brought its top manufacturing tariff rate down to 10%, and average nominal tariff to around 12% by 2008. Under a multi-year arrangement for budget support from the World Bank, Bangladesh also agreed to a regime of gradual reduction and rationalization of tariffs during the early years of the decade. Under the same arrangement, all trade-related quantitative restrictions were phased out with only WTO-compliant non-tariff measures (NTMs) remaining. Table 4.2: Progress in tariff rationalization FY01-13
Tariffs FY01 FY05 FY09 FY10 Average CD 21.1 16.3 13.8 13.7 (un-weighted) Average Nominal 28.5 26.5 20.1 23.9 protection Top CD rate 37.5 25.0 25.0 25.0 Tariff slabs 4.0 3.0 4.0 4.0 (non-zero) Source: NBR tariff database and PRI staff estimates FY11 13.5 23.7 25.0 4.0 FY12 13.6 26.5 25.0 4.0 FY13 13.6 28.3 25.0 4.0
Evolution of Trade Policy in Bangladesh

Nevertheless, it is a good time to take stock of the situation as far as trade policy is concerned. At independence, Bangladesh inherited a highly restrictive, inward-looking, import-substituting trade regime, with little debate about its relevance to the new economy whose lifeline was actually an export sectorjute and jute goods. The inherent anti-export bias of an ISI regime went unnoticed as Bangladesh chose a path of import substituting industrialization with minimal impact on industrial development. By the 1980s, the shortcomings of ISI policies became all too evident globally, and the strategic importance of export-oriented policies began to be realized, particularly in developing economies trying to enter markets for labor-intensive manufactures. Though Bangladesh began seriously dismantling its ISI orientation in the early 1990s, to this day, the last vestiges of ISI continue to haunt policymakers and many economists alike, with strong backing from the emerging entrepreneurial class in Bangladesh. A combination of economic and political crisis in the late 1980s created the atmosphere for embracing critical reforms. Moreover, deregulation, privatization, and trade openness, dominated economic thinking and shaped donor policies for developing economies. Thus, in the early 1990s, Bangladesh launched the deepest and widest set of economic reforms in its external trade and regulatory framework governing domestic production and investment. In this scheme of economic reforms was the onset of trade liberalization which included tariff reduction and rationalization, removal of quantitative restriction on imports, exchange rate flexibility, and current account convertibility.
18
PRI Quarterly Policy Briefs on Bangladesh Economy Accordingly, the following notable trends could be observed. The average tariffs showed a modest but gradual decline until FY09 (Table 4. 2). However, this decline was led by reduction in input duties rather than duties on final goods. The top rate which declined to 25% in FY05, remained stuck at that level since then. More notable was the emergence of para-tariffs like regulatory duties (RD) and supplementary duties (SD)2. The overall outcome over two decades of liberalization is as follows: while Bangladesh reduced tariffs, -- rapidly at first, and gradually later -- other countries in the South Asia region and across the globe generally moved faster. Consequently, despite two decades of liberalization, judged by the level of average protective tariffs, Bangladesh continues to be listed among countries with relatively restrictive trade regimes3.
June 2012 protection is not uniform, we find no rationale for the variable rates of protection given to different products. So, while the benefits of protection are inequitable, it is consumers who end up paying the protection tax, indefinitely. This can hardly be justified under any policy principle. Before we proceed to discuss the implications of tariff changes in Budget FY2013, a snapshot of tariff trends over the last two decades may be gleaned from Figure 4.1. What is evident is the gradual decline of average tariffs until about FY09, following which there is an uptick that continues to the current budget. Though average CD has been on the decline, para-tariffs have emerged as a rising component to push up average NPR. Figure 4.1: Average Nominal Protection Trends (FY 92-FY13)
Avg. CD Avg. Para Tarrif Avg. NPR
Budget 2013 and Tariff Adjustments

The budget comes in the wake of macroeconomic challenges stemming from rising pressures on internal and external balances in the past year. Years of generally prudent macroeconomic management have laid a solid foundation for macroeconomic stability that is a vital precondition for rapid growth. It is also important to safeguard the strong macroeconomic fundamentals that have been built, by not deviating from sound macroeconomic principles. Therefore, the greatest challenge in budget implementation lies in making sure that there is optimal degree of fiscal and monetary policy coordination to keep inflation under control, exchange rate stable, ease pressures on the balance of payments, and yet leave enough space for private sector to invest and fuel growth. Ensuring macroeconomic stability in the face of these challenges requires mobilizing adequate domestic resources to finance public expenditures on infrastructure, health and education, and therefore the government has put a lot of focus on raising revenue through tax and non-tax measures. Though a gradual shift is taking place from reliance on trade taxes to domestic taxes, customs revenue still account for some 40% of tax revenue. A number of proposals to adjust tariffs and para-tariffs have been made in the budget. A single message of trade policy that stands out in the budget statement is that the changes are done to assist local industries. Indeed, that might be so, at least for the time being. But just as a pampered child often becomes unfit to face the real world, industries propped up by high protection for too long are likely to face eventual decline as greater global competition is unleashed in coming years. Like before, there is no announcement regarding how long such industry assistance through protective tariffs will continue. And the measures tend to be ad hoc in nature, without any background research about how much protection is justified, and for how long. Also, since
2
(%)
80 60 40 20 0
Source: NBR ASYCUDA database
Nevertheless, a quick review of the increase and decrease of customs duty (CD) and supplementary duty (SD) rates is likely to lead one to believe that the predominant objective this time perhaps was higher revenue mobilization than protection, though the latter outcome is consequential and, by and large, welcomed by the import substituting producers. In a few cases (43 tariff lines), CD on intermediate goods and basic raw materials were reduced. For a large number of tariff lines (413), SD was raised. Table 4.3: Average Nominal Protection Rate, Dispersion, Maximum and General
Protective Rate for MFN Tariff Lines, FY 2000-01 to 2012-13
Fiscal Year 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 (Budget)* 2012-13 (BudgetProposals) Average Nominal Tariffs (NPR) 28.23 29.12 26.42 29.10 26.52 26.46 24.27 22.48 20.08 23.88 23.74 26.51 28.30 Coefficient of variation 74.00 76.49 84.86 89.00 96.38 102.57 93.25 107.61 126.89 153.38 156.34 165.12 156.90 General Maximum NPR 59.00 43.00 52.00 53.00 60.00 72.00 69.00 72.50 72.50 79.00 79.00 88.00 88.00
An infrastructure development surcharge (IDSC) of 4% was abolished in FY07. 3 th Bangladesh ranks 86 among 110 countries in World Banks Overall Trade Restrictiveness Index (2009); Hong Kong, China being number 1.
Source: PRI Tariff Database and staff estimation; (*) post-budget changes are not reflected
FY 92 FY 93 FY 94 FY 95 FY 96 FY 97 FY 98 FY 99 FY 00 FY 01 FY 02 FY 03 FY 04 FY 05 FY 06 FY 07 FY 08 FY 09 FY 10 FY 11 FY 12 FY 13 (B)
19
PRI Quarterly Policy Briefs on Bangladesh Economy Assessment of tariff adjustments can be summarized from Table 3 as follows: Upward trend of average tariffs for the past three years is maintained. Tariff spread is also rising as evidenced from increase in coefficient of variation General maximum NPR has also been rising; excluding rates on cars, alcoholic beverages, and tobacco, there are still about 500.tariff lines with NPR exceeding 100%.
June 2012 low tariffs of 3-5 percent for basic raw materials and capital goods, 12 percent for intermediate goods, and the top rate of 25 percent for final goods. However, on top of the 25% for final goods, for a large group of products that are produced domestically, SD and RD are generously applied. Thus tariff escalation is the highest at the last stage of processing from intermediate goods to final goods. Figure 4.3: Average NPR by Import Categories
Para-tariffs take the lead. Para-tariffs import taxes and levies other than custom duties have slowly emerged as a dominant set of trade taxes since the middle of the past decade. Supplementary duty (SD) and regulatory duty (RD) seems to have become standard instruments for raising revenue or offering protection to domestic import substituting industries, so much so that in FY2013, its share in average NPR has, for the first time, exceeded that of CD (52% of 28.3, Figure 4.2). Figure 4.2: NPR trends and emergence of para-tariffs (FY 00-FY13)
What is notable is that, since FY09, the wedge between the average NPR on inputs and final consumer goods is rising (Figure 4.3), thus augmenting effecting rates of protection. It appears to be the outcome of pre-budget consultations with producer groups only, without anyone speaking for the consumers who will eventually pay the protection tax (higher price) and also suffer welfare losses from lack of choice. In the short-term, enterprise profits may be propped up, but, over the long run, this trend is likely to have adverse consequences on productivity and competitiveness of firms that enjoy protection without an end period in sight.
Trade Policy Losing Direction

Though SD was introduced in 1991 under the VAT Act, and was meant to be a trade-neutral tax. Like the VAT, increasingly, it has come to be applied in a non-neutral fashion, i.e. it is not applied equally on imports as well as domestic sales. Indeed, it has become an expedient instrument of protection through its differential application (higher rates on imports; lower or zero rates applied to import substitutes). Likewise, RD is now seen to be used on an ad hoc basis every year, only on imports, aimed primarily to raise protection to domestic industries, though NBR hopes it will generate extra revenue. The fact that there is hardly any objection from the producer community against these applications testifies to their favorable impact on protection. So far, such rampant use of para-tariffs seems to have escaped attention of WTO Trade Policy Review, since cross-country tariff comparisons available in UNCTADs COMTRADE database do not have information on paratariffs. However, information on para-tariffs are being compiled and would soon become an irritant in multilateral trade discussions. Tariff escalation without end. One of the key features of tariff reform was the move towards uniformity. Thus from 20 odd CD tariff slabs, the tariff structure is now characterized by four non-zero slabs of 3,5,12, and 25. The system presents A substantial portion of trade policy for the coming year (FY2013) has been formulated under this budget, thanks to the proposals regarding adjustment of trade taxes. These adjustments affect profitability of import substitute production on the one hand and export competitiveness on the other with serious implications for trade as well as growth prospects. The budget essentially perpetuates the previous tariff stance with the singular statement of support to domestic (import substituting) industries. Is it sound policy in light of global competitive challenges and Bangladeshs goal of attaining higher growth and reaching middle income status by 2021? As it is, tariff protection levels in Bangladesh have been described by analysts as high. As mentioned earlier, Bangladesh regularly is being listed by multilateral observers as having a relatively restrictive trade regime. Continuation of this stance might prop up current profitability of import substituting firms. But import substitute production catering to the domestic market cannot create jobs for the two million people added to the workforce each year. Export production can. Research based on history and global experience indicates that such protection for long periods is bound to create inefficiency and undermine export competitiveness in global markets. We need to reflect if this
20
PRI Quarterly Policy Briefs on Bangladesh Economy is the kind of trade regime that will yield the 7-8% GDP growth rate in the medium-term, and 8-10% growth rate over the long-term, as envisaged in the Sixth Five Year Plan (2011-15) and the Perspective Plan (2010-21). International evidence shows that hitherto developing countries that grew at 7-8% rate for a decade were completely transformed from low-income to middle income countries; but their growth record was characterized by open trade regimes -not the kind of trade regime we are pursuing. The SFYP articulates a strategy for diversifying exports and developing a dynamic manufacturing sector. It states, the structure of incentives created by the trade policy regime still favors the production of domestic import substitutes and creates barriers for emergence of new export industries and expansion of export industries not benefitting from special measures. The SFYP then proposes removal of the remaining anti-export bias to create a neutral policy regime between import substitution and export promotion in order to focus both on manufactures that have export potential and industries which already export but whose potentials are not fully realized. It appears that these propositions have not been taken on board in formulating the FY2013 budget.
June 2012
Policy Recommendations
Trade policy orientation needs to change in order to support high growth. Trade liberalization needs to be put back on track. For that, average nominal tariffs and their dispersion both have to be reduced. The wedge between input and output tariffs is wide, and getting wider. The highest difference lies between tariff on intermediates (12%) and tariff on final goods (25%+RD+SD). Such tariff escalation breeds inefficiency and undermines competitiveness of firms in the long run. It is high time for the top tariff rate, along with paratariffs, to be scaled down, to give domestic consumers some relief. In framing trade policy, policymakers must balance interests of producers and consumers the latter group is not organized like the former.
References Dollar, David and Kraay, Art (2001). Growth is Good for the Poor, Policy Research Working Paper, The World Bank. Sattar, Z. (2012). Trade Policy Developments and the Way Forward, in Leading Issues in Bangladesh Development, Sadiq Ahmed (ed), University Press Ltd., Dhaka.
Summarizing the Key findings

Trade liberalization is stalled; but no clear direction has emerged since the dawn of the new century. Although the RMG sector is free from the shackles of high tariffs on inputs or outputs, other exports or potential exports are not. The structure of incentives underlying the trade regime favors production of domestic import substitutes over exports, creating an inherent anti-export bias. Tariff and para-tariff proposals in FY2013 budget signals continuation of the recent trend of rising average nominal protection and wider dispersion of the tariff structure. While para-tariffs have been emerging as significant component of nominal tariffs, for the first time, its share has exceeded average custom duty. While nominal tariffs on inputs (basic raw materials and intermediate goods) continue to fall, those on final consumer goods trend upwards, thus widening the wedge between average tariffs on outputs and inputs, augmenting tariff escalation at the last stage of processing. FY2013 budget proposals on trade policy do not appear to be inconformity with the articulation of the kind of trade policy needed to improve export performance and support the high growth needed to reach middle income status by 2021.
21

1st PRI Quarterly Policy Briefs

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PRI Quarterly Policy Briefs on Bangladesh Economy

Policy Research Institute of Bangladesh (PRI)

Department for International Development (DFID)

PRI Quarterly Policy Briefs on Bangladesh Economy

PRI Quarterly Policy Briefs on Bangladesh Economy

PRI Quarterly Policy Briefs on Bangladesh Economy

Is Bangladesh Banks Monetary Policy Stance Working?

Explaining inflation in Bangladesh

Is Trade Policy Losing Direction?

PRI Quarterly Policy Briefs on Bangladesh Economy

FY13 Budget and Its Challenges

10 8 6 4 2 0 2009 2010 2011 2012

Source: World Economic Outlook Database April 2012 Edition

Global economic outlook

-0.6 -3.6 -4.3 2.8 7.1

5.2 3.2 1.9 7.5 9.7

3.9 1.6 1.4 6.2 7.8

3.5 1.4 -0.32 5.7 7.3

4.1 2.0 0.9 6.1 7.9

Source: Bangladesh Bank

Source: Ministry of Finance

5.2 6.5 6.5 6.5 6.1 20.5 29.9 17.9 49.7

Growth Rate (%) 2.5 9.5

Source: Sixth Five-Year Plan (SFYP)

The New Budget

June 2012 Figure 1.5: Planned and Actual Public Investment

6 4 2 0 FY10 SFYP Public Investment FY11 FY12 FY13(e)

Actual Public Investment

24 20.7 16.7 19.5 1.9 -13.0

15.9 7.3 -5.5 -13

22 20 18 16 FY10 SFYP Private Investment FY11 FY12 FY13(e)

Actual Private Investment

Source: Sixth Five-Year Plan (SFYP)

6.00% 5.00% 4.00%

3.00% 2.00% 1.00% 0.00%

PRI Quarterly Policy Briefs on Bangladesh Economy

Source: Planning Commission and Ministry of Finance

3.30% 3.32% 2.28%

350 300 250 200 150 100 50 0

Total Energy Subsidy (PDB & Fuel)

37.9 22 19.3 -18.4 32.6 6.1 22.6

14.9 11.3 6.7 6.7 92.1 6.7 -1.9

1.5 -9.2 5.2 20.1 2.8 4.2 47.2 14.3

-2 9.9 6.5 -1.1 11.5 -6.3 18.7 8.9

10.4 18.4 7.2 8 4 12.8 29.6 100

10.9 18.6 7 7.8 7 12.4 26.4 100

9.6 14.8 6.4 8.1 6.3 11.3 33.9 100

8.7 14.9 6.3 7.4 6.4 9.7 37 100

Total Programme 16.3 10.1 Expenditure Source: Ministry of Finance

PRI Quarterly Policy Briefs on Bangladesh Economy

Is Bangladesh Banks Monetary Policy Stance Working?

Broad money (M2) growth

Private sector credit growth

Broad money (M2) growth

Private sector credit growth

Broad money (M2) growth

Private sector credit growth

Execution of Monetary Policy in Recent Years

12.72 9.15 7.46

Fiscal and Monetary Policy Coordination

Loose monetary target implementation

Tighter monetary target implementation

54.39 32.38 21.04 18.22

Nov-11, 23.4 Apr-12, 21.8 Dec-10, 18.7