Strong Financial Sector, Fiscal and Monetary Policy Reforms will be Critical to Sustain Bangladesh’s Growth Momentum

While Bangladesh recovered strongly from the COVID-19 pandemic, post-pandemic recovery was hindered by rising inflation, a persistent balance of payments deficit, financial sector vulnerabilities, and global economic uncertainty.  Monetary, fiscal, and financial reforms are essential to sustain the growth momentum going forward, says the new World Bank report, the Bangladesh Development Update April 2024.

In the fiscal year 2023, real GDP growth slowed to 5.8 percent, led by weakening private consumption and investment. Private sector credit growth also slowed, indicating a slowdown of investments. In FY24, growth is projected to slow further to 5.6 percent, before improving marginally to 5.7 percent in FY25. Thus, in the short run  growth is expected to remain below the average annual growth rate of 6.6 percent experienced over the decade preceding the COVID-19 pandemic. With right policy actions, growth is expected to accelerate FY26 onwards.

Inflation continues to erode consumer purchasing power, impacting the poor people the most. Several factors contributed to elevated inflation, including shortages of foreign exchange resulting in reduction of key imports, depreciation of the taka against the US dollar,  energy shortages and increased power prices. To keep inflation in check, Bangladesh Bank continued to tighten monetary policy in early FY24.

The government has undertaken several much-needed policy adjustments, including introducing an adjustable fuel pricing mechanism to reduce spending on subsidies; reducing export subsidies to generate greater fiscal space for development priorities; and adopting a Prompt Corrective Action framework to address financial sector vulnerabilities.

The economy faces several challenges, which require immediate and coordinated policy actions:

• The exchange rate regime remains complex. Multiple exchange rates were introduced in September 2022, discouraging foreign currency inflows, and creating market uncertainty. Some of these exchange rates have been consolidated. However, different exchange rates remain in use for interbank transactions and remittance inflows. The Consequently, the exchange rate is not market clearing.
• The Balance of Payment (BoP) deficit persists: The Current Account Deficit narrowed in FY23 and moved into surplus in the first seven months of FY24, driven by import suppression measures. But the Balance of Payments deficit widened to US$ 8.2 billion in FY23 and US$ 4.7 billion in the first seven months of FY24, as the financial account deficit widened further. Continued intervention in the forx market by Bangladesh Bank  resulted in gross foreign exchange reserves declining by US$ 4.0 billion so far in FY24, reaching US$ 20.8 billion in February 2024.
• Rationing mechanism to restrict imports continue: Measures to control imports helped to slow the decline in forex reserve. However, these controls also resulted in shortages of key capital and intermediate goods that hampered industrial activity.
• Banking sector vulnerabilities: The ratio of stressed assets in banks remains high, including non-performing and rescheduled loans. The gross NPL ratio increased to 9 percent in December 2023 from 8.2 percent in December 2022.

To stem the depletion of forex reserves, Bangladesh Bank has taken steps like reducing the size of the Export Development Fund and implementing stringent eligibility criteria, ensuring timely receipt of export earnings, and providing flexibility to banks for transferring capital between their offshore and domestic units.

Bangladesh’s growth is expected to remain subdued in the near term, due to inflation weighing on private consumption growth, and shortages of energy and inputs, rising interest rates, and financial sector vulnerabilities dampening investor sentiment. Growth is expected to increase gradually over the medium-term as inflationary pressures ease significantly, input, and foreign exchange shortages are addressed through external sector reforms, and as a result investment sentiment improves.

The following policy adjustments are crucial for Bangladesh to accelerate growth and stay on its path to achieving Upper-Middle-Income-Country status by 2031:

• A more flexible, market-clearing exchange rate would rapidly attract foreign exchange inflows through the formal channels and help reduce the financial account deficit.
• Maintaining a tight fiscal and monetary policy will help contain inflation. Fiscal policy can play a particularly important role with stronger revenue mobilization measures.
• An efficient resolution framework for NPLs is urgently needed to maintain financial stability and revive private sector credit. This framework should encompass a comprehensive strategy for addressing the stock and flow of NPLs and a prudent framework for bank resolution. As the government is considering bank mergers, it will be important to have a thorough assessment of asset quality in weak banks to protect the good banks. Guidelines on mergers and acquisitions will need to be developed as part of a comprehensive strategy on bank resolution.
• Bolster domestic revenue generation. Improving revenue mobilization is critical to increase public resources to support growth and development. At 8.2 percent, the country’s revenue as a share of GDP is one of the lowest in the world. Rationalizing tax expenditures, adopting a uniform VAT rate, facilitating comprehensive automation, and reducing supplementary duty and regulatory duty rates to the minimum necessary are key steps that can to increase domestic revenue mobilization. Bangladesh’s tax revenue relies heavily on indirect taxes like VAT. Analysis shows that there is potential to collect over three times more VAT if policy and compliance related gaps are addressed. By reducing reliance on indirect taxes by improving direct tax collection, rationalizing tax expenditures, and building a modern and integrated tax administration, Bangladesh can improve its domestic revenue mobilization.

Bangladesh has strong economic fundamentals, with a demographic dividend, growing market share in ready-made garments, and a large overseas workforce. Immediate and strong financial sector, fiscal and monetary reforms will help the country to return to a sustained and faster growth path.