A study of macro-financial challenges with rudimentary strategies to smoothen growth trajectories.

1. As is the case for any emerging economy, inflation in Bangladesh remains an unwanted
byproduct of accelerating economic growth. In FY2011, the country grew at a rate of
6.67%, with an average inflation rate of 8.8%. Inflation was high in FY2011, reaching a
peak of 10.67% year-on-year (y-o-y) in April 2011. Since then, the Bangladesh Bank (BB)
has regulated monetary expansion and credit growth, raising repo rates five times over a
period of about seven months. However, inflation continues to be a problem, seemingly
more so than in the previous fiscal, albeit the drivers have changed. This report aims to
identify the factors that are contributing to inflationary pressure, and provide an outlook for
the economy in the coming months.
Dynamics of Inflation: Food prices no longer the driving force
In the second half of FY2011, point-to-point inflation started to climb, rising from 8.28% in
December 2010 to 10.67% in April 2011. The main driver was food prices, which rose
both internationally and in local markets. At home, food inflation rose from 11.01% in
December to 14.36% in April (outlined in figure 2). At the same time, global food prices
(as measured by the FAO food index) increased from 25% in December to 38% in April.
Given that food constitutes approximately 60% of Bangladesh’s CPI basket, movement in
food prices has a noticeable effect on headline inflation.
However, by end-FY2011, the country experienced a bumper “boro” rice harvest, helping
decelerate food inflation. Food inflation slowed to 12.51% by June 2011 while overall
inflation fell to 10.17%. The end however was not in sight, as Ramadan started in August
culminating in the Eid-festival – a period of about a month wherein food prices historically
rise on a seasonal basis. The case was no different this time; prices rose and food
inflation hit 13.40% in July, before falling to 12.70% in August.
Meanwhile, non-food inflation which fell between February and April, started to rise very
sharply at the turn of the fiscal. On a point-to-point basis, non-food inflation rose from
6.46% to 8.76% between July and August 2011. Signs are afoot that this is a trend that
will sustain in the near term, barring proactive policy interventions by the government in
the near-term.
Macroeconomic Risks and Their Mitigation:
Preserving the Bangladesh Growth Story
Sajid Huq Amit
sajid.huq@bracepl.com
Aasim Tajwaar Matin
tajwaar.matin@bracepl.com
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Figure 1: CPI Inflation Figure 2: Food Inflation
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Non-food Inflation (Point-to-Point) Non-food Inflation (12-month Avg)
Figure 3: Non-food Inflation
Food prices were very high in the
second half of FY2011, driving
inflation to very high levels
Non-food inflation has become the
main driver of headline inflation in the
first half of FY2012
Source: Bangladesh Bank Source: Bangladesh Bank
Source: Bangladesh Bank

2. 2
Macroeconomic Risks and Their Mitigation
Drivers: Energy Prices, Foreign Exchange and Bank Borrowing
Revisions in Energy Prices
There have been some major upward price revisions that have caused non-food inflation to
surge. The government has targeted power supply growth of 2,400 megawatts by year-
end, for which it has opted for high-cost diesel and heavy fuel oil (HFO)-based power
projects. The long-standing problem of load-shedding exacts a heavy toll on GDP growth,
and at some level, public sentiments. Addressing the worsening energy crisis has therefore
become a priority area for the government. Driven by fuel demand of the new rental diesel
and furnace oil-fired power plants, volatile international crude prices and expansion of
diesel-powered irrigation, the government’s fuel import bills have sky-rocketed.
The energy crisis has been aggravated by the lack of new discoveries of gas. According to
the state-owned Petrobangla, daily gas demand has risen to 2,500 million cubic feet (mcf)
against the supply of 2,000 mcf. Traditionally, electricity production in Bangladesh has
been predominantly gas-based and was around 90% gas-based as of June 2010.
However, the fuel mix is changing, and liquid fuel generated electricity is already
contributing to 25% of electricity generation --(up from 5% in June 2010). The use of liquid
fuel for purposes of energy generation is expected to increase in the coming months. As
more diesel and furnace power plants hit upstream, fuel import bills will continue to
escalate.
The soaring fuel import bills have exacted a heavy pressure on the government in the form
of subsidies. In order to reduce the pressure of subsidies which is far higher than what was
accounted for in the FY2011-12 budget, the government has had to revise upwards the
price of fuel and bulk power tariff. Power tariff revisions occurred in two phases: once in
February and again in August 2011. Next, on September 18, the government increased
prices of fuels: petrol, octane, diesel and kerosene by BDT 5 per liter each, furnace oil price
by BDT 8 per liter and compressed natural gas by BDT 5 per cubic meter.
Fuel price hikes affects inflation in several ways. First, costs of agricultural production
increases. At the farmer’s level, operational expenditure for irrigation constitutes about 20%
of the total cost of production, of which diesel prices account for 10%. Second, transport
fares and carrying costs of goods increase, causing a further increase in the prices of food
items and essential commodities. An upward revision of fares of buses and other modes of
public transport follow. More indirectly, wholesalers and retailers sometimes artificially
inflate prices of commodities on the grounds of the increased fuel prices, even if they are
not immediately impacted by the hike.
It should be noted that the costs of subsidies are still very exacting, and it is believed that
despite upward revisions in price, less than 40% of the cost of subsidy has so far been
passed on to the end-customer. Without increasing fuel prices, in order to address the
ballooning subsidy bill, the government would have to borrow from banks by selling bonds
or printing new bank notes. Already, government borrowing from banks has reached
unprecedented levels as is discussed in a subsequent section. Consequently, further
rounds of fuel price hikes appear to be inevitable, as has been stated by the Bangladesh
Power Development Board (PDB).
Dollar Crisis and its Impact
Higher import bills in relation to export earnings and remittance flows have put significant
pressure on the foreign currency reserves of the country. Export growth has been steady
so far this fiscal but remittance growth is expected to be flat. Import bills on the other hand
Energy prices and power tariffs have
been revised in quick successions in
the first half of FY2012
Less than 40% of fuel subsidy costs
are passed on to the end-customer;
further fuel price hikes may be likely
Figure 4: Composition of electricity generation
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2007 2008 2009 2010 2011
Hydro Coal Gas Oil
Source: PDB and Power Grid

3. 3
Macroeconomic Risks and Their Mitigation
have escalated, putting serious pressure on the foreign currency reserves, and creating a
very threatening imbalance between dollar demand and supply.
Driving import bills are petroleum and capital machinery purchases. However, the former is
more pernicious and its effects may be rather severe. Petroleum import bills are estimated
to be $6.8 billion this year, up from $3.6 billion last year. The Bangladesh Taka (BDT),
which had been steadily depreciating against the US dollar (USD) since end of the
calendar year 2010, has depreciated further this fiscal and may worsen in the coming
months As of September 2011, the BDT has depreciated by about 8% y-o-y.
The depreciation this fiscal has also been affected by the record number of Bangladeshi
pilgrims performing the Hajj this year. An unprecedented 107,000 pilgrims from Bangladesh
are performing the Hajj this year, up from 59,000 last year. On October 10, 2011, dollars
were sold at BDT 76.40 at banks, nearly 2% higher month-on-month. Meanwhile, on the
same day, in the informal (kerb) market and different exchange houses of Dhaka, the dollar
sold at an exorbitant BDT 79.
The government has reacted to this soaring exchange rate by arranging a meeting with the
Bangladesh Foreign Exchange Dealers Association (BAFEDA). As an outcome of the
meeting, members of the BAFEDA decided to maintain the dollar exchange rate at BDT 76
at the customer level for 15 days, up to October 26, 2011. However, such fixing is not
expected to work in the longer term.
The foreign currency deficit has already impacted inflation and may continue to do so in the
coming months. However, the relationship between foreign currency deficit and inflation is
a bit indirect. In the short-term, dollar depreciation will drive up import payments by the
government, which in turn will raise subsidy costs. In response, the government will have to
adjust energy prices upwards or increase borrowing from the banking system, aggravating
inflationary conditions either way.
Bank Borrowing by the Government
The first few months of the current fiscal has seen unprecedented levels of government
borrowing from the banking system. The government’s net borrowing reached BDT 69.32
billion as of September 8 as compared to BDT 2.99 billion in the same period last fiscal.
Again, this has been driven by growing subsidy requirements in energy, power, food and
agriculture sectors. Since the beginning of September, the government has borrowed BDT
37.09 billion from the Bangladesh Bank and BDT 32.22 billion from scheduled banks via T-
bills and bonds.
As per government’s fiscal strategy for FY2012, it is set to borrow about BDT 272 billion
(about 60% of the fiscal deficit and 17% of this year’s budget) from the domestic market -
BDT 190 billion from commercial banks by issuing bonds and BDT 82 billion via national
savings certificate and other sources). The latter is set to rise and the government has
raised the ceiling of short-term borrowing from the central bank to BDT 20 billion from BDT
10 billion.
The cumulative effect of such levels of borrowing is popularly known as the “crowding out”
effect. This is a fiscal policy shock that is characterized by rising bank interest rates.
Greater government borrowing means that bank deposits are increasingly deployed to buy
government securities. Bank loan-to-deposit ratios decline as a result, squeezing bank
interest rate spreads and their profitability. Consequently, lending rates to the private sector
increases, leading to higher costs of production as well as prices of various goods and
services. Moreover, government borrowing from the Bangladesh Bank entails printing new
Government borrowing from the
banking system has risen many folds
till September
Oil import and currency depreciation
have direct impacts on inflation
Figure 5: Inflation vs. Oil Imports Figure 6: Imports vs. BDT-USD Exchange Rate
Source: Bangladesh Bank Source: Bangladesh Bank

4. 4
Macroeconomic Risks and Their Mitigation
bank notes. As soon as the fresh money lands in the market, there is an almost immediate
inflationary effect as well as a significant multiplier effect.
Outlook: Managing Deficits on a Dual Front
The government is faced with managing deficits on a dual front: foreign exchange as well
as fiscal. Below are select forecasts and analysis with regard to the macroeconomic risks:
 Come November, there is expected to be an Eid-ul-Azha effect, particularly in the
domestic money market. Impact of the dollar outflow owing to the record number
of Hajj pilgrims has, for the most part, been captured in the current dollar rate.
However, in the domestic money market, closer to the Eid festival, there is
expected to be a liquidity crunch owing to large cash withdrawals by Eid
shoppers, by companies for inventory expansion to meet retail demand, and by
cattle traders in anticipation of the peak sales season. The increase in food prices
is less sustained since the festivities last for 3 days. However, the “Eid effect” on
banking sector liquidity will be noticeable. Call money rates will increase, as will
bank lending rates, which is in turn is expected to have an indirect and slightly
lagged effect on food inflation.
 In Q1 FY2012, according to Bangladesh Bank statistics, petroleum imports
increased 151% and capital machinery 44% y-o-y. The forecast for Q2 petroleum
imports is expected to remain high and may even increase if global oil prices
increase as winters set in, in large oil-consuming countries. Although the oil price
increase may be more significant in Q3 and Q4 FY2012, owing to the gradual
bottoming of EU and US economies, and by extension, increased oil demand -
possible increases in Q2 can put pressure on government subsidy costs. Further
revisions to fuel prices in the domestic market are inevitable both because the
current revisions do not significantly relieve the cost burden of government
subsidies, and global oil prices increase.
 Forecast for remittance flows are expected to be more or less flat. Exports in Q2
are expected to show growth, but in some, deficits in trade will increase in
FY2012. The government forecast for remittance growth is 5%, down from 6.03%
last fiscal. According to the IMF, trade deficit is expected to increase by 31% by
the end of the fiscal and the foreign currency reserve of the government will be
under severe pressure. Escalating fuel import bills and flat remittance inflow may
see the reserve go below the $10 billion mark again. Theoretically, a fall below
$9.7 billion would see the government’s imports rise as the cost of borrowing
increases.
 A silver lining in the horizon is that the government has fulfilled most of the
conditions tied to availing a $1 billion Extended Credit Facility (ECF) fund from the
IMF. Consequently, the chances of receiving the funds are high.
In sum, the moment is nigh for serious and well-considered policy prescriptions wherein the
emphasis has to be on intermediate- to long-term fixes. Short-term surveillance of lending
rates, foreign exchange rates, and power generation are important; however, in order to
ensure the sustainability of macroeconomic solutions, the government has to think of
Figure 7: Int. Reserves (Months of imports) vs. Remittance
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Reserves (Months of Imports) Remittance
Source: Bangladesh Bank

5. 5
Macroeconomic Risks and Their Mitigation
creating conditions for stability in FY2012 and growth in FY2013. Of course, a
comprehensive list of policy prescriptions to manage aforementioned risks can be endless
and is beyond the scope of this report. The general theme of policy designs has to be two-
fold: increase resilience of external sector contribution to GDP growth and promote
investment as a driver of economic growth. In line with the above, we list areas that require
government attention:
 Regulatory intervention to curb sustained appreciation of land prices to facilitate
new business investments and foreign direct investment (FDI)
 Investment generation in sectors that entail large-scale employment
(infrastructure, agriculture, etc)
 Improvement in trade relations to increase trade volume with neighbors
 Diversification of export basket and destinations
 Development of and investment in port facilities
 Promotion of and investment in vocational and skill-based education in order to
increase export of semi-skilled and skilled labor
 Development of labor attaches within Bangladesh missions in existing and
potential destinations for migrant labor
 Assessment of potential of Latin American and select African countries as
destinations for Bangladeshi migrant labor
 Revival of confidence and institutional participation in the capital markets;
promotion of foreign portfolio investment (FPI)
 Development of a business and knowledge process off-shoring (BPO-KPO)
industry in Bangladesh via consultation with successful foreign BPO/KPO
enterprises
 Regulatory development to promote private equity investment (foreign and local)
in the IT value chain
Moreover, we propose the following short-term moves for consideration by the government
in order to ensure macroeconomic stability:
 Fulfillment of eligibility criteria for the said IMF loan as well as an expeditious
resolution of issues surrounding the Padma Bridge project. The inflow of an
estimated $2.2 billion dollars will have a significant impact in stabilizing foreign
exchange
 Strengthening of diplomatic ties with countries like Malaysia and Saudi Arabia to
augment manpower export and remittance
 Curbing of unnecessary imports (e.g. automobiles) to lower import bills
 Formation of a coal policy to ensure existence of an alternative source of energy
The macroeconomic situation is challenging to say the least. However, judicious policy
interventions both in the near-term and long-term, can still steer the macroeconomic ship
the in the correct direction and restore the Bangladesh success story.

6. 6
Macroeconomic Risks and Their Mitigation
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