Macroeconomic risks and their mitigation : Preserving the Bangladesh growth story (October 16, 2011)


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

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Macroeconomic risks and their mitigation : Preserving the Bangladesh growth story (October 16, 2011)

  1. 1. As is the case for any emerging economy, inflation in Bangladesh remains an unwantedbyproduct of accelerating economic growth. In FY2011, the country grew at a rate of6.67%, with an average inflation rate of 8.8%. Inflation was high in FY2011, reaching apeak 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 aperiod of about seven months. However, inflation continues to be a problem, seeminglymore so than in the previous fiscal, albeit the drivers have changed. This report aims toidentify the factors that are contributing to inflationary pressure, and provide an outlook forthe economy in the coming months.Dynamics of Inflation: Food prices no longer the driving forceIn the second half of FY2011, point-to-point inflation started to climb, rising from 8.28% inDecember 2010 to 10.67% in April 2011. The main driver was food prices, which roseboth internationally and in local markets. At home, food inflation rose from 11.01% inDecember 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 infood prices has a noticeable effect on headline inflation.However, by end-FY2011, the country experienced a bumper “boro” rice harvest, helpingdecelerate food inflation. Food inflation slowed to 12.51% by June 2011 while overallinflation fell to 10.17%. The end however was not in sight, as Ramadan started in Augustculminating in the Eid-festival – a period of about a month wherein food prices historicallyrise on a seasonal basis. The case was no different this time; prices rose and foodinflation 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 verysharply at the turn of the fiscal. On a point-to-point basis, non-food inflation rose from6.46% to 8.76% between July and August 2011. Signs are afoot that this is a trend thatwill sustain in the near term, barring proactive policy interventions by the government inthe near-term.Macroeconomic Risks and Their Mitigation:Preserving the Bangladesh Growth StorySajid Huq Amitsajid.huq@bracepl.comAasim Tajwaar Matintajwaar.matin@bracepl.com0.00%2.00%4.00%6.00%8.00%10.00%12.00%14.00%Jul-06Sep-06Nov-06Jan-07Mar-07May-07Jul-07Sep-07Nov-07Jan-08Mar-08May-08Jul-08Sep-08Nov-08Jan-09Mar-09May-09Jul-09Sep-09Nov-09Jan-10Mar-10May-10Jul-10Sep-10Nov-10Jan-11Mar-11May-11Jul-11CPI Inflation (Point-to-Point) CPI Inflation (12-month Avg)0.00%2.00%4.00%6.00%8.00%10.00%12.00%14.00%16.00%Jul-06Oct-06Jan-07Apr-07Jul-07Oct-07Jan-08Apr-08Jul-08Oct-08Jan-09Apr-09Jul-09Oct-09Jan-10Apr-10Jul-10Oct-10Jan-11Apr-11Jul-11Food Inflation (Point-to-Point) Food Inflation (12-month Avg)Figure 1: CPI Inflation Figure 2: Food Inflation0.00%1.00%2.00%3.00%4.00%5.00%6.00%7.00%8.00%9.00%10.00%Jul-06Oct-06Jan-07Apr-07Jul-07Oct-07Jan-08Apr-08Jul-08Oct-08Jan-09Apr-09Jul-09Oct-09Jan-10Apr-10Jul-10Oct-10Jan-11Apr-11Jul-11Non-food Inflation (Point-to-Point) Non-food Inflation (12-month Avg)Figure 3: Non-food InflationFood prices were very high in thesecond half of FY2011, drivinginflation to very high levelsNon-food inflation has become themain driver of headline inflation in thefirst half of FY2012Source: Bangladesh Bank Source: Bangladesh BankSource: Bangladesh Bank
  2. 2. 2Macroeconomic Risks and Their MitigationDrivers: Energy Prices, Foreign Exchange and Bank BorrowingRevisions in Energy PricesThere have been some major upward price revisions that have caused non-food inflation tosurge. 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 powerprojects. 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 thereforebecome a priority area for the government. Driven by fuel demand of the new rental dieseland furnace oil-fired power plants, volatile international crude prices and expansion ofdiesel-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 tothe 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 hasbeen 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 alreadycontributing to 25% of electricity generation --(up from 5% in June 2010). The use of liquidfuel for purposes of energy generation is expected to increase in the coming months. Asmore diesel and furnace power plants hit upstream, fuel import bills will continue toescalate.The soaring fuel import bills have exacted a heavy pressure on the government in the formof subsidies. In order to reduce the pressure of subsidies which is far higher than what wasaccounted for in the FY2011-12 budget, the government has had to revise upwards theprice of fuel and bulk power tariff. Power tariff revisions occurred in two phases: once inFebruary and again in August 2011. Next, on September 18, the government increasedprices of fuels: petrol, octane, diesel and kerosene by BDT 5 per liter each, furnace oil priceby 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 productionincreases. 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, transportfares and carrying costs of goods increase, causing a further increase in the prices of fooditems and essential commodities. An upward revision of fares of buses and other modes ofpublic transport follow. More indirectly, wholesalers and retailers sometimes artificiallyinflate prices of commodities on the grounds of the increased fuel prices, even if they arenot immediately impacted by the hike.It should be noted that the costs of subsidies are still very exacting, and it is believed thatdespite upward revisions in price, less than 40% of the cost of subsidy has so far beenpassed on to the end-customer. Without increasing fuel prices, in order to address theballooning subsidy bill, the government would have to borrow from banks by selling bondsor printing new bank notes. Already, government borrowing from banks has reachedunprecedented levels as is discussed in a subsequent section. Consequently, furtherrounds of fuel price hikes appear to be inevitable, as has been stated by the BangladeshPower Development Board (PDB).Dollar Crisis and its ImpactHigher import bills in relation to export earnings and remittance flows have put significantpressure on the foreign currency reserves of the country. Export growth has been steadyso far this fiscal but remittance growth is expected to be flat. Import bills on the other handEnergy prices and power tariffs havebeen revised in quick successions inthe first half of FY2012Less than 40% of fuel subsidy costsare passed on to the end-customer;further fuel price hikes may be likelyFigure 4: Composition of electricity generation0%10%20%30%40%50%60%70%80%90%100%2007 2008 2009 2010 2011Hydro Coal Gas OilSource: PDB and Power Grid
  3. 3. 3Macroeconomic Risks and Their Mitigationhave escalated, putting serious pressure on the foreign currency reserves, and creating avery threatening imbalance between dollar demand and supply.Driving import bills are petroleum and capital machinery purchases. However, the former ismore pernicious and its effects may be rather severe. Petroleum import bills are estimatedto 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 thecalendar year 2010, has depreciated further this fiscal and may worsen in the comingmonths 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 Bangladeshipilgrims performing the Hajj this year. An unprecedented 107,000 pilgrims from Bangladeshare performing the Hajj this year, up from 59,000 last year. On October 10, 2011, dollarswere sold at BDT 76.40 at banks, nearly 2% higher month-on-month. Meanwhile, on thesame day, in the informal (kerb) market and different exchange houses of Dhaka, the dollarsold at an exorbitant BDT 79.The government has reacted to this soaring exchange rate by arranging a meeting with theBangladesh Foreign Exchange Dealers Association (BAFEDA). As an outcome of themeeting, members of the BAFEDA decided to maintain the dollar exchange rate at BDT 76at the customer level for 15 days, up to October 26, 2011. However, such fixing is notexpected to work in the longer term.The foreign currency deficit has already impacted inflation and may continue to do so in thecoming months. However, the relationship between foreign currency deficit and inflation isa bit indirect. In the short-term, dollar depreciation will drive up import payments by thegovernment, which in turn will raise subsidy costs. In response, the government will have toadjust energy prices upwards or increase borrowing from the banking system, aggravatinginflationary conditions either way.Bank Borrowing by the GovernmentThe first few months of the current fiscal has seen unprecedented levels of governmentborrowing from the banking system. The government’s net borrowing reached BDT 69.32billion 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 andagriculture sectors. Since the beginning of September, the government has borrowed BDT37.09 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 nationalsavings certificate and other sources). The latter is set to rise and the government hasraised the ceiling of short-term borrowing from the central bank to BDT 20 billion from BDT10 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 buygovernment securities. Bank loan-to-deposit ratios decline as a result, squeezing bankinterest rate spreads and their profitability. Consequently, lending rates to the private sectorincreases, leading to higher costs of production as well as prices of various goods andservices. Moreover, government borrowing from the Bangladesh Bank entails printing newGovernment borrowing from thebanking system has risen many foldstill SeptemberOil import and currency depreciationhave direct impacts on inflationFigure 5: Inflation vs. Oil Imports Figure 6: Imports vs. BDT-USD Exchange RateSource: Bangladesh Bank Source: Bangladesh Bank
  4. 4. 4Macroeconomic Risks and Their Mitigationbank notes. As soon as the fresh money lands in the market, there is an almost immediateinflationary effect as well as a significant multiplier effect.Outlook: Managing Deficits on a Dual FrontThe government is faced with managing deficits on a dual front: foreign exchange as wellas 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 thedomestic money market. Impact of the dollar outflow owing to the record numberof 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 isexpected to be a liquidity crunch owing to large cash withdrawals by Eidshoppers, by companies for inventory expansion to meet retail demand, and bycattle traders in anticipation of the peak sales season. The increase in food pricesis less sustained since the festivities last for 3 days. However, the “Eid effect” onbanking sector liquidity will be noticeable. Call money rates will increase, as willbank lending rates, which is in turn is expected to have an indirect and slightlylagged effect on food inflation. In Q1 FY2012, according to Bangladesh Bank statistics, petroleum importsincreased 151% and capital machinery 44% y-o-y. The forecast for Q2 petroleumimports is expected to remain high and may even increase if global oil pricesincrease as winters set in, in large oil-consuming countries. Although the oil priceincrease may be more significant in Q3 and Q4 FY2012, owing to the gradualbottoming of EU and US economies, and by extension, increased oil demand -possible increases in Q2 can put pressure on government subsidy costs. Furtherrevisions to fuel prices in the domestic market are inevitable both because thecurrent revisions do not significantly relieve the cost burden of governmentsubsidies, and global oil prices increase. Forecast for remittance flows are expected to be more or less flat. Exports in Q2are expected to show growth, but in some, deficits in trade will increase inFY2012. 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% bythe end of the fiscal and the foreign currency reserve of the government will beunder severe pressure. Escalating fuel import bills and flat remittance inflow maysee 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 borrowingincreases. A silver lining in the horizon is that the government has fulfilled most of theconditions tied to availing a $1 billion Extended Credit Facility (ECF) fund from theIMF. Consequently, the chances of receiving the funds are high.In sum, the moment is nigh for serious and well-considered policy prescriptions wherein theemphasis has to be on intermediate- to long-term fixes. Short-term surveillance of lendingrates, foreign exchange rates, and power generation are important; however, in order toensure the sustainability of macroeconomic solutions, the government has to think ofFigure 7: Int. Reserves (Months of imports) vs. Remittance0.000.200.400.600.801. (Months of Imports) RemittanceSource: Bangladesh Bank
  5. 5. 5Macroeconomic Risks and Their Mitigationcreating conditions for stability in FY2012 and growth in FY2013. Of course, acomprehensive list of policy prescriptions to manage aforementioned risks can be endlessand 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 promoteinvestment as a driver of economic growth. In line with the above, we list areas that requiregovernment attention: Regulatory intervention to curb sustained appreciation of land prices to facilitatenew 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 toincrease export of semi-skilled and skilled labor Development of labor attaches within Bangladesh missions in existing andpotential destinations for migrant labor Assessment of potential of Latin American and select African countries asdestinations 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/KPOenterprises Regulatory development to promote private equity investment (foreign and local)in the IT value chainMoreover, we propose the following short-term moves for consideration by the governmentin order to ensure macroeconomic stability: Fulfillment of eligibility criteria for the said IMF loan as well as an expeditiousresolution of issues surrounding the Padma Bridge project. The inflow of anestimated $2.2 billion dollars will have a significant impact in stabilizing foreignexchange Strengthening of diplomatic ties with countries like Malaysia and Saudi Arabia toaugment 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 energyThe macroeconomic situation is challenging to say the least. However, judicious policyinterventions both in the near-term and long-term, can still steer the macroeconomic shipthe in the correct direction and restore the Bangladesh success story.
  6. 6. 6Macroeconomic Risks and Their MitigationIMPORTANT DISCLOSURESAnalyst Certification: Each research analyst and research associate who authored this document andwhose name appears herein certifies that the recommendations and opinions expressed in the researchreport accurately reflect their personal views about any and all of the securities or issuers discussed thereinthat are within the coverage universe.Disclaimer: Estimates and projections herein are our own and are based on assumptions that we believe tobe reasonable. Information presented herein, while obtained from sources we believe to be reliable, is notguaranteed either as to accuracy or completeness. Neither the information nor any opinion expressed hereinconstitutes a solicitation of the purchase or sale of any security. As it acts for public companies from time totime, BRAC-EPL may have a relationship with the above mentioned company(s). This report is intended fordistribution in only those jurisdictions in which BRAC-EPL is registered and any distribution outside thosejurisdictions is strictly prohibited.Compensation of Analysts: The compensation of research analysts is intended to reflect the value of theservices they provide to the clients of BRAC-EPL. As with most other employees, the compensation ofresearch analysts is impacted by the overall profitability of the firm, which may include revenues fromcorporate finance activities of the firms Corporate Finance department. However, Research analystscompensation is not directly related to specific corporate finance transaction.General Risk Factors: BRAC-EPL will conduct a comprehensive risk assessment for each company undercoverage at the time of initiating research coverage and also revisit this assessment when subsequent updatereports are published or material company events occur. Following are some general risks that can impactfuture operational and financial performance: (1) Industry fundamentals with respect to customer demand orproduct / service pricing could change expected revenues and earnings; (2) Issues relating to majorcompetitors or market shares or new product expectations could change investor attitudes; (3) Unforeseendevelopments with respect to the management, financial condition or accounting policies alter the prospectivevaluation; or (4) Interest rates, currency or major segments of the economy could alter investor confidenceand investment prospects.BRAC EPL Stock Brokerage Capital Markets GroupSajid Huq Amit Senior Research Analyst 0175 554 1254Parvez Morshed Chowdhury Research Analyst 0173 035 7154Ali Imam Investment Analyst 01730 357 153Khandakar Safwan Saad Research Associate 01730 357 779Aasim Tajwaar Matin Research Associate 01730 727 913Shahnewaz Kabir Research Associate 01730 727 918Farjad Siddiqui Research Associate 01730 727 924BRAC EPL Researchwww.bracepl.comWW Tower (7thFloor)68 Motijheel C/A, Dhaka-1000Tel: +88 02 951 4721-30Fax: +88 02 955 3306E-Mail: