MACRO Economics Assignment

Monetary policy of Bangladesh MGT-301

AssignmentOn

“MACROECONOMICS”

COURSE # MGT 301

Monetary policy of Bangladesh

Submitted to: Dr. Faruq AhmedProfessor, Department of Management Studies,University of Dhaka.

Submitted by:

“Perpetual”Section: AB.B.A. - 11th BatchDepartment of Management Studies,University of Dhaka.

Date of submission: 15-11-07

1


Name of Group Members(Perpetual)

Serial No

Name Roll No

1 Ramjanul Ahsan 02

2 Md. Masud Parvez 19

3 Md. Afzalur Rahman 31

4 Safayet Rahman 93

2


Letter of Transmittal

Dr. Faruq AhmedProfessor, Department of Management Studies,University of Dhaka.

Subject: Submission of assignment papers.

Dear Sir,It is an honor and great pleasure for us to submit our assignment on monetary policy of Bangladesh. This assignment was assigned to us as compulsory requirement of the course Macroeconomics (course #301) in the 5th semester.

During the process of preparing our assignment, we had the chance of experiencing and rediscovering our potentials. This assignment gave us an opportunity to apply our theoretical expertise, sharpen our views, ideas and communication skills, which will help us in our future professional career.

Thanking you and looking forward to receive your cordial approval of our submission.

Yours truly,

PerpetualSection: AB.B.A. - 11th BatchDepartment of management studies,University of Dhaka.

3


Table of Content

Monetary policy of Bangladesh

No. Part 01 (Prologue) Page No.

1. Overview of the topics 05

2. Definition of monetary policy: 06

3. History of monetary policy 07

4. Monetary policy theory 09

5. Types of monetary policy 11

6. Objectives of monetary policy: 15

7. Tools used in determining the monetary policy 15

8. Developing countries 16

Part 02 (Economic state of BD)

1. Introduction 17

2. Bangladesh : The Economic performance 20

3. Development challenge 25

Part 03 (Monetary policy statement)

1. Introduction 27

2. Macroeconomic development :outcome and outlook 27

3. Monetary policy stance 31

4. Bibliography 34

4


“Part 01”“Prologue”

1. Overview of the Topics

Monetary policy rests on the relationship between the rates of interest in an economy,

that is the price at which money can be borrowed, and the total supply of money.

Monetary policy uses a variety of tools to control one or both of these, to influence

outcomes like economic growth, inflation, exchange rates with other currencies and

unemployment. Where currency is under a monopoly of issuance, or where there is a

regulated system of issuing currency through banks which are tied to a central bank,

the monetary authority has the ability to alter the money supply and thus influence the

interest rate (in order to achieve policy goals). The beginning of monetary policy as

such comes from the late 19th century, where it was used to maintain the gold

standard.

A policy is referred to as contractionary if it reduces the size of the money supply or

raises the interest rate. An expansionary policy increases the size of the money

supply, or decreases the interest rate. Further monetary policies are described as

accommodative if the interest rate set by the central monetary authority is intended to

spur economic growth, neutral if it is intended to neither spur growth nor combat

inflation, or tight if intended to reduce inflation.

There are several monetary policy tools available to achieve these ends. Increasing

interest rates by fiat, reducing the monetary base, and increasing reserve requirements

all have the effect of contracting the money supply, and, if reversed, expand the

money supply. Since the 1970s, monetary policy has generally been formed

separately from fiscal policy. And even prior to the 1970s, the Bretton Woods

system still ensured that most nations would form the two policies separately.

Within almost all modern nations, special institutions (such as the Bank of England,

the European Central Bank or the Federal Reserve System in the United States) exist

which have the task of executing the monetary policy and often independently of the

5


executive. In general, these institutions are called central banks and often have other

responsibilities such as supervising the smooth operation of the financial system.

The primary tool of monetary policy is open market operations. This entails managing

the quantity of money in circulation through the buying and selling of various credit

instruments, foreign currencies or commodities. All of these purchases or sales result

in more or less base currency entering or leaving market circulation.

Usually the short term goal of open market operations is to achieve a specific short

term interest rate target. In other instances, however, monetary policy might instead

entail the targeting of a specific exchange rate relative to some foreign currency or

else relative to gold. For example in the case of the USA the Federal Reserve targets

the federal funds rate, the rate at which member banks lend to one another overnight.

The other primary means of conducting monetary policy include: (i) Discount

window lending (i.e. lender of last resort); (ii) Fractional deposit lending (i.e. changes

in the reserve requirement); (iii) Moral suasion (i.e. cajoling certain market players to

achieve specified outcomes); (iv) "Open mouth operations" (i.e. talking monetary

policy with the market).

2. Definition of monetary policy

Monetary policy is the process by which the government, central bank, or monetary

authority manages the supply of money, or trading in foreign exchange markets.

Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy is generally referred to as either being an expansionary policy, or a

contractionary policy, where an expansionary policy increases the total supply of

money in the economy, and a contractionary policy decreases the total money supply.

Expansionary policy is traditionally used to combat unemployment in a recession by

lowering interest rates, while contractionary policy has the goal of raising interest

rates to combat inflation (or cool an otherwise overheated economy). Monetary policy

should be contrasted with fiscal policy, which refers to government borrowing,

spending and taxation.

6


3. History of monetary policy

Monetary policy is associated with currency and credit. For many centuries there were

only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print

paper money to create credit. Interest rates, while now thought of as part of monetary

authority, were not generally coordinated with the other forms of monetary policy.

Monetary policy was seen as an executive decision, and was generally in the hands of

the authority with seigniorage, or the power to coin. With the advent of larger trading

networks came the ability to set the price between gold and silver, and the price of the

local currency to foreign currencies. This official price could be enforced by law,

even if it varied from the market price.

With the creation of the Bank of England in 1694, which acquired the responsibility

to print notes and back them with gold, the idea of monetary policy as independent of

executive action began to be established. The goal of monetary policy was to maintain

the value of the coinage, print notes which would trade at par to specie, and prevent

coins from leaving circulation. The establishment of central banks by industrializing

nations was associated then with the desire to maintain the nation's peg to the gold

standard, and to trade in a narrow band with other gold back currencies. To

accomplish this end, central banks as part of the gold standard began setting the

interest rates that they charged, both their own borrowers, and other banks that

required liquidity. The maintenance of a gold standard required almost monthly

adjustments of interest rates.

During the 1870-1920 period the industrialized nations set up central banking

systems, with one of the last being the Federal Reserve in 1913. By this point the

understanding of the central bank as the "lender of last resort" was understood. It was

also increasingly understood that interest rates had an effect on the entire economy, in

no small part because of the marginal revolution in economics, which focused on how

many more, or how many fewer, people would make a decision based on a change in

the economic trade-offs. It also became clear that there was a business cycle, and

economic theory began understanding the relationship of interest rates to that cycle.

(Nevertheless, steering a whole economy by influencing the interest rate has often

been described as trying to steer an oil tanker with a canoe paddle.)

7


The advancement of monetary policy as a pseudo scientific discipline has been quite

rapid in the last 150 years, and it has increased especially rapidly in the last 50 years.

Monetary policy has grown from simply increasing the monetary supply enough to

keep up with both population growth and economic activity. It must now take into

account such diverse factors as:

short term interest rates;

long term interest rates;

velocity of money through the economy;

exchange rates;

credit quality;

bonds and equities (corporate ownership and debt);

government versus private sector spending/savings;

international capital flows of money on large scales;

Financial derivatives such as options, swaps, futures contracts, etc.

A small but vocal group of people advocate for a return to the gold standard (the

elimination of the dollar's fiat currency status and even of the Federal Reserve Bank).

Their argument is basically that monetary policy is fraught with risk and these risks

will result in drastic harm to the populace should monetary policy fail.

Most economists disagree with returning to a gold standard. They argue that doing so

would drastically limit the money supply, and throw away 100 years of advancement

in monetary policy. The sometimes complex financial transactions that make big

business (especially international business) easier and safer would be much more

difficult if not impossible. Moreover, shifting risk to different people/companies that

specialize in monitoring and using risk can turn any financial risk into a known dollar

amount and therefore make business predictable and more profitable for everyone

involved.

8


4. Monetary policy theory

It is important for policymakers to make credible announcements and degrade interest

rates as they are non- important and irrelevant in regarding to monetary policies. If

private agents (consumers and firms) believe that policymakers are committed to

lowering inflation, they will anticipate future prices to be lower than otherwise (how

those expectations are formed is an entirely different matter; compare for instance

rational expectations with adaptive expectations). If an employee expects prices to be

high in the future, he or she will draw up a wage contract with a high wage to match

these prices. Hence, the expectation of lower wages is reflected in wage-setting

behavior between employees and employers (lower wages since prices are expected to

be lower) and since wages are in fact lower there is no demand pull inflation

because employees are receiving a smaller wage and there is no cost push inflation

because employers are paying out less in wages.

However, to achieve this low level of inflation, policymakers must have credible

announcements, that is, private agents must believe that these announcements will

reflect actual future policy. If an announcement about low-level inflation targets is

made but not believed by private agents, wage-setting will anticipate high-level

inflation and so wages will be higher and inflation will rise. A high wage will increase

a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation),

so inflation rises. Hence, if a policymaker's announcements regarding monetary

policy are not credible, policy will not have the desired effect.

However, if policymakers believe that private agents anticipate low inflation, they

have an incentive to adopt an expansionist monetary policy (where the marginal

benefit of increasing economic output outweighs the marginal cost of inflation).

However, assuming private agents have rational expectations, they know that

policymakers have this incentive. Hence, private agents know that if they anticipate

low inflation, an expansionist policy will be adopted that causes a rise in inflation.

Therefore, (unless policymakers can make their announcement of low inflation

credible), private agents expect high inflation. This anticipation is fulfilled through

9


adaptive expectation (wage-setting behavior) and so there is higher inflation (without

the benefit of increased output). Hence, unless credible announcements can be made,

expansionary monetary policy will fail.

Announcements can be made credible in various ways. One is to establish an

independent central bank with low inflation targets (but no output targets). Hence,

private agents know that inflation will be low because it is set by an independent

body. Central banks can be given incentives to meet their targets (for example, larger

budgets, a wage bonus for the head of the bank) in order to increase their reputation

and signal a strong commitment to a policy goal. Reputation is an important element

in monetary policy implementation. But the idea of reputation should not be confused

with commitment. While a central bank might have a favorable reputation due to good

performance in conducting monetary policy, the same central bank might not have

chosen any particular form of commitment (such as targeting a certain range for

inflation). Reputation plays a crucial role in determining how much markets would

believe the announcement of a particular commitment to a policy goal but both

concepts should not be assimilated. Also, note that under rational expectations, it is

not necessary for the policymaker to have established its reputation through past

policy actions; as an example, the reputation of the head of the central bank might be

derived entirely from her or his ideology, professional background, public statements,

etc. In fact it has been argued (add citation to Kenneth Rogoff, 1985.Hence the

reputation of a particular central bank is not necessary tied to past performance, but

rather to particular institutional arrangements that the markets can use to form

inflation expectations.

10


5. Types of monetary policy

In practice all types of monetary policy involve modifying the amount of base

currency (M0) in circulation. This process of changing the liquidity of base currency

through the open sales and purchases of (government-issued) debt and credit

instruments is called open market operations.

Constant market transactions by the monetary authority modify the supply of currency

and this impacts other market variables such as short term interest rates and the

exchange rate.

The distinction between the various types of monetary policy lies primarily with the

set of instruments and target variables that are used by the monetary authority to

achieve their goals.

Monetary Policy:Target Market

Variable:Long Term Objective:

Inflation TargetingInterest rate on overnight

debtA given rate of change in the CPI

Price Level

Targeting

Interest rate on overnight

debtA specific CPI number

Monetary

Aggregates

The growth in money

supplyA given rate of change in the CPI

Fixed Exchange

Rate

The spot price of the

currencyThe spot price of the currency

Gold Standard The spot price of goldLow inflation as measured by the

gold price

Mixed Policy Usually interest ratesUsually unemployment + CPI

change

The different types of policy are also called monetary regimes, in parallel to

exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The

Gold standard results in a relatively fixed regime towards the currency of other

countries on the gold standard and a floating regime towards those that are not.

11


Targeting inflation, the price level or other monetary aggregates implies floating

exchange rate unless the management of the relevant foreign currencies is tracking the

exact same variables (such as a harmonized consumer price index).

Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition

such as Consumer Price Index, within a desired range.

The inflation target is achieved through periodic adjustments to the Central Bank

interest rate target. The interest rate used is generally the inter-bank rate at which

banks lend to each other overnight for cash flow purposes. Depending on the country

this particular interest rate might be called the cash rate or something similar.

The interest rate target is maintained for a specific duration using open market

operations. Typically the duration that the interest rate target is kept constant will vary

between months and years. This interest rate target is usually reviewed on a monthly

or quarterly basis by a policy committee.

Changes to the interest rate target are made in response to various market indicators in

an attempt to forecast economic trends and in so doing keep the market on track

towards achieving the defined inflation target.

This monetary policy approach was pioneered in New Zealand. It is currently used in

the Euro zone, Australia, Canada, New Zealand, Norway, Poland, Sweden, South

Africa, Turkey, and the United Kingdom.

Price level targeting

Price level targeting is similar to inflation targeting except that CPI growth in one

year is offset in subsequent years such that over time the price level on aggregate does

not move.

Something akin to price level targeting was tried in the 1930s by Sweden, and seems

to have contributed to the relatively good performance of the Swedish economy

12


during the Great Depression. As of 2004, no country operates monetary policy based

on a price level target.

Monetary aggregates

In the 1980s several countries used an approach based on a constant growth in the

money supply. This approach was refined to include different classes of money and

credit (M0, M1 etc). In the USA this approach to monetary policy was discontinued

with the selection of Alan Greenspan as Fed Chairman.

This approach is also sometimes called monetarism.

Whilst most monetary policy focuses on a price signal of one form or another this

approach is focused on monetary quantities.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency.

There are varying degrees of fixed exchange rates, which can be ranked in relation to

how rigid the fixed exchange rate is with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authority

declares a fixed exchange rate but does not actively buy or sell currency to maintain

the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital

controls, import/export licenses, etc.). In this case there is a black market exchange

rate where the currency trades at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the central

bank or monetary authority on a daily basis to achieve the target exchange rate. This

target rate may be a fixed level or a fixed band within which the exchange rate may

fluctuate until the monetary authority intervenes to buy or sell as necessary to

maintain the exchange rate within the band. (In this case, the fixed exchange rate with

a fixed level can be seen as a special case of the fixed exchange rate with bands where

the bands are set to zero.)

13


Under a system of fixed exchange rates maintained by a currency board every unit of

local currency must be backed by a unit of foreign currency (correcting for the

exchange rate). This ensures that the local monetary base does not inflate without

being backed by hard currency and eliminates any worries about a run on the local

currency by those wishing to convert the local currency to the hard (anchor) currency.

These policies often abdicate monetary policy to the foreign monetary authority or

government as monetary policy in the pegging nation must align with monetary policy

in the anchor nation to maintain the exchange rate. The degree to which local

monetary policy becomes dependent on the anchor nation depends on factors such as

capital mobility, openness, credit channels and other economic factors.

Managed Float

Officially, the Indian Rupee (INR) exchange rate is supposed to be 'market

determined'. In reality, the Reserve Bank of India (RBI) trades actively on the

INR/USD with the purpose of controlling the volatility of the Rupee - US Dollar

exchange rate - within a narrow bandwidth. (i.e. pegs it to the US Dollar)

Gold standard

The gold standard is a system in which the price of the national currency as measured

in units of gold bars and is kept constant by the daily buying and selling of base

currency to other countries and nationals. (i.e. open market operations, cf. above). The

selling of gold is very important for economic growth and stability.Today this type of

monetary policy is not used anywhere in the world, although a form of gold standard

was used widely across the world prior to 1971. For details see the Bretton Woods

system. Its major advantages were simplicity and transparency.

Mixed policy

In practice a mixed policy approach is most like "inflation targeting". However some

consideration is also given to other goals such as economic growth, unemployment

and asset bubbles. This type of policy was used by the Federal Reserve in 1998.

14


6. Objectives of monetary policy

Since monetary policy is one instrument of economic policy, its objective can not be

different from those of overall economic policy. The three important objectives of

monetary policy are:

i. Ensuring price stability that is containing inflation.

ii. To encourage economic growth.

iii. To ensure stability of exchange rate of money, that is exchange rate of money

with other foreign currencies.

7. Tools used in determining the monetary policy

Monetary base

Monetary policy can be implemented by changing the size of the monetary base. This

directly changes the total amount of money circulating in the economy. A central

bank can use open market operations to change the monetary base.

The central bank would buy/sell bonds in exchange for hard currency. When the

central bank disburses/collects this hard currency payment, it alters the amount of

currency in the economy, thus altering the monetary base.

Reserve requirements

The monetary authority exerts regulatory control over banks. Monetary policy can be

implemented by changing the proportion of total assets that banks must hold in

reserve with the central bank.

Banks only maintain a small portion of their assets as cash available for immediate

withdrawal; the rest is invested in illiquid assets like mortgages and loans.By

changing the proportion of total assets to be held as liquid cash, the Federal Reserve

changes the availability of loan able funds. This acts as a change in the money supply.

15


Discount window lending

Many central banks or finance ministries have the authority to lend funds to financial

institutions within their country. By calling in existing loans or extending new loans,

the monetary authority can directly change the size of the money supply.

Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing the

nominal interest rates. Monetary authorities in different nations have differing levels

of control of economy-wide interest rates. In the United States, the Federal Reserve

can set the discount rate, as well as achieve the desired Federal funds rate by open

market operations. This rate has significant effect on other market interest rates, but

there is no perfect relationship.In other nations, the monetary authority may be able to

mandate specific interest rates on loans, savings accounts or other financial assets. By

raising the interest rate(s) under its control, a monetary authority can contract the

money supply, because higher interest rates encourage savings and discourage

borrowing. Both of these effects reduce the size of the money supply.

8. Developing countries

Developing countries may have problems operating monetary policy effectively. The

primary difficulty is that few developing countries have deep markets in government

debt. The matter is further complicated by the difficulties in forecasting money

demand and fiscal pressure to levy the inflation tax by expanding the monetary base

rapidly. In general, central banks in developing countries have had a poor record in

managing monetary policy. This is often because the monetary authority in a

developing country is not independent of government, so good monetary policies

takes a backseat to the political desires of the government or are used to pursue other

non-monetary goals. For this and other reasons, developing countries that want to

establish credible monetary policy may institute a currency board or adopt

dollarisation. Such forms of monetary institutions thus essentially tie the hands of the

government from interference and, it is hoped, that such policies will import the

monetary policy of the anchor nation.

16


“Part 02”“Economic state of BD”

1. Introduction of Monetary policy of Bangladesh

Monetary Policy the policy adopted by the central bank for control of the supply of

money as an instrument for achieving the objectives of general economic policy. As

stated in the Bangladesh Bank Order 1972, the principal objectives of the country's

monetary policy are to regulate currency and reserves; to manage the monetary and

credit system; to preserve the par value of domestic currency; to promote and

maintain a high level of production, employment and real income; and to foster

growth and development of the country's productive resources in the best national

interest. Although the long term focus of monetary policy in Bangladesh is on growth

with stability, the short-term objectives are determined after a careful and realistic

appraisal of the current economic situation of the country.

At 6% over the past 4 years, strong GDP growth has been underpinned by more

market-oriented economic policies, a dynamic garment sector, and substantial inflows

of overseas workers’ remittances. The lead-up to the parliamentary elections was

generally expected to be a rough patch given the country’s contentious political

environment; the constitutional mechanism of a neutral caretaker government was

expected to help smooth the way. Deepening political deadlock culminated with the

president in January declaring a state of emergency and calling o? the elections. But

the new caretaker Government has continued with established economic policies and

expedited structural and sector reforms. It has taken a broad agenda of activity,

including an extensive anticorruption drive that it sees necessary to establish better

foundations for holding the elections. GDP is forecast to maintain its recent

momentum over the medium term.

With the shifts of the policy stance of the government in various phases, necessary

adjustments were made in the country's monetary policy. In the first years after

liberation, the primary target of monetary policy was to regulate not the quantity of

money, but the direction of the flow of money and credit in support of the government

financial programme. In 1975, Bangladesh entered into a standby-arrangement with

17


IMF and the country's monetary policy got a changed shape, which fixed an explicit

target of safe limit of monetary expansion on annual basis. With this change,

BANGLADESH BANK started setting short-term objectives of monetary policy in close

collaboration of the government and tried to achieve the target by using the direct

instrument of control. The principal target of monetary control was broad money

(M2) ie, the sum of the currency in circulation and total deposits of money in banks.

The targeted growth of M2 depended on a realistic forecast of the growth rate of real

GDP, an acceptable rate of inflation and an attainable level of international reserves.

Bangladesh Bank took measures to monitor credit and monetary expansion keeping in

view the price situation and international reserves position. Efforts were made to

achieve the targeted growth of domestic credit and thereby, the money supply,

through imposing ceilings on credit to the government, public, and private sectors.

The major policy instruments available to Bangladesh Bank were to set credit ceiling

on the banks and provide liberal refinance facility at concessional rate for priority

lending. According to the national economic policy, the banks were to provide the

desired volume of credit at an administered and low rate of interest. In that situation,

Bangladesh Bank practically did not have any effective instrument for making

adjustments in the growth of money supply or for transmitting market signals into

changes in money supply. The monetary policy therefore, could not function in its

true sense. As a result the BANKING SYSTEM could not play its role as an effective

financial intermediary.

In 1989, the government adopted a comprehensive Financial Sector Reform

Programme (FSRP), following which the country's monetary policy assumed a new

orientation towards promotion of market economy in a competitive environment.

Bangladesh Bank started moving away from direct quantitative monetary control to

indirect methods of monetary management since the beginning of 1990. Major

instruments of monetary control available with Bangladesh Bank are the bank rate,

open market operations, rediscount policy, and statutory reserve requirement.

Bank rate Until 1990, the use of this instrument as the lending rate of the central bank

for borrowings of the commercial banks to meet their temporary needs was virtually

non-existent in Bangladesh. The rate was changed in a few occasions only to align it

with the refixation of the rates of deposits and advances. Moreover, the existence of

18


refinance facilities at rates lower than the bank rate substantially eroded its

significance. However, since 1990, the instrument has been put in use to change the

cost of borrowings for banks and thereby to affect the market rate of interest. Bank

rate was gradually lowered from 9.75% in January 1990 to 5% in March 1994. It was

raised to 5.75% from 10 September 1995 and further, to 7.5% and 8% from 19 May

1997 and 20 November 1997 respectively. The rate was lowered to 7% from 29

August 1999.

Open market operations (OMO) These involve the sale or purchase of securities by

the central bank to withdraw liquid funds from the banking system or inject the same

into that system. OMO allows flexibility in terms of both the amount and timing of

intervention, which did not exist in Bangladesh before 1990. Bangladesh Bank

introduced a 91-day Bangladesh Bank Bill, a market-based tool for monetary

intervention, in December 1990. The bank bill was subsequently withdrawn from the

market. At present, OMO operations are conducted through participation of banks in

monthly or fortnightly/weekly auctions of TREASURY BILLs.

Rediscount policy After the introduction of FSRP, the refinance facility was replaced

by rediscount facility at bank rate to eliminate discrimination in access to central bank

funds. Refinance facility is now available for agricultural credit provided by

BANGLADESH KRISHI BANK and for projects of Bangladesh Rural Development Board

financed by SONALI BANK. Banks are advised to extend credit considering banker-

customer relationship.

Statutory reserve requirement Cash reserve requirement (CRR) of the deposit money

banks has a significant potential to regulate money supply through affecting money

multiplier, while statutory liquidity requirement (SLR) is generally used to affect the

lending capability of the bank. Bangladesh Bank used these two instruments very

infrequently before 1990 and very often after 1990. The CRR and SLR were 8% and

23% respectively on 25 April 1991 and were reduced to 7% and 22% respectively on

5 December 1991. Later, these rates were changed twice and set at 5% and 20%

respectively on 24 May 1992. The CRR was further lowered to 4% from 4 October

1999. The downward revision in CRR and SLR were made to enable the banks to

increase their lending capacity.

19


2. Bangladesh: The Economic performance

Growth in GDP has trended up in recent years, reaching 6.7% in FY2006 (ended 30

June 2006), driven by improved domestic and external demand. his performance was

reflected in a steady expansion in industry, lifted by export-oriented manufacturing,

and in continued services buoyancy . A marked reduction in poverty accompanied

growth: the headcount poverty rate declined by about 1.8 percentage points a year

between 2000 and 2005 to 40%, compared with a decline of only about 1 percentage

point a year in the preceding decade. The improvement was somewhat faster in rural

than urban areas. Rising access of the poor to micro credit, a rapid expansion in

overseas workers’ remittances, and improvements in physical and social infrastructure

all contributed to the sharp drop in poverty. In FY2006 on the expenditure side,

private consumption propelled growth. Investment rose by 0.5 percentage points to

25.0% of GDP, bolstered by a rise in private investment. Gross national savings

increased by 0.8 percentage points to 26.6% of GDP, lifted by a rise in workers’

remittances.

Net exports of goods and services remained negative. Inflation moved up steadily to

average 7.2%. This exceeded the 7.0% limit set by Bangladesh Bank, the central

bank, in its first Monetary Policy Statement (MPS) issued in January 2006. Demand

pressures generated by excess money, a sharp depreciation in the taka (Tk) against the

US dollar (of 8.5% in FY2006), and a rise in global commodity prices (including oil),

20


all heightened inflationary pressures. Rising exports of some consumer items, pulling

their domestic prices to higher global levels, also added to price pressures.

Despite attempts to tighten monetary policy, both money and credit aggregates

expanded rapidly in FY2006. Broad money grew by 19.5%, as against the MPS

program target of 14.3% and prior-year actual growth of 16.8%. Private sector credit

grew sharply because of rising credit demand in support of domestic economic

activity, while the public sector borrowed in excess of the credit target, mainly to

finance the high cost of imports by state-owned Bangladesh Petroleum Corporation

(BPC). To tighten credit, Bangladesh Bank raised key policy rates over the course of

the year: the 28-day treasury bill rate from 6.6% in the last quarter of FY2005 to 7.1%

in the last quarter of FY2006, and the reverse repo rate from 4.5% in June 2005 to

6.0% in June 2006. Yet because of excess liquidity in the system, these measures

failed to fully restrain credit growth. he second MPS, announced in mid-July 2006,

again aimed to tighten monetary policy, both to control inflation and to ease pressures

on the exchange rate, at the same time sustaining domestic output growth. The

introduction of the MPS is a welcome development as it seeks to bring greater

predictability to the policy regime and to avoid policy surprises, which should aid the

private sector in making its investment decisions. However, to derive greater benefit

from the MPS, the Government needs to allow Bangladesh Bank greater operational

autonomy and to establish greater coordination between monetary and fiscal policies.

At 3.3% of GDP, the central government deficit in FY2006 came in below the

budgeted 4.5%. this was because of lower than planned growth in both current and

development expenditures, and in spite of underperformance in revenue collection.

21


Current expenditures were lower as a result of tighter budgetary discipline and

reductions in unproductive outlays through austerity measures.

Development spending was kept at a lower than projected level by large cost

reductions in non priority projects, fewer unproductive expenditures, and slow project

implementation. Revenues fell short of target because expected increases in collection

arising from reforms and administrative improvements failed to materialize. So while

tax-reform efforts yielded some gain in domestic value-added tax and income tax

collection, overall targets were missed in part because of lower customs receipts

stemming from tariff cuts. Domestic financing (borrowing from bank and non bank

sources) of the budget deficit amounted to 2.1% of GDP, while foreign assistance

(both loans and grants) financed the remaining 1.2%.he exchange rate came under

increasing pressure during much of FY2006, because of slowing financial account

inflows and higher import prices for oil and some other products. the currency

stabilized in the last quarter of the fiscal year, as the tighter monetary policy started to

have an effect, and the current account strengthened notably. the exchange rate stood

at Tk69.7/$1 in June 2006, representing an 8.5% depreciation against the US dollar in

FY2006. he marked depreciation in the nominal rate offset Bangladesh’s higher

inflation relative to its trading partners, and the real effective exchange rate of the taka

depreciated by 5.3% in FY2006, boosting the country’s external competitiveness.

Import growth fell sharply to 12.1% in FY2006 from 20.6% in FY2005 as

administrative controls on letters of credit were imposed and unproductive imports

discouraged. In addition, lower imports of food grains and most other edible products

offset higher imports of oil, industrial raw materials, and capital machinery. Export

growth surged to 21.6% from 14.0%, reflecting robust performance of knitwear and

22


woven garments. A decline in the trade deficit and a steep rise in remittances (24.8%)

turned the current account balance from a deficit of 0.9% of GDP to a surplus of

0.9%. Foreign exchange reserves rose to $3.5 billion at end-June 2006 from $2.9

billion a year earlier. In the FY2007 budget (announced in June 2006), the

Government shaved duties on intermediate goods from 13% to 12% and on raw

materials from 6% to 5%, as part of trade reforms agreed with the World Bank. It also

cut supplementary duties. these measures should improve profitability and

competitiveness of domestic industries, though they add to the effort needed to raise

the budget’s low revenue ratio. Financial sector reforms to strengthen the regulatory

and supervisory framework for banks made headway in 2006, though at a slower than

expected pace. he health of the banking system has improved since

2002, as seen in the declines in gross nonperforming loans (NPLs) from 28% to 14%

and in net NPLs (i.e., less provisions) from 21% to 8%. This led to significant rises in

profitability ratios. Although the private commercial banks improved to record low

NPLs of 6%, the four nationalized commercial banks (NCBs) are still weak and show

very high NPLs of 25%. he NCBs have large capital shortfalls with a risk-weighted

capital asset ratio of just 0.5% in June 2006 (as against the required 9%), compared

with 10% for the private banks. the performance of the four NCBs is monitored under

memorandums of understanding signed by each of them and the central bank, in

relation

to tightened prudential norms and lending limits. It has been mixed, though, in part

because of government-directed extensions of credit, particularly to BPC to finance its

higher import costs. the divestment of Rupali Bank, an NCB, moved forward and the

sales and purchase agreements are expected to be signed. the Government has taken

steps to corporatize the remaining NCBs and make them more autonomous while

keeping them under the regulatory purview of the central bank, with an eye on their

eventual privatization. Other areas have shown progress. Bangladesh Bank has

completed a comprehensive plan to switch over to the new international standard

framework for assessing banks’ capital adequacy under Basel II, which the

Government intends to implement from early 2009. It established a settlement system

for secondary bond trading in May 2005 and introduced mark-to-market valuation

guidelines for treasury securities effective February 2006, which have improved

operations of the inter bank and treasury bill markets. It also introduced market-based

auctions of treasury bills in September 2006 to bring greater flexibility to liquidity

23


management. Unlike many other bourses in Asia, the Dhaka Stock Exchange has not

recorded significant gains, though January 2007 saw a rise in response to prospects of

an improved political situation. Still, as indicated by the low 7.5% market

capitalization-to-GDP ratio, the equity market remains underdeveloped, largely

because of weak corporate governance, lack of high-quality share listings, and a

dearth of large institutional investors. While governance issues need to be tackled,

increasing the supply of listed shares by privatizing state enterprises through public

share offerings would help boost market capitalization and trading activity. Two

major power sector entities—Dhaka Electric Supply Company and the Power Grid

Company of Bangladesh—have already set an example by selling shares in the equity

market in 2006, under the Government’s broader goal of privatizing state enterprises.

Modernization of the National Board of Revenue gathered pace. Large taxpayers’

units for value-added tax and income tax have already been established in Dhaka, and

branches of these units are being set up in Chittagong (the second biggest city and

main port). he board is being reorganized along functional lines and an audit cell has

been set up. the central intelligence cell has detected several tax evasion cases and

secured unpaid taxes. these actions are expected to strengthen the tax machinery and

raise revenues over the medium term. In an attempt to curb corruption among tax

officials and redress taxpayers’ grievances, the country’s first tax ombudsperson was

appointed in July 2006.The Customs House in Chittagong is being split into two

entities to strengthen customs administration: one for imports and one for exports.

Computerization of customs administration has improved tax assessment and

appraisal functions.

24


3. Development Challenges

Key development challenges facing Bangladesh include upgrading the physical

infrastructure, augmenting efficiency in the financial sector, stimulating greater

foreign direct investment (FDI), and strengthening governance. Deficiencies in key

infrastructure, such as power, ports, railways, and roads, seriously hamper export

growth, investment, and opportunities for transport integration with neighbors.

In the ports segment, Chittagong port, which handles nearly 85% of imports and 80%

of exports, suffers from low productivity, labor problems, and weak management,

exacerbated by the practice of stuffing and unstuffing containers in the port (because

of limited of-dock facilities and costly railway services to move containers).

Chittagong port

is below the UNCTAD productivity standard of 230 lits per berth a day. Bangladesh

Railway is unable to carry containers efficiently and on time because of limited

locomotive and freight-car availability, congested network on major corridors such as

Dhaka–Chittagong and the corridor to India, lack of operational efficiency, and

infrastructure constraints. he main constraints facing the road sector are inadequate

maintenance funding and weak management.

As a result of weaknesses in transport operations, the country is tardy in exporting and

importing, requiring 35 and 57 days, respectively, measured from start to completion

of export/import procedures and shipment. his compares ill with neighboring

countries such as India (27/41 days export/import, respectively), Pakistan (24/19

days), and Sri Lanka (25/27 days). Similarly, costs are high. For example, the cost of

export for each container in Bangladesh is $902, compared with $864 in India, $797

in Sri Lanka, $481 in Malaysia, and $335 in the People’s Republic of China.For

Chittagong port, the focus should remain on contracting out operations to the private

sector, on allowing private operators to invest iport infrastructure, and on

restructuring its management. The caretaker Government has, in fact, transferred the

operations of Chittagong container terminal to the private sector, and has also

signaled its intention to do the same for the new mooring container terminal. For

Bangladesh Railway, the emphasis should be on ensuring greater commercial

orientation, outsourcing some business to private companies and introducing modern

management and financial systems. In roads, the priority should be on approving an

integrated multimodal transport policy and creating a road maintenance fund. Despite

25


some progress, Bangladesh is yet to establish a healthy and efficient financial system.

Ongoing banking sector restructuring must be strengthened. In the capital market, the

thrust should be on improving financial reporting and corporate governance, and

strengthening monitoring and enforcement by the Securities and Exchange

Commission. Many government-owned enterprises, including the petroleum

distribution companies and Biman Bangladesh Airlines, as well as major private

companies such as mobile phone companies with huge annual turnover, could be

prime candidates for selling shares stimulating the equity market. From already low

levels, FDI inflows further declined in FY2006, depriving the country of much-

needed capital resources along with the associated transfer of technology, skills, and

access to new export markets. Despite the seriousness of the position, the country is

yet to accord political decisions on several large FDI proposals. Corruption is an

important factor that prevents Bangladesh from achieving its potential for higher

economic growth and faster poverty reduction. he caretaker Government has taken an

extensive anticorruption stance, and as part of this will need to address the

shortcomings of the Anticorruption Commission, giving it greater independence,

scope, and resources.

26


“Part 03” “Bangladesh Bank”

“Monetary policy statement”

1. Introduction:

Following a strong growth of 5.4 percent in 2006, global output growth is projected to

be 4.9 percent in 2007 (WEO, April '07, IMF); while developing world would grow

by 7.0 percent. Economic growth in Bangladesh has also got its momentum like its

neighboring countries. Bangladesh experienced a real GDP growth of 6.63 percent in

FY 06. The growth projection for current fiscal year is 6.5 percent. The policy

strategy recently initiated and the reform programs undertaken by the government

would not only help the economy to grow by 7.0 percent in FY08 but also pave the

way for Bangladesh to become a member of the “middle income group country” by

the end of the next decade.

2. Macroeconomic development: outcome and outlook

Growth: During the last three years real GDP grew on an average at above 6.0

percent up to FY 06. The growth momentum though expected to continue in FY07,

the revised estimate of GDP growth rate has been revised lower to 6.5 percent from

the projected range of 6.5–6.8 percent largely reflecting setback in agriculture that

faced supply failure of fertilizers, shortages of power for irrigation and inadequate

rainfall. Production of aus and aman crops were 1.51 million and 10.80 million tons in

FY07 against 1.75 million and 10.80 million tons respectively in FY 06. Output of

Boro, the largest crop in the year, is estimated at 14.50 million tons compared to

14.00 million tons in FY 06. Production of maize has increased as farmers have

largely substituted maize for wheat. The latest estimate of overall food grain

production is about 27.54 million tons, slightly above than that of the last year and

less than the target 32.27 million tons for FY07.

27


Growth in the industry sector continues to be robust in FY07 owing to steady growth

in export-oriented manufacturing and increased domestic demand. Looking at the

growth trend of quantum index of manufacturing industries, it is expected that the

growth in the industry sector would be within 10.0-10.5 percent. The buoyancy of

growth in industry is supporting corresponding growth in the service sector. The

accelerated pace of growth in the transport and communications sector would likely

offset the apparent slow down in the construction and real estate sector.

Overall GDP growth, according to forecast for FY08, is expected to regain its

momentum mainly representing the conducive economic and political environment

created by the present government. Growth in the agriculture sector in FY08 is thus

likely to be higher than that in FY07 aided by the projected higher disbursement of

agricultural loans and supportive measures cited above. The industry sector is

expected to continue to show robust performance in FY08 mainly due to steady

growth in export-oriented manufacturing and new capacity addition especially in the

telecommunications and the energy sectors. Increase in import of industrial raw

materials (12.2 percent) and capital machinery (16.6 percent) during July 06–May '07

indicate that industry sector growth will sustain. The service sector is likewise

expected to experience buoyant growth in FY08. Overall, real GDP growth in FY08 is

28


projected to be 7.0 percent in line with the projection in the Medium Term

Macroeconomic Framework (MTMF).

Inflation: FY07 commenced with an average inflation rate of 7.16 percent but eased

to 6.72 percent by the end of January, '07 reflecting both seasonality and restrictive

monetary policy that was pursued. Inflation projection for FY07 was lowered from

7.0 percent to a range of 6.85-6.95 percent in the Monetary Policy Statement

announced in January 2007. In the international front, prices of fuel, metals, food

grains and other essential commodities soared, while in the internal front, selective

depreciation in the exchange rate, revision of fuel prices, production shortfall of food

items and political unrest, some of which have already been subdued, put pressure on

the prices. Inflation rate, on an average basis, went up to 7.06 percent in May '07

(8.05 percent on point-to-point basis). Inflationary pressure was mainly felt on the

food component, which went up to 8.02 percent at the end of May '07 from 7.56

percent at the end of January '07 while non-food inflation rose slightly to 5.67 percent

at the end of May '07 from 5.53 percent at the end of January '07.

Apart from steps to monitor supply in domestic markets, the government has taken

price stabilization measures to ease the pressure which include withdrawal of duties,

importation of food grain by the government, strengthening of internal procurement,

provision for subsidy on fertilizers and diesel and widening of the Social Safety Net

Programme. Besides, banks are now providing credit facilities on softer terms to new

29


importers, easing the LC margin for food items, extending time limit for customer

facility and arranging higher agricultural credit. Since global commodity prices are

not projected to fall in 2008 (WEO, IMF, April 2007) these measures may only

slightly lessen the pressure on consumer prices. Hence monetary stance of the

Bangladesh Bank over the coming quarters will continue to target the containment of

annual average inflation within a range of 6.5–7.0 percent for FY08.

External sector: Exports and imports grew by 18.50 percent and 17.83 percent

respectively, year on year basis in first ten months of FY07. Growth in worker’s

remittances was also steady at 24.52 percent up to June '07. Surplus in the current

account balance emanating mostly from robust growth in exports and workers

remittances inspite of higher growth in imports helped releasing pressure in foreign

exchange market that prevailed in the last part of H1 FY07.

With the marked increase in supply of foreign currency the foreign exchange reserves

continued to build up to reach an all time high of 5.1 billion US dollar. Mirroring

floating exchange rate management, the exchange rate of taka against US dollar,

amidst fluctuations, appreciated by 1.26 percent to Tk. 68.80 at the end June '07 from

Tk. 69.67 at the end June 06.

Some downside risks in the global perspective in FY08 remains the main concern

affecting external sector outlook. Besides, it has been apprehended that export sector

of Bangladesh may bear some pressure with the end of restrictions on Chinese

apparels by the end of 2007. However, increased flow of remittances, probable higher

FDI flow, reasonable export growth and normal import trend are expected to persist in

FY08. Bangladesh Bank will continue to use its monetary policy tools, if necessary, to

sterilize liquidity to emanate from expected higher foreign currency inflows.

Fiscal Sector: The overall deficit in the revised budget of the government for FY07

remained the same as in the original estimate and amounted to Tk. 173.64 billion or

3.7 percent of GDP, funded by Tk. 73.33 billion in foreign loans and grants and Tk.

100.31 in domestic borrowings including bank borrowing of Tk. 65.31 billion. Actual

outturn in bank borrowing is less at Tk. 59.8 billion as on 30 June '07. The budget for

FY08 projects an overall deficit of Tk. 223.13 billion or 4.2 percent of GDP, to be

30


funded by Tk. 42.55 billion in foreign grants, Tk. 63.05 billion in foreign loans and

Tk.117.53 billion in domestic borrowing including bank borrowing of Tk. 72.53

billion. BPC’s accumulated loss of Tk. 75.23 billion is included in the budget. As

indicated in the budget this will not create immediate additional fiscal liabilities as it

will be financed by a “Non-Cash Bond” issue.

From the beginning of FY07, a modified arrangement of Government’s bank

borrowings was put in place under the supervision of a Cash and Debt Management

Committee (CDMC) chaired by Secretary, Finance Division. The new arrangement

included a widened Ways and Means Advance Limit (Tk. 10.00 billion instead of Tk.

0.65 billion) and auction of treasury bills and bonds according to volumes pre-

announced in the borrowing calendar. This new arrangement segregated BB’s role in

government debt management from its monetary policy operations but there is no in-

built mechanism to limit government bank borrowings within the ceiling of budgetary

provisions.

Until now, following the changed treasury rules BB holds treasury bills and bonds at

cut off rate if market supply of fund falls short of Government’s demand set by

CDMC (which is known as devolvement). From the 4th quarter FY07, BB was

allowed to offload the devolved amount to the banks and financial institutions at the

cut off rate of last auction for the remaining period.

Recently the CDMC has agreed in principle that from the beginning of FY08 the

devolvement system will be replaced by a system where the extra amount will be

devolved on the primary dealers on the basis of underwriting. This new system will

enthuse the primary dealers to create a secondary market for government securities.

The new system will make it easier for BB to improve its monetary management.

3. Monetary Policy Stance

Recent Monetary Developments: Bangladesh Bank has been continuing to pursue a

cautious, restrained monetary stance since H2 FY05 with a view to curbing excess

demand from inflationary expectations.

31


An upward bias in policy interest rates and reintroduction of BB bills in October 2006

helped in limiting inflation around the targeted seven percent despite international

price pressure. In spite of cautious monetary policy, M2 year-on-year growth (18.2

percent) at the end of May '07 exceeded the end-June target (14.7 percent), growth

rate of private sector credit that mirrors a part of the aggregate demand grew at 15.6

percent which was lower than previous year’s growth rate of 17.1 percent. Net foreign

assets of banking sector has been continuing to grow at a rate leading to the build up

of foreign exchange reserves that reached $ 5.1 billion by the end of June '07.

BB has been continuing to follow the cautious monetary stance with a view to

ensuring that the existing inflation is not further fuelled by increased aggregate

demand. However, BB is committed to ensuring flow of credit in the productive

sectors like agriculture, small scale industries, low cost housing etc., where market

has failed to deliver. BB has already taken a decision to introduce a refinancing

scheme for housing loans for lower and middle income groups. This step will provide

impetus to the housing sector which provides employment to a large number of

people. In order to boost credit in the agricultural sector, BB requested the

commercial banks (which hitherto did not provide much agricultural credit) to come

forward, and in response to that these banks have assured to provide more than Tk.

1,000 crore as agricultural credit during next 12 months.

32


After strengthening the regulatory framework, improving the bank supervision

process, and completing procedure for selling Rupali Bank, BB is now focused on

corporatizing and restructuring the nationalized commercial banks (NCBs). The

process of corporatization of three NCBs – Sonali, Janata and Agrani – has started.

Meantime, these banks have been turned into public limited companies. NCB reforms

will increase efficiency of financial system which in turn will enhance its resilience

contributing to firm up the monetary stability.

Monetary Stance for FY08: Keeping in view the prevailing price situation and

enhanced excess liquidity emanating from moderating private sector credit demand

and increase in net foreign assets, BB’s monetary stance will continue to be cautious

in FY08. Despite persuasion of a cautious policy, growth in both money supply

(estimated) and reserve money has exceeded the program levels at the end of June

2007. In this backdrop, further review of policy interest rates may be necessary. Since

the bond/bill market is not yet developed to reduce the inflationary expectation in the

longer term, interest rate of the instruments of the shorter tenor may have to be

revisited relative to that of longer term. SLR/CRR of banks including Islamic ones

have remained unchanged since 2005. In view of the unfolding price developments

BB may review these rates. Above all, coordination among monetary, fiscal and trade

policies is required to help curb rising inflationary pressure and achieving 7.0 percent

economic growth in FY08. As before, the private sector will receive necessary policy

attention to ensure desired level of economic growth.

Apart from monetary policy stance, BB is of the opinion that the following issues to

be kept in perspective for overall economic development of the country: (a) fiscal

discipline should be adhered to by the government as strictly as possible, (b) the

spread between rate of interest on deposits and that on lending charged by the banks

should be reduced to help private sector enterprises, (c) heterodox policies to improve

production and marketing of agricultural products should be considered by the

government, (d) introduction of international prudential norms for banks and financial

institutions to be calibrated for consistency with the objective of greater financial

inclusion.

33


Bibliography:

1. www.google.com

2. www.bangladeshbank.org

3. www.banglapedia.com

4. www.thenewnation.com

5. www.financialexpress-bd .com

6. www.thedailystar.net

7. www.newagebd.com

8. www.bdnews24.com

9. www.weekipedia.org

10. www.tutor2u.net

11. www.yahoo.com

34

http://www.yahoo.com/

http://www.tuitor2u.net/

http://www.weekipedia.com/

http://www.bdnews24.com/

http://www.newagebd.com/

http://www.thedailystar.net/

http://www.thenewnation.com/

http://www.banglapedia.com/

Documents

MACRO Economics Assignment