Caution, not alarm, is the point

A lot has been said about the likelihood of Sri Lanka type financial distress in Bangladesh. Some appear dismayed by a few parallels drawn to flag the need for caution. 

The sources of comfort 

Indeed, there are solid reasons to believe Bangladesh is not exposed to the type of risks that have materialised in Sri Lanka. Bangladesh currently maintains adequate foreign exchange reserves with a 19.8% external debt to GDP ratio in 2021. The IMF Article-IV (2022) reaffirms the perceived comfort:

"The external position in FY21 was broadly in line with the level implied by medium-term fundamentals and desirable policies…All external debt indicators are below their respective thresholds under the baseline and stress-test scenarios…Favourable debt dynamics in the medium term keep the Public and Publicly Guaranteed external debt-to-GDP ratio on a declining path, and the overall public debt-to-GDP ratio stabilizes".

Foreign exchange reserves reached a record high in FY21, equivalent to seven months of imports, with the exceptional surge in remittances. Reserves are within the adequacy range varying between 4.4 and 5.7 months of imports, according to the IMF assessment.

Bangladesh's narrowly based exports are generally not too sensitive to shocks in major markets. Remittances from the growing numbers of low skilled overseas migrant workers exhibit considerable persistence and some countercyclicality. Bangladesh's external debt repayment burden currently is well within thresholds beyond which it could become disruptive. 

Fiscal policy in Bangladesh struggles to be expansionary even when it is intended to be so. Budgetary allocations often fail to get spent near targets. The extent of underperformance often leads to undershooting the budgeted fiscal deficit despite large shortfalls in revenue mobilisation relative to the target. 

Fiscal expansion, when it occurs, barely uses printing money for financing. External financing of deficits has, perhaps by default, never relied on costly dollar denominated sovereign bonds issued in the international capital markets. Bangladesh's current composition of external debt is very similar to that of Sri Lanka in the early 2000s. 

Debt is sustainable if the borrower can service it now and, and in the future. The dynamics of external debt depends on the time path of the differential between the interest rate on foreign debt, GDP growth and the current account balance. Over the past decade, Bangladesh's external debt dynamics has been favourable with an average real GDP growth of 6.4%, effective real interest rate of 2.4% and non-interest current account surplus equivalent to 0.2% of GDP. High (2.2% of GDP) infrastructure related increases in external debt occurred when growth was strong, and the current account was in surplus.

Reasons for caution 

All economic meltdowns in history have been a cumulative result of several causes over a protracted period. No crisis happens overnight and due to just one set of factors. The set of policy mistakes seen in Sri Lanka are not the only ones that lead to a crisis. The history of debt crisis is replete with stories about countries with indigenous crisis innovations. Several in extraordinary circumstances such as war; others in monetary, financial, exchange rate and fiscal management; and still others in markets for real estate and commodities. Some are just "sunspots", meaning too random to pin down.

Debt is rarely sustainable or unsustainable for sure. Experience, including that of Sri Lanka, shows debt sustainability can depend as much on shocks to the capital account (lumpy bond repayments) as shocks to the current account (fall in exports and remittances).

Debt dynamics become unfavourable when GDP growth falls short of the interest rate and the current account stays in deficit for a protracted period. A salient fact about today's world is that aggregate activity exhibits tail risks associated with global events, such as the collapse of the Lehman Brothers, Trump's election, Brexit, US-China trade tension, the pandemic, and now the war and sanctions. Vulnerabilities in Bangladesh have increased due to adverse impact of the pandemic on growth, poverty, and human capital amidst snail paced competitiveness related reforms.

Changes in debt dynamics

Sustaining GDP growth at levels higher than the effective interest rate depends to a large extent on external factors such as the winds in the global economy as well as domestic conditions. The world has seen three mega global crises in the last two decades. The economic fallout from the ongoing Ukraine crisis has certainly not passed the peak yet nor is the pandemic comfortably in the rear-view mirror. Domestic investments and institutions leave a lot to be desired.

Investments lack vigour and diversity. Private investment has stagnated, mostly in the 23-24% of GDP range, over the past decade. Public investments have increased without yet delivering a transformational asset in boosting the economy's productivity. Padma bridge could be such. However, there are allegedly several large projects that could potentially become white elephants. They add to the debt burden without doing anything for growth and equity.

Institutional weaknesses may catch up. Bangladesh has recently been downgraded from "strong" to "medium" on the debt carrying capacity indicator in the IMF-World Bank Debt Sustainability Analysis based on a weighted average of the country's real GDP growth, remittances, international reserves, world growth, and the World Bank Country Policy and Institutional Assessment score. The downgrade is driven mostly by a lower CPIA score, reflecting institutional weaknesses, as well as expected worsening of world and domestic growth projections. It lowered the total public debt threshold from 70% of GDP to 55%. External debt thresholds were also brought down. 

The composition of Bangladesh's external debt has in recent years shifted towards shorter grace period, shorter repayment period, and higher interest loans. The traditional concessional sources of external credit (World Bank, ADB and Japan) have become less concessional. New sources of bilateral loans (China and Russia) have hard terms. The cost of external debt is on the rise, at the margin and on average, albeit from a low level. 

A spike in import payments this year has turned the current account into a large deficit despite strong growth in export receipts. Non-interest current account is projected to have a deficit equivalent to 3.6% of GDP in FY22, compared with 0.4% surplus the previous year. The former is higher than the 3-3.5% of GDP non-interest current deficit consistent with a stable external debt to GDP ratio (IMF-WB DSA). Consolidating back to a stable path would depend on how policies build resilience to tail risks.

Eroding reserve buffer

Policy buffers help prevent shocks morphing into crises. Another large exogenous shock (pandemic, commodity price increases) can lead to a balance of payment and debt servicing problem if caught unprepared. The strongest foundations of being prepared are adequate foreign exchange reserves and quick access to sources of foreign currency liquidity. Bangladesh's reserves have been eroding. We don't have ready access to liquid sources of foreign currency. 

The Bangladesh Bank has sold over $4.5 billion so far this year to moderate depreciation pressure from increases in current and prospective import payments and a tapering in remittance inflows. BB recently introduced lending up to US$2 billion from foreign exchange reserves to the Bangladesh Infrastructure Development Fund if reserves are above six months of imports. Adherence to this rule will soon be tested since reserves have fallen below 6-months import level already.

Committing more reserves to longer-term uses even if they bring returns in foreign exchange a few years down the road is rather ill advised because of changed circumstances. The BB Governor recently spoke about an increase in commitment of reserves to the Export Development Fund. This assumes the presence of "excess" reserves. Given the tightly managed nature of the exchange rate, Bangladesh arguably requires higher reserve coverage. The IMF's template for assessing reserve adequacy in economies with fixed exchange rate and without access to international capital markets suggests 12.4 months of import cover.

Foreign exchange available for emergency and monetary uses is significantly less than the frequently quoted gross reserves. These, as reported by BB, have ranged between $48-44 billion this fiscal year. Short term reserve debt has risen from $5.1 billion in late December 2021 to $5.4 billion on April 20, 2022, reflecting mainly increases in liabilities to the Asian Clearing Union from $1.6 billion to $1.9 billion over four months.  Reserves in BB's own wallet is probably less than the $39 billion currently in net international reserves, given the inclusion of not so liquid $6 billion plus foreign currency claims on domestic residents and the $200 million swap to Sri Lanka.

Policymakers mantra 

Debt dynamics can turn unfavourable quicker than one wakes up to. More so when the veracity of the recent GDP growth numbers is uncertain.

The cost of foreign debt is destined to rise further because of the tightening conditions in international finance. Markets are tightening globally. Bangladesh is on course to facing harder financing terms as it travels past various "measured" per capita income milestones with the rapidity it has recently. The interest growth differential can turn unfavourable if GDP growth slows at the same time. Combined with persistent external current account deficit, a "stabilised" exchange rate and leaky capital controls, these together could become a severe balance of payment and debt servicing headaches.  

Hoping for the best and preparing for the worst is the essence of macroeconomic balancing. There is no external payment or debt distress currently.  But the conditions are tightening. The path ahead could be bumpy if the policy buffers are shallow while the lumpy payments are not accurately anticipated.

One big lesson from Sri Lanka is to do no harm to the fiscal space, reserve buffers, institutions, and structural reforms. Misplaced optimism, appeasement and looking the other way is antithetical to caution.