Turning point for the Bangladesh economy?

Forrest Cookson examines the economic consequences of 1/11

On January 11 the president appointed a new chief adviser and team of advisers. The new caretaker government assisted by the security forces then embarked on a program to eliminate corruption from governance by punishing the worst offenders of the past. Previously it had proven impossible to convict anyone of corruption and the justice administration and the courts were not strong enough to use the force of law to stop the looting. The past months have seen the pursuit of the corrupt and an all out effort to arrest and convict the guilty. But actions have consequences. This article examines the economic consequences of this January Revolution.

Forces at work
The economy has been growing rapidly through 2006. The rate of growth of GDP over the past few years has certainly been greater than 7% but the procedures underestimate output of the manufacturing and agricultural sectors. This excellent performance has been achieved by the growth of exports, the strong level of investment by the private sector, the flow of remittances to support widespread private sector growth, a strong, growing private banking system, and the emergence of a group of entrepreneurs aggressive and confident in their capacity to invest, produce, and sell.

The bureaucracy faced a daunting problem. There are plenty of regulations to enforce. Agreement on each such regulation requires a decision that opens up the officer to the accusation of taking a corrupt payment. The answer to this is to give approvals in principle or to leave an open issue unresolved. It is probably impossible to function if one insists on crossing every t and dotting every i in the regulations. As this way of dealing with problems continued, it became a way of life. The bureaucrat often received his reward, he was able to protect himself a little bit, and he could satisfy his political masters that the project was approved, etc. If you will always be accused of corruption if you approve an action, you soon learn not to approve. This has left the country with virtually every investment exposed to some unresolved issue. Every foreign investor faces this, as does every significant domestic investor. These unresolved issues hang as the sword of Damocles over the head of every investor. The same issues arose with the tax authorities. Closure was very difficult. Comfortable relationships grew up. The tax authorities were described to me by one of the NBR members as like parasites: "We want a lot but not so much as to kill the host." The reality of public administration had nothing to do with the endless reform projects attempted by the donors. But one should not be negative here. Some kind of system was operating and the government was funding itself. The last few budgets were perfectly sound. Shrewd observers of the Bangladesh economy believed that small government was good government; why one should collect taxes and swell useless government programs was a mystery.

It was into this system that the January Revolution plunged itself. Once the authorities started, everywhere it looked it found problems. It gradually dawned on the new authorities that virtually all of the Bangladesh elites were caught up one way or another in this system. Everyone was fair game. It was impossible to be successful within the system without one compromise or another -- few if any factories met the environmental regulations; few new buildings had the proper documentation for the construction plans; few companies had a transparent tax situation. The uncertainties reached everywhere: Every year payment for some $500-800 million of exports could not be traced. Government banks rescheduled loans merrily without meeting the requirements of the central bank. Large volume of loan recovery cases had piled up in the courts without resolution. The hundi system made a mockery of foreign exchange controls, financing billions of dollars of smuggled imports. True, the economy was growing rapidly as the private sector invested heavily in the manufacturing and service sector.

The consequences arrived rapidly with the January Revolution. The interest in private investment fell sharply. These were manifest in the decline or sharp slow down in letters of credit opened to import capital equipment or construction materials. Commercial construction slowed as uncertainty about building permits rose; urban residential construction of flats dropped as developers were uncertain about sales. Agreed sales fell through as buyers were worried about showing the money that they had. New factories were

Bankers immediately sensed the virtual collapse of private sector participation in borrowing. Approved loans were not taken up. New applications slowed. Banks became more difficult about the sources of finance, about the approvals for factories. Several major industrial houses fell into serious difficulties with their owners in jail or having fled the country. The operation of these establishments became increasingly difficult and over the next year will probably lead to closure of many. These manufacturing establishments cannot really be recovered and will simply waste away.

Actions properly taken against illegal seizure of property led to significant unemployment. This combined with the slow down in construction activity and the gradual closure of many establishments is resulting in unemployment of the order of 300,000 persons directly and 500,000 if the indirect consequences are included. Thus more than a million urban residents may find themselves financially impaired. In response people go home to their villages, turn to crime, or seek out other employment which is very difficult to find.

The move to contain corruption and to properly enforce the regulations of the government was an important step to improve governance. The consequence of this is however a slowdown in the rate of economic growth. This slowdown does not take into account two other factors of great importance: The impact of the floods and the developments in the apparel sector.

The impact of the flood on the economy is uncertain. The main consequence will be losses in the agricultural sector. There are various estimates of these losses but all are rather low. The floods themselves will not cause a major slowdown in the economy according to the estimates of damage that have been put forth by the government.

More serious is the pace of development in the garment sector. The real conditions here are difficult to determine. There has been a slowdown in the growth of exports of both knitwear and woven garments. There are reported low order books in woven garments. Compliance problems continue for more than 50% of the factories.

The United States labour movement is again attacking the alleged lack of compliance in the labour laws threatening the reputation of the industry. On the other hand, Vietnamese capacity is growing rapidly and restrictions on Chinese production will soon be lifted. Finally, within the United States there is some evidence of softening market demand.

The apparel industry enters a period of some uncertainty. A slowdown in garment exports will have a strong effect on the growth of the economy. In the past the garment sector has shown itself to be strong and resilient -- able tohandle challenges to its ability to compete. This is the most likely outcome, but the next year will probably be one of limited growth compared to the past.

Prospects for growth in near future: If these various factors are taken into account the economy should slow down sharply during financial year 07/08. Most observers are more optimistic, believing that private investment will recover promptly and that garment exports will remain robust. So far, the data supports the pessimistic viewpoint. The difficulty with assessing the prospects for private investment is determination of the fear that businessmen feel about undertaking new projects or expanding their output. The fear arises in some cases from being able to demonstrate clean sources of money and in other cases concern about the rising level of regulatory behaviour in some sectors.

The real conditions of the Bangladesh economy -- the ability of the businessmen, the willingness of the workers to perform their tasks, and the skill and determination with which difficulties are overcome -- are all in place. But seen from the business viewpoint the barriers to action are rising, and the government has not been able to separate the expansion of regulatory activity from the stoppage of corruption.

Inflation: Central to the policy dilemma is the inflation. While the central bank believes that the inflation rate will decline, it is actually taking little in the way of

There is a noisy argument about a restrictive monetary policy. Actually no one really thinks that monetary policy is restrictive. When the stated policy is meant to maintain investment, not raise interest rates and not appreciate, the currency it is hardly restrictive.

What is happening is clear enough: The demand for credit for the private sector is slowing. As it slows the growth of the money supply may slow if remittances and export receipts do not grow too much. This may well work out with slow growth of money supply arising as a result of a weak economy. Unfortunately this will have little impact on prices which are largely shaped by food prices and the taka/rupee exchange rate.

In late 2007 the inflation rate is beyond the control of the central bank unless the taka is revalued.
Policy dilemmas: The policy choice is a tough one:
*Stop inflation by appreciating the exchange rate, harm export prospects and slow down an economy that is already slowing.
Or:
*Allow the inflation to continue and try to maintain the growth rate by increased government deficit spending.

This is the terrible choice the government faces. Indeed, one wants lower inflation and rapid growth. The point of this article is that is impossible: the present policy mix will result in 7-9% inflation and GDP growth of 0-4%. One can expect that to continue for two years. After that, it is impossible to tell.

A different policy mix can reduce inflation and growth or it can raise inflation and growth. What is best for Bangladesh?

January Revolution in longer perspective: The forces behind the January 2007 revolution have as their objective a real change in Bangladesh through the reduction of corruption and the rebuilding of a democratic system. This article has focused largely on the economic consequences and options of the next two years. What about the longer run, say the next decade? What is the impact on the economy? The outlook is inevitably speculative but there is historical analogy and some evidence to indicate what may happen.

Bangladesh's economy is strongly linked to the rest of the world so that larger arena is a very important factor in seeing where we may be going. The next decade will see a much slower growth of the world economy as the global imbalances correct themselves. The exuberant growth of Asian economies is not likely to continue and growth rates will fall along with those of the industrial world. The American economy in particular will move towards greater concern with correcting income distribution and dealing with the problems of social security and medical care. These developments will cause export growth to be more difficult and competitive. Remittance flows are likely to continue to be strong but these are not a strong contributor to economic growth.

Bangladesh's economic development since 1975 can be divided into two roughly equal periods of 15 years. The first period is characterised by dominance of the economy by the military and the bureaucracy. The private sector was slowly growing but was a weak influence in the economy. There was a heavy burden of regulation that hamstrung the private sector. The financial sector was dominated by government owned banks, rigid rules on interest rates and bank lending, and pervasive non performing loans that the system failed to admit existed. There was certainly corruption in the system but the very limited size of the modern private sector held down major corruption.

Beginning in 1991 the world changed in Bangladesh. The emergent democratic system aligned itself with the business community. The military went off to peacekeeping missions and kept out of politics. The bureaucrats were gradually dominated by their political masters and lost power relative to the previous period. The reform program -- for much of which credit must be given to Ershad -- allowed the private sector to invest and expand with minimum harassment by the bureaucrats. The accelerating economy driven by rising levels of exports and investments by the private sector began to change the level of economic welfare and saw the emergence of a middle class living at a much higher standard than most of the country or in the past. The emergence of widespread automobile ownership is one of many examples of this. The corruption that grew with this growth had probably started to strangle it. One cannot really be sure.

But that world is gone. The pre-1991 powers that be are back running the country and the political parties are shattered. Future links between the private sector and the political parties are obscure. Future participation by business persons in politics is obscure. But we can be sure that the investment by the private sector will be less exuberant. Projects will be approached with more caution. Financing of large scale investments will be harder to achieve. Many new regulations will be created to limit corruption, improve the environment, control prices, verify financing sources, etc. The donors who are bureaucrats in instinct and behaviour will happily participate in achieving improved governance, reduced corruption, and greater corporate respon-sibility.

Foreign private investment will be more limited as the military-bureaucratic alliance will not make it easy, seeing intrigue and exploitation behind every tree. Taken altogether, Bangladesh will experience much slower growth in private investment resulting in a slower growth of the economy. With luck a new generation of businessmen will emerge with an acceptable alliance with the politicians to permit a resurgence of private investment. But realism should make us recognise that cleansing the society of corruption -- the achievement that the new revolution is undertaking -- has a cost. This cost is the reduction in the economic growth rate, possibly for several years.

The donors will teach that the reduction of corruption will accelerate growth and investment, not slow it down. This is a complete misreading of the history of economic growth. Economies show periods of 10-20 years of rapid economic growth when everything goes well. Why it goes well is not so clear. Then some event will throw the economy off its virtuous growth path. It will grow slowly for 10-15 years and then start to expand again. This used to be called the business cycle. It still goes on. Bangladesh was halfway through a period of rapid expansion. It has been pushed off this expansionary period and it will take some years to generate another round of virtuous growth.

Forrest Cookson is a Forum contributor.