The interim government is barely two months old, and it is too early to make any conclusive judgment on their economic management. While the initial signs discerned from their actions, despite numerous law and order distractions, inspire hope, the challenges ahead remain daunting.
Inflation not yet tamed
Inflation in Bangladesh has remained entrenched above 9.5 per cent for over a year now, having previously moved within the 5 per cent to 6 per cent range before the Covid-19 pandemic. Inflation globally spiked in the aftermath of the pandemic in 2021. The global economy's restart, following the sudden halt due to the pandemic, was not smooth. Supply chains were sluggish, as was the supply of labour. The Russian invasion of Ukraine in February 2022 and the subsequent sanctions further disrupted global supply chains and destabilised commodity markets. The flight to safety strengthened the US dollar, thus increasing import prices worldwide.
Bangladesh's policymakers at the time did not act as swiftly as many of our peer countries to tame inflation. They seemed to have subscribed to the view that inflation was transitory and would correct itself sooner rather than later. They spoke about tightening policies to stabilise the post-pandemic surge in domestic demand, known as “pent-up demand,” but never fully followed through, except for increasing the policy rate. This did not effectively transmit to the market because of the 9 per cent cap on retail lending rates. Monetary financing of the deficit in FY23 aggravated the problem.
There is a widely shared perception that demand management does not work when inflation is caused by supply shocks. Indeed, policymakers face a "damned if you do, damned if you do not" dilemma under such conditions. Policy tightening can still help reduce inflation, but at the cost of contracting the real economy more than the contraction already caused by the supply shocks.
These theoretical possibilities were tested in the post-pandemic, post-war global economic milieu. It turns out that the fear of a severe recession due to policy tightening did not materialise to the extent anticipated in advanced economies. However, many emerging market and developing economies faced debt distress with the rise of the dollar and interest rates. Bangladesh also faced severe external imbalances, leading to a large depreciation of the taka and a shortage of foreign exchange liquidity, which exacerbated the inflationary pressures.
The syndicate theory of inflation cannot be ruled out as a major driver, particularly in the market for essential food items. We have a general problem of organised extortion in markets and market dominance by a few large groups. The former acts like a tax on sellers, while the latter creates opportunities for price gouging. The significance of the impact of extortion on retail prices was evident in the immediate aftermath of the historic change on August 5.
The incumbent extortionists were on the run, and their replacement took some time to get organised. Prices of essentials in many markets fell temporarily. Unfortunately, the new extortionists did not take long to fill the extortion vacuum. According to several media reports, the change of players has not changed the game. The "tax" is back!
Reserves depletion stemmed for now
Bangladesh is not the only developing country in the world subject to severe external payment pressure, but it is probably one of the few countries that mishandled the policy response. Sticking to expansionary monetary and fiscal policies aggravated the pressure on the balance of payments.
Coupled with an opaque exchange rate policy introduced in mid-September 2022, this accelerated the loss of reserves and contraction of supply in the foreign exchange market. Bangladeshi businesses were unable to settle foreign exchange payments, leading to the accumulation of large payment arrears. This created a reputation problem in external financial markets, as rating agencies downgraded credit ratings and economic outlooks. The much-feared rollover risks materialised, further contracting the supply of foreign exchange.
Draconian controls on the exchange rate and foreign exchange trade by the Bangladesh Bank have recently been relaxed. In line with commitments under the IMF programme, the central bank switched to a crawling peg exchange rate regime in May 2024, with a large one-off devaluation of the taka by Tk 7 per US dollar. The forex situation has improved somewhat since then, but we are still not back to a market-determined exchange rate regime. In fact, the exchange rate has remained fixed at Tk 120 per dollar in recent weeks.
With many major money launderers in hiding, it seems the demand for dollars in the hundi market has softened, leading to a decrease in the informal market exchange rate premium. This has boosted remittance flows through formal channels, alleviating pressure on reserves and enabling the relaxation of import controls. However, this could be temporary if the old money launderers are replaced by new ones—a distinct possibility if the usual political dynamics return.
External debt burden is worrying despite being relatively low
The pressure on foreign exchange liquidity is exacerbated by the rising burden of servicing external debt. Bangladesh appears to be an outlier among developing countries, with a relatively low external debt-to-GDP ratio, yet still experiencing payment distress. Indulgence in external borrowing to finance mega projects without serious evaluation of their costs and benefits is a major reason behind this situation.
Borrowing for projects that do not contribute to increasing the productivity of the economy is a recipe for debt distress, even when debt is low relative to the size of the economy. To address this, we will need to reconsider the ongoing mega projects and be extremely cautious about those in the pipeline. It would be unrealistic to expect immediate results from a change in policy, as obligations already incurred cannot be undone overnight.
Managing the external debt burden will require utilising all avenues for concessional financing, fiscal austerity and stronger revenue mobilisation. The new team of economic policymakers seem very aware of these issues. We will likely get a clearer idea of the extent to which they follow through as they revise the FY25 budget and present an FY26 budget while keeping populist pressures at bay.
Zahid Hussain joined the World Bank in 1995 and is currently a lead economist in the South Asia Finance and Poverty group. Prior to that, he was a member of academia, with 14 years teaching experience in a number of universities in Bangladesh and abroad.
