My advice for Bangladesh

designing macro-financial policy

Strong public protests forced the long-serving Prime Minister of Bangladesh to resign and flee. The natural question is, what comes next? There’s opportunity for positive change, but great risk as well - getting political transition right is never easy.

Bangladesh has shown tremendous promise since independence half a century ago. Arguably its three most noteworthy accomplishments are: (i) impressive improvement in human development indicators such as child mortality, (ii) the development of a vibrant non-profit sector, and (iii) the country’s ability to keep religious extremism out of mainstream politics. The third accomplishment is all the more impressive, given the rising political acceptance of religious extremism in rest of South Asia as both Pakistan and India fall further into religious communalism.

As Bangladesh looks towards the future, one particular area that needs attention is macro-financial policy. Bangladesh did not properly capitalize on its impressive export growth in ready-made garments. Instead of using its export gains to build credibility in currency and financial markets, it squandered the gains through an imprudent policy that favored consumption over investment, among other flaws. This weakness was laid bare when global financial conditions tightened and Bangladesh had to seek help from the IMF. How should Bangladesh design its macro-financial policy, now that it has a fresh start?

First, announce a commitment to building real reserves while maintaining a market-based exchange rate. This can only be done by running moderate current account surpluses for a while. The target should be for Bangladesh to save a significant portion of its 20+ billion dollars of annual remittances.

The commitment to save remittances will send a clear signal for potential exporters that they can expect a favorable exchange rate, and protect the country from Dutch disease. The buildup of reserves also provides a war chest against speculative attacks, and builds confidence in Bangladesh’s domestic financial sector. This will help bring spreads come down and ease financial conditions for domestic investment.

Second, the commitment to build reserves must be accompanied by a sound macro-prudential policy that regulates leverage and international capital flows. In particular, as financial conditions ease due to reserve buildup, foreign capital would want to enter Bangladesh. But this is where Bangladesh must put in place sound rules to guide what kind of capital it prefers.

All capital inflows are not created equal for a country like Bangladesh. Bangladesh should not allow capital account convertibility for speculative “hot money” flows, or flows in non-productive sectors like land and real estate. In general, foreign borrowing for investment in largely non-tradable sectors should be avoided. Instead the focus should be to encourage foreign capital in tradable sectors that comes with technology and managerial talent that Bangladesh otherwise lacks. Joint-ventures should be strongly promoted so the technology and management skills that come with foreign capital ``stick’’ inside Bangladesh and generate positive knock-on effects. The government should stay away from the “original sin” of borrowing in a foreign currency. Bangladesh should learn from India on this front and completely avoid sovereign borrowing in dollars.

Third, the reserve and external macro-prudential policy will create space for independent monetary policy. This is the well-know “trilemma” that developing countries face - they must protect themselves from the whiplashes of global financial markets if they want to have an independent monetary policy. Once Bangladesh has this hard-earned monetary space, it must use it intelligently to manage domestic demand cycles and anchor inflation expectations.

The key to sound monetary policy is having an independent central bank with a strong board and competent leadership. Monetary policy is a technical subject, and must be lead by people with relevant expertise, who are institutionally protected from myopic political pressures. The focus should be squarely on managing cyclical fluctuations and anchoring inflation at a low level. Sound monetary policy provides the comfort and security that private sector needs in order to invest for the long-run.

Fourth, recognize the natural linkages between the policies described above and fiscal policy. Design a tax and spending policy that is supportive of broader macro-stability, encourages long-term investment, and does not promote external imbalances. For example, on the taxation side, institute a market-value based land and property tax system that funds local infrastructure and public good needs. These taxes have the merits of being less distortionary (land is a non-reproducible asset) and also curb excessive unproductive land speculation. Incentivize getting out of fossil fuel dependence by taxing carbon, use congestion pricing, and then take the proceeds to invest in public transport and renewables infrastructure.

Managing public deficits is very important to avoid extremes such as fiscal dominance. However, Bangladesh has large public investment needs as well. If properly done, such public investments create asset value and hence should not be counted against fiscal deficit. Bangladesh should adopt dynamic scoring fiscal rules to promote public investment - but this should only be done after putting in place an independent fiscal scoring body. In general, like I mentioned in the case of monetary policy, Bangladesh should establish strong and independent macro-prudential and fiscal bodies with legal cover to bring long-term credibility to macro policy. I discussed this issue in more detail in my conversation at the IMF in the context of African countries.

I will end on a personal note. My only reason for writing this post was the hope that perhaps it might be of some use to people working in Bangladesh. They of course know a lot more about Bangladesh than I ever can - so I very much welcome their feedback and questions. May Bangladesh continue to prosper!