Sajid Huq Amit sajid.huq@bracepl.com Aasim Tajwaar Matin tajwaar.matin@bracepl.

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Resisting a Global Meltdown: Bangladesh Macroeconomic Outlook FY2012

The US credit rating downgrade has battered capital markets globally. The downgrade came at a time when the EU had been long suffering from a widespread debt crisis. Previously, the smaller economies (Portugal, Ireland, Iceland, and Greece) were struggling to meet sovereign debt payments; the situation has now evolved such that even Germany, Italy and France are being squeezed. Debt crises in the Euro-zone and the US have come at a time when the Bangladesh economy is in an uncertain position to begin with. The health of the economy is certainly poorer than was the case in FY2009, when the global financial crisis had set in. Presently, the Balance of Payments (BoP) is weakened because of reduced remittance flows and rising import bills, which, in turn, has led to a continued depreciation of the BDT against the USD. Inflation (point-to-point) was around 10.17% as of June 2011. The Bangladesh Banks monetary policy statement (MPS) announced in July focuses on managing credit growth such that it takes place only for the productive sectors of the economy (agriculture, trade, and other services). The challenge of controlling inflation has become even more formidable in light of the budget deficit projection in the FY2012 budget about 0.6% greater YoY. In sum, the debt crisis that plagues western economies may have a more significant impact on the Bangladesh economy than was observed in the aftermath of the global financial crisis of FY2009 when the economy was on a much steadier footing. In the best case scenario for Bangladesh, there will be a dip in export earnings growth in FY2012 YoY, driven by reduced EU and US demand. Orders are also expected to decline because western RMG buyers are cognizant of the sizeable problems posed by inadequate infrastructure and power supply. However, the net effect on the BoP will be balanced by easing oil and commodity prices. In this scenario, GDP growth will fall below expectations, and will be in the range of 6.3-6.5 (using the governments target growth rate of 7% as benchmark *). The worst case scenario will materialize if a double-dip recession sets in, in either the US or the Euro-zone economies or both. The US and EU economies are of course highly correlated and conjoined by various channels of transatlantic systemic risk. This will squeeze the Bangladesh economy, and the BoP and inflation will be adversely affected. Export orders will take a hit across high-end segments such as leather and frozen foods, to the low-end garments which comprise the bulk of Bangladeshs RMG output. Although considered relatively inelastic with regard to its demand, in the event of a double-dip - it is the low-end consumer who is expected to tighten spending the most. Remittance flows will also slow down. In sum, in the case of a doubledip recession, Bangladeshs economic growth in FY2012 will be constrained and the resulting GDP growth will be in the 6.0-6.2% range. In sum, irrespective of the likely outcomes of the ongoing slowdown in the west, the Bangladesh economy is expected to grow at a respectable pace of at least 6%.

* These estimates are in line with GDP growth rates for FY2010 and FY2011 as calculated by the Bangladesh Bureau of Statistics.

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Time for a Double-Dip? It should come as no surprise that a country whose currency makes up 61% of global reserves, when subjected to a rating downgrade, would unnerve the global financial system. A credit rating downgrade implies that the interest payments of US sovereign debt will increase. Treasury bonds will be deemed more risky, even if slightly. Therefore, after an initial round of capital market flight and a resultant rally by treasury securities (because of their historical status as a safe haven), treasury yields will eventually increase as prices go down. However, a double-dip recession is certainly not a foregone conclusion. Signs of prolonged stagnation are of course visible. In Q2 2011, US GDP grew at a meager 1.3% and household spending 0.1% (lowest since Q2 2009). In July, existing home sales fell 3.5%, and as of August 1, the Purchasing Managers Index fell 4.4%. But a double-dip would require such broad macroeconomic indicators to worsen, especially unemployment statistics, which thus far, seem to have held up. Several possible shocks to the economy can hasten the incidence of recession. In addition to internal shocks such as the recent policy squabbles, the three main external shocks are as follows: Euro-zone Recession: The looming threat of a deteriorating debt crisis in the Euro-zone is a potentially strong catalyst for a double-dip recession in the US. Although the ECB is trying to inject liquidity and inspire confidence in the markets, its response has been slow and insufficient. In fact, the markets did not respond well to Sarkozy and Merkels rescue fund of USD 440 billion, following which European capital markets nosedived, as did the stocks of European banks. This has worried the FDIC because several European banks have significant US operations, and as a result, constitute great systemic risk to the US economy. Of course there is significant correlation between US and EU capital markets during significant bull runs. Thus a recession in the Euro-zone would lead to widespread destruction of wealth globally and could push the US economy into double-dip territory. Rising Commodity Prices: In our previous report (A decline in oil prices: Impact on Bangladesh), we expected the rise in oil prices to ease mainly due to the expectations of a global slowdown. We retain our stance that oil prices will not rise above $100 a barrel, but do expect prices to rise above their current levels. There are a couple of reasons for this. First, Chinese demand for oil tends to rise in the second half of the year (the effects of which will be further accentuated by an appreciating Yuan), and second, the Japanese earthquake has increased the countrys demand for oil (as a number of oil refining facilities and nuclear power plants therein have been shut down). The Libyan crisis also continues to restrict the global supply for oil.
Figure 1: Crude Oil Price (USD/Barrel) vs. FAO Food Price Index

US GDP growth slower than expectations, , household spending stagnant and confidence is low- all signs of a prolonged stagnation

Petroleum prices and food prices tend to move together on account of a costpush effect

Source: EIA and FAO

Resisting a Global Meltdown

Another related factor is rising food prices. Food and oil prices tend to move together on account of a cost-push effect (figure 1). High oil price raises the cost of producing and transporting food, and an exceptionally high oil price may encourage the use of bio-fuel as a substitute, thereby further raising food demand. In sum, a significant increase in the price of oil, on the back of Yuan appreciation, could push the US economy close to recession. Appreciation of the Yuan: Despite the vigilant management of demand-side factors by the Chinese central bank, inflation is rising. As of July 2011, CPI prices rose 6.5% (point-to-point) and Chinese monetary authorities have been forced to revise growth targets for the sake of inflation control. The central bank has raised benchmark interest rates three times and the required reserve ratio six times in 2011. During August 9-15, the Yuan appreciated 1.2%. As the currency is revalued, the magnitude of the trade balance in Chinas favor may become lower. In such a case, Chinas purchase of US treasury bonds may decline, paving the way for the USD to become weaker. Therefore, while the Fed attempts to keep rates low and stimulate growth, Chinese revaluation of the Yuan can undermine the Feds efforts as Chinese products become more expensive to US customers. While this does not guarantee the incidence of a recession, an increasingly strong Yuan can, in fact, exacerbate a US economic slowdown.

The Outlook for Bangladesh

During the financial crisis of FY2009, Bangladesh was cushioned from any significant impact, at least from the point-of-view of exports, because of the Walmart effect. This refers to the cushioning effect on the external sector because of the relative inelasticity of US and EU demand for low-end Bangladeshi garments and knitwear products (which constitute a bulk of Bangladeshs exports). Consequently, export growth was not affected much in FY2009. However, as per figure 2, we find that export growth fell to 4% in FY2010. We presume this to be a result of the lagged effect of declining EU and US demand. The EU and US constitute roughly 84% of Bangladeshs total export market (figure 3). Hence, the countrys external balance sheet is highly vulnerable to
Figure 2: Bangladesh Export Growth Figure 3: Bangladesh Export Markets
Middle East Region 1% Asian Region 7% Other Contries 7%

Export growth was slow in FY2010, due to a lagged effect of the 2008 financial crisis

American Region 32%

EU 53%

Source: Bangladesh Bank

Source: Bangladesh Bank

The US downgrade is not expected to have a significant impact on Bangladeshs external sector

event risks in those countries. However, we do not think that the mere event of a US credit rating downgrade will significantly affect the Bangladesh external sector. Other barriers to doing business such as inadequate infrastructure and power supply will hinder export growth, but this is not expected to reach dire proportions. In the best and most likely case that the US slowdown will continue, the Wal-mart effect is likely to set in, helped by the considerable BDT depreciation against the dollar in H1 2011. We may also see the effects of the

Resisting a Global Meltdown

China+1 policy as increasing manufacturing costs in China catalyzes a growth in western demand for Bangladeshi RMG. In the case of remittance flows - because of diplomatic overtures by the government in H1 2011 in order to increase manpower export to Saudi Arabia and Malaysia - an uptick is expected in H2 2011 from H1. Countervailing forces that will threaten to stifle remittance growth include Libyas unresolved political turmoil. The UAE could cut also back on project expenditure and the currencies of Gulf countries could take a hit, being pegged to the dollar. However, there are still other global, event-specific and regulatory catalysts expected to augment exports. As long as oil prices do not fall much lower than their current levels, the upcoming Eid festivals witness the uptick one has come to expect at this time, and the use of legal remittance channels (banks, money exchanges, etc) continues to grow at the expense of the informal and illegal hundi** remittances will be stable. On the other hand, if the US and/or Europe goes into a double dip, there will be a significant impact on the global economy. Reduction of low-end garment demand will follow the reduction of demand for high-end items such as leather goods and frozen foods. Bangladeshs export earnings will shrink across sectors. In this case, the Wal-mart effect will be countered by the sharp decline in consumer confidence that accompanies a double-dip, across low and high-income groups. Precedents (such as the double-dip of 1983 in the US) show that the second recession often cuts deeper, especially in matters of consumer confidence and retail spending. Moreover, a full-blown recession in the US and/or Europe will severely limit investments and project expenditure in the Middle East (Saudi Arabia, Kuwait, UAE, Qatar) and South East Asia (Malaysia and Singapore). This will translate to a reduction in Bangladesh manpower demand which, in turn, will curb remittance flows. The resultant declining BoP will render it hard for the government to manage the soaring inflation rate. There will, however, be some silver lining in the form of reduced oil, electricity and food prices. Cumulatively, they will put a downward pressure on inflation, thereby limiting the decline in the real GDP growth rate. In the event of a double dip, we expect the GDP growth rate to fall to 6.0-6.3% from last fiscals 6.7%. The take-away is that Bangladeshs growth rate will be respectable. At a time when western economies will struggle to ward off contraction, and the massive economies of India and China experience significantly reduced growth rates, the time is nigh for Bangladeshi monetary and fiscal authorities to capitalize on the moment, and reinforce the countrys status as an emerging investment destination.

A double-dip recession in the US is likely to affect BoP adversely; GDP growth may fall to 6.0-6.3%

** Hundi is an informal value transfer system based on the performance and honor of a network of money brokers, which are primarily located in the Middle East and South Asia

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Sajid Huq Amit Parvez Morshed Chowdhury Ali Imam Khandakar Safwan Saad Aasim Tajwaar Matin Shahnewaz Kabir Senior Research Analyst Research Analyst Investment Analyst Research Associate Research Associate Research Associate sajid.huq@bracepl.com parvez@bracepl.com imam@bracepl.com safwan@bracepl.com tajwaar.matin@bracepl.com shahnewaz@bracepl.com 0175 554 1254 0173 035 7154 01730 357 153 01730 357 779 01730 727 913 01730 727 918

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