BANGLADESH: IMF CONDUCTS FIFTH REVIEW OF PRGF

C O N F I D E N T I A L SECTION 01 OF 03 DHAKA 002741

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C O R R E C T E D COPY(CLASSIFIER INFORMATION)

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EB/IFD/OIA

E.O. 12958: DECL: 05/05/2016
TAGS: EFIN EAID IMF BG
SUBJECT: BANGLADESH: IMF CONDUCTS FIFTH REVIEW OF PRGF

REF: A. DHAKA 2640

B. DHAKA 1143

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CLASSIFIED BY ECON CHIEF DAVID RENZ REASON 1.4(d)


1. (C) Summary: An IMF mission conducted the fifth review
of Bangladesh's Poverty Reduction and Growth Facility (PRGF)
from April 30 - May 10. Although identifying several actions
the BDG must take, the IMF mission was generally satisfied
with progress to date. Key issues are reducing fuel price
subsidies and increasing revenues. Executive Board
consideration of the fifth review could take place in July
2006 and, if approved, would permit release of an additional
$90 million in PRGF funding. If consideration is delayed to
the September meeting, it is unlikely a sixth review would
take place before the PRGF expires at the end of 2006. IMF
will wait to negotiate a new PRGF until a new government is
formed following elections expected in January 2007. End
summary.


2. (U) On May 14, IMF resident representative Jonathan
Dunn briefed members of the diplomatic community regarding
the IMF fifth review of its PRGF with Bangladesh. He began
with a summary of the points contained in a May 10 IMF press
release
(http://www.imf.ogr/external/np/sec/pr/2006/p r0693.htm):

-- The economy continues to grow despite stiff competition in
the global garment industry. IMF projections of 6.5% real
GDP growth for FY 2006 (July 1, 2005-June 30, 2006) are
consistent with recent ADB projections. Inflation is
contained and the international reserve position is stable.

-- The BDG continues to pursue prudent fiscal, monetary and
exchange rate policies. Lower expenditures, particularly for
the Annual Development Program (ADP) have offset lower
revenues, limiting domestic financing needs to 2% of GDP.
The financial condition of several large state owned
enterprises (SOEs),however, has markedly deteriorated. The
mission welcomed the momentum behind reforms of the
Nationalized Commercial Banks (NCBs).

-- Bangladesh Bank (the central bank) has gradually tightened
monetary policies to reduce inflationary pressures. The
floating exchange rate system is functioning well and
depreciation of the real effective exchange rate has improved
export competitiveness.

-- Several challenges threaten continued economic progress.
Power shortages threaten near-term economic growth. Current
energy pricing policies and deterioration of the financial
position of SOEs pose risks to the government's fiscal
position and the banking system. Further improvements in
revenue collection and project implementation are needed to
sustain fiscal stability and enhance poverty reduction.

-- Bangladesh cannot sustain the financial losses and
economic costs stemming from under-pricing of energy products
-- fuel, electricity and natural gas. Reforms aimed at
eliminating general subsidies while targeting support to the
most vulnerable should be implemented.

Macro Economy Performing Well
--------------


3. (U) Dunn reviewed several key economic indicators.
Real GDP growth is now estimated at 6.5%, up from 5.6% for
FY06. Inflation is moderate at 6.25% (year-on-year) in March
2006, down from a near 8% peak. Overall revenues and
expenditures as a percent of GDP are nearly unchanged from
FY06. Revenues are 0.4% less and expenditures are 1% less
than initial forecasts. As a result, net financing
requirements are also constant, at 3.4% of GDP. Export
growth has outpaced the growth of imports while remittances
remain strong. As a result, the balance of payments deficit
is a mere 0.2% of GDP. Official reserves are essentially
unchanged from FY06 at 2.4 months of imports of goods and
nonfactor services.


4. (U) The key factors contributing to higher GDP growth,
according to Dunn, are better than expected agricultural
production, which rebounded from damage caused by the
previous year's floods, strong performance of the ready-made

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garment sector following the end of the Multi-Fiber
Arrangement, and broad-based growth in manufacturing and
services.


5. (U) Revenue growth as a share of GDP is flat. Income
and domestic VAT tax collections are up 20% in real terms,
according to Dunn. These gains were offset by lower revenues
from customs and supplementary duties and VAT on imports,
which Dunn attributed to lower import levels and corruption.


6. (C) Dunn noted several positive developments at the
National Board of Revenue. He described a "change of
mindset" at the NBR, which he attributed to the leadership of
the current chairman. As a result, NBR recognizes it needs
to reorganize along functional lines (e.g., auditing,
collections, enforcement) instead of its current organization
by type of revenue collected. He also pointed to growing
cooperation among the large taxpayer units (LTUs) in current
tax units, which focus compliance investigations on
apparently wealthy individuals and businesses known to pay
little or no taxes. Dunn cautioned that the current chairman
will leave in August. If the reforms continue, Dunn expects
them to have a real impact within two to three years.


7. (U) Expenditures are also flat as a share of GDP,
although they had been projected to increase over FY05
levels. Dunn attributed this principally to ADP expenditure
shortfalls. This has also resulted in a reduced flow of
foreign assistance to fund ADP projects, which the government
has been slow to implement. Procurement issues, especially
in the power sector, have slowed implementation significantly.


8. (U) Remittances continue to grow and are projected at
$4.8 billion for FY06. Dunn said it was unclear how much of
the increase reflects real growth and how much a shift from
the informal to the formal sector. Some bankers, he said,
believe the effect of "formalizing" remittances is
diminishing. He also noted that banks have become much more
competitive with the informal sector, offering guaranteed
two-day delivery and better exchange rate spreads.

Disturbing Trends
--------------


9. (C) Dunn noted several disturbing underlying trends.
Credit growth remains strong, at 20% for the 12-month period
ending in March. This is driving up deposit interest rates
as banks look to raise funds to meet credit demands. Dunn
also said the deposit rate spread among banks, currently
7%-13%, is also increasing, raising concerns that some banks
may be engaging in risky lending practices, while using above
average rates to compete for funds. He noted that the
central bank is gradually tightening the money supply, but
said he does not expect any major changes in monetary policy
during the current government's remaining six months. He was
neutral on the quality of central bank supervision of the
banking sector and its ability to manage problems that may
arise at any commercial banks.


10. (C) Dunn cited power sector problems (Ref B) as a major
risk to growth over the next few years. While he discounted
RMG sector claims that unstable power was causing a 30%-50%
productivity loss, he conceded the sector was facing
significant indirect costs for fuel for standby power
generation and airfreight costs (versus sea freight) to meet
delivery deadlines.

The Real Problem is Off the Books
--------------


11. (C) Dunn stressed that the real problem in the economy
is the under-pricing of energy products, which is essentially
financed off the books through the national commercial banks
and the main SOEs, especially the Bangladesh Petroleum
Corporation. Although the major problem at the moment is
fuel subsidies (diesel, gasoline and kerosene) (Ref A),
under-pricing of electricity and natural gas contributed to
under-investment in the power and energy sectors, Dunn said.


12. (U) Already facing popular discontent over rising
prices for basic food items and frequent power outages, the

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BDG has been reluctant to use existing pricing mechanisms to
adjust the domestic price of fuels in response to rising
international oil prices. As a result, fuel prices in
neighboring India are 80% higher than in Bangladesh. This in
turn has created significant incentives for smuggling,
contributing to fuel shortages in boarder regions and
inflating Bangladesh's import requirements.


13. (C) The BDG initially relied on the NCBs to finance its
imports through loans to the state-owned BPC. Most of these
loans were funded through Sonali bank, although BPC also took
loans from Agrani and Janata. Sonali is now bankrupt and
illiquid due to lending to the BPC. The BDG will have to
recapitalize it with a combination of debt and equity and
write off the loans to BPC. The BPC is no longer borrowing
from Agrani and Janata, and existing loans will likely have
to be reclassified as non-performing and probably written
off. The BPC borrowing is also crowding out private
investment, Dunn said.


14. (C) The BDG has exhausted its internal sources of
financing. It has also been late on a few payments to
Middle-Eastern lenders. It has nearly finalized a $250
million commercial loan with Standard Chartered at LIBOR 2,
with payments deferred for nine months from the first
transaction. This loan would see the BDG comfortably through
the elections, leaving the problem for the next government.

Key Conditions for Fifth Review
--------------


15. (U) Dunn said there are two key conditions the
government must meet before the fifth review can be put to
the Executive Board. First, the fuel subsidy issue must be
addressed. Second, the government must put forth meaningful
measures for increasing revenues in the next budget cycle.


16. (C) The IMF wants to see substantial increases in fuel
prices to reduce government subsidies. An 80% increase is
needed to bring prices in line with India, although Dunn said
increases of 40%-50% would probably satisfy the IMF for now.
IMF estimates 60% of the current fuel subsidies benefit the
top two quintiles, making the current subsidy highly
inefficient. Instead, IMF would like to see the government
use existing poverty support programs to target direct
subsidies to the lower income populations most in need of
assistance, mainly rural farmers. No doubt reflecting IMF
advice, Finance Minister Saifur Rahman recently told
reporters the cabinet has agreed to raise fuel prices as soon
as a support program for the poor can be put in place.


17. (C) Dunn said the IMF mission met with the Awami League
(AL) during their visit. They do not expect the AL to make a
political issue out of any government fuel price increase.
They realize, Dunn said, that they will also have to deal
with the issue, if elected.


18. (C) On revenues, Dunn said the IMF is looking for a
0.5% of GDP increase in revenue projections. Of this,
perhaps 0.2% could come from efficiencies and improved
collections; however, the remaining 0.3% will require policy
changes. The IMF is waiting for government proposals, which
should be factored into the FY07 budget proposal scheduled to
be presented June 9.
CHAMMAS