For the last few years, Bangladesh has regularly achieved a "Stable" outlook in its sovereign rating from global rating agencies Moody's and Standard & Poor's. While this is a commendable development, we need to know what are the challenges for a higher rating? How much progress has Bangladesh made in that direction? The well-known benefits of a healthy sovereign rating entail that we take a closer look at the factors used by rating agencies in assessing sovereign risk.
This brief note assesses these specific factors and identifies areas where Bangladesh has made progress - implying opportunities for higher scores - and areas where substantial challenges remain. The assessment is based on the methodology used by Moody's in its recent credit analysis report (April 28, 2015). The main message from this analysis is, by the end of Fiscal Year 2015-16, Bangladesh is expected to be considerably closer to achieving a higher sovereign rating.
OVERVIEW OF RATING METHODOLOGY: Bangladesh has been assigned a "Ba3" rating by Moody's which is three grades below the minimum rating (Baa3) categorised as Investment Grade. Moody's rating methodology is based on four broad economic categories - Economic Strength, Fiscal Strength, Institutional Strength and Susceptibility to Event risk. Each of these categories are based on multiple sub-factors. Scores to sub-factors are aggregated to give individual rankings to the four broad categories. These rankings are based on a 15-point scale ranging from Very Low [-] to Very High [+]. Finally, rankings to the broad categories are aggregated to an indicator called "Government Financial Strength" and this aggregated ranking is assigned a formal credit rating using an indicative rating range. The table below summarises each of the broad categories, the sub-factors they consist of and the latest ranking or score assigned by Moody's to Bangladesh.
One important dimension of the methodology is that while information used is mostly historical, the rating agency incorporates expectations on future metrics. This implies that current policy initiatives and what it promises to establish for Bangladesh is also considered in assigning final ratings.
ANALYSIS OF ECONOMIC CATEGORIES
Economic Strength: Bangladesh received a ranking of Moderate [-] for Economic Strength. According to the report, the main positive is Bangladesh's 6.1 per cent growth in FY 14 which was well above the median growth rate for countries with similar ratings. Main challenges include low per capita income relative to peers, inadequate investment and infrastructural weakness.
A critical point to note here is that Moody's forecasted 6.1 per cent growth for FY 15, whereas provisional data shows 6.5 growth. But rating agencies are careful about this number given significant political tensions and country-wide strikes in the previous fiscal year. The World Bank's "Bangladesh Development Update" (April, 2015) makes a strong case about methodological weakness in Bangladesh Bureau of Statistics' GDP (gross domestic product) growth calculations. The Bank points out that current methods are unable to capture economic disruptions. The Bank also states that production loss by political turmoil in FY 15 was around 1.0 per cent of GDP - the main reason it revised down FY 15 growth forecasts to 5.6 per cent earlier this year. Meaning, the economy would actually have grown at around 6.5 per cent in the absence of turmoil.
Returning to the current fiscal year (FY 16), it is safe to say that normalcy has returned and political volatility has considerably lessened. Assuming such a scenario for the entire year, we can expect real GDP growth of around 6.5-6.6 per cent, if not higher. This is based on the assumption that, in the absence of political unrest, firms and household consumption should regain the momentum they lost in the previous year. This growth figure is significantly higher than Moody's 6.1 per cent forecast for FY 15. It brings Bangladesh's growth in line with the South Asia median, which has a ranking of Moderate [+]. Also, volatility of growth is lowest for Bangladesh among peer countries. This means, Bangladesh's score on the sub-factor "Growth Dynamics" should be increased if the projected growth for FY 16 materialises.
Economic Strength constitutes two other sub-factors - scale of the economy and wealth. Higher scores in these factors depend on higher per capita GDP, improved infrastructure and higher investment. Even though Bangladesh has made it to the World Bank's lower middle-income group, per capita income remains among the lowest in Moody's rating universe.
Finally, on the issue of investment, it is important to note that Bangladesh's 29 per cent Investment/GDP ratio is substantially higher than the Ba median of 21 per cent. Moreover, Bangladesh's investment ratio is higher than countries like Thailand (26 per cent as of 2014, Source: World Bank WDI) and marginally below India's (31 per cent as of 2014, Source: World Bank WDI) - both countries have higher credit ratings. These developments imply that on aggregate, there is opportunity for Bangladesh to get a higher ranking than Moderate [-] for the Economic Strength category.
Fiscal Strength: In terms of Fiscal Strength, Bangladesh's low revenue base is the primary factor which brought down the ranking to a subpar "Low [-]". While this is understandable, some developments related to revenue base should be pointed out. First, average annual growth for both income-tax base and VAT-base has been more than 15 per cent for the period FY 11-14. The numbers would naturally have been higher if Bangladesh had not faced the crippling political scenario during and after national elections. Second, domestic-based VAT as a percentage of total VAT has experienced a linear rise since FY 2008 and stood at around 65 per cent at the end of FY 14 (Source: Fiscal Management and Revenue Mobilisation, Planning Commission, Government of Bangladesh). This shows a fundamental shift towards domestic-based revenue collection (away from import tariff) that rating agencies and international development institutions advocate. Third, the government is working with policy-institutions in removing ad-hoc tax exemptions which get in the way of a larger tax base. Finally, the current World Bank project of VAT automation is well underway and is expected to be fully operational by the end of this fiscal year.
Other fiscal dimensions which have improved are lower energy subsidy and government borrowing from the banking system. Recent policy initiative in ensuring that interest rates on National Savings Certificates are market-determined is also a welcome development.
These issues imply that a forward-looking analyst could assign higher scores on factors related to revenue base and fiscal policy. From Moody's report, both Debt burden (General Government Debt/General Government Revenue) and Debt-affordability (General Government Interest Payment/General Government Revenue) would merit an upward revision. But the undeniable truth remains that despite an expected increase in revenue base, Bangladesh will still have one of the lowest revenue-GDP ratios among countries with similar credit rating at the end of the current fiscal year. Thus the challenge remains that as long as rating agencies look at the stock of revenue (and not the trend in flows), an upward revision in Fiscal Strength is unlikely.
Institutional Strength: A score of "Very Low [+]" reflects years of below-par public institutional credibility and bureaucratic inefficiencies. This is especially pronounced in the fiscal side and can be easily seen from the performance of several fiscal indicators. For instance, development spending falls below target every year mostly due to poor governance, sub-optimal public accounting frameworks and inadequate supervision. Political economy factors is one of the main reasons getting in the way of Bangladesh transitioning to a counter-cyclical fiscal policy - which international experience shows is a more optimal fiscal arrangement than Bangladesh's present pro-cyclical stance.
On the monetary side, Moody's notes that the central bank's ability to structurally bring down inflation is limited. This view is not justified given Bangladesh Bank's pro-growth stance. As the central bank attempts to facilitate 6.5 per cent growth, an inflation rate of around the same figure is justifiable and does not necessarily reflect inability of the central bank to bring down inflation. Moody's own analysis shows that Bangladesh Bank curbed headline CPI (consumer price index) from around 11-per cent in 2011 to 6.0 per cent in less than a year. Also, a total of 20 per cent of food imports (an essential item) from only one country (India) means that inflation has a large exogenous component to it which, by definition, a central bank cannot control. On the financial side, Bangladesh Bank has remained quite credible in its commitment to addressing financial sector scams. Regular warnings to top-level executives of state-owned banks (SoCB) in terms of improving asset quality serve as evidence. Recent initiatives in the Bank Companies Act has strengthened BB's monitoring and regulatory power over the SoCBs.
On aggregate, development of institutional quality is mixed, with some positives seen in the monetary side. A notable improvement in this category will revolve around optimising large parastatals which reduce fiscal discipline. This is the sort of structural challenge which will require at least a medium-term timeline to overcome. Current information suggests that the two sub-factors in this category - Policy Credibility and Institutional Effectiveness - should retain their present scores in the next sovereign analysis. Therefore, on aggregate, Institutional Strength does not merit a higher ranking in the short-term.
Susceptibility to Event Risk: The major factors driving the "Moderate" rating in this category were political and banking sector risk. Political volatility in the first quarter of 2015 had indeed peaked to all-time highs. But since then things have calmed down considerably and there has been no such violence in the streets or continuous strikes. While we cannot rule out recurrence of political unrest, signs are that FY 16 should be relatively free from strikes and vandalism. This implies there is considerable opportunity to get an improved score on Political Risk.
The other major concern in this category is poor asset quality in the banking sector and possible shocks emanating from the state banks to the broader financial sector. This remains a daunting challenge for Bangladesh and a core hindrance to an improved score in this sub-category. It is encouraging to see that share of classified loans to total outstanding has come down in June to 9.67 from 10.47 per cent in March. The central bank has remained vigilant in curbing unscrupulous activity in SoCBs and reforms such as stronger internal control, limits on credit growth and automated financial reporting systems are encouraging initiatives. Higher score in this sub-category hinges on successful implementation of these reforms and significantly reducing balance sheet vulnerabilities in the banking sector.
In terms of government liquidity risk, Bangladesh's performance has been quite commendable. This sub-factor is analysed using General Government Debt/GDP and General Government External Debt/Total General Government Debt. Moody's own calculations show that the former has been generally steady at the 40-45 percent range for the last few years. More encouragingly, external debt has fallen almost linearly in recent times. Prudent external debt management and utilisation of concessional loans from development partners have brought about Bangladesh's comparatively low external debt ratio.
Finally, Bangladesh's performance in terms of external vulnerability is perhaps among the most impressive macro development in recent times. Brought about by an exponential rise in foreign reserves and low external debt, Moody's External Vulnerability Indicator for Bangladesh has almost halved in value in the space of just two years. The rise in reserves has allowed the country to plan for its maiden Sovereign Wealth Fund which could be invested in infrastructure or generate healthy returns from the international capital market. Possibility of spillover effects from global economic volatility is low through financial channels given a relatively closed capital account, but moderate risks remain through trade linkages. Bangladesh slipped back into a current account (CA) deficit after two years of being in surplus. But the CA deficit is less than 1.0 per cent of GDP. Even a 2.0 per cent deficit is not really a cause for concern for a consumption-based emerging economy. Countries like India and Sri Lanka have much higher CA deficits (1.6 per cent and 3.9 per cent respectively) than Bangladesh and both are expected to grow at or above the 7 per cent range. More importantly, Bangladesh has a healthy balance of payments surplus in excess of US$ 4.0 billion at the end of FY 15.
On aggregate, this category merits an improved ranking due to improvement in political scenario, impressive external stability and steady debt situation. While banking sector risk has not diminished, current policy initiatives suggest that it will slowly move in the right direction.
FINAL REMARKS: Based on the analysis presented above, it becomes evident that progress has indeed been made in at least two out of four major categories used by Moody's in its sovereign rating process. These are Economic Strength and Susceptibility to Event Risk - implying that there is an opportunity to receive higher rankings in these categories. Challenges remain in receiving higher rankings in the other two categories - Fiscal Strength and Institutional Strength. But reforms aimed at addressing these issues suggest that these factors are improving - albeit slowly. Most importantly, there is no evidence at present to assign a lower ranking in any category.
At the end of this current fiscal year, assuming the expectations stated in this note materialises, Bangladesh should be considerably closer to achieving a "Ba2" rating from Moody's. Given the similarity of the analysis with other rating agencies, the same can be said for ratings from Standard & Poor's and Fitch. This, in turn, would have major implications for foreign investment, employment and economic activity in Bangladesh.
The writer is a Macroeonomic Analyst, with a Master's degree in International Economics from Johns Hopkins University, USA.
shaque4@jhu.edu
