Millennium Development Goals

Bangladesh—Letter of Intent, Memorandum of Economic and Financial Policies

Dhaka, Bangladesh, December 18, 2003

The following item is a Letter of Intent of the government of Bangladesh, which describes the policies that Bangladesh intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Bangladesh, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

1. Bangladesh's economic performance has strengthened over the past two years, with restoration of macroeconomic stability and a renewal of structural reforms. This allowed us to increasingly shift the policy focus to boosting growth and reducing poverty in a sustainable fashion. Thus, the government launched in June 2003 a comprehensive reform program based on a poverty reduction and growth strategy as set out in our Interim Poverty Reduction Strategy (I-PRSP). This memorandum reviews progress that has been achieved so far and lays out the objectives and macroeconomic and structural policies during the period through December 2004, supplementing our Memorandum of Economic and Financial Policies (MEFP) dated June 4, 2003.

2. We have begun preparation for a full PRSP, and aim to complete it by end-2004. An interministerial Poverty Steering Committee has been set up to follow a two-staged approach--a review of implementation of the I-PRSP and then detailed thematic studies of the key issues for poverty reduction. Furthermore, pro-poor programs will be more sharply prioritized, and more fully costed into a medium-term expenditure framework. In order to help solidify domestic support for reform, we intend to strengthen the consultation process, to include broader segments of civil society and parliamentarians.

3. Recent economic performance continues to be positive. The recovery that began in early FY03 (ending June) has been bolstered by a pick up in external demand and domestic activity. Real GDP growth for FY03 thus rose to an estimated 5.3 percent on the rebound of agriculture and industrial output (Table 1). For FY04, a further strengthening in economic performance is likely. At the same time, inflation remains manageable, at under 5 percent as of September.

4. The external position has strengthened more than expected. Exports climbed by 9½ percent in FY03, due to a turnaround in the ready-made garment (RMG) sector. This reflects gains in competitiveness and a recovery in external demand. Remittances also remain buoyant, so that in spite of strong import growth, the current account registered a surplus of 0.6 percent of GDP. With a substantial increase in external assistance, gross official reserves rose by about $1 billion from June 2002 to $2.4 billion (three months of imports) by end-November 2003, well above our target. The taka has remained broadly stable since the May 31 float, but depreciated in real effective terms by 2 percent since June 2002. Moreover, external debt management has been prudent, with tight monitoring of nonconcessional debt, keeping new borrowing well below the program ceiling.

5. Macroeconomic policies are on track, with overperformance in key targets for FY03, and all indicative targets and quantitative performance criteria for end-June and end-September were met (Table 2). Strong revenue performance and expenditure discipline helped to narrow the budget deficit to 3.5 percent of GDP, below the program target of 4.2 percent of GDP. Tax revenue rose by 0.6 percent of GDP, with increases in VAT and customs duty more than offsetting a shortfall in income tax. As a result, domestic financing was halved to 1.3 percent of GDP, against the program target of 2 percent of GDP.

6. The FY04 budget is in line with the program, and includes revenue efforts and a reordering of spending priorities. The budgeted deficit--up to 4.8 percent of GDP--is expected to be financed by more concessional financing to meet the urgent need for infrastructure and social spending. Total revenue is targeted to rise by 0.5 percent of GDP, on account of recovery of tax arrears, a broadening of the income tax and VAT net, and a strengthening in tax administration. Spending priorities are to be shifted to pro-growth and pro-poor areas, with an increase of about 1 percent of GDP in poverty reducing spending. Domestic financing is to be capped at 2 percent of GDP.

7. Monetary policy was tightened in the second half of FY03 to facilitate the transition to the float. Treasury bill rates were raised and reserve money rose by only 4 percent, below program. Nonetheless, private sector credit remained robust, growing by 13 percent in FY03 and the exchange rate has been stable. Given this favorable environment, Bangladesh Bank (BB) began to ease monetary conditions in the first quarter of FY04 to better support growth. Treasury bill rates were reduced by 3 percentage points during July−October, and deposit and lending rates have also started to decline.

8. On the structural front, progress has also been made (Table 3). In tax administration, steps have been taken to revamp the bonded warehouse system, and measures have been adopted to modernize and expand the Large Taxpayer Unit (LTU) (an end-September performance criterion) and are in train to establish a Central Intelligence Unit (CIU). Similarly, the key initial steps in nationalized commercial bank (NCB) reform are being taken in line with the program approach, albeit with slippages from some of the original timetables. In particular, the special audits of the four NCBs are now underway, to be completed as scheduled at end-2003. Performance under Memoranda of Understanding (MOUs) agreed with BB has also been satisfactory, with the NCBs adhering to their lending limits and reducing operating costs. However, the contracting of new management or management support for these banks lagged at first, due to the time needed for completing the formalities for Cabinet approval for the reform approach and some startup uncertainty about the World Bank's procurement requirements for its funding support. Finally, closure of NCB branches and loss-making state-owned enterprises (SOEs) in the manufacturing sector has slowed, particularly owing to strong labor union opposition.

9. The original macroeconomic framework for FY04 (for real GDP growth of 5.5 percent and inflation of 4.5 percent) remains attainable. Global recovery along with more accommodative fiscal and monetary policies bring these targets within reach, with some upside potential. Both export and import growth should remain robust, and the shift of the current account into a deficit of 1.2 percent of GDP is expected to be covered by additional concessional financing. Although the pace of reserve accumulation has tapered off, the external outlook remains favorable. While keeping the prospects of external financing under close review, given the very good performance so far, we intend to further build up reserves to $2.85 billion by end-FY04.

10. The main medium-term risk is the phase out of Multifiber Agreement (MFA) quotas at end-2004. Since Bangladesh is highly dependent on RMG exports, the adverse impact of quota removal on the external position, output, and employment could be substantial. In addition, risks to program implementation arise from uncertainties in the political environment and capacity constraints. To mitigate these risks, the program outlined below is geared toward creating a friendly climate for investment (domestic and foreign alike) so as to boost growth and create jobs. Moreover, flexible exchange and interest rate policies will help us to enhance competitiveness and better cope with external shocks.

11. The fiscal program is broadly on course in the first quarter of FY04, reflecting good revenue collection and a backloading of discretionary expenditures. Total revenue rose by 15 percent year-on-year, but on account of nontax revenue, especially BB dividends. Lagging tax collection by the National Board of Revenue (NBR) is a matter of serious concern. NBR revenue in the first quarter rose by 9.4 percent, compared with the 15 percent annual target, mainly due to shortfalls in customs duty receipts. We expect tax revenue to grow faster in the remainder of the year, along with an acceleration in the registration of additional VAT and income taxpayers, and the phase in of the programmed revenue measures (see below). Nonetheless, we intend to track revenue performance closely and if shortfalls persist, we will take corrective actions in the context of a revised budget in February 2004.

12. To protect the program revenue target, we will ensure rigorous implementation of the following measures:

· On the LTU for income tax, the September performance criterion was met with a slight delay. Appropriate steps have been taken, and the LTU has begun to function. Over 1,000 large taxpayers--covering about 35 percent of the tax base--have been selected on objective and transparent criteria that have been published. They comprise all banks and nonbank financial institutions, telephone and satellite TV companies, enterprises with paid-up capital in the range of Tk 60-1,200 million, and company directors. The transfer of tax files has begun from over 400 local tax offices, staffing and logistical arrangements are being made, and operational manuals have been finalized.

· On the CIU, the revised organization chart agreed with the Fund staff has been approved in early December, and 1,000 taxpayers covering all major taxes are being selected for monitoring on the basis of compliance records and risk assessment. Other preparatory work is being completed, and the CIU is expected to be fully operational by end-December (a performance criterion).

· As regard the bonded warehouse system, the December benchmark on revamping this system is expected to be met. All imports for domestic consumption and most imports for export production are now subject to bank guarantees of 100 percent and 25 percent, respectively, of import duties and VAT.

13. In FY05, revenue mobilization and improved efficiency of the tax system will remain critical. We are determined to make further efforts to strengthen tax administration, starting with plans to expand the LTU system in early FY05 to cover withholding tax and VAT; we will decide the appropriate coverage of relevant taxes by the second PRGF review in consultation with the Fund staff. Moreover, we will initiate efforts to modernize the NBR, drawing on recommendations of the recent FAD technical assistance and regional experiences, and in collaboration with the World Bank and other donors. In addition, we intend to rationalize the tax system by reducing trade taxes, including supplemental duties, in FY05 budget.

14. On expenditures, the agreed quarterly spending limits will continue to be observed. Moreover, steps are being taken to improve absorptive capacity in order to speed up project selection, preparation, and execution of the Annual Development Program (ADP), so as to ensure quality investment in infrastructure and social sectors. To this end and for transparency, we have recently approved procurement guidelines to expedite release of funds and improve governance. Moreover, we intend to take timely decisions on policy reforms and fast track preparation of key infrastructure projects with the support of donors. In addition, we will strengthen the system for monitoring and tracking public expenditure, to ensure achievement of budget priorities.

15. BB will take further steps to lower lending rates to promote investment, while standing ready to react to any emergence of inflation and keeping interest rates positive in real terms. Already, BB has strengthened bank competition by publishing market information, worked to improve the functioning of interbank money market, and developed a secondary market for government securities to better circulate surplus funds among banks. Moreover, the Statutory Liquidity Requirement (SLR) ratio was reduced from 20 percent to 16 percent in November. Additional steps will be taken to broaden and deepen the government securities market, including through gradually phasing in volume-based auctions and introduction of long-term treasury bonds, so as to reduce rate volatility and develop yield benchmarks. In line with this overall easing stance, the monetary program has been revised and extended to cover the first half of FY05.

16. Reform of the National Savings Certificates (NSCs) scheme is vital, to contain the costs of financing the budget deficit as well as to make the interest rate structure more flexible and market-based. Consistent with this aim, and in view of the recent decline in other interest rates, we are making appropriate adjustments to interest rates on new issues of NSCs in line with market rates. In addition, we are taking steps to better enforce the limit on access by individuals to NSCs, and will consider affordable safety nets for the most vulnerable groups.

17. The floating exchange rate regime has increased the economy's resilience to shocks. We intend to avoid intervention in the exchange market except to smooth out disorderly market conditions, and to further build up reserves so as to reduce external vulnerability. On December 2, in order to eliminate distortions, we liberalized the exchange regime further by removing the remaining margin requirements for the opening of letters of credit on imports. We are receiving LEG/MFD technical assistance relating to the phasing out of exchange restrictions subject to Fund jurisdiction, i.e., with respect to the convertibility and transferability of proceeds of current transactions in nonresident taka accounts, and the advance payments for imports of goods and services.

18. We will continue to exercise caution in contracting suppliers' credits, and intend to stay below the ceiling for the contracting and guaranteeing of nonconcessional external debt. Funding for infrastructure will be sought first on concessional terms, especially from IDA. We will also enhance upstream monitoring and coordination of new loans in the process of being contracted.

19. The government remains committed to divesting the NCBs over the medium term, including by privatization in whole or in part. Our initial efforts are focused on curbing the flows of new bad loans and strengthening management of NCBs. For the remainder of FY04, the pace of NCB reform will be stepped up and monitoring intensified, for which a working group has been created. Accordingly, timetables for securing new management for Agrani, a sales advisor for Rupali, and management support for Sonali and Janata have been revised in consultation with World Bank and Fund staff. Over the last three months, implementation of the steps envisaged under these timetables has been on track.

20. Ahead of the completion of the first review, we expect to achieve the following: for Agrani, approval by the Cabinet's Purchase Committee of the winning bid by mid-December; for Sonali and Janata, issuance of the requests for proposal for the management support contracts and the convening of the pre-bid conference; and for Rupali, completion of technical evaluation of bids for a sales advisor. In addition, a monitoring cell under the working group will be established as soon as possible, with technical support from the World Bank, to track performance under these contracts. Furthermore, we intend to bring Rupali to the point of sale by December 2004.

21. Looking forward, we have begun consideration of the options for comprehensive bank-by-bank resolution strategies, so as to be able to adopt such strategies by end-April 2004 as envisaged under the program. Following this, we intend to draw up action plans to operationalize these strategies by end-November 2004.

22. We continue to build upon the reform initiated in the energy sector, which is key to growth and fiscal sustainability. Automatic pricing framework for energy products has been adopted in collaboration with the World Bank, and initial price adjustments for power, gas, and petroleum products have been taken under the agreed framework. An investment/ program loan for the power sector from AsDB has just been approved.

23. The government is attaching top priority to ramping up the reform of the power sector, so as to urgently upgrade the quality of services and expand the capacity of the sector. An Energy Regulatory Commission is being formed to be in place by early 2004. Furthermore, given the critical need to improve the financial performance of the urban electricity distribution systems, we are considering options for improving billing and collection. This is critical for the Dhaka Electricity Supply Authority (DESA), since DESA is responsible for over half of power distribution and 80 percent (1½ percent of GDP) of the stock of inter-SOE arrears. The restructuring of DESA is thus integral to the reform framework, and must be centered on the basic problems of heavy system losses and poor billing and collection. To advance this reform, we are securing a technical assistance credit from the World Bank to define a robust turnaround program for urban electricity distribution. This is expected to pave the way for a program for a financial and operational restructuring of DESA with donor support.

24. With respect to safeguards assessment, an audit of BB financial statements has been completed on international auditing standards by a local firm and signed by an international accounting firm. While these statements reflect improvements, they still fall short of international accounting standards. MFD technical assistance is being provided to follow up on further actions to address the identified weaknesses. We are committed to implementing the other critical recommendations of the safeguards assessment.

25. We are taking actions to fight corruption and to enhance the climate for investment. In particular, the draft law for establishing an Independent Anti-Corruption Commission (IACC) was submitted to parliament in July, is under broad consultation, and is planned for passage in the next parliament session in early 2004. Support is being provided by the USAID and the AsDB. Moreover, as noted above, the new procurement guidelines should help to curb corruption.

26. Understandings have been reached on quantitative performance criteria for end-March 2004, quantitative targets for end-June 2004, and indicative targets for the remainder of 2004 (see Table 2). Furthermore, structural performance criteria and benchmarks have also been set to cover the remainder of 2004 on tax administration and NCB reforms (see Table 3). The second PRGF review will be completed by June 2004 to reach understandings for the second-year program, focusing on the formulation of FY05 budget, tax reform--drawing on the recommendations of FAD technical assistance noted above--and SOE and NCB reforms. To facilitate program implementation, we hope to continue receiving technical assistance from the Fund in monetary operations, banking and tax reforms, and statistics. In addition, the monitoring of structural policies will continue to be closely coordinated with the World Bank, especially in the context of the upcoming DSC II.

MEFP Table 2: Quantitative Targets and Performance Criteria Under the PRGF, June 2003-December 2004

MEFP Table 3: Structural Performance Criteria and Benchmarks Under the PRGF, June 2003-December 2004