The International Monetary Fund (IMF) has already pointed out a slowdown in global growth which still continues to grow and sees no possibility of growth moving into the negative territory. The most marked economic deceleration would take place in advanced economies, the European Union (EU) in particular. Italy is going to be the worst performing economy in the EU with a projected growth rate only of 0.6 per cent this year. Germany, the largest economy in the EU is projected to grow 1.3 per cent this year. Furthermore, the EU's exports account for 50 per cent of gross domestic product (GDP), double that of China. This makes the EU more vulnerable to global downturn in economic activity. The forecast has been made in the World Economic Outlook, April 2019.
While no short-term risks are currently visible, the current slowdown in global economic activity is largely driven by long-term risks as reflected in tightening labour markets and very low productivity growth. The slowdown has also gone hand in hand with a shift in monetary policies by the leading central banks towards greater easing to forestall an anticipated immediate downturn in economic activity. All these are going to contribute to risks to the global financial system as consumer, corporate and government debt continue to rise from the exiting very high level. Increasing reliance on loose money also stimulated stock and bond markets with serious consequences. At the same time capital remains underutilised for output growth.
The other factors that are contributing to financial risks include likely chaotic British exit from the EU and escalating US-China trade disputes. Also, US is ramping up trade threats against the EU on subsidies given to Airbus. But more ominous is the US generalised drive towards deglobalisation impacting not only China, the EU, Canada and Mexico but also practically all trading nations in the world. Deglobalisation will further make playing field more uneven which in turn make it tougher for trading nations to leverage their comparative advantage. Trump is not in any compromise mode rather Bloomberg noted that Trump was sending very clear message to the April World Bank and IMF meetings that he had not yet finished with trade wars and the world would have to deal with a weakening global economy. Overall result is slower growth for wealthier nations in particular and that will have flow- on effects on the rest of the global economy.
IMF Chief Economist Gita Gopinath noted that any deterioration in market sentiment could lead to tightening financial conditions at a time when there exist very high levels of private and public sector debt in many countries. She further warned that this may cause sovereign-bank doom-loop risks. This is a situation where weak banks can destabilise government that support them and over-indebted government also can push hanks holding their bonds to experience serious liquidity crisis endangering their financial viability. Such a destabilisation of the banking system in a country can lead to a negative feedback loop. The doom-loop becomes a reality when a central bank allows domestic banks to liquidate when these banks hold the largest share of their government bonds (debt). Now with the liquidation of these banks no financial institutions are left in the country to buy government bonds (debt). The consequence is that the government goes into default along with its banks.
The bond market in Bangladesh remains fairly underdeveloped due largely to limited supply of long-term bonds and the absence of secondary markets. Most government bonds are held by state-owned banks under government directive. The National Savings Certificate (NSC) scheme with relatively high interest rates further added to the bond market slowdown. The issuance process of bonds can be time-consuming and costly for a country like Bangladesh. NSC made it easier to save by offering safe and attractive deposits with high interest rates. But the scheme has diverted away money from bank deposits. Also for the government the scheme is extremely expensive borrowing mechanism if one looks at the interest rate spread between the market rate and the interest rate offered by it. The existence of the scheme makes it much harder to work out what is the price of money (interest rate) as one can not weigh in the relative riskiness of various debt instruments.
But in Bangladesh the rise in what is termed as non-performing loan (NPL) is the main contributing factor to the woes of the banking sector so much so that it can lead to a serious banking crisis in the country with the flow-on effects on the rest of the economy. According to the latest Bangladesh Development Update by the World Bank, 10 people/institutions account for very large proportions of bank debt of 35 banks. If they fail to pay up these banks will face serious capital shortages. The implication of this statement is very clear: in the event of debt defaults by these borrowers publicly funded recapitalisation of these banks will be required to keep the banking system afloat. The WB Update further emphasised that directed loans, poor risk management and weak corporate governance lead to the rise in NPL. It also pointed out that the increasing practice of loan rescheduling and write-offs creates further stress on banks. Obviously, such practices create serious moral hazard which further encourages bank debt default. The WB Update also mentioned that loan rescheduling approved by Bangladesh Bank stood at BDT 200 billion in 2018 and five banks account for half the total NPL.
AS NPL or debt default rises, the corporate sector will be faced with interest rate hikes. A growing tightening of financial conditions could drive the economy towards downward spiral as increasing levels of debt defaults occur. The WB Update on Bangladesh further pointed out foreign direct investment (FDI) remains low at less than 1.0 per cent of GDP. It also mentioned that Bangladesh remains one of the five fastest growing economies in the world in spite of insufficient private sector investment. Net FDI inflow stood at US$910 million in the first half of FY 2019.
Bangladesh is not immune from the fallouts from increasingly tightening global financial conditions. With global equity markets falling and rising credit spreads reflecting lessened optimism may create further challenges for the country to attract FDI.
The banking system in a country operates on a safety net system provided by the central bank and the state. This safety net and deposit guarantees and other measures can have negative impact on the budget. The crisis now originating in the banking sector will weaken the position of the government which in turn will further weaken the banking system. Also there will be impact on the macroeconomic front with the rising budget deficits causing higher funding costs which in turn will lead to contractionary effects on the economy.
As Bangladesh is now faced with rising debt defaults seriously impacting on the banking industry, it needs to adopt extensive contingency planning to reduce the existing large exposure to NPL. In view of the current serious liquidity problem experienced by banks, the potential for further instability will be even more if banks continue to use short-term instruments to fund long-term investments causing maturity mis-match. Furthermore, when banks have large exposure to NPL, their capital adequacy position will weaken, further requiring publicly funded recapitalisation.
The government should stop using banks to finance large public debt associated with very large infrastructure projects. Instead it should make it more attractive to households and other investors (including foreign investors) to hold those government debt. However, Bangladesh also must factor in the key global risk factors. In particular, the outcome of trade negotiations and the direction of the global financial landscape which is increasingly becoming volatile.
Muhammad Mahmood is an independent economic and political analyst.