Bangladesh banking: Covid overwhelms Dhaka’s weak system

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Banks in Bangladesh were struggling with poor performance even before coronavirus spread to the country; the pandemic is worsening the impact of a recent policy misstep.

By William Pesek

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It is hard to think of a nation with a worse case of economic whiplash than Bangladesh, as Covid-19 wrecks 2020.

Before early March, when it confirmed its first coronavirus case, the country was tipped to be one of the year’s top performers in terms of growth and a rare beneficiary of the US-China trade war.

Fresh foreign direct investment – plus millions of factory jobs – shifted from China to Bangladesh, south Asia’s second-biggest economy, as well as Vietnam.

Covid-19 and the resulting lockdowns put the brakes on that narrative. The 8% growth economists had expected for 2020 has been revised down to less than 2%, a big blow for an economy at Bangladesh’s state of development.

The pandemic fallout is now colliding with a weak financial system that may be heading for even greater turbulence.

Before Covid-19 arrived, Dhaka already faced problems with bad loans and a banking sector that was not fit for purpose. These troubles were exacerbated by a recent move by the central bank to cap lending rates at 9%.

The policy, which took effect on April 1, risks slamming a financial sector that is already reeling from rising non-performing loans.


Not being able to price loans effectively will essentially force commercial banks to turn the tap off to the segments of economy most affected by the crisis, exactly when liquidity is much needed 
 - Beidi Gu, Rohatyn Group

“The Covid-19 crisis added salt to the wound for the banking sector,” says Beidi Gu, managing director at the Rohatyn Group.

“Not being able to price loans effectively will essentially force commercial banks to turn the tap off to the segments of economy – small and medium-sized enterprises – most affected by the crisis, exactly when liquidity is much needed.

“With the thin capitalization level, the banking system has to revert to protections against insolvency.”

The pandemic, in other words, hit Bangladesh when the economy and the banking system were vulnerable. The fear is that policymakers and bankers now have scant ability to respond to the damage wrought by the Covid-19 coronavirus.

“The high level of non-performing loans in the banking sector in Bangladesh has been an area of concern even before the pandemic,” says Naser Ezaz Bijoy, country chief executive of Standard Chartered Bank.

The problem, he adds, is that recent policy moves “take away the ability to cover the risk to the full extent. With the pandemic, the risk profile has deteriorated across the world – and Bangladesh is no exception. The impact of the interest rate cap is even more pronounced.”

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Naser Ezaz Bijoy, Standard
Chartered Bank 

That created an ill-timed double whammy. The NPL problem leaves Bangladesh poorly prepared to withstand the coronavirus fallout, while the pandemic’s implications will increase the number of bad loans.

In 2019, long before Covid-19 hit, NPLs surged by more than 117%. So-called soured loans topped $12 billion. That is not a huge tally relative to developed nations, but it is undeniably detrimental to a poverty-stricken, $300 billion economy where banks comprise more than 80% of all financing activity.

Chronic graft doesn’t help. Beneath an optimistic macro surface is an opaque system that Transparency International ranks the 14th most corrupt out of 180 nations. In south Asia, only Afghanistan fares worse on governance.

“There is nothing to be satisfied about,” says Transparency International Bangladesh executive director Iftekharuzzaman, who goes by one name.

In particular, Iftekharuzzaman calls out the government’s interference in the banking sector. Political meddling in development projects, government institutions borrowing directly from banks and putting cronies in regulatory positions mean that Dhaka’s bad-loan troubles could be worse than the official data indicates.

Iftekharuzzaman doesn’t mince words: “The state structure and governance process are often captured by agents and beneficiaries of corruption, the striking example of which is the banking sector bedevilled by loan defaults and all possible forms of swindling public money. Policies and decisions often reflect the demands of swindlers and defaulters rather than public interest, the cost of which is passed on to the common people.”

In the past, finance minister Mustafa Kamal has told the press that Dhaka is working to clean up its act, saying: “We will take strict action against all dishonest and corrupt businessmen of the country. People and organizations cooperating and helping such fraudsters will also be brought under the law and punished accordingly.”

The coronavirus is only revealing more problems, says Iftekharuzzaman. The national government has been clamping down on local officials and bureaucrats profiteering off staples such as rice.

“Such a national crisis was expected to bring out the best of human virtues,” he says, “but most regrettably and shamefully, the worst of human vices have also come out.”

Reform

In late January, the IMF estimated that eight state-run banks in Bangladesh alone account for more than 50% of all default loans, hitting a record in September 2019. A new record is still to be established by September 2020.

“Reforming the banking sector is one of the top priorities for the government to enhance the resilience of the economy,” says Anne-Marie Gulde-Wolf, the IMF’s Asia-Pacific deputy director.

The IMF, she says, recommends “resolute steps” to strengthen banking regulation and supervision, modernize state-controlled lenders, improve corporate governance, tighten criteria for restructuring or rescheduling loans and internationalize legal-system provisions for loan recovery.

“Efficient financial resource allocation with an effective banking sector would help accelerate the recovery from the Covid-19 shock,” Gulde-Wolf says, calling it a vital way to “restore the robust growth momentum.”


This new situation will require prudent management of credit risks and significant improvement of business operation efficiencies if the financial institutions are to maximize access to finance for already stressed businesses 
 - Rahel Ahmed, Prime Bank


Yet by warping the true level of risk in Bangladesh’s financial system, the rate cap runs afoul of all these goals.

Zahid Hussain, former World Bank economist, now worries about a spike in poverty as garment factories go idle. Before Covid-19 hit, forcing lockdowns and cancelling orders, only about 50 million people of the nation’s 170 million lived above the poverty line, earning more than $2 a day. As the pandemic affects incomes and food security, he says, there’s no way to estimate the broader fallout.

Hussain, though, speaks for many when he says “the 9% interest rate cap will not cover the costs and risks, thus resulting in the sector’s portfolios becoming commercially unviable overnight. This will… reduce the supply of credit to these customers, forcing them to borrow from unofficial predatory lending sources such as traditional moneylenders.”

It is a story financiers have heard before. In a recent pre-pandemic report on rate caps, the World Bank warned of “substantial unintended side-effects.”

Among them: “reduced price transparency, lower credit supply and loan approval rates for small and risky borrowers, lower number of institutions and reduced branch density, as well as adverse impacts on bank profitability.”

Timing

With financial policies, timing matters as much as context. The timing of Dhaka’s experiment comes just as the IMF is pointing out the microeconomic cracks that mar an otherwise sunny macro story that was garnering global attention.

Rising non-performing loans and low capital adequacy would hamper the banking sector’s ability to finance business investment, add fiscal burdens and hamper growth.

“Market forces should determine the lending rate, and any other arrangement, unless accompanied by subsidies from the government, will hinder the growth in business lending, especially for the smaller businesses,” says Jobayer Alam, head of SMEs of IDLC Finance.

The fallout could intensify. The 9% cap, Hussain warns, “will hurt the financial inclusion agenda” that has been a crucial part of prime minister Sheikh Hasina’s policy framework for the last 10 years.

Dhaka took its inspiration from Kenya, where the parliament set an interest rate ceiling of 4% on bank loans in September 2016. The theory seems straightforward: lowering the cost of funds and avoiding rate spikes in times of turmoil should expand access to credit for businesses and households.

Things went awry in Kenya in short order. The policy warped banks’ ability to price risk. Credit actually dried up, leaving SMEs, as well as individuals, starved for capital. The resulting turmoil in money markets increased rate volatility for bank balance sheets, costing Kenya economic growth and leaving capital markets unstable.

Nairobi scrapped the cap in November 2019. In its post-mortem analysis, the government admitted its policy had “unintended consequences that are significant and damaging to our economy.”


Global investors have seen this movie play out elsewhere. History shows that a rate cap will have highly negative, if not disastrous, results 
 - Beidi Gu, Rohatyn Group

One damning metric: lending activity plunged 5% in the 12 months ending in September 2017 alone. The only winners, it turned out, were loan sharks and other unregulated lenders who got a boost in demand. Kenyan NPLs surged to 12.3% in 2017, from 6.8% in 2015.

“Global investors have seen this movie play out elsewhere,” says Gu of Rohatyn Group. “History shows that a rate cap will have highly negative, if not disastrous, results.”

Bangladesh could fare even worse.

“What is alarming is that Bangladeshi banks would start with less of a cushion than their peers in Kenya,” Gu explains. “NPLs are already high, and profitability levels are much lower than Kenya pre-rate cap. Return on assets was 3.1% in Kenya pre-rate cap,” compared with about 0.3% in Bangladesh at the end of 2019.

The biggest losers would be SMEs and retail clients.

“What the cap does is banks will try to actually divert their loan portfolio more toward larger, bigger, better-quality assets,” says Standard Chartered’s Bijoy. “And eventually, consumption gets impacted. SMEs, which should be the engine of growth, will slow down,” which “will actually have an impact on the economy.”

Great strides

Long gone are the days when Bangladesh was synonymous with extreme political chaos and hopeless famine requiring benefit concerts by the likes of George Harrison and Bob Dylan.

Between 2010 and 2018, the proportion of workers living below Dhaka’s defined poverty line fell from 73.5% to 10.4%.

During that period, says United Nations economic adviser Daniel Gay, Bangladesh made great strides in improving education, health and life expectancy while reducing infant mortality. Although rapid economic growth helped to fuel development, success in spreading the benefits of growth are, in turn, hastening gross domestic product.

A place Henry Kissinger once dismissed as a basket case is, to Gay, “really now a success case.”

The country still has lots of heavy lifting to do. Per-capita income is about $2,000. This, coupled with Dhaka’s success in spreading the benefits of growth to rural communities, puts Bangladesh on course to graduate from the ranks of so-called least developed countries by 2024.

That trajectory has pulled in a growing number of multinational firms who dominate several important sectors including Chevron, Ericsson, GlaxoSmithKline, Nestle, Samsung, Siemens and Unilever. Now, US president Donald Trump’s tariffs are pushing more garment business Bangladesh’s way, including from Japanese company Uniqlo.

But the pandemic is throwing parts of the economy into reverse. The government’s initial response on March 26 locked down 75% of the country, throwing about 13 million people out of work overnight. The fallout from overseas as orders for manufactured goods disappear has been equally disruptive.

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Rafiqul Islam, Green Delta Capital 

The garment and textile industry, accounting for 12% of gross domestic product and 84% of exports, is suddenly in crisis. In April, for example, garment exports amounted to just $380 million, against $2.26 billion a year earlier.

The concern now, say officials at the Bangladesh Garment Manufacturers and Exporters Association, is that future orders will be diverted to economies with lower Covid-19 infection rates, for example Vietnam.

At the time of writing in May, Bangladesh had about 33,000 official cases: Vietnam had only 325. Given the extreme population density of cities such as Dhaka, fears of second waves of infection may indeed give multinational companies pause.

Foreign remittances are drying up, too. The roughly 6% of GDP derived from workers overseas sending cash back home is in clear and present jeopardy. As the virus knocks oil prices, the US, the Persian Gulf and east Asia have less need for migrant labour.

In 2019, the 10 million or so Bangladeshis working overseas sent home more than $18 billion: that is unlikely to be repeated this year. The upshot could be a sharp increase in poverty that hobbles the banking system.

“This will affect the overall balance of payments of the country adversely in the coming days,” says Emranul Huq, chief executive of Dhaka Bank.

So far, the prime minister has rolled out rescue spending of nearly $12 billion, or 3.5% of GDP. Dhaka is turning to multilateral lenders too, seeking $750 million from the World Bank, $700 million from the IMF and $500 million from the Asian Development Bank.

But such aid would probably not be enough to the plug the holes in the national balance sheet. Weakened tax revenue collection will almost certainly have Dhaka doubling down on its strategy of borrowing from banks.

The last year, even before the coronavirus, saw “unprecedented” government borrowing directly from banks, says Ahsan Mansur, executive director of the Policy Research Institute.

The bulk of the borrowing goes toward infrastructure projects aimed at reducing Dhaka’s notorious traffic.


If this can be managed well, the Bangladesh economy will recover very strongly from this coronavirus breakdown 
 - Rafiqul Islam, Green Delta Capital

As of early February, the government’s net borrowing from banks stood at $6 billion, on the way to $7 billion this fiscal year. The amount for the period could be as much as $12 billion. Not huge by western bank standards, but substantial for an economy at Bangladesh’s level of development.

This dynamic adds to liquidity problems plaguing the industry, further threatening the private sector.

It is giving rise to a “crowding out effect” that makes it harder for the private sector to gain access to credit, imperilling economic growth, says Syed Abdul Momen, head of SME business at Brac Bank.

Coupled with banks’ NPL troubles, private sector access to credit grows scarcer with each passing month.

“If this can be managed well, the Bangladesh economy will recover very strongly from this coronavirus breakdown,” says Rafiqul Islam, chief executive of Green Delta Capital. “I believe that Bangladesh’s economy will be experiencing a robust growth in the coming fiscal year, where ensuring enough liquidity in the banking sector may come as a challenge for the private-sector investments.”

Moral hazard

In general, though, there’s little faith that recent policies put forward by the government or central bank will fix the bad-loan problem or boost industry profitability.

Nor are state-owned institutions likely to be sufficiently strengthened by Dhaka’s stated priorities.

One involves forming a public asset management company to pull toxic assets off bank balance sheets. That treats the symptoms of Bangladesh’s troubles, but not the root causes.

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Rahel Ahmed, Prime Bank 

As the IMF puts it: “Considering the current regulatory and legal environment, establishment of an asset management company poses significant fiscal risks.”

Part of the concern is the government’s long history of restructuring NPLs to provide short-term relief to borrowers. This incentivizes bad behaviour.

These periodic political rescues, or amnesty programmes, have the effect of appearing to lower the ratio of NPLs. Potential defaulters get to reschedule debt on very generous terms. In many cases, companies can arrange to pay about 2% of an outstanding loan amount while spreading the rest out over 10 years at a top borrowing cost of 9%.

“The government tried to rescue state-owned banks by recapitalizing them every year for the last decade,” says Fahmida Khatun, executive director of Dhaka-based Centre for Policy Dialogue. “But this has not improved the performance of state-owned commercial banks, where NPLs account for over 30% of their total loans. Private commercial banks have also been afflicted by a loan default culture and experienced various scams.”

This culture creates a moral hazard that can encourage politically driven lending, particularly among the state-owned crowd. Too many financing projects are made according to political needs, not economic ones. In many cases, this involves politicians routing funds to their home districts for white-elephant projects that do little to enhance national productivity.

To reduce the government’s reliance on banks, the Asia Development Bank and other observers recommend that Dhaka widen the tax base, move to a value-added-tax structure and make better use of technology to police compliance. This, in turn, might free the banking system from enabling government complacency.

But the financial sector requires nothing less than a reform big bang. The to-do list is long: increased regulation and supervision; better corporate governance; tighter criteria for loan rescheduling and restructuring; modernizing state-owned commercial banks; and creating more robust systems to accelerate loan recovery. Dhaka also needs to build deeper capital markets that function more efficiently to reduce the economy’s dependence on bank financing.

“This new situation will require prudent management of credit risks and significant improvement of business operation efficiencies if the financial institutions are to maximize access to finance for already stressed businesses,” says Rahel Ahmed, chief executive of Prime Bank.

There is still time for the government to reverse course on policies that could set back development in incalculable and unpredictable ways.

It can start by minimizing the harm it is doing to a financial system coping with Covid-19.