Can Bangladesh afford to liberalise its capital account like India and China?

International experience indicates that capital account liberalisation is most successful when the process is continued in a good macroeconomic and strong BOP (balance of payment) environment. Our preliminary assessment is that, based on traditional indicators for strengthened external position, Bangladesh compares quite well with India, China, Vietnam and Malaysia all of which have much more open capital account regimes than Bangladesh. Traditionally countries try to build up a respectable level of foreign exchange reserve to self-insure against BOP pressures and fend off unanticipated sudden surge in outflow as part of its opening up of capital accounts in phases.

As shown in the cross-country Table (Table 4) for such indicators, Bangladesh's current reserve coverage of seven months of import payments, reserve level at -- per cent of M1 (cash in circulation and demand deposits) and -- per cent of broad money, and reserve levels at 14 per cent of GDP (gross domestic product) are quite respectable to protect itself from external shocks or contagion effect.  In terms of almost all indicators, Bangladesh outperforms India, while Bangladesh capital account is much less open compared with the Indian capital account regime.
IMPERATIVES FOR A PHASED CAPITAL MARKET LIBERALISATION AND MANAGING THE ASSOCIATED RISKS: Capital account liberalisation has its well-known benefits and that is precisely the reason every developed country maintains an open capital accounts regime and all emerging and growing developing countries tend to liberalise their capital account transactions and better integrate with the international capital market. As the economies grow domestic savings may not keep pace with domestic investment growth and financing of the higher level of investment from domestic sources alone would not be possible. Capital account liberalisation is believed to be a major way to alleviate financing constraint through inflow of foreign capital into the domestic economy in various forms.
The fast growing economies in Asia like Korea, China, Indonesia, Malaysia, Vietnam and India have used external private financing quite extensively in achieving higher investment and growth in recent decades. Bangladesh, on the other hand, did not try to exploit this channel for securing additional financing effectively. Bangladesh public and private sector have very little presence in the international capital market except some foreign currency-denominated borrowing by some private and public sector entities. Bangladesh has not issued any sovereign bond despite favourable external environment, and Bangladesh corporate sector has very limited exposure to the international capital market through issuance of bonds or borrowing from other sources.
The limited access has also limited private sector's ability to access funds from the cheapest sources and undermined their competitiveness by increasing their cost of doing business. The higher domestic interest rates are partly attributable to the lack of competition and inefficiencies in the domestic financial system in an environment of captive/closed market. Like every other market price of capital would ultimately depend on supply and demand for capital in the financial sector. Increased funds made available for lending would contribute to lower interest rates and increased portfolio investment from abroad would contribute to support equity/stock prices and enhance market discipline and performance.   
WHAT KIND OF RISKS AND REWARDS THIS TYPE OF LENDING POSES FOR THE VARIOUS ACTORS: Bangladesh Bank has to be aware of the potential risks of liberalising external sector borrowing. Most importantly, the default risk in foreign loans always has to be kept under strict observation to prevent crisis of confidence. The main thing that all actors need to be aware of is the risk of financial liberalisation leading to a financial crisis, somewhat like the Asian Crisis of 1997.
Many developing and transition countries opened up financially by the early 1990s and became "emerging markets" attracting foreign loans and investments. In developing East Asia, short-term commercial bank loans were the dominant form of capital inflow (Asian securities markets were underdeveloped). At first, this caused domestic booms and asset market inflation. But later, as the market sentiment turned for the worse and foreign investors pulled their money out, the balance of payments came under a severe pressure. Speculative attacks rapidly depreciated Asian currencies, and the illiquidity problem - inability to rollover the short-term bank loans since foreign banks demanded immediate repayment - occurred. The domestic banking sector froze up and domestic demand fell sharply, causing a serious recession that lasted for one to two years.
This macro shock was amplified by the balance-sheet vulnerability caused by the weaknesses of Asian banks, nonbanks and corporations. Firms in developing East Asia were highly dependent on indirect finance such as bank loans for working and investment capital and had high debt/equity ratios. Moreover, the local banks and nonbanks were exposed to two kinds of balance-sheet mismatches. They borrowed in USD and lent to domestic projects in local currency (currency mismatch). In addition, they borrowed in short-term loans but lent to long-term domestic projects (maturity mismatch). When the currency depreciation began, the balance sheets of these financial institutions were immediately hit and bad debt increased. When foreigners demanded repayment, they had no foreign cash. This started as a liquidity problem, but as the crisis deepened, it created insolvency as well.
The Asian crisis was primarily caused by the wrong speed and sequencing of external financial liberalisation. Countries liberalised capital accounts too quickly and without preparation, which caused over-borrowing by the private sector and asset price bubbles. Furthermore, the governments did not properly monitor what was happening or unwilling to stem the inflows. The lesson therefore is that countries must open up their financial sector gradually and in the right order/sequence. The pace of financial liberalisation must match the pace of strengthening of the domestic financial sector and the monitoring capability. The government must make utmost effort to improve domestic banks and securities. It is important to note that Bangladesh's corporate banking sector is still at an early stage of its learning process and therefore, it will take some time to come up to the desired form. Large-scale liberalisation would be dangerous and irresponsible.
China, India, Vietnam, Myanmar and Cambodia were not affected by the Asian crisis as much as Korea and ASEAN economies (Thailand, Indonesia, the Philippines, and Malaysia). This was not because productivity and financial institutions of the first group were superior. In many ways, their domestic systems were much worse than Korea or the ASEAN Four.  They were not directly hit because they did not open up financially at that time.
KEY FINDINGS: Bangladesh has just started its journey to access international capital market by allowing resident corporations to borrow abroad in foreign currency terms on a case by case basis. Most other emerging economies in Asia and Latin America are way ahead of Bangladesh in terms of integration with the international capital market. With strengthened BOP - as reflected through surplus external current account and overall balances in most of the years - Bangladesh has gained the capacity to liberalise its capital accounts both in terms of inflows and in selected cases for outflows.
Recent experience with foreign currency borrowing has been generally favourable and has contributed to lowering of the domestic interest rate structure. Although $5.5 billion worth of loans have been approved by the High-Powered Committee Chaired by the Governor of Bangladesh Bank since 2008, the outstanding stock of such debt is only about $2 billion, slightly over 1.0 per cent of GDP or less than 4.0 per cent of export and remittance receipts.  In most other comparator countries the corresponding figures are several times higher than Bangladesh, and accordingly Bangladesh has the capacity to go a long way in terms of foreign borrowing to support domestic investment, including infrastructure development. Bangladesh Bank should continue with its monitoring mechanism to avoid any bulging of payments to external creditors.
POLICY RECOMMENDATIONS:
* The linkage with international capital market should be deepened further in order to attain greater access to foreign financing at lower interest rates. As is the case currently, the initial emphasis should be on policies which would facilitate enhanced market access for Bangladeshi investors and issues related to outflow should be considered in a properly sequenced manner.
* Establish an automatic approval process for loans up to a certain limit. Given the positive outcomes so far, it would be desirable that Bangladesh Government like its Indian counterpart considers a two-track approach for approval of request for foreign loans: an automatic window for borrowing up to a certain limit; and for higher amounts approval on the basis of current case by case approach.
* Fight against inflation must be intensified. Domestic inflation should be brought down to less than 5.0 per cent. Bangladesh interest rate structure will never come close to the dollar or Euro interest rate structures as long as Bangladesh inflation remains significantly above the inflation rates of its major trading partners. The only sustainable approach to reduce the spread over industrial country interest rates would require a steady reduction of the domestic inflation rate and bring that closer to the inflation rates of industrial countries. The best example of this is China with inflation rates ranging between 2.0 per cent-3.0 per cent and more recently, the anti-inflation stance of the RBI (Reserve Bank of India) which helped bring down inflation to 4+ per cent from very high levels.
* Exchange rate stability is paramount for deeper capital market integration. Exchange rate stability, which entails a corresponding reduction in exchange rate risk, is an important precondition for the private sector to be able to borrow from abroad in foreign currency. The reduced exchange risk would encourage foreign lenders and investors to lend and invest in Bangladesh. As long as Bangladesh inflation remains significantly above the inflation rates of its major trading partners, there is no way that Bangladesh Bank can prevent an appreciation of the REER (real effective exchange rate) and an eventual depreciation of the nominal exchange rate.
* More clarity is needed in the regulations for hedging against exchange and interest rate risks. For large investors hedging is very important, and without proper exchange rate and interest rate hedging they are not likely to invest in Bangladesh. Currently some aspects of regulations governing hedging are subject to different interpretations, particularly with respect to the underlying transaction (such as anticipatory or current contract). Exchange rate hedging for foreign currency-denominated borrowing is hardly applied in Bangladesh, whereas in India it is mandatory.
* Tax treatment of return on investment needs much more clarity. Return on investment may or may not be subject to taxation and the applicable rates or exemption status (as appropriate) needs to be very clearly specified.  Provisions of bilateral avoidance of double taxation treaties also need to be clearly spelled out for investors to be assured about their post-tax investment return.
* Capital account liberalisation must be steady, properly sequenced and non-reversible.  Bangladesh has a long way to go in its future march toward a more liberal capital account regime. The liberalisation process should be carefully sequenced, closely monitored, and the changes should be irreversible. Every emerging economy has travelled through the liberalisation process that Bangladesh needs to travel.  Bangladesh cannot fall much behind its comparators and deprive its private sector the benefits of lower interest rates, exchange rate stability and price stability through lower inflation.

Dr. Ahsan H. Mansur is Executive Director of the Policy Research  Institute of Bangladesh (PRI).
ahsanmansur @gmail.com