How To Get More Of It

Financial systems work better in concert

Fakhruddin Ahmed

Poverty alleviation is the overarching goal of our economic and social development. During the past decade and a half, Bangladesh economy has grown at about five percent per year. Poverty has declined by more than one per cent per year during this period. Notwithstanding this progress, aggregate poverty rates are high. It is estimated that the percentage of population below the poverty line currently is about 47%. As part of the Millennium Development Goals (MDG), Bangladesh has set a target to halve poverty by 2015. This will require reduction of poverty per year in excess of 3 percent, much higher than what has been achieved during the past decade.

Although poverty is multidimensional, empirical evidence suggests that a sustained and high rate of growth is essential for sustained poverty reduction An overall real income growth rate of 6.5 to 7 per cent on a sustained basis is needed to attain the per capita income growth and hence reduction in income poverty, as envisaged in MDGs.

Acceleration of the growth rate on a sustained basis will require an increase in investment, particularly investment by the private sector. The total investment-GDP ratio of Bangladesh has been around 23-24% during the past five years. Private investment accounts for about 75 per cent of the total investment. Although the percentage of private investment has been increasing in recent years, the rate will need to accelerate further to reach a growth rate of 7 percent. In fact, along with an acceleration of private investment, an increase in selected public sector investment in priority sectors will be needed. Public investment-GDP ratio has declined from 7.4% in 2000-01 to 5.4% in 2004-05. While this decline has allowed more room for private investment, complementary public sector investment in physical infrastructure will be needed in the coming years to support a higher growth rate.

Investment needs are financed through savings which can be national or external. The relationship between finance and growth has long been a topic of interest to economists and researchers. While many believe that finance is an important determinant of growth, others argue that the development of the financial system simply responds to changing demand for economic development. Nevertheless, a large body of recent empirical research has found robust evidence that the development of the financial systems contribute to economic growth.

What are the roles and functions of the financial systems? In a broad sense, financial systems intermediate resources between savers and investors. Financial systems help achieve a better allocation of resources by pooling and mobilising savings toward higher-return investments. A good financial system increases the allocative efficiency of a given quantum of financial savings.

Bangladesh Bank: The regulator and facilitator

However, it also mobilises additional savings and channels the same to higher- return investments. An increase in private investment will require mobilising additional financial resources to finance investments in real sectors e.g. agriculture or industry.

Bank credit: The banking sector has played the dominant role in financing the investment requirements of the private sector in Bangladesh. In FY 04, industrial term loans disbursement amounted to Tk. 66.8 billion, many times higher than the amount of Tk. 2 billion issued through the capital market.

In FY 05, the amount of new capital issued in the capital market through private placements and public offerings went down to Tk. 1.2 billion as against an increase in industrial term loans of Tk. 91.4 billion, disbursed by banks and financial institutions. FY 05 witnessed a marked increase in private investment. However, the amount of new capital issued through the capital market marked a substantial decline of 50 percent as compared to the amount raised is the previous year.

Thus, the contribution of bank loans went up even higher. All these indicate an overwhelming preference for bank finance and a minor role of the capital market in investment financing.

The high dominance of bank loans in investment financing means low stake and risk exposure of the owners, on the one hand and a disproportionately high risk on the lending banks and financial institutions on the other. Banks also are exposed to asset- liability management risk arising from funding long term loans with shorter term deposits. Such risks faced by one bank can spread to other banks and the risks faced by the financial system can easily spread to the real sector with potentially serious consequences for the economy.

The problems and inefficiencies in the banking system adversely affect the allocative efficiency of resources which banks intermediate. This makes the growth contribution of investment financed by bank loans significantly lower. Empirical evidence suggests that banking and financial sector reform has high pay off in terms of adding to GDP growth. A high level of non performing assets (loans) of the banking system reflects wasted resources and lost opportunities in terms of growth and employment. The non-performing loans of Bangladesh banking system has declined significantly in recent years from about 35% in 2000 to 15.8% in June this year. The significant decline in non-performing loans has been the result of a series of banking sector reform programs and strengthening of enforcement and monitoring by the Bangladesh Bank. But the level of non-performing loans is still high. To bring down the level of non-performing loans further and to enhance growth contribution of banking assets, the financial sector reform measures must be continued and deepened. These include: further strengthening of corporate governance; better and timely disclosure of material information and financial statements; stronger auditing and credit rating; better management of a bank's and the system's internal risks e.g. operational, credit and foreign exchange risks; and successful completion of the nationalised commercial banks' (NCB) reforms, currently underway.

Capital Market: Capital market provides an alternative channel for intermediation of savings. Capital market allows small savers to share the benefits of economic growth and higher corporate profits. Capital market is also attractive to the entrepreneurs because it does not entail fixed repayment obligations as in the case of bank loans. Although Bangladesh has a domestic savings rate of about 20%, only a small percentage of savings have found their way into the capital market. By and large, individuals seem to prefer the safety of bank deposits and high yielding government savings schemes. Capital market is yet to play its role in Bangladesh's development.

Market capitalization as a proportion of GDP is another indicator of the role of capital market. Not to speak of developed countries, market capitalization even in our neighbouring countries is significantly higher than that in Bangladesh. Market capitalization in India is now about 70% of GDP. In Pakistan and Sri Lanka, this ratio stands at 20 percent and 15 percent respectively. In contrast, market capitalization in Bangladesh is only six percent of GDP. There is thus a great potential to utilize the capital market as a vehicle for long term finance.

There have been some positive developments in the capital market recently. The general index and market capitalization have both increased substantially over the past two years. More importantly, the turnover has increased, reflecting a resurgence of vitality of the market. There are strong signs of confidence in the primary market. All the IPO issues during the past two years or so were oversubscribed. Investor confidence seem to be returning after the debacle of 1996.

This turnaround and progress of the capital market have been induced by institutional strengthening and regulatory measures taken by Securities and Exchange Commission (SEC) in a number of areas. These include: automated trading system, central depository system (CDS) for electronic trading; stronger disclosure requirements; qualification of auditors etc. SEC has also strengthened its monitoring and enforcement. All these have created demand from savers for investment through the capital market.

The supply side will require attention if the capital market is to play its potentially important role. The supply of good securities to match the increase in demand and to mobilize additional savings needs to be increased. In this context, some policy decisions by the government can play an important role. Government and the regulator concerned can require some private companies to offer shares in the capital market. Mobile telephone companies which are earning handsome profits are prime candidates. Most of the 18 IPO issues during the past two years or so are banks and other financial institutions. Bangladesh Bank required these banks and non-bank financial institutions to issue IPOs. In fact, Bangladesh Bank has a calendar for IPO issuance by all those banks/NBFIs who have net yet done do.

Privatization of state-owned enterprises can also make a significant contribution to the development of our capital market at this stage. It is the government's announced policy to privatize state-owned businesses. There are some state-owned companies which earn profit or are potentially very profitable. Government-owned petroleum distribution companies are potentially good candidates for privatization through the capital market. Government may also consider a policy requiring foreign investors to use the capital market for raising funds in future.

All foreign banks in Bangladesh currently operate as branches of parent companies. Bangladesh Bank may consider a policy of encouraging these banks to be locally incorporated over a period of time. As regards local private companies, incentives should be attractive enough for them to go public, raising funds through public offerings. These relate to corporate tax differentials between public and private companies. Corporate tax is a policy instrument which can be used to encourage private companies to be publicly incorporated. The current tax differential may be perceived as too low by good companies and the overall corporate tax level too high. IPO pricing is also an issue which can be used as an incentive for good, well-run private companies to go to the capital market.

The regulators of the financial sector, most importantly Bangladesh Bank and Securities and Exchange Commission, but also the Controller of Insurance must act in a coordinated manner. This is necessary on the one hand to ensure complementary development of the markets they regulate, and on the other, to mitigate risks which can easily pass from one part of the financial sector to another. A joint, coordinated effort will help identify the risks together and take preventive, remedial measures. Such coordination also helps improve corporate governance and institutional development in the financial sector with spillover effects on the corporate sector. Some countries have formalized the coordination through agreed MOUs. In Bangladesh, this process of coordination started about three years ago at the initiative of Bangladesh Bank. This coordination needs to be deepened.

Although banks are currently the dominant source financing in Bangladesh, bank reforms can complement and reinforce the development of the securities market. Banks can nudge the potential investor to go to the capital market to raise at least part of the funds needed. Indeed overcoming the institutional constraints such as financial transparency, corporate governance, concentrated ownership is likely to help develop both banks and the capital market as complementary sources of funding private investment. Both the Bangladesh Bank and SEC have begun reforms in the areas of corporate governance, enhanced discloses requirements, better accounting practices and auditing standards, stronger monitoring and enforcement, and greater transparency. Many of these measures will also facilitate market discipline which will complement public enforcement through either the regulators or the judicial system. In both developed and developing countries, growth of bank lending and local securities markets seem to have largely moved together. For this to happen in Bangladesh, the framework of financial markets, whether of the banking system or of the capital market have to strengthen on a continuing basis.

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The writer is a former Governor, Bangladesh Bank.