It’s getting hot in here
I have a vague recollection of CPD’s Debapriya Bhattacharya talking about Saifur Rahman attempting to drive a big car in a narrow alley. He was talking about the late finance minister’s policy settings, which saw Bangladesh economy accelerate. If I remember correctly, Mr Bhattacharya’s point was that the economy was accelerating too quickly while structural problems were not addressed, and like a car in a narrow alley, speed could mean accident up ahead. Fortunately for Bangladesh, the economy didn’t suffer a crisis under BNP (or the army, or under the current government, until now).
What happens when an economy grows too fast relative to its capacity? Typically, imbalances start developing — inflation sets off, the country runs up large external deficits, private and public sectors become too leveraged, asset prices enter bubble territory. Economists typically call such economies overheated.
The London Economist has an index that checks the ‘temperature’ of 27 emerging markets. The concept is explained here. Essentially, the index is based on six indicators: inflation, GDP growth, unemployment, credit growth, real interest rate, and current account. As of June 2011, they considered seven countries — Vietnam, Turkey, Indonesia, India, Hong Kong, Brazil, Argentina — to be in the ‘red hot’ territory, at risk of a crisis.
Bangladesh wasn’t in their list. I decided to look at the data using their methodology to assess its risks. Short answer? It’s definitely getting hot in here. Fortunately, it’s not in the red zone yet, and policymakers can make a difference. Long answer, over the fold.
The Economist’s first indicator is inflation. If inflation is low and steady, then the economy is not likely to be overheating. In Bangladesh, inflation has averaged 11% in the past year. In the magazine’s list, only five countries were running higher inflation than this as of last June — Egypt, Pakistan, Vietnam, Argentina, and Venezuela. On this measure, Bangladesh appears to be near, if not in, the red zone. Hot, definitely hot.
The second indicator in their list is recent GDP growth compared to its trend. The former is measured as the average growth between 2008 and 2011, the latter as the average in the preceding decade. If the economy is growing too fast relative to its trend, then it’s likely overheating. Since 2008 fiscal year, Bangladesh’s economy has grown by 6.2% a year. In the previous decade, the average growth was 5.7% a year. This half of a percentage point acceleration in recent year seems rather small to worry about in and of itself. Definitely not hot.
The third criteria is unemployment, relative to trend. Again, the idea is that if joblessness is too low compared to the past, then the economy is running out of capacity, and is overheated. Now, I don’t have readily available data for Bangladesh’s labour market. Also, I don’t think the concept of unemployment actually makes all that much of practical sense in Bangladesh. I don’t think ‘unemployment is too low’ is a problem in Bangladesh. I am going to ignore this indicator.
Next on the Economist’s list is credit to private sector relative to the growth in nominal GDP. This is a bit complicated, but very important. So I am going to quote them:
The fourth symptom of overheating, and one of the most important, is excessive credit expansion, which can lead to asset bubbles as well as inflation. The best measure of excess credit is the difference between the growth rate in bank credit and nominal GDP. It is normal for bank lending to grow a bit faster than GDP in an emerging economy as the financial sector develops, but credit is outpacing GDP by an alarming margin in Argentina, Brazil, Hong Kong and Turkey. Lending to the private sector has increased by around 20% more than nominal GDP over the past year in both Turkey and Hong Kong.
Now, 2011 financial year (ending 30 June 2011) is the latest we have national accounts data for. Growth in the nominal economy in that year was 13.4%. In the year to mid-2011, credit to private sector grew by 25%. The excess growth in credit at that time would have put Bangladesh in the same category as the four countries mentioned above — that is, in the red hot zone. In the past six months, however, credit growth has softened to about 20%. Meanwhile, nominal growth has probably picked up a bit. But still, credit growth is probably running 5 percentage points ahead of the nominal growth. That’s still hot.
The fifth indicator is real interest rate — that is, the policy rate less inflation. Since September 2011, Bangladesh’s policy rate has been 7.25%. Inflation has run well over 11% in that time. This implies a real interest rate of -4%. Money is too cheap in Bangladesh, as it is in Hong Kong, Vietnam, Venezuela and Argentina. Red hot.
The final indicator is how the country’s current account is expected to change. The key here is ‘expected’. I am going to use the Asian Development Bank’s projection for simplicity. The ADB expects the current account to be in a deficit of 0.3% of GDP in 2012 fiscal year, compared with a surplus of 0.9% of GDP in 2011. That’s a turnaround of 1.2 percentage point — alarming. But the expected deficit is still pretty small. Should we be worried?
This seems to me is the crucial variable for Bangladesh. There is definitely a lot of heat in three areas — inflation, credit growth, and real interest rate. Money is no problem in today’s Bangladesh — and that’s not a good thing. It’s not clear that all that dough has done much for economic growth — that’s not necessarily a bad thing, better slow and steady than fast and crash. If the country can avoid running up a large current account deficit, at least it will be spared a run on its currency.
But can we avoid a larger current account deficit than what the ADB is projecting? What if oil prices rise sharply? What if the remittances dwindle? What if there is contagion from the rupee? What if, a la Krugman, there is speculative attack without any fundamental reason?
Will we have enough reserves?
Even if we avoid an external crisis, easy money is distorting the economy without tangible benefit. Ultimately, the economy is growing at 7% and not 8% because of structural, supply-side reasons. The clear policy option is to tighten monetary policy. Will Bangladesh Bank do it?
I don’t know. But I sure hope they don’t follow Nelly’s suggestion.