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5 years ago

Identifying financial cycles of Bangladesh

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The heath of the country's financial sector is a subject of much discussion for some time. Policymakers are comfortable with the current status of the sector. Experts and economists, however, express their concern over the ongoing state of things. They have identified a number of risks and weaknesses in this sector. In fact, these risks and weaknesses stoke up the controversy as to whether the financial sector is really in a safe and protected state. 

No doubt, there are quite a number of areas where things are seriously at odds. To start with, non-performing loans (NPL) are on the rise putting the banks and financial institutions at risk. NPL stood at Tk 1.10 trillion at the end of March this year. It reached 11.80 per cent of the total outstanding bank loans in the country.  The amount is also around 3.75 per cent of the Gross Domestic Product (GDP). In fact, NPL has become a major characteristic of the country's banking sector.

Again, stock market is moving sluggishly. Since the market crash in 2010, major indicators have improved moderately, but volatility still remains. After posting a robust growth in 2017, broad index of Dhaka Stock Exchange (DSE) dropped by 13.80 per cent in 2018 while average daily turnover declined by 37.0 per cent. 

Bond market is still dominated by the government's fixed-income tradable securities and there is no sign to turn it into a vibrant one. Corporate bonds and other instruments are absent. In his budget speech, the finance minister  acknowledged the marginalisation of the bond market. He said: "We have observed that, no mentionable instruments were used in our financial sector. This has led banks to give long term loans by collecting short term deposits. This creates a mismatch. It may turn out to be critical sometimes. We will take necessary measures to remove such kind of mismatch. We will encourage instruments like Wage Earners' Bond, venture capital, treasury bond including a vibrant bond market."

When the economy is growing at a faster rate with 7-plus growth on average yearly, financial sector needs to keep up.  Adequate support from the financial sector is essential to make the growth sustainable in the long run. In fact, there is no certainty that macroeconomic stability will ensure financial stability in an economy.  Despite having a stable macroeconomic condition at the moment, growing weakness of the financial sector requires some caution.

Against this backdrop, one may try to look for the patterns of the country's financial cycles to forecast the near future of the financial sector and its impact on the macro economy. Financial cycle is now emerging as an important concept globally to understand the macro-financial dynamics of an economy. It also becomes a tool to predict systemic banking crisis. Unlike business cycle which describes the rise and fall in output of goods and services, financial cycle presents the boom and burst of credit, equity and housing markets. It broadly refers to interaction among the financial factors that may cause economic fluctuations and potentially lead to severe financial stress.

There is, however, no universal definition of the financial cycle. Claudio Borio, the Chief economist of Bank of International Settlement (BIS) is a leading authority on the financial cycle theory. He defined it as 'medium-term fluctuations in financial variables' and these come with 'self-reinforcing interactions between perceptions of value and risk, attitudes toward risk, and financing constraints, which translate into booms followed by busts.' 

To put it in simple terms, financial cycle focuses on the co-movements of credit and asset prices. Both the financial asset and housing asset are taken into consideration. Now, fast increases in credit flow push the prices of equities and real estate. The increase in case of real estate or housing in turn inflates the value of collateral and subsequently potential credit. The upward supply of credit relaxes the constraints in financing. The changes in the price of property are derived by the investors' perception of value and risk. These interactions intensify swings of real economic variables (e.g. output) and alter the allocation of capital spending across industries. In case of equity price, higher credit flow inflates the stock prices and investors take more risks expecting higher profits. Their risk taking move diverts more credit to the equity market and creates some crowding-out effect on real economy. But the increased housing or equity price can not sustain for long and  declines sharply creating a financial crisis.  In short, financial cycle starts with an expansion and after reaching its peak it contracts and ultimately bursts.

So far, there is no study on the presence of financial cycle in Bangladesh. Such studies are now necessary to gauge the overall economic condition as well as predict the possible risks in future.

At least three types of time series data are essential to find out the financial cycle. These are: credit data, equity market data and real estate price data. Of these, real estate price data is not available. Almost a decade ago, Bangladesh Bank decided to collect and publish real estate or house price data. So far, there is no progress in this regard.  The central bank has, reportedly, developed a data set of housing market price with the help of the International Monitory Fund (IMF) for internal use.  Once made public, it will become the first real estate price index of the country. 

Having all these data in hand, Bangladesh Bank may try to identify the presence of financial cycle in the country and examine its main characteristics.  Several statistical and econometric tools are there to conduct the exercise. Initially, the cyclical properties of each independent variable have to be analysed. After that, the individual cycles may be combined using main component analysis to get a combined measure of financial cycle.

In other words, financial cycle is a combination of debt cycle and market cycle.  Market cycle measures the movement of stock and bond markets, while debt cycle measures the rise and fall in private and government debts.

Finding the business cycle in Bangladesh is also essential in this connection. The cycle is generally measured using the rise and fall in the real GDP. It is also known as economic cycle or trade cycle. Phases of a business cycle are: expansion, peak, recession, depression, trough and recovery. Recession and depression are sometimes combined and labelled as contraction.

Usually, duration of a financial cycle is longer than the duration of a business cycle and business cycle doesn't appear to drive the financial cycle. But financial cycle may affect the business cycle.

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