Courtesy of The Financial Times, a look at Bangladesh’s prospects as we enter 2011:

“…Bangladesh remains a paradox among frontier markets: its GDP growth trend is one of the most stable in the region, but it has high levels of asset price volatility. It proved to be one of the economies least affected by the global financial crisis, with GDP growth only slowing from 6.3 per cent in 2008 to 5.9 per cent in 2009 as the country benefited from the so-called “Walmart Effect” of increased demand for cut price garments in recession-hit economies.

While this was a source of some comfort and relief to policymakers, it also helped to inflate an asset price bubble. Managing this may be the biggest macro challenge for the country in 2011.

Underscoring the rush of enthusiasm for Bangladeshi equities, the DGEN, the Dhaka Stock Exchange’s benchmark index, has been up over 95 per cent in the year to date. Although it then fell almost 9 per cent in two weeks earlier this month, it remains comfortably one of the best performing stock markets in the world since 2007, outpacing both the Bric countries and the MSCI Frontier Markets Index.

The DSE’s current price-to-earnings ratio of 30 times is the highest in the region – twice the level of Thailand and three times the laggard Pakistan. But it is the speed of the gain and the dominance of unsophisticated retail investors that gives greatest cause for concern and suggests a major correction is due in 2011.

Unlike asset price bubbles in other EM economies historically, Bangladesh’s has not been driven by capital flows from overseas investors. In fact, foreign investor ownership of the DSE is just 1-2 per cent.

Rapid asset price inflation (evident in the real estate sector too) has instead been driven by excess liquidity, with money supply growing in excess of 20 per cent year-on-year due to a combination of three things: overseas remittances (Bangladesh receives $12bn per year); a commitment to a largely fixed Taka exchange rate against the US dollar; and little appetite for domestic capital investment, which has led banks to rechannel money into capital markets.

Direct investment in the stock market by financial institutions has increased more than 8 fold since 2006 to about TK 45 bn($630m) in 2009. The level of investment has increased further in 2010 and is likely to exceed $1bn on current trends.

Another important structural trend has been the dramatic increase in individual stock trading accounts, which have risen in number from less than 500,000 in 2006 to almost 3.5m today. As a result more than 75 per cent of trading is driven by retail investors, many of whom are newcomers to equity investments and are driven by market rumours and trend following rather than fundamental analysis.

All of this has become increasingly challenging to regulators, both Bangladesh’s Securities and Exchange Commission and Bangladesh Bank, the central bank.

While a number of regulators have said that market valuations appear stretched, it has been difficult for them to sustain effective regulatory interventions.

On Dec 19, for example, the DGEN fell 6.7 per cent on the back of both a year-end liquidity squeeze as well as comments from a recent IMF mission that the central bank needs to monitor and minimise risks to the banking system from elevated stock prices.

The sharp declines, as has often been the case in this cycle, prompted fiery demonstrations in the streets outside the stock exchange by retail investors . This in turn prompted the SEC to increase margin lending limits from 1:1 to 1:1.5. This enabled a 4 per cent recovery in the market the following day.

But higher-frequency regulatory interventions, often in opposite directions from one day to the next, increase uncertainty and the risks of moral hazard.

If there is one global lesson from the global financial crisis of 2008/9, it is that regulators should not overestimate their own capacity to control markets.

The debate over whether regulators should allow the stock market bubble to persist or take measures to “let the air out slowly” is in some ways a false one. It is not in the power of regulators to control. They cannot prevent a bubble from bursting if asset prices cannot be justified by the fundamentals.

The best they can do is limit the fall-out from a price crash – and on that front in Bangladesh there are at least encouraging signs.

Bangladesh Bank is paying more attention to monitoring and limiting banking sector exposure to the capital markets. This will be key to ensuring any major stock market correction does not have a severe impact on Bangladesh’s record of delivering stable and consistent GDP growth.”