Budget in the time of rising inflation

| Updated: June 12, 2022 21:18:36

Budget in the time of rising inflation

Last Thursday (June 9) Finance Minister of Bangladesh presented the budget for the fiscal year 2022-23 (FY23), at a time of heated inflation pressure, especially in respect of food and energy prices. The size of the budget stands at Tk 6.78 trillion and titled "Return to development trajectory after overcoming the Covid shocks". The Minister assured the nation that the country is firmly on course to achieving 7.5 per cent GDP growth during the coming fiscal year.

Such growth projection comes at a time when the World Bank in its latest "World Economic Prospects" report issued on last Tuesday (June 7, 2022) warned that the global economy is falling into a prolonged period of stagflation - lower growth and even outright contraction lasting into the foreseeable future.

Stagflation is an economic phenomenon reflected in a combination of stagnating growth, rising inflation and high unemployment. Stagflation is worrying for everyone but for a  developing country like Bangladesh it is even worse because the country is reliant on exports to wealthy countries and regions like the US, the UK and the EU. Economic slowdown in these countries will hit Bangladesh hard.  It is also to be noted that all developing countries including Bangladesh are at the receiving end of the advanced economies macroeconomic policy consequences. In fact, in the budget document there is no hint that the Bangladesh economy might slowdown or even run the risk of sliding into recession.

While reigniting the growth process in the wake of the pandemic as the budget document claimed, there is an implicit message that the benefits of growth would  reach the poor and vulnerable sections of the population among other beneficiaries of growth in the country. Therefore. the budget will not only continue with the stimulus programmes to speed up the recovery process but also scale up targeted support for marginalised people hurt by rising living costs. However, the targeted support seems not to have much covered lower middle and middle income people who are also facing significant financial stress. The government will also continue to focus on enhanced social security, housing for homeless and food distribution for low-income people. The government is also working on launching a National Insurance Scheme.

The government also increased subsidy spending to deal with rising oil, gas and fertiliser prices amounting to Tk 571 billion. In the current context such continued reliance on existing energy and food subsidies will limit adjustments in domestic prices and that will limit the ability of fiscal measures to quickly respond to more serious economic difficulties that may arise in the coming months or years.

While presenting the budget, the finance minister also pointed out that the country faces six major challenges during the coming fiscal year, 2022-23-- of which inflation and increased domestic investment have been identified as the foremost challenge. The projected inflation rate is 5.6 per cent for the next fiscal year. According to the BBS, the inflation rate in April was 6.29 per cent. However, the official inflation figure provided by the BBS is considered to be on the much lower side than the actual inflation rate. In fact, the Centre for Policy Dialogue (CPD) on Sunday (June 5) indicated that the rate of inflation is much higher than the official figure (FE, June 6).Various research organisations in Bangladesh estimate that  the inflation rate is around 12 per cent.

The estimated revenue collection for the coming fiscal year  is estimated at Tk 3.70 trillion from tax revenue and Tk 450 billion from non-tax revenue.  The total outlay at Tk 6.78 trillion leaves a budget deficit of Tk 2.42 trillion which constitutes 36 per cent of the total budget outlay. This deficit will be financed through borrowing at home and abroad. The ratio between foreign sourced and domestic sourced debt is about 40:60.

This fiscal deficit will now add to the already accumulated public debt (government debt) which is now equivalent 38 per cent of GDP (of which about 40 per cent is external debt). The debt/ GDP ratio is likely to rise to 42.1 per cent of GDP at the end of fiscal 2022-23 where domestic debt is 25.8 per cent of GDP and external debt is 16.2 per cent of GDP. And that  is also further  likely to rise to 42.9 per cent of GDP at the end of fiscal 2023-24 where domestic debt is 26.5 per cent of GDP and external debt 16.4 per cent of GDP. The debt/GDP ratio for Bangladesh  is relatively low in comparison with the US at 107 per cent, the  UK 81 per cent and Japan at 237 per cent. If output falls sharply and the deficit grows, the debt/GDP ratio for Bangladesh will further climb up. Only budget surplus or high economic growth can help reduce the debt/GDP ratio.

In Bangladesh the budget deficit is financed through borrowing from internal and external sources, foreign grants and bonds.  Bangladesh does not have  deep and liquid bond markets, making it rather ineffective. In such a situation, printing money to maintain liquidity will add to inflation.

The budget outlay is 14 per cent  up from the previous fiscal year.  In that sense, the budget appears to be mildly expansionary and there is a sense that the government seems to think that the budget bottomline does not really matter because the budget would be in deficit anyway. The budget deficit for  2022-23 stands at TK 2.42 trillion accounting for 5.5 per cent of GDP. Between 1979-80 and 2022-23, Bangladesh always ran budget deficits except for four years. It indicates the budget has a structural deficit problem rather than cyclical.

A structural deficit problem implies that even allowing for cyclical fluctuations in the economy, current government spending is being financed by borrowing. With structural deficit, therefore, a deficit will be posted regardless of the strength of the economy. A structural deficit problem implies that borrowing will become increasingly unsustainable or more expensive. A structural deficit problem can lead to a rise in interest payments as a percentage of GDP which means increasing amount of tax revenue would be needed to make debt interest payments.

Only spending cuts or raising revenue or both are methods that can get rid of structural deficits. But neither of these methods are appealing to any government and that is why structural deficits continue to linger. More importantly, spending cuts and tax concessions combined can also create a challenge more existential than fiscal. Therefore, the government could reform the taxation regime to solve the structural deficit problem.

Fiscal deficits mean accumulation of government debt which implies higher taxes in the future when debt must be serviced and repaid. According to the Ricardian Equivalence Proposition, households, therefore increase their current savings in anticipation of future taxes. As such, there would be no increase in consumption, hence no increased economic activity.

Also, a budget deficit can lead to a current account deficit. This is known as the twin deficit hypothesis. The logic behind the hypothesis is that a budget deficit results in increased consumption. This increased spending reduces national saving causing the country to borrow money from abroad. This borrowed money may also be used to buy imported goods. But empirical evidence on the hypothesis is very mixed.

More importantly, budget deficits can crowd out private borrowing, manipulate capital structure and interest rates and decrease net exports. The demand for loanable funds rises when the government seeks fund for borrowing to finance its fiscal deficit. This not only reduces the availability of funds but also increases the real interest rate and deters private sector investment.

The budget comes at a time when the Bangladesh economy also faces a current account deficit. This deficit largely reflects increasing international prices of commodities such as food grain and oil and also indicates that exchange rate pass through is much faster for developing countries like Bangladesh (approximately 6 months) creating faster increased demand for foreign exchange or more precisely the US dollar as food grain and oil  import costs continue to rise, thus creating pressures on foreign exchange reserves and  exchange rates as well.

For a trade dependent country like Bangladesh, budget deficit can boost inflation considerably. Also, fiscal deficits can widen the current account deficit and push up interest rates. An appreciating US dollar as reflected in the BDT/USD exchange rate will make debt repayment or buying commodities even more expensive. As the US Federal Reserve continues to tighten its monetary policy to contain price rises, it will at the same time also further push up the US dollar value.

Fiscal deficits are generally relied on to expand popular policies such as welfare programmes and public work, without having to raise taxes or cut spending elsewhere in the budget. But if interest payment on the debt becomes untenable through normal tax revenue or further borrowing streams, the government faces three options. It can cut spending and sell assets to make payments. It can print money to cover the shortfall, or the country can default on loan obligation as happened with oil rich Mexico in 1982 and Sri Lanka in 2022. If economic growth momentum falters, with rising interest rates in the US, debt denominated in the US dollar will be more difficult to pay. Therefore, the simple maths of that is inexorable: the government needs to identify spending cuts and taxes that it can raise.

The government faces difficult policy choices as it tries to shield the people from record food prices and soaring energy costs-- driven further by US sanctions on Russia, Iran and other countries and the Russia-Ukraine conflict which led to Ukraine mining its own ports blocking its own food grain exports. Also, the pandemic's ongoing disruption of global supply chains has led to spiralling prices of everyday items. There are also domestic constrains that are also contributing to rising prices in Bangladesh. Therefore, the principal fiscal challenge facing Bangladesh needs to be viewed in the context of high and rising inflation. As such the budget will have to have significant impact on inflation. In this context it is to be noted that policies based on inaccurate data on GDP, inflation and other leading macroeconomic variables are less likely to succeed.

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