The road to recovery amidst the global crisis
Bangladesh is a net importer of food, fertilizer, and fuel. The country also imports many raw materials and most capital goods. The rising global inflation caused import values to surge in FY2022. While exports increased, imports grew much faster resulting in a record current account deficit ($18.7 billion) that put pressure on the exchange rate and reserves. Ziaul Karim of Colors Business Magazine sat with renowned economist Dr. Sadiq Ahmed, Vice Chairman of the think tank Policy Research Institute of Bangladesh to understand the shifting macroeconomic scenario and discuss how to recover from the impending crisis. A summary of Dr. Ahmed’s views and analysis is provided below.
Recovery from Covid-19 and Emerging Macroeconomic Crisis
The covid-19 pandemic reshaped the world starting from early 2020, as it not only shook the world as millions of lives were lost but also resulted in a severe collapse in economic activities globally. Bangladesh was also hurt badly, but less devastatingly than North America and Western Europe. Nevertheless, the economy did slow down, unemployment increased, and short-term poverty surged. GDP growth collapsed to 3.5% in FY2020, down from 7.9% in FY 2019. Investment rate slowed and exports plunged, although a saving grace was the strong performance of agriculture and remittances. The government quickly responded well with a range of health and social measures to tackle Covid-19 and a series of economic stimulus packages aimed at recovering manufacturing activities, RMG exports, and micro and small enterprises. The global discovery of the Covid vaccine and anti-covid medications greatly facilitated overall covid management as Bangladesh developed an effective way to procure and administer the vaccines.
The results of these policy interventions were impactful as we could see the result from the recovered export in FY2021, remittances were plentiful; and imports also boomed. The overall balance of payments was in surplus, aided by capital inflows primarily from official assistance. Reserve build-up reached an all-time peak of $48 billion in August 2021. GDP growth and private investment recovered, and the inflation rate was low. There was optimism that the economy could revert back to the pre-covid growth path of PP2041.
This optimistic outcome got a rude awakening as Russia’s war on Ukraine started in late February. There were already global inflationary pressures building up owing to global supply disruptions caused by Covid-19. These pressures were further augmented by demand pressures fueled by the massive stimulus packages, especially in the USA. The Ukraine War added fuel to the fire by disrupting global energy, food, and fertilizer supplies. The hike in energy prices further pushed up inflation in both USA and Western Europe.
Bangladesh is a net importer of food, fertilizer, and fuel. The country also imports many raw materials and most capital goods. The rising global inflation caused import values to surge in FY2022. While exports increased, imports grew much faster resulting in a record current account deficit ($18.7 billion) that put pressure on the exchange rate and reserves. There was a partial depreciation of the exchange rate, but Bangladesh Bank sought to prevent the slide by selling reserves and accumulating short-term debt. Domestic inflation also increased owing to global inflation and the depreciation of the Taka. The government intervened by preventing full pass-through of energy and fertilizer prices and absorbing the shock on the budget. As a result, the fiscal subsidy bill has swollen. The combined effects of balance of payments, inflationary and fiscal pressures have destabilized the macroeconomy. Unless these pressures are handled well and reversed, the economy could enter a very difficult phase of slow growth and rising unemployment that would reverse the post-Covid progress.
Tackling the Macroeconomic Challenges
The Government has responded by partially depreciating the currency, putting import controls, raising tariffs, and increasing budget subsidies on fertilizer and energy products. Import controls have lowered the current account deficit, but there is continued pressure on the balance of payments, a shortage of foreign exchange, and inflationary pressure on the rise. The large loss of reserves and prevalence of multiple exchange rates have increased the short-term vulnerability of the foreign exchange market. In a heavily constrained fiscal environment and heavy dependence on imports for raw materials and capital goods, it is nearly impossible to insulate the economy from global inflationary pressure. Strong demand management policies are needed to reduce the rate of domestic inflation and the pressure on the balance of payments.
Instead of controlling inflation and balance of payments pressure through demand management, the Bangladesh policy-making is heavily focused on propping up the economy to accelerate GDP growth. This is reflected in monetary and fiscal policy management. The government is trying to promote economic growth by putting a cap on the lending rate at 9%. The tax effort has either fallen or remained stagnant. The fiscal deficit has increased. These growth-oriented policies have come under serious conflict with the need for stabilizing the macroeconomy. Low and now negative real lending rates have increased demand for private credit which has grown from 8-9% a year ago to 14% now, adding to inflationary and balance of payments pressures. Expansionary fiscal policy has similarly boosted demand instead of reducing it.
Mr. Ahmed said that Bangladesh has seen how similar efforts to boost GDP growth through tax cuts failed badly in the UK. Severe adverse market reactions brought about the fall of the Liz Truss government. Learning from the botched British experience, policy in Bangladesh must refocus on reducing demand through a judicious mix of the exchange rate, interest rate, tax, and spending policies. The massive loss of reserves reflects an unsustainable effort to prevent further depreciation of the Bangladesh Taka, which remains over-valued despite recent depreciation owing to the past misguided exchange rate management that saw a real appreciation of the Bangladesh taka by 62% between FY2011 and FY2022 (February).
The Government did take a positive step to allow the exchange rate to be market determined. But this approach soon changed course and instead adopted a multiple exchange rate (one for exports, one for remittances, and one for imports) with fixed rates for each of the transactions. The Government has now reached a situation where the further loss of reserves would imperil its foreign transactions management including short-term debt. The best course of action would be to eliminate the multiple exchange rates and let there be a uniform market-determined exchange rate.
The exchange rate flexibility should be combined with policies to reduce demand pressure in foreign exchange and the domestic markets. The most fundamental reform is to eliminate the cap on the lending rate. It is ridiculous to maintain a negative lending rate at a time when inflation is on the rise and the exchange rate is under pressure. Credit growth has to be lowered and not increased to lower inflation and reduce the demand for imports. Monetary policy should be used to monitor and adjust the movement of the interest rate as necessary.
Fiscal policy must also be used at the present time to reduce demand. Tax efforts should be strengthened through a well-thought-out and productive tax reform. Many of the elements of the required tax reform are well known. Strong political will at the top is necessary to implement the required tax reforms.
Expenditure management should focus on lowering subsidies and increasing social sector spending on health, education, water supply, and social protection. The priority given to infrastructure spending should continue but efforts should be redoubled to increase the efficiency of this spending by timely completion of projects. The fiscal deficit should be lowered to 5% of GDP or below.
The growth focus of monetary and fiscal policy can be restored once the macroeconomy is stabilized.
Suggested solution to the growing income inequality
The evidence of growing income inequality in Bangladesh is well documented. There are some who would tend to argue that this is a necessary outcome of economic growth in a market economy. Dr. Ahmed is not a supporter of this line of argument. He wrote several articles where he argued that income inequality is not a necessary consequence of growth acceleration and can be brought down through a proper use of redistributive fiscal policies.
In a market economy, income inequality arises from the unequal initial distribution of physical and human capital that tends to get accentuated over time as a larger share of economic opportunities resulting from economic growth is captured by the rich owing to their initial distribution advantage. The main solution to this inherent inequality of the market economy is for government intervention to re-balance the initial disadvantage of the poor, low-income, and vulnerable population through the use of a redistributive fiscal policy. The basic idea of the redistributive fiscal policy is secure a proportionately larger share of government revenues through higher taxation of the income of the rich and redistributing a part of that income to the poor, the vulnerable, and the low-income group through a range of social policies including creating job opportunities, giving them better access to health, education, and water supply, and through direct income transfers based on a targeted social protection program.
The best examples of successful use of redistributive fiscal policies come from the experience of countries of Western Europe. These countries raised considerable tax revenues based on a progressive income tax system and combined this with a strong social expenditure program focused on the poor, the vulnerable, and low-income group. Thus, the tax/GDP ratios in these countries tend to be in the range of 29% (Switzerland) to 46%, (Denmark) with a progressive personal income tax contributing to much of the revenues. Social spending on health, education, and social protection as a percentage of GDP range from 16% (Netherlands) to 31% (France). The results in terms of income inequality performance have been remarkably good. The Gini coefficient of income typically range between 0.26 (Belgium, Denmark, Norway) to 0.37 (UK).
The Government of Bangladesh is aware of the need for putting greater focus on lowering income inequality. This is reflected in the fact that the introduction of a redistributive fiscal policy is a core policy reform underscored in the Perspective Plan 2041 (PP2041). The Eighth Five Year Plan (8FYP) aims at initiating the first phase of implementation of this fiscal policy. Indicative targets for redistributive fiscal policies are also included in the 8FYP. But unfortunately, no serious efforts have been made so far to implement this core development policy.
Buffering the poor from accelerating inflation
Undoubtedly the high inflation is hurting the poor more than the rich, especially when food price has risen with the rising inflation. At the present time, not only did the inflation rate in Bangladesh accelerate crossing the 9% rate in August and September, but food price inflation too has also grown faster than non-food price inflation. The government’s efforts to tame inflation through price controls and energy subsidies have not worked. So, it is unlikely that inflationary pressures would subside soon.
Meanwhile, it is imperative for the Government to protect the incomes of the poor. Research shows that subsidies on energy products may help lower inflationary pressure, but they benefit the rich more than the poor. Global evidence suggests that the best way to improve the incomes of the poor is through job creation and through income transfers based on a well-thought-out social protection program. Bangladesh adopted a comprehensive National Social Security System (NSSS) in 2014. But the program has not been well implemented. The fiscal constraint has lowered resource availability for the NSSS program. Evidence shows that NSSS spending focused on the poor is merely 1% of GDP. Even that money does not often reach the poor. Research shows that there are many poor who are left out of these programs (technically called large exclusion errors) while there are many non-poor who benefit from these schemes (large inclusion errors).
The Government is well aware of these challenges as the research findings have been shared with the Government. Strong leadership is needed to revamp the existing social security programs, realign them in line with the NSSS, and provide substantially more resources to these programs. As an early start, the burgeoning fiscal subsidy bill approaching nearly 2% of GDP could be scaled back and the saved resources could be rechanneled to the poor through a revamped NSSS.