Bangladesh has experienced two years of 10% inflation that rose in July 2024 to almost 12% (point to point, one year ending in July 2024. This is the best measure of the current inflation rate). Food prices in particular increased 14%; non-food 10%.
Immediate prospects are not good: The recent floods will have an adverse impact on food supply, but that effect is temporary. More serious is the availability of fertilizer for next year’s food production. Finally, the exchange rate has depreciated and prospects are for further depreciation over the next year. The extent of the depreciation depends on: (a) The export performance; (b) the additional funds from the IMF, the World Bank, the Chinese, the ADB, the AIDB, and the Japanese Government. The outcome of all of this is very uncertain.
This inflation was triggered in 2022 by external price increases from the world economy, resulting in higher import prices. But price increases continued due to a sharp exchange rate depreciation. The depreciation of the exchange rate and the large government deficit have maintained the inflation over the past two years, despite the decline in world prices. There are many claims that the inflation arose from corruption, but the data does not support this. The inflation was triggered from the world economy; the continuation of the inflation arose from an excessive government deficit and a large depreciation of the Taka.
Inflation arises when there is a high level of aggregate demand increasing the gap between supply and demand, resulting in higher prices as markets adjust to close the gap. Inflation also arises from a decline in supply as occurred after May 2020 from Covid-19. Reduced supply due to Covid-19 added to the inflationary pressures.
A rising government deficit is the most important cause of inflation. That is, the Government is increasingly spending more money than it collects in revenue. The companies and workers that receive the money spent by the Government, in turn spend much of it, raising market demand. The first action to lower high inflation is to reduce the government deficit. This means lower expenditures and higher revenues. The latter is difficult to achieve in Bangladesh, so reducing expenditures is the main channel for the policy-maker.
What does lower government expenditures mean? Obviously, this is less purchases; avoiding hiring new employees, no increases in salaries; no new automobiles for the government, etc. Of particular importance is reducing expenditures on development projects. One point of importance is contractors or suppliers who perform their function but do not get paid. Do these get counted as government expenditures? These unpaid bills now amount to a large amount and increase the inflationary pressures.
The second major influence on demand is the level of investment by the private sector. This is dealt with by the central bank by controlling interest rates. Economists believe that when interest rates are high the earnings from a project will be lower (interest payments are a cost to the project) and hence the investor will be less likely to make the investment. The central bank attempts to control interest rates and therefore have an impact on investment and inflation. High interest rates will reduce the private sector demand for investment, reducing demands in the economy, ultimately reducing inflation.
A particular source of demand in Bangladesh that influences rural construction and consumption is the flow of remittances from abroad. The total flow of remittances into the country is much higher than the amount that comes through the banking system. This results in a substantial increase in demand that is not recognized in the usual formulation of the national accounts.
I have estimated elsewhere that total remittances in the hands of the recipients is more than $50 billion, twice the volume that passes through the financial system. This is a hidden inflationary pressure.
In brief, during the last two years, the government deficit has been larger than recorded due to the unpaid bills of the government, while the remittances passing through the hundi system have added substantial purchasing power, particularly in rural areas.
The first action to lower high inflation is to reduce the government deficit
Controlling the inflation
To control the inflation, government expenditures must be cut further to offset these hidden inflationary forces. The interim government is trying to reduce the deficit but only time will reveal if their effort will suffice. Unpaid bills are continuing to increase and particularly in the energy sector. Remittances through the informal sector should continue to be high. There is an argument that with the change in government there will be reduced capital flight and so more remittances will come through the banking system. So far this has not emerged, but perhaps the next few months will see a change.
The actual impact of interest rates on investment is more complex than the simple idea that higher interest rates will reduce the demand for investment. The impact is likely to be much less than economists believe. In Bangladesh where the banking system has a high level of nonperforming loans how much does the borrower care about the interest rate? Further in a world of variable rate loans, akin Bangladesh, an increase in the lending rate results in all interest charges in all loans increasing. This increases the cost of production everywhere and probably raises prices.
Reducing the inflation rate depends on significant reductions of the government deficit -- at the moment, the government spends too much money. The previous government was determined to increase its expenditures. Much of this was to build up the security services to unnecessary levels and to implement a very expensive energy system. These programs grew steadily, rising demand and building inflationary pressures. Both categories should be reduced.
The rising increase in the demand for imports was not supported by increases in exports and remittances. As a result the balance of payments weakened and the Taka depreciated. There was a substantial depreciation from 86 to 120 Taka/dollar. [40%] This drove up the price of imports and hence contributed to the inflation. The world inflation has slowed so the initial trigger is gone. Stabilizing the exchange rate depends largely on increasing exports. With a significant reduction in government expenditures, maintaining high interest rates, stabilizing the Taka and maintaining a slow growth of GDP the inflation can be brought under control.
How long will it take to reduce the inflation rate to 6%? The numbers that are being given are 7/8 months. This is probably too ambitious.
Government deficit depends upon the degree of funds other countries will provide. Cutting the expenditures only from decisions on the budget is unlikely to work. The considerable bills facing the government will take time to pay off. The impact on private investment from higher interest rates will work. The GDP will slow down. The exchange rate will continue to depreciate contributing to inflation but eventually will stabilize at a low GDP growth rate and a low level of investment. All of this will take time but the Interim Government seems determined to lower the inflation.
It should take 18-24 months to reduce the inflation rate from 12% to 6%. At that point GDP will be growing slowly if at all depending on the growth of exports. Investment by the private sector and the Government will be low. At this point the economy can be slowly expanded. The economy cannot really expand more rapidly than do exports; the time taken to reduce inflation should be accompanied by programs to increase exports.
Forrest Cookson is an economist who has served as the first president of AmCham and has been a consultant for the Bangladesh Bureau of Statistics.