Will the government have to turn to China for post-pandemic budget support?
“There are known knowns … known unknowns ... also unknown unknowns,” quipped the American Secretary of Defense Donald Rumsfeld in the lead up to the Iraq War.
When it comes to the economic ramifications of the Covid-19 pandemic, the only thing we know for sure is that we don’t know how things are likely to play out.
Pause here for a moment so that this sinks in. We can never know the future, no forecaster is a prophet, and no prediction is certain, but usually there is an appreciation of which scenarios are more or less likely than others. For the post-pandemic economic outlook, however, even that kind of probabilistic analysis is difficult.
This uncertainty heightens the importance of scenario analysis. Specifically, suppose economic growth turns out to be much weaker and inflation slightly higher than the government’s budget forecasts, along the table below:
The official budget forecasts are for the nominal GDP -- that is, the value of all economic activities in a year without adjusting for inflation -- to grow by over 15% a year during 2019-22. During the same time, revenue is expected to grow by nearly 20% a year, implying an elasticity of revenue to GDP of nearly 1.3 -- that is, each 1% rise in nominal GDP is expected to result in a 1.3% increase in revenue.
In the alternate scenario being analyzed, nominal GDP grows by over 9% a year during 2019-2022. The weaker economy means less revenue than that projected at the budget -- by Tk488 billion in 2020-21 and nearly Tk495bn in 2021-22. To put that in context, expenditure on pay and allowances of public servants was Tk534bn in 2018-19, and Tk500bn is about a quarter of the annual development budget in 2020-21.
Faced with this revenue shortfall, what could the government do?
Raising taxes while the economy is already sluggish is neither sensible economic policy nor plausible politics. The same goes for large cuts to the public service. In fact, there might be a need for more government expenditure: Households might need to be supported through either cash payments or public relief operations that provide food and other necessities; businesses might ask for bridging loans or other forms of assistance, merits of which would have to be carefully considered; and in the worst case scenario of deglobalization and prolonged global slowdown, Bangladesh’s low cost manufacturing dependent growth model might become unsustainable, and the government might need to consider policies to “build back better.”
Covering the shortfall
Cutting annual development expenditure might cover a Tk500bn (Tk50,000 crore) revenue shortfall in 2020-21, but that’s not a sustainable strategy if the recovery proves illusive beyond this year. The budget is already expected to be in red by Tk1,900bn (6% of GDP) in the 2021 financial year. With a weaker economy and revenue shortfall, budget deficit could blow out to nearly 8% of GDP (chart below).
How could this extra deficit be financed? What would be the consequence for public debt?
Budget deficit was already widening before the pandemic -- from 3.4% of GDP in 2017 to 5.5% of GDP in 2019. Traditionally, Bangladesh’s fiscal strategy has been to keep the budget deficit to less than 5% of GDP, the bulk of which is financed through the National Savings Certificate, and external financing amounting to about a fifth of total financing need.
As the chart shows, domestic banks have become a bigger source of deficit finance in recent years (source: Medium Term Macroeconomic Policy Statement).
In fact, the government has been explicit about changing the financing strategy from NSC towards bank and external financing. Ostensibly, this is because the cost of finance through NSC is higher than what interest government expects to pay to the banks.
By switching the financing mix, the government expects to reduce the implied interest rate paid to domestic lenders from 9.4% in 2019 financial year to 8.6% in 2021 financial year, saving about Tk60bn in 2021 financial year.
Another, more blunt way to look at the changing financing mix is that the government might find it easier to strong arm the banks to finance the deficit.
Of course, borrowing from the banks is hardly costless. Every taka lent to the government is a taka not lent to the private sector. And the banking sector was already under pressure well before the pandemic.
Taken together, it means the NSC and borrowing from the banks are not likely to be the first port of call should the government need to plug a Tk500bn hole. It’s also commendable that the government does not plan to avail the opaquely titled “other domestic” sources. While some of these sources are legitimate central bank operations to smoothly manage the government’s cash flows, they can also be accounting tricks to hide the true extent of fiscal problems.
Finally, these could refer to the central bank buying government bonds -- in simple terms, printing money to pay for government expenditure. The government has not suggested this avenue be pursued at all, and monetary policy is something deserving its own piece.
This leaves external financing as the remaining option. Will anyone lend to Bangladesh in a world awashed with debt?
There are grounds for optimism. Going into the pandemic, Bangladesh was less indebted than many of its neighbours (next chart, source: the IMF). The bulk of its debt is domestically held (the following chart, source: MTMPS). Most of the external debt is linked with large-scale infrastructure projects, and the government has not borrowed to finance the budget. Rather, Bangladesh’s macroeconomic stability over the past three decades under successive governments is well recognized.
That is, faced with strong macro-fiscal headwinds, the government could seek external finance. There are, however, grounds for caution.
Only when the tide goes out do you discover who’s been swimming naked -- goes the quip attributed to the American investor Warren Buffet. In the context of public finances, this means that during times of macro-fiscal stress, all sorts of skeletons -- underreported expenditure, contingent liabilities, undisclosed obligations -- are discovered. In addition, times of economic stress are also when banks or state-owned enterprises might have to be bailed out. That is, the debt-to-GDP ratio may well be far higher than shown in the charts.
Should the government borrow from the multilateral agencies, these hidden fiscal shenanigans might be uncovered and resolved. For example, any IMF package would involve conditionalities that will improve fiscal transparency. That, of course, may well be the very reason why the government might be reluctant to approach such institutions.
As at end 2018, the government owed $14.2bn to the World Bank and $8.8bn to the Asian Development Bank. Bilateral debt to China at the time amounted to less than $2bn. These numbers might provide the backdrop to the recent perceived tilt towards China at the expense of India.
Neither a borrower nor a lender be / For loan oft loses both itself and friend -- Shakespeare counsels in Hamlet.
Long standing political alliances, overt and covert, at home and abroad, will surely be tested should the government turn to China for post-pandemic budget support.
Jyoti Rahman is an applied macroeconomist.