The most serious economic problem now facing Bangladesh is high levels of inflation.
The impact of inflation is different from one person to another depending on their income level, stability of employment, family size etc.
The impact is most severe on the lower income groups; it is usually more severe in urban than in rural areas as farmers cultivate some of their own food and usually own or have some rights to the land on which they live.
Market prices for food will not always reflect the effective price that a farmer feels when he is producing some food items.
In Bangladesh inflation had been, over the past decade, about 6% per annum.
That is, the average or median family found that the cost of buying the things that they needed had increased 5-6% per year.
It has risen to 9% in the past two months according to the official rates.
The bundle of goods which are included cover expenditures of households in 2005-06; the actual bundle of goods now consumed is most likely to be more expensive than the 2005-06 lot.
One hopes the government will allow the Bangladesh Bureau of Statistics (BBS) to report the actual price level.
There is already great skepticism about the inflation rate.
In almost all countries high inflation rates result in falling standards of living for most persons, leading people to be discontent and anxious.
In modern economies containing inflation is the responsibility of the central bank.
However, fiscal policy is just as important but difficult to implement in a democratic society.
In Bangladesh, fiscal policy will play an essential role in reducing inflation.
But the matter is urgent and requires prompt adjustment of the fiscal position.
Causes
The cause of inflation is demand exceeding the ability of the economy to produce goods and services.
In such situations the markets will drive up prices to reduce demand to equal supply.
There are two important ways that demand can be excessive:
- Low interest rates resulting in loans in excess of saving
- The government spends too much money, more than they can collect in taxes or borrow from the public, so they just create it by the central bank buying government securities
In an open trading economy if the country has sufficient foreign exchange reserves these can be used to close the gap between supply and demand by importing goods.
Obviously, this cannot continue indefinitely.
However, drawing down the foreign exchange reserves provides time for other policies to be implemented.
Previous measures
The Bangladesh government has contained its deficit over the years to less than 5% of GDP and so this has not been a major contributor to inflation.
Interest rates are too low and this has certainly added to the high demand level, but the magnitudes are limited.
The main trigger of inflation is the high level of import prices.
This caused the Taka to depreciate more than 20%, adding to the price increases in Taka.
But the reduction of the inflation rate cannot be left to external sources and the two key necessary actions are as described above.
Action by the government is urgent.
People will soon demand higher wages to cope with rising prices.
The garment workers will enter into negotiations on the level of wages in the next few months.
Expectations of rising inflation are emerging, leading to hoarding, capital flight and anticipatory increases in prices.
All of these lead directly or indirectly to further price hikes.
Without strong policies to contain inflation the prospects are that inflation will continue above 10% over the next 18 months and may accelerate.
The widespread distrust of the official numbers contributes.
Containing inflation
The basic objective must be to reduce demand to the point that prices will stabilize.
There are two main instruments: Raise interest rates and reduce government deficit.
Raise interest rates
Real interest rates for lending are now negative, even ignoring the tax deduction.
Negative real interest rates mean money is free.
This leads to poor project selection as everyone wants to borrow so there is limited self-selection.
One has to raise the interest rates into positive territory and increase them further to ensure that investment declines.
An interest rate of 13% is needed to reach a zero real rate including tax benefits as we discussed in the third article.
To have an impact on private sector investment and interest rate of 16% would be required for banks to cover the cost of lending.
However, if the private investor believes that they can avoid repaying the loan or the interest, then there is no interest rate that will reduce demand for loans.
Currently banks must ration lending as the interest rate is capped and there is a shortage of liquidity (loanable funds) in the market.
This leads to investment in poor projects and encourages corruption to get some of this free money.
Reducing government deficit
The second action to reduce inflation is to lower the government deficit.
This is the most important action for Bangladesh.
If the government really wants to contain inflation then drastic cuts in expenditures are needed.
The government has already taken steps in this direction.
Success here is not measured by projects deferred but by a drop in actual government expenditures.
Since a significant program is needed for welfare of the poor households, it is the actual reduction after including the expenditures for the poverty reduction.
That is the test of success.
The pain of inflation reduction
Inflation is a painful economic disease that hurts almost everyone.
It tends to feed on itself and increase.
The more people believe inflation is here the faster it will grow.
When the disease hits it must be treated strongly and immediately.
Economists do not know how to arrest inflation except with tools that cause pain -- the expectations of inflation must be broken and aggregate demand reduced until everyone understands prices are not going to continue to rise.
The government approach to the IMF is to obtain funds that will allow less depreciation of the currency through use of reserves to pay for imports, while the higher interest rates and reduced government deficit will lower demand.
Lower demand will reduce imports and arrest the decline of reserves.
Over the next few years reserves can be rebuilt and the IMF repaid.
That, at least, is the theory.
We conclude with a list of the kinds of actions that are necessary.
- Continued cash program aimed at support of the poorest households.
- Implement a reduction of total government expenditures during FY23 from the base of the FY23 budget plus the support program mentioned as the first point. (My rough estimate is that a decline of 8-10% of government expenditures is needed.)
A useful step would be to stop all development expenditures other than those for projects that are 60% completed.
This should include projects that draw on foreign assistance as all such projects require local expenditures that add to demand. - No increases in lending by state banks. (Disbursements less than or equal to increase in actual loan recoveries).
- Raise interest rates on national saving instruments and increase sales.
Sterilize these funds from being used to finance government expenditures. - Remove the caps on lending rates and floor on deposits.
Allow existing loan lending rates to increase not more than 2% per annum during the next three years. - Remove restrictions on the difference in lending rates allowed between the riskiest and least risky loans.
- Do not attempt to regulate prices. This is a useless exercise and does more harm than good.
- Introduce pre-shipment inspection on imports from China and India to limit under invoicing and increase government revenue.
Introduce pre-shipment on all capital goods to limit capital flight through this channel. - Introduce immediately a program to ensure that all salaries of expatriates working in the RMG sector are correctly taxed and remittances from such persons go through the banking channel.
- Negotiate a loan with the IMF with loan conditions that allow use of the proceeds to support a single exchange rate at Tk105-106/dollar while the interest rate increases and deficit reduction programs are implemented.
These actions focus on the two key policies: 1. Raise interest rates and 2. Reduce the government deficit while ensuring the poor are taken care of.
Inflation through depreciating exchange rates is halted.
This is how you deal with inflation, strong and tough actions to get the medicine over with as rapidly as possible while letting the IMF sweeten the process a bit.
The next article will discuss how difficult things are going to be for Bangladesh over the next two years.
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
