A blessing in disguise?

Fiscal outcomes in the first half of FY22 have been just-in-time what the doctor ordered for Bangladesh. Faced with imported commodity price increases to an extent and speed not seen since 2008-09, the government needed to have buffers to treat the pains caused by the transmission to domestic costs and prices. A modest budget surplus (around Tk1,100 crore), arising from 15.4% rise in revenue in nominal terms and almost flat (1% nominal growth) total government expenditures has provided just that.

When bad is not so bad

This will not be good news under normal circumstances. The budget intended to run a deficit of Tk2,14,681 crore this fiscal year, equivalent to 5.4% of GDP (new series). Deficit failed to take off the ground in the first half not just towards the target but also relative to last year's Tk179 crore deficit during the same period. A fiscal contraction in absolute taka terms is not what an economy, clawing back from near sudden stop to a post pandemic normal, needs. 

The definition of a new post-pandemic normal is now morphing into a post-war normal whose contours await discovery. The radical uncertainties created by the Russian War in Ukraine and the emergence of a complex web of sanctions have increased the risk of stagflation in Europe and developing countries, such as Bangladesh, who depend heavily on commodity imports for both production and consumption. 

Stagflation is a period of high and rising inflation with declining or negative economic growth. It is what ravaged the global economy of the 1970s when inflation spun out of control during a period of high unemployment. Research by Larry Summers and Alex Domas shows that overheating conditions of high inflation and low unemployment, as is the case now in many advanced economies, are usually followed by recession. There are now new inflationary pressures from higher energy prices and sharp run ups in grain prices due to the Russian invasion of Ukraine and perhaps more supply chain interruptions as Covid-19 forces lockdowns in major East Asian economies. 

There is no vanilla fiscal policy response to mitigate the risk of stagflation. Policy makers face a miserable tradeoff between inflation and growth. A fiscal contraction, by running a budget surplus, can help tame inflation by decreasing aggregate demand. But it most likely will puncture growth and derail jobs recovery. A deficit could stimulate growth by boosting aggregate demand while increasing the pressure on inflation. Overheating the economy can boomerang by reinforcing stagflation and causing higher levels of average unemployment through time.

The way out

Fortunately, budget surplus or deficit is not the only mechanism through which fiscal policy can respond to incipient stagflationary pressures. The policy makers' dream is an instrument that will attack the root cause of the problem and thus overpower the tradeoff between growth and inflation. 

The root cause of the problem is the import cost push. The government can use subsidies as an instrument to temporarily hibernate the pass through of international commodity price increase to domestic costs and prices. Such temporary increase in subsidies without denting the preexisting deficit target is possible when the original deficit target is not utilised at all. 

This is the position Bangladesh was in at the beginning of 2022. Perhaps not exactly premeditated, but that does not matter. This is an advantage Bangladesh can use to mute the international price hike pass through of strategic items such as oil and gas to the domestic prices of oil, gas, and power administered by public monopolies and regulators. 

Subsidies can play the role of automatic stabilisers by caging the price increases from the ports of entry until the unknown unknowns about the trajectory of global commodity markets become more knowable. It is not an instrument orthodox economics recommends for fighting inflation. However, in the presence of administrative price controls and monopolised supply, orthodox economics is like an emperor without clothes.

Subsidies unlikely to breach debt sustainability

A rise in subsidies due to unchanged energy and power prices will most likely not breach the FY22 original budget deficit target. Total increase in subsidies to oil, gas, and power, if their domestic prices are maintained at current levels, are likely to range between Tk35,000 to Tk40,000 crores in the second half of the ongoing fiscal year. Increases of such magnitudes can be accommodated within the original FY23 budget deficit target even if the budget deficit in the second half of FY22 is almost 1.5 times the deficit in the second half of FY21. 

The original FY22 budget deficit target passes the test of macro-fiscal sustainability. In addition to being authorised by the legislature, which is important politically, this is what makes staying on the targeted path desirable if the deficit is repurposed to absorb the import cost push in case of the strategic items. Such absorption will prevent the reverberation of the import cost push to the rest of the economy. These reverberations, if allowed to occur, will certainly fuel already increasing inflation, and take the momentum away from the recovery in growth. 

The repurposing of the deficit need not necessarily be at the expense of other originally planned subsidies if the increase in subsidies merely fill the vacuum left by the inability to execute the development and other operating expenditures. Note that only 31.9% of the operating expenditure and 16.5% of development expenditure budgeted for FY22 were spent in the first half of FY22.

Breathing space for reforms 

The government has the breathing space to implement long standing reforms in the administered pricing, taxation, and subsidy regime in energy and power. To serve as efficient market signals, the world prices will have to be the drivers of changes in domestic prices, mediated by transparent domestic regulatory and taxation-cum-subsidy mechanisms that respectively cushion the volatilities (market mood swings) and internalise the externalities (carbon emissions). 

Subsidies under such a policy become a smart residual that rise from zero when the volatilities are on the upside and fall below zero when they are on the downside. If tailored to penalise differences in carbon emissions between different categories of dirty fuels, well designed pricing formulae can also make the polluters pay. 

The execution of the reformed pricing mechanisms can start with the forthcoming new fiscal year (FY23). Hopefully, international commodity market prices by then will become much less noisy than they are currently. Even if they are not, knowledge of the price setting rules, backed by credible commitment to comply with them, will help make informed choices in markets besides depoliticising energy prices. 

The government has a unique opportunity to build back better from a regime of ad hoc and often arbitrary decision-making in energy and power pricing.