Handle with care

The Bangladesh economy is going through a stressful period as is the rest of the world in varying degrees. The government has responded with fiscal, financial, and energy saving measures intended primarily to address the twin problems of the dollar crisis and rising inflation. The policy makers are grappling with difficult tradeoffs between the two. 

A series of austerity measures

Macroeconomic imbalance is a two-sided coin. On one side, it is the excess of imports over exports. On the other side, it is the excess of domestic expenditures over domestic income. The government has introduced a package of measures to tackle the imbalances on both sides. These include: 

Public expenditure cuts to restrain aggregate demand growth. The fiscal year started with a bunch of fiscal austerity measures. No vehicles, aircraft, helicopters, ships, boats, or barges can be purchased by the government, semi-government, autonomous and statutory bodies as well as state-owned enterprises and financial institutions until further notice. Even the replacements are on hold. The same institutions can spend 50% of their FY23 budgetary allocations for entertainment, travel, training, stationery, electrical equipment, and furniture. Restrictions have also been placed on the Annual Development Program expenditures. The import component in the government's own-funded projects has reportedly been paused. 

Increased duties and LC margins to discourage non-essential imports. The budget imposed protective duties on import of several non-essential consumption goods. These overlap the list of items against which BB tightened LC margins. Banks now need to impose a margin of at least 100% on opening LCs for air conditioners, refrigerators, washing machines, sedan cars, sport utility vehicles, gold and gold ornaments, ready-made garments, leather and jute goods, cosmetics, furniture, and home decor. The importer must pay 75% of the import price of all other goods in advance. All these measures are intended to reduce the demand for dollars. 

Load Shedding and austerity in electricity use to save fuel. The government has temporarily stopped the operation of domestic diesel power plants. Area-wise load shedding followed to deal with the resulting power shortage. The government also announced a slew of measures for saving electricity, including the closure of shopping malls and markets by 8pm, heat appropriate dress code and the restricted use of air-conditioners. The people are exhorted to not light up various social functions, wedding ceremonies, community centres, shops, offices, courts, and homes. Public offices have been directed to reduce power consumption by 25%. 

Prioritising import substitution. The budget speech envisaged the development of heavy industry and accelerating import substituting industrial production. It expanded measures taken to encourage domestic production of these goods and not necessarily to reduce the current demand for imports. The monetary policy for FY23, however, appears to have conflated import austerity with import substitution as a strategy for reducing the demand for foreign exchange, as evident from what the Bangladesh Bank said in the Monetary Policy Statement: 

"BB's monetary policy seeks to promote import substituting activities and dissuade the import of luxury goods, fruits, non cereal foods, canned and processed foods, etc. to reduce exchange rate depreciating pressure, protect foreign exchange reserves, and control inflation."

BB announced it was committed to create a fund dedicated to support import substituting investments. 

The expenditure cuts, if complied with, promise to deliver the intended reduction in demand pressures, including those on imports. They may be both inflation-containing and foreign exchange saving. Import restricting measures are likely to be foreign exchange saving while increasing pressures on prices. None of these risk other unintended consequences such as reducing foreign exchange earnings or creating new demands for foreign exchange spending. The same cannot be said for load shedding and import substitution policies. 

Load shedding is a double-edged sword

Foreign exchange gains from load shedding could be outweighed by losses. The administration is hoping to achieve a 20% reduction in fuel imports through area-based rotating load-shedding. The intention is to save foreign exchange spent on fuel imports, but the consequences could be very different. The fuel savings in power plants could be offset by increased use of diesel elsewhere in the economy as firms and households cope with power shortages. Even if there is a net reduction in diesel consumption, the direct foreign exchange savings could be offset by loss of production and export earnings.

Recurring power outages and low gas pressure are hurting production of most factories. These include steel, fertiliser, ceramic, shipbreaking, and apparels. Exporters fear a negative impact on the country's export earnings if they fail to deliver orders on time. A few are trying to deal with the crisis using alternative energy sources (diesel and furnace oil). Many factories do not have any alternative system to resolve the power problem. They are running factories at reduced capacity. Some allegedly cannot even use 30% of their production capacity because of power outages.

Load shedding can boomerang producing results antithetical to the policy intent. This happened in the case of Sri Lanka's ban on fertiliser imports. It worsened foreign exchange shortage within a year by increasing imports and decreasing export earnings as fertiliser shortages caused fall in domestic production of rice and tea. Load shedding could have similar effects in Bangladesh if increased diesel uses to cope with power cuts, production and export losses exceed the foreign exchange saved from reduced diesel consumption in the power plants.

Import substitution can drain foreign exchange

Import substitution policies are different from restriction on imports to cutoff demand for foreign currency from day one. Import substitution is generally not used as an instrument for managing the foreign exchange market in real time because it cannot be expected to yield immediate results in the right direction. 

There is a time lag between policy enactment and the supply response of import substitutes. In an economy, such as that of Bangladesh, where the local availability of raw materials, intermediate inputs and capital goods are sparse, imports are most likely to rise in the immediate aftermath of the policy. Machinery and construction materials must be imported to create or expand the capacity for producing import substitutes. Once the capacity is in place, raw materials and intermediate goods must be imported to get such production going. 

These gestation period imports increase the demand for foreign exchange. When import substitution support is provided in the form of higher tariff on imports, there may be some immediate reduction in demand for foreign exchange if the import demand is sufficiently price sensitive. Such reduction in import demand and hence the demand for foreign exchange may still not be sufficient to offset the increase in demand for gestation period imports. 

Such a perverse effect on the demand for foreign currency from a policy intending to reduce such demand is inevitable when the policy comes in the form of concessional financing of import substituting production. Unlike tariffs, this has no effect on the current import of items which the policy intends to substitute domestically. Thus, the BB endeavour to support import substitution through refinancing can certainly be expected to make the foreign exchange shortage worse before making it better.

There is no certainty it will make it better. Whether import substitution results in augmenting or draining foreign exchange depends on the size of domestic value added in the import substitution activity vis-à-vis the value of competing imports, both measured in world prices. 

Bear with a little digression to illustrate this point more precisely. Suppose an imported laptop costs $100. Production of a domestic substitute of the same quality requires imported inputs worth $70. Domestic value added is therefore $30 which is the amount that the import substitution saves in terms of foreign exchange even though import declines by $100. However, if domestic organisational or technological capability is weak, the value of imported inputs may exceed the value of output measured in world prices. One may end up spending more, let's say $110, on inputs to produce output substituting $100 worth of imports. In that case the policy completely backfires, even in the long run, by draining $10 from the economy.

Note that such production may still be profitable if the protection against competing imports is large enough. Suppose total protection is 50%. This means the domestic price of the same product will be the equivalent of $150. Value added in domestic price will then be equivalent to $40. A respected former Member Customs of NBR describes these as "tariff industries" which in Bangladesh is not too uncommon. 

Do not choose cures worse than the disease 

Loadshedding can save foreign exchange if it results in decreased use of imported fuel at the aggregate level, and not just in the power sector. Even this may be insufficient if load shedding causes loss of domestic production that creates demand for imports and loss of export earnings. Attempts to save diesel imports could do in Bangladesh what attempts to save fertiliser imports did in Sri Lanka – a net loss of foreign exchange! We hope the economy wide effects will be considered as the government reassesses the foreign exchange savings motivated energy conservation strategies going forward.

Import substitution aimed at alleviating the shortage of foreign exchange can worsen the shortage in an economy poorly endowed with local supply of raw materials, intermediate inputs, and capital goods. Irrespective of the form in which import substitution is supported, the demand for foreign exchange is most likely to rise in the short run. The policy could be a drag on foreign exchange even in the long run. The government must not allow opportunistic use of the dollar crisis for scaling further up the already high levels of protection to domestic oligopolies.