That terrible ‘70s show

It is now an undeniable fact that Bangladesh's inflation rate has increased beyond expectation. With non-food price inflation hitting the 7% mark in 2021, it is important to understand what is causing such a surge in the dreaded economic indicator. These factors may also help us to understand what can happen in the future. 

From macroeconomic theory and empirical research by the IMF, it is possible to consider a few indicators to gauge the extent to these upside risks to inflation. High inflation episodes in emerging market economies have historically been associated with exchange rate depreciations and twin deficits in external and fiscal accounts. 

Let us consider the external sector first. A depreciation of the exchange rate increases the price of imports. As developing countries typically import food and intermediate goods such as fuel and machinery, depreciations usually fuel inflation. 

To complicate matters further, inflation can also add to depreciation pressures. For example, in the absence of any change in the nominal interest rate, higher inflation means a country's financial instruments would yield a lower real yield, which might lead to capital outflow, putting pressure on the exchange rate. 

Infographic: TBS

Of course, if financial markets deem a country's current account deficit unsustainable, its exchange rate would be hit, potentially creating a doom loop between the currency and inflation. History of countries such as Turkey and Argentina abound with such vicious cycles. 

So, is Bangladesh at risk of a sharp exchange rate depreciation in 2022? 

One common metric to judge whether a developing country's exchange rate is likely to remain stable is to look at how many months of imports can be bought with the foreign exchange reserves held by a country's central bank. 

If the reserves dips to an amount that cannot pay for at least three months of imports, the country's currency might face pressures to depreciate. Chart 1 shows that Bangladesh Bank's foreign reserves are far above that three-months-of-imports threshold. 

Like any economic indicator, this metric needs to be assessed against a broader context, and not be judged in isolation. Higher than expected inflation in the United States means monetary policy there will need to be tightened in 2022. 

The last time the US Federal Reserves tightened monetary stance in 2013, it caused a bout of instability in the emerging markets. There is a risk of a repeat of the so-called taper tantrum. Should there be financial instability in the emerging markets,

Bangladesh might come under scrutiny in spite of the seemingly adequate level of reserves. 

It is against that backdrop, one must consider the recent IMF report that the central bank's foreign reserves might be misclassified. Perhaps it was just a matter of technical error. But when the finance minister openly muses about using the reserves to pay for government expenditure, markets may start worrying. 

If such musings happen even as the growth in credit to the government runs at a high pace (Chart 2), markets may start acting on that worry. And if this happens in the lead up to an election, it may have disastrous results. 

Because the link between fiscal policy and inflation cannot be considered without an understanding of the political economy. It is worth thinking about these links step-by-step. 

A government typically borrows heavily when it is not raising enough taxes to pay for its expenditures. There is nothing wrong with debt-financed budget deficits in and of itself. And under certain situations, it may even be the sensible policy course to pursue. 
However, if the government continues to face financing difficulties, it might start borrowing from not just the commercial banks, but also the central bank. Central bank financing of the budget deficit means a government has essentially run out of all other options, and is looking at the barrel of hyperinflation. 

Of course, that is an extreme outcome that has happened in countries like Venezuela and Zimbabwe. There is no suggestion that this is a realistic ground for worry for Bangladesh in 2022. At least one hopes so. There are, however, other links between inflation and fiscal stance that should be of concern for us. 

Expansionary fiscal policy in the form of stimulus or support to households and firms might put a floor under demand in times of recession or severe downturns. However, when an economy is already booming, or when the economy is suffering from supply disruptions and bottlenecks, fiscal expansion is likely to result in inflation.

For example, cashed up households going on an online shopping binge, causing a logjam of ships in American and Chinese ports —that is the oversimplified story of the current global inflation.

As it happens, there is a risk of fiscal expansion in Bangladesh, not for any macroeconomic reason, but because of politics. According to a study by  IMF's Christian Ebeke and Dilan Olcer of Riksbank, government expenditure typically rises ahead of elections in developing countries, and the pre-election party usually ends in post-election hangovers. 

The authors study how public finances vary over electoral cycles in 68 developing countries during the 1990-2010 period. They show that in the year of the election, government spending on salaries, subsidies and procurement — that is, stuff that can help government get a popularity boost or facilitate patronage — rises. 

After the election, however, the time of reckoning arrives, and the expenditure is typically paid for by cutting public investment and raising taxes such as tariff and import duties. Not only is the initial expenditure typically wasteful, the way it is paid for is usually harmful for the economy's long-term growth prospects.

How is this finding relevant for Bangladesh? 

Well, in the lead up to the 2018 election, Bangladesh was experiencing strong growth on the back of export and remittance earnings, and there was no obvious macroeconomic case for a fiscal expansion. Yet, public expenditure did contribute to demand, pushing the growth rate to a pace that might have been faster than the economy's supply-side potential. 

How do we know that growth was running too hot? Well, in four years preceding 2019, Bangladesh experienced higher inflation than neighbours in Monsoon Asia (Chart 3), and higher inflation is what one might expect with expansionary fiscal policy in the face of supply constraints.

As we head into the 2023 election season, the economy may or may not be benefitting from another round of exports or remittance boom. However, in an already inflationary environment, with significant supply constraints caused by the pandemic, politically motivated fiscal stance might prove very costly indeed. 

A rerun of the stagflationary 1970s —the economic malaise of slow growth and inflation — may well be a major risk to the economic outlook.
Reruns of the 1970s — with bellbottomed men with shirts unbuttoned to the navel, in the company of buxom women with hair split in the middle, beating up ugly brutes long sideburns, to the beat of a funky tune — that stuff is great on our screen. Let us not have any other 1970s rerun.

Jyoti Rahman. Illustration: TBS

Jyoti Rahman is an applied macroeconomist. His analyses are available at https://jrahman.substack.com/ 
Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.