Making sense of budget financing outcomes

Recent fiscal outcomes viewed from both budget execution and financing sides signal a contraction in fiscal deficit in the first half of the current fiscal year. The government did put back more money into the economy through expenditures than it took out in revenues, but the difference between the two in the first half of FY21 apparently diminished relative to the same period last fiscal year.

Deficit contraction came with a reversal of monetary financing of deficit and increased borrowing from commercial banks or Deposit Money Banks (DMB). Inflation hawks and the commercial banks carrying non-interest-bearing excess cash with the Bangladesh Bank (BB) ought to be pleased.

The magnitude of the impact of deficit reduction on aggregate demand and output depends on the causes of the deficit decline, changes in the composition of financing, and the state of the economy.

Deficit contraction driven by expenditure decline

Data on deficit from the execution side is available from the Finance Division's Monthly Fiscal Report only for the first four months of FY21. This shows a Tk1.97 billion surplus, compared with Tk192.6 billion deficit during the same period of the previous year. The surplus resulted predominantly from a 34.6% decline in development expenditures which far outweighed the 8% growth in revenues.

This appears not to have lasted. Deficit estimated from the financing side, which is the only way of gauging it in the absence of data from the execution side beyond October, was smaller in the first half of FY21 relative to the first half of FY20.

The sum of net foreign financing (based on BB's balance of payments data), net non-bank borrowing including sales of National Saving Certificates (NSC) and net borrowing from the banking system (based on BB Monthly Report on Government Domestic Borrowing) was Tk485 billion in the first half of FY21, compared with Tk638.3 billion in the first half of FY20. The deficit in the first half was 24% lower than the deficit relative to the same period a year ago.

A large part of the decrease in deficit appears to have come from decreased spending, not increased revenues. Fund released for spending under the Annual Development Program (ADP) declined from Tk555.7 billion in the first half of FY20 to Tk499.1 billion in the first half of FY21, notwithstanding stable project aid disbursements. Slower spending on social assistance and austerity in expenditures on vehicles, buildings, and travel contained the growth of expenditures further.

Financing mix shifted away from Bangladesh Bank

As the deficit declined, the government retired its debt to BB. According to BB's Monetary Survey data, the net debt of the government to BB fell by Tk408 billion in the first half of FY20, compared with Tk32.5 billion increase in the first half of FY21. This resulted from an increase in government deposits with BB (Tk252.4 billion) and, to a lesser extent, from not rolling over treasury bills, bonds, loans, and overdrafts (Tk153.5 billion).

The money for debt retirement to and government deposit accumulation with BB came predominantly from selling securities to the Deposit Money Banks (DMB). Sales of government securities amounted to Tk501.2 billion in the first half of FY21, compared with Tk387.5 billion in the same period of the previous year. Increased sale of NSCs, despite some tightening of the ceilings at the individual level, contributed as did the rise in disbursement of external assistance and transfer of surplus from state-owned autonomous entities.

The retirement of government debt to BB reversed the increase in reserve money that happened when the government borrowed from BB and spent that money last year. There is nothing unusual about rolling back money creation through retiring interest-bearing debt of the government to the central bank. In fact, sustained monetisation occurs only when the government finances budget deficit by issuing non-interest-bearing liabilities such as currency in circulation or central bank reserves.

The Treasury stretched the maturity of sovereign debt. The banks, riding new heights of excess liquidity, were more than happy to oblige. Of the total borrowing from DMBs in the first half of FY21, over 75% were against bills and bonds exceeding one year maturity. The share of these securities in the net outstanding government debt to DMBs increased from 64.2% at end-June 2020 to 70.9% at end-December 2020.

The maturity of government domestic debt was also stretched through increased net sale of much more expensive NSCs. The outstanding stock of longer-term NSCs increased by 10.1% in the 12 months ending 31 December 2020.

A key challenge for the Treasury is to ensure the cash flows meet future liabilities and avoid bunching up on maturities. The government's ability to adjust NSC financing is constrained by its on-tap nature for individuals and institutions. Reforms in NSCs have been widely debated for long without any traction. The open tap policy with administratively determined high interest rates have survived despite complications created in fiscal management, financial development, and monetary programming.

Liquidity injections still exceeded target

The timing of expanded borrowing from DMBs while retiring debt to BB could not have been better. It coincided with an expansionary monetary stance implemented through lower reserve requirements and policy rates; a large, unanticipated expansion in BB holding of net foreign assets; increased risk of default that cannot be priced because of the cap on lending rate, and an extended contraction in the demand for credit in the private sector. Sufficient liquidity and weak demand in the domestic economy has pushed to the back seat worries about government borrowing from banks crowding out private credit.

The increase in net foreign assets of BB far exceeded the decrease in the government's net debt to BB. Together with an increase in BB claims on the DMBs, this allowed reserve money to grow 21.3% (y-o-y), well more than the 15.5% monetary program target for the first half of FY21. Retirement of interest-bearing debt to BB, a necessary part of a deficit financing plan that does not count on monetization, increased space for BB financing of deficit going forward.

When the government sells bonds to banks to finance the deficit, the result is generally less expansionary than selling it to BB. The latter increases the monetary base while the former does not. Fiscal policy has ceased to be a source of monetary expansion. This may help dent inflationary expectations at a time when the risk is elevated by large idle liquidity in the banking system. However, the risk of such excess liquidity induced inflation is higher for assets than commodity prices in the present stage of recovery in the Bangladesh economy.

Recovery has not obviated the need for stimulus

The economy is normalising but not fast enough. A survey of 500 manufacturing and service enterprises in January by the South Asia Network on Economic Modelling (Sanem) found improvement in the state of business in the last quarter of 2020 but the catch up has slowed before reaching the pre-pandemic status. The recovery is faster in pharmaceuticals, textile, food, transport, and financial sectors while the others have lagged. Some improvement notwithstanding, the overall business confidence is still low.

A contraction in deficit is not always bad. The essence of the matter is whether the decline in public expenditure is on productive or ineffectual government activities. The former is not conducive to development, the latter may in fact be beneficial. However, restricting all ministries and agencies to spend only 75% of their FY21 ADP allocation are likely to have restrained the bad with the good. Suspension of funding for low-priority projects can be beneficial if it leads to increased spending on tackling the impact of the pandemic and faster implementation of high priority and employment intensive projects. The aggregate demand impact of austerity in the operating budget, achieved through containing wasteful expenditures that often leak abroad through imports and travel, is minimal with some bonus in efficiency.

Ongoing vaccinations, reduced uncertainties, easier financial conditions, and faster global trade should all combine to boost recovery further. It could, however, use some help from enhanced levels of well targeted deficit financed government spending. There is convincing empirical evidence that government investment multipliers are larger than consumption multipliers. Also, increase in government expenditures contribute more to output expansion when the economy is operating below capacity, as appears to be the case presently.

Revisit the monetary-fiscal policy mix

The burden of uplifting growth was largely being borne by monetary policy even before the pandemic. Fiscal policy played at best a supportive role. This has worked for some but left out many as evident from various surveys and analyses. The most recent Sanem survey in January found 10% micro and small enterprises benefitting from the bank dependent financial stimulus, compared with 46% large enterprises.

Stimulus money is better put in people's pockets rather than in the banks where they are currently. Fiscal policy needs to take a more proactive role to ensure that the stimulus reaches households and firms struggling to survive the economic impact of the pandemic because they are on the wrong sides of the pre-existing digital, financial, skills, educational, and the larger social divides.

Deficit expansion driven by rise in expenditures targeting subsidies and capital grants to cottage, micro, and small enterprises; social protection for the poor and vulnerable households; and investments in health education and employment intensive infrastructure building could work like a booster dose and mitigate the risk of perpetuating the ongoing K-shaped recovery. This need not wait for pick up in revenue or greater availability of external finance.