Our problematic macroeconomic duo

Dollar shortage and inflation were the topic of the past week. Understandably so because of the noise around exchange rates at which banks executed foreign exchange trades. This problematic macroeconomic duo is driven by global conditions and domestic demand. None of the policy options are costless while some can make things worse.

Reality check

The external current account deficit increased to $14.1 billion in July-March, compared to $555 million during the same period last year. External financing was not large enough to prevent a rise in the overall balance of payments deficit from $2 billion to $3 billion.

This understates the foreign exchange supply demand imbalance. The Bangladesh Bank has sold $5.3 billion so far this year. It adjusted the official buying and selling rates several notches in a short time. We saw a whole variety of rates last couple of weeks, including centuries.

Inflation increased to 6.3% year-on-year in April 2022, compared with 5.6% in April 2021. Both food and non-food inflation have risen. Rural inflation is higher than urban inflation. The increase in inflation cannot yet be attributed significantly to stronger dollar. The rate of taka depreciation was a tiny 1.7% in July-April.

This problem is not just in Bangladesh. South Asia's current account deficits are widening. East Asia's current account surpluses are shrinking. Inflation is projected at 5.7% in advanced and 8.7% in developing economies in 2022.

Same drivers

How has the duo emerged in Bangladesh? In short, increase in international prices, including a pricier dollar, and domestic demand underpinned divergence between supply and demand in the forex market and rise in inflation.

Merchandise import payments increased faster than rise in export receipts. Deficit in the services account expanded. The Global Supply Shortages Index and Price Pressure Index reached a 17-year high in 2021-22, pointing to persistent and elevated supply issues and price pressures on commodities. Declining remittances dried what was a booming source of forex supply during most of the pandemic.

Not all the deficit in the current account was due to international price hikes. The Bangladesh Bureau of Statistics has projected real import growth in FY22 at 45% and real export growth at 23.2%. Import price growth (7%) exceeds export price growth (6.2%), implying a 0.8 percentage point adverse shift in Bangladesh's terms of trade. This pales in comparison to the 21.8 percentage point excess growth of real import relative to exports. These imply that growth in real domestic demand outpaced growth in real income. Total consumption to GDP ratio increased from 73% in FY20 to 78.4% in FY22.

Inflation is broad based. Of the 422 items in the urban consumption basket, prices of 225 items increased more than 6% in March 2022 relative to March last year. Prices of 25 items decreased or stayed the same. Of the 367 items in the rural consumption basket, prices of 211 items increased more than 6% and prices of 47 items either decreased or stayed the same. Inflation cut across locally produced and importable as well as tradable and non-tradable, suggesting a role of domestic demand in pulling inflation.

Inflation in rural areas came not from rice but from wheat, vegetables, edible oil, locally produced food items (readymade tea), tobacco products, clothing and fabrics, infant wear, footwear, household repairing, public transport (bus, rickshaw fares), and some luxury blades and detergents.

Rice shows up more prominently in urban inflation along with fish, eggs, edible oil, sugar, tobacco, men's clothing (buttons, tailoring charge, pants, ganjees), lady's clothing (saree, scarf, blouse), infant wear (nipple feeders), kitchen utensils (locally produced plates, glass and tablespoons), household articles (mosquito coil), public transport (bus, rickshaw, launch fares), motor diesel, toilet soaps and deodorants.

These facts together suggest global market conditions cannot be the whole story. A surge in demand for both domestic and foreign goods happened particularly at the middle- and upper-income level. The surge favoured importable as evident from the rise in import-GDP ratio from 15.8% in FY20 to 23.1% in FY22.

Drivers of domestic demand

Lifting of restrictions on mobility and vaccination unlocked expenditures postponed due to the pandemic. This pent-up demand theory implies a rise in domestic saving in the pandemic ridden FY20-21, followed by a fall. Domestic saving did rise from 26.9% in FY19 to 27.1% in FY20 but fell to 25.3% in FY21, when lockdowns induced by the second Covid wave were less stringent, and subsequently to 21.6% in the lockdown-free FY22. Faster progress in the implementation of stimulus packages contributed as well.

Expenditure switching towards importable resulted from overvalued taka. This is apparent from Bangladesh Bank data on the rate which keeps Bangladesh's real effective exchange rate constant at the FY15/16 level. Excess of the REER based rate relative to the actual indicates overvaluation. This excess increased from Tk9.6 per dollar on 30 June 2021 to Tk16.7 on 8 May 2022. Overvalued taka means imports are cheaper than it would have been if there were no (or narrowing) difference between the REER based- and the actual nominal exchange rate.

Unlike global conditions, exchange rate management and domestic demand are not beyond our policymakers' jurisdictions. An orderly correction of the exchange rate is needed for external balance. Macroeconomic policies can facilitate adaptation to global conditions by shaving off some excess domestic demand.

Orderly course correction

When the de facto exchange rate regime is murky, market behaviour can become disorderly. The BB pressures the authorised dealers (ADs) to buy and sell foreign exchange from each other at the official rates. When push comes to shove, the ADs opt out of the market. The interbank market last week looked like the edible oil market – little on the shelves for trade! Asymmetries between exchange rates offered by dealers emerged from choking off interbank transactions. The BB's buying and selling rates have lost relevance for all practical purposes, notwithstanding recent adjustments.

The BB's job is to facilitate market adaptation to changing underlying conditions. The foreign exchange market is not nascent. It knows how to discover the same price for the bulk of their clients. The market makers can plan their positions with reasonable accuracy when there is fair play. Repression of practices used by traders to arbitrage away pricing inefficiencies catapult the exchange rate into a non-equilibrium state; even gate round-tripping from the foul playing banks to the curb market.

If the shock to external balance were temporary, the shortage could be largely assuaged without exchange rate depreciation by digging deeper into the reserves. Deficit decline and resurgent financing when the shock fades could be counted on to build reserves back to safer levels.

There are significant constituencies in favour of such a course. The public applaud because they associate "weaker" currency with weaker economy, including higher prices, and not the other way round. The travellers love disinflation of travel costs. Bankers appreciate their balance sheet protection. Domestic market-oriented industries celebrate more the containment of the cost of imported inputs in the present than the increased contestability in future due to weaker protection from imports. The importers are thankful for stemming the rise in cost of imports as are real estate developers and ADP project contractors. Exporters being importers as well prefer to have it both ways – nondepreciated rate for imports and open market rate for exports.

Deepen prudence

This course has a feasibility problem if the shock persists. The BB cannot let reserves reach a level where sharp adjustment in market rates become fait accompli. Avoiding such a situation requires allowing greater exchange rate flexibility when the BB has the power to fire if the adjustments are disorderly. The BB needs to grow out of the fear of flexibility and protect reserves by limiting its use only to facilitate forex market trading.

A large depreciation has occurred in the last two weeks. This should induce a forex demand and supply response and stabilise the rate assuming no new external shocks and abstinence from mindless market meddling. Diversion of remittances from the informal to the formal channel is now incentivised well beyond the 2.5% subsidy. This will augment supply. The demand response may come from reduction in price sensitive segments such as pleasure trips, shopping, and the latest iPhone.

Attention is needed to cushion the cost push from exchange rate depreciation. How much can we expect? One way to gauge is to multiply the size of the depreciation with the import intensity of the economy. If, say, the formal market rate stays at Tk95 per dollar from Tk86.5, a depreciation of about 10%, inflation can be expected to rise by 2.3%, given 23% import intensity. Taking some heat off aggregate demand, a domain of monetary and fiscal policy, can soften this push.

Monetary policy role is obstructed by the lending rate cap. Blunt instruments such as the CRR need no adjustment now. Taka liquidity has already tightened. A rise in policy rate could help keep inflationary expectations anchored and augment the impact of increased LC margins if there were a transmission path to retail lending rates.

The artillery against the problematic duo must come from fiscal policy. A more contained primary fiscal deficit than usual is one such. Austerity in public expenditure on imports, as indicated by the finance minister, will help contain demand for foreign exchange. Increased indirect taxes on luxury consumption can have broader effects while generating some revenues.

Adjust with compassion

Fiscal policy is facing a difficult challenge. Subsidies to fertiliser, LNG, electricity, and diesel are estimated by the Finance Division to blow up by Tk60 to Tk70 thousand crore absent price adjustments which, if done, will fuel and flare inflation.

The government has refrained from major price passthrough so far. Assuming import prices won't revert soon, it cannot continue this for long. The subsidy does not provide large benefits to vulnerable groups and prevents adjustments in demand for environmentally sinful products. A pragmatic way forward is to lay out a time path of price adjustments toward full cost recovery conditional on objective factors.

Expanded social assistance to poor and vulnerable families for whom the price adjustment is too stressful to bear makes common sense. Unfortunately, it is not in the cards beyond what already exists. There is no better time to reconsider than the forthcoming budget.

Zahid Hussain was the former lead economist at the World Bank's Dhaka office