Deficits and liquidity

Published : 1 June 2011, 01:14 PM
Updated : 1 June 2011, 01:14 PM

After a long spell of robust balance of payments surpluses, the economy seems to have fallen back to the old habit of running deficits. The overall balance of payments deficit, according to one forecast, will be about one and half billion dollars this fiscal year, and is likely to increase further next year. While deficits are regarded as bad news for the economy for many reasons, a major task of Bangladesh Bank (BB), i.e. controlling money supply, will be ironically made easier.

Reserve money held by BB has been driven largely by its foreign assets holding (international reserves) during the last decade. The foreign assets (FA) component of reserve money increased by nearly 12 times, while domestic assets (DA) increased by only about one-third. FA comprised only a quarter of the total reserve money in 2000-01, but by 2009-10 its share exceeded three-quarters. Since the total liquidity of the economy, referred to as broad money or M2, is a multiple of the reserve money held by Bangladesh Bank, the monetary impact of the changes in the holding of FA increases as its share in the reserve money increases.

Under the current foreign exchange rules BB's holding of foreign assets is determined by the balance of payments outcomes– a surplus increases it, while a deficit leads to a reduction. The balance of payments is determined by a large number of domestic and external variables over most of which BB has no control. But the balance of payments outcomes have a direct impact on its monetary reserves, and consequently on liquidity. BB could in principle offset, either fully or partially, the impact of changes in foreign assets on money supply by resorting to sterilising measures, which entail buying or selling domestic assets such as government securities through repo or reverse repo operations.

FA may increase or decrease by any amount depending on the balance of payments outcome, but it is not always easy to sterilise a large surplus/deficit with repo or reverse repo. For example, if the balance of payments were in a large overall surplus of say $4 billion (the surplus was $2.9 billion last year), the entire stock of DA at BB's disposal would not suffice to fully sterilise this large surplus. Furthermore, BB could not call back such a large amount of money from the financial institutions without causing some disruptions in the financial system.

A balance of payments deficit on the other hand is easier to handle in the current situation. The deficit would tend to contract the money supply in the absence of an offsetting measure by BB. If the deficit is large such that the monetary contraction would be correspondingly large, BB may engage in a repo operation to replenish the liquidity of the commercial banks. This should not be a problem since the stock of outstanding securities is quite large, and the commercial banks would appreciate, rather than resist, the injection of new liquidity given the strong demand for credit.

Although a balance of payments deficit may be temporarily advantageous from the point of view of monetary management, it could hurt the economy if it continues for some time and the cumulative deficit is large. For example if the economy were to run deficits at the current rate for a couple of years, which now seems likely, BB's international reserves could fall below three months' import payments. Such a situation will cause an erosion of confidence in the ability of the economy to meet its overseas obligations at the current rate of economic expansion. This will lead to a depreciation of the currency in the foreign exchange market. The government/BB could also impose direct or indirect restrictions to reduce import demand.

The depreciation and such restrictive measures if any will make imports dearer in the domestic market. Since much of our industrial production depends on imported inputs and machinery, industrial output will suffer. Higher import costs will push up costs of production and prices of imported final goods, especially food stuff. The price level will spiral upward causing distress among the already suffering ordinary people. This is already evident from the depreciation of the taka and double digit inflation.

Recent trends suggest that the economy will be shortly in the grip of the twin deficits, i.e. a budget deficit and a balance of payments deficit. From what the finance minster has let out so far, it seems fairly certain that the budget deficit will blow out significantly; it could exceed 5 percent of GDP during the next fiscal year. The government, which has already used up half of its tenure without significant achievements, is under pressure to perform. It will hurry to implement glitzy infrastructure projects and enhance public sector spending to both demonstrate its credentials and to distribute favours in a bid to retain electoral support. The theory of political business cycles suggests that the urge to overspend will increase as the election date approaches.

Revenue efforts are unlikely to match the higher government expenditures such that the budget deficit will increase. The government will probably attempt to finance as much of the deficit as it can with foreign borrowing, but to go by past evidence, foreign funds are unlikely to cover any more than a minor part of the total deficit. Hence, the government will be ultimately forced to rely heavily on domestic borrowing to fund the budget deficit.

If the government borrows the funds from the public or commercial banks, the interest rate will be pushed up. The higher interest rate will crowd out private expenditure or investment to make space for the higher government spending. If it borrows from the central bank, the money supply will rise that will eventually translate into increased prices. Hence the government will have to carefully weigh the consequences of the different methods of financing on the economy in the short and the long term.

The total sovereign debt is now approaching one-half of GDP. Debt servicing alone used up about 18 percent of the total revenue last year; it is fast emerging as one of the largest heads of government expenditure. Another emerging large expenditure head is subsidies. It could exceed one-quarter of the total revenue next year. These ratios will most likely rise in the near future when all the high cost gas-guzzling contractual rental power plants come into production. If there is any increase in the international oil price, and the government cannot pass on the increase to the consumers, the amount of subsidies will increase further blowing a bigger hole in the budget that will have to be plugged by even greater borrowing.

Even if the government decides to finance most of the deficit by borrowing form the public and commercial banks, which is believed to be non-inflationary, BB will not remain immune from the fall-out. Any large scale borrowing is bound to push up the interest rate which is already very high at 16 percent and above. A further increase will hurt the business sector; it will lead to an increase in loan defaults, business bankruptcies, or at the least a reduction in profitability, and consequently a reduction in business investment.

Any large scale crowding out of private business will not be accepted meekly by the politically powerful business community. They will most likely bring great pressure to bear on BB to reduce the interest rate unaware of (or not caring about) the source of the tight situation. If BB succumbs to the pressure, which is likely, the money supply will increase thus providing the wherewithal of a spiraling inflation. In other words, ultimately BB will have to bear much of the consequences of the profligacy of Ministry of Finance (or the government).

BB is now caught in a pincer of opposing demands. Its internal constituency, especially the government and the business sector, require and demand an easing of monetary policy to implement their expenditure plans, while its external constituency, the IMF and some economists among others, are baying for a tightening in order to tame the spiraling inflation. In the past IMF advice had a strong influence on BB decision-making. It remains to be seen whether the appointment of a person with substantial political clout to the highest position of BB would make a difference, and if so with what outcome.

The dilemma facing BB underscores the importance of policy coordination given the nexus between monetary and fiscal policy. BB cannot expect to pursue the optimum monetary policy independent of the fiscal policy implemented by an aggressive Ministry of Finance unless they are fortuitously consistent with each other. Unfortunately they do not appear to be so currently. Monetary and fiscal developments during the next year will have interesting lessons for both theorists and practitioners of economics.

————————
M. A. Taslim is a professor of Department of Economics, University of Dhaka.