Budget and the Exchange Rate-Inflation Connection

The FY2024 Budget has been placed in Parliament. Yet, the scope for some adjustments here and there remains until final approval by Parliament, which is expected to happen around the last week of June. 

For the better of the past month the town has been abuzz with budget talk and, alongside serious policy discourse, a lot of kite-flying has gone on. In my humble view one dimension of the economic implications of the exchange rate shock experienced in the past year has been least understood, let alone discussed threadbare. A one-time exchange rate depreciation of 25%, which is what happened in the past year, happens rarely. For Bangladesh, it was the first time the exchange rate had to be adjusted by that magnitude. We cannot simply wish away the price effect of this shock on market prices.

First, let us get these principles right out of the trade economics textbook which states that an exchange rate depreciation is the equivalent of an across-the-board export subsidy and an across-the-board import tax. In the Bangladesh context, the 25% depreciation has had the effect of raising the average nominal tariffs from 27% in June FY2023 to 33.75%, after the depreciation shock. A customs duty of 20% on an imported good of BDT 100 used to yield BDT 20 in revenue. After the depreciation, that same import now has an assessable value of BDT 125 yielding BDT 25 as revenue – a 25% increase in customs revenue without any legislation required. NBR has been reaping customs revenue at this higher rate following the depreciation shock though import controls have dampened the extra revenue collection from trade taxes. Yet, PRI projections show that NBR will be collecting 28-30% of its revenue from trade taxes this year against 26% share of trade taxes in recent years. 

PRI projections show that NBR will be collecting 28-30% of its revenue from trade taxes this year against 26% share of trade taxes in recent years.

Another principle to note. An exchange rate depreciation is inflationary. An exchange rate shock of the kind witnessed is even more inflationary when coupled with a spike in import prices. The price impact feeds through all traded and tradable goods in the domestic market and, eventually, fuels rise in price of non-traded goods (and services). The price of imported and local onion was BDT 34/kg in March 2022. It is now selling at over BDT 50/kg. A big part of it is caused by imported onion prices which now cost at least 25% more due to exchange rate depreciation, even if onion price in the sourcing country may not have changed. The same is true for many other consumer and industrial goods across the market. The national inflation rate which was 6.2% in March 2022 has risen by 50% to 9.34% in March 2023. A major part of this sharp rise in inflation can be attributed to the exchange rate shock. 

Whereas monetary expansion can also fuel inflation there is a time lag for that to happen. On the other hand, in the Bangladesh marketplace, the effect of depreciation and spike in import prices show up contemporaneously (almost immediately) in domestic inflation. That is exactly what we see happening in our neck of the woods. 

The chart below (using BBS and BB data) shows the co-movement of inflation and exchange rate since March 2022. The inflationary consequence of exchange rate depreciation is clearly evident in the marketplace and expected to last for some time unless some countermeasure is taken. 

Let me reiterate that this Bangladesh inflation is markedly different from what happened in USA and Europe. In those economies, whereas monetary easing since the Global Financial Crisis of 2008 had already caused their economies to be flushed with cash the Covid-pandemic response added fuel to the fire. Central banks in USA and Europe are trying their best to dowse that fire through interest rate hikes and monetary controls to subdue credit and consumer demand. In those economies, the underlying principle is that inflation is a monetary phenomenon and must be controlled through monetary management. Reports suggest that that is working but, at least in the USA, spikes in the interest rate are slowing down the economy with impending recession knocking on the door. Should that be a policy to follow in Bangladesh? 

In Bangladesh, the policy choice is as follows. We have no control over international prices of importable commodities. The exchange rate depreciation of 25% is here to stay and could get worse if we don’t bring the overall balance of payment in positive territory soon enough. Any attempt to manage the interbank exchange rate to, say, bring it below BDT 100/USD will cause a loss of foreign exchange reserves. So that is out of consideration. 

The exchange rate depreciation of 25% is here to stay and could get worse if we don’t bring the overall balance of payment in positive territory soon enough.

One lethal weapon that could have immediate and substantial impact on inflation is the tariff handle. There is scope for neutralising the inflationary effect of depreciation through tariff adjustment. As it is Bangladesh has the highest tariffs among its peers. It is now accepted that such high rates (for revenue or protection) create anti-export bias that subverts incentives to diversify our export basket away from readymade garments. Under the current tariff regime producers of non-garment exportable commodities find it more profitable to sell in the domestic market than to export. Now that the exchange rate depreciation has given a boost to the prevailing tariff rate by a massive 25%; it creates an excellent opportunity to reduce and rationalise tariffs (without worrying about revenue or protection loss), thereby killing three birds with one stone: a) crush inflation, b) reduce anti-export bias and propel export diversification, and c) attract FDI by infusing dynamism through a more open trade regime. 

Given that the economy is being challenged on many fronts and an IMF program is in operation, one would have hoped that this would be the most propitious time for undertaking radical tariff rationalisation. Yet, to be realistic, one can only talk of modest steps which could still have notable impacts. This is the time to reduce the top customs duty (CD) rate of 25% (which has been stuck at that rate since 2004) to 20% in one stroke. If that is considered too much then another modest option would be to simply not impose Regulatory Duty (RD) this year. RD is basically an addition to the top CD rate of 25% imposed every year almost across-the-board (on roughly one-half of the tariff lines) at 3% rate, with some higher rates as exception. Either of these ‘bold’ steps could shave off 1-2% of the current official inflation rate of 9.3% almost contemporaneously with the tariff reduction. While monetary contraction can also produce disinflation, that could take months to show impact. 

In economics another name for inflation is a ‘regressive tax’ because it adversely affects the poor much more than those who are better off. Needless to say, the current inflation is causing too much pain on a vast swath of our population who are crying out for succor. The Government must address the problem of inflation with all seriousness. The most effective weapon in its hand now is the tariff handle to tame or crush the inflation bug. Some effective action will be welcomed by all. This will be both good economics and good politics.