This time is different

The government has a tricky budget to draft ahead of the election year

A failure to adjust to changing global and regional economic and strategic landscape, poor policy choices across a range of areas, underlying political economy dynamics —there is no shortage of ways through which the respective, and successive, governments of Pakistan and Sri Lanka have precipitated the crises befalling those countries. 

Of many such mistakes and failures, fiscal profligacy, government expenditure financed by means other than revenue, stands out. And less than two years out from elections, risks of fiscal profligacy in Bangladesh shouldn't be underestimated.

According to the work of IMF's Christian Ebeke and Dilan Olcer of Riksbank, a rise in government expenditure is not uncommon in election years in developing countries. More worryingly, they show that this kind of binge usually ends badly. The authors study how public finances vary over electoral cycles in 68 developing countries during the 1990-2010 period.  

Their key finding is captured in Chart 1. 

In English, this shows that in the year of the election, government spending on salaries, subsidies and procurement — that is, stuff that can help the government get a popularity boost or facilitate patronage — rises by about 0.8% of GDP. After the election, however, the time of reckoning arrives. That expenditure needs to be paid for, and that is usually done by cutting public investment and raising taxes such as tariffs and import duties. That is, not only is the initial expenditure typically wasteful, the way it's eventually paid for is usually harmful to the economy's long-term growth prospects.

Chart 2 shows that government expenditures did indeed rise in the lead up to the December 2018 election. Total expenditure increased by 0.5% of GDP in the 2018-19 financial year, much of the additional expenditure going to subsidies and transfers. This had come after a 1% of GDP increase in the annual development program in the 2017-18 financial year. Meanwhile, government revenues dipped in FY2019 (Chart 3).

With rising expenditure and falling revenue, obviously, the budget deficit widened in 2018-19, by a whopping 1.5% of GDP (Chart 4). One might have expected the budget deficit to remain high during the pandemic. But expenditure relative to GDP declined during the pandemic as development programmes remained unimplemented, while more surprisingly, current expenditure (transfers, subsidies, civil service pays —things that might have helped the public during the worst of the pandemic) didn't rise. Meanwhile, revenue had risen relative to GDP during the pandemic. One upshot of this has been that the debt-GDP ratio (Chart 5) has not risen as much as might have been feared.

This time, however, may well be different if the government were to start a spending spree in the coming months. Chart 6 shows that the FY2019 fiscal expansion was financed by the 'domestic non-bank sector'. In English, this means that the government-financed the additional deficit by selling National Savings Certificates and Treasury securities to the households and the private sector. 

Of course, as Chart 7 shows, the economy experienced strong growth in the years before the pandemic. Buoyed by strong income growth, the household sector was in a position to finance the deficit.

Buffeted by cost-of-living pressures, will the households be in a position to support another pre-election spending binge? Will the government seek financing from the domestic non-bank sector? 

Domestic banks have become the major source of deficit finance during the pandemic. Of course, this has its drawbacks —bank finance of deficit means stress on the banks' balance sheets, and crowding out of credit to the private sector, both of which could reduce investment, jobs, and income. 

The government has a tricky budget to draft in the coming months. The current global macroeconomic environment is the trickiest in decades. And there is an election ahead.

This was first published in The Business Standard.

A few additional reading.

• Sri Lanka

Minoli de Soysa and Hannah Ellis-Peterson’s coverage from early January. The Economist’s coverage from mid-January. Tommy Stubbington and Benjamin Parkin in early February. Anusha Ondaatjie and Lilian Karunungan in early March. Also Uditha Jayasinghe. The Economist’s take in April on the looming political crisis. These could happen to a country closer to you.

Vidhura S Tennekon’s primer. Mustafizur Rahman thinks Bangladesh isn’t as dependent on China. But Zahid Hussain thinks there are still lessons to be learnt.

• Inflation in Bangladesh

Titu Datta Gupta and Jahidul Islam explain the impact on the urban middle class, while Selim Raihan show that things might be even harder for the poor.

• Fiscal policy in Bangladesh

Zahid Hussain argues that the government may have more fiscal space than feared.