The Covid-19 pressure will most likely cause the FY21 fiscal deficit to overshoot the target, driven by revenue shortfall. Domestic financing needs may be additionally deepened by external financing shortfall. Monetary accommodation of deficit is inevitable and justified to the extent driven by virus fighting and redistributive expenditures. It can become problematic if wasteful and avoidable expenditures are not clamped down.
The proposed FY21 budget seeks to spend Tk 5,68,000crores, about $67 billion and 18 percent of GDP. The 13.2 percent growth in expenditure relative to the revised FY20 Budget is modest by historic standards, although relative to the on actual spending in FY20, on which data iscurrently unavailable, the projected growth may be significantly higher.The economic challenges facing the FY21 Budget is not about size, it is about what the money will be spent on, their consistency with the changed economic priorities and the results achieved.
There is a virus around with the possibility of causing more health and economic havoc than it has already caused. The proposed budget embodies the government's fiscal strategy to tame the virus, enhance public service delivery and support the economy sail through the troubled waters. Resource mobilizationwithout causing harm to the economy and the effectiveness of public expenditures in priority areas will be critical in achieving the intended results.
Any budget that starts with unachievable resource mobilization targets will inevitably limit the effectiveness of expenditures because of indiscriminate adjustments forced by the shortfall. Something has to give with little guarantee that what gives will not be at the expense of the high priority expenditures. Setting unachievable targets builds-in such fiscal risk.
The resources mobilization targets in the FY21 budget carry such risks. About 67 percent of theresources is projected from revenues and the remaining 33 percent will be deficit financed, projected at 6 percent of GDP. This level of deficit is not a concern from the macroeconomic perspective when aggregate demand is expected to remain weak and the initial public debt to GDP ratio is about 39 percent. Irrespective of how the deficit is financed, the risk of debt distress is low. Even if the actual deficit is within target, the high domestic borrowing may tighten access to finance for the struggling formal and informal sector operators, making doing business harder than it already is.
Assuming actual deficit within target under the circumstances likely to prevail in the local and the global economies is surely heroic. The heaviest pressure on deficit in FY21 is likely to come from large revenue shortfalls. A 50 percent growth in revenues driven by 53 percent growth in tax revenues, accounting for 91 percent of the total, is unprecedented and most likely remain so.
Revenue growth comes from economic growth and the tax reforms. With the virus still around, the economy will take time to recover. When recovery is going to start is highly uncertain. Current growth projections for FY21 range between the World Bank's (WB)1 percent to 5.7 percent projected by the International Monetary Fund (IMF). The macroeconomic framework underpinning the budget assumes 8.2 percent GDP growth. This is highly implausible, given the probable states of the growth drivers in FY21. The virus is continuing to drag the wheels of production, drain the fuel out of commerce, and suppress the animal spirits. The global economy is likely to experience the deepest recession in decades with shrinking per capita incomes in most emerging and developing economies. Bangladesh exports and remittances, two major growth drivers, cannot escape the impact of such a global recession. Domestic activity is further constrained by virus mitigation measures as well as the fear of virus transmission.
A large revenue shortfall is almost a fait accompli. This is because of the tax concessions and administrative forbearance allowed under the budget to individuals and institutions to enable them to conduct their ordinary business of life in these very difficult times. Lower rates on each income tax slab and higher exemption thresholds characterize a large number of very specific tax proposals in the FY21 budget. The revenue increasing measures such as increased Advance Income Tax on garments, taxes on mobile phone use, luxury vehicles, AC launch services, AC restaurant, furniture sales, tobacco, ceramics products, advance income tax on local supply of food grains and essentials,increased generosity in whitening black moneyand the promised improvements in tax administration will at best help limit the size of the shortfall to about Tk 90,000 to 100,000 crore if economic growth is closer to the IMF than the WB projection. This will still require 15 percent revenue growth relative to the realistic projection of actual revenue collection in FY20, such as Tk 2,26,300 crores by the IMF.
The demoralizing effect of unachievable revenue target on the tax collection officials and the resulting harassment of honest taxpayers will add salt to the injuries.
Covid-19 made budgetfinancing more challenging in the outgoing fiscal year.Efforts to increase tax revenue collection, including the implementation of the revised new VAT law in FY20, with lower preferential rates applied to many items,have not produced revenue increases. Even before the COVID-19 outbreak, revenues increased by 9.1 percent during July 2019-February2020. The fiscal deficitduring the same period almost doubled to Tk 65,000 crores. Following theoutbreak, even weaker tax revenues and higher spending related to COVID-19 are projected toexceed the deficit to over 5.5 percent of GDP target in the revised budget.
With net external financing falling short of the target, most of the higher FY20 deficit has been financed bybanks. IMF estimates this will exceed Tk 1 trillion in FY20. The issuance of National Savings Certificates(NSC), a major source of financing in years preceding FY20, has declined dramatically, first in response to government measures to enforce eligibility rules and increase in source tax, and then, after Covid-19, decline in national savings.
Budget deficit in FY21 will most likely overshoot the 6 percent of GDP target, driven primarily by revenue shortfall. The challenge will be finding harmless ways of financing it. There is space for increasing public borrowing from concessional external sources. The budget projects over Tk 80,000 crores (equivalent to $9.4 billion and implying over $11 billion gross disbursement) in net foreign financing, a level never achieved in recent memory. A 15 percent utilization of the opening $48 billion aid pipeline will yield $7.2 billion, leaving a gap of $3.8 billion.
The big donors have opened new windows for providing budgetary financing to meet Covid-19 caused emergencies, in addition to their regular financing windows. Bangladesh has already availed nearly $1.5 billion. It is difficult to understand why the government decided not to apply for the bilateral debt service suspension facility offered by the OECD countries, amounting to around $300 million.
All opportunities for enhancing net external financingmustbe fully utilized keeping in mind there never is a free lunch even under emergencies. Quick disbursing funds from external sources require interventions designed smartly to meet the emergency needs within a credible short and medium-term macroeconomic framework. The government will need to demonstrate their commitment to reform policies and regulations to make lifeeasier consumers and producers at this time of unprecedented distress.
Domestic financing of deficit will rise. There are limits to how much external financing can be raised. Closing the gap by about 50 percent (additional $1.8 billion) will actually set new performance benchmarks.Non-bank sources do not look promising. When incomes are down, savings are down. The demand for National Saving Certificates willbeweak, if any. In fact, NSC holders may decide to cash out their savings to pay for their living expenses. Reliance on bank borrowing will inevitably increase.
This could be a problem for the private non-financial sector particularly if production, investment and trade begin to recover from their current low levels. Moreover, the banks are already assigned a hefty package to finance the working capital needs of the affected small and large business enterprises at subsidized interest rates. Refinancing from BB (at 4 percent interest rate) will provide additional resources of 0.9 percent of GDP. However, the banks will have to bear all the risk. They may be more than happy to park their depositors' money in treasury bills and bonds that offer 7 to 9 percent interest without any default risk.
Funding for the financial support packages may be crowded out becausethe risk differentials are too large relative to the rate of return, given the 9 percent ceiling on the lending rate. Under binding rate ceilings and deteriorating loan recovery rates, liquidity support without risk sharing will not be enough toensure smooth and unconstrained credit flow to the private sector.A large increase in government borrowing from banks may choke whatever recovery in private credit growth emergein the second half of FY21.
Reforms reducing distressed banking sector assets and increasing lending rate flexibility will better allow banks to bear the private sector credit risk. Reported NPLs before the pandemic exceeded 9 percent, with the NPLs of state-owned banks (SOCBs) reaching 24 percent. The government had started amending several laws to enforce more discipline. Repeated loan rescheduling, regulatory forbearance, and failure to deal with weak and insolvent banks hindered progress. The regulators should focus on risk-based supervision, avoid further regulatory forbearance, strengthen corporate governance, define better the public mandate of the SOCBs and put in place a framework for the effective resolution of weak banks. Changing the 9 percent ceiling into a reasonably broad band will allow better coverage of risky small borrowers.
The last option is borrowing from the BB. Such monetization of deficit may not create additional inflation risk if aggregate demand remains as depressed as it is now. However, the financial stimulus packages are also being monetized by over 1 percent of GDP. Deficit monetization is not an option that canbe used too much too long. Monetizing the excess of deficit over available external and harm minimizing domestic financing, driven by increase in virus fighting and redistributive expenditures, are worth the financial stability and foreign exchange market risks.
Such risks become problematic if wasteful expenditures are not clamped downand redistributive expenditures are vastly insufficient. This appears to be the case in the proposed budget. It risks losing both the mangoes and the sack.