A deficit budget may be contractionary

Can a contractionary budget be expansionary? In the current macroeconomic context of Bangladesh, it could very well be. Don't be shocked. Yes, this is not what we are taught in introductory macroeconomics. In fact, we are taught the opposite.

A contractionary budget means the government is taking out more money (revenues) from the economy than what it is ploughing back (expenditures). In other words, it is running a budget surplus. Conversely, an expansionary budget means the government is ploughing back into the economy more than the amount it is taking out. It is running a budget deficit. Between surplus and deficit is a balanced budget in which the government revenues equal government expenditure.

Introductory macroeconomics teaches us that even a balanced budget, not to speak of a deficit budget, is expansionary (increases output). This happens because the money the government takes out in the form of revenues reduces private expenditures by less than that because part of the money paid to the government comes from reduced private savings.

Never mind the details, but the point is that the impact of the balance of government revenues and spending on output is expansionary as long as government revenues do not exceed government spending. By implication, this means a reduction in budget deficit will shrink the size of output expansion.

This textbook prediction lacks potency in a context where private expenditures are constrained by both domestic and foreign currency liquidity as well as high inflation. If indeed the government reduces the deficit relative to the deficit actually incurred in FY24, not relative to what was planned in the FY24 budget, it may stimulate private expenditure by lowering inflation as well as easing the supply of credit and foreign exchange to the private sector.

Note that budget deficit in the first seven months of FY24 was about at the same level (Tk22,258 crore) as was the case during the same period of FY23 (Tk22,989 crore), according to the Monthly Fiscal Report of the Ministry of Finance. The actual deficit in FY23 was Tk207,193 crore against a revised target of Tk227,508 crore. 

The revised budget deficit target for the current fiscal year is reportedly Tk257,000 crore. Chances are it will be around Tk230,000 crore this year, thus exceeding last year's actual by about 13%. Thus, even this year, despite all the talk about austerity, the fiscal policy will continue to be expansionary. We have not had any deficit reduction in absolute nominal or real terms or as a percentage of GDP since FY21.

So, when I say a contractionary budget, I mean a reduction in planned deficit relative to the likely actual of around Tk230,000 crore this year. This is not what we are hearing. According to media reports, the size of the budget deficit planned for FY25 is about Tk255,000 crore. This has raised some eyebrows expressing the fear of contraction (compared with this year's revised target) which in fact is nothing but a figment of imagination. 

Yes, we all know the deficit target will most probably be undershot even if there is revenue shortfall relative to the budget target. But that is beside the point because what matters for the economy is not the actual outturn relative to the policymakers' imagination, but the actual outturn relative to what actually happened the year before. If the deficit actually incurred in FY25 turns out to be greater than the deficit outturn on FY24, it will exacerbate pre-existing inflationary pressures and crowd out private spending by choking further the supply of domestic credit and foreign exchange to the private sector. These in turn will depress output expansion.

A higher deficit will mean higher domestic financing of deficit. Higher domestic financing will mean the government will be issuing more T-bills and bonds at interest rates that are already in the lucrative range of 11 to 13% depending on maturity. Why would any sensible banker be willing to lend to the private sector at rates unofficially capped (according to business leaders) at 14% when such credit is subject to expected default cost exceeding the difference between the interest on same maturity loans to private borrowers and to government?

Private credit in such a situation will behave like leftovers, that is, the maximum amount lent will be the amount available for lending minus the amount borrowed by the government. The more the government borrows, the less the private sector gets. Thus, increased domestic financing of budget deficit will crowd out credit financing of investment in working capital and fixed assets in the private sector, thus reducing both productive capacity utilisation as well as capacity creation.

Increased domestic borrowing by the government will most likely be used for financing projects in the Annual Development Program. Not all such financing will complement foreign financed projects by covering local costs. At least some, if not most, of it will be financing projects that have import content but no foreign financing.

The domestically borrowed money will then be used to buy foreign exchange, most likely from the Bangladesh Bank or the state-owned banks, thus reducing the already dwindled supply of foreign exchange to the private sector. This in turn will constrain the import of raw materials, intermediate inputs, spare parts and capital machinery further. All of these will reduce capacity utilisation and capacity creation in the rest of the economy.

Lastly, higher deficit will most likely inflame the already close to double digit inflation. Nominal wage growth has been behind inflation for over two years now, implying falling real wages for the vast majority of the employed population. Their purchasing power will therefore continue to erode, thus shaving GDP expansion.

Even if the government budget deficit adds to output, the combined effect of the above is likely to overwhelm those embellishments. It is therefore reasonable to conclude that a decrease in the actual budget deficit in FY25 relative to the deficit outturn in FY24 could help stimulate growth while softening inflation. It is in this sense that a contractionary budget could be expansionary.