Budget walks tightrope of deficit financing and interest rate control

Graphic: TBS

The People's Republic of Bangladesh announced its 53rd national Fiscal Year 2024–25 budget on 06 June 2024, projecting an expenditure of Tk797,000 crore, showing 14.20% year-on-year growth. 

The budget relies on an estimated revenue of Tk5,45,400 crore from NRB and non-NRB taxes with foreign grants, which make up 68.43% of the total expenditure, and borrowing of Tk2,51,600 crore from internal and external sources, excluding foreign grants, accounting for 31.57% of the total spending.

The GDP growth target has been set at a stunning 6.75% in this Covid-19 and Ukraine-Russia war situation, while the inflation target is 6.50%.

The budget shortfall for the fiscal year 2024-2025 exceeds the revised fiscal year 2023-2024 budget by over 8.02%. This has sparked discussions in the banking community regarding the effects of this deficit financing on money market liquidity and debt market interest rates.

Several factors, such as lower revenue collection, underperformance in external borrowing, a significant trade balance gap, the ongoing Ukraine-Russia war, currency circulation outside the banking system, an increase in policy rates, cost-push inflation, interest-paying capacity and overall sentiment regarding the long-term economic outlook, are contributing to the expected rise in interest rates. 

Budget deficit financing FY2024–25

With the country's continuous growth, it is no surprise that a deficit budget is anticipated. However, comparing this fiscal year to the previous one, the deficit budget has seen a moderate increase of 8.02%.

The deficit budget will be financed by Tk160,900 crore from domestic sources, of which Tk137,500 crore is bank borrowing and 23,400 crore is non-bank borrowing. Finally, Tk90,700 crore will be managed from external sources to bridge the budget gap. 

Here, domestic source borrowing increased by 2.73% from the revised budget FY 2023–24, bank borrowing decreased by 11.82%, and non-bank borrowing increased by 3,291.30% from FY 2023–24. On the other hand, external borrowing increased by 18.88% from the revised FY 2023–24 budget.

Throughout history, we have consistently faced budget deficits, heavily relying on bank loans. The borrowed funds must be utilised in a manner where the interest payments can be covered by asset earnings by today or tomorrow. Failure to do so could have severe repercussions for the economy.

In this case, the nation faces two significant challenges as it continues to rely on borrowing from the banking sector. These challenges include crowding-out issues and the vulnerability to domestic currency devaluation. Despite being a closed economy, the impact of currency devaluation cannot be alleviated due to our heavy reliance on imports.

Decomposition of deficit budgeting

The projected net financing from the domestic sector has been established at Tk160,900 crore, reflecting a 2.73% increase from the revised FY 23–24. 

On the other hand, external borrowing has been set at Tk90,700 crore, indicating an 18.88% increase compared to the revised FY 2023–24 budget. Domestic borrowing comprises both bank borrowing and non-bank borrowing.

Bank borrowing:

Bank borrowings consist of various components, including the issuance of Treasury bonds, Sukuk bonds, and government special Treasury bonds like Power/Fertiliser Government Special Treasury bonds. These components are commonly referred to as long-term financing. Conversely, short-term financing within bank borrowings encompasses Treasury bills, Ways and Means Advances, and Overdraft Current.

In the fiscal year 2024–25, net long-term bank borrowing amounts to Tk1,37,500 crore. The government plans to issue Tk127,900 crore in long-term securities, with a maturity of Tk55,218 crore. 

The issuance will consist of Tk43,000 crore for two years, Tk37,000 crore for five years, Tk29,000 crore for ten years, Tk8,500 crore for 15 years, Tk8,500 crore for 20 years, and Tk2,000 crore for five years. This will result in an average monthly long-term bond auction of approximately Tk10,658 crore.

Non-Bank borrowing:

The non-bank borrowing elements outlined in the projected breakdown include various domestic savings plans, such as post-office bank accounts and specified savings tools. Net non-bank borrowing is set at Tk23,400 crore in FY 2024–25.

The government aims to issue a family savings certificate worth Tk37,000 crore and a 3-month interest-bearing savings certificate worth Tk29,500 crore. Additionally, there is a focus on US premium bonds with a target of Tk50 crore and US investment bonds with a Tk360 crore target. However, the national savings certificate rate does not reflect the current market conditions.

External borrowing:

External sector borrowing consists of two main components: foreign aid and grants and foreign loans. Foreign grants include food aid and project aid, while foreign loans encompass project aid, non-ADP project aid, and special support or credit for development. External borrowing is set at Tk90,700 crore.

In FY 2024–25, there is a significant Tk36,500 crore foreign debt maturity along with Tk20,500 crore interest expenses, potentially leading to additional strain on the foreign exchange reserve.

Impact on money market liquidity

The following reasons might further reduce market liquidity:

Reduced excess market liquidity

As of March 24, excess market liquidity is Tk166,824 crore. As of last week, the liquidity facility provided via repo is almost 57,000 crore. Also, the Tk23,065.27 special bond repo mostly artificially creates excess market liquidity. 

After netting, the excess liquidity stands at Tk86,758.73 crore. This level of liquidity will work as fuel to push the money market rate if the central bank stops providing liquidity support. However, liquidity support also contradicts contractionary monetary and fiscal policies. 

Increased policy rate:

To combat inflation, the central bank may consider raising the policy rate, which could lead to a further decline in market liquidity. However, this measure is necessary to address the issue. 

For a 0.50% hike in the policy rate, money market liquidity could decrease by Tk10,512.14 crore and Tk21,024.29 crore for a 1% increase.

To support the foreign exchange market:

The central bank will offer scheduled banks additional liquidity and position support by selling USD due to the gap between imports and exports plus remittances. If $5 billion of support is given, Tk59,000 crore will decrease. 

However, the central bank will conduct sterilised intervention by providing liquidity through repo operations. Despite this, the market may encounter liquidity problems due to uncertainty regarding the continuation of the central bank's repo facility.

Composition of domestic long-term vs. short-term debt

The budget data shows that just 25.18% of the total issuance is for long-term debt, with the remaining portion allocated to short-term securities. Additionally, 1.65% is designated for 20- and 15-year Treasury bonds. 

This strategy indicates the government's attempt to address its deficit using short-term instruments, which may be cost-effective initially but could lead to increased issuance of long-term bonds at higher rates. This is due to the perception of a higher maturity premium for investing in long-term bonds caused by higher short-term rates.

Underperformance in external borrowing and revenue collection

Throughout history, the set goals have not been met through external borrowing and revenue collection, leading to an increased reliance on bank borrowing in revised budget allocations.

Currency outside the banks

As of March 24, the currency outside banks is Tk261195.3 crore. In the Covid and post-Covid periods, the currency outside the economy increases mainly due to lower interest rates and the precautionary need for money. But now, the inflation rate is higher than the nominal rate. If we consider the excise duty, the depositor will feel more reluctant to deposit at the bank.

Undisclosed money can now be legalised against fixed rates for immovable properties and 15% tax rates for other possessions. This badly influences the good taxpayer to take advantage, which might also increase the currency outside the economy.

Projecting more outflows in foreign investment

As of June 13, the official exchange rate was 108.52, 118 after one year. The holding period return is negative 8.74%. For the same time frame, the holding period return is negative 18.51% for the DSE board index. 

A foreign stock buy with a one-dollar investment in the Dhaka Stock Exchange is negative at 27.24%. This return is enough to trigger the stop-loss limit for a foreign buyer. This will create more trouble if we do not adjust the exchange rate efficiently.

To address inflation and mitigate the impact of the mentioned factors, there is anticipation of a notable upward trend in the Treasury's yield during the fiscal year 2024–25. 

If the regulator persuades the scheduled bank to keep rates low, short-term success may be achieved, but in the long run, rates could increase. There is no alternative to increasing the interest rate to combat inflation, and this is now a natural phenomenon, which is also evident in the current state of the economy as well as projected deficit financing.

The invisible hand of the market forces will not bear any intervention from any kind of external force. 

Mohammad Shahazadul Alam Khan. Sketch: TBS

Mohammad Shahazadul Alam Khan is the head of Asset Liability Management at a reputed private commercial bank.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.