Taming the virus of imported inflation

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Zaidi Sattar, President of the Bangladesh Policy Research Institute (PRI) CollectionThe inflation genie is out of the bottle. It will take time and effort to get it back in place.

Official statistics point to point-to-point inflation of 9.1% in September this calendar year, although the 12-month moving average CPI index is around 7%. This is the highest in a decade or more.

It is the poor who suffer the most. Fixed-income earners struggle to make ends meet. Something has to be done, but this inflation is different.

The surge in domestic prices is not the result of a bad harvest in our agriculture or a disruption of industrial production.

External events caused it.

It can be called “imported inflation” because its roots are in recent external developments: post-Covid-19 supply chain disruption, Russian-Ukrainian war, rising food and energy prices and, ultimately, global inflation.

Virtually all products imported by Bangladesh have seen price increases, although international food and energy prices have come down somewhat recently.

As a result, our economy has seen an increase in the prices of traded goods as well as non-traded goods (services, transportation, etc.).

It is clear that this inflation is induced by imports.

Over the past fiscal year, we have seen a 35% increase in imports, coupled with a 34% increase in exports.

The surge in imports resulted in merchandise imports of $82 billion in FY22, compared to total imports of $60 billion the previous year.

The increase in imports was partly due to the rise in world prices of imported goods, but largely due to the import-export link that occurs when an economy mainly exports manufactured goods.

The increase in imports was not offset by the influx of foreign currency from exports and remittances, resulting in a record current account deficit of $18.7 billion or 4% of GDP.

This put pressure on the Taka-US dollar exchange rate which could not be maintained at the old rate of 86 Tk/US$ even after draining some $10 billion from the Bangladesh Bank’s official foreign exchange reserves.

Rightly, the central bank had to let the exchange rate float, which led to a depreciation of more than 20% in a few weeks.

Coincidentally, this matches the appreciation of the US dollar by about 20% over the past year.

If the taka had not depreciated, the exchange rate would have been overvalued by 20% just because of the appreciation of the dollar.

Thus, domestic import prices have increased for two reasons.

First, global inflation which has seen food and energy prices rise with ripple effects on all other traded and non-traded goods and services.

Second, the depreciation of the exchange rate increased the landed price of imports to the extent of the depreciation.

At the same time, as the domestic price of imports increased, the price of domestically produced import substitutes also increased.

All this translates into a rise in the domestic price level – inflation.

Remember that 80% of our imports consist of raw materials, intermediate inputs and capital goods, all intended for the productive sectors of the economy.

This contributes to what is called “cost-driven” inflation that has transmitted across the border.

Comments

Under these circumstances, I will argue that this inflation may not be contained by the standard demand management that we see today in most developed economies.

These economies have engaged in monetary easing for almost 12 years since the outbreak of the global financial crisis (GFC).

This was at a time when inflation was below 2 percentage points and interest rates were even lower.

They have now reverted to a process of monetary tightening (restriction of demand for credit) to deflate rising prices due to post-pandemic supply chain disruption and the Russian-Ukrainian war.

Interest rates have risen in order to control inflation by recycling demand.

This is unlikely to work in the Bangladesh scenario.

Stopping inflation must start at the border.

A phenomenon already mentioned is the depreciation of the exchange rate of more than 20% which was implemented in a few weeks.

Independently of the transmission of the price effect to the domestic market, three simultaneous impacts should be noted.

First, a 20% depreciation of the US Taka-dollar is equivalent to a 20% increase in tariffs at all levels.

This is because the dutiable value (on which import taxes are calculated by customs) of all imports is up 20%.

Therefore, any ad valorem tariff (based on value) now increases by 20%.

Simply put, a 10% tariff on imports worth Tk 100 will now yield Tk 12 in revenue on the import value which has increased to Tk 120.

This is an exceptional rate increase for NBR, without the need for any legislation.

Second, by applying the principle of uniform tariff protection, a 20% depreciation of the exchange rate has the effect of increasing the effective rate of protection by an equal amount of 20%, because it increases the price induced by the tariffs output and inputs by the same percentage point.

This means that import-substituting industries also benefit from the depreciation of the exchange rate.

Caveat: Since domestic import substitutes are imperfect substitutes for imported goods, producer prices may not increase as much as the tariff increase.

An increase in effective protection may not correspond exactly to the rate of depreciation, but there will be an increase nonetheless.

Third, exporters get an additional 20% on every export dollar — we can call this a different subsidy than the cash subsidy they receive from the state budget.

Irrespective of the fact that the prices of consumer goods have increased, since 80% of imports are destined for the productive sector, the production costs in the industrial, agricultural and service sectors have increased, also leading to higher producer prices, resulting in a one-point general inflation rate of 9.1% in September 2022.

This rise in inflation is largely driven by imports.

Remedies

An effective instrument to cancel out this import-induced cost-push inflation is to use the tariff handle.

Given that the NBR finds itself benefiting from an unanticipated 20% increase in tariffs, it is well placed to make a downward adjustment in tariffs that could help curb domestic inflation without any loss of revenue.

Even a modest reduction in tariffs will have a noticeable impact on reducing inflation.

A low-hanging fruit is the regulatory duty (RD) which is applied to 3,400 tariff lines (about 45% of all tariff lines).

About 95% of DRs are applied at 3% with a small number of products identified for higher rates (selection criteria unknown).

The DR is not a permanent element of the customs tariff but must be legislated each year.

Removing the entire RD in one go can cause the inflation to glow.

This might just be the start.

Brave hearts can do more to curb inflation.

There is no revenue loss issue for NBR because it comes from the windfall.

Domestic lobbies in favor of import substitution protection have no reason to complain as the DR is removed from the additional 20% protection against currency depreciation.

The fact is that neutralizing the price effect of exchange rate depreciation will be greater will be the downward impact on current import-induced inflation.

The removal of the DR could be a simple harmless experiment which could also have a lasting impact on the tariff rationalization which is currently being examined by a study team formed under the directives of the Office of the Prime Minister (PMO).

It could also be a win-win solution for the consumer and the producer.

To conclude, at a time when the interest rate handle has effectively been frozen so that credit restriction (i.e. demand restriction) is no longer possible by raising interest rates interest, the tariff handle remains a potentially deadly instrument to stifle imported inflation.

Current tariff levels are undermining the dynamism of Bangladesh’s economy in addition to discouraging foreign direct investment (FDI) at a time when multinational corporations (MNCs) are scouring the world for new land to park their investments.

By all accounts, Bangladesh’s tariffs are at significantly higher levels than those of its peers.

It has become a stumbling block in our strategy to boost exports and diversify them.

The sharp depreciation of the Taka-Dollar exchange rate offers an opportunity to use the tariff handle to tame the virus of imported inflation.

The author is president of the Policy Research Institute of Bangladesh (PRI)

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