Bangladesh’s economy is going through a period of stress, as is the rest of the world to varying degrees. The government responded with budgetary, financial and energy-saving measures aimed primarily at solving the twin problems of the dollar crisis and rising inflation. Policy makers grapple with difficult trade-offs between the two.

A series of austerity measures

The macroeconomic imbalance is a two-sided coin. On the one hand, it is the excess of imports over exports. On the other hand, it is the excess of domestic expenditure over domestic income. The government has introduced a set of measures to tackle the imbalances on both sides. These include:

Public spending cuts to curb aggregate demand growth. The fiscal year began with a series of fiscal austerity measures. No vehicles, aircraft, helicopters, ships, boats or barges may be purchased by government, semi-governmental, autonomous and statutory bodies as well as public companies and financial institutions until further notice. Even the replacements are on standby. The same institutions may spend 50% of their fiscal year 23 budget allocations on recreation, travel, training, stationery, electrical equipment, and furniture. Restrictions have also been placed on spending on the annual development program. The import component of government-funded projects would have been discontinued.

Increased LC duties and margins to discourage non-essential imports. The budget imposed protective duties on the importation of several non-essential consumer goods. These overlap the list of items on which BB has tightened LC’s margins. Banks must now impose a margin of at least 100% on the opening of LCs for air conditioners, refrigerators, washing machines, sedans, sport utility vehicles, gold and gold ornaments, ready-made clothes , leather and jute goods, cosmetics, furniture, and home decor. The importer must prepay 75% of the import price of all other goods. All of these measures are aimed at reducing the demand for dollars.

Load shedding and austerity in electricity consumption to save fuel. The government has temporarily halted the operation of national diesel power plants. Area load shedding followed to deal with the resulting power shortage. The government also announced a series of measures to save electricity, including the closing of shopping centers and markets at 8 p.m., a dress code adapted to the heat and the restricted use of air conditioners. People are being urged not to light up various social functions, wedding ceremonies, community centers, shops, offices, courts and homes. Public offices were asked to reduce energy consumption by 25%.

Prioritize import substitution. The budget speech provided for the development of heavy industry and the acceleration of imports to replace industrial production. It extended the measures taken to encourage the domestic production of these goods and not necessarily to reduce the current demand for imports. Monetary policy for FY23, however, appears to have confused import austerity with import substitution as a strategy to reduce demand for foreign exchange, as evidenced by what the Bangladesh Bank said in the monetary policy statement:

“BB’s monetary policy aims to promote import substitution activities and discourage the import of luxury goods, fruits, non-grain foods, canned and processed foods, etc. in order to reduce the pressure to the depreciation of the exchange rate, to protect foreign exchange reserves and to control inflation.

BB announced that it has pledged to establish a dedicated fund to support import substitution investment.

The spending cuts, if adhered to, promise to deliver the expected reduction in demand pressures, including those on imports. They can both contain inflation and save currency. Import restriction measures are likely to save foreign exchange while increasing price pressures. None of these factors are likely to have other unintended consequences such as reducing foreign exchange earnings or creating new demands for foreign exchange expenditures. The same cannot be said for offloading and import substitution policies.

Shedding is a double edged sword

Exchange gains from load shedding could be offset by losses. The administration hopes to achieve a 20% reduction in fuel imports through area-based rotating load shedding. The intention is to save foreign currency spent on fuel imports, but the consequences could be very different. Fuel savings at power plants could be offset by increased diesel use elsewhere in the economy as businesses and households deal with power shortages. Even if there is a net reduction in diesel consumption, the direct foreign exchange savings could be offset by a loss of production and export earnings.

Recurring power outages and low gas pressure are hampering production at most factories. These include steel, fertilizers, ceramics, shipbreaking and clothing. Exporters fear a negative impact on the country’s export earnings if they do not deliver their orders on time. A few are trying to cope with the crisis by using alternative energy sources (diesel and heating oil). Many factories do not have an alternative system to solve the power supply problem. They run factories with reduced capacity. Some could not even use 30% of their production capacity due to power outages.

Load shedding can backfire against the intent of the policy. This happened in the case of Sri Lanka’s ban on fertilizer imports. He worsened the shortage of foreign exchange in one year by increasing imports and decreasing export earnings, as shortages of fertilizers led to a drop in the national production of rice and tea. Load shedding could have similar effects in Bangladesh if the increase in diesel uses to cope with power outages, production and export losses outweighs the foreign currency saved from reduced diesel consumption in power plants electrical.

Import substitution can deplete currencies

Import substitution policies are different from import restriction aimed at cutting off the demand for foreign currency from day one. Import substitution is generally not used as an instrument of real-time foreign exchange market management because it cannot be expected to produce immediate results in the right direction.

There is a lag between the adoption of the policy and the response of the supply of import substitutes. In an economy like Bangladesh, where the local availability of raw materials, intermediate inputs and capital goods is scarce, imports are more likely to increase immediately after the policy. Machinery and construction materials must be imported to create or develop the production capacity of import substitutes. Once the capacity is in place, raw materials and intermediate goods must be imported to start this production.

These imports in the gestation period increase the demand for foreign currency. When import substitution support is provided in the form of a higher tariff on imports, there can be an immediate reduction in demand for foreign currency if import demand is sufficiently price sensitive. Such a reduction in import demand and hence foreign exchange demand may still not be sufficient to compensate for the increase in import demand in the gestation period.

Such a perverse effect on the demand for foreign exchange of a policy aimed at reducing this demand is inevitable when the policy takes the form of concessional financing of import substitution production. Unlike tariffs, this has no effect on the current import of items that the policy intends to replace domestically. Thus, the BB’s efforts to support import substitution through refinancing can certainly be expected to worsen the foreign exchange shortage before improving it.

There is no certainty that it will improve it. Whether import substitution leads to foreign exchange gain or loss depends on the size of domestic value added in import substitution activity relative to the value of competing imports, both measured in world prices.

Bear with a small digression to illustrate this point more precisely. Suppose an imported laptop costs $100. The production of a domestic substitute of the same quality requires imported inputs worth $70. The domestic value added is therefore $30, which is the amount that import substitution saves in terms of foreign exchange, even if imports decrease by $100. However, if the national organizational or technological capacity is weak, the value of imported inputs may exceed the value of output measured at world prices. You can end up spending more, say $110, on inputs to produce outputs by replacing $100 of imports. In this case, the policy completely fails, even in the long run, by draining $10 from the economy.

Note that such production can still be profitable if the protection against competing imports is strong enough. Assume total protection is 50%. This means that the domestic price of the same product will be the equivalent of $150. The value added to the domestic price will then be equivalent to $40. A respected former member of NBR Customs describes them as “tariff industries”, which is not too uncommon in Bangladesh.

Do not choose remedies worse than the disease

Load shedding can save foreign exchange if it leads to a reduction in the use of imported fuel globally, not just in the electricity sector. Even this may be insufficient if load shedding results in a loss of domestic production that creates import demand and a loss of export earnings. Attempts to save diesel imports could do in Bangladesh what attempts to save fertilizer imports did in Sri Lanka – a net loss of foreign exchange! We hope that the economy-wide effects will be taken into account when the government re-evaluates energy conservation strategies driven by currency savings in the future.

Import substitution aimed at alleviating the shortage of foreign exchange can aggravate the shortage in an economy poorly endowed with a local supply of raw materials, intermediate inputs and capital goods. Regardless of the form in which import substitution is sustained, the demand for foreign exchange is more likely to increase in the short term. Politics could be a brake on foreign exchange, even in the long term. The government must not allow opportunistic use of the dollar crisis to further increase the already high levels of protection of national oligopolies.