Keeping a hold on prices. Photo: Zobaer Hossain Sikder

AS a poor country, Bangladesh attaches high priority to acceleration of growth. The 2008 election manifesto of Awami League envisages a growth rate of 8 percent by 2013 and 10 percent by 2017. The finance minister's budget speech of 2009-10 reaffirms this target. The high rates of inflation in FY '07 and FY '08 put a sharp focus on price stability.

The first among top five priorities identified in the aforementioned manifesto relates to reduction and stabilisation of prices. No quantified target has been specified in this case. The budget speech implicitly endorses the objective of price stability and talks about ensuring increased supply of consumables through international trade, ensuring competitive environment in the market and protecting consumers' rights by adopting legal measures.

However, there are severe limits to policy actions to contain inflation and simultaneously accelerate growth. At the cost of repeating the simple, well-known proposition it should be emphasised that inflation involves upward movement in the overall price index. Therefore, forces operating both on demand and supply side influence its movement.

The positive components of aggregate demand in an economy are private consumption, private investment, government expenditure and exports of goods and services. The acceleration of growth in Bangladesh demands substantial increase of all these components. At the present low level of per capita income, private consumption expenditure is largely devoted to essential items despite visibly rapid increase in use/consumption of luxury items such as expensive automobiles, air-conditioners and pricey flats. Moreover, most people consider consumption as the barometer of welfare.

There is a paramount need for increasing investment in Bangladesh in order to accelerate growth. The present investment-GDP ratio in Bangladesh is about 24 percent whereas in fast growing China and India the ratios are about 45 percent and 36 percent respectively. The average annual growth of gross capital formation in Bangladesh during 2000-2007 period has been 8.6 percent as against 13.4 percent in China and 15.1 percent in India.

Bangladesh is also a country with undesirably low government expenditure. Among 44 Asia-Pacific countries listed in Asian Development Bank's Asian Development Outlook 2008, Bangladesh had the unenviable second lowest position in terms of ratio of central government expenditure to GDP. Even leaving aside the investment component of government expenditure for meeting the grossly deficient infrastructure (particularly transportation, energy, education, health, water resources, rural development), an elected political government will remain under irresistible pressure to increase expenditure on social protection net, welfare services and various subsidies.

The last positive component of aggregate demand is exports. It would be patently insensible to bring about a reduction in merchandise exports as a means of curtailing aggregate demand with a view to exerting a benign influence on price stability. The same observation holds with respect to remittances.

The above paragraphs explain why curtailment of aggregate demand is not much of a policy option if acceleration of growth remains an overriding objective. Supposing that the government takes the politically unpalatable decision to sacrifice some growth, would the reduction in aggregate demand achieve the desired result in terms of price stability?

There are at least two reasons why the result is likely to be disappointing. First, in an open, import-dependent economy, domestic prices are largely determined by international prices. The variations in aggregate demand would cause corresponding variations in the level of imports, not the price level. It may be recalled that in a comparatively less import-dependent Indian economy, aggressively contractionary monetary policy did not have much beneficial impact on inflation in 2008.

Second, contractionary monetary and fiscal policies to contain aggregate demand may have an adverse impact on domestic supply conditions through reduction in import of raw materials, intermediate goods and capital machinery, as well as aggravation of infrastructural bottlenecks. It should be noted that much of production-related infrastructure (energy, transportation etc.) is, provided by the government in Bangladesh.

In 2008, I pressed the above arguments forcefully in several rounds of discussion with IMF, who eventually yielded to the logic and did not insist on contractionary demand management policies.

On the supply side, the two sources of supply are imports and domestic production. As regards to the former, Bangladesh being a small country in the global market cannot exert any influence on the import price level through domestic policy measures. As regards to domestic production, the most important item is food grain, the price of which carries nearly 60 percent weight in the estimation of consumer price index (CPI) -- the most widely used measure of inflation. As in the case of aggregate demand, it can be argued that in an import-dependent economy, the variations in domestic supply (meaning shifts in supply curve) would bring about changes in the level of import, not in domestic price level.

In the very short run, there may be some benign impact because marginal farmers who do not have much of holding capacity may be forced to sell at low prices immediately following the harvest. Eventually, however, price will veer toward import price level, import being the only alternative option for consumers. The recent increase in the price of rice despite two successive bumper boro harvests illustrates this reality. The situation may change if the country becomes a surplus producer. However, even in that case, outward smuggling, if export is not officially allowed, would tend to bring about parity between international and domestic price level.

In light of the above, I recently undertook a simple regression analysis using import price index and food grains per capita production index as the explanatory variables for consumer price index over the last 9-year period. In both simple and log-linear forms, a statistically significant, high and positive coefficient of import price index is found. One percent change in this variable causes 0.94 percent change in CPI. In contrast, the coefficient of food grains production index turns out to be statistically insignificant.

The above analysis suggests that there are severe limits to the effectiveness of domestic policies to contain inflation while trying to accelerate growth. It is not, therefore, surprising that successive governments in Bangladesh have been pursuing expansionary fiscal policy and accommodating monetary policy. The justification for providing subsidies to food grain production arises from the need to reduce dependence on import, not from its impact on the price.

However, it is well known that inflation hits the poor hardest. It is, therefore, essential that the government maintains or even expands social protection net till acceleration of growth brings about a sharp reduction in poverty. Successive governments of Bangladesh have also actively pursued this approach.

Mirza Azizul Islam, Ph.D. is former Adviser to the Caretaker Government, Ministries of Finance and Planning.