WORKING PAPER # 02/2007

A REVIEW OF THE CURRENT HYPOTHESES ON INFLATION IN BANGLADESH

Selim Raihan and Kaniz Fatema

September 2007

SHAMUNNAY
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A Review of the Current Hypotheses on Inflation in Bangladesh

Selim Raihan1 and Kaniz Fatema2

Rising rate of inflation has become a serious concern in Bangladesh in recent years. The impact of rising inflation rate is being felt almost everywhere. The prices of essential commodities have gone up, and so is the cost of living. Countrys vast multitude of poor and unemployed people is having a difficult time to survive. According to the estimates by the BBS, the inflation rate, on a point-to-point basis, in June stood at a 10 year high of 9.20 per cent. The corresponding food inflation rate was 9.82 per cent, and BBS reported that inflation on a point-to-point basis in urban areas was 10.71 per cent. It is feared to go up even further due to floods and Ramadan. There have been a number of hypotheses put forwarded by the economists, policy makers and donor agencies, like IMF, World Bank and ADB, with regard to the causes of inflation in Bangladesh. Here we provide a brief critical overview of these hypotheses. Hypothesis 1: Rising prosperity Bangladesh has been one of the high growth performing economies over the last 10 years. The GDP base of Bangladesh is not so small that achieving high growth rates would be relatively easy, as in absolute volume terms it represents the 50th largest economy in a sample of 177 countries. Only four countries have grown faster than Bangladesh with bigger GDP volumes during 1996-2005 (Figure 1).
Figure 1: GDP Size and Growth Rate

Assistant Professor at the Department of Economics, University of Dhaka and Visiting Fellow at Shamunnay. 2 Research Associate at Shamunnay.

12.0

Average Growth, % (1996-2005)

10.0
China

8.0 6.0 4.0 2.0 0.0 -2.0 -4.0

17 19 21 23 25

Ireland UAE India

27

29

31

Size of GDP (lnGDP)

Note: The black dot represents Bangladeshs position. The data is for 177 countries, for which the information was available. Data Source: WDI (2007)

During 1996-2005, the GDP per capita of the country has also increased by 3.26 per cent per annum. In terms of the high per capita GDP growth rate Bangladesh ranks 49th among 177 countries. Only three countries have experienced faster per capita GDP growth rate than Bangladesh with bigger population size during 1996-2005 (Figure 2).
Figure 2: Size of Population and Per Capita GDP
14
Per Capita GDP Growth Rate (1996-2005)

12 10
China

8 6 4 2 0 -2
10 12 14 16 18 20 22

Russia

India

Log of Population

Note:

The black dot represents Bangladeshs position. The data is for 177 countries, for which the information was available. Data Source: WDI (2007)

The proponents of this hypothesis postulate that the high growth rate of GDP and the per capita GDP in particular has led to the creation of excess demand in the economy which resulted in a demand-pull inflation. World Bank, IMF, ADB, and to some extent the government policy makers in Bangladesh, are in favour of this view. However, such views have been questioned by some economists in Bangladesh who consider that high growth rate of GDP should not create any excess demand in the 3 economy as the growth in GDP will also ensure supply of commodities (Osmani, 2007). In our opinion, there are merits in the arguments of both sides. The rise in income (if only equitable) has the natural tendency to exert excessive pressure on demand in the economy. However, such excessive pressure on demand may be met by increased imports, if not by local production. Imports of consumer goods have been experiencing high growth during the last five years (Figure 3).
Figure 3: Imports of Consumer Goods
Import of Consumer Goods (Million Taka) 650000 600000 550000 500000 450000 400000 350000 300000 250000 200000 1999 2000 2001 2002 2003 2004 2005

We, therefore, can argue that the rise in per capita income may be one of the factors responsible for creating excess demand situation, but it cant be the major reason for inflation in recent years. However, skewed distribution of the national income does undermine to some extent the case for creating excess demand of goods and services consumed by ordinary people who are our focused group here. Hypothesis 2: Rising food prices in international market Bangladesh is a net food importing country. As a result, any rise in food prices in the world market push the domestic prices of those commodities to increase. In recent years the prices of essential commodities, like rice, wheat and edible oil have increased significantly in the international market (Figure 4).
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Osmani, S R (2007). Interpreting Recent Inflationary Trends in Bangladesh and Policy Options. Dhaka: Center for Policy Dialogue.

Figure 4: Rising Prices of Food in the World Market

International Price in US $ per M.Tonne 800 700 600 500 400 300 200 100 2000 2001 2002 2003 2004 2005 Jan, 06 Feb, 06 Mar, 06 Apr, 06 May, 06 Jun, 06 Jul, 06 Aug, 06 Sep, 06 Oct, 06 Nov, 06 Dec, 06 Jan, 07 Feb, 07 Mar, 07 Apr, 07 Rice Soyabean Oil Wheat

The rising world food prices have also serious poverty implications for Bangladesh. Using a dynamic CGE model for Bangladesh we simulated a scenario for a 50 per cent increase in the world price of rice, wheat and edible oil. It appears that, under this scenario, the overall consumer price index would rise by 2.3 per cent. This would lead to a rise in head-count poverty by 0.31 percentage point in the rural area and 0.41 percentage points in the urban area. The number of people falling below the poverty line income becomes around 69,500 in the rural area and around 23,000 in the urban area.
Table 1: Rise in world price of rice and poverty in Bangladesh
Scenario Change in CPI (%) 2.3 Percentage point increase in rural head-count poverty rate 0.31 Increase in Percentage point Increase in the the number of increase in urban headnumber of rural poor count rate Urban Poor households households 69,440 0.41 22,960

Increase in import price of rice, wheat, and edible oil by 25%

It appears from the above analysis that rising world prices of food lead to raise the consumer price index with significant margin, and as a result have some profound negative impacts on inflation and poverty in Bangladesh. Simultaneously the issue of food insecurity (or perhaps hunger) will be a matter of greater concern. Hypothesis 3: Rising fuel prices Bangladesh government increased fuel prices in April 2007. Prices of diesel and kerosene were increased, on average, by 21 per cent. Arguments have been put forwarded by the World Bank, IMF, and the ADB that the increase in fuel prices would not have any impact on rising rate of inflation, as diesel and kerosene constitute a very low share in the basket of commodities used for the calculation of

the CPIs. However, the rise in fuel prices is likely to have some indirect impacts on the prices of commodities through two major channels. First, the high prices of fuels lead to high cost for irrigation, which raises the cost of agricultural production. Second, high fuel prices increase the cost of transportation, which also raises the prices of essential items transported from remote villages to urban areas. Using the Bangladesh CGE model, we simulated for a scenario of a rise in diesel and kerosene prices in Bangladesh by 21 per cent (as executed in April 2007), and it appears that such a rise in the fuel prices increases the consumer price index by 1.1 per cent. Fuel price rise also has some poverty implications, as this would lead to an increase in head-count poverty by 0.11 percentage point in rural and 0.19 percentage points in urban areas. Under this scenario around 25,000 rural and 11,000 urban households fell into poverty.
Table 2: Rise in fuel prices and inflation and poverty in Bangladesh
Scenario Change in CPI (%) 1.1 Percentage point increase in rural head-count ratio 0.11 Increase in the number of Rural Poor households 24,840 Percentage point increase in urban head-count ratio 0.19 Increase in of urban poor households 10,910

Increase in of diesel and kerosene prices by 21%

Therefore the increase in the prices of diesel and kerosene in April 2007 has contributed to the rising trend of inflation in Bangladesh. Hypothesis 4: Growth of money supply It is often argued by the international lending agencies (i.e., World Bank, IMF and ADB) that inflation is a monetary phenomenon, and it is caused by the excessive supply of money in the economy. Until very recent past, the position of Bangladesh Bank has not been very different from this perspective. While it is true that the broad money growth increased steadily during 2001 and 2007 (with a record growth of 22 per cent in December 2006), along with a rising inflationary rate, the lessening of the broad money growth since Match 2007 did not have any impact as regard to restraining the rising inflationary trend. Guided by the monetarist approach to inflation, the Bangladesh Bank had been following a rather contractionary (cautious in its term) monetary policy, as a result of which the growth rate of domestic credit fell to 14.9 per cent in 2006-07 as against its growth rate of 20.45 per cent in 2005-06. To our opinion, such a contractionary monetary policy has been ineffective in controlling inflation. A tightened monetary policy is unwelcome when the economy has shown signs of near stagflation with slower growth, high inflation and high

unemployment. A contractionary policy is likely to have resulted in an adverse impact on investment, employment generation and economic growth for Bangladesh. Very recently, Bangladesh Bank has changed its position, and has announced to move from a contractionary monetary policy to a cautious expansionary monetary policy. We consider this as a pragmatic step. Hypothesis 5: Depreciation of Bangladeshi Taka vis--vis Indian Rupee Since 2002 Bangladeshi taka has depreciated much against US dollar while Indian rupee has been appreciating (Figure 5). This has resulted in a major depreciation of Bangladeshi taka against Indian rupee (Figure 6). India is one of the major sources of Bangladeshs imports, as imports from India in recent years constitute more than 20 per cent of Bangladeshs total imports comprised of many essential food items. As a result, import cost for Bangladesh has gone up.
Figure 5: Nominal exchange rate for Taka and Indian Rupee against US dollar (left) and Taka-Rupee real exchange rate (right)

140 Currency per dollar (2000 value = 100) 135 TK/$ 130 125 120 115 110 105 100 95 90 2000 2001 2002 2003 2004 2005 2006 Note: A movement in the upward direction indicates depreciation of the respective currencies relative to US dollar. Ind-Rs/$

Real Exchange Rate of Taka (2000 value = 100)

145 140 135 130 125 120 115 110 105 100 2000 2001 2002 2003 2004 2005 2006 Not e: A movement in the upward direct ion indicat es depreciation of t aka relat ive t othe currency in quest ion after adjust ing for inflation TK/Ind-Rs

This depreciation of Taka hypothesis seems to provide a reasonably plausible explanation to the rising prices of essential food items in Bangladesh. However, there are some disagreements among the economists and policymakers with regard to combating this situation. It has been argued that Bangladesh Banks policy of foreign reserve accumulation is not consistent with the continuing deprecation of taka in recent years. Therefore, releasing some dollar from the foreign reserve to the domestic market is suggested with a view to restrain the excess demand for dollar (e.g., Osmani 2007). However, such arguments have not been endorsed by the Governor of Bangladesh Bank. In his view, the current amount of foreign reserve is not an optimal one, and there is a danger of depleting the foreign reserve for a

country like Bangladesh (Daily Star, 9 September 2007). Even if this is true, is there any scope of rearranging the foreign exchange reserve by accumulating some others stronger currencies, particularly Euro as we now have a large chunk of trade with Europe? Hypothesis 6: Non-competitive market (Syndicate) The syndicate hypothesis argues that many middle-men, wholesalers and importers are acting as syndicates and are causing huge price hikes, by making cartels and hoarding essential goods like rice, wheat and edible oil. These cartels fix the prices of these goods, dictate supply in the market, and earn excess profits. This hypothesis has become one of the dominant hypotheses in explaining inflation in Bangladesh. There are, however, a number of counter-arguments of this hypothesis. First, it is argued that there is no concrete evidence of the existence of syndicates in the markets of essential commodities. Second, though there are imperfections in the market, and as a result consumers are paying higher prices than the perfectly competitive prices, this phenomenon cannot explain the accelerating inflation. In general, imperfect market is likely to affect the level of price, but in order to have effective influence over accelerated price rise, the market concentration must also increase at an increasing rate, which is argued to be non-existent (Osmani, 2007). In our opinion, though there are no concrete evidences of established syndicates in the markets of essential commodities, taking advantage of the weak consumer protection laws, there might be some short-term alliances among the suppliers of these goods to influence over supply and prices. This may have some impact on the rising prices of essential items. Hypothesis 7: Anti-corruption drive and disruption of supply chain It is thought that due to the recent anti-corruption drive many businessmen have contracted their usual business activities with the fear of legal actions. Furthermore, many informal marketplaces, both in rural and urban areas, have been wiped out by law forcing agencies on legal grounds. Such actions have resulted in a disruption in the established supply chains, which certainly have exacerbated the inflationary trend. In our opinion, regaining the confidence of the businessmen in their usual business activities is very important for the smooth functioning of the supply chain. This is very important, not only to curb inflationary pressure, but also to get rid of the current state of stagnation in the economy.

Hypothesis 8: Slow growth in agriculture There is a declining trend of growth in agriculture over time, especially of the crop sector in Bangladesh (Figure 7). This has resulted in less domestic production relative to the domestic demand.
Figure 7: Growth in agriculture and crop sector
10 8 Annual Growth Rate 6 4 2 0 -2 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 -4 2006-07

Agriculture Crops

Slower growth in agriculture, and especially of the crop sector, is due to a number of factors: (i) failures in timely supply of fertiliser, seed and pesticide to the farmers; (ii) increased cost of irrigation because of rise in diesel price as about 70 per cent irrigation pumps are run by diesel; (iii) decline in the availability of cultivable land because of population growth and rehabilitation; (iv) change in pattern of crop production, as there are increasing tendencies to switch over to the cultivation of exportable crops that are more profitable; and (v) wastage of about 30 per cent vegetables because of shortage of cold storage. Severe flood during July-August 2007 has also exacerbated the situation. To our opinion, slow growth in agriculture, and especially in food production, is one of the major causes of accelerated inflation in Bangladesh in recent years. Hypothesis 9: Growth of remittances Bangladesh has been experiencing a steady rise in remittance inflow over the last few years. In 2006-07, the growth of remittances was 24.49 per cent. There are arguments that such inflow has also contributed to demand-pull inflation in Bangladesh. Though there are some merits in this argument such as the Rising Prosperity Hypothesis, increased remittance inflow is unlikely to be a major cause of inflation, as the rise in demand has been supported by the rise in supply through increased imports.

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Conclusion There are number of factors behind the rising trend of inflation in Bangladesh. The factors contributed the most in the rise hike of essential items, particularly food, are slow growth in agriculture, rise in the world prices of food items, sharp depreciation of taka against US dollar and especially against the Indian rupee, and rise in the prices of diesel and kerosene.

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