Deficit Financing Strategy and Fiscal Sustainability in Bangladesh

Historically, Bangladesh's government conducted a deficit-biased fiscal policy, largely due to robust GDP growth and favourable interest rates, facilitated by the country’s access to concessional finance as a low-income country. However, persistent deficit-biased fiscal policy is not sustainable in the long term without fiscal reform as interest rates rise with the rising per capita income and development. Using annual data from 1983 to 2022, with a 2-state regime-switching model this paper finds that the government’s fiscal response to rising public debt was stabilising during 1989-1995 and 2002-2014 with 84% probability (sustainable) while the response was insignificant during 1983-1989, 1996-2001, and 2015-2020 with 80% probability (unsustainable). In addition, a time-varying parameter model in a state space framework finds evidence of unsustainable fiscal policies consistent with the regime-switching model. The main reason for fiscal unsustainability appears to be the rising interest rates due to changes in budget financing mixes, higher interest payments, and persistent expansionary fiscal policy without major fiscal reforms. The lack of fiscal policy response to the output gap, indicating an absence of countercyclical measures and no evidence of long-term sustainability, contradicts the government’s long-term fiscal objectives.