Fiscal deficits: Implications of public borrowing

Mustafa K. Mujeri | Published: August 13, 2018 21:18:51 | Updated: August 13, 2018 21:25:40

Bangladesh's present fiscal deficit may seem rather innocuous, as the economy has faced perennial and persistent fiscal deficits since independence. Historically, the country has experienced large fiscal deficits, with the growth in expenditures outpacing revenues. On the one hand, this has emanated from inadequate revenue generation due to the presence of a tax administration that tends to encourage tax evasion; and, on the other hand, it coexists alongside a substantially large and thriving parallel economy. As such, prudent fiscal management is necessary to help mobilise national savings, motivate efficient resource allocation, and facilitate sustainable economic growth.

One of the primary reasons attributed to weak fiscal performance is the inability of revenue growth to keep pace with economic growth. Revenue generation has been sluggish, with the tax-GDP (Gross Domestic Product) ratio increasing by a mere 2.0 per cent over a period of two decades. The low tax-GDP ratio primarily emanates from a narrow tax base; further, tax mobilisation is heavily skewed towards the industrial sector.

Moreover, rigidity in expenditures such as those for defence, subsidies, and interest payments on accumulated debt represents the other side of the coin. Poor fiscal discipline is further aggravated by weak management of the government's overall financial system.

A  direct  consequence  of  these  factors  is  an  inordinate  reliance  of  the  government  on borrowings  to  finance  the  budgetary  deficit.  Notably,  there  are  persistent  deviations  in  the estimated  financing  mix  of  the  fiscal  deficit.  While external borrowing sources are somewhat limited and have proved to be unpredictable in their timings, the government falls back on domestic financing through borrowings from the banking system, including both Bangladesh Bank (BB) and the commercial banks, and non-bank sources to meet its financing needs. Within non-bank sources, financing through national saving schemes and short-term Treasury bills (T-bills) has been popular.

Within the country's budgetary framework, focus is usually more on external  borrowing, as  external  debt  generates  a  'transfer'  problem; domestic  borrowing  only  transfers  resources  within  the  country. Further, external borrowing is associated with vulnerabilities that may lead to debt crises. The real sources of vulnerabilities, of course, are maturity and currency mismatches.  The  breakdown  between  domestic  and  external  debt  can make good  sense  only  if  such a  breakdown  works as a  good  proxy  for  tracking  these  vulnerabilities.

The switch  from  external  to  domestic  borrowing  may  just  help the government   to  trade  one  type  of  vulnerability  for  another.  For instance, by making the switch, Bangladesh could be trading a currency mismatch for a maturity mismatch. The switch to domestic borrowing  may create pressure  on  institutional  investors  and  banks  to  absorb  'too  much'  government  debt  and  this  may  exert  a  negative  effect  on  financial  stability. 

Further,  expanding  the  market  for  domestic  government  bonds  may  have positive  externalities  for  the  domestic  corporate  bond  market;  but  it may also carry  the  risk of crowding out private  issuers  by the  public  sector.

Recently, the government has taken up plans to issue floating rate treasury bonds (FRTBs), which will be another window for the government's deficit financing to meet its rising financial needs and develop debt profile. The difference between existing T-bond and FRTB rests in their rates of interest that would change over time based on specific criterion. As per the features of the bond, the FRTB (maturity of more than one year) will be issued at par and the coupon will be paid on the par amount.

The coupon rate will be expressed as a summation of Bangladesh Compounded Rate (BCR), which is a daily rate announced by BB and the spread is determined through auction. The coupon rate determined in auction will be set for the first quarter, and reset on every coupon payment day for the next quarter according to the BCR of that day. Individual and institutional investors will be eligible for purchasing and holding the FRTBs.

The issue of borrowing from the banking system is a subject of much debate. Relevant literature is also rife with theory and empirical evidence of negative consequences of government borrowing from the central bank.  Government borrowing limits the primary central bank function of maintaining price stability. Since government borrowing is essentially akin to 'printing of new money', it erodes purchasing power of the local currency in the form of high and persistent inflation and exchange rate depreciation. These problems become more acute  when  the  rise  in  domestic  assets,  led  by  government  borrowings  from  the central bank, significantly   outpaces   growth   in   foreign   assets.

Moreover, unscheduled government borrowing from the central bank complicates liquidity management, undermining the credibility of monetary policy. The inflation-growth trade-off is believed to depend on the level of inflation. A low level of inflation is often considered beneficial that stimulates growth. Recent empirical evidence, however, shows that the harmful effect of inflation on growth is mostly driven by the volatility of inflation. Although empirical evidence of the impact of fiscal deficit on inflation is somewhat mixed, but the influence is rather strong in developing countries like Bangladesh, which is transmitted either through monetary expansion or, more directly, through raising aggregate demand, or both.

Besides inflationary tendencies, borrowing from the central bank complicates liquidity management by injecting liquidity in the system through increased currency in circulation. This automatic creation of money complicates the monetary policy transmission mechanism. Furthermore, ease  of access  to  potentially  unlimited  borrowings from the central  bank does  not  bode  well  for the  government's incentive mechanism to  address and resolve structural issues on the fiscal front.

Such government borrowing may also cause volatility in short-term interest rates. The inability to accurately forecast government flows on a given day may create difficulties in maintaining adequate liquidity in the interbank market, which can result in excessive volatility in the overnight repo rates. Further, changes in government deposits and deviations from T-bill auction targets and seasonal swings of liquidity due to banks' lending for commodity financing may further enhance the uncertainties in liquidity projections; this may permeate to the retail market rates. These interest rate movements may not be in accordance with the trend of the monetary policy stance. 

Traditionally,  the  government  relies  heavily  on borrowings from  the commercial  banks  to  meet  its  budgetary  requirements. These borrowings take the shape of selling T-Bills and other means.  Bank lending to the public sector may potentially have a detrimental impact on financial development. While  credit  to  the  public  sector  is favourable for banks' risk profile (with a lower weight in risk-adjusted assets) as well as its profitability, it generally  tends  to  reduce  the  efficiency  of  financial  intermediation. Such credit may adversely affect both the quality of financial development and the process of financial deepening, since banks earning relatively risk-free returns from the public sector have little incentive to enhance financial intermediation.

Notably, banks normally do not get sufficient premium (risk adjusted return) on private sector lending; thus they resort to lending heavily to the public sector when the opportunity arises. The practice is particularly exacerbated when the economy faces a downturn and the premium demanded on lending to the private sector is high due to the higher risk of deterioration of credit quality. In such a case, banks would attach priority to public sector lending. Such risk aversion behaviour on the part of the banks can potentially lead to crowding out of the private sector. A more recent view, however, is the 'lazy bank hypothesis', according to which banks accumulating risk-free government securities become complacent in their risk-taking approach that reduces their incentive to expand exposure to the private sector.

One must recognise that private sector credit plays a critical role in economic development in the country. Further, banks not only promote economic growth but, also drive innovations and provide stimulus to the economy by funding productive investments. Financial sector, on the other hand, plays a fundamental role in allocation of savings to productive enterprises, favouring economic efficiency and capital accumulation. Rapid credit growth induces financial deepening, which eventually benefits economic growth.

Although there is a broad agreement on the beneficial impact of private sector credit on economic growth, probably a more important issue for Bangladesh is the impact of public policy on private investment. There also exists disagreement on the  extent  to  which  public  and private  sector  investments  are  complementary  or  act as substitutes. It is often argued that private and public sectors compete for scarce resources, which drives up prices. When public investments are financed by borrowing, market interest rates increase. It raises the cost of capital for the private sector, eventually leading to crowding out of private investment.

On the other  hand,  public  investments  in  infrastructure  is  generally  believed  to  exert  a positive  impact  on  private  investments. These  projects  involve  large  sunk costs  and  take  a longer  time-span  to  become  profitable,  enabling  the  private  sector  to  potentially  benefit from  the  spill-over  of  such  projects  during and after their completion.

Overall, the government's excessive reliance on the banking system for financing the fiscal deficit can have grave implications for both monetary and financial stability. Borrowing  from the BB  is  akin  to  printing  money,  and  feeds  directly  into inflationary  pressures.  In  effect,  such  monetisation  of  the  fiscal  deficit  dilutes  the  monetary policy  stance; and  the  impact  of  monetary  tightening  in controlling inflation can only become partially successful given the government's heavy reliance on borrowing from BB.

Financing from BB thus jeopardises monetary stability. Furthermore, large bank-lending to the public sector can potentially have an adverse impact on financial development. Credit to the public sector carries a sovereign guarantee and is generally favourable for banks' risk profile in terms of a lower weight in risk-adjusted assets. Although lending to the public sector has a positive impact on banks' profitability, it distorts banks' incentives and the process of financial deepening, since the banks that earn relatively risk-free returns from the public sector have little incentive to expand the banking market.

Recognising the potential negative effects of borrowing from BB on both monetary and financial stability, the government often looks for commercial   bank-borrowing in the form of T-bills and borrowing for commodity operations, in addition to quasi-fiscal borrowings. Such borrowings carry implications for the banks' incentive to undertake risky ventures, as profitability can still be maintained, or even enhanced, by investing in government securities.  This is particularly true for banks looking to consolidate their risk profiles given the rising stock of their non-performing loans (NPLs). If the government is found to be a captive client, banks' willingness to lend more to the government and public sector is likely to impede the productive expansion of the economy. 

Dr. Mustafa K. Mujeri is Executive Director, Institute for Inclusive Finance and Development (InM), Dhaka.

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