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Where the government should do the math carefully

M.A. Taslim | Published: May 16, 2016 18:03:37 | Updated: October 23, 2017 20:04:57


The people who are egging the government on to borrow overseas are no doubt assuming that the infrastructure built with the borrowed funds will add to the physical capital that will enhance productivity and attract more investment. Apparently this is so, but more caution is called for. Government investment is known to be highly wasteful. A number of reports have been published in the news media in the recent past that revealed that the unit cost of roads and bridges constructed by the government in Bangladesh is several times the cost of these in other countries including some developed countries. Since there are few reasons why costs here should be significantly greater than that in other countries, the high cost is just a reflection of the wastages and leakages in government projects.
A good example is the Padma Bridge. Since it is being built with local funds, all its foreign exchange spending will be paid from Bangladesh Bank (BB) reserves. If the World Bank had not withdrawn from the Padma Bridge project alleging corruption at the pre-construction phase, the bridge should have been completed by now at a cost of around US$3.0 billion. Now that the government is implementing the project the cost has already risen to nearly US$6.5 billion (including railway). Given the history of other projects it seems safe to predict that the cost will increase to US$8.0-10 billion by the time it is completed in several years. If this is taken to be the average picture then it seems reasonable to assume that the country will on average get physical investment worth one billion dollar by making financial investment of nearly three billion dollars. 
Real productivity of course does not depend on financial investment, but on physical investment. Should the government be encouraged to engage in costly oversees borrowing to build some infrastructure with low financial productivity and burden the future generation with a large external debt? 
The most persuasive argument in favour of overseas borrowing is that the domestic lending rate is very high relative to the overseas rate. This is superficially true. There are some other issues that must be taken into account before jumping to the conclusion that overseas borrowing is cheaper. The most important consideration missing from the cheap foreign loan argument is the risk factor. There are two major risks: interest rate risk and exchange rate risk. The former could be avoided by taking a loan at a fixed interest rate, but this is usually higher than the market rate. The exchange rate risk could be avoided by contracting a forward exchange rate. However, the forward rate for a currency such as taka, if available at all, is likely to be much higher than the market rate. Hence it is most likely that the loans will be contracted at the market exchange rate. The Table suggests the exchange rate risk when the loan is contracted in dollars and at a fixed interest rate.
Consider the simplified example of a business enterprise that had borrowed US$10 million at the end of 2008-09 for three years at a fixed interest rate of 5.0 per cent payable at the end of each year in dollar. The entire principal must be repaid in dollar at the end of the third year. If the exchange rate had remained constant throughout the three years, the payment schedule of the borrower would be as shown in the third column of the table. It would have paid the fixed 5.0 per cent interest every year and repaid the exact amount it had received in taka from the dollar loan. 
However, the exchange rate did not remain constant during the loan period. At the market rate the payment that it actually had to make is shown in the fourth column. The depreciation of the taka had increased both interest and principal payments in taka. Eventually the business enterprise paid 35 per cent on the amount it had borrowed rather than 15 per cent it had expected to pay. This large increase in the repayment in taka terms could put the enterprise in difficulty if it had not made allowances for the possible depreciation. It may be noted that the effective interest payment it made (almost 12 per cent) could be more than the domestic rate of the time. Depending on how much the taka depreciates, the interest burden of overseas borrowers could be very onerous to the point of turning them bankrupt. The experience of Australian business in the mid-1980s and Thai enterprises in the late 1990s who borrowed overseas should be instructive.
Another important consideration is who the beneficiary of the loan is. If the government chooses external borrowing, all loan servicing charges accrue as incomes of foreign financial corporations. However, if the loan was procured domestically, the charges would have accrued to domestic banks. This could have not only improved the health of domestic banks, but also generated a multiplier effect further increasing income and employment. If the funds were borrowed from Bangladesh Bank, any interest payments net of what it was earning previously would have eventually accrued to the government when BB transferred its surplus to the government. By borrowing overseas the government is creating business for foreign financial institutions when it could have done the same for domestic banks.
Thus, when the real opportunity cost of borrowing overseas is considered, there may not be any gains to be made by such borrowing in our current situation. The government should do the math carefully before borrowing from the financial market overseas. 
m_a_taslim@yahoo.com

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