How to ensure country’s borrowing is good?

Unless structural reforms are undertaken, the debt cycle will perpetuate

NORTHAMPTON: Public debt issuance is a tool of economic policy. Borrowing can help countries deal with countercyclical shocks to the economy and finance exceptionally large expenditures, including the ones requiring huge capital outlays such as those on infrastructure.

Countries have also used debt as a stimulus to deal with recessionary episodes, especially in the aftermath of a crisis. However, all this often leads to a huge increase in the debt-to-GDP ratio. China is a good case in point.

The Chinese government embarked on a massive public investment and infrastructure programme, spending more than 6% of GDP in discretionary stimulus measures. This ultimately resulted in an increase of 15 percentage points in the public debt-to-GDP ratio from 29% of GDP to 44% of GDP.

Pakistan has also had a history of borrowing either to resolve its budgetary or balance of payments issues. The latter has been the pivotal reason behind the country’s recent recourse to the International Monetary Fund (IMF), which is the 12th time since the 1980s.

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This has been heavily debated in the media in terms of its benefits and disadvantages. This article aims to analyse why countries borrow, whether it is good or bad and explores the link between public debt and growth.

The motives behind borrowing

A recent IMF working paper titled “The Motives to Borrow” has defined both good and bad reasons for the countries to borrow. Good reasons include using debt to finance periods where high expenditure is required, particularly during times of natural disasters.

Increasing spending during recessions can smooth out the business cycle raising output, employment and incomes. Using debt for capital outlays on public investment programmes can lead to economic growth.

However, this comes with the condition that governments must ensure two important points. First, expenditure outlay on the public investment programme should reap benefits and should not just be undertaken to access cheap finance.

Second, countercyclical policies in which budget deficits are accumulated are a good strategy to use during recessionary times. However, it must be ensured that these policies do not lead to a steady accumulation of debt and budget deficits during bad times should be offset by surpluses during times of economic expansion.

Economists have also pointed towards politicians and policymakers using bad reasons for borrowing. Politicians and policymakers are usually modelled as self-interest agents in the economics and politics literature. Their reasons for over-borrowing are usually based on their self-interest motives hinging on political budget cycles and rent-seeking.

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Politicians tend to cut taxes and increase spending in the hope of being re-elected. Moreover, political parties have preferences for different types of public expenditure and accumulate debt in order to constrain the choice of future governments. What are some of the reasons behind Pakistan’s repeated history of borrowing including the current $6 billion bailout from the IMF?

Public debt: the case of Pakistan

Latest data from the State Bank of Pakistan (SBP) shows that the country’s recent debt accumulation has been explosive. Debt as a proportion of GDP exhibits that Pakistan’s total debt has reached a whopping 85.8% of GDP.

This is much beyond the recommended 60% of GDP, internationally as well as domestically as prescribed by the 2005 Fiscal Responsibility and Debt Limitation Act (FRDL). A look at the central government’s debt paints a similar picture. The government debt increased 14.8% from June 2018 to March 2019 against an increase of 12.4% in the same period of last year.

In the given period, this is the highest growth in the central government debt in the past decade. The increase is due to a substantial rise in both domestic and external debt. Pakistan has always faced an issue of low resources to finance its expenditure. With the lowest tax-to-GDP ratio in the world, there is no surprise that the country has to repeatedly borrow from multilateral organisations.

But the important question is: how much should countries borrow? Economics explains that governments should borrow up to the point where the marginal cost of acquiring an extra unit of debt equals the social return of an additional unit of debt-financed expenditure.

Over-borrowing refers to a situation where the government borrows more than is socially optimal. Unless structural reforms are undertaken in the economy, the debt cycle will perpetuate. Democracies can curb over-borrowing through electoral systems, fiscal rules and budgetary institutions. It is high time that the policymakers pay heed.

The writer is a doctoral candidate at The Bartlett, UCL

Published in The Express Tribune, May 20^th, 2019.

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