Govt borrowing keeps pressure on private sector credit

KARACHI: High borrowing from the government has kept private sector credit constrained and resulted in interest rates remaining elevated, according to economists at leading investment banks.

“The government has consumed most of the (financial) system’s credit at the expense of the private sector,” says Hamza A Marath, analyst at KASB Securities, in a research report released to clients on Wednesday.

During the current fiscal year ending June 30, the government has accounted for fully 80 per cent of all new borrowing, with the private sector restricted to just Rs76 billion out of the Rs392 billion that has been disbursed thus far. Banks have bought Rs229 billion in treasury bonds (government-issued debt) so far this year, 44 per cent higher than the same period last year.

It is a paradox that the government faces: in order to reduce borrowing from the banks, it needs to stimulate economic growth in the private sector so that it can generate higher tax revenues. Yet until that happens, it must keep borrowing from banks, which in turn means that the private sector cannot get access to the financing that is necessary for it to grow.

Part of the problem lies in government control of commodity financing. Since the government determines the prices of most major commodities, it also has to finance a substantial portion of the commodity purchases in the country.

For example, wheat is purchased centrally by the government at what is called the “support price” from farmers and then sold, usually at a lower price, to wholesalers from whom it eventually makes it to consumers. The government bears the loss as the cost of its subsidy on food.

Only the net cost of the subsidy appears on the government’s budget. Yet in order to buy the wheat in the first place, it needs to access a much larger amount of bank financing which it pays back mostly with the proceeds from its sales of the wheat. This results in further constraints on liquidity in the banking system, especially if the government is delayed in paying the amount it owes back.

“Funds stuck in commodity financing last year damaged the credit cycle and kept short-term rates high and the yield curve flat,” said Muzzammil Aslam, economist at JS Global Capital, an investment bank, in a research note issued to clients on Thursday.

Analysts were pessimistic about the prospects of the government resolving the debt issue on its own. Both Marath and Aslam concurred that the government would need to get a substantial amount of external assistance - to the tune of some $2.5 billion - in order to be able to lower the borrowing pressure on the domestic financial system.

Marath pointed out the negative effects of government borrowing from the State Bank of Pakistan, the central bank, which is in violation of the terms of the agreement between the government and the IMF. Until the government is able to replace the monetisation of the fiscal deficit with external inflows, says Marath, interest rates will remain high and the currency will continue to depreciate.

Published in The Express Tribune, June 25^th, 2010.