Consequences of frequent borrowing

The government of Pakistan has a plan of borrowing yet another time from commercial banks over next three months. We have also sought the bailout packages from the IMF. This urge stems from the fact that the government is unable to meet its expenditures, which exceed the financial means it has.

Let’s dig into what exactly happens when central bank borrows money from the domestic commercial banks first. Central bank is actually taking money out of banking system when it borrows; controlling liquidity which, on one hand helps in achieving a few policy objectives such as stabilizing financial system and inflation while on the other hand, leading commercial banks to have lesser funds to lend that further shrinks money supply in the system.

This also influences short term interest rates if SBP borrows funds through Repos since the increased demand of funds by the central bank pushes up interest rate in interbank lending market.

Moreover, borrowing from central bank means central bank is competing with the other borrowers in credit market that leads to higher interest rates for other private sector borrowers, thus, making it more difficult for individuals and businesses to access credit and fulfil their funds deficiency to invest. This basically highlights the crowding out of private sector investment by central bank.

Let’s have a look at the other associated fiscal risks as well associated with the central bank borrowing, which is generally utilized to finance government deficits and spending. This intensifies the debt burden of government ultimately risking the debt sustainability of the country.

Moreover, if borrowing is intended towards stabilising currency, central bank may have to see its foreign reserves to pay back the debt, leading to putting more pressure on the already volatile exchange rate. This ends up at nothing else but further currency depreciation and foreign reserves depletion.

In one of the previous articles, I mentioned about the confused policy decisions taken by the government. On one hand, salary hikes by incumbent government may feed inflation, while SBP, on the other, is increasing policy rates to curb it.

I am actually directing towards the confused decision-making ability of the central bank where using all the tools aimlessly all at once makes us doubtful that SBP may compromise its independence as well by conducting monetary policy in a way that ensures its capability of paying back the debts, potentially disregarding its mandate of economic and price stability.

Another risk that we are dreading is the influence of borrowing on market perceptions. When market interprets central bank’s borrowing as a sign of financial mismanagement and stress, it erodes confidence in overall financial system of the country including the central bank.

Building on the discussion above we did on borrowing from commercial banks, let’s now shift our focus to borrowing from external sources as well. On and off, Pakistan possesses sovereign risk. No wonder Moody’s cut sovereign credit rating to Caa3 owing to fragile liquidity.

When a country is facing the prospect of sovereign default, it reaches for bailout packages. One of the recent examples is Sri Lanka that too approached the IMF for a bailout package. While examining the data available, we cannot find any general consensus on the effectiveness of IMF bailout packages.

Proponents declare that such packages are effective for inflation and balance of payment crises. We say that the effectiveness of seeking support from external sources depends on political stability, gravity of debt, performance of macroeconomic indicators etc.

Another adverse effect of borrowing from external sources, including the IMF, is losing credit worthiness, which will make borrowing more cumbersome in future.

For a country like Pakistan where the economy is precarious, borrowing may turn out to be a deadly weapon as we are leaving no stones unturned for the currency to depreciate further especially in a condition where the IMF has laid strict policies for economic contraction, high policy rate and reduced government spending, which will likely to double the hardships of common people.

The impact of accessing credit on inflation levels depends on the response of the country to borrowing. If Pakistan is seeking credit to stabilize its economy, then the borrowing will contribute to stability, else it will only become a curse by exacerbating inflation if used ineffectively.

This is obvious that borrowing from the IMF and domestic banks will further strain our backs from the heavy luggage of debt. This sparks serious concerns about debt sustainability as a large share of budget will be allocated to debt servicing, leading to crowding out spending on infrastructure and other essential services.

In a nutshell, borrowing from the IMF and domestic banks suggests that economy is facing serious liquidity and financial challenges.

Our economy is in dire straits. While acknowledging the fact that borrowing has been a source of relief for many economies but exercising caution is required when borrowing excessively considering the potential pitfalls I discussed above while also being mindful of the fact that prior to the borrowing, our foreign reserves were aiming to hit the bottom, whereas the circular debt is also multiplying. Therefore, finding the right balance is the key to effectively dealing with the situation.

Copyright Business Recorder, 2023