The State Bank of Pakistan has been grappling with a difficult trade-off in the past several years. With an insatiable government appetite for credit, how does the central bank contain the quantum of inflationary finance and yet ensure the private sector is able to secure adequate credit from commercial banks? This is all the more important as the domestic banking system is the last avenue for government borrowing, and Pakistan has been in this position for the past couple of years.
The policy outcome so far is not heartening: (1) despite a 450 bps cut in the Discount Rate over the past 20 months, net private sector lending remains anaemic; (2) spreads in the banking system remain high; (3) SBP financing of the fiscal deficit has increased sharply since Q3-FY13; and (4) the balance sheets of commercial banks continue to skew in favour of government paper.
Choudhary, Pasha, et., al. [2013] have customised a general equilibrium framework (using a Dynamic Stochastic General Equilibrium, DSGE model) that tries to capture the unique set of circumstances that currently exist in Pakistan.
The main features they sought to incorporate in their model are: 1. A dominant borrower (government) whose appetite for credit is growing as it has limited avenues for raising taxes, which means it would become interest rate insensitive;
2. A central bank that is constrained in how much credit (money creation) it can provide to the government;
3. The fact that countries with under-developed financial systems, give the government few alternatives but to borrow from domestic banks (and the central bank); and
4. How endogenously determined banking spreads would behave in such a system.
Some of these features were empirically tested on various developed and developing countries, using the IMF as the primary source of data. The Financial Development Rankings developed by the World Economic Forum [2012] were also used.
Figure S1 shows commercial banks increasingly lending to the government (the Dominant Borrower), with the public share (the fraction of government borrowing in total commercial bank lending) in Pakistan rising consistently since 2008.
The correlation between interest rates spreads and the level of financial development is shown in Figure S2. This positive correlation is to be expected, as a more developed financial system (a lower ranking) has more players than commercial banks, which creates a degree of financial competition that keeps spreads low.
In trying to determine whether there is a link between the share of government borrowing and interest rate spreads, Choudhary et. al., computed the correlation between the public share and banking spreads (Figure S3). The first thing to realise is there is no causality or universal correlation between the share of government borrowing and spreads: most developed countries show no correlation, while most developing countries post a positive relationship. The authors interpret this as implying that in developed countries, the efficiency of financial markets is such that spreads are low, and even if their respective governments are large borrowers, they are able to secure financing from other sources without putting upward pressure on domestic banking spreads.
For developing countries, on the other hand, if the government is a big borrower, and the options for alternate financing are severely limited, not only is the correlation between the public share and spreads positive, but the positive slope (Figure S3) suggests correlation becomes stronger when the financial system is under-developed. In simple terms, the association of a Dominant Borrower and high spreads, is stronger when the financial system is relatively under-developed (this assumes no policy intervention).
Taking this a step further, as interest rate spreads increase (with an increasingly dominant borrower), not only is the government crowding-out the private sector, but by pulling growth below its potential, it increases credit risk in private sector lending, which incentivizes commercial banks to place even more credit with the government, creating a vicious spiral. This crowding-out has implications for unemployment; tax collection; documentation; policy effectiveness; private investment; per-capita GDP; and many social welfare indicators.
Figure S4 reveals another insightful dimension of their analysis. The negative slope basically means that in countries with a Dominant Borrower and high banking spreads, the adverse counter-cyclical impact on economic activity is more severe. In other words, large banking spreads are more damaging - in terms of keeping GDP growth well below the country's potential - in those countries with an underdeveloped financing system and a Dominant Borrower.
CONCLUSION As in all academic research that seeks cross-country validation, there are many country-specific details that have not been addressed. Furthermore, it is very important to stress that this analysis highlights correlation and not causation. One must also realise that interest rate spreads are determined by a host of factors; not just the demand for credit from an interest rate insensitive government.
However, the analysis does provide a powerful counterpoint to orthodox economic thinking. It shows that customised analysis is better able to explain why traditional tools of economic management have failed - not just in Pakistan, but also in the OECD. It flags the need to be cautious when dealing with a large borrower, who is increasingly dominating the balance sheet of commercial banks. It also forces us to revisit the twin-mandate of most central banks (price stability and sustainable growth), which could explain why the US Fed; The Bank of England; and the Bank of Japan, have undertaken such an abrupt change in strategy to focus on growth and employment, even at the cost of higher inflation.
Looking specifically at Pakistan, the paper suggests that in an environment where private banks face a Dominant Borrower (who is increasingly attractive), the situation will require some policy intervention to avoid an adverse outcome. This is not just for the overall health of the country's economy, but also to ensure the balance sheets of commercial banks are healthy enough to withstand unanticipated shocks.-Excerpts from SBP report