Emancipating the Banking System and Developing Markets for Government Debt

Maxwell Fry

• Publisher: Routledge
• Year: 1997
• Print ISBN: 9780415156417
• eBook ISBN: 9781134730766
• Topic: Business
• Subtopic: Business General
• Index: Business

Monetary policy in developing countries is largely based on a system introduced in the 1960s. Emancipating the Banking System and Developing Markets for Government Debt illustrates how this outdated system has led to financial repression and suggests some alternatives. Maxwell Fry is one of the leading experts in this area. His book will provide a

Part I: Introduction and Debt-Deficit Dynamics

Chapter 1: Why Develop Markets for Government Debt? Overview and Summary

1.1 Introduction

FOR THE BANK OF ENGLAND’S 1995 Central Bank Governors’ Symposium, Charles Goodhart, Alvaro Almeida and I (Fry, Goodhart and Almeida 1996) surveyed the objectives, activities and independence of central banks in developing countries. One striking finding was that developing countries suffered considerably higher inflation than the OECD countries. While the proximate cause was more rapid money growth, we suggested that a more fundamental cause was that developing country governments resorted to their central banks much more for deficit financing.

For the Bank of England’s 1996 Central Bank Governors’ Symposium, therefore, we decided to investigate in more detail the four major ways that governments can finance their deficits:¹

• Monetising the deficit by borrowing at zero cost from the central bank.
• Borrowing at below-market interest rates by thrusting debt down the throats of captive buyers, primarily commercial banks.
• Borrowing abroad in foreign currency.
• Borrowing at market interest rates from voluntary domestic private sector lenders.

The typical OECD country finances about 50 percent of its deficit from voluntary domestic sources, while the typical developing country finances only about 8 percent of its deficit from this source.

Why this matters is that, for any given persistent government deficit, greater use of the first three sources is associated with higher inflation rates, lower saving ratios and lower rates of economic growth. Government recourse to the central bank inevitably leads to inflation. Indeed, such inflationary finance can be considered a source of tax revenue in that inflation imposes a tax on money holders. Throughout this book, the terms monetising the government deficit, government recourse to the central bank, inflationary finance and the inflation tax are treated as synonymous and are used interchangeably.

Financial repression, the second way of financing the government deficit, is also tax-like in that it involves forcing captive buyers to hold government debt at interest rates below market yields. By reducing its interest costs, this method reduces the government’s recorded deficit. Foreign borrowing, which for all developing countries implies borrowing and repaying foreign rather than domestic currency, constitutes the third method of financing a deficit. Part II of this book demonstrates that excessive reliance on these three ways of financing government deficits impedes economic development.

All this conflicts with the views of Robert Barro (1974, 1989) and James Buchanan (1976) on Ricardian equivalence. Barro (1989, 39) states that the Ricardian equivalence theorem, proposed only to be dismissed by David Ricardo (1817, 336–338) himself, holds that

the substitution of a budget deficit for current taxes (or any other rearrangement of the timing of taxes) has no impact on the aggregate demand for goods. In this sense, budget deficits and taxation have equivalent effects on the economy—hence the term “Ricardian equivalence theorem.” To put the equivalence result another way, a decrease in the government’s saving (that is, a current budget deficit) leads to an offsetting increase in desired private saving, and hence to no change in desired national saving.

It also follows that Ricardian equivalence implies that the method of financing government deficits has no impact on the macroeconomy.

While Barro (1989, 52) interprets the empirical evidence to provide general support for the Ricardian equivalence theorem, the evidence cited is drawn largely from the United States where the assumptions of the theorem are perhaps most likely to hold. As Pierre-Richard Agénor and Peter Montiel (1996, 127) suggest, “In developing countries where financial systems are underdeveloped, capital markets are highly distorted or subject to financial repression, and private agents are subject to considerable uncertainty regarding the incidence of taxes, many of the considerations necessary for debt neutrality to hold are unlikely to be valid.” Hence, the assumptions on which Ricardian equivalence rests (Barro 1989, 39–48) are almost bound to be violated sufficiently to negate the theorem in these countries. Indeed, Agénor and Montiel (1996, 127) conclude: “the empirical evidence [from developing countries] has indeed failed to provide much support for the Ricardian equivalence proposition.” The empirical evidence presented in Part II of this book confirms the Agénor-Montiel position.

Voluntary private sector purchase of government debt is the fourth and final way of financing government deficits. Although government deficits are generally not conducive to economic growth, this way of financing them appears to reduce the damaging effects of any given deficit. Both economic and social efficiencies are improved not only though the use of the market-pricing mechanism but also through the transparent presentation of the costs of government expenditures. When the costs of borrowing are borne openly by the public and not hidden through the use of captive buyers, the true resource costs of government spending can be properly incorporated into both economic and social choices. Even politicians’ choices can change when they are properly informed.

Hence, a move towards developing voluntary domestic markets for government debt appears to offer benefits in terms of lower inflation and higher saving and growth. High growth, in turn, alleviates the deficit. There is, therefore, some hint of a virtuous circle in which greater use of voluntary domestic markets lowers inflation and raises growth, both of which reduce the government’s deficit. In general, developing countries make too little use of voluntary private sector lenders. Hence, Part III of this book concentrates on some of the practical issues involved in developing voluntary domestic markets for government debt.

While government deficits have various negative effects on an economy, this book is concerned with the differential impacts of financing a given deficit in alternative ways. A primary question here, therefore, is what are the effects on economic growth, saving and inflation of financing a deficit through central bank credit, reserve and liquid asset ratio requirements imposed on commercial banks, interest rate ceilings and captive buyers, loans from abroad and voluntary lending by the private sector?

One point that must be stressed at the outset is that the impact of borrowing from abroad or from voluntary domestic lenders will depend on the amount previously borrowed. In other words, the level of debt accumulated from past borrowing affects the impact of additional borrowing. Just as a household finds it increasingly difficult and expensive to borrow as its debt/equity ratio rises, so too does a government because, at some point, voluntary lenders may perceive further debt accumulation to be unsustainable. While a household may declare bankruptcy, a government can renege by resorting to inflation to erode the real value of its domestic debt and by defaulting on its foreign debt obligations.

The next chapter sets the stage by discussing the government’s intertemporal budget constraint and debt-deficit dynamics. These principles are illustrated with data drawn from 111 countries for which data on deficits, economic growth and inflation are available. However, only for a smaller group of these countries are data on real interest rates and debt (both domestic and foreign) available.

Part II of this study examines the interactive effects of deficits, debts and the way deficits are financed in a large sample of developing countries. Chapter 3 examines government recourse to its central bank and the effects of the inflation tax. Chapter 4 turns to financial repression as a source of government revenue, again concentrating on its effects. Chapter 5 covers foreign borrowing and the effects of foreign debt accumulation. Part II of this book, summarised in the next section of this chapter, provides evidence that inflationary finance, financial repression and government borrowing from abroad are associated with higher inflation, lower saving ratios and lower growth rates.

Part III, summarised in sections 3 and 4 of this chapter, focuses on some of the practical issues involved in establishing a functional market for government debt in countries that have not so far developed one. Developing a voluntary market for government debt involves a fundamental change in the approach to financing the government deficit. Typically, the change occurs from a system in which most institutional interest rates are fixed and the government is financed at favourable fixed rates by unwilling captive buyers of its debt. Privileged access and captive buyers are now eschewed in favour of a level playing-field philosophy. Government now competes on the same terms and conditions as private agents for available saving. The economic principle behind the change is that a level playing field maximises the efficiency with which scarce resources are allocated throughout the economy.

Table 1.1. Government Deficits as Percent of GDP, 1979–1993

In order to obtain a better understanding of this dramatic and possibly traumatic change to voluntary market financing, it seemed sensible to choose a relatively small number of case studies. Hence, the Bank of England asked the eight central banks in Ghana, India, Jamaica, Malaysia, Mexico, New Zealand, Sri Lanka and Zimbabwe, countries that had recently developed voluntary domestic markets for government debt, to answer some questions about the process of change; all eight central banks responded.² Much of the material in Part III is based on these questionnaire responses.

1.2 The Case Against Inflationary Finance, Financial Repression and Government Borrowing from Abroad

1.2.1 Deficits, Inflation and Growth

For my quantitative analysis, I took a sample of 111 countries consisting of 21 richer OECD countries and 90 developing countries. Somewhat surprisingly, Table 1.1 shows that average OECD and developing country government deficits expressed as percentages of gross domestic product (GDP) have been virtually identical over the period 1979–1993. However, dispersion has been much greater in the developing countries.

The first empirical observation presented in Chapter 2 concerns the relationships between government deficits, inflation, growth rates and saving ratios. I find a highly significant positive relationship between inflation and government deficit/GDP ratios. Conversely, I find signif icant negative relationships between ratios of national saving to gross national product (GNP) and deficits as well as between economic growth and deficits in these 111 countries.

1.2.2 The Central Bank and Inflationary Finance

While deficits are bad, they are worse when financed by the central bank. The typical developing country financed about 30 percent of its deficit from its central bank since 1979. Excessive government borrowing from the central bank inevitably results in faster expansion in reserve money. And by causing higher inflation, rapid growth in reserve money reduces economic growth.

One way of examining the differential impact of financing a deficit from the central bank is to specify a relationship in which the impact of the deficit is itself dependent on the form of its financing. Doing this in Chapter 3, I find that, for any given deficit, inflation is higher the greater the proportion that is financed by the central bank. Conversely, saving ratios and growth rates are lower the greater the proportion of the deficit that is financed by the central bank. In conclusion, inflationary finance or the inflation tax is not a good way of financing government deficits.

1.2.3 Financial Repression

Governments in many countries force captive buyers, mainly commercial banks, to hold their debt at below-market yields. Indirectly, banks also lend at zero interest to governments through reserve requirements. Directly, banks lend at below-market rates through liquid asset ratio requirements or other balance sheet constraints.

While Chapter 4 considers several indicators of financial repression, I use the ratio of the commercial banks’ reserves to their deposits as an indicator of the captive-buyer source of government finance for illustrative purposes in this introductory summary. First, higher government deficits are associated with significantly higher reserve/deposit ratios; we detected this in Fry, Goodhart and Almeida (1996, 5). Second, inflation and reserve/ deposit ratios are positively and significantly associated, again as we found in Fry, Goodhart and Almeida (1996, 5). This positive relationship still holds after controlling for the deficit. Finally, higher reserve/deposit ratios are associated with significantly lower saving ratios and lower growth rates.

My interpretation of this negative relationship between growth and the reserve/deposit ratio is that the more the government takes from the financial system at below-market rates, the lower is the return to depositors and so the less willing is the public to hold deposits. This produces a doubly destructive effect on the ability of the banking system to lend for productive investment. First, its resource base in the form of dep...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Foreword
• Acknowledgements
• Part I: Introduction and Debt-Deficit Dynamics
• Part II: Captive and Foreign Markets
• Part III: Developing Voluntary Domestic Markets
• Appendix 1: Central Bank Case Study Questionnaire
• Appendix 2: Government Deficits as Percent of GDP
• Appendix 3: Government Domestic Debt as Percent of GDP
• Appendix 4: Government Foreign Debt as Percent of GDP
• Appendix 5: Government Debt as Percent of GDP
• Appendix 6: Government and Government-Guaranteed Foreign Debt as Percent of GDP
• Appendix 7: Continuously Compounded Rates of Economic Growth
• Appendix 8: Real Interest Rates
• Appendix 9: Continuously Compounded CPI Inflation Rates
• Appendix 10: Change in Reserve Money as Percent of GDP
• Appendix 11: Reserve Money as Percent of Broad Money (M2)
• Appendix 12: Bank Reserves as Percent of Bank Deposits
• Appendix 13: Growth Rates in Eight Case Study Countries
• Appendix 14: Inflation Rates in Eight Case Study Countries
• Appendix 15: Government Deficits as Percent of GDP in Eight Case Study Countries
• Appendix 16: Government Domestic Debt as Percent of GDP in Eight Case Study Countries
• Appendix 17: Government Foreign Debt as Percent of GDP in Eight Case Study Countries
• Appendix 18: Government Debt as Percent of GDP in Eight Case Study Countries
• Appendix 19: Government and Government-Guaranteed Foreign Debt as Percent of GDP in Eight Case Study Countries
• Appendix 20: Change in Reserve Money as Percent of GDP in Eight Case Study Countries
• Appendix 21: Net Domestic Credit to Government as Percent of Aggregate Domestic Credit in Eight Case Study Countries
• Appendix 22: Reserve Money as Percent of Broad Money (M2) in Eight Case Study Countries
• Appendix 23: Bank Reserves as Percent of Bank Deposits in Eight Case Study Countries
• Appendix 24: Real Interest Rates in Eight Case Study Countries
• Appendix 25: Central Bank Governors’ Symposium Participants
• Bibliography