WHY is the State Bank of Pakistan’s direct lending to the government primarily harmful? And why is government borrowing from commercial banks less harmful, although a bit more expensive? These two questions continue to puzzle many experts. Since direct SBP credits to the government will be illegal following the legislation of the recent amendments to the Central Bank Act, the answers to these questions are of paramount importance. Ill-informed discussions lead to misleading conclusions. So let us be informed about the related matters of lending and borrowing.
An interest-based financial system always works through the process of “financial intermediation”. The first step in this process is the mobilization of savings by increasing deposits. The secondary step is to channel these savings to investors through loans. The primary and secondary stages are essential to this process, despite their connotations. Lending cannot take place without deposit mobilization, but without lending, deposit mobilization can still take place. Our banks and non-banking financial institutions function as “financial intermediaries”. They raise deposits cheaply and lend at high rates, meeting their expenses and making a profit from a margin (the difference between lending and deposit rates).
Government borrowing from the State Bank hinders savings.
When we make a deposit, we lend our money to the bank at their deposit rate. In addition to this rate, we are comfortable knowing that our money remains safe with them and that we can recover it at any time. We therefore agree to receive a return lower than that which the banks receive by granting loans. Banks have to charge a higher rate to cover the risk of borrowers defaulting. In this system, people with an account are incentivized to save their excess funds with the lure of safekeeping, meeting withdrawal needs, making payments to others, and earning returns that would not otherwise be possible if they kept the money with them. Whenever lending rates rise, deposit rates also rise, but not necessarily at the same rate. In short, this system promotes savings, while lending funds to investors.
Now imagine that a large entity (the government) starts borrowing from commercial banks. This increases the demand for credit, without increasing deposits (savings of the people). Lending rates will then rise and deposit rates will rise thereafter, giving people with cash additional incentives to increase their deposits. This process of financial intermediation includes built-in mechanisms to promote savings, in addition to making loans accessible. In popular and even expert discussion forums on borrowing or interest rates, the whole debate revolves around “poor borrowers” and rarely around savers. So don’t expect to be enlightened by these discussions. In fact, these threads always have the ability to deceive anyone.
It should now be clear that government borrowing from commercial banks should promote savings. Is this also true when the government borrows from the central bank? Of course not. Why? Because it depresses the interest rate that would otherwise have resulted. Therefore, government borrowing from the SBP constrains savings. This leads to lower amounts of loanable funds in our financial system, which reduces investments. Our financial system becomes forced to lend to the private sector. It is not necessarily high loan rates that limit our investments. These are low savings rates. While there are many reasons for low savings, one of them is government borrowing from the SBP.
Now imagine a situation where the SBP does not extend any direct credit to the government but continues to meet banks’ demand for liquidity through open market operations. Commercial banks, in turn, continue to lend to the government, albeit at slightly higher rates, which partly passes on to depositors, encouraging them to save more. Ill-informed speakers will focus on the aspect of commercial banks taking unfair advantage of the government’s loss of power to borrow directly from the SBP and will continue to rant about matters unrelated to sovereignty, forgetting that no one can withdraw the power to issue government fiat currency.
SBP’s direct credit to the government hampers savings. It can rightly be called an “effective sparing inhibitor”. This is not the only downside of this loan which comes out of nowhere and not anyone’s money saved earlier. Direct credits lead to the printing of additional currencies. Most of us are already familiar with the inflationary impact of government borrowing from the SBP, but its main disease stems from an inhibition of savings. One could object to the reasoning advanced here and say that indirect credits to banks also lead to money printing. Even if all the money borrowed by the government from commercial banks is injected by the SBP, it will not prevent savings. Often, the amount injected is less than the amount borrowed. As savings begin to accumulate, they may decrease further. The most critical point here is that the mobilization of savings should be the main driver in meeting the borrowing needs of economic agents, including the government. Direct central bank credits should not be the primary drivers, but should still be made available to banks through open market operations or other refinancing windows as additional mechanisms.
The strong negative association between direct SBP loans to government and national savings would be extremely hard to miss by quantitative researchers of time series data, some of whom fail to find a positive association between these harmful loans and inflation. The prevailing media obfuscation of political, economic and financial issues, under the cover of an alleged loss of sovereignty, is nothing but a fear stemming from dying minds. True sovereignty comes from our own national efforts, our own savings and our own investments, as opposed to borrowed efforts, borrowed savings and borrowed investments. National sovereignty should never be confused with the ability to borrow from one’s own central bank, or the fiat to issue unlimited currency. I am happy to see that many young researchers, economists and analysts, and some older ones, are free from this confusion, which bodes well for our future.
The author is a former Deputy Governor of the State Bank of Pakistan.
Posted in Dawn, February 22, 2022