LENDING to government by central banks is as old as the evolution of central banks itself. The Bank of England started its journey in 1694 to work as government banker and debt manager to the king. Over time this traditional function of central banks has changed radically.

Currently, in most of the economically advanced countries the central banks do not finance government expenditure. In developing states, there are instances of limiting government borrowing to an agreed level. However, in a number of countries including Pakistan, central banks are bound by law to work as government’s debt manager and provide bank credit for meeting its needs.

The governments in developed economies largely float local/sovereign bonds for public subscription to meet their expenditures.

Up to 1990s, the SBP worked as debt manager of the government. Commercial banks used to invest in T-bills just to meet statutory liquidity requirement (SLR) of the SBP because of subsidised rate of 6pc on such placements as against the conventional market rate of 14pc on advances. The government also used to borrow directly from the SBP through T-bills at 0.5pc on an ad hoc basis.

Under this regime, banks found it much profitable to finance private sector due to better rates of return leaving the SBP as the wholesale outlet of government borrowing. The profitability of a banking company was directly linked with its deployment of funds in loans and advances to different sectors of the economy. Investment of banks in permanent debt was almost negligible as they did not want to lock their funds for longer periods.

Recently, the government retired the SBP loans by borrowing from commercial banks. And this is being termed as fiscal consolidation both by the government and the IMF

The financial sector reforms of 1990s drastically changed the complexion of debt management by introducing the concept of market treasury bills (MTBs) under an open auction where rate of return on investment in government securities was aligned with the market. The higher cost of borrowing (at market rates) was expected to reduce governments’ appetite for more funds from the banking system.

This was also the main theme behind autonomy of the SBP in 1997. However, things went in the opposite direction. Commercial banks deemed it more lucrative and hassle-free to invest in government securities both under floating and permanent debt, ignoring the private sector. The successive governments, particularly since 2008, have substantially borrowed from the SBP on market rates knowing that ultimately all profits of the SBP are to be transferred to the national exchequer.

In a sense, the government borrowing from the SBP is a zero-sum game because interest paid initially by the government to the SBP is returned back in shape of profit. For the year ended June 30, 2015, out of a total profit of Rs401bn, the SBP passed on Rs397bn to the federal government as profit – much more than the amount paid by government to the SBP as interest on loans. The real high cost of the government borrowing is from commercial banks.

Currently, the domestic debt management is in a highly critical phase. The government’s needs for money are on the rise and the high-cost debt from commercial banks is piling up as the SBP is constantly raising new debts entirely from banks to retire their short- and long-term loans borrowed earlier.

Under the IMF agreement, the government cannot borrow from the SBP. Recently, the government retired the SBP loans by borrowing from the commercial banks.And this is being termed as fiscal consolidation both by the government and the IMF.

Commercial banks would never revert back to private sector credit as long as they have free access to invest both in short- and long-term debt at market rates. Under these circumstances, the second doze of autonomy given to the SBP in November 2015 is not likely to bring the desired outcome.

This critical situation calls for revisiting the domestic debt management strategies: firstly, to reduce dependence of the government on commercial bank debt, and secondly, to explore ways and means to increase participation of general public in the permanent and unfunded debt.

Commercial banks may be allowed to invest in T-bills equivalent to twice their SLR level both under the floating and permanent debt. Some segments of society are awash with liquidity which could be mobilised by offering bonds and certificates of 5-10 year maturity at slightly higher rates.

This would not work as disincentive for commercial banks as they mainly thrive on low cost current and saving accounts. Flotation of sukuk in local currency is another big opportunity. All such options may be considered by the much autonomous Monetary Policy Committee.

The writer is President of Institute of Banking and Business Learning.

munir1951@outlook.com

Published in Dawn, Business & Finance weekly, February 8th, 2016