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Stop ‘subsidising’ banks and others


There are several indices that are used across the free world that rank individual countries on measures of economic and social development that these countries have taken to improve the quality of life for their ordinary citizens. Unfortunately, Pakistan ranks low or extremely low on most attributes. Many countries that were way behind us on these indices have now overtaken us and achieved remarkably better rankings, thus relegating us lower down on the ranking tables.

The argument for this sad performance invariably focuses on highlighting that we do not invest enough in the social sector improvement. There is no structured thinking to alleviate the situation and for decades the sole reason for this extremely low investment, trumpeted is that we do not collect enough taxes, which in turn is attributed to the fact that our economy is not documented, etc.

The basic premise is overlooked that, it is primarily owing to our poor investments and showing on the social and economic development measures, we are not productive enough to be competitive and generate exports and earn enough of the foreign exchange even to pay for our imports, let alone creating essential surpluses for investments.

However, Pakistan is giving away for free something between Rs 2 to 4 trillion a year in subsidies to banks and other similar institutions. This money could be reallocated and invested in the social and economic development of Pakistan that will bring long-term gains to Pakistan.

A quick look at how finances are raised by the federal government to cover the disbursements it needs to make, will facilitate the understanding of the argument. The primary resource of income of the government is taxation, and it has also some non-tax revenues; any shortfall versus the intended disbursements is raised through borrowing from banks and investors in the market, as well as some money is acquired from the foreign lenders.

There is always a substantive discussion on the inflationary impact of new money injected into the economy by government after borrowing from banks, the other side of the coin is less commented upon. When the government collects taxes, it also reduces the money supply in the system. If it were to collect more taxes than the amount it spends, it would end up with a budget surplus; simultaneously this collection would pull the equivalent of the surplus out of circulation. Historically, the already wealthy have been getting rich and masses poor on this approach to financial and economic management.

With the contemporary monetary system as it exists, money supply can grow only through creation of new debt by the fractional reserve banking system. While net foreign exchange inflows do create money, but there is no likelihood of a trade surplus even after accounting for remittances in the foreseeable future, these inflows too would be based on aid or debt taken from abroad.

In order to maintain money supply commensurate with the growth in the economy, banks would need to provide that amount through loans to the government and the private sector.

The irony is that the banks consider this lending to the government to be default-risk-free, while the government, if a demand for repayment were to come, can only fulfil its obligation either by applying a draconian tax on the public and stifling the economy or by borrowing more from the same banks or abroad or simply print money; an act which in itself will have severe adverse consequences.

The way to look at this debt growing into perpetuity is to accept that it will never be paid back. While banks may replace one private sector borrower with another, the government will grow its borrowing into perpetuity. Keeping that in mind, it does not make sense for the issuer of the fiat currency to have ever-growing debt, with an ever-growing amount of interest charge at the taxpayers’ cost.

This ever-growing domestic debt of the government is a figment of our mental construct as it will never be paid back. If instead of borrowing, the government were to run a deficit year after year, it would be adding that amount to the money supply, which is expected to be inflationary. The construct is that if the government borrows this money, it comes out of the existing money supply or through money created by commercial banks, under a watchful eye of the central bank, which will ensure that we do not end up with excessive money creation and supply.

The idea is not to do away with an independent institution like the central bank, which is empowered to regulate the aggregate money creation between the government and the commercial banks; nor to create money recklessly.

The way forward is that government would go through the annual budget making exercise but will not borrow if there is a gap between revenue and disbursements (deficit). Once the budget, including the amount of deficit, is approved by the parliament, the central bank would come into play, create new money, and credit the government’s account with the amount to cover the deficit, and simultaneously proceed to regulate the aggregate money supply by using the Cash Reserve Ratio (CRR) as its tool for regulating the private sector debt that the banks may create through the fractional reserve system.

Assuming that the government were to repay all domestic debt owed to the banks by creating new money, looking at the present situation of the bank balance sheets, we would probably need the CRR to go up perhaps ten-folds from present level so as to leave the quantum of aggregate money supply and lending to the private sector unchanged. This would leave the free-market-based banks without the subsidy currently at around Rs 2 trillion a year.

With the revised CRR and high proportion of non-earning deposits with the central bank, the commercial banks would wish to pay significantly lower interest rates on deposits they accept. On the other hand, even after earning a healthy spread, the rate of interest charged to private sector borrowers could come down significantly.

In addition to the government bonds currently held by banks, there is a significant amount held by others, as well as loans towards budgetary support by foreign lenders, which can, and should be eliminated as well. The Government has budgeted Rs 2 trillion towards interest payment to banks and another Rs 1.5 trillion to other domestic lenders (read subsidy to the wealthy) and half a trillion on foreign debt. Thus, the government could save around Rs 2 to 4 trillion a year.

Irrespective of positive or negative real rates of interest, the members of public tend to deposit significant amounts of their surpluses with banks – large amounts in non-interest-bearing accounts or lower than inflation rate earning accounts, especially when seen net of tax. However, we have observed some savers moving towards the other avenues offered by the capital market when they perceive the interest rates to be low in nominal terms on bank deposits even if these rates are actually above inflation. The non-bank investors in government bonds, in absence of such bonds, would also need to look towards the capital market. This could also give a significant fillip to the private sector capital raising.

It is time to break out of our self-imposed mental prison. What we must recognise is that whether it is government created money, or bank created money, it is the aggregate money supply that needs to be regulated, rather than a singular focus on government deficits. The government can, and should stop giving away Rs 2 to 4 trillion a year (and growing), which are effectively subsidies, to banks and others, and instead invest this money in social and economic development.