The government's financing of deficit from the banking sector will distort the overall demand and supply of loanable funds. Consequently, it will shift the aggregate demand of the loanable fund and thus make a trek in the interest rate as the government covers the lion portion of the demand segment. Therefore, the government's decision to finance the gap between its revenue earnings and expenditures from the banking sector will in the end keep the private sector away from the banking sector.
During a period of expansionary fiscal policy, the government usually spends more than that of its revenue generation. Budget deficit has been a common phenomenon in the history of Bangladesh's economy since her birth. Without much surprise, the new budget of FY 2016-17 announced on June 2, 2016 by finance minister AMA Muhith. The projected budget for the coming fiscal year is Tk 3.406 trillion which is about 15 per cent higher than that of the previous fiscal year. On the other hand, revenue collection is estimated about Tk 2.48 trillion which was about Tk 2.14 trillion in the last fiscal year. Accordingly, the budget deficit of FY 2016-17 is projected at approximately Tk 0.923 trillion which is about 6.58 per cent higher than that of last fiscal year amounting to nearly Tk 0.866 trillion. To meet the gap between the estimated budget and the revenue collection which is termed as budget deficit, the government has planned to increase its dependency on bank loan and therefore it will leave a negative impact on the private sector investment. But the question is how the government finances the consequential budget deficit. The way the government attempts to fill the gap affects the overall economy.
The government of every country has a number of sources to finance the gap. Its overspending has some powerful impacts on the economy. Level and extent of the government budget expenditure is not the concern but the fact is how it is supposed to be funded. If there is a budget deficit, the government has the option to finance it through domestic or foreign sources, or by borrowing from financial markets. Subsequently, the government withdraws money from the domestic financial market to finance its deficit, which trims down national savings and that will shrink the supply of loanable funds. Another way is to search for financing deficit through borrowing from commercial banks. When the government borrows money to meet these shortfalls then there would be an unintended consequence known as crowding-out. Accordingly, this will increase interest rate, which crowds out private investment and reduces economic growth and aggregate supply.
From the aggregate demand side, high government expenditure stimulates high consumption and increase the aggregate demand. When the government as a part of its fiscal policy reduces tax or increase purchases, it will generate a spiral in aggregate demand.
The government's financing of major part of the deficit through the banking sector will squeeze the access of the private sector in the banking system. Without grant, about 38.7 per cent of the deficit will be financed by foreign loan and about 39 per cent through bank loan. Consequently, given the level of demand of loanable fund, the government's borrowing from the banking sector will contribute to interest rate hike, which will ultimately hit the level of investment in the country as the government holds the giant portion of loanable funds.
In general, there exists a positive relationship between budget deficit and interest rate. In other words, when the government takes expansionary fiscal policy, it will boost the government spending and thus lead to budget deficit. When the government takes initiatives to finance the deficit from the banking sector, then that will distort the overall demand and supply of loanable funds. Consequently that will affect the aggregate demand of loanable funds and thus make an impact on interest rate as the government covers the lion portion of the demand segment.
Therefore, the government's decision to finance the gap between its revenues and expenditures from the banking sector will in the end keep the private sector away from the banking sector. In the long run, it will increase the interest rate. The increase in interest rates will make the lucrative investment decision a loss-making one. Subsequent borrowing by the private sector at a higher interest rate will induce them to bet on risky projects which will eventually either pay off or not. So the increase in interest rate ultimately twists the overall industrial sector of a country. Hence the government should make a close eye on the option of borrowing from the banking sector.
The writer is an MBA from University of Dhaka
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