The buzz of 'crowding out effect' of government borrowing is back in town. For a number of reasons, implementation of annual development programme (ADP) and collection of revenue during the first half of the current fiscal year not only has fallen short of the target, but also failed to match the performance of the same period of the last fiscal year. With the recent improvement of the overall political environment, the government is expected to take special measures to accelerate the implementation of the ADP. Such acceleration would compel the government to borrow from the domestic sources as collected revenue would not be adequate. Anticipated high borrowing of the government from domestic sources brings back the talk about crowding out effect.
In simple words, crowding out effect refers to an economic situation where government borrowing drives away private investment by limiting the available loans for the private sector. While crowding out effect of government borrowing is a textbook conjecture, whether this really takes place or not is an empirical question. A lot has been said on this issue without really checking the available empirics.
The reason for crowding out effect of government borrowing is simple: when a fixed amount of resources are to be shared by two candidates, if one takes more the other is forced to accept less. However, the working of an economy and the interrelationship among its different branches is not that simple. Public investment increases the profitability of private investment and hence can potentially increase it. In a developing country like Bangladesh public investment is financed partly by government borrowing. Thus, whether government borrowing crowds out private investment or not should be evaluated in conjunction with its indirect effects.
The debate whether public borrowing helps or hinders economic growth by increasing private investment has its origin in, what the economists call, the Classical versus Keynesian dichotomy. The classical doctrine assumes that an economy always operates at its full potential exhausting all its resources. Therefore, any use of resources by government eventually reduces the resources available to the private sector. On the other hand, the Keynesian doctrine does not assume full utilisation of resources; so increased government claim on them does not necessarily mean deprivation of the private sector.
The Keynesian doctrine also argues that public investment, even when financed by government borrowing, can crowd in more private investment by reducing the cost of production and increasing productivity. This school of thought assumes availability of unutilised resources as the private sector fail to invest up to the optimum level due to lack of publicly provided utilities and infrastructure. As a result, any increase of publicly provided utilities and infrastructure, even if they are financed by government borrowing, would increase private investment.
Putting these theoretical conjectures aside, let us see what do the available data say? The available data indicate no negative relationship between government borrowing and private investment during the last decade or so to argue that the former crowds out the latter. The estimated correlation between these two variables during FY12-FY13 is about 0.94. Many economists argue that the impacts of government borrowing kick in with a lag effect. Taking this assertion into cognizance, the correlation between government borrowing of the last year and the private investment in the current year is estimated. This estimate turns out to be 0.91, reiterating the positive relationship between them.
However, there is a difference between correlation and causality. Let us consider an example. Suppose, two boats are moving in the same direction with the current in a river and maintaining a distance. The estimated correlation between their speed would be positive. But this positive correlation does not mean speed of one boat causes the speed of the other. Therefore, the relationship is not causal. But the positive correlation would suffice that speed of one boat does not hinder the speed of another. Therefore, based on the positive correlation between government borrowing and private investment suffices that the former does not hinder the latter.
The methodologically sound evaluation of whether government borrowing causes increase of private investment requires use of sophisticated econometric technique. This has been done by the Bangladesh Bank in 2006, and very recently by the Bangladesh Institute of Development Studies (BIDS). Results of both of these exercises confirm that government borrowing has been crowding in and not crowding out private investment in Bangladesh. Yet many experts make a big fuss about crowding out effect of government borrowing.
Government borrowing had become a central topic of policy discourse in the past in Bangladesh. The undue emphasis on crowding out effect of government borrowing, which is not supported by available data and research, can hinder our economic development in different ways.
It has been highlighted in many economic analyses that infrastructural deficits are one of the main roadblocks to private investment in Bangladesh. Infrastructure, possessing the characteristics of public goods, has to be provided by government as market fails to supply them. Because of lack of adequate revenue, government's ability to provide them is very limited. Due to unnecessary fear of crowding out effect of government borrowing, the government may shy away from financing infrastructure through domestic borrowing. As a result, the economy cannot get rid of the shackle of inadequate capacity, and the wheel of growth cannot accelerate.
There are instances when the government was contemplating to borrow at commercial rates from international financial market by issuing sovereign bond due to harsh criticism against domestic borrowing by many experts. The real cost of borrowing of foreign borrowing has two components, (i) the agreed interest rate and (ii) appreciation of foreign currency. The second component can be very high for Bangladesh at times, although not at the moment as value of dollar against Taka has been maintained stable for quite some time. But there is no guarantee that the current situation will always prevail. In addition to domestic factors, any international shock can also trigger a change of the current situation.
The main reason to resort to the costly commercial borrowing from the international market is the alleged crowding out effect of government borrowing from domestic sources. However, the available data and research imply that there is no ground for such a policy shift as long as cost of borrowing from domestic sources is less than the cost of commercial borrowing from international financial market.
Abul Basher, PhD is Researcher at the Bangladesh Institute of Development Studies (BIDS), former economist, World Bank, and former faculty, Willamette University, USA. cccg67@yahoo.com
Government borrowing and private investment
Abul Basher | Published: February 27, 2014 00:00:00 | Updated: November 30, 2025 06:01:00
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