Why Too Much Public Sector Lending can be Harmful

International Monetary Fund. External Relations Dept.
Published Date:
June 2006
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In recent years, governments in many middle-income countries have reduced their external debt and have come to rely increasingly on domestic financing. This is a welcome development because domestic debt does not carry the sustainability risks associated with debt held in foreign currencies. But an associated development may be less welcome: in many of these countries, government debt has absorbed a fast-growing share of the credit available to the economy. A new IMF Working Paper explores the potential adverse implications of this trend for financial sector development.

Just how big is public sector credit? The study analyzes 73 middle-income countries, most of which have a financial sector but continue to face challenges in developing the sector further. It finds that the public sector soaks up more than 20 percent of total bank credit in more than half of these countries and more than 50 percent in 13 of them. Moreover, the share of public sector credit has been rising rapidly in many of these countries in recent years (see chart).

While public sector credit remains much smaller than external debt, it has been edging up slowly since the beginning of the 1990s, while external indebtedness has declined markedly. Combined with crises-induced shrinkages of some banking sectors, this trend has contributed to a dramatic rise in the average ratio of public sector credit to total credit since the mid-1990s, from 18 percent to more than 27 percent in 2003. There appears to be a broad trend to replace external with domestic borrowing: among the countries that reduced their external debt as a share of GDP between 1990 and 2003, about four-fifths increased their domestic public sector borrowing as a share of GDP. Although this trend could be due to financial deepening, about two-thirds of the countries also increased their shares of public sector credit in total bank credit.

Potential for harm

This trend in public sector borrowing is worrisome because government borrowing that squeezes the private sector out of the credit market can hurt economic growth. In addition, banks that lend mainly to the public sector might become lazy: sitting on large, relatively secure, and easy-to-maintain government debt may make them profitable but inefficient. And, in the long run, laziness could hold back the progress of financial deepening because lazy banks can be expected to have little drive to develop the banking market. Low efficiency is also likely to widen the interest rate margin between lenders and borrowers and thus increase the deadweight loss created by financial intermediation. Although there is no doubt that some government debt oils the wheels of financial development, beyond a certain level, the oil might turn into sand.

Is the lazy bank concern more than hypothetical? The study says yes. Its findings suggest that banks that are invested mainly in government debt tend to be more profitable and less efficient than others and that when the public sector absorbs higher shares of bank credit, financial deepening in developing countries slows. This syndrome occurs because the return on a loan is determined by the lending rate, the refinancing rate, administrative costs, taxes, the expected loss, and the cost of capital (determined by the risk of unexpected loss).

Loans to private borrowers tend to be disadvantageous in all these respects: they will be more costly to refinance if they are more risky, and depositors require a risk premium from banks that have riskier loan portfolios; lacking the economies of scale that benefit large public sector loans, they will be more expensive to administer; the interest on them may be subject to higher taxes than that on government debt; and the expected losses and cost of capital associated with them will almost certainly be higher than on loans to the government (unless the government is in very dire financial straits). To make private lending just as profitable as lending to the government, a bank will need to charge its private borrowers a substantial interest rate premium.

Public sector debt and credit

When governments borrow more domestically, they may end up squeezing the private sector out of the credit market.

Note: Average for 42 middle-income countries with sufficiently long data series.

Data: IMF, International Financial Statistics and World Economic Outlook, and author’s calculations.

In practice, market distortions often prevent banks from obtaining this premium. One such distortion is that banks themselves are loath to lend to borrowers who are willing to pay interest rates above a certain level because they suspect that such borrowers are involved in very risky projects. Other distortions are interest rate regulations or collusion among banks, which can produce an interest rate that exceeds the return on most private sector projects.

At the limit, these distortions could result in a segmented credit market: if private borrowers are not allowed or not able to pay the required premium, banks will first lend whatever they can to the government and only the remainder to the private sector. Indeed, while financial repression, such as deposit rate ceilings, has been receding in many developing countries, the continued large bank lending to the public sector in many developing countries suggests that such is the banks’ preference.

Banks that lend mainly to the public sector might become lazy: sitting on large, relatively secure, and easy-to-maintain government debt may make them profitable but inefficient.

There are several ways in which large lending to the public sector potentially reduces banks’ efficiency. First is its relatively high profitability; the promise of relatively high and secure profits is likely to loosen the pressure to control costs. This effect could ultimately more than make up for any efficiency gain from large-scale lending to the government.

Second, governments that rely heavily on financing from the banking sector are likely to be reluctant to relinquish control over state-owned banks—which, in turn, have been shown to be less efficient than private banks. Third, banks that lend mainly to the government are likely to have only a muted interest in competition: the fact that they all have the same large customer, whose demand is also likely to be quite insensitive to the interest rate, can be expected to exert a powerful incentive for collusion in government bond auctions.

Potential headaches

To what extent does public sector credit affect financial development? The study finds empirical evidence that large government borrowing from domestic banks tends to harm the depth and quality of financial development and at least partly offset the positive impact that public sector borrowing tends to have on liquidity in the banking system.

This finding should be of concern to policymakers, given the well-recognized link between financial development and economic growth and the increasing awareness that underdeveloped financial sectors can amplify macroeconomic volatility. They can do so, for example, by forcing financial openness on a poorly prepared economy, making it more susceptible to capital account crises. Shallow financial sectors also complicate economic policy—not least fiscal policy—such as by limiting the level of debt that an economy can sustain. And the pronounced effects, particularly on interest rates, that public sector financial activities have in thinly developed domestic financial systems, in turn, cause headaches for monetary policy.

These relationships between fiscal policy and financial development should be taken more fully into account in assessing the costs and benefits of running public sector deficits and in weighing the pros and cons of domestic versus external debt financing. The implication for developing countries is that as long as their public sectors keep absorbing a large share of bank credit, financial liberalization and improvements in the institutional environment for financial development will not yield big enough improvements in credit access for the private sector.

David Hauner

IMF Fiscal Affairs Department

This article is based on IMF Working Paper No. 06/26, “Fiscal Policy and Financial Development.” Copies are available for $15.00 each from IMF Publication Services. Please see page 176 for ordering details. The full text is also available on the IMF’s website (

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