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Why Government should be cautious on borrowed cash

By Luther Otieno | May 23rd 2017 at 09:26:25 GMT +0300

Even at an individual level, if the debt gets too high, there is little chance of it being serviced and repaid.

Individuals in heavy debt cannot go about their social and economic businesses normally; and this translates into low standard of leaving.

Furthermore, excessive use of borrowed money might translate into default that forces individuals and firms into solvency.

If you are insolvent, no one will lend you money. Indebtedness cause discomfort both at country and individual level.

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At the corporate level, there is a debate as to whether using borrowed funds add value or not. The two finance gurus, Modigliani and Miller (MM) who shaped the debt debate were combative in their idea that it does not matter whether a business finances their assets using borrowed money or shares.

At that time, MM conclusion was that merely using borrowed money to finance business does not add any value to an organisation. Their argument was that to add value to their businesses, managers must identify and invest in viable products and services.

Since then, the debate has moved on, and it is now agreed that borrowed capital has special advantages and disadvantages to be considered before borrowing. The question that remains is: at corporate level, how much debt and how much of the owners’ money (share capital) should be invested in a business to maximise the wealth of shareholders?

The same question persist at national level. In most countries, governments gets revenue from taxes, social contributions and grants receivable. At the country level, the government might want to spend more money than its revenues; in which case it has to borrow the difference.

Borrowed funds

Continuous excessive borrowing by government leads to debt accumulation. However, the government must pay interest on the borrowed funds. Interest payments become a problem to the government when the outstanding debt is too large.

The situation gets worse, and it appears our country is heading towards that, when all taxes collected is used to pay interest on borrowed funds.

The effect of this is the reduction in a country’s net worth. A country’s net worth is the difference between its assets and liabilities. A country with adverse net worth is badly exposed in terms of its foreign exchange rates and much-needed foreign investment and compromises the quality of life of citizens.

The government spends that money on public service and other commitments. Should the government want to spend more money than its revenues, it borrows the difference by issuing debt securities loans.

The government then gets the money it needs but investors are paid interest and the amount they lend at a future date.

When the outstanding debt is too large, the interest bill increases; and then investors start to worry that they won’t get their money back.

The investors will then be reluctant to lend to the government. When the government cannot borrow, it turns to the country’s central bank to lower interest rates. In this sense lowering interest rates, which basically means that it prints money and this is inflationary. This is what happened in Zimbabwe.

The trap is that whenever the central bank lowers interest rates, the government borrows more and this goes on until debt-related payments take up all the tax revenues.

When this happens, the State must now borrow everything it spends, that is whether it is borrowing to finance capital expenditure or revenue expenditure! It is not surprising that our government is borrowing externally because interest rates are relatively low, and this is the debt trap! Sooner than later, the government will discover that their core revenue meets only a fraction of its interest liability.

This is what we call financial crisis time; a time when prices of all assets plunge. There will be fire sales assets. No investor will be happy when the value of his or her investment is lost.

Instead of lending to the State, investors will be selling off their investment (bond), and this leads to rising interest rates.

Interest rates will rise because borrowers must offer attractive interest rate to lenders.

Foreign currencies

At its extreme, the government will find it difficult attracting lenders and the printing of money will have to go on. You can guess where inflation will be.

The government must tame its appetite for foreign debt to avoid the debt trap and the printing of more money in the future. We should borrow from countries with low interest rates and who trade (import) with us to facilitate payments.

Historically, loans from Europe and America are tied to exports from the borrowing country and payments made in foreign currencies.

However, in the case of the eastern bloc such as Russia, loans are tied to imports, but repayment is tied to exports. Our government must opt for loans with a lesser burden.

The writer teaches at the University of Nairobi

Modigliani and Miller bad loans
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