Low cost debt is passé

In the 20 years predating the pandemic, many central banks (67 by 2018) switched to inflation-targeting. Their operational strategy is anchored on interest rates using multiple tools. With low inflation came low interest rates on public debt, keeping interest payments steady as a share of GDP even as the debt itself continued to grow. Bangladesh was no exception.

This golden age has ended. The global economy is in a precarious state amid the protracted effects of the overlapping negative shocks of the pandemic, waves of geopolitical conflicts, including wars, escalated weaponisation of trade and finance, and broadly synchronised monetary tightening. Rising interest rates precipitated by "higher and longer" policy rates has helped the disinflation cause but raised the spectre of sovereign debt distress.

The convenience premium

There are two ways of sustaining public borrowing at a higher pace relative to growth in the size of the economy. You can put an end to the faster pace by collecting more in revenues than spending and running primary surplus (total revenues minus total public expenditure before interest). Such surpluses are small or non-existent in most economies these days due to structural and political constraints on raising taxes or cutting spending.

The other way is to borrow at a lower than market rate. The gap between the two is called "debt revenue". If the government used the amount borrowed to lend to say a private economy, this revenue would be the net earnings from doing so. The gap in returns represents an opportunity cost for the buyer of government debt and a gain for the borrowing government. Rolling over the debt at the lower rate keeps this revenue going.

Public debt is a safe haven. The government's power to "tax" in multifarious ways makes their debt instruments safe and liquid. In addition, public debt enables diversification of private credit risks by providing an alternate store of value to the private credit markets. The return on private credit is affected not just by inflation, as is holding a government bond, but also by almost any other shock to productivity or the propensity to default. Investors looking for safe assets are willing to pay a convenience premium to the sovereign by accepting a lower return.

Countries have been able to maximise this debt revenue through their strong reputation and accountable institutions. Governments in advanced economies harvest a lot more debt revenues than those in emerging market or low income economies.

Convenience premium plus

The premium reflects regulations and financial repression as well. Macroprudential policies since the global financial crisis required financial institutions to hold safer and more liquid assets. This created additional demand for government securities to satisfy the regulators' collateral requirement, increasing their prices and lowering interest rates. This additional convenience premium is labelled a "repression tax" because private agents are prodded to lend to the government at lower returns.

Adding spice to the course in the aftermath of the global financial crisis, central banks purchased long-term government bonds from private hands and replaced them with interest bearing overnight bank deposits. The interest central banks collected on the government bonds was slightly higher than what they paid to the banks. Their bond purchases depressed interest rates further and reduced the maturity of the public liabilities held by the private sector. Known as Quantitative Easing, these monetised existing debts.

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Central banks in developing economies used refinancing schemes to support exports, SMEs, inclusion, and greening. These injected money into the economy. The continuation of Quantitative Easing even after the global financial crisis in advanced economies was driven by the zero-bound problem in policy rates. Developing economies never reached zero bound, but the effects of central bank balance sheet expansion from refinancing through the banking system is nevertheless the same, keeping interest on domestic public debt lower than it otherwise would have been. They also used statutory liquidity requirement to collect repression tax from financial institutions.

The Bangladesh government has benefitted from debt revenue significantly. Effective nominal interest rate on public debt declined from 5.3% in FY19 to 4.5% in FY23. The average bank lending rate during this period was 9.6% and 7.3% respectively. Bangladesh's debt revenue mostly comes from concessional external debt and lower than market rates on treasury bills and bonds. The government incurs "debt expenditures" paying higher than market rates on National Saving Certificates.

The seigniorage temptation

The nominally fixed government debt contract gives rise to an addictive temptation. Inflation could help public debt since those at the borrowing end of such contracts gain from inflation. The inflation tax on bondholders can complement other taxes. Higher inflation may seem a price worth paying if the central bank can keep interest rates low and print some more money to pay off debt or finance government deficits.

The gain to the government from printing money is called seigniorage. It is the difference between the face value of the money and the cost to produce it. Seigniorage also comes from the interest a central bank charges on lending to commercial banks. Central Banks nowadays can create money electronically at practically no cost. Printing money is essentially borrowing without ever repaying.

Monetary financing of government deficit set a new historic precedent in Bangladesh last fiscal year. The stock of BB credit to the public sector was 187% higher at end-June 2023 relative to end-June 2022. So far this fiscal year (from July up to October 8), this has not happened. The government borrowed from the scheduled banks to build up deposits in and repay BB. Boosted by the recent 75 basis point increase in the policy rate, the rates on short-term T-bills have shot up by around 200 basis points. Supply of T-bills in the money market exceeded demand as part of reversing last year's monetisation.

The party bloopers

The interest increases negate the supposed benefits from seigniorage. BB kept the policy rates low and increased the size of its balance sheet. Believing that the rise in inflation was transitory, BB maintained the 9% cap on bank lending rate despite large currency depreciation and the persistence of high inflation. Monetisation combined with lending rate cap were both pro-inflationary stances.

Inflationary expectations are not invariant to such a stance. The debt revenues erode as investors start fearing inflation. The interest expenses of the government increase with inflation making it more likely that the government will seek to borrow more thus reinforcing the rise in rates. Since March 2022, reflecting the interest rate caps, increased interest rates at the short end of the yield curve outpaced the long end in Bangladesh. The maturity premiums on longer-term government bonds have shrunk.

The rising cost of servicing debt is increasing the risk of debt distress globally. Bangladesh's total public debt to GDP ratio increased from 32% in FY19 to an estimated 42% in FY23. While still some distance away from any breaking point, payment defaults on the part of strategically important state owned enterprises short-circuit growth. High domestic shares of government debt are associated with higher borrowing costs and lower bank credit to the private sector. No free lunch.

Inflation and sovereign default are the two risks a holder of public debt must bear. Central banks delivered steady inflation of about 2% in advanced economies through financial crises, electoral cycles, and commodity and oil price shocks. This allowed the nominal interest rates to stay low for long. Keeping deficit monetisation off the table in the past two decades made public debt safe from inflation risk. The same in Bangladesh except the 5.5 to 6% inflation rate that was higher than the 3 to 5% global median inflation rates.

Elevated debt levels have eroded fiscal buffers in many countries with rising funding costs and slowing growth. Four South Asian countries are already rated by the Moody's ratings agency or by the IMF/World Bank Debt Sustainability Analysis as in or near sovereign-debt distress and default. Historically, the vast majority of defaults occurred around the end of US monetary policy tightening cycles in countries with above-median government debt-to-GDP ratios (WB, 2023). Interest expenses of the Bangladesh government accounted for 23.2% of total revenues in FY22, up from 18.7% ten years ago. Above-average economic growth mitigates some, not all, of the fiscal risks.

A new era

The world is currently in a higher for longer phase. Interest rates across geographies are tied to the global equilibrium interest rate, often called the "r-star". This is the (unobserved but reckonable) rate at which the world demand for and supply of savings are the same. The r-star has been falling for at least two decades. Demographic transition led more people to save for retirement and a productivity slowdown curtailed the demand for capital. Higher inequality may also have contributed.

The inflation spike of 2021–22 shocked this trend, more like a police raid than neighbours complaining about the party, which is over. Demographic transition is tapering; an Artificial Intelligence induced productivity resurgence is possible and geoeconomic risk perceptions are elevated due to disruptive geopolitics, inflation volatility and shocks to financial sector balance sheets. There is likely to be a period of structurally higher inflation compared to the past two decades from global trade, climate transition, demographics and politics. All of these point to higher for longer. Nobody knows for how long.

Our recent experience warns a low debt to GDP ratio may not suffice for averting debt distress. Tight local currency, dollar shortage, high tax expenditures (perpetuated by inflation), and low revenue mobilisation can bite even through low debt. The ratcheting up of primary deficits around elections can result in primary spending rigidities. Hedging these risks requires stronger commitment to monetary policy, debt management and financial regulatory reforms by the BB and government alike.