Credit to Government has accelerated markedly over the last few years triggering a massive upswing in Money Supply in the economy, evidenced by the huge growth in deposits in the banking sector. At the same time, since the beginning of 2014, credit to the private sector, proxied by loans and advances have tapered off and even begun to decline in absolute terms.
This “contradictory” pattern needs a closer look and the core of my discussion today is to ask ourselves the not so obvious question: Is Government Really Crowding Out Private Credit, or there are other factors that have led to the observed decline in overall lending in the banking sector.
By definition, the “Crowding Out Effect”describes an economic situation where “increasing” interest rates lead to a fall in private sector investment spending.
This is reflected as a dampening of investment spending in the economy, leading to a knock on effect on aggregate output.
In theory “Crowding out” is often a result of expansionary fiscal policies where a government increases its own spending in an effort to boost economic activity.
This typically leads to an “increase in interest rates”, which are a cost variable which affect private investment decisions.
The crowding out effect therefore operates through raising the cost for funds and inhibiting the accessibility to debt financing mechanisms by the private sector.
It follows that for crowding out to occur, government must “out-compete” private borrowers for loanable funds. It is possible that this is not what has transpired in Zimbabwe lately.
My view is that Government is NOT out competing the private sector in the credit markets but rather, the deficits have operated in a roundabout way; via money creation and induction process that is driving demand for foreign exchange.
Firstly, we need to note that the market is actually awash with liquid deposits. The banking sector has recorded a massive expansion in deposits, which are also highly mobile. There is no liquidity challenge as far as banks are concerned. In fact average liquidity ratios, at over 62 percent are “too healthy”.
Secondly, interest rates have been coming down, notwithstanding that banks have been “encouraged “ to lower interest rates via persuasive policy by the Reserve Bank, very high interest rates have been seen to harm bank assets by being correlated to high loan loss ratios experienced in the first few years of dollarisation.
So how then, are we positing that government deficits, manifesting through increased lending to government by the banking sector by way of Treasury Bills and the expansion of Central Bank overdraft facilities have or are crowding out private credit? I sincerely believe that something else is at play.
The evidence on the face of it does not support the crowding out argument at all.
My theory is that we have a massive corporate savings glut in the economy.
What has in fact happened and is still happening in the economy is that the corporate sector, which should be the largest borrower in the economy, has found itself to be in a cash positive position.
As a collective, Zimbabwe’s corporate sector has turned, from being a big borrower to being a net savers: ie, corporate profits and or net free cash-flows are far exceed their capital spending.
There are a number of reasons why this has happened. Zimbabwe’s largest companies enjoy very high trading margins and strong profitability. They are strong cash generators and mostly have turned cash-flow positive. Companies have deferred capital expenditure and investment due to uncertainty and instead have been holding higher precautionary cash balances.
In fact it is public knowledge that Zimbabwe’s largest company has a significant “war chest” held mostly in cash and records a sizeable revenue stream from “net finance income”, meaning that the company is a net investor in the money market!!.
The basic conclusion is therefore that bank lending is not increasing because the “good” customers are in cash surplus positions and have no need to borrow. This leaves banks with reduced options, one of which is to lend to the Government.
By investing in “risk free” government securities, banks are finding a home for their surplus positions, albeit at suboptimal returns.
In every case, the crowding out effect is only plausible when interest rates increases in line with a rise in government spending.
By itself, the increase in the government deficit, either in the form of an increase in government spending or a reduction in taxes, should trigger increases in demand in the economy.
How this affects product output, employment and growth depends solely on the effects of government spending on interest rates.
The Zimbabwe economy is operating very far from capacity, hence government borrowing has not had an impact on rates. Instead, there has been a notable impact on money supply growth.
Crowding out can, in principle, be avoided if the deficit is financed by simply printing money, but this carries concerns of accelerating inflation.
This phenomenon, firms are now running a financial surplus, and using their spare money to repay debts, buy back their shares or build up cash reserves is actually bad for the economy.
In a well functioning economy, companies are normally net borrowers, investing in new capacity to boost future output, income and profit, while households as a group should be net savers, providing firms with the capital to invest via the intermediation process.
A cursory inspection of the banking sector in Zimbabwe will show that there is increasing indebtedness of the household sector, whilst potentially the corporate sector has become net savers.
These aspects in my view need to be fully investigated, as the implications on policy are immense. It is also noteworthy that a large chunk of the rise in corporate saving in Zimbabwe in recent years is coming from the financial sector, where bank profits have soared.
In light of the postulated increase in corporate savings, the real conundrum is that Zimbabwean firms are probably saving and not investing whilst profits are strong and money is cheap. This phenomenon has been due in large part, to the uncertain economic environment.
The new economic order is an opportunity for firms, not only to repair their balance sheets, but critically asses their capacity and perhaps begin to look at the retooling aspects that may have been shelved.
There are tentative signs that firms will be starting to borrow and invest again soon and lending should gradually a tilt away from consumers as bank lending to firms begins to grow.
Is the Crowding Out Argument the Right one at this point in time?
The “crowding out” argument may still explain why the large and sustained government deficits will eventually take a toll on future growth in the economy.
Notwithstanding the expansionary nature of Zimbabwe’s deficits, they have had the effect of reducing capital formation, not via the interest rate mechanism, but instead via the creation of distortions in the asset allocation decisions of banks and corporate entities, that are sitting on piles of cash that they could invest, if they saw good reasons to do so.
This will not happen, however, if corporate leaders remotely feel that the current positive mood is built on shaky foundations and therefore they are likely to remain reluctant to invest, with the obvious consequences for recovery.
In conclusion, the “crowding out” argument rests primarily on how government deficits ultimately impact interest rates. In our case, the market has responded in an unconventional fashion and the relationship between government deficits and interest rates has gone in quite the opposite direction.
The theoretical premise is that when there is considerable excess capacity in the economy, which has been the case in Zimbabwe, an increase in government borrowing to finance an increase in deficits will not usually lead to higher interest rates and therefore does not “crowd out” private investment or credit.
Instead, the higher demand which has resulting from the expansionary fiscal deficit have not bolstered employment and output directly, resulting increase in income and economic activity but instead led to the huge demand for foreign currency. Government spending has in fact encouraged or “crowded in” additional private spending. The crowding-in argument could just be the right one for current economic conditions. It is the excess money, from government deficits, that is driving demand in the economy, hence the severe negative impact on the foreign exchange market
The writer is an economist. The views expressed in this article are his personal opinions and should in no way be interpreted to represent the views of any organizations that the writer is associated with.