Borrowing Overseas: Quo vadis?

A section of the business community has been demanding free access to global financial markets in order to borrow funds at global interest rates. Such demand became strident when the global rates tumbled to near zero in the wake of the recent financial crisis in the developed countries. Since the domestic interest rates were very high relative to the global rates, business people perceived large savings to be made on borrowing at low interest rates in developed countries. Bangladesh Bank (BB) yielded to their demand and permitted selective external borrowing. By 2014, the Board of Investment had approved US$8.04 billion of private foreign loans (The New Age, 27 Jan. 2016).

Of late some economic experts have gone further to suggest that the government should also borrow funds from global financial institutions at the current low interest rates to fund its development projects. Since the government has been borrowing funds from overseas from the very inception of the country this would appear to be a mundane suggestion. The difference lies in the nature of source and the cost of credit. So far the government has borrowed funds mostly from multilateral organisations and aid agencies of developed country governments at concessional rates. The new suggestion is to borrow funds from private financial institutions overseas at market rates.

There is nothing wrong with borrowing funds from any source if it is profitable or welfare-improving. If the government runs a budget deficit and it has no choice but to borrow funds, it is expected that it will borrow funds in a manner that incurs the minimum cost or delivers the maximum benefit. Does borrowing overseas from private financial institutions satisfy this condition?

Nationally, Bangladesh is a net saver for nearly one and half decades (except 2011-12) implying that it earns more than it spends and consequently runs current account surpluses. The net saving of the nation shows up in an increase in the international reserves of BB. They are usually lent out to the rich countries, especially USA, at very low returns because they are held in the form of central bank deposits and treasury bills which carry near zero interest rates since the global recession. Hence, the US$28 billion that BB has in reserves yield very little return, knocking off one of the main sources of its income. If the reserves had earned 5 per cent interest, BB would have made US$1.4 billion just on its reserves.

With so much idle funds held in international reserves and domestic commercial banks awash with liquidity, it is not at all clear why the government needs to borrow overseas. If it needs, say, US$10 billion in foreign exchange to fund some development projects and borrows the same from BB paying it the rate at which they are parked overseas, BB will not lose anything but the government will save about 5 percent in LIBOR-plus rate of the commercial lenders. This will amount to a saving of nearly US$0.5 billion per year in interest payments. BB will be left with US$18 billion in international reserves which are more than adequate as a buffer for import payments.

If the government were to borrow the funds overseas it would have to pay an interest charge periodically and retire the full loan amount in a few years. Since these payments will have to be made in foreign exchange they will have to be paid from BB reserves. Hence the stock of reserves will eventually decline by the amount of interest payments and the loan amount. Therefore, whether the government borrows the fund from overseas or from BB, the reserves will decline. The point is they will decline more if the funds are borrowed from the overseas private financial market.

The situation is quite similar to the decision of the household that wants to buy an apartment (read development project). It has a time deposit (similar to reserves) of Tk20 million earning a low 6 percent interest. It can purchase a residential apartment for Tk20 million by either liquidating the deposit to pay upfront (similar to borrowing from BB), or take out a home loan of Tk20 million at a high interest rate of 10 percent (similar to external borrowing). Assuming that there are no tax or other advantages in borrowing from a financial institution, the household continues to earn Tk1.2 million per year on its deposits; but it has to pay Tk2 million in interest on the loan to the financial institution if it opts for borrowing. If the loan has to be paid in full at one go after 10 years, the household would have paid Tk20 million in interest and another Tk20 million in repaying the original loan amount. When these are paid the household would have paid Tk8 million more than it would have paid if it had bought the apartment with its deposit. It will not be rational for the household to choose borrowing over self-financing.

The people who are egging the government on to borrow overseas are no doubt assuming that the infrastructure built with the borrowed funds will add to the physical capital that will enhance productivity and attract more investment. Apparently this is so, but more caution is called for. Government investment is known to be highly wasteful. A number of reports have been published in the news media in the recent past that revealed that the unit cost of roads and bridges constructed by the government in Bangladesh is several times the cost of these in other countries including some developed countries. Since there are few reasons why costs here should be significantly greater than that in other countries, the high cost is just a reflection of the wastages and leakages in government projects.

A good example is the Padma Bridge. Since it is being built with local funds, all its foreign exchange spending will be paid from BB reserves. If the World Bank had not withdrawn from the Padma Bridge project alleging corruption at the pre-construction phase, the bridge should have been completed by now at a cost of around US$3 billion. Now that the government is implementing the project the cost has already risen to nearly US$6.5 billion (including railway). Given the history of other projects it seems safe to predict that the cost will increase to US$8-10 billion by the time it is completed in several years. If this is taken to be the average picture then it seems reasonable to assume that the country will on average get physical investment worth one billion dollar by making financial investment of nearly three billion dollars.

Real productivity of course does not depend on financial investment, but on physical investment. Should the government be encouraged to engage in costly oversees borrowing to build some infrastructure with low financial productivity and burden the future generation with a large external debt?

The most persuasive argument in favour of overseas borrowing is that the domestic lending rate is very high relative to the overseas rate. This is superficially true. There are some other issues that must be taken into account before jumping to the conclusion that overseas borrowing is cheaper. The most important consideration missing from the cheap foreign loan argument is the risk factor. There are two major risks: interest rate risk and exchange rate risk. The former could be avoided by taking a loan at a fixed interest rate, but this is usually higher than the market rate. The exchange rate risk could be avoided by contracting a forward exchange rate. However, the forward rate for a currency such as taka, if available at all, is likely to be much higher than the market rate. Hence it is most likely that the loans will be contracted at the market exchange rate. The table below suggest the exchange rate risk when the loan is contracted in dollars and at a fixed interest rate.

Consider the simplified example of a business enterprise that had borrowed US$10 million at the end of 2008-09 for 3 years at a fixed interest rate of 5 percent payable at the end of each year in dollar. The entire principal must be repaid in dollar at the end of the third year. If the exchange rate had remained constant throughout the 3 years, the payment schedule of the borrower would be as shown in the third column of the table. It would have paid the fixed 5 percent interest every year and repaid the exact amount it had received in taka from the dollar loan.

However, the exchange rate did not remain constant during the loan period. At the market rate the payment that it actually had to make is shown in the fourth column. The depreciation of the taka had increased both interest and principal payments in taka. Eventually the business enterprise paid 35 percent on the amount it had borrowed rather than 15 percent it had expected to pay. This large increase in the repayment in taka terms could put the enterprise in difficulty if it had not made allowances for the possible depreciation. It may be noted that the effective interest payment it made (almost 12 percent) could be more than the domestic rate of the time. Depending on how much the taka depreciates, the interest burden of overseas borrowers could be very onerous to the point of turning them bankrupt. The experience of Australian business in the mid-1980s and Thai enterprises in the late 1990s who borrowed overseas should be instructive.

Another important consideration is who the beneficiary of the loan is. If the government chooses external borrowing, all loan servicing charges accrue as incomes of foreign financial corporations. However, if the loan was procured domestically, the charges would have accrued to domestic banks. This could have not only improved the health of domestic banks, but also generated a multiplier effect further increasing income and employment. If the funds were borrowed from Bangladesh Bank, any interest payments net of what it was earning previously would have eventually accrued to the government when BB transferred its surplus to the government. By borrowing overseas the government is creating business for foreign financial institutions when it could have done the same for domestic banks.

Thus, when the real opportunity cost of borrowing overseas is considered, there may not be any gains to be made by such borrowing in our current situation. The government should do the math carefully and factor in its other priorities before deciding to borrow from the financial market overseas.