Seeing governments borrow money from the market is like seeing kings bathe in public. Advocates of fiscal prudence would consider this highly embarrassing, but the world over, governments these days are busy creating spectacles of sorts by borrowing more and more money from the market. You may have wondered how governments always manage to create a mountain of debt for themselves. But ever wondered how governments ultimately repay their debts?
Johnny: Well, borrowing money is obviously not a problem for any government. After all, a government’s promise to repay does not require any collateral. But I really wonder, Jinny, how governments manage to repay their debts.
Jinny: Although default by a government is not common, we can’t say that it is completely improbable. Sometimes governments, too, default in the repayment of their debts. But you would hear about a government defaulting only in extreme situations. If we ignore some of the notorious defaults by a few governments in the past, the track record of governments repaying debts appears as clean as a whistle. There are several ways by which a government actually repays its debts. I will explain them one by one.
Johnny: That would indeed be quite helpful. I am also curious to know how governments actually manage to repay.
Jinny: First and foremost, for actually repaying its debt, a government needs to develop a fiscal surplus that can be used to buy back existing government securities. Buying back securities implies repayment of the existing debt.
The simplest course for any government could be to repay the principal and interest as and when they become due, but interestingly, a government need not wait till the maturity of the government securities to pay back its debt. Often, interest rates payable on a security are a valuable consideration while deciding a buy-back.
Illustration: Jayachandran / Mint
A government is more likely to buy back a security paying a higher interest rate than a security paying a lower interest rate. Reducing the cost of borrowing is always a motive in choosing which debts the government wants to repay first. But before planning anything, the government does need to find some extra money.
Johnny: From where is this extra money going to come?
Jinny: Now that’s a genuine concern. Looking for a fiscal surplus in a government’s pockets is tougher than looking for a coin in a black hole. But some governments do manage to create surplus. Here we need to understand a little bit how governments manage their finances.
Just like individuals, a government has to constantly balance income and expenditure. Governments have only limited sources of income, which look like peanuts when we look at the mountain of expenditure.
A fiscal surplus can arise only if the government’s income exceeds its expenditure. To make that happen, a government would need to improve its income and reduce its expenses. Unfortunately, there is no fixed formula of how to reduce expenses, but when it comes to improving income, all governments have to use their famous weapon: taxes.
More taxes, both indirect and direct, help governments mobilize more resources, part of which can be used for the repayment of debts. But taxes in themselves may not be enough to repay all debts. Taxes are very helpful in meeting the yearly payments of interest, but to actually retire the mountain of debts, the government may need to think of other strategies.
Johnny: What other strategies can the government follow?
Jinny: The government can use public sector companies to its advantage. This can be done in two ways. The government can choose to keep the public sector companies with itself and use their yearly dividends to repay debts. This will produce slow but steady results. Every year, a part of the debt would get repaid, provided the government is not planning to use dividends for any other purpose.
The second option is that the government can choose to divest its holding in public sector companies at the best available opportunity and use the proceeds for repayment of debts. Disinvestment produces immediate results. A mountain of money received from disinvestment can be used to retire a mountain of debt in one shot. Most governments around the world now putting their money to bail out private enterprises expect to repay their debt by profitably divesting their holdings when the right time comes.
Johnny: But tell me, Jinny, what can governments do if none of the strategies you talked of actually works?
Jinny: When nothing works, governments can resort to their least popular choice: Borrow money to repay existing debt. But that’s not all. When borrowing becomes difficult, governments may even resort to printing notes. Such a course of action may lead to hyperinflation, which indicates that the government has gone bankrupt. So even if you get your money back, it is a worthless piece of paper. Luckily, we have many sensible central banks to prevent things from coming to such a pass.
Johnny: That’s interesting, Jinny. Governments have no problem in paying back unless their notes printing press is on strike.
What: Governments repay their debts in several ways
How: To actually repay its debt, a government needs to develop a fiscal surplus.
When: In the worst case, a government may resort to printing more notes to repay existing debt.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org