Policy backfires: Government spending plan is likely to hurt the economy

The great flood of late 2011, the worst in 70 years, had a big impact on the economy. The fourth quarter of 2011 saw Thai GDP contract at 9 per cent compared to the year before – the worst drop in 13 years. Estimates put the total damage to the economy at Bt1.4 trillion (around 13 per cent of GDP). 

To counter this negative effect, the government has implemented several measures. Two moves are notable: the first is the decree, already approved by parliament, to shift the responsibility for interest rate payments on the FIDF bonds set to bail out banks during the Asian financial crisis, from the government back to the Bank of Thailand (BOT). The second is the Cabinet approval to increase the public debt ceiling in 2012 from Bt350 billion to Bt800 billion.

These moves were made with good intentions. The objective of the first is to relieve the government’s interest rate burden – a staggering Bt45 billion per year. This will allow the government to undertake other offsetting spending programmes, especially those related to the strengthening of flood defences.

This leads to the second move – the government approval to increase public debt by Bt450 billion to create three separate funds. The first fund, of Bt350 billion, is for water management projects; the second, of Bt50 billion, is for the disaster insurance fund; and the final Bt50 billion is the add-on to the previous Bt350-billion loan to compensate the fiscal deficit.

Though created with good purposes in mind, these two moves have already backfired and are starting to hurt, rather than help, the financial sector and overall economy, since they are leading to what economists call “the crowding-out” effect.

The crowding-out effect describes a condition in which the government runs an expansionary fiscal policy to boost the economy, increasing spending beyond tax revenue and issuing bonds to cover the deficit. This new bond issuance will suck money out of the financial pool the private sector uses to finance its investment projects (or “market for loanable funds”, in the economic jargon). The interest rate, which is the price of borrowed money, will jerk up as a result of scarcer funds, hence reducing private-sector incentive to invest, which will eventually hurt the overall economy. 

This is what’s happening to Thailand right now. Consider the commercial banks’ current interest rate movement. The BOT has been cutting its policy interest rate since late last year, from 3.5 per cent to 3.0 per cent, to accommodate growth during this harsh time, but the commercial banks’ interest rates, both lending and deposit, have barely moved. The saving rate, 12-month fixed deposit rate and minimum lending rate (MLR), the three benchmark-rates, have dropped by 12 basis points at most, compared to the 50 basis points cut for the policy rate. Moreover, the latest moves have seen some commercial banks increase their borrowing rate to attract more funds. 

Why is that? The answer is, mainly because of the government’s policies. The shifting of interest rate burden means that the BOT can raise funds from the levy paid by commercial banks to the Deposit Protection Agency (DPA), raised from 0.4 per cent of total deposits to 0.47 per cent. Most of this levy (0.46 per cent) has been earmarked to service the FIDF interest payment. This increase, combined with bankers’ fear that the reduction of DPA protection from Bt50 million per account to Bt1 million (taking effect in August) will result in a run on deposits (from commercial to state-owned banks), has led to commercial banks’ current move to secure as much fund as possible. 

However, the FIDF/DPA fee factor is merely an accomplice; the main culprit is the “crowding-out” effect caused by the government-spending spree. The new spending plan means that at least Bt400 billion in bonds will be issued this fiscal year (excluding the Bt350 billion for water management projects and Bt50 billion for the disaster insurance fund, for which the government will issue more bonds before June 2013). Moreover, it is not only the government that is in need of extra funds; state-owned enterprises, the BOT and the private sector are also projected to increase their bond issuance this year (all for different reasons). Kiatnakin Intelligence, the bank’s research department, projects that the total value of bonds and debentures issued this year will be at least Bt1.8 trillion, the highest amount ever. This will undoubtedly bring higher financial sector interest rates, especially the longer-term bond yield and commercial bank’s lending rate, which will eventually lead to a higher cost of borrowing for the private sector.

In sum, although the government’s stimulus policies are designed to benefit the economy, the increase in funding demanded by these projects, if not carefully planned, will hurt rather than help the economy. It is crucial that policymakers bear this in mind when implementing any economic strategy. Otherwise, the cure could cause more damage than the disease.

 

Piyasak Manason is vice president for research and planning at Kiatnakin Bank.