BENEATH all the commentary on the details and implications of the recently concluded talks with the IMF, an important analysis has gone largely unremarked, save for one insightful article.

It grows out of an analysis presented in a special section of the last quarterly report put out by the State Bank of Pakistan (SBP). Buried in Chapter 3 of the report is a special section innocuously titled ‘Macroeconomic Dynamics with a Dominant Borrower’.

The section asks this question: “With an insatiable government appetite for credit, how does the central bank contain the quantum of inflationary finance and yet ensure the private sector is able to secure adequate credit from commercial banks?”

Translation: what do you do when the government takes all the money in the banking system and digests it as part of its day-to-day spending?

The question is important because even a first-year student of economics can tell you that an economy can only grow and create jobs and alleviate poverty and arrange investment for future growth if funds are available for investors to borrow and invest.

But when the government enters the market with an “insatiable appetite” and takes all the money, leaving nothing behind for anyone else, and spends it all on paying for things like salaries of government servants and retiring the circular debt — effectively paying for yesterday’s consumption — then of course the banks will not be in a position to lend to anyone else and provide for future investment.

The authors of the section lay out the scenario in a short four-point summary of the status quo. “The policy outcome so far is not heartening: (1) despite a 450 bps [basis points] cut in the discount rate over the past 20 months, net private-sector lending remains anaemic; (2) spreads in the banking system remain high; (3) SBP financing of the fiscal deficit has increased sharply since Q3-FY13; and (4) the balance sheets of commercial banks continue to skew in favour of government paper.”

Basically they’re telling us that a malign symbiosis has emerged. All the investible capital in our economy is being eaten up by government to pay its bills, and the banks are only too happy to oblige since lending to government carries little to no risk on the face of it.

So both government and banks are satisfied with the arrangement, which is suffocating the economy and its growth prospects.

None of the stakeholders involved have any incentive to break the relationship since they’re both getting everything they want out of it: for the banks, a steady and risk-free customer and for the government a ready avenue to avoid difficult choices like taxing key constituencies who have grown far too accustomed to making their fortunes outside the tax net.

The authors do a little exercise. They look at various countries to examine the relationship between a government “whose appetite for borrowing is growing because it has limited avenues for raising taxes” and a financial system that is underdeveloped to the point that it gives that government “few alternatives but to borrow from domestic banks”.

The authors look to see how a malignant equilibrium emerges in such a scenario and come to a troubling conclusion.

Their findings tell them that in developed countries, where the financial system is highly developed and provides more than one avenue for governments to borrow (other than commercial banks), the continued borrowing by the government does not raise banking spreads — the amount of money banks make.

But in an underdeveloped economy, they find the situation leads to a rise in banking spreads. Of course, the authors are careful enough to point out that their findings are a “correlation and not a causation”, meaning the rising banking spreads may yet be explained by other factors.

Translation: when a government that can only borrow from a few domestic banks borrows too much over a long period of time, the bankers end up making a lot of money because they know that they have a desperate customer who has no option but to borrow from them.

It makes sense, intuitively.

Have you ever noticed that an air-conditioner repairman or a carpenter or a plumber or any other service provider that you call repeatedly to fix a problem that you cannot eliminate will start charging you more and more for every visit because they feel that you have become dependent on them?

Something similar happens when a government becomes a “prolonged user of bank resources” — to use IMF jargon — and fails to fix its fiscal plumbing in order to be able to pay its bills. The banks find ways to charge the customer more and more money knowing that the customer will have no choice but to pay.

The finding leads the authors to this conclusion.

“Looking specifically at Pakistan, the paper suggests that in an environment where private banks face a dominant borrower (who is increasingly attractive), the situation will require some policy intervention to avoid an adverse outcome. This is not just for the overall health of the country’s economy, but also to ensure the balance sheets of commercial banks are healthy enough to withstand unanticipated shocks.”

Translation: something must be done otherwise the situation could explode. The malign symbiosis that has developed in Pakistan on account of a failure to fix the fiscal plumbing has hoisted a question mark atop the banking system’s ability “to withstand unanticipated shocks”.

And the only party that can fix this state of affairs is the government itself — hence the words “policy intervention”.

Fixing the fiscal plumbing of Pakistan is becoming an increasingly urgent task. Continued failure to do so is driving the country towards a financial crisis the likes of which we have never seen before, an “adverse outcome” growing out of “unanticipated shocks”.

The authors of our economic policy would do well to heed the warnings contained in this chapter.

The writer is a Karachi-based journalist covering business and economic policy.

khurram.husain@gmail.com

Twitter: @khurramhusain