4 some have argued that external grants and loans may

4

Some have argued that external grants and loans may also reduce the incentive of
governments to improve their revenue mobilization efforts and may create dependency
and rent-seeking effects within government bureaucracies (see Gupta et al (2004) or
Moss et al (2005). Assessments of fiscal sustainability necessarily must gauge such
disincentive effects, particularly given uncertainties on the long-term sustainability of
external assistance inflows. In effect, the fiscal space created in the short term may have a
negative impact on available fiscal space in the future if it reduces domestic resource
mobilization efforts.
Borrowing represents another option for the financing of additional expenditure. But
borrowing, whether domestic or external, implies the need to repay, thus raising the
question of whether the return on the expenditure justifies the cost of borrowing, and
perhaps even more relevant, whether the spending will enhance future government
revenues that can be used to finance the repayment of the loan. Governments may borrow
to finance an overall fiscal deficit, rather than with regard to a specific project or
expenditure program. But such borrowing must then be considered in the context of an
assessment of the overall sustainability of a government’s debt obligations, in terms of its
capacity to service interest and principal repayments. Such assessments typically need to
consider inter alia, an economy’s prospective growth rate, its potential for exports and
remittances, the prospective interest rate environment, the elasticity of revenue to growth,
the composition of existing debt (in terms of interest rate, maturity, currencies of
borrowing), and the terms of any new debt being considered (see IMF 2004a). Certainly,
borrowing to finance the recurrent cost of programs, particularly in the health sector, is
unlikely to be a reasonable strategy, since it would quickly build up the debt that would
then need to be serviced, generating an increased interest burden on the budget.
Domestic borrowing must be particularly managed with care, since it can quickly lead to
government budgets being overburdened with debt service obligations. No possibility
exists for such borrowing to be forgiven by external donors through debt cancellation
initiatives. And, as can be illustrated in the cases of Malawi and Zambia, thin domestic
5

capital markets can quickly result in high real interest rates that can prove a heavy burden
on a government budget in terms of debt service. Thus, in Malawi and Zambia, domestic
debt as a share of GDP has risen sharply in recent years to around 20-25 percent which,
in view of the limited degree of monetization, has resulted in a high interest rates of
around 20 percent In contrast, in Tanzania, domestic debt has halved in recent years, with
a concomitant drop in the Treasury bill rate, thus creating fiscal space by the reduction in
the overall interest bill.