Academic journal article The Lahore Journal of Economics

Government Budget Deficits and the Development of the Bond Market in Pakistan: Issues and Challenges

Academic journal article The Lahore Journal of Economics

Government Budget Deficits and the Development of the Bond Market in Pakistan: Issues and Challenges

Article excerpt

Abstract

This article examines how better discipline can be brought to fiscal policy, first, through enhanced institutional checks and balances, and second, through better market discipline. We examine the political institutions and budgetary processes that can affect fiscal policy in Pakistan. A sound fiscal policy feeds bond market development, while the bond market provides signals in relation to the prudent conduct of fiscal policy. A common dimension in this mutual relationship is the governance environment. The article concludes that instilling fiscal discipline will remain intractable unless approached comprehensively. Long-term solutions must be found in the development of political institutions and improved governance. An active and liquid bond market can play a crucial role in bringing about fiscal discipline. The real challenge lies in summoning the political will and raising public awareness to implement the required measures.

Keywords: Budget Deficit, Fiscal Policy, Bond Market, Pakistan.

JEL Classification: E62, H61, H62.

1. Introduction

Pakistan initiated financial sector reforms in the early 1990s and took regulatory and structural measures to liberalize the economy and develop financial markets and institutions. One rationale for these reforms was to institute market discipline in the monetary and fiscal management of the economy. Following the economic liberalization policies, Pakistan's financial sector has experienced remarkable growth and structural development. However, it is debatable whether the financial markets have contributed meaningfully to the execution of sounder macroeconomic management; in particular, control of fiscal deficits remains a challenge.

Besides being an emerging market, Pakistan is also an emerging democracy, or rather a re-emerging democracy whose democratic process has been interrupted a few times. The newly re-established democratic environment poses both a challenge and opportunity to review governmental processes and institutions that would be not only more in tune with a democratic spirit, but also more aligned with public interest. Democratic processes and institutions can provide the right set of checks and balances, not only political, but also in economic management. One important area in which institutions urgently need to be reengineered is the formulation and conduct of fiscal policy.

This article examines how better discipline can be brought to fiscal policy, first, through enhanced institutional checks and balances, and second, through better market discipline. We examine the political institutions and budgetary processes that can affect fiscal policy in the context of Pakistan. We then address the linkages between government fiscal deficits and financial markets, in particular the bond market. Fiscal policy feeds bond market development, while the bond market provides signals in relation to the prudent conduct of fiscal policy. A common dimension in this mutual relationship is the governance environment; an appropriate regulatory and legal environment not only fosters bond market development, but is also conducive to the conduct of sound fiscal policy. These dynamic relations are depicted schematically in Figure 1.

The article is organized as follows. The introduction is followed by a brief background of Pakistan's fiscal position, and explains how the government deficit is financed. Section III surveys the theoretical issues that arise in the political economics of fiscal policy, and evaluates Pakistan's governance and regulatory environment in light of these theories and empirical evidence from other countries. Section IV discusses the linkages between fiscal deficits and the bond market, surveying the theoretical models and empirical evidence and their relevance to developing countries. Section V outlines the development of the bond market in Pakistan and the challenges it faces in assuming a constructive role in shaping prudent fiscal policies. …

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