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January 4,1985

Deficits and Financial Change
in the Pacific Basin
Government budget positions in most Pacific
Basin nations deteriorated sharply in the aftermath
of the worldwide economic slump of the rnid1970s. Budget deficits in the market-oriented
economies of the region have since averaged
rough Iy 4 percent of thei r respective G NPs. Fi nancing shortfalls ofthis magnitude has not proven an
easy task, and, at various times, has been responsible for inflation, disintermediation, and competitive shifts among financial institutions.
This Letter explains how the need to finance large
deficits oftentimes has produced the problems
mentioned,and argues that the responses of the
market and financial regulatory authorities have
constituted an important, although frequently inadvertent, impetus to financial innovation and liberalization in a number of Pacific Basin nations.
Financing options
Governments have a number of options in financing budget deficits. At the most fundamental level, fiscal authorities must choose between borrowing abroad (i.e., from foreign investors, foreign
banks, or international agencies) and borrowing
from domestic sources. Foreign loans represent a
majorfunding source for a number of Pacific Basin
nations. Indonesia, for example, finances virtually
all of its budget deficits abroad. But this Letter will
concentrate on domestic financing and its relation
to financial innovation.

When a government chooses to finance deficits
domestically, i.t has several options: it can sell its
debtto the central bank ("monetize" the deficit), it
can persuade or require financial institutions to
absorb government debt (turning the institutions
into "captive" sources offunds), or itcan design a
"market oriented" approach to selling government debt instruments.
Monetary finance
Useofthecentral bankto finance deficits involves
increasing bank reserves, which in turn leads to
increases in the stock of money. Ultimately, the
private sector finances the budget deficit by increasing its holdings of non-interest bearing

claims -typically consisting of currency and
bank reserves or "base money"-on the central
bank at the expense of interest-bearing claims directly issued by the government. All countries in
the Pacific Basin region have at different times
monetized varying portions of their deficits.
The major drawbacks to financing sizable deficits
through base money creation, of course, are its
inflationary consequences for the economy.
Among these consequences are distortions in the
financial sector. The specific regulatory environment, including the structure of interest rate controls, determines the extent to which these distortions adversely affect the entire financial system,
financial intermediaries as a group, or various
groups of specialized financial institutions within
the financial system. For example, deposit interest
rate ceilings existing in most Pacific Basin countries are more likely to hold yields at regulated
depository institutions below market-determined
returns during periods of high inflation, and therefore cause financial disintermediation. Investors
in these circumstances turn to such alternatives as
investments in real assets and unregulated financial instruments.
Regulated institutions faced with a deteriorating
competitive position may respond by designing
new financial instruments offering market yields
in an attempt to circumvent interest rate controls.
Unregulated institutions may react by offering
new instruments designed to maximize the opportunities available from their newly found competitive advantage. Financial authorities also are likely
to respond at some point out of concern for the
adverse effects of disintermediation on monetary
control and the continued stability of the banking
system. Segments of the financial sector that do
not benefit immediately from ongoing changes
will very li~ely lobby for a return to their former
competitive position. In the end, the authorities
have a number of choices: seek alternative means
of financing deficits, liberalize the structure of
interest rate controls or, in contrast, tighten and
extend interest rate controls to cover virtually all
financial institutions and markets.

New Zealand is a prime example of a country
where borrowing from the central bank has often
been the "residual" form of deficit financing, Le.,
the authorities have usually resorted to monetizing
its debt when other forms of borrowing, such as
below-market pricing in government debt instruments, have yielded insufficient funds. Problems
with monetary control have followed. In most
years since 1975, the state of the budget has been
the largest influence on monetary growth. Consequent high and rising inflation, associated with
"low" interest rate policies and the government's
large credit demands, combined with disintermediation from the heavily regulated financial industry, have been primary reasons for the authorities to liberalize interest rate controls. They have
been major factors behind New Zealand's bouts
with financial market liberalization in 1976 and
again during the past few months.

Captive institutions
The "captive" placement of government debt involves some form of "persuasion" or coercion by
government to induce private financial institutions to absorb government paper into their port~
folios, or some formal or informal agreement on
the part of government-affiliated financial institutions to purchase given amounts of government
For example, commercial banks and other financial institutions in many Pacific Basin countries
are required to hold "secondary" reserves and/or
a certain portion of their portfolios in "liquid"
assets. Government bonds or Treasury bills often
satisfy this requirement. A less subtle, although
common, method is simply to require individual
financial institutions to absorb a given amount of
government debt. Similarly, government-affiliated
financial institutions are often legislated to hold a
major portion, and, in some cases, all of their
assets in government liabilities. For example, government pension systems in Malaysia and Singapore are required to hold a significant portion of
their portfolios in government bonds.
Using captive financial institutions to absorb government debt has the advantage of lowering the
costto the government of servicing its debt. Moreover, most Pacific Basin nations feel thatthey have
no domestic option other than monetizing their
debt. Their open securities markets are typically
underdeveloped or nonexistent. Instead, a few fi-

nancial institutions, usually commercial banks,
dominate most forms of internal finance.
One disadvantage of captive finance is that the
institutions forced to absorb relatively large
amounts of government debt at below-market interest rates are likely to be put at a competitive
disadvantage relative to "non-captive" institutions. Resulting competitive shifts between institutions, or between the regulated and unregulated
financial sectors, are likely to create pressures for
financial and regulatory changes. The authorities
could feel compelled to tighten and extend controls over the fi nancial sector to mai ntai n the competitive position of captive institutions or perhaps
even to keep them solvent. However, the authorities may also opt to lessen the burden on captive
institutions and resort to other financing channels.
Japan provides a good example of this process.
Historically, it has relied to a large extent on captive institutions to finance government deficits.
When long-term "deficit finance" bonds were first
issued in 1975,93 percent of the total was underwritten at below-market rates by a syndicate consisting primarily of the largest banks. To help stem
the rising concentration of government debt in
their asset portfolios, the Ministry of Finance eventually allowed syndicate members to sell government bonds to the secondary market after the initial holding period had expired. The secondary
market in government bonds subsequently developed rapidly, and often offered yields far exceeding those offered by the banks on regu Iateddeposits. The resu It was a sh ift in the flows of fu nds from
banks and other financial intermediaries to longterm government bonds and securities dealers.
The Japanese authorities responded to the declining market share of banks by allowing them to
issue large denomination certificates of deposit
(CDs) to attract business funds. (The Japanese authorities also were acting in response to pressure
to eliminate discrimination against foreign banks.
ByopeningtheCD market in 1979, they substantially improved these banks' access to yen funds.)
Japanese authorities also have attempted to reduce
the burden on banks by raising the yields on primary government securities to levels that more
fully reflect market-determined yields and byallowing more frequent changes in bank lending
rates. Moreover, banks have responded to the increased competition for fu nds by offeri ng "general
accounts" to individuals. These accounts operate

as demand deposits in that they can be overdrawn
using time deposits as collateral. Thus, time deposits yielding higher interest rates than those available (set by regulators at low levels) on demand
deposits are operating as transactions accounts.

Market finance
In contrast to finance by captive institutions, the
distinguishing characteristic of a market-oriented
approach is that private individuals and institutions, and public institutions behaving in a manner similar to private financial institutions, voluntarily hold government debt. Thus, a necessary
precondition for "market" placement is a structure of interest rates on government debt instruments that is competitive with alternative uses
of funds.
A major advantage offollowing a market-oriented
approach is that the government places itself on an
equal footing with other borrowers in the credit
markets. In this way, the government pays the cost
of its borrowing-the yield that society could
have earned by placing the funds in alternative
investments. One political disadvantage, of
course, is thatthe cost of government borrowing is
not disguised as it is through captive financing or
monetization. Moreover, even a market-oriented
approach to government deficit financing is likely
ultimately to create tensions in the financial system
and spur further financial change.
Several Pacific Basin governments have tried to
en hance the marketabi Iity of thei r debts by offering competitive interest rates and by introducing
attractive new types offinancial instruments. Malaysia, Thailand, and New Zealand have offered
bonds at various times that are indexed to inflation, that are small in denomination, that have
relatively short maturities, that feature variable interest rate yields, and that offer the possibility of
early redemption.
The offshoot in some instances has been greater
interest rate flexibility, i.e. more frequent changes
in interest rates in response to market conditions,
and more competitive pricing of investment instruments by the private sector as it competes with
the government for funds. Thai authorities, for

example, have in recent years tried to increase the
attractiveness of government secu rities to the nonbank private sector in a variety of ways. These
include allowing more frequent changes in bank
deposit and lending rates and paying yields on
goverment bonds that more closely approach free
market rates. The resu It has been the avai labi Iity of
a greater number of financial instruments with
market rates of interest to Thai investors. In addition, the desire ofThai authorities to help increase
the liquidity of government bonds held by commercial banks and other financial institutions led
them to establish a government bond repurchase
Although many Pacific Basin governments have
gradually or, in the recent case of New Zealand,
quite rapidly moved to more market-oriented approaches to financing deficits, these approaches
are likely to generate pressures forfurtherfinancial
change. Th is is particu larly true where some interest rate ceilings and credit controls remain in effect. Securities companies in Japan, for example,
took advantage of the development of secondary
government bond markets and their regulatory
competitive advantage over banks by offering investment trust funds backed by government bonds
bearing market rates of interest. Their innovation
took funds away from banks bound by deposit rate
ceilings and created another source of tension in
the financial system. This tension eventually could
lead authorities to allow greater deposit interest
rate flexibility.

Financing deficits domestically is likely to distort
the financial system to the extent that financial
regulations and controls are binding regardless of
the channel through which deficits are financed.
The experiences of several Pacific Basin nations
suggest thatthese pressures are likely to be met
both by financial innovation to circumvent binding controls and by regulatory changes designed
to redress competitive imbalances caused in the
process. In sum, financing large deficits is one
inadvertent force moving a number of Pacific Basin nations to a more liberal and competitive financial environment.

Michael Hutchison

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the federal Reserve Bank of San
francisco, or of the Board of Governors of the federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... free copies of federal Reserve publications
can be obtained from the Public Information Department, federal Reserve Bank of San francisco, P.O. Box 7702, San francisco
94120. Phone (415) 974-2246.


04 0PI



!!omoH 0!UJ01!10)






aAJaSa~ IOJapa::J

(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
U. S. Treasury and Agency Securities 2
Other Securities2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances 6
Money Market Deposit
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings ,
Net free reserves (+ }/Net borrowed( -)


Change from 12/28/83















Period ended






1 Includes loss reserves, unearned income, excludes interbank loans

Excludes trading account securities
Excludes U.S. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change






Period ended