Methods of Financing Deficits
Expert reviewed • 14 August 2024 • 8 minute read
Budget deficits occur when a government's expenditures exceed its revenues over a specific period. In recent years, particularly due to the COVID-19 pandemic, many countries, including Australia, have experienced significant budget deficits.
Government Borrowing
The primary method of financing deficits in Australia and most developed economies is through government borrowing. Governments can borrow money from two different sectors: domestic and international.
Domestic Borrowing
In Australia, domestic borrowing is managed by the Australian Office of Financial Management (AOFM). The main instruments used are:
- Government Bonds: Governments issue bonds to raise money from domestic investors. These bonds are essentially loans that must be repaid with interest. For example, the Australian government regularly issues bonds to finance its budget deficits. Australia's trends of issuing bonds are displayed by the following graph:
- Treasury Bills: Short-term debt instruments that the government can use to manage short-term funding needs. These are typically issued with maturities of less than a year.
As of 30 June 2023, Australia's total government securities on issue stood at A$872 billion, with Treasury Bonds accounting for the majority at A$832 billion.
International Borrowing
While Australia primarily relies on domestic borrowing, some countries also borrow internationally. Australia can thus "borrow" money from international sources in two different ways:
- Foreign Bonds: Governments can also issue bonds in foreign markets to attract international investors. This method allows access to a larger pool of funds but can expose the country to exchange rate risks.
- Foreign Loans: Governments may borrow directly from foreign governments or international organisations like the International Monetary Fund (IMF) or the World Bank.
Australia's low reliance on international borrowing reduces its exposure to exchange rate risks and external economic shocks.
Quantitative Easing
During the COVID-19 pandemic, the Reserve Bank of Australia (RBA) implemented quantitative easing (QE) for the first time in its history. Quantitative easing essentially refers to a central bank printing new money. This is done according to the following steps:
- The central bank creates new money electronically.
- It uses this money to purchase government bonds and other securities from financial institutions.
- This increases the money supply and lowers interest rates, encouraging borrowing and spending.
Australia's Quantitative Easing (QE) programme, initiated by the Reserve Bank of Australia (RBA) in November 2020, involved significant government bond purchases. By the time the programme concluded in February 2022, the RBA had acquired A$350 billion worth of these bonds. Upon termination, the central bank declared it would not reinvest the proceeds from maturing bonds, marking the end of this monetary policy intervention.
The Use of Fiscal Buffers
Governments can also use fiscal buffers to finance deficits. In Australia, this primarily involves the Future Fund. Australia's Future Fund, established in 2006, serves as a financial cushion for upcoming public sector superannuation obligations. By 31 March 2023, the fund had amassed A$205 billion in assets. Although not directly tapped for deficit financing, the Future Fund's presence offers the government increased flexibility in its financial decision-making processes.
What are the Implications of Deficit Financing?
- Economic Growth: Borrowing to finance deficits can stimulate economic growth if the funds are used for productive investments. However, excessive borrowing can lead to higher interest rates and crowd out private investment.
- Inflation: Monetary financing and QE can lead to inflation if not carefully managed. The risk of inflation must be balanced against the need for economic stimulus.
- Debt Sustainability: The long-term sustainability of public debt is crucial. High debt levels can limit a government's ability to respond to future economic crises and may lead to higher taxes or reduced public services.
- Exchange Rates: Borrowing from foreign sources exposes the country to exchange rate risks. A depreciation of the local currency can increase the cost of servicing foreign debt.