Chapter

XXIII. Expenditure Arrears

Editor(s):
Ke-young Chu, and Richard Hemming
Published Date:
September 1991
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What is the fiscal and monetary impact of arrears? How do they affect the behavior of the private sector?

At which stages of the budgetary process can arrears arise?

How can arrears be monitored? Does the accounting system matter?

The emergence of government expenditure arrears, indicating delays in a government’s payments to its suppliers and creditors, has become an important fiscal issue in many developing countries. Given accounting conventions, the presence of arrears may lead to an underestimation of expenditure, the impact of government operations and the size of the fiscal problem facing a country. Since arrears are a form of forced financing, the government’s borrowing requirement is understated, yielding a distorted picture of the sources of credit expansion in an economy. Arrears also raise issues related to fiscal adjustment. This note focuses on domestic arrears; arrears on external debt payments are discussed in the note on Debt Relief.

What Are Arrears?

In principle, the concept of arrears appears uncomplicated. They are the total outstanding obligations due for payment that the government has failed to discharge. Normally, claims that have been referred to adjudication, or are found wanting in documentation, should be excluded. Similarly, arrears arising from pay revisions with retroactive effect are also excluded. The aim is to isolate those payments for which claims have been established but which are kept pending for prolonged periods, usually for lack of necessary funds. The only obvious discretionary issue is the definition of when the time lag between the creation of a payment obligation and its discharge becomes so abnormal as to imply the existence of an arrear, or in the case of a prolonged delay, a default. In reality, the identification and measurement of arrears based on the notion of a greater than normal delay is rarely straightforward. Although legal requirements usually fix the date for payment, there can be considerable administrative lags in processing and recognizing the legal obligation to pay.

The Economic Impact of Arrears

The emergence of government arrears is likely to have implications for the allocation and distribution of resources within the economy, both through its effects on input prices and incomes, and through its macroeconomic effects. Two factors are important: the extent to which arrears are anticipated and the extent to which creditors can neutralize the impact of arrears. The most obvious allocative effect, in the short run, is that arrears constitute an alternative form of deficit financing. If forced taxation through money creation is not feasible, the government’s claim on total output is limited by available foreign financing and by the amount the domestic economy is prepared to release to the government by paying taxes or by extending credit. The buildup of arrears increases the government’s absorption of resources above this level. This initial effect, however, may be offset if the rest of the economy responds to the arrears by holding back tax payments and other fees and charges. At the same time, it should not be forgotten that there are often other transactions offsetting the accumulation of arrears to certain suppliers, for example, the prepayment of goods to other suppliers. There may also be important distributional effects of a buildup in arrears arising from the government being able to delay payment to one group of claimants much more easily than another. Finally, the accumulation of government arrears may have a serious impact on the confidence of private enterprises and households in the soundness of government financial operations. Private consumers and investors might anticipate increases in the nominal tax rate, inflation, or more generally, a deterioration in the financial situation of the country over the medium term.

Macroeconomic consequences

Goods and services

When arrears first emerge as a means of more than temporary government financing of purchases, the effective interest cost of financing arrears is wholly borne by the suppliers of goods and services (be they producers, importers, or wage earners), as the forced financing is presumably unanticipated. Over time, and in the face of further likely arrears by the government, those economic agents providing goods and services to the government may begin to adjust their pricing and production behavior to take account of such payment delays. Vendors dealing with the government may begin to charge higher prices to make up for refinancing costs, to reflect their risk premium, or to pay the bribes needed to speed up the payment process. Thus the government may have to pay prices above the market price and, with limited budgetary outlays, be forced to reduce the quantities of goods and services purchased.

The implicit interest costs of arrears are independent of whether or not providers of goods and services bid up prices to account for the delays in payment. The degree to which prices are increased only determines the distribution of the financial burden of the payment delay, for example, as between the government, by paying increased prices (and ultimately the consumers of its services through reduced services or higher taxes or fees), or the vendors, through a squeeze in their profit margins. To the extent that arrears are reflected in higher prices of those expenditure items on which arrears are frequently incurred, existing fiscal data provide a biased picture of the true weight of interest costs in the budget, not taking account of the implicit interest costs included in expenditure on goods and services.

In its normal purchases of goods and services from vendors, the government sets in motion an income-creating process that increases aggregate demand. The effects of the government incurring arrears on payments will depend upon the way vendors initially finance the production of the goods and services to be supplied to the government. If this financing takes the form of borrowing from the banking system, the impact will be no different than if the government had made the payment on time with proceeds borrowed from the commercial banks, except that the vendors will pay the interest costs; however, as noted earlier, the fiscal incidence of these costs is likely to be on the government. Thus the overall effect on aggregate demand will be very similar to that arising from bank-financed government expenditures. Alternatively, vendors might perceive the incurrence of government arrears as only a temporary phenomenon and thus reduce their cash balances below the level warranted by the prevailing interest rates and their volume of transactions. A strong effect on demand may also be expected if vendors satisfy their financing needs by external short-term indebtedness. While domestic arrears are usually passed on to other domestic suppliers, companies have adjusted to the government’s inability to meet its obligations by creating arrears to the foreign parent company. In the latter case, the government has indirectly financed its expenditure by what amounts to an inflow of foreign short-term capital.

Wages and transfers

The change in aggregate demand brought about by the creation of arrears in wage payments to government employees will depend largely upon their perception of the postponement of wage payments and their underlying consumption behavior. If, for example, the spending decisions of government employees are determined by their actual cash income, and if the government stretches out the period between paydays such that the civil servants receive only 11 monthly salaries in a 12-month period, then their private consumption will drop by 1/12

= 8 ½ percent. But, if their underlying consumption behavior is more accurately described by a permanent income model of consumption behavior, and if government employees regard delays in salary payment as only transitory, civil servants may perceive only the interest foregone on the deferred payment as a cut in permanent income. Their consumption outlays would then drop only marginally, and the temporary cash shortage would be made up by dissaving. In reality, civil servants may not have confidence in being able to recover the loss in cash income incurred by the payment delay, the drop in their permanent income will be considerably more than just the foregone interest. A similar analysis can be applied to arrears in other government payments to private households. Delays in transfer payments and in interest payments on government bonds held by the private nonbank sector will tend to reduce private consumption. The fall in consumption will be determined by the relevant consumption function and the perception of the household as to whether the payment delay represents a transitory or permanent change in government policies.

Principal repayments

The macroeconomic effects of amortization arrears are likely to be less than those arising from expenditure arrears, since the former do not set in motion an income-generating flow of goods and services from the rest of the economy to the government or engender any expectation of accrued income. To assess the effects of amortization arrears is difficult, since much depends on the response of creditors, which in turn hinges on whether such arrears were anticipated. In the extreme case of the creditor not anticipating the arrear, it could be argued that if the government fails to make a domestic amortization payment on time, the only immediate effect will be a substitution of a formal claim on the government by another one. The total amount of claims of the private sector on the government remains unchanged. This argument assumes that the government will continue to pay interest on the loan, and that the portfolio owner believes that the government will finally repay the loan. Typically, creditors might try to raise the interest rate somewhat in order to compensate for the higher risk now associated with this part of their portfolio. If, however, the government stops paying interest and so increases the perceived probability of default, a domestic amortization arrear may lead to a fall in private sector wealth, which will reduce consumption.

Arrears and inflation

At first glance, it appears likely that government arrears have an impact mainly on relative prices. As described above, suppliers are likely to react to the incurrence of government arrears by bidding up the prices at which they are prepared to sell goods and services to the government. In more general terms, in an environment characterized by financial instability, as reflected by the government’s inability to make payments on time, economic agents will include high risk premiums in the calculation of the price at which they are prepared to render goods or services. But, where the provider of goods and services is able, within the overall credit ceiling, to bridge the delay in payments by borrowing from the banks, this may add pressure to the credit market, and as in the case of additional government borrowing, push up interest rates. If this effect induces the central bank to relax monetary policy or attracts capital inflow, the outcome would also be pressure on prices. When arrears are accumulated against public enterprises, as is often the case, and are of sufficient magnitude, the financial position of the public enterprise sector may worsen. If this results in higher credit from the central bank, arrears will end up creating inflationary and balance of payments pressures. Where the creation of arrears takes place at a very late stage of the expenditure process by increasing the stock of outstanding checks beyond the normal check float and beyond the government’s short-term capacity to honor them, then significant monetary effects can be expected. Because government checks are normally highly liquid, an increase in broad money takes place, and if the demand for money does not grow at the same pace, a continued overhang of check float can be destabilizing.

Identifying and Monitoring Arrears

Controlling arrears requires a clear definition of an arrear, an inventory of arrears based on this definition, and a means of monitoring changes in this inventory. In identifying arrears, there are difficulties arising from dubious obligations that have yet to be regularized. Interlocking arrears also create problems, especially where the parties involved dispute their validity. Generally, net arrears are more relevant than gross arrears; an exception would be where tax payments are held back. Even if arrears can be identified, monitoring the subsequent discharge of arrears is often difficult. Developing an appropriate control mechanism is very much a function of existing budgetary procedures. The characteristics of the British and French types of accounting systems suggest that the monitoring of arrears is likely to be easier in francophone countries (see Chart 1). In these countries, there is greater possibility of gaining a more complete picture of the movement in government arrears by tracing the changing stock of outstanding commitments, through the stock of payment orders, to checks issued and cashed and having a reporting system at different stages of the expenditure process. In this way, the French type of budgetary system, when functioning properly, offers a direct indicator of arrears relatively early in the expenditure process. The British-type system, on the other hand, is less centralized and does not offer intermediate indicators of changes in arrears, since there is generally no centralized consolidation of payment orders issued to compare with checks issued and cashed.

Country Illustration

Monitoring arrears in Zambia

The identification and eventual resolution of a persistent government arrears problem requires the development of effective budgetary monitoring and control procedures, including adequate accounting and reporting requirements for government ministries, departments, and other specialized agencies. In the case of Zambia, weaknesses in these procedures have made it difficult to monitor the financial operations of the government, and hence the emergence of domestic budgetary arrears. Under procedures that were in effect in 1990 and earlier years, ministries and departments were required to report expenditures for which vouchers (i.e., payment orders) had been issued. Commitments entered into, but for which vouchers had not been issued, were not reported. As such, the existing reporting system did not provide an adequate early warning system to indicate whether, by how much, or in what areas budgetary commitments were accumulating, and thus creating an arrears problem. A substantial but undetermined accumulation of arrears thus occurred in 1990 and earlier years.

Chart 1.Arrears and Time Lags in the Stages of the Expenditure Process

* Data are usually available in consolidated form.

** Data are only available on a disaggregated basis.

To address these deficiencies, the Budget Office of the Ministry of Finance undertook a review of the government accounting and reporting procedures, and developed revised procedures that would allow the budget to be monitored on commitment, vouchers-issued, and cash bases. These revised procedures are now in the process of being implemented. The four largest ministries (in terms of budgetary appropriations) were the first to begin adopting the new procedures, with the view that effective implementation will take a number of years and that it was essential to cover the greatest proportion of the total budget as quickly as possible. As part of the overall effort, the government is also verifying the stock of domestic arrears from 1990 and previous years, with a view to programming a phased reduction as quickly as possible.

Bibliography

    Diamond Jack and Christian Schiller. “Government Arrears in Fiscal Adjustment Programs,” in Measurement of Fiscal Impact: Methodological IssuesOccasional Paper No. 59ed. by Mario I. Blejer and Ke-young Chu (Washington: International Monetary Fund1988).

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