Should govt pay interest on delayed domestic arrears?

Domestic arrears are generally defined as governments’ financial obligations that remain unpaid beyond the fiscal year in which they were incurred and due. These are a form of forced financing prevalent in many sub-Saharan African countries, and as such, they have become a key economic policy challenge, whether for the clearance of the existing stock or the prevention of new arrears.

Although weak fiscal institutions are a root cause of domestic arrears accumulation, high levels of arrears are generally driven by difficult-to-absorb large shocks. Shocks can have various triggers for example, an economic recession or slowdown, internal (political, security) instability, a public health crisis (such as Covid-19), or natural disasters. A government can react to the resulting revenue decline by raising non-commodity revenues and/or cutting spending.

When the adjustment is too large and unfeasible, and when more financing (including from donors) is unavailable, resorting to “forced borrowing” by accumulating arrears to close the remaining financing gap may be an inevitable outcome. In Uganda, a lot of the delays in payments are purely administrative. 

In a 2021 report titled “Strategies to clear and prevent domestic arrears,” by the Ministry of Finance, domestic arrears stood at 3.6 trillion representing 8 percent of the budget in the financial year 2019/2020. The same report recognises that: “Even though GoU has made annual budget provisions to pay arrears, the stock continues to rise.” 

Despite the prevalence of arrears, their causes, effects on both micro and macroeconomics, and consequences are not well understood due to lack of reliable and comparable data. Therefore, their true scale and cost may be hidden, and little operational guidance exists as to the best approach when it comes to arrears clearance. 

Domestic arrears can have multifaceted effects on the economy. They are damaging to the private sector and lead to stress on the banking sector, with negative ramifications for growth. They undermine trust in government and the effectiveness of fiscal policies. In particular, the fiscal multiplier declines when spending is mostly financed through arrears and can turn negative when the private sector faces high liquidity constraints. 

Shrinking of the private sector as liquidity-constrained firms, in particular small and medium-sized enterprises (SMEs), go bankrupt. This will also have knock-on effects on the creditors of such firms. Various secondary effects are also likely, eg., a higher bankruptcy rate could increase the cost of capital even to firms with access to credit; the cost of future orders of goods and services to the government could rise, as suppliers built the anticipated financing costs, including the uncertainty, into bids. 

Delays in payments also affect business investment decisions in liquidity-constrained firms. These may not only be those directly dependent on government payments, but also their suppliers as payment delays trickle downwards resulting in a reduction in aggregate demand, and finally output and growth.  

Corporate profits suffer the most when it comes to domestic arrears because unexpected delays change the present discounted value of payments. If no or a low-interest rate applies, this reduces suppliers’ profitability. 

Addressing the domestic arrears problem requires specific actions for their clearance. A clearance strategy should be consistent with maintaining macroeconomic stability, anchored on inclusive growth, and implemented transparently. 

If repayments must be rescheduled, priority should be given to payments that maximise the impact on growth. One such action is for government to start paying interest on arrears that accrual beyond 90 days. This will lessen the burden on these suppliers while acting as a deterrent measure from the accumulation of new arrears. 

Edward Ssenteza

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