State or government can raise loans or borrowing in different forms. It may obtain loans from (i) people within the country, (ii) from other states and specialized international credit institutions, (iii) by issue of inconvertible paper currency.
Whichever method is adopted by the state (government), there is limit of borrowing in each case. If that limit is crossed, the country is bound to suffer.
We discuss below the various methods of state (government) borrowing and also the limit to which the state can borrow:
(1) Internal Borrowing:
When a state finds that it is not possible to obtain further money by taxation, it resorts to borrowing from citizens and financial institutions within the country. The state may accumulate funds by raising short term loans or long term loans or by both.
How much loans the state will obtain depends upon the total physical saving of the nation and the socio-economic conditions prevailing at that time. If the state is passing through a very critical period, then it can borrow all the money which the nation saves. In that case, trade and industry will suffer because no money is left to finance them. In the normal period, however, the state can borrow only surplus funds which are left with the businessmen after meeting all the needs of the business.
(2) Borrowing from the Central Bank:
A government can raise loans from the Central Bank of the country. The Central Bank purchases the government securities, bonds and debentures from the government and advances loans against them. Almost every modem state is obtaining funds by this method.
Like other methods of state borrowing, there is no limit to which a state can raise funds by this method. The limit is reached when money begins to expand in excess of needs of the trade. This is because of the fact that when currency is issued in excess of the amount justified by the state of trade, then it inflicts incalculable loss to the community by disturbing trade and industry. It paralyses the whole of economic system.
We conclude, therefore, that every state should borrow from central bank within reasonable limits. It should not cross ordinarily the limits of safety. When a loan is raised, it has to be repaid. So why to burden ourselves too much? If, however, the existence of the state is in danger, then loan can be raised to any limit.
(3) External Borrowing:
External loan is that which is raised from international money markets, foreign government and from international agencies like “International Monetary Fund”.
When a state is in need of money, it tries to get as much loan as it can from other states. The foreign governments do not advance loans without a limit. They minutely study the budgetary position of the borrowing country, the tax-bearing capacity of the nation, the per capita income of the people and the purpose for which the loan is desired. If the position of the budget is sound and the taxable capacity of the nation is high, then a foreign government may advance sizable loan to the borrowing country.