Long shadow of govt. debt
Sri Lanka’s government debt burden is weighing heavily on the economy in respect of mounting debt service payments – a problem aggravated by steep depreciation of the rupee against major foreign currencies. In terms of the year-end exchange rate (RS/US $), the rupee depreciated by 22 percent between 2016 and 2018.
The outstanding central government debt has two components: outstanding external debt and outstanding domestic debt. The outstanding public debt comprises the central government debt plus outstanding treasury bonds for restructuring of state-owned enterprises (SOES), publicly guaranteed debt and outstanding international bonds issued by the SOES.
In 2018, the central government debt amounted to Rs.12 trillion while the public debt amounted to Rs13.2 trillion. Focus in this article is on the central government debt.
Central government debt
The central government debt-to-gdp ratio increased from 76.9 percent in 2017 to 82.9 percent in 2018 due to the combined effect of rupee depreciation, low nominal GDP growth and higher net borrowings to finance the overall budget deficit of Rs.760.7 billion, amounting to 5.3 percent of GDP.
The deficit was financed in the following manner: (a) domestic market borrowings: Rs.329.3 billion; (b) proceeds from the Hambantota port long lease: Rs.107.9 billion and (c) foreign loans: Rs.323.5 billion. Thus, 57.5 percent of the resource requirement was financed through domestic sources and 42.5 percent through foreign sources.
The government debt has been growing faster than GDP in the current decade. The cost of servicing the debt has also been increasing due to greater reliance on highcost commercial loans (both foreign and domestic). But higher government borrowings, on the whole, have failed to produce the desired economic impact.
Far from shifting to a higher growth trajectory, the economy is actually slowing down. It is tempting to argue that the government debt overhang is contributing significantly to sluggish economic growth. The more public funds diverted to debt servicing, the less available for development.
The ballooning government debt is casting a long shadow on the economy. The problem with long shadows is that they are extremely difficult to chase away. No country can live beyond its means indefinitely – especially a small country like Sri Lanka with a population of 21.7 million, a per capita GDP of only US $ 4,100 and a per capita export value of only US $ 550.
Due to its small size and dependence on foreign commercial borrowings to meet its external debt-service obligations, the Sri Lankan economy is highly vulnerable to external shocks.
In 2018, the external and domestic debt portfolios accounted for 49.8 percent and 50.2 percent of the outstanding government debt stock, respectively. The external debt is serviced in foreign currency while the domestic debt is serviced in rupees. However, about 6 percent of the domestic debt (Rs.715 billion) is denominated in foreign currency, which has to be serviced with foreign currency inflows.
Debt securities account for 39.9 percent of the government external debt and 91.4 percent of the government domestic debt. These are high-cost debt instruments (such as treasury bonds, treasury bills and international sovereign bonds), which are used to finance government debt-service payments.
The shares of the banking and non-bank sectors in the government domestic debt are 38.5 percent and 61.5 percent, respectively. The share of provident and pension funds in the non-bank sector debt is as high as 61.0 percent. These funds also comprise the largest share of government domestic debt (37.3 percent). The owners of these funds would be left high and dry if the government were to default on its domestic debt – a frightening prospect.
Domestic commercial borrowings by the central government include rupee loans, treasury bills and treasury bonds. When these borrowings become excessive, they tend to crowd out private-sector borrowing. Since private investment is the engine of growth, the crowding-out effect tends to retard GDP growth. This may partially explain why the Sri Lankan economy is chugging along like a steam boat. Under the current regime, it has averaged only 4 percent GDP growth per annum.
Debt-service payments
The government debt service payments are financed largely through foreign and domestic commercial borrowings. In 2018, total government debt service payments amounted to Rs.2.1 trillion. Domestic debt service accounted for about 75 percent of both amortisation and interest payments. 59.2 percent of total debt service consisted of amortisation payments with the balance comprising interest payments.
The government external debt service payments amounted to 15.3 percent of foreign currency earnings from the export of goods and services, while total external debt service payments accounted for 28.9 percent of these earnings. The shares of the government, the private sector and deposit-taking corporations combined and the Central Bank in external debt service payments (totalling US $ 5.9 billion) were 52.9 percent, 46.5 percent and 0.6 percent, respectively.
As suggested in a previous article, the government should seek more project loans and less commercial loans as the former are cheaper and have a longer repayment schedule. Thus, project loans exert less pressure on foreign currency reserves than commercial loans in respect of debt servicing. Due to the tightening of global financial conditions, the government will find it increasingly difficult to access foreign commercial loans, which is another reason why project loans should be substituted for commercial loans as far as possible.
In 2018, project loans accounted for 52.9 percent of the government external debt. The share of government debt in the total external debt of US $ 52.3 billion was 61.2 percent.
Domestic interest rates are much higher than foreign interest rates. Hence, the costs of servicing the domestic debt are quite high as well. To the extent possible, the government should avoid financing its debt-service payments with foreign and domestic commercial loans. This is because higher debt-servicing costs can threaten macroeconomic stability. Prudent government spending and borrowing is therefore crucial for achieving macroeconomic stability.
Sri Lanka credit rating
Credit-rating agencies such as Moody’s, S&M and Fitch are constantly downgrading the government’s sovereign rating due to large external trade deficits, the low level of foreign currency reserves and the rise in external debt service payments to alarmingly high levels. Clearly, these agencies are worried about the government’s habit of rolling over the debt year after year against a backdrop of slow GDP growth and periodic political crises, which exacerbates the refinancing risk.
Currently, Fitch has given the government a B credit rating for foreign currency borrowing. If and when this drops to the C level, alarm bells will begin to ring. Commercial and bilateral lenders may say enough is enough and pull the plug. The government will then have no choice but to go to the International Monetary Fund (IMF) with the begging bowl. An IMF bailout will be tied to a series of austerity measures, which may not be well received by the public, especially because the hardest hit in the short run are typically the poor.
Debt sustainability
Debt sustainability is defined by Development Finance International (DFI) “as the ability of a country to meet its debt obligations without requiring debt relief or accumulating arrears.”
To attain the goal of domestic debt sustainability, fiscal imbalances have to be minimised. But in Sri Lanka, fiscal imbalances are so pronounced, one wonders how close the economy is to the tipping point. In 2018, the government revenue amounted to only 13.3 percent of GDP while the government expenditure and net lending amounted to 18.6 percent of GDP.
Total debt service payments, as a proportion of government revenue, amounted to 109 percent. Thus, the government finds itself in a situation where the government debt service payments exceed government revenue.
By comparison in Malaysia (which was poorer than Sri Lanka in the 1950s), the government debt service charges amount to only about 13 percent of government revenue. To reduce fiscal imbalances without reversing the declining trend in the revenue to GDP ratio will be an exceedingly difficult task.
Income taxes account for only 18 percent of tax revenue compared with 70 percent in Malaysia. The low income tax to revenue ratio could be viewed as a serious flaw in the revenue architecture. To strengthen and expand the revenue base, a viable solution to the problem of how to boost the direct tax take needs to be found.
On the expenditure side, government spending needs to be guided by fiscal prudence norms. Excessive spending and borrowing over a long period of time results in a spiral of increasing deficits that create ever higher debt, which is what has happened in Sri Lanka.
From 1980 to 2009, the fiscal deficit to GDP ratio has ranged from a high of 19.2 percent to a low of 6.9 percent and in the current decade (2010-2018), from a high of 7.6 percent to a low of 5.3 percent. More fiscal discipline has been exercised in this decade than in the three previous decades with the fiscal deficit to GDP ratio dipping below 6 percent in several years. However, this ratio on the whole has been unsustainable, which is why the economy is now sagging under the weight of accumulated debt.
It could be argued that over the past 14 years, expansionary fiscal policy, reflected in several infrastructure projects that haven’t met their expected returns, is at the core of Sri Lanka’s creeping debt crisis. The long gestation period associated with large infrastructure projects is a factor to be taken into consideration in this regard.
Key elements of a policy reform agenda
The new president, to be elected on November 16, will have a job on his hands to turn the ailing, debt-ridden economy around. One thing is for certain: he will have to take drastic action to repair the damage caused by the failure of successive governments to exercise fiscal prudence over the past four decades. The fiscal deficit to GDP ratio in 2018 was 5.3 percent compared with the target of 4.8 percent.
According to the Fiscal Management Report 2018, published by the Finance Ministry, the target for 2020 is 3.5 percent. Malaysia was able to reduce its fiscal deficit from 5.3 percent in 2016 to 3.1 percent in 2017, thereby demonstrating that it is possible to achieve a reduction of this magnitude in one year if the government puts its mind to it.
A sustained increase in net exports and net foreign direct investment inflows is critical for building up foreign currency reserves and achieving external debt sustainability. In 2018, Sri Lanka’s foreign currency reserves amounted to a paltry US $ 6.9 billion while Malaysia’s amounted to US $ 103 billion.
Relying mainly on commercial loans to service external debt service obligations is not a viable strategy in the long run as it will serve only to precipitate a severe, rollover debt crisis. If and when this happens, the government would be forced to go to the IMF with the begging bowl. Pakistan, which is in a bigger mess than Sri Lanka, has already done so. The IMF bail-out package, conditional on fundamental macroeconomic reforms, amounts to a staggering US $ 6 billion.
In sum, a coherent and cohesive macroeconomic framework for attaining central government debt sustainability within a reasonable period of time should form the core of the new regime’s policy reform agenda for Sri Lanka. The economy has been extremely sluggish in recent years with GDP growth expected to be 3 percent or less in 2019.
The new regime must aim to achieve the following in order to boost confidence and to inspire the sorts of capital inflows and domestic capital investments needed to get the economy on a far higher, inclusive growth trajectory: macroeconomic stability, more prudent public spending, a steady improvement in domestic revenues, a reduction in public debt and caution regarding highcost public borrowing (either foreign or domestic). To implement these key reforms would take courage as well as commitment on the part of the new regime.
THE NEW PRESIDENT, TO BE ELECTED ON NOVEMBER 16, WILL HAVE A JOB ON HIS HANDS TO TURN THE AILING, DEBT-RIDDEN ECONOMY AROUND. ONE THING IS FOR CERTAIN: HE WILL HAVE TO TAKE DRASTIC ACTION TO REPAIR THE DAMAGE CAUSED BY THE FAILURE OF SUCCESSIVE GOVERNMENTS TO EXERCISE FISCAL PRUDENCE OVER THE PAST FOUR DECADES