Bonded by debt: Political controversy and economic implications

By the Economist

The government’s attempt to borrow US$ 500 million from the international money market by issuing government bonds has raised a number of constitutional and political questions. In fact, the economics of such borrowing has been in the background while the political controversy is in the forefront. Nonetheless, it is the economic ramifications of the borrowing that is most significant and perhaps motivates the controversy between the government and the opposition. The massive amount of the loan at commercial rates of interest raises a multitude of economic and financial issues of significance for the long-term economic development of the country.

First, let us focus on the constitutional and political issues raised by the threat of the UNP, that it will not honour the terms of the repayment or more crudely, that it is not bound to repay the debt incurred by the issue of the bonds. The question at issue is whether a government does not have a right to manage the country’s finances that would include the sovereign right of borrowing abroad. Governments have indulged in foreign borrowing for more than fifty years and these debts have been honoured by oppositions that have come into power.

Conversely does an opposition in parliament have a right to threaten the incumbent government that it will not repay? Does not international law provide for an obligation of a successive government to honour the debts incurred by previous governments? Without such an obligation a country would be unable to borrow funds either in the international money market or even from multilateral financial institutions and foreign governments.

What if the UNP’s threat materialises? Would it be possible for governments in the future, including UNP governments to borrow at all? What would be best is a debate in parliament and a vote for such borrowing. In fact the Financial Responsibility Act could be widened to include the requirement for a government to obtain parliamentary approval for borrowing large sums of money from abroad.

Irrespective of whether this threat materialises, it may initially result in a reluctance of financial institutions to lend to the government. This may result in an inability to raise the expected amount of funds. It is also likely that the costs of borrowing may rise as the perceived risks of lending would be higher. This, despite the money being borrowed by a government.

In the past there has been no such serious threats when previous governments borrowed funds from abroad. The country has a good record of repayment of debts. The only concessions have been the moratoria on debt repayment we received at the time of the tsunami.

The economics of the borrowing is a different issue. Foreign borrowing eases the domestic credit market. The anti-inflationary monetary policies of the Central Bank are a definite crunch on credit and therefore investment. The supply of credit and its costs are rising to extents that make investments unprofitable. This is especially so when input prices and energy costs are also rising. This can hurt exports. The foreign loan may ease the tight money policies though the risk of higher inflation remains.

The foreign borrowing would ease the balance of payments. Consequently, it is likely that there would be a significant surplus, easing the strain on the currency and retard the depreciation of the Rupee. These developments may also enable the government to not raise fuel prices any further (good politics but bad economics). Certainly the borrowed funds would make the government feel more comfortable in handling finances. It may lead to the spending of vast amounts on the war and increase the trend of extravagant government expenditure. It could ease some of the inflationary pressures in the economy, but this is not certain.

These are of course temporary palliatives. The long run impacts are serious. There is no doubt that an additional borrowing of US$ 500 million would add heavily to the country’s debt burden. At the end of 2006 the foreign debt had accumulated to Rs. 956,620 million that is approximately US$ 8696 million. At the end of May this year it had risen to Rs. 1,210,900 million that is about 11 per cent higher than 12 months before. Therefore the additional debt alone would raise the debt burden to Rs. 1,265,000 million. In addition the country has a higher domestic debt as well. At the end of May this year the domestic debt had risen to Rs. 1,560.8 billion. Public debt had risen to nearly the amount of last year’s GDP.

Last year the debt servicing costs absorbed about 28 per cent of government expenditure. In the past owing to the most foreign borrowing being from multilateral agencies at concessionary rates the cost of foreign borrowing was manageable. Even at the end of 2006 foreign debt payments absorbed only 12.7 per cent of our export earnings. However, this percentage has been increasing in recent years. The bond issue would raise that as the interest rates are higher than the country has paid in the past when it borrowed little from commercial sources and the period for repayment is much shorter than the borrowings from multilateral agencies. The government has resorted to commercial borrowing as the government can’t meet the conditions of good fiscal management required by these agencies.

There are doubts on what the loans would be used for. The government claims it would use it for infrastructure development. The fact is that infrastructure development at commercial rates of borrowing is not prudent, as such investments pay off over a long period of time. Besides, it is alleged that the infrastructure for which the money is to be spent already have been funded. It is contended that the money is in fact for war expenditure. These questions imply that the borrowing is ill-advised.

The bottomline of the bond issue is that the government is passing on a debt burden for the future. In contrast to the foreign borrowing in the late ’70s and early ’80s, when most of the funds were for development expenditure, with long periods of repayment and even some elements of grants in them, these funds may not contribute to an increase in goods and services and exportable goods in particular. It is likely that these funds would be for the war, generally termed as an “unproductive” expenditure. Consequently the debt burden in real terms would be greater. The only silver lining would be if the funds would lead to an improvement in the security situation that could usher in a period of rapid economic growth. Then the foreign debt serving costs, as well as the total debt burden would be manageable in the long-run.