The debate on the controversial dollar bond continues

By the Economist

The government’s intent to borrow US$ 500 million continues to hold centre stage in political controversy. This is perhaps the first time that a foreign loan has turned into a battle among contending political groups. The arguments for and against the bond issue, though couched in terms of economic implications, are in fact based on political commitments and political affiliations. Those who support the government, including the large array of “official economists” and the President’s “economic advisers”, are eloquent in their silence. If pressed to comment they would no doubt say something in support of the borrowing. On the other hand, those supporting the opposition and most “independent economists” and economic journalists think it imprudent to borrow such a large sum on commercial rates of interest and conditions of repayment. And this includes the JVP.

Those supporting the government have come up with novel justifications for borrowing, that are different from the original justification that was adduced that the money was for infrastructure development. The Minister of Enterprise Development, a former Finance Minister, Dr. Sarath Amunugama, who has a sound knowledge of economics, has come up with some fanciful views justifying the borrowing. He has said that the borrowing would ease the pressure on the Rupee and therefore arrest its depreciation that he considers to be the reason for the increase in prices. He is of the view that the main cause of inflation is the depreciation of the currency and therefore this loan would reduce inflationary pressure. No doubt Dr. Amunugama has made these comments with his tongue in his cheek. If borrowing were the solution to currency depreciation, then countries could always have a stable currency. In fact stability in the Rupee owing to an inflow of borrowed funds could be a serious threat to exports when the other economic fundamentals are weak.

His other reason is that since Sri Lanka is no longer considered a poor country as the per capita income exceeds US $ 1000, there is a need to borrow from commercial sources. As a middle income country, it is true we are not entitled to soft loans, but borrowing from multilateral agencies even on non soft terms would be less costly and the repayment terms spread over a long period of time. Besides this the conditions placed by the multilaterals would ensure that the funds would be used for the agreed purposes and the progress of projects would be monitored. These are conditions to which the government does not wish to agree. Commercial borrowing, unlike borrowing from multilaterals, does not impose financial discipline. This is in fact a danger, especially in the current context of financial stringency and uncontrollable public expenditure, especially on the war.

The controversy is around three issues. First whether the amount of the loan is excessive and likely to increase the country’s debt burden, particularly the foreign debt component, to an extent that would be unbearable. The second issue, the high rate of interest that the government would have to bear on a commercial loan. The third issue is the all important one of the need for a loan of this magnitude and the manner of its utilisation. There is much controversy on all three of these issues that are not independent and have related considerations and implications.

The amount of the loan and the scheme of repayment and interest rates are considered too burdensome. However the amount of the loan cannot be considered independently of the terms of borrowing and the use of the funds. A loan of US $ 500 million could be justified if its use generates a significant return in terms of goods and services and especially an increase in exports. The loan is not a small sum and would add a noteworthy amount to the accumulated foreign debt component of the country. By the end of June this year the foreign debt had increased to Rs. 1014.4 billion. This is nearly 11 percent higher than what it was at the middle of last year. The proposed loan of US $ 500 million is approximately Rs. 56 billion. Although it would be an exaggeration to say that the loan will raise the country’s foreign debt considerably, it is true that the debt would increase the debt by a noteworthy amount, change the composition of the debt and increase debt service costs.

The applicable interest rate would be the international commercial lending rate that is determined by the prime rate of LIBOR plus a premium for risk. The interest rate for this loan is expected to be around 7 percent per annum. With this loan, the proportion of debt on concessional terms would decrease, the interest costs would rise and the amortisation schedule would be more burdensome. Yet, the extent of the country’s indebtedness and the debt service costs are still manageable, as the portfolio of debt remains within reasonable confines. Only about 7 percent of our export earnings go towards the repayment of capital and interest each year at present. This would rise but not to any alarming extent. Ironically it is the total debt burden, including the higher domestic debt that is a serious fiscal problem. This additional debt compounds the fiscal liability.

The manner of loan utilisation is the paramount consideration. There is considerable political controversy on this. The government contends that the loan is for infrastructure development that is considered a serious constraint for rapid economic growth. The opposition contends that there are enough funds already committed for infrastructure development from foreign donors and that the problem lies in their utilisation. Therefore, they ask why we should go for these loans at commercial rates. Is this a camouflage? Even if, as the government claims, the funds are for infrastructure expenditure, is the borrowing justified? All expenditures on infrastructure are not economically productive to any significant extent, though they may have social benefits and perhaps long run economic results as well. Infrastructure consists of varied types of expenditure from building airports to building schools and hospitals. Infrastructure expenditure is very costly and the returns are over a long period of time. In addition, all infrastructure expenditure does not bring the same returns and the flow of returns could be long drawn out. The bottom line is that infrastructure expenditure would not contribute to a reduction in the foreign debt servicing burden for a long time as it won’t increase production of tradable goods or exports. Some only bring social returns and no direct economic benefits occur. The actual danger lies in the use of the borrowed funds for consumption rather than investment. The worst scenario would be its use for military expenditure that is not economically productive. To the extent that it is for military hardware imports, even the immediate benefit to the balance of payments by the inflow of funds would be quickly off-set by the outflow of funds for imports. To the extent that it is used for domestic expenditure in the war it would be inflationary.

There is a real danger in the availability of these funds as the government’s fiscal discipline could be flawed further. Price adjustments of imported goods, whose prices are rising may not be adjusted to reflect international prices, harmful subsides would distort prices, priorities in public expenditure could be irresponsible and wasteful government expenditure could swell. All these would result in a heavy burden on the economy in the long run. Borrowing at commercial rates and short periods of maturity would ease economic burdens in the short run while creating a debt burden in the long run.