On the road to a debt trap

~ Short term gains and long term burden of foreign debt

By the Economist

The 500 million US dollars that the government has borrowed may ease the current financial problems. However, there is no doubt that the government is passing on a debt burden to future years and the short-lived relief could lead to wrong directions in policy and aggravate the fundamental problems in the economy. The dangers of foreign borrowing are twofold. On the one hand, the foreign debt burden and the total public debt would be increased appreciably, and on the other hand, the government is likely to pursue economic policies that would aggravate the fundamental weaknesses in the economy. There would be some immediate benefits that would mask the long term adverse consequences.

There would be an easing of several problems owing to the availability of these funds to the government. Immediately, there would be an improvement of the balance of payments due to the inflow of these funds. This would strengthen the Rupee temporarily and the trend of depreciation that we have witnessed in recent months would be arrested, if not reversed. The government expects the Rupee to stabilise around US $ 110 as a result of the strengthening of the foreign exchange reserves. However, it must be cautioned, a multiplicity of other factors too matter in determining the exchange rate.

The stability in the exchange rate would give some relief to consumers as the prices of several basic items of consumption such as milk, sugar and flour, that are imported, need not increase owing to the depreciation of the currency. The availability of these foreign funds could reduce the government's borrowing from state banks and the domestic money market and thereby reduce the credit crunch. Interest rates would therefore decline and be a relief to industrialists. However, all these temporary palliatives are fraught with dangerous consequences for the future. They are sedatives that would increase the pains after an initial period of relief. This is quite apart from the increase in the debt burden that is discussed later.

The danger of the government following wrong polices is most likely owing to the availability of the funds and the political popularity of such policies. In the first instance, the strengthening of the Rupee could lead to an increase in imports and a disincentive to exports. The latter is particularly so if our production costs rise more than that of our competitors'. Another danger arises from the continuance of subsidies on imported goods, especially that of petroleum products. Subsidised prices mean that demand would be maintained at a higher level than justified by international prices. This would put a strain on the trade balance as well as increase public expenditure. A third dangerous possibility is that the government would continue to spend irresponsibly. It may lead to overspending and extravagance on the part of the government. The government can now afford foreign travel of large delegations, increase war expenditure and indulge in tamashas.

The high interest rate for international borrowing and the short term of repayment will heave burdens on the people in the fullness of time. Hitherto, most of the country's foreign borrowing has been from foreign donors or from multilateral agencies. The country's foreign debt consists of mostly borrowings from concessionary sources. In 2006 over 90 per cent of foreign borrowing was from either multilateral agencies or other concessionary lending by donors. As a consequence it was possible to contain foreign borrowing to a bearable level. In 2006 foreign debt payments absorbed only about 13 per cent of our export earnings for the year. The bond issue would increase the burden, especially as the interest rates are higher than the country has paid in the past and the period over which the capital has to be repaid is short, only five years. It would be particularly burdensome in 2012.

Foreign debt has been increasing in recent months and this loan would make it jump higher. The total foreign debt, which was Rs. 956,620 billion at the end of 2006, increased by about 30 per cent to Rs. 1,244,500 billion by the end of July this year. The additional borrowing would have raised the debt burden further. At the end of this year the public debt that consists of the foreign debt and domestic debt (the higher component) is likely to exceed the value of all goods and services produced during the year (the 2007 GDP).

The funds have been borrowed at an interest rate of 8.25 per cent. This is about 3.25 per cent above the LIBOR rate of lending that was 5 per cent last week. The LIBOR, is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market or interbank market. No wonder it was oversubscribed by twofold at this high interest rate by international standards. International banks are certainly making a huge gain lending at this high interest to a government that cannot afford to default. This would be so even in the event of a change of government, as no future government could face the risks of defaulting. This is because in such an eventuality the country will not be able to borrow from then onwards, and the consequences of such action would be disastrous. Nevertheless, the threat of not honouring the debt may have raised the rate of interest of the loan. It may also be mentioned that Sri Lanka has an excellent record for the repayment of its debt obligations that no government should blemish.

The government would continue to celebrate the over subscription of the bond issue. People would have to be apprehensive about this success that would bring immediate benefits, but which is likely to pile burdens on them in the future. This is not only due to the higher debt servicing costs but also owing to it leading the government to pursue policies that would weaken the economy. If the borrowed foreign funds are not used productively the end result would be that we may get ourselves into a debt trap.