By W A Wijewardena –
Disputing the rosy picture about Sri Lanka’s debt sustainability
In the previous article in this series, we presented the views expressed by two leading economists, Professor Sirimewan Colombage and Dr Anura Ekanayake, at a recent panel discussion on Sri Lanka’s debt sustainability opined that the country’s debt crisis, especially the foreign debt crisis, has been critical, needing quick fixing. Colombage disputed the IMF’s debt sustainability assessment that by 2025 the country would be able to sustain its debt position, assuming a drastic shrinkage in the annual growth rate of imports to 5%. An alternative assessment, according to him, based on a higher import growth of 8%, will produce a bigger gap in the availability of foreign exchange and the debt obligations of the country. This would certainly require Sri Lanka to be on alert and come out with appropriate strategies to resolve the crisis.
This article will examine the strategies to be adopted, not just for sustaining debt, but for coming out of it.
Borrowing is not a sin
Borrowing money to supplement one’s savings to undertake an investment project is not a sin if he does so knowing his limits and playing it safely. For instance, let’s consider the case of a young couple which does not have enough savings to construct a house for their use.
Postponing the decision until they accumulate enough savings will mean having to sacrifice the opportunity to begin life in a new house immediately. Besides, since there may be a cost escalation over time, they may be pursuing an elusive goal where the goal post moves farther away from them every time they make the required savings. Hence, they may borrow money from a bank now based on the prospect of having an uninterrupted income flow in the future to service the debt, that is, to repay the principal and pay interest on it.
‘Knowing limits’ means the limitation which the borrower will have in his borrowing and repaying capacity. Fortunately for him, this would be made known to him by the lending bank: the bank would see to it that he would not borrow from other sources and if he does so, would not borrow over his debt repayment capacity. A rule of thumb used by lenders is that the borrower will have at least 40% of monthly income as the take-home pay after paying the debt instalment, so that he is not driven to destitution. It would require the borrower to plan the house in such a way that it is within his financial resources. He gets into difficulty if he ignores this vital requirement.
In economics, this practice is called prudential borrowing.
Play the debt game within limits and safely
Though a private individual may play the game within his limits and safely, it is often argued that a national government would not do so and in the process may get into indebtedness. That is because they have immense sovereign powers recognised by lenders who may therefore not have qualms about extending credit to governments.
In the case of domestic borrowers, the sovereign governments can print money and repay domestic debt taking advantage of the ‘money illusion’ being felt by domestic lenders. Regarding the foreign borrowings, they may exceed the limits by mortgaging their future foreign exchange earning capacity to back the loans.
In either case, it is an irresponsible and imprudent borrowing policy. Hence, if national governments follow a prudent policy, they may also play the game within limits and safely. This was demonstrated by the colonial government in old Ceylon, when it borrowed funds to build the railway system and by the present day Singapore government, when it allowed its private enterprises to raise funds from foreign commercial markets.
Colonial government’s borrowing for the railway system prudently
Indrani Munasinghe, Professor Emeritus at the University of Colombo, in her 2002 book titled ‘The Colonial Economy on Track’ has reported that the old Ceylon’s railway system was built by the colonial administration by borrowing funds from both domestic and foreign sources (Chapter 7).
During 1862-1905 within which the entire railway system was built, the colonial government had raised £ 3.4 million by issuing debentures and stocks in the London capital market, at rates ranging from 3% to 6% per annum. To meet the local rupee expenditures, Rs 2.5 million was raised locally by issuing Ceylon Inscribed Rupee Stocks at 4% per annum.
The requirement imposed by the Colonial Secretary was that the loan proceeds should be used exclusively for the railway project, and a sinking fund should be established out of the revenues of the Railway Department to service the loans. Thus, a cost-based fare policy was adopted by the railway authorities to generate a sufficient surplus to be transferred to the sinking funds annually.
In the case of the Colombo-Kandy railway line, there was a loss in the first three years, but it was a surplus during the subsequent period. All the railway lines had generated surpluses in their operations. According to Munasinghe, in 1905, the outstanding balance in foreign loans amounted to £ 0.36 million and the balances in the sinking funds amounted to £2.6 million.
Similarly, the local loan balance was Rs 2.4 million as against a sinking fund value of Rs 2.5 million. Thus, the entirety of the loans was repaid by collecting revenue from the users of the railway system without passing a burden on to the general taxpayers. This was a unique instance of playing the game within limits and safely.
Singapore too played the game within limits and safely
Singapore, which broke away from Malaysia in 1965, did not join IMF, World Bank or ADB immediately. That conscious policy in fact denied its economy the benefit of concessionary foreign funding, which other newly independent nations, including Sri Lanka, had considered as their birthright.
Its businesses, therefore, had to borrow from foreign commercial markets under stringent loan conditions, and that itself served as the limitation factor for it to tap this source. The strict condition was that all loan proceeds should be invested in the highest earning projects, thereby ensuring safe loan repayment.
Singapore’s first finance minister, Dr Goh Keng Swee, assured the foreign lenders that they should not have any fear of leaving their savings with the tiny city state, because it would use those loans prudently and ensure the timely loan repayments. This strategy worked well and helped the country to get elevated to the status of a rich country within a generation.
Singapore joined these multilateral lending institutions in the early 2000s, not to get concessionary funding, but to make its businesses eligible for bidding for contracts involving the projects funded by these three lending institutions. That was another instance of playing the game within limits and safely.
High taxes and surplus budgets maintained by ancient Sinhala kings
There are some who believe that the way out for Sri Lanka is not to borrow at all. Their argument is based on nationalistic grounds, drawing examples from Sri Lanka’s history to prove their point. Their view is that if King Parakramabahu I, did not borrow from foreigners to build massive reservoirs like huge oceans, why should the present-day leaders resort to this obviously unhealthy practice?
This argument is flawed. On one side, during those days when there were no international lending institutions, there was only very limited option available for local rulers to borrow abroad. They could borrow from friendly or related foreign monarchs, but those loans had to be repaid not only in gold or precious stones but also by pledging unreserved loyalty to them. That was a sure way of compromising the nation’s sovereignty. On the other, the budgetary system followed by ancient Sinhala kings was completely different from the budgetary systems prevalent today. In ancient times, kings had to run a surplus budget so that resources were accumulated in the Treasury, strengthening his position.
A shortage in the budget meant the depletion of the Treasury, demonstrating the king’s weakness as a sovereign. Hence, resources were raised locally by way of high taxes and the cost of any infrastructure project had to be funded by the local population. According to Sirimal Ranawella, Professor Emeritus of the University of Ceylon, King Parakramabahu, I, who had basically followed the tax system recommended by Kautilya in his treatise on economics, The Arthashastra, had imposed two types of taxes on farmers, who were the main income earners in that ancient economy (Economic History of Ancient Sri Lanka, in Sinhala, 2014, Chapters 1 and 2).
In those days, both the land and the water resources belonged to the king and, therefore, citizens who had used them had to pay taxes on the use. The tax of the land use was 1/6 or 17% of the produce; that on the use of water was about 25% since the farmers had to use water from the king’s irrigation schemes. Altogether, farmers had to pay a tax of 42% on their produce.
Apart from this, there was the Compulsory King’s Service or Rajakaari Kramaya in which every able bodied person had to work for the king compulsorily for between 3 to 6 months free of wages. That was equivalent to an income tax of 25-50%.
With these high tax rates, the ancient Sinhala kings did not have to borrow even from friendly sovereigns abroad. All the resources needed for infrastructure developments were raised domestically via high taxes and mobilising free workers.
Modern governments have to borrow if tax incomes are low
Today, countries can raise funds domestically for infrastructure development if they can make enough savings by cutting down both the private and government consumption. Singapore, with a savings rate close to 50% of its GDP, has followed this strategy throughout. Sri Lanka has not got this luxury. Its tax income is about 13% of GDP, and does not generate funds on required amounts. Its Government is a notorious ‘dis-saver’ and, therefore, an eater of even private savings. Sri Lanka’s investment requirement is about 35% of GDP, but its savings at most stand at about 25% creating a wide savings-investment gap.
Hence, to fill the savings-investment gap, Sri Lanka has no choice but to borrow from foreign sources. Before 2009, Sri Lanka was a low-income country for international borrowing purposes; accordingly, it could borrow abroad at concessionary rates. However, with the country’s elevation to the state of a lower-middle income country, it could not tap these sources any more. Thus, Sri Lanka had to borrow from commercial sources under stringent loan conditions. That was the reason for the accumulation of foreign debt by the country snaring it in a debt trap.
Government’s patchwork to solve the crisis
The Government in 2017 enacted the Liability Management Act by way of addressing its chronic as well as acute public debt issue. It enables the Central Bank to borrow outside the Government budget in lax years, keep the money in a special account or repay high cost public debt immediately or use the loan proceeds to repay the loans that are to mature in a bunch in a given year, endangering the country’s public finances.
It has two limitations as far as Sri Lanka’s debt is concerned. One is that it only improves the Government’s cash flow and trims the peaks of debt repayment obligations without affecting the relevant year’s public finances. The second is that it is not a solution to the country’s external debt problem since a significant part of its foreign debt, now standing at $ 54 billion, constitutes debt contracted by the private sector. In fact, that amounts to $ 20 billion or 37% of the country’s total external debt. The Liability Management Act does not address this component of Sri Lanka’s external borrowings.
Consequently, as far as its mounting external and domestic debt is concerned, the long-term way-out for Sri Lanka is three-fold.
Discipline the Budget
First, its public finances have to be disciplined by taming expenditure, especially the recurrent or consumption expenditure, on one side, and improving revenues, on the other. The Government authorities appear today to take immense pride in generating a small surplus – less than 1% of GDP – in the primary account of the Budget, which represents its budgetary position devoid of interest payments on public debt. The ensuing small surplus implies that the Government has been in good behaviour with regard to its normal expenditure programs.
But, what the Government should aim at is not just a surplus in the primary account but a surplus in its revenue account, a small one to begin, with but going for a sizable one amounting to 3-4% of GDP in the medium term. This requires the Government to cut wasteful expenditure like having a jumbo-size Cabinet of Ministers and unnecessary galas involving top Government leaders in distributing Samurdhi franchises and Government jobs etc.
A sensible government will have such galas not for admitting the poor to the club, but for recognising those who have left the club by crossing the poverty-line through the Samurdhi scheme. A job award can be conveyed to the job recipient today practically at zero cost via internet, similar to the way the Commissioner-General of Examinations releases results of public examinations.
Have a proactive policy for FDIs
Second, Sri Lanka should attract the non-debt foreign direct investments or FDIs into the strategic sectors.
Vietnam, the emerging star of economic prosperity in East Asia, has done this through a strategic FDI plan covering the next decade beginning from 2020. Its aim is to attract FDIs to high tech manufacturing, high tech agriculture, education, healthcare and travel services. Vietnam believes that this strategy will help it to prepare its population to successfully face the challenges coming from the onset of the Fourth Industrial Revolution or Industry 4.0. To face Industry 4.0, Sri Lanka should begin to develop a digitally-equipped smart workforce that can function as foot soldiers in the revolution.
Join global production sharing networks
Third, it is of utmost importance for Sri Lanka to increase its earnings from the export of merchandise goods and services which are stagnant at present. To do so, it has to join the global production sharing network by producing only one or two components of high tech products for assembly in a global factory elsewhere if the country cannot host such assembly plants on its shores.
Already, two firms – Lanka Harness that supplies sensors for air bags in motor vehicles and MAS group that supplies canvass for NIKE shoes – have successfully joined the race. But the country needs a critical pool of such enterprises and the future industrial policy should be geared to developing such a pool. If foreign earnings rise at a faster rate, meeting the foreign debt obligations will not be a critical issue for the country.
Hence, what is needed is not a patchwork as is being done today but the introduction of a long term policy strategy to get out of the debt trap.
*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at email@example.com