By W.A. Wijewardena –
An Original Sin of a different type
In Biblical terms, man is condemned as a sinner forever because his first prototype, Adam, committed the Original Sin against the caution of his creator.
In economic terms, as presented first by economists Barry Eichengreen and Ricardo Hausmann in 1999 and later refined with Ugo Panizza in 2002, the Original Sin refers to a situation where a country which is unable to borrow abroad in its own currency since foreigners do not hold that currency to lend the country concerned gets into long term economic troubles by borrowing in foreign currencies from the international markets and in their own currency from domestic markets, in the second case, if it is practised over a long period of time.
Eichengreen and Hausmann came up with the concept of the Original Sin relating to a country’s increasing public debt, both locally and abroad, in a paper presented at a symposium on New Challenges for Monetary Policy sponsored by the Federal Reserve Bank of Kansas City in 1999 under the title “Exchange Rate and Financial Fragility” (available at: here).
Only a few countries can borrow their own currencies abroad
Their argument goes as follows:
There are some countries like USA, UK, France and Japan which can borrow abroad in their own currencies because foreigners hold a significant portion of their currencies as foreign reserves. This category of countries does not run into serious problems because they can repay such loans to foreign lenders by printing their own currencies. However, many countries, especially developing countries, are unable to do so because their currencies are not available for lending in international markets. Hence, they have to borrow abroad in foreign currencies and locally in their own currencies. When a country raises foreign loans in other currencies and local loans in its own currency, in the long run, it runs into a serious trouble because it gets into two types of mismatches.
Two types of mismatches
The first mismatch is a currency mismatch because the projects that are financed out of foreign borrowings generate local currency incomes, say rupee incomes in the case of Sri Lanka, and those local currencies or rupees cannot be used to pay interest or repay the principal of the foreign loans when they mature. These countries cannot print foreign currencies either to do so. So, the mismatch is that earnings are in the local currency but the obligations are in foreign currencies which they cannot produce.
The second type of mismatch is a maturity mismatch because the long gestation projects which these countries undertake such as the development of ports, airports, roads etc. are financed out of short term borrowings and therefore do not generate a sufficient cash flow to repay those loans even when they borrow in local currencies. The way out for these countries is that they have to either re-issue the local currency debt when they mature or print local currency through their central banks to repay the same. Thus, they run into serious public debt problems and those public debt problems get them into serious long term macroeconomic problems.
The subsequent generations of these countries are therefore condemned to suffer because of the sins committed by their forefathers and, according to Eichengreen and Hausmann, it is like committing a Biblical type Original Sin by them.
Critics of the Original Sin proposition
This concept of Original Sin ran into severe criticism by other economists on the ground that it no longer holds in the case of emerging economies like Singapore, Malaysia, South Korea and Hong Kong since they have been able to raise loans from abroad in their own currencies. As a result, the club of countries which can raise loans abroad in their own currencies is expanding at a rate thereby enabling the original ‘Original Sin’ countries to expiate the Original Sin over time. However, the majority of the world’s countries are still outside that club and, therefore, unable to borrow abroad in their own currencies.
In an article which Ricardo Hausmann and Ugo Panizza posted to the economic website EconoMonitor in 2010 (available at: here ), this argument has been further elaborated.
Still the majority countries are committing the Original Sin
According to the later research done by Hausmann and Panizza, there has indeed been an improvement of the countries which have been able to borrow abroad in their own currencies especially since the financial crisis of 2008. Yet, that improvement is only a marginal improvement and almost all the countries belonging to the developing world have not been able to borrow abroad in their own currencies. Out of 65 developing countries which Hausmann and Panizza studied, only 9 countries had been able to borrow abroad in their own currencies and even then, such borrowings had been limited to less than 15 per cent of their total borrowings. Hence, according to Hausmann and Panizza, the punitive power of the Original Sin is still visiting the majority of the countries in the world and thus it still remains a grave concern for global macroeconomic stability since such borrowing countries are not able to repay their loans and pay interest on them in bad ‘economic times’. It becomes a global issue because rescuing those countries with appropriate economic bail-outs is a prime responsibility of the global community today.
Where does Sri Lanka stand with respect to this Original Sin of borrowing? If Sri Lanka has committed the Original Sin, was it committed during the colonial times or after Sri Lanka gained independence in 1948?
Ceylon’s colonial masters were free from the Original Sin
At the time Sri Lanka gained independence, its public debt was an insignificant amount. Even two years after independence in 1950, the total public debt just amounted to 17 per cent of the country’s Gross Domestic Product or GDP and of that, foreign debt was just 3 per cent of GDP. Hence, in the old colonial Ceylon, the rulers had been very careful about raising public debt because such public debt was a transfer of a burden on the future generations and burdening future generations was not considered at all an altruistic gesture which the then current generations should have toward their future generations. Public debt was raised by the colonial government after a careful study of the costs and benefits of such public debt and when the rulers were satisfied that the projects that were financed out of such public debt could generate a sufficient income to pay interest and repay the principal on them. This type of a policy is considered a prudent public debt management.
A good example of this has been provided by Professor Indrani Munasinghe of the University of Colombo in her PhD Thesis submitted to the University of London under the title “The Colonial Economy on Track: Roads and Railways in Sri Lanka 1800-1905”. This thesis has been published by the Social Scientists’ Association in 2002.
Funding Ceylon’s railways: Borrow but repay
According to the data she has presented in Chapter 7 of the book, of the total cost of the railways in Ceylon up to 1905 amounting to Rs 81 million, Rs 48 million or 59 per cent had been financed out of borrowings; of the borrowings, Rs 46 million or 95 per cent had been raised in London by issuing debentures in the London capital market from time to time mostly at an interest rate of 6 per cent per annum. When the proposal for raising these foreign loans was made by the Ceylon Railway Authorities to the Colonial Office, the Secretary of State had not approved of it until the Railway Authorities had satisfied him that there was sufficient revenue for the repayment of the loans and the Authorities had taken action to build the necessary sinking funds to enable the Railways to pay them on time. Whenever the local interest rates were lower than the foreign interest rates, the decision was to raise the loans from the local markets, but still the Railway Authorities had to prove they had the repayment capacity.
A sinking fund to repay railway loans
The Railway Authorities had designed their fare structure in such a way to recover the costs, including the cost of paying interest and repaying the principal of loans they have raised. They also had kept their operational costs down so that the railways could generate a surplus. According to Professor Munasinghe, “the railways were remunerative from the start”. Hence, she says that “it was only in the first three years that it became necessary for the government to contribute to the sinking fund” to be established for repaying railway loans and as such, the railways loans had all been paid back by the railway system itself. Accordingly, the loans raised by the colonial government for the construction of the Ceylon Railways till 1905 did not bear the features of ‘Original Sin’ as defined by Barry Eichengreen, Ricardo Hausmann and Ugo Panizza, since the burden was not passed on to the tax payers in general and the future generations in an unjust manner. The sin of borrowing, if it is a sin at all, had been expiated within the life of the loans themselves.
The phenomenal rise in public debt in post-independence Sri Lanka
However, Sri Lanka’s post-independence history records a completely different story. In 1950, Sri Lanka’s public debt amounted to 17 per cent of GDP and foreign debt, 3 per cent of GDP. By 1960, the total public debt doubled to 34 per cent of GDP, but the foreign debt still remained at 5 per cent of GDP. But, after 1960, the government’s resort to borrowing and financing the untamed budget deficits caused the country to raise its public debt levels phenomenally.
In 1970, the total debt was 64 per cent of GDP, while the foreign debt was 18 per cent. In 1980, the two ratios were 72 per cent and 34 per cent, respectively. In 1989, in an alarming manner, the total public debt rose to 109 per cent of GDP, while the foreign debt rose to 62 per cent of GDP. Since then, it started to decline marginally not because the government had reduced its borrowings, but because the nominal GDP that included an element of inflation, and therefore called nominal GDP, had risen faster than the debt stock of the country. But, in the new millennium, the public debt was still at a very high level and during 2001 to 2004, it was above 100 per cent of GDP. Since then, the government’s borrowings had gone up unrestrained, but the debt to GDP ratio showed a decline mainly because of the faster expansion of the nominal GDP than the debt stock. Hence, the country cannot be complacent about the debt to GDP ratio of 79 per cent in 2011, since it is merely a statistical artefact and not a hard-earned achievement.
The recent rise in commercial and non-concessionary debt
In the last six years, another unsavoury feature has emerged in the country’s debt structure. Up to 2004, the country had used commercial debt from foreign markets very sparingly because, being a low income country, it had access to concessionary credit from donors and the multilateral lending institutions like the World Bank and ADB. However, after the country graduated from low income to lower middle income country in the first decade of the new millennium, this concessionary flow of borrowing was no longer available to the country. Accordingly, Sri Lanka had to increase its borrowings from foreign commercial and non-concessionary sources.
In 2004, the commercial and non-concessionary borrowings of Sri Lanka were just less than 5 per cent of its total foreign borrowings. This ratio went up to 43 per cent in 2011. With the new sovereign loan of US 1 billion raised in July, the commercial and non-concessionary borrowing component in the total foreign borrowings is projected to rise to 50 per cent by the end of 2012. Given the fact that the Sri Lanka government’s consumption expenditure exceeds its revenue thereby generating a sizable deficit in its revenue account, a part of the foreign commercial borrowings is used by the government for consumption purposes as well. Having an unaffordable consumption level by resorting to foreign commercial borrowings is not a prudent debt management policy at all.
In addition, there are three unsavoury features in the country’s rising public debt levels making its public borrowings a commission of the Original Sin.
Financing consumption out of commercial borrowings
The first is the emerging budgetary crisis where the government has not been able to stick to its budgetary targets. In the budget of 2012, the government had planned to keep the revenue account deficit at an insignificant level of Rs 2 billion for the whole year, compared with a deficit of Rs 72 billion or 1 per cent of GDP in 2011. However, during the first five months of 2012, the revenue account deficit has been Rs 117 billion or when prorated 3.7 per cent of GDP. If the government’s consumption is allowed to remain at these high levels during the balance part of the year, the revenue account deficit could rise to an unaffordable level of some 6 to 7 per cent of GDP. If this is the case, the entirety of the sovereign bond proceeds amounting to $ 1 billion or Rs 134 billion in local currency is being used for government’s consumption during the year. With no remunerative return on these consumption expenses, the repayment of the sovereign bonds in 2022 will be a burden to the country’s future generations.
Public debt roll-over
The second is the need for borrowing further to repay previous public debt, both foreign and domestic. Of the sovereign bond issue of $ 1 billion in July, $ 500 million will be used to repay the sovereign bonds issued by Sri Lanka in 2007. This was because in 2007 the revenue account deficit was Rs 57 billion and the loan proceeds amounting to Rs 54 billion was entirely used for the government’s consumption expenditure in that year. Similarly, the sovereign bond issue of $ 1 billion in 2010 generated rupee proceeds of Rs 113 billion but the revenue account deficit in that year amounted to Rs 120 billion. Since this consumption does not generate a cash flow for Sri Lanka to repay the bonds in 2020, as in the past, the country will have to reissue an equivalent amount of sovereign bonds in that year to repay the bonds in question. This trend of reissuing the maturing Treasury bonds and Treasury bills to generate cash to repay them has been observed in the case of Sri Lanka’s local loans as well.
Mega projects should generate earnings
Third, the available evidence suggests that the mega infrastructure projects which the government has started recently out of foreign non-concessionary borrowings too have not been put to the best commercial use to generate a regular and sufficient cash flow for repayment of such loans. In any of these cases, no sinking funds have been created to facilitate the repayment of those loans when they mature, a prudent debt management practised by colonial rulers. Since the maximum maturity of these non-concessionary loans is 10 years, it is necessary for the country to prepare viable business plans to harness the fruits of these mega projects within a next 10 year period. Since the government’s revenue base is also falling and its consumption expenditure is also rising, the repayment of these loans when they mature in 8 to 10 years will become a serious issue for the future generations of the country.
Hence, in the absence of viable business plans for mega projects and crucial budgetary reforms to discipline the budget, there is no way for Sri Lanka to prevent the Original Sin from visiting on the country’s future generations when its current foreign loans do mature in the future.
(Writer is a former Deputy Governor – Central Bank of Sri Lanka and teaches Development Economics at the University of Sri Jayewardenepura. This article first appeared in Daily FT – W.A. Wijewardena can be reached at firstname.lastname@example.org )