By R.M.B Senanayake –
In the last three years of MR’s regime economic growth was high and ranged from 7- 8.5%. The growth was driven by the government infrastructure investment program. Roads and expressways, ports and airports were built; funded by foreign borrowings mostly from China. The interest rates varied from 5-6%. But investments funded by foreign borrowing must provide a return both in local currency as well as earn or save the foreign exchange required for repaying the debt. The foreign debt was incurred largely by the government although during the last year the private sector banks and firms were encouraged to borrow in foreign currency and re-lend to the Government because the rate of interest was likely to rise for the government.
Foreign Funded Investments fail to produce returns
These government investments failed to produce returns. But every year the government is required to pay interest and repay the foreign debt. The government requires extra revenue in Rupees to buy the required foreign exchange required to repay the foreign debt. But the government revenue has not increased as a result of these investments. So it has to borrow. The Ceylon FT says the Government borrowed Rs 31.2 billion from the Central Bank. Similarly the foreign exchange by way of export revenue has not increased. So the authorities have to fall back on the Official Foreign Exchange Reserve to repay the maturing foreign debt. So the government has to borrow fresh foreign loans to repay the foreign loans falling due for repayment. The authorities have had to borrow the foreign exchange required even to pay the interest on the foreign debt.
Now, in the next few years about $ 5000-6000 million have to be repaid on foreign debt. The government requires both Rupees as well as dollars. The government revenue has not increased despite the large expenditure on infrastructure investments by the previous regime. The Rupees it is borrowing now from the Central Bank and the banking system since it exceeds the amount of savings by the public flowing into the money market. Economic journalists are saying that such money printing will cause runaway inflation. But such a result takes place only in a closed economy. In an open economy goods are imported and when the Aggregate Demand increases it spills over into an increase in imports. Since we are a highly trade dependent economy the excess demand caused by money creation leads to a worsening of the current account of the balance of payments. Our current account in the balance of payments already runs a huge deficit which is too high in relation to our capacity to repay it from our export earnings. The previous regime misled the people by ignoring the current account deficit and instead referring to the surplus in the over-all balance of payments. But that includes financing of the current account deficit from foreign fund inflows; either as foreign investments here or as foreign borrowings. But what it means is that we are borrowing foreign money or selling our assets to foreigners to fund the current account deficit. Any excess over the deficit goes to replenish our Official Foreign Exchange Reserve but it too is then built up by foreign capital inflows and not from our net earnings through the export of goods or services. In short we are rolling over foreign debt.
Roll-over of Foreign Debt is risky
The capacity to roll over the foreign debt cannot be expected to increase without limit. Even if it increases, the foreigners will demand higher and higher interest rates on such debt despite the Sovereign guarantee. Foreign borrowing is no free lunch. It is evident in the case of an individual for no individual can forever borrow money from Peter to pay Paul even at higher rates of interest. It is the same for a government. The rate of interest on new borrowings will keep on increasing. When foreign borrowings cost a high rate of interest then no government investment from such foreign finance will be economic. The local investment will have to produce higher and higher returns to justify the higher rates of interest. So the opportunities to use foreign finance as an instrument of medium or long term investment become less and less feasible. An irresponsible government of spendthrifts went on a spending spree and saddled the country with an excessive load of foreign debt. This is the country inherited by the new Government.
Assessing the Risk of Foreign Debt Default.
Economists use several measures to assess the desirable level of foreign debt. The last regime used only one and that was the debt to GDP ratio which they claimed was coming down and cited the much higher ratio which prevailed earlier. Yes, it was 59% in 2013 and was low but the composition of the foreign debt matters as much as its level. Previously much of the foreign debt was concessionary debt from International organizations like the World Bank or the ADB. Now foreign commercial borrowings constitute a significant share of the foreign debt. True we have never defaulted on our foreign debt. But that is not a plus factor but an essential factor for any foreign borrowing. A more useful indicator is the share of export earnings which have to be committed to service the foreign debt. This ratio is now 25% which is high and close to the level of 27% n several countries that defaulted on their foreign debts in Africa and Latin America. The Table below shows how the debt servicing cost is increasing. The figures for 2014 and the early months of 2015 are not.
The external debt servicing commitments in the 12 months ended November (2014) is estimated at US$ 5.7 billion and expected to increase by US$ 1.2 billion to US$ 6.9 billion by October of 2015.. Consequently foreign debt servicing is a strain on the balance of payments, as around 25 percent of export earnings are needed to meet foreign debt servicing costs. Repaying the foreign debt falling due for repayment is a challenging task for this Government.
Another indicator is the rate of growth in foreign debt compared to the rate of interest. In 2013 the increase in foreign debt was 7.1% well above the interest rate on the debt of 5% .When the rate of growth in foreign debt exceeds the rate of interest thereon, there is danger of debt default. Our rate of growth in foreign debt exceeds the rate of growth in exports, the rate of growth of the GDP or the rate of growth in government revenue all indicators of the high risk of debt default.
The options for the new Government
The new Government is pre-occupied with political problems and unable to address the seriousness of the foreign debt servicing situation. We are facing a serious crisis in the balance of payments. The growth in export earnings is quite inadequate to repay the foreign debt. The Central Bank continues to hold the Rupee/ Dollar Exchange rate almost fixed since the margin is very small and the Bank intervenes to keep the market rate within the band by constantly selling dollars from the Official Foreign Exchange Reserve. Last Sunday’s Ceylon FT said “US$ 243 million was drained off from the Official Reserve to protect the Rupee. Is it prudent to do so? The Rupee has been over-valued in terms of purchasing power parity with the U.S dollar and this situation makes our exports uncompetitive in a world where our competitors are depreciating their currencies. On the other hand our imports are too cheap and this stimulates the demand for imported goods vis a vis imported substitutes produced locally. We need to expand exports so that the burden of sustaining essential imports particularly of capital and intermediate goods does not fall entirely upon foreign finance. More import substitution is also needed for the same reason. Economists generally do not recommend controls on foreign trade since trade increases the growth rate. But when a country lives beyond its means and is on an unsustainable course then the lack of external equilibrium demands attention. The Current account Deficit is equal to the Savings-Investment Gap plus the Budget Deficit. So to correct the Current Account the budget deficit must be cut in absolute value. Bamboozling the public by reducing the budget deficit to GDP ratio will not work. The growth has to be reduced not increased. But the new Government will not want to slow down growth. But the Government must ask the question who benefited from the high growth of the previous regime. It is those who engaged in foreign trade – the importers of vehicles and other imported goods consumed by the affluent. The regime encouraged the import of vehicles 9gnoring the loss of foreign exchange and the lack of capacity of our road system to cope with a larger number of vehicles. Now it may be necessary to limit the number of vehicles entering the City through a tax on road space usage. The UNP with Ranil at its head has always managed the economy with a sense of responsibility. But good economics doesn’t seem to pay in our country where populism has long held sway at the expense of growth. So the new Government has a difficult task before it. It can ignore the ballooning current account deficit in the balance of payments only by more and more foreign borrowing. But this would worsen the foreign debt repayment problem and only postpone the day of reckoning. But that would be irresponsible economic management. Probably MR was advised by his Economic Advisers about the looming foreign debt crisis. It is perhaps this risk rather than astrology which prompted him to call for early election.
The new Government has to tackle the balance of payments problem without too much of a reduction in the growth rate. This is a difficult task for the remedy for correcting a current account deficit is not growth but deflation. The Government must reduce its budget deficit in absolute value and promote private sector growth stimulating export growth and import substitution. The previous regime accumulated payment arrears to downplay the budget deficit. All such payment arrears should be cleared by borrowing. Those officials who violated the regulations regarding the dep0loyment of funds as per budget should be surcharged. Where Ministers have misused funds they should be surcharged and the money recovered without waiting to file legal action in courts.
It must give priority to tackling the losses of the State Corporations. These State Corporations should all be listed on the Stock Exchange as China in the 19990s closing down those that were bankrupt along with their large number of employees. The others should e asked to raise capital in the stock market by way of shares or debentures. If they fail they should be sold by open tender at a price not below the net asset value but preferably at least twice such net asset value.
The only way ahead for the new Government is to tap the private sector for funds to finance the infrastructure investments program- a Public Private Partnership. But the projects must provide financial returns exceeding the costs. Priority may have to be given to those projects which can be funded as PP Partnerships.