Child’s guide to debt and debt restructuring: Part III

In the last four years from 2020 to 2023, their consumption has been so high that the level of dissaving happened to be about 6% of GDP. Therefore, the Government has been an eater of private sector savings

The problem for Sri Lanka was that the money so borrowed was not reinvested in projects that would generate a sufficient foreign exchange earning to service this debt. In April 2022, the country did not have enough foreign exchange balances to service the debt forcing it to suspend the servicing of loans received from individual countries, called bilateral lenders, and from commercial lenders, mainly those who had invested in the international sovereign bonds or ISBs issued by the Government

•  Need for borrowing and how it should be managed prudently

Aseni, whiz kid in economics, and her grandfather, Sarath Mahatthaya, an ex-official of the Finance Ministry, are having an interactive dialogue on issues relating to debt and debt restructuring, two topics of immense current interest. They have discussed two matters relating to debt restructuring, total foreign debt and its impact on the country’s indebtedness and the domestic debt optimisation. They continue their discussion.

Aseni: Sri Lanka has increased its foreign borrowing during the post-independence period. For instance, its foreign borrowing at independence in 1948 was a pittance at 4% of GDP. But the total country borrowing at $ 62 billion in December 2023 amounted to 74% of GDP. It is a well-known fact that in ancient times when the country was ruled by Lankan kings, there was no borrowing from abroad to build giant tanks like Parakrama Samudra or pagodas like Rathnamali Maha Seya. How did those kings perform those miracles?

Sarath: One thing was that there was no foreign debt market in the world at that time like today. Therefore, even if those kings desired to borrow from abroad to build those giant infrastructure facilities, they could not do so. But the main reason was their prudent budgetary policy. Unlike the deficit financing which we have today, they had a surplus budgetary policy, following the best practices adopted at that time. Kautilya, the 4th century BCE Indian Guru on economics who wrote the famous text The Arthashastra advised the king to build a treasury because that was the first guard against any adverse shock like a natural disaster locally or foreign invasion from the external side. Kautilya said that “a king with a depleted treasury eats into the very vitality of the citizens and the country”. Therefore, the kings spent less than what they earned as revenue from taxes and profits from government enterprises. 

The tax system adopted was inclusive capturing all those who are in society except those temples and villages which had been exempted from taxation. Since agriculture and trade was the main economic activities, farmers and traders were subject to taxation. Kautilya’s economics was faithfully followed by the Lankan kings as revealed in the Chulavamsa, the second part of the Mahavamsa, relating to King Parakramabahu the First. It is said that the king was well versed in the methods of Chanakya who caused the defeat of the Nanda Clan, the real name of Kautilya. 

According to Professor Senerat Paranavitana, who wrote the chapter on the tax system in the Polonnaruwa period in the Second volume of the History of Ceylon by the University of Ceylon, the main tax was on land which farmers cultivated through a franchise from the king. The tax was one sixth or 16% of the produce. In addition, every able-bodied man had to work for the king free of charge for three months under a system known as the Rajakari or a compulsory state service system. This is similar to the polls tax which is being charged by the modern governments. It therefore amounted to an income tax of about 25%. Thus, ordinary people had to pay a tax of about 41%, which is very high from modern tax standards. 

Since there was a surplus budget, the ancient kings did not have to borrow abroad to finance the giant infrastructure projects like constructing massive irrigation schemes for the people. But the king kept a surplus in the treasury to maintain his power base. 

Sri Lanka’s past Governments have been notorious spenders, consuming more than they earn. Thus, their savings have been negative, a state known as ‘dissaving’. During 1959 to 2023, the level of dissaving happened to be about 1% of GDP. In the last four years from 2020 to 2023, their consumption has been so high that the level of dissaving happened to be about 6% of GDP. Therefore, the Government has been an eater of private sector savings

Aseni: I understand it. Then, what was the reason for the post-independence governments to borrow abroad and thereby drive the country to a foreign debt trap?

Sarath: The main reason was the inadequacy of the savings by people as well as the Government to meet the country’s investment requirements. 

We can illustrate it by taking an example from an individual. Suppose you earn Rs. 100 a month and you want to buy a car which costs Rs. 1,600. Surely, your income is not sufficient to buy the car. Suppose your consumption expenditure per month is about Rs. 80 meaning that you save Rs. 20 per month. That is because savings is that part of income not consumed. Still, you cannot by the car. But if you wait for 80 months, your savings will be sufficient to buy a car provided the price of cars remain at the same level as today. This is called the savings investment gap. If you borrow now against your future incomes, you can have your car today. But the most important requirement is that you should earn the planned income without disruption to service your loan, that is, to repay the loan and pay interest on your loan. If for some reason your income gets disrupted like you lose your job or the source of income, then, you cannot service your loan. In that case, you run into a situation known as loan default. 

Sri Lanka’s past Governments have been notorious spenders, consuming more than they earn. Thus, their savings have been negative, a state known as ‘dissaving’. During 1959 to 2023, the level of dissaving happened to be about 1% of GDP. In the last four years from 2020 to 2023, their consumption has been so high that the level of dissaving happened to be about 6% of GDP. Therefore, the Government has been an eater of private sector savings. 

The rule I just mentioned above and applicable to an individual is valid for a country as well. During 1959 to 2023, Sri Lanka’s average annual investments amounted to 24% of GDP, while its national savings amounted to 19% leaving a savings-investment gap of 5%. If the Government had not been a dissaver during this period, the gap would have been a little less by 4% of GDP. If you consider the required investment level of 30% of GDP to make Sri Lanka a rich country within a generation, the savings-investment gap is 11% of GDP which cannot be filled without running into a massive debt flow to the country. Because of this reason, the successive Governments started to borrow abroad to finance the existing savings-investment gap, not the required savings-investment gap. 

The problem for Sri Lanka was that the money so borrowed was not reinvested in projects that would generate a sufficient foreign exchange earning to service this debt. In April 2022, the country did not have enough foreign exchange balances to service the debt forcing it to suspend the servicing of loans received from individual countries, called bilateral lenders, and from commercial lenders, mainly those who had invested in the international sovereign bonds or ISBs issued by the Government. 

But again, the problem was complicated because the Sri Lanka Government had failed to have a prudent debt management policy after 1983. This was not the case which the country had during the colonial period. 

For Sri Lanka to fill its savings-investment gap, there should be someone in another country willing to cut the current consumption, make a saving, and make available that saving in the form of a loan. If Sri Lanka defaults its foreign loans, those savers in other countries will not make their savings available to Sri Lanka. That is why it is crucial for Sri Lanka not to default its foreign borrowing and go for a debt restructuring

Aseni: You said that during the colonial period the colonial masters had a prudent foreign debt management policy. Can you elaborate on that?

Sarath: Yes, they had a very prudent policy of debt management. A good example is how they managed the foreign debt contracted by the railway authorities. There is a general belief that the railway system was funded out of the moneys extracted from the local population. But it was done by borrowing mostly from the London capital market and later from the local market. When the local colonial government did not have enough funds to construct the Colombo-Kandy railway line, it asked the colonial office in London for permission to borrow £ 1 million from the London capital market. The Colonial Secretary gave the permission under two conditions. One was that the money so borrowed should be used only for the railway project. The other was that the railway authorities should build a sinking fund out of the profits of the railway line to service the debt, namely, payment of interest and the repayment of the principal. 

The railway authorities maintained a sinking fund not only for the loan contracted for the Colombo-Kandy railway line but also for all the lines built by them. Accordingly, by 1905 when the whole system had been fully complete, the money in the sinking fund amounted to Rs. 41 million, while the debt liabilities of the railway authorities stood at Rs. 39 million. 

This system of maintaining a sinking fund to repay the Government debt was continued by the Sri Lanka Government till 1983. To do so, every year, moneys were allocated from the annual budget to recoup the sinking funds. But in 1983, the finance minister Ronnie de Mel was advised by Treasury officials that there was no need for tying up scarce Government revenue for sinking funds because the Government could always service its debt by further borrowing from foreign and domestic sources. This system is known as the refinancing of the debt service payments. It meant that the Government, instead of earning revenue to service its debt, made further borrowing to do so. That is why the outstanding debt levels increased in absolute terms as well as in relative terms as a percent of GDP. 

This strategy seemed to be a plausible one, but its risk is that if the Government is unable to make further borrowing for any reason, it had to use the existing foreign reserves to service the foreign debt. When the reserve levels got depleted, it could no longer service the debt. This was how Sri Lanka had to suspend the servicing of the bilateral and commercial borrowings in April 2022. 

Aseni: President Ranil Wickremesinghe addressing the Parliament said that foreigners make available those foreign funds by curtailing their consumption. Is there any truth in that statement?

Sarath: Yes, he is correct. If anybody wants to make a saving, he should necessarily cut his consumption and save the excess income. If they do not save, they cannot lend either. What happens is that by curtailing his consumption today and making available the saving to another person, he makes a sacrifice today but allows another person to have a higher consumption. The condition is that the borrower should cut his consumption on a future date and repay the lender. Since the lender is paid interest in addition to the principal amount, what is repaid is higher than the amount lent. In other words, the lender sacrifices his current consumption in preference to a higher consumption tomorrow. If the foreigners do not save and make available those savings to another person by way of a loan, that other person cannot have a higher consumption today. 

Therefore, for Sri Lanka to fill its savings-investment gap, there should be someone in another country willing to cut the current consumption, make a saving, and make available that saving in the form of a loan. If Sri Lanka defaults its foreign loans, those savers in other countries will not make their savings available to Sri Lanka. That is why it is crucial for Sri Lanka not to default its foreign borrowing and go for a debt restructuring. 

Aseni: Critics had blamed the Government for not getting a haircut or a write-off of the interest or the principal or a mixture of both from the Paris Club members. In answer to the critics, President Ranil Wickremesinghe told the Parliament that it is not the practice of the Paris Club to offer such a facility to a borrower. Is there any truth in this statement?

Sarath: The statement made by President Wickremesinghe is not accurate since there had been instances in which the Paris Club had offered haircuts of varying amounts in the past. 

When Latin American countries defaulted their foreign loans in early 1980s, the Paris Club, agreeing to what is now known as Toronto Terms, granted a partial debt forgiveness of 33 1/3% to borrowing countries. Altogether, 20 countries benefitted from this debt relief. 

Then in 1991, the Paris Club further increased the loan forgiveness levels to 50% under London Terms. Once again 23 countries benefitted from this loan forgiveness. 

A third occasion of loan forgiveness was the increase of the level to 67% in 1994 under Naples Terms. This was offered to heavily indebted poor countries or HIPCs. 

Therefore, the Paris Club does not have a hard and fast rule of not granting haircuts to borrowers when their debt is restructured. In that context, the critics are correct and the Ranil Wickremesinghe Government is at fault. What this means is that had Sri Lanka negotiated with Paris Club members vigorously and rigorously, it could have got a sizable haircut. Such a haircut is important for Sri Lanka to reduce its foreign debt levels. 

Aseni: Thanks, Grandpa for your excellent elaboration. It also has taught me a good lesson. That is we should not believe politicians without verifying for accuracy what they make as announcements. 

Part I this article can be found at https://www.ft.lk/columns/A-child-s-guide-to-debt-and-restructuring-Country-driven-to-economic-collapse-has-not-many-options-Part-I/4-763940 and Part II at https://www.ft.lk/columns/Child-s-guide-to-debt-and-debt-restructuring-Part-II/4-764243

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)