Is our aggregate debt level excessive?

by R.M.B. Senanayake

Our Gross External Debt position increased from $ 39,905 billion in 2013 to $ 42,988 billion in 2014. As a Percentage of GDP gross external debt was 59.4%. Short term debt was 9.7% and long term debt was 47.7 %. As a percentage of GDP gross external short term debt was 16.9% and long term debt 83.1 %.

Our Total Debt is 78% 
of the GDP.

Our Foreign Debt level is around 58% of GDP. Is this foreign debt level too high? What are the risks in having a high foreign debt level? There are two issues. Is the debt level for the economy too high in terms of the size of the economy and the capacity to earn and spend foreign exchange? Or is it that the foreign debt of the government is too high?

Debt and Growth

Economists are divided on whether the debt level (including the domestic debt) affects the growth rate adversely or not. In 2010 two famous economists - Reinhart and Rogoff of Harvard University used empirical data to come to the conclusion that when the aggregate debt level exceeds 90% of GDP, economic growth is adversely affected. They found that when the aggregate debt exceeds 90% of the GDP, the country experiences a sharp downturn in its growth. But subsequently three economists of the University of Massachusetts found certain errors in their calculations which undermined their conclusion. But a new IMF paper poses a more substantial challenge to Reinhart and Rogoff. Using data for debt and growth from 1821 to 2012, the authors found that growth in GDP per head is slower in countries with a debt to GDP ratio above 90% when looking at the data year by year. The problem is how to ascribe these slowdowns to debt only and not other factors. If one looks at average debt levels over 15 year periods instead, there is no evidence that countries with a debt level above 80% of GDP grow more slowly. Even countries with debt ratios of more than 200% such as postwar Britain experienced solid medium term growth (Economist of March 1, 2014 "Breaking the Threshold" Page 70.

The Economist article points out that more important than the absolute levels of debt may be their trajectory. Countries with rising public debt ratios suffer slower growth than those where it is falling - even if their accrued borrowings are already very high. This may be because budget deficits make them more vulnerable to economic instability. This is the current situation in our country since our Public Debt keeps rising with the continuous increases in deficit budgeting year after year.

Previous government depended on foreign debt for growth

The growth rate under the previous government was driven by foreign debt financed public sector investments. In fact, the private sector hardly moved. The present government will have to resort to similar foreign borrowing if it wants the public sector to drive economic growth. The economy needs a stimulus and it cannot be from larger budget deficits. It is time for us to consider seriously how long term growth in our economy should take place. Singapore in a similar situation resorted to expanded regional economic agreements. India and Pakistan have signed Free Trade Agreements with us but except for businessmen taking advantage of differential taxes between us and our partners, nothing significant has happened. We cannot protect our high cost industries forever. They must expand their production and benefit from economies of scale. They cannot do so unless they export. The Free Trade Agreements with India and Pakistan offer opportunities. But our businessmen do not have the capital to expand. They also don’t have knowledge of the Indian and Pakistani markets.

Our trade with neighboring countries has been previously driven by minority community traders who originally hailed from the subcontinent. But the third generations have lost such relationships. So we need a more active trade promotion policy. Our government should promote the local businessmen - exporters to have closer contacts with their neighbors. In the 1960s Ratne Deshapriya Senanayake, CWE Chairman, used to view the Pettish merchants as Indians who ran the business in the interests of their Indian partners. Travel to these countries should be freed from restrictions. We have the fear that we will be submerged by Indian businessmen if we throw open our economy. Yes, there will be risks. But with risks also come opportunities.

Private sector credit growth has been stagnating as pointed out by the Central Bank. Why? The economy expanded by 7.4 per cent in 2014 compared to the 7.2 per cent growth recorded in 2013. But we had growth rates of 8% and 8.2% in 2010 and 2011. Did the Central Bank curb the growth rate by tightening monetary policy too early in 2012? The Central Bank has been too pre-occupied with the control of inflation. But a certain degree of inflation, say 5%, is a benign factor for business. The problem is with our risk averse banks. They don’t take risks. In developed countries banks finance projects based on project reports. But our banks don’t take risks and insist on collateral in the form of property -mortgages of the property of the proprietors or directors.

The Central Bank will have to take a more active role and underwrite loans to the private sector and encourage the banks to lend on the balance sheet strength and the soundness of the projects. Our banks are still oriented towards the traditions of the exchange banks of the British colonial days. Those days the exchange banks, as they were called, lent mostly to British businesses in Sri Lanka and not to local businessmen. The latter could borrow only where the Shroff recommended local businessmen to get loans and the Shroffs had to take the risk of default. Only the Central Bank can coax them or even goad them out of this risk averse mentality and to lend on their balance sheets. The Central Bank might have to underwrite the loans wholly or partially initially at least. The late NU Jayawardena was alive to the problem and wanted to set up local banking agents who borrow from the banks and re-lend to local businessmen. But his ideas were not implemented.

The Peoples Bank used to provide agricultural credit for the small farmers. In fact it was set up specifically for the purpose but SLFP businessmen captured control of it and the Bank neglected its primary function and became like the other banks.

We are too concerned with the interest rates on loans and emphasize on the provision of loans without which businesses cannot expand. The interest rate includes a risk premium and cannot be the same for all businessmen. Economists refer to the natural long term rate of interest as determined by the supply and demand for savings and investment. Nowadays this concept is all but forgotten by central bankers and monetary authorites. AS inflation rises the rates of interest must also rise to enable a real interest rate which is positive. We cannot have negative or zero real interest rates without undermining savings. The economist Knut Wicksell referred to a natural rate of interest and drew a distinction between the natural rate and the financial rate of interest. The financial rate is what businessmen pay for their loans. But the natural rate is determined by the return on capital. Wicksell thought the financial rate of interest is determined by the banks. But this function has been unnecessarily taken over by the central banks. The Taylor Rule followed by central banks in developed countries tends to incorporate a real interest rate of 2% (nominal rate minus the rate of inflation). By limiting interest rates we are depriving lending to businessmen who are small and not so well known not forgetting newcomers to business. We have a large informal sector which provides credit to small businessmen. What is necessary is not so much reducing or regulating interest rates but providing loans to businessmen. Fixing interest rates arbitrarily is detrimental to such a function. The interest rate must take into consideration the rate of profit that can be earned in the economy. We have an economy that is not fully integrated and hence different rates of profit will prevail in different sectors - particularly in the informal sector which is quite dominant here. The policy of keeping interest rates real benefits the government which is the largest borrower and it borrows to invest in projects which don’t yield adequate returns. The rate of interest must ration the use of scarce loanable funds. The previous government went on a pending spree and used borrowings to fund projects which provided little or no returns.

In any case keeping interest rates low will not necessarily promote more private sector investments. Profit margins are more important than the rate of interest for businessmen who borrow money. Private investments have not shown any appreciable improvement despite the low rates of interest. Liberalizing the economy is more important than promoting private sector investment.