Excessive Government borrowing deepens the economic crisis

The increase in money supply is largely responsible for the rise in inflation to 40%, on a year-on-year basis now. This reflects how foolishly the Central Bank mismanaged the economy by following the proponents of the MMT

Tuesday, 21 June 2022 

Sri Lanka being the first country in the Asia-Pacific region to default on foreign debt in this century is facing its worst economic crisis since Independence. Pakistan was the last Asian country that defaulted in 1999. 

Amidst the lack of foreign currency, there is a severe shortage of food, medicine, fuel, and other essentials throughout the country. Shipments carrying diesel, petrol, and LP gas remain anchored off the port from time to time awaiting payments. The depletion of foreign reserves has triggered a severe scarcity of fuel, gas, medicine, and other essentials exerting widespread hardships on people. Long queues for petrol and diesel have become a common sight across the country. 

No recovery plan yet

Apart from seeking foreign loans almost on a daily basis to meet essential import bills, the Government or the Central Bank does not have any economic recovery plan to overcome the crisis. Accumulation of foreign loans in such a manner without any economic stabilisation framework makes it extremely hard to escape from the chronic debt trap. 

Domestic debt is also expected to rise with the widening budget deficit augmented by supplementary budget provisions approved by Parliament from time to time. A supplementary estimate of Rs. 695 million was approved a few days ago. 

Recently, Parliament also approved an increase in the Treasury bill issuing limit from Rs. 3,000 billion to Rs. 4,000 billion. This not only pressurises the domestic debt market but also tends to expand the money printing further destabilising the economy. 

The current predicament of the economy was forecasted by me over the last two years in this column many times but to no avail. 

Sri Lanka’s debt trap

The country’s outstanding foreign debt amounts to $ 51 billion. The outstanding domestic debt stands at Rs. 11,097 billion. Foreign debt accounts for 40% of the total outstanding debt. The ratio of gross public debt is as much as 110% of GDP. The ratio of debt service payments to Government revenue is 165%. These indicators clearly show the gravity of the country’s debt burden.  Sri Lanka’s debt burden has exceeded the benchmarks of the Debt Sustainability Assessment (DSA) adopted by the World Bank and the International Monetary Fund (IMF). The solvency ratio (gross public debt as a percent of GDP) for Sri Lanka is 115% against the safety threshold of 55%. Sri Lanka’s liquidity ratio (debt service payments on long-term public and publicly guaranteed debt as a percent of Government revenue) is high as much as 64% against the safety threshold of 23%. 

Sri Lanka’s foreign debt default disastrous

In terms of the DSA, Sri Lanka has been ranked in the “extremely speculative/substantial risk” category, along with seven other countries – Angola, the Congo, Congo DRC, Gabon, Lao PDR, Mali, and Mozambique. These countries, including Sri Lanka, were recently classified as “next in line for the default”. Now, Sri Lanka is a debt-default country.

The implications of the country’s default on foreign debt are manifold. Therefore, it urgently calls for a debt restructuring program in negotiation with the creditor countries, which is not an easy task. The restructuring may involve curtailment of a part of the debt obligations, known as a “hair cut”. Also, there is the possibility of extending the repayment period. In both cases, it is essential to win the confidence of the creditors. Given the current political and social turmoil in the country coupled with the ongoing economic chaos, confidence-building needs extra effort on the part of the Government. 

As a result of the debt default, the chances of tapping foreign borrowings to meet both the balance of payments deficit and the budget deficit have almost vanished. Before the debt default, the key credit rating agencies – Moody’s, Standard & Poor, and Fitch – had continuously downgraded Sri Lanka Government’s credit ratings on long-term international borrowings. But the Central Bank was never prepared to accept the reality and adopt the corrective measures. 

As a result of such idiotic actions of the top bureaucrats in the Central Bank including the members of the Monetary Board, the entire nation is suffering today, as elaborated in my previous article in this column (https://www.ft.lk/columns/Monetary-Board-collectively-accountable-for-imprudent-policy-decisions/4-735512). 

In the absence of foreign loans, the payments for fuel shipments during the past couple of days were to be met through a specially-arranged Indian credit line.

Domestic debt market overburdened

As there is hardly any scope for foreign borrowings, the entire burden of financing the budget deficit falls on the domestic debt market, which is not sophisticated enough to meet the large financing requirements of the Government. The Treasury bills and bonds are the two major debt instruments available in the market for the purpose.

On average, the Central Bank issues Treasury bills amounting to Rs. 100 billion at weekly auctions. Depending on the bids, the total amount or a part of the offered bills were sold in the market and the balance has to be purchased by the Central Bank causing an increase in its monetary base and money supply. Following the doubling of the Central Bank’s policy interest rates last month, a sharp increase in Treasury bills was evident in recent weeks. During the last auction held on 15 June 2022, the yield rate was 20.73% for 91-day Treasury bills, 21.90% for 182-day bills, and 22.04% for 364-day bills. 

The additional cost of funds to be incurred by the Government as a result of the rapid increase in the yield rates from the previous level of around 5% per annum to the present level of over 20% per annum is enormous. Based on the present Treasury bill yield rates, the Government has to incur an additional interest cost of around Rs. 700 billion each year. Primary balance insufficient to meet interest payments The primary balance, which is the difference between the Government revenue and its non-interest expenditure, is a clear indicator of the status of a country’s fiscal management. It shows to what extent a government can honour its interest payments obligations without incurring additional debt. In the case of Sri Lanka, the primary balance was Rs. – 1,010 billion in 2021. This means that the Government did not have sufficient revenue even to meet its non-interest expenditure. Hence, it had to borrow more not only to finance the primary balance but also to meet interest payments which amounted to Rs. 1,048 billion in 2021. 

With the sharp increase in the Treasury bill yield rates as explained above, the situation is going to be far worse this year. 

The Government’s interest cost will further increase as a result of raising the Treasury bill issuing limit by Rupees one trillion a few days ago. 

Central Bank continues money printing

The outstanding amount of Treasury bill and bond holdings by the Central Bank passed the Rs. 2,000 billion mark for the first time in its history last week. It was an outcome of a 170% increase in the net credit provided by the Central Bank to the Government over the last 12 months. It led to a 44% increase in the Central Bank’s monetary base by April 2021 causing an increase in the money supply.  Net credit to the Government which forms the Central Bank’s net domestic assets has had a greater influence on the monetary base over the last two years as its net foreign assets continued to deplete during this period. The rise in the monetary base owing to the increase in net domestic assets led to issuing of more and more currency (notes and coins) by the Central Bank, which is commonly known as “money printing”.

The total amount of currency in circulation is around Rs. 1,200 billion by now (according to our estimates), compared with Rs. 920 billion a year ago, reflecting an increase of 30%. 

The broad money supply of the country which consists of currency, demand deposits, and time and savings deposits rose by 20%, on a year-on-year basis, by April 2022. 

Fiscal-monetary reforms essential

The increase in money supply is largely responsible for the rise in inflation to 40%, on a year-on-year basis now. This reflects how foolishly the Central Bank mismanaged the economy by following the proponents of the Modern Monetary Theory (MMT) who argue that a sovereign government can print money to repay its debt without any financial limit, and there is no relationship between money supply and inflation. 

The Central Bank still clings on to the same kind of monetary policy, as it continues to fund the Government’s cash shortfalls by purchasing Treasury bills and bonds and allowing the money supply to expand. The effectiveness of the monetary policy will heavily depend on the Central Bank’s ability to act as an independent authority resisting the Government’s demand to finance its budget deficit through money printing.

The Prime Minister’s recent proposal of reversing the tax cuts enforced in 2019 could be considered the right decision taken at the wrong time. From the viewpoint of the need to reduce the Government’s excessive borrowing, such tax reforms are essential. But it is doubtful whether the Government will be able to mobilise the required amount of revenue through those tax hikes at this juncture as both the corporate sector and individuals liable to pay taxes are badly hit by the country’s ongoing economic depression. 

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(The writer, Emeritus Professor of Economics at the Open University of Sri Lanka and a former Central Banker, can be reached at sscol@ou.ac.lk.)