Economics of foreign borrowing

The US$ 500 million Bond issue has been oversubscribed twofold or more, it appears. At what cost? At an interest rate of 8.25%, way above the LIBOR (London Interbank Offered Rate) rate of lending of 5% last week. In fact, the LIBOR rate has been coming down during the last year. The LIBOR is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market). Therefore, the government has borrowed at a much higher rate.

The impression was that it had been put on hold, either owing to the vociferous opposition to it by the UNP, inauspicious conditions for us to borrow in international money markets or, owing to sober second thoughts generated by the controversy. None of these apparently had an effect on the government’s decision making.

Now that the government has gone ahead with the US$ 500 million Bond issue, at a much higher rate of interest than envisaged earlier, it is opportune to recapitulate the pertinent issues and take stock of our foreign debt. Foreign borrowing is an important lever of economic growth. It is a method of enhancing investment and economic growth. When domestic resources are inadequate to propel an economy to high levels of economic growth, foreign borrowing can be a significant means of supplementing meagre domestic savings. Effective use of foreign loans could propel an economy into higher levels of economic growth than possible with domestic investment alone.

Supplementary foreign resources could be obtained in various ways, besides commercial foreign borrowing. These foreign inflows take many forms, each with its attendant advantages and disadvantages. They could be foreign aid, foreign grants, loans at concessionary interest rates, foreign direct investment, portfolio investment and remittances from nationals living and working abroad. It is, of course, not only the amount and kind of borrowing, but the conditions of borrowing, the terms of repayment, the cost of funds and the amount of borrowing that matter. The critical issue is the purpose for which the foreign funds are obtained and used.

The substantial amount of the Bond issue at commercial rates of interest and repayment in a lump sum, in a relatively short period of five years, raises a multitude of economic and financial issues of significance. First an additional borrowing of US$ 500 million would add to the country’s foreign debt burden and foreign debt servicing costs. The foreign debt that had accumulated to Rs. 956,620 million at the end of 2006, increased further to Rs. 1,244,500 million by the end of July this year. This is about 30% higher than at the end of 2006. The additional borrowing would have raised the debt burden further.

Most of the country’s foreign borrowing has been at concessionary rates of interest, either from foreign donors or, from multilateral agencies. The current foreign debt consists of mostly borrowings from concessionary sources. Therefore, the cost of foreign borrowing is, in fact, manageable, as foreign debt payments absorbed only 12.7% of our export earnings in 2006. However, this debt servicing to exports proportion, has been increasing in recent years and the Bond issue would have increased the burden further, especially, as the interest rates are higher than the country has paid in the past, and the period over which the capital has to be repaid is short.

Notwithstanding this, we must not think that we are in a debt trap, as yet. We could be on the way to such a trap, if funds are used inadvisedly and do not generate additional export incomes. The government has resorted to commercial borrowing, rather than resources from multilateral agencies like the World Bank (WB) and Asian Development Bank (ADB), as the government can’t meet the conditions of good fiscal management laid down by these agencies. The government contends that it does not want to comply with the conditions laid down by these agencies. Further, with the country moving into a low middle income country with per capita income rising above US$ 1,000 to US$ 1,350, it no longer has access to the lowest rates of borrowing. However, the rates of borrowing from multilateral international agencies like the ADB or WB are much lower than commercial bank interest rates and the periods of repayment are much longer. Therefore, the actual reason for commercial borrowing is that it cannot comply with the conditions laid down by the multilateral funding agencies, especially, the need to contain the fiscal deficit through curtailment of government expenditure.

The most important issue is what the loans would be used for. The government claims that it would use it for infrastructure development. In fact, it is not prudent to use funds borrowed at commercial rates of borrowing and short periods of repayment, for infrastructure development, as such, investments pay off over a long period of time, while the obligations for repayment of capital and interest payments are long before any gains from the infrastructure investment. It has also been pointed out that the infrastructure for which the money is to be spent, has already been funded by aid. A wide section of informed opinion is of the view that the money is spent to get the government out of its financial and balance of payments problems.

No doubt, there would be some temporary advantages to the economy. The foreign borrowing would ease the balance of payments. This would ease the strain on the currency and the trend of Rupee depreciation may decelerate. In fact, on the very first day, following knowledge of the Bond issue being subscribed, the LKR reversed its recent trend of depreciation, to appreciate by 15 cents. By the time of reading this column on Sunday, it is likely to appreciate further. The premium on the forward exchange rate for the Rupee, also declined by the same amount. These premiums too would decline further. Interest rates are declining. The Treasury Bond market responded immediately and the credit crunch would be relieved.

It may also enable the government to not raise petrol and diesel prices any further. It could also lead to a spending spree and enhance the current trend of extravagant government expenditure without accountability. It could sometimes ease the inflationary pressures in the economy for a while. The foreign loan may enable an easing of the tight money policies, though the risk of higher inflation remains. Such foreign borrowing could also ease the domestic credit crunch.

However, the long-term impacts of increased foreign borrowing are serious. In contrast to the foreign borrowing in the late 1970s and early 80’s, when most of the funds were for development expenditure, with long periods of repayment and even some elements of grants in them, these funds may not contribute to an increase in goods and services and exportable goods in particular. It is most likely that these borrowed foreign funds would be for ‘unproductive’ expenditure. Consequently, the real debt burden would be greater. The bottom line of the Bond issue is that the government is attempting to ease the current monetary burdens by passing on a debt burden to future generations.