Sri Lanka is now entering the jaws of a debt crisis. The issues were present for decades but started to crystallise over the past two years. Sri Lanka’s debt rating was downgraded several times and commentators warned of the problem but all these were brushed off. Now that some of the symptoms are becoming evident the debate is hotting up. The problem is not easy to grasp, how should we think about this?
The simplest way to think about public debt is to consider it as postponed taxation. The Government wants to spend money but instead of raising this money through taxes it borrows the money. Raising taxes is politically challenging, citizens will start to ask questions as to why taxes are being raised. After some time if the benefits that were promised when taxes were raised are not visible further questions can arise.
Those in power, especially those who court public popularity are tempted to look for simpler ways to fund spending. Debt is an attractive solution – we can spend now and worry about repayment later. For the public, few questions arise when borrowing takes place – they feel no immediate impact from this exercise and depending on how the money is spent, may even see some benefit from it.
What happens when the debt has to be repaid? As long as a Government maintains its credibility with financial institutions it is always possible to roll it over. Governments can then opt to raise new debt to repay the old debt. The public still feels no impact, the good times continue, the Government keeps spending and no one is worried.
As the debt accumulates, so does the interest on the debt so Governments borrow again, not only to repay the principal amounts due but also the interest. Things keep snowballing and everybody; Governments and citizens remain blissfully unconcerned until a point is reached when the debt levels get to a stage where the lenders start to worry about getting repaid. When that happens, the party stops and citizens awaken to a rude shock.
When lenders stop refinancing a Government’s debt it is then confronted with the problem it has postponed and may even have forgotten – how to repay the debt. Recall that debt is postponed taxation.
The Government should have been raising taxes over the years to repay the debt it was taking but for convenience it chose not to. After years, even decades of indulgence it is now forced to confront the problem repaying everything within a short space of time.
Government revenue that should have been raised over many years or decades must now be raised within a few years. This is the austerity that accompanies a debt crisis. Governments must cut expenditure or raise taxes sharply. Had this been done over the long periods that the debt was accumulating there would be far less pressure, but when it has to be raised within a short period of time it creates a huge shock.
It is important to note that while the debt crisis is single debilitating event, the problems are those that have accumulated over a long time. None of this is recalled when the crisis breaks, the public eye is focused only on the aftermath, not the causes.
In a crisis countries call on the IMF to help. The benefit of having the IMF is that by underwriting a Government’s plans it lends credibility to the restructuring. Recall that the reason the Government is confronted with a debt crisis in the first place is because the lenders have lost confidence in the Government and refuse to lend it any more. Thus the IMF becomes necessary for an orderly restructuring process.
Depending on how bad the situation is the IMF can also lend money to the Government, these funds can help the Government tide over the immediate problem and reduce the pain of the adjustment. The IMF money provides a cushion which allows a longer period over which expenditure can be cut and/or taxes raised.
People tend to associate the IMF with the austerity measures that become necessary when the debt problem crystallises and they are blamed for the problems. The fact is even without the IMF the Government would still be faced with the same problem of raising taxes or cutting expenditure.
This, in a nutshell is the problem that Sri Lanka faces. The country has borrowed to meet its recurrent expenditure (including interest payments) as well as infrastructure. The infrastructure projects have not yielded an adequate enough return to finance the debts, which is why it becomes a burden on the taxpayer.
Now that the crisis is breaking there is little that can be done except manage it sensibly with a view to minimising the damage. Postponing the problem will only make it worse.
More importantly, what can be done to prevent it from recurring? Following the crisis of 2008 the EU put a framework for economic governance consisting of three pillars; monitoring, prevention, correction.
“The European Union’s economic governance framework aims to monitor, prevent, and correct problematic economic trends that could weaken national economies or negatively affect other EU countries.”
The key areas that need to be monitored are the budget deficit and the means by which it is financed – either debt or money creation by the Central Bank.
In the EU the monitoring of member states public finances is done by the European Commission, the preventive measures are found in the Stability and Growth Pact (which sets budget targets) and the corrective mechanism is the Excessive Budget Procedure/Excessive Imbalance Procedure. The EBT requires member states that run excessive budget deficits of more than 3% of GDP, or which fail to reduce their excessive debts (above 60% of GDP) at a sufficient pace to follow a particular set of rules to correct the problems.
Oversight
For Sri Lanka the monitoring would need to be done by Parliament and its oversight committees, the Committee on Public Accounts (COPA) and the Committee on Public Enterprises (COPE). The scrutiny of finances is carried out by the Auditor General (AG). These key bodies need to be independent and competent. Both suffer from a lack of capacity which needs to be addressed separately from the institutional reforms. The mandate of the AG should be modeled on the National Audit Office of the UK.
Sri Lanka requires rules to control
a) the budget deficit,
b) levels of debt,
c) money creation by the Central Bank.
The foundation for (a) is available in the Fiscal Responsibility Act of 2002. This needs to be strengthened along with the adoption of Medium Term Expenditure Frameworks for spending (the EU works with Medium Term Budget objectives). These would replace the annual budget process. Some amendments to the Central Bank Act and operating procedures will be required.
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