Analysis on Government Debt and Debt Financing in Sri Lanka (1977 to up to date)

Background of government Debt

There are three ways to finance the fiscal deficit. They are government debt, money creation, and
taxes. Government debt and money creation impact on economic growth adversely.
(Amirthalingam 2013) The fiscal deficit is a chronic problem of Sri Lanka and other developing
countries. [Table 1].The average fiscal deficit was 13.14 percent of GDP from 1977 to
1990. It was 9.3% from 1991 to 2000. But it was 7.7% from 2000 to 2015. (Central Bank
Report) Anyway a high amount of figure, fiscal deficit to GDP ratio is not good for macro-
The economic environment of Sri Lanka, because the fiscal deficit is financed by government debt. It is
a very popular way to finance the fiscal deficit in Sri Lanka. When fiscal deficit increases, it
causes to increase the government debt. If our country tax system is efficient, the fiscal deficit would
have financed from tax revenue. Thereby government debt could have reduced. But tax revenue
to GDP ratio has been decreasing from 1977 to 2013. [Table 1, Graph 1]. The average tax
revenue to GDP ratio was 18% from 1977 to 1984. But it was 17% from 1985 to 1995. Then
it was 16% from 1996 to 2005. But it was 13% from 2006 to 2015(Graph 2). (Central Bank
Report). But Kaldor (1963) argued that a country should impose taxes at 25 – 30 percent of GDP
to achieve economic growth. Kaldor's’ target needs to Sri Lanka to disentangle the debt
trap (Amirthalingam 2013).

The fluctuation of government debt up to 1977
Government debt has two parts. They are domestic debt and external debt. Household debt is the
debt which borrows from the local market (non- banking or banking or issuing Treasury bill or
Treasury bond) to finance the fiscal deficit. External debt is the debt which borrows from international organizations and foreign countries to finance the fiscal deficit. Domestic debt
surpassed external debt from 1977 to 1986. But external debt had surpassed domestic debt in 1987
To 1996. After that, household debt has exceeded external debt from 1997 to 2016. [Table 3 &
Graph 3]. Anyway, domestic debt and external debt cause their own problems. The obligation to GDP
ratio has reached a peak point in 1989. It was 108.7%. This rate was the highest debt to GDP
ratio in the debt history in Sri Lanka. This had happened because of the deflation of the rupee value
in 1989. When deflating rupee value, it causes to increase the cost of production. Oil and other import
production have to be paid than earlier. It causes to undermine foreign resources, and external debt
services also have to be paid more than earlier. On the other hand, due to the JVP confusion
economy had collapsed in Sri Lanka and the government had to borrow money from the foreign market,
because of domestic savings had undermined during the JVP conflict period. The GDP to external
debt ratio was 62% in 1989. This was the highest foreign debt to GDP ratio in Sri Lanka. As well
as the Mahaweli development project had implemented from 1986 to 1989, therefore, Debt to
GDP ratio had increased by 28.5% from 1986 to 1989. As well as debt to GDP ratio has declined
by 9.5% from 2004 to 2005. The reason behind that was Tsunami disaster. Many of Sri
Lankan’s creditor nations granted debt write off and interest-free periods on loans to assist the
reconstruction process during that period. (Wijeweera, Dollary & Pathaberiya 2005).Debt to
GDP ratio has decreased by 14.6% from 2009 to 2010. The reason was that the war was
finished by 2009. The war which had been three decades in Sri Lanka. (1983-2009).The aim was
behind that government had to borrow a lot of military items to defeat the LTTE. Therefore ending
war caused to decrease the government debt.

Comparison of Government debt from Asian Countries
When comparing debt to GDP ratio among Asian countries, Sri Lanka has recorded the highest debt
to GDP ratio in 2015. The figure is shown that inability of debt management in Sri Lanka. When
comparing Bangladesh and Sri Lanka. Government debt had been kept sustainable level by
Bangladesh. It was 34% in 2015. But it was 77.6% in Sri Lanka. According to the table
Indonesia, Malaysia, the Philippines, and Thailand had maintained a sustainable level in 2015.Debt to
GDP ratio was 67.2% in India, but it was reasonable they had achieved 8% GDP growth rate in
2015. But the GDP growth rate was 4.8% in Sri Lanka [Table 4]. Therefore the government should keep
GDP to debt ratio as below the threshold level. Research has concluded that the threshold level
for public debt is 59.42% of GDP. Above this level, public debt makes a negative impact on
GDP per capita growth (Cooray & Heemantha, 2013).

Composition of Domestic debt and External debt
Domestic debt has two parts as banks and non -bank sector. As well as external debt has two
parts. They are concessional loan and commercial loan. At the same time, the government can
borrow from banks or non- banks or can get a business loan or concessional loan. .Government
has borrowed debt from the non-banking sector than debt from the banking sector during 1985to2016
(Graph 4). Government has acquired concessional loan than commercial loan during 1980 to
2016. (Graph 5) But the commercial loan has been increasing from 2008 to 2016. The reason was
previous government had issued Treasury bill for foreign investors, and they had invested heavily
in Treasury bond. Second sovereign bond had released in 2009. After graduating from a lower-middle-income country, it made difficulties to borrow concessional loan (Amirthalingam 2012).
Government debt can be defined broadly and narrowly. But the debt to GDP ratio sets using
a narrow definition (Central Bank Reports). Total central government debt is called a narrow
definition of government debt. It doesn’t include contingent liabilities. A contingent liability is
a liability which government entities borrow from the market with the guaranteed issued by the
government. If government entities will not be able to pay off debt, the central government has to take
responsibility of government entity borrowings. They are Ceylon Electricity Board, Ceylon
Petroleum Corporation, Road Development Authority and Sri Lankan Airlines. The narrow
definition misleading since it does not show the actual indebtedness for which the tax players are
responsible. Therefore both of direct borrowings and contingent liabilities should take to the debt
management process.

Consequences of domestic debt and external debt
Household debt and foreign debt cause an economic problem. When the government borrows money lot
from the local market, it causes to increase the interest rate. Thereby impede the private sector
investment. This is called crowding out effect. When decreasing private sector investment, it
impacts on economic growth adversely. Increase in government borrowing may also cause
inflation through the expansion of the money supply. External debt causes to undermine the creditworthiness in Sri Lanka. Foreign currencies should be demanded when paying off international debt
services. This procedure causes to deflate the rupee value. Deflate the rupee value causes to
wane the balance of payment (BOP).
On the other hand, deflating the rupee value causes to
increase the competitiveness of export items. But our export items less than import items and
export items don’t have the strength to earn a lot. That’s why in such a situation, BOP is going to
undermine. Debt service payments are a severe financial burden to the Sri Lankan economy. Debt
repayments as a percentage of revenue have increased from 1980 to 2016. It was 98% in 2016.
Debt repayments as a percentage of exports also have increased from 1980 to 2016. It was 92%
In 2016 (Table 06). Therefore debt service payment compels a country to abandon or postpone
investment on essential development projects. Government expenditures are (Education,
Health) necessary to develop the country. As an example, before developing Singapore
had expended a lot to education. Therefore human capital development is significant to
develop the country. But the Sri Lankan situation is unfortunate. Government has to spend to interest
payment than education expenditure. This is the opportunity cost of debt servicing. In 2015
Interest payment was 22%from total expenditure. But education & welfare expenditure were
10%, Health expenditure was 8% (Table 06). Therefore the government was unable to spend
sufficiently on most important sectors which are very useful to develop the country.
Finally, I suggest procedures to reduce government debt. Fiscal deficit should finance by
tax revenues. Then the tax system should be simple, and politicians should not intervene in the tax
system what businessman evade the taxes. On the other hand, after 2005 there are lots of
corruptions and frauds had recorded. These kinds of crimes also caused to increase the
government debt. As an example, the southern high way project also has recorded corruptions. Then
debt was not enough to implement a plan, and the government had to borrow debt back to finance
the project. Therefore if we want to strengthen as a nation, we should stop corruption and
inefficient things. As well as the government would earn sufficient revenue from exports, the fiscal
deficit could have financed by export revenue, and it will cause to increase the foreign assets in
Sri Lanka. Anyway, the present government has been implementing some strategies to improve tax
compliance. Ultimately they aim to reduce the government debt. Plans are (a) “broadening
the tax base to ensure tax revenue of around 15-16 percent of GDP (b) rationalizing the tax
system while minimizing tax exemptions, tax holidays and special tax rate that are detrimental to
fair and effective tax administration (c) strengthening public financial management, particularly
commitment control and financial planning and discipline (d) eliminating unproductive
expenditure (e) Improving efficiency of State-Owned Business Enterprises.” Restructuring
process, increasing transparency of money transaction and increasing accountability are used to
increase the efficiency of State-Owned Business Enterprises. (Central Bank Report 2016).

Analysis on Government Debt and Debt Financing in Sri Lanka (1948 to 1977)

01. INTRODUCTION

In generally Government debt is referred to the debt owed by a central government of a
country. Government debt also referred to as public interest, national debt, and sovereign debt.
In Sri Lanka, Public debt can be defined as a debt owed by both the central government and other
public entities. According to the above definition, other public entities included government
corporations, government statutory boards, government academic institutions, government
banks, etc.

01.1. OBJECTIVES OF PUBLIC DEBT IN SRI LANKAN GOVERNMENT
Generally, the government borrows funds from internal sources and external sources to
meet three main goals.
➢ To meet the budget deficit.
➢ To meet the expenses of war and other extraordinary situations.
➢ To finance development activities.

01.2. SOURCES OF GOVERNMENT DEBT FROM 1948 TO 1977
When considering government debt sources in Sri Lanka from 1948 to 1977, those debts
references can be divided into two main categories.

➢ Internal Debt Sources / Domestic Debt Sources
The funds borrowed by the central government of Sri Lanka and other public institutions from
lenders within Sri Lanka. Those lenders include commercial banks, other financial
institutions, the general public, etc.
Treasury bills and Rupee loans were primary domestic debt sources from 1948 to 1977 in Sri
Lanka. Treasury bills are short-dated securities issued by the Sri Lankan government to
finance budget deficit or to finance projects. Rupee loans refer to loans denominated in Rupees.
➢ External Debt Sources
The funds borrowed by the central government of Sri Lanka and other public institutions of Sri
Lanka from foreign lenders. Those foreign lenders include foreign commercial banks,
governments, or international financial institutions.
When considering foreign debt in Sri Lanka from 1948 to 1977, external debt can be divided into
three main categories project loans, non-project loans (commodity loans), and sterling loans.

02. OVERVIEW OF GOVERNMENT DEBT FROM 1950 TO 1977

In 1950 total outstanding government debt was Rs. 654 million. It was included Rs. 529
Million domestic obligations and Rs. 125 million foreign debts (Figure 01). In 1950 domestic debt
was 13.70% of GDP while external domestic debt was 3.2% of DGP (Figure 02). When
considering internal debt sources, 14.93% represent treasury bills, 82.42% represent rupee
loans, and 2.65% represent other debt sources.
In 1977 total government debt was Rs.24, 985 million. It was included 14, 392 million
domestic obligations and Rs. 10, 593 million foreign debts (Figure 01). It was 26.20 times
improvement of domestic debt when compared with domestic debt in 1950 and 83.74 times
development of external debt when compared with external debt in 1950. As a result of this debt improvement caused to increase domestic debt to GDP ratio up to 39.50% and foreign
debt to GDP ratio increased up to 29.10% (Figure 02). When considering local debt
sources, 17.4% represent treasury bills, 72.2% represent rupee loans, and 10.4% represent
other debt sources.

From 1948 to 1977, Sri Lankan economy can be divided into 4 main stages based on
political regimes and economic policies executed by various political governments. Therefore this
analysis is done based on these 4 stages.

02.1. From 1950 – 1955 (LIBERAL MARKET ECONOMY)
In 1950, the United National Party won power, and from 1950 to 1955 Sri Lankan Government
executed liberal market economic policies. In 1950 total government debt was Rs. 654
million. (Figure 03) It was represented 16.90% of GDP. (Figure 04) According to Central
Bank of Sri Lanka, from independence to today there were colossal budget deficit except 1954
And in 1955. In 1954 the government budget surplus was Rs. 24 million and in 1955 the government
budget surplus was Rs. 117 million.
From 1953 to 1954, government tax revenue was increased by approximately 8%, government
non-tax revenue is increased by 7%, and grants were increased by 5 times. From 1953 to 1954
Total government recurrent expenditure was decreased by approximately 15%, and total
government capital expenditure has been reduced by about 14%. As a result of above
increased in government revenue and decreased in government debt was caused to
the government budget deficit in 1954. As a result of this government budget deficit in 1954,
total outstanding debt was being reduced by approximately 7%.
In 1955, multilateral donors (United Nations Agencies, the European Investment Bank, and
the International Fund for Agricultural Development (IFAD)) and bilateral donors (China,
Japan, India, South Korea, Iran and etc.) began to provide assistance to finance development
projects in Sri Lanka. As a result of this grants from 1954 1955 total government grants were
increased by approximately 40%. As well as government total tax revenue was increased by
around 14% while non-tax revenue was increased by about 13% when
compared with 1954. Even though recurrent government expenditure was increased, total
government capital expenditure was decreased by approximately 13%.
As a result of this increase in government revenue more than government expenditure, from
1954 to 1955, the government budget surplus increased by approximately 4 times. Due to the huge
government budget in 1955, the total outstanding government debt was decreased by
approximately 4%. From 1950 to 1955, 79% of total government debt was financed by
domestic debt sources, while 21% of government debt was financed by foreign debt sources
because domestic credit was more readily available than foreign credit.

02.2. From 1956 to 1964 (CLOSED ECONOMY)
From 1956 to 1964 the Sri Lankan economy was a closed economy. Up to 1956, the Sri Lankan
economy was highly depended on a few exports, and the private sector could not
undertake huge capital investment. Therefore new government started to play a major role in
the economy and ten years planning project was started to implement in order to uplift living
standard. Development policy was embedded with this 10 years plan. New government
implemented the previous government strategy of agricultural imports substitution also to
industries. Due to new economic policies implemented by the new government in 1956
government budget deficit was increased up to Rs. 42 million. Due to the increase of government
budget deficit, debt was increased up to Rs. 1208 million. It was 7.20% increase in
government debt within one year. Ten years of the development plan was implemented from
financial year 1957/58. Therefore capital expenditure was started to increase.

Within this period, the most significant incident was the government of Sri Lanka began
obtaining loans from the World Bank in 1959. It was profoundly affected to increase foreign debt
from 1960 to 1965. At the beginning of 1960, the government was facing a critical problem
concerning external reserves position. Even though more than sixty percent of the imports
were represented essential consumer items, to solve this problem in the budget of 1960 by
sharply increasing the duties of cars, petrol, liquor, and tobacco. But government expenditure
was increased more than government tax revenue from 1960. Therefore the government budget
deficit was increased from 1960 to 1965. Thus total government debt was gradually
increased from 1960 to 1965. Due to the flood in 1964, the entire government recurrent expenditure
was increased by approximately 15%. As a result of this increase in this total outstanding debt
was increased by approximately 12%.

02.3. From 1965 to 1969 (PARTIAL OPEN MARKET ECONOMY)
From 1965 to 1969 the Sri Lankan economy was a partial open market economy. In 1965 total
government debt was Rs. 4435 million and debt to GDP ratio is increased up to 54.80%.
Due to increasing government debt, the Aid Group for Sri Lanka was established in 1965 to
provide financial assistance for the Sri Lankan government. In 1966 “Walawe Ganga” project
was started. Therefore capital expenditure was increased gradually and for financed this
project had to borrow funds and it was caused to increased total outstanding debt from 1966
to 1969. As well as the drought was caused to increase total outstanding debt at the end of
1969.

02.4.CLOSED ECONOMY (1970-1976)
From 1970 to 1976 the Sri Lankan economy was again closed economy. In 1970, 20% of
recurrent government expenditure was expenditure on welfare activities. Therefore it was
caused to increased government budget deficit as well as increased in outstanding debt. In
1970 to reduce imports, the government increased tariff on imports. From 1970 to 1974, total
government expenditure and total government revenue gradually increased. But in 1975
government total expenditure was increased by approximately 25% when compared with 1974.
Therefore it was caused by increased government debt.

03. Consequences of increasing government debt
If an increase in government expenditures (recurrent and capital expenditure) or decrease in
government tax revenue and non-tax revenue lead to government budget deficit. This
government budget deficit should be financed from internal debt sources or external debt
sources. Then interest on public debt is started to increase gradually when finance budget
deficit in every year by borrowings. It also caused to decrease in private investment. This
process is called crowding out effect of government borrowings.
The growing public debt in Sri Lanka from 1950 to 1977 and its servicing costs were a significant
burden on the Sri Lankan economy. It had adverse effects on long term economic
development of Sri Lanka Because, if the government have to considerable expenditure on debt
serving, the government have to fewer resources which can be used for the development process.
Borrowing funds from both internal and external sources don’t necessary implies economic
growth of a country if the government borrows funds from domestic debt sources, it caused inflation in an economy. From 1950 to 1977, 58% of total government debt was financed by
domestic debt sources. It caused to increase in the cost of living, especially it was caused to fixed-wage earners and pensioners. It also caused an increased cost of production.

Socio Economic & political analysis of ECTA

Social analysis.

The main argument made by many professionals in the health sector is that ECTA can be severely affected by the health standard of Country. Since the rule of doctors in that country is not as good as Sri Lankan one, it could severely affect the health condition of our domestic people. The argument has been made around some statistical comparisons.

Source: Human Development Reports, UNDP

According to the given statistics in 2016, there is a vast difference between health condition in Sri Lanka & India. The life expectancy of Sri Lanka is 75 years while India only has 68.3 years. The adult mortality rate has been 276 in Sri Lanka when it has been 362 per 1000 people in India. Also, the infant mortality rate was significantly high in Indian compared to Sri Lanka. This can be taken as a sign of an adverse health service in India. Most of the Doctors in Sri Lanka is complaining that through ECTA there will be lousy performing health service will stabilize here that can hinder the health condition of Sri Lanka.
According to 2015 statistics at CIA factbook, there are 2118100 HIV/AIDS infected people in India while Sri Lanka had 4200 people. Also, India is categorized as very high risk in major infectious diseases while Sri Lanka is in a high-risk category. So, there can be a possibility to spread those contagious diseases in Sri Lanka from the free movement of people if there isn’t a proper mechanism to monitor.

Economic analysis

According to neo, classical trade theories, trade between goods or services is beneficial when there a difference between taste (demand) for products. So, there is a possibility to increase consumption in both countries if there is a trade between India & Sri Lanka. Also, when comparing the market size of two states, Sri Lanka is quite a small market compared to India. While Sri Lanka has 20 million of population, India has 1.3 billion people. Sri Lankan service providers have a significant advantage from ETCA agreement by getting the opportunity to cater to a big market.
Also, in Sri Lanka, there is a monopolistic situation in consultation or channeling service. So, there is a third level of price discrimination present in those services. People are paying higher prices for the services that they receive. The gap between marginal cost and the marginal benefit is enormous. By importing those services from India could lead to reducing those prices while industries becoming more competitive. Ultimately people would be beneficial by consuming low-priced services.
Also, currently, there are some labor deficiencies in some service sector industries. Especially in the IT industry. By importing deficit units of labor from India can eliminate the excess demand in that sector while increasing countries GDP indirectly.

Because of these labor deficiencies, the labor cost is high in those sectors. This lead to an increase in the price of the final good. When analyzing the salaries of qualified software engineers in two countries in Sri Lanka, there are higher salaries compared to India. So, the final product if think it’s a software it would have a high price because of this problem. With low-cost Indian service providers, our producers could make the product at a lower cost which enables to compete with other products.
Another vital aspect is India is the major tourist arrival country to Si Lanka currently. In the year 2016, there were 356729 tourist arrivals to Sri Lanka. Also, when compared to the 2010 statistics, the visitors have been grown up by 185% when it comes to 2016. ETCA is permitting income Indian service providers to operate in the tourism sector in Sri Lanka. Having Indian cultured service providers in the tourism sector would be attractive for Indian tourist and could end up having increased the number of arrivals from India. Also, there would be room for high-quality service received by Indian tourist since they will much familiar with an Indian setting.

The critical aspect of going to be included in the ETCA agreement is that the removal of Non-trade barriers. Unique insight has been given to this case in the event of the CEPA agreement. Primarily it has been focused to remove the port restrictions that exhibit with our export to India. Removal of non-tariff barriers will enhance shipping to India.
But in economic view, Sri Lanka is disadvantageous when analyzing the potential impact on the labor force. According to the statistics, India currently has 48.26 million people unemployed. This is twice greater than that of what Sri Lanka’s population. If these unemployed people move towards Sri Lanka, can made Sri Lankan people unemployed if they cannot compete with that low-cost arrives. High unemployment will hinder the growth of the country, and ultimately, this can lead to diminishing the standard of living of Sri Lankan people.

Sriram panchalingam has posted in his tweet account in 2015 Sep 18, there were 2.3 million applications received for 369 clerical jobs in Uttar Pradesh India. There were 152000 graduates plus 255 Ph.D. holders who have applied for this position that pays only 16000 NIR per month. With this kind of situation, there can be an enormous pressure coming from India unemployed population into our labor market.

Also, there can be a considerable brain drain issue in the Sri Lankan context since the arrival of Indian service providers would reduce the salaries in Sri Lanka. Currently, there is a high brain drain rate in Sri Lanka. In the year of 2015, 6257 professional workers have left the country. It has increased by the speed of 16.5% compared to 2014. In 2015 there are 82098 skilled workers has left the country for work abroad. It has increased by 12.2% compared to 2014. The leading issue caused by this brain drain problem is the differences in the salaries in countries. With this situation inflow of Indian workers will reduce salary levels more that will increase brain drain issue.

Another aspect is that still there is a high and increasing balance of payment Sri Lanka with India. In 2015 BOP trade deficit with India is accounted as -3530.27 US $ in a million. By ETCA, there is a possibility of increasing our trade deficit more. If so we would be worse off from the agreement. As well as growing trade deficit will severely impact on the foreign reserves in Sri Lanka. Having a trade deficit will increase exposure to foreign reserves.
A primary reason for not being able to get the best out of ISFTA is having a competitive trading structure between the two countries. This theory could apply even for the case of ETCA. Having

labor endowment economic structure there is a barrier to be a success from a service liberalization system.
In the classical theory of economics when there is competitive advantage between the two countries is related to different goods can be beneficial from trade. The comparative strength of a specific product only lies with one country. So, in the view of this theory, there is a conflict when analyzing the offer list of two countries in the proposal to the ETCA. Many services are going to be offered by both countries. Those are,

1. Computer Related Services
2. Telecommunication Services
3. Health and Social Services
4. Tourism and Travel Related Services
5. Transport Services

Only two services are not on the list of Indian offers. So, the point is if Indian services have the comparative advantage of issuing those, Sri Lankan people miss the market because of having comparatively disadvantage. Then it seems like only two functions are liberalized to Sri Lanka. It reflects that Sri Lankan authorities have not correctly analyzed the capabilities & competencies that lies with services which can cater to the Indian market.

Political impact

India is a powerful country compared to Sri Lanka. Some professionals argue that the ETCA agreement is going to sign by force. According to them, India is influencing our politicians in signing that agreement. Also, another aspect they emphasize is after signing ETCA they going to cater to the best sectors in our service sector. By taking access to the best industries in our service sector, they could have able to acquire higher portion from our GDP and high power over our economy ultimately.