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September 19, 2018

Debt sustainability in perspective

The depreciating Kenya shilling, skyrocketing interest rates and apparent liquidity challenges in public finance have rightly lead to concerns about public debt sustainability. 

Public debt arises out of budget deficits, which occur because the government expenditure exceeds revenues, as outlined in the annual budget. The purpose of public borrowing is therefore to bridge the resource gap and remains an integral part of the budget making. Consequently, the higher the budget deficit, the higher the level of borrowing in any particular fiscal year. The question is whether borrowing is necessary and why the government would choose to borrow other than budget within its revenues.  

Often times, revenue collected from taxes is insufficient to fund long term development activities, without which economic goals such as employment, education and poverty reduction may not be achieved. Public borrowing is therefore essential for purposes of investing in long-term development projects whose future returns will be able to repay the loan plus the interest in addition to meeting the economic goals. In essence economic development and debt are intertwined in a chicken and egg situation, with no definite sequence on which comes first. 

That said, sustainability of debt is important in order to ensure that public borrowing continues to bridge the resource gap on a long-term basis and that debt service does not strain government resources. However, the level at which debt becomes unsustainable is highly contextual and also vigorously debated. Besides, what matters most is not the level of debt itself, but the ratio of debt relative to a measure of capacity to repay.

Generally speaking debt is sustainable if projected debt ratios are stable or decline, while also being sufficiently low. On the other hand, debt is unsustainable if projected debt ratios increase or remain high. Consequently the ratio of debt to capacity to repay is what matters in order to avoid a debt crisis. This means to be sustainable, debt cannot grow faster than incomes and the capacity to repay it. 

Economists commonly will use public Debt-GDP ratio as an indicator of indebtedness and as a sustainability benchmark in debt management decisions. The ratio is highly specific for each country and each country establishes its own debt sustainability ratio depending on its own development agenda. Sustainability is therefore dynamic in addition to being country specific. If the rise in public debt is commensurate with the increase in GDP, the public Debt-GDP ratio would remain unchanged. Therefore, positive economic growth allows increase in public debt over time without running the risk of sustainability. Besides, public Debt-GDP ration is not a sufficient measure. 

This can be explained with an example of two households with same level of disposable income making investment decisions.  Let’s assume the disposable income of both households is Sh100,000 per month and total wealth of Sh2 million. Suppose household A borrows Sh1 million and invests in a car to ease daily commute while household B borrows a similar amount to invest in a business venture that generates Sh20,000 a month. Both households have a debt-wealth ratio of 50 per cent as an indicator of indebtedness. If for instance the disposable income of both families decline to Sh60,000, for instance because one spouse is out of employment, household A is more likely to face debt sustainability challenges, even when the indicators point to same level of indebtedness for both households. This is because the investment for household A was a consumption investment while that of household B was an income generating investment. 

The same applies to countries. Whether a particular level of Debt-GDP is sustainable is dependent on the productivity of the underlying investments. The Debt-GDP ratio is only an indicator, but it does not tell the whole story. This means before a particular level of debt is deemed sustainable or unsustainable, more interrogation is necessary. 

Often times, high indebtedness is worsened if borrowing is beyond capacity to repay compounded by unproductive use of the resources. Take an investment like the Standard Guage Railway project connecting Mombasa to Kisumu and further to Uganda and subsequently expected to be hooked to Rwanda, Sudan and Burundi. Such a crucial infrastructure investment, when well structured, is a catalyst for development and has the capacity to generate revenue that is sufficient to repay the principal loan together with interest.  In addition, it reduces the cost of doing business, increases tax base from business that rely on it and is a source of employment.  Public debt incurred for development of such a project is good debt and is unlikely to lead to debt sustainability problems.

On the other hand, debt incurred to fund consumption such as pay public wages, or run government operations that are recurrent in nature can increase the risk of debt sustainability. This is because by their nature, they are not income generating activities that would enable repayment of principal and interest in future. Good debt management would therefore require recurrent expenditure to be funded through current government revenue rather than debt.  

That said, debt sustainability is critical because high debt levels come with costs and consequences. One is increased vulnerability to external economic shocks and sudden stops to financing. One such shock is the recent strengthening of the dollar against world currencies. The local impact was a drastic depreciation of the Kenya shilling and an increase in the level of debt that was denominated in dollars. When external debt levels are high, the impact can be significant, because the space to absorb such shocks is limited. 

Two, interest rates could become much higher because the country risk premium would rise with high debt levels. This has the impact of crowding out private investment. Third, there is less policy flexibility because government can no longer afford to raise spending or increase taxes even when faced with a downturn when debt is already high. 

If debt sustainability challenges persist longer, they could escalate to the much more serious problem of debt overhang. This is the situation where the expected tax burden to finance debt is so high that it is basically a disincentive to the current investment and consumption. This in turn leads to a drag on economic activity and could start a downward spiral. Because investors expect high tax rates, they reduce investment which in turn leads to lower growth and lower government taxes. The government then has insufficient resources to fund primary expenditures. When the government in turn cuts its spending, it faces lower revenues and the risk of default on debt increases. It is a vicious cycle of debt overhang that no government would want to deal with. 

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