Sovereign debt crisis: Impacts and measures – Explained, pointwise

Introduction

Sri Lankan economy is in big crisis with a credit crunch and a slump in the GDP. The foreign reserves have reduced from US$ 7.5 billion in 2019 to US$ 1.6 billion in 2021. There are pending debt repayments of more than US$ 7 billion. Due to Sri Lanka’s sovereign debt crisis, the Sri Lankan government has recently decided to default on all its foreign debt worth US$ 51 billion as it awaits financial assistance from the International Monetary Fund (IMF). The government took this decision to preserve its dwindling foreign reserves to pay for the import of essential items. Apart from that, Rating agencies such as Fitch, and Standard & Poor’s have downgraded Sri Lanka’s sovereign debt.

What is the current economic situation in Sri Lanka?

a) The poor state of the tourism industry, b) Shortage of forex reserves: Forex reserves have dropped from over US$ 7.5 billion in 2019 to around US$ 2 billion. c) Depreciation of currency: The printing of SLRs. 800 billion by the Central Bank of Sri Lanka has led to a sharp spike in inflation. This in turn has devalued the currency, made imports costlier, added to the debt, and put the forex reserves under more pressure, d)Rise in price of food items: Sri Lanka depends heavily on imports to meet even its basic food supplies The government’s ban on the use of chemical fertilizers in farming has further aggravated the crisis by dampening agricultural production.

Due to these reasons, Sri Lanka’s public debt-to-GDP ratio was at 109.7% in 2020, and its gross financing needs to remain high at 18% of GDP, higher than most of its emerging economy peers.

What is a Sovereign debt crisis?

Sovereign debt refers to the debt issued or accumulated by any government. Governments take on sovereign debt by issuing bonds or other debt securities or by taking out loans from other countries and multilateral organizations like the International Monetary Fund.

Governments borrow money to finance the various expenses that they cannot meet through their regular tax revenues. They usually need to pay interest on such debt along with the principal amount over time.

It is also known as government debt, public debt, and national debt.

What are some unique features of Sovereign Debt?

Unlike private borrowers,

1) Governments can raise tax revenue, and also issue their own currency, 2) Governments can also be overthrown by regimes. The new regime might refuse to honor their debt obligations or incur economic sanctions that may cause their debt to lose value, 3) Defaulting sovereign borrowers are rarely subject to legal enforcement, and creditors often find it difficult to target the defaulted sovereign’s assets.

What is the status of global sovereign debt at present?

According to the asset management firm Janus Henderson, Global government debt is set to rise 9.5% in 2022 to a record US$ 71.6 trillion. This will be driven by countries such as the United States, Japan and China.

Globally governments have ramped up borrowing since the Covid-19 pandemic, as they tried to shield their economies from the fallout. That took global government debt to a record US$ 65.4 trillion in 2021, compared to US$ 52.2 trillion in January 2020.

According to Janus Henderson, government debt has tripled in the past two decades but a mitigating factor was low debt servicing costs.

About few Sovereign Debt Crisis

Sovereign Debt Crisis in the USA (2008)

Reason: Trouble in the financial market led to issues in the housing sector that aggravated into financial market decline.

Lehman Brothers were declared bankrupt leading to a full-scale crisis in the financial sector.

Measures: a) Dodd-Frank Act amended many existing legislations and created many new stand-alone provisions. b) The Emergency Economic Stabilization Act provided US$ 700 billion in bailout relief. c) Many new committees and the Federal Reserve were tasked with the responsibilities of greater financial market oversight.

Measures: Countries has been bailed out by the EU and the International Monetary Fund (IMF) with conditions to cut budgetary spending.

Sovereign Debt Crisis in the Eurozone (2011)

Reason: Accumulation of unsustainable levels of government debt by various countries of the Eurozone such as Spain, Greece, Ireland, and Portugal(popularly known as the PIGS crisis).

Greece had the biggest budget deficit of 12.7% in 2009 and one of the highest levels of public debt (160% public debt to GDP ratio in 2012) in the Euro-zone.

About the sovereign debt in India

According to the data from RBI, India’s sovereign debt (combined liabilities of the Central and State governments) to gross domestic product (GDP), at constant prices, increased to a record high of 100.86% in 2020 as against 76.86% in 2014.

With this amount, India has become the most indebted nation after Brazil and Argentina among the emerging market economies. In South Asia also, India is the most indebted after Bhutan and Sri Lanka.

What are the steps taken by the Indian government to reduce public debt?

Role of RBI: The Reserve Bank of India (RBI) is responsible for managing India’s public debt, especially debt denominated in the domestic currency. The debt of the state governments, on the other hand, is managed by the RBI under bilateral agreements.

March 1997 supplemental agreement between the RBI and the government: The supplemental agreement discontinued the issuance of ad-hoc treasury bills by the government to the RBI to finance the fiscal deficit.

The FRBM Act, 2003 prohibits the RBI from participating in the primary auctions for government loans. Together, this prevents the fiscal deficit from monetisation.

Fiscal Responsibility and Budget Management (FRBM) Act, 2003: The Fiscal Responsibility and Budget Management Act (FRBM Act) was enacted in 2003 to introduce transparency in India’s fiscal management systems by reducing the fiscal deficit.

The act mandated the reduction of the fiscal deficit to 3% of GDP, but it has been subsequently amended, and the present target is 3.1% by March 2023.

Note:

Escape clause of FRBM Act: Under this clause, the Centre can deviate from the fiscal consolidation road map. The option allows the government to widen the deficit by 0.5 percentage points in times of exigencies such as a war or calamities of national proportion.

What are the impacts of defaulting on sovereign debt by the state?

International lenders may be reluctant to lend any more money to the government unless such lending is part of a restructuring agreement.

Impact on ratings: This will make it difficult for the state to access new funds from the international bond market. For instance, the U.S. lost its traditional top spot in private agencies’ sovereign credit ratings in 2011 when Standard and Poor’s downgraded its credit from AAA to AA+.

Withdrawal of investments: While defaulting the state becomes less attractive to investors, especially to foreign portfolio investors fearing the crash of global markets.

Other impacts: Increased unemployment, reduce forex reserves, reduction in remittances, and reduce government spending on socio-economic programmes such as poverty reduction, health, etc.

What are the measures to prevent a Sovereign Debt Crisis?

Managing the debt: The governments have to maintain debt sustainability and improve measures essential for the assessment of debt sustainability. For instance developing a medium-term debt management strategy (MTDS).

Public debt management assistance: Developed countries can provide dedicated public debt management assistance to developing/Least developed countries through various international institutions such as IMF, WB, etc.

Responsible sovereign borrowing: many governments simply choose to borrow fresh debt to repay existing debt. Historically, governments have tended to borrow more money than they could actually repay in order to fund populist spending.

Hence, the governments have to bear the responsibility and must follow global best practices such as maintaining sub 3% fiscal deficit.

Debt transparency: Public debts pose a challenge to the global effort to end extreme poverty and achieve other Sustainable Development Goals (SDGs) by 2030. So, debt transparency is critical.

Creditors, donors, analysts, and rating agencies need to assess sovereign creditworthiness and appropriately price debt instruments.

What are the measures to overcome the Sovereign Debt Crisis?

Austerity measures: It refers to economic policies implemented by governments to reduce government spending in order to reduce public debt and shrink the budget deficit. Some of such measures include increasing taxes, reducing spending on government programs, reducing the salaries and wages of government employees, etc.

Sovereign debt restructuring: The debt restructurings come in two ways. a) decisive restructurings This focus on bringing the debt crisis to an end and interim restructurings that fall short of placing debt on a sustainable path, so that the country ends up relapsing within two yearswas associated with more prolonged periods of market exclusion and higher borrowing costs.

The governments should make the public debt sustainable by carefully crafting their strategy on the outlines of growth with financial stability in mind.

Sources: The Business Standard, The Hindu Business Line, World Bank, BIS, The Hindu