Columns - The Sunday Times Economic Analysis

Borrowed reserves do not shine: They swell debt burden

By the Economist

The gross official reserves of the country surpassed the US$ 7 billion levels on October 4 2010 This level of reserves is equivalent to over 6.8 months of imports. In announcing this the Central Bank also said that it was the highest ever reserves level of Sri Lanka. In other words the country’s external reserves are strong. A strong external reserves position is vital for an import export dependent economy and these reserves provide a comfortable level of such reserves. However, the manner in which the reserves have been built up is as important as the amount. The amount of the reserves alone does not tell the full story. In fact this statistic is misleading.

It would have been more enlightening if the Central Bank also disclosed how these reserves were built up. They were certainly not the result of trade surpluses. Capital inflows as remittances, portfolio investment, foreign aid and grants are among the contributors. However the most important and largest component of the recent build up of reserves has been through foreign borrowing at commercial rates of interest. The accumulation of foreign reserves has gone in tandem with an increase in foreign debt to a very high level. With both the foreign debt and the domestic debt escalating, the increase in the total public debt is massive. The consequent increase in debt servicing costs is a huge burden on the public finances of the country.

Foreign debt is at a historic height and debt servicing costs continue to increase as the government resorts to further foreign borrowing. The debt servicing costs are larger than the country’s revenue. Consequently the government requires to borrow more to service the debt. These are facts not mentioned in the claim that foreign reserves are at its height. The claim that the country has the highest foreign exchange reserves is also a misleading statement as we point out later.

The country’s foreign debt has been increasing over the years. Since 2005 the foreign debt has been increasing progressively. In 2005 it was US$ 11,354 million and the debt servicing costs absorbed 7.9 per cent of the value of merchandise exports. At the end of 2009 the foreign debt had risen to US$ 18,662 million and required 19 per cent of export earnings to be expended for foreign debt servicing. In other words nearly one fifth of the country’s merchandise export earnings went towards servicing the foreign debt. The increase in foreign debt between 2008 and 2009 was as much as 21 per cent from US$ 15,107 million in 2008 to US$ 18,662 million in 2009. The increase in 2010 is likely to be similar. Another way of looking at the high level of reserves is that the foreign debt is 2.7 times the current reserves of US$ 7 billion.

At the end of 2010 it is likely that the foreign debt would be about thrice the amount of the foreign reserves and would probably require about one fourth of this year’s export earnings to service it. This situation has arisen not only because of the increase in foreign borrowing but also due to export earnings not increasing much. While export earnings have grown by only 11 per cent in the first seven months, imports have increased by 34 per cent, thereby resulting in a huge merchandise trade deficit. If one relates the foreign debt to the trade deficit, it is likely to be of about the extent of the merchandise trade deficit.
The Central Bank’s claim that the foreign exchange reserves at over US$ 7 billion is a record level for the country is again a misleading statistic. The value of the foreign exchange reserves over a period of time cannot be compared by its nominal values as their real values have changed considerably. The Central Bank figure of the reserves being adequate for seven and a half months imports is the relevant figure. There have been many years when the foreign reserves have exceeded the equivalent of 6.8 months of import requirements.

The Central Bank may like to have a look at its Annual Report Appendix Table 4 for its own enlightenment on this.

In 1950, the year the Central Bank was founded, the foreign reserves were adequate for 10.2 months of imports and in 1951 it was adequate to finance 9.6 months of imports. In fact there were six years in the Central Bank’s 60 year history when the reserves were adequate to finance over 7 months of imports. These were 1950, 1951, 1955, 1956, 1957 and 2009. It is especially strange that the Central Bank has forgotten last year when the reserves were adequate to finance 8.3 months of imports, much higher than the current level. What is also significant is that in the 1950s when the reserves were high foreign debt was low at about 10 per cent of the reserves and not 267 per cent as it was last year.

There is no great achievement in the increase in the foreign reserves to US$ 7 billion, the equivalent of 6.8 months of the country’s imports. Had these been achieved by export surpluses, the boast would have been very valid. What is in fact disconcerting about the external finances of the country is that the foreign debt is reaching a very high level and its debt servicing costs are a drain on the country’s export earnings. The foreign debt component is adding to the massive public debt and debt servicing costs that are at an unbearable level.

There is also vulnerability in the external finances of the country as these reserves could diminish as these are mostly short term funds. Similarly funds that are being invested in the stock market are also short term contingent liabilities. Current foreign borrowing is short term and at relatively high rates of interest and therefore the debt makes the external finances quite unstable.

The absorption of about a quarter of the country’s merchandise export income and the total debt burden requiring more than the country’s annual revenue are serious issues. It is these issues that are relevant for the country’s economy not the build up of reserves by borrowing.

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