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Chinese loans and the risk of debt distress

| Updated: October 24, 2017 04:43:17


Chinese loans and the risk of debt distress

Over the past few weeks, the visit of the Chinese President has been a topic generating much discussion at various levels. While the bulk of the discussion centred on the $24-billion financial assistance and what it entails for Bangladesh's economic development and bilateral relations with China, Bangladesh's ability to absorb such monumental financing was barely explored. Of course, the signing of loan agreements and other deals bodes well for infrastructure development needed to propel the country to a higher growth trajectory. At the same time, however, we also need to take a careful look into the issue from a debt sustainability perspective.
The sheer size of the financial assistance committed by China is something unprecedented for Bangladesh. To put things in perspective, consider the fact that the largest donor to Bangladesh, the World Bank, has committed the same amount - $24 billion - over a period of four decades since independence. At current prices, $24 billion translates to more than 10 per cent of Gross Domestic Product (GDP). The Chinese commitment dwarfs those of other major development partners, such as the Asian Development Bank (ADB), which has allocated $8.0 billion for Bangladesh for the period 2016-2020.There is general optimism that Bangladesh can withstand additional external financing, which is mainly concessional with long repayment periods, without plunging into unsustainable debt. Nonetheless, what do the numbers say regarding public debt and its sustainability?
At the end of Fiscal Year (FY) 2014-15, total public debt, comprising of both external and domestic debt, stood at $64 billion, which was 33.5 per cent of GDP. Domestic borrowing accounted for 56 per cent of overall public debt, while external borrowing accounted for the remaining 44 per cent. Although domestic borrowing accounts for a relatively higher share of public debt, the absolute size of public external debt is substantial. Between FY2000 and FY2015, public external debt increased from about $15 billion to more than $26 billion, or 13.4 per cent of GDP. With a rise in externally-financed public investment in the coming years, this ratio is expected to increase further. However, at present, Bangladesh fares much better when compared to low-income countries, which have an average public debt amounting 48 per cent of GDP. 
Given that repayment periods and interest rates of external loans vary, a more appropriate metric to gauge debt sustainability is the present value of public debt to GDP, which is currently 29.5 per cent. According to the International Monetary Fund (IMF), this ratio is projected to gradually increase over a 20-year horizon, reaching 39 per cent by FY2036. The question that now arises is whether such a debt-to-GDP ratio exposes a country to significant risks of debt distress, and how the ratio might change once the Chinese commitments are taken into account. 
A relatively recent debt sustainability analysis conducted by the IMF provides some crucial, if not exhaustive, insight. Conducted in October 2015, and later updated in January 2016, the analysis finds that Bangladesh remains at a low risk of external debt distress. Moreover, it finds that the debt distress is unlikely to be augmented by significant risks stemming from domestic public or private external debt. IMF classifies Bangladesh as a frontier market among low-income countries, and ranks the country's policies and institutions as medium. Based on these factors, IMF's debt sustainability framework determines thresholds for various debt variables which provide an indication as to whether or not a country is in risk of debt distress. For Bangladesh, the threshold for the present value of public debt-to-GDP is 40 per cent. As such, Bangladesh is well below the indicative threshold, and even after 20 years, will not exceed the 40 per cent mark. Other debt indicators are also projected to stay within their specific thresholds. 
However, this positive outlook depends on a crucial assumption, which is the full implementation of the Value Added Tax (VAT) law from FY2017. This law was supposed to significantly raise public revenues which, at around 11 per cent of GDP, is currently the lowest in the world. Experts have long identified the dismal revenue generation as one of the major impediments towards higher public investment and economic growth. The increased revenue generation from the VAT law was expected to offset higher public spending on debt that would arise given the increase in external financing.
As we have seen, the government was unable to fully implement the law amidst considerable opposition from the business community. It is a major setback for revenue mobilisation and subsequently debt sustainability. Without increased revenue generation, the debt-to-GDP ratio is likely to increase sharply, crossing the threshold of 40 per cent by 2022, and may go as high as 70 per cent by 2036. The other debt indicators would similarly deteriorate. Public debt would thus be on an unsustainable trajectory, which can only be averted if significant fiscal consolidation, or lowering of government expenditure, takes place. This would then have adverse effects on poverty reduction and economic growth. Although the government seems adamant to fully implement the law from the next fiscal year, recent experience would suggest that it will continue to face tremendous resistance. 
How does this fit in with the recent Chinese commitment of financial assistance? For starters, the failure to implement the VAT law and the associated lower revenues raise concerns about the debt absorptive capacity of Bangladesh. Even without the large debt-creating flow, Bangladesh would still face considerable difficulties in maintaining a sustainable debt level, which is further exacerbated by the Chinese loans. The debt sustainability analysis by IMF includes several stress tests, one of which estimates the impact of a sizeable increase in debt-creating flows. According to the assessment, a 10 per cent of GDP increase in debt-creating flows, similar to the size of the Chinese commitment, is projected to increase the debt-to-GDP ratio to 41 per cent in FY2018, and to 46 per cent by FY2026. Although this does not imply that public debt would automatically become unsustainable, it indicates that Bangladesh may be in risk of experiencing some form of debt distress. The stress test further assumes that the VAT law will be fully implemented, which is yet to happen. If we consider the financial commitments of other major development partners on top of the Chinese assistance, especially the $12 billion for the Rooppur nuclear power plant, the increase in debt-creating flows may be as high as 23 per cent of GDP. Even if the new VAT law came into full effect, such high levels of debt inflows can cause considerable strains on fiscal management. 
That China came forward with tens of billions of financial assistance is no surprise. China has been aggressively lending to other developing countries under the umbrella of South-South cooperation. While it is understandable that the government would welcome such high levels of external financing to support infrastructure development, it is important to adopt a pragmatic approach keeping the above-mentioned factors in mind. For now, the least the authorities can do is to strengthen efforts to scale up revenue generation in a bid to keep public debt at a sustainable level. 
The writer is an economic research specialist.
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