October 21, 2024
KATHMANDU – Is Nepal on the verge of becoming another Sri Lanka? Questions of these motifs were common in Nepal’s public debate sphere after Sri Lanka defaulted on its sovereign debt in April 2022. Around the same period, another South Asian nation—Pakistan—had difficulty servicing its foreign debt.
While the doomsday predictions of Nepal becoming another Sri Lanka turned out far-fetched, can the debt distress experienced by Sri Lanka and Pakistan offer lessons for Nepal’s public finances? A closer investigation of public debt in three countries—Nepal, Pakistan and Sri Lanka—offers some answers.
First, these three South Asian nations differ markedly in their public debt levels and other public finance characteristics. While assessed as having a low risk of debt distress, Nepal has witnessed a surge in its public debt holding, from about 25 percent of GDP in the fiscal year 2014-15 to 42.7 percent in 2023-24. However, despite the peculiarities of every nation, some common patterns let us draw a few lessons.
Fiscal profligacy to serve short-term political gains is at the heart of the public debt woes. For instance, Sri Lanka aggressively used foreign loans obtained at a high cost to finance development projects and social welfare to fulfil election pledges and appease the voters. Even when the debt accumulation was spiralling out of control, the government failed to make timely adjustments and instead opted for counter-intuitive tax cuts in 2019. Covid-19 halted Pakistan’s tourism, a critical foreign reserve source. Moreover, policies such as a ban on imports of chemical fertilisers caused a decline in agricultural production and exports, hastening the debt crisis. However, the crucial factor was a long history of fiscal indiscipline, resulting in chronic budget deficits.
Likewise, Pakistan also opted for persistent budget deficits to finance development projects, often without adequate preparation and evaluation, and other politically convenient measures, such as untargeted energy subsidies and significant fiscal support to large but inefficient state-owned enterprises. The rapid accumulation of public debt in Nepal is partly due to fiscal profligacy—running persistent budget deficits to finance government expenditures, including wasteful recurrent expenditures and investments in development projects that have not undergone adequate preparations. Similarly, untargeted social security expenditures motivated by electoral considerations rather than sound assessments are rampant in the country.
Another important lesson is that the external finance landscape changes as the country climbs the income ladder. There is a gradual increase in the cost of external borrowing as the sources of concessional financing dry up or are inadequate to fuel higher development aspirations. For instance, when Sri Lanka upgraded to a middle-income country and entered the international capital market in 2007, its share of non-concessional loans was less than 20 percent. However, as its income increased, so did its borrowings from high-interest foreign sources, also called international sovereign bonds. The share of non-concessional loans increased to more than 50 percent of its total loans.
Pakistan has also seen a declining share of multilateral creditors in its external loan portfolio and an increasing concentration of bilateral creditors (primarily Chinese loans) and commercial creditors. Until now, Nepal has relied exclusively on concessional loans for external finance. It would be wise to tread a cautious path, as the country has recently graduated to a lower-middle-income category in the World Bank’s classification and is poised to graduate from the least-developed country category in 2026.
A closer investigation into the public debt of these nations also indicates that the Chinese debt-trap narrative—observations that China burdens developing countries with unsustainable debt—is perhaps overblown. The experience of Pakistan and Sri Lanka suggests that loans from China did add to the debt burden—as the interest rates are higher than that of concessional loans obtained from multilateral sources—evidence suggests that Chinese loans were obtained at interest rates lower than that of international capital markets. In Sri Lanka’s case, Chinese loans constituted a lower share of the external debt and debt servicing than what was owed to other sources, such as international capital markets. The biggest issue with loans from China seems to be non-transparency rather than its volumes and servicing costs.
Debt crises can occur at different levels of public debt. In the case of Sri Lanka, the crisis occurred when its debt to GDP was higher than 100 percent of GDP, but regarding Pakistan, debt financing difficulties were seen at a much lower level—at around 75 percent of GDP. A literature survey on public debt sustainability also shows no agreed-upon debt sustainability threshold. Moreover, the critically acclaimed book This Time is Different, written by Carmen Reinhart and Kenneth Rogoff, points out that debt defaults have occurred at levels below 40 percent of the Gross National Product. Hence, the current debt levels should not create complacency that stalls public finance reforms.
Public debt, in certain instances, is indispensable, and its just use can be instrumental in the development of a country and the welfare of its citizens. However, considering Sri Lanka and Pakistan’s experiences, it is also true that mismanagement of public finances can inflict significant pain on ordinary citizens and lead the economy down a path below its potential for a long time. Hence, it is imperative that Nepal put its public finances in order. The right time to do that is now when the crisis is not imminent.