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How to end the deadly government debt spiral

Governments should implement major structural changes to resolve their debt problems and maintain long-term economic stability. : Kishor (Unsplash) Unsplash License Governments should implement major structural changes to resolve their debt problems and maintain long-term economic stability. : Kishor (Unsplash) Unsplash License

COVID-19 triggered a massive increase in government debt, mainly in low-income countries. But it would be economically wrong to put all the blame on COVID.

The debt crisis wrecking ball is smashing through Asia. First Sri Lanka defaulted and now Laos is facing a similar crunch. The small landlocked country of 8 million bordering China owes more than half its foreign debt to its neighbour including ‘hidden obligations’, and experts say it could end up bartering away land and resources for relief.

These countries are shut off from capital markets because they’re deemed uncreditworthy by debt rating agencies. Malaysia is no exception as the COVID-19 pandemic has significantly increased government debt. The government has had to increase spending to support the economy and respond to the COVID crisis. Prime Minister Anwar Ibrahim recently revealed the country’s national debt had ballooned to RM1.5 trillion (USD$ 348 billion), more than 80 percent of GDP.

There is no doubt COVID triggered a massive increase in government debt, mainly in low-income countries, but it would be economically wrong to put all the blame on the pandemic. Before COVID engulfed the world, it was evident government and private debt levels were already on a worrying rise.

The pandemic added to this by increasing government debt in many economies as they spent big to support their populations and economies. The dramatic fall in trade, investment, and employment along with currency volatility added pressure to public finances.

The relationship between government debt and economic development is tricky, and many people believe it might hinder growth. Debt may boost long-term growth and development, but it can also strain an economy and reduce its resilience to crises. Public debt helps fund infrastructure, education, and healthcare, which will benefit the economy and society in the long run. During recessions, government debt allows the government to increase expenditures and sustain demand. However, without economic growth and higher taxes, debt may become a burden.  

Sri Lanka borrowed nearly USD$1.4 billion in 2020 and 2021 to sustain itself during the pandemic when lockdowns and the loss of the tourism industry hit the economy hard. To meet its payments the government cut services. Protests and riots ensued as prices spiked and living standards plummeted. Eventually, the debt burden became too large and the country defaulted in May 2022.

Understanding the effects of borrowing and debt levels in various nations is critical. Although external factors influenced the crisis in Sri Lanka, the main cause of the protest and anger among the citizens was due to government mismanagement. The previous administration, led by Mahinda Rajapaksa (the brother of Sri Lanka’s ousted prime minister, Gotabaya Rajapaksa), took on heavy debt to fund infrastructure projects such as building a luxurious port that has yet to generate income. Sri Lanka saw 71.4 percent of its revenue going to interest payments on debt in 2020, making it one of the countries with the highest debt service charges worldwide. 

Developed economies such as Singapore and Japan have developed strategies and policies to avoid falling into the debt trap. 

Singapore has a high gross debt of 140 percent of GDP but the city-state receives more investment returns, which make up around one-fifth of the government’s annual income, giving the city-state flexibility to keep taxes low. Singapore’s seemingly high headline debt to GDP ratio is not debt taken to fund general government operations but to facilitate investment needs. The country incurs low debt service charges, less than 0.5 percent of revenue in 2020, which is compensated by its investment returns. The country has laws that prevent its government from spending more. The Singapore government mandates a balanced budget for each term of government, which means that it cannot spend more than what it collects in revenue for the fiscal year, except in exceptional circumstances such as the COVID pandemic.

Japan, with a gross debt-to-GDP ratio of 263.1 percent of its GDP, has the highest level of government debt in the world. Its situation is unique as its debt issue is largely driven by the country’s attempts to stimulate the economy via expansionary fiscal and monetary policies. Expansionary fiscal policies comprise increasing government spending, cutting taxes, or both, while expansionary monetary policies involve boosting the money supply by purchasing government bonds and lowering interest rates by the Bank of Japan to encourage economic growth and avoid deflation. Japan is the top creditor country despite its high debt. In addition, Japanese investors own 90 percent of the debt. This means Japan borrows entirely in yen and mostly from its own citizens, reducing the likelihood of a sovereign default.

Each nation has unique challenges. Despite these variations, governments can implement major structural changes to resolve their debt problems and maintain long-term economic stability. Political will, fiscal discipline and a desire to adopt these measures to address their debt issues are required. 

The problem does not lie with the accumulated high level of government debt but with countries getting stuck in a debt trap and needing clear policies to come out of it. The best policy any government can have is to have key structural reforms. Policymakers can focus on having a clear strategy and a strong will to improve business conditions, attract foreign direct investment and increase the ease of doing business. 

Governments could move quickly with fiscal reforms and tax administrations leading to greater productivity and increasing repayment ability. It is crucial to managing debt responsibly to avoid increasing government borrowing costs, restricting private investment and economic development, raising prices and lowering purchasing power and limiting the government’s capacity to react to unanticipated occurrences or pursue other important policy objectives.

Grace Hooi Yean Lee is the Head of the Department of Economics, School of Business, Monash University Malaysia.

Nafis Alam is a finance professor and the Head of the School of Business at Monash University Malaysia. His research mainly focuses on financial regulation, and he is among the top global influencers on FinTech and RegTech. He tweets at @nafisalam.

Editors Note: In the story “Government debt” sent at: 24/02/2023 09:47.

This is a corrected repeat.

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Grace HY Lee
Monash University, Malaysia

Nafis Alam
Monash University Malaysia

Shahirah Hamid
Commissioning Editor, 360info Southeast Asia

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