Debt sustainability refers to the ability of a government to meet present and future debt servicing obligations without requiring exceptional financial assistance.

Borrowing usually plays an integral role in government finances. Governments borrow funds to meet needs in terms of infrastructure, development and expenditure. The key question is whether the government will continue to borrow comfortably but can also pay back the borrowed amount in the future.

This poses a significant challenge to developing countries as the government has substantial development needs but is also exposed to greater risks.

What Is Debt Sustainability?

The public debt of a country is said to be sustainable “if it is the government has sufficient capacity to meet its principal and interest obligations without experiencing a debt crisis.”

The definition can vary significantly depending on what is to be measured:

• Narrow definition: It may be the debt of the budgetary central government.
• Broad definition: It may cover the general government (central, state and local governments, extra-budgetary entities, and social security funds).

The scope of the assessment should ideally capture all potential debt obligations that could, in time, compromise public finances.

In advanced and emerging economies, the analysis focuses on the general government whereas in low-income countries the assessment is wider ranging encompassing public and publicly guaranteed debt.

What Is Debt Sustainability Analysis?

The Debt Sustainability Analysis (DSA) is basically a diagnostic tool used to assess whether a country’s current and projected debt burden is likely to be manageable.

The IMF and World Bank perform such an assessment particularly on low-income countries under the Debt Sustainability Framework.

Three Distinct Purposes of Debt Sustainability Analysis

1. Protecting debt relief gains: It helps countries which have received debt relief to remain on a sustainable development path.
2. Facilitating creditor risk assessment: It enables creditors to identify prospective risks in order for them to tailor their financing arrangements accordingly.
3. Helping countries to balance development needs and debt serviceability: It enables countries to meet their development needs without excessive borrowing.

The objective is to enable countries to pursue their development goals while keeping the risk of debt distress under control.

Why Is Debt Sustainability Important?

A debt problem is rarely a problem confined just to the government.

When the government defaults on its borrowings, it may be forced to divert more funds to interest and debt servicing and have less to spend on infrastructure, welfare and other development needs.

Debt distress can also have implications for investors, lenders and the financial sector in general, leading to loss of confidence, higher borrowing costs and reduced access to new finance for the government.

Debt sustainability analysis is therefore helpful and relevant to both governments and creditors in making borrowing and lending decisions.

Why Is Debt Sustainability Difficult for Developing Countries?

Developing countries are typically faced with large financing requirements and limited fiscal space but are also vulnerable to fluctuations in international financial markets.

1. Rising Global Indebtedness

Borrowing has been an increasingly important source of financing economic growth since the global financial crisis.

2. Increasing Dependence on Financial Markets

Integration with the global economy means that developing countries have access to international capital but are vulnerable to variations in global interest rates and capital markets.

3. Volatile Capital Flows

Significant inflows of foreign capital are subject to sudden swings in capital flows creating financial and exchange-rate pressures.

4. Exchange-Rate Pressure

Large capital inflows may lead to currency appreciation, potentially undermining the competitiveness of domestic industries and affecting export earnings.

5. Limited Policy Space

Developing countries have limited options in responding to global financial shocks while financing vital development expenditure.

6. Dependence on Export Markets

Access to reliable foreign markets and export earnings is critical in providing resources to sustain growth and service external debt.

7. Premature Financial Opening

Rapid integration with international financial markets exposes domestic economies to global financial volatility before their financial systems are adequately prepared.

Why Are Exports Important for Debt Sustainability?

Exports are an important source of foreign exchange for developing countries.

This is particularly relevant to developing countries that have external debt obligations that need to be servicing in the foreign currency.

Thus, debt sustainability is not only about managing the amount of borrowing but also about expanding the economy’s capacity to earn income and foreign exchange.

India’s Debt Sustainability

Public debt sustainability is of particular concern to Indian policymakers. India’s government borrowing has a long history. The nature and sources of public borrowing have evolved over time.

Prior to Independence, the borrowing needs of Indian princely states were largely met with the resources of indigenous bankers and financiers.

The East India Company used public borrowing as a means of financing the Anglo-French wars in the 18th century.

The First World War witnessed a significant increase in India’s public debt as the country’s contribution to the British exchequer mounted.

Later in 1920, the provinces of British India were allowed, for the first time, to raise loans under the local government borrowing rules issued under the Government of India Act, 1919.

The source material states that India’s combined public debt, covering the liabilities of the Central and State governments, stood at 100.86% of the GDP in 2020.

How Can India Make Public Debt More Sustainable?

There are no easy solutions to the debt problem. Sustainable public finances require a mix of improved revenue mobilisation, controlled expenditure, productive investment and efficient debt management.

1. Reform Loss-Making PSUs

The government may contemplate privatisation or restructuring of loss-making public sector enterprises as appropriate.

2. Improve Government Efficiency

Government participation in business activities should be guided by considerations of social relevance, economic viability, technological feasibility and public interest.

3. Reduce Fiscal Waste

Bringing control over unproductive and unnecessary expenditure expands fiscal space and increases macroeconomic stability.

4. Strengthen Public Financial Management

Greater usage of the Public Financial Management System (PFMS) will improve transparency, accountability and monitoring of government finances.

5. Use PPPs Where Appropriate

Public-Private Partnerships (PPPs) can serve as an important source of mobilising private resources for suitable infrastructure and social-sector projects.

6. Invest in Infrastructure and Human Capital

Enhanced infrastructure, human capital and education will increase productivity and support long-term economic growth.

7. Strengthen the Tax Base

Improving the tax base will be crucial in boosting the tax-to-GDP ratio and strengthening government revenues.

8. Encourage Alternative Sources of Finance

The government should explore alternative sources of finance to reduce its dependence on public borrowing.

9. Improve Public Debt Management

Debt management should be geared towards lower interest costs, risk reduction and development of the government securities market.

10. Promote Renewable Energy

A move towards renewable energy will reduce dependence on imported fossil fuels and conserve foreign exchange.

Debt Sustainability and Economic Growth

Debt sustainability does not necessarily mean a government should simply stop borrowing.

Borrowing can be a good thing if it is used to finance investments that increase the capacity of the economy.

Investments in infrastructure, human capital and other growth-enhancing aspects can enhance the economy’s capacity to generate income and thus make debt easier to service.

The real challenge is to strike a balance between fiscal discipline and development expenditure.

If borrowing is used judiciously and economic growth is robust, the debt burden can be contained. However, if debt keeps rising without a corresponding rise in the capacity of the economy to earn income, sustainability can be threatened.

Conclusion

Debt sustainability basically boils down to ability to repay. Governments need borrowing to finance development but borrowing must be consistent with future debt repayment capacity.

For developing economies this can be a particularly thorny issue as they are more vulnerable to global interest rates, capital flows, exchange-rate fluctuations and variations in exports demand.

For India, sustainable public debt calls for fiscal discipline, greater revenue mobilisation, productive public expenditure, efficient debt management and sustained economic growth.

The objective is not necessarily to avoid public debt but to ensure that today’s borrowing boosts tomorrow’s economy rather than becoming tomorrow’s financial burden.

FAQs

What is debt sustainability?

Debt sustainability means being capable of repaying current and future debts without requiring exceptional financial assistance.

What is Debt Sustainability Analysis?

Debt Sustainability Analysis (DSA) assesses whether a country’s existing and projected future debt is likely to be sustainable.

Why is debt sustainability important?

It helps to ensure that governments avoid debt distress while ensuring that debt servicing does not impede development and welfare expenditure.

Who conducts debt sustainability analysis?

The IMF and World Bank undertake such analysis particularly of low-income countries under the Debt Sustainability Framework.

What is the difference between narrow and broad public debt?

The narrow definition covers only the budgetary central government while the broader one covers central, state and local governments, extra-budgetary entities and social security funds.

Why are developing countries more vulnerable to debt problems?

They tend to have large development needs but limited fiscal space and are exposed to fluctuations in global interest rates, capital flows, exchange rates and exports demand.

Why are exports important for debt sustainability?

Exports generate foreign exchange which is crucial for countries that have external debt obligations.

How can India improve debt sustainability?

India can improve its debt sustainability by exercising fiscal discipline, mobilising more revenues, making productive public investments, managing debts efficiently and promoting economic growth.

Does public debt always harm economic growth?

No. Productive borrowing can finance infrastructure and human capital investments and enhance growth.

The problem arises when borrowing becomes excessive or is not backed with sufficient capacity to service the debt.