South Asia is one of the least integrated regions in the world in trade and people-to-people connections. However, the recently published World Bank South Asia Update says this region is expected to grow at just under 6 percent by 2024, faster than any other developing region. This growth rate is slower than its pre-pandemic pace of 7 percent. South Asian region has great opportunities and concerns, especially when examining indicators like central government debt as a percentage of its gross domestic product (GDP), which indicates how much a country owes compared to its economic size. A higher percentage means more obligation and a more significant challenge in repaying the principal and interest.

Debt trend

South Asia’s debt dynamics have significantly changed since the mid-20th century. Economic optimism marked the initial decades for most countries in the region in the post-colonial era. Investment in infrastructure and social development, including health, education and water supply, among others, took place to address poverty and inequality. Additionally, a push for industrialisation resulted in an uptick in borrowings. Unfortunately, the Covid-19 pandemic led to massive healthcare spending, social safety nets and economic stimulus packages, rising interest rates in developed countries, global economic slowdown, and internal political upheavals, influencing borrowing patterns. South Asian nations are grappling with the dilemma of spurring growth while managing burgeoning debts.

According to the International Monetary Fund (IMF) dataset on government debt from 1950 to 2022, Afghanistan has the highest average debt, accounting for about 64 percent of its GDP, while Bangladesh has the lowest average debt, constituting around 28 percent. The debt situation in the region showed alarming trends in 2022, with Bhutan, Sri Lanka and Maldives having debt figures that surpassed their GDPs at nearly 124 percent, 118 percent and 114 percent, respectively. Moreover, Pakistan’s debt is over three-quarters of its GDP, around 76 percent. India, the largest economy in the region, holds a debt percentage of over half of its GDP, at about 55.4 percent. Bangladesh and Nepal are in relatively healthier positions, with debts of around 39 percent and 43 percent of their GDPs, respectively. Data for Afghanistan in 2022 is unavailable.

As per the World Bank, the average debt-to-GDP ratio in South Asia had risen to around 86 percent. This was notably higher than the global average of 60 percent, indicating a potential fiscal vulnerability. Such elevated debt levels can hamper government investments in health, education and infrastructure. Moreover, a high debt profile amplifies a country's susceptibility to global economic shocks, which can have cascading impacts on its population.

Like many other emerging markets and developing economies, South Asia has seen a decisive shift towards domestic borrowing in recent years. This trend, evident since 2004, suggests increases in domestic debt have been more frequent than spikes in external debt. Relying on domestic sources might appear to shield economies from external default risks on the surface, but a deeper examination reveals its double-edged nature. Although this can offer some protection against global economic upheavals, it introduces fresh challenges. Intensive domestic borrowing can squeeze local financial markets, leading to elevated interest rates and discouraging private-sector investments. This phenomenon, often called the government "crowding out" private entities, poses risks to long-term economic growth.

Sovereign default risks

When comparing the dynamics of domestic and external debt surges, they share similar patterns in intensity, pace and duration. However, a critical difference surfaces regarding default risks: Increments in domestic government debt are less prone to defaults than those in external debt. Research spanning 44 countries over 50 years indicates a strong correlation between a percent debt-to-GDP ratio above 60 percent and default risk. This study also underscores the potential threat to long-term economic growth when debt crosses this mark.

According to the joint Debt Sustainability Analysis by the IMF and World Bank, Afghanistan and the Maldives face a high debt stress risk, highlighting potential financial concerns. On the other hand, Bangladesh and Nepal present low risks of debt stress, suggesting stable financial situations. Bhutan is at a moderate risk level, with a significant portion of its public and publicly guaranteed debt associated with hydropower project loans from the Indian government. These projects operate under agreements in which India assumes financial and construction risks and commits to buying surplus electricity at favourable rates. With time, Bhutan’s debt situation is anticipated to improve due to rising electricity exports and decreasing imports related to hydropower construction. A similar trend can be expected for Nepal, as India has targeted importing 10,000 megawatts of electricity from Nepal. Bhutan and Nepal's external debt might be vulnerable to export and currency depreciation shocks, and unforeseen contingent liabilities may impact the overarching debt.

While the region's high government debt levels are alarming, they aren't the only factor amplifying the risk of sovereign defaults. The global interest rate hikes over the past few years have further magnified these concerns. Historically, many ruins coincided with the end of the US monetary policy tightening phases, especially in nations with government debt-to-GDP ratios above the median. World Bank's South Asia update indicates that many of these defaults did not successfully reduce government debt or borrowing costs. However, those that did often featured above-average debt restructuring spurred economic growth and involved fiscal tightening. In response, several South Asian nations have pivoted towards borrowing, predominantly from domestic creditors—a strategy that can increase borrowing costs and limit bank credit availability for the private sector while reducing external default threats.

Lesson to learn

Sri Lanka's crisis in May 2022 wasn't just a financial or economic event but a humanitarian one. Years of unchecked borrowing and fiscal mismanagement culminated in a situation where essential commodities became scarce, and millions faced hardships—Pakistan's story, though distinct, bears similarities. With dwindling foreign exchange reserves and ballooning debt repayments, the nation teeters on the edge of a fiscal precipice. The situation in these two countries should be a clarion call for other nations in South Asia, underscoring the urgency of fiscal discipline and prudent economic management.

Though distressing, the debt dynamics of Sri Lanka and Pakistan offer valuable lessons. At the heart of these crises is the fundamental principle of fiscal prudence, so governments must be prudent in their borrowing endeavours, ensuring that the debts incurred are sustainable in the long run. Ideally, every domestic or foreign loan should be directed towards projects and initiatives that bolster the economy, creating avenues for future revenue generation.

South Asia's central government debt scenario, marked by some alarming figures, warrants immediate attention. The importance of transparency cannot be overstated. For low-income countries like Nepal, it is vital to capitalise on the benefits of reduced interest rates and extended loan repayment durations. The South Asian countries should prioritise fostering a resilient economy by channelling investments into sectors that offer high productivity and efficiency, ensuring timely loan repayments. A transparent approach to debt acquisition and allocation ensures that borrowed funds are used optimally, minimising the risks of corruption and fiscal mismanagement.