Nepal’s participation in China’s Belt-and-Road Initiative (BRI) has been the topic du jour. China has signed cooperative document with 126 countries and 29 international organizations. And in March this year, Italy became the first G7 nation to join the BRI. Several projects in Africa, Asia and South America have been completed. However, an undertaking of this magnitude is not without controversy. In 2018, Malaysian Prime Minister Mahathir Mohamad cancelled several projects authorised by the previous government saying they would leave Malaysia ’indebted’ to China. In Sri Lanka, the Hambantota Port was mostly funded by China. In a debt restructuring following Sri Lanka’s inability to service the debt, 70 percent of the port was leased, and port operations handed over to China for 99 years. Hence, the coining of phrases such as debt-trap diplomacy and predatory debt trap.

Beware of potential debt trap

Pakistan, Myanmar and the Maldives are countries that too have cancelled, scaled back or sought to renegotiate BRI projects over fears that the resulting debt would be too costly. In Nepal, President Bidhya Devi Bhandari just attended the second BRI forum held last month in Beijing. There is a lot of buzz around a railway link connecting Nepal with China. President Bhandari told Parliament early this month that construction of trans-border railroads with both China and India will begin in two years.

Arranging funding for the same will not be easy. The main opposition, Nepali Congress,believes Nepal should develop cross-country railroad only through grants. The ruling Nepal Communist Party wants to go ahead even if it requires taking on loans. The issue is not that simple. Rejecting a project just because it involves debt is as ill-advised as it is to take on a project haphazardly. Before undertaking a project of this size, a thorough cost-benefit analysis is prudent. It is important to remember that debt in and of itself is not bad.

Be it an individual, a corporation or a nation, debt has a place in the balance sheet. Simplistically, as long as the return on investment exceeds the interest payment, debt helps. It is when the reverse happens; a vicious cycle is set in motion. In the early years of the current century, as a bubble was forming in the US housing, house flippers minted money as home prices were rising faster than the prevailing mortgage rate. Once that stopped, the bubble burst, and its adverse repercussions were felt globally. In the government’s case, deficit spending can have a multiplier effect. But at some point, the diminishing rate of return kicks in. It is a delicate balance, and each country likely has its own optimal point. One way to measure a country’s ability to pay back its debts is the debt-to-GDP ratio, which compares what it owes with what it produces. It is a widely used tool—routinely used by credit rating agencies. Generally, a low ratio makes it easy for a country to pay back what it owes without taking on more debt.

In the fiscal year 2017-2018, which ended last July, Nepal’s debt-to-GDP ratio stood at 30.4 percent. In other words, the Rs912.6 billion in total sovereign debt made up 30.4 percent of the nation’s output. In recent years, the ratio has risen, with a low of 25.4 percent in 2014-15. In 2001-02, this was as elevated as 63.9 percent, and 66.8 percent in 1990-91. On this basis, there is room for the ratio to head higher, meaning Nepal can add to its debt load. For global context, Brunei has the lowest ratio of low single digits and Japan the highest at well over 200 percent. The US is just north of 100 percent. Looking at countries like Japan and the US, one wonders how high the ratio can go before it starts hurting the economy. There is no definitive number. In general, if an economy is growing rapidly, a high ratio is tolerable, as the country conceivably will have earned enough to gradually pay off its debt. Other factors play a role as well.

Debt-to-GDP ratio useful tool

Despite the elevated debt-to-GDP ratio, Japan has a captive buyer of its debt. Most of its debt is in domestic hands—issued in its own currency. The country runs a current account surplus, and inflation is dormant, making fixed-income assets attractive. Globally, the Japanese yen is still viewed as a safe haven. In a similar fashion, the US dollar is the world’s reserve currency. Its sovereign debt is sought-after. At $1.1 trillion, China is the largest holder of US debt, with Japan closely behind. For China, the US is a major export market, running a trade (goods) surplus of $419 billion in 2018. Most of these dollars is recycled back into purchasing US treasury securities, which helps push US interest rates lower. Not all indebted countries enjoy the same dynamics. Excessive debt was behind the Asian financial crisis of 1997-1998, which took root in Thailand. As the Thai economy boomed, massive capital inflows followed, dollar debt surged. Later, as ‘hot money’ began to leave, the government was unable to fend off speculators’ attack on the currency. The baht was floated, leading to a collapse. Debt was again the reason for the Russian financial crisis in 1998.

No country would want to go through what the likes of Thailand and Russia did. Once indebted, debt can be reduced by (1) growing faster, (2) taxing citizens, (3) cutting government spending, (4) defaulting on debt, (5) running high inflation (so the value of debt is eroded), among others. The problem for a country like Nepal is the size of its economy—Rs3.5 trillion ($31 billion). Railway projects are costly. Unless the KP Oli government secures grants from both India and China, an addition of, let us say, $5 billion in new debt will push up the debt-to-GDP ratio toward 50 percent, which is high, but not prohibitively so. On the other hand, as of the second fiscal quarter ended mid-January this year, the domestic/external mix of Nepal’s debt was 41/59 percent. External debt-funded railway projects will heavily skew this mix away from domestic. As we saw in East and Southeast Asia two decades ago, external creditors can be a fickle bunch. Nepal needs to build infrastructure, no doubt. But relying solely on external debt for financing has its risks, so rewards better be better. This is particularly so at a time when Nepal wants its sovereign debt rated.

Pandey worked in the securities industry in the US for two decades. He tweets at @hedgopia.