Lessons From Sri Lanka: Over-Borrowing, A Trap You Must Avoid In Personal Finance

With Sri Lanka, the issue of debt and over-borrowing is once again in focus. It’s a crisis from which the world can take lesson on reasons why one should avoid over-borrowing
Lessons From Sri Lanka: Over-Borrowing, A Trap You Must Avoid In Personal Finance

We certainly live in uncertain and unpredictable times. Apart from the pandemic, the Ukraine war, and floods, now there’s a debt crisis hanging like a sword on a major country in the neighbourhood that could lead it to its collapse and cause rippling effects elsewhere, too. 

Sri Lanka is now reeling under the burden of ballooning foreign debt. The country has been resorting to foreign loans to aggressively fund its infrastructure development projects under former President Mahindra Rajapaksa. 

The blunder though was that it took out major investment loans from state-owned Chinese banks to fund its infrastructure projects, including a controversial port development in Hambantota district. 

According to a recent New York Times report, over the last decade, Sri Lanka amassed a $5 billion debt from China alone. India, too, recently gave Sri Lanka an aid of $1.5 billion through a currency swap and loan deferment. The country continued to mount foreign debt without sufficient revenue. Sri Lanka currently has about $7 billion in total debt due this year. 

The country’s economic future is clearly in shambles after defaulting on payments on its mounting foreign loans – estimated to be worth $50 billion – for the first time since the country gained Independence from Britain in 1948. 

Record Debt

The Sri Lanka case is not a one-off incident. A lot of countries across the world face such dire situations. They have clearly not strategised or planned their economic situation better. 

According to the International Monetary Fund (IMF), during the pandemic, deficits increased and debts accumulated much faster than they did in the early years of the recession, including the largest: the Great Depression and the Global Financial Crisis. The scale is only comparable to the two World Wars. 

According to the IMF’s Global Debt Database, borrowings also jumped by 28 percentage points to 256 per cent of gross domestic product in 2020. Government accounted for about half of this increase, with the remainder from non-financial corporations and households. Public debt now represents close to 40 per cent of the global total, the most in almost six decades.

Emerging market and developing economies (excluding China) accounted for a relatively small share of the increase. According to the IMF, about 60 per cent of low-income countries are now in, or at risk of distress. 

Over-Borrowing Or Debt Is A Major Concern For Everyone

Over-borrowing or debt is now a major concern for every developing nation. And this worry trickles down to businesses, organisations, and individuals.

“Excess debt not only destroys individuals, but can even destroy the complete economy; and Sri Lanka is a classic example. As of February, the country was left with only $2.31 billion in reserves, but faces debt repayments of around $4 billion in 2022, including a $1 billion international sovereign bond (ISB) maturing in July. ISBs make up the largest share of Sri Lanka’s foreign debt at $12.55 billion, with the Asian Development Bank, Japan and China, among the other major lenders. Now, the current account deficit is in a mess, and the entire economy is collapsing,” says Anant Ladha, founder, Invest Aaj For Kal, a financial planning firm. 

Debt In Family Finances

Debt has become a huge component in family finances, too. Spending more money than you make is basically spending money you don’t have, or money you are yet to earn. 

Borrowing irresponsibly, and thereafter, trying to come out of a debt trap is never easy. It’s never too late to realise that paying off debt is also one of your financial goals. One lands in a debt trap when the income falls short in paying for the equated monthly instalments (EMIs), and the interest keeps piling up on the outstanding amount. 

The person ends up taking fresh loans to clear off the existing loans. In effect, he might not be paying off anything. It’s just shuffling the debt around and incurring more debt. Before he can realise the depth of the damage, the debt situation spirals out of control. 

Once someone gets into a debt trap, it becomes only tougher with time. The credit score takes a hit, and savings and goals go for a toss, while debts continue to grow monstrous in size.

Loans and credit scores share a positive correlation: the higher the credit score, the higher will be your chances of availing yourself of a loan, and negotiate the interest rate on that loan. 

“A good credit score also enhances your loan amount eligibility. And there is negative correlation between credit score and over-debt. If you utilise too much of debt, then it shows that you are debt thirsty, and there is a higher chances of your delay or default,” says Ladha. 

There are also other risks due to rising inflation. Experts feel that rising inflation and rising interest rates could be eating away the returns on your investments. And this could also increase your debt burden. 

Also, when you over-borrow and delay loan payment, your interest accrues, and you end up paying a lot extra, leaving a dent in your finances. This way, you could delay your plans to buy a house or start a family. You may be unable to save for your future, too. Moreover, you might need a second job just to be able to survive and pay off your loans. 

“Let’s say, one takes a home loan to purchase a real estate property. The assumption is that the borrower will let out the real estate property on rent and earn rental income. With this rental income, he/she plans to pay the EMIs. At the end of the loan tenure, the residential property becomes an asset. What if, in the economy, supply of real estate properties is more than the actual demand (the number of tenants are less than the available real estate property)? During the covid-19 pandemic, outstation employees returned to their respective hometowns. Real estate properties let out on rent remained empty for months. But the borrower had to pay EMIs on time. If the liquid assets coverage ratio was ignored at the first place, while opting for any loan(s), loan repayment capacity becomes an uphill task. Therefore, ratio analysis is a critical aspect, which we, as financial advisors, need to consider while working with clients reeling from a debt trap,” says Arijit Sen, a Sebi-registered investment advisor and co-founder of Merry Mind, a Kolkata-based financial advisory firm. 

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