By Madhusha Thavapalakumar Needless to say, Sri Lanka has long been a borrower under consecutive governments. Testament to this is its debt-to-Gross Domestic Product (GDP) ratio of over 86% as of mid-this year. Meanwhile, in the past 15 years alone, the country has borrowed over $ 34 billion from various international financial organisations and countries, and its loan portfolio still keeps growing. The external loans extended to Sri Lanka are mostly concessional, which could either be bilateral or multilateral. These loans are seen as more generous than market loans, and its concessionality is achieved either through interest rates below what’s available in the market, longer grace periods, or a combination of both. However, the concessionality of these loans have long been questioned on several occasions by  local politicians and economists alike, having expressed their concerns over most of these loans in fact being less favourable to Sri Lanka. Providing an in-depth look into the concessionality of loans that Sri Lanka has obtained, Verité Research, an independent think tank, recently hosted a webinar titled: “Bilateral and multilateral ‘concessional’ loans – are they really as cost-effective and ‘concessional’ as they are made to seem?”, which shed some light on the subject. This week, The Sunday Morning Business looks to focus on the important takeaways at the webinar, which concluded that the concessionality of loans is overestimated, while in some cases, these loans are less favourable to Sri Lanka.  Infrastructure financing: A decade-and-a-half of loans According to Verité Research Director Subhashini Abeysinghe, between 2005 and 2019, the Sri Lankan Government borrowed $ 34 billion in loans – 81% of which was taken for infrastructure development in the country. Following the end of the civil war in 2009, infrastructure financing saw a boom, with external financing recording 100% growth, particularly during 2010-2014 compared to the preceding five-year period. Nevertheless, following the year 2014, the boom in infrastructure financing gradually slowed down, declining by 26%. The main recipient of these loans, according to Abeysinghe, is the domestic transport sector, as 44% of the funds were channelled into it; these loans were mainly taken to construct highways, bridges, and railways.  China was the leading lender for infrastructure during the 15-year period from 2005-2019, with loans obtained from them accounting for about 33% of the total loan portfolio for the period. It should also be noted that about 81% of these loans came from five lenders – China, followed by Asian Development Bank (ADB), Japan, the World Bank (WB), and India.  Abeysinghe stated that the terms and conditions of these loans garnered a lot of interest, while loans from China frequently received a great deal of attention from both local and international media. Concessionality of ‘concessional’ loans  Average interest rates and maturity periods To analyse the concessionality of these loans, Verité evaluated the interest rates of all Sri Lanka’s foreign loans and adjusted the loans that weren’t in dollar terms to come up with dollar-denominated equivalent interest rates for ease of comparison. Accordingly, the average interest rate for International Sovereign Bonds (ISBs) was 6.6% on the dollar-denominated value, while Japan was the cheapest, with an average interest rate of 0.7%. In terms of lending countries, China’s interest rate was the highest with an average rate of 3.3% – nevertheless, still half that of ISBs. In terms of maturity periods, Verité Executive Director Nishan de Mel pointed out that ISBs have again proven to be not as favourable, explaining that ISBs have an average maturity period of eight years, whereas bilateral and multilateral loans have longer maturity periods – Chinese loans have an average maturity period of 18 years, WB loans and loans from India have maturity periods of 24 years, ADB loans have 25 years, and loans from Japan have 34 years, the highest maturity period of a lender country.   How do we measure concessionality? In order to measure the standard concessionality of “concessional” loans, Verité selected 50 high-value foreign loans taken mostly for infrastructure during the period from 2005-2018. Forty-six of these loans were taken by the Central Government at a value of $ 11.97 billion, while four, amounting to $ 1.09 billion, were taken by state-owned enterprises (SOEs). The total value of these loans was $ 13 billion and 53% was for infrastructure financing. Out of these loans, 15 were multilateral and 35 were bilateral loans.  According to de Mel, the standard way to measure concessionality is to look at the present value of the stream of payments Sri Lanka would make to repay the loan, against the nominal value of the loan. For this purpose, the grant element and tied element of each loan were measured.  The grant element is defined as the difference between the loan's nominal value (face value) and the sum of the discounted future debt service payments to be made by the borrower (present value), expressed as a percentage of the loan's face value. A tied loan is a loan a lender government makes to a foreign borrower in exchange for the promise that the borrower will use the loan to purchase goods from the lender's country. “In a present value calculation, it is a discount rate that really matters and that is what is effective. So we are using a discount rate that is effectively the discount rate in the financial markets,” de Mel stated.  The discount rate is the interest rate used to determine the present value of future cash flows in a discounted cash flow (DCF) analysis. This helps determine if the future cash flows from a project or investment will be worth more than the capital outlay needed to fund the project or investment at present. The International Monetary Fund (IMF) uses a 5% discount rate while the Organisation for Economic Co-operation and Development (OECD) uses differentiated discount rates based on various factors. Nevertheless, Verité for this purpose chose a 6.5% discount rate, which is an average rate of ISBs over a certain period. “When you get the present value and it is less than the nominal value, then you calculate the grant element. The standard IMF methodology for saying a loan is concessional is to say you have a grant element. This is also the OECD methodology.  “Is the grant element at least 35%? If the grant element does not add up to 35%, which is the difference between the nominal value and the present value calculated on an agreed discount rate, then the loan does not qualify into the category of a concessional loan, even though it does still have a positive grant element,” de Mel explained.  Nevertheless, Verite’s methodology allows it to arrive at a higher grant element than that of the IMF’s methodology, as the higher the discount rate used, the larger the grant element would turn out to be. Verite’s methodology favours the evaluation towards the lending country. Verité believes that more loans should be evaluated by assigning a larger grant element through the use of a higher discount rate, as according to Verité, this is a fair practice as they believe Sri Lanka must evaluate itself against realistic options after considering the loans it has taken, even though the IMF uses a standard rate that is globally applicable.  Amongst the above-mentioned 50 loans, 33 loans had a grant element of above 35% using a 6.5% discount rate, and these 33 loans accounted for 72% of the value of the 50 loans that Verité analysed.  The overall weighted average of the grant element of the multilateral and bilateral loans taken by Sri Lanka is 41% and this can vary by country. Nevertheless, every country has a grant element of above 30% – China, 31%; ADB, 33%; France, 35%; WB, 36%; India, 37%; and Japan, 68%. Can grant elements be eroded by the terms and conditions? Most of the multilateral and bilateral loans come with a tied element. A tied element refers to the portion of the loan that is in effect in law or in fact tied to the procurement of the goods and services from contractors connected to the lender. De Mel stated that the tied element is a problem because the moment a country’s loan has a tied element, it has to abandon its competitive bidding process with regard to procurement. “Generally, a tied element means the country cannot make that procurement from the lowest value bids; it is in some way constrained, so tied elements prevent competitive bidding, increasing the risk of cost escalation,” he added. If the grant element is completely eroded, then it would not be concessional at all – in fact, the concessionality can even go into negative territory. Verité stated that some of the loans Sri Lanka obtained are clearly at high risk of being adverse to Sri Lanka rather than concessional; such that Sri Lanka may have been better off borrowing from international financial markets rather than obtaining the “concessional” loan. Benefits of favourable financial terms being eroded Restricted unsolicited proposals and selected contractors According to Abeysinghe, the problem of tied loans or tied elements occurs mostly when taking bilateral loans. “All the projects funded by multilateral loans went through an international competitive bidding process. When there is a tied element, you can have two forms of bidding; one is national competitive bidding that is restricted only to the country of the lender. In certain cases, it can be the entire value of the loan or a portion of the loan,” Abeysinghe stated.  However, certain loans funded by tied loans had originated as unsolicited proposals. These are proposals which were initiated by the firm and not by the Government requesting a proposal. For this purpose, Verité broke down 28 loans Sri Lanka obtained via procurement methods. Out of these 28 loans, 18 loans were from China, three from India, six from Japan, and one from CIB France. Out of these 28 loans, 13 loans came through unsolicited proposals – 12 from China and one from India, while the rest of the 28 loans went through restricted proposals – one from China, two from India, and six from Japan.    Loan agreements the Government has entered into via unsolicited proposals specify the contractor’s name, which means the contractor has been pre-selected. In these situations, it is hard for Sri Lanka to figure out whether the contractor was selected through a solicited or unsolicited process. “In Japan, all the six loans went through a restricted bidding process. What is important to notice when you say restricted bidding is, in certain cases, only a portion of the loan is tied – some bilateral lenders tie only a small portion to procurement from their own country,” Abeysinghe added.  On average, out of the loans from Japan that Verité analysed, 39% of the loan value had to be procured from Japan, whereas in the case of China, it went up to 99%. Out of the aforementioned loans, 14 loans had a tied element of 100%, six loans had a tied element between 60-100%, and two loans had a minimum of 30%, which was from Japan. Analysing the non-concessionality of foreign loans The non-concessional threshold is a percentage of cost escalation that would cancel out and bring the grant element of the loan to zero such that it would make no difference to Sri Lanka if it went to international financial markets or a lender country to obtain the loan – at least in terms of the cost of servicing the loan. In this instance, even though longer loan periods may be advantageous, the cost of the loan is identical to loans obtained from international financial markets.  In many of the loans, if the cost escalation on the tied element increases to about 30-40%, the grant element would be completely negated.  Abeysinghe added that for some of the loans, a cost escalation of 4%, 9%, or 13% would completely negate the grant element – and such loans are the most vulnerable loans.  “Even the ones at 30-40% may have to be seen as vulnerable, given the little that we know and the fact that we have not published any strong material on the cost escalation of infrastructure in Sri Lanka.  “We see cost escalation on road infrastructure as being above 100% over a certain period of time, which means a cost escalation vulnerability of 30-40% still should be seen as something that is vulnerable for the loan, i.e. as having completely negated the grant element, making it adverse,” she noted.  The non-concessionality threshold is determined by how large the grant element is and how small the tied element is; the larger the grant element, and the smaller the tied element, the higher the non-concessionality threshold. Problems and solutions for Sri Lanka Compared to other alternatives of raising funds, such as ISBs, concessional loans – especially those extended by bilateral lenders – seem a lot more attractive for Sri Lanka. Adding to that, Sri Lanka, with limited financing options but a great deal of infrastructure projects, requires funding. Nevertheless, one of the main problems Sri Lanka encounters is the high risk of cost escalation, and also that some of the projects funded by tied loans have come through unsolicited proposals. According to Verité, numerous studies indicate that, in general, unsolicited proposals are associated with allegations of corruption, lack of transparency, and higher costs. In the case of Sri Lanka, research indicates that Sri Lanka's legal framework governing unsolicited proposals is not very solid, and there is much room to improve. Therefore, Verité emphasises that Sri Lanka needs to strengthen regulations around unsolicited procurement. Furthermore, Verité suggests the Government goes for competitive bidding processes in a manner that would avoid risks and costs to the Government that are not visible, by publicising the terms of the loan or project. In addition to this, openness to analyses and due diligence should also be given importance as some of the terms in loan arrangements that have been entered into in the past five years have been very adverse – and the adversity was very costly.