Thirdly, the net foreign assets (NFA) of the banking system have undergone massive contraction over the past 3 years owing to the snowballing external account deficit. The NFA of the banking system shrank from a little over PKR 1.0 trillion or 8% of M2 in Jun-2016, to -PKR 822 billion or -5% of M2 in Mar-2019. As NFA contraction reduces domestic liquidity, it has put further pressure of government debt financing on the domestic market.

Fourthly, the levy of tax on banking transaction of non-filers since July-2015 and the recent crackdown against fake accounts have resulted in a massive surge in currency in circulation (CiC). The CiC/M2 ratio which was relatively steady at around 22% till Jun-2015, has jumped to over 28% by Mar-2019. This translates into over PKR 1.0 trillion in potential banking deposits/liquidity that would have otherwise helped reduce government’s borrowing from SBP.

Last but not least, the sharp rise in interest rates since mid-2018 (625bp increase in policy rate within 12 months to 12.25% in May-2019), coupled with the uncertainty about the levels where they would peak explains the banks’ behaviour of limiting their participation in the government securities to the shorter-end of the yield curve and even hoarding liquidity closer to bi-monthly monetary policy announcements. This behaviour has been reinforced by the SBP itself which has extended a virtual put option to the banks by religiously mopping up all liquidity at a Repo rate close to the policy rate.

As with all IMF programs, reducing the current stock of government’s borrowing from the SBP seems to be a key prior action/quantitative target under the recently negotiated USD 6 billion Extended Fund Facility (EFF). The IMF’s prescription for eliminating the government’s borrowing from the SBP is to hike interest rates to such levels where the ‘markets’ meet the government’s borrowing needs. The SBP has been quick to sign up to this philosophy. The Monetary Policy Committee (MPC) noted in the MPS of May-2019, the increased government borrowing from the SBP “reflects a shift away from commercial banks which were reluctant to lend to the government at prevailing rates”. This was a surprising statement considering that the increased government borrowing from the SBP was result of a combination of factors that were discussed earlier in this note.

With a high government debt/GDP, elevated fiscal deficit and anaemic GDP growth, pushing the interest rates higher, especially the long-term bond yields closer to historical peaks works against to the objectives of fiscal consolidation and reviving growth, both of which are needed to reduce the government indebtedness. The debt servicing/GDP is set to cross 5% in FY2019, the highest in 17 years, and would climb further in FY2020. Moreover, higher borrowing costs would deter private investment thereby keeping the country trapped in a low-growth cycle for much longer.

The idea of letting the markets determine the interest rates on government securities is flawed at multiple levels. Firstly, the domestic fixed income sector is a far cry from an efficient market. To begin with, it is dominated by a handful of large banks. Also, there are serious awareness and access issues with general public’s investment in T-bills/PIBs. Moreover, the NSS itself is the biggest distortion in market based pricing. Secondly, with one-way (inward) capital account convertibility, the local banking system surplus liquidity remains invested in government securities in some shape of form. For example, even in an OMO mop-up, banks enter into REPO transactions with the SBP against T-bills. Thirdly, it is cheaper for the government to borrow in USD from the international markets than to attract money into rupee fixed income securities. The global liquidity pool for USD securities is much bigger than that available for investment in local currency securities of a developing country. Moreover, taxation and repatriation issues further increase the costs for foreign investors.

There are four main ways in which the government’s borrowing from SBP could be reduced:

1. The banks shift any surplus liquidity that they have parked with the SBP (OMO mop-up) into the government securities.
2. The SBP provides additional liquidity to banks via OMO injections and the banks in turn invest it into the government securities.
3. A part of the currency in circulation (CiC) flows back into bank deposits providing additional liquidity to the banks for investment into the government securities.
4. The NFA expansion resulting from either government’s direct external borrowing or due to other net FX inflows can help lower the government’s borrowing from the SBP. The government’s direct external borrowing reduces its recourse to the SBP while other FX inflows generate additional liquidity which is in turn invested in the government securities.

Of the four ways of reducing the government’s SBP borrowing listed above, the first two (A & B) do not require jacking up interest rates. In a stable or declining interest rate environment, the banks not only invest their entire surplus liquidity in government securities but even borrow from SBP (OMO injection) to invest more. This happened during the last IMF program period of 2013-2016 and the same had also occurred in 2001-2004. However, the amount of government’s SBP borrowing that can be reduced by shifting the surplus banking liquidity parked in OMO mop-ups and additional liquidity injections into government securities is limited due to SBP’s NDA targets and banks’ internal borrowing limits.

The growth in the currency-in-circulation is a structural issue and cannot be reduced without increased documentation of the economy. The newly unveiled amnesty scheme for assets declaration may help in bringing some of the currency-in-circulation into the banking system.

NFA expansion is the best approach to reducing government’s borrowing from the SBP. This could be achieved by a combination of long-term external borrowings by the government, incentivising private sector to raise external financing by offering forward cover, and encouraging FDI/FPI inflows.

FY2002-07 was the only period during which Pakistan achieved significant reduction in government indebtedness from over 81% in Jun-2001 to 52% in Jun-2007. This was the period of high GDP growth running at 6%, low fiscal deficit of around 3.6% and low interest rates with 6M T-bill averaging 6.8%. The authorities must realise that without ‘expansionary fiscal consolidation’, public indebtedness cannot be reduced. This requires changing the engine of growth from the public sector to the private sector and keeping interest rates higher for longer works against this objective.

*The opinions in this article are the author’s and do not necessarily represent the views of Mettis Link News (MLN)*