Penned by Asif Ali Qureshi, CFA
June 17, 2019 (MLN): The irony of having a perennially weak economy is that there is a precedence for almost every predicament. Just when a data point starts to look ominous, simply trace back its historical series long enough and you will find a time period when the situation was similar or even worse. Unfortunately, this is true for Pakistan’s current level of indebtedness although there is more to it than meets the eye.
As per the latest available data, Pakistan’s gross government debt  had reached PKR 27. 8 trillion as of end Mar-2019, equivalent to more than 74% of GDP. Depending on which GDP series  you choose as the denominator, the present level of government’s indebtedness (debt/GDP) is the highest since Jun-2002 (reported GDP base) or since Jun-2001 (current GDP base).
As evident from the Debt/GDP trajectory based on the reported GDP values for the respective years, Pakistan’s indebtedness was even higher in the 1990s than it is today. However, this should not offer any consolation, as the country later defaulted on its external debt and had to undergo multiple rounds of debt restructuring.
The current discourse on Pakistan’s debt challenge is focussed more on the form than substance. For example, the two most debated issues seem to be the government’s borrowing from the central bank (SBP) and the maturity profile of domestic debt, while the real issues are the ‘size’ of the government debt and its ‘sustainability’. The IMF’s prescribed remedy to the professed twin ills i.e. the borrowing from the SBP and the maturity profile of debt, sadly gaining traction with the local authorities, is to push the interest rates higher and higher. Before discussing why accentuating the interest rate tightening cycle would cause more harm than benefit, it is important to review the factors that led to the current situation.
Firstly, the combination muted GDP growth and elevated budget deficit over the past 10 years has pushed up the government debt/GDP ratio to 74% in Mar-2019 from 57% in Jun-2008. GDP growth has averaged only 3.7% while the fiscal deficit has been in excess of 6% during the FY2009-19 period. The reported fiscal deficit and the public debt figures exclude the off-balance sheet expenditures/debt related to the power sector and commodity financing. The aggregate amount of commodity financing and PSE domestic debt was over PKR 2.0 trillion in Mar-2019, about 5.5% of GDP, while the external PSE debt amounted to another USD 3.5 billion or 1.3% of GDP.
Secondly, the declining share of external borrowing in the total government debt from an average of 50% till Jun-2008 to around 35% in Mar-2019, has increased the burden of budgetary financing on the domestic markets. The size of the public sector debt dwarfs the domestic banking deposits. To put it in perspective, the total domestic public sector debt (public debt + commodity financing + PSE debt) amounted to PKR 20.2 trillion in Mar-2019, which was equivalent to 1.5 times the size of domestic banking deposits and 1.2 times the size of domestic banking deposits plus the National Savings Schemes (NSS). In Jun-2008, the domestic public sector borrowing was only 0.7 times the size of banking deposits plus NSS. With such massive build-up of domestic public sector borrowing, it is unsurprising that the government’s borrowing from the SBP has been increasing.
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:
- The banks shift any surplus liquidity that they have parked with the SBP (OMO mop-up) into the government securities.
- The SBP provides additional liquidity to banks via OMO injections and the banks in turn invest it into the government securities.
- 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.
- 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)*
 This comprises domestic public debt of PKR 18.2 trillion and external government debt of USD 68.4 billion
 The current base GDP data is from IMF. It translates historical GDP data from different base years to the current GDP base year i.e. 2006. The reported GDP base uses GDP values from the base year being used in the respective year.