The domestic debt witnessed positive developments during last three years (2000-03), including one-off retirement of market-related treasury bonds (MRTBs) worth Rs193 billion, thereby reducing the stream of future interest payments and resort to long-term borrowing instrument like Pakistan Investment Bond (PIB) which helped improving its maturity profile.

The spill-over impact of external developments and lowering of interest rates to all time low has helped a sharp reduction in the cost of domestic debt.

The domestic debt grew at an average of 6.9 per cent during last three years as against 22 per cent growth in 1980s and 15.4 per cent growth in the 1990s. However, as percent of GDP and revenue, domestic debt declined substantially from 50 and 307.5 per cent respectively, in 2000 to 46 and 25.6 per cent respectively.

The real cost of borrowing has declined substantially from 5.5 per cent per annum during the second half of 1990s to 1.6 per cent per annum during 2000-03. This shows a marked improvement in the domestic debt indicators including a perceptible decline in debt servicing costs and an important shift in the term structure of the domestic debt.

A component-wise analysis further reveals some interesting facts on the structure and sustainability of Pakistan’s domestic debt which is comprised of three components namely, floating debt, permanent debt and unfunded debt.

The floating debt recorded a steep fall during 2002 as a result of government’s decision to retire the SBP stock of MRTBs and ad-hoc treasury bills because the fund was created following economic sanctions after Pakistan’s nuclear test to avoid default on payments of foreign exchange liabilities.

This short-term liability was replaced by fresh long-term borrowings through Pakistan Investment Bond (PIBs) which implies that the government is locking-in the benefit of historically low interest rates. The significance of PIBs is that it carries market driven interest rates. The market response to PIBs was overwhelming and the government amassed Rs100 billion in one go from this instrument. As a result of this the share of permanent debt in GDP went up from 8 per cent in 2000 to 10 per cent in 2003.

There is an objection on this structural transformation that the government has retired low interest bearing short-term liability of MRTB and opted for higher interest bearing PIBs. A simple answer to this question is that PIBs are not redeemable before maturity which implies that reduced burden of servicing permanent debt in immediate future.

This will provide fiscal space for the time-being to spare more funds to divert them to social sector on the one hand and PIBs set a market-based long-term benchmark yield on the other hand.

The third component of domestic debt is the most important and sensitive unfunded debt.It largely comprised instruments offered by Central Directorate of National Savings (CDNS).

The acceleration in domestic debt in the second half of the 1990s was spearheaded by unfunded debt (National Savings Scheme) which grew at an average rate of 26.5 per cent during the second half of the 1990s - almost double the rate of growth of domestic debt. As a result of this, its share in total domestic debt has increased from 36.6 in 1997-98 to 45.1 per cent in 2001-02. By June 2003, its share has further risen to 49 per cent of the domestic public debt. It means the attractiveness of the returns on the NSS is mainly responsible for tremendous increase in the quantum of domestic debt in the 1990s.

The attractive real rate of return on various instruments of the NSS had hampered the flow of funds to investment in other sectors of the economy. Another manifestation of the NSS was that interest on domestic debt had accounted for at least 75 per cent of the total nominal amount of interest paid on public debt in recent years.

The borrowing through the NSS for budgetary support at extravagant rates was also responsible for a sense of complacency on the part of institutional investment. Many state-owned investment houses prospered on the risk-free high rates of return on NSS.

Many industrialists were culprit of borrowing cheap industrial loans and reinvest them into NSS to earn handsome profits. To avoid further disastrous impact of NSS, few structural changes in NSS have been made to lower cost of borrowing domestically. Realizing distortionary implications of higher rates of return offered on NSS for monetary policy, the government has started restructuring the NSS instrument during last four years.

The yield structure has been drastically changed and the profit income has been brought under the tax net. Now the yield has been linked to returns on PIBs and institutional buying of NSS is banned.

Notwithstanding this restructuring, NSS still accounted for three-fourth stock of medium and long-term domestic debt at end-June 2003. There is a dire need to cap further inflows in NSS and to replace them with a new market-based instrument of NSS on the pattern of PIBs as the principal source of non-bank financing of fiscal deficit in the years to come.

The NSS instrument carried the highest effective rate of return among all instruments of domestic debt at over 12 per cent by the end of FY 2002-03. PIBs could be used as a more effective monetary instrument to finance budgetary imbalances provided a major restructuring of the NSS instrument is taken place and secondary markets being developed for OCT (Over the counter) sale and purchase of PIBs. This will not only help the government of finding easy money to finance fiscal deficit but also strengthen the monetary market.

These changes are likely to cost in the form of political unpopularity in the short-run because adverse reaction from the people who were accustomed to risk-free high real rate of return on their investment is quite natural. It was first conscious effort on the part of the government for lowering the cost of borrowing.

Otherwise the debt problem was ballooning for two decades, no serious effort was made to slow down the pace of rapid accumulation of both domestic and external debt. By late 1990s, Pakistan had already entered in a debt trap situation. The causes of rapid growth in domestic and external debt are multifaceted.

They included: (i) persistence of large fiscal (7 per cent of GDP) and current account (almost 5 per cent of GDP) deficits; (ii) imprudent use of borrowed resources such as wasteful government spending, undertaking of low priority development projects, and poor implementation of foreign aided projects; rising real cost of government borrowing (both domestic and foreign); stagnant exports; and declining real government revenues.

Pakistan economy could not sustain the increasing trend in domestic or external debt for too long due to inherent structural problems. Pakistan economy is jaundiced with inflexible expenditure, stagnant revenues and unavoidable contingent liabilities (CLs). Contingent liabilities may stem from at least four sources: bail-outs of nationalized commercial banks and DFIs; losses of state-owned enterprises, of which KESC and WAPDA are the most significant; guarantees; and unfunded (or under-funded) pension liabilities. The government must make concerted efforts to lower losses of public sector enterprises through improved governance standards which are not at their best in these organizations.

The non-performing loans (NPLs) of the banking system are yet another area of concern for financial health of the economy. NPLs in June 2003 amounted to Rs348 billion, against provisions of Rs133 billion; the un-provided component is about 6 per cent of GDP.

The losses of state enterprises (among which KESC and WAPDA account for the bulk) amounted to Rs67 billion in federal budget 2003-04 which is close to 1.5 per cent of GDP. In recent years the fiscal cost associated with various loan guarantees issued by the government has varied from 0.5 to 1.5 per cent of GDP.

Putting all these together could easily add up to 1.0 to 3.5 percent of GDP per year. Privatization receipts could provide an offset, but privatization may not be easy in the present circumstances. The gimmick of prudent fiscal management is therefore a big task and policy makers face real challenge of matching future expenditure needs with inflow of resources. Policy makers should be very choosy and selective in specifying borrowing requirements. Whole nation is paying a price of irresponsible fiscal behaviour of policy makers in the 1980s and 1990s.

The downward rigidity in budgetary expenditures and lack of buoyancy in revenues has generated persistently large fiscal deficits over the two consecutive decades of 1980s and 1990s. This has resulted in the accumulation of public debt at a faster rate.

The debt-to-GDP ratio has risen almost uninterruptedly for the past two decades. Resultantly, the growing burden of the debt servicing over the years has made fiscal adjustment difficult to achieve. There are no quick remedies to the debt problem. Pakistan will have to live with the macroeconomic consequences of a heavy debt burden for several years.

As evident from the accompanying table, there is significant improvement in the domestic debt dynamics in recent times. Pakistan economy is able to eliminate primary fiscal deficit which was the major cause of accumulation of debt but Pakistan has to sustain primary surplus of 3-4 percent of GDP during next five years.

Primary surplus has enabled to arrest real growth of debt and marginal retirement trend is supported by healthy real growth of 7.2 percent during last three years. Another feature is the reduction of real cost of borrowing domestic debt. Table-1:

The debt buildup has already had several adverse implications:

(a) real interest rates, had risen;

(b) vulnerability to exogenous and endogenous shocks had increased; and

(c) development spending had been squeezed in an attempt to contain the overall deficit, falling from close to 10 percent of GDP in 1980-81 to around 3 percent by 2002-03.

The squeeze on development expenditure has adverse consequences for growth via three channels. First, reductions in social spending stunted the development of human capital, which is at a premium in a globalized world economy (in addition to the direct impact on the quality of life). Second, cuts in public investment, especially in infrastructure such as roads, power, water supply and irrigation, created bottlenecks and raised the cost of doing business. Third, the crowding-in role of public investment deteriorated which discouraged private investment.

This is the right time to rethink our overall borrowing strategy because we have so many multi-dimensional options available to us. A sharp decline in our debt servicing liability during last two years or so has provided a fiscal space. We can build a comprehensive debt management strategy on lowest interest rate environment prevailing inside and outside the country.