June 05, 2006	Monday	Jumadi-ul-Awwal 8, 1427

PUBLIC sector borrowing is a continuing affair for developing countries. In developed economies too (e.g. US), it can become a continuing affair, if the state misuse tax revenue at a massive scale.

For the developing countries, public sector borrowing has special significance for a very valid reason; it finances vital investment in physical and social infrastructure to facilitate the discovery and movement of resources that encourage investment in commerce, business and industry, and to undertake projects aimed at the well being and improvement in the standard of living of the people.

Being a developing country (mismanaged for the better part of past 58 years), Pakistan carries sizeable public sector debt, a large part thereof with fixed maturities. According to available estimates of the total domestic debt (close to Rs2.3 trillion), the portion with fixed maturities (PIBs Rs297 billion, market holding of T-Bills Rs614 billion and SBP’s own inventory of T-Bills Rs450 billion) adds up to over Rs1.361 trillion.

For a country needing ever larger doses of credit, managing this part of the debt has special significance because inability to re-borrow what it repays can force a government to take resource mobilization steps that could stunt economic growth.

For continued supply of credit developing country governments must offer fair returns to the lenders, meet repayment obligations on time, and by doing so, ensure the development of a healthy saving culture.

A government that does not fulfil any or all of these obligations may lose the confidence of investors in spite of the fact that lending to the government may, at least technically, be treated as a zero-risk investment. What is implied here is ‘image building’ on solid foundations for which one must have both vision and a clear sense of equity; adopting a short-term attitude can be lethal for the state’s reputation.

For the past several years, commentators had been pointing to this clever-by-half tendency creeping into the debt management system, warning the government to check its grossly under-stated inflation estimates to which it was ultimately pegging the returns offered to investors, especially on the long-dated securities. Investors duped into buying these long-dated securities are now finding it hard to hide the losses they are now suffering.

In this context, it is interesting that, despite substantial decreases in the returns on government securities, SBP’s discount never dropped below 7.5 per cent per annum. (In fact, later on, it was jacked up to nine per cent per annum) Yet, neither influential bankers nor financial analysts disputed official inflation estimates and protested over using these estimates as the basic logic for lowering returns on government securities.

During FY 05-06, so far, the government has accumulated a fiscal deficit of Rs201 billion. Yet, it has ambitious (and justified) plans to jack up the PSDP target to Rs415 billion from Rs272 billion in FY 05-06.

A huge question mark therefore hangs over the sources to be tapped for plugging this gap. Indications are that the government will face a tough time in borrowing from the private sector because investors are furious over the way they were rewarded for channelling resources to the public sector.

According to SBP figures, the banking sector’s T-Bills holdings alone (excluding PIBs) exceed their statutory reserve requirements by Rs218 billion. That is a measure of the enormous resources channelled to the government and of how much banks believed in the official estimates of inflation as well as the fairness of the returns offered to them. Their misplaced belief in past inflation estimates now infuriates investors.

Consequently, response to the recent T-Bill and PIB auctions was noticeably lukewarm. Given this investor psyche, re-borrowing would be a tough ask for the government. It is the result of its short sighted policies, a glaring example of which is its almost blind reliance on borrowing through T-Bills, realizing little that they mature quickly. Can you believe that until May, there wasn’t a PIB maturing beyond eight years?

A big negative return from excessive short-term borrowing (supposedly with the objective of lowering the borrowing cost) now that close to 40 per cent of domestic borrowing is vulnerable to interest rate changes. With interest rates now bound for a rise globally, the opportunity for borrowing large amounts on artificially depressed long-term rates during 2004 has been squandered away.

Speaking of maturing debt, securities for over Rs66 billion will mature in June and for another Rs70 billion in July thereby enlarging the total re-borrowing burden to Rs136 billion. Add to this the impact of intermittent encashment of NSS securities that defies precise estimation. A fair guess therefore would be to place the re-borrowing burden close to Rs150 billion in the next two months.

How will the market respond to a call to re-lend this huge amount? Hurt by the rapid decline in returns, neither corporate sector nor banks nor even ordinary investors appear keen on investing in government securities. Instead, speculating in foreign currencies, gold, shares, unit trusts and real estate is now high on their list. It is a bad outcome of bad policies because wholly uninitiated investors are placing their savings in risky ventures.

Banks – the largest investors in government paper – were hurt most. A huge amount of their investment (T-Bills for Rs218 billion) is in excess of regulatory requirements. On maturity of these T-Bills banks could lend a large chunk of their proceeds to the business sector and retain the rest to support their liquidity that has been at a precarious level for a while forcing banks to visit to SBP’s Discount window too often.

Corporate lenders and pension funds may invest in the up-coming mutual funds and asset management companies. So would small investors because, at least for now, these options are promising (risk-adjusted) returns well above those on PIBs, T-Bills, SSC and DSCs. Besides, these investors don’t need to hold government paper to comply with any regulatory requirements.

In the event government sticks to its guns (its faulty inflation estimates) and fails to re-borrow from the market, what options does it have to plug the gap? It could raise statutory liquidity requirements for banks and financial institutions but it cannot be too large. At the most, it could raise the requirement from current 20 per cent to 22 per cent but that will bring in just Rs54 billion based on the current total banking sector deposit portfolio of Rs2.7 trillion. However, given the fact that there is a huge credit over-hang, this move would be worth considering.

The government could go for external borrowing but that will hike up external debt as a proportion of GDP. More importantly, with demand likely to slacken after interest rate hikes everywhere and exports most likely to be hurt by this development, the government will have a tough time coughing up the foreign exchange for debt servicing. As it is, things do not look too good as far as the BoP and current account deficit are concerned.

Privatisation of more state-owned institutions is another alternative but no matter how hasty it may be (and also entail the risk of blame for under-pricing the asset sale) it is not the correct option for liquidity management. Privatisation proceeds must be invested in infrastructure development, not used for liquidity management. Selling the family silver to fund deficits caused by financial mismanagement reflects a dangerous short-term attitude.

Another option is that the government slashes its recently announced hefty allocation for PSDP. However, that will be a big setback for the government and the economy. Pakistan’s physical and social infrastructure needs a major overhaul if de-stabilization of the social and economic system, is to be avoided. Recent violence (ignition of the fuse?) against power shortages is a warning that things may be getting out of hand.

The government could opt for upping tax rates on the captive salaried class, but there will be a time lag before the hike starts to deliver the money. Besides powerful protests, the move could lead to serious consequences for the financial sector that has tactlessly expanded its consumer credit portfolio. With substantially decreased take-home salaries, consumers could default on their loans putting the financial services sector in a soup.

The scenario leaves the government only with less radical options. Firstly, it must resist the temptation to survive on short-term credit purely for lowering the borrowing cost. In a political as well as economic sense, such savings can be counter-productive.

Secondly, it must borrow, at least for medium-term, at returns that are not rooted in its faulty inflation estimates that no one believes. This policy will also make it less vulnerable to coming interest rate increases. Finally, it must shelve for good the smart trick of lowering returns on NSS securities halfway through their tenors.