Domestic Debt Restructuring (DDR) is necessary and viable.

The term’ debt restructuring’ includes three possibilities — extension of maturities (re-profiling), coupon resets or reduction of the principal. There is no fourth option. Principal haircuts are generally avoided, and they are not necessary. Re-profiling and coupon resets are sufficient to achieve policy goals.

Why restructure domestic debt?

We are in the throes of an unprecedented economic crisis. The current prescription — a ham-fisted approach of tax extortion and reducing the current account deficit by blocking legit repatriation of capital, dividends, and settlement of letters of credit — has significantly damaged investor confidence. It has penalised businesses long faithful to Pakistan. It has mocked and drained honest taxpayers.

In addition, a high borrowing cost is sucking the life out of the real economy. The government’s domestic debt is galloping to new peaks. Taxes on organised businesses in Pakistan are higher than in Western countries. Any little hope that still lingers about a good future is rapidly fading.

The generosity of foreign lenders may allow us to carry on with our ventilator economy. But it will not bring economic health. We also need deep-rooted structural reforms, tax overhaul, loosening of foreign exchange controls and fiscal discipline.

These reforms will cause pain before they provide relief. They have a high political cost. Reformers know that they will perish long before their reforms can bear fruit. Self-preservation will force the rulers to change course midway and bring back populist measures.

A well-orchestrated DDR programme can deliver significant fiscal space quickly and make deep structural reforms politically viable

A reduction in domestic debt servicing costs will deliver significant fiscal space quickly, and it can overcome the political hurdle. The government can immediately fund targeted subsidies for the needy and materially lower taxes on businesses. The additional fiscal space can be turned into a pain reliever and a growth accelerator at the same time.

Can the policy rate and business taxes come down meaningfully without the DDR?

Unlikely. The badly needed foreign exchange liberalisation and fiscal austerity under the International Monetary Fund programme will keep inflation, policy rate and business taxes punitively high for a long time, and they in turn, will strangle the real economy for an extended period.

Fiscal austerity without growth will be very tough to sustain politically and has a low probability of success.

The numbers

The numbers are straightforward. The cost of servicing domestic debt for FY24 is projected at Rs6.43 trillion or approximately 70 per cent of tax revenue.

A 50pc reduction in the debt servicing cost will immediately create significant fiscal space. It would impose an initial mark-to-market shock of Rs3.3tr on the government’s tradeable debt, assuming yields do not change.

The hit to the capital of the scheduled banks — which aggregated Rs2.1tr in March 2023 — would be lower. Banks held a lower percentage of the government’s total tradable debt and a higher proportion of short-term debt.

Ghana and Sri Lanka have already bitten the bullet though a bit late and at the prodding of foreign lenders

The annual reduction of Rs3.21tr in projected debt servicing cost would be a recurring benefit, and its net present value (NPV) is significantly higher. The recapitalisation of the banking sector, if necessary, would be a one-time affair. The NPV benefits of lower debt servicing costs to the government dwarf the potential cost of recapitalising the banks by a huge factor.

The potential mark-to-market losses and the cost of recapitalising the banking sector will be materially lower if yields come down post-DDR. And down, they will come, as we are seeing in Ghana and Sri Lanka.

If commitment to economic reforms and fiscal discipline is credible and precedes debt restructuring, the reduction in local yields can be significant and enduring. A shift in the yield curve, even halfway towards the long-term average, will reduce mark-to-market losses by approximately 60pc.

It is hard to imagine any costs to the real economy. Adding indirect benefits and costs into the analysis, including temporary loss of tax revenue from the banks, will most likely strengthen the case for DDR.

Support to banks

The irresponsible borrowing binge of the successive governments and the dearth of private sector lending opportunities amid a persisting hostile business environment has unfairly brought local banks into this fiscal malaise. Banks would need unequivocal support during the initial phase of the DDR. This can come in many ways.

The government can guarantee all deposits for a limited period. The State Bank of Pakistan can abolish the minimum deposit rate on conventional deposits. It can give exemption from recognising mark-to-market losses. As a last resort, the government can inject nonvoting sub-ordinated capital (without board seats) at concessional rates, which banks can repay from future profits.

The risk of a run on the banking system is infinitesimal. The bulk of local deposits cannot move overseas. Our banks are not dependent on foreign depositors and lenders. Their deposit base is mostly retail. The government can restrict cash withdrawals and tax them heavily. A deposit guarantee for a limited period will remove any residual risk.

Unfortunately, a DDR program in Pakistan cannot spare the banks. The largest lenders to a bankrupt borrower always bear the pain. This has also been the case in Ghana and Sri Lanka.

Major structural reforms and tax overhauls are a necessary pre-condition — a DDR programme without them will destroy a healthy banking sector. We will be out of the frying pan into the burning fire.

A well-orchestrated DDR programme can deliver significant fiscal space quickly and make deep structural reforms politically viable.

Ghana and Sri Lanka have already bitten the bullet — a bit late and at the prodding of foreign lenders. Although Pakistan has a much lower domestic and external debt, the cost of servicing domestic debt is between 5.5pc to 6pc of GDP in all three countries.

The government must show resolve and voluntarily announce domestic debt restructuring as part of a sweeping economic reform agenda.

The writer is the CEO of Magnus Investments Limited.

Published in Dawn, The Business and Finance Weekly, August 21st, 2023


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