Some believe that Pakistan’s real risks are on the external side, and the country should focus on raising money to refinance and service its external debts. However, given its low credit rating, it seems highly unlikely that Pakistan will be able to raise money from the international debt markets soon.

Moody’s Investor Service noted in its report of Feb 27 that Pakistan’s “ca” fiscal rating reflects its large debt burden and weak debt affordability. Pakistan’s total public debt stood at Rs67.3 trillion ($239 billion) on Dec 31, 2023, and accounted for 74.8 per cent of the GDP in 2023 — Rs42.6tr (63.3pc) of this was domestic debt.

The International Monetary Fund’s (IMF) current estimate of government revenue is 12.5pc of the GDP and expenditures at 20.2pc. The principal reason for the gap is interest paid on debt, which the IMF reckons to be around 8pc of the GDP. Interest on domestic debt currently accounts for more than 80pc of the total interest paid by the federal government.

Sri Lanka’s financial advisor, Lazard — a French investment bank specialising in restructuring corporate and sovereign — published a paper titled Domestic Debt Restructuring: An Exercise in Laser Surgery in September 2023. A key message of the paper was that domestic debt restructurings (DDR) “may be necessary when there is a lot of domestic debt and when the effort required from external commercial creditors to put the debt back on sustainable grounds is exceedingly demanding”.

Restructuring floating-rate bonds can help the government reduce its interest payments

Restructuring is a painful and lengthy process, and Sri Lanka has yet to complete the restructuring of $12 billion in defaulted global bonds. However, according to The Hindu, it has completed the restructuring of its domestic debts of $42bn, a process that started in June 2023.

Admittedly, Sri Lanka’s debt situation was worse than Pakistan’s when it defaulted in May 2022, but Pakistan, too, came close to a default in 2023.

Sri Lankan Banks have maintained depositor confidence and foreign exchange, and rupee liquidity stress has subsided somewhat. Post-DDR, financial conditions in the local currency debt market also eased somewhat from their crisis peak.

The government has relied heavily on hikes in electricity, gas, and petroleum tariffs and energy taxes to increase its tax and non-tax revenues and borrow heavily. This path is not sustainable and has hurt the economy. Surcharges and levies on petroleum and gas are estimated by the IMF to be around 1pc of the GDP. These indirect taxes have contributed to Pakistan’s inflation, currently around 23pc.

The federal government’s net revenues for the first six months of FY24 were Rs4tr, with net off-transfers to the provinces amounting to Rs2.4tr, an increase of 29.5pc over the corresponding period in FY23. However, the net federal revenues were not sufficient to pay even the markup on the borrowings, which climbed by 64pc to a record Rs4.2tr.

The staggering rise in borrowings and debt servicing is largely due to higher interest rates, currency devaluation, and the government’s failure to increase the tax-to-GDP ratio.

Given Pakistan’s long-term failure to increase its tax base, it is hard to be optimistic about a significant improvement in the short term. Therefore, in the immediate future, the government must reduce its borrowings to create fiscal space.

There has been a massive redistribution of wealth from the public to the financial sector due to government borrowings and high interest rates

The domestic debt of Rs42.9tr includes Rs25.7tr (60pc) in Pakistan Investment Bonds (PIB) and treasury bills of Rs8.3tr — about 74pc of the total domestic debt is on a floating-rate basis and exposed to huge interest rate risk.

State Bank of Pakistan (SBP) data shows that the scheduled banks hold nearly Rs13tr in PIBs (52pc). The SBP held Rs5.5tr in PIBs at the end of 2023. The scheduled banks and the central bank are estimated to hold around Rs20tr in PIBs — 80pc of the total.

Floating-rate bonds of Rs23.1tr represented about 80pc of the total medium to long-term (maturity of more than one year) bond exposure of Rs28.8tr. The scheduled banks hold approximately 45pc of the floating-rate bonds.

The 14 banks listed on the stock market made a net profit of Rs544.4bn during 2023, reflecting an 82pc growth compared to their total earnings last year. This growth was driven by a massive 84.8pc rise in the sector’s interest earnings due to higher interest rates. Nearly half of the gross interest income of the scheduled banks was attributable to PIBs.

There has been a massive redistribution of wealth from the public to the financial sector due to a record rise in government borrowings and exceptionally high interest rates. Failure to address this larger issue will continue to harm the government finances, leaving little fiscal space that could be used more productively instead of just benefitting the banks.

Restructuring floating-rate bonds can help the government reduce its debt servicing costs. This could be in the form of conversion to fixed-rate bonds with longer maturities and lower coupon rates and with the explicit objective of reducing the debt servicing by Rs1tr annually.

Pakistani banks are in a reasonably good financial position to withstand the cost of restructuring. Their return on equity was 26pc per the IMF, which noted in its January 2024 review, “The banking sector remains well-capitalised and profitable with improving solvency ratios. The capital adequacy ratio strengthened, and non-performing loans, while increasing slightly, remained well provisioned.”

Moody’s upgraded Pakistan’s banking sector outlook from ‘negative’ to ‘stable’ on Mar 7. It noted that the “banks’ solid profitability and stable funding and liquidity provide an adequate buffer to withstand the country’s macroeconomic challenges and political turmoil”.

There is a case for a serious and careful evaluation of a domestic debt restructuring because, it is hard to see another way to reduce debt servicing costs to create some fiscal space. Moreover, the banking industry has disproportionately benefitted from the high government securities yields. It is strong enough to bear this cost if the restructuring is done on the right lines to minimise the impact on regulatory capital.

The experience in Sri Lanka shows it can be done without harming investor confidence. Improvement in the government’s fiscal position may help the country improve its credit rating and, thereby, its ability to raise financing.

The writer is former head of Citigroup’s emerging markets investments and author of ‘The Gathering Storm’

Published in Dawn, The Business and Finance Weekly, April 1st, 2024

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