The manner in which finance ministry officials handled the debt pre-payment for PARCO, the largest long term syndicated financing in the history of Pakistan, has left a bad taste in the mouth of the financial sector.

While then finance minister Shaukat Aziz takes credit for paying off this expensive foreign debt before it was due, the way this was done raises many question over the suitability of such an exercise, say industry analysts.

In May, when the finance minister attended a signing ceremony to signal the repayment of the debt, Shaukat Aziz told his audience this loan was carrying an interest rate of 7.3 per cent while the local financing facility would charge 2.4 per cent mark-up rate. This will make a significant saving on account of interest rate, currency fluctuation risk, subsidies and increase profit, he added.

The exercise to repay the $355 million loan was undertaken when PARCO chief Shahid Hak floated this idea to the banking community. The refinancing offer was open to both local and foreign banks.

However, as the initial local currency option provided by the consortium headed by Pakistani banks was working out more expensive than the existing loan, given the large pre-payment penalty, PARCO also sought proposals for a foreign currency solution. The idea was that even after payment of all the relevant penalties, such a loan would work out cheaper in Pakistan's interests.

Based on the proposals received, the PARCO management decided not to proceed with the re-financing. However, the loan proposal was sent to the finance ministry in Islamabad, where a senior official close to finance minister Shaukat Aziz suggested that the same could be done by a consortium headed by Pakistani banks.

The senior official, whose close relation sits on the management of one of these newly privatized banks, is understood to have made this proposal on the grounds that this business should go to the Pakistani banks instead.

What happened next was a classic case of chaos. While the banks agreed to financing the deal, the proposal was to lend in rupees against which then dollars would be bought and remitted.

The problem here, however, was that the banks did not take into account the sensitivities of the foreign exchange market, which would have been adversely affected if such a large payment came through.

For its part, the State Bank sensibly refused to allow outright dollar buying to repay the loans on the grounds that it had not been consulted and that such a payment would affect the dollar exchange rate adversely.

After this, PARCO was forced into a rupee-dollar swap with a consortium of five banks to repay the foreign loan ahead of schedule. The SBP permitted PARCO to enter into the swap deal with the banks adding that the permission was necessary as the corporate sector and banks cannot enter into a rupee-dollar swap for a financial transaction. Bankers say the PARCO swap deal is the first one of its kind.

The banks with which PARCO came to an agreement with under its rupee-dollar swap include the National Bank, the Habib Bank, the United Bank, the Muslim Commercial Bank and the Standard Chartered.

In May 2004, PARCO had obtained a syndicated loan of Rs20.5 billion from these banks. A swap deal between PARCO and the five banks means PARCO would lend Rs20.5 billion to these banks for some months and borrow dollars from them for the same period.

Reports suggest that since the company was not allowed by the central bank to buy dollars from the market for prepayment of its foreign loan it may not make the desired saving in its cost of borrowing now.

Industry sources say that PARCO will end up paying more than the cost of the original loan. This is because it has moved from a US dollar fixed rate to a Rupee floating rate loan. The benchmark for this loan is KIBOR, which is more volatile and likely to rise at a faster pace in the future.

The price of KIBOR +0.25% is allegedly not the total cost of the loan, say analysts. There are hidden costs like arrangement fees. PARCO also paid a penalty of about $26 million on prepayment of this loan that it had mobilized a couple of years ago to finance the construction of its mid-country refinery.

Given that PARCO was not allowed to buy dollars outright in the market, the swap with the banks means that effectively PARCO has a US dollar loan on its books. As this loan is un-hedged, PARCO has and will continue to take exchange losses as the rupee weakens.

Pakistan had also repaid $1.71 billion to the ADB and plans to clear another $1 billion debt this year. In his budget speech, Mr Aziz said that the country would pre-pay $400 million more of expensive external debts by December 2004. In addition to pre-payment of external debt by the government the corporate sector is also retiring its foreign loans before time.