KARACHI, Oct 23: The ministry of finance is evolving a comprehensive debt policy and risk management system that goes beyond the present strategy of reducing debts and lowering interest.

The Debt Policy Coordination Office at the finance ministry would be strengthened to take care of risks, including exchange rate volatility, cash flows and bunching of debt maturities.

The move comes at a time when the external sector is under pressure from widening trade deficit and the domestic economy has been hit by soaring inflation. The rupee is sliding against the dollar and the interest rates are being hiked in a bid to price credit in response to bankers' demand.

Given Pakistan's high debt to GDP ratio and high interest expenditure to revenue ratio, the country's economic managers initially focused on slashing debt and interest rates. To quote the IMF, Pakistan's debt management practices largely followed the IMF-World Bank Public Debt Management guidelines, although they could also benefit from greater emphasis on risk management. The Fund is satisfied that the authorities are developing a risk management system to address factors such as currency exposures.

"Risks related to external debts are contained since the debt is largely long-term, concessional, multilateral or bilateral," says the IMF. But, it forgets that cheap credits become much costlier by a continuous process of weakening of the rupee against the dollar in pursuit of bigger export earnings that are outpaced by faster imports. Depreciation of the rupee is a form of subsidy that obviates the need to improve quality of exportable items at competitive prices.

To quote the Pakistan Economic Survey 2003-2004, "in case of foreign borrowings, interest cost as well the cost emanating from the depreciation of the rupee (or capital loss on foreign exchange) are taken into account. Thus, the capital loss on foreign exchange is added to the real interest cost." This is illustrated by the fact that the real cost of borrowing was much higher in the second half of the 1990s mainly on account of a sharp depreciation of the rupee against the dollar. For this period, the real cost was 5.5 per cent after adjustment of the then prevailing double digit inflation as against inflation-adjusted minus three per cent in the first half of the 1990s.

Unless the inflation and interest rates remain benign, the cost of debt-servicing rises, requiring more revenues to be raised through indirect taxes (over time corporate taxes are cut). In fact the pace of revenue and export earnings must continue to increase to sustain debt carrying capacity of the country. It requires what is officially described as prudent monetary, fiscal and exchange rate policy.

A well-managed debt risk management is also needed as Pakistan has begun to access international financial markets for bonds. A $500 million Eurobond was floated recently and this will be followed by another Shariah compliant bond soon. It is part of the strategy to reduce dependence on official bilateral and multilateral assistance.

But a key issue facing Pakistan in debt management is the productive utilization of foreign loans and credits. Foreign debt-driven investment must yield good returns to service debts.

External loans are utilized at a much slow pace than domestic financing of projects. It means cost overruns. Penalty has to be paid to the lender for the commitment charges on the unused portion of the debt. It calls for a more prudent debt policy.