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The debt volcano

May 18, 2012

AMONGST the many worrying elements in Pakistan’s current economic condition — faltering growth, record-low investment, historic inflation — it is perhaps a tough call to pick the one we should be most concerned about. Arguably, however, the most destabilising dynamic in the medium term is associated with the rapid accumulation of public debt that has occurred since 2008.

Using the expanded definition of public debt to capture quasi-fiscal items such as commodity operations, debt of public-sector entities and underlying guarantees issued by the government, total debt obligations on the sovereign balance sheet have touched Rs12.83tr as of end December 2011 — over 65 per cent of GDP. By comparison, this figure was around Rs6.5tr on June 30, 2008 — representing a near doubling of debt and liabilities on the public-sector balance sheet in less than four years.

More worryingly, the inability of the government to rein in high fiscal deficits, and the recourse to high-cost, short-maturity domestic borrowing has amplified the problem by reinforcing the negative feedback loop. The cost this rapid accumulation of debt is imposing can be gauged from the fact that debt servicing now accounts for over 80 per cent of net revenue (after transfer to provinces). This fiscal squeeze means that the government is progressively left with less and less to pay for all the other demands on the budget — including for making critical public-sector investments or for social-sector expenditures.

In addition, the magnitude of the government’s deficit-financing needs means interest rates in the economy are higher than they would be otherwise, and the actual availability of credit to the private sector has been sharply constricted, reducing the flow of new investment while seriously hurting Pakistan’s growth prospects.

What is the source of this unprecedented expansion in public debt in such a short span of time? An examination of sources of the increase in public debt in this period is instructive.

Increase in public debt, 2007-2011: Rs6.3tr Sources of increase: Exchange rate depreciation (2008-2009): Rs1.5tr Power sector losses: Rs1.3tr Debt servicing on incremental borrowing: Rs1.3tr (est) ‘Legacy’ expenditures* Rs0.9tr (* Include unbudgeted price differential claims pertaining to 2006 and 2007 paid to OMCs in 2008 and 2009, and unrecognised military-related payments pertaining to the period prior to 2008.)

From this, it is clear that a substantial part of the increase in public debt since 2008 relates to unbudgeted and unrecognised (i.e. not ‘booked’) spending pertaining to the Musharraf years. In addition, another source of increase is the unreformed power sector, whose financial viability was undermined by the acts of omission and commission by the previous government, and where the inaction of the present government has compounded the problem.

Finally, the largest impetus to the public debt stock (accounting for nearly 25 per cent of the overall increase) has come from the sharp depreciation of the rupee in 2008 and 2009. This outcome was a direct consequence of the dangerously flawed exchange rate policy followed by the government of the time between 2002 and 2007, whereby the nominal exchange rate was kept ‘stable’ against the US dollar. As a result, the rupee had become overvalued as measured by the real effective exchange rate (REER), hurting Pakistan’s international competitiveness.

The subsidy to imports and the penalty on Pakistan’s exports imposed by this exchange rate policy had begun to show in the trade figures. By 2007-08, imports had touched $40bn, with exports paying for only 48 per cent of the associated payments. The current account deficit for the year was the largest in Pakistan’s history, at nearly $14bn or 8.7 per cent of GDP.

By the summer of 2008, forex reserves were depleting at nearly $1bn a month, and by October of that year, actual, usable forex reserves with the State Bank of Pakistan had dipped to dangerously low levels. A currency crisis was inevitable, and the fall in the rupee was a natural outcome of the widening difference between hard currency payments and receipts — with no forex reserve buffers left to mitigate the pressure.

Despite all these sources of accretion in public debt, ultimately, however, the debt problem reflects a colossal failure of fiscal effort on the part of successive governments. If the tax-GDP ratio had been raised by 2005 to a passable 13 per cent from the embarrassing 9.8 per cent it actually stood at (despite vaunted claims of tax reform), by 2011 the incremental tax revenues so generated would have meant that the public debt would have been approximately 10-15 percentage points lower — at around 50-55 per cent of GDP instead of the current 65 per cent.

Lowering the fiscal deficit to a level commensurate with debt stabilisation, by a heavy emphasis on tax mobilisation as well as on expenditure reform, is the only way out of this morass. Greater fiscal discipline will slow the incremental debt build-up as well as lower the interest cost. Any resumption of external inflows that displaces high-cost domestic borrowing by the government, and a glimmer of growth, will both lend a helping hand and will be more than welcome.

Reform of the power sector will also be a critical element of the debt stabilisation strategy. The government may also need to discuss with banks holding large amounts of short-term sovereign paper, ways to increase the average maturity of their T-bill holdings. This is increasingly clustered towards the short end of the yield curve, heightening rollover risk as well as the possibility of potential disruption in financial markets.

Finally, provisions of the Fiscal Responsibility and Debt Limitation Act (FRDL) of 2005 will need to be strengthened, in particular the absence of any ceiling on government borrowing from the central bank. The absence of a hard constraint on runaway government borrowing, enforceable either by an independent central bank or a vigilant parliament, is undermining the fiscal and macroeconomic framework.

The writer is a former economic adviser to government, and currently heads a macroeconomic consultancy based in Islamabad.