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Grasping the nettle

May 31, 2012


FAMILIAR trends have tied Pakistan’s economy into a low-growth continuum. To engineer a change, the government will have to first show its policy hand and then progressively demonstrate the capacity to implement.

We need a blueprint setting out how, for example, fiscal and current account deficits will begin to be harnessed; constraints imposed by insufficient power provision will be removed steadily; a cushion to our declining foreign currency reserves will be provided; and debt servicing costs will be controlled.

Looking ahead, there are two binding constraints that we have to loosen to better accommodate other reform. The first is power supply — extensively reviewed and no comment here.

The second is the government’s mushrooming domestic debt. Doubling to Rs7.4tr from Rs3.8tr in 2009 and compounding at around 13 per cent annually, domestic government debt will double again in three years if borrowing continues at the current pace and in five-and-a-half years through just interest cost.

Servicing pressure — 85 per cent applying to domestic debt — is already acute. It takes up over 75 per cent of federal revenue remaining after provincial transfers.

Crowding out is significant. Over four years, 80 per cent of the increase in the collective loan volume of the State Bank of Pakistan and the banking system (net domestic assets) has gone to the government and the public sector (to cover losses in the power sector and public sector enterprises).

What is ‘too much’ debt in relation to the economy?

Pakistan’s total debt as of March 2012 is Rs12.8tr, with Rs5.4trn the foreign component. With GDP expected to clock in at Rs21tr, debt is roughly 60 per cent of GDP — a prudent upper limit by international yardsticks.

By itself, however, that measure is wholly insufficient.

The capacity to sustain debt depends critically on the depth of the national financial markets and on the capacity to achieve primary budget balance, i.e. matched revenue and expenditure before debt servicing.

A deficit on our primary budget balance ensures that debt can only increase for now. And our financial markets are unusually small by even regional standards.

Bank deposits here are 32 per cent of GDP. India and Bangladesh have bank deposits of 64 per cent and 53 per cent of GDP respectively. Leading emerging markets are far ahead: about 200 per cent and 300 per cent of GDP for Turkey and South Korea respectively with debt/GDP ratios in the 40 per cent range.

At 142 per cent of the collective financial stock of Rs9tr, our debt profile varies starkly from the international pattern.

The government’s domestic debt is also unusually short-term: the average maturity of non-National Savings Schemes debt is 16 months. Average maturity in larger emerging markets runs around four years in Latin America and nine years in Asia. Indian debt averages 12 years.

Rising short-term debt means fortnightly auctions of government debt averaged Rs130bn per session in financial year 2012 compared to Rs55bn two years ago — a two-and-a-half fold increase, whereas deposits have grown at nearer half that rate.

Market pressure has made the government a price-taker rather than a price-maker, which is what governments usually are given that government paper is ‘riskless’. GoP pays more for treasury bills than the country’s prime banks pay on shorter-term deposits — almost exceptional in international terms.

With negligible fixed-rate issue, the government faces double jeopardy in inflationary periods, when interest rates rise. It does not benefit from the falling present value of fixed-rate debt and incurs higher-cost short-term and floating-rate debt.

Simultaneously, with the government the dominant borrower, the SBP’s monetary policy role can be compromised in that rising policy rates merely increase the budget deficit.

By most measures, we have too much public debt. However, there is no crunch or super-inflationary wave yet because this is balanced by low private sector demand and falling investment, corresponding to a lower level of imports than otherwise. Therefore, the rupee has not come under real pressure.

In the near term, the sheer weight of debt on the national budget could cause fiscal duress and lead to financial repression, i.e. steps by the government to directly or indirectly reduce or defer the cost of debt through a variety of possible methods. Where do we go from here?

Domestic debt can be much better supported if restructured to achieve longer tenures, wider distribution and reflect a market-oriented mixture of fixed and floating issues.

Tight and technically strong oversight is needed. The government should upgrade the present debt coordination function at the Ministry of Finance to a debt management function and make it a statutory body with market professionals working alongside government officials. Day-to-day interfacing with the SBP and the financial markets would be necessary to adapt strategies in light of market conditions.

For the planned deepening of financial markets, which would also lower the cost for government funding, a debt-market development committee could be formed, including the DMO, the SBP, the SECP and leading financial entities. This would draw up a roadmap of objectives covering the following:

One, accelerated distribution of all government paper outside banks via facilitating rapid growth of debt capital markets by extending a screen-trading programme to the Karachi Stock Exchange and fast-tracking new/expanded mutual funds; facilitating access to government paper by individuals and corporates through primary and secondary markets; on-going marketing of government debt securities abroad; pursuing foreign-currency borrowings through Sukuk investors; etc.

Two, acceleration of branchless banking to draw in huge currency in circulation via promoting mediums such as telebanking; use of post offices and retailers as agents for payments and transfers; setting up a central switch that will allow all devices (Internet, phone) the capacity to make payments and transfers between banks; etc.

Three, galvanising the role of primary dealers by creating incentives for widening distribution of government issues to non-bank entities. This would need an active market-making role to be played by the primary dealers and repo facilities will need to be provided with a safety net arranged by the SBP.

A corporate bond market, which is only viable if an orderly market for government paper exists, could also then become a reality.

To conclude, we must act pre-emptively to forestall larger problems later. Bringing domestic debt under control, under a comprehensive programme, is an imperative now.

The writer is a former governor of the State Bank of Pakistan.