Does Pakistan need domestic debt restructuring?

There is growing consensus over the need for debt restructuring within the policymaking community. However, many analysts are casually selling the idea of domestic debt restructuring without fully recognizing the consequences it can have on the sustainability of domestic banking system. The idea must be pursued with a lot of care.

Pakistan’s immediate economic problem is of balance of payment (BoP). Perhaps, the focus of policymakers need not be distracted from the paramount BoP challenge. The focus needs to be on generating gross external financing requirements. Therefore, the discussion on debt re-profiling or restructuring should be confined to external debt only.

There is no doubt that the current fiscal structure is unsustainable, and that debt servicing costs are taking too high a toll, of which most of the debt servicing is domestic. However, domestic debt can be handled through domestic solutions provided the authorities demonstrate the resolve to tackle this beast.

The real thorny issue is generating gross external financing needs. For that, the first step is getting back on track with the International Monetary Fund (IMF) programme. In order to make that happen, the government needs to impose taxation measures and increase energy prices.

Only then can it go to friendly countries and request help to bridge $8 billion financing gap and thereafter, the SLA shall be signed. Going forward, another extended IMF programme in the next fiscal year is inevitable, and within that the debt restructuring may come in discussion during negotiation rounds. And that issue must be handled with caution and logic.

First, not all hell shall break loose even if Pakistan does not restructure its public debt. Let’s run some numbers. On the external side, as per the latest IMF country report, the gross financing requirement is $38 billion each for the next four years. This base case has an assumption of an average current account deficit of $11 billion and SBP reserves targeted at $17.2 billion for 2024(to grow thereafter). Given the current situation, even $10 billion in SBP reserves, and half the target current account deficit won’t be a bad position.

This would bring gross financing needs down to $22 billion. The short-term debt repayment is on average $13 billion in the next four years of which $3.7 billion is private sector debt. By lowering desired reserves target, and the current account deficit, rollover requirement in the short-term for public debt could be reduced to zero. Moreover, public sector debt amortization shall be slashed to half, and overall amortization of debt shall fall to $15 billion.

Thus, the government needs a cushion of $10-15 billion in the external sector over the next four years to dodge a messy default. Bilateral credit to Pakistan is approximately $35-40 billion, of which lion’s share belongs to China, followed by that of deposits from Saudi Arabia. Pakistan must ask these countries to either re-profile the bilateral debt or issue more debt to provide the cushion for survival. And the country can pay its multilateral debt servicing through fresh issuance, as long as Pakistan remains in an IMF programme.

However, some argue that most of the debt servicing is domestic debt, and it should be restructured as well. They say that Rs5.2 trillion debt servicing is too high for a fiscal. Yes, it is true, and perhaps this will grow more with the increase in the interest rates. However, there are ways to deal with it.

Pakistan’s domestic debt stood at Rs33 trillion as of November 2022. Out of which Rs19.5 trillion (67 percent) is long-term permanent debt – Pakistan investment bonds (PIBs) and Ijara Sukuk. Interestingly, the domestic debt has already been re-profiled as permanent debt increased from 25 percent of total debt in 2018 to 67 percent in 2022. This was thanks to the DG debt under the last regime who had introduced floating PIBs.

However, floating PIBs doesn’t solve the problem of growing debt servicing cost. The key is to get at least a fraction of the interest cost back in the fiscal kitty from eventual beneficiaries of high interest rates. And these are not commercial banks- which are only financial intermediaries operating on a spread between the funds’ provider (depositors) and the borrower (government).

There are two big funders of debt. First is SBP (State Bank of Pakistan), which holds a stock of Rs6.5 trillion of PIBs. Then around Rs6.6 trillion of banks’ lending to government is indirectly provided by SBP through the injection of open market operations (OMOs). In total, direct and indirect SBP lending is 40 percent of total domestic debt and major chunk of it should return to government as non-tax revenue.

The other big funders are deposit holders of banks, that is, ordinary citizens. Approximately Rs14 trillion of bank deposits are interest bearing where banks are bound to pay 15.5 percent (150 bps below the policy rate) with exception of Islamic deposits where the return is slightly lower. Here, banks are raising deposits at minimum 15.5 percent and lending it to the government at 17-18 percent. If interest rates move up further, banks’ margins will remain the same while depositors will benefit incrementally.

These depositors are taxed at 15 percent if their income is below Rs5 million. That is the case for most depositors. At the current rate, taxing interest income at 40 percent can yield the government an additional Rs500 billion in tax revenues. Similarly, higher tax could be applied to other borrowers of the government on interest income. In this way, an effective interest rate for the government shall reduce and help lower the fiscal deficit.

These facts should help identify possible ways to deal with domestic debt through higher taxation. And then the debt is in the process of implicit restructuring due to higher inflation. Currently, inflation averages between 25-30 percent while the policy rate is at 17 percent. Thus, the nominal GDP is growing at a higher rate as compared to debt servicing and debt which in turn is lowering the debt to GDP ratio.

Moreover, additional liquidity in the system can be generated through lowering the cash in circulation. A reduction of Rs 2 trillion from Rs8 trillion cash in circulation can generate ample liquidity to lower the interest rates. The government and SBP need to think of a workable option to rein in the cash economy.

There are several ways to handle domestic debt problems without causing a systemic risk to the banking system. And it is imperative to create space and use it wisely. And focus on expanding the tax base and curtailing public expenditure by sacrificing the holy cows in the informal economy.

Copyright Business Recorder, 2023