Anatomy of ‘Debt Management Strategy’

Pakistan’s persistent fiscal imbalance has cast a negative shadow on the overall economic scenario. Unless significant and enduring fiscal reforms are initiated and implemented with full vigour, the likelihood of improvement remains bleak.

The traditional ad hocism adopted by successive governments has been a major obstacle in aligning our fiscal matters. Consequent to a successful vote of no-confidence motion against the former Prime Minister [now convicted] Imran Khan, the Pakistan Democratic Movement (PDM) government assumed power on April 10, 2022.

They came into power with a claim to overcome financial challenges, alleviate burden on the citizens and prevent the looming risk of default which was aggravated due to poor economic policies of Pakistan Tehreek-e-Insaf (PTI) government, and its blatant violations of the conditions agreed upon in the Extended Fund Facility (EFF) programme with the International Monetary Fund (IMF) to gain political mileage.

However, during its 16-month tenure, the PDM government, led by Premier Muhammad Shehbaz Sharif, encountered various challenges, such as devastating floods, political turmoil, and interference by the judiciary in political and administrative affairs.

Despite these difficulties, they effectively averted the risk of default. The most significant challenge they grappled with was the aftermath of a catastrophic flood, which inflicted a staggering loss of more than US$30 billion upon the ailing economy of the country.

However, throughout this entire duration, no relief was extended to the citizens of Pakistan. Instead, the entire focus remained on extracting more and more revenue through existing avenues, including the imposition of extra taxes, surcharges, and duties, as well as imposing restrictions on import.

These measures were taken to establish a sufficient financial buffer for servicing external debts and enhancing foreign exchange reserves to facilitate import of essential items.

On completion of its tenure, the PDM government handed over the reins to a caretaker setup. However, after unlocking the critical 9-month US$ 3 billion Stand-by IMF Arrangement, the level of reserves has improved considerably as compared to the past few months and this development naturally raised the question: Will the people of Pakistan finally see some relief? The answer in simple words is a big NO.

The major issue with our fiscal imbalances is the huge gap between revenue and expenditure, a fact verified by the annual budget statement which states that Pakistan’s gross revenue receipt for the financial year (FY) 2023-24 is approximately Rs. 9415 billion whereas expenses for the same period are estimated at Rs 13,344.4 billion.

This huge gap between income and expenditure will be mainly bridged through borrowing. Before declining to US$ 124.3 billion in June 2023, Pakistan’s external debt surpassed US$ 130 billion at the close of June 2022. According to the IMF Country Report dated July 18, 2023, Pakistan’s gross financing requirements are slightly more than US$123 billion in the next five years.

Section 13(2)(a) of the Fiscal Responsibility and Debt Limitation (FRDL) Act of 2005, requires formulating a debt reduction plan to uphold the principle of responsible fiscal debt management. In alignment with the provisions of the FRDL Act of 2005, the Debt Management Strategy Report, which was released during Muhammad Ishaq Dar’s tenure at the Ministry of Finance, mirrors a well-balanced approach to borrowing from diverse sources, thoughtfully weighing the trade-off between cost and risk.

The report has a three-fold objective, which encompasses examining the Cost of Debt, assessing Financing Availability, and evaluating the Domestic Debt Capital Market. The report underscores that while the proportion of external debt experienced a marginal rise from 36% in 2019-20 to 37% in FY 2021-22, it remained below the established benchmark limit of 40%. This minor increase can be attributed to currency exchange rate fluctuations rather than an increase in external borrowing.

Specifically, regarding the currency composition of total public debt as a percentage of the total public debt in the FYs 2020, 2021, and 2022 in Pakistani Rupees, it stood at 64%, 66%, and 63% respectively for these years.

In contrast, it was 19%, 18%, and 21% in US dollars and 13%, 11%, and 11% in Special Drawing Rights (SDR). Meanwhile, the share of all other currencies, including the Japanese Yen, remained at 4%, 5%, and 5%, respectively, for FY 2020-21 and FY 2021-22.

The benchmark for external borrowing is set at 40% while discussing the targets for key risk indicators for the financial year 2022-23 to 2025-26, the report highlights major risks, i.e., currency risk, refinancing risk, and interest rate risks. Though increase in external debt is attributed to the depreciation of exchange rate, the government is expecting that due to its Debt Management Strategy, it will reduce the share of external public debt.

Regarding management of refinancing risks, the report indicates that the government has established a lower benchmark target for Average Time to Maturity (ATM). This is because several multilateral financial institutions extend loans with maturities ranging from 20 to 40 years at concessional rates to developing nations. However, a similar domestic market for such loans does not presently exist. Hence, until the domestic market matures, it is advisable to maintain low ATM targets for domestic debts.

In Debt Management Strategy, the government aims to reduce its Gross Financing Needs (GFN) and the GFN to GDP ratio through several measures. These include enhanced cash flow management, increased issuance of long-term debt, the development of regular Islamic-based lending programmes, and maximizing concessional financing from bilateral and multilateral development partners. However, it is crucial to acknowledge that interest rate risk plays a significant role in maintaining a substantial proportion of fixed debt in both domestic and external debt portfolios.

The report further highlights that due to a desire to minimize borrowing costs in a high-interest-rate environment, the government has been reluctant to utilize fixed-rate instruments. This is a classic example of adverse selection.

Moreover, the report points out that historical price instability has resulted in reduced demand for long-term fixed-rate government securities. Until market participation from investors such as insurance companies and pension funds, who prioritize price stability, sees significant improvement, it is prudent to establish realistic targets for these indicators.

Summary of public debt portfolio and guarantees, as per guidelines of FRDL Act of 2005, as presented in the report, reveals that in FY 2018, Pakistan’s total domestic debt was Rs 16,416 billion, while the external debt amounted to Rs 8,537 billion. However, in FY 2019, both domestic and external debt increased to Rs 20,772 billion and Rs 11,976 billion, respectively.

Subsequently, public debt continued to rise, reaching Rs 23,283 billion in domestic debt and Rs 13,116 billion in external debt in FY 2020. In FY 2021, these figures escalated further to Rs 26,265 billion for domestic debt and Rs 13,601 billion for external debt. By FY 2022, the numbers surged to Rs 31,850 billion and Rs 18,157 billion, respectively. By the end of March 2023, our public debt had reached Rs 35,076 billion for domestic debt and Rs 24,171 billion for external debt.

According to the report, average yield for domestic debt in FY 2023 is estimated at 15%, while for external debt, it’s approximately 4%. Consequently, interest expenses relative to the gross revenue ratio is roughly 62%. Nevertheless, there is anticipation that over the medium term, overall yield on the entire public debt, encompassing both domestic and external components, will decline to single-digit percentages. This aligns with decreasing inflation projections as emphasized in the report.

The FRDL Act of 2005 sets forth two crucial limits, known as the flow ceiling and stock ceiling. According to these provisions, issuance of guarantees should not exceed 2% of the GDP. Moreover, in the case of renewing existing guarantees, such renewals are considered new guarantees.

Additionally, the law specifies that the total stock of outstanding government guarantees should not exceed 10% of the GDP. However, in the FY 2022, the government issued new (rolled over) guarantees amounting to 0.7% of GDP. From July to March of FY 2023, new (rolled over) guarantees were issued by the government, aggregating to 0.2% of GDP.

The report underscores that by the end of March 2023, outstanding stock of guarantees had reached Rs 3,460 billion. The value of outstanding guarantees extended to Public Sector Entities was Rs 2,344 billion in June 2020, Rs 2,407 billion in June 2021, Rs 2,983 billion in June 2022, and Rs 3,460 billion in March 2023, respectively.

Pakistan is presently confronted with a constant rise in its borrowing needs, especially in the context of a high-interest rate environment. This has significantly amplified the financial burden associated with servicing these debts. In response to this challenge, the government should implement effective resource management tactics. This includes a thorough review of ventures that are currently running at a deficit.

For addressing the perpetual challenge, it is crucial to develop a comprehensive strategy for the revival or privatization of state-owned enterprises as needed. This is particularly important as a substantial portion of funds is allocated to cover the working capital requirements of these unprofitable entities.

Additionally, the government should overhaul its revenue-generation approach by exploring new avenues of income and avoid imposing further burdens on the already tax-paying population. This approach will enable the government to meet its financial needs through sustainable means rather than heavily relying on costly borrowing.

(Huzaima Bukhari and Dr. Ikramul Haq, lawyers and partners of Huzaima, Ikram & Ijaz, are Adjunct Faculty at the Lahore University of Management Sciences (LUMS), members of the Advisory Board and Visiting Senior Fellows of the Pakistan Institute of Development Economics (PIDE). Abdul Rauf Shakoori is a corporate lawyer based in the USA and an expert in ‘White Collar Crimes and Sanctions Compliance’)

Copyright Business Recorder, 2023