Transforming maturity profile of domestic debt

Inflation is falling rapidly, nearing a four-year low, with FY25 (July 2024–June 2025) average inflation expected to fall within the SBP’s medium-term target of 5-7 percent. The tight monetary and fiscal policies implemented over the past year are yielding positive results. The decline in global commodity prices, coupled with the high base effect, is also contributing to this trend.

To ensure inflation remains under control, the SBP should avoid getting carried away by short-term gains and continue maintaining high, positive real interest rates. At the same time, the finance ministry should focus on extending the domestic debt profile by issuing more long-term fixed-rate bonds.

As of July 2024, Pakistan’s domestic debt stands at Rs47.6 trillion, but fixed-rate PIBs (long-term bonds) account for only Rs6.3 trillion (as of June 2024), a mere 13 percent of the total. The high domestic public debt poses significant risks, particularly in terms of rolling over short-term debt (T-Bills) and repricing floating-rate PIBs and T-Bills, exacerbating the situation.

Pakistan’s economy, along with inflation and interest rates, has been highly volatile over the last decade, fluctuating between 6 percent and 22 percent. The frequent boom-and-bust cycles are a cause for concern. If economic growth exceeds 4 percent, a new crisis could emerge.

To mitigate the risks associated with domestic debt, the government should issue more long-term PIBs. The yield on 10-year PIBs in the secondary market has fallen to 12 percent, which is consistent with Pakistan’s historical average yields. Even when interest rates were as low as 6 percent in 2015, PIB yields barely dropped into single digits.

The finance ministry should not chase after the lowest interest rates but instead focus on extending the maturity of domestic debt. With Rs2.7 trillion in SBP profits, the government has sufficient liquidity and is already buying back short-term papers to save on interest costs. It should use this opportunity to replace short-term debt with long-term fixed debt and continue doing so as interest rates decline.

Financial market players—such as banks, mutual funds, and insurance companies—operate within interest rate risks as per SBP guidelines. However, the finance ministry, which does not face such constraints, should avoid speculating on interest rates. The ministry has a broader responsibility to manage the country’s debt and should not gamble with short-term market fluctuations.

Beyond debt management, the government needs to address systemic issues in the economy, such as fixing the energy sector and broadening the tax base while interest rates remain low. Without tackling these fundamental problems, even with lower interest rates, sustainable economic growth will be hard to achieve, and any recovery will likely be short-lived.

The ongoing negotiations with Independent Power Producers (IPPs), led by the energy task force, are bearing fruit, as evidenced by deals nearing completion with five power plants (four under the 1994 policy and one under the 2002 policy). However, these negotiations have had unintended consequences, as the government’s coercive approach is alienating key investors, many of whom are large business groups critical to Pakistan’s energy sector.

This issue is evident in KE’s recent open bidding for hybrid renewal projects, where only three participants joined the latest round, compared to sixteen in earlier bids. This significant drop in interest cannot be attributed to a sudden shift in market dynamics; rather, the ongoing IPP negotiations seem to be a contributing factor. Similarly, the privatization of PIA is being delayed, and one key bidder has an IPP (under the 2015 policy) that has been asked to revise its contract.

It’s time for the government to change its strategy. Enough with the coercive measures; the IPPs are willing to negotiate. A more cooperative approach will yield better results for the country. The current strategy resembles a prisoner’s dilemma, where collaboration would result in better outcomes for all parties involved.

The energy task force’s technical team has limited capacity to address the legitimate concerns of IPPs, particularly in cases of contract termination. Furthermore, their hardline approach is discouraging large businesses from investing in the sector. A more effective strategy would be to negotiate with IPP owners and offer reasonable discounts in exchange for their commitment to invest in the energy value chain. For instance, a bulk deal could involve the sale of a distribution company (DISCO) along with revised IPP terms.

The finance minister, with his extensive banking experience and strong relationships with the business community, should take over the negotiations. His involvement could be instrumental in achieving a mutually beneficial deal. Additionally, since any termination of IPP contracts would require government compensation, the finance ministry is already central to this decision-making process and should spearhead the negotiations.

Encouragingly, progress is being made on reprofiling IPP debt for CPEC projects. This initiative, prompted by a request from the finance minister during his recent trip to China, is now being worked on by Chinese officials. Chinese lenders have already offered a moratorium on debt principal payments for government-owned nuclear power plants, signaling their willingness to support Pakistan’s energy sector.

All these efforts should help reduce power tariffs. Moreover, the government should consider lowering taxes on electricity tariffs and compensating for the revenue loss by increasing the petroleum levy, especially while oil prices are declining. This, too, is a decision for the finance ministry, which may need to consult the IMF before proceeding.

The economy is stabilizing, but the government must proceed cautiously and focus on implementing sustainable reforms. Given the current political turmoil, the margin for error is extremely slim.

Copyright Business Recorder, 2024