A major economic distortion that has not attracted sufficient attention from analysts is the state of country's bond market, primarily comprising government securities. For nearly 18 months, the market is effectively dysfunctional.
Since late 2016, the government started not accepting bids for Pakistan Investment Bonds (PIBs). Even the maturities of PIBs were financed by resorting to treasury bills (TBs). However, even the mobilization from TBs were insufficient and the gap was filled by the SBP. More disturbingly, the mix of TBs and PIBs has shifted in favor of TBs, posing a significant refinancing risk as well as ever-increasing dependence on borrowings from the SBP.
This has led to a massive increase in government borrowings from the SBP. On 30-11-2018, government debt to SBP stood at Rs 6.7 trillion. This was merely Rs 1.4 trillion as on 30-6-2016, implying a five-fold increase. During the same period, the stock of investments in PIBs declined from nearly Rs 4.2 to Rs 3.1 trillion, registering a divestment of 26% in PIBs. On the other hand, investments in TBs rose from Rs.5 trillion to nearly Rs 10 trillion as on 31-10-2018. The share of short-term debt has risen beyond safe limits. This was also noted by the debt risk report for June 2018, where the shares of debt requiring re-fixing of interest rate and re-financing have both crossed the upper limit of 65% (against the band of 50%-65%) set by the government in its debt management policy, since both have crossed 66%.
This disruption is essentially a result of holding the policy rate constant for much longer than was warranted, particularly when the government was witnessing serious depletion in reserves on the face of rising fiscal and current account deficits. The policy rate was lowered, on the back of persistently low inflation during 2014-16, to a historic low of 5.75% in September 2015 and was held there until January 2018, when it was raised by 25 bps. Clearly, this was not in line with market expectations as the auctions kept producing no result for government to accept. What is most striking, and somewhat puzzling, is the fact that despite raising the policy rate by another 400 bps during the rest of the year, the market has remained as tepid as it was at the start of the year. It seems the policymakers are significantly down the curve in aligning or catching up with market expectations. Also, it is not just a question of monetary policy; a comprehensive economic strategy is sorely missing that can elevate the confidence of the markets and investors alike.
Since the economy was booming during the period 2016-18 (the growth rates of 5.3% and 5.8%, respectively, were highest in at least a decade) the low returns on government treasuries prompted banks to divest their investments both to retire SBP borrowings as well as increasing the funding for non-government/budgetary financing. Banks divested their investment in government securities from Rs 6.7 trillion as on 30-6-2016 to only Rs 3.9 trillion, which is a sizeable decline of 42%. On the other hand, the credit to private sector saw a remarkable growth of 45% as it rose from Rs 4.0 trillion to Rs 5.8 trillion. An avenue that could have lessened government borrowing from the central bank was foreign borrowing. However, not much was accomplished on this account during 2018.
The demand for budgetary support, in the meanwhile - as we noted earlier also - has shifted to central bank. But this means that the government is monetizing the debt, a trend that could unleash explosive inflation.
But there is a deeper concern that the government would like to address. This relates to the application of basic principles applicable to debt management, which are being compromised. When designing the system of auctioning public debt, the government desired to raise it borrowings on the most competitive basis. The systems of primary dealers and secondary market are all linked to regularly testing the sentiments of the market and to finance budgetary needs in the most inexpensive manner. It was also envisaged that the government would not resort to borrowings from the central bank except sparingly and primarily for ways and means purposes.
A limitation to this effect has also been imposed under Section-9C of the SBP Act, 1956, which says: "(1) Notwithstanding anything contained in sections 9A and 9B, the Federal Government borrowing from the Bank shall be such that at the end of each quarter they shall be brought to zero barring the ways and means limit that shall be determined by the Board from time to time; (2) The debt of the Federal Government owed to the Bank as on the 30th April, 2011, shall be retired not later than twelve years from that date; (3) If any of the provisions of sub-sections (1) and (2) are not observed by the Federal Government, the Finance Minister shall place before the Parliament a statement giving detailed justification for the said failure." Incidentally, however, all these provisions, at present, are non-compliant.
It is not just that there is a statutory non-compliance, the more profound happening is that the bond market has broken down. The access to central bank borrowing is used as an instrument to subvert market outcomes. In the absence of any collusive behaviour on the part of the primary dealers (bidders), or the need for some occasional erratic responses from the bidders, government cannot refuse the bids on a persistent and perpetual basis. This would mean we are closing down the market. Banks would invest in government securities only to the extent of meeting the statutory liquidity requirements. Central Bank would keep injecting high powered money (M1) to finance budgetary needs, which would expose the economy to rising inflationary pressures.
This is an untenable strategy which would have to be stopped, and earlier it is done the better it will be. But imagine the pain and upheaval that the market will have to endure when the market would be reformed. When an IMF program will be signed - which is inevitable, no matter how longer it is delayed - the required performance criteria, as in the previous program, would call for rapidly bringing down SBP debt, to let us say to Rs.2.0 trillion within two years. To achieve this, a significant rate adjustment would be required before banks would return to invest in the long-term government paper.
Before closing, we also note with concern that the office of the Director General, Debt Management Office, is vacant now for some time. This is one area where stakes are very high, as mis-steps would have major cost implications. At a juncture where bond market requires major repair job, the government cannot afford to risk some internal disorder. Accordingly, manning the debt office with the appointment of a DG and other analysts and experts is imperative.
(The writer is former finance secretary)
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