Circular debt was passed on by Pervez Musharraf's financial team that was also responsible for planting the seeds of government borrowing. When the PPP government took-over, they faced a mammoth left-over amount in the shape of government borrowing, which was close to Rs 600 billion that included energy related stock issue and other subsidies.
Recently, GoP team took a bold initiative to overcome and resolve the circular debt problem and suggested a new master instrument of Rs 270 billion to settle the existing loans of power companies.
It is highly important to properly understand and cautiously differentiate the issue involved, as it consists of two parts: one is available stock that needs to be settled and the other is flow, which requires timely price adjustments. The lingering stock of circular debt has choked the balance sheets of banks and borrowing ability of the energy companies.
Therefore, it is required to first address the stock issue and provide relief that translates into the funding of Rs 300 billion so that balance sheets are freed from obstruction. The unclogging of balance sheet will provide breathing space to all parties involved and then it is simultaneously required to keep a regular check on the flow that could range between Rs 80 billion and Rs 100 billion in pipeline. Flow requires constant monitoring because of pricing issue, leakages, structural mismanagement and corruption. It is believed that government has better control on the monthly flow that has reduced to Rs 6-8 billion from Rs 18-20 billion.
The GoP has offered two options to banks - PIBs and GoP Bonds. Option "A" is PIBs for Rs 270 billion that offers 3 instruments of 3, 5 and 10 years for equal to 20 percent, 30 percent and 50 percent facility amount, respectively. The biggest advantage of having PIBs is that it will be eligible for SLR.
Option "B" is for Rs 270 billion GoP bonds for 3, 5 and 10 years equivalent to 20 percent, 30 percent and 50 percent facility amount respectively, but it may not qualify for SLR. Presently, SLR for PIBs is 10 percent of the Demand and Time Liability (DTL) and 15 percent of the total issued. Since the size is huge many banks would also demand for an increase in 10 percent SLR of PIBs.
Considering the risk factor this is not as simple as it may sound. Banks have plenty of questions to raise at ALCO/Board level meetings, as banks treasuries cannot take decisions to invest in such a huge amount. The average life of combined three instruments could be roughly 7 years and a 1 percent move either way could mean a shift of Profit/Loss of Rs 28 billion on Rs 270 billion instrument.
The advantage of PIB is that it's a straight plain vanilla transaction until maturity. The return will be fixed, as the banks will be provided fixed coupon, the frequency of coupon will be determined later. The bigger question is: Where is the PIB going to be parked? If it is parked in Held-to-Maturity (HTM) that may suit some of the banks, as HTM does not hit banks P&L until maturity.
But if some part or even full amount is parked in Available for Sale (AFS) that could give some hope to banks that may be looking to get rid of the government paper, but AFS means that they need to offload the security within 90 days. Imagine where the market would close if banks sell PIBs just before the expiry of 90 days. The yield would surely hit the sky. Another disadvantage could be that since banks' liability books are adjusted on monthly, quarterly or six-monthly basis on market-to-market basis, this would distort banks' balance sheet at the time of maturity unless yield remains unchanged, which is not possible.
It is worth mentioning that during the era of Dr Ishrat Hussain, banks were given a special permission to shift Rs 85 billion to HTM to avoid capital erosion that caused huge damage to the debt market.
Similarly, quite a few banks would prefer option "B" that offers GoP Bond, as the profit is based on floating rates. Since, banks liability books are generally fixed on monthly, 3-monthly or 6-monthly basis, floating rates provide banks space to make Downward/Upward adjustments on market-to-market basis and that may not distort banks' balance sheet.
There are many disadvantages of GoP Bonds, as pricing will not be based on PIBs pattern. Nor is it likely to be eligible for SLR, unless special approval is given. GoP Bond pricing has been offered on floating rates based on 6-monthly T-Bills plus 15 basis point premiums, unlike earlier Public sector TFCs of Rs 85 billion that was offered to Power Holding Company Ltd (PHCL) at KIBOR + 2 percent and another amount of Rs 98 billion was offered at KIBOR + 2.75 percent.
The biggest disadvantage of having GoP Bond would be that there is no market for this paper and hence banks will have to hold the paper until maturity. This would also lead to the creation of new paper in the current system. History suggests that banks remained badly stuck with government bonds.
However, it makes no sense to offer premium on government paper. Banks are already minting money through exorbitant spread of earnings as the cost of savers. Premium will put further pressure on domestic debt, which also means more burden on tax payers.
Major banks do not have any other option and are the weak link, because when government issues a paper it becomes part of fiscal deficit. By refusing banks have two types of risk, firstly banks will be left with excess liquidity and the bigger risk could be that they could see a shift in government deposit to another accommodating bank. Total deposit amount is something around Rs 850 billion of which the government has Rs 350 billion, provinces' share amounts to Rs 300 billion and public sector contributes Rs 200 billion.
This is no more a big issue as this should be taken in the coming budget. It should be taken as a part of fiscal deficit against, which PIBs should be issued.
The bigger issue could come at a later stage when the bank accounts of power holding companies will be settled and they would once again approach banks for fresh loans. Loans are given based on a customer's balance sheets and its credit history.
Meanwhile, total outstanding stock is Rs 2.51 trillion out of which MTBs Rs 1.755 trillion, PIB Rs 577 billion and Sukuk Rs 178 billion. Treasury heads will be meeting today (Monday) to discuss the pros and cons of the MoF offer. Every bank will try to push its own demand based on their interest and will try to protect their banks interest. Major banks are aware that they cannot refuse MoF suggestion.
This meeting is likely to be followed by participating banks CEOs and presidents in the coming days. Banks net Circular debt position.

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HBL         Rs 58
          billion
NBP         Rs 47
ABL         Rs 28
UBL         Rs 25
MCB         Rs 20
BAF       Rs 19.7
SCB       Rs 13.3
ASK         Rs 10
SLIC         Rs 8
BAH        Rs 7.7
EOBI         Rs 7
FBL        Rs 4.7
HBM          Rs 4
BOP          Rs 4
NIB        Rs 3.7
CITI       Rs 2.2
SON        Rs 1.2
Silk     Rs 0.867
KASB     Rs 0.807
HSBC     Rs 0.754
Pk Ch    Rs 0.750
A.Hab    Rs 0.750
BoK      Rs 0.489
JS       Rs 0.150
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Total   Rs 268.67
          Billion
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