Over the past few months, there have been concerns about Pakistan’s debt framework, given funding concerns in the face of delayed IMF reviews, tightening of global liquidity conditions and continuous fiscal slippages. Consequently, the country’s credit rating was recently adjusted downwards by International Credit agencies (Moody’s and Fitch), to reflect the inherent risks, leading to rising debt costs internally and externally. This has led to increased market chatter suggesting restructuring of domestic debt, with options like haircut, extensions and reprofiling doing the rounds.
What is domestic debt restructuring?
Domestic debt restructuring refers to the process of reorganizing or modifying the terms and conditions of a country’s outstanding domestic debt obligations, such as government bonds or treasury bills. This is usually done in response to a country’s inability to meet its debt obligations, often due to economic challenges or financial crisis. The restructuring may involve changes to the interest rate, the maturity date, or the principal amount of the debt, and may also include debt forgiveness or debt-for-equity swaps. The goal of domestic debt restructuring is to make the debt more sustainable and manageable for the government, while minimizing the negative impact on the economy and the country’s financial system. Domestic debt restructuring can be a complex and challenging process, involving negotiations between the government, creditors, and other stakeholders. It can also significantly affect the country’s credit rating, financial stability, and access to international capital markets.
Three fundamental questions need to be answered
In order to determine whether Pakistan should undergo domestic debt restructuring, which could materially ease the debt burden on the economy, one needs to answer three fundamental questions in our view:
§ Is Public Debt to GDP unsustainable or fast approaching those levels?
§ How robust is the financial system to withstand any restructuring exercise?
§ Can we identify and mitigate the social and economic costs?
Is Public Debt to GDP unsustainable or fast approaching those levels?
Pakistan’s domestic debt as of Dec’22 stands at PKR 33.8trn (45% of GDP / 53% of total debt) which has more than doubled over the past 5 years while total public debt is set at PKR 52.5trn (73.5% of GDP). Taking a closer look at some of the major domestic debt restructuring episodes globally over the past few decades, the median public debt to GDP levels pre-restructuring was 70% while share of domestic debt in total averaged 37% (Source: IMF). Pakistan’s existing debt remains higher than average on both of these key metrics.
Moreover, if we look at debt sustainability from a debt servicing angle, Pakistan’s domestic debt servicing is estimated at close to PKR 5.6trn in FY23 (constituting 76% of FBR revenues). While these statistics are indeed concerning, the devil actually lies more in the detail (i.e., the structure of the federal fiscal account). Given the inability of the federal government to expand its revenue base, improve tax administration and recovery and/or reduce expenditures including adequate resolution of loss making SOEs, the medium to long term outlook for the fiscal account appears challenging. This, along with already high public debt levels, equates to a potential debt trap which needs addressing sooner rather than later.
One way to do so would be to revisit the National Finance Commission (NFC) award distribution, which allocates resources between the federal government and the provinces. Following the NFC award of 2010, approximately 58.5% of direct tax revenues are transferred directly to the provinces leaving the federal government with revenues (including indirect revenues) of paltry 5.3% of GDP. With estimated debt servicing obligations of 7.3% of GDP (of which 89% is domestic) and record high interest rates in play, the federal government ends up with a sizeable budget deficit prior to any spending on defense (1.8% of GDP), administrative expenditure and development expenditure. Given the current fiscal situation of the federal government in Pakistan, it may be worthwhile to consider revisiting the revenue-sharing ratio set forth by the NFC award of 2010. With a significant portion of tax revenues being transferred directly to the provinces, the federal government’s fiscal space is limited, particularly when coupled with high debt servicing obligations and record-high interest rates. One option could be to reassess the revenue-sharing formula and potentially revise it to allow the federal government to retain a larger share of the tax revenues. Alternatively, the government could explore options to share expenses with the provinces to help ease the financial burden. Additionally, improving provincial surpluses by increasing revenue collection and improving financial management can also play a significant role in reducing the debt burden.
Rationalizing federal expenses by keeping only the essential federal ministries and transferring other responsibilities to the provinces, can help Pakistan reduce its expenses significantly. Finally, implementing a system of monitoring and evaluation for federal and provincial expenses could help to ensure that resources are being used effectively and efficiently. These measures can go a long way in resolving Pakistan’s rising debt issue, ensuring the country’s financial stability in the long run.
Courtesy- AHL Research