Pakistan's Debt Dynamics: Less External Debt, Please!

Every once in a while, an ‘expert’ will expound their belief in various news media that Pakistan’s debt, especially domestic debt, should be restructured. What’s the key evidence or theory backing their arguments? Nominal figures stating the government could save an X billion amount of dollars in debt servicing.

These flimsy arguments are comical, to say the least. Another frequently cited statistic is that each 100-bps cut in interest rates saves the Pakistani government an estimated Rs 250bn. The interpretation of these figures totally misses the mark and primarily suffer from money illusion. Debt and its servicing costs cannot and should not be seen in nominal terms, alone.

Firstly, debt only has to be restructured when the borrower is unable to fulfil its financial obligations. When a borrower faces difficulty in making debt payments, creditors give concessions entailing a change in the payment terms (reduction in interest rate or extension of maturity) or a write-down (partial waive off) on the principal. This is done to avoid a costly bankruptcy case in the event of a default.

When it comes to domestic debt, the government is not close to this scenario at all as the SBP provides adequate liquidity to meet the government’s borrowing needs. Moreover, commercial banks are happy to continue funding government borrowing.

The need for domestic debt restructuring only arises if banks (or other financial institutions) decide not to fund government borrowing which could only happen due to a crisis of confidence. Historically, there has never been domestic debt restructuring which is why that crisis of confidence has not arrived.

However, hypothetically, if the government were to restructure domestic debt today, a crisis of confidence could arise in a future high debt-to-GDP ratio scenario. Which is why talks of domestic debt restructuring must not be taken lightly.

But what about the factor that really matters? Debt dynamics of domestic and external debt work differently for several reasons.

The above equation shows the domestic debt dynamics. The change in domestic debt-to-GDP ratio depends on a few key variables – real interest rate, growth rate, and primary balance. If r > g, debt-to-GDP escalates. Meanwhile, if the primary balance is negative (i.e. a primary deficit), then the debt-to-GDP worsens too.

Historically, real interest rates have averaged out around 0.1%-2.7% (depending on the choice of time period), while long-run growth rate of the economy has been 4.7%. So, in Pakistan, g > r by far which is positive for domestic debt dynamics. Implicit in this is the fact that the government has deflated its domestic debt over time – r has been low due to high inflation and central bank non-independence. Meanwhile, primary balance has been -0.5% of GDP since 1992 – which is not a good thing (IMF).

However, when you run these figures together in the equation, the total impact on domestic debt-to-GDP ratio has been negative – meaning domestic debt is sustainable or falling (in real terms).

Among this, there is an assumption that government revenues grow at the rate of nominal growth rate of the economy. Even that assumption mostly holds as nominal growth rate has been 13% while tax revenues have grown 12% over the past decade, for instance.

When it comes to external debt, the situation becomes murkier. To pay off external debt, the government does not only require tax revenue but adequate foreign reserves. Moreover, exchange rate shocks can escalate external debt payments (in local currency terms).

In the above equation which shows external debt dynamics, pcb stands for primary current account balance, while △res stands for change in reserves. In Pakistan’s case, interest rate on foreign debt r* has been 3.6% historically – much higher than that on domestic debt. Furthermore, the particularly troubling part is that this is only brought down due to concessional multi or bilateral lending.

The interest rate on commercial borrowing and bonds are usually 5% or above even in supposedly good times. Moving on, primary current account balance has been -1.9% of GDP since 1980. Even if you take out the effect of change in reserves (which is likely negative), the impact on external debt-to-GDP turns out to be positive – meaning external debt is rising in real terms or unsustainable.

This is some simple arithmetic which tell the true story of Pakistan’s debt dynamics. This is why when the Pakistani government restructured its debt in the 1970s and early 2000s, only external debt was restructured and not domestic debt. The math and some history speak for itself.