Public investment overshadowed by subsidies

January 31, 2013

RECORDER REPORT

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For the sixth consecutive year, the federal government ran a revenue deficit instead of a revenue surplus stipulated under the Fiscal Responsibility and Debt Limitation Act of 2005, says the State Bank of Pakistan in its annual report for 2011-12. A much delayed Annual Report, released on Wednesday, says the Budget deficit has emerged as a key challenge to macroeconomic stability.

In the five years of the present government (FY08-FY12), subsidy expenditure has consistently surpassed nominal public investment. While the power sector accounted for Rs 391 billion of Rs 500 billion spent on subsidies; Rs 33.8 billion last year was provided to public sector entities to pay salaries and pensions and to ensure that minimal services are provided by Pakistan Railways, PIA and Pakistan Steel Mills, etc.

SBP says that in fact, the shift from hydel to thermal power, the change in fuel mix from low-priced gas to high priced furnace oil; line losses from decayed infrastructure; theft; inadequate collection from billed units; inefficient generation units; uncertain fuel sources and the inability to cover generation costs, forced fiscal authorities to earmark funds to subsidise these units - it also reduced capacity utilisation in both private and public sector generating units, the SBP report adds.

The report says that although the increase in fiscal spending contributed to commercial activity, it did so at the cost of pushing Pakistan''''''''s budget deficit to 8.5 percent of the GDP. Without the one-off payment of the circular debt, the fiscal deficit was 6.6 percent of GDP. However, as the deficit was totally financed by the government, in reality overall fiscal gap stood at 8.5 percent of GDP. The size of fiscal deficit is not sustainable as it is contributing to inflation; squeezing out private investment; impacting the balance sheet of commercial banks; and could push the country into a debt trap, warns the central bank.

Financing the fiscal deficit in FY12 with limited external financing (covering merely eight percent of the fiscal gap) and non-bank financing of Rs 529.4 billion, of which Rs 229 billion came from mutual funds which also came from commercial banks due to limited primary mobilisation. National Saving Schemes (NSS) contributed Rs 142 billion. Despite the 12.3 percent increase in non-bank financing, says SBP, the stream of ongoing expenditure left the fiscal authorities with no other option but to first borrow from commercial banks and then from SBP itself and thereby breaching the SBP Act in the fourth quarter of FY12.

As per SBP''''''''s definition of public debt to GDP (it includes military debt, short-term debt and external liabilities) stands at 62.6 percent. However, according to Ministry of Finance the stock public debt has reached Rs 12.7 trillion as of end June 2012 and it is 61.3 percent of GDP.

Commercial banks'''''''' holding of government securities has increased from 16.4 percent in FY2008 of the total assets to 34.4 percent of their aggregate balance sheet in FY12; while lending to private sector has decreased from 52.4 percent to 39 percent of their total assets in the corresponding four years, says SBP.

The report says this has led to a lopsided exposure even though in the short run it gives comfort to banks in improvement of their risk weighted assets. Further, SBP says, there is no hard data to deconstruct private sector lending ie the demand for loans and what the banks are willing to lend. Bankers complain about lack of quality borrowers and correctly highlight non-price impediments to invest eg energy shortages, law and order situation, forthcoming elections, etc. Businesspeople on the other hand stress that banks are unwilling to lend out therefore charge high margins. In SBP''''''''s view, banks remain concerned about credit risks under the influence of a dormant borrower and hence increase risk margins on the private sector.

To get a better handle, a framework was developed to understand this problem, says SBP. "By anchoring the framework to the concept of counter-cyclical bank margins (which simply refer to the fact that bank margins include a premium for credit risks, and these risks are lower during a boom, and are higher during a recession)," SBP observed that in a near-recessionary environment with a dominant borrow (the government), an increase in the discount rate triggers an exaggerated increase in lending rates offered to non-prime borrowers. This sharply reduces private sector credit disbursements as the government becomes even more attractive. Furthermore, an increase in the benchmark rate only allows a partial pass-through in terms of the documented average lending rates, as non-prime borrowers are rationed out of the credit market. As banks'''''''' only focus on prime borrowers, the increase in the average lending rate is smaller, the report said.