Looming debt trap

The government is fast falling into a domestic debt trap; sooner it is fixed, the better it is. With government by far being the biggest client of the banking system in Pakistan, any change in interest rate has significant impact on government debt servicing. Higher the rate, higher is the servicing and to service future debt, more debt has to be accumulated today.

Asad and team have to have the realization that the adverse impact of having 400 bps plus real interest rate on fiscal balance is higher than any benefit to be accrued on lowering current account deficit through demand management. History suggests that higher fiscal deficit leads to higher current account deficit; and higher interest rates lower economic growth and impedes employment generation potential.

The objective of higher interest rates is to manage demand for curtailing external imbalances and to keep inflation in check. Inflation in Pakistan is not too high as despite over 30 percent currency adjustment, the CPI is hovering around 6-6.5 percent and even core inflation is not anywhere close to discount rate. For details read “inflation to remain in single digit”, published on 18th October, 2017 - food, and other commodity prices in Pakistan are already higher than the world. With lower oil prices outlook, the inflationary expectations are lowering too.

On external account, the currency adjustment, crackdown on money laundering and smuggling, and higher duties and other non-tariff barriers on non-essential imports (automobiles, cell phones etc) are compressing imports. The import reduction is lowering the FBR tax potential as in FY18, 43 percent of federal taxes were collected at imported stage. For details read “import compression and taxation”, published on 16th January, 2019.

The marginal benefit of interest rate hike is diminishing on controlling inflation and lowering current account deficit. However, the adverse impact on fiscal account through higher domestic debt servicing is profound. Higher rates also make it difficult to stimulate private sector investment and government has to give higher interest subsidies to incentivize export oriented and innovation seeking investment. This would further put pressure on the fiscal balance.

Domestic debt servicing as percentage of tax revenues grows in days of higher interest rates and vice versa. The ratio has gone up to an alarming level in 1QFY19 where the 6M-PKRV averaged at 7.8 percent versus average of 6.2 percent in FY18. The average has gone up to 9.7 percent in 2QFY19 and the impact on debt servicing would be visible in the fiscal numbers, which are yet to be published.

The market pulse is that interest rate is close to its peak and the cycle may start reverting by end of 2019 or start of 2020. This, on the face of it, dilutes the impact of higher interest rates on domestic debt servicing as the cost on short term papers may come down within 12-15 months.

However, the catch is in dealing with the long term papers where the recent cut off yields on PIBs suggests the MoF lacks skill to handle debt. For details read “Debt pricing - far from ideal”, published on 2nd January, 2019. The domestic debt servicing increased by 61 percent in 1QFY19 from 1QFY14; but the interest rates started falling from FY15 onwards. The anomaly is due to locking in PIBs at higher rates during 2014.

The bottom line is that domestic debt servicing reached Rs461 billion in 1QFY19 and this may cross Rs500 billion in 2QFY19 - the rate could take the full year domestic debt servicing to Rs2 trillion. The domestic debt servicing as percentage of GDP is 3.85 in FY18 and the number may be north of 4 percent in FY19. The story of total debt is not much different and the country is falling back into a debt trap. It is time the MoF gets its act together.