BR Research

Debt debate – more context!

Last week, the debt debate was contextualized beyond the absolute numbers by expressing it in terms of GDP. Some arg
Published December 9, 2019 Updated December 10, 2019

Last week, the debt debate was contextualized beyond the absolute numbers by expressing it in terms of GDP. Some argued that GDP is an arbitrary number and it could be understated. Here, debt is expressed in terms of capacity to payback - public debt (domestic and external) in terms of government revenues, and total external debt liabilities (public and private) in terms of foreign exchange earning avenues (exports, remittances and other current inflows).

The interesting finding is that right after the previous two crises (1998 and 2008), the ability to payback deteriorated in subsequent year(s) despite entering into fund programme and taking tough measures to correct imbalances. This implies that the increase in debt in 2019 is in line with historic trend, and if history is any guide, capacity to payback may improve in years to come. However, the improvement will not ensure the country to come out of frequent boom bust cycle.

The external debt to foreign exchange earnings ratio peaked at 3.4 percent in 1999, and thereafter started falling. Some say that Paris Club restricting helped the country come out of crisis. Yes, it did. The fine point is that the debt of $12.5 billion in 2000 was 98 percent of foreign exchange earnings, and today the Paris Club debt at $11.2 billion is a mere 20 percent of the foreign exchange earnings. The economic pie expanded and that component of debt became relatively small.

The external debt to foreign exchange earnings ratio thinned to 1.2 in 2006 and hovered around 1.2 to 1.5 before worsening in 2017, and is at 1.9 in 2019. The ratio has to be brought down. One way is to lower the external debt, but that will put pressure on domestic public debt burden. The other way is to enhance the foreign exchange earnings – mainly exports. The economic policies have to shift from supporting domestic demand to domestic production in efficient sectors to boost exports.

The policies were other way during Dar’s era. The industrial production declined whist services supporting domestic demand boomed. Since these services pay low taxes in Pakistan, the fiscal gap tends to increase and the pressure builds on domestic debt to finance it.

The public debt to fiscal revenues was worst in 2001 at 6.7 – two years after 1998 crisis. The situation improved till 2017 when the public debt to fiscal revenues ratio fell to 3.7. Thereafter, things went south. The ratio reached 4.8 in 2018. Last year was an abnormal year as the debt to revenue ratio sharply went up to 6.7 – almost at the level of 2001. Fiscal revenues were low last year and accumulation of public debt (including some for balance of payment support only) ballooned.

The domestic debt to fiscal revenues is at all-time high of 4.2 versus 25-year average of 2.8. The implication of this is that the domestic banking system is encroached by public financing, leaving less space for private credit. Some say that higher interest rates are lowering private credit. Yes, that is correct to an extent but the main problem is growing government debt.

Apart from the direct fiscal debt, the quasi fiscal operations are eating whatever is left in banking credit plate. The infamous circular debt is eating around Rs1.2-1.5 trillion in the form of Sukuk, TFCs and other instruments. The share of commodity finance (mainly wheat and sugar) is lower in magnitude but cannot be ignored. Not much is left for private sector lending - reduced from 27 percent of GDP in 2007 to 16 percent of GDP in 2019.

Now to have private sector led growth, domestic credit space has to be provided, avenues for capital market debt creation – both local and foreign, should be opened up. For that to happen, fiscal debt financing has to have less reliance on domestic banking sources. That is why it is emphasized to have a tilt of fiscal financing on external sources. The FY20 budget, changing the financing mix towards external sources is manifestation of it.

But that is a short-gap fix. The problem is growing public debt to fiscal revenue which has to be corrected to avert another crisis in 3-4 years. The government is relying heavily on non-tax revenues this year. But there is limited juice to be extracted from privatization, selling of licenses, government land and all. Eventually, tax collection has to increase for sustainability of fiscal side. Along with it, rationalization of expenditure is important too.

The private credit needs to be enhanced by creating space in domestic credit market, which has to be routed towards exporting sectors. The SBP credit limit for exporting sectors is enhanced, and it should be expanded to other sectors and targeted for entering into the new markets. The policies need to move away from picking winners in textile and other traditional exporting sectors.

The other element is to have FDI to lower the need of external debt for financing external imbalances. But the FDI has to move from traditional market seeking sectors to efficiency seeking. The problem of domestic seeking FDI is that part of it went out of the country in terms of buying plant and machinery and eventually the profits have to be repatriated.

For sustainably, external debt to foreign exchange earnings and public debt to fiscal revenues, need to be lowered via increased exports and tax revenues. Otherwise, the fiscal dis-saving has to be financed by foreign savings – recipe for usual balance of payment crisis.

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