EDITORIAL: Pakistan’s federal government debt reached Rs81.9 trillion by end-May 2026. The number is large, but the more important issue is the system that keeps producing and absorbing this debt. The state borrows heavily from domestic banks, banks build profitable balance sheets around sovereign paper, and the central bank is left managing liquidity in a market increasingly organized around the government’s financing needs.
Central government debt increased from Rs77.9 trillion in June 2025 to Rs81.9 trillion in May 2026, an increase of Rs4.1 trillion in eleven months. Domestic debt rose from Rs54.5 trillion to Rs58.1 trillion, accounting for most of the increase, while external debt in rupee terms moved from Rs23.4 trillion to Rs23.8 trillion. The increase is largely domestic in origin. That should not be read as comfort. The issue is domestic concentration.
Domestic debt reduces foreign-exchange exposure, but shifts vulnerability into the domestic financial system. A sovereign that relies heavily on domestic banks may face lower immediate external financing pressure, while deepening fiscal dominance at home. Bank balance sheets become increasingly exposed to the state, the government securities market becomes central to liquidity management, and private credit becomes a residual function rather than a core function of financial intermediation.
The IMF has also been flagging this problem through the sovereign-bank-central bank nexus. Pakistan hardly needs an external diagnosis to see the loop. The government runs large financing needs. Banks absorb a significant share of government securities because sovereign paper is liquid, scalable, regulatorily convenient, and commercially attractive. The central bank then manages the liquidity, collateral, and monetary-policy consequences of a system in which government debt is the dominant financial asset.
The usual crowding-out argument captures only the first-order effect. Excessive government borrowing does reduce room for private-sector credit, but the larger problem is structural. Sovereign exposure becomes the organizing principle of the financial system. Government securities are the easiest source of income, the preferred liquidity asset, the principal collateral instrument, and the reference point for money-market operations. The state becomes the axis around which banking activity is organized.
The maturity profile adds pressure. Short-term domestic debt increased from Rs8.8 trillion in June 2025 to Rs10.7 trillion by May 2026. Market Treasury Bills alone increased from Rs8.6 trillion to Rs10.6 trillion. That raises rollover requirements and leaves the sovereign exposed to refinancing and interest-rate risk. More importantly, repeated reliance on short-tenor domestic paper turns continuous refinancing into a mode of fiscal management. The underlying deficit remains unresolved; it is re-priced and rolled forward.
This creates a narrow operating loop. The deficit persists, the government borrows, banks absorb the paper, and the central bank manages the liquidity consequences. Each participant is responding rationally to its incentives. The Finance Ministry has to fund the deficit. Banks prefer high-yield sovereign exposure with low underwriting cost. The central bank has to keep the system functioning. The combined result is a financial system that becomes more efficient at financing the state than financing the economy.
Pakistan Investment Bonds declined from Rs35.0 trillion in June 2025 to Rs34.6 trillion by May 2026, while GOP Ijara Sukuk increased from Rs5.2 trillion to Rs7.5 trillion. A deeper Islamic debt market can support investor diversification and market development, but instrument switching does not amount to fiscal strengthening. The core dependence remains the same: the state continues to absorb a large share of domestic financial savings.
The external debt position looks calmer in rupee terms than the composition suggests. External debt appears relatively contained partly because the exchange rate barely moved during the period under review. There is in fact a sharp increase in short-term external debt, from Rs210 billion to Rs2.7 trillion, alongside a decline in long-term external debt. A movement of that scale should be reconciled before it is treated as a clean deterioration in external maturity risk. It may reflect timing, classification, or rollover treatment. The narrower point is still valid: the headline external debt stock is too calm a number to carry the full risk story.
The sovereign-bank nexus matters because banking-sector strength can look better than it is when profitability is tied closely to government securities. Banks may appear liquid, profitable, and well-capitalized, but part of that strength rests on the continuing assumption that sovereign exposure is practically risk-free. That assumption reduces pressure to develop private-credit capability, weakens incentives for sectoral underwriting, and encourages balance-sheet expansion around the state rather than the productive economy.
Banks do not prefer sovereign paper only because it is easy. They prefer it because the alternative is costly and uncertain. SME lending requires documentation, recoveries, collateral enforcement, sector knowledge, credit histories, and provisioning discipline. Agriculture requires cash-flow-based appraisal and field-level information. Export finance requires working-capital understanding and performance risk assessment. Sovereign paper requires an auction calendar.
The consequences extend beyond credit volumes. Banks do not build adequate appraisal capacity for SMEs, agriculture, exporters, and mid-market firms. Borrowers do not build formal credit histories. Risk-pricing remains underdeveloped. Collateral enforcement remains weak. Documentation remains shallow. The banking system earns returns and the government secures financing, while the economy continues to operate with a thin private-credit base.
The central bank dimension is equally important. The prohibition on direct central bank financing improved the formal framework, but fiscal dominance has changed channels rather than disappeared. Instead of borrowing directly from the central bank, the government borrows from banks, while the central bank manages the liquidity consequences of that borrowing. The arrangement is cleaner, but the dependence remains embedded in the system.
Expenditure reform is the other missing leg. Debt cannot be discussed honestly without discussing the expenditure structure that produces it. Interest payments are the accumulated consequence of past deficits, while those deficits reflect a fiscal framework that has struggled to rationalize recurrent spending, contain losses, discipline public-sector enterprises, and align federal and provincial fiscal responsibilities. Debt servicing is the visible symptom of a deeper expenditure failure.
The policy response has to move beyond the familiar list. Pakistan does need longer maturities, lower rollover pressure, a broader tax base, expenditure discipline, PSE reform, and better federal-provincial fiscal coordination. But the financial-sector exit from this loop requires something more specific: a deliberate shift from bank-held sovereign absorption toward a broader savings and risk-transfer architecture.
That means building non-bank institutional demand in a serious way. Pension funds, insurance companies, mutual funds, and capital-market vehicles should become larger holders of long-tenor government securities, while banks gradually move from being the permanent warehouse of sovereign risk to being originators, distributors, and intermediaries of private credit. This requires predictable benchmark supply, market-making discipline, credible secondary-market liquidity, and regulatory treatment that encourages genuine investor diversification rather than simply relabeling the same banking-sector exposure.
The second channel is private-credit market development. Pakistan needs investable private-credit paper that non-bank institutions can hold. That will not emerge by asking banks to lend more to SMEs in the abstract. It will require standardized pools of SME, agriculture, housing, export, and infrastructure credit; partial credit guarantees; first-loss structures; ratings; servicing standards; and transparent performance data. Banks can originate and service these assets, but the risk should not remain trapped permanently on bank balance sheets. A deeper market is built when credit risk can be originated, enhanced, priced, sold, and monitored.
The Rs81.9 trillion debt stock is therefore only the entry point. The larger issue is the fiscal-financial architecture behind it. Pakistan continues to run a model in which borrowing substitutes for reform, banks substitute for a deeper investor base, and refinancing substitutes for adjustment. Until that architecture changes, debt management will continue to extend the same problem across the next financing cycle.
Copyright Business Recorder, 2026
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