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BR Research

Financing options

The government budgeted deficit financing is skewed towards foreign flows. The benefit is twofold. One is to lower t
Published December 17, 2019 Updated December 19, 2019

The government budgeted deficit financing is skewed towards foreign flows. The benefit is twofold. One is to lower the reliance of government financing on domestic banking sources to create private credit space. The other plus point is that the foreign competition increases the liquidity to push down the market rates.

The government has budgeted Rs 3,032 billion fresh external loans in FY20, and accounting for repayment of Rs1,204 billion, the net amount stands at Rs1,829 billion. The domestic financing is budgeted at Rs1,308 billion and out of it, only Rs339 billion is from domestic banking sources.

Last year, government financing from domestic banking sources was Rs2,263 billion and FY09-19 annual average was Rs952 billion. If government achieves the target and continues reliance on foreign funding, rates could easily be lower than the SBP policy rate. This happened in 2002-04 and history could repeat itself in 2021-23. However, for bringing rates down substantially, curbing fiscal deficit is the key.

The interesting angle is that in the budget, there is no financing allocated for foreign portfolio investment in government papers. That is the icing on the cake. This gives government the room to not knock on the doors of global commercial banks for budgeted amount of Rs450 billion (roughly $3 bn). Portfolio investment can fetch a higher amount.

At this juncture, around $1.2 billion has come in. Initially the amount was coming in 3M paper and increasingly, the flows are pouring in higher tenure (12M TB). The next step is to invest in long term papers (permanent debt). The wait is on resolving the tax glitches.

The total marketable securities are around $57 billion and lion’s share (around 80%) is domestic commercial banks’. The foreign portfolio money of $1.2 billion is not even 2 percent. In equity market, foreign holding is around 28- 30 percent of free float. Based on it, the potential of portfolio investment in debt securities is around $15-17 billion.

Portfolio investment is better than commercial loans. The portfolio investment’s interest is paid in rupees and government has to pay this invariably – be it domestic banks or foreign hedge funds. With foreigners coming in, the competition should bring the rates down – beneficial for government. In commercial loans, the servicing is in USD and rates are higher.

The risk of portfolio investment is of it flying out in no time. That usually happens when a crisis hits the market. The crisis comes when economic fundamentals become weak, such as higher twin (fiscal and current account) deficit. Historically, the twin deficit remained in control under IMF programmes. Recently, the deficit started souring from Oct-16, right after successful completion of the Fund programme.

Now, if the portfolio investment keeps coming in., the government and SBP will have to be on toes to not let the fundamentals worsen. If they manage to keep deficits at manageable levels, the portfolio investment is likely to be sticky. There is no room for complacency.

The external budget financing in FY20 is also relying on Sukuk/Euro Bonds of Rs300 billion (around $1.5bn). The government has yet to touch this as other flows are pumping in. Either the government is waiting for fundamentals to improve further to potentially lower the rates or to simply rely on portfolio investment. Shelving Sukuk/Euro bond might not be a good idea. The government should diversify its foreign debt basket.

The other flows from multilateral agencies and bilateral friends are imperative. These are usually long term and concessional. Lower the rates, lower is the debt servicing burden and long term also carries low repricing risk. Government got $1.3 billion from ADB – which is not budgeted. Another Rs165 billion (around $1 bn) is budgeted from Islamic Development Fund, which is yet to come.

The government has budgeted RS750 billion (around $5 bn) from friendly countries. Reportedly, government is trying to convert deposits from other central banks (at $6.2 bn as of Sep-19) to loans. This will ease the pressure on Net International Reserves (NIR). NIR is usable reserves and one of the binding target of IMF. This will strengthen the intrinsic reserves. More on it later.

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