The Case Against Rearrangement of Local Sovereign Debt

Co-Authored By Syed Salim Raza | Zafar Masud and Published in Dawn, July 11th, 2023

There has been talk lately about the requirem­ent of local currency debt rearrangement for Pakis­tan, necessitated by the fact that the government’s debt servicing, budgeted for 2023-24 at Rs7.4 trillion, has increased to approximately 75 per cent of total tax collection and exceeds the net revenues, after transfer to provinces, of Rs6.9tn.

Moreover, local debt restructuring could be set as a condition by external creditors if the government seeks debt relief from them. In this article, we would argue that such a move would bring only temporary gains, while possibly creating bigger problems for the economy over the immediate- to medium-term, in terms of a hit on banks’ capital, freezing of credit markets and slowing down in economic activity.

Instead, local debt sustainability can be achieved from an adjustment in our monetary policy narrative/formulation and addressing our core challenge; i.e. the design and structure of our fiscal policy.

To begin with, let us argue that local debt restru­c­turing is out of question, as it would entail an explicit write-off, which can’t be done given the quantum of this sovereign debt to the banking sector (estimated at 85pc of bank deposits) alone.

Any such move would have ext­re­m­ely negative implications on dep­o­sitors, investors and the ove­rall banking system; small- and medium-sized banks may struggle to survive.

This is not the situation in the case of the three other countries currently going through the process of local currency debt rearrangement — Ghana, Zambia and Sri Lanka.

For example, the exposure of Ghanian banks to sovereign debt is only 40pc of total bank assets. Therefore, any discussion in this context could merely be done on reprofiling, as it seems to be the only acceptable option in case of bilateral debt. In the case of local currency, reprofiling across the board would make little economic sense. An adage, made popular by American economist Tho­mas Sowell, comes to mind: “There are no solutions, there are only trade-offs”.

Any local currency rearrangement without comprehensive restructuring of our fiscal account will be short-lived. And if we’re ready to take the bull by the horns and tackle our fiscal account deficiencies on both sides of the equation, i.e. revenue and expenditure, then no such rearrangement would perhaps be necessary, and our debt servicing will become palatable, if not immediately then over time, depending upon the extent of restructuring of fiscal account contemplated or undertaken.

While universal local cu­r­rency sovereign debt rea­rrangement doesn’t make sense, there may still be isla­nds of opportunities. For ins­tance, in 2019, the government reprofiled all its debt that was held by the State Bank of Pakistan (SBP) to longer tenor instruments, which fits the bill perfectly when there’s an inverted yield curve. Interestingly enough, we’re experiencing that at the moment.

A reduction in interest rates will bring significant savings on the public exchequer, which will outweigh any temporary gains from an all-encompassing local sovereign debt restructuring. We estimate that the government’s debt servicing costs will decline by Rs400 billion for every 1pc reduction in interest rates.

The fundamental reason for the sharp increase in our debt servicing costs is the truculent hike in policy rates from 7pc in June 2021 to 22pc in June 2023. This unprecedented aggressive monetary policy tightening was premised on the framework for inflation targeting – and that too headline inflation rather than core – which led to higher policy rates in the recent past than required.

Just to put things in context, the average spread between headline and core inflation is 2.52pc over the last decade. This could translate into savings of Rs1tn based on the current debt stock.

It could be argued that core inflation is non-food, non-energy while our food and energy costs form a much bigger part of our consumption (over 60pc) than in the developed world (approximately 15pc), and that ignoring them altogether in inflation measurements may not be appropriate.

The fact remains, however, that these prices are predominantly administratively managed and any change in policy rate would not have material impact on bringing down their demand, as these items are essential in nature and contribute to inflation from the supply side.

Globally, there’s a realisation that interest rate hikes are not successful in taming inflation under the existing circumstances. Our situation is even more complex, given the unusual sovereign local debt accumulation from the banking sector. Regardless, the impact of food and energy prices in core inflation is around 30pc in our case; therefore, targeting core inflation is adequately inclusive to tackle market demand-driven inflationary pressures.

Most importantly, 70-80pc of our banking assets are in the hands of private local and international investors. Any local currency sovereign debt rearrangement will have a direct bearing on banks’ capital requirements and trigger an immediate downgrade in credit rating.

This would put pressure on their international foreign exchange requirements, as they require more dollars to capitalise their foreign branches to run smoothly, while the balance sheets of foreign investors would also come under stress.

Barring the Bank of Ceylon, none of the banks in the countries that have recently opted for local currency rearrangement have any significant presence internationally, or have significant foreign sponsors in their banking sector. Therefore, they don’t face the complications that measures such as reprofiling could pose for Pakistan’s banking sector.

The Bank of Ceylon is overwhelmingly domestically owned and state-run and its rating has recently been upgraded to ‘CC’ from ‘Restricted Default’ after it repaid overdue foreign currency obligations.

After the passage of the SBP autonomy bill, the government’s window to borrow directly from the central bank has been closed. The sole lender to the government for funding its fiscal deficit budgeted at Rs5tn in fiscal year 2023/24 is practically restricted to commercial banks. Any local currency rearrangement, therefore, would severely impede the appetite of the banks in this respect.

The banking industry in Pakistan is one of the largest tax contributors to the public exchequer, with effective taxation rates being the highest in the country and the region. A jolt to the sector’s profitability would also impair their contribution to the government’s kitty and the net benefit to the government may not be worthwhile for a hawkish move of holistic reprofiling.

There’s definitely a need to broaden the tax base to generate more resources. According to recently he Pakistan Business Council (PBC), there is a Rs1.8tn tax potential from the real estate and retail sectors, on top of agriculture, that is currently being ignored.

All these sectors happen to be provincial subjects. For comparison, the contribution of provinces in the total tax collection of India is 35pc, while our provinces stake-up merely 10pc.

There’s a need across the various federating units, even at the municipal level, to enhance their share of tax collection to meet their own spending obligations. In our view, each sector and individual must pay their due share of taxes without any exception.

Thomas Piketty, the eminent French economist, advocates a progressive tax on the wealth of individuals based on the net value of assets they control. Tax experts have advocated implementing a Minimum Asset Tax, which targets only the wealthiest individuals and businesses, and can potentially add nearly 2pc of the GDP (Rs1.9tn) towards public revenues.

In the medium- to long-run, the government has to widen its borrowing outside the banking system – distributing local currency government securities (locally and to overseas Pakistanis) via mutual funds, miniaturizing them as small as maybe in a thousand rupee unit, to be sold by microfinance banks or national saving centres, etc.

This will help the government enhance the savings rate and get a better handle on sovereign debt pricing.

In conclusion, irrespective of a demand from external lenders, if we’re willing to sort out the gaps or imbalances in our fiscal account in a comprehensive fashion, then perhaps no local currency debt rearrangement is required.

There’s a need to recalibrate the existing subsidy structure and create room to support two priorities: a) direct handouts for the poor and vulnerable using BISP or the National Socio-Economic Registry’s scorecard; and, b) extend performance based, time-bound subsidies to harness forex/export liquidity.

This is the way we can not only enhance our much-needed social spending, but also address the chronic external account issues, as all roads lead to fiscal account at the end of the day. The good news is that it’s all in our hands.

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