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mtgondal · #49 Wednesday, May 30, 2007

Pakistan's Public Debt: A brief overview-II

EMMA XIAOQIN FAN

ARTICLE (May 30 2007): Public Debt in Pakistan: Pakistan entered the 21st Century with serious financial problems. Public debt exceeded 90% of its GDP, over 600% of its annual revenues, and debt servicing accounted for over half of current revenues. In 2001, Pakistan was the only country in South Asia to be classified as a severely indebted country by the World Bank.

Due to the inability to service external debt, there were two consecutive rounds of debt rescheduling by Paris Club members and one from the quasi-London Club between 1998 and 2001. Pakistan had to seek exceptional financing arrangements from the International Monetary Fund in January 1999, after facing a severe balance of payments' crisis. This outcome was the result of persistent and rising fiscal deficits, stagnant export receipts, declining worker remittances, and large current account deficits.

The Pakistan economy has experienced a turnaround since 2000. Growth has accelerated, and most macroeconomic indicators have improved. Public debt indicators have also shown significant improvement.

Modest growth in public debt, coupled with the strong growth in nominal GDP, led to a significant fall in public debt to GDP ratio, from 81.4% in 2001/02 to 56.1% in FY 2006 (Table 1). Over the same period, domestic public debt to GDP ratio fell from 40.4% to 29.9%, while the external public debt to GDP ratio fell from 41.0% to 26.2%. In fact, FY2005/06 is the fifth successive year that the public debt to GDP ratio has improved. This is also the first time in more than two decades that the ratio has fallen below 60%. The Fiscal Responsibility and Debt Limitation Act, 2005 envisaged a debt to GDP ratio of 60% by FY13. The actual achievement has thus exceeded the target in the Act (IMF 2006).

The improvement in the public debt to GDP ratio in FY06 was due to the fact that both domestic and external debt grew slower than GDP. The growth in domestic debt has been slightly faster than that of external debt. It rose by about 5.9% while external public debt grew by about 5.0% relative to the previous year. Total public debt stock stood at around $72 billion, about 5.5%, higher than the previous year, of which domestic public debt consists of about $38 billion. As a result of a stronger rise in domestic debt, the share of external public debt in total public debt decreased from 50.4% in FY2002/03 to 46.7% in 2005/06.

The debt servicing capacity of Pakistan has also improved over the past few years. As growth in foreign exchange earnings in Pakistan outpaced the growth in debt servicing payments, external public debt servicing as a share of exports of goods and non-factor services declined from 35.8% in 2001/02 to 14.1% in 2005/06. The external debt service to gross reserves ratio has declined from about 70% in 2001/02 to over 20% in 2005/06. International reserves act as a cushion against fluctuations in foreign exchange earnings.

Pakistan's external debt is predominately long and medium term debt. Over 99% of public and publicly guaranteed debt is over one year. Pakistan acquired about US $3.3 billion long-term loans in FY 2005/06, of which about $1.7 billion reflects the long-term flows from ADB and the World Bank.

While approximately $1.7 billion in loans were committed by international donors for the earthquake fund in 2006, the actual disbursement was limited to US $768 million, of which $673 million of the disbursement came from the ADB and World Bank. The remaining multilateral loans disbursed in FY06 were mainly to support poverty reduction and economic reforms.

The ADB disbursements in FY06 included $60 million and 70 million for social services programs to the Punjab and Sindh Governments respectively to improve the quality of human capital, specifically in education and health. Another ADB loan of $80 million was disbursed under the financial markets and governance program. Punjab received $199 million from the World Bank for education sector reform. The World Bank also disbursed a loan of $102 million for Punjab irrigation/policy-II and $69.5 million for NWFP (SBP 2005).

Clearly, the loans from the ADB and the World Bank play an important role in the government's external debt financing. The relatively high share of the multilateral loans calls for sound program/project design and implementation in order to yield the maximum benefits to the country. Indeed, the multilateral development banks are the largest creditors for Pakistan's external public debt, totalling about 51% of total public external debt in FY2005/06.

This is followed by the Paris club which accounts for about 39%. In recent years, the outstanding stock of Paris club debt declined, partly due to debt write off. Debt from other sources has been relatively small. Despite this, activities from bilateral agencies have also increased.

Pakistan also accessed the international capital market to raise funds through the issuance of Euro Bonds in FY 2006. This raised $800 million which consists of 10-year bonds of $500 million and US $300 million in 30-year bonds. The issuance of the Euro bond not only addresses the government's finance needs, but also helps to establish a long-term sovereign benchmark that would help local corporate enterprises access global markets.

4. FACTORS UNDERLINING THE IMPROVED DEBT INDICATORS IN PAKISTAN AND ISSUES The improvement in the debt indicators reflect acceleration in economic growth, improvement in fiscal conditions, increases in export earnings, and higher capital inflows. In particular, external conditions have become more favourable to Pakistan since September 2001. This has enabled relief of public debt amounting to about $3.7 billion between 2001 and 2003.

Coupled with debt rescheduling, this has significantly reduced Pakistan's debt servicing burden. There have been increased official transfers, especially between 2001 and 2004. Total official transfers amounted to about $4.5 billion from 2001 to 2006. Workers' remittances have also increased significantly, averaging around $4 billion a year during 2003-2006 compared to about $1.5 billion in the 1990s. These factors have reduced the need for external borrowing.

There has been a particularly noticeable increase in foreign direct investment (FDI) in Pakistan in recent years, reflecting the country's privatisation programs and increased investor confidence. FDI rose from $483 million in FY2002 to $3.5 billion in FY2006. The first half of FY2007 saw a further 64.6% increase to $1.9 billion.

The sale of the Karachi Electric Supply Company and the partial sale and transfer of management control of Pakistan Telecommunication Company Limited revitalised the privatisation process in 2006. FDI inflows, excluding privatisation, also rose by 70% in 2006. Strong foreign demand for Pakistani assets (including from oil-exporting countries in the Gulf region) was also reflected in the favourable terms for new bond placements in international capital markets. The FDI and other capital inflow have more than offset the current account deficit, and resulted in payments surplus of over $1 billion in 2006.

While Pakistan has significantly improved its economic performance and the debt situation, strong efforts must be made to guard against potential risks. First, the improved debt indicators in Pakistan are closely linked with favourable external conditions. To sustain sound economic performance over the long term, Pakistan must maintain political and economic stability.

Economic reforms must go on apace to sustain and improve domestic and foreign investors' confidence. A sound policy environment that attracts sustained FDI inflow is particularly important given that FDI involves long term financing and is not susceptible to sudden withdrawals. Creating a conducive policy environment for increased domestic investment is also a key.

Second, coupled with strong capital inflow, the current account deficit has increased since 2005. In FY2006, the current account deficit, excluding official transfers, more than tripled to $5.7 billion, or 4.4% of GDP as import growth outstripped export growth because of higher oil prices and strong domestic demand.

Privatisation proceeds, official grants, and portfolio investment together financed 45.3% of the current account deficit. The rising current account deficit per se is not necessarily a problem. For example, strong domestic capita formation can lead to increased demand for capital goods financed by capital inflow.

Singapore had run current account deficit for more than 10 years during its rapid industrialisation period. To a certain degree, a current account deficit and balance of payments surplus indicate the strengths of the domestic economy and the confidence of foreign investors in the domestic economy.

However, increased current account deficits raise concerns about the sustainability of financing large deficits in the medium and long term if the capital inflow is not significantly contributing to the increased productive capacity and efficiency of a country.

Third, the large inflow of official assistance and workers' remittance also poses the risks of Dutch Disease in that high capital inflow can lead to real exchange appreciation, rendering domestic tradable sectors, especially the manufacturing sectors, less competitive. The utilisation of foreign aid thus must be geared towards spending on increased productivity and to provide a conducive environment for private sector development while avoiding the fostering of a bloated public sector.

5. CONCLUSIONS: This note briefly reviewed public debt information for Pakistan. It reveals a number of important features. First, the public debt situation is closely related to broader economic performance. Accelerating economic growth, improving fiscal conditions, increasing export earnings, and increased foreign direct investment have provided the foundation for improved debt management in Pakistan.

Second, the improved debt situation is also attributable to more favourable external conditions for Pakistan since September 2001. This has led to debt relief and rescheduling, and increased official inflow and workers remittances.

While it has helped the country to achieve a significant improvement in debt indictors in the short run, it also exposes Pakistan to risks relating to the sustainability of both economic performance and debt management.

Third, in order to sustain and build on its existing achievements, Pakistan needs to deepen its structural reforms to improve the domestic investment environment, external competitiveness, sustain macroeconomic stability, and maintain political stability.

Reforms that improve a country's creditworthiness and investment climate are important for improving domestic savings and investment, attracting FDI, and diversifying the financing sources.

FDI is especially important because it not only brings in finance, but also contributes to technology transfer and improved management know-how. Pakistan has had considerable success in attracting FDI in FY06. However, much can be done to improve on this performance in the years ahead.

Fourth, sound public debt management supports macroeconomic stability and economic growth. Debt management should take advantage of favourable economic conditions to strengthen the technical and institutional capacity in managing public debt.

Fifth, multilateral development banks play an important role in lending to the Government. This calls for sound project and program designs and implementation to enhance the effectiveness of development assistance. Introducing innovative and efficient assistance approaches and practices in response to the changing context of economic development is especially important.

The recent economic development and developments in external debt show that Pakistan is at a cross road. The strong economic performance, including the improvement of the public debt situation over the past few years, if sustained, can put Pakistan on a sustained growth path. But there are real challenges and risks that need to be managed carefully. Maintaining political stability, sound macroeconomic management, and structural reforms are key for Pakistan to move forward.