Between debt and the deep blue sea

FOR each of the next five years, Pakistan owes the world $25 billion in principal repayments. It will also need at least $10 billion to finance the current account deficit, bringing total external financing needs to $35 billion a year between now and 2027. We have foreign exchange reserves of just $3 billion. For each of the next five years, the government needs to pay 5 percent of GDP to service the debt it owes to residents and foreigners. Our total tax take is only 10 percent of GDP.

Let both those facts sink in. And then quickly realise that the Centre cannot hold. For starters, there is no way we can meet our external financing needs without incurring more government debt. This is because, unlike proper emerging markets, we do not attract any meaningful FDI and our private sector does not generate inflows from abroad. However, at 78 percent of GDP, our government debt is already approaching levels considered excessive for an emerging market. As a result, borrowing abroad at a reasonable cost is getting increasingly difficult and the overhang from this debt is weighing on domestic investment, which remains stuck at 15 percent of GDP. Equally, there is no way the government can devote half its tax take to debt servicing and have enough left over to meet other critical expenses, including public wages and pensions, investment, social spending, and defence.

We could, of course, delude ourselves that everything will work out fine and try to kick the can down the road. We can pretend that we will magically grow our exports, remittances and taxes overnight while shrinking our imports and spending. In their desperation for a bail-out and to avoid admitting past mistakes on debt accumulation, there is real danger that this is what our policy makers will agree with the IMF this week. But that would be a recipe for disaster. It has not worked anywhere else in the world and it will not work in Pakistan. It would impose unbearable austerity on an antagonised population already laid low by a major cost of living crisis and political dysfunction. It would be foolish and reckless. It could spark a major social revolt.

Instead, it would be far better to call a spade a spade and accept that government debt in Pakistan is no longer sustainable. So where would this admission leave us? Our airwaves are currently dominated by a false choice between default and paying all our debts on time, even at the cost of endless austerity. But there is a third option. It involves pre-emptively restructuring our government debt, in a way that immediately and adequately frees up resources to be deployed to cushion the current slowdown and implement much needed structural reforms. We would not miss any debt repayment (the definition of a default) but would renegotiate the terms of our existing debt with our creditors such that these repayments become less onerous. While this could take some time and may lead to arrears, the IMF and financial markets would be forgiving as long as these negotiations were being conducted in good faith and would help to make our debt sustainable again.

Let us consider how this might work. My thoughts below have benefited from the excellent omnibus “Sovereign Debt: A Guide for Economists and Practitioners” edited by my friend Ali Abbas, a debt expert at the IMF. Today, Pakistan’s domestic government debt is around 50 percent of GDP and mainly held by our banks. At the same time, Pakistan’s external government debt stands at around 28 percent of GDP or $100 billion. Around fourth-fifths of this external debt is owed to the official sector, split roughly evenly between multilaterals (like the IMF, World Bank and ADB) and bilaterals (countries like China, Saudi Arabia and the United States). The remaining one-fifth is commercial, again roughly evenly split between Eurobond/Sukuk issuances and borrowing from Chinese and Middle Eastern banks. By region, we owe roughly one-third of our external debt to China and 10 percent to the old-boys network of the Paris Club, which includes Europe and the US.

In considering how a debt restructuring can be implemented, there are always two key considerations. First, which creditors to include. Second, how to distribute the debt relief evenly across these creditors, including whether to impose a haircut (a cut in the nominal value of the debt) or a lighter re-profiling (a lengthening of maturities, with no change in the principal or interest payments).

With regard to the first consideration, a key issue will be whether to include domestic debt. While it is external debt that is most difficult for us to service since it requires foreign exchange, we could create much more fiscal space by including domestic debt in the restructuring effort. This is tricky, as it would involve domestic banks and could risk their balance sheets if done in too cavalier a fashion. Moreover, the burden of domestic debt can also be reduced by alternative means, including by maintaining low interest rates, inflating it away, and imposing additional taxes on the banking sector. That said, if we do choose to go down this route, there are successful precedents, including Jamaica (2010, 2013) and Uruguay (2003). As discussed in Ali’s book, these were largely voluntary debt exchanges, featuring diverse strategies including haircuts, reductions in coupons and maturity extensions. Indeed, judging from the position that China has taken in other ongoing debt restructuring efforts, we may need to include domestic debt. Beyond this, there will also be pressure to include all external creditors. On the official side, the IMF will be excluded due to its senior creditor nature. However, others like the World Bank and Asian Development Bank have a more murky status and could be pushed to at least roll-over debt service falling due to them and possibly even provide additional long-term concessional funds, as part of a comprehensive debt renegotiation with all of Pakistan’s external creditors.

Next, our $20 billion of commercial debt would need to be addressed through either haircuts or re-profiling. These negotiations can take longer but the ability to convene creditor committees and invoke “collective action clauses” mean that they no longer can be dragged out indefinitely. Without including private debt in the debt restructuring, official bilateral creditors will never come on-board. But once they do, it is heartening to note that official bilateral debt has been frequently restructured across the world, with the Paris Club often accepting larger haircuts than that imposed on private creditors.

The major issue on the official bilateral side will be how to convince China to join the effort. As a newcomer to the debt game, China is still learning the ropes. To date, it has remained wary of both existing Western-dominated mechanisms for official debt restructuring like the Paris Club, as well as fall-out at home from being perceived as having made bad loans in its extensive lending operations around the world. But it is imperative for China to show global leadership at this critical juncture. As explained above, bringing domestic debt and multilaterals into a comprehensive operation may help coax China to join the overall debt restructuring effort.

In addition, given Pakistan’s special relationship with the Chinese, diplomatic channels can also be leveraged beyond purely economic and technocratic discussions. If all else fails, in order to address China’s concerns related to confidentiality and creating a precedent for other indebted countries, a side deal could be cut with China alone without the need to involve other creditors. Provided the operation is ambitious enough, this could work on its own given that almost one-third of our external debt is owed to China. So there you have it. For such a debt restructuring to work, the government will need to be proactive and hire professional services. Done well, it could be a game-changer for Pakistan, freeing up vital financing space in the order of $30-40 billion over the next 2-3 years and preventing mindless austerity. Delayed or executed poorly, it could backfire. The stakes are high and the hour is getting late.

Former acting governor of State Bank of Pakistan