Perpetuating the debt cycle

A lack of transparency in economic decision-making has led to a situation whereby Pakistan may be in the throes of a debt trap. Temporary measures such as borrowing from friendly nations and Pakistani expatriates to tide over the looming debt repayment and balance of payments shortfalls have become necessary to delay complying with the strictures of an International Monetary Fund (IMF) lending programme.

However short-term palliatives cannot change the fact that root-and-branch economic reforms are required and unless these are introduced at the earliest, as the government backed Economic Advisory Council is suggesting, we’ll undoubtedly soon have a feeling of déjà vu.

The China-Pakistan Economic Corridor (CPEC) initiative is a signature achievement of the previous PML-N government but when the head of the State Bank of Pakistan publicly lamented in 2015 that he was unaware of the financial implications of the CPEC project something was seriously amiss. If the person charged with formulating and implementing monetary policy is kept in the dark about expected inflows and outflows of foreign currency into the country that will affect the money supply then one can only speculate about the reasons for the opacity.

The need for speedy project execution and the complications of geopolitics may be why CPEC was kept under wraps till the deal was finally inked but then one is only hoping that the government making such decisions has the expertise as well as the integrity to take all factors into account before embarking on such a massive financial commitment. In hindsight, this is an overly optimistic view of the skill level and intentions of those involved in the decision-making.

In previous years Pakistan has borrowed from international capital markets ostensibly to shore up its international currency reserves or due to deficits in its balance of payments. The answer given by those in authority to the question of the need for foreign commercial borrowings when the country didn’t necessarily have to resort to such a measure was of two types: (a) “because we can” or (b) “it will build the country’s reputation for creditworthiness internationally thereby boosting prospective foreign investor confidence in the country”.

Pakistan’s cumulative gross borrowings (ie before any redemptions) of foreign currencies from issuance of Eurobonds and other capital market instruments amount to over $7.5 billion since 2003. The coupon rate ranges from a low of 5.635 percent for a sukuk with a $1 billion face value and 5-year tenor issued in 2017 to a relatively high 8.25 percent fixed rate coupon for a 10-year term Eurobond with a $1 billion principal value issued in 2014.

In responding to critics about the high coupon rates, the country’s financial managers, regardless of the government in power, always have a common refrain: that this was the best that they could do since the coupon rate includes not only the real interest rate required by lenders as a reward for use of their funds but also the perceived risk of default because of Pakistan’s perennially weak macroeconomic fundamentals. However, this begs the question of whether tapping the international capital markets on commercial terms was in the country’s interests given the prevailing economic situation at the time and the alternative of borrowing from lower cost bilateral and multilateral sources albeit with conditions attached.

The foreign currency borrowed through commercial sources helped to prop up the foreign currency value of the rupee anchored to some (overvalued) nominal exchange rate. However, the funds raised have at times also been invested in low-yielding US government treasury bills – meaning that the return received was far below the rates that the government had to pay to lenders. This is a bizarre situation of a poor developing country paying out of pocket to borrow funds and instead of using them for productive purposes within its borders lending these to an advanced developed country.

With external debt there is the foreign currency risk arising from the likelihood of a depreciating rupee, meaning that the burden of the foreign currency denominated debt is higher than initially assumed since it takes many more units of local currency to pay a certain amount of interest and principal in foreign currency than was expected at the time the loan was contracted.

Sovereign borrowing for periods ranging from five to ten years also exposes Pakistan to interest rate risk on variable rate issues as the coupon payment on some of the Eurobonds outstanding are periodically reset in line with changes in a benchmark interest rate such as the London Interbank Offered Rate (LIBOR) or the 10-year US government bond.

The borrowing country is also subject to refinancing risk if the government does not have adequate foreign currency to make a ‘bullet’ repayment of principal upon maturity of the bond issue.

As acknowledged in the recently published ‘Debt Policy Statement 2018-19’ issued by the Ministry of Finance (available on its website since late last month) these risks have indeed materialised. Thus global interest rates have been on an upward path since the reversal starting late 2017 of the policy of Quantitative Easing (QE) by the US Federal Reserve Bank and the announcement in December 2018 by the European Central Bank (ECB) that it has ended its QE programme. (The Pakistan government’s debt policy statement has, however, its own credibility problem since there is not a single mention of CPEC in the entire text.)

With higher interest rates in the US, the dollar has been appreciating on international currency markets which means that Pakistan is now faced with a double whammy of an appreciating dollar and higher interest rates putting enormous stress on its ability to service its external debt.

A pernicious aspect of relying on debt from commercial sources is that the sovereign borrower can use the funds in any which way and does not have to undertake any changes in its domestic economic policy. This introduces the problem of moral hazard allowing the government in power to buck its responsibility of introducing structural reforms and, in some cases, to fritter away the loan money on vanity projects or to secrete it in, say, offshore tax havens through kickbacks on fraudulent schemes (‘odious debt’).

One aspect of this entire borrowing binge that has not been discussed in any depth in the media is the fees that have been paid to the international banks that have arranged and managed the Pakistan government’s Eurobond and sukuk loans.

It would be in the public interest to know how much Pakistan has paid in fees and other indirect charges to international commercial and investment banks for the over $7.5 billion it has borrowed since 2003. Other questions arising from these transactions include: how were the lead managers and bank syndicates selected? Were competitive bids for leads managing the transactions invited? Were the fees charged in line with what other countries have been paying for similar sized bond sales?

The ongoing corruption scandal and the outrage in Malaysia over the outright theft of a significant proportion of the $6.5 billion of bond sales arranged by the American investment bank Goldman Sachs for the Malaysian sovereign wealth fund 1MDB illustrates the need for procedural oversight and open debate whenever sovereign borrowing is undertaken. As Joseph Stiglitz and Hamid Rashid write in their commentary for Project Syndicate: “There are no easy, risk-free paths to development and prosperity. But borrowing money from international financial markets is a strategy with enormous downside risks, and only limited upside potential – except for the banks, which take their fees up front.”

The writer is a group director at the Jang Group.

Email: iqbal.hussain@janggroup.com.pk