Domestic debt restructuring to help alleviate fiscal crisis

Pakistan is in the midst of an economic crisis. The government’s economic policies have eroded the investor confidence, penalized businesses, and harmed honest taxpayers. This has led to a sharp increase in the country’s debt burden, making it increasingly difficult for the government to meet its financial obligations, says Imdad Ullah Bosal, Secretary of the Finance Division, while talking to WealthPK.

A bold solution is needed to revive the economy and set it on a sustainable path of growth, he said, adding that domestic debt restructuring (DDR) is a crucial step towards alleviating the fiscal crisis.

Imdad explains that the cost of servicing domestic debt for the Fiscal Year 2024 is projected to be Rs6.43 trillion, which is approximately 70% of tax revenue. He said a 50% reduction in the debt servicing cost will immediately create significant fiscal space.

“This will impose an initial mark-to-market shock of Rs3.3 trillion on the government’s tradeable debt, assuming yields do not change. However, the hit to the capital of the scheduled banks will be lower, as they hold a lower percentage of the government’s total tradable debt and a higher proportion of short-term debt,” he pointed out.

Pakistan also needs to implement deep-rooted structural reforms, such as overhauling the tax system, loosening foreign exchange controls, and practising fiscal discipline, Imdad emphasizes. 

These reforms will be painful in the short term, but they are necessary for long-term economic growth. However, he also acknowledged that these reforms are politically difficult to implement, as they will likely lead to higher taxes and less government spending.

Continuing the discussion, he said one way to make these reforms more politically palatable is to implement a debt-to-equity swap program. This will allow the government to reduce its debt burden, which will free up fiscal space for other reforms.

He further said a DDR program will also help reduce inflation and interest rates, making it easier for businesses to invest and grow.

He further explained by giving the example of Ghana and Sri Lanka, which have already implemented debt-to-equity swaps, albeit at a late stage and the urging of foreign lenders.

The annual reduction of Rs3.21 trillion in projected debt servicing costs would be a recurring benefit, and its net present value (NPV) is significantly higher. The recapitalization of the banking sector, if necessary, would be a one-time affair. The NPV benefits of lower debt servicing costs to the government dwarf the potential cost of recapitalizing the banks by a huge factor.

The potential mark-to-market losses and the cost of recapitalizing the banking sector will be materially lower if yields come down post-DDR. And they will come down, as we are seeing in Ghana and Sri Lanka, Imdad said.

He argued that if the government demonstrates a credible commitment to economic reforms and fiscal responsibility, and if these reforms precede debt restructuring, local yields can witness substantial and lasting declines. Even a partial shift in the yield curve towards the long-term average can lead to a 60% reduction in mark-to-market losses.

In terms of the impact of a DDR program on the real economy, Bosal suggested that it is challenging to foresee significant costs. Considering indirect benefits and costs, including temporary tax revenue losses from banks will likely strengthen the case for DDR.

Attributing the current fiscal challenges of local banks to the recklessness of successive governments and the lack of viable lending prospects within a challenging business environment, Imdad advocated unwavering support for banks in the initial stages of DDR.

He proposed several measures the government can take, such as guaranteeing all deposits for a limited period, eliminating the minimum deposit rate on conventional deposits, and exempting banks from recognizing mark-to-market losses.

While the potential for a banking system crisis in Pakistan is low due to restrictions on moving local deposits overseas and limited reliance on foreign depositors and lenders, Imdad suggested that the government can enhance stability further by limiting cash withdrawals and imposing substantial taxes.
He acknowledged that a debt-to-equity swap program can have adverse effects on banks, considering they are the primary lenders to the government. Nonetheless, he asserted that significant structural reforms and tax revisions are prerequisites for a successful DDR attempt.

Concluding, he said a well-designed DDR program can quickly secure fiscal flexibility and make extensive structural reforms more politically viable. 

He cited the successful DDR programs in Ghana and Sri Lanka as examples and urged the Government of Pakistan to demonstrate its commitment to reform by publicly announcing a DDR program as part of its economic reform strategy.

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