Debt restructuring carries risks

Pakistan is mired in a debt trap as its domestic debt and markup payments have grown to unsustainable levels. The government has the option to restructure the debt to create fiscal space to revive the economy. The exercise, however, carries a high risk of hurting domestic banks and the overall economy.

Debt restructuring could be in the shape of rescheduling timelines for debt (principal amount) repayment, deferring markup payments and/ or cutting the size of total domestic debt. A recent report titled “Pakistan Economy: Is Domestic Debt Restructure Viable?”, authored by Arif Habib Limited’s (AHL) analysts Sana Tawfik and Farhan Rizvi, stated that taking a closer look at some of the major domestic debt restructuring episodes globally over the past few decades, the median public debt-to-GDP level before restructuring was 70% while the share of domestic debt averaged 37%.

“Pakistan’s existing debt remains higher than the average on both of these key metrics.” Pakistan’s domestic debt as of December 2022 stood at Rs3.8 trillion (45% of GDP, or 53% of total debt), which more than doubled over the past five years. Total public debt stood at Rs52.5 trillion (73.5% of GDP). “The pace of public debt accumulation has accelerated over the past decade amid larger fiscal deficits and drying up of foreign direct investment (FDI) and foreign portfolio investment (FPI) inflows.”

Secondly, the volume of debt servicing (markup payment) on the total domestic debt is estimated at Rs5.6 trillion in the current fiscal year, which constitutes 76% of the collection of tax revenue. “Markup payments have risen to alarmingly high levels,” the analysts wrote, adding that a very little fiscal space was left with the government to run the economy after paying 76% of revenue in debt servicing. “Continued monetary tightening (a hike of 725 basis points in FY23) with record high interest rates has been a key driver behind the surge in markup payments,” the report mentioned.

Given the inability of the federal government to expand its revenue base, improve tax administration and recovery, and/ or reduce expenditure including on lossmaking state-owned entities (SOEs), the medium to long-term outlook for the fiscal account appears challenging. This, along with already high public debt levels, equates to a potential debt trap, which needs to be addressed sooner rather than later, the analysts said. Pakistan’s banking sector holds 66% of the total domestic debt, amounting to approximately Rs17 trillion of government securities (T-bills, PIBs and Sukuk) as of June 2022. The bulk of the holdings are in PIBs (53%), followed by T-bills (34%) and Sukuk (13%).

Besides, the balance sheet structure is highly skewed towards low-risk sovereign credit, which constitutes 45% of total assets with investment-deposit ratio (IDR) of 82%. A deep analysis suggests the domestic debt restructuring will push most of the banks to “face serious solvency issues in case of any…haircuts (cutting size of domestic debt) with the risk of bank run and liquidity challenges.” In such a scenario, the central bank will need to intervene to provide major liquidity support with a number of banks requiring restructuring themselves, Tawfik and Rizvi observed in the report. A debt restructuring exercise will result in both direct and indirect economic costs. While the direct impact includes capital loss for institutions and individual bondholders, however, there remains a set of indirect impacts such as pullback of lending by the banks facing capital constraints.

Moreover, banks with weaker capital position may face deposit run with spillover effects on other banks amid lack of confidence in the ability of the central bank to ensure deposit protection. Other risks include disruption in the interbank market due to heightened concerns over liquidity and solvency. This could lead to capital flight and impact the foreign exchange reserves, exchange rate and credit ratings, they said. The analysts argued that they drew three major conclusions from the possible domestic debt restructuring. “Weak capital position of the banking sector makes debt restructuring difficult to implement with major regulatory support. Therefore, an effective restructuring exercise will require the umbrella of a long-term International Monetary Fund (IMF) programme and additional taxation measures could be possible near-term alternatives.