Pakistan: Why government first is not the right strategy

The Ministry of Finance, due to political compulsions, has learnt to ignore with a measure of disdain the advice of State Bank of Pakistan that its failure to undertake energy sector reforms and convert state-owned enterprises (SOEs) into commercially-run businesses has resulted in a dangerously high fiscal deficit. Poor delivery of public services and crumbling infrastructure have become major impediments in efforts aimed at reviving investment. What is indeed perplexing for us is why directors and senior management in financial sector are also failing to see grave consequences. It increasingly appears that these men of wisdom and foresight do not appreciate the fact that 68 emerging and advanced countries (according to Reinhart Regoff) did default on domestic debt between 1914 and 2007). These defaults took place through a number of mechanisms ranging from forcible conversion to suspension of payments. This fact is contrary to the popular belief that sovereign debt carries zero-risk since governments always honour domestic debt liabilities as they have the ability to print money. The same study shows that in 64 of these domestic default cases domestic debt accounted for almost a two-thirds of the public debt. The share of Pakistan's domestic debt in public debt has risen from 49.3 percent in FY09 to 59.1 percent in FY12. And, has risen further by 35.2 percent within this year, ie, by Rs 838 billion over and above the Rs 2.38 trillion stock of domestic debt of end June, 2012. According to State Bank of Pakistan, the early warning signs are clear on domestic debt sustainability. Fiscal deficit will soar to 8.5 percent of GDP instead of desirable level of three percent during FY13. Public debt as a percentage of revenue instead of a benchmark figure of 15 percent is around 45 percent. Domestic debt as a percentage of total revenue is 280 percent instead of 200 percent; and domestic debt as a percentage of bank deposits is nearing 50 percent mark instead of averaging 35 percent by end June 2012. With an additionality of Rs 838 billion it has now crossed or is about to cross the two-thirds mark. Financial institutions, specially local big and mid-sized banks, need to focus on the need to overcome the excessive reliance of the government on the banking system since their preferred strategy is not only contracting the space for private sector, but also pushing the government towards a virtual default on repayments to them. The systemic risk, in case of a single default on their trade earnings should send shivers down every banker's spine. Letter of Credit confirmation charges could double or triple on imports. Sustainability of banking system, inflation and price stability are the prime responsibilities of the regulator, SBP. Therefore, a dialogue needs to be initiated and a plan to restructure this domestic debt needs to be evolved before a default explodes. Default on timely payment to the power sector or a failure to meet a financial obligation is one thing but default on repayment of sovereign bonds (treasury bills and Pakistan Investment Bonds) is fraught with deleterious consequences. It would be advisable if banks themselves in their own long-term interest come up with proposals whereby the maturity profile of domestic debt could be lengthened. A portion of T-bills' held above the Statutory Liquidity Requirements of under one year could be replaced by one year tenor PIBs. Similarly, one-and three-year PIBs held could be changed with PIBs of longer tenor. A percentage of debt could be converted into zero coupon bonds or banks could off-load some of the government bonds on to the public, using mutual funds, etc, in an agreed timeline. Hesitancy on the part of some foreign banks is understandable. Their Head Offices might not agree to holding long tenor rupee bonds but local banks, which are cash rich at the moment, need to think long-term. Fearing a dip in earning opportunity on the capital deployed is encouraging them to make higher dividend payout as their earnings head towards lean times. Let the banks come up with a proposal instead of being forced by outsiders. Perhaps, SBP needs to drum some sense in its dialogue with Pakistan Banks Association. SBP knows where all this is leading. It needs to take care of public savings besides taking care of the repayment and settlement system to keep the wheel of the economy moving. The banks need to conduct a reality check with a view to assessing whether their credit strategy, which has been found to be strongly skewed towards the government, conforms to reality and greater banking sense.