Interest expenses, rupee devaluation, primary deficit financing spikes public debt

ISLAMABAD: The Finance Ministry has said that interest expenses, currency devaluation and financing of primary deficit due to the Covid-19-related economic slowdown are the major reasons for massive increase in the public debt, a statement issued by the Finance Ministry said on Thursday.

To fully understand the underlying economic realities, there is a need to analyse the sources of increase in the total public debt during the last three years

Interest Expenses: Preference towards short-term domestic borrowing in the absence of adequate cash buffers resulted in short-term profile of domestic debt at the end of FY2018. This short-term profile led to high interest cost on debt, as interest rates had to be increased significantly to curb rising inflationary pressures.

The government paid Rs7.5 trillion against the interest servicing, which explained 50 per cent of the increase in the total public debt.

Currency Devaluation Impact: The exchange value of the rupee was maintained at an artificially high level in the past, which triggered the balance of payments crisis. The transition to the market-based exchange rate regime, being an unavoidable policy choice, resulted in a sharp exchange rate depreciation leading to high inflation, high interest rates, slower GDP growth and lower import-related tax revenues.

This exchange rate depreciation added around Rs2.9 trillion (20 per cent of the increase) in the public debt. This increase was not due to the borrowing but due to the revaluation of external debt in terms of rupees after the currency devaluation, it said.

Financing of Primary Deficit: The impact of economic slowdown due to the Covid-19 pandemic mainly resulted in higher-than-estimated primary deficits. A total of Rs3.5 trillion (23 per cent of the increase) was borrowed for financing of primary deficit.

Cash Management and Others: A sum of Rs1 trillion (7 per cent of the increase) was on account of increased cash balances of the government to meet emergency requirements, as well as due to the difference between the face value, which is used for recording of debt and the realised value, which is recorded as the budgetary receipt of the government bonds issued during this period.

The government took the revolutionary and economically sound step of not borrowing from the State Bank of Pakistan (SBP) and maintaining a cash buffer, which led to a one-off increase in the debt. However, this increase in the debt was offset by a corresponding increase in the government’s liquid cash balances.

A better way to measure the level of debt is through debt-to-GDP ratio instead of looking at the absolute values of debt. In this way, it is important to highlight that Pakistan has witnessed one of the smallest increases in its debt-to-GDP ratio during the pandemic.

The global debt-to-GDP ratio increased 13 percentage points, whereas Pakistan’s debt-to-GDP ratio witnessed a minimal increase of 1.7 percentage points in 2019-20.

Pakistan’s debt-to-GDP ratio, in fact, reduced 4 percentage points, indicating a lower debt burden at the end of June 2021, compared with the last fiscal year.

To conclude, the increase in debt during the last three years occurred mainly during FY 2018/19 due to implementing difficult and unavoidable policy choices. Had the market-based exchange rate, a sustainable level of the current account deficit, adequate cash buffers and long-term domestic borrowing profile been maintained, the debt burden would have been reduced further on the back of the fiscal consolidation efforts supported by aggressive control on expenses and growth in tax and non-tax revenues.

As most of the major adjustments to the fiscal and monetary policies have been made, the debt burden is projected to decline firmly over the next few years.

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