II. Debt and Debt Sustainability Issues in Pakistan
48. It is widely believed that Pakistan suffers from acute debt problems. High levels of public and external debt are typically mentioned among the two or three most immediate economic policy issues in Pakistan.22 Many observers also argue that the usual ramifications associated with debt problems—low investment ratios, crowding out of essential social spending and development expenditure, balance of payments financing problems, and increasing constraints on macroeconomic policy management—have also begun to surface.
49. These concerns about debt problems are not surprising given that Pakistan’s public and external debt stocks at about 92 percent and 58 percent of GDP, respectively, are high by international standards. Interest payments on public debt soaked up 48 percent of revenue in the consolidated government budget, while scheduled external debt service payments reached a stunning 64 percent of current foreign exchange receipts in the last fiscal year (1999/2000). Another indication of the problem is the external debt emergency of 1998/99, when a comprehensive restructuring of Pakistan’s external debt was needed in the wake of the balance of payments crisis that began to unfold after May 1998.
50. Recent debt developments and current debt data suggest that debt problems will not disappear quickly. Under the new program to be supported by a Stand-By Arrangement with the Fund, short-term balance of payments viability requires yet another round of flow restructuring of the external debt. Progress towards achieving a sustainable medium-term debt service profile will also be an important policy challenge. Moreover, while perhaps less immediate, domestic debt has become a problem for policymakers, as the high real interest rates on domestic currency debt may push the debt dynamics on to an unstable path.
51. This Section attempts to assess the nature and magnitude of Pakistan’s actual “twin” debt problem in a historical context and to review policy options. The analysis focuses on two related sets of issues. The first set revolves around the burden associated with external and public debt. The second set concerns debt sustainability, that is, issues related to the question of how policies would need to be adjusted to ensure that external and public debt could be serviced in an orderly fashion, while other goals of economic policy, such as high economic growth and macroeconomic stability, could be met.
52. In Pakistan, as in so many other countries, public debt and external debt issues are often treated synonymously. Although they are closely interrelated, especially in view of the large share of public and publicly guaranteed external debt in both total external and total public debt, the two dimensions are nevertheless distinct. Analytically, they need to be explored separately. Public debt issues mainly concern the capacity of the government to service its debt in domestic currency while external debt issues have to do with the capacity of the economy to raise the foreign exchange needed to meet the debt service obligation toward nonresidents. Instruments and issues differ in the two domains although policy actions in either domain typically affect each other. Moreover, good policy strategies in one domain need not be consistent with good strategies in the other, and analysis along the two dimensions is required to arrive at a strategy that is consistent with overall macroeconomic objectives.
53. At the outset, it should be noted that the lack of a comprehensive debt monitoring system complicates the analysis of debt issues. In particular, the total amounts and the composition of both public and external debt remain subject to uncertainties for two reasons. First, different agencies are responsible for monitoring and reporting, which has led to the regular publication of only a subset of debt data by each agency. Second, the various components are not yet fully consolidated into total domestic public debt and total external debt. Despite these caveats, the Section attempts to provide an integral perspective on the quantitative dimensions of Pakistan’s debt problems.
54. The Section is organized as follows: subsection B addresses issues related to the burden and sustainability of Pakistan’s external debt; the subsequent subsection focuses on the same issues for the public debt; and subsection D attempts to provide a policy perspective on Pakistan’s debt problems.
B. External Debt Burden and Sustainability
55. This section analyzes the burden and sustainability of Pakistan’s external debt levels. The external debt concept used is that of total external debt, that is, the total debt that resident public and private entities in Pakistan contracted from nonresidents. The focus on total external debt is important because the severity of the 1998/99 balance of payments crisis was, in part, related to the relatively large outstanding stock of short-term private external debt at the outset.
56. External debt sustainability is concerned with the capacity of the government and other parties that have contracted external debt to service the debt in an orderly manner. Orderly debt service is, however, only a necessary condition for debt sustainability.23 Sufficient conditions for a sustainable external debt level are that the debt can be serviced as scheduled under conditions of high medium-term economic growth and macroeconomic stability. In addition, sustainability is often understood to encompass the condition that the debt service capacity is robust to possibly persistent perturbations to the anticipated path of key variables. If these conditions are satisfied, then the burden of the external debt on the economy can be considered bearable.
57. As external debt, denoted with F hereafter, covers all debt owed to nonresidents, its sustainability is closely related to external current account sustainability, especially for a country at Pakistan’s level of financial market development. Under such conditions, external debt transactions should account for a large fraction of all transactions recorded in the financial account of the balance of payments. Accordingly, it is assumed in this Section that the change in external debt is about equal to the change in net foreign liabilities.
58. Refinancing aspects are important in the case of external debt as the mobilization of foreign exchange resources for amortization payments is an issue, not the least because the willingness of nonresidents to refinance the principal remains outside government control. Even if macroeconomic policies are, in principle, consistent with best practices, expectations of nonresidents may be such that foreign exchange flows remain scarce. Hence, while for domestic currency debt it is primarily interest payments on public debt that matter, total debt service matter a great deal more in the case of external debt, especially in a country with recent balance of payments difficulties.
Pakistan’s external debt during the 1990s—stylized facts
The level of external debt
59. Pakistan’s external debt amounted to 58 percent of GDP at the end of 2000 (Table II-1).24 Over the last few years, the ratio of external debt to GDP fluctuated around 57 percent. Compared to the beginning of the 1990s, however, the external debt as a percent of GDP increased by about 9 percentage points. In terms of exports or, more precisely, current foreign exchange receipts25—another frequently used yardstick to measure the external debt burden—the external debt fluctuated around 280 percent in recent years. Compared to the early 1990s, an increase in the external debt was also registered on the basis of this benchmark.
|(In millions of U.S. dollars)|
|Public and publicly guaranteed 2/||19,480||20,297||22,276||24,368||26,548||28,108||28,121||28,709||29,000||30,480||31,010|
|Public and publicly guaranteed 2/|
|other bearer securities 3/||355||405||447||549||522||739||796||1,174||956||804||760|
|Foreign currency deposits 6/||2,116||2,203||1,989||2,227||2,920||3,192||4,158||4,353||3,655||2,556||1,739|
|(In percent of GDP)|
|Public and publicly guaranteed 2/||48.4||44.4||45.5||47.1||50.9||46.1||44.2||45.8||46.4||52.4||50.4|
|Foreign currency deposits 6/||5.3||4.8||4.1||4.3||5.6||5.2||6.5||6.9||5.8||4.4||2.8|
|(In percent of current foreign exchange receipts)|
|Public and publicly guaranteed 2/||229.0||210.5||196.3||226.1||245.4||228.3||227.0||224.8||219.0||269.3||245.4|
|Foreign currency deposits 6/||24.9||22.9||17.5||20.7||27.0||25.9||33.6||34.1||27.6||22.9||13.8|
|(In millions of U.S. dollars)|
|Short-term debt at original maturity||3,368||3,494||3,206||4,003||5,012||5,148||6,232||6,430||6,391||5,120||4,323|
|Effective short-term debt 8/||…||4,833||5,098||5,852||7,258||7,620||9,030||9,588||9,670||4,749||4,885|
The debtor and creditor composition of external debt
60. External debt contracted by the public sector or guaranteed by the government has been the dominant type of external debt by debtor for many decades. At end-1999, public and publicly guaranteed debt, henceforth public external debt, accounted for about 87 percent of total external debt at end-2000 (Table II-2). During the entire last decade, this debt category fluctuated around 48 percent of GDP and 235 percent of current foreign exchange receipts.
|(In percent of total external debt)|
|Public and publicly guaranteed 2/||88.9||88.9||89.8||88.4||85.4||85.9||81.1||80.3||81.0||83.6||87.1|
|Public and publicly guaranteed 2/||(In percent of public and publicly guaranteed external debt)|
|Eurobonds and FCBCs 3/||1.8||2.0||2.0||2.3||2.0||2.6||2.8||4.1||3.3||2.6||2.5|
|Private 5/||(In percent of private external debt)|
|Foreign currency deposits 6/||87.4||86.7||78.5||69.9||64.4||69.2||63.4||61.7||53.9||42.7||38.0|
|Memorandum items:||(In percent of total external debt unless otherwise noted)|
|Short-term debt at original maturity||15.4||15.3||12.9||14.5||16.1||15.7||18.0||18.0||17.9||14.0||12.1|
|In percent of official reserves||557.6||660.5||308.9||865.7||217.7||187.8||303.5||563.5||685.7||306.2||471.9|
|Effective short-term debt 8/||…||21.2||20.5||21.2||23.4||23.3||26.0||26.8||27.0||13.0||13.7|
|In percent of official reserves||…||913.6||491.1||1,265.6||315.2||278.0||439.8||840.3||1,037.6||284.0||533.3|
|In percent of current forex receipts||…||50.1||44.9||54.3||67.1||61.9||72.9||75.1||73.0||42.6||38.7|
61. While the dominance of public external debt remained unaffected, the 1990s nevertheless witnessed a profound change in the debtor composition of external debt, as the share of private external debt rose from about 2 percent at end-1990 to a maximum of 20 percent at end-1997.26 This increase also accounted for most of the increase in total external debt as a percent of GDP or current foreign exchange receipts registered between 1990 and 1997. With the debt crisis that began to unfold in 1999, the share of private debt decreased.
62. The debtor structure of private external debt varied during the last decade, partly because of the rise and fall of nonresident foreign currency deposits and partly because of the steady rise of other private debt. The latter debt category includes external liabilities of independent power producers (IPPs), which had begun to invest and operate in Pakistan after the market for electricity generation was opened for private sector participation in the mid-1990s.
63. In recent years, the composition of external public debt was stable in terms of creditors. At end-2000, about 80 percent was held by official creditors, about half of which is debt owed to bilateral creditors. Debt owed to the general, nonofficial public, which includes debt to commercial banks or to the general private sector in the form of bonds, only amounted to about 6 percent at end-2000. The remainder of external public debt includes military debt and short-term public debt other than debt owed to commercial banks.
The structure of external debt by instrument and maturity
64. With the large share of public and publicly guaranteed external debt owed to official creditors, Pakistan’s external debt is mostly long-term, if classified by the criterion of original maturity (maturity at the time of contraction) and is in the form of debt contracts that are generally not tradable. The share of tradable debt in the form of securities, which consists of Eurobonds and bearer securities in foreign currency, remained very small. Short-term public and publicly guaranteed external debt by initial maturity, which includes debt owed to commercial banks, foreign currency bearer certificates, and some central bank liabilities, was typically less than 10 percent of total public and publicly guaranteed external debt.
65. Private external debt was always more short-term in nature, especially foreign currency deposits. The share of demand and time deposits with a maturity of 12 months or less in total foreign currency deposits was typically above 80 percent.27 Details on the maturity structure of other private external debt is not available. According to the SBP’s latest annual report this debt category includes only medium and long-term debt (at original maturity), including supplier credits and cash loans for import financing.
66. Overall, short-term external debt at original maturity (excluding possible short-term elements in other private debt) was generally somewhat less than one fifth of total external debt during 1992–98. The amounts of short-term external debt were large enough to contribute to considerable external financial vulnerability, as the comparison with the usual yardstick of official foreign exchange reserves shows.
67. The picture on the short-term debt during the 1990s would not be complete if the rapid increase of effective short-term debt were not mentioned. The concept of effective short-term debt is more general because it includes all debt coming due over the next 12 months, including amortization payments on long-term debt, in addition to the short-term debt at original maturity. With the increasing amounts of scheduled debt service payments on medium-term public and private debt, which are discussed in more detail later, the amounts of effective short-term debt began to account for more than 20 percent of total external debt from the mid-1990s. Effective short-term debt exceeded official foreign exchange reserves by a large margin, which was yet another illustration of the increasing external financial vulnerability of the economy during the 1990s.
68. At this stage, it should also be noted that with the restructuring and rescheduling of the external debt during 1999–2000 (discussed in Box I-1), the distinction between short-term and other external debt has become blurred because some debt that was short-term, if classified by the initial maturity criterion, effectively became medium-term debt after rescheduling. Similarly, after end-1998, the effective debt also decreased if only amortization payments coming due after rescheduling are included.28 At end-2000, the outstanding amount of effective short-term debt after rescheduling was significantly lower than at end-1998.
The debt service burden of external debt
69. Arguably, the most important external debt related development during the 1990s was the dramatic increase in the debt service burden of external debt. When measured on the basis of scheduled payments, the burden almost doubled to about 13 percent of GDP by 2000 (Table II-3). In terms of current foreign exchange receipts, the scheduled debt service burden increased more than twofold to about 64 percent by 2000. Toward the end of the decade, the debt service burden, based on scheduled payments, obviously became increasingly unmanageable given export receipts and capital inflows.29 Debt service payments had to be restructured in the context of a comprehensive debt restructuring exercise, as described in Box II-1. Even after the debt restructuring and rescheduling, the actual debt service burden remained above 30 percent of current foreign exchange receipts during 1999–2000.
Box II-1.Pakistan: Debt Crisis and External Debt Restructuring After May 1998
In the aftermath of the events of May 1998, Pakistan had to embark on a comprehensive restructuring of its external debt service obligations during 1999–2000, as the debt service burden had become unmanageable. The main elements of the restructuring include:
In January 1999, the Paris Club provided debt relief on debt service from public and publicly guaranteed debt contracted prior to September 30, 1997 falling due between January 1, 1999 and December 31, 2000 (including arrears accumulated during the first half of 1999). In January 1999, the projected debt service relief granted over the 18-month period amounts to US$3.3 billion.
Pakistan froze withdrawals in foreign currency from all nonresident foreign currency deposits (FCDs) in May 1998, which amounted to US$4 billion at the time.1 Subsequently, it reached agreement with nonresident institutional investors on a more favorable repayment schedule for US$1.4 billion of FCDs. Other nonresident investors have been allowed to withdraw and cash their deposits in local currency (at the official rate until May 1999 and at the interbank rate after) or to swap them with the so-called Special U.S. dollar bonds issued by the Government of Pakistan.
In December 1999, Pakistan succeeded in exchanging three existing Eurobonds worth about US$610 million for a new six-year amortizing bond with a three-year grace period and a 10 percent coupon. Otherwise, US$450 million of repayments would have come due during 2000 (in addition, a put option on the remaining bond coming due in 2002 could have been exercised from February 2000).
In December 1999, Pakistan also reached agreement with eight commercial banks to restructure US$512 million of short-term trade credits. In addition, Pakistan rescheduled US$415 million of medium-term commercial bank credits in 1999.
The central bank succeeded in rolling over short-term and medium-term liabilities held by other central banks.
Overall, the amount of relief achieved through the restructuring of debt service obligations is estimated at about US$7.3 billion during 1999–2000. About 45 percent of the relief was provided by official, bilateral creditors.
Foreign currency withdrawals from bearer securities denominated in foreign currency (including the so-called Foreign Exchange Bearer Certificates, Foreign Exchange Bearer Certificates, and Dollar Bearer Certificates) and foreign currency deposits held by resident investors were also frozen. The corresponding outstanding liabilities amounted to about US$7.3 billion at end-May 1998.
|(In millions of U.S. dollars)|
|Public and publicly guaranteed 2/||2,999||3,317||3,753||4,694||4,301||4,749||4,554||5,015||4,549|
|(In percent of GDP)|
|Public and publicly guaranteed 2/||6.1||6.4||7.2||7.7||6.8||7.6||7.3||8.6||7.4|
|(In percent of current foreign exchange receipts)|
|Public and publicly guaranteed 2/||26.4||30.8||34.7||38.1||34.7||37.2||34.4||45.0||36.0|
|Debt service as percent of official reserves||334.0||937.7||192.2||202.2||265.4||600.9||832.3||500.1||895.7|
|Actual debt service (in millions of U.S. dollars) 4/||3,467||4,336||4,425||5,542||5,449||6,856||7,757||4,542||4,241|
|In percent of current foreign exchange receipts||30.6||40.2||40.9||45.0||44.0||53.7||58.6||40.8||33.6|
|In percent of official reserves||334.0||937.7||192.2||202.2||265.4||600.9||832.3||271.7||463.0|
70. Another dimension of the debt service burden is the extent to which debt is effectively refinanced or rolled over through new debt inflows. The smaller are the amounts of refinancing or rollover funds, the more burdensome the debt service becomes because other means of financing are needed unless the external current account is in surplus. From this angle, a noticeable rise in the debt burden was also registered during the 1990s (Table II-4). The gross debt-related capital inflows decreased quite steadily after 1993/94, both in absolute value and in terms of GDP or debt service obligations. In fact, net debt-related capital flows (debt disbursements minus amortization) decreased steadily from a peak reached in 1993/94 and turned negative in 1997/98.
|(In millions of U.S. dollars)|
|Gross debt-related capital inflows||3,148||4,499||5,556||6,150||5,764||6,251||5,513||4,875||2,927|
|Net debt-related capital flows (+=inflow) 2/||680||1,322||2,401||2,074||1,946||1,140||-481||-2,026||-3,602|
|(In percent of current foreign exchange receipts)|
|Gross debt-related capital inflows||27.7||41.7||51.4||49.9||46.5||49.0||41.6||43.7||23.2|
|Net debt-related capital flows (+=inflow) 2/||6.0||12.3||22.2||16.8||15.7||8.9||-3.6||-18.2||-28.5|
|(In percent of debt service obligations by sector)|
|Gross debt-related capital inflows||90.8||103.8||125.6||111.0||105.8||91.2||71.1||58.3||35.7|
|Net debt-related capital flows (+=inflow) 2/||19.6||30.5||54.3||37.4||35.7||16.6||-6.2||-24.2||-43.9|
|GDP at market prices||48,918||51,778||52,197||60,923||63,620||62,729||62,486||58,124||61,531|
|Debt stock, public||22,276||24,368||26,548||28,108||28,121||28,709||29,000||30,012||31,010|
|Debt stock private||2,535||3,187||4,531||4,610||6,563||7,058||6,782||5,991||4,581|
|Memorandum item:||(In millions of U.S. dollars)|
|Net debt-related capital flows after|
|restructuring and rescheduling||680||1,322||2,401||2,074||1,946||1,140||-481||1,793||362|
The dynamics of external debt and debt service during the 1990s
71. The identification and quantification of the factors that contributed to the evolution of the external debt in the past typically provides useful information on prospects and policy issues. However, as argued below, the dynamics of the external debt cannot explain the dynamics of the debt service, which was determined by the changes in the debt structure.
Explaining the External Debt Dynamics
72. As shown in Appendix A, the change in the external debt as a percent of current foreign exchange receipts between t and t+1 can be decomposed into four factors that capture the most important balance of payments aggregates:
Net exports (the noninterest current account balance)30, which determine the need for the external financing of imports given overall receipts from exports of goods and service and private transfers.
The intrinsic debt-interest dynamics, which emanates from the difference between the interest rate on external debt and the growth of current foreign exchange receipts. If this difference is positive, the dynamics of interest compounding applies, which can lead to continued increases in the external debt unless net exports are, on average, positive and large enough to offset the interest bill. In general, a positive difference is expected, although a country like Pakistan is likely to be an exception given the significant share of concessional external debt.31
The accumulation of gross official foreign exchange reserves, which requires the accumulation of external debt unless the accumulation is offset by other capital flows or the current account balance.
Other factors, including other capital inflows such as foreign direct investment, which reduce the need for the accumulation of external debt.
73. The actual decomposition of Pakistan’s external debt dynamics during the 1990s according to this scheme can be found in Table II-5.32 In the following discussion of the results, it is convenient to distinguish between push and pull factors. Push factors are factors that would have contributed to increases in the external debt ratio if all other factors had remained unchanged. Pull factors are factors that would have pulled down the external debt ratio.
|(In percentage points of current foreign exchange receipts)|
|Change in external debt||-18.2||36.9||31.7||-21.6||14.2||0.2||-9.9||52.9||-41.4||33.3||44.7|
|Contribution of determinants: 3/||-18.2||36.9||31.7||-21.6||14.2||0.2||-9.9||52.9||-41.4||33.3||44.7|
|Change in offical reserves||4.5||-5.3||17.0||3.6||-5.6||-7.1||-1.6||6.6||-6.0||5.4||6.1|
|Memorandum items (in percent):|
|Growth of foreign exchange receipts||17.7||-5.0||0.3||13.8||0.6||3.1||3.7||-15.8||13.4||4.9||3.5|
|Growth-adjusted interest rate on external debt||-11.3||10.2||4.2||-8.0||4.3||1.9||1.2||23.7||-7.7||0.4||2.1|
74. The generally large imbalance between exports and imports, which implied negative net exports (or noninterest external current account deficits), unambiguously was the most important “push” factor behind the increase in the external debt. These imbalances partly reflected Pakistan’s fundamental external vulnerability related to productivity developments in the agricultural sector. As agricultural outputs such as cotton and wheat are important determinants of the export supply potential as well as of the import needs, a series of productivity shocks in this sector during the 1990s led to highly pro-cyclical net exports. However, as illustrated in Chart II-1, cyclical variations in net exports due to a series of negative productivity shocks to the agricultural sector were only one part of the story. In addition, the overall performance of exports, including workers’ remittances during the 1990s, was disappointing, especially after significant growth in the 1980s, reflecting, inter alia, insufficient stabilization efforts and a lack of determination in carrying through the deep structural reforms needed to reduce the external vulnerabilities.
Chart II-1.Pakistan: Exports, Imports, and Net exports
Source: Staff calculations based on data provided by the authorities.
1/ Exports: exports of goods and services and workers’ remittances; imports: imports of goods and services and unrequited transfers (debit items).
2/ Net exports equals exports minus imports as defined in footnote 1.
The intrinsic debt-interest dynamics
75. Interest payments on external debt were generally another push factor. As the growth rate of total exports fluctuated with a large amplitude in the last decade, the magnitude of the contribution depends critically on the period selected for the analysis. For the entire decade, the contribution to the debt dynamics was substantial at about 42 percentage points of current foreign exchange receipts. However, this magnitude is largely the result of a sharp drop in total exports in 1999 against the background of weak external demand related to the Asian crisis and the unfolding balance of payments crisis (workers’ remittances). Between 1992 and 1998, the contribution was merely 4 percentage points of current foreign exchange receipts compared to an increase in the external debt by 33 percentage points. A relatively small contribution on average was to be expected given the relatively constant and low nominal interest rate on external debt (Chart II-2). Table II-5 also shows how in years with favorable export growth, interest payments were a pull factor because interest rates on external debt adjusted for export growth were favorably low.
Chart II-2.Pakistan: External Debt and Dynamics of External Debt Burden
Source: Staff calculations based on data provided by the Pakistan authorities.
Foreign exchange reserves and other factors
76. Changes in reserves were sometimes a push factor and sometimes a pull factor. Overall, the accumulation of reserves contributed to the increases in external debt, although the magnitude remained small as the reserves were quite often needed for balance of payments financing during the 1990s. Other determinants were a significant pull factor. These determinants include foreign direct investment, which began to contribute substantially to the balance of payments once the EPP program became operational in the mid-1990s. Other inflows were portfolio inflows, involving the sales of Pakistani assets to nonresidents.
Explaining the dynamics of the external debt burden
77. Analyzing the external debt dynamics also points to a another important aspect of Pakistan’s external debt problems. The change in the stock of external debt between 1991/92 and 1999/2000 cannot explain the sharp increase in the external debt service burden when measured against current foreign exchange receipts. As noted in Table II-5, the ratio of external debt to current foreign exchange receipts only increased by about 45 percent. Applying the beginning-of-period interest rate on total external debt, a seemingly innocuous assumption given the small variation over time, and the average debt maturity during the period to this increase suggests that the debt service burden should have increased by roughly 8 percentage points to about 39 percent of current foreign exchange receipts. The actual debt service ratio, however, more than doubled. It is important to note that this observation is not just the result of balance of payments arithmetic during a debt crisis, when rescheduling or exceptional financing is “below the line” and the calculation of the scheduled debt service “above the line” assume immediate repayment in full. If the same back-of-the-envelope calculation were done for the period 1992–98, a significant discrepancy between actual and “fitted” increase in the debt service ratio would also emerge.
78. The heavier debt service burden must be the result of either higher interest rates on the public debt, changes in the structure of external debt, or of a reduction in the growth of current foreign exchange receipts relative to that of debt service payments on the outstanding debt (at the outset of the comparison).
79. The increasing principal payments, which more than doubled both in terms of GDP and current foreign exchange receipts, were the first important factor underlying the sharp rise in the debt service burden during the 1990s. The increase in overall principal payments must be attributed largely to the increased share of private debt, which must have been more short-term on average compared to public debt. Nevertheless, in the early 1990s, a small rise in the ratio of principal payments on public debt to the stock of public debt (by about 1 percentage point as shown in Chart II-2) contributed also to the increased principal payments. This suggests that the structure of public and publicly guaranteed debt with regard to maturity or concessionality (interest rate, grace period) became somewhat less favorable between 1992–95. Since then, the structure of public debt appears to have remained broadly unchanged. As evinced by the increase in the ratio of principal payments on private debt to the stock of private debt, the effective maturity of private debt must have decreased considerably from the mid-1990s. On the basis of this measure, the effective maturity of private debt fell from roughly 10 years in 1996 to about two years in 2000.33 Again, it is important to note that this general trend began to emerge before the debt and balance of payments problems in 1999. Between 1992 and 1998, amortization payments on private debt rose from about 9 to 36 percent of the stock of private debt.34
80. A second factor was the increase in the implied interest rate on private external debt during the early to mid-1990s (Chart II-2). In contrast, interest payments on public debt rose broadly in line with the debt stock. This only supports the conclusion that the increased share of more expensive and more short-term private external debt was an important reason behind the deterioration in the debt service burden during the last decade.
81. A third and important factor behind the deterioration in the debt service ratios as shown in Chart II-2 was the sharp slowdown in the growth of current foreign exchange receipts from 1992. In the circumstances, debt service became more of a burden with sometimes large external current account deficits and a growing debt stock. Hence, the unfavorable export performance affected the debt service ratios also through the very unfavorable “denominator” effect on the debt service ratios, in addition to the effects on the debt dynamics through sometimes large external current account deficits (before interest payments).
Dimensions of Pakistan’s debt burden
82. In practice, the assessment of external debt sustainability relies heavily on the analysis of past debt dynamics on the one hand, and experience, cross-country comparisons, and rules of thumbs on the other.
A cross-country comparison of Pakistan’s debt burden
83. Table II-6 shows a cross-country comparison of indicators for the debt burden of a country, covering the period from 1990 to 1998 so that it remains unaffected by the exceptional financing received during 1999–2000. The main results of the comparison are as follows:
As a percent of current foreign exchange receipts, Pakistan’s stock of external debt was about at the average level for low-income developing countries in 1998 but above average when compared to developing countries as a group, middle-income developing countries, or to South Asia.35 Compared to heavily indebted countries, the country’s external debt remains below average.
As a percent of GDP, Pakistan’s stock of external debt was above average compared to all but heavily indebted countries in 1998.
Comparing the debt stock indicators for 1990 and 1998 shows a noticeable deterioration in Pakistan’s relative debt burden.
Pakistan’s debt service indicators are above average compared to all country groups in 1998. In 1990, total debt service was already above average, while interest payments on external debt were in the upper echelon but not at the highest level compared to other country groups.
|Total external debt||(In percent of GNP)|
|All developing countries||33.3||34.9||37.3|
|Low-income developing countries||60.0||47.6||47.9|
|Middle-income developing countries||33.7||42.5||51.0|
|Heavily indebted countries||132.8||124.5||121.5|
|Total debt service|
|All developing countries||3.7||4.6||4.5|
|Low-income developing countries||3.9||3.3||3.1|
|Middle-income developing countries||4.3||6.2||6.9|
|Heavily indebted countries||5.6||5.4||4.4|
|Interest on External Debt|
|All developing countries||1.6||1.6||1.9|
|Low-income developing countries||2.0||1.1||1.3|
|Middle-income developing countries||1.8||2.3||2.6|
|Heavily indebted countries||2.3||2.0||1.7|
|Total External Debt|
|All developing countries||155.8||129.0||146.2|
|Low-income developing countries||343.1||243.3||273.0|
|Middle-income developing countries||155.3||140.8||165.2|
|Heavily indebted countries||503.2||341.8||386.3|
|(In percent of Current Foreign exchange receipts)|
|Total Debt Service|
|All developing countries||17.4||17.0||17.6|
|Low-income developing countries||22.0||16.9||17.8|
|Middle-income developing countries||19.8||20.6||22.4|
|Heavily indebted countries||21.0||14.8||13.9|
|Interest Payments on External Debt|
|All developing countries||7.5||6.1||7.4|
|Low-income developing countries||11.3||5.9||7.4|
|Middle-income developing countries||8.2||7.4||8.5|
|Heavily indebted countries||8.7||5.6||5.4|
84. The cross-country comparison confirms the conclusion that Pakistan suffers from a heavy external debt service burden. It also illustrates how the already high debt service burden in the early 1990s was further aggravated by large external current account deficits and a deterioration in export performance.
85. An interesting outcome of the comparison is that the Pakistan’s debt service burden was above average in 1998 when evaluated against low-income developing countries, while the country’s debt stock ratios were about at average levels. In light of the previous analysis of the dynamics of the external debt burden, an obvious explanation would point to above-average shares of nonconcessional public debt and private debt with shorter maturities and higher interest rates in Pakistan’s external debt, which reduces both its grant element and its average maturity.
86. The hypothesis of a less favorable debt structure is confirmed by World Bank estimates.36 In 1997, the average grant element in the debt of low-income countries was about 44 percent, while that of Pakistan was only 21 percent. In contrast, in 1990, the average grant element in Pakistan’s external debt amounted to 35 percent, only slightly below the low-income countries’ average of about 41 percent. Similarly, in 1997, the average maturity of Pakistan’s external debt was only 12 years compared to an average of about 25 years in low-income developing countries, while in 1990, the same Chart was about 22 years for Pakistan’s external debt, and about 24 percent for low-income developing countries. At the same time, the share of private external debt in Pakistan rose from roughly 1 percent to about 20 percent of total external debt. The decreasing grant elements as estimated by the World Bank implies that in terms of the net present value of the debt, Pakistan’s debt is more of a burden when measured by the net present value of the debt stock as a percent of current foreign exchange receipts.
Rules of thumb: solvency index
87. Cohen (1988) proposed a solvency index to gauge the extent of the external debt burden. The solvency index s is the share of noninterest current foreign exchange receipts in period t that is needed to keep the external debt f (as a ratio of noninterest current foreign exchange receipts or “exports”) constant at the period t level in the future:
where the r denotes the interest rate on external debt and where x stands for current foreign exchange receipts (a hat over a variables denotes a growth rate).37 High values of the solvency index would suggest that a significant share of foreign exchange earnings is needed for interest payments on external debt, which could indicate unsustainable debt levels.
The solvency index can be computed in two ways:
The first is to compute the index based on recent averages of interest and export growth rates, and on the most recent debt to export ratio. The resulting solvency index can then be compared to the actual external debt service, which shows the extent to which the debt service burden is a function of principal payments.
The second way is to compute the interest rate on external debt, adjusted by the export growth rate, which would be consistent with maintaining the current debt and debt service ratios in the indefinite future. The computed rate can then be compared with recent actual rates, which provides for an assessment from a slightly different angle.
88. Table II-7 shows external solvency indices for Pakistan, both on a year-on-year basis and on an average basis. The averages are shown for both 1992–98 and 1992–2000 to avoid that biased conclusions are drawn because of the debt restructuring and rescheduling during the last two years.
|(In percentage points of noninterest, current foreign exchange receipts)|
|Actual debt-service ratio||30.6||40.2||40.9||45.0||44.0||53.7||58.6||75.0||64.9||44.7||50.3|
|Solvency interest rate||8.5||12.4||13.3||13.0||10.7||15.1||16.2||22.1||19.1||12.7||14.5|
|Actual interest rate||-11.3||10.2||4.2||-8.0||4.3||1.9||1.2||23.7||-7.7||0.4||2.1|
89. In the first two lines of Table II-7, the solvency index based on actual interest rate and export growth data is compared with the actual debt service ratio. The solvency index is typically small when compared to the actual debt service ratio. For example, during 1992–98, on average only 0.7 percent of current foreign exchange receipts would have been needed to keep the external debt stock constant with actual interest rate and export growth rates.
90. Lines three and four of Table II-7 compare the interest rate implied by the solvency index with the actual growth-adjusted interest rate on external debt. The calculations suggest that with the actual interest payments on external debt, which averaged about 0.4 percent during 1992–98 and 2.1 percent during 1992–2000, it would have easily been feasible to keep the debt stock constant as a percent of exports. With actual export growth rates, interest rates between about 13 to 15 percent would have been consistent with keeping the debt stock ratio constant. Such interest rate levels are, of course, well above the levels registered during the 1990s. Overall, the solvency indices suggest that Pakistan’s external debt problem is primarily a liquidity problem arising from an unfavorable amortization profile.
91. The cross-country comparison and the analysis of solvency indices suggest that the external debt problems are not related to the interest payments on external debt. Although the interest burden appears higher than that borne by other countries, especially low-income and South Asian countries in general, nominal interest rates on external debt are nevertheless sufficiently low to keep the intrinsic interest dynamics benign. Moreover, interest payments as a percent of current foreign exchange receipts are relatively low, as shown by the solvency index calculation.
92. What emerges clearly from the above analysis is that the external debt burden must be attributed to large amortization payments, which were the results of a large stock of external debt and unfavorable changes in the structure of external debt, as well as to a deterioration in the export performance. In recent years, scheduled debt service payments were extraordinary when compared to the standard benchmark in cross-country comparisons—current foreign exchange receipts. Moreover, they became even more burdensome in light of the turnaround in gross debt-related capital flows in the second half of the 1990s. It should be noted that this turnaround began before the balance of payments crisis that began to unfold after May 1998. With hindsight, one could conclude that the debt crisis that began to unfold after May 1998 had been looming during much of the 1990s.
93. A final verdict on the sustainability of Pakistan’s external debt would be premature without more detailed, forward-looking analysis of the structure of the external debt and the medium-term debt service profile. The events of the last two years obviously demonstrate that the external debt service was not sustainable, a conclusion that also follows from a comparison of Pakistan’s debt service ratios with standard benchmarks. With debt flow restructuring and rescheduling, this liquidity problem was resolved. In the short term, the available resources remain insufficient to meet the scheduled debt service obligations unless imports and per-capita consumption contracted dramatically, with corresponding socioeconomic and sociopolitical implications. It is for this reason that the new program to be supported by a Stand-By Arrangement includes another round of flow restructuring and rescheduling. The matter is less clear-cut when it comes to the sustainability of the outstanding debt stock. While the net present value of the debt is reduced with the flow restructurings and reschedulings, the answer to the question of whether the reduction is sufficient to allow debt ratios to return to levels considered as sustainable awaits further analysis.
C. Public Debt Issues and Sustainability
94. This section analyzes the sustainability and other issues related to public debt. Public debt issues are related to fiscal sustainability, that is, the capacity of the federal and provincial governments to service the debt in an orderly manner. Orderly debt service requires that the government is solvent, that is, that the net present value of government assets is at least equal to the net present value of government liabilities.38 If a government is indebted, as is typically the case, solvency requires that the net present value of future primary balances (including seignorage revenue) equals or exceeds the current stock of government (net) debt.39 Hence, on average, solvent governments will have to run surpluses in the future if real interest rates exceed real GDP growth.40
95. This solvency requirement emanates from accounting identities and is by itself not very meaningful from a policy point of view. A more meaningful approach is to examine whether fiscal policies are sustainable, that is, whether their implications are consistent with basic goals of economic policy. Following Razin (1996), fiscal policies can be considered sustainable if they are consistent with the regular servicing of the public debt as well as with high medium-term economic growth and macroeconomic stability and if they are robust to possibly persistent perturbations to the anticipated path of key variables such as growth and interest rates. In terms of instruments, the issue is the level and structure of adjustment in expenditure and revenue needed to ensure that a fiscal policy program becomes sustainable.
96. From this perspective, the sustainability of a fiscal policy program depends, among other factors, on the overall macroeconomic policy mix, the current level and structure of expenditure and revenue, and the current level and structure of the debt-to-GDP ratio. Against this background, the assessment of fiscal sustainability and robustness calls in principle for a comprehensive macroeconometric model, which unfortunately is not available for Pakistan. In the circumstances, the analysis of past debt dynamics and simple scenario analysis based on sustainability indicators are often useful for the assessment of fiscal sustainability.
Pakistan’s public debt—some stylized facts
Level of public debt
97. At 92 percent of GDP at end-June 2000, the level of net public debt in Pakistan is high by international standards (Table II-8). Net public debt is defined as gross public debt minus government deposits and its variations correspond to the budgetary financing of the consolidated federal and provincial government budgets.41 Unfortunately, it is impossible to eliminate what is usually considered a small amount of publicly guaranteed external debt that is not serviced by the budget.42 It should also be noted that the concept of net public debt used in this section excludes external central bank liabilities (including IMF credit) or other contingent government liabilities, as changes in these items do not affect budgetary financing. Other contingent government liabilities are also not included.43 The debt-to-GDP ratio has been increasing steadily since the mid-1980s, when it was 76 percent of GDP (Chart II-3). The same picture of a steadily increasing debt ratio also emerges when the debt is normalized by government revenue.
|(In billions of Pakistan rupees)|
|By residency of holder|
|(In percent of GDP)|
|By residency of holder|
|(In percent of government revenue)|
|By residency of holder|
|External 2/||…||261.5||258.6||262.5||263.9||247.1||272.3||275.0||292.5||283.7|Chart II-3.Pakistan: Net Public Debt, Budget Balance, and Interest Rates
Source: Staff calculations based on the data provided by the authorities.
Federal and provincial debt
98. The outstanding public debt is by and large debt issued by the federal government; provinces have very little debt outstanding. The constitution allows provincial governments to mobilize external and domestic loans and grants. If they have outstanding loans guaranteed by the federal government, however, their borrowing must be approved by the federal government. As about 95 percent of total provincial debt is reported to be borrowing from or guaranteed by the federal government, the provinces can not make independent borrowing decisions in practice.
Composition of domestic debit44
99. Roughly 50 percent of the public debt is denominated in domestic currency and is held almost exclusively by residents. The share of domestic currency denominated debt (referred to as domestic public debt from hereon) in total public debt has remained remarkably stable in recent years and amounted to 54 percent of GDP in terms of gross debt and 45 percent in terms of net debt at end-2000 (Table II-9). The authorities classify the issued debt instruments into three main categories, permanent debt, floating debt, and unfunded debt:
The so-called permanent debt comprises largely medium- to long-term securities held by banks and nonbanks. Prize bonds, that is, bonds with a lottery element are also part of this category. This debt component can be considered to be medium to long-term debt on an original maturity basis.
Floating debt includes short-term government papers, especially 3–12 month treasury bills, which are mostly held by banks.
Unfunded debt refers to resources mobilized through the national savings schemes (NSS) administered by the federal government’s Central Directorate of National Savings. This funding category comprises a number of instruments. Most of them are of medium to long-term maturity although their effective maturity can vary in some instances as they include put option-like elements for the holder. For example, defense savings certificates have a 10-year maturity but allow for early redemption without penalty after one year.45 Unlike most of the permanent and floating debt instruments, they are issued on tap.
|(In billions of Pakistan rupees)|
|Gross domestic public debt||448||864||987||1,130||1,283||1,491||1,729|
|Net domestic public debt||391||798||915||1,058||1,232||1,290||1,461|
|(In percent of GDP)|
|Gross domestic public debt||52.3||46.3||46.6||46.5||47.9||51.2||54.3|
|Net domestic public debt||45.7||42.8||43.2||43.6||46.0||44.3||45.9|
|(In percent of government revenue)|
|Gross domestic public debt||267.7||281.0||266.4||288.5||303.2||314.0||337.4|
|Net domestic public debt||233.7||259.6||246.9||270.2||291.2||271.6||285.0|
|(In billions of Pakistan rupees unless otherwise noted)|
|Net public debt held by the banking system||170||415||469||542||597||551||630|
|In percent of GDP||19.9||22.2||22.1||22.3||22.3||18.9||19.8|
|In percent of M2||57.0||55.2||50.0||51.5||49.5||43.1||45.0|
|Net public debt held by the central bank||90||181||164||231||224||258||391|
|In percent of GDP||10.5||9.7||7.7||9.5||8.4||8.8||12.3|
|In percent of reserve money||68.7||63.2||52.9||66.6||60.5||64.8||78.5|
100. The category other debt consists mainly of unbacked bank advances or transitory financing items such as security deposits. Bank advances are relevant mainly for the so-called commodity operations. Both the federal and the provincial governments engage in these operations, which involve the procurement of agricultural commodities such as wheat.
101. In recent years, the share of permanent decreased while that of the other two categories increased. The increase in the share of unfunded debt is especially striking. At end-June 2000, regular medium-to long-term debt accounted for less than 20 percent of domestic debt while the share of the other two categories was about 40 and 45 percent, respectively. While the average maturity structure of unfunded debt is difficult to pinpoint, the 40 percent of floating debt nevertheless constitute only a lower bound or the share of short-term debt in total net domestic public debt.
102. The increase in the share of unfunded debt during the 1990s is often attributed to the emphasis on raising the share of nonbank budgetary financing to reduce inflationary pressures arising from bank-financing of the budget. Given the segmented structure of Pakistan’s financial market, NSS instruments have in practice been the only debt instruments available to private investors and non-bank financial institutions.
103. Roughly 45 half of the net domestic public debt is held by the banking system. These holdings, equivalent to net credit to the government, in turn account for slightly less than one half of broad money M2. About one fourth of the net domestic public debt is held by the central bank, the holdings of which account for over 70 percent of reserve money. With such large shares of (net) government credit in total credit, it is clear that government financing needs and government debt have become an important and constraining factor for monetary policy.
Interest burden of the public debt
104. Overall, the average interest rate on Pakistan’s net public debt has been steadily increasing over the last 25 years (Chart II-3), both in nominal and real, growth-adjusted terms.46 Accordingly, the interest burden on public debt, as measured by budgetary interest payments as a percent of GDP, has been rising (Table II-10). In 1998, the budgetary interest burden reached, for the first time, more than 7 percent of GDP.
|(In billions of Pakistan rupees)|
|(In percent of GDP)|
|(In percent of government revenue)|
|Memorandum items:||(In percent)|
|Implied interest rate on public debt||8.3||6.5||7.3||7.6||8.2||8.0||8.4|
|Inflation adjusted 2/||-0.8||-6.5||-0.9||-5.1||0.6||1.9||5.1|
|Growth adjusted 3/||-6.3||-10.2||-5.6||-6.0||-1.9||-0.8||-0.7|
|Implied interest rate on domestic public debt||11.1||10.1||11.7||12.6||13.2||13.6||13.6|
|Inflation adjusted 2/||1.9||-3.3||3.1||-0.7||5.3||7.2||10.1|
|Growth adjusted 3/||-3.8||-7.1||-1.7||-1.7||2.7||4.4||4.0|
|Implied interest rate on external public debt||4.5||2.9||2.9||2.7||2.8||2.7||3.2|
|Inflation adjusted 2/||-4.2||-9.7||-5.0||-9.5||-4.3||-3.0||0.1|
|Growth adjusted 3/||-9.5||-13.3||-9.4||-10.4||-6.7||-5.6||-5.5|
105. The rise in the average interest rate on the net public debt is primarily the result of increases in the average interest rate on domestic currency denominated public debt, which, in connection with decreasing inflation rates and lower real GDP growth, accentuated the intrinsic debt-interest dynamics (Table II-10). This contrasts markedly with the interest burden of external public debt. The implied interest rate on this debt category remained well below inflation and real GDP growth rates, so that the relevant interest rate for the interest burden (the growth-adjusted real interest rate) remained negative.
106. The striking difference in the interest dynamics in recent years reflects the differences in the composition of external and domestic debt. As noted above, the former is owed mostly to official creditors, which often involves concessional terms so that the related interest dynamics was somewhat less affected by economic factors. Interest rates on domestic public debt on the other hand are partly market-determined and increased significantly with some financial liberalization and the trend increase in the stock of public debt. This trend is aptly illustrated in Chart II-4, which shows the 6-month treasury bill rate and the interest on defense savings certificates—an important instrument in the category of unfunded domestic debt—in nominal and real terms.47
Source: Data provided by the authorities and staff calculations.
1/ Period averages on a fiscal year basis. For example, 1999 refers to the values in the fiscal year 1998/99 running from July 1, 1998 to June 30, 1999.
2/ Nominal interest rates minus average annual inflation rate.
107. Besides general macroeconomic developments and the rising debt stock, the increase in the interest burden has sometimes been attributed in part to current practices in public debt management. In particular, NSS instruments have been issued on tap, and their rates of return used to be set with little consideration for general financial market developments or money market benchmark rates. During the 1990s, socio-political objectives such as the promotion of savings in rural areas also appear to have played a role in the determination of NSS rates of returns. Over time, a substantial after-tax return differential on NSS instruments (compared to treasury bills or bank deposits) emerged. In the second half of the 1990s, the return differential contributed to the increased absorption of private savings through the NSS, which has led to some financial disintermediation and has hampered the developments of a general market for government bonds. Mindful of these developments, the authorities have begun to reduce rates of returns on NSS instruments in 2000.
108. The soaring real interest rates on domestic debt have become a major challenge for policy makers in Pakistan. With the disappointing progress in revenue mobilization during the 1990s, their efforts to control budget deficits required the reduction of development expenditure (as a percent of GDP) and limited the scope for providing essential social and education services. Many economist would support the hypothesis that these changes in the structure of government expenditure were among the factors underlying the decrease in the average growth rate observed during the 1990s.
Public debt dynamics, 1975–2000
109. The identification of the factors that contributed to the evolution of public debt ratios in the past and present provides useful information on policy issues and constraints as well as some guidance with regard to the prospects. As shown in Appendix II-III, the change in the debt-to-GDP ratio between t and t+1 is determined by three main factors:48
Primary balance, which determines the budgetary financing needs for regular government operations. Primary surpluses alleviate the debt dynamics whereas primary deficits worsen it.
The intrinsic debt-interest dynamics, which emanates from the difference between thereal interest rate and real GDP growth. On average, this difference will be positive (except, possibly, for concessional external debt).49 Positive, so-called growth-adjusted real interest rates underlie the dynamics on interest compounding and are the key behind the potential for unstable debt dynamics.
Valuation effects, which arise from the effects of nominal exchange rate changes on the foreign currency denominated debt. A depreciation of the domestic currency against currencies in which external public debt was contracted raises the value of this debt in domestic currency term and, with less than proportional effects on domestic prices, in terms of GDP.
110. The actual decomposition of the debt dynamics in Pakistan into the main components can be found in Table II-11.50 As in the section on the external debt, the exposition is in terms of push and pull factors.
|(In percentage points of GDP)|
|Change in public debt ratio||-6.3||6.1||18.2||-8.4||0.1||1.2||1.9||2.5||-0.3||5.4|
|Structural balance 2/||…||…||5.6||5.6||1.1||1.1||1.1||1.1||1.1||5.6|
|Output gap 3/||…||…||0.2||-0.1||-0.3||0.1||0.2||0.3||-0.1||0.2|
|Discretionary primary balance||…||…||12.4||5.9||0.9||-0.9||-1.0||-2.7||-2.2||-6.0|
|Exchange rate valuation||0.0||22.5||15.4||14.3||4.9||5.9||3.9||6.8||0.0||21.5|
111. Historically, primary deficits were arguably the most important push factor behind the increase in the debt-to-GDP ratio. During the 1990s, however, the contribution of primary deficits to the public dynamics began to decrease noticeably, especially from 1995. In 1998/99, a primary surplus was recorded for the first time.
112. The decreasing contribution of the primary balance to increases in the debt ratio was the result of the more determined fiscal adjustment efforts in recent years. In the more detailed decomposition of the primary balance shown in Table II-11, the adjustment efforts are reflected in the turnaround in the discretionary primary balance from a deficit to a surplus.51 The rather volatile growth dynamics during the 1990s and the associated output gaps appear to have affected the primary balance only marginally.
Intrinsic debt-interest dynamics
113. The debt-interest dynamics was generally favorable and, as the most important pull factor, did not contribute to the rise in Pakistan’s public debt ratio during 1975–2000. This was the result of low real interest rates on public debt, especially external public debt, and relatively high rates of real GDP growth, which led to negative growth-adjusted real interest rates. Nevertheless, the intrinsic debt-interest dynamics became increasingly less favorable during the last 25 years, reflecting primarily the steadily rising real interest rates on domestic public debt and the growing debt stock.
Exchange rate-related valuation losses
114. The exchange rate-related revaluation of the public debt was another important push factor behind the increases in the public debt ratio since the early 1980s. During each five-year period, the depreciation of the Pakistani Rupee against major currencies raised the debt-to-GDP ratio, ceteris paribus, by more than 10 percentage points.
A closer look at the debt dynamics during 1996–2000
115. During the last five years, the debt dynamics differed markedly from previous periods. The ratio of net public debt to GDP gradually converged toward 92 percent and appears to have stabilized. On a cumulative basis, the primary balance became a (minor) pull factor after the continued improvements in the primary balance. At the same time, the interest factor, which determines the magnitude and sign of the contribution of the intrinsic debt-interest dynamics, converged toward zero. The cumulative 5-year pull factor was the lowest compared to any of the 5-year periods shown in Table II-11. The most important push factor during the period was the exchange rate-related valuation loss incurred on external debt.
Public debt stabilization and primary gaps
116. When the public debt is large, a threat to macroeconomic stability, and an impediment to high medium-term growth, attention typically focuses first on debt stabilization and then on debt reduction, if the latter is considered necessary. This raises the question of the fiscal effort needed to achieve this goal. Primary gaps allow for some rough estimates of the primary fiscal efforts—changes in revenue or noninterest expenditure—needed to bring the debt stock to levels considered sustainable.52
117. Primary gaps measure the additional adjustment in the primary balances needed to meet, on the basis of today’s debt stock, a debt stock target N periods ahead.53 A positive primary gap measure suggests that further adjustment beyond the current path envisaged for the primary balances is needed while a negative gap could support loosening fiscal policy. To make conclusions robust in view of parameter uncertainty, primary gap analysis should be conducted in the context of scenarios. In an iterative fashion, they can be used to examine the implications of various parameter constellations (inflation, interest rates, growth), debt stock targets, and targets for primary balances.
118. Table II-12 primary gap measures for debt stock targets in 5,10, and 15 years. They were computed on the basis of the targeted primary balance in 2001 and the end-of-period stock of public debt (in percent of GDP) in June 2000. The gap measures were computed for a range of growth-adjusted real interest rates and target debt-to-GDP ratios in order to gauge the sensitivity of the gaps to various parameters.
|5-Year Primary Gaps||10-Year Primary Gaps||15-Year Primary Gaps|
|Real Interest Rate (in percent) 2/||Real Interest Rate (in percent) 2/||Real Interest Rate (in percent) 2/|
119. For the growth-adjusted real interest rate, rates of -2, -0.7,0,1 and 2 percent were used.54 This range would be consistent with both rates observed in the most recent past and allow for some prospective increase in rates. In 2000, the actual, implied growth-adjusted real interest rate was -0.7 percent, and the average rate during 1996–2000 was -3 percent. As argued below, prospects are that this rate will converge towards 0 or even become positive. For the debt-to-GDP target rate, values ranging from 60 to 100 percent were used. At end-June 2000, the actual ratio was 92 percent. The following observations emerge from the primary gap calculations:55
For the growth-adjusted real interest rates observed in 2000 (-0.7 percent), the fiscal policy stance envisaged in 2001 (a primary surplus of about 1.5 percent of GDP) is consistent with a “gradual growing out” of debt problems. As shown in Table II-12, such a surplus would be sufficient to reduce the debt-to-GDP ratio to about 83 percent in 5 years, 73 percent in 10 years, and about 64 percent in 15 years.
For growth-adjusted real interest rates of zero, maintaining the fiscal policy stance envisaged in 2001 would lead to some reduction in stock of public debt but only over a 10 to 15- year period would the decline be noticeable.
For positive, growth-adjusted real interest rates of 1 percent, maintaining the fiscal policy stance envisaged in 2000/01 would lead to a very gradual decline in public debt in the long term. Over a 5-year period, the debt stock would remain at about 92 percent of GDP. Over 15 years, it would fall to about 87 percent.
120. In short, the calculations suggest that for growth-adjusted real interest rates below zero, the debt dynamics would remain under control in the sense that the current debt ratio would over time be reduced noticeably with a primary surplus of about 1.5 percent of GDP. Even with growth-adjusted real interest rates of zero and above, such a primary surplus would be sufficient to stabilize the debt-to-GDP ratio in the medium term.
Is debt stabilization sufficient?
121. The primary gap calculations imply that the current, relatively modest adjustment effort would be sufficient to stabilize the public debt as a percent of GDP, even if the average terms on public debt were to deteriorate somewhat. Could one not conclude that the current fiscal adjustment effort, as measured by this year’s target for the primary balance, is all that is needed for the future? It is argued here that this conclusion would be myopic, given some significant medium-term risks to the debt dynamics and the implications of possibly unchanged debt ratios on the economy. The following risk factors seem relevant in this regard:
The perspective of a relatively benign interest burden hinges on low interest rates on public debt, which, in turn, depends on the prospects for external financing at favorable terms. Relatively small changes to the current share of external budget financing have the potential to change the dynamics of the debt path significantly. For example, if some external public debt had to be repaid through the issuance of domestic debt, total public debt and the interest burden would increase at current real domestic interest and GDP growth rates. Given the external debt problems, these risks can not be ignored. While substantial exceptional financing may be available in the short term, prospects are that new external financing to the budget will be linked to the amortization of outstanding debt. In addition, as pointed out above, some long-term instruments have bullet interest payments. 10-year instruments contracted at high interest rates in the mid-1990s may keep the average growth-adjusted real interest rate on net public debt high in the medium-term even if actual interest rates decline.56
A related risk is the exchange rate risk, which was not taken into account in the calculations. With a nominal depreciation of the rupee, the debt-to-GDP ratio could stagnate or increase even with growth-adjusted real interest rates below zero.57 The significance of the exchange rate risk depends largely on the prospects for amounts and terms of net external budgetary financing, as described above.58
122. Quantifying the implications on growth-adjusted real interest rates if these medium-term risks were to materialize remains difficult. While it would seem certain that these rates would turn positive, it would be testing to predict whether they would exceed the 2 percent maximum rate used in the calculations above. Nevertheless, as far as the implications, it is clear that at roughly unchanged public debt ratios, positive growth-adjusted real interest rates are likely to lead to a higher interest burden for the budget compared to the burden today, which, in turn, would increase the overall budget deficit (given the assumption of an unchanged primary surplus used in the calculations).
123. Could Pakistan’s economy sustain higher overall budget deficits if the medium-term risks to the debt dynamics were to materialize? The experience of the 1990s suggests otherwise. The large domestic financing needs would crowd out private sector investment, thereby undermining changes for sustained high growth. They would also be an even greater burden on macroeconomic and financial policies (given less external budget financing), thereby increasing financial vulnerabilities and threatening macroeconomic stability. In the circumstances, progress toward a better expenditure structure could also be jeopardized because progress in revenue mobilization may need to offset higher interest payments and stabilize the debt. The much needed increases in productive social and development expenditures could then not be effected.
124. These considerations suggest that some reduction of the public debt (as a percent of GDP) is needed. The magnitude of the reduction would have to be determined on the basis of the prospects for medium-term external budget financing.
D. Handling Pakistan’s Debt Problems—A Policy Perspective
125. The analysis in this Section established that Pakistan suffers from a twin debt problem. Both the external and public debt stocks need to be brought down to sustainable levels. Addressing the external debt problem is urgent. Addressing the domestic public debt problem appears somewhat less urgent, given the still favorable intrinsic debt-interest dynamics and less acute debt refinancing problems, although the medium-term risks for the public debt path should not foster complacency either.
Addressing the external debt problem
126. Meeting the scheduled debt service payments is simply not feasible in the short-term given Pakistan’s balance of payments position. The country already runs surpluses in the external current account balance before interest payments, prospects for a reversal in net capital flows before exceptional financing in the short term seem remote, and last but not least, official foreign exchange reserves are already at dangerously low levels.
127. An external debt strategy would need to resolve both the short-term foreign exchange liquidity problems and medium-term external debt sustainability. Without achieving the latter, investor confidence would not recover, which would be a drag on medium-term growth and financial stability. The following elements would be key components of a policy strategy:
128. Debt restructuring and rescheduling. Restructuring and rescheduling of the debt service obligations are critical for ensuring short-term balance of payments viability, as Pakistan’s debt and capital account problems are just two sides of the same coin. Short-term debt restructuring and rescheduling may, however, not be sufficient. As indicated by the cross-country comparison of the debt burden, Pakistan’s debt burden remains high even after rescheduling and restructuring in 1999–2000. A medium-term policy strategy may need to be considered to ensure a smooth transition to sustainable levels of debt service.
129. Developing the domestic production of tradables and fostering export growth. In the short-term, export growth alone would be insufficient to ensure orderly servicing of the external debt. The short-term effects of measures to foster export growth and stabilizing domestic demand would, however, help in keeping the external current account balance at feasible levels. This remains a concern. The noticeable turnaround in net exports during 1999–2000 was in part the result of temporary increases in restrictions on current account transactions, which have in the meantime been eased or removed. Another element in the turnaround were the favorable productivity shocks in the agricultural sector in 2000, all of which may not be permanent. In the medium term, fostering export growth and tradable sector development would be the most important element of a policy strategy to bring external debt service obligations to sustainable levels. This would not only reduce the need for further external debt accumulation, which would at any rate seem inconsistent with recent capital account developments, but would also make the obligations on the existing stock of debt more bearable. In addition, the vulnerability of the tradables sector to shocks in the agricultural sector would need to be reduced.
130. Restoring donor and investor confidence. Increasing capital inflows that are not debt-creating is also important to reduce the debt burden on the economy. This would help to avoid that external financing constraints become a drag on medium-term growth. Higher export growth and the improved debt service profile after restructuring and rescheduling will, of course, contribute to raising investor confidence as they reduce the likelihood of future balance of payments difficulties. However, more determined reform efforts, including in the areas of governance and transparency, are also needed for a sustained improvement in donor and investor confidence. This would also help in debt reduction, including through privatization.
131. Prudent external debt management. Pakistan will remain a highly indebted country over the next few years. Managing the debt with a view to keep risks related to maturity structure and the terms of new debt contracts at sustainable levels will be critical. As shown above, increased shares of short-term private external debt was one reason for the increase in the debt service burden during the 1990s. Efforts should focus on mobilizing external financing at concessional terms or at terms that are consistent with the medium-term debt service capacity of the economy.
Addressing the public debt problem
132. External public debt constitutes a large share in Pakistan’s total public debt. Nevertheless, the policies needed to address the external debt problem would not immediately contribute to addressing the public debt problems. The following elements would be important in this regard:
133. Increase primary surpluses. The public debt ratio appears to have stabilized at around 90 percent of GDP. At the policy level, the next step would be to increase the primary budget surpluses to first secure the stabilization of the debt ratio and then reduce the debt stock. The latter is essential in view of the vulnerabilities in the growth dynamics related to weather and other vagaries affecting agricultural output, the prospects for higher average real interest rates on the public debt, the external financing risks, and the need to reduce the crowding out of private investment.
134. Focus on revenue mobilization to resolve dilemma between adjustment and improving the expenditure structure. The current fiscal policy stance, that is, maintaining a substantial primary surplus through expenditure containment to keep the debt dynamics in check, may not be sustainable, given that essential government spending on education, health, social and physical infrastructure is already at levels considered to be suboptimal, and the disappointing per-capita growth rates of income and consumption. Increased revenue mobilization must therefore be a policy priority, even if real interest rates may start declining once the reduction in public debt is perceived as sustainable and durable by investors. Substantial increases in revenue would allow to resolve the dilemma between increasing the primary budget surpluses over time and increasing essential government expenditure to the levels needed to support high medium-term growth and alleviate poverty. This, in turn, is needed to enable the economy to grow out of the debt problem eventually.
135. Strengthen public debt management and capital market development. After the liberalization of financial markets in the early 1990s, the rising public debt and the steady increase in the external financial vulnerability were undoubtedly the most important factors behind the increase in domestic real interest rates during the remainder of the 1990s. Nevertheless, real interest rates on the stock of domestic public debt appear high given that the domestic currency-denominated public debt is less than 50 percent of GDP. The lack of systematic debt management and the missing linkages between benchmark interest rates and NSS rates of return may have contributed to high real interest rates. The authorities should, therefore, set-up a debt management unit that would focus on minimizing the risk-adjusted costs of government borrowing. Optimizing the composition of government debt would be an important element of a debt management policy, Another essential element would be policies aimed at promoting more integrated and deeper markets for domestic currency debt instruments in general and for government debt instruments in particular. The debt management unit should also compile more detailed and timely public debt statistics, including contingent liabilities and interest payments on an accrual basis.
Given balance of payments identities, the change in the stock of external debt between the beginning of periods t and t+1 in U.S. dollar terms, denoted as Ft+1- Ft, must be equal to the sum of net exports or, more precisely, the external current account balance excluding interest payments on external debt, interest payments on external debt, and the change in official reserve assets minus other capital flows.59 The last term includes exceptional financing. Formally, this accounting identity can be expressed as follows:
where the notation follows from the ordering above. In analogy with the case of public debt, the identity can be expressed as a ratio of noninterest foreign exchange receipts Xt in period t:
where small letters denote ratios of the above capital letter variables. The term
The concept of government solvency defines a minimum requirement for sustainability. While it is inappropriate for Pakistan under the current circumstances, the concept is nevertheless useful for understanding the broader concept of fiscal sustainability.60 In the simplest possible form, its essentials can be summarized as follows.61 In each period, the government’s flow government budget constraint implies that under the assumption of pure debt financing the end-of-period public debt is given by:
Bt+1 = GEt-GRt + (1+Rt)Bt,
where B denotes the outstanding public debt, GR is government revenue, GE represents noninterest government expenditure, R is the nominal interest rate on government liabilities, and t is a time subscript. For the subsequent analysis, it is useful to rewrite the flow constraint in equation (1) in terms of the current period GDP:
where a lowercase letter variable denotes a capital letter variable as a fraction of the current period GDP (except for r, the real interest rate), and ŷ the growth rate of real GDP. The intertemporal solvency constraint requires that the flow budget constraint equation (2) is expected to hold in every period in the future, which leads to the condition:
where rg denotes the growth-adjusted real interest rate, (that is, 1 +r)/(1+ŷ)-1. The sum of the expected present value of all present and future expenditure and the current level of debt has therefore to be equal to the net present value of current and future revenue. The condition in equation (3) can be rewritten using the primary balance pb rather than expenditure and revenue:
If the growth-adjusted real interest rate is positive on average, as suggested by standard models of economic growth, the condition in equation (4) leads to the familiar requirement that the government has to run primary surpluses in the future if it has some outstanding liabilities today. In the derivation of equations (3) and (4), it was assumed that the so-called transversality condition:
holds. This condition can be interpreted as a limit on the average increase in the debt-to-GDP ratio in the future, which has to be lower than the average growth-adjusted real interest rate.62 Together, the solvency constraints in equations (3) or (4) and the transversality condition in equation (5) ensure the intertemporal consistency of a fiscal program. They provide the accounting framework for the requirements that the debt is serviced in every period and will eventually be repaid. In other words, they ensure that the government’s net worth on a present value basis is positive.
The conditions in equations (3) or (4) and (5) have constituted the core of many empirical studies on fiscal sustainability.63 In some studies, the focus lies on testing whether the primary deficit or the debt-to-GDP ratio, or the discounted debt-to-GDP ratio are stationary over a sufficiently long time period. As discussed below, stationarity of these variables is necessary for solvency but not a sufficient condition for fiscal sustainability.64 In other studies, some arbitrary steady-state, debt-to-GDP ratio is defined, which is then used to assess the sustainability of the current fiscal policy on the basis of the current level of debt and average growth rates of expenditure, revenue, interest rates, and GDP growth.
In many circumstances, the concept of fiscal solvency is not terribly useful for policy analysis for the following reasons:
(1) While it seems reasonable and pragmatic to require that the debt-to-GDP ratio be a stationary time series in a very large data sample, the requirement is weak in that it is consistent with almost any positive mean value for this variable. Even a shift in the long-run debt-to-GDP value from, say, 40 percent to 100 percent, does not violate the solvency conditions. From a general macroeconomic perspective, however, such changes would not be minor, since their implications for growth and macroeconomic policies are likely to be substantial.
(2) In many countries, the time span covered by the data sample is insufficient to allow for a meaningful distinction between stationary and nonstationary time series for the primary deficit and the debt-to-GDP ratio.
(3) Macroeconomic variables, such as the real interest rate and growth, are usually taken as given in the derivation and testing of equations (3) and (4). Many different combinations of future primary balances, growth and interest rates are consistent with solvency. These combinations must satisfy a weak technical restriction, the co-called transversality condition. This condition restricts the debt to grow on average at a rate below the average interest rate on government debt. This puts limits on government’s capacities to run large primary deficits on a sustained basis, although this constraint can be quite weak in its implications for the debt-to-GDP ratio (see, for example, McCallum (1984)). However, fiscal policies have repercussions on financial market prices and growth, and many of these combinations may not be feasible because of the economic relationships between the fiscal policies underlying the primary balance path, real interest rates, and growth rates. Given the feedback from fiscal policies to growth, and real interest rates, fiscal policy paths that involve large deficits would actually lead to increasing real interest rates, which would undermine debt sustainability through the intrinsic debt-interest dynamics. The range of fiscal policies consistent with solvency depends on the overall macroeconomic policy mix. The solvency and sustainability of certain fiscal policies, therefore, can not be assessed without taking into account macroeconomic policies in general as well as the interaction between macroeconomic variables and policies.
For Pakistan, the problems associated with the notion of fiscal solvency are particularly relevant. In the past, the growth-adjusted real interest rate on public debt has typically been negative, which would imply that solvency and debt considerations are unimportant if solvency and sustainability were treated as one and the same. The recent experience in Pakistan has shown, however, that debt problems are very important despite the negative growth-adjusted real interest rates on public debt.
The stock of public debt at the end of period t, Bt+1 is the sum of debt denominated in domestic currency and debt denominated in foreign currency:
where St+1 denotes the nominal rupee-U.S. dollar exchange rate (rupees per dollar) at the end of period t. The change in the stock of public debt during period t has three components, the government budget deficit, denoted with Dt, budgetary grants Gt, and the valuation changes. It is assumed that the government does not retire debt prematurely so that all debt is valued at face value. Accordingly, valuation changes emerge only from changes in the nominal exchange rate. The change in the stock of public debt can therefore be written as:
The budget deficit can be decomposed into the primary balance, i.e., the difference between budgetary revenues and budgetary, noninterest expenditure, and interest payments on public debt:
Dt = −PBt + RtBt = −GRt + GEt + RtBt
For the analysis of debt developments, it is often useful to decompose the primary balance into structural, cyclical, and discretionary developments as shown in the following equation:
PBt = (gra − gea)YPt + gra(Yt − YPt) + DPBt
where the notation is as follows: gra is the average ratio of government revenue to GDP, gea the average ratio of budgetary, noninterest expenditure to GDP, YP the potential output, Y the actual GDP at market prices, and DPB the discretionary primary balance, m the above formula, the first term captures the structural primary balance. The latter is given by the difference between the average ratios of budgetary revenue and noninterest expenditure to GDP. With the multiplication by potential output, one obtains the structural primary balance in nominal units. The second term captures the effect of output variations on the revenue performance.65 The third term is the discretionary primary balance, which captures all other factors. In the case of a country undergoing fiscal adjustment after a prolonged period of loose macroeconomic policies, the meaning of the structural primary is not clear because the average revenue and expenditure ratios calculated with a long data sample are very likely to overstate the structural deficit. For this reason, the average ratios for a selected period of fiscal adjustment were calculated.
With all these elements, the change in public debt can be rewritten as:
Dividing by the nominal GDP in period t yields the change in public debt as a percent of GDP:
where all small letters denote ratios or growth rates (with a hat above a letter) (the capital Y with a hat denotes the output gap in percent) and where π is the inflation rate.66 This last formula underlies the decomposition of the public debt dynamics in section II. The term rt -ŷt is referred to as the growth-adjusted real interest rate in the text. In Table 11, the term
Prepared by Thomas Helbling (MED).
See for example Hasan (1999), and Pasha and Ghaus (1996,1998).
The subsection on public debt discusses the concept of debt sustainability in greater detail.
All references to years are to fiscal years. Pakistan’s fiscal year runs from July 1 to June 30. For example, 2000 refers to the fiscal year 1999/2000.
Defined as the sum of exports of goods and services and workers’ remittances.
It should he noted that private debt includes external debt contracted by state-owned banks without an explicit government guarantee.
Only the maturity breakdown of all foreign currency deposits, including those of residents is known.
The scheduled debt service in 1999 and 2000 should be interpreted with caution because of the statistical treatment of debt items that were rescheduled by the full amount. When such debt was rescheduled for the first time, the scheduled debt service assumes full repayment of the debt. This caveat is particularly relevant for some categories of FCDs.
In the literature on external current account sustainability, the noninterest external current account balance is often referred to as the trade balance.
This issue is discussed in more detail in Appendix II-II in the context of fiscal solvency.
The decomposition was performed for the years 1992–2000. For this period, the balance of payments data is based on the same classification.
It should be noted that these maturity calculations are based on scheduled payments and that “true” effective maturity of private debt would have to be assessed after restructuring.
A minor element of crisis is already included in the debt service data for 1997/98, as the 1998 crisis began to unfold in May.
Pakistan is classified as a low-income developing country by the World Bank in the Global Development Indicators.
World Bank, Global Development Finance 2000 Yearbook, Washington, D.C: The World Bank.
It should be noted that this index is based on the assumption of constant debt repayments as a fraction of noninterest current foreign exchange receipts.
The solvency requirement is often referred to as the so-called present value budget constraint.
Other government assets are generally disregarded in this paper, assuming that the government assets are illiquid without a readily available market valuation or marketability. In the review of policy options, however, the role of other government assets will be explored, including the possible role of privatization in resolving debt problems.
Appendix II-II discusses the mechanics of the solvency requirement in some detail.
After a steady decrease during most of the 1990s (in percent of GDP) the government deposits increased considerably during 1999–2000 because of a buildup of debt-relief counterpart deposits.
It appears that publicly guaranteed external debt accounts for the wide differences in past public debt data used in the literature (e.g., Hassan (1999) or Pasha and Gaus (1998)). The SBP publishes a series on federal public debt, which includes parts of the external debt contracted by the federal government. The SBP also publishes a total public debt aggregate which includes all gross domestic and external public debt, including publicly guaranteed external debt.
For this reason, the amounts of external public debt used in this subsection are not comparable to those used in the subsection on Pakistan’s external debt. It should be noted that central bank operations are not part of the consolidated federal and provincial fiscal data (except for the profit transfer as government revenue).
The composition of external public debt was already discussed in the previous subsection.
A progressive interest remuneration over the years discourages early redemption.
It should be noted that the interest payments in the budget are on a cash basis. With rising interest rates during the 1990s, this has led to an understatement in the interest bill on an accrual basis because some long-term instruments pay bullet interest payments when they mature.
The difference between the yields on 10-year defense savings certificates and 6-month treasury bills is in principle a point on the yield curve, although the exact maturity difference is unclear because of the early redemption possibility for defense savings certificates.
Seignorage is not listed as a separate factor because the SBP profit transfers are included in regular government revenues in Pakistan. Standard Seignorage calculations would not be meaningful because of the SBP’s forward cover obligations on foreign currency deposits.
In growth theory, the difference between the real interest rate and the real GDP growth rates is usually strictly positive. Otherwise, the economy could be dynamically inefficient (see Abel and others, 1989).
See Appendix II-in for a detailed description of the methodology underlying the calculations.
The structural balance was calculated on the basis of the average primary balance during 1991–2000. The more forceful fiscal adjustment during 1996–1998 is reflected in the increasingly negative contribution of discretionary primary balance (a surplus contributes negatively to the debt dynamics).
Primary gaps were used by Buiter (1997).
The primary gap for the debt stock target N periods ahead, which is denoted with bl+N, is defined as follows:53
where the variable mnemonics is the same as in Appendices B and C. The intuition for the above definition of primary gaps is as follows: The first term in the curly brackets gives the difference, on a net present value basis, of the difference between today’s debt stock and the target.53 If the difference is positive, implying that the (discounted) debt stock target is lower than the current debt stock, the need for fiscal adjustment arises. The second term then shows the adjustment provided by the envisaged path for the primary balance—again on a net present value basis. If the fiscal adjustment need implied by the debt stock target cannot be achieved with the targeted paths for the primary balances, the primary gap is positive.
Assuming negative growth-adjusted real interest rates in the case of Pakistan is sensible despite the theoretical finding that real interest rates should exceed real GDP growth in the medium term (steady state). With concessional external lending at below-market rates, the growth-adjusted real interest on total public debt can be negative without necessarily violating the dynamic efficiency condition.
The values in the table give the additional annual adjustment in the primary balance (in percent of GDP) that is needed to reach the debt stock targets. For example, at a growth-adjusted real interest rate of 2 percent per annum, the primary balance would have to rise by 7.1 percentage points to 8.6 percent of GDP to reach a debt-to-GDP ratio of 60 percent after 5 years.
With declining nominal interest rates and falling inflation rates, the incentives for holding on to these instruments until maturity are even increased.
There is likely to be at least some temporary trade-off between exchange rate depreciation and the intrinsic debt dynamics, provided that external debt does not have to be repaid on a net basis. The increased value of the external debt stock in domestic currency terms reduces the implied interest rate on external debt given the significant share of long-term domestic public debt, which affects the intrinsic debt dynamics favorably. Over time, the trade-off is likely to become smaller because of interest rate and price adjustments.
With unchanged shares and terms of net external financing, the only effect of an exchange rate depreciation would be an immediate increase in the debt ratio. With the adjustment of domestic prices, this increase would be partly reversed over time.
If the equation is treated as an identity as in this Section, other capital flows Kt, will include by definition a residual that accounts for valuation changes and other factors that affect the debt stock value but are not related to current or capital account flows.
See Buiter (1985, 1997) and Blanchard (1990) for a more detailed discussion.
This exposition abstracts from valuation problems associated with foreign currency debt. The latter is taken into account in the analysis in the main text of the paper and included in the exposition in Appendix B.
Note that the transversality condition is irrelevant if the real interest rate is, on average, lower than the GDP growth rate. However, if this case were relevant, the economy could be dynamically inefficient (see Abel and others, 1989).
See Hamilton and Flavin (1986), Wilcox (1989), and Buiter and Patel (1992), among others.
Note, however, that the debt-to-GDP ratio does not need to be stationary to satisfy the transversality condition, which only limits its growth rate.
It is assumed that output variations do not affect expenditure since there are no cyclical components such as unemployment insurance.
It should be noted that