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Pakistan: Selected Issues and Statistical Appendix

Author(s):
International Monetary Fund
Published Date:
November 2005
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III. An Assessment of Pakistan’s Medium-Term Outlook and Public Debt Vulnerabilities4

A. Introduction

23. Pakistan’s debt situation today stands in sharp contrast to the late 1990s and early 2000s, when both the overall and external debt ratios were very high. At the end of June-2001, Pakistan’s public debt peaked at 88.8 percent of GDP, slightly over half of which was external debt. In an environment of anemic growth, declining reserves, and a rapidly depreciating exchange rate, the Pakistani economy was under a great deal of pressure. However, in a dramatic turnaround, Pakistan’s recent history has been characterized by a sound policy environment and favorable exogenous factors. Accelerating economic growth, a sizeable pick up in remittances and exports, low real domestic and external interest rates, and a stable real exchange rate policy have contributed to a declining debt path.

24. Pakistan’s pubic debt burden has declined sharply in the last four years but remains quite high. By the end of 2004/05, Pakistan’s public debt is estimated to have declined by nearly 30 percent of GDP since 2000/01. A sharp pick-up in economic activity and easing of liquidity conditions allowed for a substantial growth-interest rate differential, which was complemented by improved fiscal effort, resulting in a highly favorable debt dynamic. Still, over the past 30 years, a majority of sovereign debt crises in emerging markets have arisen when public debt levels were below 60 percent of GDP,5 about where Pakistan is today. The country’s debt-to-revenue and exports-to-debt ratios remain high as well.

25. Looking ahead, a continuation of prudent polices would ensure that debt remains manageable and the economy’s resiliency toward shocks is strengthened further. However, it is important to examine the sources of risks, given that as Pakistan’s economy is being further liberalized and better integrated with the world economy. It will have to become more flexible to deal with market volatility. This would entail building buffers against shocks, keeping debt relatively low, and judicious management of debt rollover risks. The dividend from such a strategy would be significant, especially as the fiscal space created by lower debt service costs could be used for much needed investment toward infrastructure building, human capital development, and poverty-eradication initiatives.

26. The goal of this chapter is to assess Pakistan’s medium-term outlook and public debt vulnerabilities. Economic theory provides limited practical guidance on the optimal level of public debt; hence the question is examined through multiple approaches, by an analysis of the debt structure and composition; by comparing vulnerability indicators with other emerging markets; and by using standard debt sustainability analysis (DSA) and stress tests over a medium-term projection period. For the DSA, two medium-term scenarios are considered—a baseline scenario under continued prudent policies, and an alternative low-growth scenario with policy slippages. Risks under both scenarios are considered.

27. The remainder of the chapter is organized as follows: Section B gives an overview Pakistan’s debt profile and historical dynamics. Section C assesses the vulnerability of the current debt profile with an analysis of individual indicators and overall economic conditions. Section D contains a discussion on both a baseline and an alternative medium term scenario, and associated bound tests; this is the standard debt sustainability analysis. Section E concludes.

B. Overview of Recent Debt Dynamics and Debt Profile

28. An examination of the historical path of the variables driving Pakistan’s debt dynamics—growth, real interest rate, and primary balance—is instructive (Figure III.1).6 Weak fiscal effort and low growth led to mounting debt through the 1990s. This problem was compounded in the late 1990s when liquidity conditions tightened, pushing up real interest rates. Even a change in the fiscal stance from 1998/99 onward, when the primary balance moved into a surplus, was not sufficient to contain the debt from rising.

Figure III.1.Public Sector Debt, 1995/96–2005/06

(In percent of GDP)

29. A series of external developments and measures helped turn the debt dynamics around from late-2001 onward (Table III.1) A Paris Club restructuring agreement in December 2001 allowed for a substantial easing of the external debt service burden, including debt service relief of close to more than $2.5 billion over the succeeding three years.7 Fiscal policy was tightened, and the primary surplus averaged over 2 percent of GDP between 2001/02 and 2003/04. Domestic interest rates gradually declined, allowing for a lowering of the governments cost of borrowing at the margin. Prudent monetary policy and a pick up in remittances stabilized the exchange rate. Accelerating economic activities and rising confidence in the economy created favorable conditions for the government to tap the external debt market in 2004. This made possible the retirement of existing high interest external debt, financed by new, lower interest liabilities.

Table III.1.Public Debt Dynamics, 1994/95–2004/05
1994/951995/961996/971997/981998/991999/20002000/012001/022002/032003/042004/05

Est.
Growth 1/, 2/5.04.81.02.63.74.31.93.25.06.47.8
Real interest rate 2/-7.4-0.5-5.01.42.75.7-0.34.21.5-2.4-4.2
Primary balance 3/-1.3-1.4-0.2-0.31.41.92.32.02.91.80.2
Total Public Debt 3/73.974.074.876.881.783.888.880.274.367.961.1
Change in debt 3/0.10.82.14.92.05.1-8.7-5.9-6.4-6.8
Memorandum item:
External Debt 3/38.238.439.540.740.345.639.835.031.528.2
Sources: Pakistani authorities; and Fund staff estimates.

Real GDP growth in market prices.

In percent.

In percent of GDP

Sources: Pakistani authorities; and Fund staff estimates.

Real GDP growth in market prices.

In percent.

In percent of GDP

30. The sharp downward trajectory of both domestic and external debt in recent years is striking. Between 2000/01 and 2004/05, domestic debt is estimated to have declined by 11.6 percent of GDP, whereas the external debt declined by 17.4 percent of GDP during the same time. While the Paris Club restructuring helped lower the external debt service needs from 2001/02, the growth-interest differential has played the key role in the lowering of the debt ratio.

31. Still, the level of debt is not particularly low by international standards (Figures III.2III.4). Compared to a select group of 24 emerging market economies, Pakistan’s total debt stock-to-GDP ratio is higher than two-thirds of the sample. The external debt-to-GDP ratio is also in similar cohort. The debt-to-revenue ratio, however, is the fourth highest in the sample, as Pakistan’s revenue base remains low.8 The need for continuing on a path of debt reduction is thus clear. The authorities are cognizant of this need, and the recently passed Fiscal Responsibility Law (FRL) requires that the outstanding debt stock is reduced by 2.5 percent of GDP each year through 2013.

Figure III.2.Regional Average of Emerging Market Debt

(at end-2004, as a share of revenue)

Sources: Pakistani authorities; and Fund staff estimates.

Figure III.3.Regional Average of Emerging Market Public External Debt

(at end-2004, as a share of GDP)

Sources: Pakistani authorities; and Fund staff estimates.

Figure III.4.Regional Average of Emerging Market Public Debt

(at end-2004, as a share of GDP)

Sources: Pakistani authorities; and Fund staff estimates.

32. The improvement in the debt situation has led to some changes in the composition of domestic debt (Table III.2 and Figure III.5). Following a period when institutional investors shied away from investing in fixed-rate government bonds, the holding of such paper has increased over the last four years. At end-2004/05, institutional investors held fixed-rate long-term government paper in domestic currency worth over 8 percent of GDP, comprising of over a quarter of the total domestic debt.9 At the retail end, institutional reforms led to a substantial net outflow.10 While the holding of instruments offered under the National Savings Scheme has declined of late, they remain the largest part of domestic debt. The government has decreased its reliance on treasury bills as budget financing needs have eased, with floating interest short-term papers representing just 9.4 percent of GDP at end-2004/05, compared to 17.7 percent of GDP at end-200/01.

Table III.2.Composition of Public Domestic Debt, 1996/97–2004/05(In percent of GDP)
1996/971997/981998/991999/20002000/012001/022002/032003/042004/05

Est.
Total36.337.341.043.443.340.439.336.432.9
Fixed interest debt (long-term, institutional) 1/9.68.67.26.86.88.48.99.77.7
Foreign currency debt (long-term) 2/0.50.41.81.81.71.40.90.60.4
Fixed interest debt (short-term) 3/14.814.715.917.117.712.710.79.811.9
Retail Savings instruments 4/11.413.616.217.717.118.018.916.313.0
Memorandum item:
Interest cost4.35.24.95.24.44.23.52.82.6
Sources: Pakistani authorities and staff estimates.

Comprises mostly of three government papers available to institutional investors: Federal Investment Bonds, Pakistan Investment Bonds, and Prize Bonds.

Government bearer bonds denominated in U.S. dollars.

Treasury bills.

Mostly includes instruments available for retail investors under the the National Savings Scheme.

Sources: Pakistani authorities and staff estimates.

Comprises mostly of three government papers available to institutional investors: Federal Investment Bonds, Pakistan Investment Bonds, and Prize Bonds.

Government bearer bonds denominated in U.S. dollars.

Treasury bills.

Mostly includes instruments available for retail investors under the the National Savings Scheme.

Figure III.5.Composition of Public Domestic Debt, 1996/97–2004/05

(In percent of total debt)

C. Public Sector Vulnerability: Individual Indicators

33. The previous section illustrated the Pakistan’s substantial achievement in reducing debt in recent years. The debt burden, however, is still not low by emerging market comparisons, and needs to be reduced further. This section examines a set of indicators to assess the public debt vulnerability of Pakistan at the current juncture. Assessing public sector vulnerability entails looking at both flow and stock indicators. Key flow indicators are the overall fiscal balance and the primary gap (primary balance that would stabilize the public debt ratio at the level of the previous year minus projected primary balance for the current year). Stock indicators are the public debt ratio, and measures of rollover risk (debt at remaining maturity in percent of total debt) and exchange rate risk (foreign currency denominated debt as a share of total debt). Indicators of overall economic conditions are also analyzed.

Overall fiscal balance

34. Pakistan’s overall fiscal balance has improved substantially in recent years (Figure III.6). The overall deficit averaged 3.7 percent of GDP during the past four years, compared to an average of 5.5 percent of GDP in the decade prior to that. The reduced overall deficit eased debt pressures, and will appropriately remain a key target variable in Pakistan’s fiscal policy path in the coming years. Limiting the deficit to well below 4 percent of GDP in the coming years will help contain vulnerability.

Figure III.6.Overll Balance, Excluding Grants, 1994/95–2004/05

(In percent of GDP)

Primary gap

35. Given Pakistan’s current highly favorable debt dynamics, stabilizing the debt-to-GDP ratio would require very little fiscal effort. Indeed, in 2005/06, Pakistan’s primary balance would have to worsen by more than 7 percent of GDP before the debt is prevented from declining. Pakistan’s primary gap is therefore highly favorable (thanks to a very favorable growth-interest differential), pointing at little risk of maintaining the current level of debt, at least from the point of view of fiscal effort.11

Public debt ratio

As discussed in the previous section, although Pakistan’s debt ratio has been declining, the level of debt remains quite high. However, it is lower than countries that are rated similarly by ratings agencies (Table III.3). Unlike other countries with comparable debt ratios, Pakistan’s debt is not concentrated in short-term floating rate papers, thus mitigating some of the risks. A large part of the debt is held by retail investors who do not have many alternative investment opportunities and thus are likely a stable source of financing. However, relative to its narrow revenue base, Pakistan’s debt stock is high. The authorities have stressed the need for further debt reduction as well, and are presently being guided in that direction by the stipulations of the FRL discussed earlier.

Refinancing, exchange rate, and interest rate risk

36. Based on the degree of reliance on domestic debt, Pakistan’s vulnerability to both refinancing and exchange rate risks appears broadly in line with similarly rated emerging markets. Comparable to the experience in other emerging markets in the 1990s, the domestic component of Pakistan’s public debt has been rising (Table III.3). At end-2004, domestically issued securities comprised roughly half of Pakistan’s public debt and close to the median of the select group of emerging countries.12 Additionally, international reserves stand at roughly 200 percent of short-term debt by remaining maturity—a fairly liquid position. There are also no major rollover humps in the medium- and long-term debt service profile.

Table III.3.International Comparisons: Size of Public Debt, As of End-2003
CountryMoody’s Rating 1/Public Debt
Totalof which: External
(In percent of GDP)
MexicoBaa247.115.1
BrazilB180.046.6
ChileBaa137.06.9
ColombiaBa258.928.4
CroatiaBaa343.026.4
HungaryA157.013.9
PolandA248.416.3
TurkeyB184.526.4
KoreaA332.46.0
IndonesiaB254.034.0
MalaysiaBaa156.447.3
Pakistan 2/B274.335.0
Philippines 3/B178.1
ThailandBaa134.536.2
South AfricaBaa237.16.5
VietnamBa341.933.6
Group medians 4/
Overall48.426.4
A and higher48.413.9
Ba-Baa42.527.4
B and lower79.134.0
Sources: Pakistani authorities official reports; IFS; GDF; and Fund staff calculations.

See Moody’s Statistical Handbook, September 2005. Ratings are for long-term foreign currency borrowing.

Data for Pakistan refer to 2004.

Published data on external debt for the Phillipines is not directly comparable.

Excluding Pakistan.

Sources: Pakistani authorities official reports; IFS; GDF; and Fund staff calculations.

See Moody’s Statistical Handbook, September 2005. Ratings are for long-term foreign currency borrowing.

Data for Pakistan refer to 2004.

Published data on external debt for the Phillipines is not directly comparable.

Excluding Pakistan.

37. Based on indicators of average maturity and duration, Pakistan’s exposure to refinancing and interest rate risks appears limited. On the external side, the unusually high degree of reliance on official concessional loans results in a long average duration. Short-term debt is a relatively small component of external debt (roughly 10 percent, including payments due next year on medium- and long-term debt). On the domestic side, information on remaining maturity of debt is patchy, especially as regards the National Savings Scheme instruments.13 Overall, the stock of short-term debt is estimated to be less than 30 percent of total debt stock, which can be considered moderate among emerging market comparators (Table III.4).

Table III.4.International Comparisons: Maturity Indicators, As of End-2003
CountryDomestic debtForeign debt
Average term to maturity

in years
Average duration

in years
Short-term debt/Total domestic debtAverage term to maturity

in years
Short-term debt/Total external debt
By original maturity

in percent
By remaining maturity

in percent
By original maturity

in percent
By remaining maturity

in percent
Mexico2.491.4420.736.99.952.114.7
Brazil2.610.9135.35.959.429.1
Colombia3.902.3016.07.206.7
Croatia4.0026.3
Hungary26.333.710.1
Poland2.662.1219.537.90.0
Turkey2.0919.10.0
Korea3.803.300.00.0
Indonesia12.9
Malaysia5.193.016.30.04.3
Pakistan19.94.510.2
Philippines29.19.700.0
Thailand4.719.919.010.2111.9
South Africa7.854.676.614.34.830.04.3
Vietnam28.0
Canada6.504.5026.634.712.333.1
Average4.162.7517.0127.1212.073.6514.06
Median 1/3.852.2119.3026.359.820.008.40
Sources: Pakistani authorities official reports; IFS; GDF; and Fund staff calculations.

Excluding Pakistan.

Sources: Pakistani authorities official reports; IFS; GDF; and Fund staff calculations.

Excluding Pakistan.

Overall economic conditions

38. Recent analyses of previous sovereign debt crises emphasize the need to go beyond unconditional thresholds of individual ratios in assessing debt sustainability. Reinhart, Rogoff, and Savastano (2003) suggest that a country’s initial level of debt may already be near historically “intolerable” levels. In this case, standard sustainability analyses and stress tests may not take full account of the vicious cycle of higher interest rates and sudden loss of market financing that may lead to a crisis.14IMF (2003) identifies a number of characteristics, including low ratios of revenue to GDP and low levels of trade openness, which tend to affect a country’s tolerable level of debt. Manasse and Roubini (2005) find that episodes of debt crises (including involuntary restructurings) arise under a variety of circumstances, and that it is precisely the joint effect of a number of economic and political factors that allows for an adequate assessment of debt levels. They identify combinations of factors that lead to different types of risk, namely insolvency, illiquidity, or macroeconomic instability.

39. Following IMF (2003), the level of debt that Pakistan can ‘tolerate’ appears to be lower than other emerging economies, given:

  • A low public revenue ratio. In Pakistan, a relatively narrow tax net combined with weak compliance have resulted in a comparatively low revenue ratio, possibly hampering its capacity to pay. Whereas the ratio of public revenue to GDP averages about 27 percent in emerging economies, it is roughly 14 percent in Pakistan.

  • A relatively inflexible composition of fiscal expenditures. Although the interest burden has decreased in recent years, the share of interest expenditures in total expenditures remains relatively high, at close to 20 percent. This is slightly higher than the average of emerging economies, at about 17 percent. As a result, primary expenditure allocations will tend to be relatively rigid, partly explaining the fact that in emerging economies, the primary balance tends to respond less to changes in debt loads, and the conduct of fiscal policy tends to not be “consistent with ensuring sustainability once public debt exceeds a threshold of 50 percent of GDP” (IMF 2003, p. 128).

  • Low levels of trade openness. Typical of South Asian countries, Pakistan is a relatively closed economy, with the ratio of exports to GDP significantly lower than other emerging economies, such as Philippines and Vietnam, which are similarly rated by credit agencies (see Figure III.7 below).

Figure III.7.Trade Openness: Ratio of Exports to GDP, 1990–2003

40. Based on Manasse and Roubini (2005), Pakistan would currently be classified as ‘relatively safe’. Notwithstanding the value of individual indicators, Manasse and Roubini (2005) indicates that it is often a particular combination of factors that determines the probability of a debt crisis. Given the current combination of a relatively low ratio of external debt to GDP (less than 50 percent), good reserve coverage of short-term debt (ratio less than 1.3), low ratio of external debt to public revenue (ratio greater than 2), and low inflation (rate less than 10.7 percent), Pakistan would not be considered at risk. This finding is consistent with the country’s long-term credit ratings.

41. In summary, these indicators suggest that, despite substantial improvements in recent years, some vulnerabilities exist. The flow variables (overall balance and the primary gap) indicate substantially reduced vulnerabilities, but the stock variables (debt ratio, revenue ratio, rollover risk, and exchange rate risk) point toward the need for additional consolidation. Further reduction in the debt ratio (as targeted by the authorities), and active steps to manage the rollover and exchange rate risks, would help reduce Pakistan’s public sector vulnerability in the coming years and contribute significantly toward improving the economic outlook from the already favorable position.

D. Medium-Term Public Debt Sustainability Analysis

42. A full-fledged debt sustainability analysis, moving beyond the indicators-based analysis in the previous section, provides a more comprehensive look at the medium-term risks and outlook. First, a baseline scenario is examined, incorporating an unchanged policy stance, including maintaining deficits at under 4 percent of GDP. Various risks to this scenario are assessed through a series of bound tests. Second, an alternative, low-growth scenario is prepared where growth reverts back to the average of the 1990s, incorporating assumptions of a slowdown in reforms and setbacks in the economy (as a result of a confluence of external and domestic developments).

43. The baseline scenario assumes a combination of favorable external and domestic factors, as well as a continuation of prudent policies (Table III.5). Growth averages over 6 percent per annum through 2009/10. Monetary policy keeps inflation under control, which averages around 6.5 percent. Real interest rates move into positive territory in line with higher investment demand. The authorities pursue a fiscal policy of maintaining the overall balance (excluding grants) at 3.8 percent of GDP. This is achieved by a small increase in tax revenues (resulting from continued tax policy and administration reforms) and judicious management of expenditures (while at the same time boosting capital and social spending). Large-scale privatization boosts external financing in 2005/06 and 2006/07, thus keeping debt-creating flows under check. Debt dynamics remain highly favorable, and the debt-to-GDP ratio continues to decline, although at a flatter trajectory than seen in the recent years.

Table III.5.Pakistan: Medium-Term Fiscal Framework, 2002/03–2009/10(In percent of GDP, unless otherwise indicated)
2002/03

Est.
2003/04

Est.
2004/05

Est.
2005/06

Proj.
2006/07

Proj.
2007/08

Proj.
2008/09

Proj.
2009/10

Proj.
Revenue and grants17.414.914.013.213.413.413.513.6
Tax revenue11.511.110.09.910.010.110.210.3
Of which: CBR9.59.49.09.19.29.39.49.4
Nontax revenue3.43.33.83.03.03.03.03.0
Grants2.50.60.30.30.40.30.30.2
Expenditure18.517.318.316.816.916.917.117.2
Current expenditure16.614.014.413.213.113.113.213.3
Interest payments4.33.53.23.03.23.13.13.1
Provincial4.03.93.93.73.73.84.04.1
PSDP2.72.93.53.63.83.83.83.9
Net-lending-0.90.40.40.00.00.00.00.0
Statistical discrepancy0.3-0.6-1.20.00.00.00.00.0
Overall balance
Excluding grants-3.8-2.3-3.3-3.8-3.8-3.8-3.8-3.8
Including grants-1.4-1.8-3.0-3.6-3.4-3.5-3.6-3.6
Financing1.41.83.03.63.43.53.63.6
External-0.5-0.71.73.52.11.61.51.4
Domestic1.82.51.30.01.31.92.12.2
Memorandum items:
Primary balance
Excluding grants0.51.2-0.1-0.8-0.6-0.7-0.7-0.7
Including grants2.91.80.2-0.6-0.2-0.4-0.4-0.5
Interest Payments/Revenue (ratio)28.824.723.423.324.623.923.723.5
PRSP expenditure3.53.84.64.24.44.54.64.7
Total government debt74.367.961.153.350.848.747.045.6
Domestic39.336.432.928.025.724.423.623.1
External35.031.528.225.225.124.223.422.5
Implicit interest rate (in percent) 1/5.95.45.45.76.66.76.97.2
Domestic9.18.27.99.09.69.810.110.4
External2.52.12.22.42.93.23.43.6
Nominal GDP (billions of PRs)4,8235,5336,5487,6598,7159,84011,05812,426
Sources: Pakistani authorities; and Fund staff estimates and projections.

Calculated by dividing interest expenditure by the outstanding debt stock at the end of the previous period.

Sources: Pakistani authorities; and Fund staff estimates and projections.

Calculated by dividing interest expenditure by the outstanding debt stock at the end of the previous period.

44. To achieve the FRL’s requirement of reducing debt by 2.5 percent of GDP each year, the primary balance would have to improve gradually. Estimates show that the overall deficit (excluding grants) would have to be steadily reduced to 2.5 percent of GDP by 2009/10 (corresponding to a primary surplus of about 0.5 percent of GDP) to achieve the debt-reduction strategy laid out in the FRL. The authorities have noted that they intend to reduce the overall fiscal deficit to about 3.3 percent of GDP by 2009/10.

45. The bound tests reveal only limited risks to the outlook. A one-half standard deviation (derived from 10-year historical data) real interest rate shock affects the debt path, but still leaves it on a downward slope. The same is true for a growth shock that reduces growth by one-half standard deviation in 2005/06 and 2006/07.

46. A combination of several shocks do not appear to pose major sustainability risks either (Table III.6, and Figures III.8 and III.9). A permanent ¼ standard deviation shock applied to real interest rate, growth rate, and primary balance affects the debt path no more than seen in the bound tests discussed in the above paragraph. A large real exchange rate shock however is seen to impact the debt path substantially. A one-time real depreciation of 30 percent in the dollar value of the Pakistani rupee raises the debt ratio substantially, through the ratio returns to a downward path subsequently, reaching the 2004/05 level by the end of the five-year forecasting period. A 10 percent of GDP shock to contingent liabilities occurring in 2005/06, in contrast, appears to pose little risk to the debt path.

Figure III.8.Impact of Interest Rate and Growth Shocks to the Debt Path, 1999/2000–2009/10

1/ Permanent 1/4 standard deviation shock applied to real interest rate, growth rate, and primary balance.

Figure III.9.Real Depreciation and Contingent Liabilities Shock, 1999/2000–2009/10 1/

1/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2005/06, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Table III.6.Public Sector Debt Sustainability Framework, 2005/06-2009/10
HistoryProjections
10-Year Average10-Year Standard Deviation2005/062006/072007/082008/092009/10
Key Macroeconomic and Fiscal Assumptions
Real GDP growth 1/4.12.07.06.06.06.06.0
Average real interest rate 2/0.34.1-3.5-0.40.51.31.5
Inflation rate 3/7.03.89.37.36.56.06.0
Growth of real primary spending 4/3.79.76.25.27.37.16.9
Primary deficit-1.11.50.60.20.40.40.5
Public sector debt53.350.848.747.045.6
Of which: foreign-currency denominated25.625.424.523.622.5
A. Alternative ScenariosStress Tests for Public Debt Ratio
A1. Key variables are at their historical averages in 2004/05-09/1055.252.850.047.244.6
A2. No policy change (constant primary balance) in 2004/05-09/1052.349.947.245.043.0
B. Bound Tests
B1. Real interest rate is at baseline plus one half standard deviations54.553.252.251.651.2
B2. Real GDP growth is at historical average minus one half standard deviations in 2005/06 and 2006/0753.952.150.850.049.6
B3. Primary balance is at historical average minus one half standard deviations in 2006 and 200754.052.250.849.949.1
B4. Combination of B1-B3 using one standard deviation shocks54.453.051.951.250.8
B5. One time 30 percent real depreciation in 2005/0669.466.363.761.659.8
B6. 10 percent of GDP increase in other debt-creating flows in 2005/0663.360.458.056.154.4
Sources: Pakistani authorities; and Fund staff estimates and projections.

In percent.

Nominal rate minus change in GDP deflator, in percent.

GDP deflator, in percent.

Deflated by GDP deflator, in percent.

Sources: Pakistani authorities; and Fund staff estimates and projections.

In percent.

Nominal rate minus change in GDP deflator, in percent.

GDP deflator, in percent.

Deflated by GDP deflator, in percent.

47. An alternative, low-growth scenario is also assessed (Table III.7). The scenario examines the risks of a policy setback and a less favorable external environment. In this scenario, growth falls to about 4.2 percent per annum, as capacity constraints are not addressed and inflation is not tackled forcefully. Interest rates rise, and confidence in the economy wanes owing to a lack of progress in structural reform. Fiscal policy is geared toward maintaining expenditure at an ambitious level, but revenue efforts fail to keep pace with the rising spending. Higher interest rates also push up interest costs.

48. As a result, the fiscal deficit worsens gradually, reaching 5 percent of GDP by 2009/10. The debt path flattens, and the economy’s vulnerability to shocks increase. A comparison of the debt path between the baseline and the alternative scenario illustrates the risks associated with the latter scenario (Figure III.10).

Figure III.10.Debt path Under Baseline and Low Growth Scenarios, 2004/05–2009/10

(In percent of GDP)
Table III.7.Pakistan: Low-Growth Medium-Term Fiscal Framework, 2002/03–2009/10(In percent of GDP, unless otherwise indicated)
2002/03

Est.
2003/04

Est.
2004/05

Est.
2005/06

Proj.
2006/07

Proj.
2007/08

Proj.
2008/09

Proj.
2009/10

Proj.
Revenue and grants17.414.914.013.313.413.413.513.5
Tax revenue11.511.110.09.910.010.010.110.2
Of which: CBR9.59.49.09.19.29.29.39.3
Nontax revenue3.43.33.83.13.03.03.03.0
Grants2.50.60.30.30.40.30.30.3
Expenditure18.517.318.317.317.717.818.018.3
Current expenditure16.614.014.413.613.914.014.214.4
Interest payments4.33.53.23.23.63.73.73.8
Provincial4.03.93.93.83.73.84.04.1
PSDP2.72.93.53.63.73.73.83.9
Net lending-0.90.40.40.00.00.00.00.0
Statistical discrepancy0.3-0.6-1.20.00.00.00.00.0
Overall balance
Excluding grants-3.8-2.3-3.3-4.3-4.7-4.7-4.8-5.0
Including grants-1.4-1.8-3.0-4.0-4.3-4.4-4.5-4.7
Financing1.41.83.04.04.34.44.54.7
External-0.5-0.71.73.72.32.11.61.8
Domestic1.82.51.30.32.12.22.92.9
Memorandum items:
Primary balance
Excluding grants0.51.2-0.1-1.1-1.1-1.0-1.1-1.2
Including grants2.91.80.2-0.8-0.7-0.7-0.8-0.9
Interest payments/revenue (ratio)28.824.723.424.427.728.028.528.8
PRSP expenditure3.53.84.64.44.64.74.84.9
Total government debt74.367.961.155.254.653.953.653.4
Domestic39.336.432.929.228.127.427.527.7
External35.031.528.226.026.526.526.025.7
Implicit interest rate (in percent) 1/5.95.45.45.96.97.17.37.5
Domestic9.18.27.99.510.210.510.810.9
External2.52.12.22.42.93.13.43.5
Nominal GDP (billions of PRs)4,8235,5336,5487,4308,2489,13310,08311,131
Sources: Pakistani authorities; and Fund staff estimates and projections.

Calculated by dividing interest expenditure by the outstanding debt stock at the end of the previous period.

Sources: Pakistani authorities; and Fund staff estimates and projections.

Calculated by dividing interest expenditure by the outstanding debt stock at the end of the previous period.

E. Conclusion

49. Using a number of indicators, as well as two medium-term scenarios, this chapter indicates that vulnerabilities have been reduced substantially in recent years. A continuation of existing policies would ensure a downward debt trajectory, achieving a further reduction in risks. Pakistan’s debt ratio, however, remains moderately high, and its narrow revenue base reduces fiscal flexibility given the relatively high debt service costs. While interest and rollover risks appear manageable, a large exchange rate depreciation would adversely affect the debt profile. Overall, policies geared toward further debt reduction in the medium term, anchored by the recently passed FRL, would ensure a further reduction in vulnerabilities.

References

Prepared by Taimur Baig (FAD) and Carlos Leite (PDR).

Reinhart, Rogoff and Savastano (2003) documents the history of debt defaults since the early 1800s. They find that, since 1970, 53 percent of all debt crises in emerging markets have occurred when the ratio of debt to GNP was below 60 percent. For example, Mexico’s 1982 debt crisis occurred with a debt-to-GNP ratio of 47 percent, and Argentina’s 2001 crisis with a ratio just above 50 percent.

The linkage between fiscal policy and debt dynamics is described by the following identity: Δdt ≡ (rt(dt-1) – gt)dt-1 + pt(dt-1, Z) + xt, where dt is the debt-to-GDP ratio at time t; r(d) is the real interest rate; g is the real growth rate; x is an exogenous shock to debt; and Δ is the first difference operator. The primary surplus pt is a function of the lagged public debt and other non-debt determinants such as business cycle conditions. The above relationship illustrates the well-studied link between debt, growth-interest differential, and primary balance.

The 2001 Paris Club agreement was preceded by a similar exercise in 1999. At the same time, a restructuring of $600 million in Eurobonds and $500 million in short-term credits held by commercial banks took place.

The countries in the sample are from Asia (China, India, Indonesia, Korea, Malaysia, Philippines), Latin America (Argentina, Brazil, Chile, Costa Rica, Ecuador, Mexico, Peru, Uruguay, Venezuela), Middle-East and Africa (Morocco, Lebanon, Pakistan, Turkey, Cote d’Ivoire, Nigeria, South Africa), and transition economies (Bulgaria, Hungary, Poland).

In comparison, at end-2000/01, only about 15.6 percent of government debt was in fixed-rate long-term papers.

In 2000, the government re-introduced long-term bonds and NSS rates were tied to these bonds to reduce the substantial mark-up over market returns. In 2001, institutional investors were prohibited from investing into NSS. Thus, NSS instruments became less attractive and the investor base shrunk substantially.

Unless, of course, there are major changes in the economic environment. In a latter section of this chapter, the debt path in under an alternative set of low-growth and policy setback assumptions is examined.

Overall, the table confirms the tendency for countries with a higher rating to rely less on external debt.

More information on the NSS would shed further light on rollover risks, but presently it is understood to be manageable.

“A country’s record at meeting its past debt obligations and managing its macroeconomic in the past is relevant to forecasting its ability to sustain moderate to high levels of indebtedness” (op. cit., p.1).

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