Pakistan: Selected Issues and Statistical Appendix

This Selected Issues and Statistical Appendix paper presents cross-country regression results that identify investment in physical capital and improvements in institutional quality as having the largest pay-off in terms of increased growth. The paper employs three approaches to forecast inflation in Pakistan. A leading indicator model outperforms a univariate autoregressive moving average model as well as a vector autoregressive model in terms of forecast quality. The paper presents three case studies of Pakistani public sector enterprises that have recently witnessed strong improvements in their financial performance.


This Selected Issues and Statistical Appendix paper presents cross-country regression results that identify investment in physical capital and improvements in institutional quality as having the largest pay-off in terms of increased growth. The paper employs three approaches to forecast inflation in Pakistan. A leading indicator model outperforms a univariate autoregressive moving average model as well as a vector autoregressive model in terms of forecast quality. The paper presents three case studies of Pakistani public sector enterprises that have recently witnessed strong improvements in their financial performance.

VI. Public Debt Management42

126. This section summarizes Pakistan’s public debt strategy and discusses some future challenges. Since the 1998/99 crisis, Pakistan has achieved a reduction in total debt and external debt relative to GDP as well as debt servicing costs. At present, domestic funding is cheaper than tapping international markets. However, additional Eurobond issues could contribute to establishing Pakistan in international capital markets. Looking ahead, increased use of hedging instruments could lower currency and interest rate risk.

A. Debt Strategy Objectives

127. Pakistan’s debt strategy was developed against the backdrop of the 1998/99 crisis. Throughout the 1990s, Pakistan accumulated external debt at a high rate while reserves were low. After the ban on bilateral aid in 1998, Pakistan faced acute debt servicing difficulties. The immediate response was a freeze of private dollar accounts of residents and nonresidents. This was followed by a restructuring of outstanding bonds and three Paris Club agreements to lower the external debt burden. Since 2003, a Debt Policy Coordination Office (DPCO) under the Ministry of Finance has started to coordinate and determine the government’s overall debt policy strategy.

128. The debt strategy has concentrated on four points. Reducing the overall debt-to-GDP ratio and the share of external debt in total debt to lower external vulnerabilities were two key objectives. In addition, the share of interest payments in total expenditures was to be reduced to create space for social and development expenditures. Finally, the government strove to reestablish creditworthiness by accessing international capital markets with a sovereign issue.

129. The debt management functions are divided between four main actors. The DPCO is charged with drawing up borrowing strategies including risk management and containing borrowing costs. The Economic Affairs Division (EAD) of the Ministry of Economic Affairs and Statistics negotiates foreign borrowing from multilaterals and donors. The Central Directorate for National Savings (CDNS) borrows from the domestic retail sector. The State Bank of Pakistan (SBP) is the governments fiscal agent.

130. A draft fiscal responsibility law pins down the main elements of the debt strategy. The draft law requires the government to reduce the debt-to-GDP ratio to at least 60 percent over the next 10 years. As intermediate steps, the draft law mandates that the debt-to-GDP ratio is reduced by at least 2½ percentage points per annum. Moreover, the current deficit, defined as current revenues excluding grants less current expenditures, is to be eliminated by 2006/07. The draft law is in the final stages of the legislative process.

B. Debt Instruments

131. Domestic debt is comprised of three instruments. Short term debt is issued as treasury bills (T-bills) through competitive bid auctions in 3, 6, and 12-month tenors as zero coupons. Medium-long term debt is issued as Pakistan Investment Bonds (PIBs) that have semiannual coupons and 3, 5, and 10 years maturity.43 In January 2004, the government also introduced 15 and 20 year PIBs to avail of low interest rates and provide a yield curve for long-term financing; so far there has been one auction of small volume. Another source for domestic funding are National Savings Scheme (NSS) certificates, usually with tenors of 3, 5, and 10 years. Returns on NSS certificates are tied to PIBs with a significant premium. The State Bank of Pakistan (SBP) manages domestic debt issuance for the government including the cut-off rates for T-Bills and PIBs. The CDNS administers the NSS. NSS certificates are sold on “tap” so that the volume of NSS cannot be controlled by CDNS, Ministry of Finance or the SBP.

132. Pakistan takes advantage of a wide range of external debt instruments. The existing external debt includes commercial credits, nonconcessional and concessional debt and some floating-rate bonds and a fixed Eurobond. EAD negotiates and contracts external debt in coordination with the DPCO.

C. Past Policies and Developments

133. Good progress has been made on achieving the debt strategy objectives. The debt to GDP ratio has been reduced significantly from its peak in 2000/01, largely through limiting the government’s borrowing needs, supported by some external debt write-off as well as a strengthening the Pakistani rupee. The government has reduced the share of external debt in total debt by limiting its external borrowing and pre-paying around $1 billion in relatively expensive external debt. Interest expenditure has been brought down in percent of GDP and in percent of total expenditure. External interest expenditure has been brought down through debt relief from the Paris Club and the pre-payment. Domestic interest expenditure has been brought down through NSS reform and macroeconomic stabilization that lead to a substantial fall in interest rates.

Figure VI.1
Figure VI.1

Debt and Interest Expenditure

Citation: IMF Staff Country Reports 2004, 415; 10.5089/9781451830644.002.A006

Source: National authorities.
Figure VI.2
Figure VI.2

Compositition of Debt

(in percent of total, as of end-June 2004)

Citation: IMF Staff Country Reports 2004, 415; 10.5089/9781451830644.002.A006

Source: Pakistani authorities.

134. Reform of the NSS has been a major step in reducing domestic interest costs. Until 2001, NSS certificates were issued at yields far in excess of market rates. Private individuals as well as institutional investors could buy NSS certificates from CDNS branches, post offices, and banks. Thus, NSS certificates were very attractive, crowding out other debt instruments and leading to very high interest costs. In 2001, the government banned institutional investors from buying NSS certificates and linked the return on NSS certificates to market-determined PIB yields, albeit with a mark-up. This has resulted in a substantial reduction in NSS rates. Moreover, domestic commercial banks were prohibited from selling NSS certificates in 2003 to better control the volume of issuance. The government also introduced two new certificates targeted at pensioners, widows and orphans that are linked to PIBs but with higher mark-up; in 2003/04, these two certificates accounted for the largest net inflow among NSS certificates.

135. The comprehensive Paris Club restructuring agreement of December 2001 has eased the external debt service burden. Although Pakistan approached the Paris Club twice in January 1999 and January 2001, the need for a third comprehensive rescheduling was fundamental to the overall debt strategy. About $12.5 billion out of a total $13.5 billion debt owed to the Paris Club was restructured at very favorable rates, including long grace periods. Comparable treatment was also sought from commercial banks and holders of Eurobonds. Commercial credits are to be repaid over 23 years with 5 years of grace period; ODA credits are to be repaid over 38 years with 15 years of grace period at interest rates at least as favorable as the concessional rates applying to these loans.

136. New external borrowing has been mostly on concessional terms. Pakistan has borrowed from the World Bank, the Asian Development Bank, the Fund, and other multilaterals such as the Islamic Development Bank. Loans include grant elements and long grace periods so that the debt service burden is low.

Figure VI.3
Figure VI.3

Sovereign bond spreads

(in basis points)

Citation: IMF Staff Country Reports 2004, 415; 10.5089/9781451830644.002.A006

Source: Bloomberg.

137. Pakistan has also reestablished its presence in international capital markets with a successful issuance of a Eurobond in February 2004. The $500 million five year Eurobond was four times oversubscribed and priced to yield 6.75 percent, implying a spread of only 370 bps over U.S. treasuries. The bond was rated B by Standard & Poors and B2 by Moodys. Reflecting an upbeat market sentiment, but also a scarcity value, the bond was priced in the vicinity of or slightly better than similarly rated countries. The spread over U.S. treasuries has remained consistently below its level on the date of issuance, and the bond trades in the secondary market with very little volatility when compared to other B rated sovereigns bonds that also mature in 2009 (Brazil, Turkey, Lebanon).

138. The government engaged in an interest rate swap in April 2004, effectively transforming its Eurobond obligation from fixed to floating. With the swap, Pakistan will pay 6-month U.S. dollar LIBOR plus 323 bps over the life of the bond, reducing the interest rate from the previous fixed rate as long as short-term rates remain favorable. The contract limits the interest rate risk for Pakistan during the final two years of the contract by adding a clause that caps the floating rate at 6.75 percent during this period as long as the LIBOR stays below 5.52 percent.

D. Issues for the Future

Domestic vs. external financing

139. T he budget financing requirement for 2004/05 of PR’s 145 billion will be covered mostly from domestic markets. The government expects to raise PR’s 123 billion from domestic bank and nonbank sources through issuing government securities and NSS certificates. The remaining PR’s 22 billion is projected to come in the form of concessional loans on a net basis. The government has also announced that it might issue an Islamic bond or another Eurobond in international markets during 2004/05. Such inflows could either be used to lower domestic financing needs or substitute concessional financing in case of delays.

Figure VI.4.
Figure VI.4.

Pakistan and U.S. Yield Curves

(basis points)

Citation: IMF Staff Country Reports 2004, 415; 10.5089/9781451830644.002.A006

Source: Bloomberg.

140. Presently, local debt markets provide a cheaper funding source when compared to the yields of the (only) external Eurobond. Abstracting from exchange rate risk, a 5-year PIB presently yields about 6.2 percent vis-a-vis the Pakistan’s 5-year Eurobond due 2009 that trades at a yield of 6.4 percent. However, there appear to be some upward pressures in the PIB market that could reduce the current interest rate advantage.

141. Accounting for exchange rate risk, funding via the PIBs looks even more attractive. Assuming a constant real effective exchange rate, and given current inflation projections, the Pakistani rupee would depreciate by around 12 percent in nominal terms over the next five years. Thus, the principal amount due on a Eurobond issue could be 12 percent higher in Pakistani rupees terms. Likewise, the rupee cost of the coupons will also be higher than the notional amount. The expected depreciation would therefore substantially increase the debt servicing cost differential between domestic PIBs and a Eurobond. However, a fundamental change in the interest rate environment could reverse this assessment.

Figure VI.5
Figure VI.5

Yield Curve Spread Between Pakistan and U.S. Treasuries

(basis points)

Citation: IMF Staff Country Reports 2004, 415; 10.5089/9781451830644.002.A006

Source: Bloomberg.

142. Assuming no pressure on the balance of payments, issuing a 7-year Eurobond would contribute towards building a sovereign curve. The domestic yield curve has a kink as seven year PIBs (10-year PIB issued in 2001 at 14 percent coupons) presently trade at 8.1 percent, slightly higher in the secondary market than 10-year PIBs. Although the investor base for a 5-year bond differs from that of a 7-year bond, the average ratio of prices of 7-year and 5-year bond of B rated sovereigns suggest that Pakistan may be able to issue the 7-year at an additional 35-45 bps over the present Pakistan 5-year Eurobond spreads.44 Thus, a 7-year Eurobond could possibly issued at a spread of about 325-335 bps over U.S. treasuries while the spread of 7-year PIBs over U.S. treasuries is 440 bps.

Table VI.1.

Comparable Bonds of B-rated Sovereigns Maturing in 2011 1/

article image
Source: Bloomberg.

When comparable seven year U.S. dollar bonds are not available, spreads are interpolated

143. The government also envisages issuing an asset backed, collateralized Islamic sukuk bond that will lower borrowing costs. There is a sizeable demand from Middle Eastern accounts for Islamic instruments. As such, an Islamic bond will likely result in issuance at a lower spread vis-a-vis a Eurobond issue (see Selected Issues paper on Malaysia, 2004). However, market liquidity for Islamic bonds is likely to be low because they are typically not issued as a 144A/Reg S.45 Thus, an Islamic bond would not contribute towards building a sovereign curve (see below).

Short-term vs. medium- to long-term domestic borrowing

144. The government has moved to borrowing at the short end of the curve. In 2003/04, the government borrowed mostly in PIBs taking advantage of low medium- to long-term rates. The ratio of PIBs to T-bills was four to one. With interest rates rising, the borrowing profile has changed. The SBP has started to raise interest rates in order to rein in inflation, but wants to avoid a sharp and sudden rise in rates which could choke off growth. At the same time, the government want to keep borrowing costs down. Therefore, new borrowing has been largely in T-bills, with some auctions even being scrapped to moderate the interest rate increase. Driven by inflationary expectations, PIB yields in the secondary market have increased more than T-bill rates so that the yield curve has steepened. Also, there is an irregularity at the seven year maturity where yields (on past issuance with up to 14 percent coupons) exceed yields on 10-year maturities, reflecting low liquidity in the secondary market for PIBs. A decrease in the issuance of PIBs will further add to the illiquidity in the secondary market.

145. The small volume of PIB auctions relative to market demand has contributed to maturity mismatch for banks and nonbank financial institutions. In search for return, banks have accumulated large PIB holdings—about 70 percent of outstanding PIBs—and are reluctant to sell as they would have to realize losses on their holdings due to increased interest rates.46 Thus, a large share of banks assets is long-term while their liabilities are mostly short-term. Nonbank financial institutions such as insurances and pension funds are reluctant to hold 7- and 10-year PIBs yielding about 8 percent when 12-month inflation is around 9 percent. Instead, nonbanks prefer a strategy of rolling over the 3 percent return at the short end and either expect yields to increase in the near future and/or inflation to decrease (and thus postpone buying PIBs until real rates turn positive). Market sources indicate that a major nonbank has sold about 80 percent of its PIBs holdings in the past year and is now holding only PR’s 2 billion of PIBs, citing negative real rates as the main reason to unwind his position. Thus, a large share of nonbanks assets are short-term while their liabilities are long-term.

Building a Sovereign Yield Curve

146. A sovereign curve is usually constructed over a few years. Sovereigns typically issue a 3- to 5-year bond initially and then augment the debut sovereign “point” by issuing longer dated bonds between 7- and 10-years. Pakistan’s debut 5-year Eurobond could thus be followed up with a longer maturity issue to establish a second point.

147. A sovereign curve can provide a benchmark for corporates to borrow internationally. Despite high levels of reserves and in the absence of external financing needs, several emerging market countries including China, Singapore, etc. have developed sovereign curves to enable their corporates or quasi-sovereigns to issue abroad. Presently staff is unaware of any Pakistani corporates that wants to tap international debt markets.47 However, in the medium term, borrowing costs may tilt in favor of international markets, and a sovereign curve might help corporates to access cheaper external financing. Nonetheless, a sovereign curve does not appear to be a necessary pre-condition for corporates to borrow abroad as the example of India shows. The Indian government has not issued external bonds, but some corporates have still successfully tapped international markets.

E. Vulnerabilities and Policy Challenges

148. Pakistan is vulnerable to currency mismatch and interest rate risk. In the past, the government has done little to hedge the debt service profile that includes payments in U.S. dollars, Yen, SDR, and other foreign currencies. The DPCO together with EAD has now strengthened its external debt database and has started to implement forward and option contracts that provide hedging against exchange rate movements. Interest rate swaps are also being contracted to hedge against the floating debt portfolio. Still, Pakistan is at a very preliminary stage of executing hedges. Moreover, a better link needs to be established between reserve management and the debt servicing profile. Developing a derivatives market, initially led by the banking sector, should also provide the impetus for correcting the kinks in the local bond market.

149. The Eurobond swap from a fixed to a floating rate has exposed Pakistan to changes in the global interest rate cycle. Initially, the swap entails reduced interest costs as long as the floating rate of LIBOR plus 323 bps is lower than the 6.75 percent coupon rate. And even in the last two years, the interest rate is capped at 6.75 percent, that is the coupon rate, as long as the LIBOR stays below 5.52 percent. However, in case the LIBOR crosses 5.52 percent, Pakistan would have to pay LIBOR plus 323 bps, i.e. over 8.75 percent, with no cap.

150. Relying too much on T-bills for budget financing also exposes the government to rollover risk. As interest rates have slowly started to edge up, the government has almost predominantly relied on T-bills to cover its borrowing needs. While this helps to contain borrowing costs in the short-term, it may be more advantageous in the medium-term to strike a better balance between T-bills and PIBs and thus at least partly lock in the benign interest rate environment.

151. The functioning of the secondary market for PIBs needs to be improved. Non-banks, which are an important source of budget financing, are crowded-out by banks in the PIB market. In particular, some nonbanks are critical of the primary dealer arrangement which they perceive as working to their disadvantage. The secondary market quotes are significantly higher following a primary auction—that is, large bid/ask spreads adds to the illiquidity. One way of strengthening the position of nonbanks could be to allow pass-through bids at the primary auctions. Moreover, nonbanks would like to be allowed to hold Pakistani Eurobonds; presently, only Pakistani banks can hold Eurobonds through their offshore affiliates nonresident deposits.48 Finally, liquidity in the secondary market could be enhanced by allowing the stripping of PIBs coupons which would also lengthen the effective maturity of PIBs.

152. Budget borrowing could be separated more clearly from liquidity management. The SBP uses T-bill auctions as its main intervention to manage liquidity and thus conduct monetary policy. This can lead to conflicting interests regarding the cut-off rates between the SBP and the government when the SBP wants to tighten monetary policy while the government wants to contain borrowing costs. The tension could be eased by moving more towards open market operations for conducting monetary policy and using T-bill and PIB auctions only to raise resources for the government.


  • Khan, H. Ashfaque., 2003Debt Growth and Poverty: A Case of Pakistan,” Asian Development Bank Conference, (November).

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Prepared by Manmohan Singh and Axel Schimmelpfennig. This paper has benefited from extended discussions with the authorities, especially Dr. Naseer (SBP), Dr. Khan, and Mr. Gilani (Ministry of Finance). The views of the major foreign and local banks (J.P. Morgan, Deutsche, NBP) and nonbanks (SLI, EOBI) were also solicited.


Prior to 2000, the government issued so-called Federal Investment Bonds.


Banks usually hold fixed-income instruments of up to five years maturity. Pension and insurance companies are more interested in 7-year (and longer) instruments. Aside from the longer tenor, the change in investor base contributes to the higher spreads at the 7-year and is often reflected in the steepness in sovereign curves between 5 and 7 years. The ratio of prices at seven and five year maturity is a better measure than comparing only spreads at 7 years.


The United States Securities and Exchange Commission (SEC) allows sale of privately placed securities to qualified institutional buyers (QIBs) under rule 144A. Regulation S clarifies the conditions under which offers and sales of securities outside the United States are exempt from SEC registration requirements.


A recent circular from the central bank requires banks that hold PIBs in trading accounts to mark them to market, while PIBs that are in hold-to-maturity accounts need not be marked-to-market. It remains to be seen if the expectations of an increase in local interest rates will force banks to offload PIBs held in their trading accounts. Experience from other emerging markets suggests that enforcement of this regulation may be accompanied with a sell-off in the bond market and a spike in yields. If banks hold the new issues in their hold-to-maturity accounts, such issues are unlikely to reach the secondary market (and will have no impact on the yield curve). It is interesting to note that the Reserve Bank India has allowed banks the discretion to increase the cap on their hold-to-maturity portfolio of government securities.


Furthermore, relative low cost of alternative sources of funds has meant that some large Pakistani corporates have prepaid dollar debt by borrowing in rupees. Bank credit is readily available and private sector credit grew almost 30 percent year-on-year, as of end-June 2004.


Offshore affiliates of Pakistani banks (e.g., Habib Bank) are allowed to hold Eurobonds as long as they are funded by offshore deposits. Market sources confirm that such affiliates have bought the recent Eurobond in the secondary market—another indication that the Eurobond is an attractive instrument to hold versus the local five year PIB (and thus more expensive from the budgets debt service perspective).

Pakistan: Selected Issues and Statistical Appendix
Author: International Monetary Fund