8.1 Overview

The persistent rise in the total debt over the last decades saw a notable reversal in trend during FY02, as the total debt stock edged down by Rs 105.5 billion; the year also witnessed an important shift in the term structures of both domestic and external debt towards longer tenors. The achievements reflect the country B adherence to the Debt Reduction and Management Strategy (DRMS) , as well as a one-off stock adjustment of domestic debt, enabling Pakistan to make concrete progress towards a sound and sustainable debt path.

On the external front, the successful completion of an IMF Stand-By Arrangement (SBA) restored Pakistan B credibility with International Financial Institutions (IFIs), and led to successful negotiations for a medium-term IMF assistance program, PRGF, as well as increased aid from other IFIs. Moreover, the decision to join the international war against terrorism revived the previously strained relations with bilateral creditors. This paved the way for the stock re-profiling of Pakistan B bilateral debt by the Paris Club creditors, on very generous terms. As a result, the net present value of Pakistan B external debt is expected to decline notably (see Section 8.3 for details).

The domestic debt profile shows similar improvement. A one-time adjustment substantially reduced the stock of short-term debt (reducing the stream of future interest payments), and together with increased long-term borrowings, helped lengthen its maturity profile. Furthermore, improved exchange rate management and the spillover impact of external developments helped SBP to reduce the market-driven interest rates to all-time lows, fostering a sharp reduction in the cost of domestic debt.

While the above FY02 developments are quite commendable, it is necessary to emphasize that Pakistan still has a long way to go; an exit from the debt problems will require sustained macroeconomic discipline over a number of years.

At the close of FY02, total debt stood at Rs 3,760.5 billion and the total debt to GDP ratio declined from 113.2 percent to 102.0 percent (see Table 8.1). Of the three categories of Pakistanis total debt, the highest reduction was visible in external debt (Rs 53.9 billion) followed by explicit liabilities (Rs 34.6 billion), while domestic debt registered a smaller decline ofRs 17.0 billion during FY02.

In Rupee terms, the decline in external debt is entirely due to the appreciation of the Rupee, as the stock has actually increased in Dollar terms (by US$ 1,276 million). Nonetheless, the profile of the external debt stock reflects some qualitative improvement due to the re-profiling of bilateral debt, the retirement of expensive commercial debts, and increased reliance on soft credits from IFIs. As far as the explicit liabilities are concerned, the reduction ofRs 34.6 billion was mainly driven by the repayments of maturing 3-year Special US Dollar Bonds.

There is a distinct improvement in Pakistani s domestic debt profile during FY02, with a pause in the unremitting annual increase in public domestic debt, a perceptible decline in debt servicing costs, and an important shift in the term structure of the domestic debt. By end-June 2002 the total outstanding domestic debt was Rs 1695.5 billion, Rs 17.0 billion lower than the corresponding FY01 figure ( see Table 8.1). As detailed in Section 8.2.1, this was essentially due to a one-off stock adjustment, though it does have a continuing impact in the form of a lower stream of future interest payments. On the other hand, the rising share of long-term debt as well as the visible fall in the interest cost of domestic debt suggests a more definite improvement in the debt management (see Section 8.2.2).

Table 8.1: Profile of Domestic and External Debt

As a result, most domestic debt indicators depict substantial improvement in FY02, e.g. the ratios of domestic debt to GDP, and to tax revenue, both witnessed sharp declines over FY01 figures (see Figure 8.1).

The FY02 fall in the outstanding domestic debt creates some confusion in the presence of government B Rs 136.2 billion domestic borrowings to finance a portion of the budgetary deficit, i.e. contrary to standard theory, the FY02 change in domestic debt does not equate to the financing of budget deficit from domestic sources. The answer to this puzzle lies in a one-time adjustment in the domestic debt stock resulting from the rescheduling of the country Ds external debt, that has positive implications for the composition of the domestic debt stock as well as for the cost of servicing domestic debt.2 Effectively, therefore, the adjustment acts as a quasi-fiscal surplus.

The roots of this change date back to the May 1998 economic sanctions imposed following Pakistan B nuclear test, which forced the government to declare a financial emergency. Trapped by a severe foreign exchange squeeze, the government decided to meet its external debt servicing obligations in Rupees instead of foreign currencies, at prevailing exchange rates. Accordingly, two new accounts, the [Special Account Debt Repayments I & IIDwere opened in July and December 1998 respectively.

While the go vemmentDs fiscal balance reflected steady payments over the years, these notional external debt repayments only led to rising Rupee balances in the Special Accounts. Thus, by the time these accounts were eventually terminated in July 2001, these had accumulated to a very substantial Rs 194.6 billion. It is important to note that these notional payments had no monetary impact; while the payments were funded via budgetary borrowings from SBP and led to the increase in the SBP T-bill holdings (i.e. the SBP assets rose), the monetary impact was sterilized by keeping the borrowed funds in the reserved special accounts (i.e. an increase in SBP liabilities).

In fact, it was the rising fiscal burden of wdiat were essentially notional payments that eventually persuaded an accounting change leading to the cancellation of a portion of the domestic debt stock against the accrued Rupees in the Special Accounts, reducing at a stroke the size of the domestic debt. It must be noted that these fiscal adjustments left the accrued external liability unaffected, until it too was eliminated through rescheduling of external debt, and the receipt of grants during FY02.

Pakistan B public domestic debt is divided into three categories, largely based on the maturity structure of the instruments.

As can be seen from Figure 8.2, the composition of domestic debt has seen significant changes in FY02. The year saw a reversal of the steady up-trend in the share of short-term debt, helped by the retirement of MRTBs as weQ as the greater market interest in PIBs.

This points to greater stability in the government D s funding cycle. Moreover, the fact that a larger portion of fresh long-term borrowings was through PIBs means that the government is locking-in the benefit of historically low interest rates. To put this in perspective, one of the important reasons for the govemmentD s inability to reduce its debt servicing costs significantly over the last few years, is the lingering impact of very expensive long-term debt taken in earlier years.

In sharp contrast to previous years, the outstanding level of floating debt has witnessed a reduction ofRs 180 billion during FY02 (see Table 8.2). This massive retirement is the result of a variety of factors, including the termination of the Special Account for debt repayments and bilateral grants from friendly countries. As a result, the floating debt to GDP ratio has declined by 6.5 percentage points in just one year (see Figure 8.3).

Unfunded debt largely comprises of instruments offered by Central Directorate of National Savings (CDNS). The outstanding level of unfunded debt touched the level of Rs 769.7 during FY02, with a net inflow of Rs 76.0 billion. As can be seen from Figure 8.3, the unfunded debt to GDP ratio has

witnessed a continual increase from FY93 to FY00, largely on account of higher profit rates relative to other government debt instruments, despite the absence of incremental risk factors.

Realizing the dis-intermediary impact of higher profit rates of National Savings Scheme (NSS), as well as its distortionary implications for monetary policy, the NSS instruments have been restructured during the last three years. Their profit structure has been drastically changed and the profit income has been brought under the tax net. More specifically, the profit rates on Defense Saving Certificates (DSCs) have been linked with market based PIBs and are subject to revision after even' six-month.

Furthermore, the institutional investment in NSS was banned before the launch of PIBs. This specific measure coupled with reduction in profit rates resulted in lower net inflows in these schemes (compared to average inflows in earlier years) during FYOO and FY01, which helped to arrest the increasing share of unfunded debt. However, unfunded debt to GDP ratio has again slightly increased during FY02 largely on account of higher inflows in NSS, which almost doubled as compared to last year.4 The FY02 jump appears to reflect both, the external account improvement and the fact that rates on NSS instruments did not adequately mirror the decline in market-based instruments.

Domestic debt is broadly classified into two categories by ownership, i.e. by the banking and non-banking sectors. Although, the share of the banking sector in domestic debt has been declining since FY96, this trend was more pronounced during FY02 (see Figure 8.4), mainly due to a large one-off retirement of SBP T-Bills. The increased borrowings from non-banking sources were largely driven by higher inflows in the NSS and the sale of PIBs to non-banks. Debt Held by the Banking Sector

During the second revision, the government reduced the profit rates on DSCs by one percentage point, following the reduction in PIBs coupon rates with effect from November 6, 2001, while the profit rates on SSCs were kept unchanged. This rendered the SSCs relatively more attractive as compared to DSCs, increasing their sales in the following months (see Figure 8.6).

Table 8.5: Profit Rates on DSCs and SSCs*

Interest payments on domestic debt for FY02 recorded an 8.3 percent decline (Rs 16.3 billion in absolute terms) over the preceding year. This was entirely driven by a massive fall in the cost of unfunded debt. The decline in interest payments on floating debt was almost negligible, while interest expenses on permanent debt increased by Rs 2.2 billion (see Table 8.6).

The rise in FY02 interest payments on permanent debt stems from rising stock of this component, as elaborated in Sections 8.2.3. Specifically, interest payments on PIBs rose sharply to Rs 8.5 billion as compared to only Rs 0.9'billion in FY01. Additional contributions to the rise were from interest payable on other maturing government bonds, and on liabilities of Pakistan Steel Mills.

The marginal decline of Rs 50 million in the interest paid on floating debt calls for an explanation, given that the outstanding debt saw a steep fall ofRs 180 billion and that FY02 interest rates were lower. The apparent contradiction is explained by the accounting treatment; since the interest is computed on a cash basis, the cost shifts from one year to year. If we adjust the accrued interest ofRs 14.4 billion on MRTBs, the interest payments on floating debt drops to Rs 38.8 billion, which is substantially lower than both, the budget estimates and the interest cost for FY01.

Interest payments on unfunded debt include interest payment of provincial governments, commissions, charges and the printing costs of debt instruments. During FY02, these were Rs 18.4 billion lower than in the previous year; in fact, the fall was even higher than the fall recorded in overall interest payments on domestic debt. This suggests that a portion of this saving was offset by higher interest payments on permanent debt (see Table 8.6). Also, a compositional breakdown of the interest on unfounded debt show^ that interest payments on NSS actually increased during FY02 (compared to FY01) but remained significantly below the budget target. This relatively low increase, despite heavy inflows in these schemes during FY02, is simply because the initial payments on the incremental NSS inflows will fall due in FY03 and beyond.

The considerable improvement in Pakistan B external debt and liabilities (EDL) profile during FY02 reflects the country Q adherence to the Debt Reduction and Management Strategy (DRMS). This period witnessed a reversal in the country B EDL trend through a US$ 0.6 billion reduction to US$ 36.5 billion. There was also a visible shift in its maturity profile and the cost structure (see Table 8.7). Within the EDL, while the debt burden has increased by US$ 1.3 billion, this is on very concessional terms and is more than offset by a US$ 1.9 billion fall in liabilities.

The EDL reduction in FY02 is quite creditable, but there is no room for complacency. Given the magnitude of the external debt burden, sustained macroeconomic discipline will be required over a number of years before Pakistan can completely extricate itself from the debt trap. Also, it must be

Table 8.6: Interest Payments

Table 8.7: Pakistan's External Debt and Liabilities

Note: Due to changes in definitions (as explained in Sections 8.3) the data in this table is not directly comparable with data presented in earlier Annual Reports noted that a substantial part of the FY02 improvement is based on improved debt management rather than a very strong growth of the domestic economy. Nonetheless, Pakistan did achieve a number of milestones during FY02 that will help the transition towards a sounder and more sustainable debt path:

1. The successful completion of an IMF Stand-By Arrangement (SBA) considerably restored Pakistan B credibility with IFIs by demonstrating the governments commitment to the reform agenda.

2. The governments decision to join the international war against terrorism also revived our previously strained relationships with major bilateral creditor countries. As a result, Pakistan received improved access to some key markets and saw the removal of a number of economic sanctions imposed after nuclear test and the military takeover in October, 1999.

3. These steps paved the way for the successful negotiation of a relatively generous medium-term PRGF and also led to additional assistance and support from bilateral creditors and IFIs, as reflected by the higher FY02 receipts on account of non-food aid (see Table 9.1).

4. The restructuring of Pakistan Q bilateral debt by Paris Club creditors was also on very generous terms6; the sharp reduction in the Net Present Value (NPV) of external debt (between 28 to 44 percent) was achieved without the stigma of a HIPC restructuring.7

5. Pakistan also posted a record current account surplus of US$ 2.7 billion during FY02. This was instrumental to the accumulation of the SBP foreign exchange reserves to an all-time high ofUS$ 4.8 billion by end-June 2002, as well as facilitating the retirement of the more expensive external debt and liabilities.

6. Finally, the unprecedented appreciation of Rupee/Dollar parity by 6.7 percent and resulting end to devaluation expectations (evident in the virtual disappearance of the kerb market premium) carries major positive direct8 and indirect9 connotations.

By contrast, since the liabilities have decreased in absolute terms, all of the liability indicators show an unambiguous positive change in FY02. The record level of foreign exchange reserve build up during FY02 also bolstered the ratio of foreign exchange reserves to EDL, which improved from 5.6 percent in FY01 to 13.5 percent during FY02. Another important indicator of a country Ds external debt profile is the non-interest current account balance. It reflects a turnaround from negative to positive balance since FYOO, which shows the concerted efforts of current government to bring strength and stability to external sector and check the growth ofun-sustainable external debt (see Figure 8.7).

This is computed by subtracting the entire stock of a country B EDL from its liquid foreign exchange reserves, and it simply measures the country's immediate ability to redeem its EDL. Thus the smaller the value of this indicator, the better off the country is. The sharp US$ 3.3 billion improvement in this indicator during FY02 mirrors the unprecedented accumulation of foreign exchange reserves as well as a complementary decline in the country Ds EDL (see Figure 8.8).

Prior to discussing the components ofPakistanB external debt and liabilities, it is important to note that the definitions of external debt and liabilities have undergone a small modification in FY02. Specifically, NHA bonds, central bank deposits and NBP/BOC deposits of different maturity, that were earlier components of external debt, have been re-classified as external liabilities. The change simply recognizes that funds under these heads were repeatedly rolled over and effectively had no definite repayments schedule. Accordingly, the data in Table 8.7 has been adjusted to make it comparable over the years.

The following coverage of the components of EDL is based on the revised definitions. As mentioned earlier, according to provisional estimates, Pakistan B total external debt and liabilities declined by 1.6 percent to US$ 36.5 billion during FY02 (See Table 8.7). This was achieved principally due to the retirement of commercial and private loans/credits, IDB credits, foreign currency accounts, special US$ bonds. National Debt Retirement Program (NDRP), other liabilities and NBP deposits.

This is the single largest component with an 88 percent share in the PakistanDs total external debt. However, before discussing the PPG debt in detail, it is essential to highlight the issue of revaluation, which increased the stock of PPG significantly during the last three years.

Note: Foreign Exchange Earnings is the sum of earnings from Goods, services, and income (credit entry from Item A: BOP-IMF/92) and private transfers (credit entry from Item B.7: BOP-IMF/92).

TED: Total External Debt TEL: Total External Liabilities RES: Foreign Exchange Reserves EE: Export Earnings FEE: Foreign Exchange Earnings

Despite this revaluation, some differences remained between BAD and creditors D book numbers, and the EAD finally reconciled the numbers in FY02 adopting the information provided by the creditor agencies during FY02. Since the EAD has already revalued the debt stock to a major extent, the adoption of creditors Qiumber has a minor impact on total stock of debt during FY02. However, the IMF debt is denominated in SDRs and the value of IMF outstanding debt recorded an increase ofUSS 103 million in FY02 due to valuation change in SDR/US Dollar parity.

Within total external debt, long-term public & publicly guaranteed debt has the dominant share due to heavy reliance on the official sources of financing (see Table 8.9); of this, 93 percent is from multilateral and bilateral sources. Multilateral claims are dominated by loans from IBRD, IDA and ADB, which constituted 98 percent of multilateral loans. The Paris Club creditors own 37.5 percent of the country Ds outstanding debt obligations. The bulk of these loans are from Japan, US, Germany and France.

It is evident that multilateral credit rose from US$ 10.6 billion in FY99 to 13.3 in FY01 mainly due to revaluation while the increase during FY02 was US$ 1.0 billion (see Table 8.7).

However, one of the positive aspects with respect to multilateral debt was the shift from [Hard do DsoftD loans. More specifically, Pakistan contracted soft loans from IDA at zero interest rates with a 35-38 year maturity, and paid back US$ 0.9 billion in expensive loan of IBRD. This substitution of debt from hard to soft debt is one of the key elements of the DRMS. As a part of this strategy, the following inflows were realized from World Bank and ADB during FY02:

• US$ 510 million from the World Bank (specifically IDA). This loan has maturities between 30-35 years, 10-year grace period and service charges of 0.75 percent. It aims to support structural reforms in Pakistan and focuses on governance, economic growth and the delivery of social services.

• Another loan of US$ 188 million was also realized under the Banking Sector Adjustment Credit from World Bank, the facility aims to support the restructuring process of the financial system.

• A tranche of US$ 50 million under the Trade Export Promotion and Industry Program Loan of the ADB, which was approved on March 31,1999. The facility aims to support the private sector exports by focusing on trade liberalization, financing, facilitation for trade and export, and the privatization of manufacturing units.

• US$ 100 million from the Asian Development Bank (ADB) under the Legal Reforms

Program Loan. Approved on December 20, 2001, the facility aims to support a strengthening of the legal system to improve legal protection for all, and especially for the poor and other vulnerable groups.

• First tranche ofUS$ 35.0 million realized during current fiscal year from ADBDs under Road Sector Development Program (RSDP) to uplift the roads in Pakistan. Approved on December 19, 2001, RSDP consists of a US$ 50 million policy loan to support national reforms and a US$ 150 million investment loan for a Provincial Sector Development Project. The program is taking a sequential approach, starting with Sindh province and to be extended to other provinces later on. The investment project wdll improve 164 km of provincial highways and 1,200 km of rural access roads in Sindh province. This rehabilitation wdll enhance communication between farm communities and market centers, as well as provide much-needed access to villagers for education and health facilities, and job opportunities in urban areas.

These comprise loans guaranteed directly by the federal government. Other than the oil import facilities, these are mostly cash disbursing facilities for BOP support received in one or multiple tranches, having maturities of less than two-years. The total stock of commercial loans and credit fell significantly, from US$ 1.1 billion in FYO 1 to US$ 0.3 billion during FY02, due to the repayments of PTMA credits.n The outstanding end-FY02 figure includes the amounts due under the Pakistan Trade Maintenance Agreement (PTMA), PTCL securitization and new loans contracted during last year, etc.

The IDB does not provide any cash disbursing loans, but finances the import of crude oil and fertilizer. The closing stock of this debt fell by US$ 74 million during the year to US$ 183 million at end-June 2002.

These are mainly [Suppliers Credit Schemes u(SCS) and LPay as You EamD(PAYE) credits and are contracted by private sector from multilateral sources, NCBs, and Export Credit Agencies in OECD countries. The federal government does not directly guarantee these loans, but convertibility is guaranteed by the SBP.

While the schemes still exist, they have been effectively dormant after the imposition of economic sanctions following the nuclear test in 1998. More specifically, there was an embargo on deferred payment PA YE and SCS from donor countries as well as the difficulties in exchange risk coverage from SBP. The net outflows under these schemes over the years confirm the above point (see Figure 8.10). However, in light of the recent lifting of the relevant economic sanctions, these schemes could be reactivated.

The end-FY02 stock stood at US$ 2.2 billion as compared to US$ 2.5 billion last year. A breakup of the amount by economic groups show^s that the largest component accrues to the Power sector (mainly IPPs), with the Cement sector a distant second.

The most noteworthy development is the retirement of external liabilities by US$ 1.9 billion during FY02. The end-June FY02 stock of external liabilities is US$ 3.1 billion as compared to US$ 5.0 billion last year.

Due to the hefty increase in foreign exchange reserves, SBP returned the FE-31 and FE-13 (part of FE-25 placed with SBP previously) to the mobilizing commercial banks, while the stock of FE-45 deposits fell from US$ 1.1 billion to US$ 0.4 billion during FY02 due to hard currency payments. '^ &13

As of end-June 2002, the outstanding stock amounted to US$ 0.9 billion as compared to US$ 1.4 billion at end-FYO 1 (see Table 8.7). The majority of the bonds issued had a maturity of 3-years. Thus, as the initial maturities fell due in FY02, the SBP sought to protect its fragile foreign exchange reserves by offering (1)5 percent bonus to bond-holder opting for Rupee redemptions keeping in view the kerb premium, and (2) an attractive reinvestment option, i.e., the face value of the bond could be re-invested for a further 3 years (from the date of redemption) at LIBOR + 2 percent.

The reinvestment option was relatively more attractive as compared to Rupee redemption bonus till November 2001 when the kerb premium collapsed. After the collapse of kerb premium the incentives to dollarize faded and bondholders increasingly availed the option of redemption in Rupees with 5 percent redemption bonus. Although the SBP withdrew the premium by March 2002, these Rupee redemptions continued apace in subsequent months (see Table 8.10).

NDRP was launched on February 27, 1997 to solicit funds from non-resident Pakistanis (NRPs) towards retiring the country Q external debt. Resident Pakistanis were also allowed to participate in the scheme using their foreign currency accounts, FEBCs, FCBCs, traveler cheques, remittance from abroad or by surrendering hard currency.13 The bulk of funds mobilized under NDRP scheme was placed in 5-year maturity of profit bearing deposits. These expensive liabilities are expected to be retired as they mature. The end-June 2002 stock of NDRP is reported at US$ 75 million, dowoi 50 percent from end FY01 level.

The end-June 2002 stock of NHA bonds is US$ 197 million as compared to US$ 219 million last year due to the normal repayments of these bonds.

These comprise of deposits by central banks of various friendly countries (UAE: US$ 450 million and Kuwait: US$ 250 million) placed with SBP at end-June FY01.16 The stock of these placements increased during FY02 as Libya also placed a deposit ofUSS 50 million in December 2001.

These comprised NBP Bahrain and Bank of China deposits. The end-June 2002 stock of these deposits is US$ 500 million as compared to US$ 750 million last year. During FY02, Pakistan retired the two deposits of NBP Bahrain ofUS$ 46 million (placed with GOP) and US$ 203 million (placed with SBP). The remaining outstanding amount is a Bank of China deposit.

These comprise of swaps from various commercial banks and moneychangers. The stock of these swaps declined by US$ 441 million during FY02, as Pakistan repaid all the swaps to moneychangers, the remaining stock ofUS$ 280 million is owned to various commercial banks.

Following the acute balance of payments difficulties after the nuclear detonations in May 1998, Pakistan has received two back-to-back rescheduling (January 1999 and January 2000), the first of which was accompanied by a rescheduling by the quasi London Club creditors (December 1999).17

Source: Karachi and Lahore offices of SBP

However, even after the recent consolidation period that ended in September 2001, Pakistan was still unable to rebuild its debt repayments capacity, and was therefore, again forced to approach Paris Club creditors for yet another restructuring. In view of Pakistan Us strict adherence to the IMF reform program during FY01, the response was very positive.