Before September 11, 2001, Pakistan's economy was caught in the web of a vicious debt trap. Committed outflows of foreign exchange on 30 June, 2001 exceeded inflows by $4.56 billion. Of this amount, Pakistan was able to obtain rescheduling through the Paris Club on $3.96 billion. This reschedule was on a short-term basis and was contingent on an IMF agreement being finalised, with all its stringent conditionalities.

While the debt overhang had become serious over the years, sanctions imposed by the G-8 countries on bi-lateral and multi-lateral lending after the country's nuclear tests in 1998 and subsequently after the military coup in 1999 further compounded the already precarious external debt situation. Two short-term Paris Club reschedules - one in January 1999 and the other in Sept 2001 - saved Pakistan from imminent default on its external liabilities. These were short-leash relief measures on only a part of bilateral external debt and had merely postponed the day of reckoning, as all underlying indicators with respect to external liabilities remained dismal.

The cataclysmic events of September 11, 2001 have once again catapulted Pakistan into center-stage of global geo-strategic interests. The most significant benefit vis-‡-vis external debt was achieved through the debt restructuring agreement inked with the Paris Club in December of 2001. According to this agreement, Pakistan's entire bi-lateral debt of US$12.5 billion has been substantially restructured. The Paris Club debt restructuring has meant that the debt repayment period has been extended to 38 years with a grace period of 15 years. This debt restructuring means that Pakistan's debt servicing liabilities will decline by roughly US$2.7 billion between 2002 and 2004 and thereafter between US$8.6 billion and 11 billion depending on the interest rates negotiated with individual countries.

Similarly, the net present value of Pakistan's external debt is expected to decline by 27 per cent to 43 per cent between now and 2017 (ibid). Only three other countries - Poland, Egypt and Yugoslavia - have been given such generous debt relief by the Paris Club.

Apart from the Paris Club debt restructuring, Pakistan's balance of payments have benefited tremendously from various inflows over the last year. The doubling of remittances from overseas Pakistanis, resumption of multilateral aid and bi-lateral budgetary support from the United States as well as payments for logistical support for the war on terrorism has enabled Pakistan to post a current account surplus in the year 2001-02. This has also resulted in the Pakistani currency having appreciated with respect to the US Dollar by more than 10 per cent over the year. This current account surplus has also resulted in the accumulation of reserves equivalent to more than eight months of imports at last count.

While Pakistan is no longer on the threshold of an external debt crisis in the last quarter of 2002, a number of issues pertaining to the country's external debt burden still need to be addressed. Sustainable debt servicing requires more than the reduction of the net present value of debt. It requires high and sustainable growth in GDP and in foreign exchange earnings. The country is yet to embark on a path to achieve these twin goals. It will also require that appropriate fiscal discipline is maintained so that new borrowing is not squandered in unproductive expenditures - including borrowing for current expenditure and defence.

The Musharraf government has outlined a debt management strategy based on the report of the Debt Management Committee, which was headed by Dr. Parvez Hasan. The Debt Management Committee Report (henceforth DMCR) has outlined a future debt management strategy to be followed till 2010 to reduce public debt, including its external component. The DMCR has also identified the causes for debt accumulation and its unsustainability. This is appropriate as only if we learn from past mistakes, will we be able to avoid them in the future.

Whatever shape Pakistan's future political landscape takes, the DMCR will remain the benchmark for any future debt management policy simply because it is the only comprehensive exercise that the Government of Pakistan has under taken on this critical issue. It is, therefore, important to critically appraise the approach adopted in this report. Needless to say if the government is to commit itself to a strategy of debt reduction it should be one which not only keeps external debt within sustainable limits but also does not compromise on other important goals of economic performance - growth, welfare and poverty reduction. Since there is a link between the assessment in the DMCR of the causes of debt unsustainability that took place in the 1990s and the strategy put forth, it is important to revisit the causes afresh.

This study thus seeks to address three issues. In section I, we address the causes of the debt overhang created in the mid 1990s. Through a detailed breakdown of different elements in the external account, we shall seek to explore the reasons behind the increase in different elements in the external account. Thereafter, we will also look at the relationship between the fiscal deficit and different external debt indicators in order to determine the causality between the internal deficits and external constraints.

Section II addresses the debt management strategy proposed in the DMCR. A number of targets proposed in the DMCR - such as accumulation of reserves, reduction in the net present value of debt, securing the Poverty Reduction Growth Facility (PRGF) - have already been achieved in the wake of favourbale developments in the post-September 11 geo-political scenario. However, there is no room for complacency. Over the long-term, the ability of the country to earn foreign exchange will have to be enhanced if we are to avoid slipping into another debt trap. Specifically, the debt management strategy has to be seen in the context of growth and investment revival and the trade-offs suggested in the DMCR require critical appraisal.

Section III will then move from appraisal of the DMCR to policy alternatives regarding debt management, which are commensurate with sustainable economic growth and investment in the country.

1. Causes for the increasing burden

Debt indicators are usually presented in terms of stock and flow measures. Table 1 presents stock measures of total debt stock and its share in GDP in both nominal and real terms. The DMCR correctly states that debt figures should always be analysed in real terms because "part of the debt is wiped out by inflation". Therefore it is appropriate to take inflation-adjusted numbers as the benchmark. The total debt stock, its share of GDP and its Net present Value are important indicators of the debt burden.

In terms of some of these indicators we see in Table 1 that Pakistan's debt stock more than doubled from $11.4 billion to $22.35 billion in the decade of the 1980s. In terms of its share of GDP, the debt stock increased from roughly 40 per cent of GDP to 56 per cent GDP. In the 1990s, the debt stock increased from $25 billion to $34 billion and its share in GDP increased to 61 per cent. In nominal terms, therefore, the rate of growth of debt stock was lower in the 1990s compared to the previous decade (see Table 2). In real terms, however, the rate of growth in debt stock was slightly higher in the 1990s. In terms of stock indicators, therefore, we see that there is not much difference in debt accumulation between the two periods. Popular perception that the debt stock increased much faster in the 1990s is not corroborated even by a snapshot look at the debt data presented in Tables 1 and 2.

Stock indicators, however, are not very relevant if a debt crisis is to be discerned. The defining character of external debt is that it has to be repaid in foreign exchange. Indicators of inflows and outflows of foreign exchange are, therefore, most critical in terms of tracking the onset and persistence of an external debt crisis. In the pure case, if net foreign exchange earnings (non-debt creating) are less than debt servicing requirements then debt servicing becomes unsustainable. In the case of Pakistan, net foreign exchange earnings have always been less than the debt servicing liabilities if both interest and amortisation liabilities are taken into account. Traditionally debt servicing has taken place by borrowing long-term and on concessionary rates. If we treat long-term debt as earned income, then the ratio of debt servicing to foreign exchange earnings becomes a more meaningful indicator of the ability to service debt. It is on this important indicator that we see the situation in the 1990s deteriorating.

Table 3 shows that between 1985 and 1992 the ratio of debt servicing to foreign exchange earnings hovered in the range of 19 to 33 per cent. Since 1993 it increased continuously till 1998-99. Thereafter it reduced mainly because of Paris Club rescheduling. The ratio in column 5 of Table 3, however, is inclusive of resident foreign currency accounts (FCAs) shown as inflows. Resident FCAs, as we know now, were a volatile financial instrument, which could be recalled at short notice. It should, therefore, be treated as a liability rather than earnings. A more realistic picture emerges once we net out FCAs from foreign exchange earnings. This increase a ratio on average by 3 percentage points between 1992 and 1998 (the year when resident FCAs were frozen). The immediate debt crisis, therefore, started brewing in 1992 and peaked in 1998-99 till Pakistan received a respite from the Paris Club and subsequently a restructuring on bilateral debt in 2001.

The 1991 to 1998 period thus merits special scrutiny. The DMCR mentions a number of factors of the build-up of the debt problem. The central problems according to the DMCR are large and persistent fiscal and current account deficits as well as imprudent use of borrowed funds. The latter includes "wasteful government spending, resort to borrowing for non-development expenditures and poor implementation of foreign aided projects. It also mentions weakening debt carrying capacity in terms of "stagnation and or decline in government revenues and exports -- and rising real cost of government borrowing." (ibid)

While some of these factors are specific to the domestic debt build-up, which is outside the remit of our analysis reasons of stated in the DMCR fall broadly in the realm of policy and governance failures. There is no quibble with this analysis. However, the DMCR does not adequately acknowledge exogenous factors that played their part in the country's external debt build-up. A sharp deceleration in remittance incomes and increasing interest and amortisation liabilities of debt incurred twenty to thirty years ago are exogenous to both policy making and governance at the time.

To investigate the build-up of the external debt overhang, both the external account and the fiscal deficit need to be investigated in detail.

TABLE 3

EXTERNAL DEBT SERVICING AND FOREIGN EXCHANGE EARNINGS

(US $ Million)

Period Total Debt Foreign Foreign Debt Servicing Debt Servicing

Servicing Exchange Exchange Foreign Exchange Foreign Exchange

Earnings Earnings Earnings Earnings

(net of FCA) (Net FCA)

(A) (B) (C) (B/A) (C/A)

1985 1,070 5,555 5,555 19,26% 19,26%

1986 1,339 6,246 6,246 21.44% 21.44%

1987 1,465 6,443 6,443 22.74% 22.74%

1988 1,595 7,139 7,139 22.34% 22.34%

1989 1,657 7,343 7,343 22.56% 22.56%

1990 1,803 7,681 7,681 23.47% 23.47%

1991 1,754 8,807 8,617 19.92% 20.36%

1992 2,011 10,326 9,008 19.48% 22.32%

1993 2,599 9,470 8,927 27.44% 29.11%

1994 2,996 9,389 8637 31.91% 34.69%

1995 3,447 10,517 10,136 32.78% 34.01%

1996 3,597 10,916 10,153 32.95% 35.43%

1997 3,859 11,343 9,996 34.02% 38.61%

1998 4,017 11,864 10,388 33.86% 38.67%

1999 3,873 9,996 9,457 38.75% 40.95%

2000 4,154 11,360 11,038 36.57% 37.63%

2001 3,838 13,670 13,136 28.08% 29.22%

2002 3,507 14,857 14,572 23.61 24.07%

Source: State Bank of Pakistan, Annual Report, Various Issues

TABLE 1

DEBT STOCK AND SHARE OF GDP

Years External External External to Debt Debt Debt

(Nominal) (Real) GDP Ratio

1981 11,414 23,136 40.62%

1982 12.294 23.052 48.70%

1983 13,151 23,506 46.20%

1984 14,165 23,660 45.50%

1985 15,074 23,889 48.37%

1986 16,155 24,904 50.67%

1987 17.017 25,420 51.06%

1988 18,434 26,710 48.04%

1989 20,350 28,188 50.80%

1990 22,354 29,433 56.01%

1991 24,191 30,423 53.15%

1992 25,259 30,841 51.80%

1993 27,541 32,616 53,29%

1994 29,418 33,956 56.41%

1995 30,847 34,703 50.57%

1996 32,723 35,950 51.29%

1997 33,864 36,440 53.74%

1998 35,715 37,863 57.62%

1999 36,089 37,731 60.48%

2000 34,069 34,818 56.04%

TABLE 2

Source: State Bank of Pakistan, Annual Report, Various Issues.

GROWTH IN EXTERNAL DEBT STOCK:

NOMINAL AND REAL

External Debt External Debt

(Nominal) (Real)

1981-90 7.75% 2.71%

1991-98 5.72% 3.18%

1999-2000 -2.33% -4.11%

Source: State Bank of Pakistan, Annual Report, Various Issues

Asian Development Bank (Global Development Finance 2001)