Table of Content

Introduction
In the modern state perspective, the needs constantly increase; therefore, the state has to
spend more to meet these needs. Public expenditures are generally met by ordinary public
revenues such as taxes, duties, fees, Para fiscal revenues, property and enterprise revenues,
taxes, and penalties. However, the state is faced with the public sector deficit due to reasons
such as large infrastructure investments, war, development financing, natural disasters,
economic crises, budget deficits, as well as the ever-increasing ordinary public expenditures.
To overcome this situation, they refer to borrowing.

Borrowing is the taking of money and similar values for repayment after a certain period of
time. Public borrowing refers to the legal obligation of the state to pay back the principal and
interest to the holders of the predetermined rights in accordance with a certain schedule.
Public credit and public borrowing referred as state borrowing in the economic literature
mean debts taken by government or other public institutions.

Governments in ancient and medieval ages required funding, as in modern states. But
governments did not borrow “publically” in the concept of drawing funds from a large
populace and paying principal and interest, as like deferred taxes.

Public debts are classified into various types according to their characteristics. When the
public debt literature is analyzed, it is classified into three main groups according to maturity,
resources, and voluntariness:

 Public debts according to maturities: short, medium, and long-term public debts

o Short-term public debts (floating debts) refer to debts up to 1 year. In short-term

borrowing, treasury bills and treasury guaranteed bond are used.

o Medium-term public debts refer to debts ranging from 1 to 5 years.

o Long-term public debts refer to debts more than 5 years. The instrument of long-term
borrowing is the government bond. These debts are provided from the capital markets
and have a higher interest rate than the interest rate of short-term borrowing. Long-
term debts are classified as redeemable debts and irredeemable debts.
 Public debts according to sources: internal debts and external debts

o Internal borrowing refers to a country’s borrowing from own national resources. This
borrowing has no effect on increasing or decreasing national income.

o External borrowing refers to the resources provided from a foreign country that is
repaid with principal and interest at the end of a certain period. External debt has an
increasing effect on national income when it is taken and vice versa has a decreasing
effect on national income when it is paid.

 Public debt as a voluntary basis: voluntary debts and obligatory debts

o Voluntary debts refer the debts that are lent to the state by its own will and desire.

o Obligatory debts refer to the debts which are lent by forcing to take the bonds issued
by the government. These debts are applied in times of war, natural disaster, or
economic crises. In itself, it is classified as the debts taken by full compulsion, the
debts taken by the threat of forcing, the debts taken by creating the necessary savings,
and the liabilities taken by the moral coercion.

Productive and unproductive debts are also available. If the debts are used in construction,
such as railways, power stations, and irrigation projects, which contribute to the productive
capacity of the economy, they denote to productive debts. By this way, productive debts
provide a constant flow of income to the state. The state generally pays the interest and
principal debt amount from these projects’ revenues. If the debts are used in the area such as
war, famine relief, social services, etc., which do not contribute to the productive capacity of
economy, they denote to unproductive debts. The state generally pays the interest and
principal debt amount from taxes; therefore, these debts are a burden on the society.

Today, rapidly increasing international relations have increased the importance of external
debts. The less developed and developing countries have to refer to external borrowing for
the realization of their economic development. The lack of adequate capital markets for
development in these countries and the insufficient number of technical materials and
personnel required external resources.

Internal and external borrowing amounts are adversely progressed in less developed and
developed countries. According to this, the debts of developed countries are predominantly
internal debts; the debts of less developed and developing countries are mostly external debts.
Because in developed countries, the state can easily provide the debts needed by own internal
sources. It is also important from where and how the sources of funding are provided in a
country’s economy as well as how these resources are channeled back into the economy.

As it is known, external borrowing has an increasing effect on national income when taken
and has a decreasing effect on national income when paid. Because of these features, it is
important to use for what purpose external borrowing. For instance, the development credits
that are provided in order to investing in economic development and increasing the existing
investments, contribute to the economy by using the programs and projects included in the
development plans. Development credits are dealt within four groups:

 Project credits and program credits

o Project credits are the credits that provided for the purpose of realizing the
investment projects in the development plans of the countries. Countries that request
credit provide projects with detailed information to countries or organizations that
will give credit. Project credits are accredited/opened for the financing of eligible
projects. Thus, less developed and developing countries are forced to use credits in a
productive area, while creditor countries or organizations have the opportunity to
control their credits. The biggest drawback of these credits is the long time for the
preparation, submission, and creditor approval of the project, which makes the
efficient use of credits more difficult.

o Program credits are the credits that received for the purpose of importation of raw
materials, semi-finished goods, finished goods, and spare parts required for
development targets in general. It is more flexible to use because it is not connected to
any project. Thus, with the help of program credits, import bottlenecks are eliminated
and the economy is kept in working condition. Therefore, it is a credit that is
demanded more by developing countries.

 Tied loans and soft loans

o Tied loans refer to the credit that should be used in the country which gave the credit.
In this case, the debtor country does not have the authority to spend the credit on its
own request. Nowadays this feature of loans granted by developed countries generates
to establish the system that is working in favor of the lender countries. Thus, the
creditor country has provided advantages such as new foreign market, export growth,
 employment increase, and technology transfer. In terms of the debtor country, the
situation is not bright at all. The borrower country is exposed to practices that increase
the real cost of a loan such as buying a product from creditors at a much more
expensive price than the normal market rate, transporting the goods through the
creditor country’s transport system and insuring them by the creditor country’s
insurance system. Hence, countries that receive loans remain under heavy debt
burden.

o Soft loans are credits that granted the free use of developing countries. Thus, the
debtor countries can provide the goods and services necessary for development
financing from the international market in the cheapest way.

 Debt postponement and refinancing credits

o Debt postponement is to postpone debt payment for an expired credit to a later date
in return for a lower rate of interest compared to the first interest rate.

o Refinancing credits are to pay an expired debt by the creditor country with the same
amount of a new loan (a new debt). The main reason for creditor countries to accept
debt postponement and refinancing credits is to enable them to accept some new
commitments to the debtor country with these instruments. Thus, the creditor country
can direct the debtor country’s economic policies in line with its own advantages.

Heavy indebtedness of the developing economies is one of the major challenges at the
beginning of 21st century. Needless to point out, government can finance its budget and
development efforts by borrowing or taxing the output. However, taxes tend to distort the
structure of relative prices, borrowing, if pushed beyond the carrying capacity of an economy,
creates problems of intergenerational equity, and it can cause a transfer of resources that
tends to be undermining growth. Yet borrowing has to be done to finance public expenditure
to increase social welfare and promote economic growth.

In general, public debt can be classified as sum of external debt and domestic debt. As far as
the relationship between external debt and economic growth is concerned, a reasonable level
of borrowing is likely to enhance economic growth, through capital accumulation and
productivity growth. Because at early stages of development, countries have small stocks of
capital and they have limited investment opportunities. External borrowing for productive
investment creates macroeconomic stability, external debt is also been seen as capital inflow
having positive effect on domestic savings, investment and economic growth; it implies that
foreign savings complement domestic savings to cater for investment demand. However, high
level of accumulated debt has an adverse effect on rate of investment and economic growth.
Most broad rationalization of the adverse effect of debt is “debt overhang” effect. If there is
some likelihood that in future, debt will be larger than the country’s repayment ability then
anticipated debt-service costs will depress further domestic and foreign investment. The other
channel through which debt obligations affect economic growth is known as “crowding out”
effect. If a greater portion of foreign capital is used to service external debt, very little will be
available for investment and growth. Debt-servicing cost of public debt can crowd out public
investment expenditure, by reducing total investment directly and complementary private
expenditures indirectly. However, various authors are unable to find evidence of a significant
crowding out effect, while others finds that both debt burden and debt service obligations
have reduced the investment and economic performance.

In developing countries, policy makers and international organizations have given domestic
debt far less attention as compared with external indebtedness. Issuing domestic debt, 3
whether to finance fiscal deficit or to mop up monetary liquidity, involves a complex
assessment of the costs and benefits to the economy. The justification behind creation of
domestic debt in poor countries is that it kindles development of deep and liquid internal
financial markets, protect countries from unfavorable external shocks, and mitigate foreign
exchange risk. Domestic debt can crowd in risky private sector investment by protecting bank
balance sheets and profitability. As such, investments are more proficient compared with
investment associated with low risk. Most important concern about domestic debt is
crowding out effect on private investment. When governments borrow domestically, they use
domestic private savings, otherwise that may have been on hand for private sector lending. In
turn, smaller residual pool of loan able funds was available in market to elevate the cost of
capital for private borrowers. It results in dropping private investment demand, and therefore
capital accumulation, growth and welfare. Domestic debt is also viewed as more expensive in
comparison to concessionary external financing. As a result, interest load of domestic debt
may absorb important government revenues and thus crowd-out pro-poor and growth
enhancing expenditures. High-yielding government domestic debt held by banks can make
them self-satisfied about costs and decrease their efforts to mobilize deposits and fund private
sector projects.
Background of Public Debt in Pakistan
At the time of independence Pakistan was a poor and underdeveloped country. In order to
stimulate economic growth, adequate revenues are a prerequisite but Pakistan since
independence, it is facing financial crunch. Confined revenues and savings coupled with
rising expenditures have caused situation of persistent fiscal deficit over the years. Similarly,
situation of balance of payment is also not satisfactory and Pakistan is facing current account
deficit. These deficits are filled by public debt and Pakistan has to spend considerable portion
of its GDP on interest payments of the loans. The need to service debt obligation is
undermining economic performance and resulting in collapse of development planning.
Because debt obligations and expenditure on debt servicing become a resource drain for
already limited revenues and is halting economic growth and poverty reduction efforts.
Decade of 1990s is a typical example of this situation, during 1990s Pakistan was facing
severe fiscal deficit, elevated public debt and near to the ground economic growth and rising
incidence of poverty. Developing countries with higher incidence of public debt have to cope
up with the same situation.

Several points can be concluded after examining Public debt scenario in Pakistan. Firstly,
debt problem has been in making for a long time. Inability of successive governments to
reduce fiscal deficit significantly, unproductive use of debt and stagnant growth in real
revenues has fueled the debt problem. Secondly, rising public debt in Pakistan is largely
contributed by factors like stagnant government revenues and high real cost of borrowing.
Resultantly, sharp fluctuation in real cost of borrowing, dynamics of the growth in public
debt also changed over time. Thirdly, debt problem can’t be detached from broader issues of
economic strategy and management especially policies regarding savings, exports, and
revenue, expenditure etc. Lastly, due to rising expenditure on debt servicing governments
have always reduced development expenditure instead of reducing the current expenditure.
Pakistan's increasing debt servicing requirements during 1990s exerted significant strain on
fiscal management. To meet the commitments under IMF's structural adjustment program,
Pakistan had to reduce size of the budget deficit to less than 5 % of GDP. As revenue
generation efforts are only partially successful and Pakistan is unable to generate adequate
revenues to meet expenditure. Consequently, successive governments have tried to reduce
deficit by reducing development expenditure that has hampered economic growth process
and resulted in decline in human development indicators and it has raised incidence of
poverty. Moreover, public debt servicing placed serious constraints for priorities of
government's budgetary allocations, leaving very limited resources available for development
expenditure.

Here is a trend of public debt in year wise public debt position:

Source: Pakistan Economic Survey 2017-18

Objectives
Most government debt is held in long-term interest bearing securities such as national savings
certificates, rural development bonds, capital development bonds, etc. In industrially
advanced countries like the U.S.A., the term government or public debt refers to the
accumulated amount of what government has borrowed to finance past deficits.

In such countries the government debt has a very simple relationship to the government
deficit the increase in debt over a period (say one year) is equal to its current budgetary
deficit. But, in developing countries, the term is used in a different sense.
The State generally borrows from the people to meet three kinds of expenditure:

a. To meet budget deficit,

b. To meet the expenses of war and other extraordinary situations and

c. To finance development activity.

a. Public Debt to Meet Budget Deficit

It is not always proper to effect a change in the tax system whenever the public expenditure
exceeds the public revenue. It is to be seen whether the transaction is casual or regular. If the
budget deficit is casual, then it is proper to raise loans to meet the deficit. But if the deficit
happens to be a regular feature every year, then the proper course for the State would be to
raise further revenue by taxation or reduce its expenditure.

b. Public Debt to Meet Emergencies like War

In many countries, the existing public debt is, to a great extent, on account of war expenses.
Especially after World War II, this type of public debt had considerably increased.

c. Public Debt for Development Purposes

During British rule public debt had to be raised to construct railways, irrigation projects and
other works. In the post-independence era, the government borrows from the public to meet
the costs of development work. As a result the volume of public debt is increasing day by
day.

Effects of public debts

Borrowing has an important place among the public revenues, so it’s political, economic, and
social impacts have great importance. The political effects of public borrowing are handled
within the framework of political business cycle theory. According to theory, public
expenditures increase during the election period. The government with the vote worry
increases the public investments, but prefer to finance these public expenditures with internal
borrowing instead of tax or emissions. In the short and medium term, governments, that do
not want to seem repellent for voters, transfer the debt principal and interest payments to the
next governments in the long term. This situation brings along the debt burden, which is often
worsening with an alternative to closing debt with debt in developing countries.
Economic and social effects of borrowing take place in different ways in the following
condition:

 To be long or short-term maturity

 To spend or to keep the source that provided from borrowing

 To borrow from internal and external sources

The long-term or short-term maturity of public borrowing determines the duration of the
contraction or expansionary effects. In this respect, the short-term borrowing changes the
economic conjuncture frequently, because of the more liquidity and monetization feature of
short-term debt instruments. If the resources obtained by borrowing are expended, it causes
an expansionary effect; if the resources obtained by borrowing are not expended, it causes a
contractionary effect.

In order to provide the expected results of debt policies (i.e., borrowing methods, credit
instruments, and payment and redemption methods), the economic effects of borrowing
should be well known and analyzed. At this point, the source of the public debt and the place
where it is used gain importance:

 The effect of public debt on the general level of prices

It is true that borrowing will create a deflationary effect only when it is considered as a bond
sale. Because the private sector uses its own resources for buying public bonds, therefore,
the private demand and the total demand are decreasing. This situation causes deflation by
reducing the general level of prices. However, the state purchases goods and services with
the resources that are collected from the sale of bonds or bills; thus the total demand
increases due to public demand. This situation causes inflation by increasing the general
level of prices as a result of the operation of various mechanisms.

 The effect of public debt on income distribution

The effect of public debt on income distribution depends on which income groups’ burden
with debt costs and depends on which income groups are the obtained debt sources
transferred to. This effect usually occurs during the principal and interest repayments. In
particular in the internal borrowing, if the taxpayers and the lenders to the government are
the same person or organization, there will be no inequality in the income distribution.
However, vice versa, if the principal and interest payments related to public debt are paid by
taxes collected from the middle- to low-income groups, then there is a transfer of resources
from the middle- and low-income groups to the high-income group. In terms of external
borrowing, the income distribution to favor of those beneficiaries from public expenditures
in the period which they were taken was effected by the external debts positively. On the
other hand, the external borrowing will affect the income distribution for next generation
due to the debt burden adversely (such as the reduction of public expenditures and excessive
tax payment).

 The effect of public debt on employment

In order to understand, within current economic systems, the impact of driving technological
forces on employment growth, it is important to analyze how technological determinants and
employment variables interact with public debt. In fact, the macroeconomic variable of the
public debt of countries affects, within the framework of the political economy of growth, the
government expenditure on R&D and on human resources that play a vital role to spur
employment growth in addition, the high/low level of public debt can affect available
economic and financial resources to design apt political economy of growth. Modern
economic literature considers, more and more, the role of public debt and balanced-budget
rules for spurring long-run patterns of employment and economic growth

 The effect of public debt on GDP

In 2018 Pakistan public debt was 225,435 million dollars, has increased 21,158 million

since 2017.

This amount means that the debt in 2018 reached 71.69% of Pakistan GDP, a 4.64 percentage
point rise from 2017, when it was 67.05% of GDP.

If we check the tables we can see the evolution of Pakistan debt. It has risen since 2008 in
global debt terms, when it was 97,678 million dollars and also in terms of GDP percentage,
when it amounted to 57.16%.

According to the last data point published, Pakistan per capita debt in 2018 was 1,122
dollars per inhabitant. In 2017 it was 1,036 dollars, afterwards rising by 86 dollars, and if we
again check 2008 we can see that then the debt per person was 593 dollars.
The position of Pakistan, as compared with the rest of the world, has worsened in 2018 in
terms of GDP percentage. Currently it is country number 144 in the list of debt to GDP and
60 in debt per capita, out of the 186 we publish.

Pakistan: Evolution of debt

Date Debt Debt (%GDP) Debt Per Capita

2018 225,435 71.69% 1,122$

2017 204,277 67.05% 1,036$

2016 188,515 67.63% 974$

2015 171,306 63.32% 902$

2014 155,061 63.47% 833$

2013 147,659 63.86% 809$

2012 141,819 63.24% 793$

2011 125,835 58.90% 718$

2010 107,242 60.58% 624$

2009 98,270 58.47% 584$

2008 97,678 57.16% 593$

2007 79,894 52.44% 505$

2006 73,719 53.72% 474$

2005 69,764 58.91% 457$

2004 66,810 63.23% 446$

 Date Debt Debt (%GDP) Debt Per Capita

2003 63,269 70.49% 431$

2002 59,353 76.10% 415$

2001 63,299 81.23% 451$

2000 61,184 76.80% 448$

1999 62,349 75.64% 467$

1998 54,567 66.96% 418$

1997 53,824 65.79% 422$

1996 54,334 65.49% 436$

1995 51,829 65.23% 427$

1994 49,613 72.96% 419$

 The effect of public debt on saving volume and investments

As long as the government canalizes to investing the savings that are collected by the way of
internal borrowing, national income will increase, and personal income and personal savings
tendency will increase. If the government transfers to budget deficit or consumption of the
resources which recollected by internal borrowing, it will reduce the private sector
investment amount by affecting the private sector’s total savings volume. This event is called
crowding out. The slowdown of national income growth as a result of the decrease in
investments shows the real burden of the financing with borrowing instead of tax on the next
generation. When debt is used to finance public expenditure, its real cost to society is the
sacrifice in private sector production

 The effect of public debt on economic development

If the funds provided through borrowing for economic development can be canalized to
infrastructure investments (such as dams, roads, ports, mining, agriculture), they increase the
new investments through multiplier effect. As a result, national income and employment
increase; and accordingly economic development is ensured. Nowadays, less developed and
developing countries, which make the development effort, resort to external borrowing due to
insufficient internal financing sources. The positive effects of public debt relate to the fact
that in resource-starved economies debt financing if done properly leads to higher growth and
adds to their capacity to service and repay external and internal debt. In middle income
countries, governments use public debt as an important tool to finance its expenditures.
Public debt is considered as double-edged sword .For instance, effective utilization of public
debt can increase economic growth and enhance government to achieve macro-economic
goals. Theoretically financing the development projects through public debt can provoke a
country to build its productive capacity and increase economic growth (Cohen1993). Debts
may be foreign and domestic. Mismanagement of public debt reduces economic growth and
become the biggest hurdle for the economy, a case very common in developing countries.
The Burden of Public Debt:
When a country borrows money from other countries (or foreigners) an external debt is
created. It owes its all to others. When a country borrows money from others it has to pay
interest on such debt along with the principal. This payment is to be made in foreign
exchange (or in gold). If the debtor nation does not have sufficient stock of foreign exchange
(accumulated in the past) it will be forced to export its goods to the creditor nation. To be
able to export goods a debtor nation has to generate sufficient exportable surplus by curtailing
its domestic consumption.

Thus an external debt reduces society’s consumption possibilities since it involves a net
subtraction from the resources available to people in the debtor nation to meet their current
consumption needs. In the 1990s, many developing countries such as Poland, Brazil, and
Mexico faced severe economic hardships after incurring large external debt. They were
forced to curtail domestic consumption to be able to generate export surplus (i.e., export more
than they imported) in order to service their external debts, i.e., to pay the interest and
principal on their past borrowings.

The burden of external debt is measured by the debt-service ratio which returns to a country’s
repayment obligations of principal and interest for a particular year on its external debt as a
percentage of its exports of goods and services (i.e., its current receipt) in that year. An
external debt imposes a burden on society because it represents a reduction in the
consumption possibilities of a nation. It causes an inward shift of the society’s production
possibilities curve.

Three Problems:
When we shift attention from external to internal debt we observe that the story is different.

It creates three problems:

(1) Distorting effects on incentives due to extra tax burden,

(2) Diversion of society’s limited capital from the productive private sector to unproductive
capital sector, and

(3) Showing the rate of growth of the economy.

 These three problems may now be briefly discussed:

1. Efficiency and Welfare Losses from Taxation:

When the government borrows money from its own citizens, it has to pay interest on such
debt. Interest is paid by imposing tax on people. If people are required to pay more taxes
simply because the government has to pay interest on debt, there is likely to be adverse
effects on incentives to work and to save. It may be a happy coincidence if the same
individual were tax-payer and a bond-holder at the same time.

But even in this case one cannot avoid the distorting effects on incentives that are inescapably
present in the case of any taxes. If the government imposes additional tax on Mr. X to pay
him interest, he might work less and save less. Either of the outcome — or both — must be
reckoned a distortion from efficiency and well-being. Moreover, if most bondholders are rich
people and most tax-payers are people of modest means repaying the debt money
redistributes income (welfare) from the poor to the rich.

2. Capital Displacement (Crowding-Out) Effect:

Secondly, if the government borrows money from the people by selling bonds, there is
diversion of society’s limited capital from the productive private to unproductive public
sector. The shortage of capital in the private sector will push up the rate of interest.

In fact, while selling bonds, the government competes for borrowed funds in financial
markets, driving up interest rates for all borrowers. With the large deficits of recent years,
many economists have been concerned in the competition for funds; also higher interest rates
have discouraged borrowing for private investment, an effect known as crowding out.

This, in its turn, will lead to fall in the rate of growth of the economy. So, decline in living
standards is inevitable. This seems to be the most serious consequence of a large public debt.
As Paul Samuelson has put it: “Perhaps the most serious consequence of a large public debt is
that it displaces capital from the nation’s Stock of wealth. As a result, the pace of economic
growth slows and future living standards will decline.”
3. Public Debt and Growth
By diverting society’s limited capital from productive private to unproductive public sector
public debt acts as a growth-retarding factor. Thus an economy grows much faster without
public debt than with debt.
When we consider all the effects of government debt on the economy, we observe that a large
public debt can be detrimental to long-run economic growth.

As the government imposes additional taxes on people to pay interest on debt, there are
greater inefficiencies and distortions — which reduce output further.

What is more serious is that an increase in external debt lowers national income and raises the
proportion of GNP that has to be set aside every year for servicing the external debt.
Consequently, output and consumption will grow more slowly than in the absence of large
government debt and deficit.

This seems to be the most important point about the long-run impact of huge amount of
public debt on economic growth. To conclude with Paul Samuelson and W. D. Nordhaus: 

“A large government debt tends to reduce a nation’s growth in potential output because
it displaces private capital, increases the inefficiency from taxation, and forces a nation
to service the external portion of the debt.”
References
1. Theory of Public Debt and Current Reflections by Sibel Aybarç , Published: February
15th 2019
https://www.intechopen.com/books/public-economics-and-finance/theory-of-public-
debt-and-current-reflections
2. Impact of Public Debt on the economic growth of Pakistan by Naeem Akram,
Published: December 2011
http://pide.org.pk/psde/pdf/AGM27/Naeem%20Akram.pdf
3. Public Debt: Meaning, Objectives and Problems by sanket suman
http://www.economicsdiscussion.net/debt-2/public-debt-meaning-objectives-and-
problems/12812
4. Chapter 9, Public Debt, Pakistan Economic Survey 2017-18
http://www.finance.gov.pk/survey/chapters_15/09_Public%20Debt.pdf
5. http://www.finance.gov.pk/survey/chapters_15/09_Public%20Debt.pdf
6. https://countryeconomy.com/national-debt/pakistan
7. http://hrmars.com/hrmars_papers/The_Impact_of_Public_Debt_on_Economic_Growt
h_of_Pakistan