Article for February 9, 2010

Debt Policy Statement By Dr. Ashfaque H. Khan

The Debt Office of the Ministry of Finance has released Debt Policy Statement 2009-10 in end-January 2010 to fulfill the requirement as laid out under section 7 of the Fiscal Responsibility and Debt Limitation Act 2005. This is a good document and anyone who has interest in understanding debt dynamics of Pakistan must read it. The most painful development of the last two years on Pakistans economic scene has been the unprecedented surge in public and external debt at a pace never witnessed in the countrys history. The negative fallout of massive buildup in debt would be witnessed in the medium-term when Pakistan starts repaying these loans, particularly to the IMF. Pakistans public debt (both rupee and foreign currency denominated debt) grew by almost 27% to Rs.7605 billion in 2008-09 from Rs.6005 billion a year ago, thus showing an increase of Rs.1600 billion in just one year as against Rs.1300 billion in the last five years prior to 2007-08 (2002-07). This is a horrifying development with immense socioeconomic implications for the country going forward. In the first quarter (July to September) of the current fiscal year (CFY), Pakistan has added almost Rs.500 billion (Rs.166 billion per month) to public debt reaching as high as Rs. 8100 billion as mentioned in the Statement. The analysis of the sources of the rise in public debt reveals even more disturbing developments. Public debt increased by Rs.1600 billion in 2008-09 of which foreign currency denominated debt contributed Rs.1013 billion (or 63%). However, the worrisome development is that exchange rate depreciation alone contributed 40% or Rs.636 billion to the rise in public debt while borrowing in foreign currency added Rs.377 billion or 23.3 percent. The contribution of exchange rate depreciation (40%) has surpassed the contribution of rupee component of debt (37%). Two things need to be kept in mind. First, the exchange rate depreciation has emerged as a dominant source of the rise in public debt. Second, the contribution of foreign currency debt has surpassed the rupee component of public debt for the first time in the countrys history. Such a development does not augur well as it makes the economy in general, and budget and balance of payments in particular, highly vulnerable to external shocks. The trend which was witnessed in 2008-09 continues to remain the same in the first quarter of the CFY. Over 68 percent (Rs.338 billion) contribution to the growth in public debt originated from foreign currency denominated debt while the remaining contribution came from rupee component (Rs.157 billion), thereby making the economy of Pakistan more vulnerable to external shocks. The Statement also discusses the dynamics of public debt burden and reveals a disturbing trend. While the real growth (after adjusting for inflation) in public debt burden continued

to decline at the rates of 5.8 percent and 5.6 percent during 2000-04 and 2004-08, respectively, the pendulum swung to other extreme after 2007-08 onwards. The real growth in public debt burden has increased by 9.2 percent and 3.2 percent in 2007-08 and 2008-09, respectively. This is a sad development and the main culprit has been the exchange rate depreciation. Interestingly, the Debt Policy Statement highlighted the negative consequences of sharp depreciation of exchange rate with respect to the rise in public debt in many places. However, the author attempts to defend the sharp depreciation of exchange rate by stating the currency depreciation ..should be viewed as an adjustment against the unsustainable parity of the Rupee vis--vis the US Dollar witnessed during 2001-2007. First of all, the author did not explain as what he meant by unsustainable parity during 2001-2007. Without delving into the details, I would simply refer some of the benefits that accrued to Pakistans economy during 2001-2007 as a result of unsustainable exchange rate policy. Exports increased from $9.2 billion to $17.0 billion an increase of 85 percent; foreign currency denominated debt increased from Rs.1800 billion to Rs.2200 billion an increase of Rs.400 billion in six years as opposed to Rs.1600 billion in one year; public debt as percentage of GDP declined from 80% to 55.5% -- a decline of 24.5 percentage points in six years; per capita income increased from $507 to $926 an increase of 83 percent. I can list many other benefits but I think I have made the point. On the contrary, the so called flexible exchange rate policy has caused irreparable damage to Pakistans economy. Exports, instead of rising as theory could suggest, declined to $17.8 billion in 2008-09 as compared with $19 billion a year ago. Exports stood at $9.2 billion in the first half of the CFY as against $9.5 billion in the same period last year. Thus, exports continue to slide in the midst sharp depreciation of exchange rate. The so called flexible exchange rate policy has added Rs.1125 billion in public debt on account of depreciation alone in just two years with horrific consequences for interest payment and development spending going forward. The flexible exchange rate policy has contributed immensely to the rise in inflation. The current rise in oil, sugar and pulses prices owe predominantly to the sharp depreciation of exchange rate. The rise in furnace oil price as a result of depreciation would force the government to increase electricity prices as it has committed to the IMF on automatic pass through for fuel prices. In my two articles (January 12 and February 2), I had requested the SBP and the IMF (the proponent of flexible exchange rate policy) to conduct the cost-benefit analysis of such a policy for the people of Pakistan. Let me request, yet again to these institutions to inform the people of Pakistan as how the current flexible exchange rate policy in the midst of weak external demand has benefitted them. The people of Pakistan would wait for the result of their analysis.

The writer is director general and dean at NUST Business School, Islamabad. Email: ahkhan@nbs.edu.pk