Unproductive and Indebted

Pakistan’s growing external financing needs stem from deep domestic problems?

Key highlights ?

• Pakistan’s debt burden is starting to become unsustainable, as debt servicing is crowding out essential and productive public spending.
• Pakistan is not in a China debt trap; its largest group of creditors is comprised of Western institutions.
• Collecting more taxes or cutting expenditure will only treat the symptom, not the cause of the debt problem: low savings and investment rates. ?

On May 10th, the International Monetary Fund (IMF) released its latest country report on Pakistan. Its primary function is to serve as a review of the emergency 9-month US$ 3bn programme that concluded in March. However, these country reports also contain a lot of data that is often unavailable on Pakistani government websites.

This relates particularly to future dollar financing requirements and an accurate reflection of what is owed by Pakistan to whom globally. In this week’s file, I will focus on these two aspects, taking advantage of the IMF’s fresh data compilation. Then, I will try to lay out what the numbers mean for Pakistan’s public finances as well as the ‘real’ economy.

The external debt servicing hole now dwarfs the gap left by Pakistan’s trade deficit

The general economic commentary in Pakistan has focused too much on the trade deficit the country has run for a while now, often overlooking the external debt genie that’s now well and truly out of the bottle. The IMF’s latest numbers are sobering.

• Over the next five-year period, it estimates that each year, on average, Pakistan will need to raise US$ 24.8bn in fresh funding to pay what it owes the world. ?
• Each year, on average, the money needed for external debt servicing will have to be 3.2 times that required for covering the trade deficit.

How did Pakistan get to this point of owing so much to the world, relative to the size of its economy? And how will this money be arranged (hint: more borrowing)? These are economically existential questions, but before we can get to them, we need to first know who our global creditors actually are.

Pakistan’s external debt profile is a mirror image of its foreign policy

The two tables below, based on data from the IMF’s latest report, highlight some basic yet important facts to get straight. ???

• As of December 2023, Pakistan’s total external debt stock was US$ 102.7bn, equivalent to about 30% of GDP.
• Most of this is held by two major types of creditors, multilateral banks (45%) and bilateral funders (41%); the remaining portion is split between sovereign bond holders and international commercial lenders - primarily banks.
• Contrary to a lot of the China-bashing brand of economic reporting, China is not even close to being Pakistan’s major creditor.

In the second table, I have categorised specific creditor institutions by whether they are Western or West-aligned, Chinese, or otherwise. The results are as follows:

• Western and West-aligned creditors together hold 53% of Pakistan’s total external debt. The World Bank alone holds 20% of it!
• Chinese bilateral and commercial loans combined constitute 28% of the total external debt stock, with most of it belonging to the former category.
• Saudi Arabia stands out as a relatively smaller but still significant creditor, holding 7% of total external debt.

The Chinese share was even smaller prior to 2015-16, when the China-Pakistan Economic Corridor (CPEC) kicked off, bringing with it a surge of Chinese loans and investments into Pakistan’s infrastructure and energy sectors.

The broader point to note is that both the US (indirectly) and China (directly) are now Pakistan’s key financial patrons, whereas up until recently it was only the former, a direct result of Pakistan’s choice to align with the West during the Cold War. Given the new great power US-China rivalry, and Pakistan’s compulsion to balance its ties with each, managing its external finances will become more complicated.

Not enough money for key public goods and investments

Looking at data over the last decade, the overall debt/GDP ratio has risen significantly but not alarmingly, relatively speaking. Pakistan’s gross public debt burden at the end of 2023 was about 75% of GDP, much lower than many developed and developing countries.

The immediate problem is that in the global post-Covid high interest rate environment, external debt and its servicing cost have risen sharply, as has the overall budgetary expenditure on debt servicing.

• Both domestic and external debt servicing, as a proportion of GDP, have increased over the last two years.
• Given the difficulty of increasing tax revenue and decreasing operational government spending in the short term, the result is a reduction in development and public sector expenditure.
• Development spending as a proportion of GDP, in terms of the annual Public Sector Development Programme (PSDP) has declined consecutively for the last two years, while defence spending as a proportion of GDP has contracted consecutively for the last four years. ?
• This means that Pakistan’s productivity and national security are both being put at risk.

Pakistan borrows so much because it is unproductive

Although I wrote above that the current public debt burden itself isn’t necessarily a problem, it becomes a problem when assessed in the context of Pakistan’s rate of economic growth. In other words, the country is not growing its income at a rate fast enough to be able to manage its growing debt burden. Pakistan’s average GDP per capita growth rate during the 2012-22 period was 2.5%, compared to 4.6% for India and 5.2% for Bangladesh (calculated based on World Bank data). ?

And why is that? Well, there are many reasons but I want to focus on one here: Pakistan’s very low ratio of savings and investment. It is only by channelling household and institutional savings into productive investments that growth occurs. In Pakistan, the rate of doing so has been abysmally low, as the chart below shows.

Its annual gross capital formation rate (as a percentage of GDP), essentially the proportion of national income that is reinvested, averaged 15.5% during 2012-22. The corresponding average for India was 32.1% and was 30.3% for Bangladesh. No wonder that these countries’ income per capita grew almost twice as fast as Pakistan’s in this period; they were re-investing twice as much of their incomes as Pakistan was.

Finally, let’s consider why under-investment can lead to a rising debt burden, as we see in Pakistan.

• Low investment, and hence low growth, reduces the potential amount of tax revenue the government can collect. Without instituting major cuts in expenditure, which is always politically difficult, the government’s budgetary borrowing has to go up.
• Higher borrowing leads to higher debt servicing, which reduces fiscal space for more productive public spending, as we saw above. This hinders the development of physical and human capital, both essential for growth.
• Low levels of physical and human capital keep growth depressed, leading to tax revenue shortfalls and the need for higher borrowing, creating a viscous cycle.

What now?

Pakistan Macro Files is not meant to be a prescriptive newsletter, but this analysis leads to some obvious ways in which the country’s economic policymakers need to change their thinking.

• Too much stress is put on improving tax collection in the context of public debt. Doing so will obviously create more fiscal space, but on its own it will be insufficient to drag back debt growth.
• The only real way of controlling the debt burden is to increase the rate of GDP growth.
• This requires deep structural changes to the economy; a re-orientation of the financial sector is one of them, such that greater savings are encouraged and channelled to the private sector instead of feeding the ever-hungry government. ??

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About the author

Waqas A. Rana is a development economist and founding partner at Shared Pathways, an international development consulting and advisory firm. His core area of interest is the study of economic growth strategies for developing countries. Outside of work, he likes to read literature from around the world, lift weights, run, and hike. He can be reached at: [email protected]