The rising likely hood of an eventual Pakistani default

The commodities boom, resultant inflation and the hike in global interest rates has exposed deep underlying structural issues in many of the world's economies. EM markets have taken center stage; sovereign default risk has been the talk of the town with Sri Lanka's May 2022 default heightening concerns over similar risks in other markets.

Pakistan is not far behind. Rising commodity prices have pressured the current account, worsened external stability, depleted central bank reserves and led to 15% currency devaluation over the past few weeks. The economic crisis has been compounded by delays in securing an IMF bailout; austerity measures required by the IMF have been hard to implement given the ongoing political stand off between the ruling PDM coalition and Khan's PTI.

The current situation is one of rampant inflation, significant loss of purchasing power and widespread lack of confidence and distrust in the government.

A lot of attention has been paid to the current circumstances and much has been said about Pakistan's probability of default at the current stage. For reasons I won't elaborate on (because they have been discussed at length elsewhere) I believe default is unlikely however for reasons we'll discuss further, the probability of default or at least a debt restructuring is a matter of when and not if (and may very well happen in the next 4 - 8 years if we do not correct course now).

Pakistan has had a roughly six year short term debt cycle; a period of time where debt/GDP levels peaked or troughed.

The 1998 nuclear tests and the debt restructuring in 2001

The initial 95-99 period was marked by high current and fiscal account deficits as the debt-laden growth of the 1980s came to an end. The 1998 nuclear explosions and subsequent sanctions resulted in withdrawn international funding, capital flight, draw down in FX reserves and a full blown foreign currency crisis.

Debt servicing costs (both local and foreign) had already been on the rise due to higher interest rates towards the end of the 1990s and 66% PKR devaluation between 1995 - 2000. The Discount Rate peaked at 20% during the Qureshi caretaker setup in 1999. Following a minor debt restructuring by the Paris Club in 1999, Pakistan entered its largest debt scheduling ever of $12.5 BN in 2001 which coincided with the US invasion of Afghanistan (previous rescheduling happened in 1973, 1978, 1982 and 1988). Over the coming years Debt/GDP levels fell and a crisis was averted in return for Pakistan's support in the war on terror.

De-leveraging during the Musharraf era

Between 2000 - 2007, under the Musharraf regime, inflation averaged 5.4%, real GDP grew by 5.5%, and the PKR lost 2.5% on average p.a. against the Dollar. Pakistan managed to build up reserves even as oil prices rose from $24/bbl in 2000 to $64/bbl in early 2007 and even as the Bloomberg Commodities index rose 70%.

The period from 2007 to 2018 witnessed two more leveraging and deleveraging cycles however thee were much smaller in magnitude and do not warrant much discussion.

Coming back to the present

Pakistan's Debt to GDP (debt + external liabilities) has risen from a low of 60% to 78% within a 7 year time span. Excluding external liabilities would bring this number down to between 71 - 75%.

The current account deficit is expected to close at $16 BN for FY22. Historically around 30% of the deficit has been financed through direct & portfolio investment in Pakistan while the remainder has added to debt.

Assuming even a $10 BN addition to foreign debt would take the existing $122 stock of external debt + liabilities to $132 BN. On the domestic front, a PKR 5,000 BN deficit results in projected domestic debt level of around PKR 31 TN. This results in a debt to GDP ratio of 78% as of FY22.

Assuming Pakistan successfully secures financing from the IMF and multi-lateral sources and continues to run a PKR 4 TN fiscal deficit, debt to GDP levels could rise by as much 2% a year.

In the coming 5-8 years, a 2% p.a. increase in Debt/GDP levels can be catastrophic and there are no soft corners or geopolitical favors to bank on.

Current discussions on Debt/GDP levels also ignore a host of other factors:

1. Despite a 70% increase in the Bloomberg commodities index between 2000 - 2007, Pakistan managed to significantly de-leverage its economy thanks to the 2001 debt restructuring and the monetary benefits accrued as a result of the war on terror. US Pakistan relations today are very different; if Khan comes back to power, running an "independent foreign policy" would mean no such benefits, indeed the IMF has already taken a hard stance towards Pakistan despite delusions of a "soft corner".
2. Debt/GDP levels are understated at the moment. The SBP has yet to enter into an IMF program and shore up reserves which will invariably lead to Pakistan taking on more foreign debt. Combine this with a slowing economy and a fast depreciating currency and Debt/GDP levels are sure to rise from current levels.
3. Around 15% of the PKR 30 TN domestic debt is fixed coupon long term debt. The remaining is either in the form of floating PIBs or treasury bills. This increases the sensitivity of the fiscal deficit to changes in monetary policy. At a 10% domestic interest rate, Pakistan's domestic debt servicing cost alone would be PKR 3 TN while federal fiscal revenues are around PKR 4 - 5 TN after 57.5% revenue transfer to provinces.
4. Since the global financial crisis, successive rounds of QE had resulted in an era of ample liquidity. As the monetary noose tightens, the cost of financing on foreign debt will rise significantly. Add to this the FX impact of PKR devaluation on dollar denominated debts and foreign debt servicing costs could double (currently at PKR 300 BN). Furthermore as debt sustainability becomes an issue, expect greater risk premiums even after the current crisis is over.
5. Pakistan has witnessed a steady decline in both energy and food security. Gas production in particular has gone down from 4.0 BCFD in 2016 to 3.3 BCFD currently even as gas demand has expanded with population growth. Pakistan currently faces a significant gas deficit that can only be met with expensive LNG. Pakistan needs to import around 14 - 15 monthly LNG cargoes to completely eliminate the gas deficit; this requires building expensive LNG import facilities. As the mix of LNG in the overall system increases, the LNG import bill alone can rise by as much as USD 1.0 - 1.5 BN provided we have the capacity to import. The alternative is increasingly severe gas shortages over the years.
6. Putting aside the gas deficit, there is a shortage of oil production and refining capacity. Pakistan's cotton production has declined over the years and while we were once self sufficient in wheat production, the government now plans to import 4 million tones of wheat this year. The general trend is one of falling agricultural yields and domestic oil & gas production.

The upshot is that in an era of globally tight monetary conditions, high commodity prices and geopolitical uncertainty, Pakistan can ill afford to continue down a path of energy and food insecurity which is brought on by decades of governance and corruption issues.

The dangerous notion that commodities will eventually recover and inflation will be transitory has led to central banks falling behind the curve when it comes to monetary tightening. There is very little forecasting capability when it comes to the future of commodity prices, especially given the uncertainty caused by the Russia/Ukraine war. Furthermore, net zero carbon emissions goals have reduced the incentive to invest in fossil fuels which may very well lead to a very costly energy transition, one that would be disastrous for countries like Pakistan that rely so greatly on benign global conditions.

A major debt restructuring or even default may come in the coming decade and we may not count on geopolitics to bail us out as in 22 years ago.