For several months, Pakistani economists have been warning that the country is heading towards a serious debt problem that will destabilise the economy. The overall debt, estimated at 12.7 trillion rupees in 2016, is considerably higher than the 9.5 trillion rupees in 2013. External debt, at 73 billion dollars, has also increased substantially, compared to 61 billion dollars in 2013.
There is nothing wrong with debt in itself. Private businesses borrow happily, as long as the rate of return on the debt-financed investment is higher than the cost of borrowing. Similarly, countries should borrow if their Gross Domestic Product (GDP) growth is faster than the rate at which debt is serviced (interest plus principle payments).
However, governments can shift the bad consequences associated with debt to the private sector or to the next generation. ‘Feel good’ projects, that translate into votes, but do not help the economy, do this.
Good economists, therefore, look for early warning signs.
One sign is the size of the total debt relative to the economy (total debt to GDP ratio). If this ratio rises fast, the government will either increase taxes or borrow huge amounts from banks — thus raising interest rates.
The other warning sign concerns the external debt. The cost of external debt is incurred in foreign currency, so that the appropriate ratio to focus on is the cost of external debt service to exports. A rapid increase in this ratio depletes foreign reserves, triggers devaluation and increases the cost of debt.
Using Ministry of Finance data, the World Bank estimates the debt-to-GDP ratio to be at 67.4 per cent, considerably higher than the 60 per cent limit. Interest payments will thus continue to eat into the budget, squeezing much needed infrastructure and social sector investments.
The State Bank of Pakistan estimates that external debt service-to-exports ratio at 20 per cent for 2016, which is better than the 22.5 per cent last year. The worry, however, is that exports are stagnant, even declining (27.4 billion dollars in 2016, compared to 31.5 billion dollars in 2013), which means that our ability to service future external debt liabilities is eroding.
An important message, therefore, is that there be no surprises (unaccounted for contingent liabilities) in large debt -financed investments (including those associated with the China-Pakistan Economic Corridor), and that there be improvement of export performance.
Otherwise, debt service will become a huge burden on the economy.
This article was originally published in the Herald's December 2016 issue. To read more subscribe to the Herald in print.
The writer an economist and a professor at Lahore University of Management Sciences.