In the initial two months of the current fiscal year, Pakistan has witnessed a noteworthy 5.1% surge in its central government debt. Factors such as soaring inflation rates reaching 29% and interest rates peaking at 22% during the period have contributed significantly to the increase in domestic debt. The implications of this burgeoning debt are multifaceted and require careful examination.

The finance ministry’s recent accusation, blaming the rapid growth in public debt squarely on the increases in State Bank of Pakistan policy interest rates, can be likened to a situation where someone with their own faults points fingers at others. The ministry argues that a mere 1% rise in borrowing costs results in an enormous annual increase of Rs600 billion in debt servicing expenses. A recent World Bank report corroborates this, noting that “Higher policy rates are increasing government borrowing costs, driving higher financing needs, and these needs are primarily met through increased borrowing from the domestic banking system.”

However, conspicuously absent from the statement is any acknowledgment of the government’s own extravagant fiscal policies, which have significantly contributed to the accelerated growth of its debt over the past year and a half. This includes the failure to curtail excessive and wasteful expenditures and the inability to bolster tax revenues by broadening the tax base. Furthermore, they fail to mention how the surge in government borrowing from domestic banks to finance an average fiscal deficit exceeding 7% year after year has stifled the private sector and exacerbated price inflation. While the higher interest rates certainly play a role in our debt challenges, they are not the root cause.

In this case, the blame lies squarely on the extravagant fiscal policies of the government. The State Bank of Pakistan has little choice but to increase borrowing costs to rein in aggregate demand, which is primarily driven by unchecked government spending and to mitigate inflationary pressures. The government finds itself trapped in a vicious cycle, and the debt problem is likely to worsen over time due to its increasing reliance on domestic banks for funding its fiscal deficit, especially as external budgetary support from multilateral and bilateral lenders dwindles.

Regardless of how questionable the SBP’s decision to maintain interest rates in its last monetary policy committee meeting may have been given elevated inflation, it is understandable. The government’s growing dependence on local banks for financing its deficit severely limits the SBP’s capacity to combat inflation through policy rate hikes. As of June, a significant 74% of total bank loans were directed towards the public sector, while credit to the private sector dwindled to 26.2% from 30.3% just a year ago. The only sustainable solution for the government to reduce its bank borrowings and curb the need for new inflationary liquidity injections from the central bank is to reduce the primary budget deficit.

Achieving this would require the government to narrow its budget deficit to a range of 2-3% by increasing tax revenues to 20-25% of GDP and curbing wasteful expenditures. The central government’s debt, both domestic and foreign, surged by nearly a third over the 12 months through August, reaching close to Rs64 trillion. This 29% increase translated to Rs14.4 trillion, compared to Rs49.57 trillion at the end of August 2022, as reported by the State Bank of Pakistan. Notably, domestic debt rose by 23% to Rs39.79 trillion, up from Rs32.15 trillion in August 2022, while external debt increased by 39% to Rs24.17 trillion, up from Rs17.42 trillion a year ago. The mounting domestic debt is concerning as it absorbs a significant portion of the country’s tax revenue, leaving fewer funds available for development and hindering economic growth. A substantial portion of the revenue is now allocated solely to servicing this debt, at the expense of economic progress.

In the first two months of the current fiscal year, the total central government debt has surged by 5.1%. This increase can be attributed to several factors, including the high inflation rate of 29% and an interest rate of 22% during these two months, which have driven up domestic debt. A Senate panel revealed that the country’s domestic debt has surged by more than Rs7 trillion since January of the previous year, primarily due to the SBP’s policy rate climbing from less than 10% to 22%.

According to a senior official, as a general rule, a 1% hike in interest rates results in an additional Rs600 billion in debt. The SBP policy rate rose from 9.75% in January 2022 to 12.25% in April of the same year, and then to 22% by the end of June this year. Regarding external debt, the more noticeable percentage increase can be attributed to the rupee’s depreciation against the US dollar. This means that when converted to rupees, the debt appears larger because the local currency can buy less. In August, external debt saw a significant rise, increasing by Rs1.44 trillion, which is more than double the increase of Rs700 billion from the previous month. On average, external debt increased by Rs563 billion per month between August 2022 and August 2023. The higher increase in external debt during July and August is a result of the rupee’s devaluation. The value of the dollar reached Rs307 in early September, further inflating the value of external debt when converted to PKR. However, the rupee has started to recover, appreciating by 7.5% from its lowest point, which will reflect in September’s external debt data.

Currency experts believe that for external debt to significantly reduce, the trend of the dollar’s devaluation needs to continue. A country’s ability to manage its external debt is often linked to its foreign exchange reserves. However, the SBP reported a decrease in its forex reserves, which fell by $21 million to $7.615 billion in the week ending on September 28. The country’s total foreign exchange reserves amount to $13.03 billion, including $5.42 billion held by commercial banks. For the entire FY24, Pakistan requires approximately $25 billion solely for debt servicing.

Despite the government consistently servicing its debts, there hasn’t been a substantial inflow of funds since July when the IMF provided $1.2 billion, and Saudi Arabia and the UAE also contributed. This boost raised the reserves from $4.46 billion in June to $8.15 billion.

As Pakistan grapples with the rapid expansion of its government debt, it faces a complex web of economic challenges. The surge in domestic debt driven by interest rate hikes demands prudent fiscal management. The nation’s ability to manage its external debt hinges on a sustained trend of the rupee’s depreciation, further complicating the financial landscape. Amidst shrinking foreign exchange reserves and a pressing need for debt servicing, Pakistan must navigate a precarious path toward fiscal stability in FY24.