Predictably, the Fund program has also focused on fixing the unbridled rise in government's borrowings from the central bank. For nearly three years, government has borrowed from the central bank without any restrain. In the process, the money and bond markets were rendered dysfunctional and debt profile was badly mutilated in terms of its maturity structure.
At the outset, it is important to point the position of law on the subject. Section-9C of the SBP Act, 1956, provides as follows: Notwithstanding anything contained in sections 9A and 9B, the Federal Government borrowing from the Bank shall be such that at the end of each quarter they shall be brought to zero barring the ways and means limit that shall be determined by the Board from time to time.
(2) The debt of the Federal Government owed to the Bank as on the 30th April, 2011, shall be retired not later than twelve years from that date.(3) If any of the provisions of sub-sections (1) and (2) are not observed by the Federal Government, the Finance Minister shall place before the Parliament a statement giving detailed justification for the said failure.
Evidently, the law has put fairly strict bounds on government's borrowings from the central bank. There are three elements to this restriction. First, every quarter, the borrowing, minus the ways and means limit, would be brought to zero. This essentially means that going forward from 30 April 2012, there would be no further increase in the stock of debt owed to the central bank. Second, the debt stock outstanding as on April 2012, would have to be retired by 30 April 2023. Third, in case of failure to comply with these conditions, the Finance Minister is required to lay before the Parliament a statement giving full justification of such failure.
Unfortunately, since the above provision was enacted in April 2012, barring a few occasions, it has been observed only in violation. No meaningful statement giving justifications for failures has ever been presented in the parliament. It seems not all laws are meant to be implemented, for otherwise it is hard to explain such flagrant violation of law.
But what has happened in last nearly three years is unprecedented. As on 30-6-2016, the debt outstanding to SBP was Rs 1400 billion. As on 18-5-2019, the amount outstanding was a staggering Rs 8425 billion, a six-fold increase. The economics of doing so has major implications for the welfare of people, since such borrowings are injection of hard powered money (printing of notes) in the system, which could cause explosive inflation. How has this come about?
There was a virtual break-down of auctioning process, particularly the auction for higher maturities Pakistan investment bonds (PIBs) was almost abandoned. Even within the treasury bills (TBs), it was the three-month TB which was the favored instrument of resource mobilization. Maturing PIBs were also converted into TBs as auction after auction, offered bids were rejected. This was done ostensibly in the hope of saving the debt servicing cost, since three-month instrument was least costly. All other considerations of developing an yield curve, catering to the needs of different investors classes and refinancing risks were thrown to the way side. Note that this process was resorted to at a time when the interest rates had bottomed out at 5.75% and remained so for nearly two years, from Sep '15 to December '17.
The debt profile was seriously disturbed. From less than 45% of short term date in June 2016, the pendulum swung to 66% as on 30-6-2018. More recent quarterly risk reports have not been published by the debt office. All the mismanagement was done soon after the Fund program was completed. Our own ability to practice self-disciplined economic management has simply eroded.
After three years, when the economy was pushed to the brink, an IMF program was needed. The process of correcting the money and bond markets has started. On 22-5-2019, a TB auction was conducted with a target of Rs 600 billion. Bids were received for Rs 3.2 trillion, all in three-month, and all were accepted at a weighted average yield of 12.75%, a phenomenal increase of 150 basis points (bps) compared to the last auction. This huge amount would help retire SBP borrowings by nearly 40%, a sizable effort to correct the distortion. However, the process of reform is far from over. The fact that only small amounts were bid for higher maturities (6-month 12-month) is indicative of the fact that the market is still expecting further adjustment in policy rate.
It may also be noted that the above correction is simply a shifting of SBP borrowings toward banks who were, in turn, funded by OMO injections by SBP, for they would not have the requisite liquidity available with them. In this way, the monetary policy would remain accommodative. A more durable correction would come through the build-up of net foreign assets (NFA), which would happen with reserve build-up. Besides the IMF support, ADB and World Bank would provide policy loans that would be adjustors to reserve targets under the program and contribute to NFA build-up and retirement of domestic borrowing.
The bond market correction has also started. An auction held on 29-5-2019 for PIBs of 3, 5 and 10 years, with a target of Rs 100 billion, attracted bids Rs 465 billion. The government chose to pick Rs 121 billion in three maturities (Rs 64, 32, 25 billion for 3, 5 and 10 years, at rates of 13.69%, 13.80% and 13.60%, respectively). Even though costly, this move is consistent with the objective of well-functioning bond market. The participation was quite healthy indicative of the suppressed appetite of investors because the government was accepting bids as it has unrestrained access to cheap SBP financing.
Some people would argue that this correction would basically benefit banks whose profits would swell in the process. Every economic policy has winners and losers. Besides, in the present case, they would make a tiny margin between the cost of funds from SBP and return on TBs. Even then, it should be hoped that in course of time excessive profits would be rationalized through higher returns to depositors, tax incidence and competitive pressures. More importantly, high interest rates are temporary and would soon be corrected with inflation coming down and resumption of growth.
The debt servicing for 2017-18 was 4.4% of GDP. With substantial rise in interest rate during the year, the 9-month debt servicing has already reached 3.8% of GDP. It is estimated that the cost would be 5.4% during the year as the deficit is likely to be around 7.6%.
On the face of rising interest cost, and in a welcome move, the Fund program has focused on primary deficit, which excludes interest payments. This would enable fast reduction in debt accumulation which would eventually lead to reduced debt servicing costs also. The road to reducing debt servicing cost travels via deficit reduction, which would cut down the need for borrowings. The initial adjustments, no doubt painful, would pave the way for easier economic conditions helpful for growth and stability. The key to success would be to stay the course. Our degrees of freedom for mismanaging the economy have vanished for quite some time. Hence, steady move toward implementing reforms is the only option we have.
(The writer is former finance secretary) [email protected]