To borrow or not to borrow: Empirical evidence from the public debt sustainability of Pakistan

Islam, Wajid; Ahmed, Junaid; Faraz, Naseem Working Paper To borrow or not to borrow: Empirical evidence from the public debt sustainability of Pakistan ADBI Working Paper, No. 1354 Provided in Cooperation with: Asian Development Bank Institute (ADBI), Tokyo Suggested Citation: Islam, Wajid; Ahmed, Junaid; Faraz, Naseem (2023) : To borrow or not to borrow: Empirical evidence from the public debt sustainability of Pakistan, ADBI Working Paper, No. 1354, Asian Development Bank Institute (ADBI), Tokyo, https://doi.org/10.56506/MOWJ8135 This Version is available at: https://hdl.handle.net/10419/272897 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/igo/ ADBI Working Paper Series TO BORROW OR NOT TO BORROW: EMPIRICAL EVIDENCE FROM THE PUBLIC DEBT SUSTAINABILITY OF PAKISTAN Wajid Islam, Junaid Ahmed, and Naseem Faraz No. 1354 January 2023 Asian Development Bank Institute The Working Paper series is a continuation of the formerly named Discussion Paper series; the numbering of the papers continued without interruption or change. ADBI’s working papers reflect initial ideas on a topic and are posted online for discussion. Some working papers may develop into other forms of publication. Suggested citation: Islam, W., J. Ahmed, and N. Faraz. 2023. To Borrow or Not to Borrow: Empirical Evidence from the Public Debt Sustainability of Pakistan. ADBI Working Paper 1354. Tokyo: Asian Development Bank Institute. Available: https://doi.org/10.56506/MOWJ8135 Please contact the authors for information about this paper. Email: wajidislam[email protected].pk, [email protected] Wajid Islam is a lecturer of economics at Khyber Pakhtunkhwa Technical and Vocational Training Authority in Pakistan. Junaid Ahmed is a senior research economist at Pakistan Institute of Development Economics and senior lecturer at Westminster International University Tashkent. Naseem Faraz is senior research economist at Pakistan Institute of Development Economics, Islamabad. The views expressed in this paper are the views of the author and do not necessarily reflect the views or policies of ADBI, ADB, its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms. Discussion papers are subject to formal revision and correction before they are finalized and considered published. Asian Development Bank Institute Kasumigaseki Building, 8th Floor 3-2-5 Kasumigaseki, Chiyoda-ku Tokyo 100-6008, Japan Tel: +81-3-3593-5500 Fax: +81-3-3593-5571 URL: www.adbi.org E-mail: [email protected] © 2023 Asian Development Bank Institute ADBI Working Paper 1354 Islam et al. Abstract This study aims to evaluate the public debt sustainability of Pakistan using the debt sustainability analysis (DSA) framework and fiscal reaction function (FRF). For the empirical analysis, it uses relevant important macroeconomic variables, such as public debt, external debt, primary balance, output growth, current account balance, and oil prices, over the period 1976–2021. The results of the DSA suggest that, at the 10% growth rate with a real interest rate lower than 10%, the public debt level can be brought under the 60% standard sustainable limit from the current 80% by the year 2030. Furthermore, the estimates of the FRF reveal no evidence of debt sustainability. Besides this, the COVID-19 pandemic is positively associated with the primary balance mainly due to the decrease in the primary balance from –3.5% in 2019 to –0.9% in 2020. This is expected as a large amount of debt relief was provided to Pakistan during this period. Overall, our findings indicate that, if the rapid debt accumulation trend continues, the country will be unable to bear such a hefty load of ballooning debt. Therefore, a strategy of continuing coordination of fiscal and monetary policy is crucial for robust growth momentum to keep the debt sustainable. Keywords: public debt, primary balance, current account balance, COVID-19 JEL Classification: H60, H63, H68, H69 ADBI Working Paper 1354 Islam et al. Contents 1. INTRODUCTION ....................................................................................................... 1 2. REVIEW OF THE EMPIRICAL LITERATURE ........................................................... 3 3. THEORETICAL FRAMEWORK, METHODOLOGY, AND DATA ................................ 4 3.1 Theoretical Background ................................................................................. 4 3.2 Methodology .................................................................................................. 4 3.3 Data ............................................................................................................... 6 4. MAIN RESULTS AND DISCUSSION ......................................................................... 7 4.1 Baseline Methodology: Debt Sustainability Analysis ...................................... 7 4.2 Findings of the Fiscal Reaction Function ........................................................ 8 5. CONCLUSION AND RECOMMENDATIONS ........................................................... 10 REFERENCES ................................................................................................................... 11 APPENDIX ............................................................................................................................ 1 ADBI Working Paper 1354 Islam et al. 1 1. INTRODUCTION The COVID-19 pandemic severely struck the whole world in 2020 and adversely affected the economic systems, causing unprecedented ballooning of public debt and deficits and turning the GDP negative. Some countries took swift measures to save their economies. Pakistan also adopted some measures to control the damage; however, one crisis overlapped with another, putting the country’s economy into a continuous state of turmoil. The weak economy was strongly hit by the pandemic, and, when there were some mild signs of recovery, political instability worsened the situation, and the country is now on the verge of default. This is a story of a resourceblessed country with a worrisome economic history—Pakistan. There is no denying that emerging markets like Pakistan face myriad financial problems; one such key issue is the increasing public debt, especially after the COVID-19 pandemic. Public debt is one of the vital instruments to bridge the financial gaps of governments. Its efficient use can boost economic growth and development. For the last six decades, Pakistan has frequently borrowed from external and domestic sources, causing the public debt to balloon to 84% of the GDP from 58.9% 1 in 2011 (State Bank of Pakistan 2020). Governments worldwide seek to guarantee the sustainability of public debt and economic growth to stabilize the macroeconomic indicators. However, they sacrifice investment when they are saddled with ballooning debt burdens, thus diverting considerable resources to debt servicing at the expense of employment opportunities and economic growth. Rising and unserviceable debts push countries toward debt distress, thus causing them to seek assistance and bailout packages. Such situations lead to unsustainability—being unable to meet their financial obligation (e.g. interest plus the principal amount), putting them at risk of default, as recently witnessed in Sri Lanka. Over decades, Pakistan has been facing such traditional concerns due to the mushrooming of fiscal deficits and the maturity of the country’s external debt. Pakistan’s fiscal deficit peaked at 8.1% of its GDP in 2020 from 6.5% in 2011 (Pakistan Ministry of Finance 2021). Such high fiscal and current account deficits lead to dependence on foreign borrowing (Kemal 2001). As a result, reducing public debt is a major challenge for macroeconomic stability and sustainable economic growth. To put this into context, the total public debt to revenue amounted to 667.4% of the GDP in 2020 from 479.2% in 2011 (Pakistan Ministry of Finance 2020). Unfortunately, both the public debt and the budget deficit are increasing compared with the GDP growth in Pakistan. This partly shows that the country has been facing economic mismanagement over the last few decades. The worsening condition of debt accumulation indicates that the country will soon be on the brink of a debt crisis. Therefore, it is pertinent to examine the sustainability of public debt. Besides borrowing, the empirical literature has also proposed three alternative sources of deficit financing. Firstly, monetizing debt leads to inflation. Secondly, the use of foreign reserves creates a balance of payment crisis and crowds out private investors. Thirdly, increasing taxes lead to distortions, as suggested by the Laffer curve. This is why governments turn to borrowing from internal and external sources. 1 The standard debt sustainability limit is a 60% debt-to-GDP ratio. ADBI Working Paper 1354 Islam et al. 2 Various studies have shed light on the burgeoning debt and its repayment impacts. If an economy faces a debt overhang, then the fiscal factors deteriorate over time, adversely affecting investment and reducing economic growth (Monteil 2003). The low GDP growth and budget deficits push economic into quandary, leaving no viable fiscal options, as a large chunk of government revenues is used for debt servicing. Loser (2004) showed that highly indebted poor countries (HIPCs) experience a lack of new funds due to debt servicing. Besides this, poorly structured debt in terms of currency or interest rate composition, maturity, and unfunded and huge contingent liabilities have been the main reasons for the economic crisis in various countries. In the case of Pakistan, the country scores poorly on most ratings of debt metrics compared with its regional peers—whether foreign exchange reserves for import cover, liquidity ratios, stock measures, or the debt servicing burden. The current low FX reserves and high debt levels indicate that Pakistan is facing a double-edged sword and has very little space to deal with exogenous shocks. The budget document (2020–21) highlighted that Pakistan had spent 60% of its revenue on debt servicing. Such a large portion of revenue used for debt servicing left little for other development activities and social welfare. The highly volatile exchange rate, depreciating currency value, and lack of policy commitment exacerbated the augmenting debts. Figure 1 shows the share of each year’s government procurement of domestic and external debt from 1970 to 2021. Figure 1: Domestic and External Public Debt Percentage Accumulation per Regime Source: Author’s formation from Pakistan economic survey data. Against this background, this paper answers two major questions. First, it determines whether Pakistan’s public debt is sustainable by using the FRF from 1976 to 2021. Second, it forecasts the post-COVID level of public debt until 2030 using different scenarios through debt sustainability framework (DSF). The rest of the paper is arranged as follows. The next section will provide an overview of the existing literature on different methodologies used for debt sustainability. Section 3 will shed light on the conceptual framework and methodology of debt sustainability. Section 4 will discuss the results of the estimations. Lastly, in section 5, the conclusion and policy recommendations will be provided. ADBI Working Paper 1354 Islam et al. 3 2. REVIEW OF THE EMPIRICAL LITERATURE Debt sustainability is considered a prerequisite for any indebted country’s economic growth and macroeconomic stability. Due to its significance for the economy, numerous studies have analyzed public debt sustainability levels. Starting with studies that proposed a threshold level of debt (Daniel et al. 2003; Garcia and Rigobon 2004; Celasun and Kang 2006; Melou, Sumlinski, and Geiregat 2014). Different studies have found different thresholds levels; for instance, the International Monetary Fund (IMF) (2002) pointed to a 40% debt-to-GDP threshold level, while Schimmelpfennig, Roubini, and Manasse (2003) proposed that the threshold value of debt is 50% of the GDP. However, Reinhart et al. (2003) suggested a 15%–20% ratio of debt to GDP. Another strand of literature used the FRF to measure public debt sustainability (see Abiad and Baig 2005; Islam and Biswas 2006; De Mello 2008; Hajdenberg and Romeu 2010; Burger et al. 2011; Ghosh et al. 2013; Fournier and Fall 2015; Campos et al. 2020). In addition, to recognize fiscal fatigue risks, Checherita-Westphal and Ždárek (2017) used the FRF to find primary balance benchmarks. Other country-level studies have used different techniques for gauging debt sustainability, for instance the ARDL approach for Nigeria (Awoyemi 2020), the error correction mechanism and cointegration for India (Pradhan 2014), and the Wald test and Suit test for Turkey (Yilanci and Ozcan 2008). In the context of Pakistan, Mahmood, Rauf, and Ahmad (2009) applied several debt ratios to analyze debt sustainability, pointing out that the external and public debt deviated from sustainable levels for over three decades. Jafri (2008) forecasted the external debt sustainability of Pakistan for 2009–13 through the debt sustainability assessment (DSA) technique and found that various elements, like the real GDP growth, the ratio of the non-interest current account balance (CAB) to the GDP, and the exchange rate depreciation, can lead to the accruing of external debt to GDP, thereby creating a need for debt rescheduling. The soaring external debt to GDP ratio in Pakistan is due to the difference between the interest rate and growth rate, the current account balance, and the exchange rate depreciation (Pasha and Ghaus 1997). Besides, the poor management of debt leads to debt crises (Ahmad 2011). In another study, Aslam (2001) showed that spending a significant chunk of government revenues on debt servicing in HIPCs affects the countries’ welfare. To reach debt sustainability, Chandia and Javid (2013) suggested that government revenue and expenditure are crucial in adjusting debt and that sustainable debt can be attained in the optimal utilization of resources. Comparing the debt positioning of South Asian countries, Debapriya and Zeeshan (2018) found that the debt levels of Sri Lanka and Pakistan are unsustainable due to stagnant growth and a high interest rate. A few studies have highlighted the impacts of rising debts. The recent COVID-19 pandemic also affected the debt sustainability. For instance, Della Posta, Marelli, and Signorelli (2022) showed that, through the prudent monetary and fiscal policies of the ECB, Italy has avoided a debt crisis. In another study, Debuque-Gonzales et al. (2022) evaluated the debt level as not worrisome. Timely and responsible fiscal policy guaranteed the fiscal solvency of the country. Nevertheless, Urysszek and Urysszek (2021) found that primary deficits and high debt amid the pandemic led to unsustainable debt in Poland. Vinokurov, Lavrova, and Petrenko’s (2020) findings revealed that, to maintain the debt at a sustainable level, Tajikistan required 7.7% growth in 2020 as compared with 3.8% growth in 2019. Similarly, the Kyrgyz Republic required 10.9% growth compared with 4.5% in 2019. ADBI Working Paper 1354 Islam et al. 4 Following the above empirical literature, the contribution of this study is twofold. First, the study assesses the result of two of the main approaches. Second, the study forecasts the post-COVID level of debt until 2030, using different scenarios, through DSF. In addition, the study discusses fiscal fatigue and the debt sustainability level. 3. THEORETICAL FRAMEWORK, METHODOLOGY, AND DATA 3.1 Theoretical Background Fiscal policy is the core of any strategy concerned with debt as fiscal imbalance is mainly considered a root cause of rising debt levels. A wide array of literature has suggested that mounting debt is a serious concern, and Madison (1790) termed public debt a public curse, indicating the importance of debt sustainability. Many studies have shed light on public debt and proposed models like the crowding-out effect, the overlapping generation model, and the debt overhang model. Substantial public debt leads to the crowding out of private investment from the market (Ball, Elmendorf, and Mankiw 1998). The overlapping generation models (OLGMs) state that elevated public debt lowers economic growth (Blanchard 1985; Modigilani 1961; Diamond 1965). These models explain that savings, which are supposed to be used by future generations, are spent on high public debt. Furthermore, the debt overhang shows that the national income net present value is lower than the accumulation of debt level. This happens due to the mismanagement of borrowed funds (Krugman 1988). As a result, the debt burden increases as governments take on new debts to finance the previous debt instead of spending adequately on development and productive projects, often referred to as a “Ponzi scheme” (Elmendorf and Mankiw 1999). In the light of the debt overhang model, this study assesses the public debt sustainability, considering whether the government turns to creditors to finance its previous debt obligations. Different frameworks are used to evaluate debt sustainability, such as the International Monetary Fund and World Bank’s (IMF-WB’s) DSA/DSF, which is the most widely used in the empirical literature. Apart from DSA/DSF, the study evaluates the public debt sustainability of Pakistan using the FRF. 3.2 Methodology 3.2.1 Baseline Methodology—Debt Sustainability Analysis (DSA) On the basis of the historical growth context and policy choices, optimistic and pessimistic scenarios are used to evaluate the debt sustainability in the case of Pakistan. A set of different threshold levels of interest rates and economic growth is selected carefully. Like the DSA of the IMF, we use a framework to estimate the role of the growth rate interest differential and debt sustainability. This framework is used to draw projections with the help of the historical values of important indicators. The following framework is used to make projections: ( ) ttt pbd g r d+ + + =−1 * 1 )1( , (1) ADBI Working Paper 1354 Islam et al. 11 REFERENCES Abiad, M. A., and M. J. D. Ostry. 2005. Primary Surpluses and Sustainable Debt Levels in Emerging Market Countries. 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External Debt Sustainability of Turkey: A Non-linear Approach. International Research Journal of Finance and Economics 20: 91–8. ADBI Working Paper 1354 Islam et al. 1 APPENDIX Table A1: Variable Definitions, Sources of Data, and Time Period Variable Definition Source Time Period Public Debt Debt procured by a government from internal and external sources is known as public debt. SBP, PES1 1976–2021 Primary Balance Primary balance is the difference between government revenues and non-interest expenditures. SBP, PES 1976–2021 Output Gap It is the difference between the actual and the potential output of an economy. 1976–2021 Exchange Rate The value of one country’s currency expressed in another country’s currency (used as an instrument in estimation). WDI 1976–2021 Current Account Balance A record of a country’s financial transactions with the rest of the world (used as an instrument in estimation). WDI 1976–2021 External Debt The amount of money owed from other countries or multilateral sources, which must be repaid with or without interest. It is a part of public debt. IMF 1976–2021 Oil Prices Crude oil prices per barrel. Statistica 1976–2021 Regime Dummy It is used to differentiate the regimes of democratic and dictators. 1978–1988 1999–2007 Dummy COVID Pandemic caused by the COVID virus. 2020–2021 Dummy 2000 Financial sanctions were imposed after nuclear tests. War on terror after 9/11. 2000–2021 Table A2: Debt Sustainability Forecasting Scenario 1 Scenario 2 Years r = g r < g = 0.05 r < g = 0.10 Years r > g = 0.05 r = g r < g = 0.10 2018 0.717 0.717 0.717 2018 0.716 0.717 0.716 2019 0.860 0.860 0.860 2019 0.860 0.86 0.860 2020 0.856 0.837 0.799 2020 0.914 0.894 0.836 2021 0.852 0.815 0.742 2021 0.940 0.898 0.785 2022 0.848 0.793 0.689 2022 0.983 0.919 0.754 2023 0.844 0.772 0.639 2023 1.028 0.94 0.725 2024 0.840 0.751 0.593 2024 1.074 0.961 0.698 2025 0.836 0.730 0.549 2025 1.120 0.982 0.672 2026 0.832 0.710 0.509 2026 1.168 1.003 0.649 2027 0.828 0.691 0.471 2027 1.217 1.024 0.627 2028 0.824 0.672 0.436 2028 1.267 1.045 0.606 2029 0.820 0.653 0.403 2029 1.319 1.066 0.587 2030 0.816 0.635 0.372 2030 1.371 1.087 0.569 1 Pakistan Economic Survey. ADBI Working Paper 1354 Islam et al. 2 Figure A1: Fiscal, Revenue, and Primary Balance of Pakistan Figure A2: Real GDP Growth and Fiscal Deficit Figure A3: Public Debt to GDP of Pakistan ADBI Working Paper 1354 Islam et al. 3 Figure A4: Pakistan’s External Debt Composition Figure A5: Pakistan’s Trade Balance