Pakistan’s external debt servicing for FY23 stands at 60 per cent of its exports, up from 12pc in FY11. While emerging market economies have seen a similar trend over the past decade, the increase has been relatively modest. For large emerging economies, external debt servicing as a percentage of exports and primary income increased from 12pc in 2011 to 30pc in 2020.

The external debt servicing burden looks better when one includes remittances. External debt servicing as a percentage of exports and remittances increased from 10pc in 2011 to 35pc in 2022. However, according to the Economist Intelligence Unit, the same for the median African country was only 10pc at the end of 2021, up from 4pc in 2011. Some of the few African countries which face a higher external debt servicing burden than Pakistan (as a percentage of exports and remittances) include Mozambique, Namibia, Sudan, and Zambia.

The situation is made worse by the fact that Pakistan’s foreign reserves with the State Bank cover only about a third of expected debt repayments in FY23. This includes deposits of close to $5 billion from ‘friendly’ countries. As a rule of thumb, the Greenspan-Guidotti rule suggests this ratio should be close to one.

A 2010 paper, Financial Stability, the Trilemma, and International Reserves highlights additional factors which result in the adequate level of reserves being significantly higher than suggested by the Greenspan-Guidotti rule.

Both these factors imply that the spreads on Pakistan’s five-year credit default swaps have increased by more than four times — from close to 500 basis points in May 2021 to more than 2,000 bps since July 2022 — indicating a very high probability of default.

The cycle of securing debt rollovers creates uncertainty that keeps the country out of international financial markets and deters private foreign investment

The precarious situation Pakistan finds itself in today has been in the making for at least 10 years. Pakistan’s liabilities to the rest of the world (i.e. net international investment position) have increased from $60bn in 2011 to $129bn by March 2022. Importantly, this was driven by a significant increase in borrowing from multilateral institutions and ‘friendly’ countries to finance unsustainable levels of consumption.

According to World Bank’s International Debt Statistics, almost two-thirds of Pakistan’s total external debt is held by official creditors. Unsurprisingly, Pakistan shares this similarity with several of the other countries which are currently facing debt distress.

For example, on average, only 13pc of the total external debt of debt-distressed countries is held by private creditors. This again indicates that, as in the case of Pakistan, these countries were also consuming more than what the financial markets were willing to finance.

The inadequate policy response at home in recent months only hastened the crisis. In the fourteen months between Sep-21 and Oct-22, there was a net inflow of about $8bn from external sources. This includes all external inflows net of debt repayments. However, the economy registered a current account deficit (CAD) of nearly $18bn.

The difference between net external inflows and CAD was financed from central bank reserves. As a result, with reserves decreasing by more than 50pc, the country is left exposed to changes in global financial conditions and potential default.

On the fiscal side, after delaying key policy decisions to limit fiscal deficits and CAD during the second half of FY23, fiscal authorities continue to signal to markets that they plan to run large CAD in the following years.

The International Monetary Fund’s (IMF) country report suggests that fiscal authorities expect this to be financed by an increase in foreign direct investment from $2.5bn in FY22 to $4.8bn in FY27 and an increase in (net) portfolio inflows from $447 million in FY22 to $8.6bn in FY27.

The portfolio inflows include an expected increase in (gross) inflows from private creditors from $9.9bn in FY22 to $22.9bn in FY27. It cannot be emphasised enough that when financial markets are already concerned about Pakistan’s external debt repayment capacity, such fanciful projections only exacerbate investors’ confidence.

Going forward, the policymakers only face hard choices. The country is already facing a risk of getting trapped in a cycle where it is continuously engaged in securing debt rollovers from official creditors.

The uncertainty this creates will effectively keep Pakistan shut out of the international financial markets and deter private foreign investment in the foreseeable future. Alternatively, an outright default can lead to a significant contraction in economic activity and further risk social unrest.

Nonetheless, the debtor country’s low- and middle-income citizens may not fare better under an IMF-style adjustment plan than they would in an outright default or a rescheduling of repayments that lowers the market value of the debt. Where debt is amicably restructured between the debtor country and the creditors, the defaulting country can see a rebound in economic activity in the following years.

Ahmed Pirzada is a senior lecturer at the University of Bristol, UK, and a member of the Economic Advisory Group (EAG), Pakistan

Published in Dawn, The Business and Finance Weekly, December 12th, 2022