Pakistan's Cost of Debt

On a financial front, one of the key challenges facing Pakistan is ever-booming circular debt, the payments that the government to various entities in energy value chain ranging from generation companies to fuel suppliers. Over the last decade, the circular debt has ballooned from PKR 200 billion in 2008 to PKR 480 billion in 2013, to an alarming high of PKR 1,155 billion in August of 2018. While bad management of the power sector, leading to theft and bulging line losses, is one contributing factor to this circular debt, the fundamental problem remains financial.

After the fall of the Benazir Bhutto government in 1996, a government that introduced Independent Power Project Policy, addition of new generation capacity stalled (this Dawn editorial explains). This continued till the latter half of first decade of 21st century. This gap of almost 11 years created a huge supply gap leading to massive power cuts. These power cuts were so severe that they led to rioting in country’s industrial centers and small towns. Faced with crisis, starting in 2009 the government started increasing the power generation capacity rapidly. This was further accelerated by the government of Pakistan Muslim League (Nawaz) after it assumed power in 2013 and  as per their claims 10,000 MW of power generation capacity was added in its 5 year tenure. And in this rapid expansion lies the recipe for ballooning circular debt. Power projects in Pakistan usually have a sanctioned life of 25 to 30 years. The government prefers to do these projects on 75/25 Debt to Equity ratio. However, debt maturity for these projects is 10 years. This means the projects’ tariff payment is front-loaded. Now since the country failed to incrementally increase its power generation between 1996 and 2007, rapid expansion of generation capacity impacted the weighted average tariff abruptly because of debt-servicing component of the tariff. Facing this, the government had two choices: first, to pass the increase to consumers and second, to subsidize it for the consumers. The government chose both, at times passing part of the increase to consumers and at times trying to pass it all to the consumers. When the government passed these costs fully to the consumer, it led to an increase in theft and non-payments leading to increase in receivables from consumers, leading to circular debt. When the government chose to subsidize it, it impacted the government’s finances leading to non-payments which resulted in increased circular debt.  So, the policy not to incrementally increase country’s power generation capacity led to a sudden spike in weighted-average tariffs and is at the heart of circular debt crisis.

Secondly, this 10-year debt maturity is not optimal. Utility projects have defined cashflows and when they have a sovereign-guarantee, as is in case of Pakistan (where the government provides a sovereign guarantee on off-take of power generated), it makes it a lucrative proposition to finance it through longer debt maturity. This for an amortized loan decreases debt-component in tariffs, leading to a lowering of overall tariffs in early years. Increasing debt maturity from 10 years to the life of a/the project can decrease non-fuel components of initial years tariffs by 25% to 40%, moving it on to latter years. The reasons this has not been achieved are a lack of domestic financing and an absence of serious effort on part of the government of Pakistan to encourage longer maturity debts. The government on one hand should encourage higher debt maturity and on the other should focus on increasing the debt portion of financing, encouraging higher debt to equity ratio for these projects. The combination of changing debt to equity ratio and extending debt maturity decreases non-fuel component of initial years tariffs by 35% to 50%. This levelling of cash flows can also lead to securitization of the project debt for the life of the project.

The third issue is the cost of debt itself. Pakistan’s cost of borrowing is on the higher side of global borrowing costs. Continuously running a twin deficit (fiscal deficit and current account deficit) has waned the financial market’s trust in Pakistan. For the 2017 issue, Pakistan’s 10-year sovereign Euro-bond spread over US T-bond of same maturity was around 600 b.p. or 6%, while Argentina, marred by serious financial mismanagement, had a premium of 400 b.p. or 4% at around the same time. This higher cost of borrowing is critical because Pakistan raises most of its infrastructure debt in US dollars. Going forward, the country needs to adopt a two-pronged strategy to improve its creditworthiness and to fix its current account deficit so that it could expand domestic debt borrowing for infrastructure projects and other financing needs. Recent talk of renegotiating the China Pakistan Economic Corridor deals and other such measures will be detrimental for country’s already bad creditworthiness. The country needs to embark on a program to improve the current account deficit through policies that encourage exports and foreign direct investment. It will also need to create a conducive environment for private entities to secure foreign financing through international debt markets. This requires breaking the country’s isolation from global financial markets by ensuring that the country leaves money laundering and terror-financing lists such as FATF grey list. Foreign financing to private entities will take the pressure off the government to secure sovereign-backed foreign financing for the current account. The country also needs to expand and democratize domestic debt markets by creating a conducive legal framework and encouraging domestic savings. The ultimate aim should be to create a debt market with ample liquidity and securitization to cater to the borrowing needs of projects and ventures. Short of these measures, the country will keep suffering from higher cost of debt, killing the country’s economic potential.