This news of Pakistan defaulting on sovereign debt is making rounds on the internet. However, it is important to decipher the fundamentals of a default-like scenario and the economic health of the country to evaluate whether we are going to default or not. It is imperative to deconstruct the complex jargon of sovereign default and the default risk in its entirety.
Since Sri Lanka has defaulted on sovereign debt, it has inflicted a psychological effect that Pakistan’s situation has an analogical resemblance. Sri Lanka’s economic meltdown is altogether a different story and must not be associated with Pakistan.
Breaking it Down
By definition, defaulting on sovereign debt refers to the inability to fulfill the scheduled external debt repayments to international creditors due to scant forex reserves. It is critically important to contextualize the debt mix of Pakistan; about 63% of the debt is domestic, which essentially implies it has to be paid in PKR and the country can always print more to pay off the debt (but that it has its implications/ramifications).
The external debt constitutes 37% of the total debt owed by Pakistan. To put it into context, we must decode the external debt. We owe 24% of the external debt to the bilateral countries (China, Saudi Arabia, UAE, etc.), 57% to the multilateral institutions (IMF, world bank, etc), and the rest of the debt is owed to private investors (Eurobond, Sukuk bondholders, commercial loans).
It is important to conceptualize that 57% of the debt owed to the multilateral institutions always tend to figure out a debt restructuring plan—Pakistan has had 23 encounters with the IMF, and they have always figured out a debt rescheduling, it’s just that we have to internalize their demands. Furthermore, the debt owed to countries (24%) will eventually get a rollover once we get into an IMF program, given the relationships we have with them.
The private investors are the real problem which may call on default if Pakistan is unable to pay the obligations. However, Pakistan already made the Sukuk payment of $1 billion last month, and much of the default conversation was based on the rationale that Pakistan wouldn’t be able to make a payment on Sukuk bonds. The next maturity is due in April 2024, and until then, we’ll be flirting with default and have completely averted the default as of now.
Credit Default Swap
The term ‘CDS’ (credit default swap) is constantly being used by rumor mongers to assert a default-like scenario. In simplest terms, CDS essentially is an insurance policy that provides financial protection to the investor in case of a potential sovereign default. Whenever an investor or a bondholder tends to invest in Pakistan, it purchases a CDS from an investment bank providing financial compensation against a premium.
The CDS rating does not reflect the country’s tendency to default; instead, a higher CDS percentage means that the investor would have to pay a high premium to the investment bank. Therefore, there is no resonation between CDS and sovereign default.
The economic situation, however, is still dire prevalently due to stark structural issues. Pakistan has been in a long-standing economic turmoil with a pulverized infrastructure. To solve Pakistan’s impending economic gloom, we fundamentally need to understand the root cause. The policy elite over time have systematically pulverized the process of economic development; the under-5 mortality is systematically higher than what it should be, given Pakistan’s income per capita, and about 17 million more people are illiterate in Pakistan than it should be.
Moreover, the investment rate is only half the level it should be, and our exports our merely 1% of our GDP. All these horrendous statistics are an outcome of the dreadful policy decisions by the political elite. We have unsustainable consumption patterns, with consumption constituting 94% of the GDP. Our consumption is essentially financed through imports and our export stimulus is so weak that there emerges a colossal gap between exports and imports, hence to finance this gap we borrow dollars from international financial institutions, bondholders, and other countries, eventually ending up knocking IMF’s doors.
The current economic crisis has expedited the default conversation which may—will certainly—become a reality if grandeur reforms aren’t prioritized. It is about time to institutionalize fiscal prudence and monetary discipline, move away from an import-led economy to an export orientation, and expand our tax base.
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