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The quagmire of local-law domestic debt restructuring

With collaboration from an investment professional.

As is widely understood, Pakistan is facing the dual dilemma of foreign debt servicing that has placed her foreign exchange reserves under significant pressure, and the mounting burden of domestic deficit financing, regardless of its maturity profile and merely due to its sheer quantum, at abhorrent cost. At the critical juncture that the country has appeared as of lately, the standard rubric for resolution of this problem set is to restructure public debt and lack of any development on this front has caused a lot of confusion in the markets. Dystopia, it seems, is awaited.

The incumbent finance minister, no doubt, is clearly aware of this dual dilemma, though it appears that he is unwilling to admit it publicly for the fear of causing panic in the markets. Nonetheless, foreign creditors have already panicked and are now standing off the battlefield, since long. Private holders of our publicly traded foreign debt have already booked the losses, at least in marked-to-market terms.

It is the domestic market, hence, that Q-Block (ministry of finance) is fearing the most, and rightly so, for the risk-rewards matrix is distinctly asymmetrical, as the foreign debt restructuring is bound to be perceived as a significant relief, so to speak, brought about by the finance minister efforts; costs of economic mismanagement being transferred to the outsiders. The reverse is true for the domestic debt restructuring; it is bound to be perceived as a real sham, internalizing, so to speak, the governance problem and as such treated not as a relief, other than between local social classes, and rather a real cost to the financiers, as it has to entail discretionary socializing of any relief-related costs locally.

Let us support the incumbent finance minister here and take a dive into the realm of domestic debt restructuring and pay due consideration to his apparent hesitance to proceed on this front.

The domestic debt refers to the debt that the government has raised under local law in the domestic market by floating bonds and bills. This debt, in turn, is held by commercial banks, insurance companies, mutual funds, provident funds, and other public and private sector companies either involuntarily or otherwise, i.e., as a structural and regulatory necessity for business conduct or for investment purposes.

Domestic debt restructuring, therefore and necessarily, entails a cost to the holders of this debt whereby the government either applies a haircut to the face value of this debt, reduces the promised interest rate, and/or enhances the maturity profile of it, under any given, and hopefully optimized, combination. The mercantilist socializing of this cost refers to a lost value-transfer from the domestic persons to the government; lost already, given the imperative of restructuring, a retributional transfer attempting to preserve whatever has remained, rather than to grow what had been. A lout nonetheless may still cry for the want of due diligence that never became due for holding the Sovereign’s debt.

The implications of a domestic debt restructuring are not limited to a one-time value tax on domestic debt holdings or, in other words, a one-time NPV loss to the debtholders, however. Where the government debt is a structural necessity i.e., in case of commercial banks including the central bank, insurance companies, and other regulated financial institutions, these entities may face debilitating equity erosions requiring fresh capital injections, liquidity crunches, and maintenance of minimum capital challenges. Inclusion of bills in the restructured government debt, may also result in a market freeze and a total loss of confidence. The central bank, in turn, may lose its span and scale in open market operations and potency of interventions for orderly conduct be rendered severely compromised. On the other hand, where the government debt is held for investment purposes i.e., money market mutual funds, provident funds, and within commercial banks’ portfolios where an opportunistic tilt is the underlying drive, the structural consequences might not be of significance imminently, but the general loss of savings and confidence may reverberate throughout the economy over the medium term.

These potentialities are well understood at the government level and several mitigating strategies are available to smoothen the pain. For instance, regulatory space may be granted to the commercial banks and other regulated financial institutions for minimum capital requirements, special privileges may be attached to the restructured debt instruments, tax relief incentives may be enacted for easing the equity injections, and a stabilization fund can be introduced for emergency purposes. However, for it to be materially successful, any domestic debt restructuring must stand net-positive for the government, i.e., be it not forgotten that mitigating measures have direct and potential costs.

On the one hand, the government has a clear advantage in restructuring local-law domestic debt, being as much despotic as it necessarily has to be, and on the other, a mismanagement of this exercise has potentiality of becoming as debilitating as imagination could bear. The inverted yield curve, a benign level of private credit to GDP, strong equity base of commercial banks, and lower overall development and penetration of financial markets are some of the important factors that would help the government in successfully executing a domestic debt restructuring. However, the imminency of restructuring the foreign debt, escalating fiscal deficit and a continual need to fund it domestically, narrow taxation base, and influence of special interests in the government, collectively, represents the axiomatic bull in our little china shop.

It should be well understood that the domestic debt restructuring is optional, financial repression i.e., erosion of real debt burden through inflation and selective arm-twisting of public and private financial institutions is the other well-known method of achieving the same results, albeit at the cost of an extended time scale and against a pound of flesh of the domestic economy, but invisible to the common eye.

Countries that are perpetually in policy disorders should be very careful and systemically aware of undertaking a domestic debt restructuring; the exercise is bound to be perceived as a periodic repetition thenceafter, resulting in an everlasting loss of confidence for times to come. Regardless of the timing and choice of method, only this much is certain that the domestic debt is no more an abstract chaos and that it can only be ignored for so long at the risk of facing a cataclysmic local adjustment down the road.

Regardless of the multitude of opposing views held, and the scale of efforts needed to make it a success, a timely resolution of domestic debt has several absolute advantages, and without delving into the specifics, and to not make an enumerating exercise out of it, it is sufficient to consider it as a resolution in terms of internalization of costs; a process that can hardly perpetuate indefinitely.

The finance minister indeed faces a dual dilemma and passing the buck is the right strategy, for him, and for now, but not for the nation. Rest assured that he is leaving a bed of thorns for his successor.

Ali Khizar, "The quagmire of local-law domestic debt restructuring," Business recorder. 2023-06-19.
Keywords: Economics , Foreign debt , Foreign exchange , Domestic deficit , Governance problem , Domestic debt

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