Sovereign Debt Vulnerability

The last twelve years saw US$ based benchmark interest rate close to near zero as monetary expansion reduced the cost of capital fueling an equity, credit, and venture capital boom as virtually unlimited supply of capital for chasing a finite number of investable opportunities.  As rates stayed close to zero, the need for higher yields pushed capital to be deployed in riskier propositions, one of them being emerging market sovereign debt.

As the Federal Reserve takes away the punch bowl and provides forward guidance regarding a contractionary monetary policy to ensure inflationary expectations remain anchored, interest rates are expected to increase further.  As interest rates increase, the benchmark rates move upwards, thereby also pushing up the cost of borrowing.  As interest rates increase, the cost of servicing debt for many corporations, households, sovereigns, and other obligors also increase.  As the cost of servicing debt increases, while ability to generate corresponding foreign currency remains compromised, many emerging market sovereigns may see their interest payments increasing as a proportion of their overall budget.  This would essentially mean that scarce resources that could be utilized to fund education, health, and nutrition among other fundamental human rights would now be used to make payments to debt holders.

To make things worse, the US$ continues to strengthen against other major and emerging market currency cies due to increase in rates, and the phenomenon of flight to quality.  As the overall global macroeconomic environment deteriorates, investors are ditching riskier investments for the safety of the US$.  This increases the demand for US$, and hence its price.  A stronger US$ results in depreciation of PKR and other currencies, further increasing the size of US$ debt in terms of local currency.

Pakistan is one of the more vulnerable sovereigns exposed to default risk.  The yield on its debt ranges from 16 to 22 percent depending on the maturity of its Eurobonds.  Although this does not directly affect the interest to be paid as the same is fixed at the time of issuance, this does affect the ability of Pakistan to raise more funding through international capital markets.  As there is a flight to quality, as is the case during stressed times, emerging market sovereign debt will continue to see its default risk increased.  The same has been increasing for the last few weeks as can be seen through expansion in credit default swap spreads, and higher yields across all emerging market sovereigns.

In the specific case of Pakistan, a higher interest rate would mean higher cost of debt servicing on all of sovereign commercial loans which are not at a fixed rate.  Similarly, a significant sum of project based loans are. Also pegged to LIBOR, which would see their overall cost of debt servicing increase.  As the majority of projects undertaken under CPEC had a component of foreign currency loan, they will see their cost increasing.  In the case of energy, a large number of power projects have loans denominated in US$, which will see their costs increase as well.

A sovereign debt crisis across the emerging markets is on the horizon. The credit markets for emerging market debt are going to freeze making it difficult, or more expensive to refinance, or raise more debt.  As the global macroeconomic scenario unfolds, it is imperative that Pakistan has a well calibrated external debt management strategy.

Any new external debt assumed by the sovereign should only be there to support anh specific foreign currency component of a project.  Efforts must be made to avoid utilization of external debt to service operational expenses, or something that can be managed through local currency.  Similarly, efforts must be made to conserve foreign currency given a potential liquidity crisis expected in the near term globally given a flight to quality.  Rationalizing import bills through direct and indirect interventions can save some foreign currency which can buffer up overall foreign currency reserves.  Although Pakistan approached the IMF at a fairly late stage of a balance of payments crisis, we are still not out of the woods yet.  Ability to refinance all debt expected to mature over the next twelve to eighteen months would be challenging as credit markets tighten.

Although external debt as a percentage of GDP has stayed in a stable range over the last few years, the inability to generate more foreign currency through exports or through Foreign Direct Investment to service such has made foreign debt servicing a major problem.  It is imperative that an external debt management strategy is in place, which doesn’t just assess sustainability of sovereign debt, but also any project based debt, because the same will also have to be serviced through foreign currency available with the sovereign.  Any sovereign debt assumed should ideally be self-liquidating, wherein it can be serviced through foreign currency inflows of the project, or through enhanced export generating capacity of the sovereign.

The sovereign debt crisis is only to get worse globally. We can either plan for a stressed macroeconomic environment with strained liquidity, or we can continue living on a prayer and bailouts by multilaterals, or other friendly sovereigns.

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Ammar H. Khan
The writer is the chief risk officer for Karandaaz Pakistan, an organisation that seeks to promote financial inclusion in Pakistan. He has previously worked at several financial institutions in Pakistan, both in commercial banking and capital markets

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