Group 8

Mina Khan

Funding of Fiscal
Deficits
Amna Saeed
Khan
Marzia Bilwani

Haneefa Soomro
Simra Ahmed

Sources for funding fiscal deficits

For meeting fiscal deficits the choices are external borrowing, domestic borrowing, official
grants, equity and privatization proceeds.
External borrowing can be in form of debt creating flows or non debt creating flows.

Debt creating flows are foreign inflows in form of debt which carries a fixed income
charge and have to be paid at maturity.
Non debt creating flows are net foreign direct investment, portfolio equity flows, and
official grants (excluding technical cooperation). Net foreign direct investment and
portfolio equity flows are treated as private source flows. Grants for technical
cooperation are shown as a memorandum item.

Domestic borrowing includes the following:

Non-bank borrowing: Equity can be raised by floating shares of state

enterprise on stock exchanges or selling to private equity companies or
through private placements.

Bank borrowing can be further divided into Central Bank and Commercial Bank
borrowing.

If we finance the fiscal deficit by external financing, this will cause our external debt to grow and
this will not only exacerbate our balance of payments problems but increase the interest
payments on external debt which in turn worsens the fiscal deficit problem. If we finance from
bank borrowing, we have to print money which leads to inflation and our domestic debt will also
be higher leading to increased interest payments on domestic debt and back to the fiscal deficit.
And if the deficit is financed by nonbank borrowing, this will lead to the crowding out problem
and increase domestic debt as well.

1980s
The financing of budget deficit has remained a fiscal dilemma for the various governments in
Pakistan. The eighties started with financing of the budget deficit mainly through external
borrowings and bank sources. As a result of this strategy, not only did external indebtedness
increase, but it also led to inflation in the economy (about 12.5% during the years 1981 and
1982). Hence, the government resorted to non-bank borrowings as a major source of financing
the public deficit during the period 1983-90. The move was justified on account of debt crisis in
the eighties and to prevent inflation as well. As a result of this policy-shift, inflation remained
under control (6.0% on average) during the period 1983-90. Lack of domestic resource

mobilization and the shortage of foreign loans forced the government to make a hesitant move
for additional funds from the World Bank as a part of the structural adjustment loan (SAL) linked
with stringent conditions. Resentment on part of the government has resulted in disruption of
these funds, time and again.
External financing in this decade decreased to approximately 23% of total deficit, whereas bank
borrowing was 28%, with the greatest increase seen in non-bank borrowing, funding about 50%
of the deficit.
In sum, the upsurge in the fiscal deficits in Pakistan during the eighties was the result of two
policies:

An increase in public consumption in the face of a political inability to raise

corresponding revenue.
A change in the financing mix from domestic bank and external financing to domestic
nonbank borrowing. This was partly dictated by reduced availability of funds, but was
largely the outcome of a policy choice to curtail bank financing.

The Lost Decade (1990s)

The economic performance of the 1990s was also related to the structural adjustment programs
(SAPs) of the World Bank and the International Monetary Fund (IMF). Loans from these
international lending agencies were subject to conditions on Pakistan's national economic
policies. Pakistan received its first formal loan in 1988. In Pakistan the primary focus of the
IMF-sponsored program was to lower the budget and current-account deficits. These objectives
were to be achieved by reducing public expenditures and broadening the tax base. In addition, in
1992-1993 the IMF further insisted that Pakistan reduce defense expenditures, impose an
agricultural tax, and improve methods of tax collection. These reforms were never fully
implemented, however, and the IMF-sponsored program did not achieve the desired result.
Inflation rose from 8 percent in the 1980s to 11 percent in the 1990s, although a nominal
reduction in the budget deficit was visible. Direct foreign investment did not improve and the
export sector remained sluggish.The decade of 1990s was a tumultuous period in the economic
and political history of Pakistan. Changes in political regimes were frequent and every
government led to a new agreement with IMF.
Some policies which were implemented to reduce fiscal deficit are: Wage restraint and freezing
of employment in the public sector, introduction of General Sales Tax (GST), reduction in public
expenditure, removal of subsidies, privatization of state owned enterprises (SOEs), national
saving schemes and passing down of increase in international oil prices.
In compliance with IMF conditionality, the Government of Pakistan took a number of steps to
reduce budget deficit, which included wage restraint and freezing of employment in the public

sector. Over the period of adjustment, employment cost fell from 35.5% to 32.3% of public
expenditure (Anwar, 1996).Thus Government wage policy contributed to a decline in real wages.
The middle level public sector employees, mostly clerical staff, experienced a real wage cut of
12.75 % in the first three years of the Adjustment Program. Thus freeze on wages and ban on
employment in the public sector increased both poverty and unemployment in the country.
Table 3: Distribution of Unemployment Rates
Year

Pakistan

Urban

Rural

1989-90

3.1

4.6

2.6

1992-93

4.7

5.8

4.3

1993-94

4.8

6.5

4.2

1994-95

5.4

6.9

4.8

1996-97

6.1

7.2

5.7

1998-99

6.4

8.9

5.0

Source: Kemal (2001), page 27

Regarding revenue measures, GST was introduced in November 1990. Most of the necessities
like milk, meat, eggs, vegetables, wheat and wheat flour, rice, juices and house rent, etc were
exempt from GST. Several goods and services used by the common man. The fact remains that
certain items of common use by the poor sections of society were subjected to GST, which might
have added to the number of poor people in the country.
There was a 10% decline in public expenditure on education and health which reduced activities
in the education sector by 7.6% and the health sector by 5.1%.Their results further show that the
poorest urban and rural groups were more affected more than better-off urban and rural groups
due to the spending cut in education and health expenditures.
In order to set the prices right, subsidies were removed from wheat, fertilizers, and edible oil.
This had an adverse effect on agriculture sector.
Table 4: Public Spending cuts on subsidies, education, and health
Year

subsidies (%GDP)

Health (%GNP)

Education (%GNP)

1987-88

1.50

1.0

2.4

1988-89

1.66

1.0

2.4

1989-90

1.47

1.0

2.2

1990-91

1.10

0.9

2.1

1991-92

0.94

0.7

2.2

1992-93

0.73

0.7

2.2

1993-94

0.58

0.7

2.2

1994-95

0.35

0.6

2.4

1995-96

0.64

0.8

2.4

1996-97

0.54

0.8

2.6

1997-98

0.48

0.7

2.3

Source: Various issues of Economic Survey of Pakistan

The increase in international prices of petroleum was passed down to consumers. This resulted in
an increase in power price by 8% in 1990-91. Natural gas prices to households increased by 37%
in 1988-89 (Economic survey, 1993). The increase in petroleum and oil prices not only affected
the households directly but it also had indirect impact, through increase in public and private
transport fares.
Nawaz Sharif also did privatization of State owned enterprises(SOES) under his economic
liberalization programme which greatly reduced the Government expenditure and thus reduced
the fiscal deficit.
There was a notable increase in the savings rate in the early 1990s, from an average rate of eight
per cent of the GDP in the 1980s to 17.5 per cent of the GDP in 1991.High returns of 18-20% on
the state-owned National Saving (NSS) instruments, especially over 1993-99, attracted
individual and institutional deposits. As a result, Government had a lot of access to funds to fund
the fiscal deficit. But from 1999 to 2004, there was a significant drop in the profit rates after
Shaukat Aziz took over as finance minister and then as PM. He was lukewarm towards the NSS
and too warm towards banks.
As a result, budget deficit was reduced from 7.1 in 1980s to 6.7 in 1990s.

Musharrafs Era

When Musharraf first came into power the country was in a turmoil. Pakistan had high
fiscal deficits, an unsustainable public debt (domestic and foreign) an a sharp
deterioration in the distribution of income; and a disturbing rise in the level of
unemployment and poverty.

Before 1990s, most of the deficit financing was done by banks. In the late 1990s,
Pakistans money market and bond market was initiated after liberalization reforms.
Government Bond market which issues sukuk gained momentum after the introduction of
pakistans investment bonds (PIBs) in 2000 which helped to streamline the auction of
government securities.

Pakistan's economy witnessed a major economic transformation in the last decade. The
country's real GDP increased from $60 billion to $170 billion, with per capita income
rising from under $500 to over $1000 during 2000-07". It further acknowledged that "the
volume of international trade increased from $20 billion to nearly $60 billion. The
improved macroeconomic performance enabled Pakistan to re-enter the international
capital markets in the mid-2000s. Large capital inflows financed the current account
deficit and contributed to an increase in gross official reserves to $14.3 billion at endJune 2007.

Total revenue collections increased from Rs 308 billion in 1999 to Rs 846 billion during
2007.

Extra fiscal space allowed us to increase PSDP from Rs 116 billion in 1999 to Rs 520
billion in 2007-08.

government budget deficit has significant impact on money supply and this in turn has
exerted a significant influence on the inflation and balance of payments. In other words,
the government has forced the central bank to print more money to finance the growing
budget deficit. This in turn has exerted upward pressure on prices. On the other hand,
changes in money supply have affected the trade balance through exports and imports,
which in. turn influenced the foreign exchange reserves. These results suggest that in
order to reduce inflation and balance of payments deficit there is a need to manage
monetary, fiscal and exchange rate policies simultaneously.

However, fiscal problems continued during 2008/09 and the fiscal deficit target was
exceeded by 0.9 percent of GDP, amounting to 5.2 percent of GDP. Overall revenues fell
substantially short of the targetby one percentage point of GDPprimarily owing to a
drop in tax revenues as the economic slowdown reduced the buoyancy of Pakistans two
main tax bases (manufacturing and imports). FBR tax revenues declined from 9.8 to 8.8
percent of GDP. At the same time, federal governments attempts to control spending
were thwarted by high provincial spending.

The first two months of 2009/10 suggest that fiscal instability will continue, and the first
quarter fiscal deficit target will likely be missed. Revenues have continued

underperforming: FBR tax collection during July-August 2009 increased only by 3.6
percent compared to 19.5 percent required to reach the annual target. Also, provincial
governments have continued spending at high levels, and power subsidies have remained
unaddressed by the federal government.

Foreign Aid declined further after Musharraf's coup in 1999. Still, Pakistan's help was
again required after the attacks on September 11 as part of the American 'War on Terror',
and the aid started flowing again.

In 2005, Earthquake Relief assistance was provided worth 5.4 billion (400 billion
Pakistani rupees) in aid from all around the world.

2007-2008:
The macroeconomic situation started deteriorating in 2007 because of global financial turmoil,
exogenous commodities price shocks (oil and food) and adverse security environment.
During this period, domestic and external shocks of extraordinary proportions caused large
slippages on the fiscal account. The financing plan of the fiscal deficit was also affected by these
shocks. The overall fiscal deficit of Rs 399 billion was to be financed by external sources (Rs.
193 billion), and domestic sources (Rs 131 billion). The remaining Rs 75 billion was to come
from privatisation proceeds. Within domestic sources, Rs 81 billion financing was to come from
banking sources while the remaining Rs 50 billion was to come from nonbank sources. The
domestic and external shocks not only increased the size of the fiscal deficit but also changed the
composition of financing. External resource inflows were adversely affected by these shocks. As
against the budgeted external financing of Rs 193 billion, only Rs 151 billion could be
materialized. Pakistan could neither complete the transaction of Global Depository Receipts
(GDRs) of the National Bank of Pakistan nor could it launch sovereign and exchangeable bonds
in 200708. Furthermore, some of the lending from the multilateral banks did not materialize.
Thus, the brunt of adjustments on the financing side fell on domestic sources. The borrowing
requirements from domestic sources increased from Rs 131 billion to Rs 626 billion (with
negligible privatization proceeds)an increase of Rs 495 billion. Within domestic sources, the
bulk (82.8 percent) of financing came from banks while the remaining Rs 108 billion or 17.2
percent came from nonbank sources. Most importantly, the borrowings from the State Bank of
Pakistan (SBP) reached an alarming level of Rs 677 billion. Since borrowing is essentially akin
to printing of new money, it erodes purchasing power of the local currency in the form of high
and persistent inflation and exchange rate depreciation. Such an elevated level of borrowing from
the SBP was not only inflationary but also posed serious difficulties for the conduct of effective
monetary policy. Due to the excessive borrowing from the SBP, the broad money supply grew by
15.3 percent.

2008-2010:
Pakistans economy faced headwinds like political instability, a deteriorating law and order
environment, supply shocks, a weakening of external demand, turmoil in international financial
markets and high prices for oil, food and other commodities during fiscal year 200809. In
addition, monetary overhang from previous years due to excessive government borrowing from
the central bank to finance the large fiscal deficit led to inflationary pressures in the economy
and the crowding out of the private sector. The fiscal deficit was financed mainly through
combination of nonbank and commercial banks financing which replaced SBP financing.
However, due to nonexistence of appetite from the private sector, the crowding out impact was
not a cause for concern. After keeping exchange rate artificially low during 200408, the
exchange rate plunged by around 22 percent in the period of JulyOctober 2008. Such a massive
depreciation had potential threat to culminate into a balance of payment crisis
External inflows were budgeted at Rs. 312.3 billion for 200910. However, only 60.5 percent of
the projected amount was realized in the course of the fiscal year 200910. Nonmaterialization
of Tokyo pledges had been the underlying theme as only Rs. 25.3 billion were received against a
projection of Rs. 145.1 billion made in the federal budget (revised down to Rs. 66.1 billion later).
A widening fiscal balance, was, therefore, mainly financed through domestic sources in the
absence of any proceeds accruing from privatization. This avenue is costly as this borrowing is
conducive to inflationary pressures and at the same time, translates into higher debt servicing in
view of higher domestic interest rates. In the course of the fiscal year 200910, Rs. 740 billion
was mobilized through domestic sources against a budgeted target of Rs. 390.5 billion. Of this,
much came from nonbank sources (58.8 percent of domestic financing). Interestingly, the bank
deficit financing was frozen to almost the same level of 200809 (in absolute terms) nearing Rs.
305 billion. Despite this, government relied on central bank borrowing and was not able to
comply with the net zero quarterly borrowing limits policy during FY200910. This trend is
undesirable and needs to be reversed as deficit monetization (printing of money) is one of the
factors influencing inflationary expectations in the economy. The nonbank inflows amounted to
Rs. 435.6 billion, 76.9 percent higher than the estimated magnitude. This segment of deficit
financing underwent an increase of nearly Rs. 212 billion as compared to FY2008 09. Higher
accruals in retail instruments offered by the Central Directorate of National Savings (CDNS)
coupled with a resurgence of nonbanking financial institutions interest in government papers
were the prime reasons behind this strong growth.

2010-2011:
Pakistan was struck by the greatest natural calamity in its history: The Great Floods of 2010. The
world has not seen a calamity of this magnitude in modern times. No country has had to deal

with a disaster of this scale. Inflation increased due to disruption of supplies while revenue
collection suffered. The overall assessment of damage stood at $10 billion or Rs 850 billion and
GDP growth reduced by two percent. The requirements of looking after the flood affected areas,
and allocations for their support and rehabilitation, resulted in additional fiscal strain on the
Government and the macro-economic framework had to be adjusted. The government continued
to rely on domestic avenues for budgetary financing owing to a slow pace of materialization of
FODP pledges and a general drying up of foreign funding sources. US$ 451 million received
under the IMF Emergency Natural Disaster Assistance (ENDA) for floodrelated immediate
outlays dominated the external sources of budgetary financing in the first quarter. More
importantly, a greater dependence on banking sector led to further crowdingout of private sector
credit. Banks contributed Rs.121 billion to the financing of budgetary gap during July
September 2010, while nonbanking sector provided Rs. 98.4 billion. Of the banking proceeds,
much came through central bank borrowing. This is in sharp contrast to a 27/73 banknonbank
financing mix during JulySeptember 2009. In an environment of high domestic interest rates,
this tilt towards banking industry was an expensive act. The government was able to get just Rs.
56.9 billion from external sources.

Moreover, the financial year 2010-2011 was the first in which the state bank of Pakistan planned
to issue sukuk bonds. In Pakistan, 78 Sukuk had been issued so far for an amount of Rs 637.43
billion. Out of the total 78 issues, 32 Sukuk issues for an amount of Rs 100.10 billion had been
fully redeemed.
Government of Pakistan (GoP) had issued Ijarah Sukuk on numerous occasions in past to meet
its escalating borrowing requirements. Government sector companies like Water & Power
Development Authority (WAPDA) and Sui Southern Gas Company Limited (SSGC) had also
issued Sukuk in past. Karachi Shipyard has also issued an Ijarah Sukuk in 2007.

2011-2013:
Declining external inflows due to global recession and financial crisis exacerbated the already
weak fiscal performance during the 2011-12. In the course of the fiscal year 2011- 12, Rs.1,241
billion was generated from internal avenues against a budgeted target of Rs.716 billion. Bulk of
the domestic financing came from banking sources (57.3 percent of the domestic borrowing).
The non-bank inflows amounted to Rs.529 billion, 28.2 percent higher than the estimated
magnitude. To check high borrowings, the Government promulgated an amendment in the State
Bank of Pakistan Act, whereby it has committed (a) net zero quarterly borrowing from SBP
baring ways and means limit and (b) repay SBP outstanding debt as of April 2011 in next 8 years.
The government borrowed Rs.507.5 billion from SBP during 2011-12 as compared to retirement

of Rs.17 billion during 2010-11. Moreover, total government borrowing from the State Bank
stood at Rs.1,662 billion as on June 30, 2012. As required by the SBP Act, an average annual
repayment of Rs.238 billion is essential for the next seven years to retire the outstanding debt
stock prior to 30th April 2019. This will require higher generation of revenues and/or higher
mobilization of external flows.

An unfavorable change in financing mix: Although the country had been facing high
budget deficits in the past, the key challenge in recent years has been financing the deficit. In the
past, cheaper external financing had been available, which generally covered more than half the
total financing requirements. However, receipts from this source have been declining for the past
several years and its share has dropped to only 7.3 percent in FY12. The share of non-bank
borrowing has also declined in FY12, despite a growth of 12.3 percent compared with 8.3
percent in the previous year. Moreover, a significant contribution to non-bank borrowing came
from NBFIs investments in T-bills, instead of savings mobilized through National Savings
Schemes. Thus the domestic banking system has become the major source of deficit financing,
which is not only costly, but also carries a high opportunity cost, in terms of crowding-out the
private sector. Within the banking system, financing from the central bank increased sharply
during the year, which does not bode well for Pakistans macroeconomic stability. A high budget
deficit with such an unfavorable financing mix, is difficult to sustain, particularly given the debt
burden the country already carries. The significance of this issue is amply visible from the debt
servicing obligations of the federal government, which have surpassed its tax revenues (net of
provinces share) for the first time.

Outlook: Poor fiscal discipline is only aggravated by the weak management of governments
existing aggregate cash balances with the banking system, and by the lack of cash flow
forecasting. The absence of an effective Treasury Single Account (TSA) which consolidates all
government cash balances (amounting to Rs. 553 billion at end-FY10) into a single account at
the central bank, impedes governments ability to accommodate temporary fiscal shocks. A
Treasury Single Account (TSA) is an essential tool for consolidating and managing governments
cash resources, thus minimizing borrowing costs. A direct consequence of these factors is an
inordinate reliance of the government on borrowings to finance the budgetary deficit. Notably,
there are persistent deviations in the estimated financing mix of the fiscal deficit. While external
borrowing sources are rather limited and have proved to be unpredictable in their timing,
governments ability to fall back on non-bank financing is also constrained by its on tap nature
for individuals and institutions, which causes the receipts and repayments of such flows to
remain largely unpredictable. As a consequence, the government finds it most feasible to turn to
the banking system, including both the State Bank of Pakistan (SBP) and the commercial banks,
to meet its financing needs.

The Nawaz Government

The budget deficit was 3.2 percent of GDP during Jul-Mar FY14, according to the fiscal
operations data. This was significantly lower than the level observed in the same period last year,
and the ceiling agreed with IMF. This reduced gap includes US$ 1.5 billion grant received from a
friendly country in Q3-FY14. Besides the grant, this improvement can be traced to a slowdown
in current expenditures and an increase in tax revenues. The financing of the budget deficit
during Jul-Mar FY14, came almost equally from the bank and the non-bank sources. Although,
external financing remained negative during the first three quarters of the year, this has changed
significantly in the fourth quarter.

Public debt increased by Rs 277.9 billion in the third quarter, with the significant additions to the
domestic debt stock. Moreover, the share of external financing has increased significantly after
the receipt of the US$ 2 billion from Eurobonds and US$ 1.4 billion from International Financial
Institutions (IFIs) during Q4-FY14. After a gap of seven years, Pakistan entered the international
capital market in April 2014, raising US$ 2 billion through two issues of US$ 1 billion each, with
5 and 10 years maturity, respectively. In fact, Pakistan received bids amounting to US$ 7 billion
from international investors, against an initial target of US$ 0.5 billion. This strong response of
the international market can be traced to the availability of funding and the high return that was
offered by the government.

The higher rates compared to similar bonds issued by a number of other countries in 201437 can
be attributed to the lower credit ratings assigned to Pakistan Although, the shift towards external
financing will help reduce the roll-over and interest rate risks from over reliance on short-term
domestic financing, this will lead to an increase in external debt servicing. Given Pakistans
history of external deficits, its external debt repayment capacity has been a source of some
concern. It is not surprising that the mobilization of US$ 2 billion through the Eurobonds has
raised concerns about the buildup of external debt.
Net receipts in National Savings Scheme (NSS) posted a 50.9 percent decline in Jul-Mar FY14,
compared to the same period last year. Higher encashment, announced in the budget FY14,
discouraged individuals from keeping their savings in National Savings Schemes (NSS); there
was a 50.9 percent decline in Jul-Mar FY14, compared to the same period last year. Out of the
entire amount mobilized via PIBs in the third quarter (Rs 977.5 billion), around one-half was
raised through 3 year paper, with an effective maturity of slightly more than two years. Interest
payments will add US$ 155 million annually to Pakistans external debt servicing from FY15.
Moreover, increased access to external borrowing creates more room for private sector credit
expansion.
Pakistans external debt as a percentage of GDP, declined from 29.1 percent in FY12 to 25.3
percent in FY13. This declining trend is likely to reverse in FY14, with the external inflows from
the IFIs and the Eurobond issue. Furthermore, the servicing capacity of Pakistan has been
deteriorating in the past few years. This pressure may increase as repayments of the re-scheduled
Paris Club debt come online following the end of the grace period that was agreed upon in late
2001. With this background, unless the countrys FX earnings (exports and remittances) improve
significantly, the government should be conservative in raising funds from the international
capital market.

Figure 1: The Ratio of External Debt Servicing with Foreign Exchange Earnings

Conclusion
Private investment continues to be crowded out over the years by the government's heavy
domestic borrowing. Pakistans economic performance is severely affected by fiscal
mismanagement. Large budget deficits have led the country to become heavily dependent on
foreign aid and loans as domestic financing failed to meet budget needs without undermining
macroeconomic stability and crowding out the private sector. Financing the fiscal deficit also has
numerous negative consequences (as discussed above), hampering economic progress in
Pakistan.