Crawford School of Public Policy

Is Pakistan at risk of becoming an economic failed state? Omer Majeed crunches the numbers.

As Australia wrestles with how to make the budget balance and control debt and deficit, spare a thought for Pakistan.

Between the end of 2007 and 2012, Pakistan’s external debt increased by $16.0 billion to $59.6 billion. In inflation-adjusted terms, that’s almost a 40 per cent increase in external debt in five years. To top it off, the rate of accumulation of debt has been increasing.

That level of debt has implications far beyond balancing the books. Because of financial problems caused by this debt, Pakistan’s institutions will soon start to find it hard to function. This includes the military which is essential for fighting terrorists and balancing external threats. A bankrupt Pakistan and a bankrupt military will spell nothing short of a disaster for Pakistan.

The Pakistan Muslim League – Nawaz (PMLN) Government has made the external debt situation worse. By some estimates, the PMLN government has taken on an extra $10 billion in external loans in the last 12 months. Without any resources to pay these loans back, low growth in tax revenue, a depressed economy and a depreciated currency, this external debt has the potential take Pakistan towards a financial crisis.

But the problem of external debt in Pakistan has been building for years. During the governments of Pakistan People’s Party (PPP) and PMLN, external debt increased substantially. External debt increased by around $15.4 billion between 1988 and 1999 and by $16.0 billion between 2007 and 2012. Both governments have followed an unsustainable path of borrowing both in the 1990s and since 2007. In contrast, external debt declined during President Musharraf’s administration, falling by around $0.6 billion between 1999 and 2007.

While Pakistan’s external debt has increased, the country’s ability to pay back this debt has decreased significantly. A good indicator of a country’s ability to pay back external debt is total reserves as a percentage of external debt. Between 2007 and 2012, total reserves as a percentage of external debt have decreased by 15.5 percentage points. With the recent increase in debt obligations and reduction in foreign reserves, this ratio is likely to have further deteriorated. In comparison, during the administration of President Musharraf, total reserves as a percentage of external debt increased by 31.2 percentage points.

Furthermore, it seems as if the governments of PPP and PMLN have little incentive to be concerned about paying back the external debt that their respective governments have borrowed. According to the World Bank data, the average grace period of new external debt commitments since 2007 is 6.3 years. As the election cycle in Pakistan is 5 years, the governments of PPP and PMLN have not had to be concerned about paying back this debt during their respective tenures.

Instead this new external debt is only going to be a problem for future governments and Pakistani citizens. This is a clear example of moral hazard. In economics, moral hazard is where an economic agent does not enter into a transaction in good faith, partly because he does not have to face the full cost of his decisions. Since the governments of PPP and PMLN don’t have to worry about paying back the debt they borrowed during their respective tenures, they have borrowed excessively – causing a moral hazard problem.

Pakistan’s ability to pay back external debt has been further eroded by the devaluation of the Rupee, which depreciated by around 67.3 per cent between 2007 and 2013. Such a significant devaluation means that Pakistan’s ability to pay back external debt from domestic resources and domestic revenue has been considerably reduced.

If Pakistan’s finances are not managed properly, then Pakistan runs the risk of becoming an economic failed state and dependent on international donors. Such an outcome could cost Pakistan sovereignty and financial independence.