These are challenging times for Pakistan. The South Asian nation of 249 million people battles one of its worst economic crisis. According to JP Morgan Chase Bank’s analysis, the country’s risk of running out of usable reserves to fulfil its foreign obligations has considerably increased in the fiscal year 2023-2024. Pakistan now faces the challenge of averting this risk by devising strategies to ensure sufficient usable reserves, while restructuring external bilateral debt is one option being contemplated, as recently declared by the Finance Minister. Although, later, ruled out by the Governor State Bank, the Finance Minister’s declaration suggests that the option could be in the pipeline. Some experts have also suggested that the country’s economic outlook demands debt restructuring even with the International Monetary Fund’s (IMF) financial assistance.
To better comprehend the terminology, ‘debt restructuring’ is a generic term with three variants. The first is ‘debt reprofiling’, whereby the sovereign seeks to extend the maturity dates and introduce grace periods. Another is the ‘principal haircut’, which entails a reduction in the principal amount of the debt. The final variant is ‘coupon adjustment’, involving a reduction in the interest rate on the debt. A sovereign can seek one or a mix and match of these variants from either domestic or external creditors. If Pakistan opts for debt restructuring, it may seek an extension of the repayment period for its external bilateral debt, excluding the USD 8.8 billion owed to the Paris Club, i.e., an informal group of creditor countries.
The actual process of negotiating debt restructuring, however, may not be as straightforward as being purported. The economic literature highlights three fundamental problems that can complicate restructuring negotiations. The first is the ‘credit coordination’ or the ‘holdout problem’. A conflict of interest exists among the creditors, as they have an inherent tendency to free-ride on the debt relief agreed by others since each individual creditor benefits if the debtor repays them in full and other lenders agree to debt relief. This can cause the negotiation process to remain inefficient until a sufficiently large number of creditors accept the debtor’s request for relief. The said challenge would likely be more relevant if the debt restructuring negotiations only target specific creditors, as in the context of Pakistan, since they may find selective targeting unfair. A counter argument could be that China may still step up and agree to provide debt relief, as Pakistan defaulting on its debt would not augur well for Beijing, given the strategic partnership between the two countries. However, it is important to highlight that China has ruled out debt restructuring in the past. Even if it agrees now, it may desire at least a few, if not the majority, of other creditors to do the same. Second, sometimes creditors and debtors may not want a quick resolution, as extraneous motives can come into play, causing the negotiation process to fail or stretch unnecessarily. Additionally, there exists an asymmetric information problem, particularly with respect to the creditor’s ability to judge the debtor’s capacity to service future debt obligations. This can make the negotiation process inefficient or lead the creditors to offer minimal debt relief. There should be little doubt that the challenge of ‘information asymmetry’ would likely be amplified if the creditor is unable to predict future government actions due to political uncertainty in the debtor nations, as in the context of Pakistan.
Nevertheless, should such obstacles persist (which is certainly not desirable) and circumstances demand that Pakistan undertake debt restructuring, previous such agreements from across the globe can provide some lessons that can help enhance the likelihood of successful negotiations. First, experienced as well as competent financial and legal advisors must be hired on a priority basis, and the IMF should be brought in during the early stages of negotiations to guide the country through the negotiation process. Additionally, broad consultations should be undertaken with the creditors, and all those being requested for debt relief should be encouraged to coordinate. Pakistan should also explore the possibility of bringing in more creditors within the debt restructuring process. Even otherwise, coordination between bilateral creditors being targeted should be promoted and facilitated. This will enable creditors to chalk out how each one could contribute to providing relief. Finally, it is important to refrain from requesting excessive or very little debt relief, as the former can lead creditors to perceive the process as expropriatory, while the latter can lead to insignificant restructuring.
In all cases, it is crucial to recognise that successful debt restructuring, and sustainable economic development, can only be achieved through the implementation of structural economic and political reforms that address the concerns of creditors and pave the way for long-term stability and growth in Pakistan.
Zahra Niazi is a Research Assistant at the Centre for Aerospace & Security Studies (CASS), Islamabad, Pakistan. She can be reached at cass.thinkers@casstt.com.
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