The direction of the State Bank of Pakistan (“the SBP”) to commercial banks (“banks”) regarding the applicability of International Financial Reporting Standards (IFRS-9) in respect of loans, securities, and guarantees of the Government of Pakistan has become operative with effect from January 1, 2022. Since IFRS-9’s initial issuance in 2019, an exemption till December 31, 2021 was given by the SBP to banks regarding the enforcement of IFRS-9 on the aforesaid classes of sovereign assets. As the SBP has not extended the stated exemption to commercial banks, it essentially means that the Government of Pakistan can default on its Pakistani rupee (domestic debt) obligations. In other words, the SBP has advised banks to start taking into account the probability of defaulting on sovereign loans taken by the government and, as a result, to make adequate provision in their financial statements for the potential loss on such sovereign lending. A belief that the government cannot default on domestic debt has been virtually buried.
Pakistan’s history of sovereign obligations
Since its inception in August 1947, Pakistan has never defaulted on any of its domestic debt, or obligations. Furthermore, barring the 1971 separation of East Pakistan, when a small default occurred on official bilateral debt, Pakistan had never defaulted on its “external debt”. With such a long history of impressive performance, it is curious as to why the SBP has chosen to require banks to make provisions for holding Pakistani rupee-denominated credit and securities of the federal government.
It is incomprehensible to suggest that Government of Pakistan, a sovereign state capable of printing its currency, would ever fail to fulfill its Pakistani rupee-denominated debt servicing obligations. Therefore, it makes no sense to deprive government loans and securities from the status of “risk-free” sovereign financial assets.
The SBP has not given any rationale for said change. The best explanation is its need to enforce IFRS-9. However, given that government loans and securities were subject to exemption until December 31, 2021, there has to be some basis for the withdrawal of such an exemption. This is a serious matter and the SBP should have consulted the Government of Pakistan before taking such a far-reaching step.
The foremost implication of excluding government loans and sovereign securities from the status of “risk-free financial assets” is the increase in the cost of borrowing for the government. Given that banks have been asked to make provisions in their balance sheets relating to the risk attached to such assets, their cost (interest/markup) of extending credits and investing in the government securities will automatically increase.
The SBP’s aforementioned actions would also have a negative effect on the ability of banks to extend an unlimited amount of loans and credits to the government as was in practice before the 1st of January, 2022. Regardless of prevailing interest rates, the banks would not be able to buy government debt beyond a threshold in the new scenario.
Consequently, it would be more expensive for the government to contract loans, issue bonds and sovereign paper. This will add further burden to already unsustainable debt-servicing and will also jack up the current high budget deficit.
Furthermore, the stature and ratings of the government credit and sovereign securities would take a hit. These financial assets may no longer attract creditors and investors in the same manner as was before this change.
The change is a clear signal to the financial markets that the government’s domestic obligations carry the risk of default and therefore these financial assets would lose their attraction despite being sovereign.
This development will also have an impact on the pricing of our external borrowing as, once country risk is established on domestic debt, it will have a natural bearing on the pricing of Pakistan’s foreign currency denominated sovereign debt. Recently Pakistan’s Sukuk has been priced at 7.95 percent, as opposed to a US-benchmark interest rate of 1.73 percent, which is the highest-ever profit rate on a Sukuk floated by the country.
It is intriguing that no reaction from the Ministry of Finance has been seen on such a major change by the SBP in public policy. This appears to be a decision taken by the SBP in pursuance of the so-called “autonomy” granted by Imran Khan’s cabinet through the approval of an amendment Bill to the State Bank of Pakistan Act 1956 that has been widely debated in the country. The way that the PTI government has recently bulldozed the aforementioned 2021 SBP Amendment Bill in the National Assembly, getting it passed last Friday in the Senate of Pakistan in an unprofessionally hurried manner, speaks volumes as to how much the PTI government cares about the financial sovereignty of Pakistan.
The enforcement of IFRS-9 with effect from January 1, 2022 has also strangely coincided with the prohibition, through amendment in the SBP law, on the Federal Government from borrowing from its own Central Bank. Keeping in view the serious ongoing financial crisis faced by the government, the afore-discussed action of the SBP is nothing but a serious unwarranted hit on the financial sovereignty of Pakistan.