Karachi, January 25, 2023 (PPI-OT): Ghana’s domestic debt restructuring and Pakistan

Concerns around Pakistan’s possible external debt restructuring are now expanding to domestic debt. We have received a number of queries, where ongoing Domestic Debt Restructuring Programme (DDRP) of Ghana has been of particular interest, where concerns extend to Pakistan banking sector which is the major holder of local government debt.

We highlight the key features of Ghana’s domestic debt restructuring and highlight that a direct replica of the same is unlikely in Pakistan given government’s dependence on banks and other mitigating factors. Having said that the possibility of the government extracting more out of the banks could take the familiar route of a higher tax rate.

Even assuming a corporate tax rate of 60% highlights that earning of banks would still be healthy and offer attractive valuation metrics. At long-term interest rates of 12% and higher effective tax rate, the sector would be generating a recurring Tier I ROE of 19%. The sensitized estimates project sector’s valuations at attractive levels with P/B of 0.5x, ~2.5x P/E and 15% D/Y.

Debt restructuring – will domestic debt escape untouched?

Amid Pakistan’s challenges on managing FX reserves and meeting upcoming external obligations, there has been a lot of discussion around possible external debt restructuring. The discussion is now expanding to domestic debt where we have received a number of queries on the same. The ongoing Domestic Debt Restructuring Programme (DDRP) of Ghana has been of particular interest to understand and whether a similar measure can be expected for Pakistan.

Ghana: Macro challenges choked debt payment capacity

Ghana defaulted on its external debt payments in Dec-2022. The financial crisis was led by pressures post COVID-19 and higher commodity prices combining with global monetary tightening. With government debt at 80%+ of GDP and debt-servicing cost equalling 68% of country’s revenues, the sharp LCY devaluation against US$ (+30% in the past six months) added to the burden. This not only led to declining investor confidence reflected in escalating international bond yields, but also limiting avenues of fresh FCY borrowing for Ghana.

Hence, Ghana approached IMF for financial assistance during 2022, reaching to Staff level agreement for a US$3bn program of three years in Dec-2022. The country, however, needs to deliver progress on debt restructuring before program can be presented to the IMF Executive Board for approval.

Modalities of Ghana’s domestic debt restructuring

Restructuring domestic debt as the first leg of the comprehensive debt operation, Ghana government has reached out to domestic bondholders, offering to volunteer a swap of the existing local bonds with new bonds. The new bonds would:

Hold a longer maturity, starting from 2027 and going up to 2037.

With no haircut on bonds, the interest structure offers 0% interest in 2023, 5% in 2024 and 10% from 2025 onwards.

The government has also placed some measures such as increasing risk-weight on the old bonds from 0% to 100%, eroding capital adequacies of the banking sector in Ghana, indirectly enforcing to opt for the new bonds.

Under the overall debt restructuring program, Ghana targets to bring its government debt to GDP down to 55% by 2028 (medium term).

However, no debtholder has so far stepped up to voluntarily accept the program, making the government extend the deadline twice. The current deadline is 30 January, 2023.

Parallels with Pakistan

The concerns from investors in Pakistan extend beyond macros and to banking sector as well. Given the banking sector contributes more than half to total domestic debt, investors are concerned over a similar program in Pakistan impacting banking sector’s profitability – especially in the backdrop of listed banking sector’s depressed multiples, that trades at sub 0.5x P/B for CY23E. Having said that, we brief over comparisons between Ghana and Pakistan.

Divergent domestic debt exposure of both countries

On the face of it, Pakistan lands under similar circumstances. Where domestic debt has reached 46% of GDP, its interest payment expense takes up 40% of the country’s revenue collection. On the external front, the debt mounts to 25% of GDP, out of which more than half pertain to bilateral and multilateral long-term loans (excluding IMF, Paris Club, Eurobonds and Commercial loans).

Pertaining to domestic debt, we highlight the difference in debt holder composition of both countries. Domestic debt holders in Ghana are diversified. While banks are largest holders, their exposure limits to 33% of the total bonds. Moreover, 9% of domestic bondholders are foreigners.

In comparison to that, Pak banks’ exposure to government domestic debt is 54%. Pak government pre-dominantly depends on the banking sector to broadly finance 60% of fiscal deficit every year through fresh government security investments, with remaining 40% through external sources, signifying the banking sector and its sustainability in the system.

Pak government likely to take other routes

Raising taxes

Keeping ‘sovereignty’ intact, we expect the government to opt for measures that would instead increase its tax base through higher taxes on the banking sector, rather than restructuring domestic govt debt. A 1% lower yield on existing government securities equates to ~3% additional taxes on sector’s profit before taxes. The impact may vary from bank to bank subject to asset allocation in federal government securities, which on an average is 45%.

Other corrective actions at a higher priority

We highlight IMF’s Staff report suggests Pakistan’s public debt remains sustainable over the medium term, uncertainty arises from challenging macros. Regarding domestic debt, the Fund places indicative targets around primary budget deficit and govt borrowing from SBP. We hence do not view Pakistan’s domestic debt scenario similar to Ghana’s as the Fund has been emphasizing over corrective measures in the energy sector, structural improvements in the fiscal space than measures over debt sustainability.

Increase in probability of contracting borrowing from SBP

Moreover, given restrictions on Pak govt’s borrowings from the State Bank of Pakistan (SBP) by the Fund, the govt also has limited options for local borrowings. The said restriction has led to banks expanding their balance sheet through leverage (borrowing from SBP through Repo Borrowings) and optimally avail opportunity of investments in federal government securities. With time, the banking sector’s borrowings have reached to ~Rs7.5trn (+20% of total asset base) with ~Rs6.5trn from Repo Borrowings. Any unfavourable change in yields of federal government securities would likely lead to winding up of the outstanding OMO, resulting in reducing SBP lending to banks and in turn lower availability of liquidity from the banking sector to finance govt’s fiscal deficit.

Objective of MDR can come under question

Pakistan’s banking sector at present is under the minimum deposit rate (MDR) regulation (conventional banks) where banks have to pay a minimum savings rate of Policy Rate – 1.5% (currently 15.5%) to all PLS saving accountholders (35% share in total deposits). As this regulation in a way makes banks share its spreads made on assets with deposit holders, any unfavourable change in investment yield, keeping savings rate unchanged, would likely lead to the sector calling for removal of the MDR regulation.

Analysing a worst-case scenario

In light of fiscal slippages and any extreme measure on banks regarding higher taxes, we present our earnings in the scenario of the sector being slapped with an effective tax rate of 60%.

To recall, sector’s CY23 effective tax rate reaches to ~45% (4% Super Tax + 39% Corporate Tax + some higher taxes on lower ADR levels). This would raise the government an additional Rs100bn per annum. For the sector, the measure would cut our estimated earnings by ~30%. Nonetheless, at long-term interest rates of 12% and 60% effective tax rate, the sector would be generating a recurring Tier I ROE of 19%. On revised estimates, the sector’s valuations still seem attractive with P/B of 0.5x, ~2.5x P/E and 15% D/Y.