Pakistan budget deficit 2020/2021: Understated
By using innovative payment structures and creative accounting, GoP will be understating the 2020/2021 budget deficit by 0.2% to 0.3%
Working in credit and corporate finance, I have kept myself abreast of accounting shenanigans that businesses engage in to manipulate their financial position. It was news to me that sovereign countries also use accounting tricks, derivates and creative payment structures to manipulate their financial position, mainly fiscal deficit and debt/GDP ratio.
Fiscal deficit, a government accounting concept, results when the revenues of the government are less than its expenses. It is similar to a loss in the income statement of a business when revenues of the business are less than its expenses. Businesses can finance such expenses by taking on debt, which may be reflected in the balance sheet. Occasionally businesses engage in off-balance-sheet transactions wherein such debts aren’t reflected on the balance sheet of the company. I never realized that countries can also engage in this practice.
Pakistan’s finance minister Abdul Hafeez Shaikh recently proposed an innovative payment structure for paying off the circular debt of the 47 IPPs that signed the MoU with the government. The total payment to be made is Rs.450 billion and two-thirds of it will be made in the form of 10-year floating Pakistan Investment Bonds (PIBs). The finance minister stated paying down debt in this manner (2/3 payment in the form of PIBs) will enable the Government of Pakistan to remain within the fiscal constraints set by the IMF. I covered this in my blogpost Moving the goal posts: An "Innovative" Payment Structure
From hypothetical Income Statement (IS) ie fiscal budget perspective it [payment in PIBs] is an accounting trick. If PIBs were auctioned and actual cash paid, the payment would have been reflected in the budget expense side thus increasing the budget deficit. IMF has presumably set a ceiling for the deficit. By skipping a step of auctioning PIBs, we are avoiding recognizing the expense in the budget, an accounting gimmick at best.
I love how it all boils down to accounting tricks with finance ministers whether they are chartered accountants or IMF pedigreed economists.
The Government of Pakistan will be understating its budget deficit by Rs.300 billion[1] by paying two-third of the Rs.450 billion payment in PIBs, Rs.200 billion in the 2020/2021 fiscal budget, and Rs.100 billion in 2021/2022 fiscal budget.
Are there specific standards that the Ministry of Finance follows that allows it to not recognize certain expenses in budgetary expenses of a year? For businesses, International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP) determine what can be accounted for off-balance-sheet. The auditors, if audited statements are prepared, act as an independent third party to ensure that proper accounting standards are followed in recording or not-recording such a liability. But national accounts of a country are not audited by independent third parties. The closest sovereign countries come to having their accounts reviewed is when a country issues internationally rated bonds and has its financial position reviewed by international credit rating agencies or if the country reaches out to IMF for assistance.
IFRS allows operating leases to be accounted for off-balance-sheet. The operating lease liability is off-balance sheet while the current year's leasing expense is recognized in the income statement[2]. The operating lease expense is recognized in Income Statement when the expense is incurred regardless if it is paid or not.
The government of Pakistan has Rs. 2 trillion circular debt liability outstanding. The expenses that resulted in this liability have already been incurred but are not recognized in the budget deficit. Such expenses will only be recognized when they are paid for in cash. If these expenses are settled by handing over PIBs, these will never be recognized in the budget deficit. It was a revelation for me (I had never followed national accounts) that circular debt is does not appear in national debt statistics despite the fact that it is a liability of the government. This has been the standard practice since the circular debt exists. Presumably, IMF and international credit agencies are on board with this arrangement or at least, are aware of this practice.
In addition, as per recent news, there are additional expenses that are being kept off the books
The federal budget deficit soared to nearly Rs1 trillion in the first five months of current fiscal year, which was largely in line with the annual budget target due to a continued squeeze on defence and development spending and keeping some expenditures off the books.
They said the finance ministry did not fully pay electricity subsidies and a significant amount remained unpaid, which was added to the circular debt during the period under review. Had the power subsidies been fully paid, the federal budget deficit could have been close to Rs1.1 trillion.
The total amount (off-book expenditures as well as unpaid subsidies) that the news item is referring to are approximately Rs.165 billion. Thus as per the information available to date, the budget deficit for 2020/2021 will be understated by at least Rs.465 billion.
IMF appears OK with this arrangement as this isn’t a national secret. Why would IMF be ok with such accounting gimmickry? My hypothesis is that IMF has provided financing to Pakistan under a program and it is in the interest of the IMF team that it appears Pakistan is making progress. If the program is halted because Pakistan fails to meet one threshold, IMF may have to put the program on hold and no one wants that.
What about the PIBs increasing the national debt? It turns out that multilateral agencies care more about budget deficits than the national debt. This was the case when Italy and Greece joined the EU. EU had a specified ceiling for both budget deficit and debt-to-GDP, but budget-deficit to GDP was the metric EU cared about. Both Italy and Greece engaged in derivatives transactions masking their true financial position to meet EU’s criteria.
Intended to rein in fiscal profligacy among aspiring eurozone entrants, the Stability and Growth Pact (SGP) – established in 1996 – sets two important targets for member states: a debt/GDP ratio of less than 60% and a deficit/GDP ratio of less than 3%. Of the two, the second is considered more important.
With the help of JPMorgan, Italy was able to do more than that. Despite persistently high deficits, a 1996 derivative helped bring Italy’s budget into line by swapping currency with JPMorgan at a favorable exchange rate, effectively putting more money in the government’s hands. In return, Italy committed to future payments that were not booked as liabilities.
In dozens of deals across the Continent, banks provided cash upfront in return for government payments in the future, with those liabilities then left off the books.
Critics say that such deals, because they are not recorded as loans, mislead investors and regulators about the depth of a country’s liabilities.
For all the benefits of uniting Europe with one currency, the birth of the euro came with an original sin: countries like Italy and Greece entered the monetary union with bigger deficits than the ones permitted under the treaty that created the currency. Rather than raise taxes or reduce spending, however, these governments artificially reduced their deficits with derivatives.
The budget deficit is what the EU was focusing on.
All the political emphasis in the run-up to joining the single currency was on Italy meeting the deficit criteria and showing a move towards reducing its debt. In the end, it failed to do this - the country's debt grew to 120% of GDP in 1999, without causing Italy too many problems with the EU. But it did manage to reduce its deficit to meet the 3% target, though only just, with three months to spare, and this could have meant the difference between being able to join the eurozone or, like Greece, being forced to wait.
According to sources, the cross-currency swaps transacted by Goldman for Greece’s public debt division were ‘off-market’ – the spot exchange rate was not used for re-denominating the notional of the foreign currency debt. Instead, a weaker level of euro versus dollar or yen was used in the contracts, resulting in a mismatch between the domestic and foreign currency swap notionals. The effect of this was to create an upfront payment by Goldman to Greece at inception, and an increased stream of interest payments to Greece during the lifetime of the swap. Goldman would recoup these non-standard cashflows at maturity, receiving a large ‘balloon’ cash payment from Greece. Effectively, Goldman Sachs was extending a long-dated illiquid loan to its client. [3]
Greece took it to a different level.
"Take the Greek state railway. It was losing a billion euros a year," Ms Xafa remembers.
"The Greek railway had more employees than passengers. A former minister, Stefanos Manos, had said publicly at the time that it would be cheaper to send everyone by taxi."
The authorities used a neat conjuring trick to make the problem vanish.
"The [railway] company would issue shares that the government would buy. So it was counted not as expenditure, but as a financial transaction."
And it did not appear on the budget balance sheet.
So Greece fulfilled the Maastricht criteria and was admitted to the eurozone on January 1, 2001 - but by 2004 the deception was becoming transparent.
Both Italy in 1996 and Greece in 2002 entered the Eurozone by masking their real budget deficits. Greece’s budet deficit was 1.2% of GDP in 2002 and debt/gdp at 104.9% as per the national accounts. EU cared more about the budget deficit than the debt to GDP. Similarly, IMF is fine with making the payment in PIBs as it will enable Pakistan to remain within the IMF constraints of budget deficit despite the fact that debt/GDP number will soar.
SBP governor has already told the nation that it will hear the 'Good news' soon for markets about restarting IMF programme.
Pakistan is in talks with the International Monetary Fund (IMF) to put the fiscal support programme back on track, State Bank of Pakistan Governor Dr Reza Baqir said on Monday, adding that he was optimistic about the economic outlook despite the fallout from the coronavirus pandemic.
With dwindling foreign exchange reserves and a struggling economy, Pakistan entered a three-year $6 billion IMF bailout programme in 2019, but is yet to have its second review approved, which has been pending since early last year.
“We hope to have good news for the market and the world that we are putting the programme back on track,” Baqir said in an interview on Monday at the Reuters Next conference.
Dr. Hafiz Pasha reviewed forecasts of SBP and IMF with respect to various economic metrics. He has this to say with respect to the budget deficit forecasts.
There is also considerable uncertainty about the budgetary outcome in 2020-21. The SBP projection of the deficit from 6.5 percent to 7.5 percent of the GDP is also optimistic. Tax revenues have shown a growth rate of 5 percent in the first six months and the growth rate will have to approach 45 percent in the last six months if the annual target is to be achieved. There will no doubt be an upsurge in the growth rate from February 2021 onwards because revenues plummeted by 16 percent in the last four months of 2019-20 after COVID-19. However, a 45 percent growth rate is very unlikely. There could be a shortfall in FBR revenues of almost Rs 500 billion. Similarly, the revenues from petroleum levy could be smaller than budgeted because the tax rate is being brought down to reduce the impact of rising import prices of petroleum products.
There are also likely to be some higher expenditures than budgeted. Debt servicing has increased by as much as 29 percent in the first quarter as compared to the budgeted growth rate of 12 percent. Similarly, following the second COVID-19 attack, there may be need for more relief expenditures. Further, some of the power sector circular debt liabilities may have be met from the Federal budget, as happened in 2012-13. Overall, the shortfall in revenues and the spillover in expenditures could take the budget deficit back to the level of 8 percent to 9 percent of the GDP as in the last two years.
We still have around five and a half months to go till the fiscal year end. In all the aforementioned forecasts, it depends whether the Rs.465 billion of unaccounted for expenses are included. If not, the fiscal deficit forecasts are understating the budget deficit by 0.2%-0.3%.
This is not a criticism of this policy. I didn't know that this is how government accounting works so I am just documenting my learning.
Footnotes
In the budget, PIBs are reported under bank borrowing on the RECEIPTS side. When the government auctions PIBs, the primary buyers are usually banks and funds raised appear as receipts. To balance both sides of the budget, the government has to make a matching entry recognizing the paid circular debt as expenditure. This results in an increase in the budget deficit. If PIBs are handed over to IPPs without auctioning, there will be no bank borrowing, the government will not have to recognize the expenditure and thus budget deficit is understated.
The notes to the financial statements do show the present value of the operating lease liabilities.
The below explanation is the best I have found for the Greek deal
Suppose I'm a Greek company that makes money in Euros. However, I need to borrow money to build a new factory or whatever, and I can only borrow what I need, or borrow at affordable interest rates, by selling bonds denominated in US dollars (because that's what my investors want). Also assume that the exchange rate is EUR 1 = USD 1.50.
I'm now exposed to currency risk, because today, if I want to make an interest payment on the loan of USD 1, it costs me EUR 0.67 - but if interest rates move, say to EUR 1 = USD 1, then tomorrow that same interest payment of USD 1 will cost me EUR 1 out of pocket - my costs have increased in terms of my EUR cashflows. But if the opposite happens: the exchange rate falls to EUR 1 = USD 2. Then my interest payment is only equivalent to EUR 0.50, so I'm paying less out of pocket.
Anyway, I don't want to deal with this currency risk, so I decide to lock in my exchange rate at 1.50 USD/EUR by entering into a cross-currency swap with Goldman Sachs. Every interest payment date, I pay them EUR 0.67 and they pay me USD 1, and I use that to pay interest on the debt.
On day 1, that swap has no "mark-to-market" value, because the swap rate is the same as the spot rate in the market. But if the spot rate moves, the contract becomes valuable to either me or to Goldman Sachs because one of us is paying more than we'd have to if we were exchanging currencies at the spot rate and the other is paying less.
BUT: if you enter into the swap at an exchange rate that is NOT the spot rate in the market, it will have a mark-to-market value on day 1. And so the party that's "in the money" will have to buy the swap by making an upfront cash payment to party that was out of the money (because otherwise, why would they enter into it?). That's not a windfall to the other party, though, because the party out of the money is paying out more over time than it would if the swap were struck at the spot rate.
For example: if the spot rate was 1.50 USD/EUR on the day the swap was entered, but we struck the deal at 1 USD/EUR. You pay me USD 1, I pay you EUR 1, you take your EUR 1 to the bank and exchange it for USD 1.50 - presto, you've made USD 0.50. Why did I agree to do that? Because you paid me some amount of money up front for the extra value you're getting.
So how does that relate to Greece and GS? Greece sold these out-of-the-money swaps to GS, receiving a bunch of cash on day 1 that it could then use to reduce its official national debt that was reported - the figures that were used to determine eligibility for EU membership. They still had that debt, in essence, since they had to make a higher stream of payments to GS over time - you could look at it as an amortizing loan that GS made to Greece. But the key difference is that THIS implicit debt was one that didn't get reported in the official national debt figures.