A country dives into fiscal dominance when concerns about government debt start “dominating” everything else - like an autoimmune disease that starts attacking the body’s own organs.
Reduce unnecessary government spending, enhance tax collection, and restructure existing debt to manage financial obligations more effectively.
2. Pension Reform:
Fund pensions through sustainable contributions, cut future liabilities, and shift to more sustainable pension models.
3. Monetary Policy Independence:
Strengthen the central bank’s autonomy to set interest rates independently, focusing on inflation control and economic stability.
4. Revitalize Financial Sector:
Reduce mandatory government bond holdings by banks to minimize financial repression and encourage private sector lending.
5. Power Sector Reform:
Address inefficiencies, restructure debt, and reduce government guarantees. Publicize power sector agreements with Independent Power Producers (IPPs) to expose and address hidden costs, as IPPs receive payments even without generating power.
6. Build Confidence:
Improve governance, enhance transparency, reduce corruption, and implement broad economic reforms to restore investor confidence and stabilize the economy.
These actions aim to reduce fiscal dominance, improve public accountability, and restore economic control.
May I request your comments and thoughts on the solutions to cure the extreme case of Fiscal Dominance? Solutions are obvious but please share your thoughts on an action list using priority and stakeholder impact.
Understanding Fiscal Dominance and Its Consequences
Fiscal Dominance:
Fiscal dominance occurs when a country's economic policy is heavily influenced by the need to manage government debt. This situation undermines other economic functions, similar to how an autoimmune disease harms the body's organs. In fiscal dominance, the government's debt burden influences monetary policy, financial sector health, and overall economic stability.
Fiscal Dominance Impact:
1. Loss of Monetary Policy Independence:
- Central banks lose their ability to set interest rates independently because they are compelled to keep rates high to defend the currency and control inflation driven by excessive money printing.
- Reason: High debt levels create pressure to keep interest rates high to attract capital and maintain investor confidence. The central bank cannot lower rates to support economic growth without risking inflation or currency devaluation.
2. Strain on the Financial Sector:
- High interest rates, necessary due to fiscal dominance, burden the financial sector, reducing its ability to finance private investment.
- Governments often force financial institutions to buy government bonds (financial repression), diverting resources away from the private sector.
- Reason:
With a significant portion of their assets tied up in government bonds, banks and financial institutions have less capital available for lending to businesses, stifling growth.
3. Loss of Confidence and Economic Flight:
- A broader loss of confidence among investors and workers can trigger capital flight, as they no longer trust the country’s long-term financial stability.
- Reason:
Fear of economic collapse, hyperinflation, or currency depreciation drives investors to move their money abroad, exacerbating the country’s financial problems.
Pakistan’s Extreme Fiscal Dominance
1. High Debt Service to Revenue Ratio:
- Pakistan has an extraordinarily high debt service to revenue ratio, indicating a severe case of fiscal dominance. This ratio is even higher when considering unfunded pension liabilities for the military and civilian workforce.
- Reason:
Pakistan’s high debt service ratio reflects the heavy burden of interest payments on government debt relative to its revenue. The inclusion of unfunded pensions further strains public finances.
2. Impact of Interest Rate Hikes:
- During the 2022-24 crisis, the central bank had to raise interest rates sharply, worsening Pakistan’s debt service ratio. This rate hike was necessary to prevent further currency devaluation and inflation but had devastating effects on public finances.
- Reason:
Higher interest rates increase the cost of servicing existing debt, consuming a larger share of government revenue.
3. Zombie Power Sector Burden:
- Pakistan’s decision to guarantee the debts of its struggling power sector added another layer of fiscal burden. These guarantees mean that the government is liable for the sector’s debt, which effectively adds to the national debt.
- Reason:
By supporting the failing power sector, the government’s liabilities increase without corresponding revenue, deepening the fiscal dominance problem.
4. Systemic Risks and Self-Fulfilling Runs:
- The combination of domestic debt, external debt, unfunded pension liabilities, and the burden of the power sector has made Pakistan susceptible to self-fulfilling financial runs where fear of collapse accelerates actual collapse.
- Reason:
As confidence dwindles, more investors pull out, putting further pressure on the government to meet debt obligations with dwindling resources.
Full Solution to Address Fiscal Dominance:
1. Fiscal Consolidation and Debt Management:
- Reduce the overall debt burden through fiscal consolidation, which involves cutting unnecessary expenditures and improving tax collection efficiency.
- Restructure existing debt to more favorable terms, possibly seeking relief from international creditors.
2. Pension and Public Sector Reform:
- Implement reforms to ensure that pension liabilities are funded through contributions, not through borrowing.
- Modernize the pension system to reduce future liabilities, such as transitioning from defined-benefit to defined-contribution schemes.
3. Monetary Policy Reform:
- Strengthen the independence of the central bank to ensure that it can set monetary policy without undue pressure from fiscal authorities.
- Focus on controlling inflation through monetary measures rather than using interest rates solely to defend currency or debt levels.
4. Revitalize the Financial Sector:
- Reduce financial repression by limiting mandatory bond purchases by banks, allowing the financial sector to allocate capital more efficiently.
- Introduce measures to encourage private sector investment, such as improving the business climate and ensuring financial stability.
5. Restructure the Power Sector:
- Address inefficiencies in the power sector to reduce the need for government guarantees and bailouts.
- Implement reforms to improve the operational efficiency of power companies, reducing the fiscal burden.
6. Build Investor Confidence:
- Strengthen institutions to ensure transparency, reduce corruption, and improve governance.
- Develop a comprehensive economic reform package that addresses structural weaknesses, builds investor confidence, and stabilizes the economy.
Reason for the Situation:
The underlying reasons for Pakistan's extreme fiscal dominance are a combination of poor fiscal management, excessive borrowing, lack of structural reforms, and ineffective policy decisions. The government’s failure to manage public debt responsibly, reform pensions, and address inefficiencies in key sectors like energy has exacerbated fiscal vulnerabilities, pushing the country into a severe fiscal dominance trap.
Addressing these challenges requires a multi-faceted approach involving fiscal, monetary, and structural reforms to restore economic stability and regain control over national policy.
The main point is not that the government did not share the burden of civil and military employees pensions by asking them to make handsome contributions which should have been done, but because the pension funds were never separated and invested like a portfolio to earn the profits to pay pensions. These merely remained as a commitment on paper with no funds actually being invested as pension funds.
Ouch, I mean wow what a harsh realistic analysis. I was wondering while reading how this needs to be conveyed to the authorities in Pakistan but to whom I couldn’t figure out and most importantly whether it would make a difference now?
Many discussions around IPP (Independent Power Producer) contracts highlight concerns about sovereign guarantees. How can an international agreement not hold both parties accountable for meeting specific conditions necessary for the contract’s functionality? It’s puzzling that such contracts can remain legally binding without provisions for review, inspection, termination, or suspension. My impression is that no contract with malicious intent, where a state is deceived or deliberately exposed to financial risks, should be considered valid or enforceable.
Brief Solution
1. Fiscal Consolidation:
Reduce unnecessary government spending, enhance tax collection, and restructure existing debt to manage financial obligations more effectively.
2. Pension Reform:
Fund pensions through sustainable contributions, cut future liabilities, and shift to more sustainable pension models.
3. Monetary Policy Independence:
Strengthen the central bank’s autonomy to set interest rates independently, focusing on inflation control and economic stability.
4. Revitalize Financial Sector:
Reduce mandatory government bond holdings by banks to minimize financial repression and encourage private sector lending.
5. Power Sector Reform:
Address inefficiencies, restructure debt, and reduce government guarantees. Publicize power sector agreements with Independent Power Producers (IPPs) to expose and address hidden costs, as IPPs receive payments even without generating power.
6. Build Confidence:
Improve governance, enhance transparency, reduce corruption, and implement broad economic reforms to restore investor confidence and stabilize the economy.
These actions aim to reduce fiscal dominance, improve public accountability, and restore economic control.
May I request your comments and thoughts on the solutions to cure the extreme case of Fiscal Dominance? Solutions are obvious but please share your thoughts on an action list using priority and stakeholder impact.
Yes please. Even the solutions need to be spelled out for the average big wigs in the country and then some... Brilliant article!
I agree. And how default scenario plays out for others who may have gone down this path before us?
Dear Sir,
I have conducted a research on the title: Impact Of Direct And Indirect Taxes On Sustainability Of Pakistan Stock Exchange Listed Firms.
I concluded following 13 points in a cycle: Higher Taxes to Service the Debt:
https://kurdishstudies.net/menu-script/index.php/KS/article/view/3531
Understanding Fiscal Dominance and Its Consequences
Fiscal Dominance:
Fiscal dominance occurs when a country's economic policy is heavily influenced by the need to manage government debt. This situation undermines other economic functions, similar to how an autoimmune disease harms the body's organs. In fiscal dominance, the government's debt burden influences monetary policy, financial sector health, and overall economic stability.
Fiscal Dominance Impact:
1. Loss of Monetary Policy Independence:
- Central banks lose their ability to set interest rates independently because they are compelled to keep rates high to defend the currency and control inflation driven by excessive money printing.
- Reason: High debt levels create pressure to keep interest rates high to attract capital and maintain investor confidence. The central bank cannot lower rates to support economic growth without risking inflation or currency devaluation.
2. Strain on the Financial Sector:
- High interest rates, necessary due to fiscal dominance, burden the financial sector, reducing its ability to finance private investment.
- Governments often force financial institutions to buy government bonds (financial repression), diverting resources away from the private sector.
- Reason:
With a significant portion of their assets tied up in government bonds, banks and financial institutions have less capital available for lending to businesses, stifling growth.
3. Loss of Confidence and Economic Flight:
- A broader loss of confidence among investors and workers can trigger capital flight, as they no longer trust the country’s long-term financial stability.
- Reason:
Fear of economic collapse, hyperinflation, or currency depreciation drives investors to move their money abroad, exacerbating the country’s financial problems.
Pakistan’s Extreme Fiscal Dominance
1. High Debt Service to Revenue Ratio:
- Pakistan has an extraordinarily high debt service to revenue ratio, indicating a severe case of fiscal dominance. This ratio is even higher when considering unfunded pension liabilities for the military and civilian workforce.
- Reason:
Pakistan’s high debt service ratio reflects the heavy burden of interest payments on government debt relative to its revenue. The inclusion of unfunded pensions further strains public finances.
2. Impact of Interest Rate Hikes:
- During the 2022-24 crisis, the central bank had to raise interest rates sharply, worsening Pakistan’s debt service ratio. This rate hike was necessary to prevent further currency devaluation and inflation but had devastating effects on public finances.
- Reason:
Higher interest rates increase the cost of servicing existing debt, consuming a larger share of government revenue.
3. Zombie Power Sector Burden:
- Pakistan’s decision to guarantee the debts of its struggling power sector added another layer of fiscal burden. These guarantees mean that the government is liable for the sector’s debt, which effectively adds to the national debt.
- Reason:
By supporting the failing power sector, the government’s liabilities increase without corresponding revenue, deepening the fiscal dominance problem.
4. Systemic Risks and Self-Fulfilling Runs:
- The combination of domestic debt, external debt, unfunded pension liabilities, and the burden of the power sector has made Pakistan susceptible to self-fulfilling financial runs where fear of collapse accelerates actual collapse.
- Reason:
As confidence dwindles, more investors pull out, putting further pressure on the government to meet debt obligations with dwindling resources.
Full Solution to Address Fiscal Dominance:
1. Fiscal Consolidation and Debt Management:
- Reduce the overall debt burden through fiscal consolidation, which involves cutting unnecessary expenditures and improving tax collection efficiency.
- Restructure existing debt to more favorable terms, possibly seeking relief from international creditors.
2. Pension and Public Sector Reform:
- Implement reforms to ensure that pension liabilities are funded through contributions, not through borrowing.
- Modernize the pension system to reduce future liabilities, such as transitioning from defined-benefit to defined-contribution schemes.
3. Monetary Policy Reform:
- Strengthen the independence of the central bank to ensure that it can set monetary policy without undue pressure from fiscal authorities.
- Focus on controlling inflation through monetary measures rather than using interest rates solely to defend currency or debt levels.
4. Revitalize the Financial Sector:
- Reduce financial repression by limiting mandatory bond purchases by banks, allowing the financial sector to allocate capital more efficiently.
- Introduce measures to encourage private sector investment, such as improving the business climate and ensuring financial stability.
5. Restructure the Power Sector:
- Address inefficiencies in the power sector to reduce the need for government guarantees and bailouts.
- Implement reforms to improve the operational efficiency of power companies, reducing the fiscal burden.
6. Build Investor Confidence:
- Strengthen institutions to ensure transparency, reduce corruption, and improve governance.
- Develop a comprehensive economic reform package that addresses structural weaknesses, builds investor confidence, and stabilizes the economy.
Reason for the Situation:
The underlying reasons for Pakistan's extreme fiscal dominance are a combination of poor fiscal management, excessive borrowing, lack of structural reforms, and ineffective policy decisions. The government’s failure to manage public debt responsibly, reform pensions, and address inefficiencies in key sectors like energy has exacerbated fiscal vulnerabilities, pushing the country into a severe fiscal dominance trap.
Addressing these challenges requires a multi-faceted approach involving fiscal, monetary, and structural reforms to restore economic stability and regain control over national policy.
I would request, please write that how to cope the issue
The main point is not that the government did not share the burden of civil and military employees pensions by asking them to make handsome contributions which should have been done, but because the pension funds were never separated and invested like a portfolio to earn the profits to pay pensions. These merely remained as a commitment on paper with no funds actually being invested as pension funds.
Ouch, I mean wow what a harsh realistic analysis. I was wondering while reading how this needs to be conveyed to the authorities in Pakistan but to whom I couldn’t figure out and most importantly whether it would make a difference now?
Many discussions around IPP (Independent Power Producer) contracts highlight concerns about sovereign guarantees. How can an international agreement not hold both parties accountable for meeting specific conditions necessary for the contract’s functionality? It’s puzzling that such contracts can remain legally binding without provisions for review, inspection, termination, or suspension. My impression is that no contract with malicious intent, where a state is deceived or deliberately exposed to financial risks, should be considered valid or enforceable.