Pakistan debt sustainability hinges on fiscal reforms

ISLAMABAD: The Ministry of Finance has conducted a Debt Sustainability Analysis (DSA) for 2025-2027, examining six scenarios.

The analysis acknowledges persistent uncertainties stemming from high gross financing needs.

According to the DSA Report 2025-2027, the public and publicly guaranteed (PPG) debt-to-GDP ratio is projected to decline from 68.6 per cent in FY2025 to 66.6 per cent in FY2027. This reduction is attributed to fiscal consolidation and a favourable growth-interest rate differential, which contribute to a downward trajectory for the public debt-to-GDP ratio.

In the baseline scenario, the public debt-to-GDP ratio remains below the prudent benchmark, while the GFN-to-GDP ratio is expected to steadily decrease from 25.4 per cent in FY2025 to 19.5 per cent in FY2027. This indicates a moderate risk to debt dynamics over the medium term.

The analysis notes that debt dynamics are influenced by both external and domestic factors. “Despite improvements in debt dynamics over the medium term, public debt risks remain high,” the report states.

A heat map highlights the risks, showing that the debt-to-GDP ratio slightly exceeds thresholds in the baseline scenario (70.4 per cent in FY2024). The DSA sets benchmarks for emerging markets at 70 per cent for the public debt-to-GDP ratio and 15 per cent for the GFN-to-GDP ratio.

“However, the GFN-to-GDP ratio remains high in the baseline, indicating a risk to debt sustainability. Pakistan’s debt dynamics are further complicated by potential deviations in the federal primary balance, exchange rate depreciation, slower economic growth, and the emergence of contingent liabilities,” the report warns.

Key drivers of the increasing debt ratio and GFN include these risks, though improvements in quasi-fiscal operations, external financing requirements, and market access during the assessment period offer some relief.

The analysis highlights the limited capacity to absorb primary balance shocks. While baseline fiscal projections show a consistently improving primary balance due to fiscal consolidation and stable economic growth, limited fiscal space leaves room for unexpected shifts. For example, a 50 per cent reduction in the planned primary balance would raise the debt-to-GDP ratio to 69.4% in FY2027 but keep it sustainable in the medium term. Conversely, if the primary deficit reverts to its historical average (-1.6 per cent of GDP), the debt-to-GDP ratio would rise to 73.1 per cent, jeopardising sustainability.

Adverse events, such as significantly slower economic growth, could also worsen debt dynamics. A stress test indicates that a 1 per cent standard deviation shock to economic growth in FY2025 would push the debt-to-GDP ratio to 70.7 per cent by FY2027, undermining debt sustainability.

Real interest rate risks remain moderate. The high share of floating-rate domestic debt (74 per cent as of December 2023) makes domestic debt vulnerable to nominal interest rate shocks. These shocks could increase interest payments in the near term. However, the negative differential between real interest rates and growth helps moderate the impact of nominal interest rates on the debt-to-GDP ratio and GFN. In this scenario, the debt-to-GDP ratio would reach 68.1 per cent in FY2027, compared to 66.6 per cent under the baseline. The high proportion of external debt poses additional risks through exchange rate depreciation. While Pakistan’s capacity to repay external debt obligations is deemed adequate, risks arise from inadequate export receipts, rising imports, and current account balance deterioration. Stress analysis suggests that exchange rate depreciation could increase the debt-to-GDP ratio to 68.2 per cent by FY2027, compared to 66.6 per cent under the baseline.

In a combined macro-fiscal shock scenario, the PPG debt-to-GDP ratio would exceed the 70 per cent threshold, reaching 75.2 per cent in FY2027. Lower-than-expected economic growth, a rise in the federal primary deficit, higher interest rates, and exchange rate depreciation could significantly increase public debt and GFN as a percentage of GDP. These simultaneous shocks highlight the interaction between macroeconomic and fiscal factors, posing substantial risks to debt sustainability.

The analysis also underscores the vulnerability of public debt to rising contingent liabilities. In this scenario, the debt-to-GDP ratio would increase from 68.6 per cent in FY2025 to 72.8 per cent in FY2027. A reduction in the primary balance due to higher non-interest expenditures would further exacerbate public debt, with the GFN rising by 2.1 percentage points of GDP over the medium term, the report concludes.