4.1 Recommendations for Improving Fiscal Reporting and Transparency in Pakistan

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BOX 4.1 Recommendations for improving Fiscal Reporting and Transparency in Pakistan

Given Pakistan’s high debt ratio and general fiscal stress, more attention to monitoring and disclosing subnational fiscal risks is especially warranted. While provincial debt may be under control now, the lack of transparency elevates fiscal risks in the near and medium terms.

In addition to the general recommendations presented in this chapter, the federal government or the Controller General of Accounts could establish some standards about what is considered subnational public debt and mandate a format against which all provinces must report debt stocks. Provincial debt bulletins should provide a clearer breakdown of domestic and external debt figures, especially on (1) commodity financing; (2) debt to the federal government; (3) guarantees by type/sector of institution; and (4) type of creditors. Costs of debt should also be made explicit along with information on redemption schedules. To improve transparency, reporting should be made public on the websites of the province’s finance departments and as part of the Debt Policy Coordination Office’s (DPCO) publications. Eventually, standardized provincial debt databases should be institutionalized and aligned with the federal Debt Management and Financial Analysis System (DMFAS).

Pakistani provinces should also endeavor to identify and report on contingent liabilities by reporting on the number and total amount of guarantees explicitly issued to both private and public enterprises on a regular basis. Some discussion of implicit obligations (such as those embedded in contracts for public-private partnerships) should also be included, at least qualitatively, in provincial budget documents. The governments of Punjab and Sindh do this to some extent in their latest white papers on their respective budgets, but do not undertake systematic evaluations of such implicit contingent liabilities. Continuing to improve the functioning of provincial debt management offices and the coherence of debt management strategies would help provinces build the capacity to undertake such an assessment, and in doing so minimize the likelihood of unexpected contingent liability shocks in the future.a

a. All provinces except Balochistan have established debt management units.

excessive debt must obtain approval from the MFOC for all major revenue, expenditure, and borrowing decisions. The MFOC can also withhold transfers and recommend to the minister of local government that a municipality have its fiscal powers vested in a financial management board.

As subnational fiscal autonomy grows, countries should consider instituting robust guarantee management frameworks and policies. This involves adopting the necessary legislation for the issuance of guarantees, clear procedures for assessing and monitoring such guarantees, and ideally, a register of subnational guarantees maintained at the subnational level and/or central level. In India, state governments impose guarantee fees varying from 0.5 percent to 2 percent of the total guarantee amount, but this is often waived in practice (RBI 2019a). Although several states have limits on outstanding risk-weighted guarantees, in accordance with their fiscal responsibility legislation, it is important that the states (1) calculate these risk weights accurately; (2) undertake debt sustainability analysis on total public and publicly guaranteed debt; and (3) place limits on guarantees in relation to their credit risks.

Market Pricing

Markets play an important role in influencing the fiscal behavior of subnational governments. When access to debt markets and borrowing costs reflect the likelihood of fiscal stress, policy makers have an incentive to sustain fiscal discipline (de Groot, HolmHadulla, and Leiner-Killinger 2015). There is evidence, however, that this mechanism does not function effectively. In India, yields vary too little across states to reflect any fiscal

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metrics (Saggar and Adki 2017). Our analysis confirms that the response of borrowing costs to the breaches of fiscal rules is limited (figure 4.19). Similar findings in Canada and Germany have been linked to explicit and implicit promises of central bailouts (Schuknecht, Von Hagen, and Wolswijk 2009; Booth, Georgopoulos, and Hejazi 2007).

By contrast, evidence for the United States—whose 11th constitutional amendment prohibits subnational bailouts—shows a link between fiscal deficits and borrowing costs for states. It reinforces the evidence that explicit or implicit support from the center matters (Bayoumi, Goldstein, and Woglom 1995).

Allowing markets to function in South Asia requires the development of competitive sovereign bond and debt markets that accurately price risks. Market signals for subnational borrowing in India and Pakistan are significantly distorted because of (1) implicit guarantees of the central government on subnational debt; (2) on-lending of external debt by the central government that provides an explicit credit risk guarantee; and (3) in the case of India, the joint auctioning of state securities by the RBI that pools subnational fiscal risks across states.

In addition, markets do not price the (non-) transparency in the risk premiums of government bond spreads. Bernoth and Wolff (2008) show that in addition to the level of indebtedness, the increase in the “creative” part of fiscal policy and accounting is punished by markets across the European Union at the national level. Creative accounting should increase risk premiums because if a country is nontransparent, financial markets take gimmickry as a “tip of the iceberg” signal. One concerning result of Bernoth and Wolff’s analysis is that the disciplining force of markets may not work in a monetary union. This dovetails with our results for the subnational bond market in India and weakens the hope in market forces to help discipline the fiscal affairs of Indian states. Moreover, Heppke-Falk and Wolff (2008) find evidence of investor moral hazard even in the German subnational bond market in which the larger interest paymentsto-revenue ratio of SNGs counterintuitively lowers risk premiums. As values of the ratio increase, the risk premiums decrease more strongly because a larger ratio increases the likelihood of the SNG receiving a bailout.

Enhancing market signals could involve the following measures (IMF 2018):

• Improving the quality, coverage, and timeliness of data on states’ fiscal health.

For instance, in Brazil, SNG fiscal data on deficits and debt are available on a quarterly basis and disaggregated below the state level. States should also endeavor to provide more complete information on explicit and implicit contingent liabilities. • Adopting “no bailout” clauses in intergovernmental arrangements. In Spain, SNGs that miss fiscal targets may forfeit parts of their fiscal autonomy and are required to submit restructuring plans. Adopting similar measures in Indian states could make subnational fiscal responsibility laws more credible and catalyze reforms toward greater transparency and market discipline. • Lowering the statutory liquidity ratio requirement to further liberalize financial markets and improve bond market liquidity. More liquid markets are more efficient at pricing because of higher trades that mix the preferences of diverse market participants and, in turn, help discover correct prices more effectively.

Fiscal Capacity and the Intergovernmental Framework

The intergovernmental fiscal framework must address a tension between providing incentives and insurance to the subnational governments. On the one hand, higher reliance on central transfers can weaken accountability and impose a soft budget constraint, leading to inefficient spending and fiscal unsustainability. In India, for instance, states that depend more on central government revenues tend to have higher SNG debt (figure 4.20). This is consistent with the notion of a widely documented “flypaper effect,” which suggests that greater central grant allocation attracts greater SNG expenditure—sometimes above the sustainable level.30 On the other hand, fiscal capacity at the subnational level is