Circular Debt in Pakistan

Moazzam Ali Shah

Fareesa Baig

Khizer Zulfiqar

Hammad Rizvi

Table of Contents

1. Introduction

2. Circular Debt in Pakistan

3. The Emergence of Circular Debt

4. Resolution of Circular Debt in Pakistan

IntroductionCircular debt is a situation in which a string of debtors and creditors exist in a fashion such that the net final creditor in the string is indebted to the first creditor. Every member is both a debtor and a creditor1.

Net Balance of Zero

A simplified form of a circular debt would involve, for example, three individuals. Individual A owes $100 to individual B. Individual B owes $100 to individual C. Individual C owes $100 to individual A. The net balance of all debts between the three individuals is zero.

Reconciled Positive Balance

Using a three person example, person A owes $100 to person B, who owes $50 to person C who owes $100 to person A. This circular debt may be reconciled such that C owes B $50 and the remaining debts are canceled.

Linear Debt Chains

In order for a circular debt to exist, there must be a closed loop between all parties. For example, party A owes party B and party B owes party C, but party C does not owe either A or B. This situation is sometimes incorrectly referred to as a circular debt, but is more properly termed a "linear debt chain" or a "linear chain of receivables."

Circular debt occurs when one entity facing problems in its cash inflows holds back payments to its suppliers and creditors. Thus, problems in the cash inflow of one entity cascade down to other segments of the payment chain. In Pakistan, the energy sector has faced this issue for several years. This has several implications for the economy, for example:

The resulting cash flow constraints have added to the operational inefficiencies of companies in the power sector. In some cases, power generation companies are operating below their capacity due to liquidity constraints.

The consequent increase in the power supply deficit has also contributed to supply-side constraints. Thus, it can be argued that the buildup of circular debt has led to a reduction in the potential gross domestic product (GDP) of the country. If this is true, any policy stimulus to growth could be less effective in terms of achieving the desired results.

The build-up of circular debt has led banks to accumulate alarmingly high exposures on the energy sector—outstanding credit to Pepco, independent power producers (IPPs) and Shell (oil marketing company [OMC]) stood at just over Rs485 billion at end-December 2009. To put this in perspective, banks’ outstanding credit to the textile sector—the largest industrial sector of the country—was Rs535 billion at end-December 2009.

Circular Debt becomes clearer with this example2:

It is raining, and the little town looks totally deserted. It is tough times, everybody is in debt, and everybody lives on credit.

Suddenly, a rich tourist comes to town... He enters the only hotel, lays a 1000 Rupees note on the reception counter, and goes

1 http://www.ehow.com/facts_7177074_definition-circular-debt.html

2 http://www.ehow.com/facts_7177074_definition-circular-debt.html

to inspect the rooms upstairs in order to choose one.

The hotel proprietor takes the 1000 rupees note and runs to pay his debt to the butcher. The butcher takes the 1000 rupees note, and runs to pay his debt to the farmer.

The farmer takes the 1000 rupees note, and runs to pay his debt to the supplier of his feed and fuel...

The supplier of feed and fuel takes the 1000 rupees note and runs to pay his debt to the town's grocery store that in these hard times, gave him "services" on credit.

The store owner runs to the hotel, and pays off his debt with the 1000 rupees note to the hotel proprietor to pay for the rooms that he rented when his wife asked him to leave the house.

The hotel proprietor then lays the 100 Euro note back on the counter so that the rich tourist will not suspect anything.

At that moment, the tourist comes down after inspecting the rooms, and takes his 1000 rupee note, after saying that he did not like any of the rooms, and leaves town.

No one earned anything. However, the whole town is now without debt, and looks to the future with a lot of optimism.....

Circular Debt in PakistanTo understand the circular debt situation in Pakistan, we need to look at the three major players in the scenario: The suppliers of primary energy and the power generation and distribution companies.

Suppliers of primary energy include oil gas exploration companies, oil refineries and oil and gas distribution companies. Whereas power generation companies include KESC, Independent Power producers, captive power producers, rental power producers, WAPDA Hydel and PEPCO. PEPCO is an umbrella institution managing generation, transmission and distribution companies. Around 90 percent of the power generation in the country falls under PEPCO’s area of influence.

Power consumers include individuals, industries and government sector. The circular debt in the energy sector is closely related to cash flow problems in PEPCO.

PEPCO collects tariffs from its consumer and subsidies from the government and pays to its suppliers (IPPs, OMCs and gas companies) for the procurement of power and fuel. PEPCOs tariff collection should be sufficient to meet the cost of energy supply, i.e inflows should meet outflows.

But it is not that simple, since outflows are certain as these are contractual in nature but inflows are uncertain. This means that inflows always lag behind outflows, and there is a basic cashflow imbalance faced by PEPCO.

PEPCO has the options to either use its own cashflows, avail financing or increase payables. PEPCO does maintain volumes of payables, but with rising oil prices in the international market and decline in inflows by the government, the liquidity constraints on PEPCO increased manifold because the consumers were not fully paying their tariffs.

The buildup of payments eventually led PEPCO to delay payments to its suppliers. They speeded into other segments of the

energy supply chain, the power generation companies, OMCs distribution companies and exploration companies.

The exploration companies and refineries used their own cash to finance the liquidity problems since they were at the top of the energy supply chain. This affected their expansion plans, which will have adverse consequences for the country’s ability to meet its energy needs going forward.

Furthermore, PEPCOs receivables act as an envelope for the maximum stock of circular debt.

The Emergence of Circular DebtThere are two main reasons for the buildup of circular debt:

1. End-consumer tariffs were insufficient to recover the rising costs of power generation, and the government, due to fiscal constraints, was not fully compensating PEPCO against the resulting losses3.

While all power tariffs are determined by the National Electric and Power Regulatory Authority (NEPRA), there is a difference in the way that tariff decisions are implemented for power generation companies and end consumers.

Specifically, tariffs for power generation companies are governed by power purchase agreements, which define the base tariff for power generation as well as the process for subsequent adjustments (e.g., against rising fuel costs, inflation, exchange rate changes, etc.). Thus, tariff revisions are automatically reflected in power purchase prices. NEPRA only validates the cost claims of power suppliers.

In the case of end-consumers, although NEPRA determines their tariffs, the government has a key role as these tariffs become legally binding only after being notified by the government. This severely limits NEPRA’s operational independence.

As a result of this weakness, we observed the following:

• During November 2003 to February 2007, end-consumer tariffs remained unchanged. This was because NEPRA did not allow any revision in tariffs despite requests from DISCOs.

• After February 2007, NEPRA allowed some upward revision in tariffs in response to the increase in the power purchase price. But the government-notified tariffs remained lower than those determined by NEPRA. This reflects the government’s reluctance to completely pass on the tariff increase to end-consumers. The difference between the tariff determined by NEPRA and finally notified by the government is the tariff differential subsidy paid to consumers.

On the other hand, tariffs for power suppliers (IPPs and GENCOs) continued to rise mainly due to rising fuel prices and the depreciating value of the rupee against the US dollar. As mentioned earlier, any adjustment in the power suppliers’ tariff does not require government approval to be effective.

This means that end-consumer tariffs were insufficient to recover the rising costs of power generation. The wedge between consumer tariffs and power purchase prices has been rising consistently.

Since the government was not fully compensating PEPCO against these losses, this wedge essentially shows the extent of loss that PEPCO incurred on each unit of power it supplied. Furthermore, electricity generation kept on increasing during this period, which magnified the cash flow problem for PEPCO.

2. PEPCO has also been facing problems in recovering dues from its consumers4.

3http://www.lahoreschoolofeconomics.edu.pk/JOURNAL/LJE%2015,%20SE/04%20Syed%20Sajid %20EDITED%20TTC%2011-10-10.pdf

4http://www.lahoreschoolofeconomics.edu.pk/JOURNAL/LJE%2015,%20SE/04%20Syed%20Sajid %20EDITED%20TTC%2011-10-10.pdf

Over time, PEPCO has developed significant dues from its consumers:

• Recovery of dues from FATA is very low. Similarly, a number of private individuals do not pay their monthly electricity bills.

• A number of departments in the federal and provincial governments have been delaying their payment of dues.

• There is a payment dispute between the KESC and PEPCO. These receivables increased sharply from 2006 onward. A major part of this rise is explained by private consumers where PEPCO can be most effective in terms of recovery of dues. This is an enforcement issue as some DISCOs are unable to improve recovery of their electricity bills from private consumers. In sum, PEPCO’s cash flows have thus been strained, since (a) end consumer tariffs were insufficient to recover the rising costs of power generation, and (b) the recovery of power tariffs was inadequate. In June 2006, PEPCO started borrowing from banks against government guarantees, mainly to compensate against the non-receipt of tariff subsidies from government—this is the point at which the circular debt issue emerged.

This was also when PEPCO started delaying payments to its suppliers. For example, in August 2006, PEPCO deferred its payments to IPPs initially for a few days, later extended to longer periods. As a result, IPPs began facing stress on their cash flows, which eventually forced them to borrow from the banking system in June 2007. In this way, problems in PEPCO’s cash flows cascaded down to other segments of the energy supply chain.

It may be noted that OMCs (e.g., PSO, Shell) were already facing a liquidity crunch in June 2007 as the government was delaying the settlement of price differential claims relating to fuel prices.

Thus the cash flow problem that started from PEPCO has impacted all players in the energy sector. Although the government has taken a number of remedial measures, according to our estimates, the size of circular debt by mid-January 2010 was around Rs. 150 billion.

Resolution of Circular Debt in PakistanThe strategy to resolve circular debt must focus not only on reducing the outstanding stock of circular debt but also on preventing its accumulation.

In order to reduce the outstanding stock of circular debt, the government created a power holding company in mid-2009. The purpose of this company was to acquire all debt created on PEPCO’s balance sheet due to delays in its receipts5.

As mentioned earlier, PEPCO had been borrowing from the banking system against government guarantees to offset the unpaid tariff subsidy claims. These bank borrowings were supplemented by the issuance of a term finance certificate (TFC) worth Rs. 80 billion in March 2009. Thus, by end-March 2009, the debt burden for PEPCO reached over Rs. 200 billion, which was acquired by the power holding company. This acquisition meant that the government settled the unpaid subsidy claims accrued up until June 2009. The power holding company issued another TFC worth Rs. 85 billion in September 2009. The proceeds from this TFC issuance were used to settle FATA claims of over Rs. 80 billion.

Since consumer tariffs have been insufficient to cover the cost of power generation, further build-up of circular debt cannot be avoided without sharp upward adjustment in power tariffs. According to reports, by end-June 2009, an immediate 24 percent increase in tariffs was required to cover the generation cost. The government, however, decided to stagger this increase into three phases of 6 percent in October 2009, 12 percent in January 2010, and 6 percent in April 2010. This delay in tariff adjustment translates into an increase in cost for PEPCO. In order to cover this increase in cost, the government allocated Rs. 55 billion in the FY2010 budget as subsidy for the power sector. Moreover, the government is allowing monthly adjustments in power tariffs so that changes in fuel price are passed on to consumers in a timely manner.

Despite these measures, the problem of circular debt still lingers on. This is because power consumption is still subsidized and the government does not have the fiscal space to explicitly recognize the cost of this subsidy in the budget. Indeed, political concerns are making it more difficult for the government to completely remove power subsidies. Furthermore, the policy choice is becoming more challenging owing to the possible existence of a Laffer curve in the power sector. Specifically, given that consumers are reluctant to pay their bills, and this tendency is increasing, there is a risk that going forward to a marginal increase in tariffs may result in a decline in revenue collection for PEPCO. The government would like to avoid this situation as this would reflect a complete breakdown of the social contract.

However, we must also understand that addressing the circular debt issue is important due to its adverse impacts on potential GDP. This is because liquidity constraints for entities in the energy sector have led to falls in power generation. The decline in power generation is quite peculiar. We believe this is a manifestation of circular debt as power generation companies are managing their cash flows by reducing their output. This means that by addressing the circular debt issue, we can restore a part of this loss in power generation. In fact it can be argued that to the extent that the power unavailability has increased supply constraints for the economy, the output gap has become more stringent for any policy stimulus to promote economic growth.

The decision of the government to privatize the management of the Generation companies not just betrays a weak diagnosis of the problem of circular debt but also overlooks the urgency to ensure continued provision of reliable power so that the economy remains a growing concern — the inefficiencies of Generation Companies is a relatively minor issue. The principle issue is poor governance, reflected in the sheer failure to weaken the control of powerful lobbies who continue to ride this gravy train while the rest of the population wrings its hands helplessly.

It is difficult to fathom how privatizing management of generation companies can solve the problem if electricity tariffs are not raised in a timely manner and government-managed DISCOs fail to prevent electricity theft or collect their bills regularly and

5http://www.lahoreschoolofeconomics.edu.pk/JOURNAL/LJE%2015,%20SE/04%20Syed%20Sajid %20EDITED%20TTC%2011-10-10.pdf

disconnect those not paying their bills i.e. take actions that will ensure cash flows to pay Generation Companies and suppliers of fuel regularly.

Moreover, with existing IPPs already issuing notices to the government that either their dues be paid or they will wind up their operation, it would not be a good advertisement for any entrepreneur seriously contemplating such an investment, unless he is foolhardy or knows something we don’t — the latter could be a situation in which he will get paid a minimum capacity payment without having to run the plant in the express knowledge that fuel, especially gas, would not be supplied.

So the correct solution is to either immediately privatize the management or ownership of DISCOs (under an appropriate regulatory framework) or hand them over to the provincial governments. The electricity can be supplied at the provincial borders for the provincial governments to purchase it from the Generation Companies and manage the DISCOs, thereby relieving Islamabad’s overstretched budget from the burden of this seemingly never-ending electricity subsidy.

The government should invest in alternate energy sources such as wind and solar power generation6. Also, loan swaps with commercial banks commercial banks might help ease the situation for the time being7.

The government is contemplating about issuing 70 billion rupees TFC against OGDCL reserves8, increasing the tariffs while decreasing the subsidies and investing in Thar coal.

6 http://www.nation.com.pk/pakistan-news-newspaper-daily-english-online/letters/06-May-2012/tariff-increase-and-circular-debt7 http://tribune.com.pk/story/376493/tackling-circular-debt-govt-to-issue-rs70b-term-finance-certificates/

8 http://tribune.com.pk/story/376493/tackling-circular-debt-govt-to-issue-rs70b-term-finance-certificates/