Public debt is a vital tool employed by the government to bridge government financing gaps.

Effective and efficient utilization of public debt can increase economic growth and help a government to achieve its development and social objectives. Financing development related projects can help a country to build its production capacity and facilitate economic growth. In particular, borrowing from external sources enables a country to finance capital formation not only by mobilizing domestic savings but also by tapping into foreign capital surplus. Foreign borrowing can thus lead to more rapid growth. For example, foreign borrowing increased resource availability and contributed to economic growth in South Asian countries. Borrowing allows a country to invest and consume beyond the limit of current production, and can be conducive to economic growth. However, if the public debt is not efficiently managed than it imposes the biggest curse on the economy. It is basically a double edged sword. Excessive reliance on public debt and inappropriate public debt management raise macroeconomic risks, impede economic growth, and hinder economic development. Unfortunately, Pakistan was not as fortunate and efficient in managing and utilizing its debt as compared to other South Asian countries. There is a growing recognition in Pakistan of the macroeconomic consequences of high levels of public debt resulting from the cumulative impact of large and growing budget deficits and the affiliated needs for borrowing. The heavy burden of debt servicing on the budget has frequently been highlighted by government, media and concerned citizens. In recent years, it has emerged as the biggest claimant of public resources, even more than defense expenditure and outlays on development. The resulting resource squeeze has implied a cut back in expenditures on social development, economic infrastructure, subsidies, etc. In fact, there are concerns that the country is effectively caught in a 'debt trap' whereby a high existing level of outstanding debt implies a high level of interest payments which lead to a large budget deficit that has to be financed by correspondingly large borrowings which add to the debt and so on. The result is explosive growth in debt and budget deficits which creates fundamental macro economic imbalances and has a number of unfavorable consequences including the 'crowding out' of the private sector and a decline in private investment through rise in interest rates and/or a rise in the current account deficit in the balance of payments. Budget deficits can be financed in four ways; (i) borrowing domestically, (ii) borrowing abroad, (iii) running down foreign exchange reserves and (iv) by printing money. Each form of financing
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is associated with a major macroeconomic imbalance. Money printing is associated with inflation; foreign reserve use with the onset of an exchange crisis; foreign borrowing with an external debt crisis; and domestic borrowing with higher real interest rates and possibly explosive debt dynamics. In the case of high domestic borrowings also, the budget deficit eventually get monetized. This creates strong inflationary pressures on the economy and the possibility of hyper inflation. Inappropriate public debt management raises macroeconomic risks, impede economic growth, and hinder economic development. For example, high public debt demand can increase the domestic interest rate thereby crowding out private investment. An escalating external public debt stock increases the probability of default, raising the interest risk premium charged by creditors. High interest payments further enlarge a country's public debt obligations, accelerate budget outlays, and squeeze capital investment and social expenditure. In extreme cases, governments can be forced into defaulting on public debt, which tarnishes a country's reputation and makes further borrowing difficult. All of these actions are likely to precipitate capital flight and spark financial crisis.

This research project is aimed at finding the effects of public debt on the economy. Public debt becomes important due to Debt-GDP deficit which increases as the government spending continues and the tax collection ratio is lower than interest payments. Thus these debts accumulate over a period of time if budget deficit persists and become a major hurdle in development and economic stability. Even developed economies are trying to cope with increasing burden of public debt which is becoming a major economic threat. This makes public debt or internal debt as it is known an issue of great importance for economists all over the world and there is plethora of work available on this topic concerning both developed and developing countries. Effects of public debt on economy in relation with GDP, growth, inflation and interest rates have been analyzed by many researchers. Indermit S. Gill & Brian Pinto, (2005) focus on the effects of public debt as a factor that has increased macroeconomic vulnerability of developing countries more than it has helped in economic growth. They conducted this study with the help of a conceptual framework drawn from the growth, capital flows and crisis literature for developing countries with access to the international capital markets. Kemal Dervi & Nancy Birdsall, (2006) conducted their research on the structural, long-term debt problems that tend to keep the growth rates of High debt emerging markets low, that impart an bias to the growth process, that severely constrain social spending and human development, and that make them vulnerable to capital flow reversals. The increasing public debt causes hindrances in spending on social development and as it increases the societal gaps also increase leading to further lack of development of human capital. (Ozatay F. & Sahinbeyoglu G., (2004)) in their research paper Public Debt and Effects of News on Interest Rates state that economies which inherit a stock of high public debt, are prone to risks stemming from the past macroeconomic misbehavior, even if they start to implement sound macroeconomic policies. This bad track record renders these economies vulnerable to changes in market sentiment. Any news release that increase concerns about continuation of current sound policy framework is a candidate for such a change. (Willem Hendrik Buiter, (2005) focuses on the US economy and the issue of ever increasing public debt that affects the governments revenue generating potential in context of exhaustive government spending, low national savings rate and other macroeconomic problems created due to these debts. Gul, Adnan, (2008) studied the need, causes and implications of public. He highlights that the major implications of excessive public debt are sluggish economic growth, macroeconomic
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uncertainty, decreasing development, investment crowding out, inflation, higher unemployment, deteriorating social conditions and rising poverty causing economic destabilization which itself leads to destabilization of the state. He also emphasized on the need to ensure stability of these debts. Tirelli P., (2000) in his research paper Revisiting Public Debt and Inflation: Fiscal Implications of an Independent Central Banker argue that a trade-off exists between inflation and fiscal distortions, therefore challenging the view that monetary institutions should be designed to completely remove the inflation bias where fiscal policy is decentralised and each national policymaker retains some degree of flexibility in the use of debt policy, regardless of the Stability and Growth Pact. Pakistan is also faced with the problem of huge public Debt and the effects of this have been analyzed many Pakistani and foreign researchers. (Muhammad N. Hanif, 2002) examined the situation of public debt in Pakistan and issues related to its management. He analyzed that the main issues with public debt are mismanagement of these debts that leads to un-sustainability of these debts. He suggested that rescheduling and restructuring of these debts while ensuring investment, economic growth and improving our debt management process could offer a plausible solution to this problem. (Emma Xiaoqin Fan, 2007) in her report for Asian Development Bank analyzed the situation of public debt in Pakistan in the light of debt indicators reflected as economic growth, capital inflows, fiscal conditions and export earnings. She stressed upon the need for continued FDI and political stability in Pakistan to ensure sustainability of debt indicators as public debt situation is closely related to overall economic performance of the country. It is also essential for Pakistan to implement structural reforms and public debt management measures. She concluded that Pakistans economic growth and sustainability of public debt measures is closely related to the inflow of capital from FDI, exports and political stability.

Public debt is basically the indebtedness of a central government expressed in money terms, often referred to as national debt. Some authorities exclude all government obligations other than those incurred by public borrowing from individuals. Governments may borrow to meet temporary needs, as when estimated revenue falls below or is exceeded by estimated expenditures. Short-term treasury notes, payable by increased taxes or by greater economizing, may be issued, but such a debt should not become permanent. Borrowing to finance public works, especially when widespread unemployment exists, is another source of public debt and is justified in part by their long-term social utility. There are many theories related with public debt, taxes and government spending for development purposes. We have analyzed these theories in detail and are given below: Ricardian Equivalence: Ricardian Equivalence is an economic theory presented by English economist David Ricardo in early 1800s. The theory states that that when a government tries to stimulate demand by increasing debt-

financed government spending, demand remains unchanged. This is because the public will save its excess money in order to pay for future tax increases that will be initiated to pay off the debt. Therefore, regardless of how a government chooses to increase spending either by debt financing or tax financing, the outcome will be the same and demand will remain unchanged. The implications of this theory were later discussed by Robert Barro in 1974 in his paper, Are Government Bonds Net Wealth? The major assumptions of Ricardian theory are
o o o o The model is operating in a perfect market The Interest rates are fixed The government spending follows a straight path The tax raise to pay off debt taken by government may not occur for generations.

The Barro-Ricardo model assumes that individual action can undo the effects of Government policy and that the economy does not act in a mechanistic manner. Moreover the model shows that policies can have unintended consequences. This aspect of Ricardian theory is considered very important in modern macroeconomic theories. The major arguments against Ricardo's theory are due to the unrealistic assumptions on which the theory is based. Some of these assumptions are:

o o o

The assumptions of the existence of perfect capital markets The ability for individuals to borrow and save whenever they want. The assumption that individuals will be willing to save for a future tax increase even though they may not see it in their lifetimes.

The theory provided by Ricardo goes against the more popular theories provided by Keynesian economics.

Political Economy Theory by Marco Battaglini and Stephen Coate: A dynamic political economy theory of public spending, taxation, and debt was presented by Marco Battaglini and Stephen Coate. The theory builds on the well-known tax smoothing approach to fiscal policy pioneered by Robert Barro (1979). This approach predicts that governments will use budget surpluses and deficits as a buffer to prevent tax rates from changing too sharply. Thus, governments will run deficits in times of high government spending needs and surpluses when needs are low. Underlying the approach are the assumptions that governments are munificent, that government spending needs fluctuate over time, and that the deadweight costs of income taxes are a convex function of the tax rate. This theory assumes that policy choices are made by a legislature comprised of representatives elected by single-member, geographically defined districts. The legislature can raise revenues in two ways: via a proportional tax on labor income and by borrowing in the capital market. Borrowing takes the form of issuing risk-free one-period bonds. The legislature can also purchase bonds and use the interest earnings to help finance future public spending if it so chooses. Public revenues basically are used to finance the provision of a public good that benefits all citizens. The value of the public good to citizens is stochastic, reflecting shocks such as wars or natural disasters. The level of public debt acts as a state variable, creating a dynamic linkage across policymaking periods. This theory offers a number of advantages which are: o It allows for the possibility that the government can be in perpetual debt. o It provides predictions concerning the dynamics of legislative policymaking and on the mix of public spending between pork and public goods. o It provides a sharp account of how political decision making distorts public policies. o The theory permits a welfare analysis of fiscal restraints such as balanced budget rules.

A Positive Theory of Government Debt: Fernando M. Martin (March, 2009) presented this theory. According to him, a government that cannot commit to future policy choices faces a trade-off that explains the level of debt. On the one hand, there is an incentive to increase debt and delay taxation, so as to reduce current distortions. On the other hand, initiating current prices lowers the real value of nominal debt and so there is a motive to reduce it now. The size of long-run debt will depend on the interaction of these two opposing incentives. The critical determinant is the willingness of households to substitute away from goods being taxed by initiation. To understand what determines the level of debt, note that inflation has two effects, one distortive and the other non-distortive. Since inflation distorts the consumption of cash-goods, the government has an incentive to increase debt so as to reduce current distortions. On the other hand, inflation decreases the real value of nominal debt and thus reduces the financial burden. At any given level of debt, whether the government increases or decreases debt depends on which of the two effects dominates. As debt increases, so do the gains from reducing it, since the nondistortive effect gains weight. Thus, the long-run level of debt depends on how distortive the inflation tax is.

Pakistan entered the 21 Century with serious financial problems. Public debt exceeded 90% of its GDP, over 600% of its annual revenues, and debt servicing accounted for over half of current revenues. In 2001, Pakistan was the only country in South Asia to be classified as a severely indebted country by the World Bank. Historically Pakistan has faced a budget deficit in virtually every fiscal year since its conception in August 1947. Here we are going analyze Pakistans spending structure and its link to the different types of debt since the fiscal year 1980-81 as given in table. From 1980 to 1985 Pakistans spending almost doubled from 63.6 to 116.8 billion rupees. However it is critical to note that the development expenditure during this period only increased slightly from 25 billion to 33 billion. On the other hand the defense expenditure more than doubled. This is in part explained by the political turmoil faced by the country and also its security threats. At this point Pakistan was at the forefront of the cold war climax and was fighting the war in Afghanistan against Soviet Russia. The result was a 150 billion increase in total debt. From 1985 to 1989 the government spending moved from 116.8 billion to 201.2 billion. The influx of foreign aid did little to help the debt situation as it soared to 630 billion rupees. In fact during the Zia governments 11 years, the total debt grew at about an average of 17.7 % annually. One contribution to this was the costly non bank borrowing, e.g. from national saving schemes, and the ratio of debt to GDP kept rising. Interest payments on debt also rocketed to about 28 percent of revenues. The nineties marked Pakistans shift from dictatorship to elected governments. However this was not entirely a blessing as these governments did not seem very willing to reduce the fiscal gap. During the decade the expenditure from the government made steady progress and as compared to 260 billion in 1990, it stood at a healthy 709 billion in the year 2000. However on alarming fact during this decade is that development expenditure remained almost unchanged from 1992 to 1999 and in fact came down as compared to 1995. This was a clear signal that the quality of life deteriorated during this period and major parts of the spending went to non development expenditures. One important thing to be noted here is that Public debt causes increase in the interest expense which translates into reduction of the availability of funds for social development. The same is evident from Table which shows that due to debt accumulation
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interest payments are consistently increasing at the expense of decreasing development expenditure. It is difficult to visualize a self-sustained process of economic growth without human resource development, particularly without high levels of investment in education and health. The situation was worse during the 1990s period which resulted in low social development leading to low quality of life. While even in the period of high growth no solid development has been made to increase the quality of life of people of Pakistan. Even then the debt kept rising, clear indicator of poor economic performance. The twenty first centurys dawn saw Pakistan in serious trouble. Public debt was exceeding almost 90 % of the countrys annual GDP and over 600 % of its annual revenues. In 2001, Pakistan was the only country in South Asia which was classified as a severely indebted country by the World Bank in its report. Due to the inability to service external debt, there were several consecutive rounds of debt rescheduling by Paris Club members and one from the quasiLondon Club between 1998 and 2001. Fortunately though, Pakistan received massive financial breathing space because of its participation in the war on terror after September 2001. After the tensions of Kargil in 1999 dissolved, the defense expenditure dropped in the fiscal year 2000-01 although the tensions mounted again in the end of 2001 and since then the defense budget has been on the rise at a rapid pace. The development expenditure declined during the first year of the Musharraf regime from 95.6 billion rupees to 89.8 billion. However it took a great leap next year and went as high as 126 billion rupees and by 2004 it stood at 161 billion. The year 2001-2002 saw a great lift in the total government expenditure. However public debt was ever rising albeit at a slower rate during the early days of the new government. Domestic debt declined in 2002 after a long time but this was only a minor relief. During these times, the overall macroeconomic indicators improved and the government very keenly mentioned the accelerated GDP growth rate of the economy. Increase in public debt was largely in check and high growth in GDP meant that although public debt rose in absolute terms, the debt to GDP ratio experienced a sharp dip. From 81.4 % in 2002, this ratio dropped to a credible 56.1 % in the fiscal year of 2006. Both the external and domestic ratio to GDP also declined considerably. This was accounted for by the fact that both public and domestic debt in 2006 grew slower than the annual GDP in that fiscal year. In fact, FY2005/06 is
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the fifth successive year that the public debt to GDP ratio has improved. This is also the first time in more than two decades that the ratio has fallen below 60%. The Fiscal Responsibility and Debt Limitation Act, 2005 envisaged a debt to GDP ratio of 60% by FY13. The actual achievement has thus exceeded the target in the Act. The total expenditure accelerated from 2003 onwards and doubled in four years from 2003-2004 to 2007-2008. However interest payments that dropped in 2003 almost tripled in the next four years. In 2007-2008, the total public debt to GDP ratio increased significantly again. So it is fair to say that the improvements in the early parts of the decade have now started to wither away as the fiscal deficit is starting to widen one again. In 2008, Pakistans total debt stood at 6400 billion rupees which was almost equally shared by domestic and external debt. The total expenditure is at 1874 billion and has been rising consistently although development expenditure is only 26 per cent of the total spending which is a cause of concern. Public Debt and Social Development: Public debt also causes increase in the interest expense which translates into reduction of the availability of funds for social development. As depicted in table given in Appendix, debt accumulation is causing increase in interest payment which is at the expense of decrease in development expenditure. Many of the significant indicators of social and living standards in Pakistan have reportedly gone from bad to worst in the last 10-15 years. A study, the first of its type in Pakistan, was done to identify food timid segments in urban areas of Pakistan. The study declares 39 Districts extremely susceptible, 31 very vulnerable and 19 exposed to food insecurity. Slower growth in the economy reduces the employment generation capacity of the economy increased precautionary savings caused by higher uncertainty about future income may increase poverty due to reduced growth. The most important problem faced by the people of Pakistan is theirs absolute poverty. Low per capita income has also put the country among the poorest of the low-income nations in the world. According to the World Bank Reports, Pakistan is among the High Indebted Countries & Low Income Nations of the World. A bigger part of poverty in the country is due to low investments in the socio-economic uplift of the people at all levels. Due to the adverse effects of public debt on economy, the income generating capacity of a

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large number of the population has gone drastically down. The effects on the people have been devastating due to poverty. Debt and its affect on Foreign Exchange Reserves: When a nation is spending $ 2 to 3 billion on debt servicing out of total foreign exchange earnings of $ 7 to 8 billion so it had to go to with a begging bowl to borrow $ 3 to 4 billion every year. Pakistan sustained a current account deficit of 4 percent of GDP in the 80s, 4.5 per cent in the first half of the 90s and 5.2 per cent during 95-96 and 98-99. This is a huge number for a poor country like Pakistan. Naturally when a country sustains such a large gap in external accounts, it has to borrow to fill this gap. Pakistan's external debt and foreign exchange liability continued to raise, therefore, the country's debt carrying capacity started eroding. In 1980- 81, external debt liability as percentage of foreign exchange earnings was 147 per cent, by the end of the 80s it stood at 257 per cent. As we entered into the 90s, the debt burden deteriorated and by 98-99 it stood at 335 per cent. Credit rating in international capital market was at its lowest. No country or institution was ready to lend to Pakistan because of its fragile balance of payment position. External debt & liability as % of GDP which was 64% in 1999 decreased to 28.3% in 2006. And External debt & liability to foreign exchange earnings ratio which was 335% in 1999 decreased to 128% in 2006. However, this improving trend didnt last long External debt and liability situation has started further deteriorating. External debt & liability as a percentage of GDP has become 33.5%. It has shown a 20% increase in just one year. External debt & liability to foreign exchange reserve ratio has become 4.7, showing an increase of 57%. Interest payment as a percentage of foreign exchange earning has become 4.1%, depicting an increase of 28% since 2007. Public Debt and Inflation: Public debt consists of domestic and external debt. Government has different sources to obtain domestic debt i.e. Central bank, commercial banks and non banking financial resources. If the borrowing is done through central bank, than it results in the increase of money supply. It further results in excessive increase in demand which translates into inflation. This in the end makes the poor worst off who was already having difficulty in making the ends meet. The same thing has happened in Pakistan in the current period. In the last 4 years, government has obtained excessive debt from the State Bank. The absolute increase in domestic debt is more than Rs. 1 trillion which depicts an increase of 55% from 2004 to 2008. This increase has resulted in
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highest ever inflation rate for Pakistan. Pakistans overall annual inflation rate peaked at an alltime height of more than 24.3 per cent in July 2008 from about 21.5 per cent in June. Prices of non-perishable food items rose about 35.4 per cent year on year in July 2008 while those of perishable food items rose about 22.8 per cent. This has happened due to excessive borrowing from State bank to some extent along with cost push inflation all over the world.

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Recommendations A countrys economy cannot be analyzed solely on the basis of empirical economic figures. Diverse factors like Political stability, regional security situation and relations with global community have far reaching implications on a countrys economy especially a country like Pakistan which has large External and domestic debt and whose economy is closely tied to the good will of donor agencies and countries. In the light of above mentioned factors and the analysis done above, following recommendations are made: 1. Political, military and strategic stability must be ensured that is conducive to businesses and efforts must be made to stabilize the economy. Pakistan is a highly political unstable country, so we need democracy and sense of ownership in our leadership because their deeds, whether good or bad, will determine the direction of economy. We need balance of power between our major institutions like Judiciary, government and constitutional agencies. Similarly military personnel (Generals) should not participate in politics as long as situation is not out of control. A political unstable country will shake the investors trust and investment will show more resistant to invest in a country. 2. Efforts must be made to bring in FDI as it has a very positive impact of GDP and overall economy can also with the decrease of Debt to GDP ratio as happened in the years between 2004 and 2006. We can bring in more FDI by not letting the interest rate go up because if it goes up, it will shake the investors confidence and investor will be less willing to invest due to the high cost of capital. One way to do so is that the Govt. should not borrow from commercial banks because it will crowd out private investment. As the govt. will borrow from commercial private banks, interest rate will go up due to the high demand for money and it will negatively affect private investment. Another method by which we can increase FDI is by increasing public development investment. Since the private sector and public sector investments are harmonizing in nature, the decline in public sector investment also lead to decline in private sector investment. Here public sector investment means improvement of infrastructure like roads, buildings, telecommunication system etc. 3. In context of current Geopolitical and geostrategic scenario Pakistan should demand that all it external debts from US and its allied countries should be written off for its services
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in War on terror. We think that Pakistan is making a great sacrifice in its War on terror. There was huge external political pressure from America and its Western allies after 9/11 to help them which Pakistan responded positively, so we think that those countries should help Pakistan in overcoming economy barriers. These countries should not only write off debt but also give military assistance to Pakistan as Pakistan is in state of war after 200405 and its economy is not much strong to support defense related expenditure. 4. GDP growth rate should be kept higher than the increase in debt so that Debt to GDP ratio can be improved. We can improve GDP by increasing employment opportunities, improving and maintaining better infrastructure, educating more and more people by allocating more financial budget to education and increasing skill level of employees. If we focus on these factors, our GDP can improve and we will have more capability to service our debt. 5. In Pakistan from 80s and 90s more than half of the total revenues were consumed for debt servicing alone which forced the government to cut Public Sector Development Program (PSDP). The country's infrastructure, both physical and human, started deteriorating because allocation to these sectors were started declining as percentage of GDP. Development budget should be increased significantly to improve quality of life and quality of human resources for long term benefits for the economy. 6. In Pakistan, whenever govt. needs funds it went to Central bank which provided money in form of printing more money and increasing reserve money. Overall this increased the money supply and ultimately leads to increase in demand. This increased demand resulted in inflation which is one of the major problem of Pakistan. So in order to overcome this issue domestic borrowing from the Central Bank must be minimized by Govt. and efforts should be made be made to slowdown inflation growth rate. This rise in inflation makes the poor worst off who is already having difficulty in making his ends meet. 7. Market growth in physical terms i.e. industrialization and exports should be encouraged by reducing Tax and incentives for good performance instead of increasing market size only through financial instruments like Banking sector and interest rates. 8. Entrepreneurship and Small and medium enterprises with value added products should be promoted in the country.
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9. Emphasis should be made on developing human resource as Pakistan is highly populated country. We should promote labor intensive industries because our per capita income is low and this will improve overall situation of economy and reduce unemployment. 10. Being a developing economy it is inevitable to reduce internal and external borrowing, so what the government can do to improve the economic condition is to invest these borrowings for the growth of GDP, which in return would generate revenues to service the debt and finance development programs. 11. As sovereign governments service their debt by taxing firms and households, high levels of debt imply an increase in the economic sectors expected future tax burden. It leads to the Debt Overhang in which future debt burden is perceived to be so high that it acts as a disincentive to the current investment. Investor thinks that the proceeds of any new project will be taxed away service the pre-existing debt. A proper and well implemented tax program should be introduced so that the govt. can collect maximum tax from the public as well as private sector. I think there should be tax reforms for private sector investment so that we can encourage FDI. Conclusion: From the above analysis, we can say that public debt has played Havoc with the economy of Pakistan. We are going down socio-economically. The major factors contributing towards accumulation of debt are twin deficit that our country faces. Government need to finance its deficit which itself is a burden on the economy as the expenditure side further inclines due to rising interest expense. Our governments have not properly managed and planed to cut down its deficits due to which the gap between revenue and expenditure has increased, forcing the country to obtain more debt in each fiscal year. High level of public debt has held back the government to meet its macroeconomic objectives of economic growth, price stability and viable external and balance of payment. Finally we would suggest that Government must come up with policies and structural reforms to increase the revenue and lower its current expenditure. In addition to that, it must expertly plan the retirement of the existing debt along with managing the debt servicing. FDI should be encouraged so that more employment opportunities should be created. We have to the world that we are not a failed state.

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