Domestic Debt Servicing: Pakistan's Rs. 7.3 Trillion Fiscal Constraint

The Debt-Servicing Spiral

Pakistan's public finances are caught in a historically rare bind: a government spending more than half its tax revenue before a single rupee reaches a school, hospital, or infrastructure project. In the federal budget for FY2025-26, interest payments on domestic debt alone are projected at Rs. 7.3 trillion — against a total federal tax revenue target of Rs. 12.97 trillion. That ratio, 56.8%, is not merely alarming; it is structurally corrosive.

To understand how Pakistan arrived here, one must trace the compounding logic of debt-upon-debt. Throughout the 2019-2024 period, successive governments financed fiscal deficits primarily through short-term domestic borrowing — Treasury Bills (T-Bills) rolled over quarterly. When global commodity shocks and currency depreciation drove inflation above 38% in May 2023, the State Bank of Pakistan (SBP) responded by hiking the policy rate to a record 22%. This transmitted directly into the cost of rolling over existing debt, creating a feedback loop: higher rates increased servicing costs, which widened the deficit, which required more borrowing, which increased debt further.

"When a government spends over half its revenue on interest payments, it is not governing — it is treading water. Every rupee that goes to creditors is a rupee that does not build a school."

The IMF's Extended Fund Facility (EFF), approved in July 2024 for SDR 5.32 billion, explicitly identified domestic debt management as a critical vulnerability. The Fund's Article IV consultation noted that the bunched maturity profile of T-Bills creates rollover risk, while the high policy rate — essential for inflation control — simultaneously maximises servicing costs.

The Anatomy of Pakistan's Domestic Debt

Pakistan's domestic debt of Rs. 42.4 trillion (end-FY25) is held across three primary instruments: Market Treasury Bills (MTBs), Pakistan Investment Bonds (PIBs), and Government of Pakistan Ijara Sukuk (Islamic bonds). The composition of this debt is critical to understanding the servicing burden — and why structural reform remains so difficult.

The dominance of PIBs — long-duration fixed-rate bonds — means the government is locked into high coupons for 3 to 10 year horizons. Unlike the short-term rollover risk of T-Bills, PIBs create a persistent, predictable drain on the fiscal account. The average weighted yield on outstanding PIBs is estimated at 14.2%, meaning the PIB portfolio alone generates annual interest payments of approximately Rs. 2.65 trillion.

T-Bills, while shorter duration, carry their own risk: they must be rolled over frequently (typically 3 to 12 months), and each rollover prices at prevailing market rates. With interbank yields for 3-month T-Bills hovering between 21-22.5% through FY24, the servicing cost of this tranche surged dramatically. Only the SBP's monetary easing cycle — which began in June 2024 and has brought the policy rate down from 22% to 17% as of early FY26 — offers any near-term relief.

The Crowding-Out Effect on Development

The fiscal cost of debt servicing is not merely numerical — it has direct, measurable consequences for Pakistan's developmental capacity. The PSDP (Public Sector Development Programme), the federal government's primary vehicle for infrastructure and human capital investment, has been systematically compressed as a share of total expenditure over the past five years.

The data reveals a stark trajectory: PSDP as a proportion of total expenditure collapsed from 10.6% in FY21 to just 5.9% in FY24-25, even as the government nominally increased development allocations in rupee terms. Inflation-adjusted, real development spending declined sharply. The FY26 budget's promise of Rs. 1.59 trillion for PSDP represents a recovery, but remains contingent on revenue performance that has historically underperformed targets by 10-15%.

"The compression of PSDP is not a policy choice — it is the arithmetic consequence of a debt-servicing burden that leaves no fiscal space for discretion."

The Policy Rate Dilemma

The SBP's monetary policy stance sits at the heart of the debt-servicing crisis. While the rate-hike cycle that began in September 2021 was necessary — even if delayed — to contain an inflation spiral driven by energy price shocks, currency depreciation, and commodity price surges, its fiscal collateral damage was severe. Each 100 basis point increase in the policy rate added approximately Rs. 120-150 billion annually to the government's floating-rate debt servicing costs.

The chart above illustrates the key dynamic: as the SBP began cutting rates in June 2024 (from 22% to 17% by early FY26), CPI inflation simultaneously moderated from a peak of 38.4% (May 2023) to approximately 11.8% by May 2026. This real positive interest rate environment — where policy rate exceeds inflation — is essential for SBP's credibility but means debt servicing costs decline only with a significant lag, as new borrowing reprices while existing PIBs hold their high coupons.

The Path Forward: Debt Management Priorities

Pakistan's Debt Management Office (DMO) within the Ministry of Finance has outlined a medium-term strategy focused on three pillars: (1) extending the average maturity of domestic debt to reduce rollover risk; (2) developing the capital market to introduce new instruments (inflation-indexed bonds, infrastructure bonds); and (3) achieving the primary surplus targets required under the IMF EFF to stop the debt-to-GDP ratio from rising further.

The primary surplus — a situation where revenues exceed non-interest expenditures — is the key metric. Pakistan achieved a primary surplus of approximately 1.7% of GDP in FY25, a significant structural improvement. Maintaining this requires sustained revenue mobilisation through FBR tax reforms and expenditure discipline on the current side. The FY26 budget projects a primary surplus of 2.0% of GDP, though this assumes a revenue target of Rs. 12.97 trillion that many economists consider ambitious.

The structural solution to Pakistan's debt burden is not monetary — it is fiscal. Only by broadening the tax base (from 3.2% to at least 8-10% of GDP), rationalising loss-making SOEs that generate contingent liabilities, and systematically redirecting spending from consumption to investment can Pakistan break the debt-servicing spiral. These reforms require sustained political will across electoral cycles — historically Pakistan's most scarce fiscal resource.