Monday, January 3, 2011

Circular debt: Why the free market must replace stopgap measures

Circular debt: Why the free market must replace stopgap measures

 It is an open secret that the root of the energy crisis in the country lies in underutilisation of installed power generation capacity at oil-based power plants.

Power producers have stopped short of running on full capacity due to burgeoning default in payments by consumers. This default has fed itself as the main supply chain of furnace oil – Pakistan State Oil (PSO) – has choked, bringing it on the verge of default on account of impending payments for imported furnace oil, as well as oil purchased from other refineries.

This vicious cycle is more popularly known as ‘circular debt’, appropriately named because of its self-feeding nature.
Pakistan depends on imported oil to meet one-third of its energy demands. These imports are made by the refineries, Pak Arab Refinery Limited (Parco) for example, in the form of crude oil or by PSO in the form of furnace oil.

PSO, after purchasing from refineries or international suppliers, sells the oil to power producers, who then eventually sell electricity to distribution companies such as Karachi Electric Supply Company (KESC) or Pakistan Electric Power Company (Pepco). We end up buying electricity from these distribution companies.
Our payments are channelled backwards the same way: from distribution companies to producers to oil suppliers. Circular debt is created when this cycle is broken at any stage. Usually, this happens when some of us do not pay our share of electricity consumed.

Here ‘we’ includes residential and non-residential consumers, the latter being further divided into government bodies and commercial bodies. The KESC, for instance, has taken refuge for defaults by citing non-payments by the Sindh government.

It’s not that simple
Indeed this scenario has been simplified for the sake of understanding. As they say, there is a neat and simple solution for every problem. This is incorrect, at least in this case.
Along these lines, our government and policymakers have resorted to stopgap measures – swap the circular debt with new bonds, federal government guarantees or loans. This solution may be simple, but is hardly permanent. It has merely created a wedge between present and future by ducking in the face of tough choices.

This is the equivalent of saying to highly leveraged companies: don’t worry if KESC, a provincial government or state-owned enterprise does not pay its bills, we will ‘create’ more money and pay on their behalf. We cannot print money (international donors such as the International Monetary Fund do not allow that), but we sure can borrow from the banks.

As simple as it may sound, unfortunately this is how government has been tackling the problem of swelling circular debt.

At the beginning of the current fiscal year, circular debt stood at around Rs180 billion – roughly one per cent of the gross domestic product (GDP). Leading defaulters include the KESC and provincial governments of Khyber-Pakhtunkhwa and Sindh.

The list of accused should also include the now defunct Pepco, which failed to close in the revenue-expenditure gap, despite a hefty 100 per cent rise in the electricity tariffs in less than two years.
Neither can PSO be given a clean bill as it is the only company that provides oil on credit. No privately owned company can dare to afford such facilities to risky customers. A privately owned company does not write request letters to the ministry of finance or the prime minister pleading government intervention. When faced with ‘bad’ customers, it resorts to the courts or restructures and cancels the contracts.

The solution
Our analysts, just like government, have found an easy solution to the problem in the form of calls for honest leadership. The fault lies not with any leader, it is in our statist approach and the assumption that ‘goodwill’ can deliver via governments.

We should not just be concerned with honest leaders, we should not let the system be held hostage to human weaknesses. A system entrenched with rent-seeking is a sure call for more corruption and inefficiencies.
In comparison, a system embedded with competition, rule of law and economic freedom is more likely to deliver. This is where the heart of the matter lies.

If you observe the circular debt cycle closely, you will immediately notice it is all state versus state. It’s state-owned PSO versus state regulator Pepco. It’s KESC (even after so-called privatisation) versus the government of Sindh. It’s another distributor (even after de-bundling) versus Pakistan International Airlines or Pakistan Steel Mills.

This is what happens when you bring the government to ‘correct’ the markets. When a private business fails, it closes down. When a government business fails, it is apparently given more funds. The government managers protect each other at the cost of taxpayers.

They unilaterally raise the tariffs to cover inefficiencies and corruption and routinely take new loans to pay back old ones. This is not politics – it is dirigisme. We need to dig deep and purge our transactions from the statist approach. For that we need the free market at full swing – with all its brutality, imperfections and wonders.

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