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32. Sustainable fiscal deficits. Sustainable current account deficits impose significant restrictions on sustainable fiscal deficits. The intuition underlying this can best be seen from the fundamental budgetary constraint that fiscal deficits need to be financed through external borrowing, domestic borrowing or money creation. The level of external borrowing is determined by sustainable current account deficit (as above); the level of domestic borrowing is determined by the need to avoid a domestic debt explosion and crowding out of the private sector: while the level of money creation depends upon the level of inflation. So, for any given growth. external balance and inflation targets, there is a particular level of fiscal deficit that is consistent with these targets. Thus. given Pakistan's growth target of 6 percent p.a. and the sustainable level of current deficit that is consistent with this target (defined in Table 16)'5, the sustainable levels of fiscal deficits is illustrated in Table 17 as a function of the rate of inflation.'<sup>6</sup> For domestic borrowing, we assume zero additional domestic borrowing. The rationale for this assumption is quite simple. With greater financial liberalization currently underway in Pakistan, the real interest rate on government domestic borrowings has been turning significantly positive, reaching about 3 % in 1993. As fmancial sector distortions are further reduced, GOP is likely to face the full market cost of domestic borrowing which is expected to be around 5-6% in real terms. In this situation, it will be imprudent for Paldstan to continue to increase its domestic debt because, as explained in para 25, the debt dynamics interplay-(r-g)dt-could lead 7 towards financial insolvency'.

33. The results of Table 17 are quite revealing. First, Given Paldstan's growth target of 6% p.a., an inflation target of 5% (by 1996),"8 and assuming an export growdt rate of 7% p.a., consistency of the external target (creditworthiness) requires that fiscal deficits are reduced to around 4.5-5% of GDP p.a. This is much below the 8% average of the past decade and the 9.7% reached in 1992193. Second, adding another half percentage pomt to the fiscal deficit will require, in the absence of bigher borrowing, an acceleration in the inflation rate to 15-20% p.a. This suggests that the inflationary consequences of higher fiscal deficits are substantial. Third, financing even further increases in fiscal deficits will require higher external or domestic borrowing because running higher inflation will be counter- productive for revenues. Given the trend towards increasing real interest rates, these higher borrowing will result in a serious debt problem; this in turn will jeopardize Palistan's ability to maintain growth rates at 6% p.a.

- I We assumre a growth rate of 6% p.az and export growth of 7% p.a., which yields a sustainable current account deficit of 3.1% of GDP. Roughly 70% of this is available for the public sector.

- 16 Note that this is a somewhat simplistic presentation as it ignores the general equilibrium effects of inflation on growth and current account deficits. Also, the real exchange rate is assumed to remain constant.

17 It is possible to argue that Pakistan is moving towards a more open economy. including greater international capital mobility. This means Pakistan could end up aligning its financial policies with the international market so that domestic and international interest rates are fully aligned. Even in this extreme case of perfect capital mobility, real interest rates in Pakistan are likely to be higher than in the international markets due to country creditworthiness risk considerations. Depending upon the risk premium, a divergence of one to two percentage points between international and Pakistan interest rates would still lead domestic real interest rates in the 4-5% range. With real interest rates very close to real GDP growth rate, and given the already large interest cost of domestic debt, it would be prudent to avoid any further increase in domestice debL

- ' As described in the 1993194-1995/96 PFP.