In a fiscal conundrum

Pakistan’s fiscal position in FY26 presents a paradox: apparent stability that masks deep-seated fragility. While the overall fiscal deficit narrowed to 1.6 per cent of GDP during the first 11 months (July-May) — with the July-April period falling to 1.1pc — this achievement rests on fragile foundations.

Total public debt stood at a staggering Rs83.29 trillion ($298.5 billion) by the end of March 2026, while interest payments consumed Rs6.16tr in just 11 months. The International Monetary Fund (IMF) projects a fiscal deficit of 3.2pc for FY27. With the Federal Board of Revenue missing its IMF tax target by Rs975bn and debt servicing crowding out development spending, the country walks a fiscal tightrope — stabilisation today, sustainability tomorrow remains an open question.

While headline fiscal indicators suggest some macroeconomic stabilisation, the underlying pressures become far clearer when one examines the power sector. Capacity payments, circular debt and costly contractual obligations have emerged among the largest structural drivers of the country’s fiscal stress.

The defining feature of many Power Purchase Agreements (PPAs) is the capacity payment mechanism. Under these contracts, power producers receive fixed payments to recover capital costs, debt servicing and fixed operating expenses regardless of whether electricity is generated.

The economy has reached a stage where structural reforms can no longer be postponed

Consumers therefore pay not only for electricity consumed but also for maintaining power plants that may remain idle for years. As installed capacity expanded faster than electricity demand, these fixed obligations became one of the largest components of electricity tariffs.

The financial burden is immense. During FY25, Pakistani consumers paid approximately Rs 1.81tr in capacity charges — around Rs 14.3 per unit — while actual energy costs amounted to only Rs9 per unit. Capacity payments accounted for nearly 61pc of the total electricity bill of Rs2.94tr. Projections for 2026 indicate capacity charges of around Rs 1.7tr, equivalent to roughly Rs17 per unit.

The burden is compounded by dollar-indexed returns embedded in many early Independent Power Producers (IPP) contracts. Although these guarantees attracted much-needed private investment, they also exposed Pakistan to exchange-rate risk, with every depreciation of the rupee automatically increasing government payment obligations.

Projects developed under the China-Pakistan Economic Corridor (CPEC) illustrate this vulnerability. More than 11,000 megawatts of installed capacity were financed largely in foreign currency, while receivables owed to CPEC-related IPPs have reportedly reached Rs543bn, adding further pressure to public finances.

These contractual obligations have become a major driver of Pakistan’s circular debt. When distribution companies fail to recover the full cost of electricity because of transmission losses, theft, poor recoveries and delayed subsidies, payments to power producers are postponed. The resulting liabilities accumulate across the supply chain, forcing repeated government borrowing simply to keep the sector operational.

Although the government reduced circular debt from Rs2.39tr to Rs1.61tr during FY25 through extraordinary financial interventions, the improvement proved temporary. By the close of FY26, circular debt had climbed back to approximately Rs1.84tr, well above the IMF target.

Recognising the severity of the challenge, the government renegotiated contracts with fourteen IPPs in January 2025, replacing parts of the traditional “take-or-pay” model with arrangements more closely linked to actual electricity generation. These revisions are expected to generate lifetime savings of approximately Rs1.4tr, while settling returns on equity in Pakistani rupees instead of open-ended dollar indexation marks another important reform.

However, the largest challenge remains unresolved. CPEC-related IPPs still account for roughly Rs1.4tr in outstanding receivables and continue to dominate the circular debt equation. Until these liabilities are comprehensively addressed, durable fiscal relief is likely to remain elusive.

Pakistan’s challenge is therefore not the existence of IPPs but the design of contracts that balance investor confidence with fiscal sustainability. Without a comprehensive overhaul of power-sector governance and future PPAs, the IPP model will continue to weigh heavily on public finances.

Yet energy-sector reform alone cannot restore long-term fiscal sustainability. Our broader fiscal challenge also stems from weaknesses in the intergovernmental fiscal framework, making federal-provincial resource sharing and fiscal governance the next critical area for structural reform.

Pakistan’s fiscal architecture has reached a stage where structural reforms can no longer be postponed. While the 18th Constitutional Amendment and the 7th National Finance Commission (NFC) Award fundamentally reshaped the country’s federal system by devolving greater powers and financial resources to the provinces, questions remain over whether the existing framework is delivering better public services and sustainable public finances.

These concerns are central to the World Bank’s report, Strengthening Fiscal Federalism in Pakistan, released last month. The report argues that although devolution brought government closer to citizens, Pakistan’s fiscal system has struggled to keep pace with changing administrative responsibilities, resulting in persistent fiscal imbalances, fragmented taxation and uneven service delivery.

Following the report’s release, Prime Minister Shehbaz Sharif constituted a high-level committee to review its recommendations in consultation with provincial governments and other stakeholders. The report does not advocate reversing devolution; rather, it proposes reforms to make Pakistan’s federal system more efficient, accountable and development-oriented.

Published in Dawn, The Business and Finance Weekly, August 10th, 2026