Pakistan’s economy has begun to unravel. Following years of impressive economic performance – high growth rates with apparent overall macroeconomic stability – a sharp reversal had clearly set in by the middle of last year. Since then everything has worsened.
The present situation is a catalogue of woes. Net foreign exchange reserves have fallen to worryingly low levels, enough to sustain slightly over one month of imports; inflation has touched historic highs (crossing 25% year-on-year in August, with food inflation at 34%); the rupee has shed 21% against the dollar since January; and the country’s previously best-performing equities have experienced a meltdown.
In addition, with the fiscal deficit soaring to nearly 8% of GDP for the year ended June 30, the government is facing internal payment difficulties as well – and is resorting to large-scale borrowing from the central bank.
Despite the all-encompassing nature of Pakistan’s current economic difficulties, its vulnerability is most acute in terms of its balance of payments. A marked deterioration of the external terms of trade, combined with protracted domestic political uncertainty, has led to a sharp increase in import payments and markedly lower capital inflows.
In addition, capital flight appears to have accelerated of late. The net result has been a steady depletion of the country’s forex reserves. From a peak of $16.5 billion in October 2007, Pakistan’s external reserves have declined to some $6.8 billion as of mid-September. Net official reserves with the central bank are down to some $3.4 billion, representing a projected import cover of around one month.
With debt service commitments of around $3 billion for the 2009 financial year, including a $500 million repayment of a global bond due in February 2009, and foreign portfolio investment of $2.7 billion effectively locked in without a quick exit at the Karachi Stock Exchange by imposition of trading limits, the country is effectively teetering on the brink of external default.
Not surprisingly, Pakistan’s deteriorating political, economic, as well as security situation, and the accompanying nervousness of international capital markets are well captured in the cost of insuring against default by the sovereign.
This has shot up to unprecedented levels: as of September 26, Pakistan’s five-year sovereign CDS spread was quoted at 18.50%. By comparison, Argentina stood at 9.17% and Lebanon at 5.30%.
COCKTAIL OF PROBLEMS
To compound the situation, Pakistan’s current challenge is not just economic. Fewer countries face a more complex – and daunting – set of problems today than Pakistan. Ranging from internal security to a crumbling economy, the issues Pakistan’s new government has to grapple with traverse geopolitics, domestic politics, atrophied state institutions and an increasingly strained social fabric.
Events of the past few weeks, such as the massive truck bombing of Islamabad’s Marriott Hotel – reminiscent of scenes from war-ravaged settings such as Iraq or Afghanistan – have capped a tumultuous year and a half for the country.
For several years Pakistan was a darling of international investors – and held up as a paradigm of successful reform by international financial institutions – during which period it launched several international bonds, and gained access to record levels of portfolio as well as direct foreign investment. But things started going visibly wrong in March 2007 when the former president Pervez Musharraf sacked the then chief justice Iftikhar Chaudhry in a blatant power grab.
That action brought the country to a virtual standstill for months, with huge street protests led by lawyers becoming a rallying call for a wider movement against the army and Musharraf. Around July 2007, a stand-off occurred between authorities and militants in Islamabad’s Red Mosque, which was eventually crushed by the use of massive force by the military, leading to a heavy toll in terms of casualties.
In the months thereafter, militant attacks intensified in Waziristan, a wave of devastating suicide attacks hit Pakistan’s largest cities, while a Taliban-inspired insurgency spread to the Swat valley and other tribal agencies along the border with Afghanistan.
In October 2007 Benazir Bhutto returned from exile but, in a vicious bomb attack, her convoy was attacked and over 150 of her party workers were killed. The former prime minister was eventually assassinated at an election rally in December 2007, sparking a wave of destructive riots across the country.
Moreover, protracted political uncertainty since early 2007 has been capped by pronounced strains in Pakistan’s relationship with India as well as Afghanistan earlier this year, as well as rapidly deteriorating levels of trust between the US and Pakistan.
MISDIRECTED GROWTH STRATEGIES
The dramatic slide in Pakistan’s economic fortunes since March 2007 has not been due to politics alone: a large part of the problem lay with the deeply flawed growth strategy pursued by the previous government of prime minister Shaukat Aziz. Keen to kickstart an economic turnaround in the shortest timeframe, the then-government hoped to stoke domestic demand by guiding interest rates to historic lows. This was achieved by allowing a substantial portion of the sizeable inflows into the economy post-9/11 to come through unsterilized.
A large infusion of liquidity helped to reflate the economy, but with unintended consequences. Foremost of these was the fact that economic growth was increasingly consumption-led rather than emanating from investment or the export sector.
This led to a surge in imports, especially of consumer goods, without a corresponding increase in the country’s exports. Initially, the growing trade gap was financed by privatization proceeds, and other one-off flows such as those from the US for budgetary support.
Later, there was a growing reliance on external borrowing and portfolio investment. In the 2006/07 financial year portfolio investment flows financed over 30% of the country’s external current account – indicating a substantial building up of vulnerability. A second key component of its growth strategy was ramping up the public-sector development programme. However, with tax revenues failing to keep up, and marginal projects being approved in the hope of extracting short-term growth – or for political patronage ahead of crucial elections – government spending soon led to a ballooning fiscal deficit.
The steep rise in international commodity prices through 2007, especially of oil, compounded the problem, as the government, keen to win votes, suspended an automatic price adjustment mechanism put in place earlier. This led to a massive subsidy bill (of over $7 billion in fiscal 2007/08). This combined with the overall fiscal indiscipline during the last year of the Musharraf-Shaukat Aziz political dispensation, resulted in the fiscal deficit touching nearly 8% of GDP in 2007/08 – almost twice its budgeted target.
To make matters worse, the Shaukat Aziz administration dithered on the critical reform of public finances. It repeatedly deferred imposing a capital gains tax on the country’s booming property sector and equity markets – despite a rise of 12 times in the benchmark stock index – and failed to extend the tax net to services, the fastest growing sector of the economy.
With a contribution of 53% to GDP, the services sector contributes less than 26% to total taxes. The lack of progress on structural reform in public finances and tax administration is painfully obvious in Pakistan’s tax-to-GDP ratio. At 9.5%, it is among the lowest in the world.
The failure to impose or collect new taxes meant that the government was left with no option but to borrow. With access to external financing drying up as the US subprime crisis began to take hold, and domestic liquidity with banks constrained because of the rapid pace of credit growth in the economy, the Shaukat Aziz government turned to the central bank.
Between end-June 2005 and March 2008, when the new coalition government of the Pakistan People’s Party and the Pakistan Muslim League (Nawaz) took over, central bank financing to the government had aggregated over Rs550 billion (the equivalent of 7.2% of GDP).
The domestic liquidity injection which this magnitude of monetization of the deficit has entailed has seriously undermined the central bank’s fight against inflation. Apart from creating problems for monetary management, the increase in the money base has also shown up in unwelcome ways: at the margin, it has helped stoke import demand at a time when it was already becoming difficult to finance the current account deficit.
With a fiscal deficit for the year ended June 30 of nearly 8% of GDP, and an external current account imbalance of 9% of GDP, the imperative for the new government to restore macroeconomic stability becomes clear.
Initially, the new coalition government was slow to address the issue, with valuable time – and precious reserves – consumed in formulating a viable policy response. As a consequence, market confidence plummeted and capital flight accelerated.
With pressure on reserves mounting, and the rupee coming under increasingly greater strain, especially from April onwards, the government committed a cardinal error: it did not effectively communicate its plans with the markets. The fact that the new administration was all set to embark on a fairly robust stabilization programme, in close liaison with the World Bank and the IMF, with the unravelling of subsidies as the lynchpin, should have been a central part of the market communication – but it wasn’t. This compounded the problem greatly.
STABILIZING MEASURES
To be fair, the current administration has taken measures to restore macroeconomic stability unthinkable for most governments, and especially so for one facing street protests from lawyers, an accelerating inflation rate and an uneasy alliance with political allies.
So far, diesel and kerosene prices have been raised nearly 60% since March while electricity and gas tariffs have been raised over 30%. As a result, while punishing for consumers as well as for overall economic growth, these measures will go a long way in achieving the fiscal deficit target of 4.7% for the current fiscal year. In addition, as a collateral impact, the sharp increase in administered prices of petroleum products is also likely to reduce domestic oil demand at the margin, thus helping to lower the import bill. In a wider sense, the steep upward adjustment in domestic energy prices will act as a substantial consumption tax, thus reducing aggregate demand and leading to import compression in non-oil products as well.
Unfortunately, the government’s stabilization programme doesn’t go much beyond price adjustment, and falls short in key areas. With signs that aggregate demand in the economy, while moderating, still remains strong, the government needs to put in place a stronger macroeconomic stabilization effort. There is substantial room to tighten monetary policy further, as real interest rates are sharply negative.
Fiscal policy remains the weakest link in the policy mix. Despite some ad hoc measures introduced post-budget to reduce import demand for non-essential goods, directionally, fiscal policy is underwhelming: the capital gains tax regime has not been applied to traded equities or real estate, defence spending has not been capped, the government’s development spending programme – which is full of leakages and an unwieldy portfolio of questionable projects in terms of economic benefit – has not been rationalized (so far), and no structural improvement has been made with regard to direct income taxes.
Over the past few weeks, authorities have introduced more fire-fighting measures, including imposition of cash margin requirements on imports, restricting trading hours for foreign exchange markets, tightening reporting requirements for exchange companies in case of transactions above $50,000, and suspending the provision of forward cover on foreign exchange for importers. In addition, import tariffs have been raised for a number of tariff lines.
The sharp weakening of the exchange rate since April, more by default than by design, should also contribute to stabilizing the attrition of the central bank’s external reserves. The extent to which the exchange rate move will make a dent on imports, or boost exports, remains moot, however. In real effective exchange rate terms, the rupee has depreciated substantially less than its move in nominal terms due to the wide inflation differential between Pakistan and its trade competitors.
At the same time, however, given that Pakistan does not have either the luxury of time, or the cushion of hard currency reserves, to wait for the impact of policy measures to take hold in stabilizing its precarious foreign exchange situation, enhanced assistance from multilateral as well as bilateral sources in the near term is critical.
Without a significant capital infusion to stabilize reserves, Pakistan will face severe payment difficulties by December.
The government may have no choice but to impose wide-ranging capital controls, including possibly an outright ban on certain imports, and more controversially, some action on the unrestricted operation of onshore foreign currency deposits.
While the authorities remain committed not to repeat the history of the 1998 freezing of $11 billion-worth of onshore foreign currency deposits, or the episode of the “bail-in” of private bondholders under compulsion of the IMF, they may have little choice.
This is a classic moral hazard situation. For Pakistan’s multilateral as well as bilateral development partners (the latter now banding together under a Friends of Pakistan consortium), providing the assistance upfront without more credible steps in the direction of structural adjustment may provide a reprieve to the government, and lessen its commitment to longer-term reform.
Without the longer-term reform, however, there will be no assurance that Pakistan will not find itself in a similar hapless situation several years down the road.
Sakib Sherani is chief economist in Pakistan for RBS