Rising inflation amidst subdued demand

(February 06, 2020)

This paper seeks to explain how inflation exceeded 14% in January 2020, despite subdued demand in the economy.  The explanation is simple: YoY food inflation almost touched 24% last month, and this category is the heaviest in Pakistan’s consumer price index (CPI).  With the government scrambling to control food inflation, we expect inflation to begin falling in the months ahead, and just as the January number surprised the market, the fall in inflation could be just as sudden. 

While this development contradicts the neoclassical view that inflation is driven by demand pressures, it again questions the need for SBP’s stated objective to target 200-300 bps real interest rates.  In our view, it will be hard for SBP to resist pressure to cut rates in March, and a token cut will not suffice – we suggest that SBP could cut rates by 75-100 bps.  As we have hinted at before, if the FBR revenue target become challenging in FY20 (as is likely), GoP may encourage imports as the bulk of FBR’s revenue collection is done at Karachi ports.  We summarize by noting that GoP may use the external sector gains to increase revenue collection, but the price it will pay is the growing burden of carry trades.  Word count: 1,184. 

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Assessing the IMF's assessment

(January 14, 2020)

The IMF’s Staff Report published on December 19, provides a good handle to gauge how Pakistan is doing in the EFF.  The report reveals that the IMF was just as surprised as the GoP about how sharply the current account deficit has narrowed in FY20 (the CA deficit has shrunk from $ 6.7 bln to only $ 1.8 bln in the first five months).  This comfort means the hard targets for the external sector were achieved by significant margins.  Since subsequent targets have not been adjusted accordingly, meeting them should be easy enough.  The fact that the Staff Report endorsed Rs 155/$ as a stable equilibrium, suggests that SBP will not allow the rupee to appreciate beyond this level. 

The fiscal side is less heartening.  Unlike government sources, the IMF report explains the cause of the fiscal fiasco last year, when the authorities admitted that the fiscal deficit in FY19 was 8.9% of GDP against a target of 7%.  It also reveals that against a primary deficit target (ceiling) of Rs 102 bln in Q1, Pakistan over-performed by posting a primary surplus of Rs 305 bln.  The report explains that this was because of one-off non-tax revenues, which means subsequent revenue targets will be challenging.  The full year FBR revenue target has only been reduced by Rs 265 bln, to a still ambitious Rs 5.24 trn, with Rs 3 trn to be collected in 2H-FY20. 

In terms of tone, the Staff Report was surprisingly somber.  Against the stock market optimism that the country would soon enter a growth phase, the IMF report talks about elevated risks and the need to stay firm with program objectives.  The report reveals that 15% of direct taxes and 58% of sales tax are collected at the customs stage, which shows that tax assessment and collection is concentrated at the import stage because it is easier to collect.  We take this as proof that Pakistan’s economy is largely undocumented, but were disappointed that the IMF had little to say about concrete steps to enhance documentation.  The report also reveals the lack of an action plan to meet the ambitious revenue targets. 

Our paper also touches on the concern that the likely amendment in the SBP Act to make price stability SBP’s primary objective, is not in the country’s interests.  We also highlight how the sharp increase in GoP’s cash buffers have spiked Pakistan’s domestic debt.  We conclude by saying that revenue challenges are likely to dominate policy thinking, while more fundamental structural reforms could be delayed.  We think this EFF is being managed as previous programs were (in a business as usual approach), which is not a good omen.  However, with $ 1.6 bln worth of carry trades in the country, this exposure does weaken the country’s ability to negotiate with the IMF. 

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Review of 2019

(January 02, 2020)

This is a month-on-month summary of all our 12 presentations in 2019.  It shows a sense of despair at the start of 2019 as the government was not doing enough to narrow the unsustainable external deficit; however, by the end of 2019, market sentiments were optimistic that a growth phase would start in 2020. 

In terms of the timeline of significant events, this is our list:

  • GoP only committed to an IMF program in April after the entire economic team had been changed.  While this was a positive step, the path was paved by compromising on the amnesty scheme;
  • Till June 2019, policy steps to narrow the trade deficit had not delivered.  From a record high of $ 31.9 bln in FY18, the trade deficit only narrowed to $ 29.5 bln because of lower oil imports;
  • FY20 started well as the sharp economic slowdown started narrowing the external deficit.  However, this is a double-edged sword: if economic growth picks up, it will surely put pressure on the CA deficit, which could undermine the EFF;
  • While the start of the EFF in July calmed market sentiments, the program was not customized as we had hoped.  We had hoped there would be hard program targets to push the documentation agenda;
  • We were surprised that as soon as the EFF started, SBP began to appreciate the rupee.  We asked what had changed after the sharp depreciations witnessed in May and June 2019.  The gradual appreciation continued throughout the second half of 2019, with the rupee moving from 163-164/$ in end-June to 154.9/$ by end-December;
  • There was a further change in sentiments in August, when it was announced that GoP’s debt to SBP had been shifted into long-term PIBs.  With a bearish stock market and a perceived shortage of PIBs, the excess demand for 10-year PIBs drove down yields and fueled expectations that SBP was preparing to cut interest rates.  Again, we questioned this sudden change in sentiments just one month into the EFF;
  • This sentiment was not overshadowed by the shocking admission that the fiscal deficit in FY19 was not 7.2% of GDP, but a record 8.9%;
  • November witnessed another improvement in sentiments, when carry trades (hot money) increased sharply during the month.  This eased conditions in the FX market, increased SBP’s reserves and generated domestic liquidity.  The market was now convinced that the stabilization phase was over;
  • By late December, PM Imran Khan announced that 2020 would be a year of prosperity. 

We conclude our assessment by stating that two pivotal events changed market sentiments in 2019: one, the economic slowdown that narrowed the CA deficit in FY20; and two, the sharp increase in carry trades in November.  Since these factors are still in play (but could trend the other way), it is hard to predict what will happen in 2020, especially since the EFF program targets are challenging in 2H-FY20.  Despite this uncertainty, we call for a more prominent role for economic planning, and urge the SBP/MoF to better manage market expectations. 

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The distinction between pro-business & pro-market

(December 14, 2019)

This paper proposes a different perspective on how to look at economic reforms.  The distinction between pro-business and pro-market policies, highlights the role of established business interests seeking government support for their economic interests (pro-business), as opposed to creating a more level playing field where new players are encouraged to enter the market.  Within the policy options that Pakistan faces, pro-business appears to be winning.  However, if policymakers intend to make CPEC 2.0 a cornerstone of Pakistan’s economy, they must shift towards pro-market policies.  While this will be resisted by business interests, a certain level of disruption is required for Pakistan’s economy to break out of its comfort-zone, which only allows for short-term growth phases.  

We argue that China’s unprecedented economic transformation since the 1980s, is firmly anchored to pro-market policies with a critical role for the state planning.  With growing reservations about the neoclassical paradigm that minimizes the role of the government, we advocate the use of pro-market policies, even if this disrupts the existing economy.  Seeking to achieve non-disruptive economic reforms, is tantamount to protecting the very reason why the economy needs help.  

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In Pakistan, hot money could be a very slippery slope

(November 19, 2019)

The exponential increase of foreign investment in government T-bills in the past two weeks, is staggering.  Of the $ 786 mln mobilized so far in FY20, $ 345 mln was realized in the first half of November.  This is a source of much comfort to SBP for several reasons: (1) it does not increase Pakistan’s external debt; (2) as it injects dollars into the interbank market, it reduces pressure on the Rupee and allows SBP to increase its NIR; (3) as it represents fresh liquidity, it will allow SBP to ease back on its open market operations; and (4) it provides deficit financing, which means banks will not crowd out the private sector as much as they would have otherwise.  To maintain these inflows, SBP will not cut interest rates anytime soon (even a token cut, as we had anticipated earlier). 

Hot money is not as fickle as some may claim.  Low and negative global yields are forcing yield-hungry fund managers to look at Pakistan for the first time, and as they get comfortable, such inflows could increase further.  The way to view hot money is to think about fund managers as a new player in the FX market.  At the initial stages, they play a positive role; but if things turn sour (e.g. a less than credible economic recovery or an external shock), their role could become negative and destabilizing.  While the introduction of this new player is beneficial as it creates a source of market discipline on domestic policymaking, the real issue is whether SBP will be able to influence the stock of hot money by managing the flows (in and out of the country).  This will be especially challenging as SBP has to meet NIR targets as part of the EFF. 

However, the main concern we have is that if the inflows are larger than expected, and this allows SBP to easily meet its NIR targets, this could create a false sense of comfort about the external sector.  With an appreciating Rupee and growing FX reserves, this may encourage policymakers to embark on a premature growth phase.  We say premature because hot money will do nothing to narrow the twin deficits, which is why Pakistan approached the IMF in the first place.  We are concerned that short-term thinking may use this respite to sideline tougher structural reforms, which are desperately needed to make Pakistan’s external sector more sustainable. 

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The elusive Net International Reserves

(November 11, 2019)

The first quarterly review by the IMF went well, and Pakistan should receive the 2nd tranche in early December.  There are clear signs that the economy has started to stabilize, perhaps even more than the authorities and the IMF had expected – the IMF has lowered its inflation projection from 13% to 11.8% for the year.  We agree that inflationary pressures have eased and the external deficit has narrowed significantly, but we still think there are challenges ahead.  While many have been flagging the Rs 5.5 trn FBR target for the year, we would also include SBP’s net international reserves (NIR). 

The IMF is pleased by the “higher than expected” NIR in 1Q-FY20, but this does not focus on the $ 7 bln increase in SBP’s NIR in the remaining three quarters of this fiscal year.  We argue that it is impossible to track SBP’s NIR as much of the data/information needed to compute this metric is not public information.  We also flag specific details of the NIR (e.g. adjusters) that will keep shifting the goalpost.  We think subsequent NIR targets (which are performance criteria) will be challenging, which means Pakistan will continue to face an on-going shortage of foreign exchange this fiscal year, and beyond.  This means that a growth phase (which is import dependent) is not feasible in the foreseeable future. 

While we are satisfied that the EFF has changed the trajectory of the economy and laid to rest market concerns about inflation, the Rupee and interest rates, there is little on the table about how policymakers will change the real sector (i.e. jobs, manufacturing, physical infrastructure, social development).  We argue that if policymakers only focus on the EFF, a growth strategy will not materialize.  We remind readers that the second stage of CPEC remains the most viable avenue to make real changes in the economy without breaching the EFF’s end-goals.  However, there could be a conflict of interest within the country: the economic team is more aligned with the Washington Consensus, which would be opposed to import substitution and, at best, lukewarm about CPEC. 

In our view, unless Pakistan is able to tackle its acute import dependency (and not just by setting the “right” prices – interest rates and the Rupee parity), it cannot sustain the growth that is necessary to generate jobs.  Pakistan needs an industrial policy, and CPEC 2.0 can be tweaked to become this policy.  But this requires out-of-the-box thinking, which appears to be in short supply in Islamabad. 

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New challenges, same old story

(October 11, 2019)

With headlines dominated by external events (the annexation of Kashmir, Imran Khan’s stirring speech in the UN, the attack on Aramco’s oil refinery, etc.), this paper seeks to take stock of what is happening in Pakistan’s economy.  We shall simply list the following:

A.     With the stability of the Rupee, gone are the days when people talked about the parity at 180/$.  We also think the Rupee’s stability is now taken for granted, which may not be the case as the EFF’s NIR targets are quite challenging in the remaining part of FY20;

B.     The external deficit has narrowed appreciably, but this import compression must remain in play to stay below the full year current account target of $ 6.7 bln;

C.     The import compression can be traced back to the sharp fall in demand.  This fall is driven by the weaker Rupee, the increase in interest rates, the CNIC conditions for commercial transactions, and the penalties against non-filers;

D.     With a stable currency and retail fuel prices, our average inflation projections for FY20 has fallen to the range of 11-12%.  We believe the 12.5% YoY inflation in September may be the peak as demand pressures have eased significantly;

E.      The growing inversion of the yield curve is driven by the irrational exuberance of institutional investors in 10-year PIBs.  This is sending a signal that interest rates will be cut significantly next month, which is unlikely (SBP should better manage market expectations);

F.      We argue that SBP cannot afford to cut interest rates as this could increase imports and undermine the stability in the external sector.  At best, a token cut of 25-50 bps is possible to keep the stock market bullish; &

G.     With the ban of SBP financing, the central bank will continue to use OMOs to inject liquidity into the market, even though one-sided injections go against the IMF’s ethos. 

We summarize by highlighting the resistance to fiscal reforms (the strike by traders against documentation), by saying that structural reforms should be viewed as changing bad behavior.  This is not easy and the protagonist must stand firm to ensure that such behavior is eradicated (or at least suppressed).  We also argue that while CPEC 2.0 could provide an avenue to higher growth and a more sustainable BoP, it will not solve Pakistan’s fiscal problems.  If the second stage of CPEC is FDI-funded, Pakistan could get the best of both possible worlds (stabilization and economic growth). 

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Could Pakistan resolve the Iran-Saudi standoff?

(September 30, 2019)

This paper argues that the September 14 attack on Aramco’s oil processing facility, is not a one-off event, but rather a calculated escalation by Iran.  If the Iran-Saudi standoff is not de-escalated, Iran may lash out again.  Unlike the general perception that further US sanctions on Iran are now ineffective (given the constraints under which Iran already operates), we think the blacklisting of Iran’s central bank is a significant step, which may have provoked Iran to up the ante in the region. 

Iran senses that since the US has no appetite for a new war in the Middle East (with forthcoming general elections and the impeachment inquiry against President Trump), Saudi Arabia will also be restrained in terms of what it does.  In our view, the public protests in Egypt and the scaling up of the Houthi offensive against the Saudi coalition, are related to the current standoff. 

The fact that both Saudi Arabia and the US have requested Imran Khan to mediate with Iran, reveals two things: Pakistan’s neutrality in the Saudi-Iran standoff and Imran Khan’s growing global stature makes Pakistan an ideal mediator; and two, the US-Saudi alliance is keen to avoid military confrontation with Iran.  We argue that Pakistan should embrace this opportunity.  Since Iran is primarily concerned with US sanctions that are related to the Iran nuclear deal, negotiations could involve as many as eight countries: the US, Saudi Arabia, Iran, Germany, France, Britain, Russia and China. 

Pakistan should use its goodwill with these countries to ensure their active support to defuse the Kashmir standoff.  At the UN, Imran Khan made a firm statement that the Kashmir issue could escalate into an armed conflict between two nuclear armed countries.  If the abovementioned countries come to an agreement on the Iran-Saudi standoff and Kashmir, the world would be a better place. 

While Pakistan’s economic outlook remains challenging, it could use its enhanced stature to defuse global tensions – the resulting goodwill may reduce the pain of Pakistan’s economic transition.  More broadly, these events support our 2017 view that Pakistan is part of a new bipolar global order, which includes China, Russia, Turkey and Iran (on one side), and the US, India, Saudi Arabia, Israel and the UK (on the other side).  We think these groups are slowly coalescing. 

Word count: 3,782. 

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Brexit: The Uncivil War - Part 2

(September 19, 2019)

The utter confusion about Brexit motivated this paper.  While most people are understandably jaded about the unending stream of Brexit updates, this should not take away from its importance.  While a no-deal Brexit would be disruptive for both Britain and the EU, even a deal (for departing Britain) will force both sides to adapt their economies.  We argue that Brexit can only be decided upon by snap elections, which will effectively become a second referendum on Brexit.  Britain’s political parties need to formulate a coherent view on Brexit, and a snap election will force them to do so. 

Our paper shows that a deal or no-deal Brexit (if Britons again vote to leave), could tip both Britain and the EU into economic recession, and possibly pull in the US.  On the other hand, while a remain vote may appeal to liberals and globalists, we show that this could create political instability in Britain.  What we know for sure, is that while the economic costs of Brexit are currently being debated, the political cost for Britain has been debilitating.  This political crisis may not be addressed by a vote to remain in the EU. 

We argue that hardline Brexiters have greater clarity of what they seek to achieve, which will be easier to translate into an election victory.  As in 2016, people vote on the basis of their emotions and not hard economic facts; these emotions are stronger when the message is clear.  We argue that if the next election is a vote to remain in the EU (which means a Labour coalition government with the Lib Dems and SNP), this may be the only common agenda that the coalition has.  In other words, after Brexit is declared dead and buried, the diverging views of coalition members will make the new government dysfunctional. 

Our model shows that a lose-lose outcome is most likely for both the EU and Britain.  While disappointing, this pessimistic outlook reflects the ambivalent relationship between Britain and Europe that dates back to the 1960s.  This ambivalence will allow for creative politics – as shown by the shock 2016 decision to leave the EU, Boris Johnson and his special adviser (Dominic Cummings) are well versed in formulating powerful political campaigns.  Since opinions have hardened on both sides of the Brexit debate, another leave vote could be engineered by clever political manipulation. 

There is a final point that is often forgotten in the Brexit noise: is the EU monetary union sustainable?  In other words, can Brussels keep member countries fiscally disciplined?  In our view, this depends on whether the EU parliament is able resist the shift away from liberal and centrist politics.  With the end of the Angela Merkel era, both France and Germany are witnessing the rise of rightwing and leftwing political parties.  Keeping the EU intact – and within the grand vision of a deeply integrated economic bloc – may be a tall order. 

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Egypt, Turkey & Pakistan: Uncanny similarities & sobering lessons

(August 17, 2019)

This paper seeks to place Pakistan’s IMF program within context of Egypt’s experience with an IMF program that just ended.  The similarities between the two economies are uncanny: both suffer from unsustainable twin deficits; acute import-dependency; stagnant exports; subsidies that are difficult to eliminate; and growing income inequality.  Not surprisingly, the prior actions required of Egypt, are almost identical to what Pakistan had to do, while the program parameters focus on the same metrics. 

What Egyptian commentators said about their EFF (back in November 2016) is similar to what Pakistan’s media has been reporting in the recent past.  However, the overall assessment of Egypt’s economy on completion of the EFF is disappointing: (1) income inequality has increased as subsidies were removed, while the underlying economy remains dull; (2) the program was unable to tackle the structural constraints in Egypt’s economy; (3) the flexible currency has not reduced the trade deficit; (4) Egypt’s external debt increased sharply in the first 2 years of the program; (5) given the volume of carry trades (hot money) that have entered Egypt, the country is vulnerable if global banks lose their appetite for Egyptian debt; and (6) as economic growth begins to take hold, Egypt’s BoP is again showing signs of stress. 

Nevertheless, the 3-year EFF was considered a success, as Egypt’s FX reserves have increased while the current account deficit narrowed.  In our view, the slowdown in the Egyptian economy took the pressure off the external sector, while the slashing of subsidies helped the fiscal side.  We argue that US (and Saudi support) for Egypt has seen this program through, even if the results are fleeting; Pakistan, on the other hand, may not find a lenient IMF in its program.  We think this will help Pakistan – if waivers are not forthcoming as they were in the past two programs, this will force policymakers to be more serious about the reform agenda. 

We also caution against creating a dependency on retail foreign investment, especially in government T-Bills and PIBs.  We focus on Turkey’s recent experience to show how a change in foreign sentiments can derail the local economy.  During a decade of strong growth based on a steady inflow of foreign investment, Turkey ran large external deficits while Turkish corporates borrowed vast sums in hard currency.  With the growing political differences between Turkey and the West, foreign inflows came to an abrupt end in 2018, and the Turkish economy is expected to contract in 2019.  Turkey’s central bank is now struggling to keep the Lira stable (to stem the bankruptcy of Turkish corporates) while narrowing the external deficit. 

We conclude by saying that deeper integration with the global financial markets is only beneficial if the country’s economic fundamentals are sound.  If not, foreign investment becomes a burden on policymakers, who often have to prioritize their interests over the needs of the local economy.  We also argue that a stabilization program is no guarantee that structural reforms will be undertaken.  We urge Pakistan’s policymakers not to focus on stabilization alone, but to tackle issues like import-dependency and stagnant exports.  Word Count: 5,351.

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IMF's EFF: Different or more of the same?

(July 30, 2019)

This paper is split into two parts.  The first part looks at the entire 3-year EFF period, with a specific focus on Pakistan’s BoP and the fiscal accounts.  The EFF shows that the first year is focused specifically to narrow the external deficit, while the fiscal side will be stabilized from FY21 onwards. 

In terms of the current account: (1) the trade deficit is targeted in the range of $ 24-26 bln till FY24; (2) the services balance is declining on account of the economic slowdown and reduced purchases of $s for travel, health & education; (3) primary income outflows increase during the program, which reflect higher interest payments and returns on DFI; and (4) remittances show dollar growth of 4-5 % per annum, which is too optimistic.  In terms of the financial account: (1) there are growing inflows of DFI, which suggests that CPEC-related projects would be equity financed; (2) there are growing inflows in the portfolio account, which signal Eurobond issuances, inflows into PSX, and $ investment in GoP’s T-bills and PIBs; (3) there is a significant shift in borrowing from official creditors to private investors; (4) commercial banks will borrow more from overseas sources; and (5) SBP’s FX reserves are projected to increase by $ 16 bln from now to June 2023.  We think the projected external deficits are too large, while the shift in financing is perhaps too wishful. 

In terms of the fiscal accounts, the revenue targets are ambitious, with few details about how these targets are to be achieved.  While this is disappointing, it also means that the IMF is leaving it to the authorities to figure out how to generate revenues to comply with the EFF’s indicative targets.  On the basis of this enhanced trajectory of revenues, expenditures are also on the generous side.  We are disappointed that the fiscal deficit this year will be higher than last year, and the EFF only has hard targets for the primary deficit.  This means that debt servicing will be much higher this year, which could push the country deeper into the debt trap. 

Part 2 looks specifically at the EFF targets for the year.  In terms of priority (based on the number of targets and how binding they are), the EFF ranks the external sector at the top, then the monetary sector, then the fiscal side, and finally restructuring SOEs and social development.  The program contains 4 prior actions, 6 quantitative performance criteria, 5 indicative targets and 13 structural benchmarks.  While the prior actions have already been taken, the most binding targets during the year would be to increase SBP’s net international reserves and to stop GoP borrowing from SBP. 

The period Jul-Sep 2019 will be critical, especially to narrow the trade deficit and to generate adequate tax revenues.  In our view, the most disruptive part of the program could be how SBP manages the Rupee to meet the NIR target in quarter 2 and 3.  Since the authorities cannot impose any regulations to discourage imports, the NIR targets and Rupee should be closely watched.  If the NIR target is too much of a stretch and SBP takes drastic currency adjustments to meet it, this could unhinge Pakistan’s macro stability.  Word count: 5,707.  

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Chasing inflation will unhinge the macro economy

(July 16, 2019)

This paper was released just before SBP’s monetary policy decision.  The break from the past (i.e. announcing it in the middle of the month) was clearly motivated by the need to influence banks’ participation in subsequent T-bill and PIB auctions.  There was a remarkable degree of market consensus that SBP would increase interest rates by 100 bps – the EFF report explicitly states that SBP should target a positive real policy rate, which the market correctly tracked to imply a real rate of 200 bps. 

While the IMF and SBP would like interest rates to become the country’s nominal anchor, this cannot just happen as with an on-off switch.  If Pakistani retailers do not see a causal relationship between interest rates and the demand for their goods/services, interest rates will not influence their price-setting behavior.  Nevertheless, with inflation projected to increase in FY20, SBP will continue to chase inflation, which will do little to change the inflation trajectory, but it could push the country deeper into a debt trap. 

In our view, SBP has more pressing challenges: (1) increase the maturity of Pakistan’s market debt; (2) ensure that banks do not indulge in risky lending; and (3) signal the end of the monetary tightening cycle.  These goals require a more circumspect approach to using interest rates.  While higher interest rates will support the Rupee, SBP’s narrative that inflation control requires higher interest rates is factually incorrect. 

So while SBP is expected to increase rates by 100 bps, we would suggest a larger 150-200 bps increase, and then signal that this marks the end of the tightening cycle.  Word count: 1,697. 

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No Pain, No Gain

(June 12, 2019)

This short paper is our response to the Federal Budget announced on 11 June.  In overall terms, we are pleased that it reflects the significant economic challenges that Pakistan is currently facing.  It predicts subdued growth of 2.4% in FY20 and claims that inflation could rise to 13%.  By projecting a 78% increase in debt servicing next fiscal year, the budget correctly flags the debt trap that Pakistan is in.  It also reveals that the government has decided not to compromise its spending plans for FY20, which means the anticipated fiscal deficit next year could be as high as Rs 3.6 trln, or 8.2% of GDP. 

Postponing debt consolidation implies that Pakistan’s debt will continue to grow rapidly, which is shown by the Rs 1.8 trln increase in net external financing in FY20.  This, coupled with the 34% increase in tax revenues, undermines the credibility of this well-intentioned budget.  If this quantum of external financing is not forthcoming next year, both the external and fiscal deficit targets will have to be revisited.  This means mini-budgets are likely next year.  Word count: 1,276. 

 

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The Parable of Pakistan & the IMF (Part 2)

(June 03, 2019)

This papers build on a piece we wrote in late 2016.  We summarize Pakistan’s relationship with the IMF to make a few points: (1) the start-stop relationship that dates back to the 1990s, has created a comfortable sense of familiarity between Pakistan and the IMF; (2) programs have either ended because of Pakistan’s inability to deliver on hard reforms; changes in government; or negative shocks (e.g. nuclear tests in 1998 & the military coup in 1999); and (3) programs have become irrelevant because of positive shocks (e.g. 9/11 and the collapse of oil prices in mid-2014). 

We explain Pakistan’s checkered relationship with the IMF by creating a parable: Pakistan is a sick patient who is tended to by a doctor (IMF).  Overtime (as this game is repeated) both Pakistan and the IMF become self-serving (co-dependent), whereby the patient refuses to recover and the doctor becomes a regular visitor to the patient’s house.  We explain this poor outcome in a game-theoretic setting.  

We then argue that since the last IMF program was negotiated in mid-2013, Pakistan’s position in the global order had changed.  We are closer to China; CPEC has become a reality; President Trump is polarizing the world; a stand-off between the US and Iran is threatening the Middle East; and rightwing governments are ascending.  If the next IMF program stalls because Pakistan’s policymakers have overcommitted (and targets are missed), this may push the country into a more serious one-off game, where China steps in as the doctor. 

Unlike the IMF, we argue that China would demand behavioral change and not just provide palliative care.  This would raise the stakes for our policymakers: if we continue to be self-serving (i.e. appease the status quo by not reforming), this could hurt our relationship with China and incur a heavy price for Pakistan.  Perhaps this heightened cost is required to overcome the resistance to change. 

Finally, we discuss the various groups that are resistant to change.  Following the lead taken by the World Bank, we highlight how the bureaucracy, industrialists, landowners, military and market opportunists, have resisted economic reforms either using their political power, wealth or by simply undermining the implementation of required reforms.  Given the nature of these groups, we argue that perhaps only China and the military have the incentive to put Pakistan on a sustainable path.  This means the two groups must ignore their self-interests in favor of well-intentioned policies for the country.  It also means taking on Pakistan’s vested interests.

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The glass remains half empty

(May 14, 2019)

The forthcoming IMF program has finally taken shape, and is likely to start after the federal budget is announced on 11 June.  The financial bailout ($ 6 bln from the IMF, and $ 2-3 bln from ADB and the World Bank) is smaller than expected, but the required policy changes will be demanding as Pakistan desperately needs to narrow its twin deficits.  Prior actions have been discussed in the print media, and it appears that interest rates and utility tariffs will be increased.  In our view, these increases and the budget that is unveiled, will be sufficient to show Pakistan’s intent.  The program will really take hold in 1Q-FY20, and the first set of targets will be for end-September 2019. 

The disappointing financial support could be a reflection of US government reservations about IMF money being used to repay China for its ambitious OBOR initiative.  In view of the heavy debt repayments that have been racked up, the debt rescheduling burden will fall on Pakistan’s “friends” (China, Saudi Arabia and the UAE).  Revenue targets will be a stretch, and with development spending protected, this means that insufficient revenues (and a tight primary deficit target) will force the government to slash subsidies, contain administration costs and rethink defence spending.  While these are tough decisions, it is the floating of the currency that will be the most disruptive. 

Unlike previous programs, this one means a hard landing for Pakistan’s economy.  We list reasons to be optimistic and pessimistic about whether GoP will be able to see through the 39-month EFF.  We argue that it all boils down to difficult trade-offs, which means going against the vested interests that exist in the country.  We end by arguing that policies alone will not deliver results – we are now at the stage where nation-wide campaigns are required to change certain behaviors.  Given the magnitude of the required economic adjustment, a political blame-game is a sure recipe for a stalled program. 

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Amnesty vs. Accountability

(April 29, 2019)

This paper starts with a timeline of Asad Umar’s (AU) resignation as Finance Minister.  This surprised the market and polarized business sentiments.  Some people view this change positively, blaming him for the poor state of the economy and the late engagement with the IMF, while others saw this as the elite capture of policymaking.  In our view, the fact that this happened so close to final negotiations with the IMF, is an indication of elite capture that is unsuitable for serious negotiations. 

In our view, the departure of AU can be traced to the amnesty scheme.  His version of the scheme, which was harder than the PML-N version, increased the asset classes to be targeted, and allowed for a spectrum of tax rates that ranged from somewhat lenient to penal.  These rates were to be decided by the PTI cabinet and announced on 16 April, but AU was surprised by the reaction of senior leaders in the PTI.  A new version of the amnesty scheme started making the rounds on social media on 24 April, and is much more lenient than AU’s version, and even easier that the PML-N version. 

It appears that the latest version only offer carrots to ensure compliance, disregarding the dire need to mobilize revenues, and to maintain a tax-paying culture in Pakistan.  We argue that if the scheme had been more balanced and revealed its intention to use the stick (for those who do not avail it), the country would have achieved both higher revenues and greater documentation.  In our view, the reluctance to use the stick has tainted the new finance team. 

To take this stance when the country is desperate for economic certainty, is surprising.  We look into this issue, and find that either Pakistan’s vested interests are unaware of the true state of the economy, or are sure that someone/something will come to the country’s rescue, or feel confident that the country is resilient enough to survive the current crisis. 

With heavy FX repayments and the size of the external deficit, this BoP crisis is different.  For the 12-month period from March 2019, even with a sharp narrowing of the current account deficit and a moderate increase in SBP’s reserves, the country needs almost $ 25 bln, which will not be possible without the IMF. 

In our view, the disconnect in policy thinking comes from the unwillingness of the economic elite to change bad habits, and a ubiquitous belief that Pakistan is somehow too-important-to-fail.  We argue that this is misplaced thinking, and if this mindset prevails in policymaking, Pakistan will be walking a tightrope for the next two years without a safety net.

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GoP's mixed signals, the IFI's clarity & the task ahead

(April 11, 2019)

Business sentiments are confused.  PTI has been in power long enough that it now owns the economic mess left behind by the PML-N government.  But there is some anger about what exactly this government seeks to achieve: the FM claims that Pakistan has the upper hand in the IMF negotiations, which suggests an easy stabilization program; concessions to tax non-filers signals an about-turn; the FM says further devaluation is not necessary, yet the kerb market is under pressure; and the FM talks about the need to float the currency, and is surprised when the kerb market panics.  In this confusion, opportunistic moneychangers are seeking to self-regulate the kerb market, which would be nothing short of a disaster. 

On the other hand, the IFIs have put forward a more somber and realistic outlook for the future.  All IFIs predict slower growth in FY20, with the World Bank showing a sharp curtailment of the external deficit and an increase in inflation in FY20 (presumably because of a stabilization program).  It also predicts an alarming increase in Pakistan’s debt-to-GDP ratio, showing an increase from 73.5% in FY18 to 82.3% in FY19.  In an assessment of the debt carried by a group of 40 peer countries, the IMF shows that Pakistan has the shortest maturity; the second lowest revenue stream; the largest portion of its debt maturing in any given year; and is likely to post the sharpest debt/GDP increase in the next several years.  Our calculations show that if the external deficit narrows from $ 12 bln in FY19 to $ 7 bln in FY20, SBP manages to roll over all FX swaps, and retains the same level of FX reserves; Pakistan would need $ 23 bln during the period March 2019 to February 2020. 

We talk about the amnesty scheme that PTI is considering, which is tougher that what PML-N announced in its last year in power.  While we endorse this approach towards amnesty, we conclude by saying that several factors should help the government take hard steps on the economy: (1) the sheer magnitude of problem that has to be overcome; (2) that PTI is a new force in the country’s political landscape; and (3) China.  Policymakers need to think out-of-the-box and find a customized solution to Pakistan’s overwhelming economic challenges. 

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Perspective on Pakistan's external sector

(March 15, 2019)

This illustrated paper uses a PowerPoint format because of its heavy use of data. 

This paper puts Pakistan’s BoP crisis into context.  It argues that the problem first manifested in FY17, and unlike previous economic challenges, this one was engineered by the previous government’s short-sighted exchange rate policy.  Despite significant PKR adjustments since end-2017 (and interest rate increases), the country’s trade deficit and patterns of trade, have not changed much.  To alter sentiments in the FX market, policymakers will have to allow the PKR to find its own level with minimal intervention by the State Bank of Pakistan – we suggest several policy measures to make the transition less disruptive.  Policymakers must also commit that this is a paradigm change and not a short-term stabilization measure. 

Data shows that the remarkable growth of remittances after 9/11, allowed the authorities to increase imports without a commensurate increase in exports – however, this imbalance became increasingly problematic after FY12.  The tipping point came in FY17, when remittances plateaued but the net balance in goods and services exploded.  Overcoming this external imbalance will be much harder than the stabilization programs of 2008 (with the PPP) and 2013 (with the PML-N). 

Even with soft oil prices, policymakers need to reduce the quantum of oil imports; a more flexible exchange rate should also help reduce non-oil imports.  In our view, policymakers need to target a current account deficit in the range of $ 6-8 bln per annum, and not $ 12½ bln and $19 bln as posted in the previous two years.  GoP should also consider import substitution (especially for basic food imports) and understand why non-traditional exports have stagnated over the past 15 years.  In terms of jumpstarting textile exports, we propose learning from past failures, and propose teaming up with China to enter its global supply chain.  Pakistan needs to reorient its tradable sector, even in the face of stiff resistance from the status quo. 

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A Primer on Pakistan's Inflationary Trajectory

(March 04, 2019)

This illustrated paper uses a PowerPoint format because of its heavy use of data. 

We focus on supply-push factors that determine inflation.  More specifically, we focus on administered prices like retail fuel prices, the PKR/$ parity, and power/gas utility rates, to project what could happen to inflation in the coming year.  To generate the inflationary momentum, we assume the following:

·        Jan 2019:   PKR/$ at 138.26, and petrol prices at 91.0/litre (realized);

·        June 2019: PKR/$ at 156.13, and petrol prices at 101.2/litre;

·        Sept 2019:  PKR/$ at 160.75, and petrol prices at 104.5/litre; &

·        Dec 2019:  PKR/$ at 157.53, and petrol prices at 106.9/litre.  

By June 2019, our model shows that YoY inflation will be 12.4%, while the 12-month moving average rate would be 8.0%.  While this may appear alarming, we remind the reader that inflation was abnormally low during the period mid-2014 to mid-2018 because of the collapse of oil prices in 2014.  For a country like Pakistan, which is running twin deficits above 10% of GDP, average inflation should be in the range of 7% to 9%. 

We show that food inflation (which accounts for 34.8% of the CPI basket) could hit double-digits from June 2019 to January 2020.  The utilities sub-index (which accounts for 29.4% of the basket) is already close to 12% (YoY) and will continue to increase.  Finally, transportation (which accounts for 7.2%) is already at 13% and will stay at elevated levels (12-17% YoY) till September 2019.  We then argue that other sub-indices will follow suit as retailers will look at administered prices to influence their own price-setting behavior.  We urge policymakers to bite the bullet and increase administered prices to narrow the twin deficits, acknowledging that stabilization will stoke inflation. 

The policy challenge is what to do with interest rates, as the market needs comfort that the monetary tightening cycle had ended (this is necessary to increase the maturity of Pakistan’s domestic debt).  In effect, Pakistan faces an awkward policy choice: policy orthodoxy (increase interest rates to combat rising inflation) vs. actual stabilization.  In our view, orthodoxy will not allow Pakistan’s economy to stabilize.

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Q3-FY19 Projections: A soft landing is no longer possible

(February 13, 2019)

While the currency remains stable since end November 2018, uncertainty builds about the country’s macro-economic outlook.  This makes it is very difficult to make predictions about the PKR/$ parity, inflation and interest rates.  Hence, we have proposed three scenarios that are contingent on how much leeway SBP has to manage the currency. 

Before discussing these scenarios, we highlight several factors that make us less optimistic: (1) FX repayments have reached unprecedented levels; (2) the external deficit remains stubbornly high; (3) soft oil prices will not be enough to narrow the current account deficit; and (4) fiscal pressures mean the twin deficit in FY19 will remain problematic. 

In the first scenario, SBP continues to manage the currency to eliminate volatility.  While a weaker currency is necessary to narrow the trade deficit, we argue that sentiments in the FX market will not change much, which means Pakistan will struggle with a weak BoP in FY19 and FY20.  In the second scenario, we assume a degree of currency volatility as SBP is restrained in its intervention.  The PKR loses more value, while the volatility creates an anti-import bias.  This narrows the trade deficit to the point where the PKR actually starts appreciating by September 2019.  In this scenario, FX sentiments change and the external sector is rehabilitated in FY20.  In the third scenario, we assume almost no SBP intervention, which generates significant currency volatility and a much sharper increase in interest rates.  This scenario is very disruptive for the fiscal side, and will squeeze out discretionary spending this year and next. 

We argue that Scenario 2 is the better option, despite the currency volatility it entails.  This is based on our view that unless market sentiments change, Pakistan’s BoP gap may not narrow enough to stabilize the external sector.  Borrowing may postpone the eventual adjustment, but this will also perpetuate the current uncertainty and make Pakistan’s FX repayments more unsustainable.  Word Count: 3,437.   

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Could Brexit be a marker of things to come?

(January 25, 2019)

In this paper, we analyze the Brexit issue before the 29 January parliamentary vote.  We structure the paper in three parts: one, the reasons for the utter confusion that currently prevails; two, how the Brexit issue could play out; and three, if Britain stumbles into a no-deal Brexit, what this would look like. 

In the first part, we list five factors: (1) Theresa May’s four red lines that she claims are non-negotiable; (2) how sentiments to leave the EU transcend the Euro-skepticism which has existes in Britain for some time; (3) how the Irish backstop is required to keep a soft border in Ireland, but this clause could pull Britain back into the EU against its will; (4) whether Scotland opts for independence if Britain crashes out of the EU; and (5) how May’s mismanagement of the Brexit issue has left the nation hopelessly divided.  In simple terms, the issue of Brexit cuts across party lines, which makes it very difficult to achieve a political solution. 

In our model we list all possible outcomes after the parliamentary vote.  We explain how a soft Brexit – a Norway Plus option – has a 24% probability of being realized, while a bitter political impasse could result in snap elections (chances are 35%) – this means a no-deal Brexit is more likely with a probability of 41%.  However, we argue that given the acute economic dislocation that will be experienced on both sides of the English Channel, we assume that the 29 March deadline will be extended to achieve a negotiated Brexit.  This refers to a trade deal that will protect small businesses and ensure the smooth supply of basic food products.  While many are of the view that a second referendum will give a vote to remain in the EU, we think growing concern about immigration and a tribal mindset, could unleash a wave of nationalism in Britain.  We argue that in view of growing nationalism in Europe, there may be little reason for Britain to stay within a union that is increasingly unsustainable.  Word Count: 4,526. 

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Pakistan's economic flux is not business-as-usual

(January 07, 2019)

On 26 December 2018, the Pakistan Investment Bond (PIB) was resurrected.  The authorities finally decided to accept more expensive money, borrowing 3, 5 and 10-year money at rates that reflect the 50% increase in the discount rate during 1H-FY19.  With inflation much lower than market expectations, this hike is driven by the urgent need to shift Pakistan’s market debt into longer-term maturities.  We also argue that the government is using soft oil prices to reduce retail fuel prices, to dampen food and transportation costs, and keep a cap on headline inflation.  If inflation in FY19 settles at a lower level than previously anticipated, and banks shift into longer-term PIBs, we think the monetary tightening phase may be almost over. 

With a mini-budget expected in mid-January, we propose that several key uncertainties be addressed.  First, we discuss the need to confirm the start date of the IMF program to provide some confidence to the market.  We also argue that new revenue measures should focus on those who do not pay taxes, which means the government must maintain pressure on non-filers.  As a matter of housekeeping, we suggest that the government should clarify how Pakistanis with overseas assets could regularize their wealth, and reaffirm its commitment to continue the anti-corruption and anti-encroachment policies despite the economic dislocation.  We argue that accountability and documentation are key economic goals the government should stand by.  However, these policies do not give the economy much direction: to address this, we suggest that the PTI government should announce an economic vision that builds on manufacturing, upgrading our labor force, and using CPEC to anchor Pakistan’s development agenda.  Word Count: 3,649.  

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Summary of 2018

(December 27, 2018)

In this paper, we summarize the main developments of 2018.  The narrative shows the mounting pressure on the external sector, and hesitant policy steps to rectify the problem.  While the new government’s tenure has seen significant changes in the PKR and interest rates, there is no clear signal as to when Pakistan will enter the IMF program.  This failure to calm the markets resulted in a bearish end to the year. 

However, we take heart from the on-going accountability drive, as this dovetails into the economic stabilization program.  We argue that the government may use its January mini-budget to change the tone on what it seeks to achieve in 2019.  As the country gears up for the IMF program, the government should reiterate its commitment to accountability and documentation, and announce other policy measures that will support this strategy.  This policy focus will increase the chances of a successful program.  While economic growth will surely suffer, the government should take advantage of this commercial lull to push against capital flight; create a digital record of individual asset holdings; move towards more accurate valuation of real estate; and create revenue measures that capture new payers.  We conclude by saying that global changes in 2019 are likely to be far more unsettling, compared to the short-term pain that Pakistan is likely to experience next year.  Word Count: 5,597.  

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Q2-FY19 Macro Projections: The near impossible balancing act

(December 03, 2018)

We delayed this piece hoping for more details on the forthcoming IMF program.  After the shock PKR adjustment on November 30, we decided to go ahead as we don’t expect program details till mid-to-late January 2019.  Letting the exchange rate go on the day of the monetary policy decision, and the larger than expected increase in interest rates (150 bps), has convinced the market that November 30 is a prelude to the next program.  We look at Egypt’s experience with the IMF in 2016 to show that the initial stages of stabilization can be very disruptive, but argue that Pakistan’s experience should not be as painful. 

In terms of the next program, we highlight the targets on SBP’s net international reserve (NIR), which could put further pressure on the PKR/$ parity.  However, we think that most of the heavy lifting has already been done.  We had anticipated a parity of 140-141/$ by end-June, but the November 30 event has pushed up our projections to 145-146/$ by end FY19.  Compared to our previous projections, this means higher inflation, more monetary tightening, a larger fiscal deficit and lower growth.  While this will dampen economic sentiments, if the stabilization is properly managed, GoP should be able to move on more meaningful structural reforms.  If the stabilization is disruptive, tough reforms will be postponed (again).  Word Count: 4,542.

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IMF negotiations with a Twist

(November 09, 2018)

As Pakistan negotiates its 13th IMF program since 1988, the market’s response has been mixed.  Assistance from Saudi Arabia has shored up the PSX, but the market has been disappointed by the Chinese offer to discuss Pakistan’s economic needs.  We argue that China’s response reveals that it is looking out for its substantial CPEC investment, but this is also the correct path forward for Pakistan.  To make CPEC financially viable, China will want to ensure that Pakistan’s macro economy is structurally strengthened.  This IMF-plus package should dispel the view that CPEC is self-serving, and push our policymakers to implement hard reforms. 

In September 2017, we had suggested that the best outcome for CPEC would be a scenario whereby China helps build Pakistan’s repayment capacity, in conjunction with a strictly implemented IMF program.  In our view, this is playing out.  However, it is important not to view the IMF’s concerns about CPEC as a geopolitical strategy to undermine our economic relationship with China.  We argue that China would encourage Pakistan to undertake hard reforms, and Chinese assistance would be a combination of rescheduled loan repayments and structural changes to narrow Pakistan’s bilateral trade deficit.  We repeat five areas of policy focus, and urge the government to adopt an unorthodox strategy to achieve results. Word Count: 2,488.

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Khashoggi’s murder is a point of no return

(November 01, 2018)

The premeditated murder of Jamal Khashoggi has split the Middle East.  Turkey is pushing to undermine the House of Saud, sensing that this will weaken US policy in the Middle East and isolate Israel.  These forces could change regional dynamics in favor of Iran.  Given the stakes in the Turkey-Saudi standoff, this issue will not go away till the Saudi crown prince (MBS) is removed.  If this happens, the kingdom’s foreign policy will become less aggressive, which may put an end to the war in Yemen and tone down the anti-Iran rhetoric.  In our view, as Turkey and Iran are in the same coalition in the new global order, Turkey may use this momentum to bring Iran back into the fold of the global community. 

This standoff should be viewed in context of the current situation in the Middle East.  Yemen, Libya, Iraq and Afghanistan are already unstable; if the kingdom falters, this will impact the rest of the Middle East.  This regional instability worries the US establishment, which may take charge of US policy towards Saudi Arabia – President Trump may also lose interest closer to his reelection campaign in 2020.  We end by saying that the uncertainty in the Arab world will not adversely impact Pakistan – despite the $ 6 bln aid package from the kingdom, we do not expect Pakistan to take sides.  Word Count: 4,430.

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The Last IMF Program?

(October 18, 2018)

After a hesitant start and some missteps, PTI’s economic team took two meaningful steps in mid-September 2018.  It announced a progressive increase in gas tariffs, and presented a mini-budget to reverse the previous government’s short-lived tax cuts before the July elections.  Since then, the government has conceded that it will be approaching the IMF for a bailout; increased interest rates by more than the market expected; and allowed the PKR/$ parity to depreciate to 133.7/$. 

Clearly the country has a hard year ahead.  Many are skeptical that much will change in the next IMF program.  However, we believe the PTI’s political mandate and the publication of a list of Pakistanis who own properties overseas, suggest that the government will pursue an anti-corruption drive.  We suggest that this disruptive process be embraced with a political strategy to overcome the economic dislocation.  Using the chronic circular debt problem, we remind readers just how difficult structural reforms are.  We then suggest four additional goal-driven endeavors: (1) documentation and revenue generation; (2) external sector sustainability; (3) the need for an industrial policy; and (4) regulatory and institutional strengthening.  Unlike past reform efforts, we propose a reform oversight mechanism headed by Czars, who spearhead each of these areas and keep the country abreast of progress.  We conclude that reforms of this nature cannot be conducted in a business-as-usual manner.  If the government pursues these reforms with political commitment and generates public support for such changes, the next IMF program could be Pakistan’s last.  Word: 6,074.

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Deceptive choices

(September 04, 2018)

Although the political landscape has settled, the economic picture remains confusing.  Media coverage shows that the government has yet to decide whether to approach the IMF.  We suggest there is further confusion: will the government focus on economic relief or macro stabilization?  Will the government impose hard reforms or seek a consensus?  With a record high external deficit in July 2018, the decision to cut retail fuel prices on 1 September, was perhaps not the right signal.  Furthermore, a parliamentary debate about whether Pakistan should approach the IMF is ill-advised, as the newly elected parliament would not want to lose policy sovereignty.  Finally, debating the direction of economic reforms with Pakistan’s status quo, is a non-starter.

These deceptive choices are not addressing the deteriorating balance of payments (BoP) position.  We argue that Pakistan needs both the IMF and assistance from China; it needs to signal that stabilization is more important than temporary relief; and PTI needs to follow its campaign promise of change, and not settle for negotiated reforms.  Bold policy steps are likely to be positively received and will set the right tone for the new government.  With a monthly reminder of Pakistan’s vulnerability coming from SBP (BoP data), the current macroeconomic calm cannot be taken for granted, especially against the backdrop of jitters in Emerging Market countries.  Word Count: 3,754.

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The Challenges Facing Pakistan’s Economy

(August 15, 2018)

This comprehensive paper was commissioned by the Asian Development Bank, Islamabad.  We argue that the various macro challenges facing Pakistan can be traced largely to short-term policymaking and weak state institutions.  In terms of a solution, we argue that returning to the IMF would have to be supplemented with more customized steps to: (1) accurately document all real estate holdings in the country; (2) make the Amnesty Scheme more effective; and (3) talk with our Chinese partners to rethink the focus of CPEC and narrow our bilateral trade deficit via the China-Pakistan FTA.

In a series of standalone boxes, we talk about: (1) poor policy oversight because of a politicized bureaucracy; (2) the need to pursue accountability even if it temporarily disrupts the economy; (3) how CPEC could play out; and (4) how it is in Pakistan’s interest to adopt FATF guidelines, not just to get off their grey list, but to better manage the Rupee.

With on-going developments, we discuss PTI’s election victory, and the US government’s effort to politicize the IMF and CPEC.  We propose possible first steps for the new government, with a specific emphasis on working with both China and the IMF to stabilize the country’s economic outlook.  We dismiss the likelihood that US pressure could make the IMF unapproachable.  We conclude that it is too early to decide whether the PTI government is willing to implement disruptive reforms to cleanse out the system, or settle for a gradualist approach that may not deliver results.  Word Count: 14,710.

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Q1-FY19 Macro Projections: The Challenges Facing Pakistan’s Economy

(August 15, 2018)

This comprehensive paper was commissioned by the Asian Development Bank, Islamabad.  We argue that the various macro challenges facing Pakistan can be traced largely to short-term policymaking and weak state institutions.  In terms of a solution, we argue that returning to the IMF would have to be supplemented with more customized steps to: (1) accurately document all real estate holdings in the country; (2) make the Amnesty Scheme more effective; and (3) talk with our Chinese partners to rethink the focus of CPEC and narrow our bilateral trade deficit via the China-Pakistan FTA.

In a series of standalone boxes, we talk about: (1) poor policy oversight because of a politicized bureaucracy; (2) the need to pursue accountability even if it temporarily disrupts the economy; (3) how CPEC could play out; and (4) how it is in Pakistan’s interest to adopt FATF guidelines, not just to get off their grey list, but to better manage the Rupee.

With on-going developments, we discuss PTI’s election victory, and the US government’s effort to politicize the IMF and CPEC.  We propose possible first steps for the new government, with a specific emphasis on working with both China and the IMF to stabilize the country’s economic outlook.  We dismiss the likelihood that US pressure could make the IMF unapproachable.  We conclude that it is too early to decide whether the PTI government is willing to implement disruptive reforms to cleanse out the system, or settle for a gradualist approach that may not deliver results.  Word Count: 14,710.

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FY19 starts with a bang

(July 16, 2018)

We are surprised by the magnitude of the 100 bps increase in interest rates, and sudden weakening of the Rupee in mid-July.  Our earlier projections were more conservative as they were based on the worrying dynamics of Pakistan’s twin deficits.  While we expected the caretaker government to make necessary adjustments, the manner in which it was done, suggests possible prior understanding with the IMF and aspiring political parties.  The path that has been taken, also means the next government will not have much of a honeymoon period.  Despite the promise of a fresh government two weeks from now, the confusion about the country’s economic outlook remains.  Word Count: 1,296.

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Why global media could have it wrong again

(June 19, 2018)

CNN’s reaction to the Trump-Kim summit in Singapore (June 12, 2018) is surprising.  It took little comfort from the averted threat of a nuclear exchange between the US and North Korea.  Instead, CNN was shocked that a US President was so civil with a dictator who is notorious for human rights violation.  More generally, global media outlets were dismissive of President Trump’s claim that this summit was a success.

In our view, these media outlets will become more belligerent closer to the US mid-term elections.  As they step up their criticism of Trump’s divisive policies, he is likely to respond by playing hardball.  What global media is missing, is that Trump’s uncompromising stance on immigration, and his combative stance with trade partners, play to his blue collar base and fuel tribal thinking.  We believe the showdown in November 2018 will only be about Trump and his policies, not about individual candidates or issues.  This will force aspiring Republicans to either embrace Trump’s divisive world view, or risk losing.  If Trump succeeds and the Republicans retain their majority in Congress, his second term will be more likely.  Word Count: 2,317.

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Reality Bites

(June 06, 2018)

The government has abruptly shifted gears since the caretakers took charge.  Just weeks before, the Ministry of Finance was insisting that the Rupee was not overvalued, only allowing for an adjustment during the IMF’s PPM discussions in December 2017.  It also denied the need for an IMF program.  The government has now accepted reality: the external deficit is much too large, the Rupee needs to weaken, the fiscal deficit will exceed budget targets, and there is some urgency to begin talks with the IMF.

The question is: why did key institutions tasked with protecting Pakistan’s economy, fail to take corrective policy decisions?  Despite a worsening economic outlook, these institutions remained passive – EAD did not sound an alarm (despite debt repayments piling up), and SBP kept the PKR-Dollar parity fixed (despite plunging FX reserves).  In our view, this inaction is as troubling as the economic crisis itself; Pakistan’s bureaucracy can no longer counsel its political masters.  It is therefore complicit in decisions that structurally weaken the economy.

The best the caretaker government can do, is to disclose the true state of the economy, and suggest a credible economic roadmap.  Unlike past reform programs, institutional strengthening must be a priority.  Word Count: 2,312.

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The vicious twin deficits, Part 2

(May 30, 2018)

In this paper we argue that orthodox demand management may not be sufficient to right the economy – an IMF program plus out-of-the-box solutions are now necessary.  Pakistan’s economy faces three major challenges: large current account and fiscal deficits, and a heavy external debt burden.  Efforts to manage these challenges through PKR and fuel price adjustments (and by increasing interest rates), could further stoke inflation.  This means higher interest rates and heavier debt servicing.

As in past IMF programs, if this situation is compounded by the need to reduce central bank financing to the government, the upward pressure on interest rates could become unsustainable for the fiscal side.  This, in turn, could dampen the political will to continue, which may slide into an incomplete program.

To guard against a potential fiscal blowup, PKR revenues must be increased sharply.  While the IMF is likely to focus on increasing the tax base (as it has done in the past), we think it is time for more customized fiscal reforms.  In our view, the country needs to enforce more accurate valuation of real estate holdings, and offer a “fair” amnesty scheme (for resident and non-resident Pakistanis) to draw in more people into proper financial documentation.

For the external sector, hard steps are needed to sharply narrow the current account deficit.  From a longer-term perspective, we suggest reformulating the China-Pakistan FTA to make it more balanced.  As Pakistan’s economic linkages with China grow, there is a need to ensure that the relationship is sustainable.  In effect, Pakistan’s Achilles heel (the external sector) should be fortified by CPEC, not exploited by it.  Word Count: 3,170.

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Trump scuttles the Iran nuclear deal (& the Middle East)

(May 14, 2018)

In this paper we discuss Trump’s unilateral decision to scuttle the Iran nuclear deal.  He now seeks to expand the coverage of the deal to include Iran’s ballistic missile program, and Iran’s regional presence that is deemed to be destabilizing.  We argue that the US does not expect Iran to capitulate but rather to create an environment wherein both parties cannot back down.  By threatening isolation, the US is attempting to break the will of the Iranian people and effect regime change.  It also hopes to push Iran to resume its nuclear program, which would reduce support (for Iran) from other members of the JCPOA.  However, Iran is unlikely to play by the US playbook – it will look to China and Russia for support, and expose the vulnerability of European allies to US sanctions.  This will create the need for a global trade regime that is independent of US influence.

Israel and Saudi Arabia are jubilant (they have been rooting for Iran’s isolation).  However, Iran has shown that it can withstand economic isolation while continuing to expand its regional influence.  Now the stakes are much higher with Iraq, Syria, Yemen and Lebanon already in play, while countries like Bahrain, Saudi Arabia and the UAE could also be targeted.  This could become a tipping point for the entire Middle East region.  Although Pakistan is vulnerable because of inward remittances from the GCC, it should remain neutral in the Iran-Saudi standoff.  Word Count: 3,174.

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Q4-FY18 Macro Projections: The vicious twin deficits, Part 1

(April 26, 2018)

In this paper we argue that Pakistan’s external sector poses a difficult choice for policymakers: either devalue the currency to narrow the CA deficit (which will increase debt servicing and inflation); or continue to plug this gap by borrowing (increase the country’s debt stock that makes future devaluation more painful).

In essence, Pakistan is now trapped in self-enforcing twin deficits.  Despite growing exports and firm remittances, we expect the external deficit to reach $15.3 billion for FY18.  We see the caretaker government devaluing the PKR and raising fuel prices in June 2018, to set the stage for an IMF programme in FY19.  While average inflation in FY18 will be around 3.8%, FY19 will see a return to a higher inflation trajectory.  With the average maturity of T-bills almost down to 3 months, a large increase in interest rates (coupled with PKR devaluation) would exert serious fiscal pressure after 3 months.  We therefore expect the caretaker government to be cautious and raise interest rates by, at most, 50 bps to signal future direction – it will look to the next government to set interest rates as a prelude to the next stabilization program.  In the conclusion, we raise the possibility of a staggered Amnesty Scheme and a rewritten Pakistan-China FTA as unorthodox, but necessary policy responses to Pakistan’s structural BOP problem.  Word Count: 3,209.

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The end of Globalization

(April 18, 2018)

In this paper we argue that the current US-China trade relationship is unsustainable.  We contend that economic arguments alone would likely be insufficient to roll back US consumption of China’s exports.  However, a changing geopolitical stage may provide the political impetus to push through an adjustment to a more balanced trade relationship.

One of Trump’s core promises is a reversal of the free trade paradigm that is blamed (by his political base) for ravaging US manufacturing.  This has prompted Trump’s recent stoking of a potential trade war with China, which incidentally supports Xi Jinping’s need to reduce China’s dependence on exports and infrastructure development.  Trump’s stated position makes China’s transition to a more consumption-based economy politically feasible.  As the US cedes its role as the champion of globalization, multilaterals will look to China to fill the vacuum; however, China’s preference for bilateral negotiation (as seen in OBOR) makes this unlikely.  Moreover, the emerging bipolar world order, will require lower trade dependence to allow a freer pursuit of regional interests.

In the appendix, we discuss a peace agreement between the two Koreas (orchestrated by China), which will involve North Korean disarmament in return for a withdrawal of US troops from the Korean peninsula.  Word Count: 4,610.

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The IMF Strikes Back

(March 23, 2018)

We analyze the IMF’s Post-Program Monitoring Staff report.  While much of it consists of the Fund’s usual observations rendered in IMF-speak, there are several surprising views and admissions – along with a clear suggestion that Pakistan will enter a stabilization program in FY19.

The IMF discusses CPEC in neutral-to-positive terms, in a less alarmist tone than in the past (previous reports focused more squarely on its associated risks – primarily the debt burden imposed).  However, it does address the ballooning external debt, and its discussion of Pakistan’s “capacity to repay” the Fund is essentially a signal of an upcoming stabilization program.  The IMF accepts that the EFF was “incomplete”, and pointedly draws attention to the suspect amendment of the debt limitation act.  The Fund makes passing mention of a “fiscal cadaster”, an obscure term for a database of real estate holdings in a country.  Since real estate is the true driver of domestic demand in Pakistan, such a database would provide policymakers the proper reins to Pakistan’s economy.  We conclude that the IMF puts forward a more realistic narrative about the economy, compared to what was peddled during the previous government.  While the report’s familiarity is not heartening, there are enough moments of candor and clarity, to create some hope about the next program.  Word Count: 3,838.

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Trump’s Tariffs are part of the Show

(March 15, 2018)

In this paper, we argue that Trump’s tariffs on steel and aluminum, while counter-intuitive, make sense given his particular ambitions as President.  It is true that these tariffs may stoke inflation; speed up interest rate hikes; lead to net job losses in the US; spark bilateral trade wars; and undermine the rule-based global trade regime.  Yet the tariffs are exactly what Trump’s base responds to – a broad, symbolic swipe at the rich, globalist elite.  It is the kind of disruptive action that excites his supporters, and is perhaps overdue because of the lack of progress of Trump’s economic agenda.

But there is another pragmatic motive for these tariffs: Trump is likely to use them as bargaining chips in bilateral trade negotiations.  This would directly weaken rule-based global trade and the WTO.  Broadly speaking, Trump’s actions should be viewed through the prism of reality TV: controversy is stirred; conflict is stoked; and viewers are kept guessing.  Fundamentally, Trump is not working for the good of the US or its people, but rather for his own political survival.  Word Count: 2,389.

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FATF and Pakistan’s economic outlook

(February 19, 2018)

We discuss Pakistan’s imminent inclusion in the FATF watch-list.  We argue that while placement on the list does not result in economic sanctions or a reduced capacity to borrow, it may become an instrument in the Trump administration’s attempt to squeeze Pakistan.  If the country is placed on the list and the US is unwilling to compromise, stakeholders could fear the worst – greater scrutiny of banking transactions, reduced appetite for Pakistani bonds, and pressure on the kerb market.  With Pakistan’s precarious BOP situation, SBP could step up import controls and devalue the currency.  If the US-Pakistan stand-off escalates, Pakistan may call the IMF’s credibility into question.  This could become a rallying point for other countries frustrated with US influence over the global financial system.  However, we believe the likely outcome will be an IMF program in H1-FY19, as the Pakistani market is now conditioned to expect the IMF to stabilize the external sector.  We conclude by reiterating that the long-term sustainability of Pakistan’s external sector will remain out of reach as long as aggregate demand is driven by undocumented real estate and the informal economy.  Word Count: 1,807.

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Could a clash with the US Fed endanger Trump’s presidency?

(February 08, 2018)

We focus on rising wage pressures in the US economy that led to a recent correction in the stock market, and how this could create a conflict between the country’s fiscal and monetary policies.  The Trump administration is implementing an expansionary fiscal policy (the tax cut, the pending infrastructure program) just when the Federal Reserve is planning to raise interest rates due to concerns about overheating.  As national debt increases, rising interest rates will exacerbate US debt dynamics, which will add to fiscal deficits.  Given Trump’s willingness to feud with US institutions, the Fed may become his next target.  However, the central bank isn’t just any other institution: open conflict between the executive branch and the Fed may have adverse consequences for the markets.  Word Count: 1,841.

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The Unexpected Interest Rate Hike

(January 30, 2018)

We discuss SBP’s surprise decision to raise the policy rate by 25 bps, citing inflationary pressures.  We argue that while a hike of this magnitude will do little to suppress demand, it allows the SBP to preempt resistance to its economic aims for 2018 (namely, tightening liquidity and raising interest rates).  It has taken this decision to create expectations of further rate hikes.  If these do not materialize, banks will only provide short-term financing to the government.  Therefore, to avoid a worsening of the maturity profile of Pakistan’s domestic debt, policymakers will have to accept the need to increase interest rates, regardless of upcoming elections and other political considerations.  Higher interest rates, along with a depreciated rupee, will also facilitate the country’s entry into an IMF program.  Word Count: 1,810.

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Q3-FY18 Macro Projections: Stepping into the Unknown

(January 22, 2018)

Our projections suggest that FY18 will be a transitional year for Pakistan.  Urgent policy action is required on the external front, namely the staggered depreciation of the Rupee.  This will return the country to a higher inflation trajectory, which will require further tightening of monetary policy.

We expect an IMF program in FY19.  We see the external deficit being higher this year compared to FY17, but not excessively so.  Our projections suggest that higher fuel prices and a weaker Rupee will cause inflation to peak at 8.6% in FY19, before stabilizing in the 7-8% range.  We view this return to price pressures as a reversal of the abnormally low inflation we have seen over the past two and a half years.  With average inflation projected at 4.9% this year, and fiscal management under pressure, we do not see much interest rate pressure in FY18.  Instead, we predict a 100-125 bps adjustment in FY19.

So, while the loss of macro stability will create uncertainty and require careful management, this transition was long overdue.  The artificial economic calm will be disrupted as structural issues demand substantive policy actions.  Word Count: 5,539

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Could the next IMF Program be decisive?

(December 12, 2017)

In this paper, we argue that an IMF program in 2018 is inevitable, as SBP’s unencumbered reserves reach negative $1.8 billion.  We discuss the December devaluation of the rupee, which coincided with the IMF’s post-program monitoring (PPM) discussions.  We contend that the program will focus on making CPEC liabilities transparent and payable, either by scaling back projects or delaying repayments.  The program will likely also focus on implementing more accurate real estate valuations, which will allow policymakers to account for the true wealth in the country.  This is necessary to manage the spending patterns of Pakistanis, especially on imported luxury goods.  We conclude that a confluence of geopolitics and domestic economic compulsions, may be setting the stage for an IMF program that brings real change.  Word Count: 3,334.

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The Saudi Gamble

(November 16, 2017)

We argue that the shocking arrest of several high profile Saudi princes and ministers, is a decisive moment in Crown Prince MBS’s reform campaign.  We contend that the event is best understood within the context of changing regional dynamics, and MBS’s checkered track record (e.g. the Yemen war).

Iran’s growing regional influence and Russia’s military involvement in Syria (not to mention the rift between Turkey and the US), has created a divide in the Middle East.  Saudi Arabia and the UAE have stepped up their anti-Iran rhetoric.  This muscular foreign policy is encouraged by President Trump, who is keen to achieve an outcome that suits Israel and isolates Iran.  We argue that MBS may have opened up too many fronts, which could have unsettling repercussions for the entire Gulf region.  We also believe that MBS’s urgency to sell part of ARAMCO, is part of an all-or-nothing strategy, which is very un-Saudi.  Since Pakistan has wisely decided to stay neutral in this Saudi-Iran stand-off, we fear that worker remittances from the Kingdom and the UAE could fall in 2018.  This will put further pressure on Pakistan.  Word Count: 4,449.

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Too Little, Too Late?

(October 18, 2017)

In this paper, we discuss the government’s newest “clever” policy step – the imposition of import duties on a host of consumer items.  We argue that a closer look at the list reveals that many of these imports are insignificant in value.  In fact, closely related items that are imported in substantial amounts, are left off the list.  We contend that, in the past few years, Pakistan’s economy has been coasting along because of the fall in oil prices and the initiation of CPEC.  The resulting increase in private wealth has fueled unproductive imports, which were easy to finance.  As SBP’s FX reserves started falling, the policy response was to increase borrowing to fund the external deficit.  This was coupled with a refusal to let the Rupee adjust for fear of increasing inflation and interest rates.  We conclude that this short-termism has deposited us (once again) at the doorstep of the IMF, making a stabilization program inevitable in 2018.  Word Count: 1,709.

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A Self-Induced Challenge to the US Dollar

(October 13, 2017)

We explain the dominance of the US Dollar over global trade, by likening international trade to a physical marketplace owned by the US, and used by all other countries.  The perennial demand for the dollar allows the US to run large external deficits (while the rest of the world runs a net external surplus).  Furthermore, its ability to unilaterally impede dollar transactions (by halting dollar clearing) allows the US to inflict economic pain on its adversaries.

We argue that global trade and macro imbalances cannot persist indefinitely.  China is planning RMB-denominated futures to transact with oil exporters in RMB rather than the dollar, which would reduce demand for the dollar.  We contend that Iran could be the first to opt for the RMB oil future, and as the instrument gains acceptance, the dollar will weaken while the RMB will strengthen.  This should cause US imports to fall as China’s imports from the US rise.  The rebalancing is required to make global trade more sustainable.  Word Count: 4,694.

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Geo-political Developments

(October 02, 2017)

We argue that the media coverage of the US-North Korea stand-off, dulls the true urgency of the issue.  A closer look reveals that a nuclear exchange is a distinct possibility, given the leadership of these two countries.  We use a probability distribution framework to analyze potential outcomes.  We conclude that, surprisingly, the least destructive path forward will involve a successful ICBM launch by North Korea.  Word Count: 2,972.

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Pakistan’s Balance of Payments, the IMF and China

(September 14, 2017)

We present three BOP scenarios for FY18, and argue that the likeliest scenario will involve an FX crisis resulting in an abrupt devaluation in Q3-FY18.  We then discuss potential directions the Pakistan-China relationship might take in light of the build-up of CPEC-related debt.  If China treats CPEC as a commercial venture, there could be two outcomes: (1) China helps enhance Pakistan’s FX generation capacity (by investing in the export sector); or (2) it acquires Pakistani assets when the country is unable to repay its FX debt.  We conclude that the latter would sour relations and breed resentment in Pakistan, which will undermine CPEC’s long-term prospects.  The likely way forward will involve joint ventures between the two countries that enhance Pakistan’s export earnings.  Word Count: 4,252.

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The Qatar Blockade could have geopolitical repercussions

(June 08, 2017)

In this paper (published 3 days after the blockade was imposed) we predict that Qatar would not accede to Saudi demands.  It would instead weather the diplomatic crisis and economic isolation.  We argue that the blockade pushes Qatar closer to Iran and Turkey, reinforcing the presence of an anti-Saudi bloc in the region.  We conclude that, while Qatar will have to withstand some economic pain, its massive natural gas reserves (that it shares with Iran) and associated long-term sales agreements, give it an edge in the stand-off.  Word Count: 3,410.

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Pakistan’s BOP: The Calm before the Storm

(May 31, 2017)

We argue that the brewing BOP problem is distinct from previous external sector crises – it is not driven by an oil shock, but structurally weak export revenues and a bleak outlook for remittances.  We discuss possible measures to relieve short-term pressure.  We then argue that CPEC will fail in the long term unless Pakistan’s capacity to generate FX is revived.  Finally, we contend that given Pakistan’s weak institutions and shrinking export sector, China may have to be more proactive by initiating export ventures within the country.  Word Count: 6,148.

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The Changing Global Order

(May 10, 2017)

We argue that events such as Brexit and the election of Donald Trump are a prelude to a changing global order.  We contend that current US dominance will give way to a bi-polar world with two alliances: the US Allies (India, Saudi Arabia, Israel and the UK), and the Sino-Russian Axis (with Iran, Turkey and Pakistan).  These blocs are remarkably well-balanced in terms of population, nuclear weapons, economic resources and growth outlook.  We discuss Syria and North Korea, two current flashpoints, in some detail.  Word Count: 2,907.

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Does Pakistan need an Industrial Policy?

(January 05, 2017)

We argue that a break from the Washington Consensus and a return to development finance institutions (DFIs) may be good for Pakistan.  We use examples from Asia to show that broad-based industrial development (especially within heavy industry) can be achieved through strategic government intervention.  We conclude that CPEC could provide the blue-print for Pakistan’s industrial policy, which is focused on power projects, industrial cities, transport networks and Gwadar Port.  Word Count: 2,227.

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The Parable of Pakistan and the IMF

(December 27, 2016)

We examine Pakistan’s prolonged relationship with the IMF through the parable of a self-serving doctor (the IMF) and the weak-willed patient (Pakistan).  The doctor is unable, or unwilling, to curb the patient’s bad behavior.  We argue, with the aid of a simple game theoretic model, that geopolitical compulsions and bureaucratic inertia create an environment where it is always in the interest of the doctor to string his patient along, without forcing any real, lasting change.  This pattern, which dates back to 1988, may not continue in the new world order.  Word Count: 2,029.

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Cashless in Kolkata

(December 02, 2016)

We argue that media coverage of India’s demonetization has missed the point.  Despite its poor implementation and disruptive impact, demonetization signals India’s willingness to repair and rewrite the Social Contract with its people.  We contend that by documenting its economy and curbing the use of black money, India is changing its economic orientation to book its seat at the big table.  Word Count: 2,003.

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Addressing the real economic challenges facing Pakistan

(November 21, 2016)

We discuss “non-IMF” economic challenges facing Pakistan.  We argue that Pakistan must take decisive economic steps in the spirit of India’s demonetization.  This could be achieved by documenting its increasingly dominant informal economy, ensuring more accurate real estate valuations, and curbing corruption and capital flight.  Word Count: 1,558.

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The Trump Phenomenon

(September 28, 2016)

In this paper (published over a month before the US election) we predict that Trump would create a lasting political movement and permanently transform the Republican Party.  We consider Trump’s rise against the backdrop of American workers disadvantaged by unfettered globalization; the 24-hour news cycle; social media; and the ideological shift to the center by both major US political parties.  We predict that the US will move closer to protectionism, as demands for equity overshadow the pursuit of economic efficiency.  Word Count: 2,348.

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One Belt, One Road: Building Asia on China’s Strengths

(August 12, 2016)

In this paper, we try to address some of the more worrying perceptions about CPEC, by considering China’s impelling economic and geopolitical motivations behind the initiative.  We put this into historical context by summarizing China’s unprecedented success in transforming its own economy (“The Great Leap Forward”) using a heuristic, trial-and-error style of economic reform.  This is anchored to a long-term macro vision while remaining flexible on how to achieve these goals.  We argue that CPEC’s deliberate vagueness becomes much less alarming when one abandons the “Washington Consensus” view of economic reforms.  We conclude with a consideration of possible future developments (vis-à-vis hard and soft power) for the US, UK and China till 2040.  Word Count: 9,526.

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Brexit: Why the 23rd June Referendum is just the beginning

(June 14, 2016)

In this paper (published 9 days before the vote) we predict that the UK would leave the EU.  We argue that the EU’s impact on the Britain’s economy and British culture has created a level of resentment within the British public, which will push England to reclaim its unique national identity.  We contend that Brexit may in fact help restore balance to the British economy, which has developed a lop-sided focus on financial services and high-end retail & real estate.  Word Count: 4,374.

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