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Confusing signals from D.C. unhinge the market

(October 20, 2021)

The mixed signals from Washington D.C. about the status of the EFF, have unhinged the markets.  Media stories that Pakistan had agreed to increase power and gas tariffs, coupled with the sharp increase in retail fuel prices in October, suggested that the required steps to restart the EFF had been taken.  However, the talks have ended inconclusively, and the FX market is volatile.

Since it is clear that Pakistan cannot afford to protect its citizens from rising commodity prices (especially oil), we have updated our projections for the rupee and domestic fuel prices.  The resulting increase in headline and food inflation is alarming, and the PTI government is scrambling to manage sentiments.  Given the trajectory of food inflation in FY22, we think this is the most challenging economic issue the PTI government has faced.

Although there are no details about why the IMF talks stalled, we argue that the deal-breaker could be the size of the current account deficit (CAD) for the year.  In our view, the government is asking for greater BoP leeway to achieve 5% growth this year, but the IMF wants a smaller external deficit especially at a time when Pakistan is vulnerable to external price shocks.  If the CAD target is restrictive, this will undermine growth and create more pressure on the rupee – it could also force SBP to increase interest rates more aggressively.  Greater BoP leeway would have the opposite effect.

So far this year, the economy has operated without a BoP outlook.  However, with rising commodity prices and high monthly CADs, businesses are now looking for greater clarity about the external sector as this will give them a better handle on the rupee-dollar parity and the ease of importing.  This is only possible if the EFF restarts after both sides agree on Pakistan’s BoP outlook.  In the interim period, it is crisis management as inflation surges and opposition parties pile on the pressure.  The inconclusive IMF talks raise the possibility that the EFF could be delayed, which means the end date could be extended into 2023.  This will create complications for the PTI government as it gears up for general elections.

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Shifting tectonic plates could make Pakistan vulnerable

(September 24, 2021)

The past week has seen a change in Pakistan’s economic narrative.  SBP’s monetary policy statement (MPS) released on Sept 20th justified a 25-bps increase in interest rates, but held out the hope that the authorities would safeguard the growth momentum while managing inflation and reducing the CA deficit.  By Sept 23rd the finance minister and SBP had changed their tone, with greater emphasis on curbing imports and dampening the growth momentum that is threatening the external sector.

This change in direction is required as Pakistan gears up for the WB/IMF meetings in October, where the authorities will seek to restart the EFF.  This could be complicated by the significant geopolitical changes that have taken place since the US left Afghanistan in August.  President Biden is changing the global order to focus on the perceived threat from China: he is creating new security alliances; snubbing older allies; signaling that the US is no longer the global policeman; that US military intervention is a last resort; and the US will now focus primarily to contain China’s global influence.

US-Pakistan relations are already strained because of Afghanistan, and India is now part of a new US security arrangement to monitor the Asia-Pacific region.  The cancellation of foreign cricket tour to Pakistan is an effort to isolate the country, and to play up its links with terrorist groups.  Such heavy headwinds coupled with the weak external sector, means that Pakistan must approach the IMF with caution.  Stubborn posturing from our side may delay or suspend the EFF, which could create a sense of panic in the economy.  From the IMF’s perspective, it will remain firm that Pakistan cannot increase its circular debt and must meet its revenue collection target.  Since Pakistan has decided not to renegotiate IPP tariffs with Chinese-owned producers, the IMF will insist that consumer tariffs be increased as agreed.  This means the EFF will come with upfront pain.

While the West can afford to ignore Afghanistan, Pakistan cannot.  The looming humanitarian crisis in Afghanistan will surely burden Pakistan’s limited food supply and could trigger a mass refugee problem.  If the US decides that Afghanistan’s collapse is not its responsibility, then neighboring countries would have to step in – specifically Pakistan.  This will add to the BoP pressures that Pakistan is already experiencing and could make the EFF much tougher to live with.

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Getting a handle on Afghanistan’s economy

(September 13, 2021)

While little can be said about Afghanistan’s political and economic future, the economic data for the past two decades is revealing and disheartening.  Basing the paper on country reports published by the World Bank and the IMF in April and June 2021, we would make the following points:

  • GDP growth was strong but erratic in the first decade of the US occupation (2002-2012), but this fell apart in the past several years;
  • This coincided with two key markers: (1) the end of combat operations in late 2014, which resulted in a sharp drawdown in foreign troops; and (2) President Trump’s decision in February 2020 to withdraw US troops from the country by May 2021;
  • With donor grants (not debt) financing almost three-quarters of annual government spending, which itself was about half of Afghanistan’s GDP, the sudden stop of donor funding will surely create an economic collapse;
  • Foreign grants allowed the central bank (Da Afghan Bank – DAB) to maintain a stable currency and finance a CA deficit that averaged 19.1% of GDP during the period 2011-2020. Narrowing this deficit will be very challenging;
  • The economic slowdown reduced imports, but a growing fraction of total imports is for essentials items (food, fuel, and medicines). By our calculations, Afghanistan spent over $ 3 bln last year for such essentials;
  • With DAB’s ample FX reserves frozen by the US Fed and the banking system barely operational, formal imports will shift to informal channels, which would place a heavy burden on Pakistan’s economy;
  • Because of the size of the economic imbalances in Afghanistan, this problem cannot be tackled without external assistance. This will require re-engagement with the IFIs, the resumption of donor aid, and new sources of finance and investment;
  • In our view, most inwards remittances from expat Afghans are channeled via the parallel FX market, which allows for capital flight;
  • Most of the endemic corruption is concentrated at the customs stage, which should be the main source of government revenues for an import-dependent and undocumented economy. This will have to be stamped out if the government is to provide basic goods and services to the Afghan people; &
  • The banking system does very little financial intermediation, as many private sector projects were directly financed by donors.

The immediate risk is a humanitarian crisis in Afghanistan.  This will impose a significant burden on Pakistan, both in terms of additional imports and a larger influx of refugees.  Rehabilitating the Afghan economy will also be challenging; planners must ensure that past mistakes are not repeated, and the new economic setup does not clash with cultural norms and political needs.  An urban-focused economy may not be the right solution – we think an agri-focused, trade-based economy is a better bet.

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The spectacular implosion

(August 18, 2021)

The events in Afghanistan hardly need to be flagged – mainstream media has been using all 24 hours for breaking news.  It started when the Taliban captured the city of Zaranj on August 6th and ended when they walked into Kabul on August 15th.  The fact that they managed to do this without any air power, is equally impressive.

In our blog that started on August 6th, we argued that the Taliban takeover could have dire consequences for Pakistan (and its economy).  If the conflict became a bloody struggle in the main cities, a blame game would have started, and Pakistan would have been singled out.  US sanctions would have followed.

The swift takeover has worked in Pakistan’s favor, but the chaos in Kabul airport and the fear and panic amongst Afghans who worked for the Americans, could deepen the chaos and desperation in Afghanistan.  If this happens, Pakistan could still be blamed as the mastermind.  The Taliban are trying to convince a skeptical world that they have changed, but this will take time to gain traction.  The only positive is that regional powers like China and Russia have said they will work with the Taliban government, which means Afghanistan will not become a pariah.  As we have argued before, what is happening in Afghanistan signals a new world order, and Pakistan has played a pivotal role in securing its place in the bipolar world.

This raises doubts about our relationship with the US: more simply, will the IMF program be suspended, and could the US impose sanctions against the country?  We have analyzed the stalled EFF and argue that problems started in the first year, but the pandemic helped bring us back on track.  Now, both sides are waiting for the outcome in Afghanistan to shepherd the program forward.  We argue that the program will not be halted by the IMF, but the latter will insist that the economic growth the PTI government wants in FY22, does not undermine the stability in the external sector.

We also think IK and the Establishment have decided that the country’s future is not aligned with the US (or the IFIs) and Pakistan must focus on regional trade and China’s OBOR.  It is just a matter of time before China invites Afghanistan to join CPEC-Plus, which would connect Central Asian countries via Afghanistan to port access in Iran and Pakistan.  In our view, the PTI government’s focus on geo-economics is a diplomatic way of saying that Pakistan is shifting away from the US.  We also argue that IK may use this upside to secure another term in power.

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Pakistan goes on the front foot

(August 02, 2021)

This papers seeks to discuss Pakistan’s inflation rate in the year ahead, but more importantly, the uncertainty that events in Afghanistan have created for the country.

July’s YoY inflation of 8.4% is consistent with what we have projected.  Our model shows that a weaker rupee in the period ahead and a sustained increase in fuel prices, will keep inflation elevated, but the YoY rate will not trend upwards.  This means limited pressure on SBP to hike interest rates in the next 4 to 5 months.

The growing control of the Taliban in Afghanistan, on the other hand, is far more consequential for the country.  We do not agree with media reports that the increasingly strained relations between the US and Pakistan could stall the IMF program and jeopardize the economy.  We argue that the IMF cannot afford to appear partisan, especially after the positive results in the first two years of the EFF.

The greater uncertainty comes from the shift in Pakistan’s alignment towards China, with Afghanistan being a test case of the new world order.  The Biden administration is clearly focused on China as its main competitor, and the showdown between the two will shape global events in the period ahead – at this point the focus is Afghanistan.  Pakistan cannot afford to remain neutral in this showdown, as a civil war in Afghanistan will have devastating consequences for Pakistan.  The Prime Minister has publicly aired his view that the US alone is to blame for the mess in Afghanistan, and only a political solution will avoid a civil war that will surely pull Pakistan into the conflict.  Pakistan has accused India of destabilizing Baluchistan and undermining CPEC by targeting Chinese nationals in the country.  We argue that regional countries have a direct stake in what happens in Afghanistan, and both China and Russia have shown support for Pakistan’s view that a political solution is required.

What happens in the next several weeks in Afghanistan and how the US reacts, will have an immediate impact on Pakistan.  While a shift away from the US creates significant uncertainty for Pakistan, we do not see a plausible alternative.  We argue that a peaceful Afghanistan that participates in regional trade is the best outcome, not just for the Afghan people, but also for Pakistan and the region.

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The incomplete federal budget for FY22

(June 17, 2021)

The federal budget for FY22 is focused on growth, with specific emphasis on the stock market, the IT sector, banks, reduced duties on certain items, the sale of small-engine cars, and a significant increase in development spending.  Contrary to prevailing rumors, we believe Pakistan will reenter the EFF in FY22, and a postponement of the 6th review is not an indication that relations have soured with the IMF.  However, the budget is incomplete because there is no information about the external sector.  This concern is exacerbated by the recent weakness of the rupee.

The Rs 5.83 trn FBR target has come from the IMF.  Policymakers hope that identifying tax evaders (and informing them about it) should enforce higher compliance, while providing free point-of-sale (POS) machines could increase the collection of GST.  On both counts, we don’t share their optimism.

To manage the circular debt problem, the budget has allocated Rs 682 bln as subsidy, most of which is earmarked for the power sector.  The IMF is effectively forcing policymakers to face the consequences of their inaction.  In other words, the government will have to finance the ongoing power sector losses and will not be allowed to accumulate future losses in the form of the growing circular debt.  Another indication that this is an IMF budget is the Rs 610 bln petroleum development levy to be collected next year.  This means the government will no longer be able to shelter domestic consumers from rising global prices, and the resulting increase in retail fuel prices will keep inflation elevated.

A final point about deficit financing.  The budget shows that domestic banks and external commercial sources will account for the bulk of government funding: banks will finance over 60% of the fiscal deficit, while external commercial sources will finance 22%.  We, therefore, expect significant crowding-out of the private sector next year, but without a credible BoP, we are not sure how the country will secure external financing.  That aside, Pakistan’s growth prospects next year will depend on BoP comfort, which hinges on how remittances perform in the next several months.

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Questions on economic growth

(June 11, 2021)

Models that project economic growth can be complicated as they include all sectors of the economy and a dizzying number of variables.  But that doesn’t make them accurate.  We supplement our simple model by talking with businessmen, corporate leaders and bankers, to gauge their sentiments and understand their investment decisions.  Since these players initiate private investment, their actions are a leading indicator of future imports and economic activity.  We also look at the overall environment to gauge if certain behaviors will persist.

Throughout FY19, we witnessed an increase in interest rates and a steep depreciation of the rupee to qualify for the IMF program.  This soured business sentiments even before the EFF started, and as a result, economic growth fell to 2.1%.  The sluggish growth momentum coupled with IMF quarterly targets did little to help sentiments in FY20.  Then in March 2020, the pandemic caused a significant economic disruption, which contracted the economy by 0.5%.

FY21, on the other hand, started with a bang: the lockdown ended in June 2020; the pandemic was well managed; despite being in a stabilization program, the government was able to launch expansionary fiscal and monetary policies; the rupee started appreciating; Pakistan’s BoP posted surpluses from July to November 2020; and economic activity returned to normal – and more.  In December 2020 (when November data was released), we revised our growth projection upwards to 3-4 %.

The IFIs and GoP remained conservative about Pakistan’s growth prospects.  The IFIs may have been negatively biased by the sheer magnitude of the global impact, while Pakistan’s authorities may have thought the pessimistic assessment would help them bargain for an easier IMF program.

With the growth momentum currently in play, the 4.8 % growth target is reasonable.  However, this depends on BoP comfort, which hinges on remittances.  In our view, FY21’s strong economic growth can be traced to remittances, which could be $ 6-7 bln higher than FY20.  This BoP comfort could end if monthly remittances fall next year, and IMF targets to increase SBP’s FX reserves are challenging.  How these factors play out will determine whether Pakistan can sustain its surprisingly high growth rate.

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Will the IMF concede to make the EFF less painful?

(April 26, 2021)

After the series of hectic developments following the departure of Abdul Hafeez Shaikh (AHS), there is a lull.  Technically, the EFF is in play, but behind the scene, we think the GoP and the IMF are talking about the program conditions.  Both sides have valid reasons to stand firm – the IMF will say that the previous finance team agreed to program conditions, and hard steps are necessary to stabilize Pakistan’s economy (especially the circular debt); the authorities will argue that in the midst of double-digit food inflation, a sharp hike in power tariffs and rising fuel prices could destabilize the government.  The fact that there is no media coverage of these discussions, suggests that they are sensitive, and leakages will not be tolerated.

Program details from the IMF Staff Paper released on April 8th are revealing.  The circular debt is the top priority, and tax revenues is a close second.  Both will be painful and will anger the public and the business community.  The manner in which the IMF conditions have been framed, suggests that in terms of fuel prices and the notification of power tariffs, the program seeks to limit the government’s role.  Hence, political considerations about the pain inflicted by rising utility and fuel prices, may no longer be entertained, which explains the emphasis on the autonomy of Ogra and Nepra.  However, getting the National Assembly to approve these amendments will be challenging, as no government would want to lose control on key prices.  One must realize, that the PTI government has used key prices quite effectively to bring down inflationary expectations.

In our view, the Staff Paper’s BoP projections for the next five years are depressing and alarming.  It shows that Pakistan will need to increase its current account deficits in the next five years to achieve 4-5% real growth.  However, given the rapid increase in Pakistan’s external debt in the past few years, and the fact that the authorities will have to rollover its ST debts for the next five years, the IMF hopes that foreign investors and FDI flows will increase in the years ahead – it also means that direct borrowing by GoP will be much lower than in the past.  If such private inflows are not realized, the CA will have to be much lower, which will hamper Pakistan’s economic growth.  So, while the ST outlook vis-à-vis the IMF is still uncertain, the medium-term outlook is certainly not good.

 

 

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Policy uncertainty and uncharted waters

(April 06, 2021)

The chain of events since the IMF approved the EFF (on 24th March) has created significant uncertainty.  The departure of Abdul Hafeez Shaikh (AHS) and the decision of the new finance team to renegotiate the IMF program has pushed Pakistan into uncharted waters.  Under normal circumstances, after a country receives an IMF tranche, it is understood that the program details have been accepted and the client country will begin meeting both qualitative and quantitative targets.  Looking for a new IMF program means renegotiating, which implies the program is unlikely to start in the next several months.

We argue that the change in heart could have been triggered by the contents of the SBP Amendment Bill, which has snowballed.  As things stand, the government has now decided that it needs to focus on economic growth and job creation.  This reversal (from stabilization to growth or economic recovery) may not be possible as Pakistan is facing headwinds in the external sector.  Despite running a current account surplus in the first eight months of FY21, Pakistan’s FX debt repayments in the next 12 months are much higher than available reserves.  This means the authorities must rollover several bilateral loans, which will require Pakistan to maintain a strong BoP position and seek leeway from its friends.  If the discussions with the IMF drag out (once they restart), Pakistan’s external sector is increasingly vulnerable.

Rising inflation (especially food inflation) and the need to increase power tariffs and tax revenues, appear to have dampened the public appetite for the IMF program, and political leaders across the board have joined the anti-IMF bandwagon.  However, as the lender of last resort, it is risky to take such unilateral steps with the IMF.  Furthermore, SBP’s efforts to contain imported inflation by appreciating the rupee will have to be reversed as this will surely accelerate the deterioration in Pakistan’s BoP.

While the IMF has remained silent about these unexpected developments, the institution cannot be pleased.  A feasible path forward is that the government justifies its need for economic “recovery” using Covid-19 and pointing to the revived Economic Advisory Council’s consensus view.  In our view, SBP’s autonomy is likely to be watered-down, but power tariffs will have to be increased as the circular debt has become Pakistan’s most pressing challenge.  Against the IFI’s pessimistic growth estimates for FY21(WB at 1.2 %, and the IMF at 1.5 %) we maintain our optimism, and with SBP now talking about economic growth and jobs, we do not see an increase in interest rates in May despite the likelihood that YoY inflation will soon be in double digits.

Whatever the specific reasons to reverse course on the IMF program, it is clear this is driven by domestic politics.  However, the outcome of this reversal will depend on geopolitical forces, which will be revealed by the IMF’s response.

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Why SBP may not be able to control inflation in FY21

(March 04, 2021)

February’s YoY inflation of 8.7% surprised the market, as the previous month posted a rise of 5.7%.  The surge was driven by cooking oil, pulses, fuel prices, and the hike in power tariffs.  As Pakistan gears up to restart the EFF in April and global oil prices stay firm, we project inflation to rise in the remaining part of FY21, with average inflation at 9.7% and YoY inflation entering double digits from April 2021 onward.  We argue that supply factors and a significant base effect from early 2020 will drive inflation in the months ahead, and there is little the authorities can do to control inflation.

Focusing on heavyweights in the CPI basket, the base effect is likely to be pronounced in food, utilities, and retail fuel prices.  The base effect can be traced to the sharp fall in retail fuel prices during the period March to June 2020, and the appreciating rupee since September 2020.  We also argue that other sub-categories like automobiles, motorbikes, consumer electronics, household items, and services like restaurants, fast food, and beauty salons, are likely to experience strong demand as Pakistan is currently experiencing a growth phase.  This means inflation is likely to increase in FY21, but this may not push SBP to sharply increase interest rates in the fiscal year.

We argue that the growth phase has been triggered by TERF and the strengthening rupee.  This fiscal-neutral stimulus will shift Pakistan’s external balance into a deficit in FY21, but the central bank can sustain this because of the many positives from the pandemic in 2020.  In our view, both the government and the IMF would like to take credit for how well Pakistan has done despite the challenges created by Covid-19.  Hence, we do not see SBP undermining business confidence by hiking interest rates.  FY22 will be more about austerity, but this fiscal year is likely to witnesses economic growth based on imports, a strong rupee, and business confidence.  This will come at the cost of rising inflation.

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