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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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The growth disconnect

(February 18, 2021)

Though expected, the IMF’s announcement that the EFF will resume in April 2021, has created some confusion.  The EFF appeared to have stalled in 2020, but the IMF decided that Pakistan was able to manage itself quite well last year, and 2020 will count in the 39-month program.  So effectively, Pakistan funds itself halfway through the stabilization program without even knowing it.

We also think there is a disconnect between what we see in the economy, and the IMF’s growth projection of 1½ % in FY21, which is at the lower end of SBP’s range of 1½ to 2½ %.  We stay with our view that growth will be much higher (3-4 %) because of the trade flows that Pakistan has seen in the past several months.  Since Pakistan’s economy is heavily dependent on imports, higher imports fuel economic growth.  December 2020 witnessed a near-record high for non-oil imports, and the popularity of SBP’s TERF means machinery imports will remain strong for most of 2021.  Furthermore, LSM data shows strong manufacturing growth in 1H-FY21, driven by the auto sector and construction.  Since TERF stays in place till end-March 2021, we expect strong LSM growth this year and do not think the IMF program will derail the growth momentum.

While this is good news, it is likely to be a short-term burst of economic activity.  Eventually, rising imports will begin to challenge Pakistan’s BoP and this will force policymakers to back off.  In this paper, Pakistan’s dependency on imports and stagnant exports is analyzed using monthly trade data going back a decade.  Since trade data is a leading indicator of what to expect in the real sector, we argue that the gradual de-industrialization in Pakistan has reduced non-traditional exports.  In our view, the economy is becoming more inward-looking and undocumented.  This means Pakistan will remain dependent on textile exports, but this will not allow for sustainable economic growth.  For now, the pandemic has created an environment that will allow policymakers to embark on a growth phase, but the stabilization program will re-assert itself in FY22.

 

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Will Pakistan’s elite champion economic reforms?

(February 05, 2021)

As Pakistan gears up to restart the IMF program, it is helpful to take stock of where we are and what to expect.  However, instead of focusing on repercussions like the circular debt, mismanaged PSEs, stagnant exports, and insufficient tax revenues, it is more insightful to look at the root cause that give rise to these challenges.  We identify the following: (1) no policy planning; (2) poor policy formulation that is influenced by political and business interests; (3) Pakistan’s shrinking manufacturing base; (4) the widespread undervaluation of assets and the growing undocumented economy; (5) rent-seeking in government; (6) poor social indicators; and (7) intolerance and violence in Pakistani society.

We then build on the World Bank’s assessment that policymaking in Pakistan is dominated by four groups: the political class; the bureaucracy; the military; and big business.  To gauge how these groups view the abovementioned problems, we asked several experts to rank how these groups would prioritize reforms (1 was to leave things unchanged, and 5 was to change things even if it disrupted the economy).  We found that on average, the political class was least interested in real reforms, while the bureaucracy and big business were partially interested but did not want to change a system that suited their financial interests.  The military appears to have more appetite to reform the economy but shies away from disruption.  People who want to see real change realize that reforms are, by definition, disruptive and are willing to allow a degree of dislocation to set things right.  Most of the others would lend vocal support for reforms but would prefer that the system continues as it is.

The limited appetite for change helps shed light on issues like: (1) the disconnect between the government’s narrative and what people observe; (2) how kinship ties have overshadowed the role of the government and the formal economy; (3) why CPEC is no longer a game-changer; (4) why the government has forsaken economic planning; (5) why Pakistan’s economy is becoming introverted; and (6) why it will not be possible to escape the debt trap.  Without risking disruptive changes, the EFF will just be another stop-start reform agenda that promises much but delivers little.

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An equally momentous 2021

(January 10, 2021)

Many are glad that 2020 is over.  The confined existence and loss of livelihoods will be hard to forget.  However, the fact that the pandemic was a sudden but shared experience, made is somewhat easier to bear.  With the Covid-19 vaccine being rolled out and the end of President Trump’s inglorious term in office, we caution against too much optimism about 2021.

We argue that much of 2021 will be spent coping with the momentous changes witnessed last year.  We also feel that most people are unaware of just how significant these changes are and how this will force the world to adapt to a new normal.  We list 10 factors that will shape 2021:

  1. Mutating virus: with the accelerated effort to roll out a vaccine against Covid-19, we argue that quite a few people will be reluctant to take the vaccine until a more comprehensive database is available. This means a Covid-free world will not materialize for some time;
  2. Business travel: the compulsion to use Zoom and other online platforms, will surely reduce business travel, as the latter is expensive and time-consuming. This has structural repercussions for airlines and the hospitality sector;
  3. Exotic vacations: the popularity of vacationing in exotic locations will now be countered by fears of an equally exotic disease. People will scale back vacations and be more conservative;
  4. Entertainment: lockdown stoked demand for in-house entertainment. Streaming services by Netflix, Amazon, Disney, etc., have changed how people (with purchasing power) view entertainment.  Movies and live performances may never recover to pre-pandemic levels, as people’s behavior has changed significantly;
  5. Working from home: it may have been difficult at first but working from home may have changed the normal 9-to-5 routine forever. People will demand more time with their families and to reduce their weekly commute time, while employers may discover that flexible hours are more productive and less expensive;
  6. Death of retail: this was already in play before the pandemic struck, but the lockdowns have accelerated the demise of retail shopping. World-class clothing brands and some of the largest retail chains have declare bankruptcy in 2020, and this trend will continue as online shopping becomes more dominant.  This, coupled with working from home, will hurt commercial real estate values;
  7. Job security: With the change in how people approach work, entertainment, shopping, and vacationing, many jobs may not recover even after the world becomes Covid-free. Some people have continued with their jobs in 2020, and with few options to spend their income, they have accumulated abnormally high savings.  On the other hand, many people have lost their jobs, have had to rely on government assistance, and now return to insecure jobs;
  8. Income & wealth inequality: this was already a challenge before the pandemic, but 2020 has made the situation much worse. We argue that this will increase pressure on Western governments to step up support for the poor and underprivileged;
  9. Trump’s shambolic end: public pressure to rectify the lopsided distribution of wealth, will be tested in the US as Joe Biden enters the White House. President Trump’s incitement to storm Capitol Hill is perhaps the most stunning political blunder in US history.  The good news is that the world should see the last of Donald Trump; &
  10. Long Covid: there is some concern that even for those who have recovered from Covid-19, some people could experience the early onset of diabetes, heart disease, strokes, and dementia. This could sharply increase healthcare costs, especially in those countries that provide universal care.

These issues will play out this year, which means 2021 will also be momentous.

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The initial stages of the post-Covid world

(December 17, 2020)

Pakistan is currently experiencing a second wave of the pandemic, and the government has been warning Pakistanis to strictly follow safety protocols. While daily infections and deaths are alarming and getting a lot of media coverage, the daily infection rate appears to have crested. If infections remain below 3,000 per day, it is safe to say that Pakistan has overcome Covid-19.

The rapid progress with the Covid vaccine, means the fear and uncertainty about the pandemic is finally beginning to subside. While leading countries have warned that infections and deaths will continue well into the winter, businesses can now start planning for the post-Covid world. After the disruption witnessed in Western countries, the sense of relief and jubilation is understandable, as their economies come roaring back. However, fresh policy challenges that lie ahead will be daunting. Covid has changed the way most economies operate, as lockdowns have created a premium on self-contained existence – this will not change even if social interaction returns to normal. Shopping and entertainment have moved online, as has banking and working from home. Many jobs will become redundant, and policymakers will have to strike a balance between the needs of the financially insecure and the billionaires that have made so many people redundant.

In Pakistan, the economic upside to overcoming the pandemic is likely to be limited. First, the pandemic has been less disruptive compared to most other countries; and two, Pakistan was already in a stabilization program and is expected to return to the EFF in the second quarter of 2021. We argue that since the bulk of urban employment is in the undocumented economy, managing the pandemic (from a fiscal perspective) has been easy. However, the downside is that the bulk of the economy (in terms of jobs not GDP) will continue to operate outside the ambit of government policies. This means structural reforms will be of limited value.

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Financial reforms and golden handcuffs

(December 09, 2020)

SBP’s Annual Report for FY20 carried a detailed analysis of why Pakistan’s banking system has not deepened since the financial reforms in 1991.  Unlike peer countries, Pakistan’s credit-to-GDP ratio has fallen since the 1990s, which means commercial banks have reduced their intermediation to the private sector.  Data shows that financial deepening accelerated in the 1960s as the government focused on industrial development and banks increased their branching network.  The nationalization phrase weakened the banking system in the mid-1970s, but as the economy picked up in the 1980s, so did the banking system.  Financial sector reforms did little to deepen the banking system or increase financial inclusion.  The post-9/11 economic boom was driven by private sector credit, but this was only possible because the government sharply reduced its borrowing after 9/11.  When this started to change, banks shifted to government lending and the credit-to-GDP ratio fell from 27.2% in FY08 to only 14.6% in FY15.  Since then, financial deepening depends on how much the government borrows – the more GoP borrows, the lower the credit-to-GDP ratio.

While SBP is optimistic that the banking system will deepen and financial inclusion will increase, we are not.  With record-high bank lending to the government and interest rates likely to increase in 2021, it will not be possible to entice banks to lend to the private sector.  Special refinancing schemes and policies to encourage housing finance (and lending to SMEs) should see token lending, but with a government desperate for money, banks are effectively bound by golden handcuffs.

We argue that failed fiscal reforms have undermined financial reforms, and the growing level of crowding out now makes Pakistan’s fiscal system even more unsustainable.  So, while the authorities were able to do the easy stuff (financial reforms) but not the hard stuff (fiscal reforms) in the 1990s, we now face a situation that without urgent fiscal reforms, Pakistan’s banking system will only focus on elite borrowers – the government, blue-chip corporates, and more affluent individuals.

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Trump loses the presidency but wins the prize

(November 11, 2020)

It took four days to call the US elections.  Nevertheless, President Trump is still challenging the results and die-hard Republicans have supported Trump’s defiance.  While this is embarrassing from a global perspective, it is a clear marker that US politics remains divided, and the 2020 results show that the level of polarization has increased in the past four years.  President Trump increased his vote bank by almost eight million votes in 2020, which is disheartening when looking at his performance as president.

There is much to celebrate Biden’s victory, especially in terms of a global response to the pandemic and climate change – it should also make America more engaged in world affairs.  However, Republicans have gained seats in the House and are likely to retain their majority in the Senate.  This means President Biden’s effort to legislate will be impeded by Senate, just as in the second term of the Obama presidency, which Biden has experienced firsthand.

The real disappointment is that Donald Trump is likely to remain a very powerful and divisive influence in US politics.  By grooming his supporters into a cult-like following, President Trump has become the source of the Republican Party’s grassroot support.  This means Trump has become the face of the GOP, which we think is the prize.  By leading one of the main political parties in a polarized country, Trump will not only be able to do what he does best – grooming die-hard supporters – but also influence policies and set the direction for the country.  Despite his failures as president, President Trump leaves an impressive legacy for the conservatives.  Not only will this keep the US tacking right, but it will deepen the divide in American society.

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Inflation will remain challenging in FY21

(November 06, 2020)

The government is alarmed by the sharp increase in vegetable prices and is moving aggressively to contain food inflation.  While we project food inflation to stabilize in the next few months, the steps needed to restart the IMF program and the base effect (from early 2020) could push YoY inflation into double digits from February 2021.  Compared to SBP’s inflation projection of 7-9% in FY21, and the IMF’s 8.8% prediction, our calculations show average inflation at 9.8% and a YoY rate of 13.3% in June 2021.  We argue that the CPI sub-index for utilities and transportation could experience a base effect in early 2021, which means that even if the price index remains stable, the YoY increase could be significant.  As food, utilities and transporation account for about 64% of the CPI basket, these three subindices will increase headline inflation in 2021.

The uncertainty about the IMF program will dampen business sentiments and the rise in inflation will anger the people.  With urgent steps needed to contain the fiscal deficit (via new tax measures and power tariff increases), SBP may delay hiking interest rates till Q4-FY21.

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Could the US see a blue wave?

(October 21, 2020)

The US elections on November 3rd will be decisive in many ways.  For the world, there is hope that a Biden victory will return the US into an unstable world, where the pandemic and climate change need a coordinated global response.  For Pakistan, the outlook for the divisions in the Middle East and India’s annexation of Kashmir will depend on who occupies the White House in 2021.

In our view, the divisions in the US are so deep that irrespective of the election outcome, America’s political landscape will change.  If Trump wins, the Democratic Party could split; if Biden wins, the Republican Party will split.  Unlike 2016 when Donald Trump has unique advantages, after four years of chaos in the US and the world, Trump’s style of governing has become a liability.  President Trump has decided to stay with his divisive campaign and has not reached out to undecided voters.  Trump has doubled down on his management of the pandemic, his support for heavy-handed law enforcement, and his sympathy for white supremacists.  After losing the popular vote in 2016, we think President Trump will lose the Electoral College in 2020 and the US could see a blue wave where Democrats regain the presidency and carry the House and the Senate.

Despite this, Trump is unlikely to incite violence or threaten the peaceful transition of power.  He may contest the election results but is likely to exit the White House without much drama in January 2021.  In our view, Donald Trump knows he will be disowned by the Republican Party and realizes that his business empire could collapse after he leaves; he also knows that he could be facing years of litigation.  To counter this outcome, Trump needs to revive his grass-root political support; his best bet is to create his own political party and reinvent himself.

A Biden victory will be a source of much relief in the world.  The global pandemic and climate change will be managed in a coordinated manner, and tensions in the Middle East should ease.  We also think the US will be more active in ending the Yemen war and focus global attention on India’s annexation of Kashmir.  US relations with China should improve, but trade tensions will remain.  These outcomes will help Pakistan as it strikes a difficult balance between its friends in the GCC (supported by the US) and China, which has entered a strategic relationship with Iran.  After the relief of a Biden victory, Pakistan will once again face its stubborn economic challenges with no indication that it will succeed.

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A tentative macro outlook for FY21

(October 15, 2020)

While food inflation has taken center-stage in the country, the IMF has just released its macro projections for Pakistan in FY21.  The Fund sees anemic growth of 1% and a current account deficit of 2½% of GDP; it also expects inflation to rise before settling down.  Our projections for FY21 are more optimistic: we predict real growth in the range of 2 to 3% (GoP’s budget estimate was 2.1%) and a smaller external deficit of 1.6 to 1.7% of GDP.  We argue that perhaps several positives have not been taken into account by the IFIs in the case of Pakistan, as they formulated macro projections for all member countries.  We think the early containment of the pandemic has allowed commercial activity to return to normal far earlier than people had anticipated; the strong BoP position so far in the fiscal year; the fact that construction has bounced back strongly; and we take comfort from the steps taken by SBP to monitor retail FX transactions to reduce the leakages in the FX regime.  We also argue that Pakistan’s organic growth under normal conditions should allow the country to achieve the government’s growth estimate.

EFF preconditions to restart the program will focus on steps needed to raise tax revenues and bring down the ballooning circular debt.  Facing public pressure because of rising food prices and the challenges from the political opposition, the government has little appetite for these tough steps.  Hence, we do not see the EFF restarting until 2021.

Assuming a benign BoP outlook for FY21, we expect currency flexibility and a delayed increase in retail fuel prices.  With supply-side factors more dominant in determining inflation in Pakistan, our rupee and PoL projections could push average inflation above 10%.  This will be driven by food, utilities, and transportation costs.  While we disagree with the IMF’s macro projections, we still await the next Staff Paper to better understand how the uncertain BoP outlook could impact the currency and SBP’s FX reserves.  In the interim period, the authorities need to protect the economic recovery that is underway and manage expectations of what is likely in the remaining part of this fiscal year.

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