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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. 


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. 



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.


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. 


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.


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.


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. 


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.


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.   


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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