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