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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