Assessing the IMF's assessment

(January 14, 2020)

The IMF’s Staff Report published on December 19, provides a good handle to gauge how Pakistan is doing in the EFF.  The report reveals that the IMF was just as surprised as the GoP about how sharply the current account deficit has narrowed in FY20 (the CA deficit has shrunk from $ 6.7 bln to only $ 1.8 bln in the first five months).  This comfort means the hard targets for the external sector were achieved by significant margins.  Since subsequent targets have not been adjusted accordingly, meeting them should be easy enough.  The fact that the Staff Report endorsed Rs 155/$ as a stable equilibrium, suggests that SBP will not allow the rupee to appreciate beyond this level. 

The fiscal side is less heartening.  Unlike government sources, the IMF report explains the cause of the fiscal fiasco last year, when the authorities admitted that the fiscal deficit in FY19 was 8.9% of GDP against a target of 7%.  It also reveals that against a primary deficit target (ceiling) of Rs 102 bln in Q1, Pakistan over-performed by posting a primary surplus of Rs 305 bln.  The report explains that this was because of one-off non-tax revenues, which means subsequent revenue targets will be challenging.  The full year FBR revenue target has only been reduced by Rs 265 bln, to a still ambitious Rs 5.24 trn, with Rs 3 trn to be collected in 2H-FY20. 

In terms of tone, the Staff Report was surprisingly somber.  Against the stock market optimism that the country would soon enter a growth phase, the IMF report talks about elevated risks and the need to stay firm with program objectives.  The report reveals that 15% of direct taxes and 58% of sales tax are collected at the customs stage, which shows that tax assessment and collection is concentrated at the import stage because it is easier to collect.  We take this as proof that Pakistan’s economy is largely undocumented, but were disappointed that the IMF had little to say about concrete steps to enhance documentation.  The report also reveals the lack of an action plan to meet the ambitious revenue targets. 

Our paper also touches on the concern that the likely amendment in the SBP Act to make price stability SBP’s primary objective, is not in the country’s interests.  We also highlight how the sharp increase in GoP’s cash buffers have spiked Pakistan’s domestic debt.  We conclude by saying that revenue challenges are likely to dominate policy thinking, while more fundamental structural reforms could be delayed.  We think this EFF is being managed as previous programs were (in a business as usual approach), which is not a good omen.  However, with $ 1.6 bln worth of carry trades in the country, this exposure does weaken the country’s ability to negotiate with the IMF. 

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Review of 2019

(January 02, 2020)

This is a month-on-month summary of all our 12 presentations in 2019.  It shows a sense of despair at the start of 2019 as the government was not doing enough to narrow the unsustainable external deficit; however, by the end of 2019, market sentiments were optimistic that a growth phase would start in 2020. 

In terms of the timeline of significant events, this is our list:

  • GoP only committed to an IMF program in April after the entire economic team had been changed.  While this was a positive step, the path was paved by compromising on the amnesty scheme;
  • Till June 2019, policy steps to narrow the trade deficit had not delivered.  From a record high of $ 31.9 bln in FY18, the trade deficit only narrowed to $ 29.5 bln because of lower oil imports;
  • FY20 started well as the sharp economic slowdown started narrowing the external deficit.  However, this is a double-edged sword: if economic growth picks up, it will surely put pressure on the CA deficit, which could undermine the EFF;
  • While the start of the EFF in July calmed market sentiments, the program was not customized as we had hoped.  We had hoped there would be hard program targets to push the documentation agenda;
  • We were surprised that as soon as the EFF started, SBP began to appreciate the rupee.  We asked what had changed after the sharp depreciations witnessed in May and June 2019.  The gradual appreciation continued throughout the second half of 2019, with the rupee moving from 163-164/$ in end-June to 154.9/$ by end-December;
  • There was a further change in sentiments in August, when it was announced that GoP’s debt to SBP had been shifted into long-term PIBs.  With a bearish stock market and a perceived shortage of PIBs, the excess demand for 10-year PIBs drove down yields and fueled expectations that SBP was preparing to cut interest rates.  Again, we questioned this sudden change in sentiments just one month into the EFF;
  • This sentiment was not overshadowed by the shocking admission that the fiscal deficit in FY19 was not 7.2% of GDP, but a record 8.9%;
  • November witnessed another improvement in sentiments, when carry trades (hot money) increased sharply during the month.  This eased conditions in the FX market, increased SBP’s reserves and generated domestic liquidity.  The market was now convinced that the stabilization phase was over;
  • By late December, PM Imran Khan announced that 2020 would be a year of prosperity. 

We conclude our assessment by stating that two pivotal events changed market sentiments in 2019: one, the economic slowdown that narrowed the CA deficit in FY20; and two, the sharp increase in carry trades in November.  Since these factors are still in play (but could trend the other way), it is hard to predict what will happen in 2020, especially since the EFF program targets are challenging in 2H-FY20.  Despite this uncertainty, we call for a more prominent role for economic planning, and urge the SBP/MoF to better manage market expectations. 

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The distinction between pro-business & pro-market

(December 14, 2019)

This paper proposes a different perspective on how to look at economic reforms.  The distinction between pro-business and pro-market policies, highlights the role of established business interests seeking government support for their economic interests (pro-business), as opposed to creating a more level playing field where new players are encouraged to enter the market.  Within the policy options that Pakistan faces, pro-business appears to be winning.  However, if policymakers intend to make CPEC 2.0 a cornerstone of Pakistan’s economy, they must shift towards pro-market policies.  While this will be resisted by business interests, a certain level of disruption is required for Pakistan’s economy to break out of its comfort-zone, which only allows for short-term growth phases.  

We argue that China’s unprecedented economic transformation since the 1980s, is firmly anchored to pro-market policies with a critical role for the state planning.  With growing reservations about the neoclassical paradigm that minimizes the role of the government, we advocate the use of pro-market policies, even if this disrupts the existing economy.  Seeking to achieve non-disruptive economic reforms, is tantamount to protecting the very reason why the economy needs help.  

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In Pakistan, hot money could be a very slippery slope

(November 19, 2019)

The exponential increase of foreign investment in government T-bills in the past two weeks, is staggering.  Of the $ 786 mln mobilized so far in FY20, $ 345 mln was realized in the first half of November.  This is a source of much comfort to SBP for several reasons: (1) it does not increase Pakistan’s external debt; (2) as it injects dollars into the interbank market, it reduces pressure on the Rupee and allows SBP to increase its NIR; (3) as it represents fresh liquidity, it will allow SBP to ease back on its open market operations; and (4) it provides deficit financing, which means banks will not crowd out the private sector as much as they would have otherwise.  To maintain these inflows, SBP will not cut interest rates anytime soon (even a token cut, as we had anticipated earlier). 

Hot money is not as fickle as some may claim.  Low and negative global yields are forcing yield-hungry fund managers to look at Pakistan for the first time, and as they get comfortable, such inflows could increase further.  The way to view hot money is to think about fund managers as a new player in the FX market.  At the initial stages, they play a positive role; but if things turn sour (e.g. a less than credible economic recovery or an external shock), their role could become negative and destabilizing.  While the introduction of this new player is beneficial as it creates a source of market discipline on domestic policymaking, the real issue is whether SBP will be able to influence the stock of hot money by managing the flows (in and out of the country).  This will be especially challenging as SBP has to meet NIR targets as part of the EFF. 

However, the main concern we have is that if the inflows are larger than expected, and this allows SBP to easily meet its NIR targets, this could create a false sense of comfort about the external sector.  With an appreciating Rupee and growing FX reserves, this may encourage policymakers to embark on a premature growth phase.  We say premature because hot money will do nothing to narrow the twin deficits, which is why Pakistan approached the IMF in the first place.  We are concerned that short-term thinking may use this respite to sideline tougher structural reforms, which are desperately needed to make Pakistan’s external sector more sustainable. 

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The elusive Net International Reserves

(November 11, 2019)

The first quarterly review by the IMF went well, and Pakistan should receive the 2nd tranche in early December.  There are clear signs that the economy has started to stabilize, perhaps even more than the authorities and the IMF had expected – the IMF has lowered its inflation projection from 13% to 11.8% for the year.  We agree that inflationary pressures have eased and the external deficit has narrowed significantly, but we still think there are challenges ahead.  While many have been flagging the Rs 5.5 trn FBR target for the year, we would also include SBP’s net international reserves (NIR). 

The IMF is pleased by the “higher than expected” NIR in 1Q-FY20, but this does not focus on the $ 7 bln increase in SBP’s NIR in the remaining three quarters of this fiscal year.  We argue that it is impossible to track SBP’s NIR as much of the data/information needed to compute this metric is not public information.  We also flag specific details of the NIR (e.g. adjusters) that will keep shifting the goalpost.  We think subsequent NIR targets (which are performance criteria) will be challenging, which means Pakistan will continue to face an on-going shortage of foreign exchange this fiscal year, and beyond.  This means that a growth phase (which is import dependent) is not feasible in the foreseeable future. 

While we are satisfied that the EFF has changed the trajectory of the economy and laid to rest market concerns about inflation, the Rupee and interest rates, there is little on the table about how policymakers will change the real sector (i.e. jobs, manufacturing, physical infrastructure, social development).  We argue that if policymakers only focus on the EFF, a growth strategy will not materialize.  We remind readers that the second stage of CPEC remains the most viable avenue to make real changes in the economy without breaching the EFF’s end-goals.  However, there could be a conflict of interest within the country: the economic team is more aligned with the Washington Consensus, which would be opposed to import substitution and, at best, lukewarm about CPEC. 

In our view, unless Pakistan is able to tackle its acute import dependency (and not just by setting the “right” prices – interest rates and the Rupee parity), it cannot sustain the growth that is necessary to generate jobs.  Pakistan needs an industrial policy, and CPEC 2.0 can be tweaked to become this policy.  But this requires out-of-the-box thinking, which appears to be in short supply in Islamabad. 

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New challenges, same old story

(October 11, 2019)

With headlines dominated by external events (the annexation of Kashmir, Imran Khan’s stirring speech in the UN, the attack on Aramco’s oil refinery, etc.), this paper seeks to take stock of what is happening in Pakistan’s economy.  We shall simply list the following:

A.     With the stability of the Rupee, gone are the days when people talked about the parity at 180/$.  We also think the Rupee’s stability is now taken for granted, which may not be the case as the EFF’s NIR targets are quite challenging in the remaining part of FY20;

B.     The external deficit has narrowed appreciably, but this import compression must remain in play to stay below the full year current account target of $ 6.7 bln;

C.     The import compression can be traced back to the sharp fall in demand.  This fall is driven by the weaker Rupee, the increase in interest rates, the CNIC conditions for commercial transactions, and the penalties against non-filers;

D.     With a stable currency and retail fuel prices, our average inflation projections for FY20 has fallen to the range of 11-12%.  We believe the 12.5% YoY inflation in September may be the peak as demand pressures have eased significantly;

E.      The growing inversion of the yield curve is driven by the irrational exuberance of institutional investors in 10-year PIBs.  This is sending a signal that interest rates will be cut significantly next month, which is unlikely (SBP should better manage market expectations);

F.      We argue that SBP cannot afford to cut interest rates as this could increase imports and undermine the stability in the external sector.  At best, a token cut of 25-50 bps is possible to keep the stock market bullish; &

G.     With the ban of SBP financing, the central bank will continue to use OMOs to inject liquidity into the market, even though one-sided injections go against the IMF’s ethos. 

We summarize by highlighting the resistance to fiscal reforms (the strike by traders against documentation), by saying that structural reforms should be viewed as changing bad behavior.  This is not easy and the protagonist must stand firm to ensure that such behavior is eradicated (or at least suppressed).  We also argue that while CPEC 2.0 could provide an avenue to higher growth and a more sustainable BoP, it will not solve Pakistan’s fiscal problems.  If the second stage of CPEC is FDI-funded, Pakistan could get the best of both possible worlds (stabilization and economic growth). 

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Could Pakistan resolve the Iran-Saudi standoff?

(September 30, 2019)

This paper argues that the September 14 attack on Aramco’s oil processing facility, is not a one-off event, but rather a calculated escalation by Iran.  If the Iran-Saudi standoff is not de-escalated, Iran may lash out again.  Unlike the general perception that further US sanctions on Iran are now ineffective (given the constraints under which Iran already operates), we think the blacklisting of Iran’s central bank is a significant step, which may have provoked Iran to up the ante in the region. 

Iran senses that since the US has no appetite for a new war in the Middle East (with forthcoming general elections and the impeachment inquiry against President Trump), Saudi Arabia will also be restrained in terms of what it does.  In our view, the public protests in Egypt and the scaling up of the Houthi offensive against the Saudi coalition, are related to the current standoff. 

The fact that both Saudi Arabia and the US have requested Imran Khan to mediate with Iran, reveals two things: Pakistan’s neutrality in the Saudi-Iran standoff and Imran Khan’s growing global stature makes Pakistan an ideal mediator; and two, the US-Saudi alliance is keen to avoid military confrontation with Iran.  We argue that Pakistan should embrace this opportunity.  Since Iran is primarily concerned with US sanctions that are related to the Iran nuclear deal, negotiations could involve as many as eight countries: the US, Saudi Arabia, Iran, Germany, France, Britain, Russia and China. 

Pakistan should use its goodwill with these countries to ensure their active support to defuse the Kashmir standoff.  At the UN, Imran Khan made a firm statement that the Kashmir issue could escalate into an armed conflict between two nuclear armed countries.  If the abovementioned countries come to an agreement on the Iran-Saudi standoff and Kashmir, the world would be a better place. 

While Pakistan’s economic outlook remains challenging, it could use its enhanced stature to defuse global tensions – the resulting goodwill may reduce the pain of Pakistan’s economic transition.  More broadly, these events support our 2017 view that Pakistan is part of a new bipolar global order, which includes China, Russia, Turkey and Iran (on one side), and the US, India, Saudi Arabia, Israel and the UK (on the other side).  We think these groups are slowly coalescing. 

Word count: 3,782. 

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Brexit: The Uncivil War - Part 2

(September 19, 2019)

The utter confusion about Brexit motivated this paper.  While most people are understandably jaded about the unending stream of Brexit updates, this should not take away from its importance.  While a no-deal Brexit would be disruptive for both Britain and the EU, even a deal (for departing Britain) will force both sides to adapt their economies.  We argue that Brexit can only be decided upon by snap elections, which will effectively become a second referendum on Brexit.  Britain’s political parties need to formulate a coherent view on Brexit, and a snap election will force them to do so. 

Our paper shows that a deal or no-deal Brexit (if Britons again vote to leave), could tip both Britain and the EU into economic recession, and possibly pull in the US.  On the other hand, while a remain vote may appeal to liberals and globalists, we show that this could create political instability in Britain.  What we know for sure, is that while the economic costs of Brexit are currently being debated, the political cost for Britain has been debilitating.  This political crisis may not be addressed by a vote to remain in the EU. 

We argue that hardline Brexiters have greater clarity of what they seek to achieve, which will be easier to translate into an election victory.  As in 2016, people vote on the basis of their emotions and not hard economic facts; these emotions are stronger when the message is clear.  We argue that if the next election is a vote to remain in the EU (which means a Labour coalition government with the Lib Dems and SNP), this may be the only common agenda that the coalition has.  In other words, after Brexit is declared dead and buried, the diverging views of coalition members will make the new government dysfunctional. 

Our model shows that a lose-lose outcome is most likely for both the EU and Britain.  While disappointing, this pessimistic outlook reflects the ambivalent relationship between Britain and Europe that dates back to the 1960s.  This ambivalence will allow for creative politics – as shown by the shock 2016 decision to leave the EU, Boris Johnson and his special adviser (Dominic Cummings) are well versed in formulating powerful political campaigns.  Since opinions have hardened on both sides of the Brexit debate, another leave vote could be engineered by clever political manipulation. 

There is a final point that is often forgotten in the Brexit noise: is the EU monetary union sustainable?  In other words, can Brussels keep member countries fiscally disciplined?  In our view, this depends on whether the EU parliament is able resist the shift away from liberal and centrist politics.  With the end of the Angela Merkel era, both France and Germany are witnessing the rise of rightwing and leftwing political parties.  Keeping the EU intact – and within the grand vision of a deeply integrated economic bloc – may be a tall order. 

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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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