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 lessons58

(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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