This brief note is in response to a request from a leading brokerage house in Pakistan.
The PSX bull run has seen a correction, but this has not dampened market confidence that the newly elected government, especially one led by PML-N, will return Pakistan to a path of prosperity. We argue there are serious headwinds ahead, and Pakistan would be lucky if FY25 were a replay of the current fiscal year.
First is the IMF program. While the SBA is going well, there is a growing list of structural reforms the new government must implement. This includes cleaning up the discos, reducing the pension burden, getting retailers into the tax net, restructuring loss-making SOEs, and privatizing PIA. Initial steps have already experienced pushback from FBR and the Establishment Division, and we think the newly elected government will be hard-pressed to implement these painful reforms. If the discussions with the IMF begin to stall, Pakistan could experience a risk-driven import compression, whereby foreign suppliers may shy away from shipping goods to Pakistan if they are not sure they will be paid. This would have devastating consequences for the economy.
Similarly, bullish market players are convinced that Pakistan will see sharp interest rate cuts in the longer-term EFF. We argue that inflation is falling but will not reach levels that would justify aggressive rate cuts. Furthermore, Pakistan’s BoP cannot afford an import boost that may follow aggressive rate cuts. The IMF’s projections show a gradual increase in FX reserves till FY29, which means it will not allow for an import-driven growth phase for the next several years.
Then there is the issue of how foreigners perceive Pakistan, especially the ham-fisted preparation for the Feb 8 elections. The New York Times has said that the forthcoming elections are the least credible in Pakistan’s 76 years of existence. With foreign inflows in short supply, securing $s from private sources requires political stability. The global and domestic news stream about Pakistan’s politics is anything but supportive.
Finally, global risks are rising. The standoff between the US and Iran could escalate, and if it becomes a hot war, global commodity prices will surge. This will instantly reverse Pakistan’s economic stability, as GoP does not have the fiscal space to protect consumers from rising oil prices. The war on Gaza is cementing the East-West divide, while the Global South is likely to side with the East. A war in the Middle East could be a trigger to create a multipolar world order, and a degree of economic dislocation is likely.
We thought the IMF Staff Paper (SP) would provide details of the reform agenda for the next several years, shore up momentum for structural reforms, and build confidence in the economy. Unfortunately, the document only had targets for end-December 2023, simply to anchor the 2nd review mission. While the SP was light on the reform agenda, it has repeated warnings of the exceptionally high risks to the ongoing SBA if the authorities do not deliver on its policy commitments.
The SP focuses on specific issues, alongside the groundwork to meet structural benchmarks for the SBA. The latter includes bringing the power sector under federal government control; forcing all SOEs (even profitable ones) under the umbrella of the SOE law; and restructuring FBR. The areas of policy focus (the gas sector, need for a mini-budget, and specific risk warnings) have specific messages for the authorities: (1) the sharp increase in the gas circular debt must be arrested immediately; (2) if FBR targets are missed, the authorities must release a mini-budget; (3) the external financing gap remains problematic, and without timely disbursements, the economy could suddenly destabilize; (4) the exposure of banks to the sovereign has reached alarming levels and demands fiscal consolidation or alternative source of financing; and (5) a shot across the bow for the SIFC.
With guarded language, the IMF has warned that special treatment for GCC investors is unwise, and all foreign investment must be transparent and based on a level playing field. In our view, the IMF does not want elite capture by select foreign investors, just as it is trying to dismantle the domestic elite capture. As the SIFC was created primarily to attract investment from the GCC but has since evolved into the apex decision-making body, the IFIs are closely watching how this army-government council will be incorporated into the existing system.
In terms of the five-year projections, these were disappointing. In our view, previous projections were tweaked using recent data but do not account for the seismic changes that Pakistan experienced in FY23. The key takeaway is that a credible reform agenda and projections will only be available after the next EFF is approved. This will be a long wait, especially since the next government will likely be a weak coalition.
We conclude by saying that structural reforms require a plan and a justification. So far, the structural benchmarks are standalone tasks without a holistic picture of why they are needed. Since the next government is not likely to have the traction to push through tough reforms, perhaps defacto default (and the devastating economic consequences) is the only way to motivate people and policymakers to do the right thing.
With the creation of the Special Investment Facilitation Council (SIFC) and an empowered caretaker setup, analysts see a solution to Pakistan’s external debt problem. While this is the more pressing problem, the sharp increase in domestic debt servicing since early 2022 is alarming. The IMF projects domestic debt servicing in FY24 at 53% of total expenditure, which will squeeze out other spending. Furthermore, debt servicing is being funded by short-term liquidity from SBP, which is a source of concern for the IMF.
Most government financing comes from financial institutions (FIs that include banks and DFIs). After the reprofiling of SBP’s stock of T-bills into PIBs in mid-2019, most of Pakistan’s domestic debt is in PIBs. This means debt relief is not possible unless the authorities restructure the stock of PIBs. This creates two main problems: how much of a hit will FIs be willing to take, and will FIs continue to lend to GoP if forced to take a substantial haircut. Another complication is that FIs are largely foreign-owned, and the overlap with bilateral friends that have helped bail out Pakistan is significant. Debt relief by cutting interest rates is not likely with the ongoing SBA. In our view, GoP would have to be very careful about restructuring its domestic debt, but it cannot ignore the fiscal squeeze in FY24.
To make fiscal space, the government will have to tackle several things simultaneously: increase revenues by expanding the tax net; reduce expenditures; ask FIs for a reasonable cut in debt repayments (say for 12-18 months); pay FI’s dividends/profits that have been held back; sharply reduce the demand for currency notes; rationalized the use of the open market operations (OMOs); and sell state assets and use these revenues to downsize SOEs and the government machinery.
The caretaker government should spearhead this ambitious plan, and preliminary steps have already been taken. Many would argue that selling assets should be sufficient to solve the external debt problem by generating FX. We think this is only temporary relief that should be complemented with aggressive steps to bring real estate, the retail sector, and agriculture into the tax net. We conclude by suggesting that friendly countries may have pushed for the last-minute IMF rescue, and may play a prominent role in the recovery plan. However, well-meaning plans will amount to little unless our policymakers are willing to pull themselves up by their own bootstraps.
After a year of uncertainty, businessmen crave assurance about the new normal. Pakistan’s political leadership has not been able to provide this and has escalated the political crisis into a full-blown constitutional crisis. Hence, people who drive Pakistan’s economy are looking at the IMF to settle their anxieties. While we expect a sharp focus on widening the tax net, reducing the burden of SOEs, and eliminating the losses in the energy sector, businesses will focus on external sector projections. More specifically, multinational and foreign-owned companies need to determine their future operations.
Unfortunately, the last set of IMF projections on Pakistan’s external sector was not credible. They show an adjustment in FY23 (to overcome the excesses of FY22), but subsequent years are business as usual. FY22’s $ 71.5 bln import bill depleted SBP’s FX reserves, but the IMF predicts imports in the range of $ 74 to 88 bln in FY24-FY27. In fact, the gross $ financing needs are in the range of $ 36 to 39 bln each year, driven by annual debt repayments ranging between $ 25 to 26 bln. With Pakistan struggling to secure $ 6 bln from its friends, these projections are not credible.
We argue that Pakistan needs to bring down its $ financing needs, which requires narrowing its current account deficit (CAD) and annual debt repayments. The latter involves debt restructuring, which the IMF and our authorities claim is unnecessary. This is a mistake. If the market does not accept the IMF’s BoP projections, the next EFF will not settle its anxieties.
We also flag the risk that if the authorities are not preemptive about the external debt, Pakistan could be dragged into the US-China standoff on how to deal with 3rd world country debt. The US wants China to write down its Belt Road Initiative-related debts (which would signal BRI’s failure), while China may remind the IMF about how the IFIs bailed out US banks during the Latin American debt crisis in the 1980s. This standoff will likely drag on for a while, and it would be wise for Pakistan to steer clear. The best way forward is to bilaterally restructure Pakistan’s debt with friendly countries, even if the push is not coming from the IMF. Remaining passive on the external debt will not serve the country.
An earlier paper by the same name explained how Pakistan got into the economic crisis; this one will use Sri Lanka’s experience to examine what lies ahead for us.
Sri Lanka provides a cautionary tale: a corrupt government run by one family that relied heavily on ambitious infrastructure projects (financed by China and heavy borrowing via Eurobonds) to grow the economy. After strong economic growth between 2009-2014, troubles started in 2019, as FX reserves began to deplete as the government could no longer secure $ inflows to repay its mounting debt servicing. Imports were curtailed in 2019, but the meltdown started with the collapse of tourism revenues in 2020 because of Covid-19. Instead of taking corrective steps to handle the crisis, the government continued to draw down its reserves until it could not import essentials in early 2022. Public unrest followed in mid-2022, and the economy remains dysfunctional as the IMF program will not start until the government can restructure its external debt.
Pakistan has several advantages over Sri Lanka but also shares many similarities. While talks with the IMF are ongoing and corrective steps are being taken, the country will remain in a stabilization stage if the government does not move forward on structural reforms. Stabilization measures are painful but easy to execute; structural reforms are complicated because they require political support. We argue that the past three elected governments were unwilling to implement reforms, and a shift away from democracy in Pakistan appears unlikely.
If Pakistan remains in a stabilization phase, the economy will remain tense, and growth will be erratic. Dar is currently negotiating stabilization measures, but the 9th review cannot be completed until commitments are made on structural benchmarks (aka structural reforms). This is where the current team will have to overcome the trust deficit with the IMF – if that is possible. The harsh lesson from the Sri Lankan experience is that economic reforms are unlikely with a government that does not have broad political support. Just last week, the Sri Lankan president said he could not rule out a future crisis similar to what the country experienced in May and June 2022.
Some have argued that the current economic crisis will also pass. We disagree. This paper looks at the last two economic booms: (1) Dar’s real estate/import-led consumer boom in FY16-FY18, which was sustained by a fixed exchange rate regime and soft global oil prices; and (2) Raza Baqir’s monetary stimulus that was launched under the pretext of Covid-19. The latter was multifaceted: (1) the collapse in oil prices as global economic activity came to a standstill; (2) aggressive interest rate cuts; (3) a boost to monthly remittances because foreign travel stopped; (4) SBP’s subsidized credit schemes that targeted elite business interests; (5) the suspension of certain FX debt repayments via the World Bank’s DSSI; and (6) the IMF’s emergency assistance and special quota allocation that Pakistan received. These one-offs from the IMF to overcome the impact of Covid-19 amounted to $ 4.2 bln.
The wealth generated during Dar’s boom was broadly shared, and as people felt wealthier and spent more, imports surged, and the current account deficit soared to $ 19.1 bln in FY18. However, the pace of import growth and the consistency of GDP growth meant a steady rise in economic activity. In comparison, Baqir’s boom was on steroids – it was engineered, opportunistic, and focused on elite business interests. The growth was also sudden – against the IMF’s projection that FY21’s growth rate would be 1.5%, the country posted 5.7%.
In our view, the charter of economy is a cry for help to disengage policymaking from short-term political and business interests. This shift towards opportunistic policymaking reached the next level during the PTI government. Stepping back, the past seven years show how dysfunctional Pakistan’s economic policies have become. Both governments (PML-N and PTI) sharply increased the country’s external debt without enhancing the country’s ability to repay, and Pakistan now has to deal with the consequences. This will have to change, or the government will have to live with the repercussions of being a bankrupt country. Sri Lanka is a living example of what could happen.
The past several months have been busy dealing with concerns about sovereign default. Although this issue has not been put to rest yet, we wanted to focus on structural reforms that have been on the back burner for quite some time. We list eight: (1) insufficient tax revenues; (2) loss-making SOEs; (3) the circular debt; (4) excessive use of currency notes; (5) elite capture of policymaking; (6) policy reversals; (7) an overvalued rupee and import dependency; and (8) an agri sector that is subservient to political interests. Instead of looking at what needs to change to allow the various institutions to operate more effectively, we focus on people’s habits and social norms to gauge whether genuine reforms can take root.
Changing one institution is impossible without changing others, as self-reinforcing ecosystems have been created. We take the example of the National Highway Authority (NHA), which is the largest loss-making SOE in Pakistan. Its four revenue streams are undermined by: petty corruption by the traffic police; poor collection of tolls from the country’s highways; the construction mafia; and finally, the trucking mafia. To make NHA a commercially viable SOE, these four dysfunctions would also have to be addressed. This is a common theme with other loss-making SOEs, and SOEs are just one of eight problems.
The government has been unable to reform the economy for the past four decades because it lacks the political will and the moral authority to change people’s behavior. In the current situation, getting past the prior actions to restart the EFF is a tall order, which means the chances of real reforms are remote. We argue that the social contract in Pakistan has become too weak to allow the government to change people’s behavior in a meaningful way. Therefore, the outlook for economic reforms is contingent on whether a new social contract can be written between the government and the people of Pakistan.
There is a sense of panic in policymaking circles. A social media story about emergency steps that are required to avoid a crisis went viral a few days ago and prompted a stern response from the Ministry of Finance. The rebuttal acknowledged Pakistan’s economic challenges but laid all the blame on external factors. It also said the talks with the IMF were going well, and the economy was heading toward stability. We disagree. We argue that even if things go smoothly with the IMF, with Christmas fast approaching and the IMF’s structured approval process (after the 9th review is completed), the next tranche may not be forthcoming till early February.
This paper argues that two issues may dominate the negotiations: the strictly managed rupee in a distorted FX market; and the hesitation to impose the full PDL and GST on diesel. Then there is the issue of a mini-budget that incorporates new revenue measures to ensure that the primary deficit remains under control. Possible prior actions on the rupee and imposing the 17% GST on fuel, will unleash a new wave of inflation and force Dar to eat his words. Furthermore, with exports falling and the post-flood recovery in the rural sector, the monthly external deficit may not fall further. Another issue is the gradual choking of the economy, where constrained imports hamper economic activity and have created a shortage of cash dollars in the country. The abnormally large kerb premium is reducing monthly remittances and instilling a sense of dread about the future.
This creates a Catch-22 situation for the PML-N: it faces two options, both of which are painful. The preferred option is to wait and see – and hope things do not blow up – but this risks stalling the EFF and stumbling into a full-blown economic crisis. Time is not working in the government’s favor, and inaction could see the country enter a Sri Lanka situation. We are not talking about months but weeks.
The best course of action is to declare an economic emergency and take decisive steps to finalize the 9th review. The government should not make false claims to calm the market, as the latter is losing trust in its economic governance. We also argue that given the magnitude of the economic challenge, political parties need to back off from politics and focus on the plight of the people.
Inflation is alarmingly high but tends to fade from the public discourse soon after the monthly numbers are released. In this paper, we argue that inflation is a slow burn, which means that while price hikes anger households, they get through by tapping into savings. However, if inflation remains elevated month after month (i.e., prices continue to increase rapidly), most Pakistani families will be forced to make hard decisions on what they can no longer afford to buy. It is a known fact that elevated inflation pushes more people below the poverty line and increases income inequality. This is more acute in countries where salaried earners cannot push for wage increases.
So far, the coalition government has done little to address the anger that is building against the rising cost of living. The 26.6% YoY inflation in October was driven by food (with a weight of 36% in the CPI basket), utilities (24%), and transportation costs (6%). These essentials dominate the spending pattern of the average household. We argue that while the current political chaos has pushed the economy on the back burner, the authorities will have to refocus this month to carry the EFF forward. This means policymakers will have to wind down untargeted subsidies, which means food, utility, and transportation costs will increase further.
This also means Dar will have to get over his infatuation with a strong rupee. From the IMF’s perspective, politicizing the rupee parity in a distorted FX market is an unnecessary provocation. However, letting go of the rupee will surely unleash another bout of price hikes. The resulting public pain could generate an anti-government movement that may dovetail with the agitation by PTI supporters. While there appears to be an effort to de-escalate political tensions, the growing anger with rising prices could play in favor of PTI and the unpredictable IK.
There are too many things happening across the world that could impact Pakistan:
In this paper, we argue that these factors indicate a growing East-West divide, with China, Russia, India, and Saudi Arabia on one side, and the US, EU, and UK on the other. This signals a shift away from a US-dominated unipolar global order. The US and its allies are asking countries to choose sides, as shown by the disappointment with Saudi Arabia and India. Pakistan is caught in the middle and cannot sidestep this issue: its economy desperately needs IMF assistance and debt relief. In this toxic mix, enter the combative Dar.
Dar wants to repay Pakistan’s $ debts in full to Paris Club countries, Eurobond holders, and Pakistan’s commercial lenders, but wants to renegotiate with our Eastern friends (China, Saudi, and a couple of GCC countries). Dar also wants to lump the EFF and the floods into a combined deal, effectively seeking fiscal space for the economy.
Dar has already allowed some EFF conditionalities to slide, to provide relief to the people (the recent cut in fuel prices) and reduce inflation (by cutting power tariffs). This makes for difficult meetings, as the IMF will not appreciate the half-hearted implementation of program conditionalities. Furthermore, the Fund may not allow the government to use the floods to provide untargeted subsidies. With the West looking for leverage to change Pakistan’s vote, the economy’s health is at stake.