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Viewing Pakistan’s economy through a political lens

(June 09, 2024)

This paper is a departure from the past.  We have been arguing that from an economic perspective, there is much confusion about the forthcoming budget, which should be the roadmap that has been vetted by the IMF.  The issue becomes what will parliament accept, what will it reject, and how will the IMF respond.  However, if one looks at the budget from a political perspective, the outlook is less confusing.

Building on events from early 2022 (when Russia invaded Ukraine) we focus on the political maneuvering that resulted in the vote of no confidence against the PTI government.  Just months after IK’s February relief package, the PDM government took responsibility for a hemorrhaging economy while trying to revive the IMF program.  The sharp increase in fuel prices in May-June 2022 ignited inflation which would eventually average 30% by mid-2023.  This hurt PML-N politically, which was unable to recover even by the 8 February 2024 elections.

NS initially withdrew from active politics, lamenting his past treatment and Pakistan’s lost economic potential.  However, in recent months he has become politically assertive, by elevating Ishaq Dar as Deputy Prime Minister and retaking the presidency of PML-N.  As the FY25 budget looms, we suggest a possible political scenario that could play out on 12th June.

In this scenario, PML-N could reject the IMF-vetted budget and opt for a populist relief package that entails slashing interest rates, cutting fuel prices, capping power tariffs, overtaxing captive payers, and strict controls on the FX markets (aka the Dar exchange rate regime).  This would be a short-term strategy to shore up NS’s fading political fortunes by wading into an economic abyss.  As the economy slowly gets paralyzed, the government could call for early elections, which most people predict will be swept by PTI.  In effect, this would be a replay of what happened in February-April 2022, when IK announced an unsustainable relief package, handed over the reins to the next government, and then blamed the government for his policy mistakes.  This time around, PML-N will announce an unsustainable relief package (by rejecting the IMF) and just before the economy seizes up, call for early elections, and hand over the economy to the next PTI government.  To facilitate this, the judiciary will be nudged to release IK from jail and allow him to participate in the next elections.

This is one possible scenario, but looking at it from a political lens, it is compelling.  If there is a U-turn on 12th June, this should not be viewed as a cataclysmic event but just another political play with the Pakistan economy held hostage.

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The Exchange Rate Outlook: MoF versus IMF

(June 03, 2024)

This short paper is based on an article written by Shahbaz Rana in the Express Tribune on 2 June.  Because of the stability of the rupee since November 2023, and in the run-up to the FY25 budget, the market and public pressure is mounting for a people and market-friendly budget.  Extrapolating on the content of this article, we project what the IMF and MoF think the rupee-dollar parity will look like in FY25.

The MoF is working on the assumption that the rupee will average 295/$ in FY25, while the IMF thinks the rupee could hit 328.4/$ in June 2025.  Doing the numbers, there is a significant divergence between the two viewpoints, which will have a direct impact on inflation next fiscal year.  MoF is of the view that average inflation will fall to 12% in FY25, but incorporating MoF’s projections into our supply-driven model predicts average inflation at 17.5%.  If we use the IMF’s projections, inflation could exceed 22%.

Since both institutions see a weaker rupee in FY25, the anchor for economic stability will end soon.  If this drives inflation beyond GoP’s projection, and SBP tries to keep the rupee on track, the resulting overvaluation of the rupee could increase the trade deficit.  Exporters, who are already angry at the sharp increase in energy costs, may respond by reducing exports.

In terms of interest rates, the 11.8% YoY inflation in May will put tremendous pressure on SBP to cut rates next week.  We think a 200-bps cut is likely, but future cuts will depend on the IMF’s prior actions and their impact on inflation.  In our view, interest rate cuts in FY25 are unlikely.

The economic pain the IMF program has in store will be incredibly challenging for a weak coalition government.  The PM is already showing signs of dithering, which means parliament may reject fundamental pre-conditions for the IMF program.  In our view, Pakistan has never before faced such a stark choice between the political demand for relief, and the economic compulsion to bite the bullet.

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What is the IMF thinking?

(May 22, 2024)

The latest IMF Staff Paper was released on 10 May.  As expected, the focus was on expanding the tax base, timely tariff increases to freeze the circular debts, a flexible rupee, and restructuring all SOEs without exception.  Compared to past Staff Papers, the latest one is uncharacteristically blunt about the exceptionally high downside risks that Pakistan faces.

While we are also apprehensive about the 7 June budget session – this will be an austere budget within the backdrop of two years of 20%+ inflation – the IMF’s 5-year macro projections reveal the IMF’s roadmap to recovery.  Projecting so far into the future is a tricky exercise, but it suggests how the external and fiscal sectors should be managed.

We focus on six sets of projections to better understand Pakistan’s road to recovery:

  1. Domestic debt servicing will increase in FY25, and after a small fall in FY26, will continue to rise till FY29. In effect, SBP will have to maintain positive real interest rates, the private sector will continue to be crowded out, OMOs will increase further, and banks will remain the main source of government financing;
  2. Erratic non-bank financing is projected to become a steady source of financing in the years ahead, while external budget financing will dwindle from FY26 onwards;
  3. Tax revenues from imports and fuel sales will post healthy growth in the future. The IMF predicts growing imports from FY25 onwards, financed primarily from friendly countries; if this is not forthcoming, we could see the petroleum development level (PDL) exceed custom revenues within the next five years;
  4. Available external financing must exceed the CA deficit so SBP can build its FX reserves;
  5. Imports will have to be financed by exports and remittances. If these inflows post a shortfall, the authorities will have to reduce imports by keeping interest rates elevated and/or weakening the rupee; and
  6. As a sweetener, the IMF projects 4½-5% growth during FY26-FY29, but this is based on healthy $ inflows. After two years of a declining stock of $ debt, the IMF sees a steady increase in Pakistan’s external debt from FY26.

The IMF will insist on positive real interest rates, not to reduce inflation but to keep import demand down.  Hence, Pakistan will have to live with elevated interest rates and inflation.  Furthermore, there is no room for import-driven growth in the next five years.  Finally, if the authorities fail to document and tax non-filers, the IMF will insist the burden be placed on the average citizen via fuel prices and utility rates.

The government realizes the budget session will be exceedingly difficult, but it doesn’t have a choice but to announce the IMF-vetted plan.  The choice is stark: push through the difficult legislation and deal with the political and public pushback, or Pakistan could be staring at sovereign default in 2024.

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Inflation projections for FY25

(April 05, 2024)

With YoY inflation falling in March, expectations are growing that interest rates will soon be cut.  Building on expected IMF requirements and the recent hike in energy prices (utilities and fuel), we have projected inflation for FY25.  The outlook is not as heartening as the government would have us believe; we predict average inflation in FY24 at 25.6%, and only a slight improvement next year as our model projects average inflation at 23.0% in FY25.  In effect, the inflationary pressure that Pakistan has experienced in the past two years, will persist in FY25.

Driving this persistent cost of living increase is the price of energy (electricity and gas tariffs, and the retail price of fuel) and a more flexible rupee as the government seeks a longer-term IMF program.  Fuel prices are expected to increase in Q4-FY24 as GST could be imposed to shore up revenues this year, while there are strong expectations the PDL ceiling (currently at Rs 60/liter) could be increased in the Finance Bill for FY25.  The point is that taxes on fuel are easy to collect, and if the government is concerned about its primary surplus target for FY24 (which will be an indicative target for the next IMF program), a tax on fuel is an easy and predictable source of revenues.

Food prices will be difficult to manage as transportation costs will increase with diesel prices.  Our model shows that while average food inflation has been falling since September 2023, it could start increasing from January 2025.  Similarly transportation costs could start rising from January 2025.  The cost of household utility bills has been increasing since September 2023 and is projected to peak in October 2024 at 38.7%.  Since food, utilities, and transportation, accounts for over 64% of the CPI basket (which is a proxy for the spending pattern of the average household), FY25 will be another difficult year for the average Pakistani.

With sluggish GDP growth projected till FY26, and salaries unable to match the rise in prices, most households could experience a 15-20% fall in purchasing power in the two years till June 2025.  Many of these households will fall below the poverty line.

With no fiscal space to protect consumers, and an added goal to force non-filers into the tax net, the challenges ahead are significant.  Many will argue that this government does not have the political will to deliver on these promises.  In our view, the IMF is not in a compromising mood with Pakistan, and will insist on additional revenues, no subsidies, no increase in the circular debts, and to sharply reduce the hemorrhaging in SOEs.  This is a make-or-break moment for Pakistan; if the country cannot deliver, it may still stumble into sovereign default.  It’s effectively a choice between taking on the sacred cows or watching the entire economy implode.

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Irrational Exuberance

(February 04, 2024)

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.

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January’s IMF Staff Paper is disappointing

(January 25, 2024)

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.

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Pakistan’s domestic debt must be handled with care

(August 06, 2023)

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.

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Will the next EFF provide certainty?

(April 25, 2023)

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.

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This time is different – Part II

(February 02, 2023)

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.

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This time is different

(January 23, 2023)

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.

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