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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.
The numbers are alarming. According to an IMF paper released in September 2022, Pakistan’s debt servicing in FY23 is $ 15.6 bln, the current account deficit is projected at $ 9.3 bln, and SBP needs to increase its reserves by $ 6.4 bln. This means Pakistan needs at least $ 31.3 bln this fiscal year. The good news is the country should receive flood-related relief; the bad news is that Pakistan’s external financing needs for FY24-FY27 is a whopping $ 150 bln, which averages to $ 37.5 bln each year.
We argue that this debt overhang started accumulating five years ago, and the country will struggle in the years ahead. Unfortunately, the IMF’s projections of the external sector and efforts to sustain Pakistan’s external debt are not credible. According to the Fund, a growing share of Pakistan’s high $ financing needs will come in the form of FDI and portfolio investment. In the past, these flows were erratic, which effectively means that Pakistan does not have a roadmap for the external sector.
The paper argues that Pakistan needs comprehensive debt restructuring (not just flood-related debt relief) and must also rethink its imports and exports. The increasingly frequent boom-bust cycles can be traced to Pakistan’s acute dependency on imports, which needs to be urgently addressed. This may go against the free market ideology of the Washington Consensus, but with a growing East-West divide, this is perhaps the time to customize Pakistan’s recovery with economic planning and policy commitment. However, since such a path will threaten the status quo, no one will champion this break with convention.
As the economic uncertainty becomes more acute, business interests may realize that without significant changes, the viability of their businesses could be threatened. We take comfort from the honest assessment by the ex-finance minister, Miftah Ismail, who said the economic model in Pakistan is unsustainable, and policymakers do not account for the future cost of their decisions. Does this mean the status quo is reconsidering its position?
The flooding in Pakistan has overshadowed the EFF. Still, the alarming slide of the rupee is a reminder that without a credible economic roadmap, the business community will continue to suffer. We have argued that the September 2022 IMF Staff Paper could be viewed as a pre-flood roadmap that will likely change once the flood damage and donor grants have been finalized. However, if one looks at the list of quantitative performance criteria (QPCs) versus the structural benchmarks (SBs), it becomes clear that the QPCs will change in the post-flood EFF, but the SBs may not.
Putting aside the catastrophic flooding, Pakistan’s performance in this EFF has been very poor. The IMF was blindsided by IK’s relief package of late February 2022, and may be concerned that the ruling government is sending mixed signals about recently committed reforms. The lack of tangible results will be seen as a failure of the EFF (& embarrassing for the IMF), which explains why the list of SBs is growing – six new conditions were included in the February 2022 Staff Paper, and an additional eight have been included in September. In total, there are 18 SBs that the authorities must meet by June 2023.
The behind-the-scenes work is building up, and some of the tasks are politically sensitive: (1) a schedule of future fuel price hikes is a prior action that could derail the program if they are not met; (2) the authorities must declare the beneficiaries of large government contracts; (3) two undercapitalized private banks have to be liquidated by end-May 2023; (4) SBP must wind down its refinance schemes and shift this task to a separate DFI; (5) an asset declaration system is to be created for top government officials (including elected and unelected cabinet members); and (6) NAB needs to be more effective to curb the growing incidence of corruption. Some of these reforms are politically sensitive and will test the resolve of this government in this period of acute political uncertainty.
September should have been a period of market calm and more certainty. However, the rupee has lost value in the past week, and the pace increased as the week progressed. This has unnerved businesses, especially those that are import-dependent. We are not surprised by the growing economic uncertainty as the floods are a game changer, and the IMF Staff Paper reflects the conditions before the floods. We argue that it will take some time to renegotiate the EFF in terms of the quantum of the flood damage and the international assistance the country expects.
In this paper, we analyze the confusing situation by discussing key uncertainties: (1) the quantum of the flood damage and expected foreign aid; (2) how the EFF’s program details will change to account for the economic and social damage from the floods; and (3) how these events will impact domestic politics. Using a game theoretic approach, we identify four scenarios whereby the government is perceived to have managed the floods and the EFF well or poorly. In our view, this analytic construct provides a better handle for predicting the economic and political outlook of the country.
If the two challenges (floods and the EFF) are well managed, this will boost the standing of the ruling government at the direct expense of PTI and Imran Khan. It would also allow the coalition government to see through the full term (till mid-2023) and make it likely to win more seats in the next general elections. However, if the majority perception is that the government has poorly managed the floods and the revised EFF, this will have the opposite effect. While much of this will remain uncertain for a while, it is clear that the rebuilding effort must be at a level that can withstand more frequent rains, as witnessed this year. Finally, global climate change has shown its destructive power to Pakistan.
The relief that Pakistan will not default provides some room to focus on other challenges facing the economy. In the past two years, the increase in money supply (M2) has been high, and this will figure prominently in the EFF. M2 started its steep rise in September 2021, first driven by an increase in private sector borrowing and later because of heavy government borrowing from February 2022. As of end-July 2022, the credit disbursed by the banking system exceeded its total deposits by almost Rs 6 trn. This surplus liquidity has been provided by SBP, mainly in the form of heavy one-sided open market operations (OMOs) and the various refinance schemes offered by SBP. The amended SBP Act (2022) and the EFF will ensure that the central bank takes concrete steps to reduce the growth of M2 in FY23.
Program details of the EFF should provide a clearer picture of what is required. If the outstanding volume of OMOs is to be reduced, banks will likely prioritize the government over the private sector. Risk appetite falls during an economic slowdown, and if banks sense that interest rates will increase further, the safest strategy is to be conservative and lend to the federal government. Unfortunately, this will crowd out the private sector and squeeze economic growth. With the benchmark interest rate already at 15%, the authorities will shy away from aggressive rate hikes; however, if money market liquidity becomes very tight (i.e., the government’s credit needs exceed available liquidity), interest rates will have to increase.
The market is celebrating the restart of the EFF, even though this program is all about austerity. Adverse global conditions will not help, while the ongoing political crisis may not allow policymakers to give their full attention to the economy. So while Pakistan is no longer facing default, it will have to confront its economic reality, and the political cost of managing this economy will increase.
Uncertainty about the Staff Level agreement weighs heavily on the markets (FX and PSX). People are asking whether the hard steps have worked and when Pakistan’s economy will return to normal. On the other hand, the finance minister has been trying to assure the market that an agreement will soon be announced, but his words are now sounding hollow. At the same time, expectations are turning positive as commodity prices are falling as the global recession digs deeper.
We address these concerns by stating that it is too soon to claim that Pakistan is over the worst. In fact, we argue that an unsustainable external debt makes the IMF more relevant if Pakistan is to consider restructuring its external debt. With Sri Lanka declaring bankruptcy, and a few other developing countries heading towards bankruptcy, the IMF may have to create a playbook for orderly restructuring. So for those asking when things will return to normal, the blunt answer is that Pakistan may be entering a new normal.
In terms of the status of the EFF, we argue that there is a trust deficit with the IMF, which is understandable after the blatant reversal of Pakistan’s commitments when IK announced his ill-advised relief package. In addition to this, there are other reasons for the delay, which will be challenging to overcome after Eid. The results of the Punjab by-elections could push the country into early elections. At the same time, the IMF understands that it can only finalize program details with this coalition government or the next elected government, which means the ruling coalition should ink the agreement soon as the country may not get through the next 3-4 months while disengaged from the IMF. We remain confident that the Staff Level agreement and the release of the next tranche are weeks away, so businesses and market participants should be patient. If Pakistan does embark on debt restructuring, it will usher in a new era for the country. Hard reforms will no longer be an option but a necessity.
The Rs 60/liter increase in fuel prices has shocked consumers. Many of us had anticipated a significant hike, but the actual increase has created a political firestorm. While the finance minister is confident that this increase is sufficient to restart the EFF, we still think further increases are required. The commitment made to the IMF is to cover global prices and also impose an additional PDL and a 17% GST. This could push fuel prices close to Rs 300/liter, which should become clear when the FY23 Budget is announced.
People think the PML-N coalition government has effectively signaled its intention to stay in power till its term ends in 2023. We still think the prerequisites to restart the EFF could impose a fatal blow on any political party, which means we stand by our prediction that a caretaker government will soon take charge.
Instead of gauging who is to blame for the current crisis, we look back at the PML-N and PTI terms in power. Both governments opportunistically used a collapse in global oil prices to jumpstart the economy. After the short-term growth boost, Pakistan entered into a BoP crisis and had to be bailed out by the IMF – we are at the same place again. The point is our policymakers are good at capitalizing on a positive external shock, but flounder when they have to manage a negative shock. With fuel and food prices likely to remain elevated with the ongoing war in Ukraine, the policymaking skills needed now are lacking. This means the economic outlook for the next month will remain murky.
Instead of analyzing the reasons for the market slide in recent weeks, we focus on an increasingly obvious fact: Pakistan’s government is bankrupt, but a small minority of Pakistanis are very rich. We argue that the bulk of household wealth comes from real estate, which is grossly undervalued. Since the resulting capital gains are undocumented and generate substantial purchasing power, tax collection suffers despite strong consumer spending. With a preference to use of cash for economic transactions, Pakistan’s economy is largely undocumented, which means tax revenues lag behind government expenditures. Furthermore, a large part of this undocumented wealth is spent on imported goods, which creates a perpetual BoP deficit. In effect, Pakistan suffers from persistent fiscal and external deficits, which makes it one of the most frequent clients of the IMF.
We argue that structural reforms need to break this cycle of prosperity, as investment in undeveloped land is lucrative, unproductive (no jobs are created), and allows investors to hide their real wealth. We also argue that since the informal economy (that accounts for the bulk of employment) operates outside the ambit of government policies, the government can limit its role by not looking out for the vast majority of Pakistanis. With most people taking care of themselves (with help from friends, family, and a well-knit community), the government often partners up with elite business interests in a self-serving web of relationships. This is the basis of the elite capture of policymaking. As a result, there is no long-term economic planning, and what we have are short-term elite-focused policies that result in boom-bust cycles.
Looking ahead from the current crisis, we question whether Pakistan can return to the relative comfort of the past. Since Pakistan has experienced many economic crises, many are confident that Pakistan will overcome this one and return to normal – we disagree. In our view, the size of the economic imbalances is much too large; Pakistan’s friends are more reluctant to help; and Pakistan needs to restart the EFF to avoid sovereign default. From the experience of the past few decades, the current government does not have the appetite for structural reforms (though it may take corrective steps like increasing fuel prices), while the previous government left behind an economic mess. Hence, the next government will have to overcome serious economic challenges, and if the past is any indication of what is likely, the outlook for Pakistan is bleak.
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