Protected Papers

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.

The war in Ukraine is heading into its third month and is likely to continue for a while.  Positions on both sides have hardened, as the Western alliance (under the umbrella of NATO) appears to be looking for a military solution in Ukraine.

From the US (and NATO’s) perspective, Europe has stepped up, and despite its trade ties and dependency on Russian natural gas, it has joined the US in imposing strict economic sanctions on the Russian economy.  With his reputation as an autocrat, Western leaders have blamed Vladimir Putin for this war, and targeted his close associates and family.  The fact that Putin has changed his military strategy, is taken as a sign of failure, and his effort to intimate NATO appears to have backfired spectacularly.  With the war going against Russia, the Western alliance feels that further pressure could trigger a change in regime, while a humiliating retreat will not allow Russia to intimidate its neighbors again.

The Russian perspective is very different.  While many may say that this is Putin’s biased narrative, it is compelling.  The West is mocking the Russian Army and has forgotten that its predecessor (the Red Army) effectively defeated Nazi Germany.  The US engineered the end of the Soviet Union, targeted Eastern European countries to join NATO, and is now encircling Russia with Finland and Sweden also joining NATO.  Furthermore, the US is openly arming Ukraine and using Ukrainians to fight a proxy war against Mother Russia.  Finally, the US wants regime change in Russia and has a long history of doing so across the world.  From Putin’s perspective, Russia is not just another country but a superpower, and cannot be treated this way.

With this disconnect and the fact that there is no effort to move towards a settlement to end the war, the war in Ukraine could escalate beyond its borders.  Without a global institution that could force the two sides to step back, each must hold back or risk a direct confrontation.  We argue that the US is calling the shots and appears to want a military solution; in our view, if the US doesn’t change its Ukraine policy, the war will become unpredictable.  Against this standoff between the East and the West, IK’s anti-US agenda and his attack on political dynasties that have been supported by Western powers, could seriously complicate Pakistani politics.

News of the IMF’s nod to extend the Extended Fund Facility (EFF) and increase the total funding to $ 8 bln, has been celebrated by the markets.  The PSX rallied and the rupee gained against the dollar.  There is no denying the need to restart the EFF, not just to provide confidence about Pakistan’s FX situation, but also as a hedge against external shocks emanating from the ongoing war in Ukraine.

The new finance minister claims that the IMF has provided some leeway to gradually reduce the fuel subsidies, which will make life easier in the weeks ahead.  This is a source of much relief, and the government will see this as an early victory for Shehbaz Sharif.  However, the end goals of the EFF should not change much, and what lies ahead will be summarized in the next IMF Staff Paper after the 7^th review is completed.

The question that remains unanswered is what factors have improved Pakistan’s relations with the IMF.  Some would argue that geopolitical forces are at play, while others may suggest that this is a more realistic assessment of the conditions facing import-dependent countries.  This is hard to answer, but one thing is clear: the IMF may allow for actuals (i.e., no binding targets for key parameters like the fiscal deficit and CAD) for end-June 2022, but FY23 will be a different story.  The issue is what does Pakistan have to do in return, and will the next elected government have the appetite for hard reforms?

Despite the political clarity in the past week, the outlook for Pakistan remains uncertain.  Shehbaz Sharif (SS) has behaved responsibly by stating that Pakistan cannot afford to disengage with the IMF, while the next finance minister (Miftah Ismail) has Tweeted that IK’s fuel subsidy is unsustainable and will have to be reversed soon.  This leaves the SS government with conflicting goals: one, to create the groundwork for the next elections which will take some time; and two, hand over charge to a 3-month interim government as soon as possible so that corrective steps can be taken.  No politician would want to take ownership for a sharp increase in fuel prices just 3 months before general elections.

As things stand, PTI appears to have the momentum with the people, while SS has to deal with a hemorrhaging economy and an unpredictable coalition.  As incumbents, however, the ruling coalition has the opportunity to do good things, but their individual compulsions (they will be competing against coalition partners in the next elections) will push them to be self-serving.  If this government begins to show some cracks and early elections are called within a month, it will play to PTI’s advantage.  In our view, if elections are held under these circumstances, it could very well give us the same composition in the provinces and the center, as what we had under IK’s term.  Even after the elections, how will the country deal with the economic emergency and bridge the growing political divide?

With the early end of IK’s term as prime minister, the new coalition government is gearing up to take charge.  With Shehbaz Sharif as the new prime minister and Miftah Ismail talking to the media like the next finance minister, this has brought some calm to the markets.  This is necessary after the sharp weakening of the rupee and reflects how a PML-N led government resonates well with the business community.

We argue that the new government will have to take immediate measures to stabilize the economy and bridge the gap with the IMF.  This means there is much economic pain in store, but there will be greater clarity about the future.  Having said this, how the politics will play out could have significant ramifications for the country and the economy.

If the opposition parties manage to win power in the next election, Pakistan’s relations with the West will improve and we should be able to work with the IMF; if IK manages to regain power, it is unchartered waters for the country.  There is too much at play to formulate a credible political and economic outlook for Pakistan.

We thought Pakistan’s dire economic outlook would keep the opposition on the sidelines (of power), but the 27^th March no-confidence vote suggests that the political calculus has changed.  In an insightful analysis by Fahd Husain in the Dawn (17^th March), he argues that the coordinated opposition strategy will succeed in removing IK from power, unless PTI agrees to early elections if the opposition takes back the call for a no-confidence vote.  From the perspective of the strained negotiations with the IMF, and the likelihood that the PTI relief package will have to be reversed, a 3-month interim government would be able to bring Pakistan back on track with the EFF and allow the political class to save face.  If general elections take place in July 2022, the new government will either continue with the ongoing EFF or initiate an almost identical program soon after coming into power.