Protected Papers

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.

The relief package announced by IK on 28^th February is a blessing for the average Pakistani, but it does complicate the on-going EFF.  Since the tone of the IMF Staff Paper released in February 2022 was stern, additional impediments to the EFF are not a good idea.  However, IK may not have had a choice on the matter.  With the opposition gathering support in its long march to Islamabad and talk of a no-confidence vote against the Prime Minister, and Brent prices above $ 100/b, PTI is now fighting for its political survival.  If these untargeted subsidies remain in place for the next 4 months, inflation will fall, economic growth could hit 5%, and SBP may be able to retain interest rates at current levels.  From a political lens, this upside is perhaps worth the risk.

There is much confusion about whether the IMF was informed about the package in advance and secured its approval.  It is obvious the IMF would not be happy with this, as Pakistan is already struggling with a large fiscal deficit and has been reprimanded for hiding other initiatives in quasi-fiscal operations.  We argue that the IMF must have been informed, but the fiscal impact of this package will have to be recalculated and incorporated into the EFF targets.  We also think the GoP’s estimate that the cost will only be Rs 250 bln is unrealistic, as global oil prices are likely to remain elevated with the on-going war in Ukraine.

The outlook is for tense IMF negotiations and the likelihood that the freeze on fuel prices and power tariffs will not last 4 months.  The relief package is a pure political play with economic consequences – hence, it is business and usual for Pakistan.

On 14 February, two articles in the Dawn created a sense of foreboding about the EFF.  IK stated that without a two-thirds majority in parliament, his government would not be able to get existing laws amended as required by the IMF.  Next to this article was another that discussed how the IMF wanted a new state-owned enterprise (SOE) law passed by parliament before end-June 2022.  So, is the newly minted EFF already in trouble?

After the two prior actions (the mini-budget and SBP Bill) to restart the EFF, the IMF may have realized this is the only way to get the government to move on required structural reforms.  After the bruising experience to fulfill these prior actions, the government wants to signal that it is unwilling/unable to do more.

SOEs have been a policy focus in past IMF programs, but little has been done to reduce their losses or improve efficiency.  Since loss-making SOEs underpin the circular debt problem, this focus is required.  We argue that SOEs are a microcosm of what is wrong in Pakistan: (1) a bureaucratic mindset that reduces efficiency and makes them less dynamic; (2) as SOEs are regularly bailed out by the federal government, there is little incentive to reform; (3) inadequate internal checks mean SOEs are used by politicians and businessmen to serve their interests; and (4) corruption, nepotism, rent-seeking, and overstaffing, have become norms in SOEs, with senior management (acting on behalf of the government machinery or business insiders) resisting any effort to privatize the company.  Given the fiscal burden of SOEs, the IMF wants the authorities to take hard steps to restructure and eventually privatize these SOEs.

In our view, there will be heavy resistance to a new SOE law that seeks to reduce staff, hold management accountable for losses/corruption, or impose strict oversight that challenges entrenched political interests.  Asking the National Assembly to approve an effort to end rent-seeking, political nepotism, and overstaffing, is tantamount to asking the political class to forego the rewards that lured them into politics in the first place.  This will be hard to achieve but desperately needed.

The IMF is getting more specific in its demands, knowing that such changes will not be politically palatable.  Perhaps this is an indication that after three decades of failed reforms, the IMF is now saying that if you do not get specific things done (with legal cover and enforcement), there is no point coming back to the Fund for help.  With Pakistan not in the good books of the IMF (and the US government), the EFF is gearing up to be a demanding program, but something that Pakistan’s economy desperately needs.

After much anticipation, the IMF released its Staff Paper on 4^th April 2022.  This much-needed reality check paints a sobering picture of Pakistan’s economy, highlighting the strong demand conditions created by the expansionary fiscal and monetary policies launched in mid-2020.  For the first time, we have a credible set of BoP projections for FY22, and the required austerity in the remaining part of the fiscal year will be challenging.  With a current account deficit (CAD) target of $ 13 bln, this means the authorities must try to contain the external deficit to within $ 4 bln in the remaining 6 months.  This means a weaker rupee, possible interest rate hikes, and continued usage of import margins and exchange restrictions to bring down imports.

The performance targets for Q1 and Q2-2022 do not appear to be too daunting, but the new structural reforms required in the next several months will be tough.  The IMF has stated that a new state-owned enterprise (SOE) law would have to be approved by parliament, and SBP should move to permanently ban all refinance schemes.  This is likely to trigger a political backlash (SOE law) and resistance from the business elite (ending refinance).  The BoP target that SBP’s FX reserves should be $ 21.2 bln by end-June 2022 will also be difficult, as this entails a buildup of $ 5.5 bln after financing the CAD in the remaining part of FY22.

The Staff Paper provides a clear explanation for why the IMF made the mini budget and SBP Bill prior actions for the EFF.  The mini budget was required to reverse the fiscal liberties taken by the authorities in the FY22 budget, while the SBP Bill seeks to eliminate SBP’s role in political and business causes.  From this vantage point, restarting the EFF is returning to the primary objectives of the stabilization program, which is now more relevant given the BoP crisis that the country faces.

The program will be painful, but this is the cost the country will have to bear for the short-term elite economic boom the authorities launched under the guise of battling the pandemic.

Growing uncertainty about the Russia-NATO standoff regarding Ukraine has unnerved global markets.  With Pakistan’s current account deficit (CAD) above $ 9 bln in 1H-FY22 and oil prices close to $ 90/b, this could become an oil shock that will hit the country hard.  We argue that this development is one of three flare-ups that the US currently faces: the others are Houthi drone attacks in the UAE and the standoff with China over Taiwan.  We think Russia, Iran, and China are testing the US by marking out their spheres of influence to challenge the post-WW2 global order.  The odds are strong that one (or more) of these pressure points could result in armed conflict.

Any flare-up could create an oil shock.  Pakistan’s weak BoP would be further pressured, and this would require hard steps to manage the external deficit.  An oil shock could also compel the IMF to be less stringent with member countries, which may give our policymakers an opening to seek some leeway in the forthcoming EFF.  More importantly, an external shock will allow the economic team to change its flawed economic narrative and focus exclusively on stabilization.  This could be a godsend, as the policy measures taken so far to contain the CAD are not showing results, and Pakistan is running out of time (and FX reserves).

In January 2021, we listed 10 issues that would shape events in the new year.  We flagged mutating covid; sluggish business travel; no appetite for exotic vacations; the transformation in the entertainment business; the effectiveness of working from home; the existential threat to the retail sector; job security concerns; income/wealth inequality; Trump’s shambolic end; and confusion about long covid.

These10 factors will continue to shape events in 2022.  Covid will continue to mutate, and repeated booster shots could make people increasingly wary of taking more shots; business travel will remain subdued as will exotic vacations; Hollywood will remain subservient to streaming services; corporates will have to rethink employee management as people demand flexible work hours; inequality will continue to shape politics across the world; Trump’s authoritarianism will continue to threaten US democracy; and the West and Asia have chosen very different approaches to covid, which means travel impediments are here to stay.  However, since 2022 has started on a negative note (unlike early 2021 when people were optimistic), the year may play out better than expected.

Making predictions for Pakistan is more challenging.  The status of the EFF lies at the heart of the economic and political uncertainty.  Media reports paint a bleak assessment of whether the two key prior actions (parliamentary approval for the Finance and SBP Bills) will be done in time for the end-January IMF board meeting.  However, the confidence of the economic team suggests that PTI has the required votes, and despite the political blustering, the Bills will be approved.

We argue that the current management of the FX market will have to change, and further rupee weakness and demand management will be required.  While the EFF will come with upfront pain, Pakistan needs the IMF to weather the mounting BoP pressures.  We end by highlighting the sharp reversal in business sentiments during 2021: the first quarter saw optimism as the rupee appreciated and SBP’s monetary stimulus boosted domestic demand, but this optimism faded in mid-2021.  This boom-bust cycle played out in just one year, an indication of the short-term policymaking that still plagues Pakistan.