Protected Papers

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.

The IMF Staff Agreement means Pakistan is on track to restart the EFF.  Two prior actions are required: the government will now have to get both the Finance Bill and the SBP Bill approved by parliament.  In our view, both should be passed: the Finance Bill may be unpopular with businesses, but previous governments have had to do this before, and understand that this is part of the game.  The SBP Bill is controversial, but the IMF has conceded on the “autonomy” clauses, but it has not conceded on fiscal and quasi-fiscal measures.

While the government will retain control on how SBP operates (and SBP’s top management is not immune from accountability), the central bank cannot help the government on the fiscal side.  This means the amended SBP Act will ban government borrowing from SBP, and GoP cannot rely on SBP profits to increase its non-tax revenues.  This will make fiscal targets more challenging.

That aside, Pakistan’s BoP problems persist, and the authorities must narrow the current account deficit (CAD).  This means the FX market will remain volatile, especially as the monthly CAD is not likely to narrow significantly in the next few months.  Furthermore, with the unexpected 150 bps rate hike, and YoY inflation likely to enter double digits in November, the market expects further increases.

We list several positives and negatives on Pakistan’s economic outlook.  Positives: the government is moving fast to meet the prior actions; oil prices have fallen recently; a new Covid strain will dampen international travel (which should help remittances); global supply chain bottlenecks are easing, and there is much optimism about the IT sector in Pakistan.  The negatives are more pressing: undocumented wealth and the preference for imported goods (amongst the rich) will keep imports high; income/wealth inequality means the economic pain is concentrated on the poor and middle class; food inflation will remain elevated; Afghanistan is a political and economic challenge for Pakistan; the PTI government’s global image has been tainted by the Taliban takeover and its negotiations with TTP and TLP, and monthly inflation and CAD data will continue to dampen business sentiments in the months ahead.

Till the EFF restarts in January 2022, the authorities will have to manage market anxieties and public anger.  We argue that the government should be decisive about stabilizing the economy, and not send mixed signals about achieving high growth while maintaining economic stability.

The mixed signals from Washington D.C. about the status of the EFF, have unhinged the markets.  Media stories that Pakistan had agreed to increase power and gas tariffs, coupled with the sharp increase in retail fuel prices in October, suggested that the required steps to restart the EFF had been taken.  However, the talks have ended inconclusively, and the FX market is volatile.

Since it is clear that Pakistan cannot afford to protect its citizens from rising commodity prices (especially oil), we have updated our projections for the rupee and domestic fuel prices.  The resulting increase in headline and food inflation is alarming, and the PTI government is scrambling to manage sentiments.  Given the trajectory of food inflation in FY22, we think this is the most challenging economic issue the PTI government has faced.

Although there are no details about why the IMF talks stalled, we argue that the deal-breaker could be the size of the current account deficit (CAD) for the year.  In our view, the government is asking for greater BoP leeway to achieve 5% growth this year, but the IMF wants a smaller external deficit especially at a time when Pakistan is vulnerable to external price shocks.  If the CAD target is restrictive, this will undermine growth and create more pressure on the rupee – it could also force SBP to increase interest rates more aggressively.  Greater BoP leeway would have the opposite effect.

So far this year, the economy has operated without a BoP outlook.  However, with rising commodity prices and high monthly CADs, businesses are now looking for greater clarity about the external sector as this will give them a better handle on the rupee-dollar parity and the ease of importing.  This is only possible if the EFF restarts after both sides agree on Pakistan’s BoP outlook.  In the interim period, it is crisis management as inflation surges and opposition parties pile on the pressure.  The inconclusive IMF talks raise the possibility that the EFF could be delayed, which means the end date could be extended into 2023.  This will create complications for the PTI government as it gears up for general elections.

The past week has seen a change in Pakistan’s economic narrative.  SBP’s monetary policy statement (MPS) released on Sept 20^th justified a 25-bps increase in interest rates, but held out the hope that the authorities would safeguard the growth momentum while managing inflation and reducing the CA deficit.  By Sept 23^rd the finance minister and SBP had changed their tone, with greater emphasis on curbing imports and dampening the growth momentum that is threatening the external sector.

This change in direction is required as Pakistan gears up for the WB/IMF meetings in October, where the authorities will seek to restart the EFF.  This could be complicated by the significant geopolitical changes that have taken place since the US left Afghanistan in August.  President Biden is changing the global order to focus on the perceived threat from China: he is creating new security alliances; snubbing older allies; signaling that the US is no longer the global policeman; that US military intervention is a last resort; and the US will now focus primarily to contain China’s global influence.

US-Pakistan relations are already strained because of Afghanistan, and India is now part of a new US security arrangement to monitor the Asia-Pacific region.  The cancellation of foreign cricket tour to Pakistan is an effort to isolate the country, and to play up its links with terrorist groups.  Such heavy headwinds coupled with the weak external sector, means that Pakistan must approach the IMF with caution.  Stubborn posturing from our side may delay or suspend the EFF, which could create a sense of panic in the economy.  From the IMF’s perspective, it will remain firm that Pakistan cannot increase its circular debt and must meet its revenue collection target.  Since Pakistan has decided not to renegotiate IPP tariffs with Chinese-owned producers, the IMF will insist that consumer tariffs be increased as agreed.  This means the EFF will come with upfront pain.

While the West can afford to ignore Afghanistan, Pakistan cannot.  The looming humanitarian crisis in Afghanistan will surely burden Pakistan’s limited food supply and could trigger a mass refugee problem.  If the US decides that Afghanistan’s collapse is not its responsibility, then neighboring countries would have to step in – specifically Pakistan.  This will add to the BoP pressures that Pakistan is already experiencing and could make the EFF much tougher to live with.

While little can be said about Afghanistan’s political and economic future, the economic data for the past two decades is revealing and disheartening.  Basing the paper on country reports published by the World Bank and the IMF in April and June 2021, we would make the following points:

• GDP growth was strong but erratic in the first decade of the US occupation (2002-2012), but this fell apart in the past several years;
• This coincided with two key markers: (1) the end of combat operations in late 2014, which resulted in a sharp drawdown in foreign troops; and (2) President Trump’s decision in February 2020 to withdraw US troops from the country by May 2021;
• With donor grants (not debt) financing almost three-quarters of annual government spending, which itself was about half of Afghanistan’s GDP, the sudden stop of donor funding will surely create an economic collapse;
• Foreign grants allowed the central bank (Da Afghan Bank – DAB) to maintain a stable currency and finance a CA deficit that averaged 19.1% of GDP during the period 2011-2020. Narrowing this deficit will be very challenging;
• The economic slowdown reduced imports, but a growing fraction of total imports is for essentials items (food, fuel, and medicines). By our calculations, Afghanistan spent over $ 3 bln last year for such essentials;
• With DAB’s ample FX reserves frozen by the US Fed and the banking system barely operational, formal imports will shift to informal channels, which would place a heavy burden on Pakistan’s economy;
• Because of the size of the economic imbalances in Afghanistan, this problem cannot be tackled without external assistance. This will require re-engagement with the IFIs, the resumption of donor aid, and new sources of finance and investment;
• In our view, most inwards remittances from expat Afghans are channeled via the parallel FX market, which allows for capital flight;
• Most of the endemic corruption is concentrated at the customs stage, which should be the main source of government revenues for an import-dependent and undocumented economy. This will have to be stamped out if the government is to provide basic goods and services to the Afghan people; &
• The banking system does very little financial intermediation, as many private sector projects were directly financed by donors.

The immediate risk is a humanitarian crisis in Afghanistan.  This will impose a significant burden on Pakistan, both in terms of additional imports and a larger influx of refugees.  Rehabilitating the Afghan economy will also be challenging; planners must ensure that past mistakes are not repeated, and the new economic setup does not clash with cultural norms and political needs.  An urban-focused economy may not be the right solution – we think an agri-focused, trade-based economy is a better bet.

The events in Afghanistan hardly need to be flagged – mainstream media has been using all 24 hours for breaking news.  It started when the Taliban captured the city of Zaranj on August 6^th and ended when they walked into Kabul on August 15^th.  The fact that they managed to do this without any air power, is equally impressive.

In our blog that started on August 6^th, we argued that the Taliban takeover could have dire consequences for Pakistan (and its economy).  If the conflict became a bloody struggle in the main cities, a blame game would have started, and Pakistan would have been singled out.  US sanctions would have followed.

The swift takeover has worked in Pakistan’s favor, but the chaos in Kabul airport and the fear and panic amongst Afghans who worked for the Americans, could deepen the chaos and desperation in Afghanistan.  If this happens, Pakistan could still be blamed as the mastermind.  The Taliban are trying to convince a skeptical world that they have changed, but this will take time to gain traction.  The only positive is that regional powers like China and Russia have said they will work with the Taliban government, which means Afghanistan will not become a pariah.  As we have argued before, what is happening in Afghanistan signals a new world order, and Pakistan has played a pivotal role in securing its place in the bipolar world.

This raises doubts about our relationship with the US: more simply, will the IMF program be suspended, and could the US impose sanctions against the country?  We have analyzed the stalled EFF and argue that problems started in the first year, but the pandemic helped bring us back on track.  Now, both sides are waiting for the outcome in Afghanistan to shepherd the program forward.  We argue that the program will not be halted by the IMF, but the latter will insist that the economic growth the PTI government wants in FY22, does not undermine the stability in the external sector.

We also think IK and the Establishment have decided that the country’s future is not aligned with the US (or the IFIs) and Pakistan must focus on regional trade and China’s OBOR.  It is just a matter of time before China invites Afghanistan to join CPEC-Plus, which would connect Central Asian countries via Afghanistan to port access in Iran and Pakistan.  In our view, the PTI government’s focus on geo-economics is a diplomatic way of saying that Pakistan is shifting away from the US.  We also argue that IK may use this upside to secure another term in power.