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This papers seeks to discuss Pakistan’s inflation rate in the year ahead, but more importantly, the uncertainty that events in Afghanistan have created for the country.
July’s YoY inflation of 8.4% is consistent with what we have projected. Our model shows that a weaker rupee in the period ahead and a sustained increase in fuel prices, will keep inflation elevated, but the YoY rate will not trend upwards. This means limited pressure on SBP to hike interest rates in the next 4 to 5 months.
The growing control of the Taliban in Afghanistan, on the other hand, is far more consequential for the country. We do not agree with media reports that the increasingly strained relations between the US and Pakistan could stall the IMF program and jeopardize the economy. We argue that the IMF cannot afford to appear partisan, especially after the positive results in the first two years of the EFF.
The greater uncertainty comes from the shift in Pakistan’s alignment towards China, with Afghanistan being a test case of the new world order. The Biden administration is clearly focused on China as its main competitor, and the showdown between the two will shape global events in the period ahead – at this point the focus is Afghanistan. Pakistan cannot afford to remain neutral in this showdown, as a civil war in Afghanistan will have devastating consequences for Pakistan. The Prime Minister has publicly aired his view that the US alone is to blame for the mess in Afghanistan, and only a political solution will avoid a civil war that will surely pull Pakistan into the conflict. Pakistan has accused India of destabilizing Baluchistan and undermining CPEC by targeting Chinese nationals in the country. We argue that regional countries have a direct stake in what happens in Afghanistan, and both China and Russia have shown support for Pakistan’s view that a political solution is required.
What happens in the next several weeks in Afghanistan and how the US reacts, will have an immediate impact on Pakistan. While a shift away from the US creates significant uncertainty for Pakistan, we do not see a plausible alternative. We argue that a peaceful Afghanistan that participates in regional trade is the best outcome, not just for the Afghan people, but also for Pakistan and the region.
The federal budget for FY22 is focused on growth, with specific emphasis on the stock market, the IT sector, banks, reduced duties on certain items, the sale of small-engine cars, and a significant increase in development spending. Contrary to prevailing rumors, we believe Pakistan will reenter the EFF in FY22, and a postponement of the 6th review is not an indication that relations have soured with the IMF. However, the budget is incomplete because there is no information about the external sector. This concern is exacerbated by the recent weakness of the rupee.
The Rs 5.83 trn FBR target has come from the IMF. Policymakers hope that identifying tax evaders (and informing them about it) should enforce higher compliance, while providing free point-of-sale (POS) machines could increase the collection of GST. On both counts, we don’t share their optimism.
To manage the circular debt problem, the budget has allocated Rs 682 bln as subsidy, most of which is earmarked for the power sector. The IMF is effectively forcing policymakers to face the consequences of their inaction. In other words, the government will have to finance the ongoing power sector losses and will not be allowed to accumulate future losses in the form of the growing circular debt. Another indication that this is an IMF budget is the Rs 610 bln petroleum development levy to be collected next year. This means the government will no longer be able to shelter domestic consumers from rising global prices, and the resulting increase in retail fuel prices will keep inflation elevated.
A final point about deficit financing. The budget shows that domestic banks and external commercial sources will account for the bulk of government funding: banks will finance over 60% of the fiscal deficit, while external commercial sources will finance 22%. We, therefore, expect significant crowding-out of the private sector next year, but without a credible BoP, we are not sure how the country will secure external financing. That aside, Pakistan’s growth prospects next year will depend on BoP comfort, which hinges on how remittances perform in the next several months.
Models that project economic growth can be complicated as they include all sectors of the economy and a dizzying number of variables. But that doesn’t make them accurate. We supplement our simple model by talking with businessmen, corporate leaders and bankers, to gauge their sentiments and understand their investment decisions. Since these players initiate private investment, their actions are a leading indicator of future imports and economic activity. We also look at the overall environment to gauge if certain behaviors will persist.
Throughout FY19, we witnessed an increase in interest rates and a steep depreciation of the rupee to qualify for the IMF program. This soured business sentiments even before the EFF started, and as a result, economic growth fell to 2.1%. The sluggish growth momentum coupled with IMF quarterly targets did little to help sentiments in FY20. Then in March 2020, the pandemic caused a significant economic disruption, which contracted the economy by 0.5%.
FY21, on the other hand, started with a bang: the lockdown ended in June 2020; the pandemic was well managed; despite being in a stabilization program, the government was able to launch expansionary fiscal and monetary policies; the rupee started appreciating; Pakistan’s BoP posted surpluses from July to November 2020; and economic activity returned to normal – and more. In December 2020 (when November data was released), we revised our growth projection upwards to 3-4 %.
The IFIs and GoP remained conservative about Pakistan’s growth prospects. The IFIs may have been negatively biased by the sheer magnitude of the global impact, while Pakistan’s authorities may have thought the pessimistic assessment would help them bargain for an easier IMF program.
With the growth momentum currently in play, the 4.8 % growth target is reasonable. However, this depends on BoP comfort, which hinges on remittances. In our view, FY21’s strong economic growth can be traced to remittances, which could be $ 6-7 bln higher than FY20. This BoP comfort could end if monthly remittances fall next year, and IMF targets to increase SBP’s FX reserves are challenging. How these factors play out will determine whether Pakistan can sustain its surprisingly high growth rate.
After the series of hectic developments following the departure of Abdul Hafeez Shaikh (AHS), there is a lull. Technically, the EFF is in play, but behind the scene, we think the GoP and the IMF are talking about the program conditions. Both sides have valid reasons to stand firm – the IMF will say that the previous finance team agreed to program conditions, and hard steps are necessary to stabilize Pakistan’s economy (especially the circular debt); the authorities will argue that in the midst of double-digit food inflation, a sharp hike in power tariffs and rising fuel prices could destabilize the government. The fact that there is no media coverage of these discussions, suggests that they are sensitive, and leakages will not be tolerated.
Program details from the IMF Staff Paper released on April 8th are revealing. The circular debt is the top priority, and tax revenues is a close second. Both will be painful and will anger the public and the business community. The manner in which the IMF conditions have been framed, suggests that in terms of fuel prices and the notification of power tariffs, the program seeks to limit the government’s role. Hence, political considerations about the pain inflicted by rising utility and fuel prices, may no longer be entertained, which explains the emphasis on the autonomy of Ogra and Nepra. However, getting the National Assembly to approve these amendments will be challenging, as no government would want to lose control on key prices. One must realize, that the PTI government has used key prices quite effectively to bring down inflationary expectations.
In our view, the Staff Paper’s BoP projections for the next five years are depressing and alarming. It shows that Pakistan will need to increase its current account deficits in the next five years to achieve 4-5% real growth. However, given the rapid increase in Pakistan’s external debt in the past few years, and the fact that the authorities will have to rollover its ST debts for the next five years, the IMF hopes that foreign investors and FDI flows will increase in the years ahead – it also means that direct borrowing by GoP will be much lower than in the past. If such private inflows are not realized, the CA will have to be much lower, which will hamper Pakistan’s economic growth. So, while the ST outlook vis-à-vis the IMF is still uncertain, the medium-term outlook is certainly not good.
The chain of events since the IMF approved the EFF (on 24th March) has created significant uncertainty. The departure of Abdul Hafeez Shaikh (AHS) and the decision of the new finance team to renegotiate the IMF program has pushed Pakistan into uncharted waters. Under normal circumstances, after a country receives an IMF tranche, it is understood that the program details have been accepted and the client country will begin meeting both qualitative and quantitative targets. Looking for a new IMF program means renegotiating, which implies the program is unlikely to start in the next several months.
We argue that the change in heart could have been triggered by the contents of the SBP Amendment Bill, which has snowballed. As things stand, the government has now decided that it needs to focus on economic growth and job creation. This reversal (from stabilization to growth or economic recovery) may not be possible as Pakistan is facing headwinds in the external sector. Despite running a current account surplus in the first eight months of FY21, Pakistan’s FX debt repayments in the next 12 months are much higher than available reserves. This means the authorities must rollover several bilateral loans, which will require Pakistan to maintain a strong BoP position and seek leeway from its friends. If the discussions with the IMF drag out (once they restart), Pakistan’s external sector is increasingly vulnerable.
Rising inflation (especially food inflation) and the need to increase power tariffs and tax revenues, appear to have dampened the public appetite for the IMF program, and political leaders across the board have joined the anti-IMF bandwagon. However, as the lender of last resort, it is risky to take such unilateral steps with the IMF. Furthermore, SBP’s efforts to contain imported inflation by appreciating the rupee will have to be reversed as this will surely accelerate the deterioration in Pakistan’s BoP.
While the IMF has remained silent about these unexpected developments, the institution cannot be pleased. A feasible path forward is that the government justifies its need for economic “recovery” using Covid-19 and pointing to the revived Economic Advisory Council’s consensus view. In our view, SBP’s autonomy is likely to be watered-down, but power tariffs will have to be increased as the circular debt has become Pakistan’s most pressing challenge. Against the IFI’s pessimistic growth estimates for FY21(WB at 1.2 %, and the IMF at 1.5 %) we maintain our optimism, and with SBP now talking about economic growth and jobs, we do not see an increase in interest rates in May despite the likelihood that YoY inflation will soon be in double digits.
Whatever the specific reasons to reverse course on the IMF program, it is clear this is driven by domestic politics. However, the outcome of this reversal will depend on geopolitical forces, which will be revealed by the IMF’s response.
February’s YoY inflation of 8.7% surprised the market, as the previous month posted a rise of 5.7%. The surge was driven by cooking oil, pulses, fuel prices, and the hike in power tariffs. As Pakistan gears up to restart the EFF in April and global oil prices stay firm, we project inflation to rise in the remaining part of FY21, with average inflation at 9.7% and YoY inflation entering double digits from April 2021 onward. We argue that supply factors and a significant base effect from early 2020 will drive inflation in the months ahead, and there is little the authorities can do to control inflation.
Focusing on heavyweights in the CPI basket, the base effect is likely to be pronounced in food, utilities, and retail fuel prices. The base effect can be traced to the sharp fall in retail fuel prices during the period March to June 2020, and the appreciating rupee since September 2020. We also argue that other sub-categories like automobiles, motorbikes, consumer electronics, household items, and services like restaurants, fast food, and beauty salons, are likely to experience strong demand as Pakistan is currently experiencing a growth phase. This means inflation is likely to increase in FY21, but this may not push SBP to sharply increase interest rates in the fiscal year.
We argue that the growth phase has been triggered by TERF and the strengthening rupee. This fiscal-neutral stimulus will shift Pakistan’s external balance into a deficit in FY21, but the central bank can sustain this because of the many positives from the pandemic in 2020. In our view, both the government and the IMF would like to take credit for how well Pakistan has done despite the challenges created by Covid-19. Hence, we do not see SBP undermining business confidence by hiking interest rates. FY22 will be more about austerity, but this fiscal year is likely to witnesses economic growth based on imports, a strong rupee, and business confidence. This will come at the cost of rising inflation.
Though expected, the IMF’s announcement that the EFF will resume in April 2021, has created some confusion. The EFF appeared to have stalled in 2020, but the IMF decided that Pakistan was able to manage itself quite well last year, and 2020 will count in the 39-month program. So effectively, Pakistan funds itself halfway through the stabilization program without even knowing it.
We also think there is a disconnect between what we see in the economy, and the IMF’s growth projection of 1½ % in FY21, which is at the lower end of SBP’s range of 1½ to 2½ %. We stay with our view that growth will be much higher (3-4 %) because of the trade flows that Pakistan has seen in the past several months. Since Pakistan’s economy is heavily dependent on imports, higher imports fuel economic growth. December 2020 witnessed a near-record high for non-oil imports, and the popularity of SBP’s TERF means machinery imports will remain strong for most of 2021. Furthermore, LSM data shows strong manufacturing growth in 1H-FY21, driven by the auto sector and construction. Since TERF stays in place till end-March 2021, we expect strong LSM growth this year and do not think the IMF program will derail the growth momentum.
While this is good news, it is likely to be a short-term burst of economic activity. Eventually, rising imports will begin to challenge Pakistan’s BoP and this will force policymakers to back off. In this paper, Pakistan’s dependency on imports and stagnant exports is analyzed using monthly trade data going back a decade. Since trade data is a leading indicator of what to expect in the real sector, we argue that the gradual de-industrialization in Pakistan has reduced non-traditional exports. In our view, the economy is becoming more inward-looking and undocumented. This means Pakistan will remain dependent on textile exports, but this will not allow for sustainable economic growth. For now, the pandemic has created an environment that will allow policymakers to embark on a growth phase, but the stabilization program will re-assert itself in FY22.
As Pakistan gears up to restart the IMF program, it is helpful to take stock of where we are and what to expect. However, instead of focusing on repercussions like the circular debt, mismanaged PSEs, stagnant exports, and insufficient tax revenues, it is more insightful to look at the root cause that give rise to these challenges. We identify the following: (1) no policy planning; (2) poor policy formulation that is influenced by political and business interests; (3) Pakistan’s shrinking manufacturing base; (4) the widespread undervaluation of assets and the growing undocumented economy; (5) rent-seeking in government; (6) poor social indicators; and (7) intolerance and violence in Pakistani society.
We then build on the World Bank’s assessment that policymaking in Pakistan is dominated by four groups: the political class; the bureaucracy; the military; and big business. To gauge how these groups view the abovementioned problems, we asked several experts to rank how these groups would prioritize reforms (1 was to leave things unchanged, and 5 was to change things even if it disrupted the economy). We found that on average, the political class was least interested in real reforms, while the bureaucracy and big business were partially interested but did not want to change a system that suited their financial interests. The military appears to have more appetite to reform the economy but shies away from disruption. People who want to see real change realize that reforms are, by definition, disruptive and are willing to allow a degree of dislocation to set things right. Most of the others would lend vocal support for reforms but would prefer that the system continues as it is.
The limited appetite for change helps shed light on issues like: (1) the disconnect between the government’s narrative and what people observe; (2) how kinship ties have overshadowed the role of the government and the formal economy; (3) why CPEC is no longer a game-changer; (4) why the government has forsaken economic planning; (5) why Pakistan’s economy is becoming introverted; and (6) why it will not be possible to escape the debt trap. Without risking disruptive changes, the EFF will just be another stop-start reform agenda that promises much but delivers little.
Many are glad that 2020 is over. The confined existence and loss of livelihoods will be hard to forget. However, the fact that the pandemic was a sudden but shared experience, made is somewhat easier to bear. With the Covid-19 vaccine being rolled out and the end of President Trump’s inglorious term in office, we caution against too much optimism about 2021.
We argue that much of 2021 will be spent coping with the momentous changes witnessed last year. We also feel that most people are unaware of just how significant these changes are and how this will force the world to adapt to a new normal. We list 10 factors that will shape 2021:
These issues will play out this year, which means 2021 will also be momentous.
Pakistan is currently experiencing a second wave of the pandemic, and the government has been warning Pakistanis to strictly follow safety protocols. While daily infections and deaths are alarming and getting a lot of media coverage, the daily infection rate appears to have crested. If infections remain below 3,000 per day, it is safe to say that Pakistan has overcome Covid-19.
The rapid progress with the Covid vaccine, means the fear and uncertainty about the pandemic is finally beginning to subside. While leading countries have warned that infections and deaths will continue well into the winter, businesses can now start planning for the post-Covid world. After the disruption witnessed in Western countries, the sense of relief and jubilation is understandable, as their economies come roaring back. However, fresh policy challenges that lie ahead will be daunting. Covid has changed the way most economies operate, as lockdowns have created a premium on self-contained existence – this will not change even if social interaction returns to normal. Shopping and entertainment have moved online, as has banking and working from home. Many jobs will become redundant, and policymakers will have to strike a balance between the needs of the financially insecure and the billionaires that have made so many people redundant.
In Pakistan, the economic upside to overcoming the pandemic is likely to be limited. First, the pandemic has been less disruptive compared to most other countries; and two, Pakistan was already in a stabilization program and is expected to return to the EFF in the second quarter of 2021. We argue that since the bulk of urban employment is in the undocumented economy, managing the pandemic (from a fiscal perspective) has been easy. However, the downside is that the bulk of the economy (in terms of jobs not GDP) will continue to operate outside the ambit of government policies. This means structural reforms will be of limited value.
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