Protected Papers

SBP’s Annual Report for FY20 carried a detailed analysis of why Pakistan’s banking system has not deepened since the financial reforms in 1991.  Unlike peer countries, Pakistan’s credit-to-GDP ratio has fallen since the 1990s, which means commercial banks have reduced their intermediation to the private sector.  Data shows that financial deepening accelerated in the 1960s as the government focused on industrial development and banks increased their branching network.  The nationalization phrase weakened the banking system in the mid-1970s, but as the economy picked up in the 1980s, so did the banking system.  Financial sector reforms did little to deepen the banking system or increase financial inclusion.  The post-9/11 economic boom was driven by private sector credit, but this was only possible because the government sharply reduced its borrowing after 9/11.  When this started to change, banks shifted to government lending and the credit-to-GDP ratio fell from 27.2% in FY08 to only 14.6% in FY15.  Since then, financial deepening depends on how much the government borrows – the more GoP borrows, the lower the credit-to-GDP ratio.

While SBP is optimistic that the banking system will deepen and financial inclusion will increase, we are not.  With record-high bank lending to the government and interest rates likely to increase in 2021, it will not be possible to entice banks to lend to the private sector.  Special refinancing schemes and policies to encourage housing finance (and lending to SMEs) should see token lending, but with a government desperate for money, banks are effectively bound by golden handcuffs.

We argue that failed fiscal reforms have undermined financial reforms, and the growing level of crowding out now makes Pakistan’s fiscal system even more unsustainable.  So, while the authorities were able to do the easy stuff (financial reforms) but not the hard stuff (fiscal reforms) in the 1990s, we now face a situation that without urgent fiscal reforms, Pakistan’s banking system will only focus on elite borrowers – the government, blue-chip corporates, and more affluent individuals.

It took four days to call the US elections.  Nevertheless, President Trump is still challenging the results and die-hard Republicans have supported Trump’s defiance.  While this is embarrassing from a global perspective, it is a clear marker that US politics remains divided, and the 2020 results show that the level of polarization has increased in the past four years.  President Trump increased his vote bank by almost eight million votes in 2020, which is disheartening when looking at his performance as president.

There is much to celebrate Biden’s victory, especially in terms of a global response to the pandemic and climate change – it should also make America more engaged in world affairs.  However, Republicans have gained seats in the House and are likely to retain their majority in the Senate.  This means President Biden’s effort to legislate will be impeded by Senate, just as in the second term of the Obama presidency, which Biden has experienced firsthand.

The real disappointment is that Donald Trump is likely to remain a very powerful and divisive influence in US politics.  By grooming his supporters into a cult-like following, President Trump has become the source of the Republican Party’s grassroot support.  This means Trump has become the face of the GOP, which we think is the prize.  By leading one of the main political parties in a polarized country, Trump will not only be able to do what he does best – grooming die-hard supporters – but also influence policies and set the direction for the country.  Despite his failures as president, President Trump leaves an impressive legacy for the conservatives.  Not only will this keep the US tacking right, but it will deepen the divide in American society.

The government is alarmed by the sharp increase in vegetable prices and is moving aggressively to contain food inflation.  While we project food inflation to stabilize in the next few months, the steps needed to restart the IMF program and the base effect (from early 2020) could push YoY inflation into double digits from February 2021.  Compared to SBP’s inflation projection of 7-9% in FY21, and the IMF’s 8.8% prediction, our calculations show average inflation at 9.8% and a YoY rate of 13.3% in June 2021.  We argue that the CPI sub-index for utilities and transportation could experience a base effect in early 2021, which means that even if the price index remains stable, the YoY increase could be significant.  As food, utilities and transporation account for about 64% of the CPI basket, these three subindices will increase headline inflation in 2021.

The uncertainty about the IMF program will dampen business sentiments and the rise in inflation will anger the people.  With urgent steps needed to contain the fiscal deficit (via new tax measures and power tariff increases), SBP may delay hiking interest rates till Q4-FY21.

The US elections on November 3^rd will be decisive in many ways.  For the world, there is hope that a Biden victory will return the US into an unstable world, where the pandemic and climate change need a coordinated global response.  For Pakistan, the outlook for the divisions in the Middle East and India’s annexation of Kashmir will depend on who occupies the White House in 2021.

In our view, the divisions in the US are so deep that irrespective of the election outcome, America’s political landscape will change.  If Trump wins, the Democratic Party could split; if Biden wins, the Republican Party will split.  Unlike 2016 when Donald Trump has unique advantages, after four years of chaos in the US and the world, Trump’s style of governing has become a liability.  President Trump has decided to stay with his divisive campaign and has not reached out to undecided voters.  Trump has doubled down on his management of the pandemic, his support for heavy-handed law enforcement, and his sympathy for white supremacists.  After losing the popular vote in 2016, we think President Trump will lose the Electoral College in 2020 and the US could see a blue wave where Democrats regain the presidency and carry the House and the Senate.

Despite this, Trump is unlikely to incite violence or threaten the peaceful transition of power.  He may contest the election results but is likely to exit the White House without much drama in January 2021.  In our view, Donald Trump knows he will be disowned by the Republican Party and realizes that his business empire could collapse after he leaves; he also knows that he could be facing years of litigation.  To counter this outcome, Trump needs to revive his grass-root political support; his best bet is to create his own political party and reinvent himself.

A Biden victory will be a source of much relief in the world.  The global pandemic and climate change will be managed in a coordinated manner, and tensions in the Middle East should ease.  We also think the US will be more active in ending the Yemen war and focus global attention on India’s annexation of Kashmir.  US relations with China should improve, but trade tensions will remain.  These outcomes will help Pakistan as it strikes a difficult balance between its friends in the GCC (supported by the US) and China, which has entered a strategic relationship with Iran.  After the relief of a Biden victory, Pakistan will once again face its stubborn economic challenges with no indication that it will succeed.

While food inflation has taken center-stage in the country, the IMF has just released its macro projections for Pakistan in FY21.  The Fund sees anemic growth of 1% and a current account deficit of 2½% of GDP; it also expects inflation to rise before settling down.  Our projections for FY21 are more optimistic: we predict real growth in the range of 2 to 3% (GoP’s budget estimate was 2.1%) and a smaller external deficit of 1.6 to 1.7% of GDP.  We argue that perhaps several positives have not been taken into account by the IFIs in the case of Pakistan, as they formulated macro projections for all member countries.  We think the early containment of the pandemic has allowed commercial activity to return to normal far earlier than people had anticipated; the strong BoP position so far in the fiscal year; the fact that construction has bounced back strongly; and we take comfort from the steps taken by SBP to monitor retail FX transactions to reduce the leakages in the FX regime.  We also argue that Pakistan’s organic growth under normal conditions should allow the country to achieve the government’s growth estimate.

EFF preconditions to restart the program will focus on steps needed to raise tax revenues and bring down the ballooning circular debt.  Facing public pressure because of rising food prices and the challenges from the political opposition, the government has little appetite for these tough steps.  Hence, we do not see the EFF restarting until 2021.

Assuming a benign BoP outlook for FY21, we expect currency flexibility and a delayed increase in retail fuel prices.  With supply-side factors more dominant in determining inflation in Pakistan, our rupee and PoL projections could push average inflation above 10%.  This will be driven by food, utilities, and transportation costs.  While we disagree with the IMF’s macro projections, we still await the next Staff Paper to better understand how the uncertain BoP outlook could impact the currency and SBP’s FX reserves.  In the interim period, the authorities need to protect the economic recovery that is underway and manage expectations of what is likely in the remaining part of this fiscal year.

Fears of a second wave serve a purpose: Pakistanis should be alert to ensure that the success against the pandemic is maintained.  In our view, the infection numbers and trajectory are not alarming enough to justify a panic or feed concerns that another lockdown is likely – unlike Western countries, India, and Latin America, Pakistan has largely contained Covid-19 cases and life has returned to normal.

The increase in daily infections since mid-September can be traced to the opening of the economy.  Schools and restaurants have opened up, and social gatherings are now permitted.  Hence, social interaction and exposure have increased, which means infections will increase.  Despite this, we argue that the early success in containing the pandemic should make the authorities more proactive, and this can be seen in the selective closure of restaurants and other hotspots.

It is a stylized fact that commercial and social activities have returned to normal, and business sentiments have returned to pre-pandemic levels.  This is in stark contrast with many countries that are struggling with the pandemic and are currently posting record-high infections.  This means the global recovery will be delayed and remain uncertain.  We argue that while the domestic impact of the pandemic has been limited, the global spillover will adversely impact both remittances and exports in the coming year.

We suggest three takeaways: the global disconnect in fighting the pandemic will delay the global recovery; active cases in Pakistan will not overwhelm the country’s health infrastructure, and the early success with containing the virus should ensure that the government will remain vigilant to keep the pandemic at bay.  We end with the view that many Pakistanis may not celebrate the victory as it will force the country to refocus on its stubborn economic problems.  The restart of the IMF program (which we expect in 2021) will be a grim reminder that little has changed in 2020.

Pakistan’s economy is no longer hampered by the pandemic, but an economic recovery is nowhere in sight.  We argue that events outside the country could have a stronger bearing on the economic outlook than domestic politics and policymaking.  Although the external deficit has narrowed sharply in recent years, we think policymakers are being cautious by not signaling a growth phase.  Increasing economic growth will require imports, and the market is still unsure about the country’s BoP position this fiscal year.

The flux in global and regional events add to the uncertainty.  The US heads into a bitter and potentially disruptive election; Iran has recently signed a 25-year strategic alliance with China (and downgraded its relations with India); the UAE has formally recognized Israel; and there have been signs of strained relations between Pakistan and Saudi Arabia.  We build on our 2017 paper that proposed a new bipolar world order, and suggest that recent events in the Middle East could be telltale signs of the new system coming into existence.  Unfortunately, while Pakistan’s long-term interests are with the Sino axis (China, Russia, Iran & Turkey), its economy is largely dependent on US allies (Saudi, UK, Israel, India and the IMF).  This new Great Game in the Middle East region could force Pakistan to choose sides.

Global economic fundamentals will not help.  Remittances from the GCC are likely to fall, and exports could be adversely impacted by the global recession.  As air travel picks up, remittances could fall further and put pressure on the currency.  For an import dependent country like Pakistan, the stability of the rupee and the availability of hard currency are the most important factors that drive commercial activity.  How the foreign exchange issue is resolved depends on how Pakistan’s friends view our foreign policy stance.

With Pakistan’s impressive containment of the pandemic, thoughts are shifting to the economic recovery.  With the government opening larger segments of the economy, people are talking up a V-shaped recovery.  While demand conditions are improving and the government can take credit for how it has managed the pandemic, there are mixed signals: the government is talking up the economic recovery, but key policy parameters tell another story.  More specifically, the weakening rupee (despite a marked improvement in the BoP during FY20) and rising retail fuel prices, are dampening business sentiments and could constrain the recovery.

We argue that Pakistan’s external sector may not allow for much of a recovery.  Pakistan’s economic growth is heavily dependent on imports, and SBP’s FX reserves are not that comfortable.  The paper illustrates the acute level of import dependency in the past decade, and argues that a growth burst is too risky given the heavy dollar repayments in the year ahead.  The pandemic may have spared Pakistan, but the world economy is still struggling and this will surely impact us.  Our primary concern is worker remittances and whether Pakistan can secure new loans for friendly countries in the GCC and China.

Perhaps SBP’s exchange rate management seeks to ensure that improved business sentiments do not push the country back into a BoP problem.  In effect, Pakistan’s economic recovery hinges on the EFF that has yet to be reactivated.  As expectations of an economic recovery gain momentum, policymakers need to remind the country that the outlook remains challenging, and the best way to do this is to push the IMF to restart the EFF and share this outlook with domestic investors.  We end with a more sobering assessment: Pakistan must wean itself off imports, but this will be resisted by Pakistan’s business elite and the IFIs.  Having said this, policymakers need to realize that structural changes are desperately needed in Pakistan’s external sector, and rupee management alone will not deliver the level of import substitution that is now required.

Pakistan appears to have controlled the pandemic far better than anticipated.  Daily infections have been falling since mid-June, and accounting for the people who recover from Covid-19, the number of currently infected is only 25,513 as of 28th July.  For a country of Pakistan’s size, this is very impressive.  We realize that risks remain – especially with Eid and Moharram in August – but given the success so far, we are confident the government will ensure that health protocols remain in place to ensure there is no second wave.

While Pakistan’s containment of the virus is impressive and people are aware of this, it may not necessarily improve the economic outlook.  Anecdotal evidence suggests that retail volumes are up since the lockdown ended in May, but demand conditions for a broad spectrum of businesses remain weak.  It is important to realize that the monthly pick up in sales (e.g. in cement, autos, iron/steel) is based on the deep slump in May and June, but looking at it on a year-on-year basis, the numbers are distressing.  Furthermore, since a large part of Pakistan’s economy is undocumented, analysts and policymakers do not really have a handle on the level of depressed demand in the economy.  In terms of returning to normal, this is only possible after a certified vaccine has been implemented across the country.  Despite positive news that vaccine trials are at an advanced stage, it is safe to say that Pakistan (and the rest of the world) will not be free of the pandemic till well into 2021.

In the interim period, since Pakistan’s economy is largely undocumented, the policy reach to bailout SMEs (which provide the bulk of urban employment) is severely limited.  We argue that despite the cost of remaining undocumented, businesses will not rush to document their activities, as they do not trust government promises and the tax collection machinery.  The Social Contract that underpins a buoyant fiscal system has been ripped to the point where real change now requires a reset in the entire governance system.

In terms of the immediate outlook, we flag the disconnect between the sharply lower external deficit (especially in the last quarter of FY20) and the weakness of the rupee since early June.  We argue that returning to the EFF and keeping SBP’s FX reserves above a certain level, may be the reasons for keeping the rupee weak.  A better outcome with the pandemic could trigger pressure on the external sector, which may reverse the sharp narrowing of the current account deficit.  Since Pakistan’s BoP for FY20 was only $ 3 bln (against a $ 6.6 bln target), the authorities may want to protect these gains when facing a challenging fiscal front in FY21.  In effect, Pakistan’s recovery will be slow, and the golden opportunity to push documentation is perhaps too challenging for the incumbent government.

Despite the fact that the federal budget for FY21 was released in June, businesses cannot plan for the year ahead.  With Pakistan about to restart the EFF – which was interrupted by the coronavirus – the roadmap for FY21 will be announced when the next IMF Staff Paper is released.  Since this will require data consolidation for FY20, further discussions between GoP and the IMF, time to write up the report, and the IMF’s board approval, this document may not be published till mid-to-late August.  Having said this, Pakistan’s economy has fared well so far, and is well placed to handle the external shocks expected in FY21.

The other piece of good news is that the spread of Covid-19 appears to be coming down.  Since late June, daily infections have been falling, and if this trend continues for the next few weeks, it is safe to say that Pakistan has reached it peak much earlier than anticipated.  The fact that global infections are breaking record highs, should be a source of satisfaction for the country.  However, we argue that the economic fate of individual countries is not tied to how well the specific country has managed the pandemic.  For an interconnected world, we highlight that the impact of the pandemic has been very uneven across the world, which will complicate the path towards recovery.  If the economic recovery in the G7 is delayed (e.g. the US is back in panic mode and Europe is still very cautious), this will hamper the economic prospects in EM and frontier countries.  In our view, demand conditions will remain subdued as long as the virus is viewed as a threat; furthermore, the lack of clarity about the specific pathogen (e.g. the number of strains of coronavirus, the incidence of re-infection, the lingering threat to cognitive capacity, etc.) will continue to dampen sentiments.  Until the virus is fully understood and health protocols are strictly followed, global demand will not allow for a full recovery.

The upshot is that government policies to jumpstart the supply side can only go so far when demand remains cautious.  Until the pandemic is credibly controlled, this status quo could persist right through 2021.