Brewing Economic Crisis

 Dr Maleeha Lodhi
 Special advisor Jang Group, former envoy to the US and the UK

The greatest danger to the country’s stability today comes from a worsening economy. This danger has been further heightened by the far-reaching economic impact of Karachi’s descent into bloody mayhem.

The economic outlook has been steadily deteriorating. With policy paralysis setting in and no corrective actions or reform measures in sight, an economic breakdown might be unavoidable. Political leaders are already in campaign mode and prone to fiscal profligacy in distributing patronage to garner votes.

There are two views on Pakistan’s near term economic prospects. The official view is that the country will continue to coast along and face no serious economic peril as a number of advantageous factors are in play. They include a marked improvement in the current account of the balance of payments. Foreign exchange reserves have increased to $18 billion. This includes nearly $8 billion from an IMF standby loan. It also reflects unexpected export earnings of over $24 billion this year ($19 b last year) and an unprecedented rise in remittances of $11 billion, up from $8.9 billion in 2010. What are in fact windfall – and transient – factors have produced a sense of official complacency.

This has become the basis of the government’s calculation that it needs to do little or nothing as the economic situation will hold till elections – for the Senate as well as general elections, which may be called early if the ruling party secures a majority in the upper house. Thus a government that has shown little will to reform expects to muddle through into the polls and beyond.

In coming months this ‘favourable’ scenario based on windfall factors, providing comfort to the government, are all likely to reverse themselves. The large oil price bill will begin to exert pressure on the balance of payments. As will external debt repayments. The rise in exports has reflected a price, not a volume effect, and was a consequence of an increase in global commodity especially cotton prices. With cotton prices already coming down, the ‘extraordinary’ export performance may be short-lived. In its last quarterly report the State Bank sounded a warning on this count. July’s figures already indicate a declining trend. Imports meanwhile will continue to rise pointing to a widening of the trade deficit ahead.

As for remittances, the sudden rise appears to partly reflect export proceeds that are being channelled back as remittances to avoid taxes. Signs are that having reached a peak these will begin to come down. Even if they continue for sometime, remittances are not a durable way to manage the balance of payments deficit.

The higher oil import bill, levelling off in exports, accumulation of external debt obligations, as well as a build up of domestic demand pressures (reflecting rising prices due to excessive money creation) will all combine to deplete the country’s foreign exchange reserves. Real reserves are in any case less than the officially stated $18 billion as they include around $4 billion of the State Bank’s own deposits. Part of the remaining $14.7 billion is also borrowed money.

That is why the more compelling and realistic view of the economy is that a combination of factors including unaddressed structural problems and the external economic environment are contributing to a brewing crisis that can acquire dangerous proportions if strong policy actions are not taken now to avert that.

For the past year or so the economy has been on a downward trajectory. This is due mainly to the deteriorating fiscal position and the failure to achieve revenue and expenditure control targets as well as the continued financial haemorrhaging of public sector enterprises. Instead of fiscal consolidation the government has engaged in excessive borrowing from the State Bank and commercial banks.

This has inescapably fuelled higher inflation. This fiscal year’s trillion-rupee budget deficit will be financed by printing more currency notes and commercial bank borrowing in the absence of significant revenue mobilisation and spending restraint measures. This will push prices up further.

Several indicators point to an economy that is now like a runaway train hurtling towards derailment, with little to stop a train wreck given the ruling coalition’s priorities and lack of reform commitment. This risks pushing the economy into a crisis in 2012 as a result of one or both developments mentioned below. The increasingly likely global economic slowdown and associated recession in Pakistan’s major export markets will also have deleterious effects on an already fragile economy.

Indeed large and accumulated foreign debt payments combined with a larger oil import bill and a falling trend in exports and remittances can set into motion a declining trend in foreign exchange reserves. This can gather momentum within months leading to a foreign exchange crisis. If a direct reserves crisis is delayed for a set of reasons, the build up of inflationary pressures will lead to an increase in import demand, depreciation of the exchange rate and a depletion of reserves. The economy has little resilience to withstand such a challenge.

Meanwhile three consecutive years of low growth have left per capita incomes stagnant, aggravated poverty and worsened unemployment. This has generated widespread public discontent.

The slowdown in growth reflects many factors including falling public and private investment, inflationary pressures as well as the uncertainty produced by a worsening law and order situation. It also reflects production disruptions caused by crippling power outages and energy shortages. These disruptions will dampen growth further, hit exports and erode business confidence. Lack of resolution of the continuing circular debt problem in the energy sector will compound these issues and impose a mounting burden on the budget.

With no restructuring planned of the mostly insolvent state enterprises any one of them could collapse in coming months with serious consequences for the economy. Railways is already in a state of collapse with PIA not far behind.

Meanwhile an increasing oil import bill will coincide with the country’s repayment of a number of external debt obligations, starting with $1.2 billion to the IMF in February 2012. Also worrying is the accumulation of foreign debt service payments later in the year including another $1.1 billion to the Fund. Between 2012 and 2015 Pakistan has to repay all of the $7.9 billion borrowed from the IMF since 2008.

All these factors will feed into and exacerbate the other. It is their confluence that poses the danger of a financial crisis resembling that of 2008. This occurred when the twin deficits of the budget and external account soared to record levels, forcing Pakistan to turn to the IMF for emergency financing to avert a possible default.

Suspended since May 2010 the IMF programme will terminate in September 2011. Its absence has meant a decline in inflows, which combined with a reduction of net inflows from donors, including the US, has meant less than targeted ‘external resources’ presumed by budget-makers.

Once a drawdown of reserves begins the exchange rate will come under pressure and capital flight will accelerate. Speculative pressures will then speed up the erosion in reserves. Once this process starts it will acquire an uncontrollable momentum of its own and the country could head towards a situation of default.

In this scenario of looming crisis, the psychological factor could become a decisive game changer, leading to an evaporation of business and public confidence. This in turn could produce a further depreciation of the currency as people begin to convert rupees into dollars as a hedge and also take them out of the country. A run on the currency can have very debilitating consequences, and will be hard to reverse.

All of this is avoidable. But it requires a serious plan of policy reforms and strong political will. Neither is available today as election politics take precedence over other considerations including the country’s economic stability. 

This article first appeared in The News International, August 24th, 2011 edition


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