Written by Shreyans Bhaskar.
Recent rounds of consultations between the International Monetary Fund (IMF) and the Government of Pakistan have again raised speculations that the country could be heading towards another IMF bailout, after the 3-year IMF Extended Fund Facility (EFF) ended in 2013. The IMF has longed talked about the Pakistani rupee being overvalued, and in December last year there was a relaxation of controls on the currency by the State Bank of Pakistan (SBP), the central bank. The result? The rupee depreciated by almost five percent within a week against the dollar. While the currency had remained stable for quite some time before this, much of that is owed to the SBP, which manages the currency via a “managed float system” (also called a dirty float), under which the central bank is actively involved in managing the exchange rate by buying and selling currencies. The SBP had managed to artificially maintain its exchange rates, while the country’s foreign exchange reserves declined dramatically, leaving the country highly vulnerable to a payments crisis.
An IMF deal will weaken the ruling party ahead of the elections, which must be held by July 2018, and therefore the government will try and hold off from a deal as long as it can.
In November, the SBP chose to sell US$2.5 billion in dollar-denominated bond. The decision just a month later to no longer artificially maintain the rupee’s value indicates a realisation on the part of the authorities that they cannot be in denial about the weakening currency anymore. Thanks to weak exports, the country’s current account was in a four percent deficit in the Fiscal year 2016/17. The deficit has increasingly widened, and the rupee’s recent slide will increase the cost of imports. To top this, the decline in foreign exchange reserves mean that the country’s import cover is diminishing; and that will mean that oil imports and the import of capital goods will cost even more.
What it means for the larger picture
Every coin has two sides, and the weakening rupee means Pakistan’s exports will become more competitive. Given that the country’s major exports, such as textiles, raw cotton and rice have a low elasticity of demand, the gains from cheaper exports will be offset by the costlier imports of oil and capital goods. This is further accentuated by two factors, both related to the Middle East. Firstly, there has been a drying up of job prospects for expatriates in the Gulf region, and Pakistan (and other South Asian countries) have been hit hard. The inflow of foreign exchange has also been hit. Another worry is the political instability in the Middle East. A drastic increase in oil prices (due to production cuts) could bleed Pakistan (and other oil importers) much more. And in Pakistan’s situation, this is accentuated by poor foreign reserves.
Excluding forward swap agreements with commercial banks, the country had got usable foreign exchange reserves of just US$6.86 billion in November 2017. Even with the currency swap amount included (which technically is part of the reserves of commercial banks), the country can just about support only three months of imports. There isn’t as much panic as there should be over this issue; as the country’s GDP growth remains robust. Even the IMF, which has red-flagged the other macroeconomic concerns, remains bullish on economic growth. The ruling Pakistan Muslim League-Nawaz (PML-N) government has major infrastructure investments, and the China Pakistan Economic Corridor (CPEC) will aid in the trade of merchandise goods. However, this is just half the picture.
Just another story of politics trumping economics
The movement of the country’s finances has more to do with politics than it might appear. The government replaced the Governor of the SBP just days after the value of rupee showed a slight fall in July. A cardinal rule that must be meticulously followed is that the central bank should enjoy a high degree of autonomy. Clearly, this was not the case here, and this is where the idea of institutional strength becomes important. The strong GDP growth gives the SBP several tools to manage the rupee well, however, it also needs autonomy and positive decision making from the finance ministry. The status quo cannot remain. The country has faced bouts of political unrest and instability, which have diverted attention away from the economy. The government is in flux after the powerful PML-N leader and then prime minister, Nawaz Sharif was unseated from office by the judiciary after corruption allegations. The finance minister who had moved to change the SBP governor in July was removed amidst corruption charges.
The country is headed to a general election later this year, and therefore bold decisions will be difficult to take. This increases the risk of fiscal slippage. In 2016-17, the country’s overall fiscal deficit widened to 5.8 percent of GDP, and the public spending spree is likely to continue, as the propensity to spend is higher during an election year. The embattled state of the current government means that any major policy changes will come only after the general elections. The authorities did not want the rupee to depreciate because of its non-economic repercussions, such as knock-on effects on inflation (as crude oil imports would become more expensive, and would have an upward impact on consumer prices). However, prudent economic policymaking dictates that the cost of this short-term adjustment should be borne in the present, as it will set the economy for more sustainable and stronger growth in the longer term.
What happens now?
The Pakistan government has reiterated that it will not seek another IMF bailout package. This, again could be linked to political exigencies. An IMF deal will weaken the ruling party ahead of the elections, which must be held by July 2018, and therefore the government will try and hold off from a deal as long as it can. However, much will depend upon how long Pakistan’s foreign exchange reserves can hold out. The government has held auctions of Islamic Sukuk and euro bonds to raise foreign exchange, and the government will continue to use a variety of instruments to fund its foreign exchange reserves, and hold off from an IMF programme in the short term.
However, an IMF programme may be inevitable in the longer term, as short-term measures are likely to run out of steam. Further, the economy will require reforms, including the independence of central bank operations, the rationalization of subsidies, the relaxation of tariffs as well as increasing the efficiency of tax collection. The government will also need to undertake structural reforms aimed at invigorating investment, and move Pakistan away from its cycle of growth, which is consumption driven, while other sectors remain stunted.
Pakistan has favourable demographics, and a lack of saturation in the economy means that there is a lot of room to grow. Policy making needs to be fixed, and the country’s economy will take an upturn immediately.
Shreyans Bhaskar is a Research Analyst working with the Economist Intelligence Unit in New Delhi, India. Image Credit: CC by Wikipedia Commons.