The latest report on Pakistan’s economy produced by the International Monetary Fund (IMF) lays stress on two key vulnerabilities that pose a danger to the fledgling stabilisation effort that was launched in November 2008. These two vulnerabilities are the growing fiscal deficit on the one hand, and a weakening external account on the other.
Regarding the external account, the biggest impact of continuously sliding reserves will be felt in the value of the currency. With large withdrawals looming in the form of debt service obligations, the impact is no longer something to be whispered about. “[S]taff considers the rupee to be somewhat overvalued relative to fundamentals” says the report, going on to add that “declining reserves, strains in global financial markets, and commodity price variability suggest there is considerable uncertainty about the extent of overvaluation.”
In plain English: “The rupee is set to fall against the dollar, but we cannot say by how much”. The only way to pre-empt this outcome is to heed the advice offered up in the State Bank’s quarterly report: “Pakistan must make all efforts to ensure the resumption of financial inflows.”
The IMF stops short of such a categorical declaration, perhaps because efforts to resume financial inflows in the short-term have a great deal to do with the Coalition Support Funds that are stuck, which in turn have a great deal to do with ongoing high-profile military diplomacy between Pakistan and America.
The government is getting broadly similar advice from the representative of its creditors and its own central bank — which is that you can’t go it alone. Pakistan may have shut down Nato supply routes thinking that the cost such a move would impose on Nato forces in Afghanistan would be prohibitive, and like last time, it would compel America to heed Pakistan’s wishes in the war on terror. But if the IMF and State Bank advice is read properly, it clearly tells us that the cost for Pakistan is also very large indeed. So in this ‘mutual assured destruction’ gambit, who will blink first? The answer lies in that zone of “considerable uncertainty” that the IMF mentions with regard to the extent of the impact that frozen inflows will have on the value of the rupee.
The report contains gems buried everywhere in the narrative. I particularly liked this sentence for its Godfather-esque quality — “Any further contemplation of monetary policy loosening should await clearer disinflation signals, and the SBP should be ready to tighten policy if inflation or external pressure increases.” Translation: “Don’t even think about lowering interest rates any further!”
Banking sector vulnerabilities are repeated throughout the report, at one point making reference to the need to quickly pass deposit insurance legislation that apparently has already been drafted. The language is similarly tough: “Action is needed to address the NPLs (non-performing loans) and bank supervision should be strengthened. Remaining problem banks need to be resolved without delay.” Note the last two words, “without delay”. These “problem banks” may not be very large and do not present any systemic risk as such, but nobody knows how a bank failure will play out in Pakistan for one simple reason: our banks have been state-owned for the past four decades or so of our history.
Could a contagion effect break out, where a small bank failure triggers panic withdrawals and sends the rumour mill into overdrive, forcing other well capitalised banks to also come under stress? Quite obviously so, which is why the IMF repeatedly calls for addressing the rising NPLs, strengthening bank supervision and also passing deposit insurance legislation. But above all, it urges the government to nip the problem in the bud and resolve problem banks “without delay,” meaning “get your ass moving on this gentlemen!”
And this is not the only area where urgency is required. Regarding fiscal issues, for instance, the report says that the year-end deficit is likely to hit seven per cent of GDP, which is higher than the 6.6 per cent of the last fiscal year. “[F]iscal vulnerability is high and needs to be addressed urgently,” the report says, going on to add that the last NFC Award has made the job more difficult because of a “large and unbalanced devolution” of spending responsibilities to the provinces.
Rising domestic debt is the most likely outcome of continued fiscal deficits, presenting “substantial rollover risks” due to the banks appetite for shorter tenors. The report echoes Moody’s assessment of Pakistan’s banking system in pointing out that growing sovereign exposures on bank balance sheet present ‘event risk’ for banks.
All of this has been known for a long time now. The urgency of the language is to be noted, as are the growing stakes in the ongoing freeze in relations with our largest creditor and ally.
Published in The Express Tribune, February 9th, 2012.
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