External sector: PML-N’s Achilles’ heel?

As general elections loom, a key part of the incumbent PML-N’s narrative is its ostensible success in reviving the economy since it took power in 2013. But this narrative is showing cracks, with the International Monetary Fund (IMF) recently dealing a significant blow.

The IMF published the first ‘post-programme monitoring’ report last month. This is the process through which the IMF engages regularly with a country that has completed a programme, in order to assess its repayment capacity and overall economic position until loan repayments are completed.

The key message of the IMF report is that while the GDP growth momentum is likely to be maintained — it is expected to be 5.6% for the ongoing fiscal year — Pakistan’s debt sustainability in the medium term is deteriorating. The IMF’s projections regarding the external account released last month are much more negative compared to its own views in July 2017, which were relatively optimistic.

Balance of payments is the key concern

While in July last year the IMF projected foreign reserves by 2022 to be at $20.4 billion, that estimate has now been revised sharply downward to a much lower figure of $7.1 billion by 2023. According to the IMF, in the fiscal year 2018-19 Pakistan’s foreign reserves will be sufficient only for 1.8 months’ import cover, which is projected to drop to one month’s cover by 2023 (at least four months’ import cover is considered sustainable).

In fact, going by the IMF’s figures (which are based on the government’s data) the country’s net international reserves (what is left after accounting for short-term liabilities) for this fiscal year are actually negative $724 million. This has come about because since 2016, gross foreign reserves have declined by about $6 billion, while the State Bank of Pakistan’s (SBP) short-term foreign liabilities have roughly doubled.

Consequently, the IMF has dramatically increased its prior estimates of Pakistan’s gross external financing needs over the next five-year period: $24.5 billion in 2018, increasing to $45 billion by 2023.

The IMF report also predicts a substantial rise in Pakistan’s foreign debt component in the next five-year period. From $93.4 billion in 2018, it has been projected to increase to $145 billion by 2023, an increase of 55%. This rate of increase would be much faster than that witnessed in recent years. The key drivers of this will be China-Pakistan Economic Corridor (CPEC)-related debt to China, government borrowing to cover for inadequate domestic revenue mobilisation, and a rising trade deficit.

All of this suggests that the IMF considers risks to Pakistan’s external debt repayment capacity to have gone up significantly, since it expects foreign exchange inflows to be reduced even as liabilities increase over the next five years. In its report, it blames this imbalance on a persistently over-valued exchange rate over the last two years, low interest rates leading to higher domestic demand and imports, and loose fiscal policy leading to growing borrowing needs.

Government banking on CPEC

In its report, the IMF has noted the PML-N government’s divergent and more optimistic view about the economy’s future course. Authorities in Islamabad have acknowledged rising pressures on the balance of payments, but argue that CPEC-related investment in multiple sectors of the economy and bridging the electricity supply gap will generate enough growth to manage higher external debt in the medium term.

The government has also said that its recent measures of imposing higher import duties on a number of items, allowing exchange rate devaluation and increasing the interest rate will all contribute towards curtailing the current account deficit and mitigating external financing requirements projected by the IMF. However, the SBP’s government-sanctioned actions, since December 2017, of allowing the exchange rate to fall by about 10% and increasing the interest rate by 0.25%, are reactive measures with limited efficacy, taken once the authorities realised that the external account was under more pressure than they hoped.

Outlook

There are reasons to be skeptical of the government’s argument that current investments will sufficiently increase the economy’s capacity to handle higher foreign debt obligations, at least in the short term.

Firstly, pressure on the external account is likely to intensify in the current and next fiscal year. While exports have recovered somewhat this year, the sector’s international competitiveness remains low. Remittances are keeping steady but not showing significant growth. An uncertain global oil market and its impact on economies like Saudi Arabia — home to the largest Pakistani expatriate community in the Middle East — means that growth in remittances is unlikely to match the rising external financing needs in the coming years. And while CPEC investments will contribute to future growth, they will continue adding to Pakistan’s foreign debt component and import volumes as the initiative gathers pace in the coming years.

Second, it is certain that in line with the IMF’s view, Pakistan’s external financing requirements over the next five years will rise substantially. Thus, it is highly likely that we will increase our borrowing from international capital markets. However, raising further debt in this way in a cost-effective manner is likely to become more challenging for two reasons. First, after the US Fed’s decision in March to raise interest rates by 0.25% and its intention to raise the rates further during 2018, global credit markets for countries like Pakistan will become tighter. Second, Pakistan’s worsening balance-of-payments position automatically pushes up its sovereign debt risk profile, in turn raising the risk premium future foreign creditors will demand.

Lastly, growth is at risk from deteriorating fundamentals. Despite downplaying the IMF’s concerns in the March report, the PML-N government is undoubtedly cognisant of the challenges. Thus, it is not surprising to note news reports that Islamabad has submitted different proposals to China and Saudi Arabia for bilateral financial assistance. These efforts notwithstanding, risks to macroeconomic stability are likely to persist and even grow in the medium term.

Domestic demand is likely to stay strong in the current fiscal year as well as fiscal year 2018-19. However, growth could slow down if the next government is forced to undertake a relatively large devaluation or increase interest rates significantly in response to mounting external account pressures. While we are not there yet, economic policymakers will need to make some hard choices in the coming months.

Published in The Express Tribune, April 13^th, 2018.

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