Sliding reserves

If reserves continue to decline, government may find itself caught between populist demands and displeasure of army.

In case you missed it, the sign said Caution: steep slope ahead. Next to the sign there was a small picture of a sharp downward slope. It was placed there to warn travelers on this road that they should brace themselves for a steep descent that could test the traction on their tires.

The steep slope ahead is the decline in our foreign exchange reserves that have, in the first quarter of the fiscal year, dropped by more than what our financial managers had bargained for. With our old friend, the current account deficit, back in our lives again and that fair weather mistress — foreign inflows — having reliably and predictably abandoned us one more time, the drop in our reserves should become a serious worry.

For the entire family of macroeconomic indicators that the textbook introduces you to — fiscal deficit, GDP growth rate, trade deficit and inflation — none gets our government leaders moving the way a drop in foreign exchange reserves does. Historically, we have seen reserves as the primary metric with which to measure our economic health, and even today, much of the complacency towards our economic difficulties comes from the fact that our reserves are ample — even if only for the moment.

But a very complicated picture is in the works as the moment passes.

Our reserves are on a downward trajectory that will accelerate as the big ticket debt repayments kick in, beginning in February. A matching uptick in inflows is unlikely to materialise given the economic travails stalking the world economy and our stormy relationship with our benefactor — the US. The only scenario that could potentially slow this drawdown somewhat is a collapse in oil prices, but even this is unlikely to reverse the process.

Complicating the picture is the approach of the elections.

Historically, declining reserves have spelled eras of tough decisions for the incumbent government. All three coups in our history have occurred when foreign exchange reserves hit historic lows. Not surprising since reserves are an important indicator of an army’s capacity to sustain a fight, how else to arrange for the replenishment of fuel and ammunition stocks that get consumed at a rapid rate under hostilities? After all, you can’t fly an F16 on CNG. No wonder our political leadership has always attached such importance and significance to maintaining reserves as their primary economic responsibility — it is perhaps the most ‘strategic’ economic variable that exists in an environment like that of Pakistan, where fiscal and natural resources are there for the asking of the khaki overlords of civilian politics. And governments that have failed in their responsibility to maintain

If reserves continue to decline, the government is likely to find itself caught between the populist demands of the elections and the displeasure of the armed forces. Backstopping the reserves will require one thing above all else: repairing the relationship with the IMF. And two obstacles await the government when it comes around to this inevitability.

First and most important, is the state of the relationship with the US, and loss of goodwill universally. And second is the unfinished business from the last standby facility that expired end September. It’s unlikely that the world community, led by the United States, will stand by and watch Pakistan go under, regardless of the state of our relationship with our superpower patron. But it’s also unlikely that they will be very forthcoming, preferring instead to watch from the sidelines and wait till the very last minute before stepping in, to ensure that the recalcitrant and ungrateful beneficiaries of their ‘generosity’ have learned a valuable lesson.

In any event, the downward sloping outlook on our foreign exchange reserves could mean big trouble ahead, especially if it picks up pace.

Historically, whenever reserves have started declining, they have activated large processes that governments struggle to control. First come concerns regarding debt obligations, then concerns about the currency, which triggers a panicked flight into dollars, which drains bank liquidity. If the government proves unable to contain this downward trend, like it did in 1999, the military steps in. And whenever the trend has been contained, like in 1997 or in 2008, it has been done with help from the IMF.

Published in The Express Tribune, October 20^th, 2011.