By Ghulam Haider
The World Bank has projected Pakistan’s GDP growth to around 2 percent in the fiscal year 2023 while inflation will rise to 23 percent, with preliminary estimates suggesting that the national poverty rate for Pakistan can increase by 2.5 to 4 percentage points, pushing between 5.8 and 10 million people into poverty.
Pakistan remains exposed to external conditions, with the macroeconomic outlook sensitive to global commodity prices and financing conditions. Higher international interest rates, deteriorations in market sentiment, and tighter global financing conditions would pose challenges to accessing affordable external financing.
Pakistan’s economic outlook faces substantial risks from further potential increases in world energy and food prices due to ongoing Ukraine–Russia conflict and slower global growth due to rising inflation.
Concerns are rising again over the health of Pakistan‘s economy as foreign reserves run low, the local currency weakens and inflation stands at decades-high levels despite the resumption of an International Monetary Fund funding programme in August.
The IMF programme was meant to stabilise an economy that has been in a tailspin for months. The nuclear-armed country has suffered from external shocks like other developing nations heavily reliant on imports of oil, gas and other commodities.
But then Pakistan was hit by major floods in late July-August this year that killed more than 1,500 people and caused billions of dollars worth of damage, heaping even more pressure on its finances.
The biggest worries centre around Pakistan‘s ability to pay for imports such as energy and food and to meet sovereign debt obligations abroad. Before the floods hit, external financing needs for the 2022-23 financial year (July-June) were estimated at $33.5 billion, according the central bank.
That figure was to have been met on the back of a challenging target of almost halving the current account deficit and debt rollovers from friendly countries. The floods have catapulted the projections. Exports are expected to slump and imports to grow to make up for essential commodities lost in the flooding of millions of hectares of farmland.
Foreign exchange reserves with the central bank hover around $7 billion and commercial banks hold another $5.7 billion. That covers imports for barely a month, despite IMF funding.
Pakistan‘s rupee has nosedived 20% since the start of the year and hit its weakest level on record in August, reflecting both the country’s fragile financial situation as well as the strong dollar itself.
The decline in the currency is pushing up the cost of imports, borrowing and debt servicing, and in turn, will further exacerbate inflation running already at a multi-decade high of 27.3%.
Why are markets spooked?
The IMF programme assuaged immediate default fears, but concerns have resurfaced. With initial estimates putting flood losses at $38 billion and financing needs rising, the United Nations Development Programme suggested Pakistan to suspend international debt repayments and restructure loans with creditors.
Global bond markets reacted sharply. The government clarified it was only seeking relief from bilateral creditors, and would meet private debt obligations.
The economic situation is not the only concern. Pakistan is in the grip of political instability, and the government faces a popular opposition leader – former Prime Minister Imran Khan – pressing for early elections in the first quarter of 2023.
A pro-reform finance minister has been replaced with a so-called reputed interventionist, Ishaq Dar. Moments after being sworn in, he spoke about reducing interest rates, curbing inflation and strengthening the rupee. Dar’s populist comments once again threw debt markets into a frenzy.
The main policy interest rate is at 15%, well below inflation of 27% and projections of an average of around 20% for the year.
What are Pakistan’s options?
Immediate solutions include financing and compressing demand for imports, but domestic needs are rising. However, with investors demanding a 26 percentage point premium to hold Pakistan‘s international bonds over safe-haven US Treasuries, Pakistan is locked out of international capital markets.
There have been some indications the next IMF disbursement could be quicker and front-loaded to help Pakistan combat the floods, but the programme runs out mid-2023. The government says it expects increased financing from other multilateral lenders.
Saudi Arabia, United Arab Emirates and Qatar had pledged some $5 billion in investments. That would boost both finances and confidence. Energy payment facilities from Riyadh and Doha, from whom Pakistan buys liquefied natural gas (LNG), will also ease pressure on the country’s current account.
Pakistan is talking to bilateral debt holders, including the Paris Club, to restructure payments. But China is the key, holding nearly $30 billion of Pakistan‘s debt, including loans by its state-owned banks.
Will Pakistan default?
Pakistan has never defaulted on external debt obligations. The central bank chief and the former finance minister have stressed that it was not facing imminent default.
The government made payment of $1 billion on bonds maturing in December. It has interest payments worth around $600 million for the 2022-23 fiscal year but the next full bond redemption is not until April 2024.
All major credit ratings agencies have lowered their outlook since June – all rate the country as highly speculative and risky. Pakistani officials have said the country will be able to meet short-term repayments.
Another South Asian country, Sri Lanka, has defaulted on its debt and the president and government have been toppled in widespread protests caused by the economic crisis.
Pakistani officials say there are big differences between Pakistan and much smaller Sri Lanka, which had also not defaulted in modern times before the current crisis.
How did Pakistan get there?
The crisis has been fuelled by political turmoil and external shocks from the global commodity crunch. Typically, a third of Pakistan‘s import payments relate to energy. In the last financial year, petroleum group imports, including LNG, more than doubled to $23.3 billion from a year earlier, according to the statistics bureau.
Most of Pakistan’s electricity is produced using LNG, prices of which remain elevated and which will be in shorter supply with the winter approaching. Higher energy bills propelled Pakistan‘s current account deficit to over $17 billion – close to 5% of the GDP – in the last financial year, six times higher than 2020-21, despite record high remittances from abroad.
An overheating economy also contributed to the widening deficit. Imports rose 42% to a record $80 billion in the last financial year; exports also hit a record of nearly $32 billion but grew 25%.
Pakistan, a country of around 230 million people with a $350 billion economy, has long struggled with its external accounts, and the IMF has bailed it out over 20 times since 1958.
Since independence in 1947, Pakistan has seen military coups, wars with India, insurgencies, the influx of millions of refugees from Afghanistan and mis-governance, all of which have undermined long-term policymaking.
Pakistan has limited industrial production capacity and failed to develop ways of substituting imports during times of economic expansion, leaving it vulnerable to external shocks.
The floods have had a substantial negative impact on Pakistan’s economy. Prior to the floods, the economy was already facing a difficult adjustment to regain macroeconomic and fiscal stability.
Implementation of government plans for fiscal consolidation is likely to become more challenging, given extensive relief and recovery spending needs, and slower growth of tax bases due to weaker economic activity.
While relief measures are needed to cushion the human and economic impacts of flooding, delays in fiscal consolidation will heighten risks to macroeconomic and fiscal stability, in the context of high inflation and fiscal and current account deficits.
The World Bank stated that the slower growth will reflect damages and disruptions caused by catastrophic floods, a tight monetary stance, high inflation and a less conducive global environment. Recovery will be gradual, with real GDP growth projected to reach 3.2 percent in the fiscal year 2024.
The report noted that macroeconomic risks also remain high as Pakistan faces challenges associated with a large current account deficit, high public debt and lower demand from its traditional export markets amid subdued global growth.
In line with fiscal consolidation efforts and lower subsidy expenditures as a share of GDP, the primary deficit (excluding grants) is forecast to narrow from 3.1 percent of GDP in the fiscal year 2022 to 3 percent in the fiscal year 2023, despite negative impacts to revenue bases and increased expenditure needs due to the floods.
The fiscal deficit is projected to contract by one percentage point to 6.9 percent of GDP in 2023 and is expected to gradually narrow over the medium term as revenue mobilization measures take hold, particularly GST harmonization and personal income tax reform. In the context of high inflation and rapid nominal GDP growth, public debt as a share of GDP is projected to gradually decline over the forecast period, despite continued primary deficits.
Ballooning import bill
Flooding is expected to lead to higher goods imports, reflecting domestic demand for food and cotton, while exports, particularly rice and textiles, are expected to decrease. Despite flood-associated effects, the CAD is expected to narrow slightly to around 4.3 percent of GDP in 2023 from 4.6 percent in 2022, in line with stronger remittance inflows. The CAD is projected to shrink further in the fiscal year 2024 as exports recover from flood impacts.
To manage short-term risks, the government needs to strike a delicate balance between progressing on the required fiscal consolidation and meeting relief and recovery needs. In the context of high domestic and external financing needs, ongoing political uncertainties, and upcoming elections, maintaining market confidence will be critical.
Clearly articulating and effectively implementing an economic recovery could help manage market perceptions. It will be critical to maintaining a tight monetary policy stance; pursue fiscal consolidation to the extent possible, including through the tight targeting and prioritization of any new expenditures; and proceed with planned structural reforms, including in the energy sector.
Rising energy prices have also been a major contributor to inflation, reflecting higher global energy prices, a weaker rupee, as well as much-needed upward adjustments to government-administered energy prices. With hikes in fuel prices and tariff adjustment on electricity pricing, energy price inflation surged in August 2022 to 80.7 percent in urban areas and 67.8 percent in rural areas.
It further stated that in the context of Pakistan’s economy, expansionary fiscal policies and the delayed monetary policy response led to economic overheating, further contributing to inflationary pressures. Global financial market tightening as well as rising imbalances also contributed to a marked depreciation of the Rupee, which further exacerbated inflationary pressures. More recently, energy prices increased rapidly as the government phased out subsidies and reduced energy tax exemptions, in an effort to contain the associated fiscal costs and curtail the further accumulation of energy sector debt.
The report noted that inflation has a particularly negative welfare impact on poorer households in Pakistan. However, previous policy responses to rising inflation have emphasized reducing energy prices through delays in energy price adjustment and the introduction of energy tax exemptions and direct government interventions in agricultural markets. This has been suboptimal for several reasons. Firstly, subsidies and tax exemptions have contributed to pro-cyclical fiscal expansion, fueling inflation, and feeding into medium-term fiscal sustainability challenges.
Secondly, providing subsidies and tax relief on fuel and electricity have been heavily regressive, with better-off households benefiting disproportionately. Lastly, distortionary agricultural and energy policies (including subsidies, public procurement, and price caps for agricultural goods and high import duties) have undermined efficient resource allocation and price signals. Policy measures could instead focus on managing overall inflationary pressures while protecting the poor and most vulnerable.
Reducing import duties
Reducing import duties on sensitive food products can help reduce food prices at a relatively low cost. This is especially relevant in the current context where higher food prices are driven by flood-related disruptions. Removing distortions that artificially increase the prices of goods that are heavily consumed by poorer households can help to mitigate short-term impact while supporting medium-term growth.
The import duties can add up to 18 percent to the price of sensitive food items. The foregone import duty revenue associated with a six-month elimination of import duties on selected sensitive food items is relatively minor, estimated at Rs. 7 billion (less than 0.06 percent of the estimated total expenditure in the fiscal year 2022).
The Bank also recommended policy measures which include maintaining macroeconomic policies that contain inflationary pressures and maintaining the independence of the State Bank of Pakistan (SBP), combined with proactive and data-driven monetary policymaking to support price stability objectives.
“The recent floods are expected to have a substantial negative impact on Pakistan’s economy and on the poor, mostly through the disruption of agricultural production,” said Najy Benhassine, the World Bank’s Country Director for Pakistan.
“The Government must strike a balance in meeting extensive relief and recovery needs while staying on track with overdue macroeconomic reforms. It will be more important than ever to carefully target relief to the poor, constrain the fiscal deficit within sustainable limits, maintain a tight monetary policy stance, ensure continued exchange rate flexibility, and make progress on critical structural reforms, especially those in the energy sector,” he added.
Pakistan seeks to keep China close
On November 1st‑2nd the Pakistani prime minister, Shehbaz Sharif, met China’s president, Xi Jinping, and the outgoing premier, Li Keqiang, in the Chinese capital, Beijing. The two sides reaffirmed ties and agreed to push ahead with key projects under the China-Pakistan Economic Corridor (CPEC), which remains the main avenue of economic co‑operation between the countries.
The trip was significant, as Mr Sharif became one of the first foreign leaders to meet Mr Xi after the latter secured a third consecutive term as general secretary of the Chinese Communist Party in October. Pakistan is keen to reinforce China’s role as a key ally and investor, especially as financial support will dwindle after the IMF package expires in 2023.
The Chinese side probably prioritised a meeting with Pakistan, as the latter has recently stepped up engagement with the US to secure financial aid in the wake of devastating floods in mid-2022, and also to secure US support for its removal from the Financial Action Task Force’s grey list. We believe that these overtures will have made China uncomfortable, especially as the US suggested that China should partially write off Pakistani debt to provide fiscal relief.
Both sides agreed to expedite the biggest project under the CPEC, Main Line 1, which aims to upgrade Pakistan‘s principal railway line. However, as a result of severe fiscal constraints on Pakistan and debt concerns over the terms of previous infrastructure projects completed under the CPEC, we do not expect progress in the near term. Chinese firms assured Mr Sharif about the completion of Gwadar International Airport by early 2023. The two sides will also aim for an early launch of the Karachi Circular Railway, although we do not expect this before mid‑2023.
China and Pakistan remain key investment allies
During the visit, Pakistani authorities requested the rollover of a US$6.3bn loan that matures in June 2023. China will remain wary of extending financial support to Pakistan, which has a risk of defaulting on sovereign debt over 2024‑25 without continued financial assistance. Consequently, future loans are expected to be provided in tranches, with tough attendant conditions.
Pakistan and China also signed a deal to clear trade settlements in the Chinese currency, thus evading the pitfalls of sanctions when trading in US dollars. This deal will help Pakistan to import cheap oil and grain from Russia, while also supporting China’s ambitions for internationalising the renminbi.
China will remain Pakistan‘s chief financial, military and diplomatic patron. While lending more cautiously, it will remain in China’s interest to support economic stability in Pakistan, using the country as a counterweight to India, with which both countries share a frosty relationship.
Pakistan‘s political regime changed in April 2022, with Shehbaz Sharif of the Pakistan Muslim League (Nawaz) taking over as prime minister after Imran Khan lost a vote of no-confidence in his Pakistan Tehreek-e-Insaf-led coalition government. Balance-of-payments strains will persist, and Pakistan is likely to default on sovereign debt obligations if the ongoing IMF package is cancelled.
However, China will remain a major strategic ally of Pakistan. Relations with India will remain strained, although a full-fledged conflict is unlikely. Floods that occurred in mid-2022, as well as significant monetary tightening, will have a dampening effect on growth. The security situation will remain parlous, while political stability is also tenuous.