Managing the BoP

Pakistan today faces an incipient financial crisis. Gross foreign exchange reserves of the SBP stand at $10.8 billion as of the 8th of April. They have plummeted by $5.5 billion in five weeks after the end of February. They are now adequate to provide import cover of only one and a half months. The minimum cover required for a safe level is three months.

The position with regard to net internal reserves is even more worrying. They were already negative as of the end of December 2021. Exclusion of foreign exchange liabilities, consisting of central bank deposits of other countries with the SBP, SWAP funds, etc., and the debt with the IMF, from the gross foreign exchange reserves of the SBP, had led to net international reserves of negative $0.6 billion then. Now it is likely that net international reserves are down much further to almost negative $10 billion.

There are also large pending liabilities up to the end of June 2022, including external debt repayment of almost $7.5 billion. The likelihood of a current account deficit of $6 to $7 billion from April to June will also contribute to further pressure on the foreign exchange reserves of the SBP.

The fundamental reason for the severe deterioration in the balance of payments is the over 50 percent growth in the value of imports in the first nine months of 2021-22. This is the consequence initially of rising international prices of commodities due to the strong recovery of the world economy after the lessening of the incidence of Covid-19. More recently, from March onwards, the Russia-Ukraine war has added to the level of commodity prices. For example, soon after the war started the price of crude oil jumped up to $130 per barrel and has since stabilized at close to $105 per barrel.

There is need to recognize that the 70 percent worsening in the trade deficit has happened at a time when the stabilization process was apparently underway. The rupee has slipped in value from Rs 157.31 per US$ in end-June 2021 to Rs 188.51 per US$ by 10th of April 2022, with little or no intervention by the SBP in the foreign exchange market. Simultaneously, the policy rate of the SBP was increased from 7 percent to 9.75 percent. It has been raised further recently to 12.25 percent.

Other measures have been adopted to control imports. This has included the introduction of regulatory import duties of 5 percent to 60 percent by the FBR on 599 import items at the 8-digit level of the Harmonized Code on the 30th of June 2021. The SBP also imposed a 100 percent import margin requirement on a number of items. This list has been expanded recently by 177 items. Also, the interest rate on loans for cars has been raised.

However, the impact of these measures on the level of imports has been marginal. Despite the levy of regulatory duties, the effective duty on non-oil imports has declined from 9.1 percent to 7.2 percent. Clearly, there is need for FBR to explain this fall in the presence of high regulatory duties.

The primary element of the strategy for stopping further erosion of foreign exchange reserves must be strong measures for controlling and restricting sharply the volume of imports. At the minimum a reduction of 20 percent is required in the magnitude of imports. This implies an annual curtailment in imports of almost $15 billion.

The new Government must appreciate that there is no scope for following the policy of ‘business as usual.’ On a crash programme basis, big steps must be taken to prevent further erosion of reserves. The recent increase of over Rs7 per dollar in the value of the rupee may not be sustained. Unless there is a fundamental restoration in market confidence with strong measures the rupee may start slipping once again. A new development has been warning signals for the first time from international credit rating agencies that Pakistan may be moving towards a position whereby it may not be able to honor its external payment liabilities, a position like what Sri Lanka is already facing today.

Fitch, in its recent assessment of Pakistan, has forecast a current account deficit of $18.5 billion in 2021-22. It believes that the country’s access to private creditors is challenged now by rising global interest rates and heightened risk aversion. It has indicated that any setbacks to reform or the IMF programme would make access to external financing even more difficult to Pakistan. Bloomberg and Moody’s have also identified the increasingly precarious financial position of Pakistan.

Already, there has been difficulty in floating international bonds and obtaining loans from foreign commercial banks. The annual budgetary target for flotation of bonds in 2021-22 is $3.5 billion. In the first eight months, $2 billion have been raised. Now the yield on 10-year Pakistan sovereign bonds has risen sharply to almost 15 percent.

Similarly, there has been less inflow of loans from foreign commercial banks than anticipated. The annual target is $5 billion, out of which $2.6 billion have been received up to end-February. Now the interest rates charged are likely to be significantly higher in the presence of the global hike in interest rates and stronger risk perceptions about Pakistan.

The additional problem is the effective suspension of the IMF Programme currently. This will substantially reduce the inflow of concessional assistance from the World Bank, ADB and the IDB.

What then should be the key elements of the strategy of the new Government to restore some stability in the balance of payments position and prevent further hemorrhaging of foreign exchange reserves? Continued deterioration of reserves could even lead to a run-on foreign currency deposits and Roshan Digital Accounts.

First, talks must resume immediately with the IMF. Pakistan must try and get the seventh and eight review combined by early presentation of the Federal budget for 2022-23. This was the case in 2018, when the budget was presented on the 28th of April. It may now be presented in the beginning of the second week of May 2022.

The budget must include a strong agenda of tax reforms to generate additional revenues of up to 1.5 percent of the GDP. This will include reforms in the personal income tax, move towards a progressive corporate income tax, integration of federal and provincial sales taxes and higher provincial direct taxes. This will compensate for the withdrawal of the petrol levy and raise significant net additional revenues.

A key measure for controlling imports will be the levy of higher customs duties. All imports will need to be covered, with the exception of basic food items and medicines. Currently, there are four standard duty slabs of 3, 11, 16 and 20 percent. These will have to be raised to 5, 15, 22 and 30 percent respectively. This measure will significantly reduce imports, without raising prices of essential items which are imported. Eventually, import quotas may have to be introduced on non-essential and luxury imports.

In conclusion, Pakistan could find itself in an economic quagmire. The new Government, which consists of a coalition of many political parties, must use this as an opportunity to arrive at a consensus on structural reforms and take the country out of a very difficult situation, which could have a devastating impact on the lives of the people of Pakistan, like what we are currently observing in Sri Lanka.

(The writer is Professor Emeritus at BNU and former Federal Minister)

Copyright Business Recorder, 2022