There are many articles that are being written about what Pakistan needs to do to get out of its economic morass, this author, on the other hand, takes a different view. The premise of this article is that Pakistan will enter an IMF programme and looks at what to do before enter the programme; our financing options once we are in an IMF programme and what are the steps we will have to take during the programme.
While the economic literature abounds as to the pitfalls of the shock-free market economics of the International Financial Institutions (IFIs), the author believes that these institutions have learnt from their previous mistakes. Also the fact remains that Pakistan has few financing choices when it comes to the yawning gap that we face on the current account side. Assessing the situation from a political angle that IMF at this point would be a most convenient scapegoat to pass on difficult measures such as subsidy adjustments in electricity, agriculture, provincial financial imbalances and so on - all valid problems that need to handle irrespective of the lender or economic cycle. As for the help from "Friendly Countries", our government can rest assured that they realize what our structural shortcomings are, and that they need to be addressed for long-term progress to take place. These friendly countries will be hardly willing to lend us a helping hand unless there is a tight leash - someone must protect their money and investment, and in the eyes of most of them the best guardian would be the IMF. If the mutterings in Islamabad are to be believed, this is the gist of what has been conveyed to our government by the Chinese government, no less - if they feel this way let us not dream about out of the way help from other fair-weather friends.
I. Pre-programme steps:
-- The IMF latest staff report highlights demand pressures, inflation and interest rates as areas of concern. The staff report uses familiar language that should not be of any surprise to seasoned IMF programme watcher. It is rather sad that the issues discussed are the same as they were around 20 years ago, starting with the need to focus on demand pressures. In justifying the need for SBP to further tighten monetary policy in para 22, the IMF report states:
"Staff recommends further tightening of monetary policy to slow domestic demand and import growth, strengthen demand for rupee financial assets, and mitigate the potential pass-through from the exchange rate adjustment to inflation."
Thus, it is abundantly clear that we will need to make some structural adjustments before we go to any programme, to have some negotiating leverage. While we agree that demand pressures have been pushing imports, increasing interest rates will not necessarily address the above problem. In Pakistan, domestic demand is not driven by consumer borrowing from commercial banks, but rather by the wealth-effect that resides in real estate holdings, which are largely undocumented. Given how real estate transactions are managed in the country, the government has little, if any control over the wealth effect.
-- There is no question that on a Real Effective Exchange Rate Basis (REER) our currency is overvalued. Recently, the currency is trading in the range of Rs 124.25-124.50 to the dollar in the inter-bank, there is room for at least 5% deprecation taking it to Rs 130 mark. This depreciation should be in a managed fashion unlike the previous bouts of depreciation where the SBP calls the five large banks - who are normally short USD - and tells they should just cover from the market, a euphemism for let the PKR slide. Per se, the depreciation of the PKR is not the problem, it is the sudden and unannounced spikes in the exchange rate and volatility that ensues that really spooks both local/foreign investors. It gives the impression of a government not in control of its finances. If you were to contrast this with anywhere else in the world, you would see that the central banks go to great lengths to prepare markets for any change, choreographing a series of events such as minutes, seminars and public press conferences before the actual move takes place. The SBP will have to do the same before any such depreciation, meaning that the SBP press release must come before not after the volatility/damage has been done.
-- The second major step that the needs to be taken before we enter a programme is that we will need to unwind existing PKR-USD FX-swap positions. The proliferation of the FX-swap as a source of funding, a mechanism to inflate FX reserve numbers and not as a hedging tool, by the SBP is only going to make this recent crisis harder. The turbulence in the economy is going to soon spill-over into the FX swap market in the last quarter of this year, giving rise to concerns over the ability of the SBP to roll over their funding requirements and manage their liquidity risk. This turmoil will raise questions about banks' ability to continue to effectively manage the local economy, as well as the external financing gap it could create. As of the latest numbers FX-swaps stand at USD 6.68 billion as of 31 May 2018, FX-swaps by Chinese Banks, ie, ICBC, which is a separate head stand at USD 2.707 billion as of 31 December 2017 and this position does not include the number of the FX-swap directly between the SBP and the PBOC. These numbers need to be looked into especially as there might be more than meets the eye when accounting for reserves in hand. Meaning, that there might be double counting in the reserves number as once the USD are counted in reserves when they land as FE-25 deposits with banks and then when the SBP does a PKR sell-buy (PKR buy-sell from the banks' perspective) the USD are counted again as reserves. If so, the situation is much more precarious than we have been leading to believe.
-- An increase in interest rates will also be mandated by any IFI. While in itself, this might not be a bad thing keeping in mind that our core inflation is running at 7.6% while the discount rate is at 8%, a gap of less than 0.5%, historically this difference has been around 1.50%-2.00%. So, to return to balance at least a 1.5% increase in interest rates will be mandated. From an economic viewpoint, this is sound advice but has real world implications, especially when we want to help not hinder industry. This pitfall can easily be worked around by adjusting the inflation calculation to be more expansive than it is now. Right now, the way inflation data is collected is that only 40 cities, predominately urban or semi-urban centers, and 76 markets - there is a clear urban bias. The need of the moment is to expand the net to include rural locations and incorporate the rural inflation component. The broad components of core inflation are:
-- Alcoholic beverages and tobacco
-- Clothing and footwear
-- Housing, water, electricity, gas and others (main culprit in pushing core-up, 22% increase)
-- Furnishing and household
-- Health
-- Transport
-- Communication
-- Recreation and culture
-- Education
-- Restaurants and hotels
-- Misc. goods and services
All the above will show a significantly lower number for rural locations and will provide a significant dampener to the core number by making the number more representative and doing away with the urban city bias. Thus, reverting the average differential between core and the discount rate to its mean - without having to increase interest rates.
-- Settlement of agricultural and energy sector liabilities. While the energy sector circular debt gets quite a bit of press coverage, the agricultural debt of the GoP gets short changed - in terms of coverage. Settlement any of these debts will require the SBP to expand its balance sheet temporarily in order to relieve the circular debt and stoke economic activity, the latter being part of its stated mandate. It is important to note that all these measures will be temporary and not a permanent solution to our lingering structural problems. Structural adjustments to electricity prices and doing away with support prices will have to be done, losses at public and state enterprises will have to be limited, aggressive belt tightening will have to be pursued and privatisation undertaken. People will be more willing to take swift pain in the first year of the government, while the incompetency of the previous government are still fresh in their minds, rather than further down the road. It is important to understand that forcing GoP to write off the circular debt (or take on PHPL's receivables, which boils down to writing off these receivables), is just a book-keeping entry that will not impact the market or the banks. But such a settlement will add an additional 1.7% (of GDP) burden on the fiscal deficit for FY19. The next stabilization program will be strict about bringing down the primary fiscal deficit in FY19, with the expected increase in debt servicing (both domestic and external) and the settlement of the circular debt, the fiscal deficit in FY19 is likely to be in the range of 81/2-91/2% of GDP. The spike will be similar to what we saw in 2013 when we cleared the circular debt payments, but this will be one-time pain.
-- A massive control of expenditures, PSDP rationalization will have to take place, as well as engagement with the military will have to be done as they are the single biggest source of unaccounted for expenditure.
-- There has been recent chatter about the need for restructuring the domestic or international debt, in author's view, it is a big 'no'! Such a step will invariably undermine investor confidence in much a similar fashion as the freezing of the USD accounts had in 1998. While the local debt is not the problem as it is PKR denominated, there are serious questions surrounding our foreign borrowing. We have maturities worth USD 2B in 2019 and the USD 1B in 2021 - these are the real problems. Turkey's recent currency crisis is serious and could be a harbinger of potential problems in EM with the end of 'easy money'. This 'easy money' since 2008, allowed countries like Turkey and Pakistan to finance large CA deficits and keep their currency stable (similar to Asian Crisis). This end of 'easy money' will also make access to Eurobond markets a bit trickier if not pricey for Pakistan. Whatever the case defaulting on our obligations is not a solution, rather it is a recipe for multi-year disaster.
-- There can be good faith negotiations on the CPEC project needs to be undertaken, the contracts and terms should be made public both on CPEC and any bilaterally negotiated long-term contracts, ie, Qatar LNG contracts. Focus should be on the Pakistan-China FTA (to immediately narrow the trade deficit), and to nudge CPEC to become more export-focused. The GoP leadership should first visit China, and then later approach the IMF with a game plan. There is a need to restructure/roll-over Chinese loans. This adjustment to the relationship is required for a more sustainable relationship between the two countries, especially after the economic mismanagement in FY18. The Chinese must be explained very delicately that as the first major experiment in their 'One Belt, One Road' initiative they need CPEC to succeed - with quite a bit of positive press coverage. Thus, adjustments need to be made to make sure that this project succeeds and so that the Chinese initiative is not seen a new 'East India Company.' It has to be made clear to them that this is their first major foray outside their borders to project power - something that they lack experience as compared to other world powers - so it is important that their projection of power should be seen as benevolent and not tyrannical, or their will be severe backlash from the host country, after which all bets will be off. Hence the IRRs on some, if not all the Chinese projects need to be revisited.
-- Rationalization of imports has to be done on a war footing and the country can look into the invocation of 'WTO Article XII on Restrictions to Safeguard the Balance of Payments", after getting a competent legal opinion. The emphasis being on 'competent legal opinion', because Pakistan seems to completely lack the ability to obtain good legal advice, case and point being our lost arbitration cases.
-- We will need to engage in settlement negotiations with all the parties against whom we have lost arbitration proceedings.
* The IMF acknowledges that the EFF programme is incomplete and to their credit, at the very start (para 1) the Staff Report states:
"While the EFF had helped to support macroeconomic stability and address structural challenges, the policy agenda remained incomplete."
Such a candid admission is new for the IMF and could be indicative of them either.
-- The Fund admitting failure. (Highly Unlikely)
-- The Fund being open to more unorthodox approaches. (Maybe)
-- The Fund will negotiate a hard position/programme for Pakistan (Most Likely)
* In Para 29 the fund report talks about the Fiscal Responsibility and Debt Limitation Act (FRDL) that was passed in 2005, as a requirement for the then on-going IMF program. The FRDL sought to elevate the decision to increase the country's sovereign debt to the parliament, in an effort to restrain policymakers from adding to the country's debt. The FRDL was amended in 2016 to limit the federal budget deficit and limit the debt-to-GDP ratio at 60% up to FY18, and then bring this ratio down in 15 years to 50%. However, Pakistan's policymakers found a loophole. As the Staff Report states in footnote 6:
"The FY2017/18 Budget Act changed the definition of debt subject to the mandated limits from gross debt to net debt.17"
These definitions will need to revert to the original and the government will need to strengthen the FRDL further. The disclosure that the FRDL was artificially satisfied in past IMF programmes could indicate a significant change in the IMF's attitude.
* The subject of the NFC Award will need to be revisited or at least a discussion will need to be started. The IMF also states the same in para 36 of its latest staff report
* Before we go to the fund we need to start work on establishing a Fiscal Registry, which refers to a comprehensive register of all asset holdings in a country. A starting point the real estate sector that is the largest repository Pakistani wealth in Pakistan would be perfect. The Staff Report touches on the need to create a centralized electronic register of all real estate holdings/properties, which I agree with. Demand for non-productive real estate as a primary store of value needs to be discouraged and the gross undervaluation of real estate holdings must be addressed. This would also be a critical first step in documenting Pakistan's economy and forcing all Pakistanis into the tax net.
II. Financing Options Before Entering a Programme:
* Before we go into any IMF negotiation it is very important to show the market that the market still has confidence in us as a creditor. A small USD 2 billion 10 years and 15 years issue would be most advantageous as it would stretch out our debt maturity profile. The questions arise at what cost? This is where our Chinese and GCC friends come in. Managing an auction and making sure that the lowest bids are accepted can easily be done if the counterparty Sovereign Wealth Funds or government banks of the said countries participate only. Secondly, the bonds can be structured in such a way that payments can be accrued towards the end of the maturity, etc, affording us some breathing room.
* The Non-Resident Pakistani bonds that are being touted are also a good solution, but the amount raised will not be enough to cover our gap. This bond will also have to be structured smartly so as not to increase our USD obligation rather paying interest and principal at maturity in equivalent rupees. There are many ways that these notes can be structured - a good starting point would be to look at some of the instruments being offered by the Philippines for their non-residents.
* The least favoured step in author's view would be to ask friendly countries, ie, China, the UAE, Qatar and Saudi Arabia for large long-term deposits in our central bank, but this type of help would come with significant strings attached. There is precedence of such behaviour by the GCC countries, like when Qatar deposited USD 5 billion into the central bank of Egypt during the tenure of Mohammad Morsi and China has also deposited USD 2 billion in our central bank via a currency swap.
* Once we have implemented the above steps in the first few months and then go to the IFIs they will be much more receptive to us.
III. In-programme steps
* The most difficult steps will have to be taken during the program these mainly consist of the following:
-- FBR restructuring.
-- Economic and Tax survey - like what Shaukat Aziz tried to conduct.
-- Restructuring of SOEs and Discos.
-- Full scale implementation of renegotiated NFC award.
-- The discontinuation of fuel subsidies.
-- The discontinuation of agricultural subsidies - Sugar, Wheat, Cotton, Fertilizer.
-- The take-over of provincial banks - which serve mainly as wealth transfer vehicles for the poor depositors to the rich who have the political clout to access credit. These institutions act as vehicles for the siphoning of deposit resources from one province to another, without significant contribution to the growth of the home province.
-- True independence of the central bank
-- Expenditure control
-- SRO elimination
-- The elimination of rent-seeking behaviour in our enterprises
-- Improvement in statistical data etc.
If permanent changes are not made to the economic fundamentals of the country, permanent new sources of revenue not utilized and gaping balance sheet hole not plugged, our position will be not at 0 but minus 1.
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