BoP projections: risk and uncertainty

The year, 2022-23, closed with a truly remarkable reduction in the size of the current account deficit by 84% to just above $2.5 billion only from close to $17.5 billion in 2021-22. Such a large containment in the size of the current account deficit has never been achieved before.

However, despite this achievement the foreign exchange reserves of the country plummeted by $5.2 billion during the year. This was due to a big reduction in the net inflow into the financial account in 2022-23. It declined from a net inflow of $11.3 billion in 2021-22 to a net outflow of $1.8 billion in 2022-23.

Therefore, if there had been no big containment of the current account deficit during the year, Pakistan would most likely have been unable to meet its external payment obligations during 2022-23.

The fundamental question is how the quantum reduction in the current account deficit was achieved in 2022-23? The containment in the deficit is due primarily to a very big reduction in the imports of goods by as much as 28%, equivalent to a fall in imports in US$ of $19.5 billion.

An analysis of the trends in imports during the year reveals the magnitude of contribution of different factors as follows:

(i) Trends in international commodity prices implied a 4% reduction in the unit value of Pakistan’s imports in US$. Consequently, this contributed to an almost $3 billion decline in imports.

(ii) Exchange rate policy and the policy of enhancing interest rates were used intensively during the year to reduce imports. The exchange rate depreciated by almost 40% between end-June 2022 and end-June 2023.

Simultaneously, the policy rate of the SBP soared from 13.75% to 22% in these twelve months, with a big negative impact especially on the import of machinery. This combination of very restrictive monetary policies is estimated to have reduced imports by 10%, equivalent to $7 billion.

(iii) The SBP introduced restrictions on imports of goods and there were long delays in the clearance of import consignments. This is estimated to have led the reduction in imports by almost 14%, equivalent to $9.5 billion.

Therefore, the above three factors combined contributed to a massive reduction in imports by $19.5 billion in 2022-23.

However, there were months in 2022-23 when there was a wide divergence between the open-market and the inter-bank exchange rates of the rupee. This led to the diversion of export earnings and remittances to other channels. The estimated magnitudes are $3 billion and $4 billion, respectively. Further, the payments for services were brought down by $2 billion.

Overall, the reduction in the current account deficit can be attributed to the following:

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Reduction in the Trade Deficit in Goods:           $17 billion
Reduction in the Trade Deficit in Services:         $2 billion
Reduction in Net Secondary Income:                  $4 billion
Overall Reduction in the Current Account Deficit:  $15 billion
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There is need also to highlight that instead of the physical restriction on imports if a market-based exchange rate policy had been fully adopted, as recommended by the IMF, then there would have been the need for a much bigger devaluation of rupee of over 60% to limit the current account deficit to $2.5 billion only. This would have implied higher inflation by 5 to 6 percentage points.

However, while physical controls over imports necessitated less depreciation of the rupee and thereby less inflation, they created major supply shortages and impacted adversely on the GDP growth rate. This is manifest, for example, in the 10% reduction in value-added by the large-scale manufacturing sector in 2022-23.

Turning next to the expected balance of payments position in 2023-24, the first set of projections has been made by the IMF in the Staff Statement on the new 9-month Stand-by Facility of $3 billion. These projections are as follows:

(i) Exports of goods are projected to increase in value by over 10%, despite a decline in the $unit value of exports of almost 10%. This implies that the anticipated growth in the volume of exports is as much as 20%.

(ii) Imports of goods are expected to rise by over 24%, from $52 billion in 2022-23 to $65.7 billion in 2023-24. Import prices in $ are anticipated to increase by 5%. As such, the volume of imports is projected to increase by 19%.

(iii) The trade deficit in services is likely to be higher by $1 billion.

(iv) Home remittances of workers are projected to be higher by almost $6 billion in 2023-24, with a high growth rate of almost 22%.

(v) Based on the above projections, especially imports, the current account deficit will rise to almost $6.5 billion, equivalent to 1.8% of the projected GDP in 2023-24. This is much higher than the deficit in 2022-23, but relatively moderate by historical standards. The IMF expects the deficit to be financially sustainable in the presence of a surplus in the financial account approaching $10 billion in 2023-24, as compared to a deficit of $2.5 billion in 2022-23.

The achievement of the above projections is based by the IMF on the adherence to a strict market-based exchange rate policy and the continuation of very high interest rates. The divergence between the open market and the inter-bank exchange rates must be limited to only 1.25%.

There are a number of problems with the above IMF balance of payments projections for 2023-24. First, the increase in imports of almost $13 billion is an overstatement of the space available in the balance of payments for the expansion of imports.

The physical restriction of imports in 2022-23 is estimated above to have led to a reduction in imports of $9 billion. Withdrawal of these restrictions should stimulate imports by a corresponding amount. Further, the rise in import prices and higher import demand due to GDP growth rate of up to 2.5% in 2023-24 should increase imports by 7.5%, equivalent to $4 billion.

However, the IMF expects the monetary policies to continue being very restrictive. The rupee is expected to depreciate by over 20% and the policy rate to remain close to 22%. This will reduce imports by an estimated $4 billion. A more realistic estimate of the level of imports of goods in 2023-24 is $60 billion, rather than close to $65 billion. However, this will necessitate a much larger depreciation of the rupee.

Second, an increase in exports of goods of $3 billion is anticipated by the IMF in 2023-24. This is close to the estimate of the diversion of exports to the other channels in 2022-23. However, the IMF expects this to happen even with a big fall in $ export prices of 10%, which alone will reduce exports by $3 billion.

As such, exports are likely to show a marginal increase of up to $1.5 billion. With imports likely to be lower by almost $.5 billion than the projected level by the IMF as shown above, the trade deficit should be $3.5 billion lower than the level projected by the IMF in 2023-24.

Third, the IMF expects remittances to be higher by almost $6 billion, equivalent to a growth rate of almost 22%. The $4 billion or so diverted to the hundi market in 2022-23 should come back into the official banking channel, with a market-based exchange rate policy. Beyond this, a further $2 billion increase may well be on the optimistic side.

Further, the net primary income outflow is likely to be higher by$1 billion due to larger repatriation of profits and the trade deficit in services bigger by $0.5 billion. The overall impact of the above changes in IMF projections is a current account deficit of the same magnitude of $6.5 billion. However, this will require much more intensive use of monetary and fiscal policies in 2023-24.

The balance of payments outcome in the month of July 2023 can act as an initial, though tentative, indication of likely trends in 2023-24. First, imports have shown a growth rate of 33% in relation to the level in June 2023, when the most severe import restrictions were in place.

This does indicate a transition in the import policy. However, imports of goods are still below the average monthly level projected of $5 billion in 2023-24. This is due primarily to a big reduction in imports in the petroleum group which is likely to change in the months to come.

Exports of goods have shown a disappointing performance. They are almost exactly at the same level as in June 2013 and almost 5% less than the level in July 2022. As highlighted above, more aggressive measures will need to be taken to boost exports.

During July, the rupee actually maintained its value. Faster depreciation will be required in coming months. In particular, rice exports should increase sharply following the rise in international price. The big increase in cotton arrivals should also facilitate export of textiles.

Remittances have also declined by 19% in relation to the level in July 22 and by 7% compared to the level in June 23. A significant increase has been anticipated above in remittances in 2023-24. If this does not happen in coming months, then the current account will become much more vulnerable. Already, at $0.8billion in July 2023, it is much higher than the projected monthly average of $0.54 billion in 2023-24.

Finally, there is a need to look at the projections by the IMF in the financial account of the balance of payments for 2023-24. They are very optimistic in nature. Disbursements of loans are expected to be 52% higher, while amortization payments are projected to be 41% lower, with large rollovers.

This favorable outcome will hinge on continuation of the IMF Stand-by Facility and success initially in meeting the performance criteria of end-September.

Overall, the above analyses have clearly highlighted the high level of risk and uncertainty in the balance of payments projections for 2023-24. Foreign exchange reserves have started declining after mid-July and are already below the target level of $9 billion.

The caretaker government and the SBP will have to focus on reducing the uncertainty associated with the level of imports, exports and remittances and be ready to take appropriate and timely policy actions. This needs to start with an immediate reduction from over 3% to 1.25% in the difference between the open market and the inter-bank exchange rate.

Copyright Business Recorder, 2023