Foreign currency requirement for taming inflation

In the year 2016 an operational limit to the debt-ceiling was introduced whereby the annual federal deficit (excluding grants) was not to exceed 4% of GDP over the period FY2018-21 and 3.5% of GDP thereafter. With the aim to bring down public debt below the 60% of GDP limit provided under Fiscal Responsibility and Debt Limitation Act, 2005. These limits were never achieved since then.

Domestic and external lenders are important for any government in a developing economy, but significant increases in deficits over the years amidst persistently low income and increasing expenses have made them ever more important. Not for what they have already lent but for the money they need to consistently provide every year for the government to operate.

This bodes well for the lenders in the short term, including the domestic banking system, which are happy to have a customer that has a never-ending demand for money.

Growing government borrowing from the banking sector had already increased its exposure to 54.6 percent of the banks’ assets as of end June 2022. Mostly because the amount lent to the government annually exceeds the amount of increase in deposits generated by banks. This has been the case in almost every year now and FY23 was no exception.

Despite borrowing in such size from the domestic banking system, it accounts for only a limited share of the total deficit of the government each year.

Borrowing from Non-Bank sources, including insurance companies, mutual funds, companies, individuals, etc., are other domestic borrowing options. All the incremental domestic sources combined are still insufficient to fund the fiscal deficit of Rs 7.5 trillion, therefore incremental foreign sources must be utilised.

Rising interest rates in the developed world are attracting money as investment in their bonds is considered safe. While on the other hand, the investors demand a higher premium for investing in riskier assets, especially in a country with a speculative grade bond rating, which limits the availability of external financing from the international banks and bond markets.

The lack of availability of financing from foreign sources kept the domestic banking sector under pressure during the first half of CY23. The State Bank of Pakistan (SBP) had to inject liquidity into the banking system through Open Market Operations by printing local currency.

Despite some improvement, money supply has already increased substantially more than the increase in supply of goods. This mismatch allocates more money to same quantity of goods which fuels inflation and thus the 30% 12 month moving average inflation.

The FY24 had a good start when the IMF made disbursement under the Stand-By Arrangement in addition to bilateral receipts. Since the start of August 2023, however, there has been no increase in net foreign currency inflows, as the new receipts are sufficient only for meeting the debt servicing requirement.

Nonetheless, the first quarter of FY24 shows a comfortable position in the fiscal account. The government was able to meet 16% of its foreign financing requirement, but the remaining 84% is still to be raised in the nine months. In case of any shortfall, the burden will shift to the domestic sources, which will already be exhausted after contributing their budgeted share:

The fiscal situation in Q1 and Q2 is usually better as there is a space created by deferring expenses and early receipt of surplus of approximately Rs 1 trillion from SBP. However, accordingly, only 13% of the required annual financing was obtained in Q1, while the remaining 87% is to be obtained in the remaining 9 months.

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     Budgeted FY-24 deficit financing (Rs in billion)      
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                          FY-24   Financing    Financing to
                                  obtained Q1   be obtained
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Bank borrowing            2,860     1,076             1,784
Non-Bank borrowing        1,906     (547)             2,453
Privatization                15                          15
Net Domestic borrowing    4,781      529              4,252
Net external reciepts     2,724      425              2,299
Financing obtained vs     7,505      954              6,551
to be obtained                       13%                87%
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Besides this, the SBP projects a fiscal deficit in the range of 7-8% of GDP vs 6.5% planned by the government, which translates into additional financing need of Rs 500-1,500 billion which could take fiscal deficit up to Rs 9 trillion.

Any shortfall in net foreign inflows or slippage in the fiscal account would require the State Bank to inject further liquidity into the system by printing money in Q3 and Q4 of FY24, which will continue the ongoing inflation cycle.

Foreign currency borrowing requirement is often connected with the need to finance the current account, however in case of Pakistan, the fiscal deficit size has grown so large that it could not be managed without incremental foreign currency inflows. On the flip side, there are hopes of large foreign direct investments (FDI) under the initiatives of Special Investment Facilitation Council.

Either new loans or FDI, the country needs another US$ 8 billion net increase in foreign currency inflows to tame inflation.

Copyright Business Recorder, 2023