Fragile balance of payments

There is a growing perception today that we face an incipient financial crisis in our external transactions. Is this happening suddenly due to a 'shock' like a big jump in oil prices in previous crises of 2008 and 2013? The answer is an emphatic no. It is due to growing structural weaknesses of the economy. The underlying structural problems include falling exports and stagnant remittances, build up of external debt and repayments thereof because of rapidly growing commercial and short-term external debt and on-going speculative and hedging activity with respect to the rupee.
The ongoing IMF programme up to September 2016 provided an external buffer of $6.2 billion. The IMF Staff Mission not only colluded in accepting the manipulated statistics but also generously accepted the violation of many performance criteria and structural benchmarks. Consequently, little structural reforms were implemented during the tenure of the program. Within one year after completion of the Program, the underlying weaknesses of the economy have come to the surface.
The year 2018 promises to be full of action and unfolding events. Inevitably, there will be considerable political and economic uncertainty. We will most likely observe the same election cycle, which comes once every five years. In effect, there will be three governments in 2018. The incumbent government is likely to continue till early June 2018 and then hand over to a caretaker government. Following the elections, a new government will take over for the next five years.
The outlook for 2018 will hinge on answers to the following questions: What policies are likely to be adopted by the present government as it focuses on improving its prospects of success in the forthcoming elections? What impact will these policies have on the economy, especially on the balance of payments? What will be the posture of the new government in the last quarter of 2018 as it assumes power?
The present PML (N) government is currently faced with a difficult economic situation. Last year, the current account deficit increased by as much as 156 percent and reached $12.4 billion, equivalent to 4.1 percent of the GDP. During the first five months of 2017-18, economic conditions have deteriorated further. The current account deficit stands at $6.4 billion, an increase of 91 percent. This is largely due a burgeoning of the trade deficit to $ 12.1 billion, an increase of $ 3.2 billion over the level in the corresponding period of the previous year. However, exports have increased for the first time since 2013-14 by 12 percent. But this growth has been neutralized by the jump of 23 percent in imports. Reserves stand at $14.3 billion as of 15 December 2017, after the receipt of $2.5 billion from the flotation of bonds.
Reserves could have fallen further if the SBP had not accessed on a short-term basis the resident and non-resident foreign currency accounts. Recent estimates are that the magnitude of these transactions has approached $6 billion, equivalent to almost 90 percent of the deposits. As such, the true reserves of SBP are $ 8.3 billion. These are not even adequate to provide import cover of two months,
What is likely to be the policy stance of the present Government up to June 2018? The prospects are for the following:
(i) A move of 5 percent has been made for devaluation of the rupee recently, under IMF pressure, as compared to the over valuation of 20 percent or more. Any further move is unlikely. This it is felt could add to inflationary pressures and adversely affect election prospects. Instead, measures like levy of regulatory duties and cash margins on imports of non-essential items and export incentives will continue to be relied on for stabilization of the economy. However, these are likely to be inadequate.
(ii) Additional financing through flotation of Euro/Sukuk bonds, and higher commercial/short-term borrowing will be the primary means to sustain reserves. Already, there has been commercial borrowing of over $1 billion in the first five months and the Government has floated bonds of $2.5 billion. These sources may be used to generate an additional $2 to $3 billion by end-June 2018. The basic objective will be to engage in a 'holding operation' till the elections.
What will be the outcome of the above-mentioned policy stance on the balance of payments in 2017-18? Exports are likely to grow by over 10 percent. However, imports could rise more rapidly by over 16 percent, while remittances remain static. Consequently, the year 2017-18 could close with an all-time high current account deficit of over $16 billion, equivalent to almost 5 percent of the GDP.
Second, excessive borrowing to finance this deficit could preserve foreign exchange reserves with the SBP at possibly near $10 billion, equivalent to two months of imports, up to June 2018. But if the amount accessed from the FCAs is excluded net reserves then could be as low as $ 4 billion.
The total external debt is estimated at $ 88 billion currently. It is expected to rise to above $93 billion by end-June 2018. In effect, during the tenure of the present government, external debt will have increased by $33 billion or by over 50 percent in five years. The external debt will be equivalent to almost four times the projected exports.
The arrival of the caretakers in June 2018 will essentially involve 'business as usual' and no fundamental change in policies, barring possibly greater downward flexibility in the exchange rate. Hopefully, foreign exchange reserves will not fall down to a critically low level during the period of the elections.
Come September 2018, a newly elected Government should be in place. As in the previous election cycles of 2008 and 2013, this Government will be compelled to take strong actions on the front of balance of payments and public finances. Controlling the fiscal deficit is necessary to avoid more pressure on the balance of payments.
The fundamental question then will be whether the new Government opts to go back to the IMF, as happened in 2008 and 2013. This time, the loan size will have to significantly larger than in the last EFF of $6.2 billion due to much bigger financing gaps. It is also likely to include major prior actions like a quantum devaluation of the rupee, jump in power tariffs and enhancement of tax rates.
In addition, there will be many performance criteria and structural benchmarks. These will be not only economic but also possibly non-economic in nature. These could include constraints on the size of the portfolio, nature and pace of implementation of CPEC and possible moves in other non-economic fronts. Much of the pressure could come from the largest IMF Board member, the USA.
The new government will have to negotiate very well with the IMF and play the card that in the absence of support it will not be in a position to repay the loan from IMF of $6.2 billion. At no stage should any non-economic conditions be accepted.
Failure of negotiations with the IMF will leave the nation no other alternative but to very aggressively embark on the path of self-reliance, hopefully with some support from friendly countries. This will necessitate resort on a fast track basis to extremely strong actions to tackle the multifarious structural problems in the national economy.
There are three critical areas where deep and wide-ranging reforms will be required. These are in the domain of trade, fiscal and monetary policies. The risk is that in the event of a fall in reserves to a precariously low level a very large devaluation may even become necessary.
The set of strong policy measures may be taken following the declaration of a Financial Emergency under Article 235 of the Constitution of Pakistan. This will greatly enhance the legality and justification for taking the necessary actions.
The overall Policy Framework will have to be greatly strengthened and implemented. Otherwise, Pakistan may find itself potentially facing a default eventually in its external transactions. Sometime ago, Bloomberg Markets has identified ten countries, including Pakistan, as prone to a technical default in the foreseeable future. As such, implementation of vigorous and wide ranging measures is required if severe dislocation of economic activity and heavy costs on the people of Pakistan are to be avoided. A high quality of governance, building of political consensus and distributing fairly the burden will be essential pre-requisites for achieving success.
The bottom line is that Pakistan is entering a difficult phase in its economic history. There is a great risk that the incipient financial crisis may transform into a real crisis by the middle of 2018. Such a crisis is likely to be deeper and more protracted in nature.
(The writer is professor Emeritus and former Federal Minister)