The external balance of payments position of Pakistan has deteriorated sharply in the last two years. This is reflected in the extraordinary jump in the current account deficit. Non-debt creating inflows and external borrowing have not been adequate in filling this gap. Consequently, the pressure has fallen on the foreign exchange reserves. From $18.1 billion at the end of 2015-16, reserves have fallen cumulatively by 48% down to $9.5 billion by end May 2018. These reserves are not even adequate to provide for import cover of two months.
The current account deficit stood at $4.9 billion in 2015-16, equivalent to 1.8% of the GDP. It spiraled up to $12.6 billion in 2016-17, a jump of 157%. Seldom has this happened in the history of Pakistan. At 4.1% of the GDP, it was clear that the size of the deficit had approached an unsustainable level.
The process of deterioration has continued in 2017-18. The current account deficit in the first 11 months has approached $16 billion. This represents an increase of 43% over the level in the corresponding period of last year. By the end of the year, the deficit is expected to be $17.5 billion to $18 billion, equivalent to between 5.6% and 5.8% of the GDP. Pakistan has entered the list of countries such as Egypt, Turkey and Argentina with large and chronic current account deficits.
There are a number of reasons why the current account deficit has deteriorated so much. The economy of Pakistan has traditionally had a small share of exports. This share has declined since 2007-08 from 11.8% of GDP to only 7% of the GDP by 2016-17. In fact, after 2013-14, exports had fallen by 13%. Pakistan now has one of the lowest export ratios among developing countries.
The dependence on imports has been substantially greater. The imports to GDP ratio stood at 14.8% in 2015-16. This implied a trade deficit in the year of almost 7% of the GDP. Fortunately, for a long time, the flow of remittances had contributed in a big way to filling the trade gap. The residual deficit was more than fully financed by foreign direct investment and net external borrowing, including that from the IMF during the period, 2013-14 to 2015-16.
The problem started in 2016-17 with an 18% jump in imports. Exports were flat and after a long time home remittances actually fell by 3%. The result was a burgeoning of the current account deficit. The fast growth in imports has persisted in 2017-18, with a growth rate of 16% up to May 2018. Fortunately, there has been some revival of exports from the very low level, with growth of 13%. Also, remittances have shown some increase once again of 3%. However, the large growth in imports continues to put pressure on the current account.
There is need to understand the unprecedented growth in imports. This has happened at a time when oil prices remain low in comparison to peak levels attained in earlier years, like 2012-13. As such, there has been no major 'oil price shock' yet. There are two reasons for the upsurge in imports. Due to the policy of maintaining a, more or less, stable nominal exchange rate since 2013-14 there had been a considerable degree of overvaluation of the rupee. By the end of 2015-16, the real effective exchange rate had risen by almost 21%. This implied that imported goods had become considerably cheaper than domestically produced goods.
Also, Pakistan had been through a process of trade liberalization since 2010-2011. The economy had been opened up by bringing down the maximum import tariff from 35% to 20%. This had reduced the effective level of protection to domestic industries. On top of this, the FTA with China has made them more vulnerable.
Consequently, the year 2016-17 saw a big upsurge of 16% in imports of food items, 44% in transport vehicles, 120% in LNG, 14% in textiles and 33% in other imports. There has since been a fall in the value of the rupee in 2017-18 of about 10% on average. Nevertheless, there continue to be big increases in imports of a large number of items. In particular, machinery imports are up by 20%, due partly to investment in the CPEC projects. Other notable increases are a big jump of 20% in imports of transport vehicles, 20% in petroleum and LNG imports, due to the recent hike in oil prices, 17% in chemicals, 29% in iron and steel and so on.
There is no doubt that if imports persist at high levels and even grow further, the current account deficit will be completely unsustainable. With reserves already down, if the deficit remains large in 2018-19 then the economy will be in the throes of a financial crisis.
There are major constraints to the extent to which the inflows into the financial account of the balance of payments can finance a large and current account deficit. The relatively small deficit was more than fully financed in 2015-16 and reserves grew. But in 2016-17, the substantially larger current account deficit was financed to the extent of 81% by inflows into the financial and other accounts. This has fallen to 60% in 2017-18, thereby putting much greater pressure on foreign exchange reserves.
The year 2017-18 is likely to close with a net financing gap in the balance of payments of at least $6.5 billion, with a current account deficit of $17.5 billion and net financing of $11 billion. This means that reserves will fall to $9.6 billion by the end of the year, significantly below the level required to provide import cover of two months.
What is the outlook for 2018-19? According to the budget estimates for next year, the MoF expects a fall in net external borrowing by government from over $7 billion this year to about $4.5 billion next year. Part of this decline will be due to the maturity of a bond of $1 billion early in 2019, higher amortization of commercial loans and smaller floatation of Sukuk/Euro bond. Given the likely magnitude of private investment and other inflows, the total financing available for financing the current account deficit will not be more than $8.5 billion.
The current account deficit next year will be impacted by two opposing factors. The cumulative depreciation of the rupee will have some restraining influence on the trade deficit. However, higher oil prices could neutralize this effect. Therefore, the current account deficit could remain close to $17 billion.
The implication is that in a, more or less, 'business as usual' scenario in 2018-19 reserves could fall further by $8.5 billion to an extremely low level of near zero. Clearly, this is too risky a path.
The option, of course, is to go back to the IMF. Based on past Programmes in Pakistan and Programmes elsewhere in countries with current account deficit above 5% of the GDP, the Fund could ask for a large depreciation of the currency and other measures as prior actions. Will the government in place at that time be willing to do this? If yes, than the current account deficit could be reduced to $13 billion in 2018-19 from $17.5 to $18 billion this year. On top of this, Pakistan will be able to get more funding internationally of up to $3 billion in the presence of the Fund Programme, for example, by more assistance from multilaterals, larger floatation of bonds and higher commercial borrowing.
The Fund has about $6 billion left from Pakistan's SDR Quota, given the outstanding loan of over $6 billion. If $4 billion is made available in the first year of the new Programme, then the total financing mobilized could reach $15.5 billion. This will enable reserves to rise by $ 2.5 billion to $12 billion, enough to provide import cover of significantly over two months in 2018-19.
Structural reforms on the fiscal, monetary and trade fronts in 2018-19 and subsequent years under the aegis of a Fund programme should restore the viability and sustainability of Pakistan's external transactions. Prime importance will also have to be attached to a sizeable fiscal deficit reduction to restrain the level of aggregate demand and thereby put less pressure on imports and the current account deficit.
Therefore, there appears to be no option now but to seek a new Programme with IMF soon after the induction of the newly elected government. Meanwhile, the caretaker government ought to invite the IMF on a priority basis for the routine Article IV consultations. This could fast track the subsequent negotiations by the next government. There is need also to prepare contingency plans if a lot more action on different fronts is asked for than anticipated currently and which are inherently unacceptable.
(The writer is Professor Emeritus at BNU and former Federal Minister)
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