There has been appreciation of the success achieved in bringing down the current account deficit in the external balance of payments by over 45% in the first four months of 2022-23. In absolute terms, the decline is large at $2.5 billion.
At $2.8 billion in these four months and if this trend persists the likelihood is that the current deficit will be below the level set in the IMF (International Monetary Fund) programme of $9.4 billion for 2022-23. Consequently, the external financing requirement for the year will be somewhat less than envisaged.
But there is a catch. Despite the $ 2.5 billion reduction in the current account deficit, there has actually been a fall in foreign exchange reserves held by the SBP (State Bank of Pakistan) of $1 billion to $8.8 billion, between end-June and end-October. Why has this happened?
There is need to recognise that there are two major parts of any country’s balance of payments. These are respectively the current account and the financial account. The former records transactions in the form of exports and imports of goods and services, interest payments to foreign lenders, repatriation of profits by multinational companies operating in Pakistan and the inflow of remittances from Pakistani expatriate workers.
The focus of the financial account of the balance of payments is on capital flows, including foreign direct and portfolio investment, borrowings and repayment of external debt by the government, private sector and commercial banks.
The balance of payments should ideally see an improvement simultaneously in the current account and in the financial account. The imbalance arises when any improvement in the current account is neutralized by a decline of net inflows into the financial account.
This is exactly what has happened in the last four months. The current account improved and the deficit declined from $5.3 billion to $2.8 billion. However, the financial account deteriorated sharply from a net inflow of $5.7 billion in the period, July to October, of 2021-22 to $1.9 billion in the corresponding months of the on-going financial year. This is equivalent to a big drop of 70% and larger in absolute magnitude than the improvement in the current account. Consequently, foreign exchange reserves declined by $1 billion.
The deterioration in the financial account of the balance of payments is very worrying. With a surplus of only $1.9 billion in the first four months and if the rate of net inflow remains the same in coming months, then the annual inflow will not exceed $6 billion. This is much lower than the projected magnitude of $12.7 billion in the projections agreed with the IMF for 2022-23.
The big shortfall of inflows is due to a number of factors. First, foreign investment has declined substantially by 54%, whereas the Programme projection is for the annual increase to be as much as 78%. Second, the net inflow of borrowing by the government has fallen by 30%, whereas it is targeted to grow over the twelve months by 16%. Therefore, if the short-term trends continue then there is the likelihood of a fall in foreign exchange reserves to a critically low level by June 2023.
There are other imbalances also of a worrying nature. The borrowings by Government in the first four months have been predominantly from multilateral agencies. $1.2 billion has come from the IMF and $2.3 billion from the development banks, especially the ADB (Asian Development Bank). This is 83% of the total borrowing in the first four months of 2022-23. According to the sources identified in the last IMF staff report, the targeted share of multilateral agencies is 47%.
Therefore, the expectation is that 53% of the annual inflow in 2022-23 will be from private international lenders, either by flotation of Euro/Sukuk bonds or by borrowing from international commercial banks. No bonds have been floated in the four months from July to October 2022 and the new inflow of commercial borrowing is only $200 million.
This brings us to the crux of the risks associated with the movement in the balance of payments of Pakistan. The existing low reserves and the severe downgrading of Pakistan’s credit rating have made international private sources of lending very averse to extending any loans to Pakistan.
The financing proposed from these sources in the federal budget documents in 2022-23 is $2 billion by flotation of Euro/Sukuk bonds and $7.5 billion of borrowing from international commercial banks. If these flows do not materialize fully then instead of the foreign exchange reserves rising by $6 billion as projected by the end of 2022-23 in the IMF staff report, they could fall to a critically low level and bring Pakistan perilously close to a default situation.
The unfortunate reality is that even in the presence of an IMF programme, private lenders are unwilling to extend loans to Pakistan. Surely, the IMF should play a more active role in eliciting support for Pakistan at this time.
What are the fallback options? A further big reduction in the trade deficit will create shortages of petroleum products, raw materials, and intermediate goods. This will throttle economic activity and combined with the massive damage inflicted by the floods lead to a big fall in real per capita income and mushroom growth in unemployment.
The alternative is to get the development banks to extend more loans to Pakistan especially for reconstruction after the floods. The recently concluded Summit in Egypt may lead to some funds flowing into Pakistan to counter the negative effects of climate change. Also, major bilaterals like China may be motivated to extend more support to Pakistan.
Overall, the financial situation of Pakistan is increasingly precarious. The balance of payments must become more balanced with simultaneously both a reduction of the deficit in the current account and larger inflows into the financial account. This is essential for the foreign exchange reserves of Pakistan to rise to a relatively safe level by the end of 2022-23.
Copyright Business Recorder, 2022