Foreign exchange reserves with the State Bank of Pakistan have started falling, in the, more or less, immediate aftermath of the end of the IMF Program. The process of decline started from November 2016. Reserves at the end of October 2016 stood at $18.9 billion. By the end of January 2017, they have fallen to $17.6 billion, thereby registering a decline of $1.3 billion. The IMF had projected in its last Review that reserves would increase to $19.6 billion by January 2017. As such, the shortfall in relation to this target is $2 billion.
In the last week of January 2017, the decline was as much as almost $800 million. Thus was precipitated primarily by a one-off return of the safe deposit of $500 million with the SBP to China. The remaining $300 million is clearly due to a further deterioration in the balance of payments position in January 2017. The decline in reserves could have been larger if Pakistan had not gone for early flotation of $1 billion of Sukuk Bonds in October 2016. In addition, the gross level of borrowing internationally from commercial banks was $900 million in the first five months of 2016-17. Almost 70% of the budgeted annual borrowing in 2016-17 from these two sources combined has already taken place.
The pressure on reserves is due to a number of structural factors. The principal reason is the increase in the current account deficit in the balance of payments by $1.7 billion in the first half of 2016-17, in relation to last year. As opposed to this, receipts on the financial account have increased by only $ 150 million. In particular, both net foreign assistance to government and FDI have shown hardly any growth in relation to the level achieved in the first half of 2015-16.
What are the prospects for the remainder for 2015-16? A fillip has been provided to exports by the announcement of a significant export incentive package However, as indicated by the SBP, the rupee has appreciated significantly due to its linkage with a strengthening US $. It has risen in value with respect to euro, the UK sterling and Japanese Yen by 4%, 7% and 10% respectively, since June 2016. The export rebates in the incentive package largely compensate for the appreciation of the rupee, without significantly enhancing the competitiveness of our exports.
There are also a number of risk factors. The first relates to the rise in international price of oil. In relation to the average price in the second half of 2015-16 of $ 39 per barrel, the price currently is almost 34% higher. This could imply a higher oil import bill in the second half of 2016-17 of almost $ 1.2 billion.
Second, the CPEC-related imports of power generating machinery have not yet peaked. According to the SBP, these were about $ 500 million only in the first half of 2016-17. They could rise substantially in coming months if the target of eliminating load-shedding by 2018 is to be achieved. However, it is hoped that this jump in imports will be financed mostly by increased FDI, especially from China.
Third, global trade is going through a period of increased turbulence due particularly to the arrival of the Trump administration in the US. If this leads to greater protectionist tendencies and potentially a trade war between the US and China, then there is likelihood of a major fall in the volume of world trade. This could adversely affect Pakistan's exports to major markets.
Fourth, a factor that has not yet been identified is the possibility of 'speculative' pressure on imports. Between July and October 2016, imports increased by only 2%. However, in November and December 2016 combined they have gone up sharply by almost 16%. This, more or less, coincides with the period when the gap between the open market and the interbank exchange rate of the rupee began to widen. Importers may now be inclined to open L/Cs at a faster rate to avoid higher costs due to any anticipated depreciation in the value of the rupee.
A risk factor of non-economic nature is the product of greater political uncertainty. This may precipitate on exodus of more foreign capital out of the stock market, which is fortunately booming currently. Foreign portfolio investment has already become negative.
There is no doubt that strong corrective actions have to be taken urgently to arrest the decline in foreign exchange reserves. Large external borrowing may not be a viable option in the medium run in the face of greater risk perceptions by potential lenders.
The government needs to consider adjusting the value of the rupee to remove to the extent possible the overvaluation of the currency currently, expedited by the strengthening of the US $. This is potentially the first best option as it will help in simultaneously further promoting exports and in reducing imports.
Alternatively, if other options are to be considered then particular imports may be subjected to higher regulatory duties and/or larger import margin requirements. Exports may be supported by expanding the incentive package to cover more exports, including large subsidies to agricultural items like wheat and sugar. Also, the export rebate may be enhanced for encouraging new value added exports and to facilitate entry into emerging markets. Simultaneously, other steps like faster refunds to exporters must be put in place. If not, then there is a risk of faster depletion of foreign exchange reserves in coming months, with its concomitant implications on stability and growth of the national economy.
(The writer is Professor Emeritus and former Federal Minister)