Tough conditions

IFR IMF/World Bank Report 2022
19 min read
Jason Mitchell

Climate events added to Pakistan's political turmoil, while IMF deal comes with demands

Pakistan could be forced to default on its foreign debt during the next couple of years – in the wake of political turmoil and an environmental catastrophe – despite a new US$1.2bn agreement with the International Monetary Fund.

In July and August, record monsoon rains and glacier melt in the country’s northern mountains triggered floods that have killed at least 1,391 people, sweeping away houses, roads, railway tracks, bridges, livestock and crops. Huge areas are inundated and hundreds of thousands of people have been forced from their homes. Sindh province, in the country’s south, has seen 466% more rain than average. The government says the lives of almost 33 million people – out of a population of 227 million – have been disrupted. It estimates the damage at US$30bn (the country had a total GDP of US$348bn in 2021, according to the IMF).

The last severe floods to hit the country occurred in 2010 and caused damage in 78 districts, but it is estimated that the latest floods have caused damage in 118 districts, including major economic hubs.

The fresh natural catastrophe comes on top of other environmental calamities blamed on climate change. Earlier in the year, the country suffered from a searing heatwave. In May, Jacobabad, one of the hottest places in the world, in Sindh province, hit 51 degrees Celsius.

The low-income country – which had annual income per head of US$1,562 in 2021, down from US$1,600 in 2015 – has also been experiencing significant political turmoil. Imran Khan – who became prime minister in August 2018 and represents the political party, Pakistan Tehreek-e-Insaf (PTI) – was ousted in April in a no-confidence vote in the National Assembly, bringing a coalition led by Shehbaz Sharif’s Pakistan Muslim League-N (PML-N) into power. Shehbaz Sharif is the brother of former three-time prime minister Nawaz Sharif and will hold power until October 2023, when the next general election is due to be held.

Khan was removed from office after he fell out with the country’s powerful army and intelligence services. He had previously said that he would not recognise an opposition government, claiming that there was a US-led conspiracy to remove him because of his refusal to stand with Washington on issues against Russia and China’s interests. In August, Pakistan's police charged Khan under anti-terrorism laws. Their investigation comes after he accused the police and judiciary of detaining and torturing a close aide. The political situation is now extremely tense.

On 29 August, the IMF agreed to provide Pakistan with a a further US$1.2bn in financing, bringing total disbursements under the fund’s programme to the country to about US$4.2bn. It is also considering an extension of its programme until the end of June 2023 (it had been due to expire in October this year), and also an increase in the size of the total package to US$7bn (from US$6bn originally). The agreement should also unlock financing from other countries. Bilateral lenders like China and Saudi Arabia had been reluctant to provide loans to Pakistan without an IMF deal in place.

Stalled agreement

Pakistan’s bailout programme – originally agreed in 2019 – stalled in early-April when the then prime minister Imran Khan rolled out fuel subsidies and cut taxes. The new government has been in talks with the IMF for a number of weeks over the resumption of the agreement.

In August, in an unusual move, Pakistan's army chief, General Qamar Bajwa, approached the US government for help in securing an early disbursement of the IMF funds, amid the worsening economic situation owing to a shortage of foreign exchange reserves (they fell to about US$7.83bn in mid-August).

Investors have become increasingly concerned that Pakistan could be at risk of a default as it struggles with a widening current account deficit and a depreciating currency in the wake of soaring global commodity prices and tighter credit conditions.

At the time of the agreement, the IMF said: “Pakistan is at a challenging economic juncture. A difficult external environment combined with procyclical domestic policies fuelled domestic demand to unsustainable levels. The resultant economic overheating led to large fiscal and external deficits in full year 2022, contributed to rising inflation and eroded reserve buffers.

“Accelerating structural reforms to strengthen governance, including of state-owned enterprises, and improve the business environment would support sustainable growth. Reforms that create a fair-and-level playing field for business, investment and trade necessary for job creation and the development of a strong private sector are essential.”

Pakistan’s government has slashed its economic growth projections by more than half in the wake of the floods that have inundated a third of the country. It reduced its forecast to only 2.3% growth this year from a target growth rate of 5% set in June. Inflation is projected to go up from the range of 24%–27% and could touch 30%.

Pakistan’s total debt and liabilities swelled to Rs59.7trn (US$258.2bn at September exchange rates) in 2021–22 fiscal year, a Rs12trn increase on the previous fiscal year. Its debt rose in only one year by the equivalent of one-fourth of the total debt accumulated in the past 74 years, according to the State Bank of Pakistan, the central bank. The increase is blamed on the Covid-19 pandemic but also profligacy by Khan’s administration.

The country requires about US$3.16bn to pay dollar bonds and loans this year, US$1.52bn next year and US$1.71bn in 2024, according to analysts. In July, the central bank said the country’s US$33.5bn external financing needs are fully met for financial year 2022–23.

Gareth Leather, senior Asia economist at Capital Economics, a London-based economic consultancy, said in a research note: “The resumption of the loan deal between Pakistan and the IMF should put the economy back on a more secure footing and limit the biggest downside risks. But the cuts to government spending that the deal requires, combined with hikes to interest rates, will cause growth to slow sharply over the coming year.”

The IMF agreement will help shore up Pakistan’s weak external position, according to Capital Economics. Foreign exchange reserves have fallen by more than 50% since January and are now equivalent to just 1.5 months’ worth of imports. The currency, the Pakistani rupee, was also down around 16% against the US dollar between the start of the year and August.

As the price for a deal, Pakistan has agreed to a significant tightening of its fiscal policy. The government will now be aiming for a primary surplus of 0.4% of GDP in fiscal year 2022–23 (which runs from July 2022 to June 2023), compared with a deficit of 2.4% of GDP in fiscal year 2021–22. In order to achieve this, the government has agreed to raise petrol prices, abolish fuel subsidies and raise taxes. The agreement also includes a commitment for monetary policy to “guide inflation to more moderate levels”.

Inflation reached a 13-year high of 21.3% year-on-year in June and looks set to rise further over the coming months following the cut in fuel subsidies, according to Capital Economics. The central bank has raised interest rates by 525bp since the start of the year (the main policy rate stood at 15% in September) and analysts are forecasting rates could increase by a further 150bp before the end of the year. In mid-September, the sovereign’s 10-year government bond had a 13.069% yield.

No stranger to the IMF

“Pakistan is, of course, no stranger to IMF deals,” said Leather. “The country is currently on its 22nd agreement. In the past, Pakistan has often reneged on a deal once the acute phase of the crisis has passed. The danger is that history will repeat itself and that Pakistan finds itself back in the same situation in a few years’ time. To make the deal more palatable to the population (and reduce the chances of this happening again), the government and the IMF have agreed a number of measures to help safeguard living standards. Despite the overall squeeze on government spending, spending on social security will increase by 45% for the coming fiscal year.”

Moody’s says that the IMF approval of the US$1.2bn disbursement and loan programme enhancement is credit positive but risks remain. The IMF financing and the additional support from bilateral partners that it will catalyse will ease pressure on the country's dwindling foreign exchange reserves.

“Pakistan’s ability to complete the current Extended Fund Facility programme and maintain a credible policy path that supports further financing remains highly uncertain,” said Grace Lim, an analyst at Moody’s. “The government may also find it difficult to continually enact revenue-raising reforms, such as steadily increasing petroleum levies and raising power tariffs, particularly in the run-up to the next general elections scheduled for 2023.”

In early June, Moody’s reviewed the country’s rating and left it stable at B3 but changed the outlook to negative from stable.

“The decision to change the outlook to negative is driven by Pakistan's heightened external vulnerability risk and uncertainty around the sovereign's ability to secure additional external financing to meet its needs,” said Lim.

“We assess that Pakistan's external vulnerability risk has been amplified by rising inflation, which puts downward pressure on the current account, the currency and – already thin – foreign exchange reserves, especially in the context of heightened political and social risk.

“Pakistan's weak institutions and governance strength adds uncertainty around the future direction of macroeconomic policy, including whether the country will complete the current IMF Extended Fund Facility programme and maintain a credible policy path that supports further financing.”

Fitch Ratings has Pakistan rated at B- with a negative outlook. Pakistan's debt to GDP was about 73% in full year 2022, broadly in line with the current 'B' median of Fitch Ratings-rated sovereigns. This followed an earlier GDP rebasing in full year 2021, which lowered the debt ratio by 12%. It expects the debt-to-GDP to decline to 66% in full year 2023 and remain on a downward trend. This is helped by high inflation and a modest primary deficit, which it is forecasting at 0.9% of GDP in full year 2023, down from 2.8% of GDP in full year 2022.

A low foreign exchange exposure at just over 30% of total debt has limited the negative impact of the currency’s depreciation on the debt dynamics.

Low revenue

One of the country’s biggest economic issues is low general government revenue, which amounted to only 12% of GDP in full year 2022. Other analysts estimate that less than 2% of the population pays income tax. It is one of the main reasons the country’s debt-to-revenue (at more than 600% in full year 2022) and interest-to- revenue (at about 40%) are significantly worse than the 'B' median of sovereigns rated by Fitch.

“The revision of the outlook to negative in July reflected significant deterioration in Pakistan's external liquidity position and financing conditions since early-2022,” said Krisjanis Krustins, director, sovereign ratings at Fitch.

“We assumed IMF board approval of Pakistan's new staff-level agreement with the IMF (which happened on 29 August) but saw considerable risks to its implementation and to continued access to financing after the programme's expiry in June 2023 in a tough economic and political climate. The next category down from B– in the rating scale, a rating in the CCC category, would indicate that default is a real possibility.

“Pakistan's political scene remains highly volatile. Former prime minister Khan has led large-scale protests across the country and scored regional election victories, but has recently appeared in court under the anti-terrorism law.”

The Pakistani media has also been reporting that the IMF and Saudi Arabia have discussed the possibility of Pakistan being able to borrow up to US$2.8bn from the fund against Saudi Arabia's Special Drawing Rights quota, but this has not been confirmed yet. Clearly, performing on the IMF programme is critical to Pakistan's access to other multilateral and bilateral lenders and potentially market financing, says Fitch.

Furthermore, in August, it was reported that Saudi Arabia had agreed to renew a US$3bn deposit at Pakistan’s central bank to bolster the country’s depleted foreign exchange reserves. The world’s top oil exporter – which has traditionally provided financial aid to Islamabad – also agreed to support Pakistan with US$1bn in petroleum products over a 10-month period.

China is one of the most important providers of bilateral financing to Pakistan, with US$18.4bn in lending (including a US$4bn deposit) in June 2021, representing 20% of Pakistan' external debt, not including a further US$6.7bn from Chinese commercial banks. The World Bank is also one of the biggest lenders, accounting for 21% of the country's external debt in June 2021.

“The Pakistan economy grew quickly last fiscal year, but we expect real GDP growth to slow to around 4% per year as a result of high inflation, a weaker currency, and tighter fiscal and monetary conditions,” said Andrew Wood, an analyst at S&P.

“Higher food and energy prices are an important channel of stress for the economy and its external position, and this has been compounded since the start of the conflict in Ukraine. We estimate the government’s net debt position at around 74% of GDP, which is moderately higher than prior to the pandemic.

“Financial support from the IMF and other multilateral and bilateral partners is critical, in our view, toward the stabilisation of Pakistan’s external position. We consider political risk to be elevated and this could have bearing on important policy decisions over the coming quarters. Structural reforms that support Pakistan’s business environment and macroeconomic stability would be important pillars of an enduring economic recovery.”

Infrastructure spend

Many analysts attribute Pakistan’s present economic woes to a large extent to its massive spending on infrastructure projects, including the Gwadar-Kashgar railway line, which connects the port city of Gwadar to the rest of Pakistan and China. In 2019, the 1,328km-long new railway from Jacobabad and Quetta via Basima and Gwador was estimated to have a cost of US$4.5bn. In June 2020, Pakistan also gave approval for the US$7.2bn project to upgrade the railway between Karachi and Peshawar. Many of the projects form part of the China-Pakistan Economic Corridor.

The government has financed many projects through long-term debt instruments and depended heavily on external borrowing rather than financing from domestic institutions.

“A lot of what is happening in Pakistan comes down to governance and governance issues,” said Shandana Khan Mohmand, who leads the governance research cluster and the Pakistan Hub at the Institute of Development Studies, a think tank based in Brighton in the UK.

“I think there are four words that really capture the combination of issues that the country is facing today: tax, productivity, gender and polarisation.

“Tax because there is a lack of taxation. Productivity refers to a lack of productivity. Whatever money is coming from the IMF, where and how is it being used? How is all the debt that Pakistan has incurred being used inside the country? It’s a lack of productive investment. It’s gender in the sense that most of the country’s labour force – in other words, women – are not actively involved. They are just not part of the labour force. And it’s polarisation that is the really big issue right now. Voters and parties are so polarised that it’s not about policymaking and finding solutions; really, it’s just about an ‘us versus them’ politics. Within that, from a voter’s perspective, it doesn’t matter what kinds of policy your government is making as long as it’s your side.”

Pakistan was in dire economic shape before this year’s natural catastrophes happened. The heatwave and floods have only made matters a lot worse. The latest IMF bailout will help the country to endure a tough period and could avert a debt default. However, the country must undertake profound structural reforms if it is to get its finances on a sounder footing and enjoy more economic stable growth in the future.

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