Interim challenge
Dr Maleeha Lodhi
Tuesday, February 26, 2013
The writer is special adviser to the Jang Group/Geo and a former envoy to the US and the UK.
With electioneering in full swing, peoples attention is focused on the political transition that lies ahead. But the fate of the economy is as consequential for the country as the approaching election. A precarious economy marked by widening internal and external imbalances has heightened the risk of a financial crisis erupting right in the middle of the transition and before a new government assumes power. This urges the need for responsible economic stewardship during the brief tenure of the interim government.
Although the caretaker governments principal responsibility will be to supervise free and fair elections, it will also have to keep a watchful eye on a deteriorating economy and take necessary measures to prevent an economic breakdown.
This should not be misconstrued as an argument to extend the life of the interim administration. The purpose here is to stress the need to manage the economy prudently in a period where the important (holding credible elections) and the urgent (averting economic crisis) will compete for attention.
There are compelling reasons for this. Virtually all macroeconomic indicators point to significant worsening of the economy: low or falling growth, rising budget deficit, high inflation, declining revenue collection, growing losses in public sector enterprises, record government borrowing from the State Bank and commercial banks, plummeting domestic and foreign investment, and a deeply troubled energy sector that continues to strain government resources and impede economic activity.
Power sector subsidies alone cost the exchequer between Rs150 billion and Rs300 billion a year. In the past five years Rs1.5 trillion have been spent on these subsidies, the equivalent of $16 billion, enough to finance the Bhasha Dam project with money to spare. On top of this, the governments fiscal profligacy ahead of elections has further compounded the weak state of public finances.
It is the countrys perilous external position that can be the trigger for a crisis. Exports have been stagnating and foreign direct investment has slipped to an all time low. In the first seven months of this fiscal year FDI was just $525 million. Imports have also been declining and while the current account gap is not as large as last years and remittances from overseas Pakistanis remain robust (around $13 billion last year), this is not enough for the country to meet its external financing requirements when foreign exchange reserves are depleting.
The present level of reserves held by the State Bank is around $8.1 billion, which cover about two months of imports. This will drop by another $400 million this week when another payment is made to the International Monetary Fund (IMF). This fiscal year reserves have steadily eroded at around $500 million a month. External inflows have tapered off while repayments have had to be made to the IMF on the $11 billion loan contracted in 2008.
As the reserve cushion has begun to erode so has confidence. This has put rising pressure on the balance of payments and the rupee, whose value has sunk to a historic low against the dollar. When the rupee crossed a psychological barrier earlier this month and traded at Rs100 to a dollar, this rang alarm bells.
With more repayments due to the IMF, foreign exchange reserves could dwindle to a level that barely covers a months imports by this fiscal years end. Between now and end-June, Pakistan needs to pay $1.5 billion to the Fund and another $1.2 billion to other lenders. Reserves will therefore fall much below $6 billion in the absence of any foreign inflows. Programme lending from other multilateral agencies is off the table, absent an IMF package.
The present reserve level includes about $2 billion in what are called swaps/forwards. In plain language this means that to shore up reserve numbers the State Bank of Pakistan (SBP) has borrowed $2 billion from banks in exchange for rupees. As swap operations are often short-term less than three months if banks decide not to roll them over, $2 billion of reserves could disappear quite quickly.
Another expedient measure the central bank has resorted to is to sell about $300 million a month into the market this fiscal year. By continuing to sell to defend the currency, the SBP has been running down reserves. If it persists with this policy, reserves would fall further.
There are two aspects to the countrys weakening position on the external account. One, drawdowns of reserves could produce a cash flow crisis, when the country will simply not have enough foreign exchange to meet its external financing gap. A balance of payments crisis would then follow.
But before this happens a second, more likely scenario might materialise. As reserves continue to dwindle, this could spark panic in the market especially in anticipation of the fact that in the next fiscal year debt service payments of another $6.2 billion have to be made to the IMF and other international creditors. Confidence could start evaporating when the market perceives that the country wont be able to service its foreign obligations.
When panic sets in people start converting rupees into dollars as a hedge against risk. This pressure can prompt the SBP to run down reserves very quickly. And if the central bank does not use its reserves, the rupees value plunges. This in turn will fuel another round of inflation, produce a sharp rise in import costs for fuel and of course aggravate the problem of a runaway fiscal deficit.
This is not an unfamiliar scenario. It resembles the trajectory of developments that culminated in the 2008-09 balance of payments crisis, which was only resolved by emergency financing from the IMF.
The tenuous state of public finances today means that the country has little resilience to withstand an economic shock. In a fraught economic and security situation any negative political development can tip the economy over apart that is from panic over low reserves.
All of this creates the imperative to skilfully manage the economy in a politically challenging and difficult environment. The interim administration may in fact have to take important decisions in consultation with major political parties to prevent the economy from going off the cliff.
If political consensus can be built, the interim government can utilise the time available to it to take economic measures that might be politically difficult for the incoming government to take at the outset of its term. Such actions would also help the country transition into a new Fund programme, which is unavoidable because without substantial inflows the country would be pushed towards default on its external obligations.
There are a number of fiscal, monetary and energy sector policy actions that a caretaker government could take after securing approval of the main political stakeholders. This would help avoid a perfect storm that is building up, stabilise the economy and lay the basis for an eventual IMF programme. Some domestic resource mobilisation measures would be excluded from the purview of an interim government, as they require legislation. This includes new taxation. But tax revenue could be raised in other ways by executive action. For example by removing zero-rated concessions on sales tax for a number of sectors and eliminating exemptions granted under statutory regulation orders (SROs) on income tax, withholding tax rates and sales tax.
In the power sector the interim administration could initiate action to phase out the untargeted tariff differential subsidy, which helps the rich more than the poor, costs the economy the equivalent of 2.5 percent of GDP a year and is a major source of the fiscal deficit. The troubles of the power sector alone are enough to sink the economy.
Irrespective of an IMF programme, these are some of the urgent actions the country would need to take to prevent an economic storm that may not wait for a new government to be in place to wreak havoc.
The caretaker government will therefore need to take care of more than an election. It may have to act to save the country from an economic meltdown.
Dr Maleeha Lodhi
Tuesday, February 26, 2013
The writer is special adviser to the Jang Group/Geo and a former envoy to the US and the UK.
With electioneering in full swing, peoples attention is focused on the political transition that lies ahead. But the fate of the economy is as consequential for the country as the approaching election. A precarious economy marked by widening internal and external imbalances has heightened the risk of a financial crisis erupting right in the middle of the transition and before a new government assumes power. This urges the need for responsible economic stewardship during the brief tenure of the interim government.
Although the caretaker governments principal responsibility will be to supervise free and fair elections, it will also have to keep a watchful eye on a deteriorating economy and take necessary measures to prevent an economic breakdown.
This should not be misconstrued as an argument to extend the life of the interim administration. The purpose here is to stress the need to manage the economy prudently in a period where the important (holding credible elections) and the urgent (averting economic crisis) will compete for attention.
There are compelling reasons for this. Virtually all macroeconomic indicators point to significant worsening of the economy: low or falling growth, rising budget deficit, high inflation, declining revenue collection, growing losses in public sector enterprises, record government borrowing from the State Bank and commercial banks, plummeting domestic and foreign investment, and a deeply troubled energy sector that continues to strain government resources and impede economic activity.
Power sector subsidies alone cost the exchequer between Rs150 billion and Rs300 billion a year. In the past five years Rs1.5 trillion have been spent on these subsidies, the equivalent of $16 billion, enough to finance the Bhasha Dam project with money to spare. On top of this, the governments fiscal profligacy ahead of elections has further compounded the weak state of public finances.
It is the countrys perilous external position that can be the trigger for a crisis. Exports have been stagnating and foreign direct investment has slipped to an all time low. In the first seven months of this fiscal year FDI was just $525 million. Imports have also been declining and while the current account gap is not as large as last years and remittances from overseas Pakistanis remain robust (around $13 billion last year), this is not enough for the country to meet its external financing requirements when foreign exchange reserves are depleting.
The present level of reserves held by the State Bank is around $8.1 billion, which cover about two months of imports. This will drop by another $400 million this week when another payment is made to the International Monetary Fund (IMF). This fiscal year reserves have steadily eroded at around $500 million a month. External inflows have tapered off while repayments have had to be made to the IMF on the $11 billion loan contracted in 2008.
As the reserve cushion has begun to erode so has confidence. This has put rising pressure on the balance of payments and the rupee, whose value has sunk to a historic low against the dollar. When the rupee crossed a psychological barrier earlier this month and traded at Rs100 to a dollar, this rang alarm bells.
With more repayments due to the IMF, foreign exchange reserves could dwindle to a level that barely covers a months imports by this fiscal years end. Between now and end-June, Pakistan needs to pay $1.5 billion to the Fund and another $1.2 billion to other lenders. Reserves will therefore fall much below $6 billion in the absence of any foreign inflows. Programme lending from other multilateral agencies is off the table, absent an IMF package.
The present reserve level includes about $2 billion in what are called swaps/forwards. In plain language this means that to shore up reserve numbers the State Bank of Pakistan (SBP) has borrowed $2 billion from banks in exchange for rupees. As swap operations are often short-term less than three months if banks decide not to roll them over, $2 billion of reserves could disappear quite quickly.
Another expedient measure the central bank has resorted to is to sell about $300 million a month into the market this fiscal year. By continuing to sell to defend the currency, the SBP has been running down reserves. If it persists with this policy, reserves would fall further.
There are two aspects to the countrys weakening position on the external account. One, drawdowns of reserves could produce a cash flow crisis, when the country will simply not have enough foreign exchange to meet its external financing gap. A balance of payments crisis would then follow.
But before this happens a second, more likely scenario might materialise. As reserves continue to dwindle, this could spark panic in the market especially in anticipation of the fact that in the next fiscal year debt service payments of another $6.2 billion have to be made to the IMF and other international creditors. Confidence could start evaporating when the market perceives that the country wont be able to service its foreign obligations.
When panic sets in people start converting rupees into dollars as a hedge against risk. This pressure can prompt the SBP to run down reserves very quickly. And if the central bank does not use its reserves, the rupees value plunges. This in turn will fuel another round of inflation, produce a sharp rise in import costs for fuel and of course aggravate the problem of a runaway fiscal deficit.
This is not an unfamiliar scenario. It resembles the trajectory of developments that culminated in the 2008-09 balance of payments crisis, which was only resolved by emergency financing from the IMF.
The tenuous state of public finances today means that the country has little resilience to withstand an economic shock. In a fraught economic and security situation any negative political development can tip the economy over apart that is from panic over low reserves.
All of this creates the imperative to skilfully manage the economy in a politically challenging and difficult environment. The interim administration may in fact have to take important decisions in consultation with major political parties to prevent the economy from going off the cliff.
If political consensus can be built, the interim government can utilise the time available to it to take economic measures that might be politically difficult for the incoming government to take at the outset of its term. Such actions would also help the country transition into a new Fund programme, which is unavoidable because without substantial inflows the country would be pushed towards default on its external obligations.
There are a number of fiscal, monetary and energy sector policy actions that a caretaker government could take after securing approval of the main political stakeholders. This would help avoid a perfect storm that is building up, stabilise the economy and lay the basis for an eventual IMF programme. Some domestic resource mobilisation measures would be excluded from the purview of an interim government, as they require legislation. This includes new taxation. But tax revenue could be raised in other ways by executive action. For example by removing zero-rated concessions on sales tax for a number of sectors and eliminating exemptions granted under statutory regulation orders (SROs) on income tax, withholding tax rates and sales tax.
In the power sector the interim administration could initiate action to phase out the untargeted tariff differential subsidy, which helps the rich more than the poor, costs the economy the equivalent of 2.5 percent of GDP a year and is a major source of the fiscal deficit. The troubles of the power sector alone are enough to sink the economy.
Irrespective of an IMF programme, these are some of the urgent actions the country would need to take to prevent an economic storm that may not wait for a new government to be in place to wreak havoc.
The caretaker government will therefore need to take care of more than an election. It may have to act to save the country from an economic meltdown.
