Looming economic storm?
Dr Maleeha Lodhi...The writer is special adviser to the Jang Group/Geo and a former envoy to the US and the UK.
Unending political turmoil in the country has brought the business of government to a standstill. Nowhere is the paralysis more consequential than in its impact on a sinking economy.
With political leaders attention distracted from governance, economic risks are multiplying. The downward economic spiral is being reinforced by uncertainty and the governments failure to address the challenge of structural reform.
Whatever the political outcome of the confrontation between the government and other state institutions, a protracted stand off can accelerate the countrys descent into economic chaos. Such a dire situation can only be averted by urgent and decisive policy action, which does not seem forthcoming. Upbeat official statements about the economy including the one last week by the prime minister suggest that the government is either in denial or ignorant about reality.
The main reason for the steady deterioration in public finances lies in the widening budget and balance of payments deficits and the onset of a number of negative economic trends. Their confluence with emerging geopolitical developments the US-Iran confrontation and its likely impact on international oil prices is now exposing the country to the danger of economic shocks that it has little resilience to withstand.
The deteriorating economic picture is characterised by several inter-related factors that have been reinforcing each other in a vicious cycle. Economic growth is stagnating, inflation is rising, domestic and foreign investment is falling, energy shortages are causing widespread production disruptions, government revenue is insufficient to meet even debt and defence expenditures, bankrupt state enterprises are collapsing, unemployment is increasing and so is economic disparity and poverty. With solvency concerns of their own most foreign creditors are increasingly unwilling to bail out the country.
Instead of seriously addressing fundamental problems of resource scarcity by raising additional revenue and cutting wasteful expenditure, the PPP-led coalition has been borrowing its way out of this situation. It has done this in the mistaken belief that people and the economy have a limitless threshold to tolerate higher inflation, the inescapable consequence of the State Bank increasing the money supply by printing more notes. This has heightened the danger of hyperinflation and the currency precipitously losing value. Yet the government continues to downplay this risk.
The principal reason for official complacency is the level of the countrys foreign exchange reserves. Over $16 billion in reserves (according to State Bank figures at the start of 2012) are regarded as a comfortable cushion to enable the ruling coalition to coast along to general elections without facing a cash flow crisis. In other words, the government has enough foreign exchange to finance the current account deficit (the gap between international payments and receipts) and meet external debt liabilities and this obviates the need for any policy actions now.
There are several problems with this short-sighted and self-serving view. One, reserves held by the State Bank are $12.8 billion. The remaining $4.1 billion held by commercial banks are matched by equivalent foreign exchange liabilities to their deposit holders. The international practice is not to regard these as reserves. Two, the bulk of the State Bank reserves is borrowed money including roughly $8 billion from an IMF loan.
Three, and more substantively, the calculation that a comfortable level of reserves will hold through the year rests on precarious ground. Once political and economic uncertainty combine to erode confidence reserves can start depleting quite rapidly in a hard to control process. Several factors can intervene to puncture the governments calculation.
In an environment of evaporating confidence and concerns about instability people will begin to hedge against uncertainty by changing rupees for dollars. This will intensify pressure on the exchange rate. A rise in import demand driven by the speculative dynamics of an uneasy economic outlook can also place an additional burden on the balance of payments. This can also intensify capital flight.
This can result in an unanticipated drawdown of reserves and a looming foreign exchange crisis. If external factors higher oil prices beyond the countrys control also kick in, the ineluctable consequence will be further depletion of reserves to meet a rising import bill. This in turn will bring the country a step closer to insolvency.
This suggests that there is little basis for the governments assumption that it neednt worry about an economic crisis erupting in 2012 and can therefore leave that possibility to be contemplated and confronted after the elections. Several macroeconomic indicators point to a disturbing trend. Together with policy paralysis they can accelerate two kinds of dangers to economic stability: hyperinflation and a balance of payments crisis. The latter could be a replay of 2008 when the twin deficits of the budget and external account soared to record levels forcing Pakistan to turn to the IMF for emergency funding to avert a possible default.
Among the more troubling indicators is the spike in government borrowing both from the central and commercial banks. Borrowing for budgetary support hit a record high of Rs840 billion in the first half of the current fiscal year compared to Rs208 billion in the corresponding period of the previous year. This reflects increasing requirements to finance the widening fiscal deficit that could easily reach eight percent of the GDP this fiscal year.
Meanwhile the burden on the budget has been increasing due to the governments inability to meaningfully address the problem of insolvent public sector enterprises and the rising cost of power sector subsidies. These are estimated at over one billion rupees a day. The governments decision to assume PSE debt by issuing special bonds of around Rs400 billion is a questionable effort that shifts the fiscal burden to monetary policy.
The trade deficit has also been widening. The export surge in the previous fiscal year turned out to be temporary. Latest figures show exports to be stagnating. The trade deficit rose to $11.4 billion in July-December 2011 compared to $8.2 billion in the corresponding period in 2010. Because the export rise represented a price (higher world commodity prices) and not a volume effect it was bound to be short-lived.
More disconcerting is the fact that declining exports also reflect the onset of recession in western markets and production disruptions caused by the energy crisis at home. As no quick easing can be expected on either of these fronts a further fall in exports is possible. This will increase the requirements to finance the balance of payments deficit.
Already the current account deficit has shot up to over $2.1 billion in the first six months of this fiscal year. This negative trend is likely to consolidate in coming months due to a higher import bill and servicing of external debt including payments due to the IMF between February and June 2012. This will happen at a time when foreign inflows are drying up.
Financing external payments in excess of remittances will further run down reserves. Along with high domestic inflation this will put the exchange rate, which depreciated substantially in the first part of this fiscal year, under greater stress. The rupee traded at a record low, over Rs90 to a dollar earlier this month, reflecting market anxiety over the deteriorating economic outlook and rise in import payments. Official interventions to defend the exchange rate will only drain foreign exchange reserves.
All this means that public finances are now in deep disarray. This situation can only be reversed by a change of course that a reform-averse government has shown no inclination to undertake. This has aggravated a runaway fiscal crisis that is now threatening to push the economy over the precipice. What can hasten this process is the present political gridlock. At a time when the countrys finances are crumbling and political survival is trumping everything else, continuing uncertainty can propel Pakistans more quickly into an economic abyss.
Dr Maleeha Lodhi...The writer is special adviser to the Jang Group/Geo and a former envoy to the US and the UK.
Unending political turmoil in the country has brought the business of government to a standstill. Nowhere is the paralysis more consequential than in its impact on a sinking economy.
With political leaders attention distracted from governance, economic risks are multiplying. The downward economic spiral is being reinforced by uncertainty and the governments failure to address the challenge of structural reform.
Whatever the political outcome of the confrontation between the government and other state institutions, a protracted stand off can accelerate the countrys descent into economic chaos. Such a dire situation can only be averted by urgent and decisive policy action, which does not seem forthcoming. Upbeat official statements about the economy including the one last week by the prime minister suggest that the government is either in denial or ignorant about reality.
The main reason for the steady deterioration in public finances lies in the widening budget and balance of payments deficits and the onset of a number of negative economic trends. Their confluence with emerging geopolitical developments the US-Iran confrontation and its likely impact on international oil prices is now exposing the country to the danger of economic shocks that it has little resilience to withstand.
The deteriorating economic picture is characterised by several inter-related factors that have been reinforcing each other in a vicious cycle. Economic growth is stagnating, inflation is rising, domestic and foreign investment is falling, energy shortages are causing widespread production disruptions, government revenue is insufficient to meet even debt and defence expenditures, bankrupt state enterprises are collapsing, unemployment is increasing and so is economic disparity and poverty. With solvency concerns of their own most foreign creditors are increasingly unwilling to bail out the country.
Instead of seriously addressing fundamental problems of resource scarcity by raising additional revenue and cutting wasteful expenditure, the PPP-led coalition has been borrowing its way out of this situation. It has done this in the mistaken belief that people and the economy have a limitless threshold to tolerate higher inflation, the inescapable consequence of the State Bank increasing the money supply by printing more notes. This has heightened the danger of hyperinflation and the currency precipitously losing value. Yet the government continues to downplay this risk.
The principal reason for official complacency is the level of the countrys foreign exchange reserves. Over $16 billion in reserves (according to State Bank figures at the start of 2012) are regarded as a comfortable cushion to enable the ruling coalition to coast along to general elections without facing a cash flow crisis. In other words, the government has enough foreign exchange to finance the current account deficit (the gap between international payments and receipts) and meet external debt liabilities and this obviates the need for any policy actions now.
There are several problems with this short-sighted and self-serving view. One, reserves held by the State Bank are $12.8 billion. The remaining $4.1 billion held by commercial banks are matched by equivalent foreign exchange liabilities to their deposit holders. The international practice is not to regard these as reserves. Two, the bulk of the State Bank reserves is borrowed money including roughly $8 billion from an IMF loan.
Three, and more substantively, the calculation that a comfortable level of reserves will hold through the year rests on precarious ground. Once political and economic uncertainty combine to erode confidence reserves can start depleting quite rapidly in a hard to control process. Several factors can intervene to puncture the governments calculation.
In an environment of evaporating confidence and concerns about instability people will begin to hedge against uncertainty by changing rupees for dollars. This will intensify pressure on the exchange rate. A rise in import demand driven by the speculative dynamics of an uneasy economic outlook can also place an additional burden on the balance of payments. This can also intensify capital flight.
This can result in an unanticipated drawdown of reserves and a looming foreign exchange crisis. If external factors higher oil prices beyond the countrys control also kick in, the ineluctable consequence will be further depletion of reserves to meet a rising import bill. This in turn will bring the country a step closer to insolvency.
This suggests that there is little basis for the governments assumption that it neednt worry about an economic crisis erupting in 2012 and can therefore leave that possibility to be contemplated and confronted after the elections. Several macroeconomic indicators point to a disturbing trend. Together with policy paralysis they can accelerate two kinds of dangers to economic stability: hyperinflation and a balance of payments crisis. The latter could be a replay of 2008 when the twin deficits of the budget and external account soared to record levels forcing Pakistan to turn to the IMF for emergency funding to avert a possible default.
Among the more troubling indicators is the spike in government borrowing both from the central and commercial banks. Borrowing for budgetary support hit a record high of Rs840 billion in the first half of the current fiscal year compared to Rs208 billion in the corresponding period of the previous year. This reflects increasing requirements to finance the widening fiscal deficit that could easily reach eight percent of the GDP this fiscal year.
Meanwhile the burden on the budget has been increasing due to the governments inability to meaningfully address the problem of insolvent public sector enterprises and the rising cost of power sector subsidies. These are estimated at over one billion rupees a day. The governments decision to assume PSE debt by issuing special bonds of around Rs400 billion is a questionable effort that shifts the fiscal burden to monetary policy.
The trade deficit has also been widening. The export surge in the previous fiscal year turned out to be temporary. Latest figures show exports to be stagnating. The trade deficit rose to $11.4 billion in July-December 2011 compared to $8.2 billion in the corresponding period in 2010. Because the export rise represented a price (higher world commodity prices) and not a volume effect it was bound to be short-lived.
More disconcerting is the fact that declining exports also reflect the onset of recession in western markets and production disruptions caused by the energy crisis at home. As no quick easing can be expected on either of these fronts a further fall in exports is possible. This will increase the requirements to finance the balance of payments deficit.
Already the current account deficit has shot up to over $2.1 billion in the first six months of this fiscal year. This negative trend is likely to consolidate in coming months due to a higher import bill and servicing of external debt including payments due to the IMF between February and June 2012. This will happen at a time when foreign inflows are drying up.
Financing external payments in excess of remittances will further run down reserves. Along with high domestic inflation this will put the exchange rate, which depreciated substantially in the first part of this fiscal year, under greater stress. The rupee traded at a record low, over Rs90 to a dollar earlier this month, reflecting market anxiety over the deteriorating economic outlook and rise in import payments. Official interventions to defend the exchange rate will only drain foreign exchange reserves.
All this means that public finances are now in deep disarray. This situation can only be reversed by a change of course that a reform-averse government has shown no inclination to undertake. This has aggravated a runaway fiscal crisis that is now threatening to push the economy over the precipice. What can hasten this process is the present political gridlock. At a time when the countrys finances are crumbling and political survival is trumping everything else, continuing uncertainty can propel Pakistans more quickly into an economic abyss.
