Pakistan Must Raise Lending Rates, Cool Economy: Andy Mukherjee
By Andy Mukherjee
Nov. 9 (Bloomberg) -- Bondholders are getting less jittery about the risk of Pakistan's economy overheating and stalling.
Looking at credit-default swap prices, Prime Minister Shaukat Aziz, the architect of Pakistan's spectacular economic revival in recent years, must feel relieved.
The cost of buying protection against default by the Pakistan government on $10 million of sovereign debt fell to $181,250 this week from $285,000 on June 26.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a borrower's ability to repay debt. The moderation in the insurance cost shows that bondholders are discounting the threat posed to the rapidly growing economy by the ``unholy trinity'' -- booming consumerism, burgeoning state spending and cheap money.
Pakistan's trade gap widened 32 percent in the first quarter of the fiscal year that began July 1. Imports rose 13 percent from a year earlier, while export growth was about 3 percent.
The trade imbalance has been exaggerated by oil prices. Machinery imports to create new capacity have also played a part. ``Perhaps the most troubling aspect of the import bill is the dark side of consumerism -- the increasing volume of consumer goods imported,'' said Ahsan Javed Chishty, an economist at securities firm BMA Capital Management Ltd. in Karachi. Led by autos, consumer durable imports jumped 42 percent from a year earlier in the nine months through March 2006, Chishty said in an Oct. 15 note to investors.
Election Cycle
Although tax collection is on target -- not surprising for an economy projected to grow 7 percent or more this year -- there is ``no sign that fiscal policy will be less expansionary ahead of elections in 2007,'' Irene Cheung, an analyst at ABN Amro Holding NV in Singapore, said in a note to investors this week.
The government's budget for the current year includes a planned 15 percent increase in civil-servant wages and similar gains in pension payments and subsidies on everything from food and fertilizer to energy and cement.
With the Asian Development Bank predicting Pakistan's budget deficit at 5 percent of gross domestic product for the current fiscal year, higher than the government's 4.2 percent target, the onus is on the central bank to cut total demand in the economy.
The State Bank of Pakistan boosted the discount rate by half a percentage point to 9.5 percent in July, the first increase in the benchmark in 15 months. Simultaneously, the monetary authority cut liquidity in the banking system by raising reserve requirements to 25 percent of deposits from 20 percent.
Fighting Inflation
Inflation, which in September hovered close to a 13-month high of 8.9 percent, may slide back, allowing the government to meet its target of a 6.5 percent climb in consumer prices this year, the Asian Development Bank said last week.
It might take another round of interest-rate increases to tame inflation; and the expectation is that the central bank would rather raise the cost of credit than allow its hard-won macroeconomic stability to come under a cloud.
While announcing a review of Pakistan's B2 foreign-currency rating, five levels below investment grade, for a possible upgrade, Moody's Investors Service yesterday struck a cautionary note about overheating. ``Despite its optimism over the state of Pakistan's economy, Moody's maintains some reservations concerning persistent inflationary pressures, the deteriorating current account balance and a relaxation of fiscal policy,'' the ratings company said.
Foreign direct investments, remittances from Pakistani workers in the U.S. and Saudi Arabia, and the overseas money pouring into the Karachi stock market, Asia's best-performing in the past five years, are all supporting the widening current account gap for now. Yet there's no room for complacency.
Reserves, Risks
Pakistan has about $14 billion in foreign-exchange reserves, which can only pay for about six months of imports.
While that would have been considered a healthy level before 1990, the average for developing countries nowadays has risen to about eight months of imports.
Pakistan's capacity to sustain a sudden loss of confidence in its currency is greater than it used to be, though it is by no means permanent. For more-sustainable financing of the current account gap, the political risk premium must narrow, BMA Capital's Chishty said.
That might be difficult in the short run.
Even if it's ultimately successful, the peace process with neighboring India will be long. Meanwhile, relations are souring with Afghanistan, where the government in Kabul accuses Pakistan of helping the Taliban regroup.
Musharraf's Next Move
There are also fragile internal politics to consider: In August, a no-confidence motion against Prime Minister Aziz had the backing of 136 lawmakers, 36 short of the number needed to topple him. ``And it is these 36 votes that will determine the state of government come 2008,'' Chishty said.
Investors are also unsure if President Pervez Musharraf will give up his job as the army chief when parliamentary approval for him to run both the state and the military lapses in 2007. If he does become a civilian president, how stable will Pakistan's political system be?
A capital-account surplus of $8 billion this fiscal year will comfortably cover a current-account deficit of $6.5 billion, Chishty said. However, if that shortfall widens to $8.5 billion, as forecast by the Asian Development Bank, financing it will become a much tougher proposition.
The business cycle needs containment, even as the election timing demands there be no letup in expansion.
The State Bank of Pakistan should have no hesitation in hitting the brakes.
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