The financial meltdown

The economy is moving irrevocably towards a big financial downturn. The balance of payments numbers for 2017-18, released recently, highlight the magnitude of the impending problems in 2018-19. The trade deficit, on a quarterly basis, has risen systematically from $7.3 billion in the first quarter to $8.7 billion by the fourth quarter. For the year as a whole, the trade deficit is $31 billion, equivalent to almost 10% of the GDP. Imports are now 224% of exports.
Similarly, the current account deficit has shown a quarterly rising trend. The deficit was $3.5 billion in the first quarter and has increased by 66% to $5.8 billion in the last quarter of 2017-18. The annual current account deficit has approached $18 billion, equivalent to 5.8% of the GDP. This is the highest deficit ever in absolute terms and the second highest after 2007-08 as a percentage of the GDP.
The conclusion by now is that the measures on both the export and import fronts have failed to narrow the trade deficit. Imports have continued to exhibit fast growth at 14% per annum. The combined moves of imposition of regulatory duties on selected items, 100% cash margin on luxury goods and devaluation of the rupee by almost 15% failed to bring down the level of imports.
Exports have shown growth after a lapse of four years. However, the growth rate at 12.6% has remained lower than the increase in imports of 14%. Also, almost one-third of the increase is due to the higher international price of rice and subsidized exports of wheat and sugar. The increase of about 9% in exports of textiles and other manufactures has been somewhat disappointing in the presence of the sizeable export incentive package.
The current account deficit of $18 billion has been financed to the extent of 66% by inflows mostly into the financial account of the balance of payments. The remainder, 34%, has been catered for by a big decline in foreign exchange reserves of $6.4 billion. These reserves stood at $9.8 billion at the end of 2017-18, not even enough to provide import cover for two months.
Actually, the ‘true’ level of reserves is even much lower. The month of June 18 saw an injection into the SBP of ‘swap’ funds of $1548 million, presumably from China. Earlier, foreign currency deposits with the commercial banks have also been largely swapped with SBP. As such, the reserves, net of swap funds, are probably not much more than $2 billion.
This is beginning to be reminiscent of what happened after 1996. On paper, foreign currency deposits were reported at the time as in excess of $8 billion, but in reality the actual availability and backing of these deposits with dollar balances was only $1 billion or so. Almost $7 billion had been used up earlier to finance imports. This implied little buffer against sanctions in 1998 after the bomb explosion. Eventually the foreign currency deposits had to be paid out in rupees in 1998.
The financial situation is very fragile because if reserves drop further then a point will be reached when the foreign currency deposit funds will begin to be used once again to finance imports. This must be avoided at all costs.
What then are the short-term prospects for the country’s external transactions and their sustainability? During the last quarter of 2017-18 and the first two weeks of July 2018, reserves of SBP have been falling weekly by almost $400 million. If there is some delay in the formation of the new Government following the elections then reserves could dip further by over $1 billion.
The problem is that if we are to go to the IMF for a bail out then any undue delay reduces the ability to negotiate with the Fund. The IMF is also likely to be concerned with Pakistan’s ability to repay the past EFF loan of $6.4 billion. A repayment of almost $ 500 million is due this year. This will increase to almost $ 900 million in 2019-2020 and to over $1150 million in 2020-2021.
The magnitude of the problem can be assessed by estimating the external financing requirements for 2018-19. The year, 2017-18, has closed when the financing needed to cover the current account deficit and total external debt repayment was $24 billion.
During the current financial year, the current account deficit is unlikely to come down in relation to the level last year of $18 billion. There may even be some increase. Inclusive of the rising burden of external debt repayment, a conservative estimate of the external financing requirement for 2018-19 is $ 28 billion. This is the case especially if reserves are to be kept at about two month level of imports to preserve the ability to borrow internationally.
The gross inflow into the financial account was under $18 billion in 2017-18, inclusive of $2.7 billion of FDI, $1.5 billion of ‘swap’ funds, $2.5 billion from the flotation of Euro/Sukuk bonds, $11.3 billion of gross borrowing and from other sources. Even if this quantum of financing is replicated in 2018-19, there will remain a gap of $10 billion.
Will the IMF be willing to extend a loan facility of $10 billion in the first year of a new Program? This is unlikely as only about $6 billion is left in the SDR quota of Pakistan with the Fund. Clearly, for this to happen the IMF will have to be generous with Pakistan as it has been with other borrowers like Greece and Argentina.
However, this is unlikely unless Pakistan is willing to accept, first, harsh prior actions including a big further devaluation of the rupee, rise in tax rates and energy prices and cut in development spending including a slowdown of CPEC. Second, other difficult actions may be asked for behind the scenes on the non-economic front, including possibly a compromise on the security front.
The only card that we have at this point is that the Fund would like to avoid a situation where Pakistan is unable to start repaying its earlier loan. But a quantum jump in financing is very unlikely.
The bottom line is that the country is in such a big financial quagmire that going to the IMF will not solve fully the problem. Even in the presence of a Fund Programme, draconian measures will still be required in the first half of 2018-19 to reduce the financing needs and prevent depletion of the residual foreign exchange reserves.
Unfortunately, the time of ultimate reckoning has come. The new Government will have the extremely difficult task of taking Pakistan out of the financial meltdown that is ongoing currently. We hope and pray for its success.

Courtesy: Business Recorder

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