Pakistan has three options to get its economy back on track, but it would require the blessings of the Pakistani military-Jihadi complex
Pakistan’s new Prime Minister Imran Khan accurately diagnosed the economic problem of the country and emphasised on the immediate need to reduce debt. However, the solutions that he suggested were, at best, timid.
He spoke about austerity measures, reduction in corruption levels, channelling remittances through legal channels, and exhorted citizens to pay their taxes. But the scale of Pakistan’s economic problems is such that even a stellar execution on these fronts is unlikely to make a dent.
Barely left with forex reserves worth two months of imports, Pakistan is expected to negotiate a bail-out package with the International Monetary Fund (IMF) soon.
Typically, a currency crisis is the result of an overvalued currency and debt-fueled investment boom in non-tradable sectors like construction. Both these elements are present in the Pakistan economy in good measure. Between 2009 and 2017, Pakistani REER (exchange rate adjusted for relative inflation) has appreciated by an average of 3.5 per cent annually. Recent trouble in the external sector started in FY 2017 when the current account deficit (CAD) more than doubled in a single year, jumping from $5 billion to $12 billion. In FY 2018, the CAD is estimated to be around $18 billion (5.7 per cent of GDP).
With such a haemorrhaging current account, a paltry forex reserve of $10 billion is unlikely to make policy makers comfortable. There are three options on the table right now: securing a bailout package to prevent possible default; an immediate stabilisation strategy to bring CAD to a manageable level; and deep structural reforms that improve domestic productivity and growth. All three options are equally challenging right now.
Option 1: The bailout package
The usual candidates for this are China and the International Monetary Fund (IMF). Given the strained geopolitical relationship between China and the US (the largest shareholder of IMF), Pakistan will find it difficult to tap both sources at once. Since the outgoing PML-N government had availed an IMF credit facility just five years ago, negotiations with the IMF are likely to be far more onerous this time. Doubtless, the IMF will insist on tough conditions such as closer scrutiny over CPEC outflows, particularly so since the bailout package is likely to be Pakistan’s largest ever.
There are political constraints to this option as well. Asad Umar — now appointed as the new finance minister — had previously hinted that yielding to US’ political interests in Afghanistan will increase Pakistan’s chances of securing IMF loans. A correction in Afghanistan, however, requires the Pakistani army to rethink its strategy which it is unlikely to. What might instead happen is that the Pakistani army will amplify the so-called Islamic State’s presence in Afghanistan while projecting Taliban as the lesser of the two evils, a reconcilable actor that can be negotiated with.
China will be caught between the usual dilemma of lending more and pretending all is well and cutting its losses by reducing financial exposure. It will most likely opt for a ‘satisficing’ approach — prevent a catastrophic meltdown without making the kind of financial commitment necessary to tide over the crisis.
Option 2: Reduction of the current account deficit
Even if Pakistan manages to get a bailout package, they will have to do something to correct their burgeoning CAD. Their short-term stabilisation strategy will have to make a difficult choice between defending the currency by raising interest rates and letting it depreciate. This is a classic policy dilemma, as these strategies are somewhat diagonally opposite in nature. A high interest rate leads to capital inflow resulting in currency appreciation; conversely, expected currency depreciation triggers capital outflow and offsets interest rate hike.
As of now, Pakistan seems to be having the worst of both worlds. In 2018 itself, the State Bank of Pakistan has raised its policy rates three times. Now the reverse repo rate, the ceiling of the short-term interest rate corridor, stands at 8 per cent. Further increase will adversely affect domestic economic activity. But even devaluation is likely to be a costly option as many Pakistani corporations have acquired substantial exchange rate risk owing to CPEC. The Pakistani rupee has already lost around 14 per cent this year, making it one of the worst performing Asian currencies, according to a Bloomberg report.
Option 3: Undertake structural reforms
A balance of payment crisis is ultimately a symptom; the real problem is the weak productivity growth and structural problems in the economy. A credit-fueled boom, especially in the non-tradable sector, is bound to be unsustainable. Furthermore, Pakistan has one of the lowest tax-to-GDP ratios in the region, making it hard to provide public goods on a sustainable basis. A structural reform package will involve pruning unproductive government expenditure, increasing tax compliance and switching domestic expenditure away from imports. These measures are likely to be unpopular, at least in the short to medium term.
In his speech, Khan did not question why the Pakistani army continues to rapidly increase its defence expenditure despite achieving deterrence stability with India. Neither was there an acknowledgement that Pakistan’s policy of harbouring terrorist groups is the biggest impediment to sustainable economic growth. Clearly, these larger structural issues that have stunted Pakistan’s growth continue to remain out of bounds of the civilian administration. This predicament illustrates that as long as the Pakistani military-Jihadi complex continues to run the show, there won’t be anything Naya in Naya Pakistan.
Avinash Tripathi and Pranay Kotasthane are with the Takshashila Institution, a centre for research and education in public policy