The writer is special adviser to the Jang Group/Geo and a former envoy to the US and the UK.
The political temperature continues to rise in the country. With that speculation mounts as to when general elections will be called. Although the media is focused on the government-judiciary standoff and the opposition’s challenge, economic realities rather than political battles will likely determine the election timing.
Looming large in the government’s calculus of when to go to the polls will be the increasingly perilous state of public finances and the steadily deteriorating economy. Until recently the ruling coalition smugly assumed it would coast along to elections, due in early 2013, without encountering an economic crisis. Now it cannot be so sure.
The downward economic spiral is being accelerated by a number of unmitigated, negative trends. Internal and external financial imbalances are worsening, national debt has hit an unprecedented level and energy shortages continue to cripple businesses and spark public protest. Also the prospect is growing of balance of payments vulnerabilities producing a full-blown financial crisis sooner rather than later.
Meanwhile the PPP-led coalition continues to send different signals on election timing to keep its political rivals off balance. At times it hints at early elections once the budget is out of the way. But after the Supreme Court found Prime Minister Yousuf Raza Gilani guilty of contempt, PPP leaders vowed not to yield to demands for early elections especially when opposition leader Mian Nawaz Sharif raised the ante.
Behind this political posturing lies an ineluctable reality. The deteriorating state of the economy will be the crucial factor in the ruling party’s decision about when to go to the polls. No government after all can take the risk of a 2008-type financial crisis emerging before seeking the electoral mandate.
There are unmistakable signs now of a gathering economic storm in the absence of tough policy measures that the government will simply not take before elections. This also explains why the government “informally” approached the IMF last month – according to reliable reports – for discussions on a new programme and fresh funding to stave off a possible foreign exchange crisis.
The economic scenario in fact becomes bleaker by the day. Growth is stagnating, domestic and foreign investment has dried up, the budget deficit has ballooned to its highest point since 2008, government borrowing has reached a record level and the runaway fiscal problem is pushing the economy to the precipice. Interagency debt and power losses have reached an alarming level and now threaten financial, and indeed social stability.
Among many disturbing economic trends, the widening current account deficit in the country’s balance of payments has emerged as the major near-term risk to financial stability. According to the State Bank this widened to $3.08 billion in the first nine months of the ongoing fiscal year. Finance Ministry projections suggest this will reach $4.1 billion at the end of this fiscal year.
The latest trade figures confirm what many experts had warned – that the export ‘surge’ two years ago would be transient, as it reflected a price, not volume effect, and that the import bill would rise substantially due mainly to higher international oil prices.
This is exactly what has happened with the trade gap widening to $17.7 billion in ten months, $5.5 billion more than the officially estimated annual figure, with two months left in this fiscal year. Exports have stagnated while imports have surged making the trade gap 45 percent higher than in the same period in the previous year.
Remittances from overseas workers remain robust. But they are not sufficient to meet financing requirements of the balance of payments at a time when the capital account has been deteriorating as net inflows taper off. With foreign capital inflows drying up and official expectations of US financing failing so far to materialise, an inescapable consequence looms. This is a draw down of foreign exchange reserves to meet accumulated external liabilities, including to the IMF. The first instalment of repayments on the IMF loan of $8 billion was made in February. Another is due this June.
As reserves begin to deplete at a time when net foreign inflows have turned negative, it will become increasingly difficult to finance a larger current account deficit. This risk has been heightened by the government’s inability to secure the alternate financing it was counting on by the sale of 3-G licenses collection of proceeds from PTCL’s privatisation to Etisalat, and early resumption of US assistance.
Unless the government is able to raise funds from somewhere, the spectre looms of an economic emergency resembling that of 2008, when the country was on the brink of external debt default. At that time when elections were around the corner and policy paralysis ensued, foreign exchange reserves plummeted and the budget deficit reached a dangerous high. Record budget and balance of payments deficits and erosion of confidence produced a foreign exchange crisis. This was resolved only by emergency funding from the IMF. This time around a rescue package from the IMF appears unlikely without the government undertaking front loaded, tough policy reforms.
In the past couple of years government officials pointed to the build up of foreign exchange reserves to dismiss suggestions of a relapse into a 2008-like situation. They chose to overlook the fact that the bulk of ‘record’ reserves were borrowed funds including $8 billion from the IMF loan. Now official complacency has given way to growing anxiety about the rapidly weakening external position and rising balance of payments vulnerabilities.
In its last quarterly report released in March, the State Bank acknowledged that “the external sector had weakened at a rate faster than expected and the fall in financial and capital inflows had exerted pressure both on foreign exchange reserves and the rupee.” It warned that financing the current account deficit would be a “challenge” as both debt and non-debt inflows had fallen.
This situation has compelled a government that allowed the previous IMF arrangement to end last year, to again contemplate a Fund programme in the coming fiscal year. Whether or not this materialises it does suggest that the government may now be calculating that it might not be able to reach the end of its term next year before the onset of a cash flow crisis.
The biggest challenge, as reserves begin to deplete, would be to anticipate and act before market confidence is shaken by the pressure of falling reserves. Experts who focus only on absolute reserve numbers miss the point by ignoring the psychological ‘confidence factor’. There is an indeterminate point at which falling reserves begin to erode confidence. Once this happens reserves start to deplete quite rapidly in a process with an unstoppable momentum.
In an environment of incipient crisis people will hedge against mounting risk by converting rupees to dollars. This can intensify pressure on the exchange rate. A rise in import demand fuelled by the speculative dynamics of a deteriorating economic outlook can then put additional stress on the balance of payments and intensify capital flight.
This in turn can result in a precipitous drawdown of reserves, which would accelerate a foreign exchange crisis and push the country closer to insolvency.
The government’s budget financing by heavy bank borrowing has not yet translated into hyperinflation because the drawdown of foreign exchange reserves to finance the rising current account deficit is offsetting the monetary impact of excessive creation of net domestic assets in the banking system. The crisis, both of external debt default and of high domestic inflation will hit even harder when reserves are unavailable to finance the external deficit and neutralise the inflationary impact of excessive domestic government borrowing.
The government will obviously try to avert this dire outcome. But it would prefer to hand over responsibility to a caretaker government much before the economy goes into a tailspin. The need to shift the burden of dealing with such a crisis will likely compel the government to call elections earlier than it might otherwise want.