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Opinion

December 15, 2011

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Evading crisis

Evading crisis
The current economic management team has been sitting relaxed taking no real initiative to move the country out of its deep rooted economic problems.
The budget deficit is out of control and the political leadership is unwilling/unable to take fiscal measures to raise revenue and reduce expenditure. As a result, the economic management team has found an easy way out to finance the rising budget deficit through bank borrowing, the only tactical change being a shift from direct borrowing from the SBP last year to borrowing from commercial banks. This round about method of budget financing by the SBP is equally inflationary, highly hurtful for the private sector and increasingly risky for commercial banks.
The government-driven expansion in the net domestic assets of the banking system has begun to find its way in the foreign sector in the form of depreciation of the exchange rate and drawdown of foreign exchange reserves.
The public reaction to the rising rate of inflation may not be strong enough to compel the government to reduce its excessive bank borrowing, but there is no doubt that it will steadily put pressure on the balance of payment leading to fast depletion of foreign exchange reserves. The real question is not whether or not reserves will continue to go down, but rather how long the reserves can last before the emergence of a foreign exchange crisis.
The existing level of foreign exchange reserves, built with repayable borrowed funds, is providing false comfort and a sense of complacency to the economic team misleading it to believe that they can weather the storm beyond the forthcoming elections without policy reforms/foreign exchange crisis. However, the approach to continue to finance the budget deficit by borrowing from the banking system and to rely on the drawdown of foreign exchange reserves to finance the widening balance of payment deficit is both unwise and unsustainable.
In addition to the severe harm that such an approach will inflict on an already fragile economy, there is a real possibility that the government may get trapped in a foreign exchange crisis before the end of its current tenure.
The government will never run out of rupees as long as the State Bank of Pakistan is willing to accommodate it. But neither the SBP nor the government has the ability to print dollars, and the threat of exhaustion of foreign exchange reserves needs to be taken seriously.
When foreign exchange reserves fall below a critical threshold, say, below $10 billion, increasing speculative demand for foreign exchange will accelerate the process of depletion of reserves.
It maybe added that without taking measures to bring the budget under control and stop reliance on bank borrowing to finance the rising budget deficit, there is no chance that the government can get into another standby arrangement with the IMF. In the circumstances, the government will have to find a way to escape the bullet of potential external debt default on its own or face its consequences.
While we do not have access to all the necessary information for a precise forecast, our back-of-the-envelope calculations based on published data make it clear that in the absence of economic reforms the government may face a foreign exchange crisis before the end of 2012.
The foreign exchange reserves of the SBP stood at $12.9 billion on December 2, 2011. In October, the last month for which data are available, the country recorded an overall deficit of $635 million in its balance of payment. If it is taken as the average deficit per month up to December 2012, the reserves will decline to $4-5 billion by end-December, 2012 on that basis. Additionally, the SBP will have to repay $2.4 billion to the IMF before December 2012, reducing reserves to an alarmingly low level. Speculative purchase of dollars for imports and capital flight may expedite the timing of the foreign exchange crisis.
Looking at the situation in another way, we arrive at the same conclusion. The current account deficit stood at $1.6 billion during the first four months of the current fiscal year, the latest period for which data are available. If the same trend continues up to end-December, 2012, there will be an additional current account deficit of $5-6 billion during November, 2011-December, 2012. Its financing, combined with the IMF repayment of $2.4 billion, will bring down reserves to less than $5 billion by end-December, 2012.
Additional drawdown of reserves will depend on the extent of deficit in the other capital account items, which will most likely be in a large deficit both because of reduced disbursement of foreign loans and increased amortisation payments excluding those to the IMF. There may easily be an additional drain on reserves in the range of $1 billion to $2 billion up to December 2012, depending on the level of disbursement of new long term loans. According to these calculations, and if nothing unusual happens, SBP reserves will decline to $2-3 billion by the end of December, 2012.
If the flow of remittances slows down from the recent levels or there is a large net capital outflow or a sharp decline in direct and portfolio foreign investment those would be added adverse factors.
In a crisis, the government will be tempted to engage in unusual measures like oil imports on deferred payments or market-based borrowing from abroad by floating bonds on expensive terms or mortgaging future remittances to tide over the looming foreign exchange shortage, but that will only accentuate the problem in the long run.
Rather than relying on unsustainable and expensive stop-gap arrangements when the crisis begins to knock at the doors, the government should evaluate its options well ahead of time and act promptly to avoid the emergence of a foreign exchange crisis.
The best course is to take budgetary reform measures to lower budget deficit and reduce reliance on domestic bank borrowing and negotiate a new standby arrangement with the IMF. If the IMF involvement is to be avoided, then the economic team will be well advised to draw up a contingency plan to preserve reserves that should include steps to increase exports, attract more foreign remittances and curtail imports and at the same time start implementing its own home-grown programme of major economic reforms.
The main point is that the government should act now to avoid the emergence of a foreign exchange crisis in the near future rather than to handle it haphazardly when it actually takes place.

The writer is a former governor of the State Bank of Pakistan.
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