Widening GDP, fiscal, external deficits pose serious risk to repay foreign debt

ISLAMABAD: While extending warnings about eroding macroeconomic stability amid widening fiscal and external deficits, the International Monetary Fund (IMF) has highlighted that Pakistan’s Net International Reserves (NIR) have declined from $7.476 billion in September 2016 to negative $0.724 billion till mid Feb 2018, posing serious risks to the country’s ability to repay its external debt and liabilities.

“Risks to this outlook are largely on the downside, given a difficult political setting and the possibility of further widening external and fiscal deficits in the coming months,” the IMF states in its latest Post Programme Monitoring (PPM) report released on Thursday.

The awaited PPM report released by the IMF after getting approval from Pakistan’s Prime Minister Shahid Khaqan Abbasi states that Pakistan’s macroeconomic stability gains achieved during the EFF have been eroding amid widening external and fiscal imbalances.

It states that risks to Pakistan’s medium-term capacity to repay the IMF loans could increase on current policies. An elevated current account deficit and increased external obligations are expected to double external financing needs in the medium term, taking a further toll on foreign exchange reserves.

While real GDP growth has continued to accelerate, external and fiscal imbalances have significantly widened in the context of strong domestic demand growth, limited exchange rate flexibility, accommodative monetary policy, fiscal slippages, and limited progress with key structural reforms.

As a result, foreign exchange reserves have been declining, despite significant public sector external borrowing in recent months. “Alongside, risks to Pakistan’s medium-term capacity to repay the Fund have increased. An elevated current account deficit and increased external obligations are expected to double the external financing needs in the next three to five years, which could take a further toll on foreign exchange reserves” the PPM report states.

As a result, scheduled repayments to the Fund as a share of gross reserves could rise to nearly 15 percent by 2022. Risks to this outlook are largely on the downside, given the difficult political setting and a possible further widening of the external and fiscal deficits in the coming months.

A significant refocusing of near-term policies is needed to arrest the widening imbalances and preserve macroeconomic stability. Swiftly addressing the fiscal and external imbalances will be important to mitigate the substantial downside risks.

The authorities’ recent moves to tighten monetary policy and to allow some exchange rate adjustment are welcome and should be complemented with further steps to phase out foreign exchange interventions to preserve external buffers and improve competitiveness, while allowing for greater exchange rate flexibility on a more permanent basis. Administrative measures to support the balance of payments should be phased out as soon as conditions allow. Alongside, further monetary tightening, stronger fiscal discipline, and decisive efforts to contain losses in public enterprises would help reverse external imbalances and reduce fiscal risks.

It further states that Pakistan’s economic growth has continued to strengthen. Improved energy supply, investment related to the China-Pakistan Economic Corridor, strong credit growth, and continued investor and consumer confidence, have been underpinning growth, which could reach 5.6 percent this fiscal year within a favourable inflation environment. “Yet, macroeconomic stability gains achieved during the 2013–16 EFF have been eroding, putting this outlook at risk,” it states and added that the current account deficit has been quickly widening, reflecting strong domestic demand amid an overvalued exchange rate, fiscal slippages, and an accommodative monetary policy stance.

As a result, foreign exchange reserves have been declining, reaching 2.3 months of imports as of mid February 2018, despite significant external borrowing. Net international reserves have declined from $7.5 billion at the end of the EFF to negative $0.7 billion in mid-February 2018. As a result of fiscal slippages in FY 2016/17, debt-related vulnerabilities have increased.

Policy efforts need to focus on arresting the widening imbalances, preserving macroeconomic stability, and supporting private-sector-led inclusive growth. The authorities’ recent moves to tighten monetary policy and to allow some exchange rate adjustment are welcome and need to be complemented with continued exchange rate flexibility to safeguard external buffers. Going forward, further monetary tightening, stronger fiscal discipline, and decisive efforts to contain losses in public enterprises would help address external imbalances and fiscal risks. Careful phasing in of new external liabilities, resuming medium-term fiscal consolidation, and accelerating other growth-supporting structural reforms will be critical to reinforce macroeconomic stability and promote higher and more inclusive growth.

Against the background of limited exchange rate flexibility, international reserves have significantly declined, eroding confidence.

Maintaining a largely stable nominal exchange rate amid mounting external pressures has led to losses of international reserves. Despite significant external borrowing by the government, including several syndicated bank loans and an international Sukuk and Eurobond issuance of $2.5 billion, gross reserves of the State Bank of Pakistan (SBP) declined from $18.5 billion at the end of the EFF to $12.8 billion in mid-February 2018—equivalent to 2.3 months of prospective imports, or 50 percent the IMF’s reserve adequacy (ARA-EM) metric.

Alongside, the SBP's net short derivative position has doubled to $5.4 billion, bringing net international reserves (NIR) down from $7.5 billion to an estimated negative $0.7 billion over the same period. Following strong growth until May 2017, the stock market has corrected by nearly 20 percent, while external bond spreads have remained relatively close to emerging market averages.

External sector imbalances are expected to rise further. Despite continued recovery of exports and some moderation of import growth, the current account deficit is expected to widen to $15.7 billion (4.8 percent of GDP) this year. In the medium term, the current account deficit is expected to remain elevated at about 3.8 percent of GDP, owing to continued real exchange rate misalignment and slow recovery of remittances. On current policies, and based on the authorities’ ambitious external financing plans, gross international reserves are expected to further weaken to $12.1 billion (2.2 months of imports) this year, with risks skewed to the downside. Reserves are expected to continue declining in the medium term. The fiscal deficit will likely remain elevated.

On current policies, staff projects the budget deficit (excluding grants) to reach 5.5 percent of GDP this year (5.9 percent of GDP underlying deficit excluding one-off operations). Stronger tax revenue (12.9 percent of GDP, up from 12.5 percent last year)—owing to robust import growth, higher oil prices, the recent exchange rate depreciation, and imposition of regulatory duties—and lower interest expenditure are expected to provide a moderating effect on the deficit.

In addition, the authorities’ decision to restrain the budgeted surge in development spending and to closely coordinate with the provinces to maintain fiscal discipline will be helpful. That said, the pre-election period could pose significant risks to maintaining fiscal discipline. Over the medium term, quasi-fiscal losses and arrears by PSEs are expected to persist and the fiscal deficit will likely remain elevated, at around 5.8 percent of GDP, as growing interest expenditure and PSE’s subsidy requirements would be counterbalanced by improvements in revenue collection.

Pakistani authorities expect higher growth and lower imbalances in the period ahead. The authorities thought that staff’s baseline scenario does not adequately reflect their recent policy measures aimed at fiscal consolidation and improving the external account, including through containing development spending, exchange rate adjustment, and measures to curtail imports and promote exports in the short term. The authorities believe that these will generate a significant fiscal impact and restore sustainability of the balance of payments in the medium term. Under an upside scenario based on the authorities’ projections, faster revenue growth, supported by ongoing efforts to broaden the tax net, and a higher fiscal surplus at the provincial level would contain the general government budget deficit (excluding grants) to 5 percent of GDP in FY 2017/18.

In addition, a stronger impact of the recent exchange rate depreciation and other policy measures on the trade balance could help contain the current account deficit to 4.4 percent of GDP in FY 2017/18. With this, gross reserves could stabilise at about $13.9 billion this year and recover to 2½–3 months of imports in the medium term.  

Macroeconomic stabilisation gains and the ongoing cyclical momentum would lift real GDP growth to 6 percent this year and 6.5 percent in FY 2018/19, supported by higher investor confidence. The authorities also emphasised their resolve to take additional policy measures to address the current macroeconomic vulnerabilities as needed, the report concluded.