Towards Stagnation

The new government in Islamabad will be faced with very difficult choices. If it goes to the IMF, as happened in 2013, then the required actions could include steep devaluation, a hike in tax rates, a big cut in development spending, escalation in power tariffs, etc.

By: Dr. Hafiz A. Pasha
Published: February 12, 2018
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2018 is likely to be characterised for us with extremely high uncertainty on both the political and economic fronts.

The year started on a grim note with an announcement from Washington that the US authorities have decided cessation of assistance to Pakistan, both security-related and economic.

At home, the ruling PML-N suffered a major jolt in the collapse of its coalition government in Balochistan following a rebellion in its ranks that caused the resignation of the provincial chief minister.

The national scene was further aggravated by the public outcry, and subsequent police brutality, in the Punjab city of Kasur after the kidnapping-rape-murder of a local eight-year-old girl, Zainab, by a paedophile.

The opposition parties are trying to build pressure on the Punjab government, demanding the resignation of Chief Minister Shehbaz Sharif on the Model Town tragedy.

Earlier, the month of December saw the first move towards devaluation of the rupee after almost four years. The currency has since fallen by about 5 percent in the inter-bank market.

Meanwhile, to oversee the economy, a new finance team has been put in place at the Centre, with two technocrats and a parliamentarian, while the prime minister continues to be the finance minister.

Further action on the exchange rate will probably be postponed till after the elections, as the incumbent government is unlikely to be willing to bear the political cost of higher inflation at this time.

Hopefully, an uninterrupted political process would see the third successive civilian government completing its tenure in 2018. The incumbents will relinquish power within the next five months to a caretaker setup with the primary responsibility to hold general elections. A new, elected government will then be inducted for the next five years.

In the face of these political events, the economy may take a back seat despite the indications of an incipient financial crisis.

Among a number of equally relevant questions about the economic prospects for 2018, the two fundamental ones are: where does the economy stand today and how vulnerable is it to a full-blown financial crisis in the latter part of 2018? What impact will this have on the lives of the people, especially the poor?

I have attempted to answer these queries in two parts. The first describes the current state of the economy, while the second presents the scenario of the balance of payments in the presence of an incipient financial crisis.

Mixed signs

The economy is currently showing some mixed signs.

The initial expectations about the growth of the agricultural sector are unlikely to be realised. The area sown under cotton has remained low and there have been reports of pest attacks. The latest estimate is that the output will be below 12 million bales.

The forthcoming wheat crop is likely to be hit by a severe water shortage during the Rabi season.

Consequently, the overall growth rate of the agricultural sector is unlikely to exceed 2.5 percent in 2017-18.

The large-scale manufacturing sector has started well in 2017-18. Up to October, the growth rate recorded is close to 10 percent.

In subsequent months there could be some loss of momentum due to delayed start of crushing by sugar mills, decline in refinery output due to phasing out of furnace oil in electricity generation, limited growth in quantity of textile exports and failure of some industries to compete with relatively cheap imports.

Overall, the GDP growth rate in 2017-18 is unlikely to be significantly above 5.0 percent, as shown in Chart 1. The SBP has projected a range of 5.0 to 6.0 percent, while the World Bank and the IMF expect a figure approaching 5.5 percent.

The rate of inflation remained low up to November 2017. December witnessed a small upsurge to 4.6 percent. Inflation is likely to accelerate in the coming months, due particularly to rising oil prices and electricity tariffs. It is expected to approach 7.0 percent by June 2018.

    Exports have started growing in 2017-18 for the first time since 2013-14. There has been some positive response to the export incentive package and the prices have been significantly higher in the case of rice, cotton cloth, bed wear and readymade garments.

This improvement is likely to be sustained and the annual growth rate may reach 12 percent.

Imports have continued to show, more or less, the same high growth as in 2017-18. Product groups like oil, transport equipment, iron and steel, textile inputs, etc., have all shown high growth rates. Imports of machinery have moderated somewhat.

However, rising oil prices are likely to put pressure on the import bill. Consequently, imports are expected to show a high double-digit growth rate of 16 percent in 2017-18. This will imply that the trade deficit could increase by almost 20 percent, thereby leading to a larger current account deficit.

The critical numbers to watch would be the current account deficit as well as the overall balance of payments. Last year it jumped up well over two times to $12.4 billion equivalent to 4.0 percent of the GDP. This year it is likely to approach $16.8 billion, almost 5.0 percent of the projected GDP.

The SBP has projected the deficit in the range of 4.0 to 5.0 percent of the GDP, while the IMF expects it to exceed 4.0 percent.

Public finances are also under pressure in 2017-18. The growth in tax revenues is beginning to falter.  As the election approaches, the government is likely to go on a spending spree to consolidate its position. Already, in the first six months, the deficit has reached 2.5 percent of the GDP and is on its way to approaching 6.0 percent by the end of the year. Two years ago it had come down to 4.6 percent.


Incipient financial crisis

The process of destabilisation of the economy since 2016-17 continues unchecked with both the fiscal and current account deficits showing, more or less, explosive growth.

With the latter reaching $12.4 billion last year and approaching $16.8 billion this year, the fundamental issue is to find venues for financing this large gap. Otherwise, there will be enormous pressure on foreign exchange reserves.

By November 2017, reserves had fallen further by $3.4 billion. In December, the flotation of $2.5 billion Euro/Sukuk bonds stabilised the situation.

Currently, reserves stand at $14.1 billion, implying an import cover of close to three months. This includes short-term borrowing of over $6 billion by the SBP from the commercial banks against the foreign currency account deposits.

The new risk factor is the cessation of foreign assistance by the US. The direct impact is relatively small at less than $1.0 billion. However, there could be some major indirect implications.

First, this could increase negative perceptions of the credit worthiness of Pakistan especially if the IMF does not provide a ‘letter of comfort’ under US pressure. Already, agencies like the World Bank and the ADB have disbursed only 18 percent of the committed amount of $2.1 billion for 2017-18 in the first five months. Future commercial bank borrowing and bond flotation could become more difficult and more expensive.

The balance of payments position is becoming increasingly fragile with concomitant implications on the level of reserves.

The likely path of foreign exchange reserves up to end-September 2018 is presented in Chart 2. This is based on the assumption that the gap in the current account can be financed to the extent of 50 percent through foreign investment, plus net external borrowing, including another flotation of Euro bond of $1.0 billion.

The projection indicates that foreign exchange reserves could fall to below $10 billion by end-June 2018. This implies an import cover of less than two months.

By September 2018, reserves could decline further to below $6.0 billion, barely enough to provide import cover of more than one month. The economy will be back to the situation in 2013 when the PML-N government assumed power.

     The new government in Islamabad will be faced with very difficult choices. If it goes to the IMF, as happened in 2013, then the required actions could include steep devaluation, a hike in tax rates, a big cut in development spending, escalation in power tariffs, etc.

The likelihood of a tough programme is greater if the US puts pressure on the executive board of the IMF.

Unfortunately, irrespective of the path chosen, there is a real danger that the economy could go back to a period of ‘stagflation.’ Inflation may approach a high double-digit rate and the GDP growth rate could fall to below 4.0 percent in 2018-19.

We can only hope and pray that the new government later this year is able to manage the situation skillfully by adopting appropriate trade, monetary and fiscal policies and ensuring that the process of adjustment is front-loaded and the burden is equitably distributed.

About the Author
Dr. Hafiz A. Pasha
is the dean of Beaconhouse National University and the vice chairman of the Institute of Public Policy. He is also serving as the chairman on the Advisory Panel of Economists to the Planning Commission and as the Convenor of the Economic Council of the PM.