Political disruption, panic behind temporary liquidity crisis
PAKISTAN media commentators and society as a whole seem to be in shock. The sharp and sharp fall of the rupee against the US dollar, the inflation rate of 24%, the depletion of foreign exchange reserves, a large unforeseen current account deficit, continuous peaks in the policy rate with its impact on interest rates. Bank lending, the slowdown in the approval of remittance imports, the erosion of market capitalization of listed companies have combined to create a situation of panic. Feelings of nervousness and uncertainty about the way forward have drawn speculators into the foreign exchange market, pushing the demand for the dollar beyond its true market-determined value.
Exporters are reluctant to convert their earnings in the hope of an even better rate. The fall in exports in July bears witness to this trend. Importers are keen to increase their normal demand for dollars to avoid further losses from future depreciation. The supply and demand mechanisms of a normally functioning market are distorted. From July 2018 to March 2022, the Rupee has depreciated cumulatively by 35% while over the past 3.5 months the fall has been 40% – quite an exceptional move.
The purpose of this article is to explore whether these extraordinary movements are the result of a solvency crisis (i.e. a default), a liquidity crisis or simply the result of a panic created by a fear unjustified and misperceptions. On solvency, the IMF’s latest debt sustainability analysis in its February 2022 Article 4 consultation report shows that public debt levels are likely to continue to fall provided Pakistan follows through. the adjustment path agreed under the Extended Financing Facility.
Economic fundamentals for foreign exchange earnings show a 27% increase in exports of goods and services and a 6% increase in inward remittances. Total foreign exchange earnings were $75 billion in the fiscal year ending June 2022, compared to $67 billion the previous year, a positive variance of 12%. Foreign exchange earnings represent the country’s ability to service its debt and its external commitments. Pakistan was able to repay principal and interest amounting to $16 billion despite the big external shock of the commodity super cycle which doubled and tripled fuel and food prices. Policy measures have been taken to stay on the path of adjustment. Subsidies on petroleum products have been removed.
POL proceeds were levied on the Petroleum Development Tax. Electricity tariffs were raised with rebasing and monthly and quarterly adjustments. The federal budget was revised with additional taxes worth 2.5% of GDP, with the provinces transferring 700 billion rupees as cash surplus and hence the primary budget would have a surplus of 0, 4% of GDP. Key rates have seen a steady upward movement in light of inflationary pressures. The exchange rate is determined by the market and not fixed by the SBP.
The way the debt burden is portrayed in popular discourse is highly flawed for several reasons. There is also a serious misunderstanding about the debt burden as figures of Rs 47 trillion are announced quite often. Debt in absolute terms of nominal rupees with horrible debt per head has been highly politicized.
Comparisons are made regarding the increase in the total stock of debt again recorded during the period 2008-2013 in absolute figures with those of 2014-2018 and 2018-2022. This annoying trend has spread and is now part of our popular folklore. First, total debt stock and liabilities are the sum of domestic debt and external debt. Converting the stock of external debt under a rapidly depreciating exchange rate regime would drive up the total number of rupee-denominated debt even if there is no additional borrowing of one dollar.
All opposition parties as well as their supporters in the media would castigate the ruling party for increasing the debt burden of the people of Pakistan due to its irresponsible behavior, incompetence and mismanagement. This blame game continues unabated with changes in government.
Second, the risks of domestic debt are quite different from those of external debt. While both create debt service liabilities for fiscal purposes and therefore affect fiscal balances, the risk profiles of the two vary from each other. Domestic debt must be paid in rupees which can be printed or the central bank can acquire these obligations on its balance sheet by creating reserve currency. This implies that possible inflationary pressures would be created, but there is no risk of default, which is a real threat in case of debt dominated by foreign currencies.
Countries that have suffered from debt crises have faced solvency and liquidity risks in managing their currency risk. Pakistan’s total outstanding debt and liabilities as of June 2022 consist of 60% domestic debt and 40% external debt. Therefore, the discussion of a potential default should focus on external debt and liabilities (EDL) and the ability to service that debt on time.
Third, the composition of debt by type of creditor is important. Pakistan’s total external debt and liabilities ($130 billion as of March 2022) consist of public and government-guaranteed (PPG) debt and liabilities of $109 billion and sector debt deprived of 21 billion dollars. Public debt and liabilities of $102 billion are borne by the Government of Pakistan and service payments are made through the budget.
The publicly guaranteed debt of $7 billion consists of loans contracted by state enterprises and financed from their revenues. Private sector debt is the obligation of private sector borrowers, but the SBP provides the currency cover for payments. It is therefore necessary to distinguish between the implication for the balance of payments and the budget of the federal government.
Fourth, solvency indicators assess the ability to repay loans in the long and medium term while liquidity indicators mainly concern the short term (less than one year) and maturities falling during this year. In the case of Pakistan, long- and medium-term loans represent 89% of EDL’s total public external debt. Taking an even more conservative view by including swaps, central bank deposits, Naya Pakistan certificates, portfolio investments and maturities to be settled under short-term debt, the total comes to 11, $2 trillion with the ratio of short-term debt to total EDL around 11% – not something to worry about.
The composition of long- and medium-term public debt is also skewed in favor of official creditors — multilateral institutions including the IMF (37%) bilateral governments (32%) or two-thirds of long-term debt. Only a third is in the form of bonds and sukuks (9%), commercial banks (8%) and central bank deposits (7%). Loans from multilaterals are concessional or mixed with maturities of 20 to 25 years, a grace period of 5 years and an interest rate below the market. Sri Lanka had 50% of its debt in the form of international bonds.
Let us now turn to the liquidity crisis. Yes, there is a short-term liquidity crunch as many bilaterals are also awaiting IMF program approval. The government also secured additional deferred oil payments and RLNG payment facilities from Saudi Arabia and Qatar, agreed to sell some of the shares of listed state-owned companies on a government-to-government basis. It would also strengthen its reserve levels after repayments and financing the current account deficit. Oil, wheat and cotton prices are falling on international markets. Import restraint measures would also help. Going forward, Pakistan’s external financing needs for the year 2022-23 are estimated to be $34 billion. According to the State Bank of Pakistan, this amount has been blocked. $16.4 billion would be disbursed by multilateral institutions and through the Saudi oil facility. $9 billion would be rolled over by the Chinese, Saudi Arabia and the United Arab Emirates. The IMF would release $4 billion as the remaining tranches. FDI and portfolio investment flows are expected to bring in $3.5 billion. Naya Pakistan bonds and certificates would fill the balance amount.
A review of the vulnerability coefficients for FY2022 reveals that public and publicly guaranteed (PPG) debt liabilities to foreign exchange earnings and PPG debt, and liabilities to exports of goods and services improved compared to FY2021, but there was a deterioration in PPG debt and foreign exchange reserve commitments for the reasons mentioned above.
The analysis above shows that the political turmoil since March 2022 and the uncertainty have created a temporary liquidity crisis in the foreign exchange markets with an abnormal downward movement of the rate. The panic created by this unfavorable movement had repercussions on the money and stock market, international commercial transactions and the real sectors of the economy. On the international scene, the contagion effect from Sri Lanka and other emerging countries in debt distress as well as the appreciation of the US dollar, the Fed rate hikes and the reversal of capital flows from emerging markets to safe havens, supply chain disruption in China have aggravated the situation.
The release of IMF tranches is likely to trigger further disbursements by multilateral institutions and official bilateral creditors. This should ease the liquidity constraints the country is facing. We can conclude from the above analysis that we need to (a) keep the political temperature low and reduce uncertainty, (b) follow the adjustment path agreed with creditors and (c) initiate reforms structural challenges in the areas of energy, taxation, state enterprises, agricultural productivity, export promotion, so that we do not remain dependent on foreign savings for our survival.