Pakistan’s Balance of Payments Crisis

The new government will face many challenges, but arguably the biggest challenge is the balance of payments crisis being faced by Pakistan that has been brewing for quite some time. In this article, at the very beginning I would explain why this situation emerged and its consequences for the economy. And finally, I would suggest measures that need to be introduced to cope with the situation.


Despite remittances remaining in the range of $14 to 19.6 billion over the past five years, current account balance has remained in deficit and it is continuously growing. It may be noted from Table 1 that the current account deficit was $2.496 billion in FY2013, which increased to $17.994 billion in FY2018 that is an increase of more than 7-times. During this time period, however, the GDP increased 1.4-times. As a percentage of GDP, the current account deficit increased from 1.08% in FY2013 to 5.6% in FY2018. It means that this year, on net basis, an additional amount of $18 billion (or 5.6% of GDP) is paid to foreigners. 

    Let us further focus on the last three years as they depict major change. In FY2016, the account deficit which was $4.867 billion increased to $12.439 billion the following year, and now stands at $18 billion, an all-time high. The main reason for this increase is due to an increase in trade deficit in goods and services from $22.3 billion in FY2016 to $30.86 billion in FY2017, which has risen to $36.3 billion in FY2018. Other components of the current account remained virtually constant during these three years.  

 

Current account deficit of $17.994 billion in FY2018 was financed through borrowing and foreign capital inflow of $12.4 billion.  Since inflow of capital was less than the required amount, therefore, $6.12 billion of foreign exchange reserves was used. If this trend persists and no measures are taken to correct the situation, then very soon remaining reserves with the State Bank of Pakistan (SBP) will largely deplete or Pakistan will have to acquire more external debt. 


Total import of goods between FY2017 and FY2018 has increased by $7.2 billion. This increase is attributed to imports of Food Group by $0.082 billion, Machinery Group by $1.3 billion, Transport Group by $0.6 billion, Petroleum Group by $2.7 billion, Textile Group by $0.5 billion, Agriculture & Other chemicals by $1.2 billion, Metal Group by $1.1 billion, and Miscellaneous Group by $0.06 billion. So the major increase is in Groups of Machinery, Transport, Petroleum, Chemicals and Metals. These are all necessities to run the country and its wheels. Policymakers have very limited options to cut down imports of these groups. For example, putting a ban on motor cars (CBU), motorcycles (CBU) and luxury mobile phones for some time may help save about $600 million. By restricting imports of ‘Other Textile Items’, about $1 billion can be saved. However, within Textile Group, which mainly consists of raw materials to run the textile industry, its import should not be curtailed. Remaining two Groups, Food and Miscellaneous, both witnessed an increase in imports of $142 million in FY2018, which is a minor increase. Of these, the Food Group consists mainly of tea, spices, pulses and edible oils. Some commentators in the media are focusing on food items, and someone even suggested cutting imports of apples, but these suggestions are made without giving any consideration to what will be saved. Such austere suggestions erode society’s trust in the system and should be avoided.


Overall, exports of goods and services increased to $30.0 billion in FY2018 as compared to $27.5 billion in FY2017, which is an increase of 9.1%. Whilst exports of goods increased by $2.83 billion, the exports of services dropped by $0.32 billion. About 73% of exports consist of Food Group (19.3%) and Textile Group (53.7%). Remaining 27% exports comprise of a large number of products including carpets, sports, leather, surgical goods, cutlery, chemicals and pharmaceutical, engineering, etc. These remaining products are virtually the unrealized potential of Pakistan that needs to be promoted to increase total exports.


Increase in exports of goods failed to keep the pace with increase in imports of goods and services. This widening trade gap is at the core of the growing current account deficit, which has drained foreign exchange reserves. The pertinent question is, from what sources has Pakistan paid to bridge the gap in payments to foreigners? Three of the main sources used are foreign borrowing, foreign investment, and foreign exchange reserves.

When sudden adjustments in currency are made, rather than gradual, it results in more disruption in the economy. This is because when currency depreciation is largely to make up for all previous inactions, then the forex market sentiments overshoot currency depreciation above to its long run equilibrium value. During this time period, disruption to the economy finds its way and compensation is impossible to those who face the brunt of disruption.


Current account deficit of $17.994 billion in FY2018 was financed through borrowing and foreign capital inflow of $12.4 billion.  Since inflow of capital was less than the required amount, therefore, $6.12 billion of foreign exchange reserves was used. If this trend persists and no measures are taken to correct the situation, then very soon remaining reserves with the State Bank of Pakistan (SBP) will largely deplete or Pakistan will have to acquire more external debt (Table 2).


The reserves held by the SBP now stand at $9.064 billion, while those held by commercial banks are $6.62 billion, making total foreign exchange reserves at $15.683 billion (Table 2).


What are the underlying causes that climaxed and led to the BOP crisis? The situation can broadly be depicted with high levels of external debt and liabilities ($91.761 billion as of March 31, 2018) and current size of official forex reserves of $9.1 billion that are about half of this year’s current account deficit. This implies that Pakistan has a largely compromised capacity to make international payments.


Current account deficit is identically equal to the dissaving by the private sector and public sector. Incidentally, the private sector in Pakistan saves more than it invests. The only reason for current account deficit thus left is large fiscal deficit. This can be seen from Table 3, which shows that in FY2018, the current account deficit to GDP ratio was 4.1%, the fiscal deficit stood at 5.8%, while the net private savings was 1.7%. 

 

Pakistan kept its currency overvalued by about 20 to 25 percent, which contributed to a decline in exports and increase in imports. Since November 2017, Pakistan has been slowly depreciating its currency. The previous government at the end of its tenure and the caretaker government depreciated the currency sharply, which made foreign goods and capital more expensive, consequently the country started facing a painful disruption. Earlier, slower depreciation could not correct the overvaluation problem. Now as market forces are allowed to determine the value of the currency, it has unleashed a self-correction mechanism leading to a big fall in the value of Pak rupee. Since, inflation has also started to upsurge, it will further put pressure for currency depreciation.


When sudden adjustments in currency are made, rather than gradual, it results in more disruption in the economy. This is because when currency depreciation is largely to make up for all previous inactions, then the forex market sentiments overshoot currency depreciation above to its long run equilibrium value. During this time period, disruption to the economy finds its way and compensation is impossible to those who face the brunt of disruption.


Depreciation of currency over the past few weeks suggests that it has not removed overvaluation of the currency, instead it has caused increase in excess demand for foreign currencies, which has unleashed an unending depreciation.


Rapid loss of foreign exchange reserves forced the government to not only depreciate the currency but simultaneously introduce some additional steps to reduce the trade deficit. Both the previous government and caretaker government used regulatory duties to stem the growth of imports, while the SBP has imposed a cash margin of 100% on 132 imported items. 


Suggestions for Policy Reforms
The prevailing situation described above suggests that Pakistan is virtually into a balance of payments (BOP) crisis. It got pushed into this situation due to adoption of inappropriate policies in yesteryears. To come out of this situation Pakistan would need a sizeable financing. International rating agency Moody’s has graded Pakistan’s economy with “B3 (negative)”, i.e., the economy is highly speculative. With this rating, Pakistan will not be able to obtain financing on affordable terms to meet its international payments’ obligations. 


Unfortunately, every new government starts its tenure with a program of macroeconomic stability, because every previous government virtually messes up the economy before leaving the helm of affairs. New government spends most of its time on macroeconomic stability with support from international finance institutions (IFIs). Conditionalities imposed by IFIs reduce the pace of growth and do not leave enough space for social investment. My humble suggestion is that this time policymakers should take some tough forward-looking macroeconomic decisions instead of going to IFIs to meet financing needs.


With the expectation that the currency will further depreciate, exporters and emigrants slow down remittances. Therefore, a quick economic recovery is necessary. With stability, FDI, workers’ remittances and export receipts will start pouring into the country, which will stem fall in the value of currency. If macroeconomic instability remains, then with high expectation of future depreciation, importers would try to make more and more future contracts with foreign suppliers at spot exchange rate creating more pressure for further depreciation. This practice needs to be regulated.


As noted earlier, current account deficit is mainly due to fiscal deficit. One of the prime reasons for fiscal deficit is the sizeable servicing of public debt. Therefore, the new government should take appropriate measures to cut down the size of debt. The measures could be restructuring of debt, systematically raising revenue, and rationally reducing government expenditures.


Remove all Statutory Regulatory Orders (SROs). SROs erode tax revenues and increase corruption and cronyism. SROs also erode competition in the market because they treat different individuals and entities differently. In this regard, legislatures’ disclosure of interests including business ties, investment and employment would be a constructive and confidence-building step in the system. 

Current account deficit is mainly due to fiscal deficit. One of the prime reasons for fiscal deficit is the sizeable servicing of public debt. Therefore, the new government should take appropriate measures to cut down the size of debt. The measures could be restructuring of debt, systematically raising revenue, and rationally reducing government expenditures.


A large number of withholding taxes are collected by the withholding agents. How much of collected revenue is actually passed on to the Federal Board of Revenue (FBR) is anybody’s guess. Also, if the withholding agents are doing this job then the relevant question is, what is FBR doing? This tax policy is hurting both businesses and exports.
Current account balance can be improved either by controlling imports or by expanding exports. As far as imports are concerned only 2 to 3 billion dollars can be saved by controlling imports of motor vehicles, petroleum products and textiles. It may be noted that import restrictions increase smuggling. To feed smuggling, smugglers use hundi, which reduces remittances through official channels and tax revenues are lost. So unless strict border management is ensured to tackle the menace of smuggling, there is a high possibility that smugglers will circumvent the policy objectives.


A realistic policy should largely focus on increasing export base and basket of export goods with a bigger variety. With the kind of products Pakistan sells internationally, the objective of export expansion cannot be achieved. This is because elasticity of export products is very low, that is when world income increases, the demand for our goods hardly increases. Therefore, there is a need to encourage production of high-end products.


Moreover, Pakistan needs to take measures to improve competitiveness. Competitiveness can be improved by depreciating the currency, provided domestic prices do not rise. This may be realized perhaps in the immediate run because as soon as the exchange rate changes pass-through then the positive effect of depreciation is eroded (see my article published in Hilal, May 2012). A better policy under current situation would be to increase productivity that should reduce domestic prices to improve competitiveness even without a need for currency depreciation. Productivity improvement can be achieved through innovation, which in turn would require increase in R&D expenditure and concerted efforts.


Under-invoicing of exports is another major problem faced by Pakistan. Exporters under-invoice to keep their capital in foreign safe havens. In this way, precious foreign exchange earnings are lost. At the same time, to fly their capital overseas, importers also over-invoice their imports. These practices raise current account deficit and ultimately put pressure for currency depreciation. Taking appropriate measures, as I suggested in one of my earlier article published in Hilal (May 2011), will not only reduce current account deficit but will also improve tax revenue collection.


The writer is a Professor of Economics at the School of Social Sciences and Humanities at NUST, Islamabad. 
E-mail: [email protected]
 

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