From Poor Economy to Debt Default

Written By: Dr Zafar Mahmood

A sovereign debt default occurs when a country does not meet a debt payment (principal or interest), i.e., it fails to meet the terms of a contractual agreement. A country that repudiates its debt faces the threat of sanctions such as loss of access to short-term trade credits, trade sanctions, seizure of assets, etc. In practice, however, the observed punishment does not correspond to what some might think. It may be noted that whereas domestic loans are supported by substantial collateral, the assets that can be appropriated in the event of sovereign country's default are often negligible. International experience suggests that defaulting governments have seldom been punished, either with direct sanctions or with discriminatory denial of credit. Countries try to avoid default not because of the collateral damage associated with default but because of the country's reputation. A country's incentive to make loan repayments is to preserve its future access to international credit and trade. Moreover, defaulting on sovereign debt may undermine the country's capacity to obtain beneficial deals in multilateral organizations. A default thus can have lasting effects on the country's growth, trade and the financial sector.

Why do then countries default? Studies distinguish three different causes: (a) liquidity problem (only a cash flow problem); (b) sustainability problem (the country may never be able to service its debt out of its own resources); and (c) unwillingness to pay (a country decides to stop paying it well before it is insolvent). Ultimately the decision of defaulting however, resides in the political sphere. The cheerful celebration of the December 2001 Argentine default by its Congress certainly suggests that losses for the defaulter were not big enough. Some studies indeed show that the welfare effects of the default are unambiguous: on the one hand there are output contractions and financial crises; on the other hand it alleviates the fiscal situation because debt payment falls. Why do, then, markets lend to countries that defaulted? An explanation is found in the procyclical nature of capital markets that lent vast sums to emerging markets in boom periods (associated with low returns in industrialized countries). In fact, it may be argued that lenders are paid accordingly for the risk they take. However, it is this same process that produces “sudden stops” in borrowing countries, and that triggers default episodes. Sometimes there is “excusable default” defined as a default triggered by bad shocks. In such a case, both creditors and debtors have incentives to renegotiate, and it is optimal to have a debt relief (or partial default) than a total disruption of debt. The incentives of lenders and borrowers to reschedule or restructure debt obligations are quite different. The incentive for lenders is to recover as much possible value of defaulted debt (provided that the penalty, in terms of seizure of assets, is much smaller than the amount defaulted). The incentive from the borrowers' view point is to minimize the output and other economic costs of a default.

Historical evidence suggests that countries that have defaulted on their external debts have done so repeatedly. Including the recent episode, Argentina has defaulted 5 times since 1824. This is not an exclusive characteristic of Argentina provided that other countries in the region have defaulted on a similar number of occasions. For instance, Brazil and Colombia have defaulted 7 times while Venezuela 9 times. If this historical account tells anything is that defaulting is not new. However, the latest Argentine's default of 2001 has some distinctive characteristic that puts it in the Guiness Book of World Records of the default history: it was the largest in the history of international bonds with over $82 billion. Argentine Debt Default Background: During most part of the early 1990s, Argentina outperformed most other countries in Latin America in terms of economic growth. However, in the late 1990s, due to the decision to peg its currency to the U.S.Dollar, pro-cyclical fiscal policies and extensive foreign borrowing left Argentine unable to deal with a number of global economic shocks. This ultimately led to the outburst of a severe currency, sovereign debt and banking crises. To understand the causes of crises, few important background events are in order. As government spending could not be matched by taxation and financial market borrowing, the authorities became dependent on inflation to finance the rising deficits (known as inflation tax, seigniorage). This led to a sharp rise in inflation (hyperinflation). By 1989, inflation reached to an annual rate of 3,080 %. Political support to deal with hyperinflation once-and-for-all grew.

The government introduced radical economic reforms in line with the dictate of the Washington Consensus. Beside others, the reforms included the privatization of state-owned enterprises, deregulation of the economy, reduction in trade restrictions, etc. With the implementation of these reforms, Argentina won great admiration from all international finance institutions, especially from the IMF. On the Wall Street, Argentina had become one of the most favourite emerging market; the country was able to borrow relatively cheap in U.S. Dollars and thus became the biggest issuer of emerging markets debt in the late 1990s. This made the country increasingly dependent on foreign capital. Earlier in 1991, to tackle hyperinflation, Argentina also introduced a Currency Board (the so-called Convertibilidad). The Convertibilidad acted like a monetary authority, which was required to maintain a fixed exchange rate with a foreign currency. This policy objective required the conventional objectives of the Central Bank to be subordinated to the exchange rate target. Among its major features were; (1) the introduction of a new currency, the peso (which amounted 10,000 Australes), which was set at an exchange rate of one peso to one U.S. dollar, and which was perfectly convertible and; (2) a new law was introduced, which permitted the Central Bank to issue new pesos only against new foreign exchange reserves. The Convertibilidad had many aspects of a dollarization: contracts made in dollars acquired the same status as those made in the local currency (including bank deposits and credits).

The Convertibilidad laid the foundation for (temporary) exchange rate stabilization. Argentines could now freely convert their pesos into dollars. Since then bank deposits and loans in dollar became widespread. After the implementation of these reforms, the Argentina economy entered a period of economic growth between 1991 and 1997. Under the Convertibilidad regime – inflation came to an end, there was an initial period of high growth rates, and there was a substantial surge in capital inflows. This new regime did not prohibit the state from having budget deficits. However, such deficits could not be financed by the Central Bank, but only through borrowing. Much of the latter consisted of foreign borrowing. The public sector continued to be in deficit due to: (1) the payments of the debt services, which grew from approximately 4% of the GDP around 1993 to more than 10% by the end of the decade and; (2) the need to finance the social security system with pesos, as most of the young taxpayers had transferred to the private system. In 1994, the Argentine government partially privatized the public pay-as-you-go social security system that had been in existence since 1967. This decision was strongly promoted and supported by the World Bank and the IMF and had a major impact on Argentina's fiscal accounts. The loss of revenue, plus accumulated interest costs, amounted to nearly the entire government budget deficit in 2001. As a side-effect of the Convertibilidad, the Argentine economy was especially vulnerable to foreign crises. The outbreak of currency crises in Asia, Russia and Brazil in 1997 caused capital to flow out and the Brazilian devaluation made the trade deficit worse. As Dollars were flowing out of the Currency Board, the decline of the Dollar reserves reduced the money supply and raised interest rates. Moreover, the currency crises raised the cost of borrowing for emerging markets. Brazilian devaluation reduced the competitiveness of Argentine producers. Meanwhile, the prices of Argentina's agricultural export products fell. All this led to a sharp reduction in exports, which caused sharp rise in current account deficit that pushed the country into recession.

The growth rate of Argentina's GDP began to slow down in 1998 and in 1999 it began to experience a negative growth rate, which continued until 2003. The most pronounced decline occurred in 2001 and 2002, when the country experienced the collapse of the Convertibilidad system. This decline in growth also produced dramatic increases in poverty. For instance, unemployment grew from 13.2% in 1998 to 21.5% in 2002; the proportion of the population living below the poverty line grew from 35.9% in 1998 to 57.5% in 2002. Moreover, the rate of investment, which was already declining in the late 1990s, took a plunge from 1999 on, dropping from 19.1 % of GDP to 11.3 % in 2002. By the time of De la Rua's government (December 1999 to December 2001), there was a consensus among economists that devaluation was imperative. Policymakers hesitated due to devaluation's perceived financial and political risks involved and the De la Rua's government adhered to the view that the main problem was not the exchange rate overvaluation but fiscal deficit. This view led the government to have a tight fiscal policy with the expectation that fiscal adjustment would entail lower risk premiums and consequently interest rates, which in turn would reduce the debt service payments, one of the principal components of the public expenditure. However, these policies reinforced the recessionary trend and undermined market confidence in the viability of the Convertibilidad.

Argentina kept on maintaining its peg with U.S. Dollar, which left it unable to respond to the growing economic problems, as it could not apply monetary policy under fixed exchange rate regime. In fact, when U.S. Dollar appreciated (between 2000 and 2002), its highest level in 15 years, the peso became overvalued. Moreover, the exchange rate peg was not supported by nominal price and wage flexibility which further reduced Argentina's instruments to deal with currency overvaluation and decreased the credibility of the exchange rate regime. As foreign investors lost their confidence in the Argentina economy, it had to face increase in cost of borrowing. Consequently, the country virtually lost its access to the international financial markets in July 2001. By the second half of 2001, the public began to fear the possibility of devaluation and there was increasing speculation against the peso. The situation was worsened by a unique feature of the Convertibilidad. In particular, local banks were able to offer deposits in foreign currency to the general public, and the Central Bank guaranteed that these were secured. Therefore, the peso speculation converted into a bank run, as the public withdrew their savings from foreign based accounts into cash.

In order to sustain the Convertibilidad, the government established severe restrictions on capital movements and cash withdrawals from banks in December 2001. This measure infuriated the general public and produced massive social unrest and political turmoil. To avoid a massive peso withdrawal from the banks the government declared a bank holiday on December 20th, which lasted until January 3rd, 2002. The collapse of the De la Rua's government and the successive governments led to the abandonment of the Convertibilidad. Argentina abandoned its Convertibilidad in January 2002 after a severe recession. To some, this emphasized the fact that the currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. However, Argentina's system was not an orthodox currency board, as it did not strictly follow currency board rules – a fact which many see as the true cause of its collapse. They argue that Argentina's monetary system was an inconsistent mixture of currency board and central banking elements. It is also thought that the misunderstanding of the workings of the system by economists and policymakers contributed to the Argentine government's decision to devalue the peso in January 2002. The economy fell deeper into depression before a recovery began later in the year.

The new government of Duhalde (2002-2003) decided to compulsively convert foreign-currency bank deposits into pesos at a rate of 1.4 pesos per dollar when the market rate was 2 and even reached 4 pesos per dollar. Additionally, to avoid a generalized bankruptcy bank credits in dollars were converted at a rate of one-to-one rate. On December 24th the service payments of a significant part of the public debt were suspended (it initially affected $61.8 billion in public bonds and $8 billion in other debt instruments). It did not include debt contracted with multilateral institutions (such as the IMF, the World Bank and the Inter-American Development Bank) of about $32.4 billion and guaranteed loans of $42.3 billion. This turned out to be the largest default in Latin American economic history, as the foreign private debt amounted to $ 82 billion out of $ 153 billion. Besides, the extra premium paid by Argentine bonds significantly influenced the Menem (1989-1999) and De la Rua's governments' decisions. As financial markets disbelieved the country's capacity to repay its foreign debt, those governments introduced tighter fiscal policies. However, following the contractionary policies, markets offered a higher discount on those bonds, which in fact worsened the country's financial situation. As expected, the default followed. How did then the 2001-2002 Argentinean default impact it?

• Immediate Sanctions: The value of Argentine's foreign assets was very small compared to its foreign debt. Threat of sanctions and seizure of assets occurred only rarely. Some of its bondholders tried to take legal actions in the courts of New York to attach Argentinean Central Bank funds in the New York Federal Reserve. However, it proved difficult for them to convince the courts. The latter held that since Argentinean funds belonged to Argentina's Central Bank, which was considered an entity separate from the Argentinean government, the claims had to be denied.

• Future Sanctions: Another type of sanction is the loss of access to international credit. It may be noted that the amount of credit declined dramatically in 2001 and reached a low point in 2005 (there is no information for 2002 to 2004 because the country was in total default and there were no financial operations). Credit began to flow in again in 2005 and by 2006 reaching the levels of 1994-95. Thus, these types of sanctions were of short durations.

Interestingly, net foreign credit to Argentina began to decline before the default. Net foreign portfolio investment dropped from U.S$ 11.5 billion in 1998 to U.S$ 8.7 billion in 1999 and to U.S$ 6.8 billion in 2000. Although, the decline in 2002 can be interpreted as reflecting the default, this is not the case of the previous years. Thus, the decline in the inflow of portfolio investment cannot be solely blamed in the default, but rather on the deterioration of the economic situation and especially the increased evidence of the lack of sustainability of the Convertibilidad. It must be underscored that the end of the Convertibilidad entirely changes the dependence of Argentina on foreign capital. During the 1990s, the emission of debt was mainly associated with the necessity of acquiring foreign reserves to maintain the currency board and the payment of interest. After 2002, both conditions disappeared, and this gave the Argentine government more room to negotiate.

• Immediate Effects: Aerolíneas Argentinas was one of the most affected Argentine companies, cancelling all international flights for various days in 2002. The airline came close to bankruptcy, but survived. Several thousand newly homeless and jobless Argentines found work as cartoneros, or cardboard collectors. An estimate in 2003 put the number of people scavenging the streets for cardboard to sell to recycling plants at 30,000 to 40,000 people. Such desperate measures were common given the unemployment rate of nearly 25%.

Argentine agricultural products were rejected in some international markets, for fear they might arrive damaged by the chaos. The United States Department of Agriculture put restrictions on Argentine food and drug exports.

• Impact on Growth and Trade: The default had little impact on either growth or trade. The dramatic decline of growth in the years 2001-02 was a direct consequence of the collapse of the currency board, and it can be claimed that the default was the result of the crisis rather than the cause of it. The default may not be separated from the deep economic recession and regime's collapse, and therefore its specific contribution may be difficult to quantify.

In addition, the resumption of spectacular rates of growth in 2003 had little to do with the default. As far as trade is concerned, exports stayed at about the same level in the years 1997-2002, while dramatically rising in the years 2003-2006. As far as imports are concerned, their decline began in 1998, plunging in 2002, but recovered rapidly after 2003. Import declines cannot be explained by a lack of credit related to the default, but rather by the dramatic decline of the GDP, the decline of investments and the spurt in import prices due to the devaluation of the currency.

• Impact on the Banking Sector: The contraction of the economy in 1998 resulted in rising non-performing loans. The January 2002 economic reforms, including the abandoning of the Convertibility Board, the pesofication of bank deposits and loans at two different exchange rates caused a wave of defaults and liquidity problems for companies. The default rate of rated issuers was as high as 60%. The apparent solid position of the banking sector could not prevent the sector, including both domestic and foreign banks, from being affected by the crisis too. Amongst others, Argentina's largest privately owned bank, Banco Galicia, and several foreign banks such as the Bank of America, CitiGroup, FleetBoston and J.P. Morgan Chase & Co suffered heavy losses.

• Foreign Direct Investment (FDI): The default did not reduce FDI, which was a feared consequence. Even in the worse time of the crisis, that is 2002, FDI, though substantially lower, never disappeared. Also, the collapse of the financial system should certainly not be attributed to the default but to the non-sustainability of the Convertibilidad. The internal financial system recovered very fast after the new macroeconomic equilibrium was put into place.

• Recovery from Crisis: Negotiations with bondholders, which began in 2002, dragged on until June 2005, when President Kirchner made an offer which consisted of the exchange of old bonds for new ones. The new bonds amounted to 25% of the value of the old debt. Kirchner made it clear that this offer was not negotiable and he gave bondholders one month to accept or reject the offer.

Within that time 76% of the bondholders accepted the offer. The remaining 24% were not repaid and kept on trying to regain their investment through foreign legal actions. The unilateral offer was indirectly supported by other actors' inaction and lack of initiative, together with extraordinarily good international conditions. Both the IMF and developed countries' governments adopted a laissez-faire approach to the sovereign crisis resolution. Moreover, the low interest rates in the United States, and the narrowing of emerging bond spreads improved the conditions of the offer. The government also took for granted the position of local financial investors (mostly retirement and pension administrators who were obliged to invest a certain proportion of their capital in public bonds), which provided a “floor of acceptance” of about 30%. The default itself eliminated one of the principal components of the public deficit, that is, the need to pay huge sums as interest on the debt, and by 2002 the prices of the Argentinean exports were rising dramatically.

Argentina's recovery from the economic crises was indeed due, mainly, to the improvement in the trade balance. It went from being negative in the late 1990s to a surplus in 2000, and this surplus rose dramatically in the subsequent years. The surplus was the result of two factors: (i) the country's exports, which hardly ever declined, rose substantially, as a result of both a strong world demand for the country's products, and also the substantial devaluation of the peso; and (ii) there was a dramatic decline of imports, due to both the rise of poverty levels and the decline of investments. Overall the collapse of the Argentine's financial system did not have any significant effect on international trade. The fact that there were no disruptions after the default may be explained by the fact that Argentine's exports were concentrated on traditional agricultural markets and primary goods with well-established financial services and prices on the rise, or tied to the Mercosur with politically managed quotas. The strong growth of exports also strengthened the finances of the government, as the major export items were taxed. In fact, the government's budget had a surplus from 2003 on. However, as in the case of government revenues, the level of expenditures also expanded, which, in turn, contributed to economic expansion.

The devaluation of the currency after loan default did not produce an immediate rise in the level of prices, mostly due to the existing high unemployment rate and to the freeze of public utilities' prices and other price controls introduced by the Duhalde and (mainly) Kirchner (2003-2007) governments. Economic recovery was attributed to the achievement of a new macroeconomic equilibrium. Those authors stress that the policies implemented were different from those common in the 1990s. In particular the new governments imposed new exchange rules that compelled exporters to liquidate dollars in the local market and imposed capital controls. In fact these measures were so successful that the Central Bank was compelled to absorb the excess of foreign currency to avoid the appreciation of the peso.

• Lessons for Emerging Economies: Argentina crises were due, mainly, to internal problems: the lack of an internal adjustment to accompany the Convertibilidad, which led to an unsustainable external debt situation. The default was a “way out” and Argentina got away with it due to the favourable external conditions, leading to huge trade surpluses, which led to growth and the growth, in turn, led to a softening of the country's bad reputation in global financial markets. The default thus could certainly not have been declared at a better time. Also, the fact that Argentina was smart enough not to default with the multilateral institutions was crucial because this line of credit remained open and the Argentine government made the announcement regarding the debt restructuring.

• Was the Argentina default really necessary? Evidence shows that default dramatically alleviated the government's burden, as debt servicing as a proportion of total government expenditures declined to 9.2% in 2004. However, the servicing of the debt might have been quite manageable in an expansionary period.

The fact that the default was done in a climate of political turmoil, mostly as a reaction to the failure of the policies implemented in the previous decade showed that the default was an immediate necessity rather than an unwillingness to recognize the debt. It was celebrated by the Congress as a political triumph with the expectation that it was necessary to avoid further macroeconomic restrictions. In a framework of fiscal, financial and political crisis, defaulting on foreign creditors was a short-term fiscal alleviation whose consequences would be the responsibility of an unknown future government.

All in all, two important points need to be made that are special features of the Argentine case. First, Argentina faced several favourable conditions in the aftermath of the 2002 economic crisis. The abandonment of the Convertibilidad alleviated the government's dependence on foreign capital and placed the country on a positive growth path that lasted several years. Moreover, the country's terms of trade entered in a favourable phase, which significantly contributed to the economic growth. Second, the default was declared concomitantly with a catastrophic economic, political and social crisis reduced its significance and it made multilateral institutions more sympathetic to the Argentine government debt restructuring process. Many analysts thought default would lead Argentina into a long period of stagnation and would keep it outside the world's financial markets for a long period of time. This did not occur! Argentina's experience indeed corroborates the historical fact that many, if not all, defaulters “get away with it.”

Argentina default was caused by the undesirable convergence of several economic events: a hard currency peg, currency overvaluation, economic rigidities, inappropriate fiscal policy, external shocks, large scale foreign currency borrowing followed by a “sudden stop” in capital inflows and continuing support of IMF played an important role in the course of crises. This together with the political and social turmoil that accompanied the events made the Argentine crisis one of the most severe emerging market crises in history. As world economic growth in the early 2000s was strong, Argentine producers benefited from the strong depreciation of its currency. The Argentine economy was able to recover rather quickly. Nevertheless, deep structural reforms were never implemented.

The writer is an HEC Foreign Professor and presently on the faculty of NUST Business School, Islamabad. This email address is being protected from spambots. You need JavaScript enabled to view it.

Current State of Oil Market and its Impact on the Pakistan Economy

Written By: Dr. Zafar Mahmood

The current spectacular drop in the oil price that began in the summer of 2014 brought the price down to $34 per barrel this month. This is a result of a number of factors that increased supplies and brought down demand. The decrease in demand can be traced back to declining economic growth in China, the recession in Japan, economic downturns in Germany and other parts of Europe, and increased energy efficiency in the United States and Europe. Conversely, the increase in supply was caused by the unanticipated and sharp increase in US and Canadian oil production, the increase in oil production from Russia in recent years and the ability of producers such as Iraq and Libya to maintain output despite their political instability. Added to this is that Organization of the Petroleum Exporting Countries (OPEC) and Russia are determined not to cut production to shore up prices. And now Iran has started pumping crude oil in large quantities for export markets.

The US crude oil stockpiles climbed to the highest level in more than 85 years, giving a bearish outlook to the market. This is a confirmation of a larger physical supply surplus. The slump has slashed earnings of Royal Dutch Shell and Chevron, while Exxon Mobil has reduced its drilling budget to a 10-year low.

Oil is traded globally at a single price, with small adjustments for transportation costs and oil type. Thus, major changes in oil supply or demand in one part of the world change oil prices around the globe. Most of the oil is traded on spot markets between commercial entities with little or no government involvement. Oil prices are quite volatile. This is mainly due to the lag time inherent in the oil industry’s capacity to respond to changes in supply and demand.

The supply of oil is dependent on geological discovery, the legal and tax framework for oil extraction, the cost of extraction, the availability and cost of technology for extraction, and the political situation in oil producing countries. Both domestic political instability in oil producing countries and conflicts with other countries can destabilize the oil price.
Global trends in oil prices since 1987 are worth noting (Figure 1) that reveal the oil price shocks are invariably followed by 2 to 3 years of weak economic growth.

From 1999 till mid-2008, the price of oil rose significantly. It was due to rising oil demand in countries like China and India. In the middle of the Great Recession of 2007–2008, the price of oil underwent a significant decrease after the record peak of US $145 a barrel in July 2008. On December 23, 2008, West Texas Intermediate (WTI) crude oil spot price fell to US $30.28, the lowest since the beginning of (2007-2010) recession. The price sharply rebounded afterwards and rose to US $82 in 2009. On January 31, 2011, it hit $100 for the first time since October 2008 on concerns about the political turmoil in Egypt.

For about three and a half years the price largely remained in the $90–$120 range. In the middle of 2014, price started declining due to a significant increase in oil production in USA, and declining demand in the emerging countries. By January 2015 the price of oil reached below $50. A record dip below $44 was reached in mid-March 2015. The price increased upto $60 in the following months. Oil prices decreased to a six-year low to $36 on December 11, 2015 and to $34.09 on February 5, 2016. Some analysts speculate that it may continue to drop further.

Figure 1: Trends in Crude Oil Price

Interestingly, oil prices are not at a historic low. Oil price cycles are quite normal. Throughout the past century of trade, there have been instances in which the price of oil has swung from high to low and then back up again. Therefore, while low prices will likely to continue in 2016, we are sure that they will eventually follow the normal cycle and rise – though not necessarily back to the historical highs of the last three years.


currstate.jpgThus, while various economic trends and geopolitical factors will inevitably impact the global oil market, changes in oil prices should be seen as not unprecedented or unpredictable but as the result of basic economics, driven only by the two mechanisms of supply and demand. However, to understand the factors that affect supply and demand, a deep understanding of geopolitics and the producers of oil around the globe is also necessary.

Proven reserves of crude oil in Pakistan are 247.5 million barrels (1 January 2013). Pakistan’s annual consumption of petroleum products is around 23 million tons. Indigenous crude oil meets only 16% of total requirements while 84% requirements are met through imports in the shape of crude oil and refined petroleum products. Pakistan now follows a market-based policy, in general, for the oil sector. OGRA is maintaining reserves equivalent to 20 days of petroleum demand and is making all efforts to enhance this capacity. Pakistan’s petroleum consumption is about 22.9 million metric tons per annum. Sustained low oil prices will spur shifts in consumer behaviour and industry performance. The overall trend of cheaper oil is likely to have deep implications for the Pakistan economy.

Impact of Declining Oil Prices on Pakistan
Economic Growth: Fall in oil prices are expected to stimulate economic growth in Pakistan. A study analyzing changes in GDP growth shows that if oil prices drop from $84 to $40, it would result in GDP growth of 0.5% to 1.0% for developing countries like Pakistan. Many sectors of the economy would directly benefit from the resulting lower cost of fuel (the agricultural and automotive sectors in particular would benefit).

Current Account Balance: Oil imports account for one third of Pakistan’s total imports. For this reason, the price of oil affects Pakistan a lot. A fall in oil price would drive down the value of its imports. In 2013-14, Pakistan’s petroleum import bill was $15.36 billion, which has come down to $11.86 billion in 2014/15, a 22.8% decline. This would certainly help narrow the current account deficit and increase foreign exchange savings.

The fall in global oil prices may be beneficial for the consumers and economy, but it also has its pitfalls. Directly, it affects the exporters of petroleum producers in the country. Besides petroleum products, Pakistan is also currently exporting condensate crude oil due to lack of its refining capacity in the country. Any fall in oil prices thus negatively impact exports and current account balance.
Many of Pakistan's trade partners and buyers of its exports are net oil exporters. A fall in oil price may impact their economy, and in turn hamper demand for Pakistani products. This would adversely affect the Pakistan economy and companies.
Inflation: A fall in oil prices comes as a windfall to consumers. Low oil prices, along with other factors, have helped reduce inflation. A 10% fall in crude oil prices results in 1% fall in inflation, a study concluded. A decrease in inflation could lead to further cuts in interest rates, increasing credit availability and boosting overall growth prospects since there would be more money available for infrastructural and corporate investment. The decrease in inflation, and the overall improved economic outlook would boost investor sentiment.

Fiscal Impact: The Government of Pakistan makes sure that its budgetary tax collection target fixed for oil sales is met irrespective of crude oil prices. It uses various means and measures (implicit taxation) to meet its revenue targets. As there are no subsidies given on oil sales to any of the users and tax revenue targets are met; therefore, there is no fiscal impact of fall in oil prices. However, a fall in oil prices reduces public sector companies' losses, like PIA and Pakistan Steel Mills, and thus should help narrow fiscal deficit, though marginally.

Rupee Exchange Rate: Exchange rate depends, beside other factors, on the extent of changes in the current account deficit. A high deficit means the country has to sell rupees and buy dollars to pay its bills. This reduces the value of the rupee. A fall in oil import bill is a good omen for the rupee. However, the downside is that the dollar strengthens every time the value of oil falls. This should negate any benefit for our currency from a fall in the current account deficit.


Foreign Direct Investment: Foreign countries whose economies may be adversely affected by the fall in oil prices may reduce FDI flows to Pakistan. Default in loans given to Russia and shale gas developers in USA could lead to instability in the global banking industry, which could cause investors to err on the side of caution and pull money out of developing countries like Pakistan.

Petroleum Producers: Low global crude oil prices limit incentives for the upstream oil sector. Consequently, it would adversely affect the current exploration policy in the country. Investment in domestic oil production is likely to be negatively affected by low prices leading to lower contribution from this sector to GDP growth. For the past few months, the slide in oil prices has pulled down PSO share price from Rs. 441.75 on June 19, 2014 to Rs. 292 on October 1, 2015, with some revival to Rs. 337 on February 14, 2016 (see Figure 2). Likewise, the share price of OGDCL experienced a free fall from a high of Rs. 280 on August 1, 2014 to Rs. 102 on February 14, 2016 (see Figure 3).


Environment: Low oil prices impose a challenge for policymakers to achieve some of their environmental targets. Following the collapse of oil prices, the government may get slow in adjusting natural gas prices. With lower prices in place for oil, natural gas demand may be further affected. The proliferation of private vehicles, which run on diesel and petrol, could significantly increase emissions; unless, changing technologies and tightening environmental controls introduce low oil-intensive growth, significantly reducing energy-intensity levels.

In the end, while Pakistan waits for a more opportune time to make upstream oil projects viable, it should speed up crude procurement to build its strategic reserves. In addition, revive the Iran-Pakistan gas pipeline project and secure long-term contracts commensurating low expected future oil prices.

The writer is a Professor of Economics at School of Social Sciences and Humanities at NUST, Islamabad. This email address is being protected from spambots. You need JavaScript enabled to view it.


Written By: Dr Sania Nishtar

Privatization has become an intensely polarized subject in Pakistan with politically charged rhetoric dominating discussions. Substantive debates around its policy rationale and the institutional prerequisites necessary for its success have not been given priority. With this, as a context, five questions are being flagged to further objective discussions on the subject.

First, are we getting the framing on privatization right? Privatization is generally viewed through the narrow lens of 'sale of state enterprise' in Pakistan. This is evidenced by a covenant of the Privatization Policy, which envisages it to be “...a mechanism for the reduction of debt...” In effect privatization is linked to the fundamental question of the role of state in the economy. It is part of a broader policy choice involving deregulation and liberalization. Privatization is part of a set of policy changes, a government can espouse to make private sector the engine of growth, with the understanding that the role of the government is to provide an enabling policy, impartial oversight, transparent regulation and a level playing field for market operators.

Public-private engagement in state governance happens on a spectrum, at the extreme end of which is total transfer of ownership of enterprise, or public property from government to the private sector, which is what privatization entails. Opening up of a sector, previously a government monopoly to the private sector can also be labelled as such. At the other end of the spectrum is out-sourcing or contracting-out of certain functions, from the government to private entities. Although this also involves private-private collaboration, it is distinct from 'privatization'. To understand what a government can, and what it cannot, privatize and where public-private engagement in a contractual format becomes relevant, the functions of government should be brought to bear. Policy-making is an essential government function and cannot be privatized. Regulation is also a core function of the state, but can be out-sourced to an autonomous entity, with a public mandate. Several regulatory functions are currently being performed by autonomous entities in Pakistan, with the Oil and Gas Regulatory Authority (OGRA), Pakistan Electronic Media Regulatory Authority (PEMRA), Pakistan Telecom Authority (PTA), being examples. Countries also have experience in contracting out other government functions such as revenue collection to private entities. Governments can opt to contract out service delivery in areas such as health and education to private entities on the premise that the private sector has better outreach and/or management capacity to deliver a pubic mandate if it is financed publicly. In policy parlance, this approach is referred to as 'purchasing services from the private sector', an approach Pakistan has already experimented with. Running industrial enterprise is not a core function of the government unless certain exceptions compel it to do so. These exceptions must be clearly appreciated. When there is no incentive for the market to play a role in an area that needs to be served; when an equality gap needs to be bridged; where a strategic objective stands to be gained for the country; or when a specific impetus needs to be lent to open a sector, government involvement in market activity/enterprise may be justified, otherwise activities should be left to market operators.

This brings us to the second question of how privatization becomes relevant in Pakistan. Over the years, Pakistan has established a long list of Public Sector Enterprises (PSEs) which do not fall under the list of exceptions mentioned above. They are additionally inefficient and are a burden on the national budget. Billions of rupees, which could have been spent on welfare, national development, and debt retirement, are being used to pay for their inefficiencies. The government, therefore, has to make a choice between two options, both of which could potentially improve the efficiency and effectiveness of sick PSE's – either reforming governance arrangements while continuing to have state control or by opting to transfer them to the private sector through privatization. For Pakistan, both options remain challenging. The country has a bad track record of introducing corporate culture in PSEs on the one hand and has also been unable to auger public confidence in the process of privatization, on the other. This notwithstanding, the list of ineffective PSEs must be examined to explore which option fits best to reform each. As privatization is a complex procedure and not an ordinary auction, a robust and transparent process becomes critical for its success

The third question, therefore, focuses on the process safeguards, which are necessary for the privatization process. Many PSEs listed on the privatization list do qualify to be there. It is not the rationale that is questioned but the process, which becomes a point of contention. Today the opponents of privatization in Pakistan may not be ideologically opposed to the idea but are fearful that the transactions may be carried out in a non-transparent and/or unfair manner, state assets could be sold at throwaway prices, political cronies could be rewarded for allegiances, that in the process of 'stabilizing' these enterprises state resources may be unnecessarily spent and that strategic objectives could be compromised. Privatization vests enormous power of patronage in governments and these concerns are a real risk.

Government can hedge against these risks by ensuring full legal safeguards and water tight procedures and by upholding the highest standards of transparency and accountability in the privatization process. A number of imperatives emerge. As a starting point, the governing norms of privatization in Pakistan should be revisited. These include the Privatization Commission Ordinance 2000, the Privatization Policy 1994, and the privatization programme paper, which also lists the names of the units/entities to be privatized alongwith respective divestment strategies to be adopted.

The policy has been amended once in 2009 and needs to be revisited since it has been two decades since its formulation. It does, however, outline several robust principles but the key question is one of their implementation, as discussed later in this comment. The 2000 Ordinance provided for establishment of the Privatization Commission. It is being inferred that legislative authorization for individual privatizations are implicit in the framework, in other words it is being taken as a 'framework authorization act'. However, lessons from other countries show that legislative authorization is usually needed to change the status of individual PSEs as well. A legislative cover can have beneficial impact with reference to transparency and policy support for privatization.

In terms of the process, measures to avoid conflict of interest assume great importance while appointing board members of the Privatization Commission and the agencies to be privatized, which is where due diligence becomes critical. In the case of evaluators and external advisors involved in the privatization process conflict of interest concerns are equally relevant and can be mitigated through a strong contractual process. Also in relation to the process, due attention to job security, wages and benefits of incumbent staff become important, with the general rule being that their contractual rights should continue to be honoured after transfer of ownership. The Pakistan post-privatization experience has been plagued by inconclusive resolution of labour issues, with the case of the PTCL pensioners being illustrative.

The fourth question relates to the institutional arrangements necessary for the success of privatization. Adequate capacity assumes importance in this respect. Pakistan has vested administrative responsibility for privatization in the Privatization Commission and in doing so it has become compliant with the internationally recommended policy, which requires countries to have independent privatization units. But does the Commission have adequate capacity? Does it has a culture of promoting accountability and transparency? Is it adequately resourced to engage private actors who have the capability to negotiate and safeguard their interest in privatization transactions, as they should? Since engagement with the private sector demands certain institutional capabilities within the government system, the government should privatize a PSE only after an appropriate regulatory framework for the privatized entity has been created. Given Pakistan's past performance with regulatory arrangements, a massive effort needs to be put in place to step up government regulatory capacity and develop it for sectors and mandates which are being privatized.

Also, in terms of institutional arrangements, when a government retains an influence in the PSE following privatization, it is critical that it creates the right accountability of state functionaries who represent the government's interest on board – it isn't entirely appropriate to give government functionaries per diems several times their monthly salary as this could potentially undermine their impartiality. The fifth question: have we taken stock of evidence and are we drawing on lessons from the past whilst planning for something this large? There has always been a tendency in the country to make sweeping policy-changes without regard to evidence. Since decisions need to be evidence-guided past experiences become important. Pakistan has vacillated between several waves of privatization and nationalization. Since its inception in 1991, there have been two phases of privatization between 1992-94 and then 2001 onward, with 167 transactions to-date. It would be important to draw lessons from these experiences. There are many principles of privatization articulated in the 1994 policy against the backdrop of which impact could be gauged. For example, was there any net benefit to the government with privatization? What was the quantum of increase in revenue? What percentage of this was used for debt retirement and was the 10% meant to be committed for welfare in the 2000 Privatization Ordinance actually channelled towards it? The policy stated that “monopolistic trends will be curbed” and that “safeguards will be introduced to achieve broad based ownership and prevent concentration of resources in a few hands”. To this effect did our past experiences in privatization lead to cartelization? Did they concentrate assets in a few hands? What has been the impact of privatization on narrowing the wealth gap? Was there any collusion in the valuation of assets? What value did the injection of resources into the PSEs prior to their privatization bring? Was there ever a precedent in terms of giving minority share-holders precedent over majority share-holders? How many privatized units actually functioned after they were handed over to the private sector? Has there been an analysis of the motivation of the buyers? There have been reports, which allege that the primary motivation in some of the privatization deals was to strip the assets of their real estate value – to what extent are these true? The policy also intended to mobilize investment for PSEs from overseas Pakistanis and foreign investors. To what extent was that enabled? Have we prioritized privatization of the loss making enterprises before putting the profit making ones up for sale, which is a cardinal rule in privatization?

Have we insulated sectors and organizations that are strategically dangerous and economically unjustifiable to privatize? Some enterprises have been subject to the privatization processes, but have not been transferred to private ownership in their entirety. What have been the determinants of that? What has been the private sector's experience with the privatization process, overall and have we ever factored their side of the story into analysis? Have we conducted any analysis on this subject at all? How many Masters and PhD students whose degrees are supported by the Higher Education Commission, and hence tax payer's expense, are conducting research in this area? How many studies have been commissioned by Planning Commission, Privatization Commission or donors interested in this subject? Embarking on the process, without drawing on lessons from the past and making remedial action poses a risk for the process. The greatest risk for the privatization process is the lack of accountability within the state system, as a result of which public sector functionaries cannot be held accountable for their inability to safeguard state and/or public interest in privatization deals. The current state of PSEs is reflective of a style of governance, to which all past regimes are contributory. Years of appalling governance, evidenced in crony appointments at the leadership level, recruitments without regard to competency or organizational needs, rampant procurement collusion and lack of accountability of decision making have landed these organizations in the current state of affairs. Brokering privatization under the same shadow of governance is setting it up for failure.

Privatization is indeed an option for some of the entities listed in the privatization list. It can accrue benefits to consumers, workers, investors as well as government. We need fundamental reform of governance, one that puts decision makers' accountability at the core of state system before expecting to reap its benefits towards the goal of economic reform.

The writer is a former Federal Minister and holds a Fellowship of the Royal College of Physicians of London. A PhD from Kings College, London, she is an eminent social scientist and regularly contributes in national print media on issues of health, governance and public policy.

This email address is being protected from spambots. You need JavaScript enabled to view it.


Sudden Currency Appreciation of Pak Rupee

Written By: Dr Zafar Mahmood

How is the exchange rate determined in Pakistan?

Exchange rate of Pak rupee with dollar was fixed up to 1982 when the Central Bank (CB) used to intervene in the market to defend the fixed rate. Afterwards, exchange rate was left to the market to determine as is now in Pakistan, of course with occasional intervention by the CB. Under the flexible exchange rate regime, the exchange rate depends on how the demand-supply balance of foreign currencies moves. When the supply for dollars rises with demand staying constant then each dollar cost less rupees to buy it. If domestic markets get reassured about the future of the economy then private holders of dollars sell them, leading to an increase in the value of local currency. Thus, movements in the exchange rate do not always reflect economic fundamentals, but are also driven by sentiments prevailing in the market.

The Pak rupee was exchanged for dollar in the inter-bank market at 105.5 on 4thMarch 2014, at 104.4 on 6th March, at 103.7 on 7th March, at 102.9 on 8th March, at 98.5 on 12th March, at 97.02 on 26th March, and at 98.17 on April 2nd. Concomitantly, Pakistan's total foreign exchange reserves declined to $7.6 billion on 7th February-2014 from $13.5 billion a year ago because of large repayments to the IMF and others. Foreign exchange reserves held by the Central Bank were even lower, at $2.84 billion. But it started rising after mid-February and rose to $4.8 billion by14th March, went down to $4.42 billion on 21st March, but went up to $5.365 billion. Marked improvement in foreign reserves was mainly due to support from bilateral lenders and remittances inflow. It would be pertinent to note that under the IMF guidelines December-2013, the CB undertook some corrective actions including using higher policy rates, purchases in the foreign exchange market, and greater exchange rate flexibility. In the above context, questions are being asked: What caused sudden rupee appreciation? How the economy is being affected by the appreciation? Will this appreciation last for some time to come? This article attempts to answer these questions one-by-one. Causes of Sudden Appreciation:

The source of sudden appreciation is the information spread about improvement in economic fundamentals and future outlook of the economy, which caused a reversal in market sentiments. Positive developments as described in the latest CB Monetary Policy Statement are: almost all major economic indicators have moved in the desired direction over the past few months. Growth of 6.8% in Large Scale manufacturing improved aggregate supply in the country. The fiscal deficit has been contained during the first half of the fiscal year while the private sector credit has increased. Moreover, positive sentiments in the market are due to a noticeable increase in foreign exchange reserves and a larger than anticipated decline in inflation. Another key factor that induced the sentiments has been the IMF's approval of the government's pace and thrust of reforms. Pakistan's Eurobond now trades at a premium, this strong performance on the existing Eurobond should help placement of the new issue. All those who were expecting continued depreciation were surprised by sudden appreciation and quickly took new positions to off-load their dollar holdings which increased dollar supply in the market further appreciating the rupee.

Having seen through the peak period of IMF repayments, there are now numerous inflows lined up in the next few months. This includes an IMF tranche of about $550 million by the end of May, a 3G/4G auction in April, and Eurobond issuance in about 2 months. Meanwhile, the government's decision to use foreign currency deposits held by commercial banks to the tune of US$500 million has also eased dollar supply constraint in the interbank forex market. It may be noted that during this period, US dollar also fell against pound by 0.85%; so some appreciation of rupee is due to dollar depreciation.

Despite IMF repayments of $692 million are due up until end of June, the expected inflows will raise reserves. This indicates of improved external liquidity, thus reducing impending repayment dangers. All these expectations have enabled market to hold rupee at its appreciated level. After-Effects on the Economy: A sudden appreciation of the Pakistan currency is seen by critiques as no good for the economy. They argue that it will cause tremendous job loss in Pakistan due to loss in international competitiveness. Ask importers who have made forward contract, as they always do in advance. Some of them have lost their fortune. Anyways, imports will rise as with appreciation we have to pay less for imported items. Is this a desired outcome for an economy which is struggling to boost exports to create employment and avert a Balance-of-Payments (BOP) crisis? Doubts are expressed over the stability of the currency at current levels. Our major export industry, textile, which is already facing fierce competition from other textile exporting countries, has come under pressure with appreciation. Provided appreciation is translated into a fall in the prices of non-traded goods in the country along with a fall in the prices of imported inputs used in the export-oriented industries, exporters will benefit. Otherwise, they will face the brunt of appreciation.

In case, this sudden appreciation is without the backing of strong macroeconomic fundamentals then volatility in currency will take place in the near future. Consequently, with rising export prices exports will decimate and import-bill will be higher. Remittances inflow will also slow down. Thus, appreciating currency to the point where the country is no longer competitive in the international market can cause the economy to be in the stagnations and will thus have adverse implications for the BOP.

Some one might think that with appreciation of rupee the import price may go down, which may result into lowering of inflation. The appreciation may not solve the inflation problem at all if it is due to large inflow of capital. Net capital inflows will increase the volume of currency in circulation resulting into increased inflation. So a policy of sterilization, whereby government issues domestic bonds to wipe out increased money supply, would be needed to neutralize the adverse implications of foreign capital on inflation. Pakistani residents holding assets in Pak-rupee have become richer as they can buy more foreign goods with rupee-denominated assets. There will be a fall in public debt servicing to the extent of appreciation at the time of servicing. At the same time customs duty revenues will fall with decline in imports in Pak rupee. Therefore, actual net fiscal implications are ambiguous.

Anticipated Length of Appreciation: It all depends on how accurate and credible information market is receiving from different quarters about turn-around in the economy. Even if the information is partially correct the market will reverse its sentiments and rupee will start depreciating to its original position from where it started gaining strength. Despite strict instructions from the CB to exchange companies to reduce the rupee-dollar exchange rate spread in interbank-open forex markets, it is currently about Rs.2.5. It implies there is a shortage of dollar supply in the open market and that unless supply improves, rupee may soon depreciate. This spread is also increasing the possibility that Pakistani expatriates use the illegal Hundi system to remit their money instead of the formal banking system. This will further put a pressure on the rupee for depreciation. Moreover, foreign exchange dealers are not selling dollars though they are buying it as they are anticipating depreciation of the rupee.

In sum, every one understand the advantage of a strong currency, therefore the CB should carefully manage its revaluation so as not to cause unnecessary and avoidable damage to the economy. The current size of reserves does not provide any comfort to the economy. The net capital inflows remain considerably lower than the current account deficit. There is a need to further build the reserves. A timely influx of anticipated foreign capital inflows is likely to improve the BOP position. The economic situation may have started to improve but everything is not very satisfactory. Unless concerted structural reforms are introduced in the economy supported by appropriate monetary and other economic policies, the BOP position will remain under constant threat. Reliance on bilateral inflows may provide some short-term stability, but it is the persistent private capital inflows that will ensure long-term macroeconomic stability, including a stable exchange rate. Let me close on a cautious note: US dollar has started gaining recently as the Federal Reserve is expected to start hiking the interest rate, which will certainly put a downward pressure on Pak rupee!

The writer is an HEC Foreign Professor and presently on the faculty of NUST Business School, Islamabad.

This email address is being protected from spambots. You need JavaScript enabled to view it.

Follow Us On Twitter