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The global economic and financial backdrop is becoming increasing challenging for emerging economies. Pakistan, with its large external financing needs and political instability, looks at particular risk of a crisis. According to Fathom’s Financial Vulnerability Indicator (FVI), the probability of a banking crisis in Pakistan is currently elevated by historical standards, while the probability of a sovereign crisis rises above 70% by the second quarter of 2023. We discuss recent developments and prospects for the country.
Inflation in Pakistan had already begun to rise quite smartly in 2021 and soared further in 2022, as prices for key imports such as food and energy surged following Russia’s invasion of Ukraine. Headline inflation currently stands at 25% on a twelve-month basis — well above the 7.5% average of the previous decade. Food price inflation is currently 29%, while core inflation, excluding food and energy, is also elevated at 12%. The central bank began raising interest rates last autumn, amid a strong economic recovery; but it has been behind the curve, resulting in negative real interest rates, and fuelling further overheating in the economy.
The surge in prices of food and energy imports has also had a significant negative impact on Pakistan’s trade and fiscal positions. The visible trade deficit has leapt from an average monthly level of around $2bn in the decade up to 2020, to an average of almost $4bn in 2021 and the first half of 2022. The International Monetary Fund (IMF) forecasts that the current account deficit will increase from just 0.6% of GDP in 2021 to over 5% in 2022, and a still elevated 4% in 2023. At the same time it is forecasting high, but declining, fiscal deficits of 5.8% and 4.2% of GDP in 2022 and 2023, resulting in massive twin deficits.
As the current account position has deteriorated and the external financing environment has become increasingly difficult, foreign exchange reserves have fallen sharply. In June they were below $11bn, enough to pay for around one and a half to two months of goods imports. The Pakistani rupee has depreciated by around a third against the US dollar in 2022, further raising the costs of imports and pushing inflation yet higher. Significant political uncertainty has also weighed on the currency, after Imran Khan lost a no confidence vote and was ousted as prime minister in April, to be replaced by Shehbaz Sharif.
A recent positive development was the completion of a staff-level agreement with the IMF on Pakistan’s Extended Fund Facility, and its possible extension until June 2023. Subject to IMF board approval, this would provide Pakistan with access to some additional IMF funding, and increase its chances of securing additional official financing.
Nevertheless, in order to reach agreement Pakistan has agreed to various policy measures, including fiscal tightening to achieve a primary surplus. Clearly this could add to the political risks facing the government, with an election due by October 2023 at the latest. Indeed, the victory of Imran Khan’s party in an important provincial election on 17 July has raised the spectre of ongoing political instability, with Khan calling for an early general election. Meanwhile, the country still has large external financing needs over the fiscal year ending June 2023, which include the current account deficit, and principal payments on external debt of around $24bn, and over subsequent years.
All in all, with a challenging period for the global economy and financial markets ahead, Pakistan looks at significant risk of following in the footsteps of Sri Lanka, which has been plunged into economic and political crisis. It is unlikely to be the last country to do so, however.
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