The IMF Deal
By Nayyer Ali MD
Pakistan finally came to an agreement with the International Monetary Fund to bail out the country from a balance of payments crisis brought on by its mammoth trade deficit. The deal took over six months to negotiate, and some critics felt the government was taking too long to come to terms with the IMF.
Prime Minister Imran Khan and his team delayed finalizing a deal with the IMF so they could reduce the size of the IMF loan and make Pakistan less dependent on IMF money. Last year, Pakistan’s dollar funding needs looked like they were over 13 billion dollars, and to get that kind of money from the IMF was going to be a tough road. Khan, however, was able to cut that burden in half by getting over 7 billion dollars pledged by Saudi Arabia, the UAE, and China, which brought the final IMF package down to 6 billion dollars.
But to get that money, Pakistan had to agree to terms demanded by the IMF. No country ever goes to the IMF unless they have run out of all other options, and they cannot raise dollars through the private sector. For Third World countries, if they have large dollar loans coming due, without a source of dollar funds to cover that debt, this results in a “balance of payments” crisis. Without IMF help the country would have to default on its dollar debts which would create massive economic havoc, far worse than agreeing to IMF conditions.
The IMF wants the recipient of any such loans to stop the policies that created the balance of payments crisis in the first place, and to match government spending and revenue more closely so that going forward the government would be able to pay the interest on its loans.
How did Pakistan get into this mess? There were basically two major failures. First was a deliberate policy of keeping the exchange rate of the Pakistani rupee too high in value compared to the dollar. An overvalued currency is great for consumers, as they get to buy sought after imported foreign goods at a sharp discount to their real value. But this has a terrible consequence, it prices Pakistani exporters out of the market. For Third World countries, it is hard to generate export growth unless you are a low-cost producer, and if your currency is overvalued, no one will want to buy from you. With the rupee almost 35% overvalued, Pakistani consumers were getting a 35% discount on their purchases, while exporters were charging 50% more for their exports to their customers, who abandoned Pakistan to buy from others. The result was that over the 10 years since Musharraf left office, Pakistani exports stagnated around 24 billion dollars a year, while imports exploded from 25 billion to over 50 billion dollars. The gap, around 30 billion dollars, was the trade deficit, and until 2017 was covered up by remittance dollars that also exploded in the last 10 years, reaching over 20 billion dollars a year. These remittance dollars that overseas Pakistanis sent home allowed the PPP and PML-N governments the fig leaves needed to cover up Pakistan’s abysmal export performance and massive trade deficit. But the game finally ended in 2018, when the trade deficit grew so large as to overwhelm even the 20 billion dollars of extra foreign currency remittances were providing. This finally forced the government to confront reality and let the Pakistani rupee slide from 105 to the dollar to 145 to the dollar. It is probably near fair value at present, but as higher Pakistani inflation continues, that rate will have to further weaken to keep the currency at fair value.
In addition to the trade deficit and balance of payments crisis, the other major problem confronting Pakistan is the rising budget deficit. Put simply, the country was spending far more than it was raising in taxes. This put further pressure on the government, as investors could tell this was unsustainable. Pakistan’s national debt burden, which declined from 100% of GDP in 1999 to 50% when Musharraf left office, has climbed back up to 80% due to the abysmal mismanagement of the PPP and PML-N governments over the last ten years. The high budget deficits have stoked inflation, which is running around 9% per year at present.
The IMF has placed three main conditions on Pakistan. First, Pakistan stop manipulating its currency and allow the market to determine the exchange rate. This is what all modern economies do, and it is actually difficult to create a balance of payments crisis if you have a floating exchange rate. The market will fix your problem by forcing its discipline on you long before you can run up a massive trade deficit. This will be the first time in Pakistan’s history that it has had a floating exchange rate if the government actually carries this out. A new head at the State Bank of Pakistan (SBP) signals the government is serious about this. Under the IMF Accord, the SBP will oversee the currency, and its new head is a former IMF economist.
The second condition demanded is that the government raise taxes and cut spending such that the primary budget deficit is less than 1% of GDP next year. A “primary deficit” is how much the government spends minus its taxes but does not count the money paid on interest on government debt to be part of that spending. A primary deficit of 1% would be an actual deficit of around 4%, which is a contraction compared to the current 7% deficit. This contraction of spending will slow down the economy.
The third demand will also slow the economy, which is to shrink the subsidies that the government spends on. There are two main subsidies in Pakistan, first is subsidized energy prices, particularly petroleum and electricity, and second is subsidized poorly run government companies like Pakistan Steel Mills, PIA, and the Pakistan Railways. Hundreds of billions of rupees that should be spent on healthcare, education, and infrastructure, are wasted on these sectors. The IMF wants this spending curtailed, and further privatization to occur. In the Musharraf era, major privatizations were carried out, particularly in banking and telecoms. But in the civilian era, no major privatizations have happened because the politicians love controlling companies they can use to provide patronage jobs to their supporters.
This IMF deal has not been finalized. The government needs to present the next year’s budget in June, and get it passed. That budget will be Imran Khan’s first, and the IMF sees it as a major test of whether Pakistan is willing to comply with its terms. Only then will it release the funds.
The IMF gets criticized a lot by the recipients of its loans. But the IMF never forces anyone to take its money. No one goes there unless they are desperate and have no choice. The IMF then forces countries to do what any first-year economics student knows are the basics of running a market economy. When dealing with some Third World countries, the pattern is that the IMF sets terms, the country complies partially for a brief period, but then returns to its terrible policies, and gets into further trouble. When done right, the IMF has had major successes over the years. The IMF actually bailed out Britain in the late-1970’s, Britain went on to recover under the market reforms of the Thatcher era. Turkey’s modern economic growth traces back to a successful IMF program put in place in 2002 just before Erdogan came to power. And during the 2008 Financial Crisis, the IMF was very successful in helping a number of countries get through that period, even in Europe.
Pakistan’s economy will slow, this year to 3% growth, and likely be subdued for the next year too. But after that, if the government complies with the program and reaches these targets, then we should see growth pick up, exports surge, and the economy prosper. If done right, in four years when Imran Khan will go back to voters, he may find himself in a strong position to win again. Already, the decline in the exchange rate has resulted in a sharp decline in imports and a rise in exports, with the trade deficit shrinking significantly.
