October 14 , 2022
Pakistan Faces Economic Headwinds
After two consecutive fiscal years of roughly 6% economic growth, Pakistan’s economy has faced major problems in the first quarter of this fiscal year. Growth has slowed sharply while the stock market has dropped and the Pakistan Rupee exchange rate against the dollar fell all the way to 240 before rebounding to about 220. Inflation, which was running about 10% back in the spring, has surged to over 20% on an annual basis. What is ailing the economy, and what needs to be done to right the ship?
Pakistan did remarkably well in the two years after the pandemic began. Economic growth was solid, exports surged, and remittances allowed Pakistan to keep its current account in balance, as the sum of remittances and exports equaled the import bill. Inflation was running about 7-10%, which was higher than Pakistan’s long run average of about 6%, but still in an acceptable range. The State Bank of Pakistan was trying to run a carefully balanced monetary policy, one that allowed the economy to grow but did not allow inflation to spiral out of control.
2022, on the other hand, revealed a number of challenges to the economy. First was the burst of worldwide inflation that hit commodity prices very heavily early in 2022. Pakistan, which has to import almost all of its energy needs, is particularly vulnerable to oil shocks, and oil prices doubled between mid-2021 and spring of 2022. This caused the import bill to surge to over 7 billion dollars per month, an amount that could not be covered by exports and remittances, which created a widening current account deficit. To cover that, Pakistan needed to borrow. This, however, was not easily done, as Pakistan could not come to a full agreement with the IMF on its IMF package, and without that other lenders were not willing to come forward.
Sri Lanka had an economic meltdown for similar reasons a few months ago as it could no longer pay for imports. But Sri Lanka had two key differences. First, it was using a fixed exchange rate, which allowed imbalances to build until they finally burst suddenly and catastrophically. Pakistan has been using a floating exchange rate, which has resulted in a gradual and far less disruptive adjustment. Secondly, Sri Lanka had a lot of dollar-denominated debt owed to private lenders. Pakistan’s foreign debt is mostly to friendly governments who are far more willing to rollover the debt and not demand payment at inopportune times.
The fall in the rupee has had its predictable effect in making imports more expensive. This has resulted in a fall in imports and the current account deficit has been shrinking in the last two months. Exports continue to do reasonably well. Oil imports are down 20% from their peak, and electric power generation is down 10% from last year.
Inflation has accelerated as mentioned. The only sure way to bring it down is to push down the excessive demand in the economy. To do that the SBP has to keep interest rates high. Just like the Federal Reserve in the US, the SBP has pushed rates up, but at its last meeting it left the rate unchanged at 15%, which is far higher than the 3.25% rate currently in the US. While US rates are not high by Pakistani standards, they are high enough to suck capital into the US from around the world, and drive the dollar higher against all currencies. This partly explains why the Pak Rupee has declined so much. The decline in the Rupee compared with the Euro, Yen, or Pound is not nearly so dramatic. In fact, when adjusted for the impact of inflation and looking at all of Pakistan’s trade partners, the Rupee is about fair value. The SBP is hoping that a 15% interest rate combined with the decline in global commodity prices in the last few months will bring inflation back to tolerable levels in Pakistan.
What is interesting is that inflation by itself does not prevent economic growth. The best performing economy in the last three years in the world has been Turkey, which has grown a total of 18%. It did this with an inflation rate that has approached 70%. The growth is the real growth, after taking into account the inflation. Turkish inflation has pushed down the value of the Lira and boosted Turkish exports, while there has been high domestic demand. President Erodogan has rejected mainstream economic thinking and has prevented the Turkish Central Bank from fighting inflation with the usual tightening of credit and raising of interest rates. How this will end for Turkey is unclear, and a dangerous hyperinflation cannot be ruled out.
In the short-term Pakistan needs to bring its exports and imports back into closer alignment. Pakistan exports about 35 billion dollars per year but imports 70 billion dollars or more. That gap is mostly covered by 30 billion in remittance dollars, but it would be far better for Pakistan to export 70 billion dollars and use that 30 billion in remittance money for investments. One of Pakistan’s biggest economic headwinds has been chronic underinvestment.
In the longer run, Pakistan needs to get its politics in order. The instability of a government that took power through arcane Parliamentary maneuver is obvious and is greatly contributing to Pakistan’s economic troubles. Fresh elections are needed as soon as possible so a government that is legitimate and stable can be formed. Judging by public opinion and rallies, a new election would sweep Imran Khan back into office. This next year will be a difficult one for Pakistan’s economy, but if inflation can be tamed and politics put in order, the rest of the decade could be quite good.
