Pakistan’s Next Crisis is Guaranteed
Pakistan’s current economic crisis is caused by a spike in oil and gas prices leading to a sharp drop in foreign exchange reserves. The government has reserves worth a month of imports and would not have met their debt commitments without an IMF bailout.
This is not the first IMF bailout for Pakistan: it’s the 23rd! The problem is not only about this specific crisis, but that the Pakistani economy has extremely poor policy that makes economic growth almost impossible. It is inevitable then, that economic crises happen so often.
The reason why this happens is because the Pakistani elite do not want it! They do not have the incentives to increase economic growth whether due to corruption, military control of the government and or general incompetence. Until this changes, it is very likely that Pakistan will have low economic growth, and inevitably more crises like this
From Crisis to Crisis
The current economic crises in Pakistan and Sri Lanka (both articles from Noah Smith, recommended) might seem like they’re because of this moment. It might seem as if the crisis is because of a specific action taken by a specific person (like the Sri Lankan debt binge in 2019), or because of some unlucky event (like the Russian invasion of Ukraine which raised food and energy prices). But when you look at the economic history of post independence Pakistan, it doesn’t seem like this was a one off thing. The country has had 23 IMF bailouts since independence, and it doesn’t seem as if any of them has led to structural change.
The imports go boom
The immediate reason for Pakistan’s crisis is simple: they will run out of foreign exchange reserves and not have much to pay their foreign currency debts. They will run out of foreign exchange reserves because their central bank sold most of them in defending the currency’s value.
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The central bank had a problem: in 2022, the Russian invasion of Ukraine led to higher energy and food prices. Pakistan’s largest import is petroleum, its second largest is gas and its third largest is crude oil. The current spike in oil prices from about $70/barrel to $120/barrel and spike in natural gas means that the country’s import bill increases. It is very hard to have a lesser quantity of oil and gas because it’s so important to several functions like electricity and transportation, so consumers end up accepting the price increase in the short term. So, for countries that have to import these products, it ends up in a higher import bill for them. Pakistan’s imports in June are up 16% over May’s, and 24% over last June’s.
Pakistan’s Trade Deficit (in millions of PKR)
(Millions of PKR on the Y-axis via this)
The problem is that when your imports exceed your exports (and in the absence of foreign investment), this usually leads to the currency depreciating. Pakistan not only has had more imports than exports, but also has had declining foreign investment, which means that there is strong selling pressure on the currency. Fewer people want to buy Pakistani rupees and more want to sell them. The State Bank of Pakistan tried to reduce the effect of this by buying Pakistani Rupees and selling foreign currency. But the selling pressure was so strong that they were close to running out of money. In August 2021 the SBP had about 20 billion USD of foreign exchange reserves. On 15th July, they had only 9.3 billion of reserves.
The problem is that in the last month, Pakistan imported about $7.8 bn of goods and services and exported only $2.9 billion worth of items. It is likely that the import bill increases, due to increasing gas prices, and the currency depreciates more. Should the SBP want to defend the currency’s value, they’ll be facing stronger selling pressures and will have to spend more to defend the currency’s value.
Paying the money back
The other problem is that Pakistan has a serious external debt problem. The country has about $100 billion in foreign denominated liabilities, out of which $81 billion is government debt. Out of that $81 billion, about a billion comes due in less than a year. It is almost guaranteed that the numbers from the PBS in the link above (from March) are an understatement, as the government has been borrowing rapidly in the financial markets.
The problem is that the massive fall in the PKR’s value has meant that it takes a lot more PKR than it used to to pay the foreign denominated debt. The Pakistani government will have to spend much more on debt payments than it used to.
It is unlikely that the government will not have the money to pay its debts over the long run. Financial markets have recognised this and Pakistani bond prices have fallen about 40% in the last few months. It is possible that the country won’t have enough foreign exchange reserves to make foreign bond payments, and if it does, it will be at the expense of spending the money somewhere else important.
See Bloomberg for more on it
Some facts about the economy make it almost inevitable that they will have foreign exchange crises.
For almost all countries that do not produce fossil fuels at home, they end up importing them. This is true for China, Japan, India and Germany. (America became a net exporter of oil in 2019, but might return to being a net importer this year). Pakistan has multiple problems in its energy sector. The first is that everytime the price of oil and gas increases, their import bill also increases.
A higher import bill is one problem. The government taking the cost of imports on the fiscal makes it worse.
More Money More Problems
Every government faces political problems when energy prices rise. But Pakistan is probably unique in trying to solve those problems with subsidies that are unsustainable. In the previous fiscal year , there were power subsidies of about 378bn PKR versus a budgetary allocation of only ~150bn PKR. In this fiscal year, they would be about 500bn PKR making about 5% of the budget.
The problem here is clear. When the government commits to subsidising fuel if the price goes up, it takes an implicit liability on its budget. If fuel prices go up, it has to increase spending at the same time when the balance of payments is facing stress. This will make fuel cheaper, and instead of rationing the quantity of fuel via higher prices, will encourage its consumption leading to a higher subsidy cost. The government is converting a balance of payments problem to both a balance of payments problem and a fiscal problem.
You can model the Pakistani government as sort of being short the price of oil and natural gas, and that has been a terrible trade so far.
The government seems very committed to keeping them, in light of the upcoming elections in 2023 (although they do know the risks themselves).
Power Problems II
And along with the subsidies, the other problem is that for the same political reasons, the previous government refused to increase energy prices even after the Russian invasion of Ukraine, and only when the new government came did they increase the price of power (and that too barely)
The other problem is that many of the subsidies that the government promises to power distribution companies do not get paid. This paper estimates it at about 12% of GDP, although the IMF puts it at around 6% of GDP. Regardless of the actual number, this is a serious problem! If power distribution companies do not get the subsidies they are promised, they are unable to make payments to anyone up the supply chain. Which makes the existing problem of higher prices worse by increasing the number of problems in transmitting electricity.
The Budget Problem
Along with the Power Problems, Pakistan has another serious problem. It does not collect very much in taxes, but spends as if it did. To cover the difference the government borrows money, usually in foreign currency.
We Don’t Pay Taxes Here
Pakistan has a low tax to GDP ratio of about 13% which is far lower than comparable countries (Thailand at 17%, India at almost 18% and Turkey at 18%). There are a few reasons why this happens. The first is that the government is under political pressure to give exemptions to political supporters, especially right before elections. Along with that the direct tax base is very narrow. Only 2.9 million Pakistanis pay income tax out of a population of 220 million people. There are also several exemptions to the sales taxes which reduce the amount of revenue
The current sales tax system is also very fragmented with provinces collecting services tax and the federal government collecting the goods tax. The system as a whole is cumbersome and hard to deal with. Along with that, there are several negative effects of the current tax system. There is no mechanism to claim tax credits on inputs, and so exporters face higher costs compared to other countries
The Debt Problem
For many countries of Pakistan’s development level, it is generally harder to borrow large amounts at long durations domestically. The local debt markets wouldn’t be able to support large amounts at long durations and even if they did, the interest rates would be much higher. So, governments choose to borrow in foreign currency above. As said above, they have about 80 billion in foreign debt (which is an understatement given it is likely that the government has borrowed more in the last year).
The sharp fall in the Pakistani rupee’s value means that the cost of servicing the debt too would have increased, and put a further strain on the already limited foreign exchange reserves.
The foreign debt creates a serious foreign exchange constraint for Pakistan. The country has to generate enough foreign currency to service its debt or risk defaulting on it and being cut off from the financial markets.
The oil spike is bad luck, subsidising oil during the oil spike is bad policy, the long term problem of low tax collections are worse than that, but borrowing money in foreign currency to fund expenditures is the ultimate sin. Debt by itself is not bad, but the problem is that Pakistani governments are using it to spend it on expenditures and not productive investments.
All of these make foriegn exchange crises more likely. The reason why other countries manage to avoid this is because they have economic growth that keeps money flowing in. A very good way to avoid repeated economic crises is to have consistent economic growth.
The Growth Problem
And the previous 1600 or so words are only hinting towards what is Pakistan’s biggest problem. Its economy is unproductive, and is not growing to the extent to which its political aspirations ask for. It is not wrong for Pakistani voters to ask that they don’t spend over half their incomes (see the CPI basket here) on food and energy. But the problem is that their incomes are not growing fast enough.
There are three parts to this. First, productivity growth in Pakistan has been low and declining. Second, this is caused in large part by onerous government regulation and command of the economy. Finally, everything described above is a symptom of the above two problems.
A small caveat: Pakistan is not very poor, but has had slow growth relative to its neighbour India, and Bangladesh (which was part of the country from 1947-71).
Productivity is (almost) everything
For an economy to grow, you need capital and labour. More machines and more people, make countries richer. But the problem is that only adding more machines and people can’t go on forever. Countries also have to use them productively. It makes little sense to have increasing use of factors like capital and labour if they’re not being used productively. Except for a few periods, this has been the case in Pakistan. Most economic growth has come from adding more resources to the Pakistani economy, and it is only in a few decades that economic growth has come from productivity improvements rather than adding capital and labour.
You can see examples of this in multiple places, but I’m going to focus on one extreme one: exports. Pakistani exports are concentrated in a few low value products and in very few firms. The top 25 firms make about a quarter of Pakistan’s total exports, and all of them in textiles. Exports are good because they cause firms to compete in the global market and make them more productive. They also lead to foreign exchange earnings which help the balance of payments problem.
The productivity problem also shows up in the size of firms. Just like India, Pakistan has too many small firms. As this World Bank article notes, the average small firm in Pakistan has only two employees.
And the diagnosis of the problem is that the Pakistani economy has a productivity problem.
Big Government, Big Problems
The Pakistani government bears responsibility for their low productivity in two ways. First the onerous regulation that pervades much of the economy keeps the country poor, and corruption high. Second, the state owned enterprise sector takes up too much capital and is very unproductive.
It is very hard to start a firm in Pakistan. It takes about 17 days and costs about 6% of your annual income. This makes new firm entry very hard, and means that existing firms are protected and more productive new firms don’t enter the market. And even after they do start it, running one is difficult. Regulatory laws are poorly enforced and government inspectors are commonly corrupt.
The tax system also makes it harder to export. States and provincial governments have a mix of indirect taxation powers which leads to regulatory uncertainty for firms. Many times products are taxed twice by both of them and they can’t claim credits for it. The GST does not allow firms to deduct input GST costs which makes them disadvantaged globally. It is also very hard to import capital goods in Pakistan because of the tariffs involved in importing them. This reduces exports because these imports are used to produce items that will be exported again later.
See this from the IMF’s Article IV report
Worst of all, the uncertainty leads to a focus on low value exports (about 60% of exports are textiles comprising simple linen, knitwear etc and another 20% is food like rice and fish).
Capital Sucking SOEs
Pakistan has a problem: its state owned companies are very unproductive. The usual problems for all state owned companies exist here. SOE managers are poorly motivated, poorly incentivised and poorly run.
Out of 213 SOEs, only 85 are commercial (for making money) versus strategic (for some national purpose like energy security for example). Non financial commercial SOEs had assets amounting to 44% of GDP but generated only 0.4% of employment. Despite having 44% of GDP in terms of assets, their revenues amounted to only 14% of GDP. Revenues aren’t counted in GDP though, profits are. The net profit of Pakistani SOEs has been negative since 2014 and over one third of them have consistently lost money.
Credit too is extended to the SOEs far above the private sector. Bank loans to the government and SOEs grew at more than double the rate of private sector bank loan growth from 2019 to 2021. To add to all of this, SOEs have contingent liabilities of more than 7% of GDP which would be a burden on the government budget if the contingencies occur.
The Reform Problem
Nothing I’ve said above is new. Pakistani economists have been lamenting for years that structural reforms aren’t happening. Here is former Pakistani Finance Minister Shaukat Aziz all the way back in 1999
Pakistan was in severe economic crisis. We were known as a "one-tranche country". We used to take one tranche from the IMF. We were constantly in Fund programs. We would violate all the conditions of the program and it would be stalled, and then we would go back. This was the routine more or less. We had severe balance-of-payments problems. We did not know how to meet our foreign exchange expenses beyond a certain day. Our debts were technically in default; some were past due and no new credit was available from the market
Source: Asia Society
IMF reports have said this since 2001 (from when the first digital reports are available). And even today, the need for structural reforms is well known. Here is Atif Mian from last week:
So why aren’t Pakistani politicians taking action? After all the problems are clear. Their solutions too are clear. It is just not clear how they can implement them and stay in power.
Elections make it difficult
It is almost an article of faith that getting re-elected for a government requires cheap energy and food prices. After all, they form a majority of Pakistan’s consumption basket. And to be fair to the government, they did try. They signed natural gas deals in 2015 with Russia and one with Qatar this year. And the Russian invasion did make it difficult by increasing oil and gas prices which in the extreme cases led to blackouts and rationing. Pakistani politicians have the strongest incentive to do anything and everything to get the lights back on. It is unsurprising that they chose to subsidise oil and gas and put price controls.
The Elite Bargain
The deeper problem beyond the impulse to subsidise energy is that the Pakistani establishment does not have an elite bargain that leads to good economic policy. What does that mean? In every country the major political parties and other important stakeholders (the public, military and the media) agree on a set of norms.
They agree on the goal of the government (in China that was very explicitly to get powerful via economic growth), and to a lesser extent, the means to do it. In Pakistan, the problem is that it is each for himself. The major political parties do not take the actions needed to increase economic growth (like reducing the regulations for businesses or reducing the import tariffs) because they do not see the point in it.
Sometimes there are important stakeholders that prevent reform. The Pakistani Army via the Fauji Foundation and other trusts controls several businesses (one of the first search suggestions in the dropbox is “Fauji Foundation cement”), and they have a great deal of political power in the country. The army is widely believed to control the government from the inside, and it would not be surprising if they had stopped trade liberalisation to protect their core financial interests.
Pakistani politicians themselves make large amounts from corruption, and it would make sense for them to keep the show running as it is because it personally benefits them. A more liberalised economy would lead to their existing sources of rent being destroyed and new people coming in place.
I’m more or less convinced that unless the government has a change of heart and decides to fight the special interests that force it to have such poor economic policy, these crises are inevitable.
And I’ll leave you with this meme to end it
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Good read! Love macroeconomic articles.