Staff Report
ISLAMABAD: The International Monetary Fund (IMF) has issued a warning over growing challenges to Pakistan’s economy due to the possibility that the geopolitical tensions in Israel and Gaza may exert pressure on the currency rate and external stability.
Furthermore, political unrest ahead of the next elections might influence how reforms are implemented and policies are decided. The IMF believes that Pakistan faces additional risk as a result of its mounting debt.
Pakistan has agreed with the IMF under structural benchmark conditions to further jack up gas prices and the deadline for notification has been envisaged at February 15, 2024. The government also agreed with the IMF to develop a plan to strengthen internal control systems in lending operations, including updates to collateral policy and counterparty eligibility policy, in line with recommendations from the 2023 safeguards assessment.
The government failed to implement the average premium between the interbank and open market rate which will be no more than 1.25% during any consecutive five business-day period.
“Downside risks remain exceptionally high. External financing risks are exceptionally high and delays in disbursement of planned financing from IFIs or bilateral partners could pose major risks to the government’s programme given limited buffers.
“Any external financing shortfalls would increase the government’s reliance on expensive financing from domestic banks and could further crowd out private credit. Higher commodity prices and tighter global financial conditions, including due to the intensification of geopolitical conflicts, could put pressure on the exchange rate and external stability.
“Additionally, political tensions ahead of the upcoming elections may weigh on policy decisions and reform implementation,” the IMF stated in its staff report on Pakistan released on Saturday. The IMF assessed that despite a notable improvement in market sentiment since June, risks to debt sustainability remain acute given large gross financing needs and scarce external financing. Assuming decisive implementation of programme policies, which would be sustained over the medium term, and adequate multilateral and bilateral financing, public debt would remain sustainable. However, policy slippages, insufficient financing or elevated gross financing needs, the realisation of contingent liabilities and downward risks to the baseline could all undermine the narrow path to debt sustainability. With low reserves and scarce market financing, FX payments will remain a persistent challenge, and real interest rates have become an adverse driver of debt dynamics, with interest absorbing more than half of general government revenue.
“Pakistan’s capacity to repay the Fund is subject to significant risks and remains critically dependent on policy implementation and timely external financing,” says the IMF. The Fund’s exposure reaches SDR 5,972 million (or 294 per cent of quota and about 103 per cent of projected gross reserves at end of January 2024) with purchases linked to the review. With the completion of all purchases under the arrangement, it would peak at SDR 6,673 million in March 2024 (329 per cent of quota and about 102 per cent of projected gross reserves at the end of March 2024).
Exceptionally high risks, notably from delayed adoption of reforms, high public debt and gross financing needs, low gross reserves and SBP’s sizeable net FX derivative position, the recent decline in inflows, and sociopolitical factors jeopardise policy implementation and eroded repayment capacity and debt sustainability.
Restoring external viability is critical to ensure Pakistan’s capacity to repay the Fund, and hinges on strong policy implementation, including beyond the SBA. Uncertainty about global economic and financial conditions amid several successive shocks, adds to these risks. Adequate and timely execution of the firm and credible financing assurances from official creditors remains essential to mitigate these risks. The authorities’ programme is on track, with tentative signs that the economy is stabilising and external pressures are easing. While demand remains weak, economic activity is picking up, although gradually, and inflation has started to decline, though remaining elevated. External pressures have eased somewhat and the SBP has taken advantage of inflows to begin rebuilding FX buffers. Fiscal performance has also improved, with the general government registering a primary surplus in FY24Q1. While the current SBA has provided a much-needed respite and the caretaker government deserves credit for its steadfast implementation, Pakistan’s medium-term challenges remain acute, and the current policy efforts need to continue to address them sustainably.
Ensuring a market-determined exchange rate is critical to help buffer external shocks, rebuild SBP’s FX reserves, and support growth. Restoring public confidence in the exchange rate system and deepening the FX market will require allowing price signals to function without impediment and decisively abandoning tight management of the FX market. Relatedly, signalling strongly that repatriation of profits and dividends will not be restricted remains indispensable to attract high-quality FDI. Imperfect FX market functioning undermines economic activity and thus the intense fixation by politicians and other stakeholders on the level of the exchange rate is ultimately damaging to private inflows and growth. The existing exchange restriction and the MCP should be eliminated as soon as possible. Maintaining financial stability requires continued vigilance. This includes ensuring all banks and microfinance banks are compliant with the minimum capital requirements or exit the market. Passing the legal reform of the crisis management framework is crucial to ensure the authorities have the appropriate powers and toolkit to deal with weak institutions.
