Turbulent times for Pakistan’s economy

Standard Chartered in its Global Research report released on Friday forecasted its view of a strong US dollar (USD) into year-end on the back of persistent global uncertainty, as well as poor outlook for Pakistan’s balance of payments (BoP).
A key reason for Pakistani rupee (PKR) strength in Q4-2010 and Q1-2011 was the unexpected improvement in the current account. However, this is unlikely to persist. While remittances may remain strong, a wider trade deficit and higher interest payments are expected to push the current account back into deficit in FY12 (ends 30 June 2012). At the same time, the financial account is likely to stay on a weak footing in the absence of substantial official inflows. Accordingly, they forecasted USD-PKR at 94 by end Q4-2012. We recommend that Pakistani exporters maintain neutral hedge ratios on USD receivables, as our USD-PKR forecasts are broadly in line with forwards, said Sayem Ali and Priyanka Kishore in the report.
Forex reserves decline on widening current account deficit:
Pakistan’s Forex reserves declined sharply to $17.1 billion (5.7 months of import cover) as of 8th October 2011 from $18.3 billion at end-June due to a widening current account (C/A) deficit and large external debt payments. The C/A turned to a $1.2 billion deficit in Q1-FY12 (ended September 2011) from a $500 million surplus in Q4-FY11. The C/A deficit for Q1-FY12 was significantly larger than the central bank’s full-year forecast of $2 billion (0.8 per cent of GDP). We expect expansionary fiscal policy and accommodative monetary policy to drive up import demand, turning the C/A to a deficit of 1.2 per cent of GDP in FY12 from a surplus of 0.3 per cent of GDP in FY11, they added.
The trade deficit widened to USD 4 billion in Q3-2011, up 82 per cent from $2.2 billion in Q2, due to higher oil imports and weaker export demand. Exports declined 18 per cent q/q to $6.1 billion in Q3-2011 due to lower commodity prices and weaker demand from the US and EU. Pakistan posted record export receipts of $25.5 billion in 2010, primarily due to the windfall from record-high cotton prices and higher wheat exports. However, the decline in cotton prices and weak demand from the EU and the US, Pakistan’s main export markets; has led to a slowdown in export growth.
Import demand has remained strong, driven by higher demand for crude oil and petroleum products. Pakistan meets 80 per cent of its energy demand through oil imports. The oil bill for the first eight months of 2011 increased by 34 per cent (YoY) to $10 billion which exceeds the sharp increase of 27 per cent (YoY) increase in 2010. The country’s growing dependence on oil has increased its vulnerability to oil-price shocks; in many ways, the PKR is even more vulnerable to a BoP crisis at present than it was in 2008, when the currency depreciated 28 per cent. Oil imports in 2011 are likely to surpass $14 billion, more than the size of the entire $11.3 billion IMF bailout.
Overseas workers’ remittances, a key anchor of rupee stability over the last two years, dropped sharply to $890 million in September from $1.3 billion in August, contributing to the larger C/A deficit. This was primarily due to the widening exchange rate spread between the inter-bank and informal open markets, with clients drawn to the higher premiums offered in the open market.
Rate cuts will boost import demand:
Since the conclusion of the IMF program in September 2011, the policy focus has shifted to boosting growth. The policy mix has shifted towards expansionary fiscal policy backed by an accommodative monetary stance. The central bank cut policy rates by an aggressive 150bps at its 8thOctober meeting in a bid to boost investment and reduce funding costs for the government. We expect these measures to boost growth to 4.0 per cent in FY12 from 2.4 per cent in FY11, said both the experts.
The policy focus has shifted to supporting growth:
The government is counting on higher growth and stronger corporate earnings to attract foreign investment and fund the external financing gap. This is a risky manoeuvre and the aggressive rate cuts implemented by the central bank in Q3-2011 will increase pressure on the rupee in the short term. Higher demand for goods and services will translate into higher imports, given that Pakistan is a large net importer of energy and capital goods.
Relations with IMF, US weigh on official inflows:
The $11.3 billion IMF Stand-By Arrangement ended in September 2011. Disbursement of the final $3.2 billion tranche of the IMF loan was suspended due to delays in key tax and expenditure reforms, leading to a widening fiscal deficit and an increase in government debt. The unsuccessful conclusion of the IMF program has put at risk official aid flows of $1.3 billion from the World Bank and the Asian Development Bank (ADB).
Disbursement of the remaining $3.2 billion of IMF loan a worry:
Official aid flows are the largest contributor to the financial account, and in their absence, funding the widening C/A deficit will become even more difficult. The government is already in talks with the IMF for a new loan. However, early indications are that the IMF will demand action on key reforms before releasing funds, including the elimination of subsidies and the introduction of new tax measures. Relations with the US are also critical. US aid flows to Pakistan’s military remain suspended, including $1.34 billion of payments under the Coalition Support Fund. Disbursement of non-military aid, including the $7.5 billion pledged under the Kerry-Lugar Bill, has been slow, with less than $200 million released in FY11. The government is budgeting for $500 million of grants from the US government in FY12, including pledges made under the Kerry-Lugar Bill and at the 2009 Tokyo donors’ conference.
FDI and portfolio investment decline sharply:
Weak credit metrics, the unstable political and security environment, and the absence of a credible reform programme have discouraged foreign investment in Pakistan. After record inflows of $5.4 billion in FY08, FDI declined sharply to $1.6 billion in FY11. In Q1-FY12, FDI inflows declined 28.4 per cent YoY to $283 million. Similarly, portfolio investment in equities and securities witnessed an outflow of $46.5 million in the quarter ended in September 2011.
FDI inflows are slowing, and portfolio flows have reversed:
The government projects FDI inflows of $1.65 billion in FY12. The $2.6 billion privatisation of Pakistan’s largest telecom operator was completed in 2005; however, $800 million was held up due to legal and property-related issues. The government hopes that by resolving the outstanding issues, it can convince the UAE-based company to release the funds. The government is also budgeting $850 million of receipts from the auction of 3G licences, which has attracted significant market interest. However, the timeline for the auction is unclear, and legal and regulatory hurdles need to be cleared in order for it to go ahead. There is a clear risk that these inflows might not materialise during the current fiscal year, which would complicate the financing of the C/A deficit.
Large external debt payments:
In addition to lower external funding, the Forex reserves will come under pressure due to higher external debt payments, including $1.2 billion of repayments to the IMF. Total debt repayments in FY12 are a staggering $4.2 billion, and we expect them to rise further to $5 billion in FY13, they said, adding that Pakistan will struggle to retire the IMF loan and maintain its FX reserves position.
Forex outlook:
Rupee has weakened sharply since early Q2-2011 (despite a recent recovery), more than reversing the gains registered at the beginning of the year. Sayem Ali and Priyanka Kishore expect this downtrend to be sustained over the coming months due to the following factors: A key reason for PKR strength in Q4-2010 and Q1-2011 was the unexpected improvement in the C/A. However, this is unlikely to persist. While remittances may remain strong, a wider trade deficit and higher interest payments are expected to push the C/A back into deficit in FY12.
Corporates transaction risk:
They further said that their USD-PKR forecasts are broadly in line with USD-PKR forwards, especially through Q3-2012. As such, Pakistani exporters should maintain neutral hedge ratios on USD receivables. The same is the case for Pakistani importers with USD payables.