Pakistan has evaded the threat of default, but it lingers, ready to devour the state. The State Bank of Pakistan estimates Pakistan’s total external debt to be at Rs2.42 trillion as of August 2023, with Rs2.04tr loans from the International Monetary Fund as of June 2023. In April 2022, Sri Lanka defaulted on its external debt of $54.3 billion. Economists have speculated that Pakistan will end up like Sri Lanka due to their similar economies.

A default is never sudden but rather a domino effect of events. In the case of Sri Lanka, the downturn began in 2019 with the fall of the tourism industry, which is the third largest source of foreign reserves after remittances and the garment industry. In 2018, the industry generated a whopping $4.44bn in reserves, constituting 5.2pc of the gross national product (GNP).

However, in 2019, the influx of tourists decreased considerably due to security concerns after the Easter Sunday Bombings. Soon after, Covid-19 forced the country to shut its doors to visitors. The industry contracted to $0.62bn in 2021, a mere 0.7pc of the GNP. Even after the pandemic, the industry struggled to revive due to the ongoing Ukraine-Russia conflict.

Parallels can be drawn between Sri Lanka’s tourism industry’s collapse and Pakistan’s agriculture industry’s collapse. In June and August 2022, massive floods buried 9.4 million acres of crop area in Pakistan, as per the Food and Agriculture Organisation, affecting 33m people dependent on it.

International relations and economic strategies averted Pakistan’s crisis but perpetual debt reliance is unsustainable

The floods resulted in a food security crisis; Pakistan must import wheat and other crops to fulfil its food requirements. However, since the country has lost one of its primary export, ie agrarian produce, the foreign reserves may be insufficient to afford imports.

The Planning Commission of Pakistan estimated the damage caused by the floods at $3.7bn, and $9.24bn in the long term. The state’s GDP has contracted by 0.5pc in the last fiscal year and is projected to reach 2.3pc by 2025, considerably low compared to the 6.1pc growth in 2022.

However, the default analysis isn’t purely economical; a country’s international relations can determine default and stability. Sri Lanka was required to restructure its debt obligations with major creditors, ie China, Japan and India.

However, only India stepped in by providing financial support of $4.5bn through loan deferrals, currency swaps, credit lines, etc, subsequently facilitating Sri Lanka’s International Monetary Fund (IMF) bailout. China and Japan’s support was passive and based on humanitarian grounds. China offered support of $7.4bn but refused to help restructure Sri Lanka’s loans and provide further assistance primarily since China considers the IMF a trade and power rival.

Similarly, Pakistan had to seek financial assurances of $8bn from its top lenders, ie China, UAE, and Saudi Arabia, to avoid default. China played a crucial role by rolling over and refinancing a debt of almost $7bn, granting Pakistan breathing space to fulfil its critical debt obligations. China’s support of Pakistan can be credited to the Belt and Road Initiative and the China-Pakistan Economic Corridor.

In 2023, the IMF demanded that Pakistan provide financial assurances from other lenders to release the remaining $1.1bn tranche from the Extended Fund Facility 2019. China, Saudi Arabia, and UAE immediately provided financial assurances; China rolled over its $2bn debt and UAE and Saudi Arabia pledged $1bn and $2bn, respectively.

Not only did the IMF release the payment, but it also entered into a $3bn Standby Agreement in July. Sri Lanka’s lack of foreign support was its undoing, while Pakistan benefitted from its international relations.

Not only were external factors like floods and Covid-19 hampering Pakistan and Sri Lanka’s economy, but internally, both countries also struggled. Pakistan’s then finance minister, Miftah Ismail, at that time, alarmed many Pakistanis since he had removed any sort of peg, and Pakistan had shifted to a free-floating exchange rate. His ideology was to abide by IMF policies to procure IMF deals faster and without hassle.

However, his replacement, Ishaq Dar, followed with the exact opposite approach, ignoring the IMF. A managed floating rate was introduced to keep the dollar rate near Rs220. Unfortunately, this meant the foreign exchange reserves with the State Bank went from $8.8bn in August 2022 to $3.11bn in January 2023.

Since the dollar rate was being pegged at a lower rate than the informal market, this meant dollars were being introduced into the country through informal channels or not at all; this was exemplified by remittances dropping from $2.7bn in September 2022 to $1.9bn in January 2023.

The government, fearing default,

shifted back to a free-floating rate in January 2023. Instantly, the dollar

went from Rs228 at the start of January 2023 to Rs277 by its end; our reserves were no longer being used to keep it at a lower rate.

This was done to appease the IMF so that they and other nations might be more willing to deal with us. Fortunately, this did work, and the IMF agreed to a deal, and Pakistan managed to avert default for the time being.

This lacklustre approach is similar to Sri Lanka, whose central bank, throughout 2020-23, constantly interfered when the Sri Lankan Rupee fell. It became particularly problematic when, in 2022, the Sri Lankan Rupee fell by 50pc against the USD and all of the central bank’s reserves were used to maintain the ad hoc peg. This meant they went from $6.4bn to only $2.3bn in their foreign reserves, and the country had to declare default.

Currently, Pakistan is performing better and is abiding by the IMF policies of a free-floating rate. Remittances have recovered and foreign exchange reserves have also increased to $7.51bn during the week that ended on Nov 3. Pakistan’s global significance and current economic strategies help prevent default, but perpetual debt reliance isn’t sustainable. We must break this cycle.

The writers are students at the Lahore University of Management Sciences

Published in Dawn, The Business and Finance Weekly, November 13th, 2023