PAKISTAN is once again in the danger zone owing to allegations of terror financing, and the situation can translate into economic damage.

The Financial Action Task Force (FATF) decided last month to place Pakistan on a grey list of nations that are not doing enough to combat terror financing.

Pakistan’s failure to comply may damage its reputation as an investment destination, which will lead to economic losses. Moreover, the country may also face increased transactions costs, restricted access to international financial market and the downgrading of its banking sector’s rating.

The economic fallout of the listing is contextual. Speculating economic costs, therefore, must involve reasons expounded for and context of inclusion, economic and political state of the country and the likelihood of a successful demonstration of compliance in addition to compliance itself.

More than compliance, it is the demonstration of compliance that will decide how long we stay on the FATF watchlist and what economic costs we face

Being on the grey list may have varying impact across the countries and over time. Therefore, suggestions that there will be no economic impact based on the previous experience are generalised and political.

Pakistan was on the grey list during 2012 to 2015 on charges of money laundering. But this time around, the primary charge is terror financing. One can clearly understand that given the level of distrust, the response of the international community would be much strict this time.

Restrictions on Pakistan’s access to the international financial market may be stricter this time than in the 2012-2015 period.

Rating agency Fitch has already revised the outlook on Pakistan’s long-term foreign and local currency issuer default ratings to negative from stable on account of a partial reversal of gains made under a three-year IMF programme that ended in September 2016.

Other agencies like Standard and Poor’s and Moody’s are also likely to downgrade country’s sovereign debt rating. The ongoing episode of political instability multiplies this risk. Financial institutions may tighten the lending or will add higher risk premium to markup. Both outcomes can put the economy in distress.

Given the fact that Pakistan is posting historically high trade deficits, the demand for borrowing is at the highest level. The deficit may further widen as the FATF watchlist may serve as non-tariff barrier to the country’s exports.

The flow of foreign currency may also shrink. At the same time, any increase in the cost of borrowing would also hurt the economy. The impact is directly proportional to the size of the economy; therefore, it will be much bigger than the previous episode of 2012-2015 as Pakistan’s current $300bn-plus economy needs a flow of resources to grow at 5pc.

Increased transaction cost and reputational loss also discourage foreign investment and the inflow of remittances. It is the foreign direct investment (FDI) that will suffer the most.

Capital is very sensitive to uncertainty. Already facing political instability, Pakistan may witness capital flight if it continues to be on the grey list for more than a year.

This can cause a decline in government revenues and general economic activity.

If the listing period gets longer — for which odds are higher — we may end up going to the IMF. But the IMF, World Bank and other international lenders may play cold given the fact that the FATF motion comes from the United States.

Being on the watchlist also has repercussions for Pakistan’s banking sector. Rating agencies can demote ratings of individual banks, particularly those operating abroad. This may put the banks under strict regulations, thus reducing their overall competitiveness by increasing compliance costs.

In addition, foreign banks may leave the country or may increase the cost of borrowing to domestic and public sectors. Overall, it squeezes the chances of joint ventures. The corporate sector, particularly companies working with the United States and other western clients, will face a disproportionate setback.

Though the present listing may be politically motivated, compliance is mandatory for Pakistan. The cost of no reforms will be much higher than the cost of reforms.

A well-targeted diplomatic exchange needs to be structured to demonstrate to the global community in general and related authorities in particular that we are serious about curbing money laundering in all its forms and that we have zero tolerance for terror financing. We also need to exhibit it clearly that we are open to work with stakeholders in this regard.

More than compliance, it is the demonstration of compliance that will decide how long we stay in the list and what economic costs we face. This is where Pakistan appears to have failed.

The writer heads Policy Solutions Lab at the Sustainable Development Policy Institute

Published in Dawn, The Business and Finance Weekly, March 5th, 2018