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The narrow path
SOVEREIGN defaults bring about a lot of misery in their wake from long lines for medicines and infant formula to social unrest and political violence. Surprisingly, defaults are very common as 147 defaults have taken place worldwide since 1960.
Ever since Pakistan’s Credit Default Swap (CDS) rates have shot up, many people have become worried about the health of the economy, wondering if the economy is heading for a crash landing, especially as the global economic situation has taken a turn for the worse once again.
Despite these challenges, there is a path available to Pakistan’s economic policymakers through October next year, but it is very narrow and treacherous and can easily become unnavigable.
Anxieties regarding Pakistan defaulting peaked in mid-November as CDS rates reached an all-time high. This government’s critics were quick to predict an economic default through various WhatsApp messages, memes and YouTube videos.
Mass expectations of impending economic doom reached such a high level that the finance minister was forced to break his silence in order to calm nerves.
Despite the hue and cry, the fact is that CDS are thinly traded instruments, which only indicate the cost of insuring against sovereign default as CDS rates are not the probability of default itself.
The rise in CDS rates is mainly driven by domestic political instability and by the brutal global economic conditions, including recessions in China, Europe and the US.
What could be driving the intense chatter regarding default?
Pakistan’s economy faces strong headwinds, but, at least in the case of the external account that was on the brink of a liquidity crisis a few months back, economic policymakers have been able to turn things around, for now.
Pakistan’s imports were down 20.15 per cent year-on-year after the first five months of the present fiscal year. Though exports and remittances are down too, the massive contraction in the import bill will significantly reduce the current account deficit.
If present trends continue with respect to imports and lower international oil prices, Pakistan may end the year with a current account deficit around $5 billion, thereby removing pressure on Pakistan’s exchange rate and its foreign exchange reserves.
Analysts had earlier concluded that Pakistan had more than enough financing available in this fiscal year. This proactive reduction in Pakistan’s current account deficit will further improve Pakistan’s ability to narrow the financing gap.
If CDS rates do not portend default and if current account numbers are much healthier than before, then what could be driving the intense chatter regarding impending default? Interes-tingly, people suddenly talking about default around mid-November was also strongly correlated with intense political activity around that time.
In the past, this government’s critics have tried to stir up a frenzy about impending default so as to force the political system to move towards early elections. This phenomenon could be why impending default started trending on social media again.
In trying to stir up a frenzy, this government’s critics are making two grave errors. First, where the critics believe that ratcheting up pressure on the government will move the political system towards early elections, the reality could not be further from this assumption.
For whenever there is talk of impending economic collapse, it forces more people to repose their trust in this government as one political party in this coalition is often linked with better economic management compared to the present opposition.
Second, and somewhat alarmingly, there is a real danger that if belief in impending economic collapse attains critical mass, massive anxiety could actually bring about the collapse as people would stop spending and investing thereby turning an idea originally conceived to gain political leverage into a self-fulfilling prophecy. This age of social media, where fake news takes no time to become viral, is especially vulnerable to such negative outcomes.
Pakistan is not defaulting, but the world remains in the clutches of an economic crisis. Where China’s economy is suffering from renewed lockdowns due to zero-Covid policy, Europe and the US are left with no option but to increase interest rates to get a grip on runaway inflation, the highest in 40 years, thereby putting brakes on economic growth and job creation.
This economic turmoil will impact Pakistan’s economy negatively. On top of this, the need to divert funds towards relief, rehabilitation and reconstruction in the wake of the floods will reduce this government’s fiscal options. And, then there is the political opposition, which will not turn the other cheek whenever this government makes policy mistakes. All in all, a very potent mixture.
Still, there is a narrow path available to policymakers through October next year. But, this path is as narrow as a knife edge and leaves no room for error or even experimentation like reducing interest rates in the face of staggering inflation.
Pakistan must maintain course with a tight fiscal and monetary regime, resisting the urge to provide politically motivated subsidies unless targeted towards the most vulnerable sections of society.
The working relationship with the IMF should also continue in order to ensure that Pakistan finishes the present programme, albeit with a new economic and fiscal framework as the previous targets have become irrelevant due to the floods.
A big reduction in the current account deficit has created some breathing space but this will not last forever. In the final analysis, Pakistan’s policymakers will have to take tangible steps to increase the country’s exports.
Defaults are bad news and the word should never be used casually. In the case of Sri Lanka, default brought about a lot of misery for the common people; from long lines at petrol pumps to the lack of government-sponsored insulin. In Lebanon, where default led to the currency losing 90pc of its value, half the population now lives in poverty.
Pakistan’s economy faces no immediate threat but the global economic conditions are very challenging, with the IMF warning that the worst is yet to come. The country’s policymakers will have to tread a narrow policy path very carefully.
The writer completed his doctorate in economics on a Fulbright scholarship.
Twitter: @AqdasAfzal
Published in Dawn, December 9th, 2022
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