The liquidity crunch

Disorderly movement in key markets has been observed in recent months. High volatility of the rupee against all major currencies, abnormal surge in Pakistani credit default swaps and Pakistani international bond yields surged over 50 percent on an annualized basis. Less than a desirable image.

The resumption of the IMF program was linked to the inherent expectation of economic stabilization and a return of confidence in the markets. The board’s approval of the program in late August gave markets a temporary boost of confidence – which proved short-lived. The recent change in the economic team has given sentiment in the Pakistani foreign exchange (FE) market a renewed upward trend.

Troubled markets reflect a heightened dollar liquidity crunch engulfing the economy. A multitude of factors led to this crisis. The excessive delay until August 29, 2022 to have the IMF as an anchor has primarily helped push the economy through an agonizing odyssey.

It slowed the flow of program and project loans from multilateral and bilateral partners at a time when Pakistan’s external financing needs surged to $17.4 billion on the back of a burgeoning current account (CAD) deficit. Total gross funding needs for FY22 escalated to $34.3 billion, but regulators were only able to raise $26.9 billion. This resulted in a sizable deficit of US$7.4 billion, leading to a drop in the State Bank of Pakistan’s (SBP) foreign exchange reserves. The ordeal has continued in FY23, with SBP reserves shrinking 18 percent in the first three months.

Central banks hold foreign exchange reserves to ensure liquidity to meet a country’s international financial obligations and to reassure markets. The erosion of reserves over a short period of time has kept markets in suspense.

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Foreign direct investment (FDI), an instrument that creates no debt, fell 26 percent, or $60 million, in the first two months of FY23 compared to the same period last year. Political uncertainties are weighing on investment sentiment, particularly when the global scenario is less supportive of foreign capital flows. US Federal Reserve rate hikes have reversed capital flows out of emerging markets (EM). Outflows from EM bond funds have reached $70 billion in 2022. The Ukraine crisis has diverted other major funds. All of this adds to the specter of an intensified dollar liquidity crisis in Pakistan.

The liquidity crisis is having a serious impact on the real economy. The 16.5 percent drop in Pakistani bulk production in July 2022 partly reflects the impact of administrative restrictions on opening L/Cs to save valuable foreign exchange. Global stagflation and domestic flood damage are likely to weigh on exports. Pakistan’s export growth could fall well short of the estimated 13 percent increase to $35.9 billion in FY23. Taking the first quarter run rate, merchandise exports may not surpass the $30 billion mark — that’s really worrying.

On the other hand, additional food and cotton needs may result in imports exceeding the estimated $68.7 billion in FY23. And so, the estimated CAD$9.3 billion for FY23 could be surpassed. Estimated US$33.3 billion in foreign financing to cover debt payments and CAD, even if made available, could barely cover CAD surge.

A revision of the macroeconomic projections has become unavoidable. Estimates of FY23 GDP growth, budget deficit and CAD will need to be reassessed due to the severe negative impact of the floods on agriculture, livestock and infrastructure and the adjustment of the rupee.

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A revised macro framework can form the basis for further negotiations with the IMF. The provider of last resort is aware that the country still lacks macro-stability. Increased support from the ongoing IMF program and eliciting the concessional window of rapid financing instruments can help alleviate the crisis and build foreign exchange reserves.

Overcoming the liquidity crisis is a prerequisite for macro stabilization and market confidence. Fast-tracking projects funded by multilateral funding and highlighting new infrastructure projects due to flooding can expedite the pipeline of international funds. $1-2 billion in program loans can be accelerated by completing agreed-upon reforms. ADB’s $1.5 billion countercyclical financing facility, even at a slightly higher premium, is a welcome move.

Market signaling will play a role. The authorities’ confirmation of the $7 billion renewal of existing facilities with bilateral partners for FY23 is critical. $4 billion in new funding commitments from China, Qatar, Saudi Arabia and the United Arab Emirates remain hazy. Part of the money is promised as an investment in Pakistan. In the face of a weak economy and political turmoil, investment money can only become a reality by taking concrete steps and bypassing a congested system.

The import bill can be lowered. Conservation is today’s energy policy and energy policy is economic policy for the foreseeable future. A conservation plan can bring down the import bill of petroleum products from a FY22 peak of $23.3 billion. Additional FX savings are possible by securing RLNG and oil on deferred payments from Saudi Arabia and Qatar for FY23. At the same time, consumption compression is necessary in order to reduce imports.

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There are echoes of foreign debt restructuring through a UN policy note. This can be seen in the context of a Paris Club debt restructuring and the recent debt service suspension initiative. Specifically, $1.175 billion in Paris Club payments due in FY23 may be deferred to allow some fiscal space for flood relief spending.

The bilateral debt restructuring does not imply default on Pakistan’s trade and borrowing obligations. Authorities should plan to refinance Sukuk’s $1 billion bond issue due December 5, 2022. The containment market for foreign exchange also requires steps to increase liquidity through administrative measures to control smuggling and manage excessive foreign credit card payments. Other areas include swift action against banks allegedly involved in excessive charges for letters of credit, reducing the deadline for export earnings held abroad and allowing FE 25 accounts to be converted. The country must immediately ensure that a liquidity event does not become a solvency problem.

Building buffers can help meet funding needs in the event of delays in expected inflows. The authorities need to start thinking about a plan to ensure the long-term sustainability of the country’s chronic balance of payments problem. This requires a path to a much more humble CAD. Rethinking how companies finance machines by raising funds abroad are some ideas that research can turn into concrete feasibility studies to reduce CAD.

A lasting solution to our dollar liquidity challenge is to rethink the course of the growth model based on productivity, global integration, fostering competition and strengthening the country’s human capital base.

The author is a former adviser to the Treasury Department. He tweets @KhaqanNajeeb and can be reached at: [email protected]

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