- Upbeat momentum on the back of huge infrastructure projects involving the China-Pakistan Economic Corridor (CPEC).
- The CPEC is however widening external imbalances.
- The current account deficit is worsening; the overvalued rupee and foreign exchange reserves are also under pressure.
- The external debt service is rapidly growing and could force Islamabad to seek a new IMF programme after the summer elections.
- Short-term political risk has a negative outlook as a result of falling liquidity.
- Increasing financial dependence on China.
- Security risks have improved but remain high.
Robust GDP growth at a 10-year high
Pakistan’s economy is in strong shape, and has been accelerating since 2016. After having grown by a decade-high 5.3% during the 2017 financial year (FY) (from July 2016 to June 2017), GDP is expected to climb to 5.6% during FY 2018. Several factors are contributing to this positive economic cycle, from higher private consumption to rising exports in a sustained global environment and the stabilising of workers’ remittances from the Middle East. This confident economic climate is characterised by strong double-digit credit growth. Furthermore, the China-Pakistan Economic Corridor (CPEC), worth USD 62 billion, is clearly a major growth driver through massive Chinese-funded projects – mainly by Chinese public companies – which are slowly improving transport infrastructure and energy supply. The CPEC is a long-term plan that will help to maintain the growth outlook at a solid 5% for the next five years.
In order to achieve long-term growth at higher rates, the country is counting on the improvement and expansion of infrastructure thanks to the boost from the CPEC, but it would also need to raise insufficient domestic investments (15.8% of GDP in FY 2017).
The CPEC precipitates a swift rise in external vulnerabilities
As frequently happens in economies driven by sudden, major foreign direct investment (FDI), large macroeconomic imbalances can occur. Between 2013 and 2016, Pakistan received financial assistance from the IMF, which allowed the country to tackle a liquidity crisis while restoring macroeconomic stability and budget discipline. However, since the end of the IMF programme and with the acceleration of CPEC projects, those achievements have quickly evaporated. In addition, the reform drive slowed down during this election year. Therefore, to make the necessary adjustments and avoid a new balance of payments crisis, Islamabad could again be constrained to request a new IMF programme after this summer’s general elections.
On closer inspection, it turns out that all main macroeconomic indicators have been rapidly deteriorating. More specifically, the external position has weakened greatly since last year as a result of higher imports of FDI-related capital goods and soaring oil imports – Pakistan is a proportionally heavy oil importer – which have been rapidly widening the current-account deficit (from around 10% in FY 2016 to an expected 30% of export revenues in FY 2018).
One mechanical consequence is the depreciating pressure on the Pakistani rupee. It slid by nearly 10% in four months (i.e. by 5% in December and by 4.5% in March) to an all-time low vis-à-vis the US dollar after the State Bank of Pakistan (SBP) temporarily withdrew support, which in practice consisted of making two devaluations. The likely further weakening of the external position will continue to put pressure on the rupee, which will be contained by the intervention of the central bank (in turn putting pressure on foreign exchange reserves).
Pakistani authorities are divided between: (i) preserving the country’s liquidity by tolerating a more flexible rupee that could boost exports via improved competitiveness, and (ii) preventing inflation from rising too much ahead of the election. This second option is unpopular as it would first hit the large, poor share of the population, harm consumption and further swell heavy import costs, and thus the current-account deficit. However, the SBP might have to allow extra depreciation of the overvalued rupee later this year. Meanwhile, the inflation rate has increased since 2017 partly due to a weaker rupee and rising oil prices. It is expected to end in FY 2018 at over 5%, i.e. below the SBP’s 6% target rate.
Chinese loans swell external debt, and in turn erode liquidity
Financing the sizeable CPEC plan translates into higher external debt. Starting from moderate levels (27.5% of GDP in FY 2017), external debt ratios are on a constant long-term upward trend fuelled by sovereign bonds and costly commercial loans. The main worry comes from a heavier debt service since 2017 – forecast at 26.6% of export earnings by 2020 – as non-concessional lending by Chinese development banks has been rapidly increasing. In the near future, external debt repayments will absorb a growing share of current-account receipts and put pressure on liquidity. The more external debt sustainability decreases and the financing gap in the balance of payments widens, the more foreign exchange reserves will be drained, and Islamabad will have to issue costly sovereign bonds, as seen in recent months.
The managed exchange rate regime and a large deficit of the overall balance of payments will continue to push down foreign currency reserves to weaker levels in the coming months. After reaching a record high of USD 20.5 billion in October 2016, foreign exchange reserves then tumbled by 32% in the subsequent 16 months, and are now equivalent to less than 2.5 months of imports. Gradual liquidity erosion could lead Credendo to downgrade its short-term political risk rating – currently at 4/7 – during H2 2018, and could increasingly justify financial support from the IMF and/or bilateral donors this year.
The heavier public debt servicing is also weighing on the federal government budget. It adds to the already rising trend in expenditure linked to CPEC-related public spending and the upcoming elections. Therefore, heightened spending could largely offset the expected improvement in revenue and tax collection, and thus keep fiscal deficits high, i.e. above 5% of GDP in the long term. As a result, public debt is forecast to remain around a high 67% of GDP.
Increasing financial dependence on China, high albeit reduced security risks
Pakistan has become increasingly dependent on China via the fundamental CPEC project, in both economic and financial terms (China is its primary supplier of goods, with a 30% share). The fact that Islamabad has accepted the use of the RMB for future bilateral trade and is contemplating Chinese “Panda” bonds as an option to meet some of its wide financing needs rather than taking on new IMF loans illustrates this trend. This financial interconnection has also strengthened since the suspension of US aid earlier this year, justified by Islamabad’s failure to fight terrorism groups. Thus, ties with the Chinese ally will continue to deepen, also politically to form a bloc in the face of the US-Indian alliance.
This is taking place within a context of strained relations with India, particularly regarding the Indian Kashmir, where violence has intensified. Security and terrorism risks remain high across Pakistan, notably in sensitive areas where the CPEC projects are underway, such as Balochistan and Kashmir. However, it should be borne in mind that over the past three years overall security risks have declined significantly, after the army waged an effective war against Islamist militants in tribal areas.
In spite of deteriorating economic and financial risks, and political uncertainty in the run-up to the general elections, Credendo is unlikely to change Pakistan’s medium- to long-term political risk (currently at 6/7) in the coming months.
Analyst: Raphaël Cecchi – email@example.com