The season of rate hikes and policy tightening is in full swing around the globe. The latest 50 basis point hike by the Federal Reserve jolted emerging economies as investors rushed across the Atlantic. Now, with subsequent similar increments planned throughout this year, the federal funds rate – the overnight interbank borrowing rate – is likely to climb above 2% by the year-end. Naturally, developing economies are following suit to prevent the egress of foreign investment and ease the bite of inflation cruising the surge in the US dollar. Pakistan is no different as it continues to chase stability in an inherently unstable environment. The conflicting geopolitical variables, internal political drama, and illogical economic policies – a confluence of these factors is pushing Pakistan into the abyss. Nonetheless, misery is avoidable if prudent policies get implemented – and fast!
The recent decision by the State Bank of Pakistan (SBP) to hike the benchmark interest rate by 150 basis points to an 11-year high of 13.75% is wielding a mixed impact. On a positive note, the decision is in-line with the market expectations predicted by expert economists. Thus, the markets have already adapted to the announcement – avoiding consequent volatility. Moreover, the rate hike is a central step to harness inflation – spiking to a 30-month high of 13.8% in May. Nonetheless, the SBP has increased the policy rate cumulatively by 675 basis points since September 2021. Still, inflation has lingered in double figures – climbing from 11.5% in November to 13.4% in April. While it is premature to claim that a hawkish policy is radically futile, tightening interest rates is not enough to grapple with the existing economic woes.
The searing inflationary pressure in Pakistan is mainly due to the geopolitical tensions in Europe. The Russian invasion and the retaliatory sanctions from the West have rilled the global commodity markets. Russia and Ukraine (combined) account for almost 30% of the global wheat supply. The Ukrainian seaports in the Black Sea – currently blockaded by Russian forces – are crucial to worldwide exports. And containment measures inflicted on the Russian economy are fanning prices of staple commodities like wheat, corn, and seed oils. Even global reluctance to trade with Russia – one of the biggest energy suppliers in the world – has bumped crude and gas prices into the abnormal territory. Cargoes of Liquefied Natural Gas (LNG) – initially bound for Asia – have redirected to Europe to replace millions of tonnes of gas imported from Russia. And as I’m writing this article, the Brent benchmark is rallying over $120/barrel – up from around $60/barrel last year. As a result, inflation in Europe has breached 9% year-on-year while the Consumer Price Index (CPI) measured US inflation clocked at a four-decade high of 8.4% in April. As LNG trades at a premium and crude prices continue to persist in triple figures, how can Pakistan – an energy importing nation – evade the brunt of imported inflation?
Pakistan’s import bill is weighted heavily apropos of petroleum imports – constituting roughly 25% of the total outflows. Imported furnace oil makes up about 31% of Pakistan’s energy mix crucial for electricity production. The sky-high fuel prices have already pushed the oil and petroleum import bill over $20 billion for the first ten months of the current fiscal year – more than double compared to the same period in 2021. With no sign of easing tensions in Ukraine, and Europe discussing options to impose an embargo on Russian energy imports, Pakistan’s trade deficit is likely to breach the $50 billion marker by the culmination of this fiscal year. Yet, growing exports and record-high remittances have allowed breathing room to the current account balance – currently hovering at a deficit of $14 billion. Curiously, excluding oil and petroleum imports, the Current Account recorded a surplus for the second consecutive month in April. Hence, the rapid depletion of the forex reserves held by the central bank – standing near $10 billion – is predominantly due to the oil payments made to the international market. Given the unfortunate context currently hosting inflation, how can a rate hike ease the price pressure? How can we expect to dilute inflation without even addressing a resolution to energy-import-driven inflation? And why is the focus on demand-side policies and not supply-side variables?
Demand-side policies are casting a contrarian effect on the economic stability of Pakistan. Unlike the United States, Pakistan is a developing economy that thrives on growing consumption, investment, and industrialization. While many analysts believe that a nearly 6% growth rate is unsustainable in the presence of macroeconomic imbalances, demand-curbing policies without supporting guidance are detrimental to export growth. The policy rate, for instance, is already abnormally high compared to the regional economies of India and Bangladesh. A persistent (and unnecessary reliance) on monetary policy has made credit costs unaffordable for the business community of Pakistan. Competing for international orders in markets – such as apparel or leather – now adds an artificial burden on domestic exporters. Naturally, prohibitive credit costs would put Pakistani exporters at a competitive disadvantage against regional rivals – especially in the markets with homogenous products. Ultimately, Pakistan risks losing international standing in growing markets or compromising on quality to maintain a competitive price-cost parity – both could plunge the export revenue of Pakistan. Moreover, as over 90% of Pakistan’s imports are essential goods, they been historically price inelastic. Thus, a high policy rate threatens to plummet export proceeds instead – further widening the trade deficit.
Additionally, the high policy rate continues denting the government budget due to heavy domestic borrowing. Almost 75% of commercial deposits have been lent to the government of Pakistan via recurrent auctions of T-bills and Pakistan Investment Bonds (PIBs). The SBP has been restricted from directly funding budgetary support to the government under the State Bank of Pakistan (SBP) Amendment Act 2021. Yet, the central bank has continued to provide trillions of rupees in liquidity to commercial banks through longer-tenure Open Market Operations (OMOs) – indirectly financing the cash-strapped regime. During his 45-month stint in office, former Prime Minister Imran Khan accumulated record borrowings worth Rs 21 trillion. With the IMF program on hold and multilateral lenders eyeing prospects of resumption on the sidelines, the government is again turning to commercial banks. However, the yields (traditionally settling at a 1% to 2% spread from the benchmark rate) are exorbitant. According to the Pakistan Bureau of Statistics (PBS), the yield on three-month T-bills stands at 14.3% in the secondary market, while six-month and twelve-month T-bills yield 14.5% and 14.6%, respectively. Hence, high policy rates and excessive OMOs are inadvertently ballooning the budget deficit – already hovering at Rs 5.6 trillion – via excessive interest payments.
Fortunately, the political chaos is settling after months of uncertainty, and fuel prices are inching towards reality. However, the Rupee is still trading near record-low in the interbank market – sustaining high import costs. Meanwhile, completely eliminating petroleum subsidies could likely push inflation to 18% by the end of this fiscal year. Banning about three dozen luxury imports is the latest step towards progress. However, it is merely a populist move as luxury goods accounted for only 1% of the total import bill of Pakistan. Thus, more stringent measures are needed to stabilize the economy. Pakistan’s Eurobonds have lost almost one-third of their value in the secondary market. And according to Dr. Khaqan Hasan Najeeb, the finance ministry’s former adviser, Pakistan’s default risk – measured by the Credit Default Swap (CDS) – has spiked to over 1,549 on the global index. Pakistan is scheduled to make repayments worth $4.5 billion on maturing global bonds in June. Unless the IMF resumes the $6 billion loan program, international borrowing is beyond approach for Pakistan. Commercial borrowing is also edging its limit as Pakistan cannot afford to borrow at existing yields. Thus, approaching multilateral and bilateral lenders is the only available option in the short run.
In the long run, supply-side reforms are the need of the hour. Currency swaps with China could hedge Pakistan’s sensitivity to sharp movements in the US dollar. National oil refineries should be upgraded to enhance their throughput and reduce the burden on the import bill. Meanwhile, the policy rate should get lowered to allow the export-oriented industries to grow and mitigate the trade imbalance. Ultimately – sensible, independent, and complimenting monetary and fiscal policies are pivitol to channel Pakistan through the choppy waters of uncertainty currently upending the global economy.