Managing economic risk

Having entered its sixth month in office, Prime Minister Nawaz Sharif’s government has to deal decisively with a number of urgent economic challenges even as it has taken the necessary first steps to stabilise the economy.

The most immediate vulnerability lies in the country’s external position. Foreign exchange reserves have plunged to a critical low in the past two months. This has resulted from a sharp rise in the current account deficit, with the import bill surging, capital flows at a virtual standstill and continuing external debt repayments, including to the International Monetary Fund (IMF).

Reserves have also depleted at an accelerated rate because the central bank has been intervening in the interbank market to shore up the value of the rupee. Running down foreign currency reserves to buy rupees contributed to reserves dwindling to an alarming level in early October – to just under $4 billion, and not enough to cover even a month’s imports. By the end of October however, reserves (held by the State Bank) had recovered to $4.2 billion.

This still puts reserves in the range that precipitated the 2008 balance of payments crisis. The important difference is that there is now an IMF programme in place. But more repayments loom to the IMF (on the earlier loan) and other creditors. In November around $744 million is due to the Fund as well as an unspecified amount owed to others.

An IMF mission is currently in Islamabad to conduct a quarterly review of progress as required under the Extended Fund Facility (EFF) arrangement that was agreed in August for a fresh three-year $ 6.6 billion loan. Once this review is concluded, which is contingent on Pakistan meeting several conditions agreed with the Fund, the IMF’s executive board will meet in mid-December to approve the release of the next tranche of the loan – around $540 million.

Herein lies the challenge for the country’s economic managers. With more outflows than inflows expected in the next few months, managing the reserve position acquires critical importance especially to avert any precipitous erosion of market confidence. Some analysts have critiqued the design of the IMF programme for not anticipating that it would take time for reserves to build and that a period when outflows could exceeded inflows (given the staggered nature of EFF disbursements and time lag for financial resources to flow from other multilateral agencies) could leave Pakistan in a precarious position, struggling to meet its external finance requirements.

That may be true. The IMF may also have underestimated the balance of payments gap. This is why the government has asked the Fund for additional upfront money to help it tide over this fragile situation. But this still leaves the government with the daunting task of managing a tight reserve position in the next six months to meet liabilities and prevent any panic in the market.

This is especially so as funding committed by other multilateral institutions and bilateral partners, conditioned on the IMF deal, is not likely to kick in for another four to five months. The government therefore has to deftly negotiate this period and signal to the market that it is proceeding according to a plan to address the balance of payments problem and build reserves over time.

In meeting this challenge the government faces an inevitable trade off, which the central bank has already been struggling with in recent weeks – between preserving reserves and defending the currency. Initially the State Bank of Pakistan fulfilled the ‘prior action’ committed to the IMF by starting net purchases of foreign exchange. But thereafter it reversed course especially after the panic that gripped the currency market on September 26.

On that day the exchange rate witnessed unprecedented volatility as market sentiment fluctuated wildly. This in turn led the central bank to undertake almost daily interventions to shore up the value of the rupee. The danger of panicked and disorderly interventions is that they can eventually drive the reserve level so low as to produce the very outcome they aim to prevent: a currency collapse when reserves run out.

This danger has to be mitigated by consistent, steady and proactive action to maintain the reserve level while ensuring that exchange rate adjustment occurs in an orderly and planned way rather than being driven by speculative trading or panic. This may not be easy. Indeed the price of mismanaging the reserve level and market/public expectations is so high that economic managers need to carefully calibrate the outcomes and ensure that reserves are not run into the ground.

While this remains an area of vulnerability, the government has shown resolve on other fronts in taking measures essential for fiscal consolidation. This has put it on track to fulfil all the performance criteria (except the quantitative target for foreign exchange reserves) for the end-September quarter of the IMF programme, required by the technical memorandum of understanding with the Fund.

While sustained budget management will remain the bedrock of efforts to fix the economy, the fiscal deficit target is on track for the first quarter of this fiscal year. Much of the adjustment has come from the rise in electricity tariffs. The energy sector tariff plan will reduce and eventually end the huge and unsustainable expenditure on power subsidies that has been such a crushing burden on the exchequer. The first round of price increases for commercial, industrial, bulk and large consumers is expected to reduce subsidies by the equivalent of $1.7 billion on an annual basis.

On the revenue side, the first step towards additional mobilisation has been the issuance of ten thousand tax notices based on large potential tax liabilities. But the next step is more crucial – following up on these notices and ensuring collection.

More important will be action promised by the government to widen the tax base by implementing a three-phase plan to eliminate Statutory Regulatory Orders (SROs). The SRO regime is a shameful system of tax concessions and exemptions granted to special interests that has long denuded the exchequer of billions in lost revenue.

The government intends to eventually end the SRO practice by an act of parliament. But the first step to that end, planned for this December, will be to separate ‘necessary’ SROs – such as those for free trade areas – from those granting exemptions or concessions, which will be eliminated. If it is able to move in this direction the government will send an important signal that it puts the public interest before that of its own political constituency: big business. It will also be able to reduce the fiscal deficit without imposing new taxes.

The government is set to announce a gas levy in December 2013, which also aims to generate fiscal savings. This won’t be popular and will test the government’s ability to stay the reform course in the face of potential opposition. But having held firm on electricity tariffs as part of its broader energy strategy, the government has shown initial seriousness about reform.

Its privatisation plan has also sent a positive signal. But as with everything else, much will turn on how this is executed. It should be conducted in a transparent and fair manner to avoid favouritism or “crony capitalism”. Success will be measured by how this helps the economy as well as ordinary citizens by provision of more efficient services, as for example by PIA.

As the government seeks to manage both the urgent and important it should address two other areas that are essential for effective policy implementation. One, it needs a communication strategy to explain what it is doing and mobilise public support for its economic measures. Building confidence at an economically fraught time is especially necessary in today’s 24/7 media environment.

Two, institutional reform remains the missing link in the government’s reform agenda. Appointing a capable person to head FBR for example is a necessary but not sufficient move. Without institutional strengthening even well-devised policies stand little chance of being robustly enforced.

The writer is special adviser to the Jang Group/Geo and a former envoy to the US and the UK. Twitter: @LodhiMaleeha