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The office of denial

There is a difference between a good and a bad finance minister: the former keeps his nation informed about the true state of the economy and prepares public opinion for adoption of appropriate policy measures to keep the economy healthy; the latter misreports facts and lulls the public into believing that all is well – till the economy begins to unravel itself.

Pakistan’s new finance minister, Saleem Mandviwalla, has started his job on a wrong footing. He is in a state of denial about the state of the economy. This he demonstrated in his first press conference on February 26 and the decisions taken at the Economic Coordination Committee meeting he chaired the same day. The flaws in his understanding of policy issues and his approach to the country’s economic management are too obvious to be ignored.

First, without showing real understanding of the economic history of the country, he declared that “Pakistan had never faced bankruptcy in the past, nor would it in future.” He even dubbed as “rumour-mongering” serious analyses done by professional economists on the balance of payments, and their warnings about the looming foreign-exchange crisis.

He perhaps does not know, or cannot remember, that Pakistan has been on the slippery slope of a balance of payment crisis for the last two decades, and has resorted to frequent use of IMF resources and rescheduling of external debt to avoid debt default.

In fact, the IMF has labelled Pakistan as one of the “prolonged users” of its resources without any progress in efforts to address the structural disequilibrium in its balance of payments. The reason is that no government really realised the gravity of the situation, and each one of them engaged in temporary patchwork, which has led to the present debt trap.

Second, the minister has demonstrated his lack of concern about the precarious budgetary and monetary situation by approving substantial financial packages for PIA and the Pakistan Steel Mills to bail them out of financial bankruptcy, and by releasing funds for wasteful government spending before the elections. It may delay the financial collapse of bankrupt public-sector enterprises and hoodwink people into voting for the present government, but it will put the country on the fast track towards financial bankruptcy.

The reality is that the government is unable to generate enough revenue to meet even its non-debt-servicing non-developmental current expenditure. Accordingly, a part of its current non-debt-serving expenditure, all debt-serving and debt repayments, and all development expenditure is by now being financed through borrowing, creating the classic situation of debt trap.

In addition, public-sector entities are being bailed out by government-guaranteed debt, creating enormous contingent liabilities for the federal government. Moreover, huge price subsidies are being provided, and letting them float as unrecorded liabilities has led to underreporting of the budget deficit.

Third, the minister has adopted an administrative approach of talking tough and ordering the foreign exchange market to bring down the exchange rate below that dictated by the market. His assumption is that the exchange rate is being driven by speculation and manipulation.

The reality is that the nominal exchange rate has depreciated fast because of excessive money creation by the government to finance the government’s rising current and development expenditure, which generated intense inflationary pressures.

The minister should understand that he cannot order the nominal exchange rate to appreciate when the State Bank of Pakistan (SBP) is busy printing currency notes excessively to finance the rising budget deficit and its foreign exchange reserves are rapidly depleting. In fact, the real effective exchange rate has appreciated in the recent past, which implies that, based on relative inflation in Pakistan compared with its trading partners, the nominal exchange rate should depreciate further.

Fourth, the minister seems to believe that he could accelerate the inflow of home remittances to cover the wide trade gap. The mysterious rise in remittances in the recent past partly reflects the diversion of black money and illegally-held capital abroad through remittance channels without any fear of being questioned about the sources of the funds.

Moreover, there has been an inevitable need for workers abroad to send more remittances to maintain their families in the context of fast rising cost of living in the country. These are neither reliable nor durable sources of financing the balance of payments.

Finally, let us give the minister some facts and figures to remind him that the country is faced with a serious threat of a foreign exchange crisis and an explosive domestic budgetary and monetary situation.

State Bank reserves are, as of now, under $8 billion. Out of this, $1.1 billion are deposits of the commercial banks which they are mandated by the SBP to keep with it as a special reserve requirement on the commercial banks’ foreign currency deposit liabilities. Additionally, about $2-3 billion of these reserves are either already earmarked as advance purchases by the private sector or are matched by the deposit liabilities of the SBP to foreign central banks and governments. That leaves the freely usable foreign exchange reserves of the SBP at about $4-5 billion.

Let us now look at the foreign exchange requirements of the country until December 2014. The IMF website shows that Pakistan will have to pay SDR2.4 billion in the remainder of 2013, and SDR1.4 billion in 2014, which amounts to a total of SDR3.8 billion to be paid before December 2014. Assuming an SDR-dollar rate of SDR1=$1.52, it amounts to $5.8 billion.

Add to that a deficit of about $1-2 billion annually in the capital account reflecting other debt repayment and net capital outflow in the absence of direct foreign investment and bilateral and multilateral assistance tied with an operative IMF programme. Even if the foreign remittances continue to pour in at the present rate, the current account of the balance of payments will record a deficit in the range of $3-5 billion per annum.

Thus, in the period up to December 2014, the country will require net foreign exchange resources of the order of $11-12 billion as against the free reserves of the SBP of $4-5 billion.

Given this wide gap, the country will have to either default on external debt – and thereby face disruption in its foreign trade and turmoil in its international financial relations – or face scarcity of imports of essential commodities, which will adversely affect people’s day-to-day life and productive activities in the private sector. The third, and more sensible, alternative is to adopt a strong package of policy reforms to correct the fundamental equilibrium in the balance of payments, on whose basis a new financial programme could be worked out with the IMF.

As regards the budgetary and monetary situation, it is already precarious and it is likely to get worse. The money supply has increased by eight percent during July 1, 2012-February 15, 2013, as against five percent in the same period last year. The entire expansion in money supply reflects massive public-sector borrowing from the domestic banking system to finance a rising deficit in its fiscal operations.

With drying foreign budgetary support and lagging revenue generation, the amount of domestic bank borrowing is bound to accelerate in the remainder of the year. This will not only result in further pressure on the SBP’s reserves and the exchange rate but also hurt private-sector investment and increase the vulnerability of the banking system.

The saving grace is that the tenure of the present finance minister will come to end soon with the installation of an interim government. However, what is worth emphasising for his successors is that proper treatment of the sick economy will require a sharp cut in the budget deficit and monetary expansion and initiation of export-led growth through structural reforms. That will pave the way for a new IMF programme to galvanise international financial support to ease the pain of policy adjustment in the transitional period.

The writer is a former governor of the State Bank of Pakistan.

Dr. Muhammad Yaqub, "The office of denial," The News. 2013-03-02.