FeaturedNationalVOLUME 19 ISSUE # 15

Unforeseen challenges

In a comprehensive assessment conducted by the Ministry of Finance, Pakistan’s economic future is scrutinized through the lens of various financial risks. This examination sheds light on crucial factors, including external debt, fiscal deficits, and climate vulnerabilities, all of which impact the nation’s fiscal stability. As we delve into the intricacies of these challenges, it becomes evident that strategic measures are imperative to steer the country through the complexities of its financial terrain.

The Ministry of Finance has pointed out eight critical factors related to financial risks that it believes could worsen Pakistan’s economy. These key factors include macroeconomic imbalances, increasing debt, guarantees, climate degradation, losses in state-owned enterprises (SOEs), risks in public-private partnerships, fiscal indiscipline in provincial governments, and governance challenges.

In its Fiscal Risk Statement for 2023-24, the Ministry of Finance highlighted the volatility in Pakistan’s inflation rate over the past few years. This volatility is attributed to various factors, including currency devaluation, energy costs, and global food prices. The Pakistani rupee has significantly depreciated in recent years, influenced by factors such as trade imbalances, external debt, political instability, and global economic conditions. The State Bank of Pakistan (SBP) is actively responding to the rising inflation by increasing the policy rate. The government is also implementing effective policy, administrative, and relief measures to control inflation and stabilize the economy.

The report acknowledges a deteriorating inflation outlook with heightened risks to external stability. The uncertainty surrounding the future adjustment path in energy prices poses a significant upside risk to inflation. However, a potential moderation in international commodity prices could contribute to a reduction in inflation. Exchange rate adjustments, passing on the impact of energy price increases, and higher interest rates could enable prices to decline over the medium term, leading to macroeconomic and fiscal benefits.

The government’s goal is to reduce the fiscal deficit by expanding the tax net, rationalizing subsidies, and promoting economic growth. However, the challenge of rising debt servicing could impede deficit reduction. The FRS outlines three scenarios to analyze fiscal risks, projecting outcomes based on different factors.

Scenario 1 envisions the impact of low-cost financing options, resulting in the federal fiscal deficit touching 3.0% of GDP. Scenario 2 explores the consequences of a 50% reduction in non-tax revenues, leading to a fiscal deficit of 5.4% of GDP. Scenario 3 considers the reactions to a growth rate below projections, projecting a fiscal deficit of 3.9% of GDP by FY2026.

Over the last five years, the government’s total public debt has exceeded the prescribed limit of 60% of GDP under the FRDL Act. Consistent fiscal deficits, averaging 6% of GDP since 2010, have led to a rapid build-up of debt. Factors such as unfavorable movements in interest and exchange rates, along with contingent liabilities, can further contribute to an increase in debt.

A significant portion, 40.8%, of the total public debt is attributed to external debt, posing a potential vulnerability to the government’s fiscal position. This susceptibility arises in the face of high current account deficits, diminished foreign exchange reserves, and a weakening exchange rate. The combination of a lack of foreign exchange reserves and substantial external payments has led to liquidity challenges, destabilizing both the exchange rate and domestic interest rates. This, in turn, adds to the burden of external loans, measured in local currency.

Ongoing fiscal deficits necessitate the refinancing of maturing government debt, coupled with raising additional debt to address fiscal shortfalls. The high proportion of short-term debt introduces significant refinancing challenges during periods of slower economic growth, heightened fiscal deficits, or reduced investor confidence. Managing this refinancing risk becomes crucial, emphasizing the need for the government to achieve and sustain a longer average time to maturity for both domestic and external debt. Issuing debt with longer maturities reduces the frequency of debt rollovers and mitigates refinancing risk, aligning with the current medium-term debt strategy.

To ensure a gradual reduction in external debt concerning Foreign Exchange Earnings (FEE) over time, maintaining a zero current account deficit before interest payment is essential. This requires a higher growth rate in FEE compared to the interest rate paid on external debt. Although the current account deficit showed improvement in the first three quarters of FY2023 due to government measures curbing imports, the amortization of external debt is on the rise, primarily due to the repayment of short-term commercial debts.

In FY2022, the stock of guarantees stood at 4.5% of GDP. Guarantees issued against commodity operations, not included in the estimated stock within annual limits on new issuances, are based on the premise that these loans are secured against the underlying commodity and are essentially self-liquidating. However, there is a fiscal risk associated with these guarantees, particularly in commodity operations by entities like TCP, Passco, and provincial governments, where a significant part lacks underlying collateral due to issues such as theft, unpaid subsidies, and wastage during storage.

Pakistan’s vulnerability to the impacts of climate change is evident, ranking among the top 10 countries, according to the Global Climate Risk Index 2021. Projected increases in the number of days per year with a heat index greater than 35°C expose Pakistan to more severe, frequent, and prolonged droughts. The melting of Himalayan glaciers poses a major threat, with 33 glacial lakes identified by the Ministry of Climate Change as prone to hazardous glacial lake outburst flooding (GLOF), putting millions of people at risk. According to the Climate Vulnerability Monitor, Pakistan is the 12th most climate-vulnerable country globally, emphasizing the urgent need for action, as highlighted in the Fiscal Risk Statement (FRS).

In conclusion, Pakistan finds itself at a critical juncture where addressing fiscal risks is not just a priority but a necessity. The intricate web of challenges, from external debt dynamics to climate change impacts, demands a holistic and proactive approach. The Fiscal Risk Statement (FRS) emphasizes the need for long-term strategies, prudent fiscal policies, and urgent climate action. As Pakistan charts its financial course, a resilient and adaptive approach will be paramount in ensuring economic stability and safeguarding against unforeseen challenges on the horizon.