The term “Default” means a breach of contract or broken promises. The International Monetary Fund (IMF) defines a country as in default when the government is either unwilling or unable to repay its creditors. Sri Lanka, Ukraine, Zambia, Lebanon, and Argentina are among the economies that have defaulted on their debt in recent times, cash-strapped Pakistan is on the brink of default and/or at least in the danger zone as inflation is rising, the dollar getting stronger, cost of borrowing mounting and global growth decelerating. Several international financial institutions and economists are raising the alarm about the catastrophic debt crisis of Pakistan. The political instability, complicated domestic policies, and a difficult external environment have pushed the country to a challenging economic juncture.
The foreign exchange reserves held by the State Bank of Pakistan (SBP) have fallen to $5.82 billion, the lowest level in nearly eight years and hardly enough to cover one month of imports. A recent swift depletion of forex reserves is the result of the $1 billion payment against the maturing Pakistan International Sukuk (Sharia-compliant bond) and other external debt repayments. Reuters estimated that Pakistan has to pay more than $33 billion to its foreign lenders in the coming financial year, including debt repayments of $23 billion and $10 billion in the current account deficit. In order to ensure enough reserves to pay its debt obligations, reduce its massive current account deficit, and evade the sword of default, Pakistan is in desperate need of foreign aid.
Pakistan may not be in the Sri Lanka situation yet but it is not very far off as there are some parallel symptoms like dynastic politics, populist decisions like import bans, narrow export base, and unnecessary expenditures. If we compare both countries on the repayment capacity, Pakistan has a small proportion (almost seven percent) of its foreign debt in international bonds like Sukuk and Eurobond. The rest of the debts are a composition of bilateral, multilateral, and commercial debt, which can be rolled over from time to time. However, the Sri Lankan situation was different where the majority of foreign debts were acquired through floating international bonds whose repayment was a must to avoid default and could not be rolled over.
As per SBP Governor Jamel Ahmad, the current economic crisis of the country is predominantly caused by devastating floods and exacerbated by some exogenous factors like global recession, the Ukraine-Russia war, and the commodity super-cycle. However, he has provided assurances that Pakistan will repay all its loans on time. “Pakistan will continue to make timely loan payments while inflows are expected to increase significantly in the second half of the current fiscal year,” Jameel said in a podcast. He is giving statements that are heavily reliant on the generosity of friendly countries for survival. But what if things do not work as the governor is describing? What if the forex reserves held by the SBP continue to fall? What if Pakistan defaults?
There is a plethora of empirical literature available that postulates that financial mismanagement and political instability have become frequent catalysts of sovereign default. They were the major reasons for defaults by Ecuador in 2018 and 2020, Ukraine in 2015, Argentina in 2014 and 2019, and Sri Lanka in 2022. Unfortunately, Pakistan is currently dealing with both culprits of sovereign default.
The first consequence that Pakistan may face after getting default or having no forex in the kitty is trouble in borrowing again and likely having to pay massive interest rates if it gets the chance. This puts a severe impact on the exports and imports of the country. Additionally, the borrowers try to withdraw money from the financial institutions due to low or no trust in the government. Secondly, foreign investors try to exit the defaulting country by selling their local assets which leads to the crashing of the exchange rate in foreign markets. Again, this channel will influence the trade sector as imports become expensive when the domestic currency depreciates. Thirdly, in an attempt to cope with the chaos of loan payments, Pakistan’s economy may face a massive tax increase and spending cuts followed by extreme austerity measures. Fourthly, default or zero FX reserves might start riots on the streets leading to poorer living standards and a severe banking crisis.
The main ingredient of any country’s default, “political instability”, is likely to give a rough period to Pakistan’s economy. In this chaotic environment, the political parties should exhibit moderation and take critical actions to settle this deadlock that has overcast the clouds of uneasiness and uncertainty. The general public is more concerned about the struggling economy than their filthy plots and campaigns to stick to power.
Due to confusion and ambiguity, the general public might try to take all their money out of the banking system. In order to avoid money withdrawal, the government may close down its major banks which might invigorate the banking crisis. Fifthly, the turmoil generated by all these channels can be experienced in the stock exchange. Until the situation is stable, no investor might be willing to buy shares in a period of uncertainty. Moreover, Pakistan can face a loss of reputation and its economic ratings might decline which can make it even more difficult to borrow money and conduct trade deals. Someone might ask “Why cannot Pakistan simply print Pakistani rupees in the default period to disburse the salaries of government employees and pay off the local currency debts?” The increase in money supply by printing more money might lead to hyperinflation which can be even worse than defaulting. Also, printing more money to finance government expenditures might worsen the SBP rating on different indices of central bank independence.
How to avoid this tidal wave of default and speedily shrinking forex reserves? Pakistan needs to take some drastic measures as a debt-trap country cannot continue living paycheck to paycheck. Populist decisions like import bans are reckless and counterproductive as they lead to an increase in the cost of living via a higher inflation rate. Sri Lanka has experimented with the import ban policy to prevent the outflow of forex reserves which ends up as a massive failure. Our reforms must be focused on superfluous expenditures like subsidies and non-combat military budgets. Additionally, to prevent the leaking of millions of dollars in untapped revenue and to deal with the matter of tax evasion,
Pakistan needs a structured and targeted approach. The pressure on the rupee would go away only with the FX inflow and/or freezing of outflows. In this regard, the government needs to devise novel ways to curb the cross-border smuggling of dollars and other items. Moreover, Pakistan needs a strong macroeconomic and financial regulatory structure to ease the economic costs of a crisis. Information flow plays a vital role in the expansion of chaos and uncertainty in an economy. To avoid the spread of misinformation, the government needs to conduct honest public communication through media professionals dedicated to honest reporting about the economy.
The main ingredient of any country’s default, “political instability”, is likely to give a rough period to Pakistan’s economy. In this chaotic environment, the political parties should exhibit moderation and take critical actions to settle this deadlock that has overcast the clouds of uneasiness and uncertainty. The general public is more concerned about the struggling economy than their filthy plots and campaigns to stick to power.
