Ratings and risks

The global financial system is showing increasing signs of strain, raising concerns about a variety of potential outcomes, ranging from contagion between markets to disruptions in financial products.

About a third of the global economy is expected to contract this year or next. The energy crisis created by the conflict will continue to weigh heavily on the Eurozone, but rising prices are inflicting serious hardship virtually everywhere in the world.

Unfortunately, Pakistan is one of the countries in the world most affected by the three Cs (Climate, Covid and Conflict). Moody’s Investors Service announced on October 6, 2022 that it had downgraded the local and foreign currency issuer ratings and the ratings of the Government of Pakistan’s senior unsecured debt to Caa1 from B3. The ratings were downgraded to Caa1 due to increased government liquidity, external vulnerability and debt sustainability issues following the catastrophic floods of June 2022.

The floods have aggravated Pakistan’s liquidity and external credit problems and increased social spending needs while government revenues have been reduced. Pakistan’s foreign exchange reserves fell to barely a month of imports, exacerbated by a depreciating currency and consumer prices up 27%.

Pakistani Finance Minister Ishaq Dar’s comments sparked heated discussion in the country about whether Pakistan’s rating by one of the world’s most prestigious rating agencies is realistic and whether all relevant factors have been taken into account. Let’s take a look at where Pakistan’s economy is and how to move forward.

The prospect of an IMF bailout for Pakistan will not be enough to revive the country’s ailing economy, prompting him to advocate tougher emergency measures. The recent catastrophic floods have put a strain on an already struggling economy, with the government predicting $30 billion in damages. In the aftermath of the calamity, Pakistan will export less and soon buy more staple foods. To cover imports, Pakistan will need additional dollars. This will put pressure on the exchange rate and increase the trade imbalance.

The IMF’s acceptance of a $1.17 billion loan tranche at the end of August was intended to give confidence to other countries to provide support, but partners appear to be giving the cold shoulder. Pakistan’s reputation has suffered from the government’s habit of soliciting financial aid without implementing significant structural reforms. On the other hand, Saudi Arabia has indicated that it is willing to extend its $3 billion deposit with the State Bank of Pakistan for another year. However, that won’t even come close to solving the country’s problems.

Following the announcement of the resumption of IMF support to Pakistan, the Pakistani rupee briefly strengthened against the US dollar. However, it has continued to decline over the past month, reaching 239 to the dollar; inflation reached 27.3 percent in August, the highest level in Pakistan for the past 47 years.

As soon as Ishaq Dar arrived in Islamabad, discussions around a fixed exchange rate resurfaced. He regained control of the national economy in the same way he had done before. A $20 billion current account deficit in 2018 was the direct result of Dar’s obsession with keeping the rupee artificially overvalued against the dollar. An artificially high rupee made importing cheaper than producing or selling goods. Our industry sank, exports plummeted and imports that we could not afford increased, bringing us to the brink of bankruptcy until the PTI took over. The explicit scenes are set to replay in a few months.

The exchange rate is so variable this month that it is impossible to predict the finances and profitability of a project. Rupee volatility has prevented new investment and rising interest rates are increasing the cost of financing working capital. These conditions raise fears of hyperinflation, chronic fuel shortages and default in Pakistan.

In the light of the facts presented, the current task is to understand how we can extract ourselves from this precarious situation in which we risk losing everything.

Every adversity is an opportunity to get stronger and better and to build yourself. The incumbent government needs to make a compelling case for the IMF and make the most of the IMF’s Resilience and Sustainability Fund. By taking this step, we will be able to secure long-term funding that is both reasonable and sustainable. In addition, it will allow us to build infrastructure resilient to the effects of climate change and overcome other difficulties in the long-term structure.

Boosting private climate finance plays a crucial role in our efforts to reduce greenhouse gas emissions, limit climate change and adapt to its impacts. Appropriate pricing of climate risks, development of new financial instruments, broadening the investor base, broadening the participation of multilateral development banks and development finance institutions and improving climate information are essential elements of the solutions.

The SBP must act decisively to bring inflation back to its target and avoid unanchoring inflation expectations, which would weaken its credibility. Clear communication on policy decisions, price stability and tightening will be key to maintaining credibility and preventing market instability.

Exchange rate flexibility helps economies adjust to the differential pace of monetary policy tightening. But in the case of Pakistan, movements in the exchange rate impede the monetary transmission mechanism of the SBP and generate wider risks to financial stability.

Exchange rate flexibility helps economies adjust to the uneven speed of monetary policy tightening. However, in the case of Pakistan, exchange rate fluctuations impede the monetary transmission mechanism of the SBP and pose vast threats to financial stability. In light of this fact, what course of action should we take?

Historically, flexible exchange rates have been used as shock absorbers. However, flexible exchange rates may not offer complete protection against external shocks, mainly when financial markets are not functioning properly. Accordingly, the government should use a combination of instruments, such as foreign exchange intervention, macroprudential and capital flow management policies.

The author is director of the Business Finance Program at Birmingham City University, UK. He tweets @HafizUsmanRana