External accounts
According to reports by a number of international financial institutions, Pakistan is facing severe external pressure, arising from increasing imports of capital goods as well as investments under the China Pakistan Economic Corridor (CPEC). This pressure has been increasing fast. While foreign exchange reserves have been dwindling, current account deficit of dollar 18 billion in FY18 has eroded the country's ability to meet external obligations. The country's imports which had become a great concern could not be curtailed despite certain steps taken by the PML-N and Caretaker governments to halt the widening trade deficit. The coverage for external debt servicing, though adequate at the moment, could weaken in the medium-term.
It is relevant to point out here that forex reserves held by the SBP decreased by dollar 5.1 billion in FY18, falling from dollar 14.58 billion in July, 2017 to dollar 9.5 billion in July, 2018. In its last policy decision, the SBP had increased interest rate by 100 basis points to 7.5 percent in a bid to cool down the heating economy and control rising inflation. This would further weaken the government's fragile fiscal position. Pakistan's debt affordability has weakened significantly from already low levels in the event of a sharp and sustained increase in the cost of debt. The C/A deficit stood at dollar 18 billion or 5.7 percent of GDP during FY18. Though Pakistan continued to borrow mainly from bilateral sources during the year, foreign exchange reserves declined by over dollar 5 billion during 2017-18 to stand at dollar 9.5 billion or equivalent to about two months of imports.
Needless to say, the forex reserves would decrease to dangerously low levels if the C/A deficit is not curtailed substantially. Realizing the gravity of the situation, the newly-elected government seems inclined to approach the International Monetary Fund for a bailout package although it is also considering other options like borrowings from other countries, floating bonds for the expatriate community and a drastic cut in non-essential imports. The imports are rising due to increasing domestic demand. The expansionary fiscal policy of the country has certainly added to domestic demand. During FY18, overall fiscal deficit of the country hit a five-year high of 6.6 percent of GDP or Rs 2260 billion and the current fiscal year is not going to be different. The rise in the interest rate structure and a substantial depreciation of the rupee would raise debt servicing cost and increase expenditures on imported goods.
Another reason for higher imports is the heavy investments related to the CPEC. Pakistan has a dollar 56 billion agreement with China under this arrangement and its exports to Pakistan reached dollar 11.45 billion during FY18. Moody's rating agency recently said that the C/A deficit is likely to settle lower at 4.8 percent of GDP during FY19, down from 5.7 percent in FY18. It is difficult to agree with this statement because of the improbability of such a large decline in the C/A deficit in the absence of drastic changes in external sector policies or in the terms, conditions and calculations in the CPEC-related projects.
Anyhow, C/A deficit has amounted to about dollar 2.2 billion during July, 2018 which is not a good omen. Also, Moody's has emphasized that a rise in policy rate would weaken the government's finances. Although there is nothing wrong with this statement; monetary policy of the country is always dependent on inflationary pressures in the economy and C/A balance cannot be made hostage to fiscal policy of the government. The new PTI government will have to act very carefully in order to tackle the crisis in the external sector.