If bets were to be taken on the stability of Pakistans borrowing capacity, without much research, most would bet for the worse outcome. In a sense, such bets are regulated by derivative exchanges such as the CME in Chicago in the name of credit default swaps (CDS).
Simply put, CDSs are a way to hedge against default of a borrower, sort of an insurance against the creditors risk in case of non performance. The creditor pays a premium - spread - to a broker who assumes the risk of default.
The spread shot up to more than 1300 basis points in 2008, it has receded in recent days to levels lower than 500 basis points. Pakistans credit rating has also improved from B- to B and it has assumed a position behind Venezuela, Greece, Argentina and Ukraine.
So, what happened?
"Pakistan has followed through with its debt servicing commitments in the past few months, and there aren any maturing liabilities in the next quarter" according to Khalid Iqbal Siddiqui at Invest and Finance Securities.
Side by side, current account indicators have been posting promising results in recent weeks. Foreign exchange reserves have soared to $16.7 billion, remittances have posted a record $8.9 billion for FY10 and trade indicators also cast a positive light as exports grew to $19.4 billion, up 10 percent.
Creditor confidence in the countrys ability to make good its commitments is increasing as a result. But, it must be mentioned that the CDS market for Pakistan is highly illiquid.
"Often a single transaction can change the trend in CDS, when it comes to Pakistan", according to one analyst following the market.
And in this case, an investor may have made a trade on Pakistan, speculating on expectations of an improved rating, a stabilizing exchange rate or some other indicator.
Relative movements of South Asian countries like Sri Lanka and Bangladesh may also be a factor impacting the spread. "Since March, the spreads of Sri Lanka and Pakistan have been moving quite closely" said Hamza Marath, analyst at KASB Securities.
Very high levels of fiscal borrowing and sticky inflation pose risks to the improvements in the CDS position of Pakistan. Expectations of a hike in the discount rate point to the fiscally constrained economic situation at home.
On Tuesday, IMF delegates reminded Islamabad that the stand-by agreement hinges upon the successful implementation of
eformed GST. Without foreign inflows, Pakistan could find itself in a very tight spot once repayments on the multilateral loans kick in 2012.
Prudent economic management and delivering on its commitments to multilateral donors may help improve the financial position and thereby confidence in Pakistan debt. And if that doesn happen, we may find ourselves in a debt trap.
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