The growing CAD

The debate over current account slippages is once again gaining traction in the mainstream media. Most commentators do not seem to appreciate that in principle, running a current account deficit is not necessarily a bad thing. Instead, many developing economies have mild current account deficit, which is healthy. The catch is whether foreign financing from long-term debtors and investors is secured to finance CAD (current account deficit). If global investors are betting on growth in a particular economy, they will keep on financing its CAD - as has been observed in India. However, if any economy's short-term debt obligations are higher and investment is minuscule, even mild current account deficit sends jitters - such as the case of Pakistan today.

The crucial element is to encourage economic growth without jeopardizing country's foreign exchange reserves. Without it, any economic growth primarily dependent upon domestic consumption cannot sustain. The trajectory of current account in terms of GDP is similar in India and Pakistan. But Pakistan had three major balance of payment (BoP) crises - 1998, 2008, and 2018, in the last three decades while India has had none during this period. The primary reason for the frequent boom and bust cycle in Pakistan is thinning reserves and rising short-term liabilities that are obtained to finance them.

In 1998, SBP reserves fell $1 billion mark. In 2008, SBP foreign reserves fell below $5 billion during one quarter, while the toll was around $7 billion in 2018. In terms of import cover, in 1998, the cover was marginally of one month. In 2008, the coverage was barely two months, and it was around 1.5-2 months in 2018-19. If any similar situation arises, invariably the red flags will be raised.

However, the situation emerging in 2021-22 is nowhere close. Right now, SBP reserves are building, and the import coverage is around 3.5-4 months. After including commercial bank reserves, the country has an import cover close to five months. The coverage in India ranges around 12-15 months. That is the missing comfort in Pakistan, and that increases the short-term debt obligation as lenders are not betting for longer tenors. And the reliance largely falls on IMF, multilaterals, and bilateral flows; and not on market-based flows.

In order to take Pakistan out of this crisis, tables must be turned. The story of Pakistan needs to be sold to the international investors and lenders. Otherwise, the country would keep muddling through, and its foreign policy would continue to be compromised in exchange for few billion dollars from friendly nations. For that to happen, reserves - with emphasis on quality reserves - building is the key, and till that time, the current account deficit must remain mild. That is why accelerating growth momentum beyond the natural economic momentum is not advisable. In other words, economy is in its natural expansionary phase, and running expansionary fiscal and monetary policies at the same time could be counterproductive.

The problem with Pakistan's economy is that its net international reserves (NIR) are negative. NIR is calculated by subtracting short-term foreign currency liabilities and IMF's stock of credit from central bank's gross reserves. The figure was negative $15.2 billion in June 2019, and it is around negative $3-4 billion as of June 2021. Thus, there is significant improvement of $11-12 billion in 24 months. However, the number is still in the negative, and it will be a long journey before the cover reaches anywhere close to June 2016 figure of positive $7.9 billion. This implies that despite having an improved current account position in 2020-21, external vulnerabilities still exist.

This is not the time to become comfortable based on recent improvements in foreign reserves. External account management under SBP still has a lot of ground of to cover. This implies that the country cannot afford to run a high current account deficit at this time. A delicate balance is needed between monetary policy and a growing CAD. In words of SBP Governor, manageable deficit should be $6.5-$9.5 billion (2-3 percent of GDP). Anything beyond that needs to be checked. The Ministry of Finance must take note, and avoid running highly expansionary policy that might undo the good work done in the last two years.

The political leadership needs to get it straight that there is no linkage between the electoral cycle and economic growth cycles. The crises in 2008 and 2018 could have been averted (or the magnitude could have been manageable) had the then outgoing government not run expansionary fiscal and monetary policies at the same time, when economic cycle in fact warranted caution. The irony is that the governments that threw caution to the wind and ran expansionary policies, failed to get re-elected anyway. The message to PTI's economic team is to learn from the mistakes made by its predecessors.

As mentioned in this space earlier, there are some parallels between 2021-22 from 2007-08. Back then, the crisis largely emanated from not passing on the increase in commodity (mainly oil) prices on to the consumers. The international commodity prices are currently on a bull run. If history is any guide, they will eventually revert to mean, as was the case in 2008. However, the timing remains uncertain. For a small economy such as Pakistan, a few quarters of high price (without passing the same on to consumers) can be fatal. The government should not flirt with high volatility in the international oil prices and must pass on the impact to consumers.

The good news is that oil prices came down a bit in the last week or two. That gives some room for government to enhance petroleum levy (PL) without reducing consumer petroleum prices. And fall in oil prices would have a positive impact on the current account balance. The other thing the government needs to do is to keep a close eye on the imports of automobile, and other products. SBP should not be afraid to use its first line of defence - exchange rate - to curb import-based demand, and the monetary policy committee may welcome a token increase in the policy rate, sending the right signal to the market.

The objective should be to build reserves. Quality reserves should help bring NIR in shining green. The PM should think beyond the election cycle and must keep SBP and monetary policy independent. Such a policy sends the right signal to the investors. The country needs quality FDI, long-term debt, and portfolio investment. It also needs private sector to raise foreign investment and debt from international market. The problem is that the external account management is overly dependent on the government. This is in sharp contrast to the case in India.

One reason for lack of private sector interest is strict capital flows regime for private sector where historically inflows are always encouraged but outflows were kept restricted. Now SBP is opening up this regime, but its pacing with caution due to relatively low level of reserves and flexible exchange rate regime. The more quality reserves are built, the more open the regime would be and that could attract private capital into the country. Till that time, over-ambitious growth targets should be kept under check to curb imports. The economic policies of 'Naya Pakistan' should decouple the economic cycle from the electoral cycle.

Copyright Business Recorder, 2021