Market-determined exchange rate pushes up cost of external debt: World Bank

ISLAMABAD: Pakistan has a market-determined exchange rate, which makes the country’s servicing cost on external debt susceptible to steep exchange rate depreciations, says the World Bank.

The Bank in its latest report, “South Asia Economic Focus, Coping with Shocks Migration and the Road to Resilience”, stated that beset with Sri Lanka’s economic crisis, Pakistan’s catastrophic floods, a global slowdown, and impacts of the war in Ukraine, South Asia faces an unprecedented combination of shocks on top of the lingering scars of the Covid-19 pandemic.

The report noted that over 50 percent of the country’s external debt is denominated in US dollars, although external debt constitutes only 37.6 percent of total public debt.

Pakistan’s interest payments on government debt are budgeted to increase from 4.7 percent of GDP in the fiscal year 2022 to 5.1 percent of GDP in 2023 (July 2022-June 2023), it added.

The report noted that exchange rate movements and political factors can also contribute to rising debt-related costs. In countries that have large public debt in foreign currencies, such as Sri Lanka, Pakistan, and Maldives, exchange rate depreciation against the issuing currency can increase the debt servicing costs as percent of government revenues.

In Sri Lanka and Pakistan, the local currency has depreciated 80 percent and 36 percent vis-à-vis the US dollar since the beginning of 2022, respectively. Accordingly, the exchange rate and oil prices together account for around half of the total deviations of 2022Q2 inflation from the long-run average.

Although Pakistan has a floating exchange rate regime, its increased debt payment and lack of external financing led to falling foreign reserves, which are now enough to cover little over a month’s imports.

The Bank further stated that in Pakistan, growth in the fiscal year 2022-23 has been downgraded as a result of the floods from 4.0 percent in June to 2.0 percent, as coping with the aftermath of the flooding will complicate and delay overdue macroeconomic adjustment.

On the supply side, agricultural output will be significantly impacted, with over 9.4 million acres of crops affected, resulting in significant losses to the wheat, date, and rice crops; as well as the cotton crop, an important input for textiles.

The forecast assumes the IMF programme remains on track but with adjustments to accommodate the required fiscal response to the flood damage. It also assumes that the Government continues with planned energy prices and other structural reforms despite political pressures arising from flood impacts; and the central bank can continue to maintain a tight monetary stance and a flexible market-determined exchange rate. Growth is forecasted to recover moderately in 2023-24, supported by a recovery in agricultural production and reconstruction, dissipating global inflationary pressures, and improved confidence from the continued implementation of macroeconomic stabilization measures.

In the case of Pakistan, tight fiscal space amid large debt servicing dues will necessarily lead to limited government expenditure.

Under the sudden stop scenario, growth in the region would be 0.9 percentage points lower than baseline in 2022, with differing effects across countries in the region.

Moreover, the effect compared to baseline would be smaller over time. The largest adverse effect in 2022 would be for Pakistan, as this would force the country to tighten fiscal expenditures so drastically that growth would be 4 percentage points smaller than in the baseline. The country will clearly need the support of external financing in the coming year or two, it added.

South Asia’s vulnerability to climate change—once again showcased by the damages from floods in Pakistan—highlights the urgent need to improve climate resilience.

In Pakistan, the fiscal deficit (including grants) is expected to fall to 6.8 percent of GDP in the fiscal year 2023 from 7.8 percent in 2022. Effective revenue mobilization measures, including GST harmonization and personal income tax reform, and increasing grants are expected to countervail the fiscal pressures of the flooding.

The recent flooding in Pakistan submerged one-third of the country. Flooding risk is expected to increase in intensity and unpredictability due to climate change. Rebuilding disaster-hit infrastructure can be expensive. Instead, investment in disaster preparedness could reduce the losses from these natural disasters and allow the region to grow without having to spend on continual rebuilding.

Pakistan’s early warning system was not as effective in some regions. The country developed a 10-year national disaster management plan in 2012, including early warning systems. In 2013, a dedicated funding source was created to provide grants to fund up to 70 percent of projects that build resilience to extreme weather and geophysical hazards. In 2018, the country initiated a $2 million countrywide risk assessment project that covered 15 districts. Despite the progress in disaster risk reduction and funding, a study found a large regional disparity in flood warning systems in 2015, and as of 2017, the country still had a limited flood forecasting system outside of Islamabad-Rawalpindi.

The more services-led economies (India, Nepal, and Maldives) are expected to maintain a reasonable recovery trend despite headwinds, while Afghanistan, Sri Lanka and Pakistan are in more precarious shapes and will see poverty increase in 2022 amid severe domestic crises. In Pakistan, business confidence remains subdued in 2021 and has been dipping since mid-2022.

The ongoing war in Ukraine, the floods in Pakistan, and the tightening of global financial markets constitute crude interruptions to the recovery from Covid-19 that was underway in South Asia. High commodity prices and rising international interest rates are exacerbating balance of payments pressures, particularly in Sri Lanka and Pakistan. As a result, 2023 will be a difficult year for the region just as they emerged from the pandemic.

Copyright Business Recorder, 2022