In days of pandemic, it is hard to devise a macroeconomic strategy for a developing country like Pakistan. There is not much fiscal space and fiscal deficit is already hovering around all-time high. Even opening up of sectors during lockdown would have limited growth impact as factories may choose to work on lower capacity due to plummeting demand.
The bigger worry is external account. On one hand, the country is less connected to the world to have mild impact relative to others. On the other, thin foreign exchange reserves are making the situation precarious. Pakistan does not have enough buffers to sustain.
In the absence of a large fiscal stimulus, some say that monetary easing can give fiscal space to cope with the crisis. But such economic relations are not linear. Every step has some impact on the other variables. There is a trade-off between monetary policy and exchange rate. The country never really had a flexible (market based) regime. One needs to adapt to this reality.
Ever since the monetary easing of 225 bps, the exchange rate slipped. Exporters are holding back dollars in anticipation of currency depreciation. Foreign portfolio investment is evaporating anyways based on global thinking of moving out of emerging markets. The local industry is not much leveraged for a really meaningful impact of lower interest rates in domestic debt servicing. Leveraged businesses are getting principal payment deferment and some are having option of mark-up relaxation as well.
In case of currency depreciation, most businesses (apart from exports) have higher cost implications. It is not good for inflation outlook either (though inflation is expected to be lower than earlier estimates). That is why the pros and cons of monetary easing should be carefully deliberated.
Some say that since Pakistan has a net positive impact on current account in the aftermath of COVID-19, there should be less worry on exchange rate due to monetary easing. They probably are right (but no one can be sure) on current account; but do not forget weak financial and capital account implications. Pakistan has just come out of a severe balance of payment crisis, important to not fall back again.
For example, India or Thailand kind of economies are more integrated to the world and have relatively higher dent on exports, tourism and capital flows than Pakistan. Their balance of payment slippages could have been higher in magnitude. But Pakistan does not have cushion for even a mild impact.
Think of it like a blue-chip export oriented highly leveraged company at PSX versus an SME with no bank loan. The blue-chip company has a strong sponsor which could inject cash or get more leverage from banks and would be able to sustain a lull period. On the other hand, SME without any external support can be out of the businesses much sooner.
Pakistan economy is like a SME in the bigger scheme. Hence threats are more. The country has external repayment of $4-5 billion in Apr-Jun and $13.5 billion in FY21. There is desperate need of new loans and rescheduling of earlier. Market flows are drying out – no new portfolio investment, bonds cannot be issued and buzz is that commercial lenders are not giving up rates at this point.
In such days, it is critical to keep a close eye on external health to not let the country fall in the debt trap again. The currency is already under pressure and there are signs of dollarization. In the past three weeks, SBP reserves are down by $1.6 billion -13 percent of total.
In the last week, banking reserves (FE25) increased by around $100 million. This is implying domestic savings are converting to USD. Such trend was visible in Jan19-Jul19 during which banks’ reserves increased by $587 billion and after the increase in policy rate and gradual currency depreciation, the conversion in PKR started taking place – banking reserves fell by $1.2 billion during Jul19-Feb20. That had helped SBP lower its off-balance sheet liabilities.
The policy response should be to stop this trend of increase in FE25 accounts at the cost of SBP balance sheet and off-balance sheet assets. Monetary policy should take account of these factors. Market pundits fear that if SBP reserves fell below $8 billion (currently at $11.2bn), this could create a much bigger crisis.
Having said that, SBP has a policy of targeting expected inflation by keeping real interest rates between 1-3 percent. Now with inflation expected to be lower than earlier expected, another rate cut in May cannot be ruled out. But before that happens, SBP or government should have firm commitments from multilaterals and bilateral for arrangement of external buffers.