As Pakistan grapples with a backlog of imports and dwindling export volumes, steadily depleting its fragile foreign-exchange reserves, on June 29, the International Monetary Fund (IMF) announced a staff-level agreement with Pakistani authorities.
This agreement entails a nine-month Stand-by Arrangement (SBA) worth 2,250 million special drawing rights (equivalent to about US$3 billion, or 111% of Pakistan’s IMF quota).
In fiscal year 2022, the current account deficit (CAD) reached a staggering $17.4 billion, a significant increase from the $2.82 billion gap observed in FY21. After severe floods in 2022, the government faced numerous challenges, leading to a loss of creditors’ confidence and a decline in forex reserves.
In response, the government swiftly implemented austerity measures to avoid a potential default on foreign debt and import bans on all goods except essential food and medical items.
The country witnessed a substantial decline in CAD early this year, reaching a 21-month low of $242 million in January despite the government’s efforts. This decline was accompanied by forex reserves plummeting to a mere $3 billion, leaving the economy vulnerable to macroeconomic shocks.
Figure 1: Pakistan’s Current Account Balance (in US$ billion)
The domestic industries rely upon imported inputs to sustain production, where intermediate goods account for 53% of total imports. They faced widespread disruption due to the government’s protectionist measures and import restrictions. This resulted in high attrition rates, diminished export productivity, and significant disruptions in commodity chains.
Foreign investments
Deficits in both the current and capital accounts aggravate the balance-of-payments (BoP) situation and hinder Pakistan’s economic progress. The unstable and hostile business environment has resulted in a decline in foreign direct investment (FDI).
High tariff rates, political unpredictability, terrorist concerns, stringent tax and interest-rate regulations, and demanding security clearance requirements have consistently discouraged foreign investment, making it arduous for international investors to fund domestic enterprises.
The decline in FDI and inadequate technology transfer have affected labor productivity growth, leading to reduced gains from production and inaccessible economies of scale for the past two decades.
The period between 2003 and 2007 witnessed a notable increase in FDI inflows due to favorable domestic and external factors.
The government implemented several measures to enhance security and boost investor confidence. These included privatization initiatives, liberalizing and deregulating the economy, streamlining bureaucratic processes and stimulating private-sector growth. This presented appealing investment opportunities for both domestic and international players.
The groundwork for the China-Pakistan Economic Corridor (CPEC) was laid during this time, accompanied by increased investments from China and other regional countries. However, economic advancement was hindered by Pakistan’s energy crisis, political unrest, infrastructure bottlenecks and the 2007-08 US-led financial crisis, which impeded foreign investments.
Figure 2: Pakistan’s Foreign Direct Investment (percentage of GDP)
BoP constraints
The decline in Pakistan’s exports can be attributed to the low investment and savings cycle, which drains foreign currency from the country’s reserves. Additionally, Pakistan’s limited integration with the global and regional economy is a significant deterrent for foreign investors.
The absence of industrialization hampers producers’ productivity and competitiveness, redirecting domestic consumption preferences toward imported goods and widening the trade deficit. The inability to boost exports amid a constantly depreciating currency reflects the prevailing inefficiency across sectors.
Pakistan’s export capacity remains stagnant compared with other emerging economies. This poses a substantial challenge for the recovery of Pakistan’s BoP, requiring sustained amendments to bring it down to sustainable levels.
Pakistan seems to conform to a BoP-constrained growth model, wherein a simultaneous deterioration in the external balance accompanies any growth-rate development. The country’s projected growth rate is 3.8% adjusted for its BoP and structural parameters.
Breaking free from this cycle necessitates various trade and diplomatic measures. Critical steps include revising export capacity, diversifying and expanding the trade base, and prioritizing productivity over subsidising profits.
Learning from countries such as the Philippines and Vietnam, which have outperformed Pakistan in terms of trade openness, is crucial. Pakistan must expand the range of exported goods beyond textiles and rice, improving trade openness to drive economic growth and bolster foreign-exchange reserves.
To achieve this, Pakistan should explore diversifying its foreign investment partnerships beyond its current allies, including China, Saudi Arabia, the United States, the United Kingdom, and the United Arab Emirates. By forging new diplomatic relationships and establishing effective ties, Pakistan can attract more capital inflows and further enhance its economic prospects.
Pakistan’s economy finds itself entangled in a vicious cycle of an unbalanced BoPs, with a persistent deterioration in the external balance accompanying any growth rate development. Overcoming this challenge necessitates comprehensive trade and diplomatic measures.
Pakistan can break free from this cycle by revitalizing its export capacity, diversifying the trade base, and prioritizing productivity.
Emulating successful models from countries like the Philippines and Vietnam and expanding foreign investment partnerships through effective diplomacy will contribute to Pakistan’s economic growth, bolster foreign-exchange reserves, and lay the groundwork for sustainable development in the longer horizon.
A more detailed article by this author can be found here: Debt ad Infinitum: Pakistan’s Macroeconomic Catastrophe.