Ratings and risks

The global financial system is displaying rising signs of strain, raising concerns over various potential outcomes, ranging from contagion between markets to ruptures in financial products.

It is anticipated that roughly one-third of the world economy will shrink this year or the next. The energy crisis created by the conflict will continue to weigh heavily on the Euro region, but rising prices are inflicting serious difficulty practically everywhere in the world.

Unfortunately, Pakistan is one of the countries in the world most affected by the three Cs (Climate, Covid, and Conflict). Moody’s Investors Service announced on October 6, 2022 that it had reduced the local and foreign currency issuer ratings and the senior unsecured debt ratings of the government of Pakistan to Caa1 from B3. The ratings were downgraded to Caa1 because of increasing government liquidity, external vulnerability, and debt sustainability issues after disastrous floods in June 2022.

The floods have worsened Pakistan’s liquidity and external credit problems and increased social spending needs while government revenue has been reduced. Pakistan’s foreign reserves have fallen to barely one month’s worth of imports, exacerbated by a depreciated currency and consumer prices rising 27 per cent.

The comments made by Pakistan’s Finance Minister Ishaq Dar have sparked a heated discussion in the country about whether the rating assigned to Pakistan by one of the most prestigious rating agencies in the world is realistic and whether all relevant factors were considered. Let’s examine where Pakistan’s economy stands and how to move forward.

The prospect of Pakistan’s bailout from the IMF will not be sufficient to kickstart the nation’s flagging economy, prompting it to advocate for more stringent emergency measures. The recent catastrophic flooding has strained an already struggling economy, with the government predicting $30 billion in damage. As a result of the calamity, Pakistan will export less and buy more basic foods soon. To cover imports, Pakistan will need extra dollars. It will put pressure on the exchange rate and increase the trade imbalance.

The IMF’s acceptance of a $1.17 billion loan tranche at the end of August was intended to give other countries confidence to contribute support, but partners appear to be giving the cold shoulder. Pakistan’s reputation has suffered due to the government’s habit of soliciting financial aid without implementing any significant structural reforms. On the other hand, Saudi Arabia has indicated that it is willing to extend its deposit of three billion dollars with the State Bank of Pakistan for another year. However, this will not even come close to tackling the country’s issues.

Following the announcement that the IMF would restart its support for Pakistan, the Pakistani rupee briefly strengthened against the US dollar. However, it has continued to decline over the last month, reaching 239 to the dollar; inflation reached 27.3 per cent in August, the highest level in Pakistan in the past 47 years.

As soon as Ishaq Dar arrived in Islamabad, discussions around a fixed exchange rate emerged again. He resumed controlling the nation’s economy in the same manner he had previously. A current account deficit of $20 billion in 2018 was the direct outcome of Dar’s obsession with maintaining an artificially overvalued rupee compared to the dollar. An artificially high rupee made it cheaper to import than to produce or sell commodities. Our industry hollowed out, exports fell, and imports we couldn’t pay grew, bringing us to the brink of bankruptcy until the PTI took over. The explicit scenes are about to play out once more in a few months.

The exchange rate is so variable this month that it’s impossible to predict a project’s financials and profitability. Volatility in the rupee has prevented new investment, and rising interest rates are raising the cost of financing working capital. These conditions raise fears of hyperinflation, chronic fuel shortages, and default in Pakistan.

In light of the presented facts, the current task is to figure out how we may extract ourselves from this precarious predicament in which we stand to lose everything.

Every adversity is an opportunity to become stronger and better and to build oneself up. The incumbent government must establish a convincing argument for the IMF and extract the utmost benefit from the IMF Resilience and Sustainability Trust. By taking this action, we will be able to obtain funding on a long-term basis that is both reasonable and sustainable. Moreover, this will allow us to construct resilient infrastructure to the effects of climate change and overcome other difficulties in the long-term structure.

Boosting private climate financing plays a crucial role in our efforts to reduce greenhouse gas emissions, limit climate change, and adapt to its repercussions. Appropriate pricing of climate risks, development of novel financial instruments, expansion of the investor base, broadening of the involvement of multilateral development banks and development finance institutions, and improvement of climate information are essential components of the solutions.

The SBP must move decisively to bring inflation back to target and avoid de-anchoring inflation expectations, which would weaken its credibility. Clear communication on policy decisions, price stability, and tightening will be vital to maintain credibility and prevent market instability.

Exchange rate flexibility helps economies adjust to the differential pace of monetary policy tightening. But in Pakistan’s case, the exchange rate movements impede the SBP monetary transmission mechanism and generate broader financial stability risks.

The flexibility of exchange rates assists economies in adjusting to the unequal speed of monetary policy tightening. However, in the case of Pakistan, exchange rate fluctuations impede the SBP’s monetary transmission mechanism and raise wide-ranging threats to financial stability. In light of this fact, what course of action should we take?

Historically, flexible exchange rates have been used as shock absorbers. However, flexible exchange rates may not provide complete protection from external shocks, mainly when financial markets are not functioning smoothly. As a result, the government should employ a combination of instruments, such as currency market intervention, macroprudential, and capital flow management policies.

The writer is director of theBusiness Finance Programme at Birmingham City University, UK. He tweets @HafizUsmanRana