Business & Finance Review

Sinatra recorded this number back in the mid-1950s. That era was known in some parts of the world as the "Fabulous Fifties". In Pakistan, however, we had budget deficits even back then – and we've still got budget deficits, of course. The only difference is that the deficits have grown bigger and bigger with each passing year. The forthcoming budget for fiscal 2008-09 is likely to see the deficit hitting an all-time high. Replace the line "learning the blues" by the line "learning the pre-budget blues" in the Sinatra song and you could use the lyrics as a metaphor for the dilemma currently faced by our budget-makers.

All the economic macro-indicators seem to have gone from bad to worse in recent weeks. Last week, oil prices hit a record $135 a barrel. That's 35 per cent more than the price at the start of calendar 2008 and double the price of a year ago. Oil prices have quadrupled over the last five years. If this rate of increase continues, prices could hit $150 a barrel within the next few months and $200 a barrel by 2012, with disastrous consequences for Pakistan's ever-widening trade gap. This, in turn, would put more pressure on the country's balance of payments and further erode foreign exchange reserves.

Pakistan has already spent $11 billion on importing oil in the first ten months of the current fiscal year. By the end of fiscal 2007-08 on June 30, the total annual oil import bill could be as high as $13.3 billion – equivalent to 78.23 per cent of the country's total current annual exports. At $150 a barrel, the annual import bill would amount to $14.77 billion, assuming that there is no increase in the present level of demand. At $200 a barrel, the annual import bill would be $19.70 billion – a figure higher than Pakistan's total current exports. So where would we find the foreign exchange for all the country's other imports?

Using the country's current foreign reserves of $12.207 billion (reserves of $9.48 billion held by the State Bank as on May 10, 2008 plus reserves of $2.359 billion held by commercial banks) to finance imports would eat up the reserves in a year, leaving the country bankrupt on the foreign exchange account. The only other option would be to finance imports through foreign loans. But where are we going to get foreign loans of over $19 billion a year, given the fact that foreign loan inflows to the country have never totaled more than $5 billion in the past?

That's just one of the problems that budget-makers and the country's other economic managers are going to have to address if they want GDP growth to continue and foreign exchange reserves not to be wiped out. This is no theoretical scenario but a very real possibility staring the country in the face. After all, it was only a few years ago that our foreign exchange reserves were only a few hundred million dollars – barely enough for two weeks worth of imports.

The only positive offsetting factor in the balance of payments position has been a 19.53 per cent rise in remittances from overseas Pakistanis. In the first ten months of the current fiscal year, remittances rose to $5.319 billion from $4.450 billion in the same period last year. This, coupled with foreign aid inflows of about $5 billion during the current fiscal year, has eased pressure on the balance of payments to some extent.

In this context, however, it needs to be remembered that most of the aid inflows are in the form of loans that have to be serviced and repaid and thus cannot be lumped under the heading of "external resources" as budget-makers tend to do, year after year. Loans are not "resources"; they are debts that have to be repaid.

Moreover, the rise in remittances is not because of government policies but is the result of many overseas Pakistanis living in the United States not wanting to keep their savings in that country in the years since the events of 9/11, out of fear that the US banking authorities could freeze such funds at any time.

Furthermore, Pakistan cannot bank on aid and remittance inflows continuing at their present rate, since the government has no control over the quantum of such inflows continuing at their present level. Such inflows can go down at any time due to a host of external factors, including the uncertain political situation in the country.

On May 15, international credit rating agency Standard & Poor's (S&P) cut Pakistan's sovereign rating to 'B' from 'B + and its long-term local currency rating from "BB' to "BB –', citing pressure from expanding budget and trade deficits against a volatile political setting. On Friday, May 23, international credit rating agency Moody's followed suit for similar reasons, including deteriorating fundamentals and policy paralysis in Pakistan's economy.

These cuts in sovereign ratings are going to make it harder for Pakistan to raise money from the international bond market. Pakistan last ventured into the international debt market in 2007. Political turmoil, including the lawyers' movement triggered by the judges' issue, has already forced the country to put plans for another sovereign bond issue this year on the backburner. "The outlook is negative," S&P said in a statement.

Moreover, these cuts in sovereign ratings may force the government to consider asking the multilateral donor agencies such as the International Monetary Fund for more funding, including budget support, since raising money from international and domestic markets is going to be a lot more expensive. Requesting the IMF for funds is certain to revive the conditionalities imposed by the agency on Pakistan in the past, putting the country's economy into a straitjacket.

One element of any such straitjacket is likely to be pressure from the IMF to do away with subsidies, especially to the agricultural sector, and increase electricity and gas tariffs. This would make Pakistan's electricity prices, already the highest in the world, even more expensive, which, in turn, would increase manufacturing costs and make the country's goods less competitive in export markets.

The resulting decline in foreign exchange earnings would further increase the country's ever-widening trade gap, which, fueled by soaring imported oil prices and stagnant levels of exports, is currently running at about $1.6 billion a month, or $19 billion a year on an annualised basis.

Faced with the worst inflation since the 1970s, the State Bank of Pakistan raised interest rates on May 22, sending the benchmark KSE-100 share index crashing down from the recent highs by 625.26 points, or 4.52 per cent, on May 23, wiping out Rs 187 billion of market capitalisation in panic-selling triggered by a 1.5 hike in the discount rate to 12 per cent, which obviously will make borrowing more expensive.

To make matters worse, the State Bank last week imposed a 35 per cent margin on the opening of letters of credit for imports. Previously, there was no such mandatory requirement and banks were free to open LCs even on zero margins depending on their own assessment of their clients' credit-worthiness. The imposition of a mandatory margin of 35 per cent is going to hit industry badly, especially factories that depend on imported raw materials.

Having to pay such a high margin is going to impose a severe strain on these factories working capital, forcing them to cutback sharply on their quantum of imports. Since many such factories use imported raw materials to manufacture goods for export, any drop in their production is bound to reduce the quantity of goods they can make for export, with a consequent drop in foreign exchange earnings. This, in turn, will further widen the country's trade gap and put even greater pressure on the balance of payments.

Business community leaders have criticised the measures taken by the State Bank under the pretext of curbing inflation. They said these measures would hurt businesses that are already under severe pressure owing to the high cost of doing business and tough global competition.

However, 38 products have been exempted from the 35 per cent LC-margin requirement, including food items, petroleum products and machinery used in industry and agriculture. Most of these items, however, do not contribute significantly to exports. Also, this list of excluded products is likely to open the door to more corruption, since it will give the concerned government officials discretionary powers to include or exclude particular products from the list.

As if all this were not bad enough, there is also a view that the State Bank's effort to curb inflation through higher interest rates is likely to fail, just like previous such attempts, because inflation in the country in recent years has been caused mainly by soaring imported oil prices which, of course, are not affected by increases in interest rates.

Credit disbursement to the industrial sector is already on the decline. Many industrial units are under immense financial pressure and are finding it increasingly difficult to stay afloat. The State Bank's policy of keeping interest rates high in order to curb inflation has slowed down industrial growth, which, in turn, has adversely affected exports and foreign exchange earnings.

Import costs have also risen due to the fall in the value of the rupee against the dollar, which is currently trading at over 70 rupees to the dollar. According to some analysts, the cost of imports has risen by 10 to 12 per cent in recent months due to the fall in the value of the rupee.

Given all this, the lyrics of the song "Learning the Blues" seem particularly apt. I wonder whether officials in the Ministry of Finance know the song. If they don't, I'd be happy to provide them with the full text of the lyrics.