IMF deal to soothe Pakistan’s external vulnerability but political uncertainty is now the key risk

In our?recent assessment?on the dollar financing gap for Asian frontier countries, Pakistan ranked second, only after?Sri Lanka that is already in default.?For many investors, Pakistan’s economic potential stemming from its relatively large economic size,?favorable demographic trends?and critical geographical location still makes it attractive, especially considering the revival of an IMF bailout. However, risks are still unneglectable as we shall explain in this note.

Since our assessment, we do observe considerable improvements in Pakistan’s external financing. Most notably, the completion of?the combined seventh and eighth reviews of the Extended Fund Facility (EFF)?by the International Monetary Fund (IMF) on August 29th?allows for an immediate disbursement of about US$1.1 billion. In addition, the EFF program is extended from end-September 2022 to end-June 2023 and the size is enlarged from about US$6 billion to US$6.5 billion. This means the EFF program should provide Pakistan with about US$3.9 billion of funds for the rest of FY23, which, together with bridge financing from friendly countries, will be enough to cover most of the?external financing gap of US$4 billion,?estimated by the State Bank of Pakistan.

But the IMF program resumption should be read with caution as the program is contingent upon the fulfillment of some medium-term reforms to restore macroeconomic stability and fiscal sustainability. These include fiscal discipline to achieve a small primary surplus of 0.4% to GDP in FY23 (Chart 1), the withdrawal of fuel subsidies and a tighter monetary policy aiming at lowering inflation to the medium-term target of 5-7%.

In other words, the Pakistani government will have to ensure that the IMF conditionalities are fulfilled to maintain the EFF program. This, however, is more complicated than ever as the ruling coalition is relatively weak with only three-seat marginal majority in the National Assembly. And more recently, the by-election victory of former PM Imran Khan in the most populous state of Punjab is seen as?a foretaste of what could happen in the general elections by October 2023.

A change in administration, though, will likely put the IMF program at risk as the reform targets could deviate given that many of the policy adjustments required to resume the EFF program, i.e., the removal of fuel subsidies and fiscal discipline, are clearly not favored by the general public. For instance, the energy tariff hikes aiming to facilitate negotiations with the IMF since late May have eroded household purchasing power and shattered consumer confidence, which plummeted from 41.46 in May to 31.60 in July (Chart 2). This sudden collapse in sentiment is worse than at the start of the Covid outbreak.

In short, the recent IMF deal will help ease Pakistan’s external financing concern in FY23, but uncertainties still linger over whether the Pakistani government will be willing to comply with the conditionalities needed to keep the IMF program beyond June 2023. On the positive side, we see improved external liquidities into 2023 as the FED may start to pivot away from the very high rates. Still, any further deterioration of the external environment as well as renewed political difficulties could be disastrous for Pakistan given its already fragile external profile.

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