The IMF's sudden positive turn on Sri Lanka and, possibly Pakistan, is a response to the mounting contagion risk for frontier markets

Good news for Asian frontier markets (FMs) have just come with Sri Lanka and, possibly soon Pakistan. In fact, the International Monetary Fund (IMF) has just approved a $3 billion bailout with $333 million immediately disbursed to help the cash-strapped country shore up its mismanaged economy, and subsequent funding will be conditional on IMF’s review every six months. That said, uncertainties remain in the details of Sri Lanka’s debt restructuring which is next on the agenda. Although China has agreed to coordinate, it has only promised a 2-year moratorium versus the 10-year offered by the Paris Club. In addition, whether Chinese creditors are willing to extend the maturities along with the Paris Club will also be key to the recovery value of Sri Lanka’s external debt at the end.

For Pakistan, the IMF is quoted to have seen “substantial progress” toward meeting the policy commitments for the next tranche of $1.1 billion whose disbursement has stalled since November 2022. One should not underestimate the importance of such disbursement for Pakistan’s debt repayment stress as it brings access to more external funding from other multilateral lenders. It is also important to recall that after the IMF staff concluded their visit on February 10, the Pakistani authorities accepted all the strict terms set by IMF and had passed the IMF-dictated Finance Supplement Bill on February 21. Yet, it was not enough for IMF to disburse the loan but rather to have asked Pakistan to seek more external financing to buffer the country’s current account deficit up to the end of current fiscal year (June 2023).

Given the difficult negotiation process in the past, the positive feedback from IMF today seems a bit surprising as Pakistan just announced new fuel subsidies last week without consulting with the IMF, especially as fiscal policy reform was deemed critical for the country to strike this lifeline deal. As such, the sudden turn in IMF’s attitude may reflect its deeper worries about frontier economies’ funding needs in the mist of the financial crisis in the US and Switzerland, which is also being extended to the rest of Europe.

In our?last piece, we assessed Asian frontier markets’ external funding gaps, and Pakistan recorded a deficit of 3.3% of GDP, the worst among Asian FMs (Chart 1). That is, following the already in-default Sri Lanka, Pakistan has the highest pressure in debt repayment, and default will be at the door if it can’t secure enough financial support. In fact, after the collapse of SVB, sentiment barometers have seen sizeable retreat as the price of Pakistan’s dollar bond maturing April 2024 fell 960 bps and the Pakistani Rupee has depreciated 2.3% against the USD even though the dollar index weakened amid fear of risk (Chart 2).

All in all, the softening of IMF’s stance is good news for Asian FMs, but it may hint at deeper downside risk of the brewing financial crisis.

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