With the attention of economists and financial analysts absorbed by the banking crisis, other clouds on the horizon are being neglected. I see sovereign default in emerging markets as one of those risks.
There are quite a few countries on the critical list; this article deals with Pakistan, a country of 230 million people, the fifth most populous in the world.
This article discusses the probability of default and implosion in Pakistan and possible impact.
a, The risk of default and implosion in Pakistan
Pakistani bond yields are at distressed levels. Hard currency reserves are dwindling rapidly (at about three weeks of imports). GDP has been stagnant over the past five years. The country needs to pay down $22 billion of debt in the coming year, and $80 billion over the coming three years. The rupee has devalued by 60% over the past year, while inflation has recently exceeded is in the range of 23-46%, depending on whose measures are used. Rating agencies are consistently downgrading Pakistan (Fitch just downgraded to CCC— “Default is a real possibility”). Droughts and heat waves are becoming more frequent. Record rains recently caused flooding of a third of the country, pushing another 8-9 million people below the poverty line. Food shortages and price surges have resulted in mobs looting restaurants and trucks carrying foodstuffs.
The political situation is explosive, with a populist outsider, Imran Khan, likely to win elections this summer, pitted against the establishment and military, whose support he would need to govern. His last stint as prime minister was characterized by bouts of anti-Americanism and a breakdown of relations with the military. He has loudly voiced concerns that the upcoming elections are rigged against him, and that he may not accept the results. He blames the current prime minister for an attempt on his life, still nursing a leg wound.
Pakistan has some $126 billion of external debt. Should a default occur, the probability of an IMF rescue plan coming together—a la Sri Lanka—is less than assured, for several reasons:
The likelihood of implosion is augmented by Pakistan being among the most vulnerable countries in the world to climate change while lacking the capital on institutions to deal with it. Further climate shocks might accelerate the downward spiral.
Should there be default, without an IMF rescue package, an economic death spiral could result in a failed state. Even with a rescue package, the downward spiral may be too strong to overcome.
b, The impact of default or implosion
Default would create a recession. A rise in energy prices and taxes, a likely condition of an IMF package, would add to the severity of the recession. Devaluation would lead to higher inflation. A tightening of monetary policy to defend the rupee could result in a wave of bankruptcies. The man-in-the-street is likely to suffer even more than now.
Default could have a ripple effect on Pakistan’s creditors—most notably China. A default could create a perception of higher risk in lending to emerging markets—contributing to rising interest rates and difficulty in financing government bonds across all emerging markets.
Perhaps the most terrifying prospect is that in the case of civil disobedience or civil war, the fate of Pakistan’s nuclear facilities could be up for grabs. Pakistan may have the privilege of being the least stable of all countries possessing nuclear weapons.
Let me finish on a positive note. As the saying goes, hope for the best, and prepare for the worst. There are a few optimists in Pakistan. Goldman Sachs, for example, forecasted as recently as December 2022 that Pakistan would not default, and that by 2075, it would be the sixth largest economy in the world, provided “appropriate policies and institutions” are in place—in my opinion, a strong assumption in the case of Pakistan.
This article discusses the probability of default and implosion in Pakistan and possible impact.
a, The risk of default and implosion in Pakistan
Pakistani bond yields are at distressed levels. Hard currency reserves are dwindling rapidly (at about three weeks of imports). GDP has been stagnant over the past five years. The country needs to pay down $22 billion of debt in the coming year, and $80 billion over the coming three years. The rupee has devalued by 60% over the past year, while inflation has recently exceeded is in the range of 23-46%, depending on whose measures are used. Rating agencies are consistently downgrading Pakistan (Fitch just downgraded to CCC— “Default is a real possibility”). Droughts and heat waves are becoming more frequent. Record rains recently caused flooding of a third of the country, pushing another 8-9 million people below the poverty line. Food shortages and price surges have resulted in mobs looting restaurants and trucks carrying foodstuffs.
The political situation is explosive, with a populist outsider, Imran Khan, likely to win elections this summer, pitted against the establishment and military, whose support he would need to govern. His last stint as prime minister was characterized by bouts of anti-Americanism and a breakdown of relations with the military. He has loudly voiced concerns that the upcoming elections are rigged against him, and that he may not accept the results. He blames the current prime minister for an attempt on his life, still nursing a leg wound.
Pakistan has some $126 billion of external debt. Should a default occur, the probability of an IMF rescue plan coming together—a la Sri Lanka—is less than assured, for several reasons:
- No matter who wins the elections, there will be cries of political illegitimacy, making IMF negotiations more difficult, especially pushing through hard political reforms, like energy and tax increases. Pakistan has a tradition of economy-crippling strikes.
- The IMF itself has asked Pakistan to approach creditors (e.g., China) and obtain new credits, showing hesitation to step in as lender of last resort.
- Relaunching growth in Pakistan is hampered by a lamentable investment in human capital. Pakistan ranks 141 out of 174 countries on the Human Capital Development Index. There is a higher than 45% illiteracy rate. As of 2019, only 62% of children of primary school age were enrolled in school. A massive brain drain is robbing the country of some of its best talent.
- After 22 lending programs to Pakistan, and allegations of funding a terrorist state, the IMF has reason to be reticent in funding Pakistan. A recent IMF mission to Pakistan in February 2023, failed to result an agreement on unlocking a mere $1.1 billion from an existing 2019 IMF facility, in part because Pakistan insists on its regressive tax policies (raising sales tax rather than introducing property tax).
The likelihood of implosion is augmented by Pakistan being among the most vulnerable countries in the world to climate change while lacking the capital on institutions to deal with it. Further climate shocks might accelerate the downward spiral.
Should there be default, without an IMF rescue package, an economic death spiral could result in a failed state. Even with a rescue package, the downward spiral may be too strong to overcome.
b, The impact of default or implosion
Default would create a recession. A rise in energy prices and taxes, a likely condition of an IMF package, would add to the severity of the recession. Devaluation would lead to higher inflation. A tightening of monetary policy to defend the rupee could result in a wave of bankruptcies. The man-in-the-street is likely to suffer even more than now.
Default could have a ripple effect on Pakistan’s creditors—most notably China. A default could create a perception of higher risk in lending to emerging markets—contributing to rising interest rates and difficulty in financing government bonds across all emerging markets.
Perhaps the most terrifying prospect is that in the case of civil disobedience or civil war, the fate of Pakistan’s nuclear facilities could be up for grabs. Pakistan may have the privilege of being the least stable of all countries possessing nuclear weapons.
Let me finish on a positive note. As the saying goes, hope for the best, and prepare for the worst. There are a few optimists in Pakistan. Goldman Sachs, for example, forecasted as recently as December 2022 that Pakistan would not default, and that by 2075, it would be the sixth largest economy in the world, provided “appropriate policies and institutions” are in place—in my opinion, a strong assumption in the case of Pakistan.