9/11, Pakistan’s Economy, and the IMF

Date: May 23 2006
Speaker:
Mushtaq Khan , Citibank vice president and Wilson Center Pakistan Scholar. Commentators :
Andy Baukol , U.S. Department of the Treasury
Shahid Javed Burki , former finance minister, Government of Pakistan
Manuela Ferro , World Bank

Event Summary:

Pakistan-watchers should not be misled by the country’s rosy economic growth figures. Pakistan faces fundamental problems in the financial sector that are not presently being addressed, warned Mushtaq Khan , the Wilson Center ‘s 2005-06 Pakistan Scholar, at a May 23 event organized by the Asia Program.

Prior to late 1999, Pakistan was in the throes of an unsustainable cycle of borrowing and spending, which policy makers were unable to halt. Following the October 1999 coup that brought him to power, General (now President) Pervez Musharraf faced a bankrupt country as the IMF program in Pakistan was suspended and foreign exchange reserves fell to dangerously low levels. There was a palpable urgency to revive the IMF reform program needed for debt relief, which was essential after the freeze of foreign currency accounts in May 1998, following Pakistan ‘s nuclear tests.

In the aftermath of 9/11, Pakistan ‘s financial situation improved dramatically: remittances flowing into Pakistan soared, the value of the Pakistani rupee appreciated, and a fiscal consolidation occurred as the ratio of Pakistan ‘s deficit to its GDP decreased. As external financing surged, the government no longer needed to borrow from banks, which led banks that were “flush with liquidity” to lend to the private sector. Although Pakistan started experiencing impressive economic growth, Khan contended that this growth was (and is) based on “cheap credit, not economic fundamentals.” The Pakistani economy is currently imbalanced because it is fueled by credit-driven growth, which in turn is stoking an already large external deficit. The appropriate policy response in the banking sector is to tighten interest rates; however, both policy makers and the economic elite strongly resist this step.

While Pakistan is not as vulnerable to abrupt capital flight as Southeast Asia or Latin America , the financial trends of the Central Bank are disturbing because “any external shock has the ability to reduce or undermine the repayment capacity of the private sector.” Fiscal reforms are lagging, while domestic debt servicing will soon create new fiscal pressures. Despite high growth rates, fundamental problems such as excessive private sector credit and inadequate social development are being masked by a political compulsion in Islamabad and Washington to display high growth levels. Although Pakistan ‘s Achilles’ heel — foreign exchange — was resolved with 9/11, a false sense of security has stagnated the delivery of critical fiscal reforms. In essence, the financial flows that resulted from 9/11 have done Pakistan a disservice as they have melted the discipline in economic management that had been achieved in the two years prior to 9/11.

Commentator Andy Baukol agreed with Khan’s analysis that higher levels of external financing in Pakistan , post-9/11, had allowed the financial sector to “avoid some of the difficult policy issues.” Baukol noted that the IMF had attempted to streamline its conditionality to address the rapid credit growth. It remains to be seen how much Pakistan progresses in privatizing the state banks, as international confidence ultimately lies in the ability of private, rather than state, banks to efficiently manage their loan portfolios.

Shahid Javed Burki warned about the dangers of a consumption-driven rather than an investment-driven growth. Is Pakistan heading for another economic shock, he asked, given that the management of the market in Pakistan is being done not with economic fundamentals, bur rather by speculation? This speculation is not sustainable, Burki emphasized; only a “large dose of structural reform” can save the situation.

The interesting point, Manuela Ferro added, is how these imbalances developed in Pakistan . What is the political economy that leads to these cycles of boom-and-bust? Why are there no self-correcting mechanisms in the national financial institutions? Ferro contended that the real Achilles’ heel in Pakistan is not the foreign exchange shortages Khan emphasized, but Pakistan ‘s very slow social development.