External financing needs are expected to continue to mount in the medium term. The elevated current account deficit and rising external debt service, in part driven by CPEC-related outflows (loan repayments and profit repatriation), are expected to lead to higher external financing needs, which are expected to rise from $21.5 billion (7.1 percent of GDP) in fiscal year 2016-17 to around $45 billion by fiscal year 2022-23 (9.9 percent of GDP).
Despite significant external borrowing by the government, including several syndicated bank loans and an international sukuk and Eurobond issuance of $2.5 billion, gross reserves of the State Bank of Pakistan (SBP) declined from $18.5 billion at the end of the EFF to $12.8 billion in mid-February 2018-equivalent to 2.3 months of prospective imports, or 50 percent the IMF''s reserve adequacy (ARA-EM) metric, the report states.
Macroeconomic stability gains achieved during the Extended Fund Facility (EFF) have been eroding, putting the growth outlook at risk, the Fund adds. The report pointed out that Pakistan''s current account deficit has been quickly widening, reflecting strong domestic demand amid an overvalued exchange rate, fiscal slippages, and an accommodative monetary policy stance, which resulted in decline of foreign exchange reserves.
Net international reserves have declined from $7.5 billion at the end of the EFF to negative $0.7 billion in mid-February 2018. As a result of fiscal slippages in fiscal year 2016-17, debt-related vulnerabilities have increased. Careful phasing in of new external liabilities, resuming medium-term fiscal consolidation, and accelerating other growth-supporting structural reforms will be critical to reinforcing macroeconomic stability and promote higher and more inclusive growth.
Against the background of limited exchange rate flexibility, international reserves have significantly declined, eroding confidence. Maintaining a largely stable nominal exchange rate amid mounting external pressures has led to losses of international reserves. The Fund cautioned against the use of administrative measures to reduce external imbalances. Regulatory duties on imports, cash margin requirements, and the export support package are unlikely to facilitate a sufficient external adjustment in the absence of continued exchange rate flexibility. These measures may also adversely impact competitiveness in the medium term with distortions and increased dependency on regulatory protection and fiscal incentives. Staff recommended removing the regulatory duties and cash margin requirements as soon as conditions allow.
The Fund further noted that the authorities have adopted administrative measures and allowed some exchange rate adjustment to mitigate these trends, albeit with limited effect. In addition to maintaining cash margin requirements on payments for consumer imports, they have significantly raised regulatory duties on many imported intermediate, consumer, and luxury goods to contain import growth. The export support package has been extended with easier qualification criteria. Furthermore, in December 2017, the authorities allowed a 5 percent depreciation of the rupee/dollar exchange rate. Nonetheless, reserve losses have continued, pointing to limited effectiveness of these measures to date.
The SBP''s net short derivative position has doubled to $5.4 billion, bringing NIR down from $7.5 billion to an estimated negative $0.7 billion over the same period. Following strong growth until May 2017, the stock market has corrected by nearly 20 percent, while external bond spreads have remained relatively close to emerging market averages.
Public and publicly-guaranteed debt is expected to remain elevated, marginally declining from 70 percent of GDP in 2016-17 to 68 percent of GDP by 2022-23. Alongside, gross fiscal financing needs will likely exceed 30 percent of GDP from 2018-19 onward, in part reflecting increased debt service obligations.
Mobilizing affordable external financing could become more challenging in the period ahead. The authorities'' success with contracting external borrowing (over $10 billion in 2016-17 and more than $6 billion so far in 2017-18 has been instrumental in softening the impact of the rising external imbalances on foreign exchange reserves. While the level of external debt (27.4 percent of GDP in 2016-17) has remained moderate, continued mobilization of external financing at favorable rates could become more challenging in the period ahead, against the background of rising international interest rates and increasing financing needs.
External sector imbalances are expected to rise further. Despite continued recovery of exports and some moderation of import growth, the current account deficit is expected to widen to $15.7 billion (4.8 percent of GDP) this year. In the medium term, the current account deficit is expected to remain elevated at about 3.8 percent of GDP, owing to continued real exchange rate misalignment and slow recovery of remittances. On current policies, and based on the authorities'' ambitious external financing plans, gross international reserves are expected to further weaken to $12.1 billion (2.2 months of imports) this year, with risks skewed to the downside.
Pakistan''s public and publicly guaranteed debt reached 69.7 percent of GDP by the end of 2016-17, close to the level of the previous fiscal year (70 percent of GDP), while public debt excluding guarantees was about 67 percent of GDP. Debt levels are higher than envisaged in the debt sustainability analyses (DSA) during the 2017 Article IV consultation, largely reflecting the significantly higher fiscal deficit (by 1.3 percent of GDP relative to the Article IV projections), due to revenue underperformance and a sizable increase in provincial development spending. Net public debt also increased to around 62 percent of GDP. And 30 percent of total public debt is foreign currency denominated.
Public and publicly guaranteed debt is projected to remain close to 70 percent of GDP by 2023 under the baseline. Public debt excluding guarantees is projected to stay around 66- 67 percent of GDP. In the absence of strong consolidation measures, the fiscal deficit excluding grants is expected to remain at close to 6 percent of GDP through the medium term, resulting in elevated debt levels. Adverse shocks, notably to economic growth and the primary balance, could lead to public debt ratios well above 70 percent. Contingent liabilities from restructuring of loss-making PSEs represent additional fiscal risks.
Gross financing needs are projected to reach above 30 percent of GDP (compared to 29 percent in 2016/17), largely accounted for by domestic loan amortization. While improvements in the debt profile have been made in recent years, resulting in moderate shares of short-term and foreign exchange-denominated debt that sit between the lower and upper early warning thresholds, high gross financing needs may pose potential rollover risk. 3. Fiscal consolidation needs to be strengthened to improve debt dynamics, build sufficient fiscal buffers, and gradually achieve legally mandated debt targets. The high levels of public debt and gross financing needs present significant fiscal risks and need to be addressed in a timely fashion through fiscal tightening to improve debt sustainability.
Strong consolidation efforts are also critical to preserve the credibility of the fiscal responsibility framework: in the absence of significant policy effort, the projected public debt trajectory sits higher than that stipulated in the revised FRDL Act with a limit of 60 percent of GDP on net general government debt until 2017-18 and a gradual transition toward 50 percent of GDP over a 15-year period.
The external DSA shows that the projected path for external debt is sustainable but subject to increasing risks. Gross external debt as a percentage of GDP-having been on a declining trend until 2015-is expected to increase and peak at about 32 percent of GDP in 2021. Bound and stress tests suggest that the external debt-to-GDP ratio would be affected by adverse shocks. While sensitive mostly to current account and exchange rate shocks, the external debt ratio would exceed 45 percent only under the real depreciation shock scenario. External risks are also highlighted by the projected decline in foreign exchange reserves and rising gross external financing needs, which are expected to increase to about 9.9 percent of GDP in 2023 (from 7.1 percent in 2016-17).
Despite solid growth, Pakistan''s macroeconomic stability gains achieved during the EFF have been eroding amid widening external and fiscal imbalances. While real GDP growth has continued to accelerate, external and fiscal imbalances have significantly widened in the context of strong domestic demand growth, limited exchange rate flexibility, accommodative monetary policy, fiscal slippages, and limited progress with key structural reforms. As a result, foreign exchange reserves have been declining, despite significant public sector external borrowing in recent months.
Risks to Pakistan''s economic outlook and capacity to repay are largely on the downside. Demands for higher spending in the pre-election period could raise the fiscal deficit, including at the provincial level. A more gradual deceleration of imports (for example, due to higher oil prices) and slower recovery of exports and remittances could further widen the external deficit, report maintained.
Tightening global financial conditions and changing investor sentiment could complicate mobilization of external financing, particularly if external and fiscal imbalances are not proactively addressed, eroding confidence, private investment, and economic growth.
Deterioration in security conditions could also negatively affect investment. Lower growth in key trading partners or further appreciation of the real effective exchange rate could accentuate these trends.
The Fund further said that continued scaling up of China-Pakistan Economic Corridor (CPEC) investments could accelerate the buildup of related external payment obligations. Pakistan''s capacity to repay could deteriorate at a faster pace, with faster depletion of foreign exchange reserves and significant implications for economic growth.
Economic growth has continued to strengthen. Improved energy supply, investment related to the CPEC, strong credit growth, and continued investor and consumer confidence, have been underpinning growth, which could reach 5.6 percent this fiscal year within a favorable inflation environment.
Risks to this outlook are largely on the downside, given a difficult political setting and the possibility of further widening external and fiscal deficits in the coming months.
Policy efforts need to focus on arresting the widening imbalances, preserving macroeconomic stability, and supporting private-sector-led inclusive growth. The authorities'' recent moves to tighten monetary policy and to allow some exchange rate adjustment are welcome and need to be complemented with continued exchange rate flexibility to safeguard external buffers.
The IMF suggests a significant re-focusing of near term policies to arrest the widening imbalances and preserve macroeconomic stability as well as accelerating growth supporting structural reforms to reinforce macroeconomic stability and promote higher and more inclusive growth.