By Zafar-ul-Hassan Almas
The financial crisis, which has been developing at Wall Street, has got people worried in developing countries around the world. The stock exchanges, in developing countries have crashed and things look bleak for the financial markets. The people are drawing parallels with the Great Depression of 1929, but this time the world economy seems far more reliant and countries are far more intertwined with each other.
The depth and breadth of the financial crisis is yet not known. The crisis has generated instability by speculative trade, which has far-reaching implications around the globe. The crisis has the potential to disrupt the very foundations of the international monetary system. The situation is not limited to the meltdown of financial markets, the real economy at the national and international level, its institutions; and its productive structures are also in difficulty. This financial meltdown inevitably, backlashes on consumer markets, the housing market, and more broadly on the process of investment in the production of goods and services.
Pakistan is living in a highly integrated world and a major turmoil of this magnitude and would definitely create certain implications for Pakistan’s economy. Pakistan already reeling from high food and fuel prices could face adverse consequences of the global financial crisis. The country’s economy is already confronted with worst kind of macroeconomic imbalances and obviously need financing desperately. Pakistan’s economic growth has slowed down and the ripple effects of this financial crisis may or may not hit with same intensity or severity as it is doing to the developed world, but still there are various channels through which the crisis may hit Pakistan economy.
The crisis affected area, United States and Europe, hold a fundamental value for Pakistan’s economy. The financial turmoil is more then likely to affect Europe, Japan and North American countries with full intensity. Pakistan’s external sector comprised of trade, foreign investment, remittances, and capital flows is interwoven with these countries. All these indicators of external sector have more than 50 per cent of the stake in this region. The growth model being followed in Pakistan over the years is highly dependent on foreign capital inflows, mainly from these countries.
More than one-half of Pakistan’s external trade is dependent on these countries. The country could be hurt if demands for its export products dropped significantly, foreign investment declines substantially and if the terms of trade are affected. Pakistan has a very inelastic import structure and if exports are hit by a crisis than the current account deficit is likely to go beyond the sustainable limits. There is an agreement among analysts that countries with heavy external financing needs are potentially more vulnerable to a credit crunch. Pakistan’s current account deficit had already touched $14 billion which is 8.5 per cent of its GDP, in 2007-08. In the current fiscal year, the ambitious reduction in the CAD is planned but still need a financing of around $12 billion. If import compression measures fail than the financing needs would be more than that.
Pakistan’s external inflows projections hinges upon inflows from GDR’s and sovereign bonds in the fiscal year 2008-09. In the current situation any inflows under these heads are most unlikely. Standard & Poor has downgraded its long-term credit rating for Pakistan to triple c plus and this is the third downgrading of this calendar year. This rating will heart some investment prospect as well. The current crisis is aggravated by rising cost of external borrowing on the one hand and scarcity of availability of external inflows coupled with volatility of oil prices in the international market on the other. Internal security situation is adding miseries to our external woes. Non-debt creating inflows like FDI and portfolio inflows had shown great resilience to external crisis last year but sustainability of this resilience is likely to be hurt.
The presence of foreign banks in Pakistan expands access to credit as well as financial services, which can spur efficiency and innovation in domestic banks, however, ripple effect of shocks from the credit squeeze in the US has impact on local financial markets through these banks. Pakistan has concentration of almost all foreign banks in the country. They account for one-tenth of deposits in the country in 2007-08.
There are substantial changes taking place in the interrelation with the structure-forming elements in the global financial market which is seriously affecting the financial-credit mechanism in the developing countries, which have not yet developed the financial and economic structures. Countries like Pakistan sensitively react to the structural changes in the financial space. The banking and the entire financial system is much stronger now, after years of restructuring. Pakistan’s financial institutions had not invested in derivatives that had exposure to risky investment bankers. Moreover, better supervisory oversight and risk management practices introduced by the SBP have strengthened bank balance sheets while Bank asset quality, profitability, and capital adequacy have also improved remarkably in recent years.
If the small size of the Pakistan’s financial market has traditionally been a hindrance to a more efficient economy, it may actually prove to be an advantage in the current situation. There are deficiencies in the operations of the banking system, and it does not fulfill its function as finance intermediary. Hence the traditional channels of influence between financial market and real economy do not function in all respects.
Cash flow financing remains a major source of funding for domestic companies and securitization is the least sought after option. Acquisition of share capital through the stock exchange is not a significant source of funding. Share holdings do not account for a major part of household assets, so the direct impact of falling share prices on consumption is not likely to be substantial. A lack of confidence in banking system has also traditionally prevented a significant sector of households from keeping their savings in banks. Hence, the impact on households of a possible burst in bank insolvencies will be minimal. In addition, the majority of deposits are in the state-owned banks or banks with sizeable government presence.
Pakistan‘s stock markets and the real sector are not integrated to a great deal with international markets which provide some immunity to these two sectors. Pakistan is also fortunate in the crisis by not having fragile instruments like commodity futures, hedge funds, derivative markets, etc. These are few sectors where gravity of the crisis may affect with full intensity.
Indirect effects may thus become prominent in evaluating the consequences of the financial turmoil on the real economy. Jolts to corporate and household confidence are possibly the most significant negative implications of these developments. The economic slowdown in the US and Europe could naturally affect demand for Pakistan’s exports. Coupled with the pass-through effects of ongoing price hikes in oil and food-commodities, the harsher external environment today may inevitably place downward pressure on our growth prospects in the immediate period. In economies like Pakistan with a low degree of financial intermediation, the aggregate demand is not so elastic relative to the interest rate, making the fiscal policy more responsible for aggregate demand control. But even if Pakistan were to avoid major hits to the real economy, declines in share prices, higher interest rates and a weaker currency are realized events, and it is unlikely that they will pass without consequences for macroeconomic stability.
The tight liquidity situation particularly hampers the operations of small banks and banks with limited resources, so the possibility of insolvency and bankruptcy cannot be ignored for some banks. Pakistan is facing a gimmick of financing huge fiscal deficits in 2008-09 and if liquidity constraint remains intact with limitations on external financing, the demand for State Bank resources will grow at a faster pace. The unwillingness of the SBP to finance the deficit may have serious implications for fiscal operations. This will attract major cuts in growth enhancing development expenditure because current expenditure offers little room for adjustment. The development expenditure has crucial for job creation and interlink ages in the economy.
The refinancing of fiscal deficit without SBP finances may prove to be difficult, and will further tighten liquidity conditions and could lead to insolvencies for some companies and banks as well as add further pressures on taxation options.
Our foreign currency reserves are stored in foreign banks which cannot be bankrupt but even in that case, we will not be losing our money because they are placed under guarantees and have been insured. Some fraction of foreign exchange reserves are transferred to the management of internationally recognized banks and financial markets, and have been placed in securities. SBP may thoroughly track the state of its financial partners with whom it co-operates and must possess operational information.
The other likely impact would be on the value of our currency. The years of our linkage with the dollar has significance for us. Any drastic depreciation of dollar may give a hard hit to Pakistan. In 2007-08, Pakistan has added $4.2 billion to its stock of external debt without borrowing a single penny only because of depreciation of dollar versus major currencies like euro and the Japanese yen. It seems as if Pakistan has not taken this event very seriously and should carefully design a plan of action to avoid the first and second rounds of this crisis. In spite of all our complacency, we have avoided the contagion of sub prime crisis, but it is the most unlikely proposition that the crisis will not affect Pakistan without taking corrective measures.
Source: The News, 20/10/2008