What Pakistan can learn from Sri Lanka’s troubles

A closer look at South Asia’s debt crisis

Pakistan is on the precipice of disaster. The country faces a shortage of foreign exchange, inflation hit a multi-decade high of 31.5% last month and the prospect of a sovereign debt default looms large. There are parallels with the situation faced by Sri Lanka a year ago, which could give some clues over the path ahead for Pakistan.

OMFIF spoke to Reza Baqir, former governor of the State Bank of Pakistan, about the country’s fragile economic situation. Baqir highlighted that Pakistan has a longstanding history of failing to take ownership of its economic policies and that the seeds for the latest crisis were sown last year. The deterioration in the terms of trade, primarily due to surging energy prices, alongside accommodative fiscal policy caused strains in the balances of payments. Deeply negative real interest rates and the decoupling of the official exchange rate from the market-led unofficial rate added to imbalances. The devastating floods last autumn were another blow to the economy.

Given its shaky external position, it will be a tall order for Pakistan to meet its large debt obligations this year. Securing a $1.1bn disbursement from the International Monetary Fund, under the existing Extended Fund Facility deal, will be crucial.

To improve the country’s standing with the Fund, policy-makers have adopted a more orthodox approach this year. The public purse strings have tightened, the overvalued currency was devalued and the central bank has raised interest rates by 400 basis points, to 20%, including a 300bp hike last week. Crucially, though, the IMF will need to deem Pakistan’s debts as sustainable before it can release additional funding. The government’s recent policy shift may not be enough to meet this requirement.

Baqir remarked that it may also require financing assurances from Pakistan’s allies before the IMF is confident enough to provide funding to Pakistan. The country has reportedly received $2bn in loans from Chinese banks in recent weeks. But more financing would probably be needed to stave off a default.

In the meantime, stabilising the economy is a pressing issue for Pakistan’s government. Sri Lanka offers some lessons on this front. In February, OMFIF hosted a virtual roundtable with the governor of the Central Bank of Sri Lanka, Nandalal Weerasinghe, who highlighted the improvements in the country’s economic conditions since last year’s crisis.

Having been in freefall for much of 2022, Sri Lanka’s foreign exchange reserves and currency have stabilised in recent months. Inflation is starting to fall sharply, having peaked at 70% in September, albeit it is still running at 50%. And after months of wrangling, the government has reportedly secured financing assurances from major bilateral creditors, including China, which will probably pave the way for a fresh IMF deal.

There is still a long road to recovery in Sri Lanka. The economy is likely to contract this year. There are questions over the implementation of necessary structural reforms, such as ensuring the independence of the central bank. And, despite the good news over financing assurances, a debt restructuring has yet to be finalised. The delays and opacity over Sri Lanka’s restructuring offer a cautionary tale to Pakistan if it were to default.

In any case, Sri Lanka’s economy is on surer footing that it was a year ago. This is for a few reasons. A debt default and capital controls stemmed the bleed in reserves and have given the economy some breathing room. The central bank has tightened policy which is helping to overcome imbalances. This has been complemented by fiscal consolidation under a more politically stable government, after mass protests resulted in the resignation (and exodus) of President Gotabaya Rajapaksa last year.

Recent policy tightening suggests that Pakistan is starting to follow this playbook. Policy paralysis is a risk though. Baqir outlined that, under the constitution, ‘the National Assembly will be dissolved at the latest by August, which means elections. And a new government will not be in office until towards the end of the year’. A changing of the guard may come at a time when decisive policy-making is required to manage the economic crisis. This could also compromise the existing government’s credibility as it heads to the negotiating table with lenders.

Nikhil Sanghani is Managing Director of Research at OMFIF.

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