Pakistan, China, and the IMF

Pakistan’s incoming prime minister Imran Khan recently tweeted to let “President Erdogan and the people of Turkey know we are praying for their success in dealing with the severe economic challenges confronting them, as they have always succeeded against adversities in their glorious history.”

While Pakistan and Turkey enjoy close historic and warm relations and many Pakistani leaders have expressed admiration for Erdogan, Imran Khan would be well advised not to mix emotions with strategy in either international politics or when looking for models of economic success. Turkey’s economic crisis has been caused by a combination of factors but principally due to a growth strategy that relied heavily on foreign debt and Erdogan’s authoritarian style of governance—a problem that was exacerbated by an overblown sense of Turkey’s regional and global importance.

The Turkish lira has fallen about 40 per cent against the U.S. dollar this year. It is not a mere coincidence that Turkey’s external debt to GDP ratio is the highest among the larger countries in the developing world, followed by South Africa, Mexico, Argentina, Russia, Brazil, and Pakistan. These countries have one thing in common: an external debt to GDP ratio of more than 30 per cent.

Much has been written about Pakistan’s current economic crisis and whether the new government will have to go to the International Monetary Fund (IMF). While financing the rapidly growing external account deficit is the immediate challenge, it would be a big mistake to blame it on just the previous government of Nawaz Sharif.

Pakistan’s economic woes are well known and are repeated ad nauseam in local and international media and in other forums. Pakistan’s current economic crisis is just another reminder that it is a dysfunctional state whose elites have used foreign money to help them ride through periodic crises without addressing the fundamental issues. Pakistan holds a world record of 21 IMF programs implemented since 1958, 14 of them after 1980. As soon as the economic situations stabilised, Pakistani policy makers went back to business as usual, pretending they were undertaking some “structural reforms.” Will this time be any different?

The immediate reasons for the current crisis include Pakistan’s hugely misconceived energy policy and the financial structure of China Pakistan Economic Corridor (CPEC) power projects. Former prime minister Nawaz Sharif’s government wanted to rapidly build additional power generation capacity to overcome the country’s chronic power shortage problem. It approved 21 coal-driven power projects with the expected total cost of $35 billion. Not all of this $35 billion “investment” is in the form of equity. The debt to equity ratio for many of the power projects is 3 to 1 (75 percent debt, 25 percent equity) with the return on invested equity reported to be as high 34.5 percent.

The projects were approved without a holistic and broader macroeconomic policy framework and were motivated by Nawaz Sharif’s desire to deliver on his 2013 election promise of preventing future power shortages. Fast forward to 2018: Pakistan’s current account deficit rose by 40 percent to a record $18 billion due to an increase of $7.6 billion in imports. By comparison, exports rose by just $2.4 billion. Around 70 percent of the rise in the import bill during 2017-18 was due to imports of energy products, capital equipment, and related raw material. For example, Pakistan imported 11.2 million tonnes (costing around a $1 billion) of coal in 2017 compared with 3.42m tonnes in 2013.

I had written for Pakistan’s daily DAWN on June 22, 2013: “Pakistan’s unfavourable high cost energy mix lies at the core of the energy crisis. Today, the plants using imported oil represent the single largest source of electricity generation due to a flawed policy of supporting oil-powered plants by guaranteeing a minimum return to the investors.”

I also wrote that the energy crisis was not about the installed capacity because the structural reasons go far beyond just the high debt levels of the energy sector, bad governance and corruption given the high level of transmission and distribution losses, idle capacity, and our inability to exploit hydro, wind, and solar resources.

Unfortunately, any criticism of the CPEC has been considered almost blasphemous in Pakistan and met with media frenzy and shrill outbursts from hyper-nationalists. It it worth explaining here why the power projects (which account for over 50 per cent of investments for the $62 billion CPEC program for Pakistan) are not investments.  It is a misnomer to call anything a “private investment” when profit is guaranteed by the government. This is the case with almost all CPEC power projects because the equity holders are guaranteed to earn rates of return believed to range from 17 to 34 percent. Such “investments” are, in effect, quasi governmental debt because the government is obligated to pay an agreed internal rate of return on invested equity regardless of whether the projects actually make money. Pakistan’s official external debt of $91.7 billion (31 percent of the GDP) does not include this quasi government debt which could be as high as $10 billion.   

A strategy financed largely through foreign currency debt which sought to build infrastructure by guaranteeing profits through projects with the government seems to have fallen apart. While the total generation capacity has increased in the last five years, it has not helped Pakistan to grow its exports, which have remained almost flat during the same period. Mr. Miftah Ismail, the former finance minister, may be right that for the next five years, Pakistan’s total annual debt repayments and profit expatriation by Chinese companies would be below $1 billion, but he has not taken into account the pressure on the external account due to the import of raw materials and capital goods related to the CPEC projects. To reduce pressure on the current account in the immediate future, Pakistan may seek medium term credits from countries such as Saudi Arabia and Kuwait for oil and other raw material imports.

The most serious consequence of providing government guarantees for profits is the distortion of the most efficient allocation of resources in an economy by encouraging the rent-seeking behaviour of its famously venal business elites. It is ironic that some large business groups who benefited from favourable tax exemptions or subsidies in the past also jumped on the bandwagon of CPEC power projects as a means to make easy money. According to the Pakistan Economic Survey 2017-18, a government publication, tax exemptions for various affluent businesses amounted to $4.4 billion in just one year. This is much more than the “corruption” of $2.5 billion Nawaz Sharif was accused of by Mr. Khan. A level playing field in a competitive economy should be free from such policy distortions.

Pakistan, for decades, has followed a set of policies that has encouraged investments in real estate, guaranteed profit projects, and allowed certain industries to enjoy unfair tax exemptions.  This has discouraged industrialisation on a broader scale, contributed to Pakistan’s failure to achieve the high growth rates achieved by many other countries in Asia, and limited its ability to grow its export rate. Since 1980, exports from India and Bangladesh have grown at a rate that is more than five times that of the growth of Pakistan’s exports.

In the most immediate future, removal of all such policy distortions and deregulation of all sectors of the economy from unnecessary government controls should be among the top priorities for the new government. If it cannot provide meaningful incentives, it should at least remove some of the disincentives faced by entrepreneurs and industrialists. This may require a detailed review and possible renegotiation of the terms of all projects, including projects under CPEC, where rate of return is guaranteed and elimination of tax exemptions is granted through ad-hoc administrative measures. However, the entrenched elites and their friends in the bureaucracy are most likely to mislead the new government into wild goose chases like “looted wealth” abroad instead of reforming a system built on patronage under the protection of a military and civil bureaucracy that seems to be incapable of  addressing the complex challenges Pakistan faces. It remains to be seen whether the IMF will once again bailout Pakistan, a country that has been described as a curious case of Dutch Disease, but without the oil.


The writer is a former Citigroup banker, columnist and an independent consultant.