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S&P turns screw on Pakistan

Pakistan's economic outlook, already darkened by internal violence, strife on its border with Afghanistan, soaring inflation and a plunging stock market, took a turn from bad to worse this week with the decision by Standard & Poor's to downgrade its foreign-currency rating. Along with other emerging stock markets, Pakistan's has taken a battering as global confidence has eroded. The Karachi All Share Index is down 40.5% from its high on April 18 this year, the Karachi 100 a similar amount, and the narrower Karachi 30 is down 47.4%.

Yet ironically, the banking sector, which has benefited from financial reforms that began several years ago under finance minister Shaukat Aziz, has been a bright spot and has proved relatively immune from direct fallout from the US financial crisis. Its capital adequacy ratio is about 12.1%, which is above international standards. Pakistani banks are legally prohibited from investing in low-quality assets and are therefore not exposed to the subprime crisis.

The broader market declines have followed a fairly steady descending-tops trend line from April, although the averages have been extremely stable since the end of August, when the government took measures to stabilize the market.

In June, the government imposed a 5% trading collar, in August it put a short-term floor under stock prices, and last month it banned short selling and set up a stock market stabilization fund. The finance and energy sectors of the stock market have attractive valuations, but both foreign direct investment and the participation of foreign institutional investors have declined precipitously since last year.

Foreign funds fled Pakistani equities especially during the uncertain economic and political conditions in the run-up to decide a successor as president to Pervez Musharraf, with a net exit of US$400 million in the three months preceding the elections. According to one report, foreign institutional investment was down from a high of $1.8 billion in 2007 to $20 million just 10 days ago.

This complicates management not only of the external debt but also of the current account deficit and fiscal deficit. It was little surprise that four days ago, the Asian Development Bank (ADB) gave Pakistan a $500 million loan as part of a larger ($1.5 billion) package to try to guarantee economic stability specifically by providing foreign currency reserves as well as promoting general economic development through job creation.

Last month, the ADB revised its growth forecast for the country downwards. Whereas the average rate of growth has in recent years been as high as 7.5%, but falling to 5.8% last year, the ADB lowered its projection to 4.5% for the current year. This was due largely to political instability, which impedes inflation-fighting - to decreased demand as a result of tighter monetary policy, and to a slowdown in the rate of production of commodities as well as an increase in their prices. Consumer price inflation rose past 25% in August, compared with 6.5% a year earlier.

On the other hand, foreign exchange reserves are declining, as a result of which the rupee continues to weaken - the currency is down 21% since the beginning of the year. Countervailing options include selling off more public sector enterprises to foreign investors and new incentives for expatriate Pakistanis to increase their foreign remittances.

Standard & Poor's, fearing that Pakistan would fail to meet interest obligations of $3 billion on its external debt, this week cut the country's long-term foreign-currency rating to CCC+ from B. The US-based rating company also noted that rising political risk from increased violence is threatening the business environment.

Two weeks before, Moody's maintained a B2 rating on the government bond but cut the outlook from stable to negative. "The likelihood of further domestic political tumult amidst a growing tide of religious extremism and high inflation could slow structural reform and fundamentally weaken much-needed capacity to generate higher savings, tax revenue and foreign exchange," Aninda Mitra, Moody's sovereign analyst for Pakistan, commented.

Pakistan is the world's riskiest government borrower, according to credit-default swap prices from CMA Datavision, with investors concerned by a deterioration in security that saw 53 people killed in a bomb attack on the Islamabad Marriott hotel last month, according to a Bloomberg report.

More than 2,000 people were killed in Pakistan in 2007 in terrorist attacks that the government blames on militants opposed to its support of the US-led campaign against terrorism, Bloomberg reported.

Credit-default swaps are contracts based on bonds and loans and are used to speculate on a company's ability to repay debt. Pakistan's five-year credit default swap indicates that its sovereign debt trades as high as 2,050 basis points. An investor would thus need to pay $2.05 million annually to insure against $10 million of Pakistan's sovereign debt, according to S&P's.

The government is trying to borrow $100 billion from the US, the UK, and the International Monetary Fund to help service the external debt (which amounted to more than one-quarter of domestic gross product at the end of 2007). It is in negotiations with the United Arab Emirates on economic aid, to which security and political conditionalities would probably be attached, and it is putting off paying its oil bill to Saudi Arabia. (The country's oil imports cost over $1.1 billion per month.)

In sum, while it was thought president Musharraf's resignation might accelerate economic reforms, thus giving foreign investors hope that the country's fiscal problems were not beyond resolution, the political class now finds itself caught between the Scylla of the political risk that those necessary reforms will create, accelerating already vertiginous security problems, and the Charybdis of the reforms themselves.

Big European banks believe that more fiscal and monetary tightening is necessary, because in their view interest and inflation rates have not reached their peak.

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URL:  http://www.robertcutler.org/blog/2008/10/sp_turns_screw_on_pakistan.html
First published in Asia Times Online, 9 October 2008.

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