Pakistan is walking a financial tightrope. The Islamic republic’s economic situation looked pretty dire before the credit crunch struck emerging markets. Now that investors are scrambling for safe havens, it looks even worse. Moody’s Investors Service has just downgraded the outlook of Pakistan’s sovereign bonds—already in junk territory—to negative, prompting fears of a default against its $45 billion (Rs2.1 trillion) foreign debt, equivalent to 31% of gross domestic product, or GDP.
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Politically, recent months have been tumultuous for Pakistan, marked by one big assassination, the end of military rule, a number of terrorist attacks, and increasingly volatile relations with the US, its traditional ally.
Investors fear the worst for the economy. Pakistan’s five-year credit default swaps are now the riskiest in the world, trading at around 1,500 basis points (one basis point is one-hundredth of a percentage point). There are good reasons. Pakistan is running a current account deficit equivalent to 8% of estimated GDP in 2008. Foreign exchange reserves have withered from $16 billion one year ago to just $9 billion, enough to cover just two months of increasingly expensive imports.
The situation might be even worse than it appears. The benchmark Karachi 100 index has declined 35% this year, roughly in line with the fall of India’s top 30 stocks. Yet foreign investors in Pakistan—who might otherwise have sold out—have been prevented from withdrawing as much as they might have by the regulator’s decision to impose a trading floor on shares.
There’s no easy way for Pakistan to right itself. The bombing of the Marriott Hotel, popular with foreigners in Islamabad, is only the latest sign of the country’s deep divisions. Plans by the finance ministry to raise money through asset sales and the removal of fuel subsidies are politically fraught.
A default sounds unavoidable. But ironically, Pakistan’s political woes may be the very thing to help avert that particular disaster. The international community sees the country as an important pawn in the battle against Islamic extremism. Default could leave it prey to the worst forces. Pakistan is understood to be seeking help from the Saudis, the World Bank, the International Monetary Fund and Group of Eight nations. It’s likely to get what it needs.