Old-fashioned emerging market crises aren’t history yet

Photo: Bloomberg
Photo: Bloomberg


The economies of Pakistan and Sri Lanka are sadly still beset by problems whose solutions are obvious

The Pakistani rupee (PKR) dropped nearly 10% against the United States Dollar (USD) last week as foreign exchange companies removed a de-facto cap on its conversion. The action included the largest intra-day PKR decline, both in absolute and percentage terms (9.6%). In some ways, Pakistan’s plummeting currency is a sign of the continuing grave economic crisis that the country finds itself in. In other ways, it is the first hopeful sign that Pakistan may be willing to agree to four main conditions set out by the International Monetary Fund (IMF) to continue with its rescue plan. That Pakistan finds itself in this position for the 13th time is evidence of insufficient structural reforms of its macro-economy.

Last week, the country’s reserves slipped to just 15 days of import cover. Economists believe that a minimum of about six months of import cover is required to maintain liquidity in the external sector. Pakistan recorded an inflation rate of 24.5% in December 2022, necessitating a policy interest rate hike to 17%, the highest in nearly 25 years. Skyrocketing inflation and a dysfunctional external sector together left its 200 million citizens with a food and energy shortage.

To India’s south, Sri Lanka has been battling an economic crisis for a few years. This crisis was exacerbated by covid and the resulting decline in tourism-related foreign exchange earnings. The Sri Lankan economic movie has many common elements with the Pakistani one, and has been causing enormous hardship to its citizens, particularly beginning in early summer of 2022. There have been widespread power cuts and shortages of food and essential items, including medicines.

The narrative arc of these economic crises is broadly similar. Successive populist governments have funded their largesse with debt. These borrowings have primarily been in foreign currencies, US dollars and the Chinese Renminbi (RMB) in both cases.

Sri Lanka’s economic growth rate has been gradually falling over time, from 7% in 2015 to 2% in 2019, going into the pandemic. Pakistan was able to maintain a growth rate of about 5% for several years going in 2018, but it has declined since then. The tax contribution in both countries is a paltry 9% of gross domestic product (GDP). A shortage of growth, combined with a low tax base, has meant more borrowings, externally and domestically, to finance government programmes. This has led to twin current account and fiscal deficits.

As confidence in the country and its currency declined, exporters of goods and services demanded pre-payment for goods, resulting in stronger demand for hard currency, which added pressure on the exchange rate. As the currency was not allowed to find its market value (as was the case in Pakistan until last week), hoarding and black-market activities gained strength. Both countries are today running current account deficits in excess of 4% of GDP and budget deficits that are nearly 10% of GDP. Economic mismanagement was exacerbated over time by chaotic political leadership in both countries. This cocktail fits the classical pattern from the ‘emerging market crisis’ playbook.

There are a few differences between the two countries. Sri Lanka’s is an export-oriented economy that is import dependent for most of its basic goods. Unlike other modern export-oriented countries, it has not diversified its export base beyond agricultural produce (tea) and garments. The absence of tourists during the pandemic caused an unfortunate further decline in much-needed foreign exchange revenue. Pakistan’s industrial sector is disproportionately owned by its government or (indirectly) by it army. Lack of dynamism in its industrial and services sectors has not allowed Pakistani companies to turn competitive. Recent wide-spread floods have had an enormous human and economic impact. This devastation has added to its problem, particularly through food inflation and displacement of people.

The standard IMF response playbook is also in evidence. Even as an IMF delegation is expected in Pakistan this week, the Fund has recommended a ‘Washington Consensus’-like set of stringent measures. These include freeing the exchange rate, cutting government expenditure and raising the tax base. In particular, the IMF wants Pakistan to withdraw electricity subsidies, rationalize gas tariffs to international levels and remove a ban on Letters of Credit. This can only be sustained in the long term if a greater proportion of Pakistan’s economy moves into diversified private hands. In the meantime, citizens will have to tighten their belt. Successive corrupt and nepotistic regimes have not been able to convince their citizenry of the required austerity.

It is indeed tragic that such old-fashioned crises are still playing out in emerging markets. Nepal appears to be going down the same disastrous path. While its foreign exchange reserves are still adequate, they are declining at a fast rate. If the Nepalese government does not act prudently this year, it will tip Nepal’s economy over.

A little over 30 years ago, India faced a similar crisis. Despite the political implications of multiple coalition governments, India’s actions at that time steadied the ship. Hopefully, Pakistan and Sri Lanka will use this opportunity to do the same.

P.S: “That which does not kill us makes us stronger," said German philosopher Friedrich Nietzsche

Narayan Ramachandran is chairman, InKlude Labs. Read Narayan’s Mint columns at www.livemint.com/avisiblehand

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