The Looming Debt Default
Emerging economies are facing a high risk
“The debt crisis facing developing countries has intensified … A comprehensive approach is needed to reduce debt, increase transparency, and facilitate swifter restructuring—so countries can focus on spending that supports growth and reduces poverty. Without it, many countries and their governments face a fiscal crisis and political instability, with millions of people falling into poverty.”
— David Malpass, World Bank Group President
Adversely impacted by the catastrophic impact of climate change, the Covid-caused economic meltdown, and more recently, the war in Ukraine, which immediately darkened the outlook for many developing countries that are major commodity importers or highly dependent on tourism or remittances, most developing nations are facing a catastrophic debt crisis in the coming months. As rich countries are in a fire-fighting mode to tame soaring inflation, most of the highly-indebted poor countries are feeling the heat. An important South Asian country Sri Lanka has already defaulted on its debt and many others are on the brink as high inflation rates, slowing economic growth, rising interest rates and an unending devaluation of their currencies against the US dollar coalesce into a perfect storm that could set off a wave of messy defaults and inflict economic pain on the world’s most vulnerable people.
Poor countries owe, by some calculations, as much as $200 billion to wealthy nations, multilateral development banks and private creditors. Rising interest rates have increased the value of the dollar, making it harder for foreign borrowers with debt denominated in US currency to repay their loans. Defaulting on a huge swath of loans would send borrowing costs for vulnerable nations even higher – investment flows to the developing world have already been abating as rich countries are trying to cope with high food and energy prices and big creditors, particularly China, have been slow to restructure loans – and could spawn financial crises when nearly 100 million people have already been pushed into poverty this year by the combined effects of the pandemic, inflation and Russia’s war in Ukraine. The danger poses another headwind for a world economy that has been sputtering toward a recession.
And as crises have shown over and over again in recent decades, the financial collapse of one government can create a domino effect — known as contagion in market parlance — as skittish traders yank money out of countries with similar economic problems and, in so doing, accelerate their crash. The worst of those crises was the Latin American debt debacle of the 1980s. The current moment, emerging-market watchers say, bears a certain resemblance. Like then, the Federal Reserve is suddenly ratcheting up interest rates at a rapid-fire clip in a bid to curb inflation, sparking a surge in the value of the dollar that is making it difficult for developing nations to service their foreign bonds.
Although experts believe that mass defaults in low-income countries won’t spur a global financial crisis given the relatively small size of their economies, yet the potential is causing policymakers to rethink debt sustainability. In part, that’s because defaults can make it harder for countries like the United States to export goods to indebted nations, further slowing the world economy and possibly leading to widespread hunger and social unrest – as Sri Lanka drew closer to its default last year, its central bank was forced to arrange a barter agreement to pay for Iranian oil with tea leaves.
Those under the most stress tend to be smaller countries with a shorter track record in international capital markets. Bigger developing nations, such as China, India, Mexico and Brazil, can boast of fairly robust external balance sheets and of foreign currency reserves. But in more vulnerable countries, there’s widespread concern about what is to come. Bouts of political turmoil are arising around the globe tied to soaring food and energy costs, casting a shadow over upcoming bond payments in highly-indebted nations such as Ghana and Egypt, which some say would be better off using the money to help their citizens. With the Russia-Ukraine war keeping pressure on commodity prices, global interest rates rising and the US dollar asserting its strength, the burden for some nations is likely to be intolerable.
As for Pakistan, the risk of default is looming large as the country’s foreign exchange reserves dropped to a nearly four-year low of $6.7bn — just about enough to cover four to five weeks of imports, according to the State Bank’s numbers released on December 08. Although the Governor State Bank of Pakistan, Jameel Ahmad, is confident that all debt repayments are on track – Pakistan is to return $4.7 billion in actual over the next seven months – and foreign exchange reserves are expected to increase in the second half of the current fiscal, experts still believe that the country faces a high risk of default. For instance, former federal finance minister Miftah Ismail states that Pakistan’s default risk has reached a dangerous level, claiming that the country is on the verge of default. In his tweet, Dr Ismail wrote that “I don’t know what is the best dollar rate, only the market can determine it.” Imports were $80 billion and exports $31 billion last year, and the No.1 priority of Finance Minister Ishaq Dar shouldn’t be to make imports cheaper & export harder, which is what an appreciated rupee does.” Moreover, in his article “A Consistent Downward Slide,” he wrote: “Today, our default risk has climbed up again and reached dangerous levels. This risk won’t vanish even after the December bonds are paid off. At the risk of sounding an alarm, I have to say that we have no room left for error. Concrete measures that reassure markets and lenders are urgently needed.”
Besides Dr Miftah, former chairman Federal Board of Revenue (FBR) and renowned economist Shabbar Zaidi has also warned that Pakistan has technically entered default as the government lacks financial resources for making imports.
Pakistan’s perceived risk of default has sharply risen to 79.33% in the wake of current political turmoil and uncertainty surrounding the ninth review of an International Monetary Fund (IMF) bailout package. The country’s five-year credit-default swaps (CDS) increased from 7,550 basis points (bps) on November 15 to 7,933 bps on November 16, constituting a single-day of increase of 383.8 bps. The default risk perception stood at 7% in March this year. Pakistan’s default risk is increasing due to multiple factors including a delay in the IMF ninth review, weak foreign exchange reserves and political turmoil. Pakistan needed at least $32 billion during this fiscal year to meet its foreign obligations and the government should secure the IMF review and required funds for the remaining fiscal year at the earliest to give confidence to the market and stabilize the economy.
Pakistan is currently in an IMF program and is seeking further inflows to bolster its foreign currency reserves. So, there is an urgent need to bring about macroeconomic stability to reverse the perilous position, for which the continuity of the IMF program is essential. However, during the ongoing 9th review discussions, the IMF has indicated that “not all end-September quantitative targets have been met,” which could be, inter alia, one of the reasons for the formal review mission timeline not yet being announced. Uncharacteristically revealing the failure to meet targets during ongoing review discussions could indicate dissatisfaction with Pakistan’s performance. Slippages in budgeted expenditure and revenues have resulted in a material primary fiscal deficit as opposed to the small surplus that had been agreed upon in August at the conclusion of the combined 7th and 8th reviews. The slow provision by the government of information necessary for proper diagnosis is likewise unhelpful.
Furthermore, the IMF may be disappointed with the SBP purportedly instructing banks to institute administrative measures to control imports through delays in the processing of LCs. Additionally, by forcing licensed forex dealers to only transact at SBP-recommended exchange rates, the central bank in effect is trying to manage the rupee parity price against the dollar. Suppressing the trend movement in the exchange rate goes against the market-determined mechanism agreed upon with the IMF under the Extended Fund Facility (EFF) program. Artificially managing the rupee will not only exacerbate the deteriorating reserves situation, which are well below program target levels to start with but also signals to the lender a lack of commitment to structural reform, which is a fundamental tenet of the EFF program.
The forex administrative measures have fuelled the growth of an undocumented curb market for currency transactions as volumes at the SBP recommended rates have shrunk to negligible levels. This has contributed to the reduced inflow of foreign exchange. With almost a 10 percent difference between the curb market rate and the interbank rate, more of the workers’ remittances are being channelled through informal means such as hawala/hundi. The inflow of remittances in Pakistan fell nearly 16 percent in October 2022 on a year-on-year basis. The uncertainty in currency markets would also encourage exporters to delay the conversion to rupees of export dollar proceeds in anticipation of future depreciation.
The government appears not to have so far presented a realistic plan to meet shortfalls arising from expanded expenditures and less tax revenue generation due to the economic slowdown as well as to ensure adequate response to the floods. It has also failed so far to secure USD 4 billion in financing from friendly countries to support the program. Finance Minister Ishaq Dar should now avoid bellicose bluster, but rather undertake corrective policies that focus on successfully concluding the 9th review with the IMF. Failure to do so is almost certainly going to result in sovereign default, and in the resulting irremediable turmoil, the poor will suffer the most.