Pakistan: 6 Questions for Emerging Markets Debt Investors

Recently, I visited Pakistan on a research trip and met with investors, companies, politicians, and policy advisors throughout Lahore, Karachi, and Islamabad to explore investment risks and opportunities. Here are six questions emerging markets debt investors should consider.

Will political volatility increase post elections?

General elections were held in Pakistan on February 8. The Pakistan Muslim League-N (PML-N) party won 75 seats, the Pakistan’s People Party (PPP) won 54 seats, and Pakistan Tehreek-e-Insaf (PTI) independents won 93 seats, with smaller parties winning the remaining seats. 134 seats out of 266 seats are needed to form a government.

Despite delays in vote counting and disputes regarding the validity of election results, a coalition government led by the PML-N and PPP parties will likely govern Pakistan. PTI leader Imran Khan remains in jail, and Shehbaz Sharif could return as prime minister, with Asif Ali Zardari likely assuming the role of president. In addition, half of Pakistan’s senate is retiring in March 2024. Businesses typically look for elected ministers to advance reforms.

The International Monetary Fund (IMF) has continued discussions with government officials, and investors are likely to favorably view any kind of long-term policy to strengthen the economy. The current IMF stand-by arrangement (SBA) program concludes in March 2024, and it will be critical for Pakistan’s new government to negotiate another long-term program with the IMF.

It will be critical for Pakistan’s new government to negotiate another long-term program with the IMF.

Is Pakistan too big to fail?

Pakistan has a cash-flow problem. I spoke with two former finance ministers, and they both emphasized Pakistan’s need to reduce its fiscal deficit.

Local currency debt is more of an issue than external debt given its higher debt stock and exposure held by local commercial banks. If local currency debt were to default, local commercial banks could also default, as they effectively finance the central government by buying local debt.

However, the idea of suspending or delaying debt payments is socially or culturally frowned upon, particularly within financial or governmental circles in Pakistan. There is a strong reluctance or resistance to consider such a moratorium, possibly due to concerns over the country's financial credibility, fear of negative impacts on its credit ratings, and potential geopolitical repercussions, especially considering the diverse sources of its debt. Around 30% of its debt is external, of which roughly 50% goes to multilateral agencies, 30% to China, and 10% to other bilateral creditors.

On the bright side, friendly nations have become more pragmatic when deciding to lend to Pakistan, though the era of easy deposits and rollovers is likely over, with growing demand for equity and board seats. But there is little incentive for China, the United States, and the Gulf Cooperation Council (GCC) to see an unstable Pakistan. These countries likely want to see Pakistan do well.

Who will be the next finance minister of Pakistan?

The role of the finance minister is critical for Pakistan as it seeks to negotiate a new SBA program with the IMF. There is a chance that Pakistan's next finance minister will be Muhammad Ishaq Dar, a senior politician who has previously held the position four times. However, the country’s next government could also nominate a less familiar candidate.

The eventual choice for finance minister may impact markets. During Dar's stint as finance minister from 2013 to 2017, a nearly $7 billion loan from the IMF was approved, and the country's growth rate sat at roughly 5%, inflation was at 4%, and its currency was stable.

Current economic conditions are different, and markets and investors tend to react to the appointment of key economic officials based on their track record and policy stance. When Pakistan’s new government announces the next finance minister, investors will likely parse through any past comments on economic policies and the individual’s relationship with the IMF. Investors will also likely view comments that align closely with the IMF's program conditions and recommendations in a positive light.

There is little incentive for China, the United States, and the GCC to see an unstable Pakistan.

What is the focus of Pakistan’s fiscal policy?

The Pakistani government is targeting a 0.4% primary surplus this fiscal year, and so far, it is on track. The current interest-to-revenue rate is about 65%. Historically, it’s been closer to 40%, but the increase is primarily due to local debt servicing. Sovereign debt investors should closely monitor Pakistan's commitment to achieving a primary surplus amid its high interest-to-revenue ratio. While the target of a 0.4% primary surplus indicates fiscal discipline, the elevated interest-to-revenue rate poses a risk to debt sustainability. The reliance on local debt servicing, accounting for 88% of the burden, further exacerbates this risk.

Meanwhile, Pakistan’s tax-to-revenue rate sits at roughly 10%. Most of the country’s taxes are generated from imports, and there’s no tax incentive at the provincial level because the federal government would compensate losses and taxes would lead to lower popularity of provincial leaders. The low tax-to-revenue ratio and heavy reliance on import taxes could signal vulnerabilities in Pakistan's revenue-generation capabilities. Investors should assess the potential for broadening the tax base and the political will to implement such measures.

In addition, there is a huge discrepancy between gross domestic product (GDP) contributions and tax contributions by sector in Pakistan. For example, the agriculture sector contributes 23% of GDP but only 0.6% of tax revenue. This indicates a skewed economic structure that could affect fiscal stability and growth prospects. At some point, the Pakistani government may need to consider bringing other sectors into the tax base but doing so may be politically difficult. Investors should consider the implications of any reforms aimed at addressing these imbalances and the potential resistance such measures may face.

Could lower oil prices make policy rate cuts easier?

Pakistan is currently experiencing high inflation, with rates sitting at 29%, while policy rates are at 22%. Both businesses and the central bank expect policy rates to decline, as the country is already past peak inflation. Pakistan’s central bank expects inflation to drop below 20% year-over-year, with significant disinflation projected before June 2024. Falling inflation can lead to lower interest rates, potentially boosting bond prices.

Significantly, power and gas tariffs, which make up about 25% of Pakistan's consumer price index (CPI) basket, have seen substantial increases, with gas tariffs rising by more than 150% in some instances. This has implications for future inflationary pressures and consumer costs.

Regarding the external sector, Pakistan’s current account deficit is projected between 0.5% and 1.5% of its GDP. Most current account forecasts seem to be based on oil prices at $90 a barrel. Pakistan is a net importer of oil; therefore, lower oil prices would help to reduce Pakistan’s external financing needs.

The Pakistani government may need to consider bringing other sectors into the tax base but doing so may be politically difficult.

What is Pakistan’s privatization outlook?

Pakistan has gone through long periods of mismanagement, with policymakers often focused on short-term management. To spur reforms—including investment and privatization in Pakistan—the Special Investment Facilitation Council (SIFC) was set up in June 2023.

However, practical challenges and a bureaucratic, rather than financial, focus may hinder effective implementation and materialization of investments.

There has recently been progress in privatizing Pakistan’s national airline, Pakistan International Airlines, but efforts have been met with employee protests. Obstacles that prevent privatization of loss-making, state-owned companies could dampen investor confidence and potentially delay meaningful economic improvements.

In Summary

In a post-election landscape, Pakistan faces political volatility and economic hurdles that will likely require careful policy management. Inflation is likely to normalize, which will help lower debt servicing costs for the country in 2024. We believe that a new IMF program will help investors gain confidence in Pakistan’s efforts to further consolidate its debt and push through reforms that could help it become more resilient to future potential shocks.

Johnny Chen, CFA, is a portfolio manager on William Blair’s emerging markets debt team.