Islamabad, March 24 – If the war in Iran does not end quickly, it could deliver the most devastating shock to Pakistan's economy in living memory, according to a report. Pakistan remains particularly vulnerable to the evolving fallout of the war, and its economy faces several challenges, considering that it imports the majority of its fuel and food from West Asia and relies heavily on remittances from the Gulf.
"The country's misfortune is compounded by timing. This is not an economy facing a shock from a position of strength. It is one that has been bruised by four years of painful stabilization, marked by a historic cost-of-living crisis and an unprecedented decline in income that has wiped out the gains of the last decade. In virtually all its previous crises, Pakistan has been pushed over the edge by rising commodity prices. But this usually happens after a period of domestic overheating," wrote Murtaza Syed, former acting governor of the State Bank of Pakistan (SBP), in The News International.
Pakistan's vulnerability is further increased because it has virtually no room to respond to an external shock. With less than three months of import cover, Pakistan's foreign exchange reserves remain thinner than in almost any other country. Pakistan's public debt burden is difficult to manage, as the government's debt is worth 70 per cent of Gross Domestic Product (GDP), and gross financing needs are among the highest in the world, leaving little room for countercyclical action.
Higher oil, gas, and fertilizer prices will increase transport and food costs, leading to a recession. A prolonged slowdown in West Asia will impact remittances and external financing, and an unsettled regional environment will put extreme pressure on the Pakistani currency, leading to inflation.
"Some may hope that the current IMF program will cushion the blow. But this is false comfort. Although necessary to prevent default, the Fund program will not by itself solve the problem. The size of the program cannot be materially increased because Pakistan's repeated past borrowing has nearly exhausted the limits under the Fund's access rules. And in the absence of stronger buffers, the latest Staff Report has already warned that the program will remain contractionary in the face of a surge in commodity prices," wrote Murtaza Syed.
In the current situation, fiscal tightening, higher interest rates, and depreciation of the exchange rate will be unavoidable. However, this will also exacerbate the slowdown at the very moment when Pakistan's economy needs breathing space. This policy mix will be unable to protect the most vulnerable from stagflationary shock. The standard IMF playbook for demand compression will be a dangerous gamble that could cause unrest and affect the already battered social fabric.
"A better and safer response can be engineered. But it will require swift action and an honest assessment of the limits of the current policy framework. If the war drags on, Pakistan should not rely solely on austerity. A more optimal policy mix would involve targeted fiscal and monetary stimulus for vulnerable households and firms, together with some foreign exchange intervention and temporary import restrictions to reduce disorderly volatility in the rupee and a surge in inflation," wrote Murtaza Syed.