THERE is no immediate danger of unravelling the notable success Pakistan has achieved in its external sector. But there are several worrying signs that cannot be ignored for long-term health of the economy. Two large negative economic shocks suffered by the country — the sharp increase in oil prices and the recent earthquake — totalling at least six per cent of the GDP, have weakened the underlying balance of payments position.

Even before the earthquake struck, the current account balance of payments was showing a sharply deteriorating trend; the deficit during the first four months of FY 2006 ran at the annual rate of $6 billion or over five per cent of the GDP.

Furthermore, the shift to a large deficit has apparently not been accompanied by an increase in the investment rate (which remained at a modest level of 17 per cent of the GDP in FY 2005), suggesting that the current account deficit is financing consumption rather than investment.

Domestic savings (at 11-12 per cent of GDP in FY 2005) remain extremely low; national savings (which include the large net transfer payments from abroad, including remittances) were a little over 15 per cent in FY 2005. Unless trends change in the coming months, the greater self-reliance of the Pakistani economy could be in jeopardy.

The saving–investment gap financed by external flows (after taking into account very substantial transfer payments) could rise to 30 per cent in the current fiscal year 2006 — an unsustainable level in my view.

There are three reasons why the recent deterioration in the current account balance of payments does not pose an immediate threat to external financial stability. First, the external debt levels have come down very sharply since 2000. Second, a significant part of the recent deficits has been financed by equity flows and privatization receipts rather than debt flows. Third, foreign exchange reserves remain high at $11.4 billion though they have come down significantly as a proportion of foreign exchange payments and external debt from their peak in 2003.

Total external debt grew only modestly from $32.1 billion in mid-2001 to $34.0 billion in mid-2005, cushioned in part by privatization receipts. Meanwhile, exports and worker remittances have risen sharply. As a result external debt, as a percentage of exports of goods and services, dropped from over 300 to less than 200 per cent over the period.

Furthermore, the average terms of external debt have softened considerably because of large debt relief from the Paris Club, retirement of expensive debt and substantial concessionary assistance, especially from the IDA. This is reflected in an even sharper drop in the ratio of external debt service payments to exports of goods and services from 36.7 per cent in FY 2002 to 15 per cent in FY 2005.

However, Pakistan’s external debt burden, though significantly reduced, is still higher than low debt countries that typically have external debt and debt service payment ratios to exports of 100 per cent and 10 percent respectively.

Ideally, it would appear desirable to reduce the external debt burden further at least moderately. But in fact, borrowing needs will grow, notwithstanding expected large equity flows. Not only is the current account balance of payments deficit already large, but also the prospective investment needs are substantial. There is an especially strong pent-up demand for external borrowings for public sector projects after more than a decade of very low level development spending.

At the Pakistan Development Forum meeting in Islamabad in April 2006, very large borrowing requirements for infrastructure projects were identified. Further, the government appears to be close to a decision on the Kalabagh Dam, which will involve substantial external outlays. The pace of large defence equipment purchases has picked up, as has the borrowing for addition to the PIA fleet. The planned contracts with Independent Power Producers (IPPs) for meeting the future generation needs of the power sector would also add more or less fixed foreign exchange obligations, very much akin to debt service.

Last but not least, the large reconstruction needs of infrastructure damaged by the earthquake would no doubt add to borrowing requirements. The recent donor conference has been extremely successful in mobilizing $6 billion for earthquake reconstruction needs and donors have been generous.

But it is unrealistic to assume that the majority of the funds will be available in the form of grants and extremely concessionary assistance and would be additional to the assistance that was normally expected. For instance, of the pledges of $2 billion from the ADB and World Bank, at best, a fraction is likely to take the form of additional grants/concessionary money. IDA funds with the World Bank, and special funds with the ADB, are extremely constrained and their country-wise allocations are largely pre-determined.

Large external borrowings and growing levels of nominal external debt, by themselves, need not cause a problem provided the debt servicing capacity, represented by exports of goods and services, grows in line and provided the average terms of the loans remain reasonable.

The external borrowing plans need, however, to be placed in the context of an external borrowing strategy that aims at keeping borrowing and debt at sustainable levels. Pakistan does not have a clearly articulated external debt strategy or at least such a strategy is not in the public domain. This is in sharp contrast to the very openly stated goals of public debt management, which are now enshrined in the parliament-approved fiscal responsibility law. This law places clear limits on new public borrowing and aims at bringing down the public debt-to-GDP ratio to 60 per cent.

In order to avoid possible future foreign exchange crises, it is necessary for the government to adopt an external debt management strategy which complements and reinforces the public debt management goals. There can be multiple dimensions of such a strategy including levels of overall debt in relation to GDP, foreign exchange earnings, proportion of short-term debt, ratio of foreign exchange reserves to external debt, currency composition of debt etc.

But in my view, a fundamental goal of this strategy should be to at least maintain, if not to reduce, the ratio of debt service payments to exports of goods and services, which at present is around 15 per cent.

If such a goal is adopted as government policy, it will require that the net future borrowing as a percentage of existing debt must be in line with the growth in export earnings, provided the average terms of new borrowing remain at the present level of concessionality.

However, it is likely that with Pakistan’s growing borrowing requirements, the terms of borrowing — both the interest rate and the average maturity — would harden (the average interest rate on external debt was only 2.2 per cent in FY 2005). In such a case, the growth in net external debt would have to be substantially below the rate of growth of foreign exchange earnings, the extent of the hardening of the terms of the debt determining the scale of borrowing.

The broader point is that there are definite limits to debt sustainability of external — as well as public — debt. An external debt management strategy should define clear parameters and goals governing future borrowing to avoid exceeding safe limits.

This external debt strategy should also be a part of an overall external finance strategy. External finance needs can be met by either borrowing or equity flows. One of Pakistan’s problems in the past was excessive reliance on external borrowing.

With greater confidence in the economy, foreign investment flows have picked up sharply and a substantial part of privatized assets have been purchased by foreign investors. Pakistan badly needs foreign investment to supplement its own resources, to upgrade technology, and to assist in expanding and diversifying its exports.

I do not, however, share the view held by some that large current balance of payments deficits financed mainly by equity flows do not matter because there are no fixed foreign exchange obligations. While it is neither desirable nor possible — in a liberal economic regime — to tightly regulate foreign private investment, the overall level of current account balance of payments deficits (foreign savings) must remain under policy scrutiny to ensure that the dependence on foreign flows does not become excessive and net inflows finance investment rather than consumption.

A rule of thumb that no more than 20-25 per cent of domestic investment should be financed from net foreign savings could be instituted as part of an external finance strategy (as mentioned above, there is some danger that the investment gap financed by net foreign inflows may rise to 30 per cent during FY 2006, exceeding the suggested ceiling). This will permit the acceptable level of current account balance of payments deficit to rise as the investment rate as a percentage of GDP rises. At the same time, it will ensure that external flows do not directly or indirectly finance consumption. This kind of limit would be in addition to the limits on external borrowing suggested above.

A balance between external finance and domestic resource mobilization would also assure that the benefits of growth accrue principally to nationals and the investment income payments, either in the form of interest or profits and dividends, do not become a major burden on the balance of payments.

Maintenance of an adequate level of external reserves must be another integral part of any external finance strategy. The very large build-up of reserves over the last few years was widely criticized in the country. To some extent, the massive accumulation of foreign exchange reserves reflected depressed domestic economic activity in the first years of the stabilization efforts. But more basically the increase in reserves, after living on the edge of debt default for many years, was needed to create confidence in the currency.

As economic activity has picked up, foreign exchange reserves have, relatively speaking, come down despite substantial growth in exports and other foreign exchange earnings. In mid-2003 the total foreign exchange reserves were equal to nearly eight months of foreign exchange payments. Currently, the reserves are equal to about five months’ payments. There should of course be flexibility in reserve management, such as building reserve levels in times of positive economic shocks and windfall gains and running those down in times of unexpected shocks such as oil price increases or natural disasters, such as the earthquake.

However, a lesson of recent experience is that a comfortable level of reserves is an essential ingredient for attracting remittances, private investment flows, and obtaining good terms of market borrowings.

The government needs to put in place an external finance strategy in a timely fashion to assure markets, investors, and the public that the hard won victory in the external sector will not be allowed to be dissipated, more challenging external circumstances notwithstanding.

The writer is a former chief economist of the World Bank