The State Bank of Pakistan (SBP) is watching financial markets more closely as our internal political crisis deepens and as new developments unfold after US President Donald Trump’s threats.

“We’re watching every important development to ensure banks’ operations remain normal,” says a senior central banker. “So far there’s no sign of any unusual activity taking place in banks or forex companies. But just in case it happens we are ready to respond.”

Banks and forex companies kept working normally after the July 28 ouster of the then prime minister Nawaz Sharif by the Supreme Court, in connection with cases of money laundering.

“So far there’s no sign of any unusual activity taking place in banks or forex companies. But just in case it happens we are ready to respond”

“But Donald Trump’s threat of cutting aid to Pakistan and a veiled warning of even going beyond that (over what he perceives as our shortcoming in fighting the war on terror) can potentially upset markets.

Panic-driven drawdown on deposits and volatility in exchange rate movements, particularly in the open market, cannot be ruled out if the situation is not saved from deteriorating further,” warns a senior executive of one of the top five banks.

“All depends on how our government and state institutions manage the post-threat situation and how fast the US itself signals a softening in its stated stance.”

Even if the crisis created by anti-Pakistan remarks of President Trump is managed well, that would not mean an “early resumption of inflows of Coalition Support Fund”, feared a foreign banker.

The current situation marked by continued surge in the current account deficit (from $4.87bn in FY16 to $12.12bn in FY17 and then from $662m in July 2016 to $2bn in July 2017), can weigh down on economic growth. It would also make effective, pro-growth, monetary management difficult for the SBP.

Keeping a check on inflation and on the currency in circulation, continuing with a stable interest rate policy, saving forex reserves from falling, transmitting the right signals on exchange rate movement, all can become more challenging.

Even the hard-earned deceleration in the pace of growth in the currency in circulation achieved in FY17 may become difficult to sustain.

Yearly flows of the currency in circulation fell to Rs577bn in the outgoing fiscal year from Rs779bn a year earlier, sending signals to the markets that the then government and SBP both were serious in right-balancing growth in this regard and ultimately containing expansion in the parallel economy.

Democracy is evolving in Pakistan and tightening the nuts and bolts of our economy requires some unusually tough trade-offs. Besides, fresh elections are due next year. Internal political crisis and the recent uneasiness in Pak-US relationship may have a negative impact on our economy.

Moreover, the country is preparing for the next election towards the end of this fiscal year, and that too at a time when the PML-N is upset with the unseating of Nawaz Sharif.

We’ve already got signals (via the new prime minister’s formation of a large federal cabinet, increase in salaries and perks of bureaucrats and intensions expressed of accelerating work on politically sensitive projects) that the spending spree will gather momentum as the elections draw nearer, bankers and analysts say.

Besides, foreign debt servicing and generous defence expenditures to fight terrorism and to remain prepared for any misadventure from across the border, amid lower than targeted revenue generation would force the government to continue to breach the limits of borrowing from the banking system, sources in the SBP say.

And if the government opts for more borrowing from the central bank than from the banking system (or goes for note printing), that would fuel inflation.

Whereas excessive government borrowing from banks can potentially crowd out the private sector, reversing the gains of a big 68pc growth in private sector lending in FY17, even its unusual borrowing from the SBP can be harmful for businesses’ growth due to the resultant spike in inflation.

And in that case, even if the central bank continues to ignore businesses’ call for depreciation of an overvalued rupee, retaining a stable monetary policy would be very difficult.

Central bankers say a high growth in currency in circulation flows, that had been the case prior to FY17, is only a symptom of structural weaknesses that allow the parallel economy to expand with all its negative consequences on the real economy.

With 53pc population remaining financially excluded and only about 20pc having bank accounts (as of 2015), with a fund-starved government relying heavily on prize bonds for generating non-bank debts and the number of active tax payers standing around 1.21m (according to 2015 stats), no effective deterrent for the growth of the parallel economy can work effectively.

Besides, illicit money is parked conveniently in the scantly-regulated real estate sector at home as well as in safe havens abroad.

And skewed and selective law enforcement plus high-denomination currency notes continue to facilitate corruption.

“In this environment, the central bank’s job becomes too tough, requiring trade-offs unheard of elsewhere, particularly at times of political uncertainty or amid threats to regional stability,” sums up a former senior central banker. “And we are currently in such times.”

Published in Dawn, The Business and Finance Weekly, August 28th, 2017