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Brewing storm

October 30, 2017

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IN recent years emerging market debt has been a haven for international investors looking for higher yields. Loose monetary policies pursued by developed economies’ central banks have fuelled demand for riskier debt instruments, allowing emerging and frontier-market economies like Pakistan to cheaply meet their foreign financing needs. The good times, however, might be coming to an end; in the words of Warren Buffett, we might soon “discover who’s been swimming naked”.

On Oct 24, a sell-off in the bond markets drove the 10-year US treasury bonds to a seven-month high of 2.44 per cent. This was prompted by speculation that Donald Trump would appoint a monetary hawk as the next chief of the Federal Reserve and that the administration will be able to push through tax reforms by the end of the year. Jeffrey Gundlach, dubbed the King of Bonds by Barron’s, tweeted: “The moment of truth has arrived for secular bond bull market! Need to start rallying effective immediately or obituaries need to be written.”

In recent years, Pakistan’s economic managers have relied heavily on the international bond market to meet foreign exchange needs. This has led government external debt to rise by 20pc, from $46.9 billion in 2015 to $56.4bn in 2017, according to the State Bank.

Dark clouds are gathering on the economic horizon.

The nature of these borrowings, however, should set off alarm bells. Firstly, a significant proportion of loans are

being raised through commercial debt that must be paid in less than five years. In this fiscal year alone, over 40pc ($4bn of the $10bn) of the external loans raised by the government have come from commercial borrowings with a tenure of under three years.

Secondly, as developed economies’ central banks are beginning to raise interest rates, the government is increasingly relying on floating rate debt instruments, eg 67pc of loans raised between July 2016 to March 2017 have a floating rate cost structure, exposing Pakistan to rate hikes by the Federal Reserve.

The reliance on short-term borrowings means that 22.5pc of Pakistan’s total external debt has a maturity of less than three years while 17pc is due in three to five years. This means the government will have to pay back or rollover $14bn of the $62.5bn external debt in 2020, while another $10.3bn will have to be rolled over or paid back in 2022. This amount will be in addition to other external financing requirements caused by a large current account deficit.

Given Pakistan’s history, it is likely the government will have to rollover a significant proportion of these loans upon maturity.

This is where the end of the bond bull market comes in. Rising bond rates in the US could significantly erode the government’s ability to raise these loans. Treasury bonds are viewed as risk-free debt and market participants add a risk premium to these rates for emerging market debt instruments. As the 10-year Treasury bond rate rises, the interest rate for emerging market debt will increase, making it more expensive for countries to rollover existing debt or raise new debt.

Also, countries with a high proportion of floating rate debt, like Pakistan, will face higher interest rate payments. The resultant increased debt servicing requirements will raise the risk premium investors demand for providing new loans, setting off a vicious cycle that makes it harder to meet interest obligations.

These economic headwinds could turn into a perfect storm for Pakistan if, firstly, record low oil prices, and the LNG prices that are indexed to oil, rebound in the wake of stronger global growth. Higher interest rates in the US, which will increase the value of the dollar, could add further momentum.

Secondly, declining foreign reserves, coupled with a strong dollar, could lead to downward pressure on an already overvalued rupee, increasing the inflation rate and the debt burden. The risk premium on Pakistan’s floating rate debt would rise in sync with this, setting off another balance-of-payments crisis.

Historically, the destructive forces of economic crises are unleashed when a whole host of issues coincide with one another.

Pakistan’s relatively open economy, with its addiction to foreign financing for stability, is faced with multiple risks. While the powers that be are banking on the good times to continue, dark clouds are gathering on the horizon.

Current efforts to deal with these risks, such as increasing duties on imports, are akin to applying band-aid on a festering wound. It seems that the goal is to survive until the elections, after which Pakistan’s most reliable surgeon, the IMF, will be called in yet again.

The writer is a South Asia analyst at Albright Stonebridge Group in Washington D.C.

Published in Dawn, October 30th, 2017