The Russian invasion of Ukraine in February 2022 sent inflationary shockwaves to nearly all oil-importing countries, including the US. The US responded by adopting a tight monetary policy regime manifesting in several rounds of interest rate hikes that weakened a basket of currencies against the dollar.
With weaker local currencies and a rising oil import bill, emerging markets faced a double jeopardy of swollen current account deficits (CAD) and bourgeoning debt servicing and repayment obligations.
The ruling elite in many of these countries assuaged their constituencies by shifting the blame to supply-chain disruptions caused by the Russia-Ukraine conflict. The events that took place in Egypt, Pakistan and Sri Lanka later reflected that follies committed by policymakers brought each of these three countries on the brink of default.
Some structural cracks developed by Sri Lanka in the aftermath of Covid and the lack of an active International Monetary Fund programme tipped it over the red line while Pakistan and Egypt made last-minute recoveries.
Egypt, Sri Lanka and Pakistan’s economic woes stem from the follies of those at the helm
March 2022 was a watershed month in many ways: Sri Lanka had already started experiencing the initial choking of a default. It had to repay loans worth $7 billion while its forex reserves, which stood at $3.1bn by the close of 2021, had fallen to $1.9bn at the end of March. Egypt’s foreign exchange reserves were nosediving, which was a harbinger of macroeconomic difficulties.
Instead of respecting the changing dynamics of the global economy, including the need to adopt strong fiscal discipline in the face of rising budget deficits, Pakistan’s premier began to throw money at the prospect of winning over constituents that would otherwise stand by the side of an opposition rallying for his ouster. His ouster ultimately took place in April 2022, which sent the volatile economy under an intense wave of political instability and put the country at great risk of economic default.
What was common in all three cases was that the exchange rates had been kept artificially overvalued. As Pakistan’s noted economist Shahid Javed Burki remarks, finance ministers “equate price of the dollar with manhood”. The muscular management of the dollar in Pakistan not only resulted in an overvalued exchange rate but also created a schism between the interbank and open-market rates that created distortions and led to the formation of a black market for the dollar.
In Egypt, the pound was devalued by 36 per cent in a year, yet financial experts suggested in November 2022 that it was still overvalued by 10pc.
Policymakers were also reluctant to raise interest rates despite run-away inflation. Monetary policy committees and central banks seemed keen to trade off the objective of controlling inflation for lower interest payments which had expanded to consume more than 40pc of government revenues in all three countries.
The interest rate in Srilanka was at 7.5pc until the first week of April 2022, when it was raised on the directions of the International Monetary Fund (IMF). Surprisingly, all that while when it was leapfrogging to default, the interest rate at 7.5pc was much below inflation which was clocking over 20pc.
The Srilankan case was also peculiar because its economy depended asymmetrically on a sector that was a natural victim of Covid-19. The tourism sector, which provides livelihood to around 11pc of the Sri Lankan population, was closed during the pandemic, pushing five million people below the poverty line.
The government decided to compensate for lost livelihoods by designing a generous cash transfer programme financed through an unsustainably large budget deficit. It kept announcing one deficit budget after another, ignoring the unmanageably large debt burden the deficits were creating until February when the global inflationary pressures began to expose these inherent cracks in the economy.
Public expenditures in Egypt had also continued with a casual disregard for the changing global macroeconomic situation. Exorbitantly high subsidies on electricity and unplanned investments in mega development projects created fiscal imbalances that led to massive trade and current account deficits.
Imports touched an all-time high of $7.7bn in March 2022, while the current account was at a record low of $-5.8bn in Egypt. By July 2022, foreign exchange reserves had fallen to $33.4bn from $40.9bn in Dec 2021. The experiences of these countries make a didactic story for almost all the fifteen emerging and frontier markets that have defaulted or are vulnerable to default. Srilanka did not head to default in the aftermath of the Russian invasion of Ukraine in February 2022 but, in fact, had begun to show the first signs of default in January 2022 when its imports touched an all-time high of $2.2bn.
Policymakers in Egypt and Pakistan also made mistakes, but their economies weren’t as heavily dependent on a single sector badly impacted by Covid. Both of these countries had active IMF fund facilities, which enabled them to lay their hands on ready financial assistance.
Pakistan received a tranche of $1.17bn in September, while it took Egypt a little longer, seven months from April to November of 2022, to receive IMF balance of payments support. The IMF programme ensured that it pulled them back from a point tantalisingly close to default. Since the same couldn’t happen in the case of Sri Lanka, those calling the shots there ended up being on the wrong side of history.
The writer is an economist based in Islamabad.
He tweets @asadaijaz
Published in Dawn, The Business and Finance Weekly, May 22nd, 2023