JUST before deciding to boycott the Bonn conference in its Lahore meeting last week, the federal cabinet had briefly touched upon the possible implications of a suspension of US financial assistance in the wake of mounting tensions with Washington over the killing of 24 Pakistani soldiers in Nato air strikes.

Finance Minister Hafeez Shaikh was asked to prepare a more detailed briefing on the subject for the next cabinet meeting.

Even if it is not worried, the government appears to be cognisant of the possible economic and financial fallout of deteriorating relations with the US. Therefore, says a federal finance ministry official on condition of anonymity, the ruling coalition (and even the military high command), is yet undecided about the level and extent to which it will want to scale down its cooperation with the US and Nato in the war on terrorism.

Opinion is divided over potential impact of Pakistan-US tensions on the country’s economy. Many say the US could cut its non-security assistance under the Kerry-Lugar bill, which pledged to provide Pakistan $7.5 billion spread over five years, if the tensions continue to mount in the days to come. The US disbursed only a tiny fraction of $1.5 billion during the last financial year.

Additionally, analysts say, the American military funding could also be suspended. Moreover, other bilateral (as well as multilateral) lenders and donors having a stake in the war on terror could also follow in the footsteps of the US, creating more problems for Islamabad.

“Pakistan is most likely to face risks given the fact that we are heavily dependent upon external official — and to some extent private — capital inflows,” says Mohammad Imran, capital market dealer at the Soneri Bank in Karachi.

“The US also enjoys a lot of influence over Europe and multilateral lenders (like the IMF, World Bank and  Asian Development Bank). The US decisions will also affect their decisions,” says Imran who points out that a further cut in external inflows will have negative implications for the economy in general and balance of payments position in particular.

Macroeconomic risks to the economy have already started showing again, forcing the central bank to reverse its policy of monetary easing. The overall balance of payments during the first four months of the current fiscal to October has deteriorated to $1.40 billion from a surplus of $149 million last year. The foreign exchange reserves has dropped to $16.88 billion during the week ending November 25 from record high of $18.34 billion on July 30. The exchange rate is under pressure, also because of current tensions with the US.

Sayem Ali, country economist for Standard Chartered Bank, reckoned that Pakistan required external financing of up to $5 billion during the current financial year to keep pressure off its depleting foreign exchange reserves and falling currency.

Multilateral and bilateral official capital flows are already drying up.

The official US assistance dropped to $179 million during the last year while multilateral lenders like the World Bank and the Asian Development Bank are delaying disbursement of their promised project and programme assistance. Islamabad hopes to receive Rs414 billion from external sources during 2011/12. Last year, it received Rs290 billion against the budgeted amount of Rs367 billion.

“Financing deficit and oil imports will be a big challenge for the government (if the international pledges for financial assistance do not materialise). We don’t have many options,” Sayem notes. But he is of the opinion that the decisions of other bilateral and multilateral lenders will not be affected by the deteriorating Pak-US relations in spite of Washington’s influence on them.

Analysts feel that the fears of the possible economic and financial fallout of souring bilateral ties stem from the fact that Pakistan’s economy is entrenched with the economies of the United States and Europe. Together, the US and the European Union accounted for just less than one-third of Pakistan’s export revenues of $25.5 billion, almost one quarter of the workers’ remittances of $11.2 billion and more than one-third of foreign private investment of $2 billion during the last financial year.

Arshad Khan, economist and a visiting professor at the NUST, who has done extensive post-doctoral research on the relationship between American policies towards Islamabad and their impact on foreign investment, says the US policies will not leave any impact on Pakistan’s economy in the long-run.

“Domestic policies are more important and always have a deeper effect on the economy,” he notes, saying the deterioration in Pak-US relations could have short-term implications. He points out that Pakistan had survived American sanctions during the 1990s.

But he admits that the American and European official and private capital inflows are necessary for rapid growth.

“This is because we are a debt-based economy,” he notes, adding Pakistan could achieve faster growth if it started using its domestic resources to build the economic infrastructure.

One thing that every one agrees with is the need for better governance and economic and tax reforms in the country.

“If we improve governance and set our systems and priorities right, we can achieve economic self-reliance and grow at a much rapid rate,” stresses Mian Mohammad Mansha, a leading industrialist and chairman of the Muslim Commercial Bank.