Historic flooding in Pakistan has spawned one of the world’s worst humanitarian crises, covering c1/3 of the country’s landmass and affecting c33 million people (nearly 15% of its population). The death toll has reached >1,500 people and the floods have damaged c1.7 million homes and sent c600,000 people to camps throughout the country, according to the National Disaster Management Agency. Crop production has been wiped out in many areas, resulting in the loss of between 1/3 and 1/2 of Pakistan’s cotton crop. Thousands of kilometres of roads and hundreds of bridges have been swept away.
It will take several weeks if not months for the full extent of the damage to be known, but the Planning Commission has revised its estimate to US$17-18bn (c5% of GDP) from the initial US$10bn. Meanwhile, UN Secretary-General Antonio Guterres puts the losses at US$30bn (c8% of GDP) and the National Flood Response Coordination Center (NFRCC) says they could be as high as US$40bn (c11% of GDP).
This comes at a time of elevated political and economic uncertainty, with former PM Khan doubling down on calls for early elections despite his pending legal challenges and Pakistan narrowly avoiding default by resuming its IMF programme last month. While the humanitarian toll will undoubtedly be devastating, in the following note we attempt to parse the macroeconomic implications of the floods.
Until the full extent of the damage is known, it will be hard to parse the macroeconomic impact. There will be a material growth impact, with the Ministry of Finance and State Bank of Pakistan both revising their FY 22/23 growth forecasts to 2%, which is 2-3pp below their baseline forecasts. However, the 2010 floods caused damages of around US$10bn and reduced growth by 2pp, meaning the growth hit could be significantly greater based on the larger damage estimates. This could push growth into negative territory, especially when the reduction is applied to the IMF’s more modest 3.5% baseline.
Inflation reached 27.3% yoy in August, and is likely to rise even further due to the impact of the floods on crop production. The IMF projected in September that inflation would fall to 15% by the end of FY 22/23 and average 20% for the year, resulting in a “broadly neutral” policy stance by the SBP on a forward-looking 12-month basis. While the SBP may choose to look through some of the flood-induced price increases as temporary, it will still need to raise its policy rate above the current 15% to prevent a more severe and sustained breach of its inflation target. The next MPC meeting is scheduled for 10 October.
Pakistan's currency has also been under pressure. After staging a rally in the first half of August, PKR is now down by 10% over the past month and 30% over the past year versus the US$, and forward markets are pricing another 18% of depreciation over the next 12 months. Exchange rate flexibility will serve as an important shock absorber and aligns with the IMF’s advice to limit FX market intervention, which took place frequently in the first quarter of the year. However, it will also exacerbate inflationary pressure, raise the cost of external debt servicing in PKR terms and raise the external debt/GDP ratio.
While flood-induced stagflation will cause enormous hardship, from a macro perspective this will be overshadowed by the fiscal and balance of payments (BOP) impact. The estimated “damages” will not translate one-to-one to increased spending, as repairing and replacing damaged infrastructure will take place over many years. However, the government will have to increase its support to those most impacted by the crisis, resulting in a one-off spending increase that derails the government’s plans to consolidate the primary balance by 2.5pp (from -2.3% to +0.2% of GDP) in FY 22/23.
The growth slowdown will also weigh on revenue collection, which was behind target by c12% on a pro-rata basis over the first 19 days of September. While the IMF will likely be flexible in its fiscal targets given the scale and one-off nature of the crisis, higher spending and lower revenue in the current FY crystalise into more persistent slippage if new spending is not scaled back in a timely and complete manner once the effects of the crisis have faded and if the floods result in a more permanent erosion of Pakistan’s already limited tax base (with tax collection reaching just 10.2% of GDP in FY 21/22).
From a BOP perspective, the impact could be even more dire. The SBP’s liquid FX reserves rose by US$1.1bn in the week of 2 September on the back of the IMF’s latest US$1.16bn EFF disbursement, but resumed their downward trend the following week and are still alarmingly low at just c1.2 months of trailing goods & services exports and c55% of external public amortizations due in FY 22/23. This leaves very little margin for Pakistan to avoid a BOP crisis.
In a report at the beginning of the month, the IMF projected reserves would nearly double to US$16.2bn by the end of FY 22/23 under Pakistan’s renewed EFF programme based on gross external financing requirements (GEFR) of US$30.8bn (8.4% of GDP), including external amortizations of US$20.5bn and a US$9.3bn (2.5% of GDP) current account deficit. This would be met by a US$31bn external funding pipeline, US$2.2bn of FDI, and US$3.8bn of funding under the EFF.
However, the flooding will weigh on exports via damaged infrastructure, disrupted factory operations, and reduced production of cotton, a key input for Pakistan’s textile exports. It will also boost food and cotton imports to offset the decline in domestic production and increase capital imports to repair and replace damaged infrastructure. This will widen Pakistan’s current account deficit, making it necessary to secure even more external funding to prevent a further drawdown of reserves and avoid a BOP crisis.
Some of the impact will be mitigated by PKR depreciation, and the government may also choose to maintain or expand import controls put in place earlier in the year (which they have committed to remove before the end of FY 22/23 under the EFF but which the IMF may grant some leeway on). However, the main determinant of whether Pakistan is able to avoid a BOP crisis will be the extent to which Pakistan’s international partners are willing and able to plug the additional financing gap.
While support from the UN and other bilateral partners has already started to trickle in, it is not nearly enough to offset the likely BOP impact, and Pakistan’s government will have to solicit further support from donors in the months ahead. Its case will be bolstered by a recent paper by World Weather Attribution, which estimated that climate change intensified the rainfall that caused the floods by up to 50%, pinning some of the blame for the flooding on major greenhouse-gas-emitting developed countries.
Calls have been increasing for financial aid from richer countries that have been the main contributors to climate change, to poorer countries that have felt the brunt of the impact. This will likely be a key topic at this week’s UN General Assembly in New York and the COP27 climate summit in Egypt in November, with Pakistan as a key test case for the extent to which developed nations are willing to accept the blame for climate change-induced damage in developing countries.
Pakistan’s strategic importance as a populous nuclear state in a region riven by conflict is also likely to bolster its case for aid. However, it is still not clear if Pakistan’s bilateral and multilateral partners will step up to the extent needed to prevent an unsustainable drawdown of Pakistan’s limited FX reserves.
Fixed income implications
Finance Minister Miftah Ismael says that Pakistan will “absolutely not” default on its debt obligations despite the floods and pledged to pay off an upcoming US$1bn Sukuk amortization when it matures in December. Indeed, the IMF’s Debt Sustainability Analysis earlier this month said that “Pakistan’s public debt continues to be judged as sustainable with strong policies and robust growth” and forecast a steady decline in Pakistan’s public debt stock from 79% of GDP at the end of FY 21/22 to c60% of GDP by the end of FY 26/27 (including government guarantees but excluding contingent liabilities from circular debt and other loss-making SOEs, estimated at 2.2% and 5-6% of GDP, respectively).
There is little risk of a major debt explosion, with the 2.3% of GDP primary deficit in FY 21/22 already in line with the debt stabilising level despite the fiscal slippage that occurred that year. Even under the most extreme shock in the DSA, public debt rises to just 70% of GDP in FY 26/27 (10pp above the baseline) and gross financing needs to 22% of GDP (5pp above the baseline). These findings echo the DSA we conducted in June, which found little risk of distress from a solvency perspective.
However, the IMF flags significant downside risks, including “higher interest rates, a larger-than-expected growth slowdown due to policy tightening, pressures on the exchange rate, renewed policy reversals, slower medium-term growth, and contingent liabilities related to SOEs.” And with the floods exacerbating external imbalances, leading to negative revaluation and denominator effects, and worsening the real growth-interest rate differential, an updated DSA would be less favourable.
Debt also looks far less sustainable from a liquidity perspective. The IMF projects interest payments will eat up nearly 40% of government revenue in FY 22/23, though the total will likely be higher due to lower revenue and rising interest rates. While external interest is projected to be just c15% of the total interest bill in FY 22/23, total public external debt service (eg including amortizations) is projected to reach over 50% of exports and 40% of revenue versus IMF thresholds of 21% and 23%, respectively, for low-income countries with a strong debt-carrying capacity.
The outlook is equally alarming from the BOP perspective, given dangerously low reserves and a large GEFR of 8.4% of GDP in FY 22/23 (see above). So, despite relatively favourable solvency indicators, Pakistan will be unable to avoid default without an influx of fresh external funding over and above what has already been pencilled in to its IMF programme (which includes US$7bn of rollovers, including the US$3bn deposit recently rolled over by Saudi Arabia, and US$4bn of new financing from bilateral, multilateral, and commercial partners).
Esther Perez Ruiz, the IMF’s Resident Representative to Pakistan, said in a recent statement that the Fund will work with “others in the international community to support, under the current programme, the authorities’ relief and reconstruction efforts.” While the IMF’s continued support is positive, it will not be sufficient without other official partners augmenting their commitments (which already amount to over US$11bn in FY 22/23 per programme estimates), especially given downside risks to the assumed US$10bn pipeline of external commercial financing to the government in FY 22/23.
If external partners step up to plug Pakistan’s financing gap, the IMF accommodates flood-induced slippage into its programme targets, and Pakistan keeps on track with the rest of its IMF reform targets, then Pakistan may still be able to avoid default, despite the weaker economic outlook and increased probability of default caused by the floods. However, there is very little margin for error, with the floods potentially exacerbating reform fatigue and the difficult political backdrop raising the risk that the government backtracks on its reform promises, which would quickly lead to distress.
That said, with a recovery value range of US$53-71 at a 12% exit yield based on our June DSA versus a cash price of <US$50 for the PKSTAN 7 ⅜ 04/08/2031s, we think the risk of default is already priced in. The impact of the floods has already been baked into bond prices as well, with bonds down by c16pts (c25%) since mid-August and trading just above the US$47.5 lows seen at the height of the EM sell-off in July.
We still see US$70 as a reasonable upside for the ‘31s if Pakistan manages to tread the narrow path to recovery, implying c20pts of upside, but the floods will prolong the achievement of that target and lead to a lower trading band over the next 6-12 months. That said, with bonds still below our estimated recovery value, we think the upside far outweighs the downside, notwithstanding Pakistan’s elevated probability of default.
As such, despite the negative impact of the floods, we maintain our Buy recommendation on the PKSTAN 7 ⅜ 04/08/2031s at US$49.3 (20% YTM) as of cob on 20 September on Bloomberg.
Pakistan: IMF Board approval grants temporary reprieve, August 2022 (Curran)
Pakistan: SBP on pause as IMF optimism and lower trade deficit boost rupee, August 2022 (Curran)
Pakistan: Khan’s support endures despite repression, implying army is split, August 2022 (Malik)
Pakistan eurobonds are compelling value, July 2022 (Curran)
Pakistan: IMF staff-level agreement may help avert crisis, July 2022 (Curran & Malik)
Pakistan: Rising inflation prompts much-needed rate hike, July 2022 (Curran)
Pakistan: DSA and restructuring analysis shows bonds are near recovery value, June 2022 (Curran)
Pakistan: Crackdown on protests and IMF talks futile, but value reflects crisis, May 2022 (Malik & Curran)
Pakistan: Rate hike provides breathing room but not enough on its own, May 2022 (Curran)
Pakistan shows signs of progress on IMF programme, April 2022 (Curran & Malik)
Imran Khan is out as old parties prevail, for now, April 2022 (Malik & Curran)
Our discussion with the State Bank of Pakistan, April 2022 (Curran)
Pakistan hikes rates as political crisis reaches a crescendo, April 2022 (Curran & Malik)
Pakistan’s early elections are positive for Imran’s PTI and investors, April 2022 (Malik & Curran)
Pakistan’s no-confidence vote: Last stand for the opposition, not Imran Khan, March 2022 (Malik & Curran)
Pakistan’s Eurobonds collapse on rising risk, but may have overshot fundamentals, March 2022 (Curran)