Pakistan, with its heavy dependence on foreign capital flows and trade, stands particularly exposed. Stocks are likely to take an immediate battering, while the rupee-dollar exchange rate will inevitably slip further. The deterioration of exchange rate will, in turn, make imports including fuel and palm oil even more expensive than they already are. Pakistan has a progressive and dynamic financial sector which has grown rapidly particularly in the last few years, in response to the mounting financing needs of the economy. Predominantly bank-based in performing its basic function of financial intermediation, it also includes a wide range of financial institutions operating as Non-Bank Financial Institutions, Insurance companies, Microfinance banks, Islamic banks and the Central directorate of national savings, in addition to swiftly evolving financial markets. The outbreak of COVID-19 has led to a global macroeconomic shock of unprecedented magnitude. The recent government change in Pakistan has been peaceful, but raises near-term policy uncertainty even as the country faces external and fiscal challenges from rising commodity prices and an increase in global risk aversion. The outgoing government lost public support and the backing of coalition allies against a backdrop of rising inflation. Pakistan’s new government is facing the daunting task of managing a stuttering economy with huge deficits.
The central banks responded aggressively to avoid deep recession in the economies. Short-term interest rates, which were already low in most advanced economies, quickly fell to around zero in all advanced economies. Emerging markets also experienced sharp declines in short-term interest rates, approaching zero in several countries. Financial sector plays a vital role in the development and growth of any economy. Banking sector is considered to be an important source of financing for most of the businesses. The important factors affecting interest rates are (a) the money supply or liquidity-asset supply, which is largely demand deposits, (b) the business demand for funds measured by the volume of new orders being placed with business in relation to the working capital of corporations. The lower the interest rate, the more willing people are to borrow money to make big purchases, such as houses or cars. When consumers pay less in interest, this gives them more money to spend, which can create a ripple effect of increased spending throughout the economy.
Commercial banks play a vital role in boosting the economy’s performance through their financial activities by accepting deposits and lending money. The banking sector of both developed and developing economies of the world is affected by risk. To deal with monetary crisis in developing countries, the banks should focus on the soundness of the banking system by managing various types of risks. The State Bank of Pakistan raised its key policy rate by 125bps to 15%, to fight the surging inflation amid sharp depreciation of the rupee. It was the sixth rate-hike since the monetary board started policy normalization process in September last year, pushing the borrowing costs the highest since April of 1999. Domestically, as energy subsidies were reversed, both headline and core inflation increased to a 14-year high. Further, the central bank reiterated that headline inflation is likely to remain elevated around current levels for much of FY23 before falling sharply to the 5-7% target range by the end of FY24, driven by tight policies, normalization of global commodity prices, and beneficial base effects. Also, the monetary policy committee noted that higher rate should help cool economic activity, prevent a de-anchoring of inflation expectations and provide support to the rupee in the wake of multi-year high inflation and record imports. The result also revealed that 1% increase in interest rate will cause a decline of GDP growth by 26.6%. The result for interest rate impact on GDP of Pakistan is strong rather than inflation changes. Because inflation rate fluctuation also put impacts on interest rate. The recent oil price shock will push up the current-account deficit, adding to already high gross external financing needs from an elevated debt-repayment schedule. We now forecast a current-account deficit of around 5% of GDP (around $18.5 billion) for the fiscal year ending June 2022 (FY22), up from 4% in our February review. We expect this to moderate to around 4% in FY23, as oil prices ease.
Pakistan faces $20 billion in external debt repayments in FY23, though this includes $7 billion in Chinese and Saudi deposits that we expect to be rolled over. Higher trade deficits and capital outflows have driven a sharp depreciation of the Pakistani rupee against the US dollar. This, along with debt repayments, has put pressure on liquid foreign-exchange reserves with the State Bank of Pakistan (SBP), which fell by $5.1 billion between end-February and 1 April 2022, to $11.3 billion. We believe the decline also partly reflects repayment of a $2.4 billion loan from China that is slated to be renewed. In April 2022, the Federal Shariat Court of Pakistan (FSC) stated in a decision that ‘riba’ or interest is prohibited in Islam, including relating to banking transactions. The FSC directed the government to adopt sharia-compliant modes while borrowing from domestic or foreign sources in the future. The FSC set an implementation timeline of five years to convert the economy of Pakistan into “equitable, asset-based, risk sharing and interest-free economy” by end-2027. The Islamic finance industry in Pakistan is expected to continue its growth trajectory over the medium term, driven by strong government push and steadily rising public demand for Islamic products. However, the industry faces key challenges that could slow its growth such as the still-developing Islamic finance regulatory framework. In April 2022, the Federal Shariat Court of Pakistan (FSC) stated in a decision that ‘riba’ or interest is prohibited in Islam, including relating to banking transactions. The FSC directed the government to adopt sharia-compliant modes while borrowing from domestic or foreign sources in the future. The FSC set an implementation timeline of five years to convert the economy of Pakistan into “equitable, asset-based, risk sharing and interest-free economy” by end-2027. If court orders are implemented effectively, the Islamic finance industry could receive a large boost in the medium term. However, uncertainties loom over policy implementation as court judgments on this subject were issued previously but with limited effect on the banking sector.
The size of the Pakistani Islamic finance industry is estimated to have crossed $42 billion at end-1Q22. Islamic banks are the largest contributor to the Islamic finance industry at 67% (total assets), followed by Sukuk at 26% (outstanding amount), Islamic funds at 6% (total assets) and Takaful at 1% (total contributions). Pakistan has the second-largest Muslim population in the world with very low banking penetration. The government seeks to increase financial inclusion through promoting Islamic finance, as part of the National Financial Inclusion Strategy. Only 21% of the adult population had a bank account in 2017, with 13% of adults citing religious reasons for not having them, according to the World Bank. Higher US interest rates will also hurt foreign portfolio investments in Pakistan, as individuals and corporations will be looking to take advantage of low-risk returns. Similarly, as an economic slowdown or recession takes hold, demand for major exports like textiles, leather and sports goods is likely to fall. As the US is Pakistan’s biggest trading partner, the impact will be particularly severe on the local economy. Making export goods will also get more expensive as fuel and electricity costs rise. Remittances are also likely to fall as Pakistanis living overseas are forced to adjust their spending in response to prevailing economic conditions. On the upside, demand for oil the main driver of economic activity and other commodities is likely to gradually contract, resulting in a drawdown in prices. A current-account deficit of around 5% of GDP (around $18. 5 billion) for the fiscal year ending June 2022 (FY22), up from 4% in our February review. We expect this to moderate to around 4% in FY23, as oil prices ease.
