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A Catch-22 Situation

Lying on the brink of sovereign default, Pakistan needs to devise a long-term strategy to ensure that the economy escapes from the clutches of this perpetual challenge.

By Aadil Nakhoda | January 2023


Pakistan is once again on the brink of default. After Lebanon, Sri Lanka, Russia, Suriname and Zambia, Pakistan is another country where the risks of economic default are significantly high as rising borrowing costs, inflation and debt all stoke fears of economic collapse. Finance Minister Ishaq Dar believes Pakistan will not default on any of the international payments as Pakistan’s one year probability of default is merely 10% as opposed to what he regards as a highly dubious number of 93%. Former (PML-N) finance minister Miftah Ismail, in stark contrast, says Pakistan’s default risk won’t vanish even after the December bonds are paid off. As the two finance ministers of PMLN face-off, the economic policymakers need to come up with a strategy to avoid default and ensure that the economy escapes from the clutches of this perpetual challenge.

Whenever the threat of a balance of payment crisis looms in the country, the first steps taken by the policymakers is to limit imports by imposing restrictions on various imports, consequently increasing the price of the imported goods into the country that further fuels inflation. Borrowing data from the State Bank of Pakistan (SBP), the current account deficit in the first four months of FY23 was $2.8 billion, decreasing from $5.3 billion reported for the same period in FY22. Export receipts have increased marginally by $250 million, while import payments have decreased drastically by $2.7 billion. The trade deficit reported by the SBP was $3 billion less in the first four months of FY23 than in FY22. With the threat of default still looming in December 2022, it is likely that the government may increase the intensity of the import restrictions as consumers and importers face increasing constraints in making payments to foreign vendors and sellers. This may further reduce the trade deficit, which was at approximately $40 billion in FY22. This increased from $28.6 billion in FY21, a year when trade was massively hit by the COVID-19 pandemic. The current account deficit, on the other hand, increased from $2.8 billion in FY21 to $17.4 billion in FY22. The current account deficit in October 2022 was reported at $567 million, down from $1.8 billion in October 2021. It is quite evident that import restrictions are squeezing the import payments. However, such measures can create shortages in the economy, particularly in the production of import-dependent essential goods.

Given that many industries depend on the imports of intermediate goods and raw materials to produce essential goods for the domestic market, the fall in imports has a significant impact on the local economy as it curtails the ability of domestic producers to meet their supply. It further adds to the challenges as it reduces the ability of domestic businesses to generate employment. The overall business confidence reported in the Business Confidence Survey, carried out by the State Bank of Pakistan in collaboration with the Institute of Business Administration, Karachi, reports low levels of confidence in the business community on the economic conditions prevailing in the country. The current capacity utilization in the industrial sector was at 63.6% in October 2022, decreasing from 72.2% in October 2021. The indicator on current employment was at 48.4 as businesses feel that they are unlikely to create jobs in the prevalent economic environment. Given the high rates of import dependency, it is likely that import restrictions imposed as a result of the impeding balance of payment crisis this year has adversely impacted domestic production in the country. The import payments on machinery into Pakistan have decreased by more than $1 billion year-on-year in the first four months of FY23 as importers report significant constraints. On the other hand, the import payments on the petroleum group have increased by more than $2 billion in the first four months of FY23. Imports of raw and intermediate textile products have also decreased, which indicates a likely decline in the production of textile products.


Pakistan’s external debt and liabilities as a percentage of GDP, as reported by the SBP, was approximately 40% at the end of June 2022. Majority of the public external debt is either long-term multilateral or bilateral. The foreign exchange reserves dwindled to $6.7 billion on December 2, 2022. Although, $23 billion was repayable and $10 billion was the current account deficit at the beginning of the current financial year, the SBP has alleviated concerns as it points out that the remaining debt repayments amount to $4.7 billion. This is primarily due to rollovers by multilateral and bilateral donors. However, the challenge is the lack of dollar inflows to bolster the reserves.

Although, the policymakers are facing a massive predicament as the pressure on the external front continues to mount, policy decisions can have detrimental effects on the economy. For instance, the desire to reduce the current account deficit by restricting import payments may help stabilize the pressure on the rupee and reduce the trade deficit but also is likely to adversely impact production as well the domestic prices of important imported goods through shortages. On the other hand, the desire to attract more dollar inflows by increasing the policy rate fixed by the SBP can have adverse impact on economic growth rates. Keeping the trade-offs in mind, Pakistan requires an urgent need of dollar inflows into the economy to build the foreign exchange reserves. It is imperative to meet the conditions imposed by the IMF, while approaching other multilateral donors as well as friendly countries to provide a much-needed relief. The main aim of the policymakers must be to address the shortfall in dollar reserves, keeping in mind that import restrictions only have a limited impact, which is not enough to keep the reserves at the desired level given the financing needs. Tapping into further external sources of funds is the need of the hour.

First and foremost, the policymakers must clear the wedge between the formal and informal currency markets, which can likely increase inflows of dollars that are needed to a great extent in such a crisis-like financial situation. Second, the government should ensure maximum funding from the IMF and other donors as inflow of funds is extremely critical at this time. Third, the government must not adopt policies that further reduce the business confidence. The reduction in capacity utilization and the ability to generate to employment can have long-term impact on the economy, making the road to recovery even bumpier. In essence, it is critical to ensure that policies to improve competitiveness and productivity are adopted in respect to the long-term horizon while ensuring stability on the external front in the shorter term. The trade-offs involved do create a dilemma, a catch-22 situation for the economic policymakers.

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