Following a regime change this April, Pakistan finds itself on a perpetual rollercoaster. The political turmoil has triggered investor fears and economic instability, and the country is considered to be in the "danger zone" for default. In light of Islamabad’s nuclear-armed status, strategic location, and massive population, a default would have far-reaching impacts and international fallout. However, the situation seems to have now improved. As the International Monetary Fund (IMF) structural reforms program hangs in limbo, depleting foreign reserves and elevating import payment pressure, market uncertainty has risen considerably, compounding economic risks.
Causes of the Crisis
After a brief constitutional deadlock, Imran Khan became the first Pakistani prime minister to lose a vote of no-confidence while opposition leader Shahbaz Sharif of the Pakistan Muslim League-N (PMLN) assumed power. Khan and his party, the Tehreek-e-Insaf (PTI), lost their parliamentary majority as their main coalition partners abandoned ship. Khan had also previously lost the support of Pakistan’s powerful military, which declared its "neutrality" shortly after a disagreement over the appointment of the new intelligence chief.
Resolving to make a swift comeback, the PTI kept the political temperature high by launching fierce social media campaigns and alleging a foreign conspiracy was behind the regime change. Instead of waiting for the next elections on 23 August 2023, rallies were held throughout the country, prompting uncertainty about the longevity of the Sharif government. At the same time, rampant political polarization and over-politicization of society eroded national unity and stability. As investors backed away, the stock market became progressively more erratic and, in the sharpest drop in a week since 1998, the rupee tumbled by 7.6 percent to 228 rupees per dollar.
First, Prime Minister Shahbaz lacks decision-making authority since he is not a party head: the PMLN belongs to his elder brother, Nawaz Sharif, who has been prime minister on three separate occasions. Shahbaz has to consult with his party before making decisions, which has resulted in late implementation of various economic measures required by the IMF and worsened economic conditions.
The new "unity government" is comprised of 11 political parties that share power, which means that consensus is required before any major steps can be taken.
Second, Pakistan’s IMF program was derailed in February when the previous government backed away from its commitments and cut the recommended petroleum subsidies. This wasted precious time, since negotiations with the IMF had to be relaunched by the new Finance Minister Miftah Ismail. As a result, a $1.7 billion tranche that was due to Pakistan was not released, which exacerbated market uncertainty.
Third, Ismail had to meet IMF requirements and make unpopular decisions that had previously been avoided, such as increasing petrol and diesel prices. In addition to political setbacks, inflation peaked, the stock market hit new lows, and the Pakistani rupee fell against the US dollar. Lastly, the IMF set new conditions for continuing the loan program and sought guarantees from "friendly countries" who could help Islamabad. The World Bank and Asian Development Bank (ADB) also wanted various modalities to be completed.
With foreign currency reserves at $9.8 billion, just enough to cover five weeks of imports, Islamabad finally managed to reach a staff-level agreement with the IMF in July. However, the tranche remains delayed until the end of August and the weeks ahead will still be tense. The Ministry of Finance and State Bank of Pakistan released a joint statement indicating that all conditions for the IMF review had been completed and the economic crisis was only a temporary situation that would be rectified in the coming weeks.
As per the State Bank (SBP), once the current account deficit is reined in and market sentiment becomes more positive, the rupee will appreciate just as it did at the beginning of the IMF program in 2019. The SBP stated that the rupee became undervalued and that the dollar overshot it in the forex market for various reasons, but that it would recover its real value in two to three months. The rupee is expected to do well and to stage "a strong rebound" in August. Most economic indicators have remained promising despite the political turmoil in the country.
The rupee is not the only currency that has fallen against the US dollar. Other global currencies such as the pound sterling and the euro also took a hit. The rupee exchange rate came under pressure due to a global surge in the value of the US dollar and hoarding of dollars by private businesses. The dollar has reached a 20-year high, with the Dollar Index (DXY) up 10 percent year-to-date and 15 percent over the past twelve months.
Western countries have felt these repercussions as well, with strikes in the UK, early elections in Italy, and U.S. President Joe Biden’s approval ratings falling by 37.7 percent. The Pakistani rupee has simply found it more difficult to remain stable due to domestic political uncertainty.
Pakistan’s foreign exchange reserves were depleted primarily due to increasing outflows, while inflows—mainly loans expected from the IMF, World Bank, ADB, and allies such as China, Saudi Arabia and the UAE—slowed down. This was also partially due to delays from February onwards in completing the IMF program review, due to Khan’s policy changes and the regime change in Islamabad.
After the IMF tranche is received, stability will return. However, the crisis will not be completely at an end until the next election is scheduled. The opposition is likely to demand elections this year, while the current government prefers to hold elections in August of next year. Nevertheless, this economic crisis is a long-term issue and cannot be fixed by a change of government. Any disruption will further complicate the remaining three reviews of the IMF package, spur negative ratings, and constrain Pakistan’s access to market financing. Certain external factors could also continue to have negative ramifications for Pakistan, such as the Ukraine conflict and rising U.S. interest rates, resulting in investor risk aversion.