Pakistan Country Risk Report Q1 2020
We at Fitch Solutions believe that the Belt and Road Initiative's China-Pakistan Economic Corridor (CPEC) will improve Pakistan's growth prospects over the long term, driven by an expected increase in exports as trade relations and export competitiveness improves. Moreover, various infrastructure projects will likely help to deepen physical and human capital in the country. That said, we see financing as a potential challenge to future CPEC projects in the short run, as private investors will continue to be deterred by Pakistan's poor business environment.
We expect Pakistan's balance of payments to strengthen over the coming months, as the USD6bn bailout package from the International Monetary Fund (IMF) will help Pakistan to rebalance its economy. Foreign direct investment as part of the China-Pakistan Economic Corridor projects and loan packages from other international partners will also provide some support to Pakistan's reserves. We believe that the sustainability of the external balance over the longer term hinges on Pakistan's ability to deliver a material improvement in its fiscal balance.
We are revising our forecast for the State Bank of Pakistan (SBP) to maintain its policy rate at 13.25% for the remainder of FY2019-20 (July-June), versus our forecast for a 50bps hike previously. With a new base year (FY2015-16) for the Consumer Price Index (CPI), Pakistan is likely to record a smaller inflation figure going forward versus if inflation was computed with the previous base year (FY2007-08). We have revised our forecast for inflation to average 11.5% in FY2019-20, from 13.0% previously, as subdued oil prices and slowing economic growth will help to reduce inflationary pressures.
We believe that clashes between India and Pakistan could intensify over the coming months due to India's revocation of Kashmir's special status, although the conflict is likely to be contained within Kashmir. While not our core view, we see rising risks of military conflict between India and Pakistan, given the likelihood of an extended Indian military presence in Kashmir, and Pakistan's interest in challenging India's control of the region. China, an interested third party, is unlikely to materially intervene in the conflict as long as the Line of Actual Control separating it and India is respected. In light of ongoing elevated tensions between the two nations, we are revising our short-term political risk scores for India and Pakistan to 67.6 and 47.1, respectively out of 100, from 71.0 and 47.5 previously.
Pakistan would need to achieve a material improvement in its fiscal outlook to ensure long-term sustainability of its current account and reserves. Owing to the country's large fiscal deficit (estimated by the Ministry of Finance to come in at 7.2% for FY2018/19), Pakistan has been trapped in the vicious cycle of borrowing to finance its debt and government spending. This has contributed to the high interest rate of 13.25%, depreciatory pressures on the currency and a widening current account deficit. Failure to sustainably narrow its fiscal deficit could also lead to inflation as the government leans on the SBP for additional borrowing, as had happened in 2008, 2013 and 2019 ahead of the IMF bailout packages. Should inflationary pressures persist, there could be the risk that Pakistan tries to return to a fixed-exchange rate regime in an effort to contain inflation, which would renew downward pressure on reserves.
Risks to our forecasts are for the SBP to continue hiking its benchmark policy rate. Inflation could come in above our forecasts if the government continues to borrow excessively to fund its fiscal spending, or if oil prices start to rise in the case of a sustained disruption to oil supply. This could prompt further rate hikes from the central bank to curb inflation.
Risks to our currency forecast are weighted towards rupee weakness. If Pakistan fails to achieve the targets laid out by the IMF, the disbursement of the IMF loan could be delayed. This would likely have a negative impact on investor sentiment and spur capital flight from the country. Pakistan's emerging market status also makes its domestic assets particularly vulnerable to a sell-off in episodes of market risk-off sentiment. Specifically in the region, elevated tensions between Pakistan and India over the disputed Kashmir region also puts the Pakistani rupee at risk of a significant sell-off in the event of a further escalation in violence in the Kashmir valley.
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