2021: What just happened? What comes next?

Rarely have we seen such a sharp and rapid reversal in a government’s fortunes as we saw in 2021. The year opened with growth powering ahead, the fiscal and current account deficits narrowed, the government basking in the applause of the business community. The economy had turned the corner, we were told. Growth had returned, foreign exchange reserves were high, the twin deficits had been conquered and the curse of repeated boom bust cycles finally broken. The State Bank Governor took to the air around March to declare that this particular bout of growth was different from all preceding ones because it was sustainable whereas the earlier ones were not. Inflation was still high, but it was due to one off factors, we were told, which would be sorted once the temporary disruptions, such as a poor wheat harvest the previous year, were taken care off by the end of the wheat harvesting season in June.

But by year’s end it had all vanished. The current account deficit is now powering ahead faster than anything else, and if present trends continue till the end of the fiscal year, it could come in as high as $17 billion, too close to comfort to the $18 billion “record high deficit” that this government never ceased to remind us all it inherited from its predecessors. The State Bank projects this figure to be closer to $13 billion by June, largely in the expectation that import pressure will subside in the coming months due to falling commodity prices and lower demand at home. Even at $13 billion, it will be a challenge to manage. Inflation has spiked to touch 11.5 percent with no signs of abating any time soon. The exchange rate has depreciated by more than 18 percent since the start of the year and remains under pressure. Interest rates have spiked by 275 basis points in three months as the “forward guidance” issued by the State Bank at the start of the year promising all further rates will be “gradual and measured” was abandoned dramatically due to “unforeseen circumstances”. 

Meanwhile the applause from the business community at the start of the year gave way to an acrimonious exchange of serious allegations between government ministers and industry leaders by the year, driven on by gas shortages and rising interest rates. The country’s apex chamber, the FPCCI, called the gas crisis a “conspiracy” against the government, and implied that its own ministers were involved in it. 

The one thing that remained constant from the beginning of the year till the end was the government’s desire to resume the IMF program, which was suspended in April 2020 following the imposition of the lockdowns. Two key demands – to pass an amendment to the State Bank Act giving the central bank sweeping autonomy to make decisions free from governmental interference, and a finance bill to withdraw a vast array of tax exemptions along with sharp curbs on development spending – are proving to be serious sticking points. The year began with the government promising to get back onto an IMF program within weeks. It ended with this promise being repeated with no end in sight.

Along the way we saw two trajectories diverge. One was the government’s triumphant rhetoric about restoring growth. “We have moved from stabilisation to growth” declared Shaukat Tarin in June during his budget speech. “After considerable effort, the government has finally succeeded in stabilising the economy and putting it on the path of growth.” A few months earlier the government was celebrating an unusually high GDP growth rate figure of 4 percent that took most analysts by surprise. They revelled in the attendant growth in revenues, 18 percent, which they argued was “the highest in five years”, the growth in exports, 14 percent, which they said was “remarkable” and owed itself to government support. “A variety of concessions were offered to revive the export industry” Tarin declared in his budget speech, “which included rebates, duty drawbacks and subsidies on utilities”.

But below the surface and triumphalism, trouble was brewing. Key indicators of economic health were cratering while key metrics of growth were hitting a plateau. Food inflation nearly doubled between January and April before coming off its peak, giving the State Bank the opportunity to declare that this trend was “largely supply driven and transient”. The index of Large Scale Manufacturing, one of the key metrics they used to argue for their industrial revival, had already peaked in January, and by the summer had fallen back to the same levels it was at a year earlier at the start of the whole growth story. 

More worryingly, the dreaded current account deficit made its return at the same time as this triumphalism was rising towards its peak. From January to March it crossed $600 million while the government swatted away concerns about it by saying it is driven by one off events like unusually large wheat imports due to a bad harvest. From April to June it crossed $2.5 billion. By year end it was still contained at below $2 billion (for the full year) giving the government room in which to argue that it remains “manageable”. 

None of these trends subsided. Inflation proved to not be transient and by year end the State Bank was forced to raise its fiscal year inflation target to 11 percent from 9 percent. The current account deficit powered on, crossing $3.4 billion by September and $7 billion by November. The large scale manufacturing index flattened out around 140, oscillating slightly around this level from July to October, below its level from the same period in the previous year. The rupee approached 180 to a dollar in the interbank market and scarcities began to be reported in the open market in many cities around the country, forcing the State Bank to announce more and more measures to restrict its sale.

All this was coming. Anybody who read the agreement that Hafeez Shaikh had signed with the IMF back in April knew the growth boom they were touting was built on a massive stimulus and that stimulus had to be unwound. It could not continue.  Shaikh had effectively agreed to roll back all the industry support that Tarin listed as his government’s successes, grant autonomy to the State Bank so it could never again become a source of lending to the government or runaway printing of money through refinance schemes. A raft of new taxes had to be imposed, expenditure cuts implemented and interest rates hiked. 

Days later Shaikh was unceremoniously dismissed and replaced with Tarin who backpedalled on all these commitments and promised he would renegotiate the conditions with the IMF. In June Tarin announced an expansionary budget with higher expenditures targets and an ambitious tax target that banked heavily on the potential revenue windfall from expanding the use of tax registered point of sale machines in retail outlets. All summer he argued that he would produce the revenues the IMF wanted to see without burdening industry and consumers with heavy taxes on essential items or fuels. In short, he agreed to power ahead with the stimulus through high government spending and low interest rates, thinking that somehow he would be able to manage the resultant fallout. 

The State Bank played along. In March the Governor gave televised interviews touting the revival of growth, pointing to the rising foreign exchange reserves, and argued that “this time the growth is sustainable, unlike previous episodes”. But instability was already knocking at the door. In May the exchange rate was hit by a strong bout of volatility and began a slide that took the rupee from 150 to a dollar to 175 by October, with no end in sight. Foreign exchange reserves were being built through heavy recourse to borrowing, with two bond flotations in March and July that raised $3.5 billion between them. 

By September the consequences of powering on became too large to manage. Reports emerged of massive State Bank interventions in the foreign exchange markets to try and dampen the volatility that had battered the exchange rate all summer. The current account deficit continued rising, and despite a fresh injection of $2.8 billion by the IMF as part of a global initiative to support foreign exchange reserves around the world to mitigate the effects of the Covid lockdowns, Pakistan’s foreign exchange reserves (held by the State Bank) fell from a peak of $20.1 billion in August to $18.1 billion by the middle of December. Had an additional $3 billion in borrowed support from Saudi Arabia not arrived in late November, this figure would have been closer to $15.1 billion. The level of the reserves by now had fallen to below 2.8 months of import cover, far below their level in August of 3.3 months.

In September the realisation began to sink in among top levels of government decision making that serious course correction is needed. Tarin spoke for the first time of “overheating” in the economy, a situation where growth is accompanied by rising inflation and destabilising deficits, particularly the current account deficit, which puts pressure on the exchange rate. The State Bank shifted gears and raised interest rates for the first time since the massive rate cuts from the summer of 2020, announcing that it would now be “gradually tapering the significant monetary stimulus provided over the last 18 months.” 

But the acknowledgement was still muffled and muted. In the accompanying statement released with the rate hike decision, the State Bank could still say that real interest rates will “remain accommodative in the near term” barring “unforeseen circumstances.” But circumstances did not cooperate with their wishes. The October and November current account deficits remained high, taking the five month figure to $7.1 billion and putting the economy on course to hitting a level it had last hit in 2018. 

And then came the jolts. In two surprise moves the State Bank sharply hiked the discount rate by 2.5 percent citing “unforeseen circumstances” and announced a new calendar that would see more frequent monetary policy decisions. The financial markets smelled blood and started demanding sharply higher yields in government debt auctions and the flight to the dollar picked up pace. The finance minister lashed out at the banks, accusing them of engaging in speculative trades in foreign exchange, and threatened them with punitive action in a televised interview. The State Bank Governor dialled down some of these remarks in a subsequent interview given to Profit magazine, saying he would not call the banks’ behaviour speculation, preferring the term “self fulfilling expectations of buyers and sellers” instead. 

Tapering the stimulus was going to be tricky business, it seemed. And to top it off a fresh bout of winter gas shortages hit the economy, borne in large measure from mishandled LNG purchases made earlier in the year, when winter supplies have to be arranged. Reports emerged of surplus furnace oil stocks imported against faulty demand projections made by the power division, while refinery stocks filled up to the brim with furnace oil that the power sector was not lifting, forcing cuts in throughput or outright shutdowns. Everything was starting to fall apart. The business community, particularly the textile exporters who had been the darlings of government largesse during the growth boom, took to the airwaves to accuse the government of severe mismanagement while government ministers shot back accusing them of being rent seekers addicted to subsidies. The entire narrative of triumphalism around the growth figures was now inverted, with the love affair between government and big business turning looking more and more like a messy divorce.

The year 2021 began with industry booming, exports rising and the government touting its growth miracle. It ended with industry closures, rising debt, inflation, deficits and pressures on the exchange rate. It began with the government saying it had revived the economy. It ended with the same government acknowledging that the economy could not afford to grow in the way that it was. 

If 2021 felt a bit like the high an addict gets from a fresh injection, 2022 will be the hangover. A government fractured from within, with its relationships with key power brokers in the country frayed severely, and battered at the ballot box will have to undertake a tough adjustment to reality. It will have to impose hefty taxes on an inflation-burdened citizenry, further raise interest rates on a business community already at loggerheads and find a way to work with the opposition to get critical legislation passed through parliament. Their hopes are pinned, for the moment, on the projection that global commodity prices would have peaked by March. But if “unforeseen circumstances” should once again intervene to dash those hopes, they could find themselves chasing the financial markets in an effort to find the right yields at which government debt becomes palatable for its creditors. Already their forays into global markets for a fresh Sukkuk floatation have not attracted as much interest as their earlier forays did in 2021. Without fresh financing coming in from abroad and bereft of political capital at home, the government is likely to be left clutching at straws for a lifeline as it heads into an election year.