The Coming Eclipse of Pakistan?

India and Pakistan have been locked in a perennial conflict since their inception. While the conflict manifests itself in many forms, the most prominent are an arms race and several wars and skirmishes. While we often see comparisons on arms and ammunition in this context, we often forget the elephant in the room – the economy which finances the arms purchases through tax revenue. This is not often a point of major concern in the Indian context as the economy has been growing at a decent pace and the military doesn’t occupy a disproportionate share of the tax revenue. On the other hand, Pakistan is a security-obsessed state with a dysfunctional economy and low tax revenue.

While India’s economic story is well known, this piece will be dedicated to analyzing recent trends in Pakistan’s economic situation and making a few predictions: short, medium and long term. I’d like to argue that the “Eclipse of Pakistan” relative to India is certain. By 2030: one of the following scenarios is going to happen, with the second one being most likely:

1. A drastic change in its national narrative – an end of the idea of Pakistan.

2. Financial suffocation followed by economic shrinkage, making Pakistan another Venezuela/Somalia – both impotent states

3. Balkanization

To reason out how and why this happens, let us examine three postulates, based on which the argument will be laid out:

1. Taxation in an extractive system: Pakistan is a banana republic, with a well-entrenched elite who are rentiers and avoid paying tax, causing an abysmally low tax-to-GDP ratio which has a low probability of rising efficiently. For political reasons, Pakistan cannot raise direct taxes and the only efforts it has made have been through indirect taxes. In short, the only way Pakistan can raise tax revenue is by taxing existing tax-payers. This, in fact, doesn’t help as it reduces the GDP and hurts growth.

2. Government Expenses: There is a low probability that Pakistan will be able to reduce its government expenses, even during the worst of times. This is due to the following reasons:

(i) Military budget: The military is the de facto ruler in Pakistan and grabs a huge part of the federal budget. Even during the recent financial crisis in Pakistan, the already bloated military budget was not cut and got an 11% increase in 2018-19. We can compare that to India’s 3.1% increase at the same time when there wasn’t even a financial disaster on the horizon.

(ii) Politics and elite capture: Pakistani politicians often dabble with projects which cost a huge amount to the state exchequer and look great on headlines. However, they end up becoming white elephant projects, due to high levels of corruption and lack of proper planning. A popular example of this is the set of BRT systems installed in Lahore and Rawalpindi-Islamabad. The latter cost more per kilometre than that of Los Angeles!

Similarly, their own commodity businesses are subsidized using state finances, with sugar as an example. This is a vicious cycle, as artificial subsidies provide no incentive to improve productivity and rising costs create more financial pressure on the state.

(iii) Debt servicing: Since 2009, Pakistan has been on a debt binge, and now has external debt liabilities worth more than $100 billion. The interest payments on internal and external debt are something Pakistan cannot avoid unless it intends to default on them.

3. External financing addiction: While we see PM Imran Khan travel to world capitals with the figurative begging bowl, we are reminded that this is not the first time that this is happening. Amb Hussain Haqqani talks about it in his books, that right from Jinnah’s time, utilizing the “geo-strategic location” has been the preferred mode of generating finances for the state. While the details are well-documented, a brief summary is as follows. Pakistan has traditionally received money from 5 sources in 3 buckets:-

(i) The West: This mainly includes the US and IMF. The US has historically provided finances to Pakistan for acting as its power projection unit, be it against the Soviet Union or purportedly against the Taliban. The IMF has bailed out Pakistan 12 times since 1988.

(ii) China: China looks at Pakistan as a way to reduce India’s influence and hence the two have an “all weather” friendship. In this regard, China has repeatedly provided finances in the form of loans and grants and has made Pakistan a part of the Belt and Road Initiative.

(iii) Gulf states: Saudi Arabia and UAE have also been generous donors to Pakistan, especially since the oil shock of 1973.

Current Scenario

As of April 2019, Pakistan is going through an economic crisis, which can be detailed as follows:

Trade: Exports are much lower than imports, and a current account deficit of $18B in FY 2017-18. This is unsustainable, as it is 5.7% of GDP and 241% of forex reserves as of Dec 2018. Continuing this could wipe out Pakistan’s forex reserves. A large part of it happened because Pakistan signed a Free Trade Agreement with China. This imbalance and various other factors have led the Pakistani Rupee to fall and reach as low as 153/USD in May 2019.

Internal Finances: Pakistan also faces a fiscal deficit of 5.8% of GDP in FY 2017-18, which is projected to go to 7.2% in FY 2018-19 unless major taxation changes are brought in. In fact, the Imran Khan government took major steps to improve tax collection, but those efforts did not yield any change. What is more concerning is the fiscal deficit-to-tax revenue ratio, which was 44% for FY 2017-18 and might even go up. As a benchmark, the ratio for India was about 18%. In other words, Pakistan is spending far more than it collects and is unable to collect more.

Because of the currency depreciation (and various other factors), Pakistan’s consumer price inflation has gone up, reaching 8.82% in April 2019. In an attempt to stem that inflation, the State Bank of Pakistan (Pakistan’s central bank) continuously raised interest rates, to 12.25% in May 2019, which was 5.75% at the beginning of 2018.

External Finances: Pakistan is known for its addiction to external finances and the last 30 years have not been any different. 12 IMF programs (more than once every 1000 days) have happened since 1988 and the 13th one is being discussed. Starting in 2009, Pakistan has been on a debt binge, leading to the current levels of around $100 billion. With the onset of a forex crisis, PM Imran Khan has been on a begging spree to friendly countries looking for bail-out packages, with limited success.

Let us also put this into perspective that for the last few years, Pakistan has reached such an unsustainable balance of payments condition that it has had to take new loans to pay back older loans. This is usually a precursor to financial ruin. According to a report, debt worth $27B will mature by 2021. A minimum of $20B is needed for financing the current account deficit until then, and close to $50B to manage all the external transactions. Finally, Pakistan has a significant probability of being placed into the blacklist by the Financial Action Task Force, in the company of North Korea.

Geopolitical factors

I’d like to argue that the geopolitical factors that have ensured a smooth flow of foreign money into Pakistan no longer exist. Historically, Pakistan has survived on being in the right alliance which provided both money and security, at the expense of sovereignty. Let us look at the three buckets individually.

1. United States: The US has provided money to Pakistan primarily to act as or assist in its power projection in the South and Central Asian region. In the 1960s, Pakistan was part of the CENTO and SEATO alliances and became a US ally in the late 1970s and 80s. Finally, Pakistan was a “frontline state” in the War on Terror, until 2012, when American money started drying up. The Pakistani habit of hunting with the hound and running with the hare irked the US, which led to a reduction in money flow.

From the mid-2010s, the US has been in a geopolitical rivalry with China and Pakistan is an ally of China. The US subsequently cut off most of the remaining financial assistance to Pakistan. This is unlikely to be reversed as China provides a presumed military deterrent against India, which Pakistan always regards as a top priority.

2. China: China has been a benevolent “all-weather friend” for Pakistan, mainly through loans for CPEC and some grants. However, China is going through an economic crisis and is unlikely to shell out more money. When Pakistan begged for bailout packages in 2018, China gave less than $5B, that too as debt. In fact, there are indications that China is running out of US dollars, and will be much more stringent in giving out money in the future. The US-China trade war has also threatened the dollar availability.

3. Gulf States (UAE and Saudi Arabia): The Gulf states enriched themselves following the oil shock of 1973, which provided them with a huge surplus. They provided money to Pakistan to finance madrassas catering to their version of Islam. However, as I have argued in a previous article, this money is also unlikely to arrive. India is already one of the largest customers of oil and is projected to be the demand growth driver of oil in the next decade. India can use this leverage to ensure Gulf money doesn’t reach Pakistan.

Let us also note that the above geopolitical factors will continue to be relevant in the next decade till 2030, and quite likely till 2040 too.

China has entered a 30-year period of economic difficulties and the general direction of the country is towards becoming a totalitarian state. This does not bode well for economic growth, and we are more likely going to see a closed off and isolated China.

Saudi Arabia is over-reliant on oil revenues and has a plan to build a set of non-oil industries as part of the Vision 2030 plan. They need access to the Indian market for both the oil and the potential non-oil industries if the Vision 2030 plan works out. India is quite likely to have a GDP greater than $6 trillion in 2030, and such a market can’t really be ignored.

Finally, with the dissolution of the Soviet Union and the end of War on Terror, the US is unlikely to have an interest in this region. The US is more interested in countering China’s geopolitical ambitions, and Pakistan is a thorn in that balance. This geopolitical rivalry is likely to continue at least until 2030. Even beyond that, the US is unlikely to provide money to Pakistan as there is no likelihood of a problem flaring up in Afghanistan or any other country for which Pakistan is relevant. There is a possibility of a conflict with Iran, but that isn’t as important to the US as the post 9/11 scenario was. The only other possibility of American help to Pakistan in the future is in case of an Indo-US geopolitical rivalry, which is also unlikely. India has clearly demonstrated its lack of imperial ambitions and does not pose a threat to the US.

Short Term Scenario: A Default

In the short term, the shortage of forex reserves and economic isolation are the most relevant factors. Since the Imran Khan administration started, Pakistan has been facing a forex crisis and a falling currency. When there was no significant cash inflow, Pakistan resorted to some steps which remind us of cargo cults. That includes firing top officials including the finance minister and replacing them with a team which happened to have succeeded in getting foreign money during Musharraf’s time.

With this drop in forex reserves, Pakistan has also significantly lost the ability to manipulate the currency, a power it had in the past. Let us also make it clear that Pakistan’s economy is largely reliant on textiles and agriculture, which aren’t quite known as 21st-century industries. Plus, because of the extractive system, productivity is low. This explains why even a currency devaluation did not lead to an increase in exports.

A large part of the forex crisis is caused due to a rise in imports from China, and curtailing those imports is going to be politically difficult for Pakistan. On the other hand, the best case of a “bail-out package” is about $6 billion from IMF. It is only enough to sustain Pakistan for 6 months as it is losing forex at the rate of $1B/month. Austerity measures can push this to a year or so. This is also threatened by a possible FATF sanction, which can virtually quarantine Pakistan, economically. Add the debt repayments coming up in the next two years to the situation, and it is clear that a default on the debt is extremely likely, despite what the former finance minister might have claimed. Sanctions by the FATF will only advance the date of default by a few months.

Meanwhile, the economy is heading into the doldrums. Inflation is approaching double digits and SBP has been raising interest rates to arrest it. This has led to economic suffocation, and GDP growth is predicted to decelerate to 2.7% in FY2020. According to economist Hafeez Pasha, close to 1 million people have already lost their jobs, and 4 million have fallen below the poverty line. He projects this to grow to 8 million people in the next two years if IMF provides a bail-out package i.e. the best case scenario. The consequences will be a lot worse if a deal is not struck. Given the fact that IMF has asked Pakistan to roll over loans from China and the Gulf states, the chance of a deal happening appears bleak. It is not an easy job to convince China and Saudi Arabia to provide $5B and $6B loans again, as the above geopolitical factors list out.

On the other hand, if Pakistan manages to fulfil IMF’s pre-conditions, irrespective of whether it gets the money or not, there will be an immense amount of pain to the people and a fall in growth rate. IMF’s conditions on Pakistan are to make the economy financially sustainable, hence Pakistan has been asked to plug all unproductive leakages of government money (subsidies) and increase the inflow of money (taxes). Because of Pakistan’s extractive system, the taxes will most likely be levied on the existing taxpayers, a large part of it through indirect taxes. This will cause high inflation and a significant reduction in people’s spending power, which will effectively suffocate economic growth. It might also help in reducing imports, and stabilize the current account for the time being. A recent paper estimates that a 1% increase in indirect taxes will result in a 1.68% drop in GDP growth rates. In preparation for the upcoming high inflation, SBP has already raised its interest rates, constricting capital to an already ailing economy.

Medium and Long Term

Irrespective of the IMF program, Pakistan’s economic strength is going to decrease, leading to a further weakening of the state. The IMF program will shrink the dollar-denominated size of the economy but will get it to temporary stability. Beyond that (2022), it will be international begging as usual.

Medium Term: Fiscal Deficit

The most relevant factor in the medium term will be the fiscal deficit, and there are 3 reasons behind that:

1. Institutional factors will not change.
2. There will be a serious shortage of capital
3. Military spending will come at a heavy cost to development spending.

For the last 30 years, Pakistan’s extractive system has dis-incentivised innovation and suffocating economic growth. This will not stimulate any form of entrepreneurship or creation of new industries, and a gloomy situation shall remain over the medium term.

Aided by high-interest rates, high inflation and a possible default on external debt, there will be a serious shortage of capital for the economy to grow fast over the medium term. This will appear in the form of stagnating/falling manufacturing and large scale unemployment.

Finally, the Pakistan military is the controlling giant whose hunger never ends. Its priorities and spending requirements are dependent on the threat perceptions of the neighbourhood and not the economic situation of the country. An interesting point to note is that the military’s financial demands are often in USD, as it imports most of its equipment. With India’s growing military budget, the Pakistan military will similarly attempt to increase its budget in USD terms. Even as of 2018-19, the military budget is impinging on development expenditure, and the trend indicates that military spending will push out a large part of it. A peace deal with India would work wonders, but India has gone hawkish recently, and this is unlikely to change in the next 10 years. The threat perception shall remain.

With multiple points of pressure on the fiscal budget, there is not to be any control on spending, and fiscal deficit shall increase. A stabilization forced by the IMF will only be temporary. With a lack of funding sources and pressures to increase the budget, Pakistan will end up withdrawing from many of its responsibilities such as education and also print notes to fund the state. We are already seeing some evidence of this happening. This creates a risk of hyperinflation.

Long Term: Plateau and Eclipse

At the same time, India is likely to continue a decent GDP growth, even in USD terms, while Pakistan is likely to shrink further. As an example, Pakistan’s USD GDP shrunk at the annual rate of 2.4% from 2017 to 2019, reducing from $305 billion to $280 billion, simply due to the fall of the Pakistani rupee. A USD/PKR rate of 158 would mean that Pakistan’s per capita income would be half that of India, with India’s economy being 12 times that of Pakistan.

A similar continuous reduction of the Pakistan economy in USD terms by 2% per year and a growth of the Indian economy by 5% per year will change the ratio from 12 in 2019 to 18 in 2025 and 25 in 2030. For comparison, the same ratio for Sri Lanka and India is about 32. In other words, Pakistan’s relative strength is going to continuously decrease and get closer to that of Sri Lanka, if at all Pakistan manages to survive till 2030.

Economic Ceiling

I’d like to argue that Pakistan has hit an economic ceiling, beyond which it won’t see any major economic growth in USD terms, even if other countries provide aid to it.

First of all, new industries are unlikely to emerge with the lack of innovation and unqualified talent pool. With continuous power crises and competition from other countries, there is a question mark on textile production too. On the other hand, Pakistan’s labour productivity has also plateaued,

A large part of the USD growth of Pakistan’s GDP from 2009 to 2019 was overvalued with an artificially inflated currency. The depreciation happening these days appears to be a mere correction.

Similarly, economic growth without foreign aid in Pakistan will be anaemic. It will be either of two scenarios: anaemic growth with a stable currency, or debt-fuelled fast growth with an overvalued currency. The latter is much more harmful, as Pakistan is recently discovering. Debt payments form more than 4% of GDP, and it is also impinging on development expenditure.

The Eclipse

Continuously rising military expenditure coupled with anaemic economic growth does not bode well for the fiscal situation of Pakistan. With a shortage of finances to run the country, the state will have two options: Either to keep reducing expenditure on basic governance work or to print money. There is evidence that Pakistan is already doing a mix of both in 2019, but which aren’t yet seriously impactful.  As printing notes is a vicious cycle, we are seeing Pakistan at a situation where Venezuela was in 2016.

We might see serious hyperinflation around the mid-2020s, creating a Venezuela-like situation. Alternatively, we might see the state absolving itself of responsibilities in the name of national security, and approach a Somalia-like condition. For reference, if the PKR reaches 360, Pakistan’s per capita income will be that of Somalia.

Either way, the state will become seriously weak in the 2020s, and create a collapse-like situation. This will be a crucial phase for Pakistan, where three scenarios are possible:

1. Balkanisation – if Pakistan disbands its military
2. Destruction of the idea of Pakistan and a new democratic country emerging – if the people unite and overthrow military power.
3. A situation similar to Somalia or Venezuela – if the Pakistan military manages to hold the country together and remain dominant – the most likely scenario

Foreign aid will not be as effective anymore, as Pakistan’s GDP has increased a lot since the 2000s, the last time foreign aid was significant. Pakistan’s economy was around 0.6% of the US economy in 1960, today it is closer to 1.6%. This means that the US will have to shell out at least three times more money as much as it used to in 1960 to be able to sustain Pakistan the same way as then. The chances of this happening are bleak.

There is also the risk of India blocking out foreign aid by creating other types of incentives for donor countries. As India’s economic size grows and it grows more assertive diplomatically, it can lay out an argument that any country will have more to gain by dealing with India.