What is a Default - A Pakistan Scenario

Asad Ejaz Butt in The Dawn

When Pakistan’s dollar reserves fell below $5 billion in December, and its credit default risk had reportedly become too high for analysts to ignore the possibility of an imminent default, the central bank made a policy decision to allow the opening of import letter of credits (LC) in a staggered manner to ensure spreading of the dollar reserve over a longer period of importing time.

The idea was to allow the government some diplomatic time to knock on the doors of friendly countries and multilateral organisations, including the International Monetary Fund (IMF). The Fund had dilly-dallied on the ninth review to force monetary authorities in Pakistan to take the first steps towards a few baseline reforms, including the relegation of the dollar to the markets. Markets that the central bank and the government regards as ripe with imperfections.

The rupee was finally devalued last week which automatically implied that it was left to a market that had the propensity to sell it to gain dollars. This provided IMF with the confidence to schedule the ninth review, which is now ongoing in Islamabad. It is likely that the IMF’s review will be completed, and default, as was predicted by some and wished by a few others, didn’t happen.

However, while the media thundered about the staggeringly high levels of inflation and alarmingly low levels of reserves, and analysts evaluated an infinitely large number of scenarios that would lead to a default, no one from the economists ever explained what a default meant and what would have happened to the economy if it took place. 

From the mid of November to the end of January, I was asked this question many times: “is Pakistan going to default, or has it already defaulted?” None of those asking the question seemed to know what it meant for a country to default and what would happen if it did. Last week, for the first time, someone asked me what Pakistan’s economy would have looked like under the influence of default.

Put in very simple terms, a default for a country like Pakistan with large exposure in commercial loans means defaulting against commercial debt. Bilateral debt can be rolled over, while debt from multilateral organisations often has long-term maturity cycles making a country’s default vulnerability depend primarily on commercial loans.

So, imagine if Pakistan’s reserves had declined to such low levels that it would have defaulted against its commercial debt. This would have led the central bank to refuse commercial lenders’ payments to repay or service their debt.

That would have reflected in the further downgrading of the country’s ratings by agencies like Moody’s and S&P, dampening the trust of other international lenders and, after that, the government’s ability to raise new commercial debt.

Since the dollar inflows would have declined due to limitations of debt inflows, you could have only imported as much as you exported plus the dollars that expat Pakistanis remit from all over the world. This would be like a situation where you are forced by circumstances to keep your current account deficit close to zero.

Many of the imports that you would not afford would be inputs to the industry. While that would impact exports, the slowdown would impact production in the non-exporting sectors, pulling down the overall level of production in the economy. The natural consequence of all of this is the classic saga of too much Pak­istani rupee chasing too few goods.

Inflation would have skyrocketed as the local currency that people would be holding would not translate into consumable items. Contraction in the economy due to production losses would have seen many people get laid off in a span of weeks, leaving some with money but nothing to buy and many without even money to buy. Economists call such situations characterised by slow growth but high unemployment and inflation ‘stagflation’.

This was played out in Sri Lanka in the summer of 2022. It suspended repayments on about $7bn of international loans due out of a total foreign debt pile of $51bn while it had $25m in usable foreign reserves.

Pakistan has around $3bn in reserves against an external debt pile of $126bn. Pakistan, in December 2022, was definitely headed in the Sri Lankan direction. However, we did not default and any chance of doing so has been left far behind.

Reviving even mere inches away from default is a world different to an actual default since, in the former case, you can resume business as usual as soon as a multilateral like the IMF returns with a few dollars in hand. However, in the latter case, even multilateral balance of payments support will take years to rebuild the economic edifice.

Pakistan didn’t default, and those who thought what happened to Pakistan in December of 2022 was a default must realise that a real default would have been much scarier than a few hundred LCs being opened with delay.

This piece is based on several conversations held with Mubashir Iqbal and Haider Ali.

Stagflationary global debt crisis looms – and things will get much worse

 


The global financial and economic outlook for the year ahead has soured rapidly in recent months, with policymakers, investors and households now asking how much they should revise their expectations, and for how long. That depends on the answers to six questions.

First, will the rise in inflation in most advanced economies be temporary or more persistent? This debate has raged for the past year but now it is largely settled: “Team Persistent” won, and “Team Transitory” – which previously included most central banks and fiscal authorities – must admit to having been mistaken.

The second question is whether the increase in inflation was driven more by excessive aggregate demand (loose monetary, credit, and fiscal policies) or by stagflationary negative aggregate supply shocks (including the initial Covid-19 lockdowns, supply-chain bottlenecks, a reduced US labour supply, the impact of Russia’s war in Ukraine on commodity prices, and China’s “zero-Covid” policy). While demand and supply factors were in the mix, it is now widely recognised that supply factors have played an increasingly decisive role. This matters because supply-driven inflation is stagflationary and thus raises the risk of a hard landing (increased unemployment and potentially a recession) when monetary policy is tightened. That leads directly to the third question: will monetary-policy tightening by the US Federal Reserve and other major central banks bring a hard or soft landing? Until recently, most central banks and most of Wall Street occupied “Team Soft Landing”. But the consensus has rapidly shifted, with even the Fed Chair, Jerome Powell, recognising that a recession is possible, and that a soft landing will be “very challenging”.

Moreover, a model used by the Federal Reserve Bank of New York shows a high probability of a hard landing, and the Bank of England has expressed similar views. Several prominent Wall Street institutions have now decided that a recession is their baseline scenario (the most likely outcome if all other variables are held constant). In the US and Europe, forward-looking indicators of economic activity and business and consumer confidence are heading sharply south.

The fourth question is whether a hard landing would weaken central banks’ hawkish resolve on inflation. If they stop their policy-tightening once a hard landing becomes likely, we can expect a persistent rise in inflation and either economic overheating (above-target inflation and above potential growth) or stagflation (above-target inflation and a recession), depending on whether demand shocks or supply shocks are dominant.

Most market analysts seem to think that central banks will remain hawkish but I am not so sure. I have argued that they will eventually wimp out and accept higher inflation – followed by stagflation – once a hard landing becomes imminent because they will be worried about the damage of a recession and a debt trap, owing to an excessive buildup of private and public liabilities after years of low interest rates.

Now that a hard landing is becoming a baseline for more analysts, a new (fifth) question is emerging: Will the coming recession be mild and short-lived, or will it be more severe and characterised by deep financial distress? Most of those who have come late and grudgingly to the hard-landing baseline still contend that any recession will be shallow and brief. They argue that today’s financial imbalances are not as severe as those in the run-up to the 2008 global financial crisis, and that the risk of a recession with a severe debt and financial crisis is therefore low. But this view is dangerously naive.

There is ample reason to believe that the next recession will be marked by a severe stagflationary debt crisis. As a share of global GDP, private and public debt levels are much higher today than in the past, having risen from 200% in 1999 to 350% today (with a particularly sharp increase since the start of the pandemic). Under these conditions, rapid normalisation of monetary policy and rising interest rates will drive highly leveraged zombie households, companies, financial institutions, and governments into bankruptcy and default.

The next crisis will not be like its predecessors. In the 1970s, we had stagflation but no massive debt crises because debt levels were low. After 2008, we had a debt crisis followed by low inflation or deflation because the credit crunch had generated a negative demand shock. Today, we face supply shocks in a context of much higher debt levels, implying that we are heading for a combination of 1970s-style stagflation and 2008-style debt crises – that is, a stagflationary debt crisis.

When confronting stagflationary shocks, a central bank must tighten its policy stance even as the economy heads toward a recession. The situation today is thus fundamentally different from the global financial crisis or the early months of the pandemic, when central banks could ease monetary policy aggressively in response to falling aggregate demand and deflationary pressure. The space for fiscal expansion will also be more limited this time. Most of the fiscal ammunition has been used, and public debts are becoming unsustainable.
 
Moreover, because today’s higher inflation is a global phenomenon, most central banks are tightening at the same time, thereby increasing the probability of a synchronised global recession. This tightening is already having an effect: bubbles are deflating everywhere – including in public and private equity, real estate, housing, meme stocks, crypto, Spacs (special purpose acquisition companies), bonds, and credit instruments. Real and financial wealth is falling, and debts and debt-servicing ratios are rising.

That brings us to the final question: will equity markets rebound from the current bear market (a decline of at least 20% from the last peak), or will they plunge even lower? Most likely, they will plunge lower. After all, in typical plain-vanilla recessions, US and global equities tend to fall by about 35%. But because the next recession will be stagflationary and accompanied by a financial crisis, the crash in equity markets could be closer to 50%.

Regardless of whether the recession is mild or severe, history suggests that the equity market has much more room to fall before it bottoms out. In the current context, any rebound – such as the one in the last two weeks – should be regarded as a dead-cat bounce, rather than the usual buy-the-dip opportunity. Though the current global situation confronts us with many questions, there is no real riddle to solve. Things will get much worse before they get better.

There is ample reason to fear big economies such as the US face recession and financial turmoil writes Nouriel Roubini in The Guardian