Many economists consider the financial crisis of 2007/2008, also known as the Global Financial Crisis of 2008 the worst financial crisis since, the Great Depression of the 1930s. It resulted in the threat of total collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. The direct impact of the global financial crisis on developing countries including Pakistan has been limited due to non-integration of the domestic financial sector with the global financial sector (IMF, March 2009). However, the crisis has set in motion global recession which has not spared the low income countries.
How the recession affects an economy depends, among other things, on the state of the economic fundamentals of the country when the recession sets in. Economies with sound macroeconomic indicators will be able to face the recession with expansionary policies. However, countries with poor macroeconomic indicators at the onset of the recession can follow the expansionary policies only at the cost triggering a crisis of greater proportion.
The global recession has posed policymakers around the world with unprecedented challenges. Severely damaged financial sectors seemed immune to most responses, while fiscal stimuli and other policy tools have, at best, been sluggish to establish some stability in economies dealing with the spill over of the financial crisis into other sectors and a general economic slowdown. In a little over a year, what started off as a sub-prime crisis in US mortgage and housing markets, has amplified to a global economic downturn of an extraordinary scale, bringing to an end four years of booming economic growth across the world.
In developed economies, strains in the financial sector, a drying up of credit, and an increasing amount of risk aversion in the face of limited information about potential losses, led to the closing of many credit lines and the evaporation of financing mechanisms. Commodity producing sectors in these economies were hard hit by these events, resulting in a general economic deceleration rather than a crisis limited to the financial sector.
In emerging economies, the slowdown manifested itself through various channels. Volatility in financial markets led to a flight of capital. Furthermore, access to external financing became all but impossible and spreads on bonds widened to record levels. Countries relying on trade as a primary means of boosting economic growth saw trade volumes disappear as trading partners in the rest of the world struggled to deal with the slowdown in their domestic economies.
The global financial crisis is impacting the real and social sectors of developing countries through multiple channels. The linkages between developed and developing economies have deepened as well as broadened over the past two decades in the wake of intensifying globalization.
As the slump in the global economy prevailed, the Pakistan’s economy witnessed a period of significant instability and a deterioration of most macroeconomic indicators. The timing of the crisis, and Pakistan’s response to domestic developments might seem contradictory to a layman. As governments around the world lowered interest rates and implemented expansionary fiscal measures to revitalize their economies, Pakistan underwent a phase of fiscal tightening, and a stringent monetary stance with discount rates remaining relatively high for most of the period (discount rates remained at 15 percent till April 2009).
Fiscal, Monetary, and External debt policies of Pakistan have primarily been driven by the underlying need to resurrect significant macroeconomic imbalances in the domestic economy, rather than as a response to the financial crisis and global economic slowdown. The financial sector of the economy is still in its developing stages with limited, albeit growing, linkages with global markets. As a result,
Pakistan has been relatively well insulated against the contagion in international financial markets. It is remarkable to note that Pakistan is among a handful of countries with a positive rate of growth, and among a very few with the lowest decline in real GDP growth as compared to other countries affected by the global financial crisis. (UNESCAP, Mansoor Ali, 2009)
Before Financial Crisis
Pakistan’s economy grew at an impressive in the first half of 2000s. GDP growth touched 9 percent before declining to 6.9 percent. The growth performance was driven by strong growth in manufacturing and services. The industrial sector grew at an average annual rate of 9.5 percent led by small and large-scale manufacturing, electricity and gas distribution, mining and quarrying and construction. The service sector also expanded considerably with growth reaching 8.2 percent in 2008 up 7.6 percent in 2007. Though the service sector exhibited a broad based growth however the financial sector was a major contributor to the growth of the service sector. The average growth of 15 percent in financial sector was spurred by wide ranging reforms in the financial sector including laying down the minimum paid up capital limit for the banks, which led to injection of more equity into banks.
The global recession, as we know, was preceded by a steep surge in commodity prices the world over. Pakistan being a large importer of fuel oil and other commodities ended up importing inflation. Commodity prices especially those of fuel oil increased dramatically in 2007, however the year being an election year in Pakistan, the then government, in accord with political cycle theory, chose not to pass on the oil price hike to consumers. A substantial part of the electricity consumed in Pakistan is generated using furnace oil. With the increase in oil prices the cost of production of electricity also increased but the government again refrained from passing on the increase to the consumers. The decision not to pass on the increase in cost of fuel and electricity to the ultimate consumers obviously worsened the fiscal deficit.
Pakistan being an importer of oil and commodities the current account deficit increased sharply and the impact was accentuated further by the decline in capital account surplus. Pakistan’s current account deficit had stood large even before the financial crisis unfolded, but a host of factors had allowed the country to finance the deficit through inflows on the capital account.
International as well domestic environment was congenial to capital inflows and the current account deficit was comfortably financed from grants and foreign aid on soft terms from bilateral and multilateral institutions, sovereign debt issues in international financial markets and proceeds from privatization of profitable public sector enterprises. However, as the financial crisis led to a liquidity crunch, it became difficult to float debt issues in the international financial markets at affordable terms and find buyers for planned privatization deals. Aid flows also slowed down for a while for geo-strategic reasons. These factors had an adverse impact on the external account. The state of balance of payments suggested that the exchange rate, if left completely to market forces, would depreciate. However the intervention of the monetary authority in the foreign exchange market averted a significant fall in the value of domestic currency.
The intervention mechanism primarily used, which had been in vogue since November 2004, was to provide foreign currency, from the country’s foreign exchange reserves, to the oil companies for the import of oil. Therefore as the oil prices increased, the intervention increased as well. A sharp depreciation of the domestic currency was avoided in Fiscal 2006-07, but at the cost of depletion of foreign reserves to dangerously low levels.
The Impact of Crises
The global financial crisis had the potential to influence the economies of developing/less developed economies through four channels. These include; trade in goods, capital flows, remittances and equity values. Pakistan’s exports are concentrated in terms of trading partners as well product – United States and Europe are the major trading partners and textiles comprise the main product exported. With sharp contraction of demand in the western economies Pakistan exports declined 6.4 percent in 2009. However as the imports also declined 10.3 percent on the back of slowdown in economic activity therefore the net effect through the trade channel may not have been too large.
FDI increased slightly from $5026 million in 2007 to $5078 million in 2008. The increase in FDI mainly reflected on-going FDIs and fell sharply in 2009 to $3209 million. The KSE – 100, the major stock market index plummeted 60 percent, from a peak of 14814 points in December 2007 (market capitalization of Rs. 4.57 trillion) to 5865 points (market capitalization of Rs. 1.85 trillion) in December 2008 declining to 4929 points (market capitalization of Rs. 1.58 trillion) in January 2009.
However the outflow of the portfolio investment from Pakistan was $510 million given the magnitude of market capitalization. This is an indication of the non-integration of the domestic market with international market.
During fiscal year 2009, Pakistan received remittances from overseas Pakistanis to the tune of US $ 7.8 billion. United States, Saudi Arabia, UAE and United Kingdom are the four major remitter countries to Pakistan, with roughly 70 percent of the remittances coming from these countries. Not only, the remittances from Pakistan’s overseas 4 workers did not register a decline, against fears to the contrary, but rather maintained a healthy growth trend. Except for a marginal decline in remittances from the United States, the inflows from other major remitter countries were not affected.
A sudden change in volume of remittances from overseas workers has wide ranging consequences for the labour exporting countries. It was feared that faced with recession, the labour importing countries would lay off workers. The countries hosting migrants being naturally more concerned about their own citizens, the migrant workers were likely to be among the first ones to be laid off during recession. The lay-offs would cause the remittances to decline and induce the return of the migrant worker to their home country, thereby increasing unemployment in home country.
The decrease in remittances would adversely influence aggregate consumption and investment in the labour exporting countries. Moreover remittances are an important source of foreign exchange for the labour exporting country and any decline in the amount of remittances would cause an adverse impact on foreign exchange reserves and hence the value of the country’s currency vis-à-vis other countries. This in turn has the potential to affect number of other macroeconomic variables such as inflation, fiscal deficit and even output.
Theoretically, there are at least four possible reasons why remittances not decline during recession. The first line of reasoning is in accord with the notion of life cycle hypothesis put forth by Modigliani way back in 1950s (Modglianni, 1954). Under the life cycle hypothesis economic agents tend to smoothen their consumption pattern over their lifetime. One reason for the non-drop in remittances could be that the dependents of the overseas remitters, faced with inflation due to increase in commodity prices and then the global recession, were finding it difficult to maintain their consumption pattern. The remitters helped them maintain the consumption pattern by remitting more out of their savings.
The second reason could be that that the laid off overseas workers are returning with their hard earned savings. Such one-off remittances have compensated for the decline in periodic earnings that were being remitted earlier. If this argument holds true than the one-off increase in remittances could be the precursor to a decline in future. A third possibility put forth by Labella and Ducanes (2009) is that migrant workers are either in occupations that have been rejected by domestic workers 5or are in occupations that continue to be in strong demand despite the economic downturn. We feel that other than return migration it is a combination of the reasons mentioned above that averted a decline in remittances in the wake of global financial crisis.
As the remittances continue to exhibit a rising trend therefore it is clear that increase in remittances is not owed to return migration (Amjad and Din, 2012). The labour outflow data available for only a few countries suggest that while the outflow from Pakistan to UAE declined during October 2008 – July 2009 the outflow to Saudi Arabia in fact increased. This partly explains non-decline in remittances from the GCC countries. These countries, especially Saudi Arabia, reportedly initiated massive public sector projects to cope with recession.
After The Crisis
In the wake of the global financial crisis Pakistan witnessed a sharp decline n economic activity – growth declined from an average of 7.3 percent during 2004-07 to 3.7 percent in 2008. Growth slowed down further to about 1.2 percent in 2009 as the adverse security environment emerged as new constraint to economic growth. The external accounts were under slight pressure even before the crisis. The country’s imports being largely inelastic, the external accounts registered further deterioration after the crisis.
The current account deficit in Pakistan grew to 8.4 percent of GDP in 2008 from 4.8 percent in 2007 and the deficit fell to 6 percent of GDP in 2009. The fiscal deficit worsened significantly rising to 7.4 of GDP by 2008 from 4.3 percent a year earlier.
Tight budgetary position and weak government revenues called for launching austerity programs and the development projects were the obvious candidate to receive the cut. Job losses during recession are but obvious. The major sectors to cut jobs included automobiles, construction and textiles. During the first half of 2000s growth in Pakistan was driven by private consumption fuelled by cheap access to consumer credits. As economic fundamentals weakened and the monetary policy tightened consumer spending on durables contracted which hit hard the automobile and other consumer durable sectors. The construction boom fuelled again by the cheap availability of credit decelerated.
The construction industry with its extensive backward and forward linkages has a large multiplier effect. Therefore the slowdown in construction hit the job market particularly hard. Pakistan’s exports, as mentioned earlier are highly concentrated in the textile with close 60 percent of the export earnings being generated 7 by the sector. The recession in United States and Europe, the main recipients of textiles exports from Pakistan, led to contraction in export of textiles, which certainly contributed to job losses.
Pakistan’s banking sector is made up of 53 banks, which include thirty commercial banks, four specialized banks, six Islamic banks, seven development financial institutions and six micro-finance banks. According to the 2007 – 2008 Financial Stability Review from the State Bank of Pakistan (SBP), Pakistan’s banking sector has remained remarkably strong and resilient, despite facing pressures emanating from weakening macroeconomic environment since late 2007.
According to Fitch Ratings, the international credit rating agency with head offices in New York and London, ‘the Pakistani banking system has, over the last decade, gradually evolved from a weak state – owned system to a slightly healthier and active private sector driven system’.
Dr Farukh Saleem (2009) states in his independent report that the data from the banking sector for the final quarter of 2008 confirms a slowdown after a multi – year growth pattern. In October 2008, total deposits fell from Rs3.77 trillion in September to Rs3.67 trillion. Provisions for losses over the same period went up from Rs173 billion in September to Rs178.9 billion in October. At the same time, the SBP has jacked up interest rates: the 3 month treasury bill auction saw a jump from 9.09% in January 2008 to 14% in January 2009, and bank lending rates are now as high as 20%.
Overall, Pakistan’s banking sector has not been as prone to external shocks as have been banks in Europe. Liquidity is tight, certainly, but that has little to do with the global financial crisis and more to do with heavy government borrowing from the banking sector, and thus tight liquidity and the ‘crowding out’ of the private sector.
Karachi Stock Exchange
The Karachi Stock Exchange (KSE) has been in a free fall from the year high of 15,000 points to 9,200 in three months, forcing the government to intervene by placing a floor and proposing a bailout plan13. That was due to the global economic meltdown and insecurity in the country which increased investor’s anxiety, during the period July-December 2008. These gloomy events have had an adverse impact on the performance of Pakistan’s equity market.
According to estimates of the State Bank of Pakistan, foreign investment in the Karachi Stock Exchange stands at around $500 million. Other estimates put foreign investment at around 20 per cent of the total free float. During 2006 – 2007, foreign investors were actively investing in KSE-listed securities.
However, the year 2008 was a miserable one for the KSE. The benchmark KSE has undergone a sharp reversal in the rising trend of its leading KSE-100 index. The index underwent a huge loss of 58.3 per cent to close at 5,865 points on December 2008 as against December 2007.
Political instability, the financial crisis, a troubling macroeconomic scenario, an active insurgency in the Federally Administered Tribal Areas (FATA) and NWFP, hyper inflation, a ballooning trade deficit, an unsustainable budgetary deficit and a worrying drop in foreign currency reserves created a dark, threatening cloud over the market. Moreover, the KSE growth was based on speculation. Therefore, it has shown a falling trend after the bursting of the speculative bubble.
The country’s economy heavily relies on remittances sent by the more than three million overseas Pakistanis in Europe, the Middle East and the U.S. It is like a goldmine for Pakistan, playing a key role for stability in the balance of payments and mitigating unemployment problems. These overseas Pakistani send $7 billion a year, more than the loans the country received from foreign countries.
According to the ministry of finance, the flow of remittances has remained robust during the last seven months of the fiscal year 2009 despite the global economic meltdown. The oil-rich countries along with the United States accounted for more than three-fourth of the remittances during the first seven months of the current fiscal year 2008-200916. The remittances sent by these communities are not only helpful in poverty reduction in Pakistan but also in decreasing budgetary deficits.
There is a strong likely hood that this single largest source of foreign exchange may come under stress. The financial crisis will have a significant impact on the size of remittances, which Pakistan receives from the West. It would not only affect the businesses of this community but their job prospects. Throughout Pakistan, at least one family in every village is dependent on regular remittances to survive. The country would, therefore, be in deep crisis if remittances are seriously affected due to the financial crisis in the West.
Foreign Direct Investment
Challenges Going Forward
Pakistan faces a plethora of challenges that stem from both the domestic environment as well as the negative outlook of the global economy. Having successfully stabilized the economy, reinforced its reserve position, curtailed fiscal and current account deficits and managed a reduction in inflationary pressure, the government can now focus on boosting economic activity and providing growth impetus. In order to achieve an increase in production and the desired level of growth, efforts must be concentrated on increasing capacity of industry, and removing inefficiencies which would allow productive sectors to function at optimal levels. While the targets set by fiscal and monetary policies are a considerable step towards this, implementation and coordination going forward will be key factors. The impact of the global crisis has so far been very limited, but a few credible threats still remain.
The future of workers’ remittances is uncertain given the fact that employment in host countries is limited. The external sector still faces multiple threats in the form of a further reduction in international demand and secondly, a recent rally in international commodity prices as investors seek refuge could potentially reverse the gains registered in the current account balance. With regards to external financing, if current conditions in international markets persist, the government will have to increase reliance on funding from multilateral and bilateral agencies. It is vital that fiscal, monetary, and external debt policies work in tandem to protect the sectors exposed to the international crisis, while striving to re-establish domestic economic growth.
The purpose of this study is to analyze the impact of the global financial crisis on Pakistan’s economy. It begins with the impact of the financial crisis on the external sector of economy along with financial institutions and socioeconomic situation.
The study will also highlight the root causes of Pakistan’s financial crisis. It will also evaluate how the government is managing the problem through different policies, and what the best solution would be to get rid of this economic situation.