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CPEC – change of economic course or a debt burden?

Nearly all will say CPEC is a game-changer, but some will ask for whom? Others will flag that CPEC is the largest foreign investment into Pakistan, but many will question whether the country will be able to bear the debt burden resulting from it. The ongoing debate on financing the burden of CPEC needs to be analyzed based on facts rather than opinions.

The total committed amount under CPEC of $50 billion is divided into two broad categories: $35 billion is allocated for energy projects while $15 billion is for infrastructure. The entire portfolio is to be completed by 2030. Energy projects are planned for completion by 2020, but given the usual bureaucratic delays, it won’t be before 2023 that all projects are fully operational. Infrastructure projects such as roads, highways, and port and airport development, amounting to $10 billion, can reasonably be expected to be concluded by 2025, while the remaining projects worth $5 billion would spill over into the 2025-30 period.

Foreign investors’ financing comes under foreign direct investment; they are guaranteed a 17 percent rate of return in dollar terms on their equity (only the equity portion, and not the entire project cost). The loans would be taken by Chinese companies, mainly from the China Development Bank and China Exim Bank, against their own balance sheets. They would service the debt from their own earnings without any obligation on the part of the Pakistani government.

Import of equipment and services from China for the projects would be shown under the current account, while the corresponding financing item would be FDI brought in by the Chinese under the capital and finance account. Therefore, as far as the balance of payments is concerned, there will not be any future liabilities for Pakistan.

CPEC’s second component, i.e. infrastructure, is to be financed through government-to-government loans amounting to $15 billion. As announced, these loans would be concessional with 2 percent interest to be repaid over a 20 to 25-year period. This amount’s debt servicing would be Pakistan government’s obligation.

In the case of CPEC investments, it is difficult to see how these outflows will be booked, since technically they will not be on government account: each project will earn its own money and service its own obligations. These outflows will not be booked as external debt service obligations of the state since government debt is a direct loan whereas CPEC is investment against a loan.

In light of the above, if we assume that additional burden on the external account is not to exceed $3.5 billion annually, then the question is to identify a non-debt creating resource that will off-set this additional burden. In reality, to properly afford the CPEC projects that are being undertaken, the country will need to lift its exports by as much as 14 percent annually, boost its productivity, and give a large spur to private enterprise to get the wheels of domestic investment moving again. If the export slowdown was due to energy shortages, the availability of increased supplies should boost exports fetching higher foreign exchange revenues. Investment in energy and infrastructure will further result in incremental growth in GDP.

PRESENT POSITION OF PAKISTAN’S EXTERNAL ACCOUNT

Although growth in Pakistan has improved in FY2017 mainly on recovery in agriculture and manufacturing sectors, the government needs to address fiscal and external sector vulnerabilities that have reappeared with the wider current account deficit, falling foreign exchange reserves, rising debt obligations, and consequently greater external financing needs. This is further validated by Asian Development Outlook report that warns Pakistan’s external sector situation could become unsustainable due to a lack of policy actions. At present, however, official foreign currency reserves can still cover the current account deficit and external debt payments.

In 2017-18, the reserves are expected to be slightly below the sum of the current account deficit and scheduled debt repayments, creating an external financing need. Since the IMF program came to an end a year ago, external economic indicators have started to deteriorate. The current account deficit has doubled to 4 percent of GDP or $12.1 billion, which should ring alarm bells in the concerned quarters of the government. Mounting debt and deficits in Pakistan is raising the prospect that an abrupt rise in interest rates or tougher borrowing conditions might be damaging.

The current account deficit is expected to remain high in fiscal year 2018, projected at 4.2 percent of GDP, with rising imports, declining remittances, and stagnant exports. Imports are expected to continue to increase as growth spurs domestic demand that domestic production cannot meet. Financing Pakistan’s burgeoning trade deficit remains a key challenge as remittance inflows, however substantial, continue to fall. Worker remittances have shown some unexpected improvement, however, in the first 2 months of fiscal year 2018, increasing by 13.2 percent from the same period in fiscal year 2017. If this rebound can be sustained for the rest of fiscal year 2018, it may ameliorate the projected deficit. The share of exports in GDP nearly halved from 13 percent in fiscal year 2006 to a dismal 7.1 percent in fiscal year 2017. Exports fell annually by 2.5 percent on average from fiscal year 2013 to fiscal year 2017 due to lack of competitiveness and bad conditions for modernizing investment, leaving persistently low value addition to fetch low unit prices.

In the near future, the government must carefully manage external debt, the balance of payments and their financing requirements, while instituting macroeconomic and structural reforms to support economic stability and expansion as well as to make Pakistan more competitive and fiscally sustainable. This has become increasingly important given the increasing government and CPEC-related repayment obligations.

The writer is a Karachi based freelance columnist and is a banker by profession. He could be reached on Twitter @ReluctantAhsan

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