US decision to cap interest rates to hit Pakistan

By Khurram Baig
Feb 16 - 22, 2004

The overall slowdown in the US economy is showing a turnaround but the recent decision by the Fed to continue to keep interest rates low likely to hit Pakistan economy: Among the major sufferers will be indicators like GDP growth, foreign investment, exports and balance of payments. This downturn in the US was triggered by the cycle of rate cuts by the US Fed over the past two years and tax cuts introduced soon after that.

Recent reports suggest that while the economy is recovering the labour market is suffering badly and economists wonder if this coupled with fast economic growth could fuel inflation.

Pakistan is just one of the several economies that will be affected by this and growth in emerging Asia has already weakened as a result of the economic slowdown in the US and higher oil prices. We can expect the effect to be most prominent in the newly industrialized economies (NIEs) and Asian countries, particularly those where the process of corporate and financial restructuring has lagged.

It is clear that the pattern will have important ramifications for the global economy, including Pakistan. Because of the composition of Pakistan's GDP where agriculture accounts for a significant for 25 percent of the total, aggregate growth is not as synchronised with the global economic cycle as one may expect.

As can be expected, however, there is a greater degree of correlation between Pakistan's exports and global and US economic cycles. On a single-country basis, the US is Pakistan's largest export market, accounting for roughly 25 percent of its export receipts. Further exacerbating the vulnerability of our exports is the fact that the European Union (EU) accounts for 30 percent of total exports (the largest destination as a region), which itself has been significantly correlated to the US economy in the past. Thus, a possible slowdown in the US is likely to have a knock-on impact on the EU and Japan as well, ranging from moderate to mildly severe. The magnitude of the effect on the global economy will depend on the extent and duration of the slowdown in the US. It should be noted that the cycle of aggressive easing of US interest rates by the Fed, is likely to keep the economy from decelerating a bit longer.

However, in the short/medium-term, this effect on Pakistan may be countered to a significant extent, by the fact that the recent appreciation of the Euro against the US currency, if sustained, is likely to translate into an improvement in the competitiveness of Pakistan's exports to the Euro-zone (which is a larger destination as an export market). On the positive side, a slowing down of the global economy will almost certainly precipitate a softening of international commodity prices such as oil and cotton. In the case of the former, this will be good news for countries such as Pakistan, which are heavily dependent on oil imports. However, in the case of a softening of cotton prices, Pakistan's export receipts from textile exports may be hurt.

The individual export sectors most vulnerable to a recession in the US are the ones with a high degree of direct sales to US-based companies. Using this benchmark, the following items/sectors fall into this category (with relative approximate share in total USD export earnings within parentheses): 1) Knitwear/hosiery (50 percent); 2) Cotton made-ups (50 percent); 3) Readymade garments (40-45 percent); 4) Towels (50 percent); 5) Medical products (45 percent); and 6) Bedwear (25 percent).

The next level of vulnerability is for those categories whose export markets are themselves positively correlated with the US, or for which there is a derived-demand originating from US-based companies. On the basis of available data, the latter cannot be reasonably estimated. For the former, we are using a stylised assumption that the EU, Japan and Hong Kong economies have a fairly high positive correlation with the US economy.

On this basis, using a benchmark of 25 percent of total exports being routed to any one of these markets, the following items/sectors fall into this category (with relative approximate share in total USD export earnings within parentheses): 1) Cotton yarn (50 percent); 2) Cotton fabrics (25-30 percent); 3) Leather apparel & clothing (40-45 percent); 4) Carpets; 5) Sports goods (40 percent).

On balance, the effect of the former is likely to outweigh the impact of the latter development, translating into a slight easing of pressure on Pakistan's external account in aggregate terms. This is predicated on the experience of previous episodes of recession in the US economy, where the international price of oil fell drastically as compared to cotton. From the perspective of the exchange rate, it has already triggered a weakening of the US dollar in international markets, which should provide a reprieve to the Pakistan rupee. For import-dependent corporate importing in USD terms, this may lead to a slight easing of cost pressures as well as a reduction in liquidity strain. Finally, the cycle of interest rate cuts in the US will eventually be followed by cuts in key interest rates in the Euro-zone, as well as in benchmark rates such as Libor. This will alleviate the debt servicing costs on those contracts which are benchmarked to any of these rates.

Growth is expected to be relatively well maintained in China and India. In China, a gradual shift to a more neutral fiscal policy stance is appropriate given the considerations of medium-term sustainability. In India, the easing of the monetary policy should be supported by continued improvements in the environment for private investment and substantial reduction, over the medium-term, in the overall public deficit.

The world outlook remains subject to considerable uncertainty and a prolonged and deeper downturn is clearly possible. Against this background, macro-economic policies, particularly on the monetary side, will need to be pro-active to guard against the possibility of a steeper than expected downturn.