For Pakistan, a Global Downturn Adds to Woes
from Global Economy in Crisis

For Pakistan, a Global Downturn Adds to Woes

CFR Senior Fellow Daniel Markey writes that the global financial downturn is exacerbating preexisting economic problems in Pakistan.

November 18, 2008 3:54 pm (EST)

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Over the past five years, a rolling series of political and security crises have gripped Pakistan, but throughout much of this turmoil a relatively robust macroeconomic outlook provided a source of stability and opportunity. From 2004 to 2007, gross domestic product (GDP) growth ran over 7 percent annually, and bullish investors--Pakistani and international--fed a massive expansion in Karachi’s stock market. The Pakistani economy was typically viewed as one of the shining accomplishments of President Pervez Musharraf’s regime, and Shaukat Aziz, a former Citibank executive turned prime minister, sought to portray Pakistan as an attractive developing market, open for global business and investment.

But over the past eighteen months, Pakistan’s economy has nosedived. This downward turn has been compounded--but was not caused--by the recent global financial meltdown. Pakistan’s political and military instability worried investors as early as mid-2007. Rising global food and energy prices fed inflation and weakened the Pakistani rupee. GDP growth is down to 3 percent to 4 percent in 2008, inflation is at a thirty-year high of 25 percent, the stock market is down about 35 percent since the start of the year, and the rupee has depreciated by 23 percent against the dollar over the past ten months.

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Persistent weaknesses in the Pakistani economy--a heavy dependence upon remittances from overseas labor, a high rate of domestic unemployment, an inadequate power generation/distribution network, and a low-skill labor pool--now loom larger than ever. If the global downturn persists, Pakistan’s garment- and textile-heavy export industry will suffer from reduced consumer demand, and its agricultural sector is not yet competitive enough to capture the benefits of higher world food prices.

Having proudly proclaimed its freedom from the "beggar’s bowl" of International Monetary Fund (IMF) loans in 2005, the Pakistani government now urgently requires an injection of $4 billion to $5 billion in order to avoid defaulting on sovereign debt obligations. Efforts to secure a bailout from other sources, especially prior benefactors China and Saudi Arabia, have so far come up short, leading Pakistan to accept reluctantly a $7.6 billion loan from the IMF on November 15.

"The government faces challenges on all sides: international lenders, opposition politicians, and the military."

The new civilian government of President Asif Ali Zardari is understandably apprehensive about IMF conditionality because it would likely force unpopular government budget cuts and tax hikes. That said, there is a silver lining in IMF conditions: The imposition of external discipline on Pakistan’s historically profligate civilian leadership could encourage a range of much-needed reforms and discourage manifest corruption. By adhering to IMF conditions, Pakistan may impress other donors with its fiscal discipline and convince them that sending money to Islamabad could actually have a positive lasting impact.

In the short to medium term, Pakistan’s economic troubles could prove politically destabilizing in at least two ways. First, opponents of the ruling government, led by Nawaz Sharif’s faction of the Pakistan Muslim League (PML-N), may use the economic downturn as a rhetorical bludgeon to try and force another political transition. The Pakistan People’s Party (PPP) now holds the commanding heights of the presidency and has a ruling coalition in parliament, so the PML-N’s options are limited. But Sharif’s party could attempt a power play by adding economic woes to a growing list of anti-PPP grievances, sparking a crisis in public confidence and mobilizing paralyzing street demonstrations in the hope of precipitating new elections. Because the PML-N holds sway in the Punjab, Pakistan’s dominant political heartland, a mass movement of this sort could shake the government to its core.

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Second, even though Pakistan’s new army chief, General Ashfaq Parvez Kayani, has taken several steps away from political power in the aftermath of Musharraf’s resignation, the military jealously guards its share of the national budget and might reengage politically if confronted with major cutbacks. But the army is not especially eager to reimpose itself in national politics after the exhausting decade of General Musharraf’s rule, and it appears to have reached a tentative modus vivendi with the PPP government. Given the nature of the economic crisis, the army may well accept an IMF-imposed budgetary straightjacket for a short period. Even so, it will hold Zardari accountable and could eventually place financial demands upon his government that make it even less popular and more vulnerable to challenges by the opposition.

In short, the PPP government faces challenges on all sides: international lenders, opposition politicians, and the military. Within the PPP’s own coalition, there are additional pressures to advance narrow agendas and reward constituencies with patronage. Pulled in so many directions at once, the economic crisis could bring about a collapse of the sitting government within the next six months.

But even if Pakistan’s ruling coalition should manage to weather the immediate storm, the state’s precarious financial condition will have negative long-term implications for the fight against terrorism, militancy, and extremist ideologies. Pakistan’s civilian institutions already fall short when it comes to maintaining public law and order, infrastructure, and education. The challenge presented by the Pakistani Taliban, global terrorists, sectarian militants, organized criminals, and a wide array of other antistate actors cannot be confronted without enhancing state capacity and expanding economic opportunities for the nation’s burgeoning, youthful population. Historically, where Pakistani state institutions have not met the needs of its people, alternative structures--whether tribal, militant, or feudal--have entered the vacuum. The scarcity of state resources could accelerate the trend toward a fragile, hollowed-out state more susceptible to outright failure.

Unless mitigated by outside assistance, Pakistan’s budget crunch will also constrain the army’s ability to conduct operations in the tribal areas bordering Afghanistan. At present, a costly Pakistani military offensive in the northern tribal agency of Bajaur is meeting unexpectedly fierce resistance, forcing the army to extend its efforts by at least several months, if not longer. The army says it will undertake similar operations in the other agencies of the Federally Administered Tribal Areas (FATA) where it will meet similarly hardened opposition, especially in the Taliban strongholds of North and South Waziristan. These operations are essential elements in an effort to reduce the activities of militants and terrorists who use Pakistan as a safe haven to mount operations into Afghanistan and further afield.

"Having proudly proclaimed its freedom from the “beggar’s bowl” of IMF loans in 2005, the Pakistani government now urgently requires an injection of $4 billion to $5 billion in order to avoid defaulting on sovereign debt obligations."

In addition to the initial costs associated with dislodging militants from the tribal areas, Pakistan’s security apparatus--police, paramilitaries, and/or tribal militias--will need to build effective structures to keep the peace. Because the FATA lacks effective, modern institutions and suffers from deep economic underdevelopment, a long-term counterinsurgency approach in the region will necessarily amount to a tremendously expensive state-building project, not entirely dissimilar from ongoing international efforts in Afghanistan. Pakistan alone would not have been able to foot the bill for a sustainable development plan for the FATA even prior to its economic troubles, and now it will be even more dependent upon outside assistance.

This September, in an effort to coordinate international donor activities, the Bush administration organized a "Friends of Pakistan" group on the sidelines of the United Nations General Assembly summit in New York City. The group includes many of Pakistan’s major donors and reconvened in mid-November in Abu Dhabi to develop a framework for international economic cooperation with Pakistan. In addition to improving the flow of information about specific donor plans and programs, this sort of multilateral effort might also work to raise and allocate assistance resources in a transparent manner, thereby building greater confidence among donors and encouraging smaller contributors to pool their resources. The November meeting offered no specific promises of foreign aid, but a trust fund was proposed and will be discussed at future sessions.

As a nuclear state with entrenched terrorist networks and a recent history of unprecedented internal violence, Pakistan can ill afford the additional stress that would be imposed by a prolonged global recession. A state on the verge of bankruptcy and distracted by domestic political opposition cannot be an effective U.S. partner. Pakistan’s fragility represents a strategic threat to the region and the world, so as Washington contemplates spending hundreds of billions of dollars to shore up U.S. markets, it should also be considering ways to place the far smaller Pakistani economy on a sounder footing.

The Friends of Pakistan group is a good start, and President-elect Barack Obama has signaled his intention to expand civilian assistance programming in Pakistan by as much as threefold. But even these efforts may not be sufficient. A serious push to bring sustainable development programming to Pakistan in an era of global recession would require an international investment in personnel and institutions that dwarfs current civilian efforts in Afghanistan. At the very least, as the new Obama team assesses its foreign policy priorities, Pakistan’s economic fragility must rank near the top of the list.


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