The aim of this post is to highlight the possible financial impact of the matter of Raymond Davis’ immunity and the worsening of relations between the USA and Pakistan.

A leading Investment Bank of Pakistan, InvestCap has come up with their report which is being posted below. Though we have not sought their permission on the same, we apologize in advance to them. The idea is that we want to show to the ‘ghairat brigade’ and our media to think before they speak and demand for worsening of relations between US and Pakistan.

The full report can be read here

Pakistan-US relations – Even against the odds – A money manager’s view

The rising concern that Pakistan cannot survive without the critical military, economic and social sector support from its key ally the United States of America, is surely a phenomenon that Pakistan’s economic managers do allocate major weightage for economic considerations. Though a tough issue to handle, our this week’s piece is about assessing the economic impact that Pakistan may face, if US cuts down economic and political level connections and support with the country as a result of a completely unfavorable decision for the US coming out of the talk-of-the-town Raymond Davis case. Though Pakistan has paid hefty economic cost so far standing by this most important ‘friend’ of Pakistan, the immediate withdrawal of the present relation may result in rapid worsening of the already shaking economic numbers of Pakistan economy and its people’s plight.

Few key economic similarities between Pakistan and the US

Interestingly, Pakistan and the United States, the key allies on many an issue, have been surfing through more or less same sorts of economic woes, foremost is the ballooning fiscal deficit (US’s 2011 fiscal deficit expected at 9.8% while Pakistan’s at 6-7% of GDP), though latter stands with a better ability to handle problems through stringent austerity checks. Moreover, rising spendings (primarily the non-developmental ones), insufficient tax collection to coup up with the fiscal deficit, and shortening of the debt maturity profile leading to rising borrowing costs with greater amount of liabilities leading to worsening asset base and heightened rollover risks, are few more key macroeconomic areas that need immediate attention for both the countries. For Pakistan, additional expenditure incurred in context of the war on terror led to fiscal pressures, while non-materialization and delays in external financing caused additional burden on domestic financing, which in turn escalated a greater number of problems through continued monetary tightening, investment crowding out, subdued growth, more unemployment and, last but not the least, persistently higher inflation.

With or without …USA

The impacts of a complete cut off from the US, which is an unlikely situation as both the allies critically need each other, can be seen in the form of direct and indirect economic considerations. Direct considerations include immediate economic impacts highlighting country’s total trade and investments with the US, while indirect considerations paint a larger picture in the shape of:

1. a medium to long-term influence of the US over Pakistan’s trade with other pro-US countries primarily the Middle Eastern region/Arab world
2. Direct US support in context of bilateral relationships through commitments such as Kerry-Lugar Bill and Coalition Support Fund and
3. influence over uni or multi-lateral donors like the International Monetary Fund (IMF), World Bank (WB), Asian Development Bank (ADB) and Islamic Development Bank (IDB), which have already linked the continuity of all the aid/grants/social sector funding disbursements to the positive node in the form of the Letter of Comfort (LoC) from the IMF. In addition, potential ratings downgrades as a result, from the int’l rating agencies i.e. Moody’s (current rating at B3) and S&P (current rating B-), will only worsen off country’s foreign inflow situation.

Even the direct impact looks awful

Remittances, perceived as a savior of the external account so far, can also be impacted as a large portion of the current flows drift down from the US (19% of the total remitted amounts as of 7MFY11, 3rd largest source of remittances after Saudi Arabia and the UAE). Moreover, investments in the country in the form of both Direct and Portfolio, have considerably been contributed by the US (15% contribution in the foreign direct investment and a whopping 94% share in portfolio investment towards Pakistan during 7MFY11). As far as trade between the two countries is concerned, Pakistan stands as a net exporter to the US (with Pakistan having largest trade surplus with the US) as share of US in the country’s exports stood at 18% while imports’ share at mere 3% during 6MFY11. Given this situation, we ran a crude sensitivity on Pakistan’s external account situation for FY11, inclusive and exclusive of above mentioned direct considerations. In this regard, the current account deficit of the country balloons to a massive USD9.1bn (from current estimates of USD2.9bn) while a more dramatic impact is observed on country’s forex reserves (refer to table for the complete picture).

Breaking ties – gainers or losers?

All in all, the reality cannot be overlooked that the US stands out as the single most important source of foreign inflows in the country. Needless it is to state that, considering the indirect economic implications, as well as much bigger political consequences,  cutting ties with the US can altogether alter the political and economic  structure of not only Pakistan, but the entire region. However, in reality, it is highly improbable that such a case can materialize since Pakistan would not be the sole loser, but the loss would accrue to the entire region as well as the US, barring wider social consequences arising out of the same. Pakistan’s economic losses are also tied to the ongoing war and associated fundings from coalition partners. An abrupt and awkward twist in the same could further have dramatic consequences specifically in context of law and order situation in the region. Given this situation, we deem it improbable that ties with the US will break to a point of no-return and remain positive as far as the longer term outlook of Pakistan is concerned.

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