Pakistan | Security implications of a debt default

We forecast that a debilitating economic downturn is likely in Pakistan in 2023. Such a scenario would exacerbate an ongoing political crisis and worsen security risks for organisations operating there.

This assessment was issued to clients of Dragonfly’s Security Intelligence & Analysis Service (SIAS) on 23 June 2023.

• We assess that there is a more than even chance of a sovereign debt default in Pakistan this year
• A debt default would almost certainly aggravate political and security risks
• The operating environment for businesses in Pakistan is likely to remain challenging over the coming year even if the country avoids a default

Due to the government’s seeming inability to stem the depletion of its foreign-exchange reserves, we now assess that there is a more than even chance of a debt default this year. And that even if this does not occur, rampant inflation and high unemployment levels are likely to lead to outbreaks of civil unrest, as well as further capital flight.

Debt default more likely than not this year

Pakistan’s ability to avoid a debt default, namely failing to repay on time the interest or principal on its loans, is under question. Much of this debt is reportedly owed to Chinese state-linked financial institutions and private creditors. According to international media reports, Pakistan has to make $900 million in foreign debt repayments this month (June) and around $23 billion in the 2023/24 fiscal year. Its foreign-exchange reserves were at just over $4 billion as of 9 June.

Pakistan is unlikely to meet all of these debt-repayment deadlines. Despite Islamabad’s efforts so far this year to obtain funding from friendly countries, it has only received limited financial support from China and the UAE. And according to the latest official World Bank data from 2021, even before the current economic crisis, Pakistan’s debt-service ratio (debt repayments compared with exports) was 34.1%. This meant that Pakistan spent a high proportion of its export revenue on debt repayments, relative to other developing countries. This has almost certainly worsened since then.

The government is unlikely to remedy the decline in its reserves and currency. Normally, a weakening currency would lead in time to a new equilibrium by making exports more competitive, so maintaining inflows for foreign currency. But flooding in August 2022 continues to hamper Pakistan’s export industries, such as textiles. These industries appear to be struggling to purchase inputs for production, due to a US dollar shortage. So the government appears unable to prevent a balance-of-payments crisis from unfolding.

Security implications of a debt default

Several clients have asked us about the implications of a default (or signs that one is coming) in Pakistan. Plausible immediate consequences would include disruption to supply chains, capital flight (due to weakened investor confidence), a rise in the cost of borrowing from abroad, and layoffs in the textile and manufacturing sectors. Several months of policy uncertainty and economic instability would probably ensue, based on how recent debt defaults in Sri Lanka and Zambia have played out.

A default would lead to a reduction in imports, due to a lack of foreign-exchange reserves to purchase them, as well as a spike in inflation. Companies would then struggle to borrow money to invest, impinging on domestic demand growth and very probably pushing unemployment up still further over the months that followed.

We assess that the already-high risk of civil unrest would deepen in the months after a foreign debt default. This is due to the resulting economic impact on citizens, especially through the erosion of living standards and layoffs in exporting industries. Amid such conditions, at least several thousand people would be likely to protest in major cities, including Islamabad and Lahore. The former prime minister Imran Khan would probably use hardship to mobilise his supporters against the government.

Greater economic uncertainty and higher inflation following a default would also aggravate what is an ongoing political crisis. Khan has organised large protests and called for a replacement of the government since he was removed from office in April 2022. The authorities have since arrested and released him over corruption charges, which he claims are politically motivated. A default occurring before a general election due in October would be especially impactful, in our analysis, as it would put pressure on the government to postpone the election in order to stabilise the economy. This in turn would undermine government legitimacy and incentivise Khan to escalate his criticisms of the government.

Business environment to remain difficult regardless

The economy in Pakistan is likely to worsen in 2023 even if the country does not default. Inflation exceeded 37% in May – a record high. And the government this year has raised interest rates and imposed capital controls, impeding trade and economic growth. In a sign that the operating environment for business is likely to remain extremely challenging this year, dozens of foreign businesses, including in oil and gas, and the car manufacturing sector, have shifted their operations out of the country in recent months, according to international media. This will have implications for the rates of productivity and economic growth that Pakistan’s economy is able to achieve over the long term (more than five years).

Persistent shortages in foreign exchange are likely to continue to make it difficult for businesses to access US dollars from banks to pay for imports. According to local media outlets, several thousand containers are currently held up at Karachi Port, and companies are accumulating fines for them. The Karachi Wholesale Grocers Association, a union of commercial importers, this week reportedly announced a halt to the import of food and beverages from 25 June, citing an inability to obtain US dollars from the central bank.