Many Loose Ends

*South Asia in Crisis

Sushil Khanna

As the spectre of the pandemic receded and economies around the world opened once again, much of South Asia was engulfed in a severe debt and balance of payments crisis. The most dramatic was the case of Sri Lanka. Unable to repay its creditors, Sri Lanka was shut out of all foreign financing. The supply of essential imports like fuel, food and even domestic transport of farm produce collapsed, leading to hoarding, and a steep jump in prices of essentials from 40 to 200 percent. The crisis paralysed the economy, shutting schools and offices and as anger mounted, people invaded the President’s palace, and the top leadership fled the country.

Pakistan faced a similar situation of imminent debt default a few months later. First signs of economic distress emerged soon after Prime Minister’s Imran Khan’s government was defeated in a parliamentary vote, and a new government took over. The crisis again manifested itself as a foreign exchange crisis and reserves declined to a record low, while cost of imports, especially petroleum zoomed, thanks to the Ukraine war. It reached its peak in March 2023 as the value of Pakistani rupee declined and prices were rising at the rate of 40 percent per month. As Pakistan had not fulfilled its part of the bargain with International Monetary Fund as per the 2019 bailout, there was little to hope of an early repeat bailout. High inflation, a weakening currency, and dangerously low foreign exchange reserves, along with the high cost of doing business, intensified the grim economic outlook. Moody’s Investor Service, in its latest report, warned of a possible default of $7 billion in repayments due in the coming months.

The Pakistan's rupee depreciated to a record low of Rs 287 per USD, (from Rs 140; 1 USD in 2019), following the delay in the negotiations over the conditions for concluding the agreement with the IMF to unlock a $6.5 billion loan. To avoid debt default Pakistan sought commitments for new loans from Saudi Arabia and the United Arab Emirates. "We have received an indication from Saudi Arabia about getting something", the Pakistan Minister of State for Finance said in March end. Pakistan was to repay about $3 billion of debt by June. Meanwhile, the State Bank of Pakistan raised the key interest rate by 100bps to an all-time high level of 21 percent on April 4 (after a 300bps hike in March), aiming to tackle record inflation and stabilise the economy.Pakistan’s economic crisis would have deepened if the International Monetary Fund (IMF) bailout was refused. Total foreign reserves had fallen to $9.82 billion with the State Bank of Pakistan holding only $4.24 billion, which was enough to pay for just three weeks of imports.

What has happened in Sri Lanka and Pakistan is not so exceptional in the region. Seemingly, the war in Ukraine and the subsequent spike in petroleum and food prices seemed to be the immediate cause of the crisis that has propelled India’s neighbours–Pakistan, Nepal, Bangladesh and Sri Lanka to approach the IMF for assistance under its Extended Fund Facility (EFF) to shore up their fast-depleting foreign exchange reserves.

What is the basic reason and structural weakness that have plunged South Asia region into crisis? Could India be, being the region’s largest economy, play any important role of assisting its neighbours?

Despite the historical reality that till the middle of 20thcentury, South Asia was an integrated market under British control, it is surprising to see the high fragmentation and very low economic integration, low trade and economic relations in South Asia.

On the one hand, South Asia has close geographical proximity and the existence of bilateral and multilateral free trade agreements (SAPTA / WTO), on the other, it is one of the least economically integrated regions in the world. Intra-regional trade in South Asia accounts for barely 5 percent of the region’s global trade. This makes South Asia one of the most disconnected regions in the world, especially when compared with other regions such as East Asia and the Pacific, where intra-regional trade accounts for approximately 50 percent of the total trade, and Sub-Saharan Africa, where intra-regional trade has improved over the years to 22percent. Intra-regional trade in the South Asian region (including Myanmar) amounts to only 5.6 percent (2017).

In fact, all South Asian countries trade on better terms with distant economies than with their own neighbours. This can be shown through an index of trade restrictiveness. Based on global trade data, such an index generates an implicit tariff that measures a country’s tariff and non-tariff barriers on imports. In India, Nepal, Pakistan, and Sri Lanka, the indexes are two to nine times higher for imports from the South Asia region than for imports from the rest of the world! In other words, instead of lowering duties and barriers to their South Asian neighbours, the SAARC countries discriminate against their immediate neighbours in favour of western imports.

The responsibility for this low integration lies with the ‘big brother’ India. Initially it was India’s import substitution and industrialisation strategy launched in the late 1950s that disrupted historical trade flows and movement of people and services in the region. Rail and road connections too were disrupted as neighbours became enemies. Even after India opened to the world in 1990s, it remained wary of its immediate neighbours. Protectionist policies, high logistics cost and above all lack of political will and a trust deficit inhibited South Asian integration. What is more, India with contiguous land borders with almost all the countries of the region, hampered closer economic ties amongst them by discouraging overland movement of trucks and containers through Indian Territory. Thus, Nepal, Bhutan and Bangladesh’s efforts to boost intra-regional trade was made impossible as the goods needed to pass through India.

With India turning its back on economic integration, and even occasionally harassing neighbours by imposing blockades, the field was left open to other rivals. China stepped up its economic engagement and offered concessional trade credit to sweeten its entry into the South Asian market. Some like Pakistan had a long strategic and dependent relationship with China, but other South Asian countries too turned to China. In 2018, China’s trade with SAARC counties (other than India) is approximately double that of India. Compared to India’s total exports of US$ 30 bn to its seven neighbours, China exports are at US $ 60 bn. Even if Pakistan is excluded - given its long-term dependence on China, and the embargo on Indian imports- China’s trade with India’s other neighbours is above US$ 49 bn. Not surprisingly India’s economic influence over its South Asian neighbours is limited.

Despite the 2006 South Asia Free Trade Agreement (SAFTA), there has been little progress. In SAFTA about 40 percent of India’s imports have been on the ‘sensitive list’ where duties are not lowered. In addition, India has launched the world’s second largest anti-dumping investigations and imposed restrictions indiscriminately against all trade partners. Though the largest number of such investigations are against Chinese imports, even South Asian neighbours have faced anti-dumping duties restrictions. Anti-dumping tariffs and restrictions have been imposed on imports of jute goods from Nepal and Bangladesh, on float glass and car batteries from Bangladesh; on Vanaspati from Nepal and Sri Lanka. Similarly other countries which already have a large trade deficit with India have imposed duties and restrictions. Since 2019, Pakistan has banned Indian imports. All this has pushed South Asian neighbours to trade with China and ASEAN countries.

Another surprising feature of SAARC economies is the similarity in their economic structures and weaknesses. All SAARC countries have been poor exporters of manufactured goods and services, although India with its expanding service exports is partly filling up the persisting very large deficit in goods. All the countries of South Asia have continuous and large trade deficits. Pakistan has the largest trade deficits with imports being twice its exports, but others too run large deficits. So how do they finance their imports?

Unable to provide jobs for the teeming millions, South Asian countries provide for the largest outward migration of poorly educated workers, mainly to the Gulf oil producing countries, including nurses, construction labour and domestic workers. Thus, India accounts for about 5 million migrant workers (not including skilled software personnel), Pakistan has 3.3 million while Bangladesh has 2.1 million and Sri Lanka has 7 lakh, while Nepal has 5 lakh (not counting migrants to India across the open border).

Flowing from this large labour migration, South Asian economies receive large remittances from these poor workers who slave to feed their families back home. India is the world’s largest recipient of remittances at $ 90-100 billion a year. But Pakistan and Bangladesh too are amongst the top 10 countries in the world. This partly fills the gap created in their balance of payments by poor export capacity and large trade deficits.

As Table 1 shows, all South Asian countries have significantly large trade deficits. For all of them, remittances were significant to fill in the deficit caused by trade deficits.

In the case of India, remittances in 2021 filled in the entire trade deficit. In case of Nepal and Bhutan the trade deficit was largely with India and financed with Indian aid (grants and credits). The remaining three, namely Bangladesh, Pakistan and Sri Lanka had current account deficits as large as 3.5–3.8 percent of GDP. That is because all three have incurred large interest payments on account of government and private sector international borrowings that are often as large as 40 percent of their export earnings. This fact explains their large current account deficits despite large remittances. What is more none of them, unlike India, were able to attract significant foreign investment. Hence borrowing was from global financial markets or bilateral and multilateral assistance.

Sri Lanka and Pakistan
Both Pakistan and Sri Lanka have been beneficiaries of China’s aid as loan and credit to finance infrastructure investment as part of the ‘Belt and Road’ projects. Repayment of these loans became due as several of these projects were commissioned. These repayments coincided with the global hike in energy prices.

As economies opened after the Covid lockdown, the war in Ukraine pushed up prices of oil and gas which for all South Asian countries form a significant proportion of their imports. Current account deficits widened for all countries. They needed to be financed or imports needed to be restricted, which the countries found difficult to do.

But what caused the total breakdown in Sri Lanka and Pakistan? It is argued that both countries were limited in their response because of their own respective political economies. In both these countries, it is the elite capture of policies and the breakdown of governance that were key factors.

Pakistan, for two decades or more, has been unable to manage its balance of payments, especially after 1998 nuclear bomb explosion. As the West imposed sanctions and official aid dried up, a panic-stricken government froze all foreign currency accounts held by non-resident Pakistanis. These NRP foreign currency accounts had remained insensitive to changes in economic fundamentals. However, poor decisions by the government in relation to the freeze on these accounts, added to the pressure caused by shrinkage of official flows consequent on the undermining of the ‘rentier’ value of Pakistan in the region’s geo-politics, produced a sharp fall in foreign currency inflows and precipitated the financial crisis. Even today, Pakistan finds it difficult to attract deposits and investments from its non-resident citizens. According to media reports Pakistan faces capital flight through illegal channels.

Since 1954, the IMF has been forced to support Pakistan 24 times. But according to many Pakistani economists, the liberal and massive American aid that poured into Pakistan in the 1980s, as the country joined US campaign to oust Soviet backed regime in Afghanistan, infected Pakistan with the Dutch Disease like effect. The easy money meant governments ignored domestic resource mobilisation, and inflow of liberal foreign exchange raised the value of Pakistani rupee undermining industries and exports.

Since the beginning of the new millennium and especially after the attack on the World Trade Centre 2001, Pakistan once again began to receive foreign assistance (reminiscent of cold war days), not so much bilateral aid, but support from the IMF and the World Bank. Pakistan has lurched from one bailout to another with occasional episodes of large assistance from Saudi Arabia and China.

What is more successive governments have ignored IMF conditions to raise more domestic resources. Thus, 11 out of 12 IMF programmes since 1988 were abandoned in the middle or scrapped altogether —and the country has become known as a “start-stop adjuster”. Governments have tried to “game” the IMF, and achieved partial success each time. This time too, the IMF programme of 2019, as large as 6 bn dollars was on hold as the country’s governments continued to ignore the conditions agreed with IMF.

The recent crisis was triggered by the fact that the war in Ukraine coincided with the political instability when Prime Minster Imran Khan was replaced by Shahbaz Sharif. That uncertainty grew whether the government would survive the forthcoming election.

Aggravating the crisis were unsustainable subsidies on power and fuel which the politics of the country made difficult to reduce. It precipitated the suspension of the 2019 IMF bailout programme. Deepening the crisis, Pakistan’s tax collection has been low by South Asian standards, with governments able to collect only 10 percent of GDP. The Pakistani elite, like their other South Asian compatriots are adept at avoiding taxes. Moreover, the government has been reducing tax rates, to attract investments. Also, Pakis-tan’s saving, and investment rate has been amongst the lowest at 14 percent of GDP, compared to 30 percent for Bangladesh, Sri Lanka and India.

For years, Pakistan has lived beyond its means with large external sector imbalances – namely large trade and current account deficits which required it to constantly borrow from friends and commercial financial markets. It has failed to attract foreign investments and faces capital flight with rich Pakistanis buying property and assets in Gulf economies. Unable to meet its debt obligations, Pakistan would repeatedly approach the IMF for support.

Pakistan’s external debt exceeds $124 billion amounting to about 40 percent of its GDP. What is more, 30 percent of its external debt is owed to China, which too has been generous in granting loans to bag construction contracts for its companies, but it has become shy about deferring repayments. Most recently, China has agreed to defer $2 bn loan repayment and provided $700 million as emergency assistance.

The case of Sri Lanka is curious. After the civil war in 2009, the Rajapaksa family consolidated their hold on the government and embarked on a rapid growth strategy. The country embarked mainly on a bilaterally financed infrastructure investment programme. Alongside these borrowings for investments in ports, energy, and transport, the Sri Lankan government also borrowed by issuing international sovereign bonds(ISB). Some $17 billion worth of ISBs were issued from 2007 to 2019 which carried high interest rates, often as high at 8 to 9 percent in dollar terms.

On being elected as the President in November 2019, the Gotabaya Rajapaksa administration instead of tightening the belt, slashed direct taxes. Personal income tax exemption was raised from Rs. 5 lakh p.a to Rs. 30 lakh p.a. Similarly, corporate tax was reduced from 30 to 24 percent, agro-based companies (tea plantations) and IT companies were exempt from tax. Value added tax (VAT) was reduced from 15 percent to 8 percent. Furthermore, in the name of simplifying the tax system the government eliminated the Nation Building Tax, the Economic Service Charge, and the Debt Repayment Levy. In a bid to boost Foreign Direct Investment (FDI), the government removed all restrictions under the Strategic Development Projects Act, and firms executing projects deemed strategically important were granted tax exemptions for up to 25 years (many were Chinese funded projects).

By 2020, largely because of these populist measures to please the rich and the corporate elite, Sri Lanka’s tax-to-GDP ratio fell to a historic low of 8.1 percent in 2020 and is now among the lowest in the world. These cuts even alarmed the IMF, which generally favours tax reduction, as they sharply increased budget deficits and the excess demand leading to a sharp increase in imports. The Covid lockdown and disruptions further reduced revenue collection and required the government to increase social expenditure.

Following reckless borrowing, the country’s external debt rose to $ 58 bn or 65 percent of its current GDP from 29 percent of its GDP by 2019. The share of ISBs in total debt tripled to 36 percent by 2022 from 12 percent in 2019. What is more, the36 percent debt on ISBs, accounted for 70 percent of the interest payment. Soon it was forced to default on its commercial debt and all short-term funding evaporated. This debt default – announced in April 2022 amid foreign currency shortages, triggered blackouts, fuelled queues, and street protests, which forced the Rajapaksa brothers to flee the country. This resulted in shutting off all foreign loans accompanied by capital flight from the stock market as well as illegal capital flight by Sri Lankan nationals, both residents and non-residents.

India provided short term loans of about $ 1 bn to buy Indian commodities including petroleum products and supported the Sri Lanka’s application for IMF - EFF assistance. China, which like in the case of Pakistan, accounts for 20 percent of the loans dragged its feet, delaying the IMF agreement.

The crisis in South Asia points to the high cost the region has paid due to political differences and suspicion resulting in the failure to see the gains from closer economic integration. India as the largest economy had an opportunity to help develop its neighbours who would have provided a growing market for its goods, several fold larger than the current paltry total of $ 30 bn. A unified and integrated South Asia would carry greater heft and long-term resilience, facing climate change to security and economic challenges together. Rather than look to western markets and funds for development South Asia needs to look towards its immediate neighbours. South Asia’s salvation lies in peace and closer economic ties with each other. ooo

Kathuria, S. (Ed.). (2018). A glass half full: The promise of regional trade in South Asia. World Bank Publications
Editor’s note: Officially the South Asia Association for Regional Cooperation (SAARC) comprises of eight countries, including later entrant Afghanistan.
Khan, M. Z. (2009). Liberalisation and economic crisis in Pakistan. Rising to the Challenge in Asia: A Study of Financial Markets: Asian Development Bank, 9.
Ehtisham Ahmad and Azizali Mohammed (2012), “Pakistan, the United States and the IMF: Great game or a curious case of Dutch Disease without the oil?” LSE Asia Research Centre Working Paper 57

* An earlier version of this article appeared in ‘Zuva’, the magazine of ‘Pakistan-India People’s Forum for Peace and Democracy’.


South Asia: Key Indicators from Balance of Payments Accounts 2021

Trade Balance+($ bn)
(% of GDP)
Remittances ($ bn)
(% of GDP)
Current Acc Balance ($ bn)
(% of GDP)

[Source: World Bank: World Development Indicators +Trade in Goods and Services]

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Vol 56, No. 17-20, Oct 22 - Nov 18, 2023