China's strategic bet: Saving Pakistan from default to secure geopolitical ally

March 21, 2023 (MLN): Pakistan is facing a potential default as early as June unless it secures aid from the International Monetary Fund (IMF). If Pakistan defaults, China would have much to lose - far beyond a financial hit. Broader strategic considerations might tip the odds toward China playing a constructive role in helping Pakistan weather the crisis.

Pakistan is an important geopolitical ally of China in the region - a strategic counterweight to an ascendant India, as Bloomberg reported. 

China has also been investing in major infrastructure projects in Pakistan under a $65 billion China-Pakistan Economic Corridor. A stable Pakistan is in China's interest. Any turmoil in the economy and associated social unrest that could result from a default would threaten that stability, it noted. 

China has already stepped up, providing $700 million in loans on Feb. 25 and $500 million more on March 4, boosting Pakistan's foreign exchange reserves, which amounted to $4.3 billion as of March 10.

Even so, that's not enough for Pakistan to clear its funding crunch. It has $7 billion in external debt repayments due by June and a $1.2 billion hole in its current account to fill from March to June.

The government assumed that it will be able to roll over $4bn of its debt - and squeeze by with its small reserve cushion.

However, there's no guarantee that other creditor nations, including Saudi Arabia, that have pledged to support Pakistan will agree to roll over their loans.

The base case is that the IMF will deliver the remaining $2.6 billion in aid under the current bailout program by June - helping Pakistan wiggle through the immediate crisis - as the country has fulfilled most of the IMF's conditions, it said. 

If the aid does not arrive, though, China will likely help plug the gap to head off a default. Even if Pakistan makes it through the summer crunch, it won't be in the clear. Its external financing requirements in the fiscal year through June 2024 will be around $30 billion - a sum that far exceeds the funding available to Pakistan through its foreign exchange reserves and foreign capital inflows.

Pakistan's public debt is unsustainable. It's on track to reach 71% of GDP by end-June. The estimates indicate the sustainable debt level is only up to 53% of GDP - making an eventual restructuring inevitable.

In any fair restructuring, China will likely have to take an $8bn haircut or roughly 32% of a total write-down that external creditors will need to make to return the country to a sustainable debt path.

The analysis rests on a basic view - that the financial costs to China from propping up Pakistan are well worth the strategic benefits of a more stable ally in the region.

If China doesn't help Pakistan, the latter might have to seek another IMF bailout program or more external aid from allies to avoid default next fiscal year. If the assistance fails to materialize, China will likely step up again.

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