Pakistan's external sector: gains build momentum, but challenges linger

Inflation is cooling, interest rates are steady, and remittances are pouring in – signs that Pakistan’s economy is finally catching a breath. But beneath the surface, the country’s external sector is still walking a tightrope.

And just as things seemed to be settling down, the newly elected U.S. president threw a wrench into global trade dynamics – launching a surprise power play with a sweeping push for tariff reciprocity.

Pakistan’s external sector is navigating a delicate balancing act, showing signs of resilience with improved financial conditions while grappling with persistent challenges on the external debt side.

As of February, the country has made notable progress in stabilizing its economy, bolstered by easing inflation (due to stability in exchange rate) and an IMF staff-level agreement on the first review of the $7 billion Extended Fund Facility (EFF) and a new 28-month arrangement under the Resilience and Sustainability Facility (RSF) for $1.3 billion.

However, the first eight months of FY25 (8MFY25) have also highlighted underlying vulnerabilities, with a widening trade deficit, external financing concerns, and looming debt repayments posing risks to financial stability.

Trade balance and import pressures

Pakistan’s trade deficit held steady at around $2.3 billion in February, as exports dipped 6% while imports surged 10%, driven by recovering economic activity amid lower interest rates.

During the first eight months of the fiscal year 2024-25, imports climbed by 7.4% to $37.8 billion, with oil imports playing a major role. In December, oil import volumes hit their highest level since June 2022, reflecting a shift toward formal banking channels.

Export performance

On the export front, the cement sector demonstrated robust performance. Cement and clinker exports surged by 27%, reaching $208.06 million, up from $163.90 million in the same period the previous year. This growth underscores Pakistan's strengthening position in regional construction markets.

Pakistan’s non-textile exports rose 2.38% to $9.89 billion in 8MFY25, driven by a 19% surge in engineering goods and strong growth in cement (26.9%) and footwear (15.5%). However, leather garments, sports goods, and carpets saw declines. Despite mixed trends, the sector remains resilient with growth potential.

Textile products remained Pakistan’s leading export category, making up 52.8% of total exports. Topline Securities forecasts textile exports to rise to $18-19 billion by the end of FY25, up from $16.7 billion in FY24.

Pakistan’s IT exports stood at $305 million in February, up 19% YoY but down 3% from January. This marks the 17th consecutive month of YoY growth since October 2023, pushing 8MFY25 earnings to $2.48 billion, a 26% increase.

Current account dynamics

In February, the current account deficit contracted to $12 million, down from January's deficit of $399 million, primarily due to higher remittances. Despite this monthly deficit, the cumulative current account for the eight months of FY25 remained in surplus at $691 million, a significant improvement from the deficit of $1.73 billion during the same period last year, as per SBP data.

While the import bill exceeded export earnings, strong remittance inflows more than compensated for the widening trade deficit. Given these trends, especially resilient worker remittances, the current account outlook has improved, with projections now ranging between a slight surplus and a 0.5% deficit of GDP in FY25.

Remittances and foreign exchange reserves

Worker remittances played a pivotal role in offsetting trade deficits. Remittances increased by 38.6% in February, as compared to the same month last year to $3.1 billion, amid rising formal transfers and stable currency, providing a crucial buffer for the current account and supporting foreign exchange reserves. The bulk came from Saudi Arabia ($744.4 million), the United Arab Emirates ($652.2 million),the United Kingdom ($501.8 million), and the United States ($309.4 million).

The Pakistani rupee held steady, providing a sense of confidence that kept remittances flowing. Since September 2023, the interbank exchange rate gap between the U.S. dollar and the rupee has hovered within a narrow 0.5% to 1% range, signaling stability in the currency market.

The Pakistani rupee edged down 0.3% against the U.S. dollar in February, a shift likely driven by an uptick in imports, according to trade data. Meanwhile, transactions through formal banking channels kept the exchange rate deviation steady at 0.7%.

Foreign exchange reserves surged to a high in November, even as the trade deficit widened. However, a growing current account shortfall later triggered a decline in reserves.

Policy implications and outlook

The SBP's Monetary Policy Committee paused rate cuts in March, maintaining the interest rate at 12%, citing concerns over currency stability and the trade deficit. Future rate adjustments are anticipated, contingent upon achieving more certain inflation targets.

The MPC has assessed the inflation to come down further before gradually inching up and stabilizing within the target range of 5 – 7%. Rising remittances and export gains in cement and IT services offer optimism, but a growing import bill – driven by higher oil demand and global commodity prices – adds pressure. Still, strong remittances and steady export growth have helped offset elevated imports.

The State Bank sees these trends aligning with expectations and maintains its current account balance projection of a surplus and a deficit 0.5% of GDP during the fiscal year 2024-25. Net financial inflows remained subdued, largely due to a shortfall in planned official funding. In January, inflows dropped 56% year-over-year to $364 million, with $349.6 million from loans and $14.6 million in grants.

So far, only $4.9 billion has been received against the FY25 budgeted target of $19.3 billion, highlighting the gap in external financing.

Yet, the path ahead is far from smooth. Fitch Ratings has flagged Pakistan’s external financing risks, with over $22 billion in debt repayments looming in 2025. The European Union, too, has reminded that continued access to duty-free exports under GSP+ hinges on improvements in human rights and governance.

The improved current account outlook, along with the expected realization of planned financial inflows, is likely to increase the SBP's FX reserves beyond $13 billion by June.

Policymakers are likely to give their attention more towards diversifying exports, improving energy efficiency to curb dependence on oil, and pushing forward structural reforms to lay the groundwork for long-term, sustainable growth.

The mixed performance of Pakistan's external sector during 8MFY25 highlights the need for comprehensive policy measures to maintain stability and drive long-term progress.