Pakistan Faces Default on Its Huge Foreign Debt

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"The option of defaulting on those loans has never even been seriously considered," says Sakib Sherani, chief economist for the Royal Bank of Scotland (RBS) in Pakistan and an adviser to the government. "But even if they don't have the willingness to default, that doesn't mean it couldn't happen."

Just to keep afloat, Pakistan's recently appointed financial adviser to the Prime Minister, Shaukat Tarin, has asked the World Bank, the Asian Development Bank, and other lenders for just under $4 billion in loans.

And then there's the measure of last resort—the International Monetary Fund, which is likely to impose strict tariff reductions in exchange for the loans. It's not a pleasant option for Pakistan, which has tried for decades to be free of the IMF's influence. Already, a team from Pakistan has been meeting with the IMF in Washington. "We don't have the luxury of foreign exchange reserves to prolong negotiations by a few months," says Sherani. "So the closer [Pakistan] gets to running out of foreign exchange, the likelihood of turning to the IMF gets stronger."

IMF: "Plan C"

Pakistan hopes things don't come to that—newly appointed Finance Minister Shaukat Tarin has referred to the IMF as "Plan C"—and is waiting for a conference later this month in Abu Dhabi with an informal group called the Friends of Pakistan to see if soft loans or delayed oil payments to its Middle Eastern allies could buy it some breathing space.

But the crisis's impact on Pakistan's real economy, which was already reeling from a 60% increase in oil prices since the beginning of the year and inflation at a 30-year high, has been severe. Last year it was the star performer among Asia's indexes, but for now the Karachi Stock Exchange is in complete paralysis. On Aug. 27 the exchange introduced a circuit breaker that prevents prices from falling. Trade, which had already halved by 50% from January to May, to about 150 million shares a day, has dwindled to a few thousand per day.

"We were faced with a problem of sharply depreciating currency. We had investors panicking, very thin volumes, and the market was falling again," say KSE president Adnan Afridi. "So [in August] we put in the much-talked-about floor."

Afridi plans to remove the floor on Oct. 27. Investors are bracing for a nearly 20% drop, and the government is planning to provide a backstop by selling a put option to foreign investors that would limit their downside losses. "In the backdrop of what's happening globally, with local banks under a lot of liquidity pressure, it [was] probably not a bad thing to freeze things for a while," says Credit Suisse's Khan. "But the sooner they remove the planks from beneath the floor and let the market forces determine the fair level, the better it will be."

Inside Pakistan, though, the situation is seen as just another crisis in a year during which Pakistan People's Party leader Benazir Bhutto was assassinated, military dictator Pervez Musharraf resigned, the country's first civilian government in seven years took office, and terrorists have launched major attacks. Says Shamim Ahmed Shamsi, the head of the Lahore Chamber of Commerce: "Basically, what we need is a short-term measure so that things can return to some sort of 'normalcy,' even with a little bit of short-term borrowing."

Restored confidence in the stock market—and the entire economy—may come soon via foreign aid, especially if this economic crisis distracts Pakistan's leaders for too long from the conflict right on its border with Afghanistan. As Zardari never tires of reminding the world, Pakistan is on the front lines of the war on terror. Indeed, U.S. Assistant Secretary of State Richard Boucher arrived in the country over the weekend, and a series of missile and artillery attacks claimed to have killed several insurgents near the border with Afghanistan. "Pakistan really is a problem, but they will definitely get assistance from the U.S. and Europe because of this al Qaeda thing," says Mark Mobius, executive chairman of Templeton Asset Management, who invests exclusively in emerging markets. "I'm not too worried about it."

Srivastava reports for BusinessWeek from New Delhi. Balfour is Asia Correspondent for BusinessWeek based in Hong Kong.