Pakistan Turns to China's Deep Reserves

Pakistan has reached a critical new phase in its long-deteriorating financial situation, as investor flight and bleeding of national reserves force the country to scramble for international funds to shore up its economy. With the global financial crisis draining coffers in the United States and Europe, the key U.S. ally in the war on terrorism is seeking help from an old friend newly flush with cash: China.

President Asif Ali Zardari arrived in Beijing on Tuesday for a four-day state visit as concern has surged over a possible debt default by Pakistan that could cripple its economy and spark more civil unrest. While the amount of money Pakistan needs in the short term is relatively small -- $4 billion to $6 billion -- analysts say the climate of crisis and public anger over domestic bailouts in the United States and Western Europe have made even a modest infusion from its Western allies politically difficult.

Pakistan's bid for Chinese cash underscores the potential of Beijing's $1.9 trillion in foreign reserves, the largest in the world, to boost its global influence. The government is now seeking as much as $3 billion in emergency assistance from China, as well as assistance from oil-rich Gulf countries including Saudi Arabia and the United Arab Emirates, according to a senior Pakistani official. Pakistan's central bank governor, Shashad Akhtar, is in Washington this week to review a draft plan for overhauling the country's finances with the International Monetary Fund, potentially paving the way for future aid.

U.S. military and intelligence officials fear that Pakistan's increasingly precarious economy will compound an already unstable political situation and undermine military cooperation. Both al-Qaeda and the Taliban leadership are located in the rugged, economically depressed region along Pakistan's western border with Afghanistan. The Bush administration and Congress have been shaping a long-term economic and military assistance package for Pakistan, but there is no indication the United States is able to step in with a short-term financial lifeline.

Pakistan is going to the Chinese now "because you go to the guys with the money," a senior International Monetary Fund official said. "And right now, the Chinese are the ones with the money."

Securing as much as $6 billion would buy the government the breathing room it needs, analysts say, to begin a desperately needed overhaul of its budget to sustain Pakistan's battered economy in the longer term.

Pakistan's financial problems go back at least a year, with current and past administrations borrowing from the central bank to sustain generous state subsidies on gasoline and diesel. As global oil prices surged, the government of former President Pervez Musharraf curried favor with average Pakistanis by having the state absorb the shocks. Musharraf ousted a democratically elected government in 1999 and ruled until a civilian coalition was voted into office last spring, headed by Prime Minister Yousaf Raza Gillani. The government forced Musharraf from the presidency in August, electing Zardari as his replacement in September.

Analysts and IMF officials say the current government has made notable progress in lifting those subsidies in recent weeks to ease the budget. Yet the global credit crunch and concerns over security have worsened investor flight, with as much as $1.2 billion a month fleeing Pakistan during the summer. National reserves over the past year have fallen 67 percent, to $8.3 billion, leaving the country ill-prepared to deal with financial turbulence as more investors pulled out in recent weeks as the U.S. crisis spread globally.

That has fed two major fears. First, that Pakistan may not be able to secure the funds to avoid a debt default early next year. And second, that investor concern over its potential insolvency could grow into a panic in coming weeks, leading to a far broader capital pullout that could jeopardize the country's financial system.

Unprecedented inflation, political instability and the growing threat from Islamist insurgents have all had sharply negative effects on investor confidence, said Sakib Sherani, chief economist at ABN Amro Bank Pakistan.

"It is clear that Pakistan is facing challenges in its balance of payments. Without cash inflows we are losing about $1 billion a month, which is untenable," Sherani said. "On the one hand, you are paying more for imports in Pakistan; on the other, you have less cash inflows."

On Oct. 6, both Standard & Poors and Moody's downgraded Pakistani bonds. "Only Seychelles has a lower rating, and it has already defaulted on its debt," said John Chambers, managing director with Standard & Poors in New York.

To curb losses, Pakistan in recent weeks has set new rules on stock trading aimed at preventing even sharper sell-offs of Pakistani companies. Some analysts are concerned that the new government may resort to freezing foreign capital, a measure Pakistan took in the 1990s after being slapped with global sanctions for conducting a nuclear test.

The Pakistani government is seeking to ease those fears by bolstering its central bank reserves with funds from China and Gulf states. China and Pakistan have a long history of economic cooperation, based partly on decades of weapons sales, and a lifeline now, particularly so small a sum, would not be seen as unusual. "The Pakistanis like to call the Chinese their all-weather ally, and the U.S. their fair-weather friends," said Daniel Markey, senior fellow at the Council on Foreign Relations. "This kind of loan could be seen as self-serving by the Chinese, and continue that impression."

A senior Pakistani official said the government requested in July that Saudi Arabia chip in with an "oil facility" -- or an agreement that would grant Pakistan concessionary terms and delayed payments and on roughly half the oil it imports. One reason investors are more concerned about Pakistan now is that Saudi Arabia has not yet responded.

Analysts say the Pakistanis may have better luck at a meeting early next month in the United Arab Emirates of the "Friends of Pakistan" -- a group of countries including the United States and Britain that are considered close allies. They are counting, sources close to the talks said, on countries seeing the danger of an economic collapse in Pakistan and the threat that poses to the war on terror as worth the relatively small price of financial assistance.

A last option might be seeking a lifeline from the IMF, though such an agreement is seen as politically difficult for the new government. Pakistan paid off the last of several IMF loans in 2005, with Musharraf hailing the accomplishment as a breaking of the nation's beggar's bowl. By seeking IMF help now, analysts say, the new government may find itself in the difficult position of explaining to the population why it needs to glue that bowl back together.

Pakistani officials, however, are meeting with IMF officials in Washington now, seeking their "seal of approval" on the plan to rein in runaway spending threatening to bankrupt the government. Although IMF officials say the Pakistanis are not seeking a loan, IMF approval of their economic plans could pave the way for other institutions, including the World Bank and Asian Development Banks, to offer lending. It could also make approval of an IMF loan at a later date happen faster.

"What they want is an endorsement in principle," a senior IMF official said, "something that would make financial support go more smoothly if they decide they do need to ask for it."