As noted in The Wall Street Journal, as the shockwaves from the U.S. financial crisis ripple across the globe, the big question on many investors’ minds is: who’s next?  As the article states:

“…Other countries are susceptible to trouble: Wednesday, Standard & Poor’s said it was considering downgrading Hungary and Ukraine. Both countries have large current account deficits and tumbling currencies; both have sought consultations with the International Monetary Fund in recent days.

One indication of how imperiled a country is can be gleaned from the price of insuring its debt for five years. As risks rise, so does the cost of the insurance, or credit default swap.

These days, there are several countries with credit default swaps trading at levels indicating a high degree of distress and potential default – among them Ukraine, Venezuela, Pakistan, Argentina, and Kazakhstan.

Pakistan and Argentina are the riskiest of the bunch, by this measure. The annual cost of insuring $10 million of debt issued by those countries for five years has soared in recent weeks: as of Wednesday, it involved an upfront payment of over $4 million plus $500,000 a year, according to Markit, a credit research firm.

Venezuela and Ukraine weren’t far behind, with a price tag of an upfront payment of over $3 million plus $500,000 a year. Kazakhstan cost $1.5 million, plus $500,000 a year.

Of course, these figures don’t mean a default is imminent, since they’re also reflecting the broader turmoil in financial markets. But they point to the most vulnerable spots in what is rapidly becoming a world of hurt.”

And, Stratfor (subscription required) further added on regarding Pakistan’s increasingly unsteady position

“…The World Bank could provide Pakistan with $1.4 billion under its Country Assistance Strategy program in order to help Islamabad avoid bankruptcy, Reuters reported Oct. 13. The wire service quoted an unnamed bank official as saying that the money, upon approval by the bank’s board, would be disbursed over the next nine months, targeting various sectors of the Pakistani economy. Some $800 million would go to budgetary support, while the remaining $600 million would be allocated to portfolio investment.

Pakistan, squeezed by the economic and financial gyrations of recent months, is looking abroad for help in order to stay solvent. This is not the first time Islamabad has been in such dire economic straits, but — facing a growing jihadist insurgency and a tight global financial environment — may find itself this time with nowhere to turn.

Pakistan’s Economic Predicament

Pakistan’s economy is under pressure from a number of directions at once, and the country relies heavily on foreign capital for its economic well-being.

Pakistan maintains a high national debt — currently about 56.9 percent of gross domestic product (GDP) — as well as a high budget deficit, estimated at 7.4 percent of GDP for the 2008 fiscal year (which ran from July 1, 2007 to June 30, 2008). Most of the government’s budget goes toward interest payments, defense and subsidies. In 2008, the government’s total subsidy bill was about 2.6 times higher than budgeted; subsidies on fuel and power amounted to 2.9 percent of GDP, and food subsidies (primarily wheat) were about 0.5 percent of GDP.

The country’s economy is dominated by services (53.04 percent of GDP), industry (26.6 percent) and agriculture (20.36 percent) — but because of dampened economic activity in all three sectors, real GDP growth dropped to 5.8 percent in 2008. In agriculture, floods and pest attacks reduced rice and cotton production, while industrial production and services were hit by acute power and gas shortages. Taken together, these factors explain the rapid depletion of Pakistan’s reserves after five years of economic growth: Foreign exchange reserves stand at about $8.32 billion, barely enough to cover two months of import costs.

Pakistan has a trade deficit roughly equivalent to 9.34 percent of its GDP. Most troublesome among its imports are oil and food, whose prices soared in 2008 and only recently began to come down. The country’s oil import bill jumped by about 56 percent in fiscal 2008, and the food import bill rose by about 46 percent. Other imports include machinery, plastics, paper and paperboard, transportation equipment, iron and steel. Exports include textiles, rice, leather goods, sports goods, carpets, rugs, chemicals and manufactured goods.

In addition to all this, Pakistan is facing a capital crunch from multiple sides because of a decline in capital inflows, on which Islamabad relies to limit its budget deficit. Net capital inflows declined some 22 percent in 2007-2008 to $8.3 billion, while foreign direct investment stood at $5.1 billion and remittances increased from $5.5 billion in fiscal 2007 to about $6.5 billion in 2008. Portfolio investments, however, declined sharply.

In short, Pakistan’s economy is under a great deal of strain. The government needs some $3 billion immediately simply in order to avoid default on its loan obligations. To eliminate its deficit, Pakistan needs to reduce its expenditures (21.5 percent of GDP in fiscal 2008) by roughly a third. A spending reduction would help give Islamabad some breathing room, provided that there were no further drops in corporate borrowing, foreign investment or exports. Each of these areas has already seen decline, however.

Pakistan might avoid defaulting on its debt, but it has a very small margin for error. And even if it dodges the bullet now, it will be living with the threat of default for some time to come.

Bankruptcy, should it happen, could unleash a massive tidal wave of social unrest — Pakistanis have been known to riot over much lesser issues. This, together with the existing insurgency, could lead to a major breakdown of law and order, which the civilian government would not be in a position to handle. Such conditions could pave the way for the imposition of martial law by the civilian government and/or the military.

And crackdowns on unrest under the current circumstances could definitively push the country to a full-fledged civil war — exactly what the jihadists on both sides of the Afghan-Pakistani border would like to see to advance their goals.

International Assistance, Maybe

For Islamabad to turn things around will require increased investment, but foreign investment has become a terribly scarce commodity in the wake of the global credit crunch. And even if credit were flowing freely, Pakistan is a state that appears to be in the process of unraveling — making it a singularly unattractive place for investors.

In this context, the World Bank proposal of $1.4 billion in aid is something Islamabad desperately needs. Pakistan received a $500 million loan from the Asian Development Bank earlier in October. But even this will not last very long under the current circumstances. Meanwhile, Shaukat Tarin, a 25-year veteran of Citigroup who was appointed Oct. 8 as the finance adviser to Prime Minister Yousaf Raza Gilani, is trying to raise as much as $10 billion in emergency assistance to help Pakistan avoid defaulting on its debt.

Islamabad is also expecting $3 billion to $5 billion in assistance from the “Friends of Pakistan” — a group formed Sept. 26 comprising the United States, Canada, Britain, France, Germany, Italy, Turkey, Saudi Arabia, United Arab Emirates, China, Japan, Australia, the European Union and the United Nations. In addition, Pakistan is relying on remittances from some 3 million Pakistanis living in North America, Europe and the Persian Gulf region and hoping to benefit from the drop in oil prices to avoid having to default on its loans. It is also hoping for Saudi help in the form of a concession on oil imports.

It remains to be seen just how much assistance comes from the Friends of Pakistan group and from the Saudis. Also, there is only so much that the World Bank and the Asian Development Bank can offer. That leaves the IMF as the only other alternative for some time to come. It comes as no surprise, then, that Tarin has been holding talks with the IMF in Washington.

There is, however, a major political problem in dealing with the IMF because of the terms attached to the loans, which call for major overhaul in the way the Pakistanis manage their finances. The IMF requires that debtor states tighten their financial operations and eliminate many expenses that the Pakistanis may deem necessary. In addition to spending cuts, the government will eventually have to repay the loan and will probably need to increase tax revenues to do it — a political risk that Pakistan’s nascent democratic regime can ill afford to take. Islamabad needs a high level of spending to enhance its popularity — or in the case of the current Pakistan Peoples Party-led government, to thwart its growing unpopularity.

Each of these forms of assistance could be a considerable help for Pakistan, enabling it to avoid defaulting for now. It will likely remain in the danger zone, however, because of the dire economic conditions at home as well as the global financial crisis.

…Pakistan usually services its existing debt by borrowing more. But this time, that is not an option in the light of the global drying-up of credit — and of unprecedented domestic circumstances.

Political instability and economic problems are hardwired into the Pakistani political fabric and have been endemic throughout the country’s 61-year history. In the past, both were managed by the military through direct or indirect interventions and by deals with the United States. But both sets of issues have arrived at a turning point. The military’s ability to deal with political troubles is complicated by the jihadist insurgency, by deteriorating relations with Washington and by the global liquidity crunch. Together these factors make it extremely difficult for Pakistan to slow or reverse its downward slide. The weak civilian government, already under strain from increasing political chaos, cannot afford to put in place policies that might make economic sense but would create the very social upheaval it is trying to avoid.

For now, it appears that Pakistan may have bought itself some time with the World Bank loan. But in order to back away from the precipice of default and bankruptcy, Islamabad will need to cut spending aggressively and see a turnaround in its capital inflows. The political and security situation in the country is such that both are easier said than done.”