Muhammad Sajjad/AP
Peshawar, Pakistan

Pakistan, Iceland on the Brink of Bankruptcy

October 08, 2008 05:45 PM
by Anne Szustek
Pakistan’s financial reserves are nearly dried up; offshore haven Iceland is near economic implosion—when a government goes bankrupt, what happens on the international sphere and on the ground?

Awash in Red

Pakistan’s central bank had some $16 billion in foreign currency reserves as of this past winter. And Iceland went through a transformation from one of Europe’s poorest countries to one of the world’s 10 richest, as deregulation of the country’s banking sector in the mid-1990s resulted in the country becoming a magnet for trillions of dollars’ worth of foreign exchange deposits.

Now the two economies—both falling under the emerging category, albeit at different levels—are gasping to make ends meet. The Pakistani rupee has dropped more than 21 percent in value since the start of 2008 and the country’s central bank holds $8.14 billion in foreign currency. If Pakistan’s liabilities are carried forward however, the country’s actual coffers may only come out to some $3 billion—sufficient to buy a month’s worth of staple imports such as foodstuffs and oil.

Since July 2007, the Icelandic krona has dropped more than 46 percent versus the euro, prompting the country to peg its currency to the predominant EU monetary unit and seek a €4 billion (about $5.7 billion) loan from Russia to shore up its reserves and help bolster its currency.

The countries have different case stories in how they came to be fighting for economic survival. Iceland’s banking sector dwarfed the rest of the economy over the past decade. The country’s banking sector is eight or nine times larger than its gross domestic product. High interest rates beckoned scores in foreign deposits—far exceeding locally held accounts and exposing the country to the financial ills of the world at large. The fact that most bank accounts in Iceland are in foreign currency rather than krona impedes the country’s central bank’s efforts to keep up the banks.

As for Pakistan, skyrocketing oil and fuel prices on top of a government allegedly rife with corruption have been weighing down on the nation’s finances. Rises in prices for oil and food have pushed up Pakistan’s bills for those commodities by roughly one-third since the start of the year. Pakistani President Asif Ali Zardari told The Wall Street Journal that the country needs some $100 billion in bailout money from other countries. Styling it in terms of bolstering counterterrorism efforts, he was quoted as saying in U.K. paper The Daily Telegraph, “The oil companies are asking me to pay $135 [per barrel] of oil and at the same time they want me to keep the world … and Pakistan peaceful.”

Pakistan’s sovereign debt credit rating from Standard & Poor’s is currently CCC+, meaning it is near default.

Historical Context: Past government bankruptcies and courses of action

New York City was on the verge of bankruptcy in 1975, but stayed solvent after the teacher’s union agreed to put $150 million toward the city’s municipal bonds. The situation was so dire that the city had devised a contingency plan to determine which city services would get paid first: the top three being the police and fire departments, respectively, sanitation and public health, and food and shelter aid programs. Mayor Abraham D. Beame drafted a statement set to be released on Oct. 17, 1975, saying that the City of New York was issued a court order to protect its holdings from creditors.

Under Chapter 9 bankruptcy, developed during the Great Depression, municipalities are protected from seizure of assets by creditors and are entitled under U.S. bankruptcy law to negotiate repayment terms. In addition, the 10th Amendment effectively grants immunity to municipalities from bankruptcies, as that body of law is federal in scope, yet not part of the Constitution. As municipalities are under the authority of individual states, any law not enumerated in the 27 amendments is at the discretion of the states.

In reality, when a government goes bankrupt, until the government gets its books in order, public services are cut while taxes and fees go up. Governments often print more money to “cover” debts.

To deal with the government’s default early this decade, in January 2002, Argentina abandoned its peso’s one-to-one peg with the dollar and had all dollar-denominated bank accounts in the country changed over into local currency, exchanged into an “official” rate set at 1.4 pesos to the dollar.

The local currency rapidly devalued. That summer, Argentina stopped fulfilling its debt load.

There was a silver lining in this however: the subsequently cheaper exports resulted in an influx of hard currency, bolstering the Argentinean economy. On top of a successful debt swap in 2005 of $81 billion in defaulted Argentinean bonds in exchange for new debt instruments worth some $0.35 on the dollar, that Latin American economy has largely bounced back.

Neighbor Brazil had similar woes during the mid-1990s. Its public sector was nearly bankrupt after decades of bungling by military regimes. The administration of Brazilian President Itamar Franco implemented the Real Plan, which pegged the local currency, the real, to the U.S. dollar. This tided inflation and increased inflows of foreign currency. A public fiscal readjustment program was developed, which led to growth that helped clear some of the country’s current account deficit and assuage foreign investors’ trepidation about the emerging market economy.

American hedge fund Elliott Associates took a decidedly harsher approach in regards to $11.8 million spent on bad Peruvian public debt. Peru’s government settled in 2000 after a four-year court battle for nearly $56 million.

Less recently, German, British and Italian warships blockaded Venezuelan ports after the country defaulted on its debt in 1902. And in 1881, European countries picked away at the Ottoman Empire’s customs houses after Constantinople, by then known as “the sick man of Europe,” failed to pay up, drained by years of war against Russia.

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