There was news that Pakistan’s expensively-dressed Prime Minister will donate his wardrobe for the flood-hit people. A very noble gesture indeed; but nobler still will be for the Prime Minister to donate at least half of his Cabinet which will save enormous amounts of money. And this is serious talk as Pakistan is in the eye of a storm which has the potential to destabilize the entire system that we have so far been able to save. It has been estimated that the flooding in Pakistan will inflict serious damage on its economy, posing another challenge for a cash-strapped government struggling to keep a recovery on track amid high inflation and a relentless Islamist insurgency.

Wall Street Journal has reported that Assistance from the International Monetary Fund and Western countries will likely help Pakistan avoid another brush with bankruptcy as it tries to cope with the damage, which by some estimates may reach $43 billion. But the floods will weigh heavily on economic growth this year and leave a long-term mark on the economy.

“The hit on the growth rate is going to be very severe,” said Philip Wyatt, a senior economist at UBS. “We can see a loss of one or two points of economic growth, depending on the damage.” In the fiscal year ended June 30, Pakistan’s economy grew 4.1%. Moody’s Investors Service, which had expected Pakistan’s economic growth to expand to 4.5% this fiscal year, may lower its estimate to 3% to 3.5%, analyst Aninda Mitra said.

The flood began in July and at one point covered one-fifth of the South Asian nation, or land roughly equivalent to the size of Uruguay. It has damaged crops sown over 1.93 million acres, or 776,996 hectares. Cotton output will shrink to 11.76 million bales from the 14 million bales estimated at the start of the season by Pakistan’s food and agriculture ministry. Cotton is an important raw material for the key textile export sector, one of Pakistan’s few sources of export income.

According to the United Nations, the disaster has affected close to 20 million people, killing 1,500 and leaving 1.2 million homes damaged or destroyed. Coping with the social and economic costs of the catastrophe will strain the government’s finances. The budget deficit was already on track to reach 4.5% of gross domestic product before the crisis but now could widen to as much as 6% to 7% of GDP, said Mr. Mitra of Moody’s. That is a grim prospect for a country that had external debt totaling $55.63 billion as of June 30. President Asif Ali Zardari‘s government has been reaching out to other countries for help. A delegation met with IMF officials Monday in Washington. Donors including the U.K. and the European Union have so far pledged almost $500 million in additional help.

Moody’s is unlikely to upgrade Pakistan’s credit rating in coming months due to the devastation from the floods and other challenges, but the country’s current B3 rating “adequately captures the risk” of the likely economic slowdown and is unlikely to be downgraded further, said Mr. Mitra. A B3 rating is just one notch above the C level, which applies to countries in effective sovereign default, and makes it hard for a country to issue bonds in the international market.

The natural disaster is the latest setback for the Pakistan economy, which after several years of strong growth almost ground to a halt in 2008, hurt by budget overruns, a loss in export competitiveness due to high inflation, and an insurgency that continues unabated. On Monday, while emergency workers worked to shore up levees in two southern cities, at least 36 people were killed in three separate bomb attacks across the country, and 12 suspected militants were killed in U.S. drone attacks near the Afghan border.

Concerns about the economic fallout have kept pressure on Pakistan’s financial markets, though the impact has been moderate. The cost of insuring against a default or restructuring of Pakistan’s bonds remains at very elevated levels, but has been relatively steady in recent weeks, a sign that investors anticipate IMF and U.S. support to prevent any fiscal crisis. The spread on Pakistan five-year credit default swaps was quoted at 1,099 basis points Tuesday, roughly on par with those of other high-risk sovereign bond issuers like Venezuela, but well below early-2009 highs of over 2,100 basis points during the global financial crisis.

Pakistan’s benchmark stock index, KSE-100, has fallen 7% so far in August, but is up 4% so far this year, roughly in line with other emerging market indexes. The Pakistan rupee, one of Asia’s weakest currencies in recent years, has fallen in recent days, but has found support above its record low against the dollar of 85.84 rupees hit on Aug. 2, helped by expectations that remittances from overseas Pakistanis, which have averaged around 10% of GDP in recent years, may rise to help families at home cope with the floods.

But analysts expect the rupee to remain under pressure in coming months due to Pakistan’s current account deficit and high inflation rate, which ran at 12.3% in July. The floods are likely to push up food prices and transportation costs for other goods, likely eliminating any chance that inflation might fall below 10% this year, said Mr. Wyatt at UBS.

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