Moody’s report flags economic fallout for Pakistan amid escalating tensions with India

As India and Pakistan teeter on the edge of another diplomatic standoff after the April 22 terror attack in Pahalgam, a stark economic warning has emerged from global ratings agency Moody’s. Released on May 5, the Moody's report outlines how the latest escalation could unravel Pakistan’s fragile path to recovery, derail its fiscal reforms, and push it back toward financial instability.

In its latest assessment, Moody's stated that “a sustained escalation in tensions with India would likely weigh on Pakistan’s growth and hamper the government’s ongoing fiscal consolidation.” The global rating agency warned that prolonged geopolitical stress could “impair Pakistan’s access to external financing and pressure its foreign-exchange reserves, which remain well below what is required to meet its external debt payment needs.”

Pakistan’s foreign exchange reserves currently stand at just over $15 billion, a fraction of India’s $688 billion, raising red flags about its ability to service debt in the near future.

In contrast, Moody’s noted that India’s economic exposure to Pakistan is negligible, with less than 0.5% of its total exports heading to the neighboring country in 2024. As such, the agency does “not expect major disruptions to India’s economic activity”, even in the case of sustained tensions.

However, there could be a fiscal cost to India, Moody’s acknowledged, noting that “higher defence spending would potentially weigh on India’s fiscal strength and slow its fiscal consolidation.”

India’s macroeconomic stability, bolstered by robust public investment and private consumption, remains intact for now, but prolonged tensions could still put pressure on its fiscal targets.

Pakistan is already walking a tightrope with the International Monetary Fund (IMF), and Moody’s fears the latest developments may derail progress on its reform agenda. The IMF’s executive board is scheduled to meet on May 9 to review the country’s performance under the ongoing $7 billion Extended Fund Facility.

In April, IMF staff reached a staff-level agreement with Pakistan for a $1.3 billion climate resilience loan spanning 28 months. If approved, it will bring total disbursements to $2 billion, including $1 billion under the existing bailout programme. But any instability or deviation from reform commitments could stall this funding pipeline.

According to the IMF, “Pakistan has made significant progress in restoring macroeconomic stability and rebuilding confidence despite a challenging global environment.” Finance Minister Muhammad Aurangzeb has assured the IMF that Islamabad remains committed to reforms, but that commitment may be tested as political and security tensions rise.

Once considered one of South Asia’s most promising economies, Pakistan is still grappling with the aftershocks of its worst financial crisis in decades. In the aftermath of the COVID-19 pandemic, a combination of poor governance, soaring inflation, and mounting debt brought the country to the brink of sovereign default in 2023. According to data from the State Bank of Pakistan and IMF country reports, inflation surged to a record 38.5 per cent in May 2023, while interest rates climbed to 22 per cent among the highest in the region. Foreign exchange reserves plummeted to just $3.7 billion, barely enough to cover a few weeks of essential imports. Meanwhile, the debt-to-GDP ratio hovered dangerously around 70 per cent, and between 40 to 50 per cent of the federal government’s revenues were being consumed solely by interest payments.

For nearly five years, Pakistan remained on the Financial Action Task Force (FATF) grey list, which significantly constrained its access to international financial markets. It narrowly escaped default in mid-2023 after securing a $3 billion Stand-By Arrangement from the International Monetary Fund, along with emergency financial assistance from Saudi Arabia, the United Arab Emirates, and China.

Investor confidence has taken a sharp hit since the Pahalgam attack. Between April 23 and May 5, the KSE-100 index has plunged by over 8,400 points, as traders brace for potential military escalation and further economic fallout. The sustained market meltdown reflects deepening anxiety over the Indo-Pak tensions, particularly amid fears that the crisis could derail Pakistan’s fragile economic recovery and jeopardize its upcoming IMF review.

The April 22 attack, allegedly carried out by Pakistan-backed militants, killed 26 civilians in Jammu and Kashmir. In response, India suspended the Indus Waters Treaty, halted trade via the Attari border, slashed diplomatic ties, and granted the military full autonomy to retaliate. Pakistan responded by suspending the 1972 Simla Agreement, banning Indian flights from its airspace, and terminating remaining trade links.

Moody’s geopolitical risk assessment emphasizes that flare-ups between India and Pakistan are not unusual, but warns that this time the stakes are dangerously high. While a full-blown war remains unlikely, even a localized conflict could derail Pakistan’s tentative recovery and send its economy spiraling once again.

With the IMF’s critical review just days away, Islamabad faces a dual challenge: navigating rising external pressures while staying the course on deep economic reforms. The world is watching, and for Pakistan, the cost of miscalculation could be economically catastrophic.