Pakistan's balancing act: Iran FTA vs US alliance

Amid concerns about potential sanctions from the US, Pakistan and Iran are on the verge of finalising a Free Trade Agreement (FTA). The two nations had signed a Preferential Trade Agreement (PTA) in 2004 and are now seeking to bolster their economic cooperation. Pakistan, known for its home textiles, exports ready-made garments (RMG) as well as home textiles in some quantities to the sanctioned oil-producing nation and stands to benefit from further expanding trade ties. However, such an agreement will likely come with specific terms and conditions.

Enhancing trade cooperation

Bilateral trade between Iran and Pakistan has historically been volatile due to the sanctions on Iran by UN and various countries like the US and the UK, and the souring of bilateral relations between Iran and Pakistan. Despite these challenges, the trade relationship has experienced notable growth, with a significant 33.33 per cent increase observed between 2022 and 2023.

Figure 1: Bilateral trade between Pakistan and Iran (in $ bn)

Source: Ministry of Foreign Affairs, Pakistan

Trade between Pakistan and Iran is mainly concentrated on textiles, with Pakistan exporting a modest amount of home textiles to Iran. However, overall exports from Pakistan to Iran remain relatively low. The primary objective of the deal is to significantly enhance economic cooperation between both nations. During Iranian President Seyyed Ebrahim Raisi's recent three-day visit to Pakistan, he and Pakistani Prime Minister Shehbaz Sharif committed to raising their annual trade volume to $10 billion within five years.

Reaching this ambitious target will require a compound annual growth rate (CAGR) exceeding 10 per cent, a goal that both nations intend to pursue despite the sanctions imposed on Iran.

Unlocking mutual benefits in trade and economy

Pakistan stands to gain significantly from trade, particularly in the textile sector. Under the PTA, textiles benefit from a reduction in the Customs Broker Duty, ranging from 10 to 20 per cent, and a relatively low tariff of around 4 per cent. This potentially enhances the competitiveness of textile exports.

However, the most significant benefit lies in accessing gas and energy resources from Iran. The gas pipeline project, initially agreed upon in 2009, could provide substantial relief to the struggling Pakistani textile industry, which faces a severe crisis due to soaring energy prices. Iran, too, would benefit, as its exports are limited due to sanctions. With the Pakistani government implementing austerity measures and reducing energy subsidies, the manufacturing sector is under increasing pressure. Completing the gas pipeline from Iran could alleviate some of these challenges by providing a more stable and affordable energy source for industries like textiles.

With the prospective FTA, along with the liberalisation of goods entry, Pakistan stands to benefit from a reduction in overall energy prices, which have been a persistent challenge since 2022. According to the International Energy Agency (IEA), Pakistan allocated substantial subsidies in 2022, amounting to $7 billion for electricity, $9 billion for oil, and $11 billion for gas. However, in pursuit of economic stability, these subsidies must be reduced, leading to higher per-unit prices for gas in Pakistan.

Currently, the general industry pays approximately $7.72 per million metric British thermal units (MMBtu) for gas, while export-oriented industries face a higher charge of around $9.87 per MMBtu. The gas pipeline holds the promise of mitigating these pressures by facilitating access to more affordable energy sources, potentially easing the burden on industries grappling with high energy costs.

Figure 2: Sector-wise gas prices in Pakistan in February 2024 (in $ per MMBtu)

Source: S&P Global commodity insights

Rising gas prices and power shortages pose a significant threat to Pakistan's textile industry, jeopardising its export competitiveness and potentially triggering a major downturn. Textiles already represent a substantial portion, around 59.52 per cent, of Pakistan's total exports. However, the impending FTA and the completion of the gas pipeline could offer a lifeline to the sector. These developments have the potential to alleviate cost pressures, enhance production efficiency, and bolster export capabilities within the textile industry. By providing access to more affordable energy resources, the FTA and the gas pipeline offer promising prospects for sustaining and even expanding Pakistan's textile exports, despite the current challenges.

Figure 3: Group-wise share in Pakistan’s exports in 2022 (in %)

Source: Pakistan Bureau of Statistics

Iran's proposal for expediting the completion of the gas pipeline holds the promise of enhancing the competitiveness of Pakistan's textile sector. A direct pipeline from Iran to Pakistan would effectively reduce the cost of gas, consequently lowering the overall production costs for industries reliant on this energy source.

Moreover, the FTA between Iran and Pakistan presents an opportunity for Pakistan to expand its textile exports to a market where Pakistani textiles are in high demand. However, it is crucial to acknowledge that such agreements come with their own set of costs and risks. Pakistan may find itself navigating delicate diplomatic waters, potentially straining relations with existing allies in the process. These geopolitical considerations underscore the need for Pakistan to carefully weigh the economic benefits against potential political repercussions in its pursuit of a smooth economic future.

Pakistan's dilemma

Pakistan's foremost partner in foreign trade and economic benefits is undeniably the United States. As a key destination for Pakistani exports, the US plays a pivotal role in Pakistan's economic landscape. In 2023, Pakistan exported goods worth $6.28 billion to the US, reflecting a modest growth of approximately 3 per cent.

Furthermore, the US is one of the largest sources of foreign direct investment (FDI) for Pakistan, further solidifying their economic ties. Consequently, for Pakistan, navigating the prospect of signing an FTA with Iran represents a delicate balancing act, as it seeks to advance its economic interests without jeopardising its relationship with the US.

Figure 4: Pakistan’s exports to the US (in $ bn)

Source: ITC Trade map

In 2022, nearly 85 per cent of Pakistan's total exports to the US comprised textiles, with apparel and home textiles making up a dominant 80 per cent within that category. Given this heavy reliance on the US market, upsetting US is not a viable option for Pakistan. However, Pakistan seeks relief from high gas prices to ensure the sustenance of its export-oriented industries like textiles, which is why it aims to enhance trade ties with Iran.

Despite these aspirations, the US has issued warnings of potential sanctions on Pakistan should it pursue a trade deal with or deepen involvement with Iran. Therefore, Pakistan finds itself in precarious waters.

Figure 5: Pakistan’s textile exports to the US (in $ bn)

Source: ITC Trade map

This gives rise to the question: Will Pakistan go ahead and sign the FTA with Iran? The robust opposition from the US to Pakistan signing this FTA adds layers of complexity and potential delays to the process. Despite Pakistan's aspirations to successfully sign the deal and revive the stalled construction of the gas pipeline, which has languished for 15 years, the looming threat of US sanctions casts a shadow over the entire endeavour.

Moreover, the reluctance of banks to engage in transactions with Iranian firms, driven by the fear of facing US penalties, further complicates matters. Consequently, the realisation of the FTA and the completion of the gas pipeline may be prolonged, potentially spanning several years. Considering these challenges, Pakistan may need to explore alternative avenues to diversify its trade relationships and mitigate the risks associated with its reliance on the US market.

ALCHEMPro News Desk (KL)