Saturday, 12 September 2009

PAKISTAN’S CURRENT ECONOMIC CRISIS—AN IMPERFECT STORM

Prepared by

Zubair Iqbal

Retired Economist IMF, Current Adjunct Scholar MEI (Middle East Institute, Washington, D.C.)

The current economic crisis in Pakistan can be traced not only to the continuation of inappropriate macroeconomic policies but also to a sudden and debilitating weakening of the international economic and financial environment. Given the weaker domestic economic foundations, Pakistan’s economy was more seriously affected by external forces than its competitors. Interestingly, the issues—sharply declining growth, rising unemployment, increasing poverty, high inflation, and widening external imbalances—are easy to grasp, policy options to address them are also not difficult to articulate, but there is seemingly a singular lack of will to implement the needed reforms in a timely fashion. In particular, political inaptitude, lack of national consensus on economic objectives, and a continued misreading of the depth of challenges faced by the economy-- in the face of a worsening security situation-- have compounded the crisis. Although, recently there has been some recognition of the underlying problems, the authorities are seemingly unable or unwilling to take the bull by the horns. Hence the deepening vicious circle—inaction and declining ability to act feeding on themselves-- militating against corrective action.

This note aims at analyzing factors underlying the recent economic deterioration, assessing the current situation and future outlook, identifying the needed policy reforms, and suggesting ways to break the vicious circle.

WHAT WENT WRONG?

It has become fashionable to trace the current economic malady to “wrong” growth strategy of the past 60 years. This is neither meaningful nor helpful in understanding the current policy imperatives. Yes, there has been a secular weakening of institutions but that is not an excuse for inappropriate policies. Pakistan’s economy has typically gone through “booms and busts” as policies have not been changed expeditiously to respond to changing conditions. The current crisis is a link in the same chain—albeit, more serious because of the deeper international economic downturn.

It should be recognized that, during the 1990s, some reforms were undertaken with financial support of multilateral lending institutions—IMF, World Bank, Asian Development Bank--, imperatives of a globalizing world economy, and shrinking access to global savings (both from official and private sources). Although many of these reforms were haphazard, the economy had experienced some important structural changes. Steps had been taken to conform prices of publically supplied goods and services, including the exchange and interest rates, to market conditions and to reform the financial sector. Steps had also been taken to get budget outlays under control by reducing some subsidies and improve tax administration. During 2002/03-2006/07, as the external resource pressures were eased (through debt relief, and restoration of external private capital flows), these reforms were instrumental in allowing the expansionary policies of the previous government to generate a temporary surge in growth. At the same time, improved external environment and domestic political stability facilitated effective private sector investment decisions which contributed to an improvement in factor productivity.

However, higher spending in the face of limited production capacity and primary focus on credit-financed consumption and imports, led to a re-emergence of macroeconomic imbalances. External current account deficit started to widen as export growth slowed and dependence on uncertain external private capital inflows grew. Concurrently, private sector investment stagnated while public sector investment was not adequately focused on addressing the looming shortages of infrastructure (particularly, energy and water) and improving competitiveness. Fiscal deficits started to widen and—combined with an overly expansionary monetary policy—inflation started to increase briskly, which also appears to have worsened income distribution and reversed progress in reducing poverty. Notwithstanding large capital inflows over this period, the economy had not deepened enough through investment in productive capacity to withstand external and internal shocks.

    By the end of 2006, there was firm evidence that continuation of the ongoing policies would be counterproductive. The authorities initially misread the emerging situation and no timely corrective action was taken. And then the crisis of judicial independence erupted, which with elections looming, drastically reduced room for politically unpopular steps, including mobilization of revenues and rationalization of expenditures. It also appears that the private sector lobbied for increased subsidies and maintaining expansionary policies characterized by increasingly negative real interest rates and an appreciating rupee. As export competitiveness declined, official subsidies to the manufacturing sector were increased rather than adjusting the exchange rate, further worsening the fiscal position without benefiting exports. In the event, national savings fell further and the corresponding external current account deficit rose, putting pressure on foreign exchange reserves and the exchange rate. There was little cushion left to “finance” the way out of the looming crisis.

The deteriorating economic situation was dramatically worsened by the sharp increase in world oil and food prices in 2007/08, the worldwide financial crisis, and the subsequent global economic contraction. The authorities’ decision not to immediately pass on the higher prices and recourse to printing money to pay for the burgeoning government expenditure—a politically expedient ploy— meant a further reduction in external reserves and escalation of domestic inflation. Exports slumped while the import bill rose sharply, and capital inflows fell on account of global economic slowdown and political uncertainty in the country. It should be emphasized that the impending economic crisis would have happened even if oil prices had not gone up; it simply brought the underlying unsustainability of policies to the fore sooner and more dramatically.

Not surprisingly, growth fell in 2007/08 to about 4 percent from an average of over 6 percent during the previous four years. Budget deficit shot up to almost 7 percent of GDP as revenues declined by more than one percent of GDP and expenditures rose by about 3 percent of GDP. With a sharp increase in money supply as the deficit was financed mainly by borrowing from the State Bank of Pakistan, inflation more than doubled to about 22 percent(end-of-year basis). Reflecting, in part, the dissavings at the government level (rising fiscal deficit), overall national savings fell to an all-time low of less than 14 percent of GDP. Although investment fell slightly, the saving-investment gap rose sharply to an unsustainable level of over 8 percent of GDP with a corresponding increase in external current account deficit. In the process, gross foreign exchange reserves fell to the equivalent of less than three months of imports—a dangerous level, indeed, for Pakistan’s economy in the deteriorating global environment.

Problems were compounded by a total disregard of economic crisis by the new government in the initial period; valuable time, during which the crisis could have been staved off, was lost. On the other hand, Pakistan’s competitors took early corrective policy steps and established a solid basis to bounce back once the current global downturn is reversed. The volatile political and security situation continued to undermine economic confidence and militated against early corrective policy response.

PRESENT SETTING—GLASS HALF EMPTY

By mid-2008, Pakistan was confronted with a moment of truth. Its approach to the so-called “friends” for emergency assistance had failed and it had to seek financial support from the IMF to support its economic program in order to stave off further deterioration, stabilize the economic situation, and to lay down foundations for sustainable recovery. Although the program underlying the arrangement with the IMF is quite mild given Pakistan’s economic situation, its implementation so far has been inadequate.

The present economic position is somber and highly vulnerable to internal and external shocks. Reflecting energy shortages, inefficiencies in the large scale manufacturing, poor export performance, and credit restraints, the real GDP growth is estimated to have fallen to about 2 percent in 2008/09. While national savings showed a modest increase, investment remained low and underpinned the low growth of GDP. The fiscal deficit at an estimated 5 percent of GDP is significantly higher than the official target. Only a part of the deterioration can be explained by unbudgeted outlays on internally displaced persons. Revenue collection has declined further as tax evasion has reached an all-time high. With monetary expansion contained, inflation has fallen but remains unacceptably high at 13 percent with serious implications for the standard of living, poverty, and income distribution. Core inflation remains prohibitively high at about 16 percent.

The external position of the economy improved on account of a sharp drop in imports ( by 10 percent) on account of lower oil prices and continued increase in workers’ remittances. Exports, on the other hand, declined by 2 percent as traditional exports, such as textiles, plummeted reflecting declining competitiveness and a stagnant world economy. Moreover, reflecting political uncertainty and security concerns, net capital inflows fell by about $3 billion (by 40 percent) over the previous year. While external reserves were built up through IMF financing, exchange rate weakened further in line with the market conditions as the State Bank of Pakistan showed “flexibility” about its level. However, the financial sector showed signs of increasing stress as the share of nonperforming loans increased under the weakening economic conditions.

The near- and medium-term outlook, under the current policy stance, remains difficult and vulnerable to a number of external shocks such as oil price increases, potential political instability, and the regional security situation. Weaknesses in the infrastructural capacity will also continue to constrain growth.

The latest IMF forecasts show that even if energy shortages were to be adequately addressed and the fiscal position is less onerous than in the recent past, growth will recover only modestly to about 3 percent in 2009/10 because of the negative effects of global economic stagnation, little pick up in domestic investment, and continued insecurity. If adequate restraint is maintained against bank financing of the budget, global oil prices do not increase significantly, electricity tariff rates are increased gradually, and monetary policy is not eased prematurely, inflation can be expected to decline to below 10 percent in 2009/10. The external position will also improve only marginally.

These outcomes, however, will critically depend upon the maintenance of a tight fiscal position which will, above all, call for an acceleration of tax reform effort so as to generate a significant increase in revenue in 2009/10 and sustained into the medium term. At present, given the political uncertainties, it is unclear whether the authorities will be able/willing to implement difficult, but necessary, reforms in the tax system, reductions in direct and indirect subsidies, and the needed control on provincial outlays. It also presupposes that any shortfalls in donor disbursements under the Tokyo Agreement will not be made up through domestic financing. In this context, it is unclear as to whether the recent reduction in interest rates was opportune. In the event of an expansionary fiscal stance supported by an easy monetary policy, the authorities will have to accept a further weakening of the rupee.

Medium-term growth will remain hostage to low domestic savings and investment, reaching the 6 percent a year level—average rate of growth registered during 2002/03-2007/08—only in 2014/15. In the event, given the expected population growth, income per capita would increase only marginally over the next 5 years and poverty would remain high. Given the head start that other countries in the region and other competitors have over Pakistan, such a development will put Pakistan behind them by about a decade! Political ramifications of such a development are not hard to grasp.

WHERE DO WE GO FROM HERE?

Pakistan is presently encountering a dual problem: macroeconomic imbalances and inflationary pressures arising out of a dysfunctional fiscal system supported by a compliant monetary policy stance; and low domestic savings which, given the present outlook for capital inflows, are inadequate to sustain a level of investment needed to achieve a high growth rate over the long run that will be necessary to reduce poverty without inflation and with debt sustainability. It is worth noting that average savings in countries in the same income category as Pakistan are significantly higher than in Pakistan; for example, India’s savings rate is about 30 percent as compared with 14 percent in Pakistan! Over the past year, the apparent shortage of energy has also added to the gravity of the two fundamental problems identified above.

These are inter-related problems and have to be dealt with under a comprehensive reform program. Primary factors underlying these challenges are: low level of revenue mobilization and out of control expenditures, policies discouraging improvement in productivity in both agriculture and manufacturing; and large implicit and explicit subsidies (estimated as equal to about 4 percent of GDP) which are needed to sustain certain inefficient private manufacturing activities—these subsidies increase budget deficit, reduce savings, allow the maintenance of prices such as exchange and interest rates out of line with market conditions, and promote speculative activities. Moreover, inappropriate sector-specific policies have continued to misallocate resources. Finally, the deteriorating official capacity to formulate and implement effective policies has become a major impediment. Above all, there is no convergence between the interests of the ruling elites and the masses—this lack of national consensus has resulted in a policy gridlock. Inaction has continued to build upon itself, fueling corruption, thus progressively reducing the effectiveness of policy responses.

The policy stance should be shifted to rebalance growth from the past heavy dependence on consumption and imports to higher investment and exports. This will call for not only fundamentally correcting the macroeconomic imbalances, but also sustainably and significantly increasing savings, reducing dependence on uncertain foreign capital inflows, and redirecting foreign and domestic investment to export-oriented activities. It is to be hoped that foreign capital inflows would eventually resume as the economy returns to a sustainable path. Of course, a significant reduction in insecurity will be a pre-condition for the success of the proposed policy reform. While a full implementation of the current adjustment program which is supported by the IMF should help get over the short-term macroeconomic crisis, there will have to be a paradigm change in the philosophy underlying Pakistan’s development strategy.

Without fundamental reforms of the fiscal sector aimed at raising domestic revenues and increasing room for outlays to improve the abysmally poor infrastructure—energy, education, water resources, R&D in agriculture, and transportation-- any sustained improvement in growth outlook is unrealistic. Any attempts to increase domestic spending through bank financing will reignite inflation, destabilize exchange rate, encourage uncertainty, and promote capital flight, thus worsening the already fragile situation. The recent easing of monetary policy should therefore be revisited to ensure that it would not compound the effects of the current expansionary fiscal policy. Finally, a sharp increase in reliance on external capital to compensate for lower domestic savings will not only increase cost of financing, but also weaken debt sustainability, thus hurting the longer term outlook for growth.

It is critical that early steps are taken to reform the tax system. In particular, the planned VAT tax should be implemented in 2009/10 while tax administration is improved to at least reduce tax evasion which, at present, is an endemic problem. New avenues for additional taxation and a more equitable sharing of burden should be seriously considered; agricultural income, real estate, and capital gains are readily available avenues. It is critical that steps be taken to ensure that the elites—which have been notorious and brazen in not paying taxes—step forward and settle their liabilities. If necessary, major tax evaders should be given exemplary punishment. Such an action could break the gridlock that has paralyzed effective policy actions so far. Official external financing could also be made conditional on steps to improve revenue mobilization over a defined 2-3 year period. It is worth noting that at 9 percent of GDP, tax revenue in Pakistan

is one of the lowest in the world and well below the average level for economies in the same income per capita range as Pakistan.

Delays in implementing the critical energy sector reforms will not only drain the budget through subsidies, but also hurt the medium term growth prospects. It is necessary to determine whether it is a problem of low tariffs or of electricity theft—the latter could not be solved through increases in tariffs. Closely associated with the energy issue, and of fundamental long term importance, is the issue of emerging water shortages which would have debilitating effect on agriculture. Major investments are needed to drastically improve water supply and irrigation so that agricultural growth could underpin long term growth and food security without which political stability could not be ensured.

While the near-term savings-investment decisions can be influenced by changes in the budget and monetary policy, the longer term savings-investment patterns are primarily structured by the relative openness of the economy, policy biases for allocation of resources, and the ability of the financial sector to attract, mobilize, and allocate savings—both domestic and foreign. In Pakistan, non performing loans have started to increase significantly on account of excessive and speculative lending in the recent past, and the sharp economic slowdown. Moreover, the large interest rate spreads have encouraged capital flight and disintermediation. Bank regulation and supervision need to be strengthened. Increased competition in the financial sector would help resource mobilization and allocation.

Some of the critical prices, such as the exchange rate and the interest rate structure, have been distorted to support private sector activity which, in turn, have raised subsidies and perpetuated inefficiency in resource use. This is an opportune time to correct such prices, particularly the exchange rate. It is critical that Pakistan’s export competitiveness is restored so that it is ready to compete when the world market emerges from the current contraction. While the rupee has depreciated in nominal terms over the past year, it is unclear whether the level is consistent with the expected external current account deficit. Given the lags in response to the exchange rate correction, an early action would be highly desirable. Such an action will provide the much-needed space and time for the authorities to put in place structural reforms that will be needed to sustain the required export-orientation of the economy.

GOVERNANCE?

None of the proposed reforms will make any headway without a dramatic and sustained improvement in governance—not simply in terms of formulation of policies and strengthening of institutions to implement them. At the core, there is a need to develop the national consensus on economic challenges faced by the country and proposed solutions, and for all actors—political parties, military, civil society, elites, and the masses--to buy into it. At present, such a consensus does not exist. The ruling elites do not seem to fully grasp the enormity of the crisis and are therefore more interested in seeking external financing to “finance” the way out of the problem—as in the past—rather than face it heads on.

At this juncture, the donor community can play a critical role to forge the needed consensus. It is critical that donor financing must be conditional in order to ensure that Pakistan takes painful, but necessary, steps that are needed for it to durably ensure growth and thus eliminate the need for global handouts every so many years. One way would be for such assistance to be tied to reform programs agreed with multilateral lending agencies.