Friday, 18 September 2009

On Zubair's Reply--Rethinking Pakistan's economy

Thank you Zubair for a nice comment!

On the Tyranny of Macroeconomics

I have often lamented that we Pakistanis do not engage in civilized debate and too quickly get into the mode of “argument and personal attacks.” Zubair’s comment is heartening and welcome as an offer to expand a debate so that all of us can learn.

Zubair argues that “There is little doubt in the argument that unless macroeconomic conditions are right and sustainable, economic development cannot be maintained.” Frankly on the surface this statement looks like “motherhood and apple pie” but dig a little deeper and you begin to worry.

Think about it! Zubair’s statement can be rephrased in medical terms as There is little doubt in the argument that unless vital signs (body temperature and blood pressure) are right and sustainable, “life” cannot be maintained.” Does that mean that treatment should focus only on maintaining those vital signs without treating the underlying cause! Most of us know that if a patient has cancer or some serious underlying disease, the symptoms may show up in body temperature and other macro indicators but for a complete cure, the fundamental problem has to be addressed.

My point is that the fundamental problem is political economy and governance and without reform in those areas gains to macroeconomics may be temporary. So let me assure Zubair it is not that I wish for macro-profligacy, but that we should learn from the failed Fund strategy of the last 30 years where macro policy was the only objective. In fact the preoccupation with getting the macro numbers right, has hurt domestic governance and institutions. Case in point is the over-centralization of the economy and the excessive power to the ministry of finance. Macro-policy cannot be fixed without fixing policymaking, political economy and governance. This is the reason that I think that our continuous discussion on macro without looking at the micro determinants may be a mistake.

On increased taxation

Zubair goes on to say that “In this context, I fail to understand the merit of your criticism of improving revenue generation. Simply because the Shaukat Aziz administration squandered the increase in revenues does not make the proposed policy "wrong".” Again no one disagrees that the state should collect more revenues and our revenue GDP ratio must be in line with comparator countries. But with the current state of the civil service, the nature of the state and the elite, I find it difficult to hope for any success to this policy!

Moreover as I have argued frequently, modern fiscal theory regards taxation to be based on some form of a social contract. Governments tax in return for some service that they provide. And there is an expectation that government expenditures will be for the good of the people. My view is very simple that given the extensive misuse of expenditures for VIP pleasures (houses, cars, foreign trips), elite subsidies (gifts to the rich, elite Clubs, prime land, Polo, golf etc), false titles (meaningless cabinet positions, dead agencies), it is hard to justify revenue increases without a proper expenditure review and reform. I point out several areas such as government perks (repeat housing, cars foreign trips etc), elite subsidies (elite Clubs, prime land, Polo, golf etc), false titles (meaningless cabinet positions, dead agencies) where savings can be made and efficiencies achieved.

I also challenge the notion that Pakistanis are under-taxed! There are too many hidden forms of taxation that this ‘9 percent of GDP’ figure does not include. This is also an area we should debate. But I will not take that up here.

On attacks on economics

On whether the criticism was “flippant”, like any other subject economics learns from fresh data and the recent crisis has brought a lot of fresh data. Similarly the continual failure of fund program and donor programs should also teach us something.

It is not surprising that a lot of earlier wisdom has been called into question. Not only Krugman but Volker, De Long, and many other luminaries are questioning our state of knowledge. Yet economists carry the additional burden that the body public seems to feel adequately qualified to talk most authoritatively on economics. Indeed with the aid of a few well known World Bank/IMF statistics amateur economists love to tell economists off and offer big policy announcements.

Physicists have been quarreling over quantum mechanics and are now talking of strings with no real evidence to back them. Dawkins and Gould have argued on evolutionary biology in the harshest of terms. No one accuses them of ideological bias and no one suspects their motives. Yet if economics argue about monetarism or the role of government; it is time for all and sundry to pick on economists (nayyar ali).

Like any other subject economics is evolving science learning from observation and experimentation responding to evidence and anomalies with paradigm shifts and fresh theory. This “evolution’ and “paradigm shift” should not be seen as “ideology” and provoke accusations of “narrow focus”, ‘neo-liberal” and other such epithets. Debates occur in every subject and the best of them occur among the giants of the subject. Einstien and Neils Bohr had their differences, Wittgenstein and Popper did not talk to each other. I can quote many more.

Debates are never flippant and certainly Nobel prize winners like Krugman are not “flippant.” He has a serious point to make and we should be humble enough to be mindful of it even if it challenges our comfortable precepts based on many years of received wisdom!

On Conditionality

Zubair says that “"Conditionality" has been given a bad name by countries like Pakistan which have been able to break it and still continue to obtain financing.” This interpretation assumes that the donors are benign and also know what good conditionality is. There is much literature to suggest that conditionality itself if flawed. Even ex Fund members like Musa and Morris Goldstein have criticized conditionality. People like Conway, Killick, Easterly and Collier have conducted ample research on conditionality to even make the Fund change its mind.

Despite silly assumptions on economics, economic research has shown that for a country to change course deeper changes in behavior and institutions are required. Neither the design nor the method of implementation of those changes is immediately obvious. Should we assume that the donor has all the information and the capacity to make such deep changes in complex societies? Is it something that visiting teams can do in a short span of time? Are donor agencies totally altruistic and competent to make such reform? Will their own agendas and biases as well as career concerns not come in the way? Will such imposed reform be “locally owned?” Does change not have to made locally? If so why does it need to me envisaged globally?

Can you imagine doing the US health care reform through conditionality? Would the World Bank or the IMF be able to do it? There are a number of design issues involved which without local debate and research cannot be solved. There are political economy issues without which the reform will not be “locally owned”. So if it will not work for the US, why should it for Pakistan?

As I said conditionality is a complex subject and a lot has been written on it and many serious thinkers are now very shy of pushing it too hard!

On Solutions

Zubair then issues a challenge to me “I would encourage you to propose an alternative approach to addressing the economic problems that we are currently facing.” And of course we Pakistanis cannot miss an opportunity for making sarcastic personal remarks “ I am sure, after having spent almost thirty years advocating the IMF-supported adjustment programs, you have acquired the wisdom and experience to propound an alternative.”

I am sorry I have to disappoint you by admitting that I have no silver bullet no neat prescription that will make Pakistan rich country. My view is that any serious policy analyst or thinker will have to take this viewpoint. Countries are complex and changing the direction of their societies and economies should not be considered a cavalier proposition. Donor reports do not have complete solutions as well. If they did we would be a high income country by now.

I will be immodest enough to say that I have developed certain lines of thinking which if we begin to seriously develop may lead to better outcomes but that after a lot more work at both research and implementation. These are:

1. Governance related issues.

a. One important issue is civil service reform which I argue is central governance. Within civil ervice reform we have to get the strategy right and focus on perks. See PIDE Website has more material on this. (and this is certainly more than increasing salaries

b. You might also wish to look at issues of judicial reform that I have written about. Can send you a copy if you like.

c. One important forgotten area is the need for organizing religion. http://www.opendemocracy.net/article/how-to-solve-pakistan-s-problem

2. I have argued extensively that our growth strategy is deeply flawed as it remains steeped in yesterday’s thinking.. Growth strategy and Pakistan’s Economic Planning is being conducted on the ideas from thinking of the sixties and may be responsible for many of our problems. http://www.opendemocracy.net/article/how-to-solve-pakistan-s-problem

3. The stifling of our “domestic commerce” sector may be at the heart of many of our problems including slow growth and fundamentalism. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=986881

http://www.pide.org.pk/pdf/PolicyViewPoint/PolicyViewpointNo.1.pdf

4. Lack of knowledge of economic geography in our economic policy debate may be another reason why our cities lack the dynamism that could launch growth. http://www.pide.org.pk/pideweb/pdf/policyviewpoint/PIDE%20Policy%20Viewpoint%20(Urdu%20Version).pdf

5. I have also argued that is a fallacy to focus on sectors and “private sector development” without worrying about entrepreneurship. And what Pakistan lacks is entrepreneurship. http://ideas.repec.org/p/pid/wpaper/200729.html

Let me stop here. While I will not ever claim that I have anywhere near a solution, I have developed some thinking in a number of areas where further work may help develop policy ideas. That is all a researcher can do. A complete solution is not possible and we should not even look for it. We should look for directions of movement and along the path develop further solutions and hope development will emerge eventually (Easterly also argues for this approach).

However, I do think that we must also share a vision for Pakistan for debate and understanding or possible goals for us. For that reason I have written a vision for Pakistan. http://www.pide.org.pk/pdf/Highlights/vision2030.pdf

On engagement

So I hope Zubair that you will now not accuse me of not working on any solution or be sarcastic about my 30 years experience. It would be nice to engage on these issues meaningfully. In societies that developed, there was full and diverse intellectual engagement. Why is it that our society lacks engagement? Why is it that we wish to huddle in small select groups not on the basis of ideas but on personalities? Why is it that we do not cite each other or review each other’s work? On this issue, please see http://www.pide.org.pk/pdf/Sad_Plight.pdf

Wednesday, 16 September 2009

Zubair Iqbal's reply

ConYour comments, though oft-repeated, are valuable and should be considered for continued progress toward an alternative solution--if possible--for Pakistan's economic malaise.

There is little doubt in the argument that unless macroeconomic conditions are right and sustainable, economic development cannot be maintained. Hence, there is little merit is being flippant about macroeconomics, even by a Nobel laureate. I agree that one should not disregard the building blocks--which in cases such as subsidies to maintain a "wrong" exchange rate and promote protectionism are a cause of macroeconomic imbalances--but a tighter macroeconomic stance strictly adhered to, would force corrections to prices and, thus, help restore sustainable growth.

"Conditionality" has been given a bad name by countries like Pakistan which have been able to break it and still continue to obtain financing. I agree conditionality works only if strictly enforced--it is in the long term interest of the country as well as creditor countries. But so-called political realities get in the way--they are not a favor to Pakistan, they are a palliative which string the poor country along. I would rather have strict conditionality, in particular, by donor ,who should be ready to "walk away" if Pakistan is not willing to set its house in order. One conditionality that I would strongly support is linking disbursements by donors under the Tokyo Agreement to a permanent and durable improvement in tax revenue generation so that Pakistan will have the in-house capacity to finance its fiscal needs. This will not only strengthen its ability to face shocks, but also improve equity with sound economic development.

In this context, I fail to understand the merit of your criticism of improving revenue generation. Simply because the Shaukat Aziz adminstration squandered the incease in revenues does not make the proposed policy "wrong".

It is good to know that you consider the issue of poor governance as central to the malaise that we are facing. The question is how do you fix it--a slow process will get us nowhere as we are already lagging behind our competitors. I would like to see a dramatic--convulsive?--action to get the masses force a change in the attitudes of the ruling-- as you call it, rent-seeking-- elites. A confrontation with tax evaders could break the vicious circle, reduce the power of rent-seekers, and get a virtuous cycle moving.

I would encourage you to propose an alternative approach to addressing the economic problems that we are currently facing. I am sure, after having spent almost thirty years advocating the IMF-supported adjustment programs, you have acquired the wisdom and experience to propound an alternative.

Saturday, 12 September 2009

Comments on Zubair Iqbal’s “PAKISTAN’S CURRENT ECONOMIC CRISIS—AN IMPERFECT STORM"

Nice piece by Zubair! It is typical of most economic writing (other examples are Ashfaq and Meekal) in Pakistan which has now been conditioned to think “macro-first” ignoring the underlying micro and institutional problems.

Written in typical IMF fashion giving primacy to macroeconomics assuming that it is independent o political economy, institutions and governance. For example

“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. ???”

This is what Krugman calls the dark age of macroeconomics.

Failure of underlying institutions and lack of policymaking capacity can only manifest itself through poor policy choices. Add to that the deliberate attempt by the powers that be to destroy policymaking capacity (case in point Tariq Hasan at HEC in the earlier regime and K Mirza at CCP now), policy has to be inappropriate. So statements like “weakening of institutions ….(are) not an excuse for inappropriate policies” are difficult to understand. Later Zubair accepts this in a throwaway sentence (which we always use in bureaucracies to cover our back side).

“Finally, the deteriorating official capacity to formulate and implement effective policies has become a major impediment.”

I would argue that this is central to the issue and not a final footnote.

There is also a presumption that course correction in macroeconomics policy can be made in real time.

“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.”

As if in a few months the mistakes of the last 5 years could have been corrected. With the tax base eroded, an ongoing civil war, a judicial crisis and power shortages and global crisis, I think it is unfair to blame the new democratic government.

He is too kind to the earlier government when he says that the crisis began to show itself in 2006. Indeed the inappropriate policies were evident by 2004 when interest rate and exchange rate policies of the central bank were totally misguided and windfall of a rescheduling was wasted. These misguided policies were directly the result of the lack of capacity in the government. They genuinely did not understand! Some senior officials used to argue that we need expansionary monetary policy for growing the economy. They were also given the comfort by the “usual advisors” that short term macroeconomic stability backed by capital inflows will lead to long term gains. There was no need for fundamental reform because capital inflows will lead to growth. Recall our Banker PM used to shun learning and analysis publicly saying that he knew it all through his practical banking. He was also fond of telling stories on how full hotels were and was always publicly counting the megaprojects were coming in.

Most of the solutions proposed have been tried for many years without success. Surely that should tell us that something is wrong in our solution. Yes the donors and the “usual economists” want an increase in the tax/GDP ratio. And they have wanted that for the last 30 years. But this has not happened?

We are told that

“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.”

This assumes that when the government has additional resources, like it did in the 2000s when aid was increased, that it did use the expenditures wisely. People like Furrukh Salim and Shahid Kardar have documented the waste in government. Our leaders –both current and past—jet around the world as if they were on a frequent flier program costing the exchequer 4 billion rupees if he media is to be believed. VIP cavalcades expensive housing and many other government pleasures is what our expenditures are used for. Public sector perks account for 14% of expenditures larger than our outlays on education and health. Should we not look at these? Perhaps political economy requires that these should be addressed at the same time as a tax increase.

Finally Zubair acknowledges governance. Now he comes close to accepting the primacy of governance in determining economic outcomes.

“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.”

So where are the efforts to improve governance and policy capacity in governance? And what does he suggest other than an improvement in the tax/GDP ratio.

What should we do? He has a simple solution! More conditionality!

“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.

Is that not what we have been doing for the last 60 years! We have had a fund program based on conditionality for 20 of the last 30 years. World Bank ADB even DFID conditionality has been riding us forever. Remember IPPs social action. If conditionality were the answer, we should have arrived!

We need a separate discussion on conditionality which many of my economist friends who are advising the government from overseas now seem to be asking for. But certainly the onus should be on them to explain why we need more conditionality, why it did not work in the past (in both military and political governments) and why it will work now.

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.