Imbalances in the economy
By Aftab Ahmad Khan

Pakistan’s economy despite commendable growth in GDP during the period FY2003- FY 2007 at an average annual rate of 7.0 per cent per annum and an expected reasonably well performance in this behalf in the range of 6.6-70 per cent in FY08 is confronted with the heightened threat of macro-economic complications if prompt steps are not taken to correct the imbalances reflected in a significant savings-investment gap, worrying fiscal indicators, large external current account deficits and disturbing inflationary pressures.

Savings and investment rates in Pakistan are low (amounting to 18.0 per cent and 23.0 per cent of GDP in FY07 respectively) in relation to historical growth of the economy and relative to many low income countries. At these rates of savings and investment, it would not be possible to support future economic growth of 8 per cent per annum which is socially necessary. Efforts to maintain a high rate of growth without mobilizing more national savings would result in a rapid accumulation of non-concessional external debt with serious consequences for the balance payments position of the country in the not too distant future.

Various reasons have been put forward to explain Pakistan’s unimpressive savings performance. These include the large unorganized, or ‘black’ economy whose savings are not captured in official statistics, a feudal outlook characterized by wasteful expenditure and ostentatious living, a development strategy which has emphasized the production of consumer goods, a high population growth rate with a concomitant high dependency ratio, and the low level of per capita income.

The most frequently cited reason, is however, a culturally induced bias in favour of consumption. But while such a bias would affect the propensity to save, it cannot by itself explain all aspects of Pakistan’s savings performance and by constantly citing this factor, the importance of other determinants tends to be either disregarded or discounted. In our case, it is quite evident that inadequate returns on financial savings and unequal and inefficient distribution of credit have exercised an inhibiting impact on the process of savings and investment. Admittedly, the real rate of return is not the only determinant of savings, but the evidence suggests that it is a far more important factor than the bankers and policy makers have acknowledged for a long time.

The main imbalance between savings and investment in Pakistan arises in the public sector. A sound fiscal position has a crucial role to play in ensuring macro-economic stability, promoting sound economic growth and alleviating poverty. Mismanagement of fiscal policy often results in destabilizing inflation, devaluation of currency, high interest rates, inefficient investments and aggravation of poverty.

The over-all fiscal deficit annually averaged 7.0 per cent of GDP in the 1980s and 1990s. It was brought down to 4.3 per cent of GDP in FY07. In the current fiscal year (FY08) it has been targeted at 4 per cent of GDP. According to SBP’s First Quarterly Report for the current fiscal year on the state of the economy, the budgetary deficit is likely to be higher than the target if appropriate policy measures are not taken. In the first quarter of FY08, bank borrowing for budgetary support rose to Rs69.9 billion as against Rs34.5 billion in the same quarter in FY07.

The budgetary deficit in this quarter (Rs158.1 billion) increased to 1.6 per cent of GDP against the deficits of 1.0 per cent and 0.5 per cent during the corresponding quarters of FY07 and FY06 respectively. The revenue balance in this quarter moved to a deficit despite an increase of 22.3 per cent in total revenues compared to Q-I of FY07. This is a disturbing feature on the fiscal front, as Fiscal Responsibility and Debt Limitation (FRDL) Act binds the government to keep its revenue balance at least zero from FY08 onwards.

The higher fiscal deficit during Q I- FY08 is mainly attributable to an increase in total public expenditure-development as well as current.

Development expenditure grew by a massive 89.5 per cent, while the current expenditure registered a significant increase of 39.2 per cent compared to the same period in FY07.

The revenue collection at Rs312.6 billion during Q-I FY08 was no doubt impressive as it depicted a growth of 22.3 per cent over the corresponding quarter in FY07. Net tax collection by the Federal Board of Revenue (FBR), however, decelerated due to slower growth in direct taxes. Indirect taxes, on the other hand, registered a growth of 14.2 per cent during July –October FY08 as compared to 9.0 per cent in the same period last year. This increase is mainly attributable to higher import growth.

According to SBP data, government borrowings from the central bank as well as the commercial banks, totalled Rs243.9 billion between July 1, 2007 to January 6, 2008 as against Rs63.5 billion in the corresponding period of 2006-07.It is obvious that Pakistan has to take all necessary steps to avoid large budgetary deficits (more than 4 per cent of GDP); otherwise, as experience of a number of developing countries with large and growing fiscal deficits shows, we can easily enter into a trap wherein an upward spiralling cycle of inflation-devaluation, rising interest rates-higher wages and salaries-more inflation could have an adverse impact on growth and lead to large scale capital flight.

All this highlights the importance of a significant fiscal adjustment including a major resource mobilization effort and measures to control and rationalize expenditures, accompanied by steps aimed at improving tax administration.

A worrisome aspect of the current state of the economy is the firming up of inflationary pressures. Consumer Price Index (CPI) surged to 9.3 per cent in FY05. In FY06 and FY07 it was 7.9 per cent and 7.8 per cent respectively.

According to federal Bureau of Statistics (FBS), CPI inflation was recorded at 8.79 per cent in Dec. 2007 against its level in Dec. 2006. Food inflation was at the higher level of 12.21 per cent. FY08 CPI inflations target of 6.5 per cent is likely to be exceeded by around 2 per cent.

The persistence of uncomfortable inflationary pressures in the economy suggests that effective medium term policies to control these are necessary. These include maintenance of tight monetary policy, avoidance of high fiscal deficits, measures to enhance productivity, encouraging market competition and investment in food processing and storages.

The importance of keeping inflation low cannot be over-emphasised. An endemic rise in prices destroys the continuity of economic life and economic processes, the basis of contract, of foresight, of the incentive to work and save and invest, for it threatens a flight from money, makes organizes business like banking and insurance difficult, turns investment into a gamble, impoverishes body of persons who finance business and industry on terms of fixed return and others who depend on fixed incomes, renders cost and efficiency in business of little account, honesty of no meaning, thrift on longer a virtue but sheer folly and thus undermines the economic foundations of civil society and leads to ultimate collapse of the economy.

It is generally insufficiently appreciated that many of our social, political and administrative problems have their roots in the persistent rise in prices.

History tells us that countries in a state of inflationary ecstasy are generally prey to administrative breakdown, class conflict and disorder – the precursors of a totalitarian government.

Successful inflation control requires the determined pursuit of an integrated approach covering fiscal, monetary, commercial, exchange rate and income policies of the government as well as measures to check cost-push impulses stemming from infrastructure bottlenecks and imperfections of competition.

Aside from savings-investment gap, deterioration in key fiscal indicators, increase in inflationary pressures, the other significant imbalance pertains to the current external payments position of the country.

According to SBP, the current account deficit in our balance of payments in FY07 was US$ -7094 million. This deficit during July-October FY08 was $ -3071 million. The SBP very correctly warns that the current account deficit is quite high and may deteriorate further due to the rise in international oil prices and expected increase in competition in textile exports. The foreign exchange reserves of the country have also been under pressure and there has been a weakening of Pak rupee against the US dollar. The country’s over-all foreign exchange reserves declined form US$16.4 billion at the end of FY07 to $15.5 billion by December 12, FY08.

Pakistan’s foreign trade imbalance is disturbingly large. According to FBS, earnings through exports during July-December 2007, the first half of the current fiscal year, amounted to $8.70 billion – an increase of 3.7 per cent over the same period of the previous fiscal year. Import payments during July-December 2007 amounted to $16.95 billion, an increase of 13.8 per cent over the same period of 2006.

The weaknesses of Pakistan’s balance of payments stem from a narrow export base, large external debt service payments and unsatisfactory demand management which by stimulating domestic absorption curtailed the available surplus for exports.

By vigorously pursuing a policy aimed at efficient import substitution and enhancing competitiveness of our exports, it should be possible for Pakistan to strengthen its external accounts.

The rate of growth of our exports should be at least the same as the rate of growth of imports. For this purpose there is a need to establish a neutral regime vis-à-vis export promotion and import substitution. There is also a need for rationalization of exports. Furthermore, there has to be more emphasis on quality control of important export products as well as on strengthening the institutional infra-structure for exports such as credit insurance, trade fairs and export promotion council. These export promotion measures, of course, have to be buttressed by a supportive demand management policy.

Policies to rectify the current economic imbalances will yield positive result only in a milieu characterized by macro-economic stabilization. It is obvious that without prudent fiscal management and enforcement of austerity, the economy cannot be put on the path of sustained robust growth within the framework of a milieu characterized by financial and external sector viability. 

Courtesy: Journal of The Institute of Bankers Pakistan