Challenges to macroeconomic stability

By Zafar-ul-Hassan Almas

Pakistan’s economy is currently facing four major challenges, that is, deceleration in economic growth, unprecedented spike in inflation (particularly food inflation), a growing fiscal deficit, and the widening of trade and current account deficits. Among these challenges, fiscal, trade and current account deficits are largely the outcomes of external shocks of extra-ordinary proportions accompanied by policy inaction during most part of the outgoing fiscal year (2006-07). Fiscal and the current account deficits are intertwined and the result of many uncertainties surrounding the economy. The Federal Budget 2008-09 has failed to suggest policy measures to tackle the menace of widening twin deficits.

The deceleration of the economic growth is the culmination of many problems like poor performance of the commodity producing sector. The economic growth therefore decelerated to 5.8 per cent mainly because of the dismal performances of major crops such as wheat and cotton (together they contribute over 20 per cent and 4.2 per cent to agriculture and GDP, respectively) and the lackluster performance of the manufacturing, particularly large-scale manufacturing at the back of a series of domestic and external shocks (political instability, a worsening security environment, severe power shortages, weaker external demand and the rising cost of doing business).

The contribution to growth of 5.8 per cent mainly originated from the services sector which contributed 4.2 percentage points out of 5.8. Now when the financial sector has reached point of saturation and wholesale & retail trade sector showing signs of moderation, we expect some slowdown in the economic activity in the services sector. Thus Pakistan has to locate a new growth power house in the economy and the production sector is the prospective candidate for it. The production sector is crucial for generating employment and providing kick-start for investment cycle.

The greatest of the threats to macroeconomic stability is coming from ever rising inflation. Overall inflation, particularly food inflation, at 17.2 per cent and 25.5 per cent, respectively in April 2008 are the highest ever in over three decades. It is always difficult for policy makers to adjust inflation abruptly. The oversized spike in inflation owes to high global prices of food, fuel and other commodities driven by weaker Pakistani rupee; gradual removal of fuel, food and power subsidies; and monetary overhang on account of excessive borrowing from the SBP to finance fiscal deficit. These have been mainly responsible for sharp pick up in prices during July-May 2007-08. Inflationary pressure is not likely to ease, at least, in the next two / three years because the factors responsible for this year’s rise in prices will remain present with differing intensities. The weaker governance may likely to further the problem. The recent inflationary problem was the outcome of poor administrative grip over usage of extra-market procedures by unscrupulous elements.

The hard earned macroeconomic stability of the last five years or so was underpinned by stringent fiscal discipline. The developments in the out going fiscal year suggest that fiscal discipline is itself extinguishing because of the large slippages in the Budget 2007-08. As against the target of 4.0 per cent of GDP, fiscal deficit for the year is estimated at around 7.0 per cent of GDP. Slower-than-the targeted real GDP growth and the adverse law and order situation resulted in lower-than-the targeted tax collection. Failure to pass on the increases in the international prices of oil and food to domestic consumers severely affected current expenditures as the government continued to finance these increases through the budget, with subsidies rising to an unsustainable level. A subsidised power tariff also added to the slippages. The extra-ordinary increase in development spending was not consistent with a stable macroeconomic framework.

The increase in fiscal deficit coincided with a sharp build-up in the current account deficit which was aggravated by massive decline in the external financial flows. Previously, the debt creating and non-debt creating inflows in the financial account were more than off-setting the extent of the current account deficit and the overall balance remained in surplus since 2001. However, the year 2008 saw for the first time in recent year’s depletion of foreign exchange reserves to the extent of $4 billion. Consequently, the government was forced to rely heavily on SBP for budgetary financing. This has complicated further the monetary management in the country.

Government borrowing from the SBP has reached an all time high, leading to excessive monetary expansion and thus becoming one of the principal sources of inflationary build up in the country. In other words, financial indiscipline during the outgoing fiscal year has already caused severe macroeconomic imbalances, for which, Pakistan is likely to pay a heavy price in terms of deceleration in growth and investment, and the associated rise in poverty; the widening of current account deficit and the attendant rise in public and external debt; a loss of foreign exchange reserves and the associated pressure on the exchange rate, and most importantly, higher inflation and the accompanying rise in the interest rates. There is no better way to explain the central importance of fiscal discipline in promoting growth and investment. The era of fiscal profligacy that spearheaded the down fall in the 1990s, seemed to come back on the forefront. Fiscal year 2007-08 has reminded us clearly that even one year of fiscal indiscipline is enough to damage several years of efforts to restore macroeconomic stability. The political leadership should bear in mind that this situation could not last longer and if it does so, the day of reckoning would be at arms length.

The slippages in the fiscal account as well as the unprecedented rise in the prices of oil and food items have contributed to the widening of both trade and current account deficits. The current account deficit during the first eleven months of the fiscal year (July-May) amounted to $ 13 billion – up by 80 per cent over the same period last year. The impact of the rising current account deficit on the country’s overall balance of payments was further compounded by a decline in financial and capital account flows on account of a drop in net portfolio investment, delays in the planned floatation of a Sovereign Bond and Global Depository receipts (GDRs) and putting on hold the floatation of an Exchangeable Bond. Accordingly, the overall balance of payments is in deficit which is partly financed through reserves draw-down. Such a large current account deficit is not sustainable and has detrimental effects for macroeconomic stability in the country.

Now it is time to have really serious thinking about these striking problems because these four problems collectively has the full potential to destroy strongest of the economic fundamentals in the world in just one or two years. One year of policy inaction and complacency is already ended without any positive note but if the situation prolonged into the second year, it would be disastrous. We want macroeconomic stability for political stability and prosperity in the country. Good governance and professional management is the universal recipe for all sort of problems. The same recipe could be replicated in our system and surely it would give very good result. Macroeconomic stability is crucial for job creation, investment promotion, productivity enhancement and many positive things. For prolonged period of macroeconomic stability we also need food and energy security. The government has already formed a task force for food security and we also need a task force for energy security. Our focus should be sustainable quality growth, lower and tolerable inflation, moderate fiscal and current account deficits and exchange rate stability. These are ingredients for macroeconomic stability and economic well-being.