Pakistan’s economic crisis

The economic losses incurred on account of terrorism, by all accounts, pale in comparison to what the country has received in terms of aid. Thus, since 2008, with only a brief period of respite, the economy has been buffeted by an unprecedented succession of adverse shocks that has pushed the economy into the grip of “stagflation”

It is fairly common for the Pakistan media to describe the economy as being in a “crisis” or “bankrupt”. Even professional economists, who should know better, enjoy tossing those words around with a casualness that is unbecoming of the profession since it only serves to heighten uncertainty. So, it is well to ask, is the economy in crises and/or bankrupt?

An answer to this question is only possible if we look back at recent economic performance and evaluate it. Since 2008, the economy has been through extraordinary difficult times. A confluence of unforeseen, negative exogenous domestic and external shocks has posed a huge challenge for policy-makers. The starting year 2008 was not a propitious one. Externally, it marked the beginning of a severe financial crisis resulting in “The Great Recession” in the US and its spread through contagion-effects throughout the world. In the run-up to that crisis, global prices of commodities, especially oil, rose exponentially. The domestic economy was already under immense strain reflecting the lagged effects of the overly-expansionary macroeconomic policies of the previous government. The fiscal and external deficits had widened and inflation, already high, was accelerating. The severe external terms-of-trade shock (changes in the ratio of the price of Pakistan’s exports relative to imports) that impacted the economy proved to be a mortal blow. It swelled the fiscal deficit as the high price of imported oil was not passed-through to the end-consumer. On the external side the soaring unit price of oil and strong import volume growth caused the deficit to rise to an unprecedented 8% of GDP. Headline inflation hit an unheard-of 27% while “core” inflation also soared to new high of 18%. Not surprisingly, real economic growth received a serious set-back.

To be sure, there were policy mistakes. The worst mistake was policy paralysis which manifest itself in denial and dithering. The new government seemed overwhelmed by the rapidly unraveling economic situation and looked around desperately for easy options. A new concoction called “Friends of Democratic Pakistan” appeared, lending to the naïve expectation that it would help Pakistan with quick-disbursing, free and unconditional aid. Whether contrived or spontaneous, the government’s decision-making skills were further clouded with headlines in the press that should Pakistan turn to the IMF for balance of payments support there would be a “social holocausts” in Pakistan.

Bereft of ideas and gullible friends, Pakistan did finally turn to the IMF. However, postponing this decision till the bitter end only made the imbalances more severe and the needed adjustment measures more painful. An earlier recourse to the Fund would have meant a shallower down-turn and a smaller loss of output and employment.

The stabilization phase has generally worked well and swiftly in Pakistan. However, given the depth of the imbalances that had been built-up, the turn around this time was slower and more prolonged. Nevertheless, economic growth started to pick up and inflation fell sharply and at one point touched single-digits. Confidence came back, there was some evidence of reverse capital flight and the rupee stabilized. The IMF’s “catalytic” role opened the doors to new aid flows and gross foreign exchange reserves started the long climb back to more comfortable levels, bolstering market confidence. Although fragile, the economy seemed to be on a path of recovery.

The economy’s upward trajectory was soon interrupted by a new shock, the “Mother of All Floods” and the entire macroeconomic framework unraveled. Spending, especially development spending was slashed and re-directed towards rehabilitation and renewing damaged and destroyed capital stock. Fresh taxes were imposed to finance this rebuilding. The GOP-IMF program, despite having “accommodated” the shock with a higher deficit ceiling, started to slip with missed targets becoming commonplace suggesting either a loss of focus or that “adjustment fatigue” had set in. Nevertheless, given the wide swath of destruction caused by the floods, year-on-year growth of 2.4% could be said to be a not entirely unhappy outcome when most observers thought that the economy would actually contract. The biggest casualty of the floods was inflation with the headline rate being driven by food inflation, reflecting supply-side disruptions in production, marketing and trade of food items.

If we superimpose on these developments the on-going negative effects of crippling power outages and domestic shocks emanating from terrorist activities, it should hardly surprise that private investment, typically the main driver of growth in Pakistan, has fallen to levels not seen in decades. The Economic Advisor’s Wing of the Ministry of Finance calculated that the power crisis had shaved off as much as 2% off economic growth. There are no estimates of the cost to the economy from adverse shifts in the external terms-of-trade but the losses are likely to be very significant. The economic losses incurred on account of terrorism, by all accounts, pale in comparison to what the country has received in terms of aid. Thus, since 2008, with only a brief period of respite, the economy has been buffeted by an unprecedented succession of adverse shocks that has pushed the economy into the grip of “stagflation”, defined as below-trend GDP growth and high inflation and unemployment.

Most will agree that the conduct of macroeconomic policies in Pakistan in recent years has been lackluster and inconsistent. The initial progress under the GOP-IMF arrangement gradually gave way to the all-too-familiar pattern of “start-stop-adjustment”. Fiscal deficit reduction all but stalled as tax revenue failed to keep up with spending demands and rigidities in the structure of spending. The rising price of imported food and oil this year, which harks back to the crisis year 2008, has ominous implications for headline inflation going forward. Two successive wage increases of 50% and 15% while aiming to provide “relief” could turn out give an unwelcome impetus to wage-push inflation.

Much has been written about the new budget for 2011-12. A non-charitable view is that it is “non-serious” and was made by masters of obfuscation and “window-dressing”. A more charitable view would be that the budget, while falling short of what was needed and engaging in a bit of poetic license with the numbers, strives to make the best of a bad hand of cards. It has also tried to please many people even if it has pleased no one in the end. The much-hoped-for drive against the rich has turned out to be a bit of a damp squib raising questions about the achievability of Rs 50 billion coming from “administrative improvements”. Even if the tax revenue target is met, something which is far from assured, the tax-to-GDP ratio is unlikely to rise to more than 9.3% of GDP in 2011-12, which would mark another year of woeful implementation of tax administration by the FBR. Externally, the global economy is becoming inhospitable with risks tilted on the downside. The US recovery appears to have hit “a soft patch” and there are growing concerns of a US debt-default unless the debt-ceiling is raised by August 3, 2011 while Europe faces a sovereign debt crisis with Greek bonds trading lower than Pakistan’s. Asian countries are tightening policies in an attempt to attenuate overheating pressures and there is unease that China, the world’s second biggest economy, could be heading for a “hard-landing” because of over-investment. None of these developments will be helpful to Pakistan.

Our exports have done well in FY11 mainly because they have been riding the crest of high global unit prices; however, there are already signs that the crest has peaked. The only remaining unknown that has, along with exports, helped achieve an end-year current account balance of payments surplus is the mysterious and seemingly unstoppable surge in workers’ remittances. But few would want to hazard a guess about remittance inflows going forward. Some economists suspect that the wall of “hot” money flowing into Asia in search of better yields is also coming into Pakistan via the remittance channel since no questions are asked and no taxes are paid if these inflows are remittances. Others give credit to the State Bank’s “Remittance Initiative”, while still others point to ‘round-tripping’ and money laundering. There is probably some truth in all these hypotheses.

How well the 2011-12 budgets are implemented in the period ahead will, to state the obvious, be crucial. However, Pakistan’s recent track-record in budget implementation has not been inspiring with annual slippages of 2-2.5% from target becoming the “new normal”. The provincial budgets have disappointed again having failed to generate a surplus of about 0.6% of GDP in the aggregate as expected and agreed to in the NEC. Thus, like last year, the macroeconomic framework is already off-track -- although it is still salvageable. Both the federal and provincial governments have built in sharply rising development spending levels which, even allowing for the low base, seems to be overly-ambitious. There would appear to be an attempt to inject a fiscal stimulus into the economy even though the room for such a stimulus is highly circumscribed by the over-arching need for a tight fiscal stance to bear down on inflation. It is possible the authorities have taken this risky gamble to offset falling private investment as private investors stay on the side-lines in a “wait-and-see” mode. Should the development spending-led fiscal stimulus fail to durably boost the economy and fiscal slippages (re)occur because of spending rigidities elsewhere, it will only squeeze the private sector further, keep market interest rates high, lead to a further build-up of debt and provide an unwelcome boost to inflation.

There is little to suggest that domestic constraints and shocks will ease any time soon. These include the persistence of power outages and the volatile security situation. None seem to be resolvable in the short-term with the economic uncertainty they engender weighing on hopes for a positive response from the private sector. The strangle-hold of circular debt is still with us, untargeted and fiscally burdensome subsidies are still too large (and possibly under-stated in the budget). The PSE’s, unless restructured and/or privatized with a sense of extreme urgency, will continue to impose a large drag on the economy.

The above narrative should help to bring out that the Pakistan economy has been through extraordinarily difficult and turbulent times which in terms of their frequency, duration and intensity have few parallels in our history. This needs to be acknowledged and accounted for in seeking to answer why the economy has performed poorly. However, although delicately poised and vulnerable to shocks, the economy is neither in crisis nor is it bankrupt. The present level of foreign exchange reserves provides an adequate “cover” for projected imports (the standard measure of reserve adequacy) and Pakistan continues to service its external debts in full and on time. Indeed, the present reserve cover suggests that Pakistan does not have an immediate “balance of payments need”. Attempts to restart the GOP-IMF program, or enter into a new program is, it would seem, aimed largely at altering IMF (net) in the balance of payments from a negative number(an outflow) as IMF repayments start in FY12, to a positive number (a net inflow). There is much talk about the high level of debt but the debt-to-GDP ratio is not worryingly high with a good part of the increase being attributed to exchange rate depreciation which was very large and abrupt just prior to turning to the IMF in 2008. Even then, the debt-to-GDP ratio is not high enough for Pakistan to be classified as a Heavily-Indebted-Poor-Country (HIPC) and therefore eligible for debt relief and debt write-off.

None of this is intended to suggest that we can be sanguine or complacent in the period ahead. As experience teaches, on unchanged policies and absent resolute policy implementation, the economic scene can unravel very quickly and we could see a repeat of the deep crisis experienced in 2008. That would be a serious set-back. Clearly, daunting policy challenges remain. The agenda of structural reform remains large and unfulfilled and inflation continues to be a serious economic concern that, in the present environment of high food and oil prices and likely fiscal slippages in FY12, is unlikely to fall much further in the immediate term. This would mean that Pakistan would have endured the ravages of double-digit inflation for a consecutive period of five years and perhaps longer which, in the absence of a well-funded and robust social safety net, has disconcerting implications for poverty levels (mitigated somewhat, one hopes, by rising workers’ remittances). Furthermore, the continuation of below-trend output growth in FY12 means that unemployment and underemployment can be expected to remain high until the economy recaptures its trend rate of growth of about 6.5% per annum and employment starts growing again.

Looking ahead, the greatest uncertainty pertains to the up-coming elections and what this portends for economic policy-making. If the authorities succumb to the seductive charm of crowd-pleasing macroeconomic populism (as, for example, delays or inadequate pass-through of administered price adjustments, new subsidies, or faltering implementation of needed structural reforms), the risks to the macro-economy will rise sharply and the hitherto vacuous and inaccurate declarations of crisis and bankruptcy may come to haunt us as we rush into the path of another storm.