Pakistan’s Economy on the Razor’s Edge: Reform Imperatives

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Zubair Iqbal*


The deterioration of the Pakistan economy over the past 2-3 years can be attributed mainly to the continuation of inappropriate macroeconomic policies since, at least, 2005/06. The sudden and debilitating weakening of the international economic and financial environment added to the turmoil. While the major economic challenges – sharply declining growth, rising unemployment, increasing poverty, high inflation, and widening external imbalances – are easy to grasp and policy options to address them are also not difficult to articulate, there is a singular lack of will to implement the needed reforms in a timely fashion.

The strategy pursued in the first six years of the decade, which focused  on  accumulating  external  reserves  as  protection  against external terms of trade shocks without strengthening domestic policies, predictably proved to be ineffective. In addition, political inaptitude, lack of national consensus on economic objectives, and a continued misreading of the depth of the challenges faced by the economy – in the face of a worsening security situation and global financial meltdown – have compounded the crisis. Although, recently there has been some recognition of the underlying problems, the authorities are apparently either unable or unwilling to take the bull by the horns. These have deepened the vicious cycle in which inaction and a declining ability to act have militated against corrective action measures are not taken expeditiously, it could permanently derail from its potential growth path estimated at about 6-7 percent per annum. The obvious fallout would be incremental unemployment pressures which, in turn, will spur political instability. The recent tentative steps to move away from the precipice need to be built upon so that the vicious circle can be converted into a virtuous cycle.

The Dye is Cast

It has become commonplace to attribute the current economic malaise to the “wrong” growth strategy or strategies pursued during the past 60 years. Such reiterations are not only meaningless but also unhelpful for understanding the current policy imperatives. Undoubtedly, there has been a weakening of institutions but that cannot be proffered as 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. In most cases, booms have been associated with increases in foreign funding followed by busts when such inflows ceased or debt service payments rose. Foreign inflows have had an unintended consequence in as much as they have reduced domestic effort to mobilize savings and effect liberal policy reforms, thus leaving the country without adequate resources when the crutch provided by such funding was withdrawn.1 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 in response to the shrinking access to global savings (both from official and private sources). Although many of these reforms were haphazard, the economy 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 as well as reforms in the financial sector, and privatization. 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 eased (through debt relief, increased foreign aid, and resumption of external private capital inflows), these reforms were instrumental in allowing the expansionary policies of the previous government to generate a temporary surge in growth. At the same time, the improved external environment and domestic political stability facilitated effective private sector investment decisions which contributed to an improvement in factor productivity.2

However, higher spending in the face of limited production capacity and primary focus on credit-financed consumption and imports, led to the re-emergence of macroeconomic imbalances. The 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. Given the focus on consumption and import-led growth, the economy had not been deepened enough through investment in productive capacity to withstand emerging external and internal shocks.

By the end of 2006, there was firm evidence that continuation of the ongoing policies would be counterproductive. The external current account and the fiscal deficits had reached 5 percent of GDP, respectively. The  authorities  initially  misread  the  emerging  imbalances  which were masked by the continued brisk growth 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. 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 consequent 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.3

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 un-sustainability of policies to the fore sooner and more dramatically. The deepening domestic and external imbalances would have sapped external reserves and, under unchanged policies, would have forced an intensification of controls, capital outflow, and drop in growth.

Not surprisingly, growth fell in 2007/08 to about 4 percent from an average of over 6 percent during the previous four years. The budget deficit shot up to over 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.4On 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.

Moment of Truth, 2008

By mid-2008, Pakistan was confronted with a moment of truth. Its approach to the so-called “friends” for emergency assistance had failed. It had to seek IMF resources to support its economic program for staving off further deterioration, stabilize the economic situation, and to lay the foundations for sustainable recovery. The belated promises of assistance by “friends” under the Tokyo Agreement remain to be honored.

Although the program underlying the arrangement with the IMF is quite mild given Pakistan’s economic situation, its implementation so far has been mixed. The original program, supported by an arrangement with the IMF for $7.6 billion for about two years – subsequently augmented to $11.3 billion – called for reducing the fiscal deficit to 4.2 percent in 2008/09 and 3.3 percent in 2009/10 while allowing for increased spending on the social safety net. It envisaged important reforms in tax policy administration, and cutbacks in subsidies, while monetary policy was to be tightened to fight inflation and protect external reserves. Increased donor support, a reduction in financial account pressures, and continuing IMF assistance were expected to allow a significant increase in international reserves to a more comfortable level.

With security pressures, unexplainable delays in the implementation of fiscal reforms – especially for raising tax/GDP ratio – and delays in the fiscal deficit target had to be revised upwards: even the most recent targeted deficit of 5.2 percent for 2009/10 may not be met. This is not to detract from a callous failure of the so-called “friends” to meet their obligations which had been considered critical for meeting pressing social and development needs, avoiding excessive recourse to domestic financing, and thus meeting the fiscal targets.

The present economic position is somber and highly vulnerable to internal and external shocks. Reflecting energy shortages, inefficiencies in 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 and is not projected to exceed 3 percent during 2009/10. While national savings  have shown  little increase during the two years, 2008/09-2009/10, investment has fallen, underpinning the low growth of GDP. Only a part of the fiscal deterioration can be explained by unbudgeted outlays on internally displaced persons or security. Revenue collection has declined further to an all-time low of 14.3 percent as tax evasion has continued to grow. 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 unacceptably high at about 16 percent.

The external position of the economy improved somewhat 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 6 percent in 2008/09 and are expected to fall further by over 2 percent in 2009/10 as traditional exports, such as textiles, plummeted reflecting declining competitiveness and a stagnant world economy. Moreover, because of political uncertainty, lack of market confidence in the sustainability of official adjustment policies, and security concerns, net capital inflows fell by about $3 billion (by 40 percent) in 2008/09. While gross external reserves have been built up through IMF financing, net reserves remain low. The exchange rate weakened further in line with the market conditions as the State Bank of Pakistan showed “flexibility” about its level. Furthermore, 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. In addition, vulnerabilities remain strong on account of the continued revenue shortfalls, an increase in nonperforming loans, energy subsidies, and large dependence on commodity imports. Weaknesses in the infrastructural capacity will also continue to constrain growth.

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 in the medium term because of the negative effects of global economic stagnation, little pick up in domestic investment, and continued insecurity. Also, the external position will see only a gradual improvement. Moreover, even 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 may not see a significant decline until after 2009/10 (Table 1).

Table1. Pakistan—Basic Economic Indicators, 2004/05-2011/2012

GDP growth (%)              7.1          4.1          2.0          3.0          4.0          4.5

Inflation (%)       7.8          12.0        20.8        11.0        7.0          6.0

Budget deficit/GDP(%)  -3.6        -7.3        -5.0        -5.2        -4.1        -3.2

Tax revenue/GDP (%)    10.5        10.6        10.2        10.7        11.4        12.2

Savings/GDP (%)              17.9        13.5        14.1        14.2        16.3        17.0

Ext. current account defi- cit/GDP (%)

Government debt/GDP (%)

-3.4        -8.4        -5.6        -4.2        -4.6        -4.5

57.0        58.4        55.6        56.4        55.8        54.7

Sources; Government of Pakistan, and IMF.

outlook will, critically depend upon the maintenance of a tighter fiscal position, strengthened competitiveness, and improved governance so as to reduce the vulnerabilities listed above. In the short run, generation of employment opportunities is critical for the success of the medium term strategy. In this context, elimination of energy shortages will provide the much needed spur to the use of installed capacity, facilitating growth, improving employment opportunities, and creating room for higher revenues, thus easing the path of adjustment over the medium term.

Fiscal reform 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 any further reduction in interest rates would be 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, with attendant domestic inflation.

Medium-term growth will remain hostage to low domestic savings and investment. Reaching the growth rate of 6 percent a year level – average rate of growth registered during 2002/03-2007/08 – even by 2014/15 would, given the outlook for external financing, call for domestic savings to increase to at least 21 percent of GDP in 2014/15 from 14 percent presently. Even if the above is realized, 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, the scenario above will put Pakistan behind them by about a decade! The political ramifications of such a development are not hard to grasp. Hence the need to do more than that envisaged above.

Reform or Low Growth Trap

Pakistan is presently encountering a dual problem: (1) macroeconomic imbalances and inflationary pressures arising out of a dysfunctional fiscal system supported by a compliant monetary policy stance; and (2) low domestic savings which, given the present outlook for capital inflows, are inadequate to sustain a level of investment needed to achieve a higher 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 in 2008/09! 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. The 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). These subsidies, which are needed to sustain certain inefficient private manufacturing activities, 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 – poor governance – 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.

A new strategy is needed to not only shift the focus of growth, but also alter the mode of implementing policies. 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 significantly increasing savings in a sustained fashion, reducing dependence on uncertain foreign aid, and redirecting foreign direct 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. While a significant reduction in insecurity will be a pre-condition for the success of the proposed policy reform, a sustained implementation of policy reforms to cement market confidence will be central. Full implementation of the current adjustment program which is supported by the IMF should help get over the short-term macroeconomic crisis and help lay foundations for the needed 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, health, water resources, 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 the 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 about 10 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 keep actual growth well below the potential growth rate in the short run, but also drain the budget through subsidies, and 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.5Closely 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 and Challenge of Implementation

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. There is incontrovertible evidence that difference in governance explains the differences in growth paths of developing countries. This is an area where Pakistan has experienced widening gap with its competitors in the region and at large.6

At the core, there is a need to develop national consensus on the 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. In particular, consideration should be given to linking disbursements with irreversible domestic actions to raise revenues and domestic savings rate over a defined period so that domestic savings rise enough in a durable fashion to permanently obviate the need for foreign aid. The importance of policy reforms and commitment to their implementation is thus self-evident.

(The views expressed in this article are solely of the author and in no way reflect views or opinions of the Middle East Institute)


1              See Moyo, Dambiso; “Dead Aid: Why Aid is Not Working and How There is a Better War for Africa;” Farrar, Straus and Giroux, 2009. Prof. Bhagwati noted that in the absence of conditions for proper use, aid is more likely to harm than help growth by discouraging or postponing necessary policy reforms.

2              For detail see IMF Country Report on Pakistan, N0. 08/21, January 2008. See also IMF, Pakistan-Public Information Notice, 17 December 2007.

3              Economic Survey of Pakistan, 2007-08, June 2008. For a good analysis of the emerging crisis see IMF, Pakistan – Request for Stand-by Arrangement, 20 November 2008.

4              An important example of the lackluster approach to the mounting economic problems is that, in the first six months of the new government, finance ministers were changed three times and secretaries of finance twice  which did not provide continuity of policy implementation and mixed signals to the market, leading to significant capital outflows.

5              The emerging consensus for energy reforms calls for an early settlement of the circular debt followed by repairs of installed capacity to increase production of electricity. Estimates show that the latter can be achieved in a few months and would cost only a fraction of the planned outlays on rental units.

6              For more details on the role of governance in growth see: Mark Gradstein, “Governance and Growth,” Journal of Development Economics, Vol. 73, Issue 2, April 2004, pp. 505-518; and Mushtaq H. Khan, “Governance, Economic Growth, and Development since 1960s,” background paper for the World Economic and Social Survey, 2006.