FAISALABAD (December 18 2008): The external shocks have put Pakistan in a very difficult situation. However, inducing a reduction in aggregate demand through recessionary policies to cure problems that have strong supply-side causes (ie the oil and food price shocks and poor infrastructure) will not help Pakistan. This was stated in Asian Development Bank paper titled 'Analysis of Pakistan's Macroeconomic Situation and Prospects' published recently.
Authors of the analysis, Jesus Felipe and Joseph Lim, observed that Pakistan's latest growth experience during 2003-2007 was the result of short-sighted policies, driven by high remittances of overseas workers, FDI, 'hot money' and loan inflows, as well as some government pump-priming.
While initially this led to high growth, it has now become clear that this growth model failed to address the main problems afflicting the Pakistani economy: (i) a crisis of confidence in the political order and a strong perception of a weak government, unable to undertake strong economic measures, such as improving revenue collection, switching from price subsidies to income subsidies, and solving the power and water shortages; (ii) a neglect of the supply side of the economy (ie, productive capacity, technological upgrade of the economy); and (iii) inability to address the increasing fiscal and current account deficits.
Like other developing countries that have implemented questionable domestic policies, external shocks put Pakistan in a very difficult situation, However, inducing a reduction in aggregate demand through recessionary policies to cure problems that have strong supply-side causes (ie, the oil and food price shocks and poor infrastructure) will not help Pakistan.
Often international institutions have been excessively preoccupied with fears of inflation. Excessive austerity has forced countries to cut unnecessarily on high-return public investments, and has led to higher unemployment and to larger gaps between actual and potential output. All this has ended up harming the growth.
The very painful lessons of the East Asian crisis (although it had different roots), and of the subsequent Turkish and Argentine economic collapses (as a result of the "shock treatment" approach) have led some economists to recommend more heterodox economic policies in periods of crises.
Achieving political stability is a key piece of the solution. Austerity measures in the monetary and fiscal fronts will not bring back, on their own, the much-needed confidence. Likewise, the situation requires a co-ordinated effort at the international level, they added. With this in mind, they suggested, any sensible solution to Pakistan's problems will have to consider:
(i) A coherent economic program that tackles macroeconomic imbalances, as well as a long-term program that leads to the modernisation of the economy.
(ii) On the fiscal front, the government must have enough political muscle to: (a) implement progressive direct taxes to generate more revenue; (b) switch from price subsidies to income subsidies with clear targeting mechanisms for poor households; (c) protect vital social and economic services when poverty is increasing; and (d) allot funds to address the power and water shortages.
(iii) To address the external deficit and the fall in international reserves, it will be unavoidable to look for grants and concessional loans. But over and beyond this, the government should be aggressive in upgrading and diversifying the country's export basket.
(iv) To address the increase in prices, a combination of moderate monetary policies, elimination in the budget of the programs with a strong inflationary bias, and a program of incomes policies to prevent inflation expectations should be put in place.
Jesus Felipe and Joseph Lim said that Pakistan's fiscal deficit is the result of a low revenue-generating capacity, more than fiscal profligacy. Nevertheless, the government has to analyse the structure of spending, eliminate all superfluous categories (including subsidies) and projects with questionable benefits, and get rid of unprofitable state-owned enterprises. They said that these measures will also help address the inflation problem. Likewise, the law should limit (eg, through the Fiscal Responsibility and Debt Limitation Act 2005) the maximum amount that the government can borrow from the SBP.
It is important to note that budget deficits are not sins, if they are well understood, and adequately managed. Moreover, they need not always reflect loose fiscal stance, but may signal stagnation in a destabilised economy. Government expenditure and fiscal policy in general should be seen from the point of view of how to keep the total spending in the economy at the rate that would buy all the goods that is possible to produce.
Fiscal policy should be conceived as a mechanism that balances the system, exogenously increasing aggregate demand (eg, by injecting expenditures) whenever private sector spending falls short of a full employment level of effective demand.
Studies for the Organisation for Economic Co-operation and Development (OECD) countries show that fiscal tightening achieved by increasing taxes and cutting public investment tends to be contractionary and unsustainable. In the case of developing countries, the empirical evidence indicates that expenditure composition is critical.
While increases in spending on government wages and salaries tend to have a negative impact on growth, expenditures on other goods and services and capital projects tend to raise the growth rate significantly. Therefore, fiscal policy has to be tailored to country-specific conditions to foster growth. On other words, the "quality" of the fiscal deficit (ie, the use of expenditures) is a key issue. Fiscal responsibility is not about permanent balanced budgets but about the quality of the deficits, and whether the public debt accumulated is sustainable.
Revenue collection should be enhanced by, for example, introducing a tax on real estate transactions. Likewise, the tax base should widen so that direct taxes, rather than indirect, contribute more to government revenues. Also, a higher share of taxes should be extracted from the service sector, given that it represents over 50 percent of GDP but contributes only a quarter to total tax revenue.
How to reduce the current account deficit poses another dilemma (the government envisages import growth in the range of 6.5 percent and export growth at around 15 percent for 2008/09). Reduction in growth will lead to a decline in import growth. However, oil imports will remain high if the price of oil does not decline.
On the other hand, export growth may not pick up in the short term, given the current international scenario. For this reason, the 2008/09 exports target, set at $22.1 billion, may not be achieved. It is crucial, therefore, to put in place policies to improve export growth. Diversification and quality improvement are essential to make Pakistan less dependent on exports of textiles. Likewise, efforts must be made to attract FDI in the commodity-producing sectors of the economy.
