The recession shock

Pakistan will suffer heavily from the implications of the global economic downturn unless drastic measures are adopted to arrest the situation

By Hussain H Zaidi
The world’s leading economies either are in recession or are heading for it. The global economic downturn, which started last year, is all set to continue during the current year as well. According to the International Monetary Fund (IMF), the global economy will grow by a meager 0.5 percent in 2009. This will be the lowest growth rate for more than half a century. The IMF has further predicted that, on average, developed economies will shrink by 2 percent during the current year. For instance, the German economy will contract by 2.5 percent, while the Japanese economy will shrink by 2.6 percent.
The global recession is likely to have significant implications for Pakistan, particularly in terms of fall in exports, capital inflows and jobs. Before we look into these implications, we need to answer three important questions:
1) What is recession? Market economies are susceptible to periods of recession and high inflation. Recession is a downturn in economic activity in which actual gross domestic product (GDP) falls well below the potential GDP. The fall in GDP is accompanied by fall in corporate profits, real incomes and employment. Generally, the major cause of a recession is the fall in consumer demand or spending. Since investment demand is derived from consumer demand, investment also falls. As investment demand falls, the demand for labour further falls, resulting in unemployment. The fall in aggregate demand drives prices down. Since wages are sticky in downward direction, corporate profits fall, leading to a fall in stock prices. The reduced demand for credit pushes down the market interest rate, leading to a fall in the value of the domestic currency. Recessions last a year or two after which the normal economic conditions are restored. However, a recession may also lead to a depression in which fall in output and employment is both protracted and severe.
How to deal with recession? According to John Maynard Keynes, arguably the foremost economist of the modern era, recession is essentially weakness of the aggregate demand and, therefore, its cure lies in stepping up the aggregate demand. This can be done by pursuing expansionary fiscal and monetary policies. The government should increase public spending, reduce taxes and cut interest rates. These measures will stimulate the economy by increasing people’s purchasing power. As people spend more, demand for goods and services will increase. Businesses will respond by stepping up their investment, which means hiring more workers and, thus, further pushing up incomes and the aggregate demand. Some economists believe that market forces have the capability to restore the economy to its normal position and that government intervention will only worsen the situation. Even if this argument is sound, politically no government can afford to do nothing while people are being rendered jobless. Hence, governments act upon the Keynesian prescription. For instance, the US government has recently come up with a $787 billion stimulus package, dubbed by President Barack Obama as the "most sweeping" recovery package in the American history. The package provides for tax cuts and increase in public expenditure, and is aimed at saving or creating 3.5 million jobs.
3) How recession in one country affects other countries? In the first place, during recession, domestic purchases fall and, thus, imports of both finished and intermediate goods decrease. Secondly, in order to save the domestic industry and jobs, governments are tempted to pursue protectionist policies, which means raising trade barriers. For example, the US stimulus package contains ‘Buy American’ provisions, which provide that public works and procurement funded by the package will use only domestic goods. Thirdly, due to capital crunch at home, foreign direct investment (FDI) outflows are reduced. For instance, according to the United Nations Conference on Trade and Development (UNCTAD), global FDI inflows decreased 21 percent during 2008. Fourthly, fall in incomes and job losses lead to reduced demand for migrant labour as well as restrictive immigration rules, as a result workers’ remittances shrink. In the context of the global recession, migration from developing to developed countries will fall. The World Bank has predicted decline of 6 percent in remittances worldwide during the current year.
Finally, we come to the likely effects of the global recession on Pakistan. For Pakistan, the 27-member European Union and the United States are the two largest export markets, accounting for nearly 55 percent of its exports. Japan and China are also major export markets for Pakistan. Recession in these countries will strongly reduce the demand for Pakistani exports.
The decrease in the country’s exports will be both indirect and indirect. The direct effect will be on export of finished goods, such as made-ups, garments, and sports and surgical goods. The indirect effect will be on export of intermediate goods, such as yarn and fabrics, which undergo value addition in these countries and are then exported to other countries.
Since exports are an important instrument of job creation, fall in exports will affect jobs and, thus, incomes and output. This impact should be studied in conjunction with other factors, such as inflation, energy crisis and increase in interest rates, which impact adversely on exports by raising the input costs. Fall in exports will also add to Pakistan’s record current account deficit.
Another impact on Pakistan will be in respect of terms of trade (ToT) – the difference between export and import prices. Favourable or improved ToT enables a country to buy a larger quantity of goods (imports) in exchange for a smaller quantity of exports. Given the size of markets in the EU, China and the US, the fall in imports will depress their world prices and, thus, prices of Pakistani exports. The result will be deterioration in Pakistan’s ToT.
A country’s overall welfare is positively related to its favourable ToT. A developing country like Pakistan needs to import machinery, equipment and raw materials to maintain the growth momentum. Deterioration in ToT will make it difficult for the country to buy the necessary industrial goods and, thus, may slow the growth momentum. Unfavourable ToT will also compound the balance of payment and fiscal problems, because the country will be forced to borrow to bridge the trade imbalance.
FDI inflows into Pakistan will also be affected. During the last few years, Pakistan attracted healthy FDI considering bad law and order situation and political uncertainty. During FY08 and FY07, Pakistan received FDI worth $5.15 billion and $5.12 billion, respectively. During the first seven months of FY09 (July 2008-Jan 2009), FDI worth $2.20 billion was registered. However, due to recession in Pakistan’s major sources of FDI – the US, UK and Japan – foreign investment in Pakistan is likely to be reduced. The reduction in FDI inflows will affect domestic output, jobs and foreign reserves.
Like FDI, workers’ remittances have played an important part in Pakistan’s growth. During the last six years (FY03-FY08), remittances worth $28.87 billion were recorded. During the first seven months of FY09, Pakistanis living abroad remitted $4.28 billion. The likely fall in workers’ remittances will affect private spending and savings, as well as put pressure on foreign reserves and the exchange value of the rupee. Moreover, tightening of immigration laws in Pakistan’s foreign labour markets will increase the employment level in the country.