Apr 20, 2010

In the red

Pakistan needs to develop indigenous resources to cope with its economic problems
By Hussain H. Zaidi

While the government is taking credit for forging consensus among political parties on the 18th Amendment to the Constitution, the economy is largely on the debit side of its balance sheet as shown by major macro-economic indicators.

The State Bank of Pakistan (SBP) projections (2nd Quarterly Report FY10) put the real GDP growth for the current fiscal year (FY10) between 2.5 and 3.5 percent against the original target of 3 percent, revised target of 3.3 percent and actual growth of 2 percent during FY09. The improved performance of the large scale manufacturing (LSM) sector -- which grew by 2.3 percent during July-January FY10 compared with negative growth of 5.4 percent during the corresponding period of the FY09 together with enhanced demand for exports -- may help achieve the modest growth target. However, the persistent supply side constraints, the law and order situation, and political turmoil may serve as a drag on economic growth.

The economy will thus continue to register lackluster growth for the second consecutive year. What is worse, slow economic growth will be accompanied by persisting inflationary pressures. Average consumer price index (CPI) inflation for FY10 is projected to be in the range of 11-12 percent at least 2 percentage points higher than the 9 percent target. However, it is significantly less than that during FY09 when it was 21.7 percent.

Average inflation (CPI) had dropped to 13.6 percent at the end of December 2009 compared with 20.3 percent a year earlier. The fall in inflation has been due to price deflation caused by recession and weaker domestic demand. However, inflationary pressures are likely to be sticky in the downward direction partly due to surge in international commodity prices in the wake of global economic recovery and partly due to increase in cost of doing business caused by power shortage, increase in utility charges and the precarious security environment.

The combination of slow growth and high prices, stagflation as it is called, does not bode well for the economy. Usually, there is a trade-off between high GDP growth and low inflation. However, sometimes, the economy reaches a stage where this choice is no longer available. The result is increase in prices accompanied by contraction of output growth and consequent fall in employment and incomes. In FY08, GDP growth went down from 7.0 to 4.1 percent, while inflation went up from 7.8 to 12.0 percent. In FY09, GDP growth further slipped to 2.0 percent, while average inflation was around 22 percent.

The stagflation can be attributed in the main to three factors: One, stabilisation policies pursued by the government reflected in restrictive fiscal and monetary policies on the one hand slowed the pace of the economy and on the other contributed to inflation due to reduction of subsidies and increase in energy prices. Two, the war on terror has had negative economic repercussions and together with the global recession affected investment level and export performance. Three, the energy crisis has increased the cost of doing business and discouraged investment.

The injection of capital inflows from the IMF has saved the country from having to default on debt re-payment, made it possible to pay for imports and helped improve balance of payments (BoP) position. However, the IMF assistance is a bailout and not a development package. The purpose is to help the country service its debt, make payment for imports and build up its reserves. It can be of little use in saving the country from stagflation. Instead, IMF conditionalities have aggravated the situation by making for restrictive fiscal and monetary policies.

As in the last year, the government is likely to miss the fiscal deficit target of 4.9 percent of GDP for the current fiscal year as well. During July-December FY10, fiscal deficit was 2.7 percent of GDP compared with 1.9 percent for the corresponding period of FY09. SBP projections put fiscal deficit between 5 and 5.5 percent of GDP. During FY09, fiscal deficit was 5.2 percent of GDP. Despite reduction in development spending, fiscal deficit will increase partly due to surge in security related expenditure and partly due to snags in revenue collection.

For FY10, development spending estimates were Rs763.1 billion, which were revised to Rs616 billion and are now projected to be only Rs510 billion. During the first half of FY10, the actual development spending was Rs116 billion, which suggests that even Rs510 billion projections are on the higher side.

On the other hand, current expenditure in FY08 was Rs1.86 trillion. The actual expenditure during FY09 was Rs2.04 trillion against the budget estimates of Rs1.86 trillion. For FY10, budgetary current spending estimates were Rs2.10 trillion, which were revised upward to Rs2.26 trillion and are projected to be 2.40 trillion.

There has been improved performance on containing current account deficit. During July-Feb FY10, the current account deficit was 2.2 percent of GDP compared with 6.8 percent for the corresponding period of FY09. According to SBP forecasts, for full FY10, current account deficit will be less than 4 percent of GDP -- substantially lower than 5.3 percent during FY09. The improved performance on the current account is partly due to 8.2 percent negative growth of imports (during July-Feb FY10) and remittances of $5.8 billion (during July-Feb FY10). On the other hand during the same period exports grew by merely 2.7 percent compared with 3.5 percent during the corresponding period of FY09.

When economic growth shrinks, investment level goes down, jobs are lost and incomes fall. Consequently, unemployment and poverty levels rise. The rise in unemployment and poverty further reduces the aggregate demand, resulting into lower investment demand and thus slower GDP growth. Increased poverty and unemployment have enormous social cost, because the affected people can become a convenient tool in the hands of destabilising forces. This is particularly relevant to Pakistan, which is facing an insurgency in its northwestern part.

Economic development requires sustained growth in the economy. Contraction of growth hampers development efforts, and makes it difficult for a country to break the shackles of underdevelopment and backwardness. Sluggish growth, especially lackluster performance of the commodity-producing sector, increases supply-side inflation.

To ward off supply-side inflation, a country needs to import more, which puts additional pressure on the balance of payment (BoP) position. This places a country like Pakistan in a dilemma. If imports are restricted (by increasing applied tariffs, for example), inflation goes up. But if increased imports are allowed and exports do not go up significantly, current account deficit increases. Finally, as economy slowdowns, revenue receipts fall.

To steer the country out of this difficult situation, the government needs generous foreign assistance. Mere re-adjustment of policies, though important, will not be enough. In the long run, Pakistan needs to develop indigenous resources to cope with its economic problems. In the short run, the country needs cash inflows in the form of either foreign investment or economic assistance.

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