The IMF factor

Do we have options in place of the IMF loans to keep the wheel of our economy moving?

By Hussain H. Zaidi

The International Monetary Fund (IMF) has so far given $7.27 billion to Pakistan out of the total credit of $11.3 billion under a 25-month stand-by agreement (SBA) effective since November 2008. As the government faces the gigantic task of the repair of infrastructure and rehabilitation of the people displaced by floods and copes with their overall economic impact, it will need more multilateral assistance, including that from the IMF. Not only that, the government has also approached the fund to relax some of the performance requirements -- particularly those relating to budget deficit -- under the existing programme.

When Pakistan went to the IMF in October 2008, the economy was preciously placed. Fiscal deficit had increased to 7.6 percent of GDP (at the close of FY08), trade and current account deficits had reached $21 billion and $14 billion respectively (at the close of FY08), foreign exchange reserves had depleted to $7.31 billion (as on October 17, 2008), inflation was around 25 percent and the exchange rate had nose-dived to Rs82.37 per American dollar.

Accordingly, the SBA has been geared towards addressing Pakistan's macro-economic imbalances requiring the government to significantly reduce fiscal and current account deficits, discourage government borrowing from the central bank as a source of deficit financing, maintain high interest rates with a view to reducing inflation, ensure exchange rate flexibility, increase tax-GDP ratio and removal of energy subsidies.

Let's look at to what extent these targets have been achieved. We start with the fiscal balance. Fiscal deficit, whose containment forms the main pillar of the edifice of the IMF programme, was to be reduced to 4.2 percent of the GDP in FY09, and then to 3.4 percent in FY10. The FY09 target was missed as the fiscal deficit was recoded at 5.2 percent of GDP. The FY10 fiscal deficit target was subsequently increased to 4.6 and then to 4.9 percent. However, the revised target could not be attained as fiscal deficit of reached about 6 percent of GDP.

These fiscal deficit figures have both credit and debit sides. The credit side is that compared with 7.6 percent for FY08, the fiscal deficit during last two fiscal years has been significantly reduced. The debit side is that during each year, the fiscal deficit surpassed the target. Moreover, the reduction in fiscal deficit has been made possible not by cuts in current expenditure but by those in development spending. For instance, during FY10 the Public sector Development Programme (PSDP) was reduced from Rs646 billion budgetary allocation to Rs490 billion.

By contrast, the actual current 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 actual expenditure was to the tune of 2.40 trillion.

These changes in the sizes of development and current spending are quite understandable as given the political economy of Pakistan any attempt to reduce fiscal deficit has to face three constraints: (a) a major portion of the public finance is eaten up by defence expenditure and debt-servicing; (b) security related expenditure has to be increased to ward off the growing menace of terrorism; and (c) tax-GDP ratio of less than 10 percent due to lack of a tax culture along with the inability to widen the tax net. This also explains why budgetary targets for bringing down the fiscal deficit are revised every year and even these remain elusive.

There has been improved performance in containing the current account deficit. During FY09, the current account deficit was curtailed to 5.3 percent of GDP ($8.8 billion) and further to 2 percent ($3.5 billion) during FY10. The improved performance is due both to fall in the trade deficit and rise in workers' remittances from abroad. The trade deficit fell to $17 billion in FY09 and to $11.4 billion in FY10, while the remittances rose to $7.8 billion and $8.9 billion in FY09 and FY10 respectively.

The State Bank of Pakistan (SBP) has been maintaining high interest rates with a view to controlling inflation. In November 2008, the policy discount rate was increased by two percentage points to 15 percent. In April and August 2009 the rate was cut by one percentage point each bringing it to 13 percent. In November 2009, the interest rate was reduced to 12.5 percent. In August last, the interest rate was hiked to 13 percent.

Despite changes in interest rate, strong inflationary pressures have persisted. During FY08, average inflation was 12 percent, which rose to 20.8 percent during FY09 and was brought down to 13 percent during FY10. The fall in inflation in FY10 was due partly to price deflation caused by global recession and partly to weaker domestic demand.

The rupee, which had fallen sharply against the dollar between July and November 2008, recovered some of its ground after the first tranche of the IMF assistance was received in November that year and the exchange value appreciated to 79.72. Though subsequently the rupee depreciated selling for about 86 per dollar at present, but for the capital inflows from the Fund, the exchange rate would have been even worse.

A modest economic recovery was made in FY10 as the growth rate increased to 4.1 percent surpassing the 3 percent target and 1.2 percent revised growth rate for the previous fiscal year. The major budgetary targets for the current fiscal year (FY11) include (a) economic growth of 4.5 percent, average inflation of 9.5 percent, (c) fiscal deficit of 4 percent of GDP, (d) development expenditure (of both federal and provincial governments) of Rs766.5 billion, and (e) projected tax revenue of Rs1. 66 trillion including direct taxes of Rs657.7 billion and indirect taxes of Rs1.12 trillion -- 9.8 per cent of GDP.

The havoc wrought by floods will, however, necessitate revision of these targets. According to conservative estimates, floods have washed away at least 1 percentage point of the potential GDP growth; therefore attaining growth rate in excess of 3 percent will be quite an achievement. Most of the development funds will be diverted to rehabilitation and repair activities. As the economic growth shrinks, revenue receipts will come down and inflation will go up. Ministry of Finance apprehends average inflation of 25 percent during the current fiscal year. Current account deficit may also increase due to heavy food and cotton import at a time when world commodity prices are on the increase.

The injection of capital inflows from the IMF has no doubt saved the country from having to default on debt re-payment, made it possible to pay for imports, helped improve balance of payments (BoP) position and foreign exchange reserves (reported to be $16.55 billion at the end of July 2010) and stemmed the exchange rate deterioration. Still, the IMF conditionalties can hardly provide a durable basis for overcoming the BoP and related problems for which the economic fundamentals will have to be improved. Take for instance, the exchange rate. Where the rupee settles against the dollar will depend partly on demand for and supply of the greenback and partly on the domestic inflation level. Similarly, the current account balance will depend on the country's exports and imports of goods and services, which themselves are primarily contingent upon the domestic supply side situation.

The IMF conditionalties have slowed the pace of the economy by making for restrictive fiscal and monetary policies, which have negatively impacted growth and job creation. The government argues that such policies were necessary to put the economy on strong fundamentals and is likely to continue with the same.