It’s in the details

The real cause of concern is that structural constraints remain unaddressed

By Hussain H. Zaidi

The major thrust of the State Bank’s review of the economy during the financial year 2009-2010 (FY10) is that even when the economy performed well, the fundamental structural weaknesses remained unaddressed. In the presence of these weaknesses — large fiscal deficit, monetization of the debt, a narrow tax base, inefficient public sector enterprises, circular debt, energy shortage, a narrow export product range and low level of savings and investment — the economic recovery will remain fragile.

The economy made a moderate recovery during FY10. The real GDP grew by 4.1 percent compared with the target of 3.3 percent and revised growth figure of 1.2 percent for the preceding fiscal year (FY09). The manufacturing sector registered healthy growth of 5.2 percent surpassing the 1.8 percent target and negative growth of 3.7 percent during FY09. Large scale manufacturing (LSM), which accounts for more than 70 percent of industrial output, grew by 4.4 percent compared with negative growth of 8.2 percent during the preceding year. However, the LSM growth was not symmetrical as some of the sub sectors—electronics, rubber, engineering, automobiles and leather—registered strong growth while sub sectors like textiles, food and beverages, petroleum, metal, and wood products contracted.

The services sector expanded by 4.6 percent exceeding the 3.9 percent target and 1.6 percent actual growth in FY09. The growth of services was well supported by manufacturing growth. However, the agricultural sector grew only by 2 percent missing the 3.8 percent target and well below the 4 percent growth registered in FY09.

The current account deficit came down to 2 per cent of GDP ($3.49 billion) against the target of 5.3 percent and actual figure of 5.7 percent ($9.21 billion) during FY09. Trade deficit fell to $11.42 billion from $12.62 billion, while remittances increased to $8.90 billion from $7.81 billion during FY09. The fall in trade deficit was not merely due to decrease in imports ($31.05 billion from $31.74 billion) but also due to increase in exports ($19.63 billion from $19.12 billion). Exports grew by 2.7 percent compared with 6.4 percent contraction during the preceding year. However, foreign direct investment (FDI) inflows came down to $2.20 billion from $3.72 billion.

Fiscal deficit surpassed the 4.9 percent target to reach 6.3 percent of GDP despite drastic cuts in development spending as the Public Sector Development Programme (PSDP) was slashed from Rs646 billion budgetary allocation to Rs490 billion. Current expenditure surpassed the Rs2.26 trillion revised target to reach Rs2.40 trillion. Revenue receipts increased from Rs1.67 trillion to Rs2.05 trillion. However, as a percentage of GDP revenue fell to 14.2 percent from 14.5 percent a year earlier. Tax-GDP ratio also fell to 10 percent from 10.3 percent.

Investment-GDP ratio fell to 15.2 percent from 17.4 percent and against the 20 percent target. National savings-GDP ratio however increased to 13.8 percent from 13.2 percent but still missed the 14.7 percent target. CPI inflation dropped to 11.7 percent from 20.8 percent but still missed the 9 percent target.

Thus, the economic recovery in FY10 was not based on strong fundamentals. Sustained growth needs to have strong foundations, such as high level of savings and investment, moderate rate of inflation and fiscal consolidation, otherwise it will create domestic and external imbalances just as the growth towards the close of the General Musharraf period did.

The engine of GDP growth is investment or capital formation. The major cause of less than desirable level of investment is low savings-GDP ratio. As the SBP notes, Pakistan’s saving rate is the lowest in emerging Asia. Major reasons for this include a consumption-oriented society, losses by public sector enterprises, low and highly skewed per capita income, and lack of appropriate saving instruments. To fill the gap between the actual level of savings and the desired level of investment, foreign investment, particularly, foreign direct investment (FDI) is needed. However, mainly due to political uncertainty and bad law and order situation, the FDI is on the decrease despite the fact that Pakistan has a very liberal FDI regime.

Pakistan has one of the lowest tax-GDP ratios in the world. Two options are available to the government to increase tax revenue: one, to broaden the tax net, for instance, by taxing agriculture income; two, to increase the existing taxes. For reasons political, the first option has not been exercised, with the result that those who already pay tax — the salaried class — are burdened with more taxes. The government can substantially raise tax-GDP ratio by levying tax on agriculture income. Successive governments including the present have toyed with the idea of levying agriculture tax. But the enormous political influence of the landed gentry has prevented materialization of such an idea. Hence, it is the salaried class which bears the brunt of government efforts to shore up revenue either through direct or indirect taxes, such as the general sales tax (GST).

The SBP review also contains projections for the current fiscal year (FY11). The major budgetary targets for the current fiscal year (FY11) included (a) economic growth of 4.5 percent, (b) 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 percent of GDP.

The havoc wrought by the floods has however necessitated revision of these targets. The central bank has projected the GDP to expand between 2 and 3 percent, inflation in the range of 13.5-14.5 percent, imports of around $35 billion (up from $31.7 billion original projection), fiscal deficit of about 6 percent and current account deficit of 4 percent (up from the 3.4 percent target). Exports and remittances are, however, projected to surpass the targets to reach $21 billion and $10.5 billion respectively.

Rehabilitation of the flood-hit people will put serious pressures on the public exchequer in a situation when revenue collection is likely to be lower due to disruption of economic activity. It is here that the SBP sees an opportunity to take some tough decisions. These include widening of the tax base, the tax system reforms and adoption of austerity measures. However, if the past is any guide, the efforts to re-prioritize budgetary allocation will end up in diverting development expenditure to rehabilitation of floods affected people. As for broadening the tax base, it is easier said than done and the only measure will be a reformed general sales tax (GST) incorporating features of a value added tax (VAT) — a sovereign commitment to the IMF — which will add to inflationary pressures.

The major economic indicators in the post floods scenario present a mixed picture. During the first quarter of the current fiscal year (FY11 July September), current account deficit (without official transfers) went up to $741 million compared with $570 million for the corresponding period of the last financial year (FY10 July September). Imports increased to $8.2 billion compared with $7.4 billion; however, exports also rose to $5.2 billion compared with $4.6 billion. FDI dropped to $381 million from $477 million; however, remittances increased to $2.6 billion from $2.3 billion. Inflation (CPI) went up to 13.8 percent from 10.7 percent. The real cause for concern, however, is that the structural constraints remain unaddressed.