AN ECONOMIC CRISIS STATE?

Dr Meekal Ahmed

A trend-setter in Asia up to the sixties, economic management in Pakistan has steadily deteriorated to the point where the economy has, for the past few decades, lurched from one financial crisis to the next. At the heart of the problem has been the poor management of public finances and deep-seated unresolved structural issues in the economy that bad management and poor governance has exacerbated. The consequences of this secular decline in economic governance are plain to see: macroeconomic instability, high inflation, poor public services, criminal neglect of the social sectors, widespread corruption, crippling power outages, growing unemployment, deepening poverty and a deteriorating debt profile.

The Early Years

Pakistan has experienced many crises in recent years. Each one of them has been a caricature of the previous one with an economic boom, typically fuelled by official aid inflows, followed by bust which ends in a severe balance of payments crisis. In the early years, the economic scene was marked by relative stability, strong growth and low inflation. In Ayub Khan’s era, Pakistan was considered to be a ‘model of development’ and ‘aid-effectiveness’. Ayub Khan was deeply interested in economic development. He placed the Planning Commission under the President’s Secretariat and himself became the Chairman. The Planning Commission was staffed with some of Pakistan’s best and brightest economic minds. It was ably supported by a number of fine economists from the former East Pakistan who worked in the Pakistan Institute of Development Economics, as well as economists and policy analysts from the Harvard Advisory Group. Ayub Khan listened to their advice and often deferred to their judgment over the views of the mighty ICS/CSP. Pakistan’s Second Five- 184Year Plan came to be widely regarded as the best produced in Pakistan and the developing world. It was not only well-crafted and technically sound but embodied targets and objectives that were realistically ambitious. The report on the Evaluation of the Second Five-Year Plan showed that most plan targets had been met or exceeded both in the macroeconomic field and with respect to projects and programs bearing testimony to the fundamental soundness and realism of the plan.

Pakistan was also blessed with other fine institutions led by persons of great integrity and competence: PIA, WAPDA, the Railways, PICIC, IDBP, the State Bank, the ICS/CSP, and so on. All these institutions operated at high levels of efficiency and in the case of commercial entities were profitable. The economy grew at a steady pace with some sectors such as manufacturing racing ahead at double-digits. Inflation remained tame with agricultural productivity boosted by the fruits of the Green Revolution. The domestic and external deficits were kept in check. Of course, at the time, the economy was closed and tightly controlled and rationing of some food items and especially foreign exchange was commonplace. Yet there was no evidence of price pressures suggesting that the underlying balance between demand and supply was being maintained. Even exports performed well despite the clumsy and opaque ‘Bonus Voucher Scheme’ with its multiple exchange rates. It is true that foreign aid, at that time mostly in the form of outright grants and PL-480 grain shipments paid for in rupee counterpart funds and thus non-external debt-creating, fuelled much of the growth. By supplementing domestic savings, aid allowed Pakistan to invest more than might have otherwise been possible with domestic resources alone. Importantly, the aid was well spent in building social and physical infrastructure, in particular large hydro-power dams in the context of the Indus Basin Treaty which was brokered by the World Bank. The investment to incremental capital-output ratio, a good summary measure of capital efficiency, was low and produced high real growth rates per unit of capital invested. Plan projects and programs were well-prepared using the ‘best-practice’ techniques of project appraisal and analysis of the time. Monitoring of projects was rigorous and conducted on-site; project cost over-runs and delays were minimal; project benefits were delivered as promised; corruption was not spoken of and Plan guidelines were respected and Plan discipline enforced.

The external environment was exceptionally benign. The global economy was in the midst of an unprecedented period of expansion which started at the end of World War II with world trade growing at a healthy pace, markets relatively open, and little global inflation. Thus the economy experienced few of the shocks that could derail its steady upward trajectory and challenge policy-makers. Ayub Khan was a victim of economic success. The revelation by none other than the Chief Economist of the Planning Commission—his most beloved institution which he headed—that twenty-two families controlled 70 per cent of manufacturing and 90 per cent of banking and insurance business in the country jolted his regime to its foundations. It was a supreme irony that Ayub Khan was following the growth philosophy as espoused by the Chief Economist of the Planning Commission in his Cambridge PhD thesis turned book, ‘The Strategy of Economic Planning’. Growth philosophy argued that in the initial stages of economic development some concentration of income and wealth in a few hands was necessary and appropriate to stimulate ‘animal spirits’ and foster the conditions for rapid growth. Considerations of equity and income distribution could be tackled at a later stage of development. The reaction to the revelation of concentration of wealth in a few hands was hostile and swift. Pakistan’s industrialists came to be called ‘Robber Barons’ who had earned monopolistic profits behind high walls of protection, subsidies and government patronage. An empirical study by Professor Lawrence White of New York University lent credence to this proposition. Furthermore, some of the industries that had been set-up behind high protective tariff barriers were generating ’negative value-added’ when their inputs and outputs were valued at ‘world’ prices (rather than being valued at distorted domestic prices).

Factor price distortions, including an over-valued exchange rate had led to the choice of highly capital-intensive techniques of production, generating little employment per unit of capital and output. One study by an East Pakistan economist of repute calculated that factor intensity in Pakistan as measured by the capital-labour ratio was higher than in an advanced country like Japan. There had been economic growth to be sure; but it had been distorted in terms of factor proportions and allocative inefficiencies. Most importantly, it had exacted a high price in terms of inter-personal and, more ominously, inter-wing disparities in income and 186wealth. In West Pakistan the revelation of concentration of income and wealth provided the springboard for the rise of Mr Z.A. Bhutto’s People’s Party and its socialist agenda. In East Pakistan Mujibur Rahman used the finding of concentration of wealth in a few hands, mostly belonging to families in the West, to argue that East Pakistan had been exploited and robbed of its resources and wealth through policy-induced distortions in the inter-wing terms-of-trade. Yahya Khan took over without much economic dislocation. There were a few tough words about the concentration of wealth but the government did not do much except set up a toothless Monopoly Control Authority with an ostensible mandate to look at and punish anti- competitive behaviour. It never did amount to much. The 1971 war placed pressure on government spending and imports and the dismemberment of the country gave pragmatic argument for the nationalisation of the financial sector.

Bhutto had little patience with economic matters. His nationalisation program was a shock to the system and a grievous blow to private sector confidence that would take years to rebuild. New private sector investment came to a virtual halt.

There was much (concealed) capital flight as businessmen took their money out of the economy either before or after nationalisation and it would be many years for this capital flight to reverse itself.

The economic effects of the break-up of Pakistan were profound. It caused vast disruptions to the financial and corporate sectors that had operated on the basis of a single country. The State Bank of Pakistan had been pushing the Pakistani commercial banks into increasing lending in East Pakistan while their deposit base was almost entirely in the western wing where most, if not all of them, were headquartered. The dissolution of the country created an imbalance between assets and liabilities that left most of the banks (with the solitary exception of the National Bank) in virtual bankruptcy; the same applied to the insurance sector where the largest private insurance company—Eastern Federal—was headquartered in Dhaka and lost access to its assets while most of its liabilities to life policy- holders were resident in the western wing. Nationalisation was the only way that a total bankruptcy of the financial system was avoided, especially as this postponed any question of compensating the shareholders, depositors and policy-holders. Many observers remain convinced that nationalisations of the financial system was a negative turning-point for the economy but this was 187only a proximate cause: the real cause lay in the country’s break-up. The corporate sector suffered similar fracturing of balance-sheets since some of the more adventurous business firms (like the Adamjees) were operating in both wings and lost their investments in the eastern wing at one stroke. To add insult to injury—and given the time lags involved in the income tax administration, many of these firms continued to be pressed for taxes on earlier years’ profits earned in the eastern wing! That the private sector survived at all in the wake of this calamity and with the additional ideological nationalisations imposed by Mr Bhutto is, some feel, nothing short of a miracle. That said, nationalisation was by and large well-received by the people who saw it as an election promise fulfilled and a means of redressing the evils of concentration of wealth and wide disparities in income. Bhutto’s boldest move on the economic front was to sharply devalue the Pakistan rupee and bring it closer to its ’equilibrium’ value. The years of clinging to an artificially appreciated rate of Rs. 4.76 per US dollar, which was propped up by tight controls on foreign exchange and which created many distortions in the economy were finally over. His government faced the challenge of the first oil-price shock and turned to the IMF for short-term financing but there was not much conditionality attached and no reforms were implemented. To be fair to Mr Bhutto, the gods were not kind to him. Each year brought a drought or a flood—negative domestic exogenous shocks— which hurt growth and caused a pick-up in inflation. Yet the economy was kept afloat and on a reasonably even keel thanks to Bhutto’s diplomatic success in securing financing from friendly Islamic countries (including $500 million from the Shah of Iran) and the Gulf, as well as an emerging new phenomenon: rising workers’ remittances which were becoming an important source of financing the external accounts.

From Aid-Fuelled Growth to Volatility

Zia’s regime represented the second episode of aid-fuelled growth after Pakistan became a ‘front-line’ state with the Soviet invasion of Afghanistan in 1979. His economic policies were otherwise unremarkable and devoid of any bold initiatives. The economy was kept on a stable path thanks to the ultra-conservative approach of the inimitable Ghulam Ishaq Khan who, as the country’s financial kingpin, had an aversion to changing the economic status quo and little time or patience to hear about IMF/World Bank recommendations of freer markets, privatisation, exchange rate flexibility and a bigger role for the private sector. In a World 188Bank document outlining the conditionality of a Structural Adjustment Loan for Pakistan he wrote succinctly by hand, ‘I am not prepared to hand over the management of the Pakistan economy to the World Bank for $250 million’. That was the end of that discussion. While foreign aid once again was the main driver of growth, it cannot be said that the aid Pakistan received during these years was well spent. Indeed, as we know now, much of the aid was diverted to the military. Zia had other things on his mind and left much of the economic management to his Finance Minister who was content to keep a steady hand on the levers of economic policy. It must have been a blow to a hugely stubborn and proud man when Pakistan was forced to enter into a three-year arrangement with the IMF (an Extended Fund Facility) because of balance of payments difficulties. The program was treated as a secret document with only one copy of the program conditionality kept under lock and key. Even secretaries of ministries and divisions were not called to the meetings with the IMF so they could not present their views, had no idea of what had been agreed to or what they had to implement. In any event, the IMF program was abandoned without completing it or undertaking any economic reforms of substance (apart from minor tinkering with the trade and import tariff regime and some cosmetic steps towards restructuring the public enterprise sector), one of the many IMF programs that would meet the same fate.

The first signs of macroeconomic volatility seem to have started with the Benazir government. Her first tenure was labelled a ‘comedy of errors’. There was some truth to that unflattering label despite the steadying hand of her experienced and able Advisor of Finance whom she, sadly, did not listen to often enough. Once again in economic distress, Pakistan entered into a major IMF program at the inception of her government. On a visit to Washington DC, the Managing Director of the IMF was so taken by her that he added $100 million with his own pen to the $1.2 billion the IMF staff had recommended for Pakistan. This was done on the understanding of cutting trade protection by 30 per cent while meeting a fiscal deficit target of 5 per cent of GDP. In the budget that followed, she did neither, bringing the IMF program to an ignominious halt. Following much discussion and new commitments, the IMF program was re-started. Even then, economic growth was lackluster and volatile, fiscal 189slippages were routine and inflation picked up. Despite IMF resources there was constant pressure on the external accounts as manifest by the (growing) disparity between the parallel market for foreign exchange (or the ‘hundi’ rate) and the official market rate. This was because the budget was subject to extreme spending pressures since her weak mandate meant she had to please everyone. Budget supplmentaries (approvals for more spending not provided for in the original budget) became commonplace. The disparity between the official and ‘hundi’ rate was also widening, as the Prime Minister would give instructions to the State Bank not to move the exchange rate because it gave her a bad press and suggested economic failure. She was always concerned about ‘my forex position’ as she called it. But to her credit must go two accomplishments. She granted the State Bank of Pakistan a degree of autonomy (even if it was under IMF pressure and was part of a ‘prior action’ in the IMF program meaning an action to be taken before the program was approved) taking it out of the grip of the Ministry of Finance. Pakistan’s tax- to-GDP ratio hit a short-lived peak during her twenty months in power in her first tenure in office. Once convinced, and that was never easy because she was opinionated and liked to argue, she showed a capacity to take bold measures and accept the political backlash. This was sustained and well- orchestrated with Nawaz Sharif and his ‘bazaar-power’ snapping at her heels from the Punjab asking his supporters not to pay taxes. Clandestine efforts were also made to spread panic in the foreign exchange market by planted rumours of massive capital flight. Pakistan’s foreign exchange reserves took a frightening dip as the contrived rumours turned into a self-fulfilling prophecy. However, the situation stabilised quickly thereafter. Sharif’s ‘Far-Reaching’ Reforms Nawaz Sharif is widely regarded as bringing about an economic revolution in Pakistan with his ‘far-reaching’ economic reforms. His ’no­ questions-asked’ foreign currency deposits (FCDs) were a haven for tax evaders and under-filers—the scourge of Pakistan’s economy—that could now ‘whiten’ their ill-gotten income with no taxation and no fear of detection. With no foreign exchange reserve cover to back them up, these deposits quickly swelled to close to $12 billion, of which 80 per cent belonged to resident Pakistanis who had converted their ill-gotten wealth into dollar accounts with no fear of questions as to the source of this income. To add insult to injury to those who did pay taxes, these FCDs were handsomely 190remunerated at above-market rates, guaranteed against exchange risk and allowed unrestricted withdrawal facilities. These features and capital gains from exchange rate depreciation made the scheme a highly attractive instrument. Since this was an age before concerns about ‘money laundering’ were openly talked about the IMF gave muted approval to this ‘far-reaching’ reform. However, as the IMF cautioned, an ‘open capital account’ (which incidentally inverted the sequence of external liberalisation since the current account should have been opened first) meant that economic policies would have to be especially disciplined so as not to shake the confidence of these holders of foreign exchange. The IMF also warned that the overhang of such foreign exchange demand liabilities, unmatched by parallel reserve accumulation, heightened the economy’s vulnerability to downside risks and that bad policies or an adverse exogenous shock would quickly manifest itself in capital flight and bring the economy to its knees.

But many feel the Fund was not forceful enough. As the Fund’s Independent Evaluation Office report on Pakistan noted, ‘at the authorities request, the FCDs owned by residents were reported in the balance of payments “above the line” as part of private transfers (like workers’ remittances) and even FCDs held by non-residents were not included in the stock of external debt’. Furthermore, FCDs held by residents, even though they represented a liquid claim on the central bank’s foreign exchange holdings and generated a large ‘open’ position for the central bank, were not netted out for the purpose of program monitoring of net international reserves, or NIR (where changes in NIR are an important part of program conditionality). The benefit to government of these resident FCDs was that it had access to foreign exchange that could be used to finance the external current account deficit. It also allowed the Sharif government (including, to be sure, successive governments) to postpone taking the necessary but difficult policy measures to address the fundamental disequilibrium in the balance of payments. However, by encouraging rapid ‘dollarisation’ of the economy it eroded confidence in the rupee, reduced the tax base, caused huge losses to the State Bank because of the exchange risk guarantee and immunity from enquiry, legalised capital flight and promoted the growth of the underground economy. Finally, at a policy level, the rising proportion of resident FCDs in total money supply constrained monetary policy management. Controlling 191domestic liquidity became more difficult and behavioural relationships between reserve money (operational target) broad money (intermediate target) and inflation (ultimate objective) became more complex. Despite the economy’s new vulnerability and the need to foster an environment of macroeconomic stability and low inflation, the government embarked on a number of grandiose schemes, the most notable of which were motorways and airports (all financed by non- concessional external borrowing) with the piece de resistance being the yellow cab scheme. In short order, as rows of yellow cabs filled the parking lots at the Karachi Port, Pakistan’s foreign exchange reserves started to dwindle with alarming speed until there was only $150 million left in the kitty (equivalent to about a day’s worth of imports) against foreign exchange demand liabilities of $12 billion. Once again Pakistan turned to the IMF to bail it out.

Shifting Sands

General Musharraf acknowledged that he did not know economics. But he was a good listener, loved long-winded, coloured power-point presentations and he learnt well. As usual, given the precarious state of the economy with low foreign exchange reserves, Pakistan entered into an IMF program, which took the shape of a three-year highly concessional Poverty Reduction and Growth Facility (PRGF) with high access. Despite the arrangement, foreign exchange reserves initially continued to hover at the very low level of $1-1.7 billion. This changed dramatically after 9/11 reflecting the reverse flow of capital and re-flow of workers’ remittances into the official market, both of which occurred in response to fears of possible investigation of transactions in the money-changer market. Debt relief from the Paris Club, increased disbursements of foreign assistance by the US after Pakistan’s cooperation in Afghanistan, also contributed to the reserve build-up. In one year alone, foreign exchange reserves surged by more than $4 billion, boosting confidence, stabilising the exchange rate and reducing the disparity between the official and parallel market rate for foreign exchange. Indeed at one point the parallel market rate was less depreciated than the official exchange rate.

In a remarkable first, the government actually completed the three- year PRGF. Whether this was done with a sleight of hand or not remains 192a mystery. Pakistan had earlier confessed to cooking the fiscal books and showing a lower fiscal deficit than the true one. Without taking the Office of Executive Director in the IMF into confidence beforehand, which may have allowed the matter of misreporting to be handled quietly, the new Finance Minister stunned the IMF with a letter of admission of misreporting of the fiscal deficit. An IMF mission was sent to Pakistan to investigate the matter and submitted a report to the IMF Executive Board. Pakistan was fined millions of SDRs (the IMF’s synthetic unit of account) for this indiscretion and had to return money to the IMF since it had been accessed (drawn on) in the context of an IMF program and therefore under false pretences (IMF News Brief No. 00/23). Whether this practice of massaging the data to meet targets continued under the PRGF remains unknown. With a few exceptions, Pakistan’s national accounts are poor and bear only a passing resemblance to the reality on the ground. This is especially so with regards to the fiscal accounts where an unknown but certainly large amount of spending, particularly US-funded military spending, is undertaken off-budget. The fiscal accounts, typically the cornerstone of an IMF program are a tempting target for discreet and deft manipulation. With the IMF program completed, there was much rejoicing and backslapping over having broken the ‘begging bowl’ and regaining our ’economic sovereignty’. To more sober and thoughtful minds, and especially in the light of our past experience, many hearts sank since such boastful declarations usually signal the beginning of another end. And so it was this time as well. Now unconstrained in its decision-making, the government embarked on a hasty and ill-conceived dash for growth taking comfort from a significant level of foreign exchange reserves, sharply rising workers’ remittances, up-grades by rating agencies, large inflows of foreign private direct and portfolio investment, new bond flotation, and plentiful aid. The principal instrument to further the government’s growth objective was to use monetary policy to finance consumption, a bizarre strategy in a savings- constrained economy with a large savings-investment gap (which was mirrored on the external side by the large disparity between imports and exports). To ‘kick-start’ the economy, interest rates were cut sharply to below inflation which meant that they were negative in inflation-adjusted terms flooding the economy with cheap money and excess liquidity. In the initial period, with some ‘slack’ in the economy (as reflected in underutilised labour 193and capital and a negative output-gap) growth did pick up and inflation stayed low. However, this slack was quickly taken up and the economy moved to above its ‘potential growth’ limit, defined as the maximum speed at which an economy can grow-given labour and capital resources and the shape of the technical progress function—without igniting inflationary pressures or straining macroeconomic imbalances.

The underlying trend of inflation is always a good indicator of resources pressure in an economy. Inflation was unusually low in the aftermath of September 11 at around 2 per cent per annum but started to pick- up. By the time inflation had reached 5-6 per cent per annum there was no cause for undue alarm since that is Pakistan’s long-term ‘steady-state’ rate of inflation and one could argue that inflation had reverted to its long-term trend. There would have been even less cause for concern on the inflation front if the growth upswing had been accompanied by improvements in economy- wide Total Factor Productivity (TFP) that would augment the economy’s potential non-inflationary growth limit. While a pick-up in TFP typically occurs in the initial phase of an economic upturn (as output grows faster than the existing stock of inputs of labour, capital and technology), the growth of TFP should reflect a permanent structural shift in the production function that is sustained and can therefore support the higher non-inflationary growth potential of the economy. There is no evidence to suggest that TFP growth following an initial pick-up was either permanent, structural or was sustained. To a discerning economic observer it should have been clear that the economy had started to ‘overheat’ as aggregate demand raced ahead of the economy’s aggregate supply potential largely fuelled by consumption. In addition to the loose and highly accommodative monetary policy stance of negative real interest rates, the fiscal deficit instead of serving as a counter- cyclical tool and attenuating demand pressures on the up-swing (as it normally should) was becoming dangerously pro­cyclical. Thus, both fiscal and monetary policy was imparting a strong expansionary impulse, pushing up inflation and spilling over into the external sector leading to surging imports while ‘crowding out’ exports when economic policy should have been aiming to do the reverse. The fact that the exchange rate was appreciating in real effective terms (a ‘stable’ nominal exchange rate set against a background of rising domestic inflation) made matters worse as export profitability was squeezed and the export-to-GDP ratio fell. As the external deficit widened 194there was sustained downward pressure on the country’s foreign exchange reserves. This is always an unambiguous sign of an economy under stress. A paper prepared by the Social Policy and Development Center as early as 2005 presented some striking numbers all pointing towards economic overheating. Economic growth was a solid 8.4 per cent, the highest in the world. But growth was not being driven by investment and net exports. It was being led by consumption and imports rather than the more sustainable route of investment and exports. In 2005 real private consumption rose by 17 per cent (double the rate of the previous year), imports by 44 per cent, exports by only 8 per cent (the large difference between imports and exports or net exports shaved off as much as 5 per cent from growth), private fixed investment rose by a modest 4.8 per cent, public investment fell 5 per cent and inflation accelerated into double-digits. Despite these numbers, which denoted an economy under stress, the 2005-06 budget took on an ominously expansionary and pro-cyclical stance. Apologists for General Musharraf’s regime argue that once it had become clear that the economy was overheating, the State Bank of Pakistan moved into a tightening phase and raised its policy interest rate to cool the economy. If that was the case the State Bank was hopelessly behind the policy-making curve. This is because it takes twelve to fifteen months for a change in the policy interest rate to start to affect outcomes. In view of these long lags, the State Bank should have acted pre-emptively at the first unmistakable signs of economic overheating (of which there were many) to dampen demand pressures and subdue inflation, which had now developed a worryingly unstoppable dimension.

With speculative bubbles developing in consumption, the real estate sector, the stock market and commodities such as gold, and accelerating inflation, all that was needed to tip an overheated economy with heightened vulnerability over the edge was a small unanticipated exogenous domestic or external shock.

This came in the form of the large ’twin global shocks’, the first of which was the surge in the global price of oil and other commodities; and the second the worst global financial crisis since the Great Depression.

The former pushed Pakistan’s fiscal deficit to beyond 8 per cent of GDP as the higher price of oil was absorbed into the budget as subsidies and was not passed through; correspondingly the higher imported cost of oil and commodities swelled the external current account deficit to in excess of 8 per 195cent of GDP.

The ‘Great Global Recession’ also hurt the demand for Pakistan’s exports at a time when import volume and unit values were rising strongly. The new government inherited an economy in growing disarray as the lags from the deeply flawed policies of the previous government worked themselves out. Instead of quickly taking stock of the rapidly deteriorating economic situation and implementing strong corrective measures, the government seemed stupefied. A new concoction named ‘Friends of Democratic Pakistan’ (FoDP) pledged fresh assistance to Pakistan at a conference held in Tokyo, Japan but it was clear—or should have been clear—that translating these pledges into actual inflows that would help the budget and/or the balance of payments would take time. The Finance Minister informed the people that he had a ‘Plan A’, a ‘Plan B’ and a ‘Plan C’ in mind when it should have been clear to him that the only game in town was Plan F—the IMF.

Countries that are in economic distress are reluctant to turn to the IMF for assistance, since doing so is an admission of economic failure and of a loss of control.

Articles in the Pakistan press about ‘fiscal servitude’ and the ‘social holocaust’ an IMF program will bring in its wake, whether contrived or spontaneous, did not help the government make up its mind.

However, delaying, prevaricating and hoping that someone would come to Pakistan’s rescue only made the task of economic adjustment more painful. It is self-evident that the wrenching pain of adjustment and the strength of the corrective measures that would be needed to put the economy back on track would have been smaller and the costs in terms of lost output, employment and poverty less if Pakistan had turned to the IMF earlier rather than later.

As domestic and external deficits widened and inflation continued to climb, confidence was lost and there ensued unprecedented capital flight amid a rupee/dollar exchange rate in virtual free-fall.

The stock market collapsed as private portfolio investment fled to safer heavens, bubbles popped and our foreign exchange reserves, in a painful repeat of the past, started to disappear with astonishing speed, at one time declining $700 million in a single week. In the end, Pakistan had no recourse except to turn once again to the IMF for ’exceptional financing’. It is highly likely that the FoDP made their support conditional on Pakistan engaging with the IMF.

196In hindsight it is true that the twin external exogenous shocks served as the tipping point for the economy. But these shocks were neither the precipitating nor the initiating force behind Pakistan’s latest economic crisis; they exacerbated it but did not cause it. The root cause of the crisis was the short-sighted and heedless pursuit of unsustainable policies, both fiscal and monetary, that produced an illusion of consumption-led growth and prosperity for a while but was bound to self-destruct With a little bit of foresight, attention to the build-up of pressures and carefully-calibrated pre-emptive steps to cool the economy, the economy would have made a ‘soft landing’ and Pakistan could have been as well-placed to cope with the twin exogenous shocks as other developing countries were. The economy could have continued on a less spectacular but more sustainable growth path with macroeconomic imbalances tending towards correction and inflationary pressure easing. Other developing countries had room to use their fiscal position as a counter-cyclical tool and ease monetary policy to cushion the turbulent downburst arising from ‘The Great Global Recession’ since their starting position was stronger.

Pakistan had to do the reverse. It had to tighten its macroeconomic policy stance, curb the fiscal deficit and push up interest rates in an effort to dampen demand pressures and inflation and forestall a full­blown balance of payments crisis and debt-default. The people of Pakistan were once again put through a painful exercise of economic readjustment. As economic growth slowed amid soaring inflation which hit an unprecedented headline rate of 26 per cent (core inflation which strips out the volatile components of inflation such as food and oil and is an unambiguous reflection of the underlying stance of macro­economic policies also hit an unprecedented high of 18 per cent), the economy was trapped in the grips of stagflation. Unemployment rose and millions of households were pushed back into poverty as high inflation cruelly eroded their living standards. Was the IMF Culpable? It has been argued that the genesis of the crisis as described here is exaggerated because the IMF—the ever-watchful guardian of fiscal and 197monetary rectitude—would have said something. However, the truth of the matter is that with the IMF program having been completed, it had no leverage over the conduct and direction of Pakistan’s economic policies. The annual obligatory Article IV Consultation discussion which the IMF holds with all member-countries (advanced and developing) is, compared to program negotiations, a relaxed affair and is taken lightly. This is unfortunate because IMF ‘surveillance’ over member’s policies (whether they have an IMF program or not) goes to the heart of the IMF’s mandate. The IMF is duty-bound to point out emerging risks and unsustainable policies and make recommendations for timely corrective action. How it should convey the message and what kind of language it should use has been the subject of much debate amongst IMF staff, management and the Executive Board. There is always the risk that strong words may rattle markets and precipitate a crisis when there was not one to begin with. On the other hand, the IMF can be too nuanced and subtle in its language (sometimes dubbed as ‘Fund- speak’) in glossing over fault lines. It has happened in South America and most infamously in the Asian Crisis of the 90s as well as in Mexico and Russia. Critical turning points can be missed, the language in staff reports to the Executive Board is insufficiently forthright and the IMF is caught off- guard when the crisis erupts.

Were the Pakistani authorities warned of the unsustainable nature of their policies or the economy’s heightened vulnerability to shocks, and impending disaster? There is reason to believe they were, but only in private. These warnings were rebuffed with the Bushism that, ‘You are either with us or against us’. In one case a critical report on the performance of the Pakistan economy was re-written, toning down the language and the Mission Chief’s name was removed from the document. Obviously, neither the Pakistani authorities nor the JMF’s Executive Board read the original unexpurgated report. That report presented in stark hard- hitting terms the escalating risks of an impending crisis and urged urgent corrective action in the fiscal, monetary, structural and exchange rate areas. Is the IMF therefore culpable in Pakistan’s most recent crisis? To an extent it was. The IMF is a professional organisation with some of the best macroeconomists under one roof but it is neither clairvoyant nor omnipotent. The IMF has also made mistakes and some very grievous ones. In Pakistan’s case, the IMF has not been the overbearing, rigid and inflexible detractor that it is made out to be. It has not had a profound and deep impact on policy- 198making in Pakistan. Its influence has been intermittent, if not marginal. Those in Pakistan deeply committed to reforms lament the fact that the IMF has been insufficiently tough on Pakistan laying itself open to the charge that its policies serve to perpetuate Pakistan’s corrupt ruling elites. Time and again Pakistan has been left off the proverbial hook when economic adversity and a need for exceptional financing from the IMF to stave off a financial crisis would have been the best time to push through deep seated and lasting reform. These remarks apply to other multilateral lending agencies as well—the World Bank (WB) and Asian Development Bank (ADB).

Ownership of Reforms

The list of reforms Pakistan needs on the macroeconomic and structural side is a long one. It is also an agenda that remains largely unfulfilled even after sixty-three years and many failed IMF programs. Pakistan’s record of taking reform steps and then rolling them back had earned it the sobriquet of ‘stop-start adjustment’. An IMF program gets some reforms implemented as part of its conditionality but as soon as the program is over or ended by the authorities themselves mid-way, all the reforms are rolled back. Tax exemptions and concessions are a case in point. The IMF will insist that these exemptions and concessions be removed since they fragment the tax base and reduce revenue, are wasteful and ineffective. They are removed only to be put back once the IMF program is over. At the next program—and there always is another IMF program lurking down the road—the charade is repeated. Selective tax concessions and/or exemptions are doled out again to the politically powerful, the budget is burdened with ill-targeted subsidies which accrue largely to the rich and crowd-out much needed investment in social and physical infrastructure, and import protection is raised for specific products and sectors. Tax revenues fail to keep up with even the nominal growth of the economy because of poor compliance, corruption and insufficiently vigorous audits of tax under-filers. The phenomenon of reforms being rolled-back and vitiating any good that may have been done is a striking manifestation of a lack of ‘program ownership’. Pakistan needs to ‘own’ reforms not only under­ take them, haltingly and grudgingly, or with a sleight of hand, under IMF duress. Program conditionality cannot substitute for ownership. The Fund has erred in this respect hoping that tighter conditionality can make up for a lack of ownership. The view so often heard that there can be no reforms because of powerful ‘vested interests’ has some weight but is not entirely 199persuasive. There are vested interests in other countries as well, whether in Brazil or India or Indonesia. Yet these countries have implemented reforms, they manage to keep their macro economy on a stable low inflation track, they anticipate and implement corrective measures promptly when risks emerge, they take bold decisions, and they do not turn to the IMF to bail them out every few years because they have mismanaged their economy and run out of foreign exchange reserves. At the technical level, Pakistan has the talent of bright economic minds even if the best and the brightest had fled from the country to greener pastures in the Bank and the IMF around 1970. The talent of those who are still in Pakistan needs to be harnessed and their voices heard so they can convince the political leadership that reforms, which make for a more efficient and egalitarian economy and make inroads into poverty, are in their interest. These people have the skill to develop an economic and financial strategy of growth and poverty alleviation, which is underpinned by well-articulated policy measures and structural reforms. Even if the IMF needs to be called in, it should be Pakistan’s program, and not what the IMF gives us, to which we react. Other countries do this. They present their own program to the IMF and treat the associated financial assistance as a reward of their belated display of virtue. This is the only way to ensure ‘ownership’, the most critical ingredient in successful and lasting reform implementation. This is not to suggest that only economists can solve our economic problems and save the day. Pakistan has had the good fortune to produce some of the finest civil servants, who have served with distinction in key economic ministries and the central bank. Many of them have a deep and abiding commitment to reforms, listen to advice, understand the issues and know the art of the possible. Even economists know, or should know, that the ideal textbook solution to an economic problem is not always possible or doable. They must then work with second-best alternatives keeping in mind ‘ground realities’ and administrative and technical absorptive capacity.

The 2008 twenty-two-month IMF SBA has produced some positive results although the economic situation remains—to use a much-loved IMF word—‘fragile’. Pakistan’s external deficit is sharply down with most of it due to lower international prices for our imports but also due to 200macroeconomic adjustment taking root. Foreign exchange reserves have reached more comfortable levels; growth is picking up despite the strong headwinds associated with power shortages and a difficult security situation; asset markets have stabilised and the announcement of fresh inflows of US assistance following the ‘Strategic’ talks led to an appreciation of the rupee versus the US dollar. Market confidence is returning, interest rate spreads denoting country risk are narrowing and the international rating agencicfappear to be close to up-grading our debt. Yet, despite these positive developments, risks abound. Fiscal slippages, especially on the spending side related to defence and security cloud the economic picture. Government borrowing from the central bank, which injects ‘high-powered’ money into the economic system and is therefore highly inflationary, has been in excess of prudent limits and inconsistent with the need to control inflation. The phenomenal, but not well- understood, rise in workers’ remittances despite the turmoil in the Gulf countries, notably Dubai, shows signs of slowing down. This could portend the unwinding of a prolonged ‘stock adjustment’ process which when completed may see workers’ remittances fall off sharply and weaken the external current account. Inflation appears to be making an unwelcome comeback suggesting that the process of monetary easing may have to be halted, or reversed, which will hurt growth. Given these extant and emerging risks, it is well that the budget for 2010-11 attempts at another year of macroeconomic stabilisation. This would be good for inflation, which needs to come down further even if the end-of-period inflation target of 9.5 per cent per annum is disappointingly unambitious. The relatively tight stance of macro policies should also ensure that the external deficit, a key source of vulnerability in the Pakistan economy and always a binding constraint, is kept in check and gross foreign exchange reserves stay at comfortable levels despite an anticipated pick-up in import volumes and prices as the domestic and global economic recovery gathers strength. Much of the debate on the fiscal measures in the budget has been overshadowed by a vigorous—if ill-informed—debate on Pakistan’s commitment to the IMF to transition from the present GST (which operates in VAT-like-mode) to a full-fledged VAT. Some of the concerns and criticism are self-serving like that which comes from the wealthy with business interests in the National Assembly (dubbed as the centre of conflict of interest) who probably fear that the 201VAT will trap them in a seamless chain of value-addition, force them to document and pay some taxes for a change. Having successfully corrupted the GST through ‘fake and flying invoices’, or fake refund claims, they would have to start afresh to corrupt the VAT regime which would take time and effort and where success is not guaranteed. Some concerns are valid, especially the lack of education of all stakeholders on what VAT means and entails. In most other countries which moved to a VAT regime, the process of education is started eighteen months or more in advance. There is concern about the impact of VAT on inflation. This seems to be over-stated since the present GST rate can vary from 17-27 per cent. Moving to a single 15 per cent standard rate should actually reduce taxes and hence prices across a broad range of commodities, an outcome which the Competition Commission of Pakistan needs to ensure and enforce. A high VAT threshold means that economic activity which is valued at below the threshold (Rs. 7.5 million) is exempt from VAT altogether. Neither the IMF nor the Government of Pakistan should be taxing or want to tax every ‘khoka’ or ‘ghara’ (small one-man retail shops and hand-driven cart retailer respectively) down the street. There are a limited list of exemptions, such as food, health services, education and medicines that are VAT-exempt, which impart some progressivity in the VAT regime. One would have hoped that private health and education institutions would not be exempted from VAT. Yet the VAT is an indirect tax and the budget regrettably took no measures to bring back progressive taxes such as the wealth tax, gift tax or inheritance tax which should never have been removed in the first place.

Most importantly, with the VAT not in place by 1 July 2010, Pakistan would have missed a ‘performance criterion’ under the on-going GoP-IMF SBA program. This would, technically-speaking, bring the program .to a halt and no further drawings can be made on IMF resources until Pakistan requests and receives a ‘waiver’ for non-compliance from the IMF’s Executive Board. In the meantime, there is much discussion about a ‘reformed’ GST (instead of the VAT) although it is not clear what that means and, if feasible, raises the question: why was the GST not reformed a decade ago?

Whatever the final outcome, the question remains whether the Executive Board will grant the request for a waiver and whether Executive 202Directors will ‘buy into’ the ‘reformed’ GST as an equivalent, if not superior, substitute for the pure VAT. The US as the largest shareholder in the IMF is being lobbied intensely to soften its own stand and soften up other Executive Directors (especially those representing other G-7 countries) on the IMF Executive Board. It is amusing to see Pakistan play politics with the IMF (neither for the first time nor the last) while also complaining that the IMF is a political—and not a professional— institution dominated by, and serving, the interests of the same G-7. If the waiver is granted (and there could be more than one request for waivers as there appears to be a breach of another ‘performance criterion’, namely, zero net borrowing from the central bank at end­ quarter), the SBA program can be restarted. It would be in Pakistan’s interest to do so and not allow the momentum of the adjustment program to stall. The task of stabilisation is unfinished and the critical transition to a higher growth path is on hand. Provided infrastructure constraints can be eased (such as in the energy sector) and the security situation improves for the better, there is no reason why the economy cannot post a growth rate of GDP of around 5–5.5 per cent in 2010–11 and move closer to potential of 6.0–6.5 per cent GDP growth the following year. Once the SBA is over at end-2010, it would be surprising if the US and the other G-7 countries do not ask that Pakistan stay engaged with the IMF, since a stable macroeconomic environment strengthens the odds that aid inflows will be used wisely and well. Indeed, the grant of waivers for non-compliance of performance criteria mentioned earlier could well be given subject to Pakistan’s commitment to a follow-on IMF program. The major donors know our undistinguished record of economic mismanagement and ‘stop-start-rollback’ record of adjustment. Whether we like it or not, an IMF arrangement serves as a disciplining force on the conduct of our economic policies. Pakistan should use the IMF as a political flack-jacket to push through deep-seated reforms. The IMF is used to playing that role and can take the flack. Many countries, both developing and advanced, use that ploy as well to good effect, the latest example being Greece where deep public-sector pay and pension cuts and fiscal austerity have been fiercely resisted but will go through as a condition for IMF and Euro-loans. Greece has no choice and the Euro-countries led by Germany and France would not want to see the Euro currency fail. Removing the IMF’s disciplining force, no matter how much it is disliked and criticized could 203cause us to revert to the all-too-familiar paradigm of unconstrained decision- making which time and again has got us into trouble. There are several possibilities of further IMF engagement. One possibility would be to ask the IMF for a ‘precautionary’ follow-on SBA (and not draw on relatively expensive SBA resources and exacerbate our external debt). One could also think of a looser arrangement, a sort of ‘shadow’ program that mimics an actual IMF arrangement but does not entail request for IMF resources. However, given the size of Pakistan’s outstanding debt to the IMF, which exceeds 100 per cent of its quota, Pakistan may have no choice anyway but to submit to ‘Post-Program Monitoring’ with six monthly reviews that are published, implying a close watch over the conduct of our macroeconomic policies. Whatever Pakistan’s relations with the IMF in the immediate term, Pakistan needs to abjure the temptation to resort to overly-expansionary macroeconomic policies that only create the all-too-familiar cycle of boom, bubbles and bust. Pakistan’s political leadership and policy­makers need to recognise that there is an asymmetry between good and bad policies and their outcomes. Bad policies will quickly lead to bad outcomes from which there may be no turning back as negative dynamics take hold in a cumulative and circular self-fulfilling downturn. The rewards of implementing good policies takes a frustratingly long time to be felt because confidence of economic agents once lost is difficult to regain; moreover those who suffer from reform recognise their losses quickly and want to offset them rapidly while the beneficiaries either fail to appreciate their ‘gains’ or take a much longer time to do so. All governments are impatient to show results and want to be seen as responsive to the expectations of the people. But experience should teach that there is little to be gained by policy-induced distortions of macroeconomic policy instruments, such as interest rates that are close to zero or negative after adjusting for inflation encouraging excessive consumption and imports, imprudent borrowing, building up debt and discouraging savings. This creates a mirage of prosperity and a short-term burst in growth but eventually self-destructs. Nor is there anything to be gained by hastily conceived unviable spending initiatives that crowd-out more essential spending on education, health and other physical and social infrastructure which are critical to boosting the economy’s medium-term growth potential. 204There are many who argue, and rightly so, that talk about ensuring macroeconomic stability and low inflation is a non-starter unless governance issues are addressed first. There is no doubt that good governance is inextricably linked with good economic policies and vice- versa. The subject of good governance encompasses a daunting and vast field but by any calculus Pakistan ranks poorly when compared to other developing countries. No doubt, bad governance as manifest in mismanagement, deep-seated corruption and a flaunting of the rule of law, extracts a heavy toll in all sections of Pakistan society and creates the kind of economic instability and wrenching crisis that Pakistan has witnessed so many times before. Macroeconomic Reform Agenda With a new economic team in Islamabad, Pakistan can either move forward or relapse to its old ways of destructive macroeconomic populism and face another balance of payments crisis in a very few years. Yet, despite the unhappy burden of economic history and heavy odds, a program of reform is neither dauntingly difficult nor impossible to implement. First, Pakistan needs to realise that macroeconomic stability and an environment of low inflation is pro-growth and pro-poor. No country has grown at a strong and steady pace while it is being buffeted with macroeconomic instability and high and variable inflation. The Asian Tigers succeeded in bringing poverty levels to the low teens by the determined implementation of pro-growth policies that simultaneously kept inflationary pressures in check. Bringing inflation down and keeping it down should be the government’s highest priority since it will foster growth, reduce inter-personal tensions and alleviate poverty. Inflation is often called the ‘cruellest tax of all’ because it hurts disproportionately those who can least afford to bear it or to offset it as the rich are most enabled to do.

At the very minimum, controlling inflation will require keeping the fiscal deficit—the root cause of recurring macro-instability, high inflation and balance of payments crises—under control. Time and again Pakistan has lost control of its fiscal situation because of tax revenue shortfalls and current spending over-runs. Keeping a control on the fiscal deficit should be spearheaded by spending restraint and where possible spending cuts since experience elsewhere has shown that spending cuts tend to be lasting and are associated with successful adjustment. Introducing the practice of zero 205budgeting and/or pay as you go might be a fruitful way to proceed. The Fiscal Deficit and Debt Limitation Act needs to be taken seriously and the Finance Minister called to account in the National Assembly to explain why deviations have occurred from the desirable path of fiscal adjustment and what the authorities plan to do to get it back on track and contain debt levels consistent with the stipulations of the Act. On the monetary side, the State Bank needs to move to a system of inflation targeting and target an inflation ‘band’ rather than the present practice of targeting a single-point estimate which is unrealistic, gives a spurious impression of exactitude and is based on what looks good and acceptable from a political perspective. While the technical pre-requisites for inflation targeting are onerous, they can be met. However, inflation targeting is not a magic bullet. It cannot work under a regime of ‘fiscal dominance’ where monetary policy is hostage to the vicissitudes of and slippages in the budget. In such an unbalanced policy regime, monetary policy will have to be tighter than it needs to be since it will be constantly seeking to off-set the demand pressures coming from the fiscal side in an effort to keep inflation down. The resulting high interest rates will stifle growth. Only a reasonably tight fiscal stance can give monetary policy the room and flexibility to guide policy interest rates and hence influence economic activity and market expectations of inflation.

The State Bank can start to target an inflation band of around 5–7 per cent per year and then gradually lower it and tighten the band as experience is gained and the transmission mechanisms between monetary policy action and output-price outcomes is better understood. The State Bank Governor should have a clause inserted in his contract that failure to meet the target band will call for an explanation in an open letter to government. Repeated failure to miss the band should result in the dismissal of the Governor as in other countries. The present IMF conditionality that there should be zero net borrowing from the State Bank of Pakistan at each end-quarter should become a law, not because it is an IMF requirement but because it is good for Pakistan and it will foster financial stability by putting a hard ceiling on net government borrowing. Similar ceilings should be placed on overdrafts and borrowing by provincial governments. Exceeding these ceilings should invite punitive fines. The Governor of the State Bank should not desist from bouncing a few checks as a signal that financial indiscipline and fiscal recklessness will not be tolerated. This was done in 206regards to provinces exceeding their ‘ways and means’ advances when for the first time in Pakistan’s history the State Bank refused to honour payment orders issued by provinces in excess of their limits. This practice needs to continue. Second, while the control of spending is important, Pakistan needs to learn to tax and do so equitably and effectively. Income earned in any economic venture should be subject to taxation. There should be no sector of the economy that is un-taxed, whether it is agriculture, the stock market, real estate or the services sector because there is no economic or moral justification not to tax income-earning activity in those sectors. A country which collects a stagnant 8–9 per cent of GDP in tax revenues (a ratio which risks falling further unless the VAT or the ‘reformed’ GST produces positive and sustainable results that can push our tax-to-GDP ratio to at least 15 per cent over the medium-term) does not have much of a future because it will never have the resources to finance essential social and physical infrastructure by the public sector, the key to boosting the economy’s medium-term growth potential and complementing investment by the private sector. With a broader tax base with only a few selective concessions and exemptions, there should be room to cut tax rates (where rates are perceived to be high) while stepping up tax compliance through a sustained and vigorous program of random forensic and on-site tax audits. Third, Pakistan needs to introduce social safety nets for the poor and vulnerable to protect them in times of high inflation and/or sharply slowing growth when wage earners are put on short-time on reduced pay or lose their jobs entirely with no unemployment compensation. The Benazir Income Support Program (BISP) is the first social safety net that Pakistan has developed and its implementation should be stepped-up to reach the poorest households. It will not be perfect and there will be leakages, corruption and misallocation. The scheme also risks being politicised. The BISP can be refined and better-targeted over time with experience and the process of ’learning-by-doing’. Cash transfers to poor households should be conditional on skill development so that the transferee can become economically independent. Fourth, Pakistan needs to move away from reliance on politically­ driven and volatile ‘foreign savings’ or more specifically official bilateral 207aid inflows. In addition to other debilitating effects, aid sets up perverse incentives by alleviating the pressure to implement urgently needed domestic reform. Indeed, there is evidence that foreign aid has over the years tended to supplant rather than supplement domestic savings. In place of aid, Pakistan should foster the conditions for raising domestic savings (and reducing government dis-savings via the budget) by ensuring that banking deposits are remunerated in positive real terms and government savings instruments are linked to and fluctuate with nominal GDP growth rather than set through government fiat by committee. Issuing inflation index-linked bonds may also be a good idea since that would put pressure on the authorities to keep inflation in check. In additional to raising domestic savings, official aid inflows should be substituted over time with a concerted effort to attract Foreign Direct Investment (FDI) inflows which embody the best managerial and marketing skills and ‘best-practice’ technology, especially to the lagging and undiversified export sector as other successful developing countries have done. While FDI will remain tentative under the present difficult security situation, Pakistan’s growing domestic market and the untapped potential for developing new exports and finding new export markets makes the country an attractive destination for such investment. To be sure, this will mean addressing, inter alia, the country’s acute power shortages and implementing a true fast-track ‘one-window’ operation for FDI approvals. Fifth, and following from the above, Pakistan needs to implement a well-designed and coherent export-led development strategy. Despite the persistence of a large trade deficit, which has not been brought down over time, Pakistan has never articulated an explicit export-led development strategy. For sixty-three years the ‘commodity concentration’ and market destination of our exports has remained broadly unchanged. In other words, we export the same mix of commodities to the same markets. Exports as a ratio of GDP have stagnated and at times fallen suggesting, inter alia, that economic policies are ‘crowding out’ or penalising exports. The unit price we receive for our exports is roughly half of what our competitors obtain in the world market for the same product, a dismaying fact which points to the unutilised scope for boosting export revenues from even the existing export base. While the large-scale manufacturing sector gets most of the policy attention not least because 208of its powerful lobbies, it represents the tip of the manufacturing sector iceberg. Some 80 per cent of output, 87 per cent of employment and 70 per cent of Pakistan’s exports emanate from the Small and Medium Enterprise (SME) sector. Boosting the growth of the SME sector through targeted incentives that are performance based and technical assistance would pay large dividends as the scope for exports from this sector is exploited. Since these exports are labour-intensive, growth in the SME sector has important implications for employment, wages, income distribution and poverty alleviation. Pakistan also needs to address the issue of export quality, meet the highest standards of packaging and hygiene and adhere to tight delivery dates, the so-called ’non-price’ determinants of exports. Markets once lost because of deficiencies in these areas are difficult if not impossible to regain. Sixth, while maintaining macroeconomic stability is the prerequisite for achieving sustained growth with low inflation, Pakistan needs to implement efficiency-enhancing structural reforms that boost Total Factor Productivity (TFP). There exists a National Productivity Organization in Pakistan but it is not clear how effective it has been in raising TFP. Studies on ‘Growth Accounting’ round the world have shown that economic growth is not fully explained by factor accumulation (more labour and capital inputs of unchanging quality) but by permanent upward shifts in the production function brought about through technological progress. Technological progress in other countries typically accounts for 70 per cent of growth and factor inputs for only 30 per cent. In Pakistan the situation is reversed. Technological progress makes a small (about 24 per cent) contribution to growth. This suggests that growth in Pakistan has been resource-intensive and factor-deepening and thus inefficient and wasteful. This has to change. Technological improvements and closing the ’technological gaps’ between Pakistan and more advanced developing and industrial countries needs to be given the highest priority in policy- making, whether in agriculture, manufacturing, energy, transport, exports or services. No country has progressed without sustained and rapid improvements in TFP over time.

Seventh, reforms of the macro economy will prove to be unavailing unless Pakistan addresses the challenge of restructuring Public Sector Enterprises (PSEs) which incur staggering losses that exceed the size of the development program. Adding their losses as ‘quasi-fiscal deficits’ to the 209narrower concept of the fiscal (budgetary) deficit would raise the Public Sector Borrowing Requirement (PSBR) by 2-3 per cent of GDP and provide a more honest—and more daunting picture—of the pre-emption of the public sector on the economy’s resource envelope. To be successful and lasting PSE restructuring needs to start with the acceptance of the fact that it will have to be accompanied by draconian job and wage cuts across all levels of management and staff. Pakistan’s recent experience with the restructuring of the banking system which was financed by a soft World Bank loan is instructive. All persons asked to leave employment were given a severance package or ‘golden-handshake’. This experience needs to be replicated. Concurrently, management should commit to an up-front meaningful cut in salary and perks that are then held constant in nominal terms for, say, three years with no bonuses. No PSE restructuring anywhere in the world has been unaccompanied by a labour shake-out and a freeze on wages, salaries and bonuses of the retained workforce. Raising TFP and cutting costs with an unchanged workforce is impossible to achieve. Finally, Pakistan needs to keep a careful watch on the evolution of the ‘real’ exchange rate, namely, the nominal exchange rate adjusted for inflation since the exporter is interested in the ‘real’ value of the rupees he earns per dollar of exports after allowing for inflation and not the nominal value before adjusting for inflation. Too often in the past, because of political pressure and the mistaken belief that a ‘stable’ nominal exchange rate is a reflection of good policies, the exchange rate has been allowed to appreciate in real terms, giving the exporter fewer real rupees per unit of exports. Price competitiveness, as reflected in the real exchange rate is an important—albeit not the only or exclusive—determinant of export success. Only by bringing our domestic inflation rate down in line with (or below) our competitors and trading partners can a stable nominal exchange rate be consistent with constant (or rising) real export profitability. Higher domestic relative inflation means that we need to push the nominal exchange rate downwards as we do now just to compensate for our higher relative inflation differential vis-à-vis our trading partners and competitors. This is a self- defeating policy since it makes the task of inflation control doubly-difficult as a depreciating currency pushes up import costs which percolate into the cost and price structure of other goods and service in the economy. This is a broad brush listing of some of the key macroeconomic reforms that Pakistan urgently needs to implement. However, reforms of the macro 210economy need to be underpinned by sectoral and micro policy action. Much can be said about these sectoral reforms but that should be left to the sectoral experts in agriculture, energy, education and skill development, and health services. Suffice it to say, the true potential of Pakistan’s agriculture sector remains largely untapped and new sources of growth can and must be found. Pakistan needs to move away from being a single-cash-crop economy and diversify into higher value-added commodities for domestic consumption but especially for export. It is self-evident that we must solve the problem of crippling power outages if the economy is to resume steady growth and create new employment opportunities. The unfortunate saga of the rental power projects is an evil that the economy will have to live with as a short-term solution until more cost-efficient sources of power can be brought on stream, including hydropower and nuclear power. In the social sectors such as health and education, the government should use hard rising floors to protect development allocations for these sectors and keep them in line with or ahead of inflation. A system of floors will also help safeguard allocations in times of fiscal stringency. The practice of cutting development spending or withholding releases of funds for ongoing projects and programs to meet fiscal targets needs to stop. Since across-the-board cuts in development are non- discriminatory, they play havoc with the economic viability of good projects by pushing up costs and lowering promised benefits. By lowering investment efficiency, and the rate of return on the public sector capital stock, such unpredictable cuts undermine the medium-term growth potential of the economy and reduce TFP.

Postscript: The Great Flood of 2010

The Great Flood in the summer of 2010 caused widespread damage to the economy, especially to major and minor crops and the livestock sector. Irrigation, transport and power sectors were also badly hurt. Manufacturing was for the most part spared by the ferocity of the flood. The World Bank and Asian Development Bank’s estimate of the flood damage was around $10 billion. What all this means for the economy going forward is difficult to tell but a plausible scenario can be sketched out.

In the very short-term (perhaps the first two quarters of 2010-11), real GDP is likely to contract by about 1.5 per cent amidst a spike in inflation, especially food inflation trapping the economy in stagflation from which it 211emerged only recently. Both the domestic and external deficits will come under strain. In the former case this would be because of the need to spend vast sums on rehabilitation and rebuilding damaged/destroyed physical and social infrastructure as well as pay one-time compensation to those affected or displaced by the flood. Externally, exports could falter—especially of traditional items such as textiles and leather. Import demand will be strong- led by food, raw cotton and the import content of replacement capital investment. Nevertheless, the external side need not come under undue pressure. Workers’ remittances could see a significant further rise as families ask for larger transfers to cope with their needs for food, clothing, shelter, medicines and buying of livestock and other agricultural inputs lost in the floods.

Foreign aid inflows (including reimbursement from the US Coalition Support Funds), additional IMF financing under their low-conditionality natural disasters facility ($451 million), as well as further drawings under the ongoing SBA arrangement should help keep foreign exchange reserves at a comfortable level with a ‘cover’ of five to seven months of projected imports. The government announced new ‘measures’ in a revised budget for 2010–11 to reflect post-flood realities. On the revenue side, it tabled before Parliament the Reformed GST (RGST) with a single rate of tax of 15 per cent along with a sweeping elimination of exemptions as well as bringing the hitherto untaxed services sector under the RGST net.

Since the old GST tax rates varied from 17 per cent to 25 per cent, a single 15 per cent rate of tax under the RGST could imply price reductions across a broad range of items. In Autumn 2010 the authorities announced a temporary flood surcharge on incomes above a certain exemption threshold in addition to a doubling of the Special Excise Tax on selected non-essential imports to 2 per cent. Fears of a renewed bout of inflation resulting from these measures appeared to be overblown. Nevertheless, the Competition Commission of Pakistan (CCP) will have to be vigilant to ensure that price reductions do take place where taxes have been cut while being watchful about cases of price-gouging or other anti-competitive abuse in the new tax environment. The CCP’s excellent track record of enforcement gives confidence that they will help to protect the interest of the Pakistani consumer. On the spending side, non-interest non-defence expenditures at the federal level have been frozen in nominal terms, whilst the public sector 212development program has undergone a drastic cut in size with new projects put on hold and implementation of ongoing, externally-financed projects and programs being accelerated. Along with the cut, there was significant reprioritising of the development program, shifting resources to sectors directly helpful to and related to post-flood reconstruction. The provinces have also been asked to pare down their overly ambitious development program to bring them more in line with their technical and administrative capacity to implement them. This would reduce their presently large deficit budgets. Taken together, these revenue and expenditure-saving measures at the federal and provincial levels are expected to yield a consolidated (federal plus provincial) overall fiscal deficit of around 4.7 per cent of GDP in 2010–11, which by all accounts has the begrudging blessings of the IMF who would have wanted the pre-flood end-year deficit target to remain unchanged at 4 per cent of GDP. However, even with this upward revision in the deficit target, Pakistan should be in a position to secure the next tranche under the continuing SBA, provided the Executive Board of the IMF approves requests for waivers for non-compliance of performance criterion, since the measures taken now have been delayed and the performance criterion set earlier were breached.

The government did not take advantage of the crisis to push through more radical—and highly desirable—measures, such as imposing a 10 per cent tax on the market value of all immoveable properties (residential and commercial) in the major cities, along with insisting that the provinces tax agricultural income above a certain threshold from land not affected by the floods. To many, a deep flaw in the recent National Finance Commission (NFC) award—which saw a significant shift of resources devolve to the provinces—is the lack of any conditionality. Fiscal devolution should have been accompanied by a clear understanding that, should the provinces fail to raise their own revenues, releases from the NFC award would be withheld by the amount of the tax revenues foregone. There has not been any hint of bringing back more progressive forms of taxation, such as the wealth tax or gift tax, which would not only be revenue-enhancing but would also impart greater progressivity to the tax system. However that may be, if the authorities are able to achieve a consolidated fiscal out-turn of 4.7 per cent of GDP in 2010–11, aggregate demand pressures in the economy would be reduced, government borrowing and hence interest rates would decrease, the private sector would be ‘crowded-in’ and inflation could start to subside 213quickly, thus enabling the central bank to cut its policy rate of interest and boost growth.

The Great Flood has caused widespread hardship and misery— displacing some twenty million people who were already poor and vulnerable—and significant capital destruction. However, the task of rebuilding the capital stock presents a unique opportunity for Pakistan to build a new and invest in new-vintage technologies that would raise productive efficiency and boost Total Factor Productivity. Once the relief phase is complete, the task of rebuilding could result in a sustained surge in domestic demand led by new investment. Provided this phase is handled in the context of an overall macroeconomic framework that is prudent and fully-financed by non-inflationary methods, real GDP growth could rebound in a V-shaped recovery accompanied by significant gains in employment, wages and poverty reduction with the demand stimulus lasting for three or four years. After contracting in the first two quarters, real year-on-year GDP growth in 2010–11 could be in the region of 2–3 per cent—an estimated outcome that is in line with the central bank’s most recently published report on the economy. Such an outcome could be said to be satisfactory, given the dire starting circumstances. Once economic recovery takes hold, Pakistan’s policy-makers should take the opportunity to start the process of implementing the macroeconomic and structural reform agenda sketched out in the main body of this chapter with far- reaching structural reforms making the economy resilient, more efficient and self-sustaining.