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 unremarkable.

The economy was kept on a stable path thanks to the ultra-conservative approach of Ghulam Ishaq Khan.

He was:

• the country’s financial kingpin.
• averse to:
  • changing the economic status quo
  • the recommendations of IMF/World Bank for freer markets, privatisation, exchange rate flexibility and a bigger role for the private sector.

In a World Bank 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.

Foreign aid once again was the main driver of growth. But the aid Pakistan received during these years was well spent.

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.