Macroeconomic Reform Agenda

1. 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.

2. Pakistan needs tax 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.

3. Pakistan needs to introduce social safety nets for the poor and vulnerable.

This will protect them during high inflation or slow growth.

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.

4. Pakistan needs to move away from reliance on politically driven and volatile ‘foreign savings’ or more specifically official bilateral aid 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.

5. 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.

6. 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.

7. 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 narrower 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.

8. Pakistan needs watch the ‘real’ exchange rate, namely, the nominal exchange rate adjusted for inflation.

This is because 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.

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.