Electoral will meets economic reality in Pakistan

SAKIB SHERANI ET AL

ARTICLE (April 04 2008): We posit that the most immediate, as well as pressing, economic challenge facing the incoming administration is to restore fiscal order. In our view, without macroeconomic stability, the political government will not be able to deliver on its electoral promises in a sustainable manner.
As a result of policy inaction in addressing structural issues over a protracted period, and a wrong set of economic priorities, in our view, followed over the past several years, Pakistan’s economy faces a grave set of challenges. Among the many issues, which range from high inflation to power deficits and water stress, the most immediate and pressing is the need to restore fiscal order.

Policy-induced imbalances on a wide front have seriously eroded hard-won macroeconomic stability. If left unaddressed, these threaten to reverse the gains made on the economic front in the last few years – gains which have proved largely transient in key areas – while greatly degrading the capacity of government to meet longer-term challenges.

While pressure on the coalition government to reduce the economic hardship of the electorate is understandably intense, the policy response needs to balance the alleviation of palpable hardship in the short term, with the ability to provide sustained benefits over the longer term. Given the sharp constriction in available fiscal space, it is our belief that adopting a policy course in the short run that raises expectations of ‘relief’ may not be wise, in either political or economic terms. (It follows from this that we have reservations about ’100-day’ programs).

In the longer term, however, we believe it is a misconception to view the available choices in purely binary terms, ie that ‘macroeconomic stability’ (a much-maligned term, loath to politicians not just in Pakistan) is mutually exclusive to ‘pro-poor’ agendas. Raising revenues by broadening the tax base meaningfully, in conjunction with rationalising bloated government/public sector expenditures can free fiscal resources, which can be diverted to targeted subsidy programs. Ignoring macroeconomic stability, on the other hand, will eventually also undermine the ability of the government to influence economic growth, as growing fiscal and monetary constraints limit its ability to run appropriate policies. As experienced in the 1990s, this will slow down both investment as well as growth, hurting the poor.

In addition, a large part of the problems facing the average citizen relate to inadequate or complete non-delivery of public goods and services, in spite of budgetary allocations. In this sense, improving delivery outcomes is a governance, rather than a purely fiscal, issue. Improved governance, rather than one-shot programs, will deliver more meaningful, and more sustainable, results, in our view.

In essence, the dilemma of delivering short run ‘gains’ that may come at the expense of longer-term interests or health of the economy, distills into an agency issue at the heart of governance – how to incentivise elected political governments to think beyond an election cycle.

OVERVIEW:

The incoming government is being greeted by a less-than-sanguine picture of underlying economic conditions. Over the course of the past approximately two years, we believe that fiscal profligacy on the part of government has seriously eroded macroeconomic stability. The fiscal deficit has reversed course sharply, and for the first half of the fiscal year (July-December) has been recorded at 3.6% of

GDP, only 0.4 percentage points lower than the full-year target set in the budget. On current trends, the budget deficit for the full fiscal year is likely to cross 6% of GDP, even after countervailing measures. To put this into perspective, and to allow for a comparison with the 1990s, our estimated outturn for the fiscal deficit in FY08 translates into the equivalent of 7.5% of GDP using the previous series of national accounts (with 1990-91 as base year – see Chart 2).

In addition, the external account has posted widening imbalances, with the current account on course to cross US $10.5 billion in FY08 (to over 6.6% of GDP – Chart 3). Forex reserves have been depleting since the start of the fiscal year (Chart 4), with a net hemorrhaging of US $3.6 billion from July to 15 March (net foreign assets of the banking system, based on weekly monetary data).

Based on the last available numbers, we estimate unencumbered liquid Fx reserves with the central bank to total US $11 billion (net of forward sales/swaps) for the week ending 29 February.

As a consequence of widening imbalances, government budgetary borrowing has risen sharply, with public debt increasing by an annualised 16% by the end of the first quarter (July-September FY08) – reversing the trend of relatively tame growth over the 2002-06 period (Chart 5).

A corollary to higher government borrowing is a fairly rapid increase in debt servicing costs. Interest payments in the first six months of FY08 have soared over 52% versus the corresponding period in FY07, after recording a 50% yoy jump in FY07 (Chart 6).

A large part of the increase in public debt has come via monetisation of the fiscal deficit, with the government sector borrowing from the central bank for year-to-date FY08 touching Rs 367 billion (US $5.8 billion, or the equivalent of 3.7% of full-year GDP) as of 15 March (for more details see next section).

In conjunction with the oil/commodity price shock, fiscal indiscipline, in our view, has been a major contributor to underlying inflationary pressure in the economy, with an unfavourable dynamic for domestic inflation in the near term. We expect full-year CPI inflation to cross 9% by end-June. Unsurprisingly, at the core of the deterioration in the macroeconomic environment is a rapid weakening of the fiscal position.

FISCAL NUMBERS: The most recent official data releases paint a worrisome picture, especially on the fiscal side. The budget deficit for the first half of the fiscal year (July-December) has been recorded at 3.6% of GDP, only 0.4pp lower than the full-year target set in the budget.

While ‘one-off’ items such as expenditure overruns in the run up to elections, energy-related subsidies, and disruptions to revenue collection in December, exacerbated the outturn, we believe that the underlying trend of high government spending and a narrow revenue base is at the root of the growing imbalances.

Compared to the corresponding period of FY07, the fiscal deficit has widened 111% for 1HFY08 (July-December 2007). Expenditure growth has outstripped revenue collection. Current expenditures have ballooned 33%, accelerating a trend recorded over the past several years.

On the back of higher public sector borrowing, a turn in interest rates, and unanticipated lumpy repayments of national savings scheme instruments, debt servicing (interest portion) has recorded a substantial increase, rising 52.6% in 1HFY08 vs 1HFY07. In addition, defence spending has also registered a 14.7% increase.

The other big contributor to the sharp rise in public expenditure is the ‘development’ spending heading under the Public Sector Development Program (PSDP). PSDP expenditures have risen nearly 53%, making them the second biggest contribution in absolute terms to the increase in the fiscal gap for the first half of FY08 (after interest payments). The increase in PSDP spending is a continuation of the trend over the past few years.

While the rise in PSDP spending has been touted as an achievement of the Musharraf-Shaukat Aziz era, we have reservations both about the size of the outlay as well as the quality of the projects portfolio.

Apart from the fact that some portion of ‘non-civilian’ spending is parked under this heading (such as construction of ‘strategic’ highways and new cantonments), the PSDP appears to have been used as an instrument of political patronage, in our view, especially in the run up to the national elections.

In addition, we believe that project selection has remained less rigorous than desired, with the result that projects with questionable economic value, or a lower-order priority, appear to have been pushed through, attracting sizeable funding commitments from the budget. Finally, there is the question of the substantial leakage that occurs from the PSDP – a feature of the 1990s that appears to have remained largely intact.

Anecdotal evidence such as the dramatic collapse of a large section of the Northern By-pass in Karachi a few months after construction, or the construction of a major portion of the ‘strategic’ Makran Coastal Highway at least twice in the space of a few years (owing to substantial damage caused by heavy rain), among other examples, only serves to reinforce public scepticism.

With elections out of the way, the release of the pending tranche of logistics payments by the US, and a slow transition to the new political government inevitably putting the brakes on big-ticket public spending, the second half’s fiscal numbers should be better. Even after adjusting for one-off factors, however, we now anticipate the FY08 fiscal deficit to likely be around 6.2% of GDP.

To put this into perspective, and to allow a comparison with the 1990s, our estimated outturn for the fiscal deficit translates into the equivalent of 7.5% of GDP under the previous series of national accounts (with a base year of 1990-91). In comparison, the average fiscal deficit recorded during the decade of the political governments (1989-99) was 7%, with the budgetary gap touching a peak of 8.8% of GDP in 1991.

Going forward, with the unrelenting upward march of world oil prices affording no respite, and the very real possibility of the government footing a huge subsidy bill on the new wheat crop (by rough estimates, to the tune of around Rs 30-40 billion), the incoming administration will face a pretty severe constriction of fiscal latitude – not unlike the 1990s. In addition, the continued large fiscal strain imposed by strategic enterprises such as Wapda, Kesc, and PIA (see Chart 7), combined with a standstill in the tax-to-GDP ratio, will also exert pressure on the budget, pointing to the painful lack of progress in the more difficult structural reform over the past several years.

The net result of expenditure overruns and declining momentum in revenue collection, in conjunction with the commodities price shock, is likely to be a breach of two key provisions of the Fiscal Responsibility and Debt Limitation Act in FY08.

1. The budget will record a revenue deficit for fiscal year FY08 ending June 30, 2008.

2. Public debt will not decline by a minimum of 2.5 percentage points of GDP for the second consecutive year.

If indeed this is the case, the change in the path of the public debt trajectory should be a cause for concern. Mainly on the back of healthy increases in nominal GDP, the public debt to GDP ratio declined each consecutive year, from 100% in 1999 to 55.2% in 2007. Hence, a reversal of course viz. the public debt path will represent the first increase in the ratio in nine years.

Also in our view, the previous government’s funding strategy is likely to compound the woes of the next government. Since 2005, the Ministry of Finance has relied excessively, we believe, on borrowing from SBP (ie monetising the deficit), in an effort to limit the increase in interest payments.

In doing so, it has cumulatively borrowed Rs 593 billion (equivalent to US $9.8 billion at the average exchange rate for the period, or 7.2% of average GDP) directly from the central bank over the past three and a half years.

For the current fiscal year, almost 70% of the incremental increase in domestic public debt has come from budgetary borrowing from the central bank, significantly raising the short-term component of the government’s local currency debt.

From the Ministry of Finance’s perspective, and purely from an annual budgetary point of view, the funding strategy involving borrowing from the central bank appeared to be ‘low cost’ in that:

1. On the one hand, the government was paying ‘below-market’ interest rates (from what otherwise would have been the case had GOP borrowed from the primary market), while on the other, it was ‘recovering’ its interest payments via higher central bank profits;

2. Private borrowers could be protected from being ‘crowded out’; As a perennial exercise, this debt strategy’s shortcomings are obvious to us – and have repeatedly been pointed out by the central bank. Apart from the fact that the government’s unchecked borrowing from SBP has served as a counter-weight to the tight monetary policy the central bank is running to fight inflation, this strategy is purely short term in nature.

Ultimately, the central bank has to reverse the stockpile of net domestic assets (NDA) on its balance sheet, by offloading the same to banks. At that stage, it could crowd out private borrowers as well as pressure interest rates upward.

Given the excessive reliance on borrowing from SBP – an avenue which is now increasingly restricted – the new administration could face an uptick in interest payments on public debt as the floating debt is ‘re-priced’ at market clearing rates.

All in all, the incoming government is more than likely to face a fairly substantial constriction in fiscal space, unless it is offset by significant expenditure containment – or, in the short run, by budgetary grants such as the one-off Saudi oil aid amounting to US $300 million.

POLICY FIXES: Despite the gravity of the challenges at hand, all does not appear to be lost. With prudence and determination, and a bit of luck, the situation is largely retrievable, in our view. Some suggestions follow.

IN THE SHORT RUN, THE NEW GOVERNMENT SHOULD:

– Be prepared to sacrifice economic ‘growth’ in the near term. We are of the opinion that a growth-centric paradigm aiming to achieve impressive headline rates of GDP expansion via fiscal stimulus and a surge in domestic liquidity is at the root of Pakistan’s current imbalances.

– Reduce the subsidy burden on the budget by running more targeted programs.

– Run a small, but efficient, government. Reduce the size of the cabinet which was bloated, in our view, under the Shaukat Aziz-run administration. Cut the number of federal ministries and divisions, by reducing overlap of functions.

– Re-prioritise all spending, especially within development spending. The portfolio of projects under the PSDP needs to be critically re-examined for ‘importance’, ‘criticality’, and ‘economic benefit’. Projects with questionable benefits need to be axed, while leakages due to delays in execution, faulty implementation, and/or corruption need to be minimised.

– Discretionary current expenditure needs to be curbed. Some suggestions: a wage freeze for military personnel/civil servants can be effected, together with a halt to any further generous perks and privileges accorded to parliamentarians. No new vehicles and/or office furnishings for government servants should be allowed for the next three years.

– Redirect borrowing for budgetary support from the central bank to non-bank sources such as Pakistan Investment Bonds (PIB), with a re-profiling of the maturity structure of the debt into longer-term tenures.

– Introduce a ceiling on annual government borrowing from the central bank by an amendment to the Fiscal Responsibility and Debt Limitation Act 2005.

– Enhance revenue generation by allowing the capital gains tax exemption on equities to lapse on June 30, 2008, and introduce a tax on real estate transactions. This will promote equity in taxation, as well as serve to deflate elevated real estate prices which are hindering new investment. It will also re- start mortgage financing and construction activity.

– Aim to achieve a neutral or a surplus revenue deficit situation by September-end this year;

IN THE LONGER TERM:

– Initiate measures to increase the tax to GDP ratio by at least one percentage point a year through ‘structural’ improvements – ie by widening the tax base. More than agriculture, the services sector appears to offer the greatest prospects for further revenue enhancement. Recent growth has come mainly from the services sector, which now accounts for 53% of GDP but contributes only 26% to total tax revenue.

– Reduce the huge strain on fiscal resources imposed by the remaining state-owned enterprises, mainly PIA, Wapda and Kesc. We believe that this can only be achieved through a more effective restructuring effort on the part of government, which will require, first and foremost, that these enterprises are not viewed as ‘quick fixes’ for creating new employment.

– Develop alternate energy sources, and expand conservation efforts. Make energy conservation targets more ambitious.

– To ensure better supply of food grains, and to reduce the import bill, maximum focus should be directed towards enhancing agricultural productivity. Pakistan has reached the frontier of its extensive farming strategy, and now needs to re-orient its agriculture sector towards higher value-added (and less water-intensive) crops. By galvanising crop research and extension services, productivity levels can be raised substantially. In terms of administration, the agriculture sector is a provincial subject. However, a lack of ownership (and funding) of the sector is apparent, and needs to be reversed.

RISING TO THE CHALLENGE?

Given the foregoing, the key question is whether the coalition government is up to the task. On this score, we believe the new government is handicapped on at least three fronts.

The first, and we believe foremost, handicap stems from the fact that the economic hardship of a large swath of the populace is both palpable as well as real, increasing the pressure on the coalition parties to deliver some immediate steps towards alleviation. A period of viciously high inflation, especially food inflation, has burdened the average Pakistani over the past few years. To put this into perspective, using the Consumer Price Index (CPI) as the inflation gauge, the price level has risen over 27% cumulatively over the past three years. Food inflation has been a major contributor, rising 32.6% over the 2005-07 period.

A toxic combination of domestic crop shortages and the sharp run up in global commodity prices was compounded by bad governance, with reports of extensive hoarding and smuggling of sugar and wheat, in particular. (In 2006, the President shelved a National Accountability Bureau inquiry into the sugar crisis, reportedly citing a threat to the ‘stability’ of the government).

Compounding the economic misery of the population has been the fact that while top-line economic growth appeared impressive over the past several years, the headline figure masked the extremely skewed nature of the gains.

In addition, the economic expansion generated under the finance team led by PM Shaukat Aziz was relatively ‘jobless’ in nature, with employment gains artificially inflated via the use of the ‘unpaid family help’ category – a statistical construct that accounted for the bulk of the jobs created over the past five years (Chart 9).

The combination of high inflation, limited job creation, and extremely skewed income gains proved electorally lethal for President Musharraf’s political allies. Little wonder that when polled in February 2008, 86% of the respondents reported either a ‘worsening’ of their individual economic condition, or ‘no change’ over the previous year – up from 70% in December 2006 (Chart 10), and a surprisingly high percentage for an economy supposedly experiencing a ‘miracle’.

Hence, the platform on which the anti-Musharraf parties ran was mainly an economic one, as encapsulated in their manifestos (see below), though antipathy towards the ex-General’s actions against the judiciary, his pro-US stance, and the military operation against the Red Mosque in Islamabad appear to have also contributed to his allies’ heavy electoral defeat.

============================================================================================================ Table 1 : Party manifestoes (extracts) ============================================================================================================ PPP PML-N ============================================================================================================ Main goals of economic policy Full employment Reduce rich-poor divide High, sustainable growth Expand employment Contain inflation through opportunities Achieve 100% enrollment prudent monetary and fiscal policies levels Growth with equity Guaranteed employment of ‘at New employment opportunities least’ 1 year to one working member of poorest 25% to be provided to over three Major policy commitments families via labour-intensive million persons in public as well as private sector Public Works Programme Employment guarantee of two National Employment Fund, years to all youth completing National Education Corps and Intermediate, Graduation and Land Development Post-Graduation in a given Corporations to be established year All children in govt primary Tax holiday of three years for schools to be provided stipend all new industries New industrial estates Minimum wage to be enhanced alongside motorway Education in public sector Conditional cash transfers to institutions up to higher poor families secondary to be free of cost Special programs for least Minimum wage to be enhanced developed districts Senior citizens over 65 years Reasonable food prices to be with no source of income to be maintained throughout the provided financial support year ============================================================================================================

The second limitation the incoming coalition government may face in dealing with the fiscal situation is ‘ideology’. Both the PPP and the PML-N are growth-centric in their approach, and broadly prefer supply-side responses over demand-management. This bias is clearly reflected in not only the two parties’ election manifestos but also their performance viz the economy while in government during the 1990s (Table 2). High government expenditures coupled with weak revenue collection led to persistently large fiscal deficits, averaging 7% over the 1989-99 period. Between the two, the PPP appears to have been moderately more successful in containing expenditures, as well as the budgetary gap.

===================================================================================================================== Table 2 : Economic performance of political parties FY89-07 ===================================================================================================================== Avg for period, % of GDP unless specified: ===================================================================================================================== Avg. CPI Real pvt Real GDP inflation investment ===================================================================================================================== Fiscal Years Party in power growth (%) Fiscal deficit Gross revenue Expenditure (Y/Y %) (y/y % chg) ===================================================================================================================== FY89 – FY90 PPP-P 4.7 7.0 18.3 25.9 8.2 10.0 FY91 – FY93 PML (N) 5.0 8.1 18.1 26.2 11.0 6.1 FY94 – FY96 PPP-P 5.4 6.0 17.6 23.6 11.7 4.4 FY97 – FY99 PML (N) 3.1 6.7 15.9 22.7 8.4 0.0 FY03 – FY07 PML (Q) 7.0 3.6 14.4 18.5 6.6 9.4 Memo: FY03 – FY07* PML (Q) 7.0 4.3 17.3 22.2 6.6 9.4 ===================================================================================================================== *using 1990-91 as base Source: Ministry of Finance; ABN Amro Bank (Pakistan) Ltd =====================================================================================================================
In our view quite obviously, a note of caution is in order regarding the outturn during the 1990s. Definitive conclusions about the effectiveness of policies of different political governments since 1988 cannot be readily drawn from the data presented above for a number of reasons.

First, successive governments faced a difficult set of conditions from 1988 onwards. The first PPP government with Ms Bhutto as Prime Minister inherited a stock of public debt whose dynamics were already unfavourable, while the first PML-N government in 1990 was faced with a crippling round of US economic sanctions relating to Pakistan’s nuclear program, which had a far-reaching impact on investor perceptions and capital inflows. Similarly, the country was sanctioned yet again during the second PML-N government (1997-99) on account of its response to India’s testing of nuclear devices with its own round of tests.

In fact, Pakistan’s economy lurched from crisis to crisis in the 1990s, with devastating floods and a ruinous viral attack on the key cotton crop in the early part of the decade, and a prolonged period of ethnic strife in Karachi that cast a shadow over the economy. To make matters worse, the transition to democracy that began in 1988 was uneasy, with at least seven different governments coming to power (including caretaker set-ups charged with overseeing elections) between 1988 and 1999.

Hence, considerable extraneous influences – from geopolitics to weather-related – exerted themselves over this period, worsening an already fragile economic condition. In addition, the outturn on the parameters chosen in Table 2 does not reveal an important dimension of economic policymaking – the extent of reform introduced. In this context, the 1990s saw considerable progress in liberalising the economy – particularly in the case of tariff reform and financial sector liberalisation – under both PML-N as well as the PPP governments.

That said, not all economic outcomes during the 1990s were exogenously determined. We posit that policies adopted by the two mainstream parties in power largely worsened an already precarious situation – both economic as well as political – with a dangerous drift towards polarisation in the country.

In addition, there were a number of substantial offsets to the otherwise dire economic situation. Liberalisation of the capital account in the early 1990s by the first PML-N government – combined with tax exemptions and constitutional guarantees against expropriation – encouraged reverse capital flight and a very rapid build-up of balances in onshore foreign currency accounts (FCAs).

The hard currency from these accounts, coupled with inflows of ‘hot money’ under the FE45 scheme for offshore institutional investors, was used by the authorities to finance the growing external imbalances through the 1990s. The other significant offset was the Saudi oil facility (essentially a grant), which was made available after Pakistan tested its nuclear devices in 1998, and continued till 2003. In total, this grant amounted to several billion US$s.

Returning to our argument concerning potential impediments to running an economic program with a stabilisation thrust, the third handicap is embedded in politics. Almost by definition, pursuing a course of action that may be deemed to increase the economic hardship of the electorate may be a non-starter for a four-party coalition.

The fact that the PPP is coming back into government after a twelve-year interregnum, while the PML-N is staging a comeback after being removed by General Musharraf’s coup in 1999, reduces the likelihood of stabilisation policies, in our view. Hence, the ‘natural’ instinct for the coalition government may be to finance its way out of the current situation, rather than to adopt a path of adjustment, not unlike the course of action chosen by the predecessor administration. If so, we believe that it will only be delaying the inevitable.

CONCLUSION:

Pakistan faces a difficult economic situation, even as the political transition to a popularly elected government has proceeded far more smoothly than anticipated. The current rough patch for the economy is not entirely unexpected, given the deeply flawed growth strategy that was being pursued since 2002. By and large, and despite the exogenous shocks, Pakistan’s imbalances are policy-induced. Herein lies one important piece of good news – that the situation can be reversed.

It remains to be seen what policies are introduced, and how effective they will be in addressing the imbalances. However, one thing is clear, in our view: a ‘muddle through’ approach will not succeed. Without forceful measures, including possibly politically unpalatable ones, Pakistan may be unable to successfully navigate out of the current difficult situation.

(By ABN Amro Bank NV, Islamabad)

 Courtesy: Business Recorder