ARTICLE (June 05 2008): Introduction: The Budget season is here again. But this year”s budget is unique because of a number of factors. First, there are high expectations from the democratic government which has acquired the reigns of government after a gap of eight years. Second, it comes at a time when the economy is in the midst of an unprecedented level of stress following a period of apparent buoyancy.
After the bonanza following 9/11, the economy revived achieving not only high growth and macroeconomic stability but also some poverty reduction. However, the growth was neither inclusive nor sustainable. Till last year there was little realisation or acceptance of how vulnerable the foundations of that so called ”buoyancy” was and how gradually the economy was heading towards difficult times. The unravelling started last year. By the time the new government took power, the economy had already been through power and atta crises and the price hike had assumed alarming proportions.
How grave is the current macroeconomic situation? Pakistan is facing serious economic challenges in terms of high inflation and unsustainable fiscal and current account deficits. The revised estimate of fiscal deficit is 9.5 percent of GOP as revealed by the Ministry of Finance in April 2008.
This unsustainable fiscal deficit is putting pressure on monetary policy, resulting in higher growth in monetary aggregates. This monetary expansion together with higher international oil and food prices has already translated into high double-digit inflation.
Moreover, the projected estimate of current account deficit for 2007-08 has crossed 8 percent of GDP, soaking up foreign savings and resulting in depletion of foreign exchange reserves and increase in foreign debt. These deficits and the alarming level of inflation have affected the pace of economic growth. There are signs that GOP growth would be below 6 percent in 2007-08, below the current year”s target and the growth rate last year.
This challenging economic situation leads independent economists as well as policy makers to ask the fundamental question: “what are the fiscal policy options that can help control the slide in the economic fundamentals? How can the poor and the vulnerable be protected from the burden of economic adjustment?” This pre-budget report gives SPDC”s perspective in this regard and attempts to present feasible options available to the budget makers in Islamabad to improve the macroeconomic situation and insulate the poor from the burden of adjustment.
The report has five sections. Section 1 discusses current macro economic trends. Section 2 presents the macroeconomic scenario for 2008-09. Section 3 presents the contours of tax policy for improved resource mobilisation and redistribution. Section 4 discusses the policy choices with regard to oil pricing. Finally, Section 5 discusses social protection in Pakistan and evaluates various social safety net options available to the government in Pakistan at a time when relief to the poor must have topmost priority.
MACROECONOMIC TRENDS IN RECENT YEARS: An important question which arises is whether the current state of economy is a result of recent external shocks or whether the economy was moving in this direction and corrective policy measures were not taken timely to reverse the deterioration in trends or at least limit them? It appears that our present economic predicament is a result of a combination of factors, both of a short and long term nature. Furthermore, the factors are both domestic and exogenous in character. We discuss these below.
The GDP growth rate peaked in 2004-05 at 9 percent. Since then there has been a gradual decline in the growth rate, most pronounced in the manufacturing sector. Also, there has been considerable volatility in agricultural growth and the average growth rate is down in the current decade to 2.5 percent as compared to over 4 percent in the 90s. Much of the buoyancy has been concentrated in the services sector.
Inflation has been threatening the economy since 2004-05 as shown in Table 1.2. Cumulative inflation from 2004-05 to 2006-07 has been 27 percent in the overall CPI and 33 percent in food prices. As per the recent press conference of the Governor of the State Bank, food inflation at present is 25 percent on a year-to-year basis.
What has caused this spiralling inflation of almost an unprecedented level in recent history? Since 2002-03, the monetary policy stance has been expansionary. There was lack of sterilisation of foreign exchange flows which came into the country after 9/11. The initial impact was, of course, growth in output in 2003-04 and 2004-05, which peaked at 9 percent.
Thereafter, monetary expansion has increasingly spilled over into higher inflation, due to limits of capacity. The initial boom was basically a release of ”repressed growth”. The precipitous fall in interest rates sparked off an explosion in private sector credit and raised aggregate demand in the economy. Expansionary monetary policy also helped in creating ”fiscal space” due to the sharp fall in interest payments.
Overall, it appears that inflation was initially monetary in character. Monetary policy remained ”too easy for too long”. Come 2007-08, structural dimensions added to inflation due to “external shocks” of raising oil and food prices. However, the impact had not been felt directly till recently because of limited pass through into domestic prices.
An indirect effect has come via the sharp jump in the subsidy bill that has raised the fiscal deficit which has been financed largely by borrowings from the Central Bank. It is clear that the expansionary fiscal policy is now putting pressure on monetary policy. Consequently, inflation has reached double-digit level and is acquiring a ”spiralling tendency” as domestic prices (for example, energy) are being adjusted upwards.
The economic managers did a good job of fiscal stabilisation up to 2003-04 as shown in Table 1.3. This was due, first, to severe containment in development expenditure and fall in interest payments following the rescheduling of debt. There was over a 3 percent of GDP drop in public expenditure. However, there was no improvement on the revenue side.
Deficit started increasing after 2003-04 as public expenditure was built up once again with rising PSDP and higher non-interest current expenditure. By 2006-07, public expenditure had exceeded the 1999-2000 level by 0.5 percent of the GDP.
Deficit approached the 4.5 percent level. We witnessed an emergence of revenue and primary deficits. The former implied that the government had started to borrow to run its day-to-day operations.
It is not clear if there was full accounting of expenditures in earlier years. In 2006-07, interest payments went up sharply by 1 percent of GDP due particularly to the maturity of Defence Saving Certificates (DSCs). Also, it is not clear if defence expenditures (due to operations in the North), export subsidy payments, jump in pre–election development spending by provincial governments, etc were fully accounted for. It is not surprising that the so-called “unidentified” expenditure reached a peak of 1.4 per cent of the GDP in 2006-07. If such expenditure did take place then the ”true” fiscal deficit had already approached 6 per cent of the GOP in 2006-07.
Perhaps the biggest disappointment of fast growth was that this was not translated into an increase in the tax-to-GDP ratio, which remained stagnant around 10-11 percent. This stagnation can be attributed to a number of factors, including, decline in tax rates, plethora of concessions and exemptions given and inability of the taxation authority to expand the tax base. Detailed discussion of these factors is presented in Section 3.
The large deterioration in the fiscal deficit position in 2007-08 is attributable both to domestic factors and external shocks. The former includes costs of military operations in Swat and unbudgeted export subsidy. External shocks include the impact of higher oil prices in the form of deferred claims of Oil Marketing Companies (OMCs), wheat import subsidy and higher power subsidy to WAPDA (due largely to rise in costs of fuel).
An additional complication in 2007-08 is the reliance by the government on financing the large incremental deficit, of 5 % per cent of GDP, primarily through borrowings from the Central Bank. This has led to magnetisation of the deficit. Presumably, this was done to keep a lid on interest rates and to prevent a large-scale crowding-out of the private sector, thereby jeopardising the process of growth.
In effect, the policy choice has been in favour of higher inflation to support growth in the face of shocks.But such a policy could prove counterproductive because the negative real rate of interest in the economy could discourage saving and increase the investment-saving gap, leading to corresponding rise in the current account deficit, which is what has happened.
BALANCE OF PAYMENTS:
Pakistan experienced a strong balance of payments position in earlier years of the new millennium. After 9/11, the jump in private transfers led to current account surpluses from 2001-02 to 2003-04. Thereafter, there has been a steady deterioration as shown in Table 1.4.
Source: State Bank Of Pakistan, Annual Report IMF Article 4 Consultation”s Press Releases
Strong growth in aggregate demand, liberalisation of imports due to falling tariffs, falling interest rates and emergence of consumer financing increased demand for imported consumer durables while private investment (mostly with imported machinery) also rose because of the fall in financing costs. Therefore, unprecedented growth was experienced in imports. As shown in Table 1.5, non-oil non- food imports increased by over 38 per cent and 31 percent in 2004-05 and 2005-06 respectively. The marginal propensity to import jumped up three times in relation to the 90s. Clearly much of the increase in this period was due to the jump in ”non-essential” imports.
This was sustained by fairly rapid growth in exports up to 2005-06.
— excluding oil and food imports
Thereafter exports began to falter. Favourable developments in the capital account starting with debt rescheduling and larger aid inflows improved the reserve position. Reserves peaked at 6.5 months of imports of goods and services in 2002-03 and fell to about 3.5 months by 2005-06. Recovery to 4.5 months in 2006-07 was due to exceptionally large foreign direct investment flows.
The balance of payments started becoming unsustainable because of high level of imports, loss of momentum in exports, reliance of financing on volatile capital inflows like portfolio investment. Come 2007-08, the rise in oil prices and food imports along with continued growth in non-oil, non-food imports has led to a large deterioration in the current account. Simultaneously, foreign direct investment inflows are beginning to dry up. A speculative element has probably entered into import demand because of falling reserves and depreciating exchange rate, which has already fallen by about 14 per cent.
MACROECONOMIC SITUATION IN 2007-08:
The macroeconomic targets for the year 2007-08 were set at the time when perceptions about the economy continued to be optimistic, at least in government quarters. As shown in Table 1, 6, the expectations were that Pakistan will enjoy a GDP growth of 7 percent, with a relatively low level of inflation and sustainable level of fiscal deficit. As a result, an optimistic target of 7.2 percent was set for GOP growth based on sector-wise growth targets of 4.8 percent for agriculture, 9.9 percent for manufacturing and 7.1 per cent for services.
However, due to a combination of factors including large exogenous shocks, wrong or absence of policy response and a neglect of emerging structural problems in three key sectors-energy, agriculture and exports, the nine month official statistics lead to the conclusion that the targets will be missed by wide margins. The revised estimates for GDP growth is 5.8 percent (a decline of 1.2 percentage points in relation to target) with: 1.8 percent in agriculture, 5.0 percent in manufacturing and 7.1 percent in services sector.
In contrast, the revised estimates for inflation, fiscal deficit and current account deficit have greatly exceeded the targets set for 2007-08 of 6.5 percent, 4 percent and 5.9 percent respectively. At present, the rate of inflation is close to 11 percent, while the fiscal deficit may exceed 9.5 percent of GDP and the current account deficit could reach 8 percent of the GDP.
Our estimates show that even the revised estimates for GDP and sectoral growths are difficult to achieve. For instance, nine month statistics showed a growth of 4.8 percent in the manufacturing sector. Given the high level of power load shedding and limits to capacity utilisation it is expected that the growth rate for the year will not exceed 5 percent. Similarly, in the presence of low wheat and cotton crops, the growth rate of agriculture is likely to fall below 2 percent. The service sectors continue to show a degree of resilience with a combined growth rate of 6 percent.
As mentioned earlier, the high single digit inflation in the last three years and the soaring inflation this year have built-in inflationary expectations. Consequent behavioural changes along with soaring prices of energy and food and rupee depreciation have introduced spiralling inflation as reflected in the monthly inflationary trend. We believe that the monthly trend is likely to continue in the remaining two months of current fiscal year. As such the year will close with an inflation of 11 percent rather than the target of 6.5 percent for 2007-08.
Pakistan”s key fiscal magnitudes based on nine month performance shows considerable deviations from the budget estimates for 2007-08. While tax collection by Federal Board of Revenue (FBR) is expected to be lower by Rs 35 billion, the expenditure side shows significant variation. The revised estimates for three major heads of current expenditure, namely interest payments, defence and subsidies are Rs 450 billion higher than budgeted.
Due to higher international fuel prices and food prices revised expenditure on subsidies has increased from Rs 114 billion to Rs 365 billion (more than tripled). Similarly, interest payments on external and domestic debt have increased from Rs 375 billion to Rs 499 billion (an increase of 33 percent). Likewise, defence expenditure has goneup from Rs 275 billion to Rs 350 billion (an increase of 27 percent). Other current expenditure has also increased from Rs 230 billion to Rs 276 billion (an increase of 20 percent).
The SPDC estimates for current expenditure deviate from revised expenditure on two heads: subsidies and other current expenditures. SPDC estimates show that expenditure on subsidy would be Rs 315 billion instead of Rs 365 billion because fuel prices have been increased and WAPDA tariffs have been raised by 9 percent. Similarly, the Ministry of Finance has already taken some corrective measures to check expenditure growth, such as reversion of unutilised amounts in various divisions. According to our estimates these measures could save upto Rs 50 billion (see Table 1.7).
Historically, cutback in development expenditure has been a popular policy response to fiscal crunch in Pakistan. Continuing with the tradition, it seems likely that development activities will be curtailed. Given this, we project a cutback of Rs 90 billion in development expenditure in 2007-08. Based on these calculations, we project that the fiscal year will end with an overall fiscal deficit of Rs 767 billion, which is 7.5 percent of GOP rather the revised estimates of Rs 957 billion, or 9.5 percent of GDP as of April 2008.
BALANCE OF PAYMENTS POSITION: Balance of payments has become a major source of concern in the present macroeconomic situation. Persistent deterioration in the current account balance over the last three years has brought the economy to the brink of a financial crisis. As shown in Table 1.8, current account deficit is expected to approach $13.5 billion at the end of fiscal year 2007-08, with an increase of $6.6 billion as compared to 2006-07. As a percentage of GOP, it will increase by 2.6 points from 4.9 percent in 2006-07 to 7.5 percent in 2007-08, which is clearly unsustainable.
The major source of current account deficit is the ballooning trade deficit, which has shown a massive increase of 57 percent over the last fiscal year. The increase in the deficit reflects a surge of over 29 percent in imports while exports have increased by about 15 percent in the same period. One of the main reasons for higher values of imports is increasing international prices of crude oil and food items particularly of wheat and palm oil.
Moreover, import of raw cotton and fertilisers have also increased significantly. In the case of Pakistan, a rise in merchandise imports also brings forth an increased demand for shipping and insurance services, which are also largely imported. Hence, the external deficit on services has also widened from $4.2 billion in 2006-07 to $6.7 billion in 2007-08. On the other hand, private transfers have increased by $1.4 billion.
On the financing side, as shown in Table 1.8, FDI and Portfolio investment together may decline from $8.4 billion to $3.5 billion. Moreover, increase in the foreign aid component is expected to remain under $800 million. This situation has left no option but to finance the deficit through depletion of foreign exchange reserves, which would face a depletion of $5.8 billion. Moreover, as a result of worsening of external account, Pak Rupee has been unable to hold its grounds against US Dollar. Since the beginning of current fiscal year, about 14 percent depreciation has already occurred till May 21, 2008, although there has been a modest recovery in recent days.
In conclusion, we expect that the fiscal year 2007-08 will close with unsustainable levels of the twin deficits and high inflation. Clearly, budget 2008-09, which is the fiscal policy statement for the forthcoming year will have to focus on reducing the deficits and bringing the economy on the path of stability. In a precipitate set of actions. State Bank of Pakistan has moved to stabilise the economy.
This represents a reversal of the growth-oriented monetary policy over the last five years. Is this a case of ”too much, too late”? In fact, evidence of the ”over-heating” of the economy had become visible since 2004-05 and SBP ought to have gradually changed the monetary policy stance to curb inflation and contain aggregate demand. But the money supply continued to expand rapidly by as much as 19 percent in 2006-07.
Now with inflation acquiring a runaway character and imports rising rapidly with a precipitous fall in reserves and exchange rates, SBP has opted to raise interest rates sharply in the economy. Whether this will contain aggregate demand hinges crucially on the nature of fiscal policy to be announced in the federal budget of 2008-09. If the fiscal deficit is brought down sharply by about 2 per cent of GDP and less reliance placed on borrowing from the Central Bank then monetary and fiscal policies could reinforce each other not only in restoring confidence but also to containing inflation. But it is clear that temporarily at least the process of adjustment will imply some loss of growth.
Over the last few years SPDC”s reports have been highlighting the problems of widening macro-economic imbalances, rising rate of inflation and growing income disparities in Pakistan. This year the problems have come to a head particularly due to the policy in action during 2007 external shocks of rising oil and food prices and the more recent emergence of some political instability.
The budget for 2008-09, therefore, comes at a time of growing economic difficulties although there are high expectations of relief for the people from the newly elected democratic government. There are numerous challenges and the policy makers face difficult choices in the area of fiscal policy.
Historically, SPDC has presented reports after the announcement of budgets. This year we have also prepared a pre-budget report. The objective is to present a civil society perspective on the policy choices involved in the preparation of the budget.
We hope that this report will be of some assistance not only to the government but would also help in stimulating debate on key public policy issues of today.
[The writer is Managing Director Social Policy and Development Centre (SPDC).]
(To be continued):
Courtesy: Business Recorder