Jun 162008

By Shahid Javed Burki

This is a good time for Pakistan’s new rulers to take some decisions that will not only heal the economy but also change some of its structures. Policymakers respond in two different ways to serious economic crises.

Those who are bold use the opportunity to deal with the causes behind the crises since most of the time crises are produced by structural flaws in the economic system. It is best to identify the flaws and remove them from the system. This way the problems would not occur again. Those who are less bold apply bandages to the wounds that have appeared and hope that the underlying disease will not reappear again.

Pakistan’s policymakers have usually opted for the second approach, preferring short-term fixes rather than deep structural changes. Not surprisingly, the result was recurrence of crises produced by the same faultlines in the economy. Of the many structural problems faced from the time since its birth sixty years ago, two have been particularly important. The first is poor human development. The second – the one that will concern me in this article – is a low domestic savings rate which did not yield enough resources for the economy to invest.

If the economy is to grow at seven to eight per cent a year – a rate of growth sustained by a number of economies in Asia – it must invest close to 30 per cent of the gross domestic product. Pakistan has a domestic savings rate of only 22 percent which can support a growth rate of less than six per cent, perhaps no more than 5.5 per cent a year.

The country has done well when domestic resources were augmented by foreign capital flows. The reliance on external savings is not a wise policy to follow since foreign flows are unreliable. On a number of occasions, foreigners have reduced the amount of money they were providing the country. Each time that happened, the amount invested and hence the rate of GDP growth declined. For the country to climb out of this roller-coaster ride, it must increase the amount of resources generated from within the economy.

Domestic savings come is three forms – savings by the government, those by the corporate sector and those by individual households. Public policy influences all three, in particular savings (or disavings) by the government. This is where budgets enter the picture.

Ever since the state withdraw from playing a dominant role in the economy – as happened during the period of President Pervez Musharraf – policy instruments available to it for effecting the economy have been reduced to basically two. These are the fiscal and monetary policies. Whereas, the monetary policy is controlled by the State Bank of Pakistan, the country’s central bank, the fiscal policy is the responsibility of the Ministry of Finance. The State Bank can change the monetary stance any time; the Ministry of Finance usually alters the fiscal policy only once a year, when it announces the budget for the year that follows. This is one reason why the budget receives so much public attention.

The budget for the financial year 2008-09, announced by the Finance Minister on June 11, is a particularly important policy statement for two additional reasons. First, it is the first major policy statement by the government that assumed power following the elections of February 2008. Second, it comes at an exceptionally difficult time for the economy.

After a period of relative calm for about six years, the economy has run into rough weather and has lost its balance. This is evident on three fronts – inflation, fiscal deficit and balance of payments deficit. The budget can influence all of them. Before examining the policy embedded in the budget announced on June 11, it would be useful to look at the way the fiscal deficit has behaved over the last several years.

Fiscal deficit is the difference between government’s revenue and expenditure. Government’s revenues come in two forms; tax and non-tax. Expenditures also come in two forms; current and development. The data provided in the accompanying table show some interesting trends over the last decade. The government of President Pervez Musharraf inherited a difficult fiscal situation in 1999. In the two previous years, fiscal deficit had averaged at seven per cent of the gross domestic product; two percentage points higher than what experts consider to be the sustainable level for Pakistan.

While government’s revenues were reasonably high – about 16 per cent of GDP – expenditures were even higher. The difference was of the order of seven per cent mostly because of current expenditures. Non-development expenditure was close to 20 per cent of GDP. It was clear to the new set of policymakers who took office after General Pervez Musharraf intervened, that major adjustments had to be made to restore economic balance. They went to the IMF for assistance and received the advice that significant adjustments had to be made.

This was done over a three-year period by putting the lid on current expenditures which declined to an average of 16 per cent a year, a reduction of nearly four percentage points compared to the levels reached in the late 1990s. The most significant reductions were obtained by constraining government employment and putting a lid on government salaries. Further reductions in non-development expenditures became possible after 9/11 when, led by the United States, the donor community reduced the country’s outstanding debt by a significant amount. This lowered the interest payments Islamabad paid to its creditors.

These adjustments, while reducing the fiscal deficit, also made it possible for the Musharraf administration to increase development expenditure. In the last three years of the Musharraf period, development expenditure increased to an average 4.5 per cent of GDP. This was one percentage point higher than in the late 1990s and almost double the share in the first three years of Musharraf.

The policymakers faced the same kind of challenges in preparing the budget for 2008-09 that confronted the Musharraf government in 1999. The fiscal deficit and the balance of payments deficit in terms of the proportion of GDP had reached unsustainable levels. Adjustments needed to be made to reduce the fiscal deficit by raising taxes and constraining government expenditure. Islamabad also had to deal with the pressures on lower income groups as a result of the increase in the prices of food and fuel.

However, in preparing their proposals and presenting them to the National Assembly, the policymakers have opted for the approach adopted by their predecessors: they have not attempted to bring about structural changes in the economy, preferring to tinker at the margin. That said, there are some attractive features of the budget.

An attempt is being made to help the poor by creating a new fund that would provide them with cash transfers. On the revenue generation side, some rates have been adjusted to increase the burden on the rich. Some items of luxury consumption would cost more and the higher income groups will pay more for some of the services they use, such as cash withdrawals from the banking system. These changes will help to raise some additional tax revenues for the government. I have calculated the impact of these proposals on government revenues and expenditures and the size of the fiscal deficit. These calculations are shown in the table. They are more reasonable than the estimates provided in the budget.

The budget proposals may also reduce conspicuous consumption by the rich. The changes, however, will be marginal and will not make much of a difference to one of the most important structural weaknesses in the economy: dependence on external flows for a significant proportion of gross investment.

What could the policymakers have done to deal with the structural faultlines that continue to affect economic performance. Those who made the budget could have taken four additional measures.

One, they could have created fiscal space for the provinces thus creating the opportunity to both raise additional government revenues and greater provincial control over public expenditure. This could have laid the basis for increasing domestic resources by bringing government closer to the people.

Two, they could have significantly reduced current expenditure by the centre by eliminating some of the functions it should devolve to the provinces.

Three, they could have provided for public works programmes for creating employment opportunities for the poor in both rural and urban areas.

And four, they could have further rationalized the tariff structure by levying regulatory duties on imports that feed consumption by the rich without doing much to increase investment in the economy.

A quick glance at the budget gives me the impression of a glass half full; it could have been filled a bit more to address the problems that continue to produce recurrent crises in the economy. The policymakers chose not to go that route.

Courtesy: Daily Dawn, 16/6/2008

 Posted by at 7:36 pm

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