Dr. Farrukh Iqbal - Dean & Director IBA

Pakistan's economic performance and prospects: Rebound or reflux?

Speech given at the launch of the report entitled The State of the Economy by the Burki Institute of Public Policy on January 16 in Islamabad

The pattern of economic performance in Pakistan in the last five years has gone something like this: there was a run of five years of rising growth and stable prices; it was accompanied by a deteriorating current account deficit and, in the last two years, by a widening fiscal deficit as well.

In the last year, that is FY18, growth reached its highest level in fifteen years at 5.8%. However, as the economy seemed to be chugging along merrily to all those who watch only growth, the reserves position was deteriorating. Net reserves with the SBP, which had been rising for 3 years, suddenly slipped from 18 billion US dollars in FY16 to 16 billion in FY17 and then plunged to just under 10 billion in FY18.

What happened? Why did we fall off a cliff when we seemed to be doing so well on growth?

If there is a lesson that I have learned from following short term macroeconomic developments in Pakistan for the past three decades it is that episodes of short term growth do not translate into a trajectory of high and sustained long run growth. Why is this?

The main reason for this disconnect is that our policy makers do not take advantage of short run recovery and stabilization episodes to make progress on deeper structural challenges whose resolution would permit sustained long run growth. The two key structural challenges for us are in the areas of fiscal discipline and export promotion.

Let me use the fiscal discipline point to illustrate our dilemma.

It appears that the government of the day focuses on getting out of an inherited fiscal hole with the help of borrowed money and, as soon as it is part of the way out of the hole, it starts digging again.

Let me illustrate this behavior using the past five years as an example. When it took power in 2013, the PML government found a big fiscal hole. It reported a deficit of 8.2% of GDP for FY13 which it blamed on the previous government. To climb out of this hole it entered into an agreement with the IMF under which it engaged in fiscal consolidation efforts. Fiscal consolidation is a polite word invented by the IMF to refer to the process of reducing a fiscal deficit by cutting expenditures and raising revenues. Helped by a decline in the price of oil, the government was able to reduce the fiscal deficit to 4.6% of GDP in FY16 at which point the IMF program ended. Promptly, the government began digging again. The fiscal deficit rose to 5.8% in FY17 and further to 6.6% in FY18, at which point the PML government was replaced by the PTI government.

The PML government played out a pattern that was very similar to one played out by the PPP government before it. And other governments before these two.

Why do I say this is a repeating pattern? Not just because of the last two examples but the many more that have preceded these. Pakistan has gone to the IMF 14 times in the last 4 decades; on average once every 3 years. There are always different excuses and exigencies but the broad pattern is roughly the same.

Growth achieved on the basis of funds borrowed to support consumption rather than investment cannot be the basis of a sustained trajectory of prosperity. The debt repayment burden that is entailed brings the system to a halt sooner or later.

Has our growth been primarily based on consumption? I am sure there are many nuances here but I am struck by one statistic that has long characterized macroeconomic developments in Pakistan. This is the fact that the ratio of private investment to GDP has fluctuated around 10% of GDP for thirty years. Meanwhile, India's private investment rate has generally been almost twice as high. Similarly, Pakistan's public investment rate has been fluctuating between 4% and 5% of GDP while India's has been almost twice as high on average.

I suspect this big difference in our relative investment rates is behind the 2 to 3 point difference in average growth rates as well, a difference that has kept India's per capita income well above that of Pakistan over the last ten years.

The stagnation of the private investment rate is consistent with another structural feature of the Pakistani economy and that is its failure to get on to a path of export-led growth. Almost every country that has had sustained high growth rates in the past fifty years has done this, at least initially, through labor intensive manufactured exports.

A comparison with Bangladesh is instructive. Bangladesh now exports $37 billion compared to Pakistan's $24 billion. Moreover, despite not having any cotton of its own, it exports $30 billion worth of garments compared to $13 billion of all textile products for Pakistan.

What prevents Pakistan from exporting more? Surveys of existing and potential exporters suggest that the following factors have impeded exports the most: (a) high energy costs and unreliability of supply; (b) tax and customs policy and administration; and (c) exchange rate policy.

The crux of our structural problem takes the form of a trade-off between the objectives of fiscal restraint and export expansion. Most Pakistani governments have chosen to approach the task of fiscal consolidation by keeping taxes high on those who are in the tax net, delaying tariff refunds to exporters, and maintaining an overvalued exchange rate to keep debt servicing costs manageable. All three measures act as disincentives to exports. At the same time, most Pakistani governments try to promote exports by providing input and output price subsidies. This goes against the goal of expenditure restraint.

The way out of this dilemma is to pursue revenue enhancement policies that do not impose a disincentive on exporters and to promote export expansion through policies that do not expand the fiscal deficit. In other words, to collect revenues by widening the tax base and improving collection procedures. And to expand exports by improving the investment climate rather than by offering subsidies. These more-desirable policies are impeded by political forces that do not wish to pay taxes and bureaucratic forces that do not wish to lose incomes from bribes.

What will the new government do? Will it pursue the standard path of fiscal consolidation for a few years and then start digging a bigger fiscal hole for reasons of political expediency? Will it promote exports through fiscally irresponsible means? Or will it develop a medium term path that ensures that the stabilization achieved through fiscal rectitude in the initial years is accompanied by policies that will put the economy on a sustainable growth path? Will we witness a true economic rebound or merely a reflux?