Playing the ‘moral hazard’ game
By Shahid Javed Burki
Monday, 29 Nov, 2010
THOSE of us who have argued for years that Pakistan needs to develop a new type of relationship with the world outside are finally getting their voice heard.
Some recent developments seem to indicate that the donor community is prepared to finally tell Islamabad that it needs to do much more than it has done in the past to stand on its own two feet, giving up the foreign clutch on which it has been leaning for so long.
As has been noted in these columns on many occasions, the country does well whenever there is a large inflow of foreign capital. The rates of GDP growth during the periods of Generals Ayub Khan, Ziaul Haq and Pervez Musharraf were high – about 50 per cent higher than the structural rate of increase in national output – not because the military was in charge. The rates were high because, for strategic reasons, Washington chose to pour financial resources into Pakistan.
The US strategic interest in Pakistan reappeared after 9/11 and its money started flowing in again in copious amounts. During most of this period of almost ten years the military was in charge. That is no longer the case. It is for the first time in Pakistan’s relations with the United States that a civilian government is in place as Washington’s interest in Pakistan’s economic development has acquired considerable strategic significance.
It is not because Washington is dealing with a bunch of civilian interlocutors that the message being given has changed. The donors have learnt from experience that they should not encourage the “moral hazard” approach to economic policymaking pursued by Pakistan in the past.
The term moral hazard is applied by those working in the field of finance when the regulatory system encourages excessive risk-taking. This happens in the belief that a foreign government or some other well endowed entity would come to the rescue if the risks that were taken turn sour.
One example of the working of this approach was the large-scale rescue of the American banks by the government to save them from collapse once the risks they had taken with what has come to be called “subprime” lending resulted in heavy losses. Washington stepped in with a large dose of financial aid to the banks that were considered to be “too big to fail”. More recent examples are the rescues of Greece and Ireland by the European community working with the IMF.
The same kind of approach was shown towards Pakistan on several occasions when some bilateral or multilateral donor step ped in to save the country’s economy from collapsing. It had happened in December 1996 when, on leave from the World Bank, I was placed in charge of Pakistan’s finance.
Upon arriving in Islamabad I was told that the country was close to bankruptcy with the State Bank of Pakistan running down its foreign reserves to the point at which it was unable to honour its obligations to the “preferred creditors.” This term is applied to the International Monetary Fund, the World Bank and the Asian Development Bank. Default on any of these institutions means that the country resorting to such a tactics would be shut out of the international financial system. A move in that direction is extremely hazardous.
To save the country from that situation I travelled to Beijing and was able to get a soft loan from the Chinese prime minister that helped us to tide over the payments problem we faced. An amount of $500 million was deposited immediately into Pakistan’s account in New York at the Federal Reserve Bank.
A trip to Abu Dhabi by me brought in some additional resources. I recount that story in order to underscore the important point that by resorting to the moral hazard approach we may be able to tide over the immediate financial difficulties, but each time Islamabad takes that line it erodes the confidence of the international financial markets.
Pakistan found itself in a difficult situation once again in 2000 when it went to the IMF to get support to save itself from bankruptcy.The Fund is obliged to respond to requests from its member states under what are called the “articles of agreement” – the institution’s charter. It enters into a Stand Bye Agreement (SBA) with the member facing a crisis situation under which it is able to draw down a certain multiple of its quota – the share it has contributed to the IMF capital – but only after it has agreed to fulfil a number of conditions. Most of these relate to the way the country manages its fiscal system.
The Fund’s board – the ultimate authority in the institution – does not like large budgetary deficits. There is a belief that large fiscal deficits by increasing domestic demand for goods and services also weaken the external situation as imports exceed exports and have to be paid out of the accumulated foreign exchange reserves.
The SBA 2000 with the Fund was successfully concluded and then Prime Minister pledged that the country would never return to the IMF with a begging bowl in hand. Three years later the same prime minister, however, presided over a sharp expansion in the size of the budgetary deficit and encouraged the State Bank to flood the economy with cheap money.
This was done to help the ruling party to win the 2008 elections and for President Pervez Musharraf to stay in office. A heavy price was paid for this profligacy. By the time the prime minister left office Pakistan was once again close to the brink of economic disaster.
The accumulated reserves were being depleted at a speed at which they would have been exhausted within a matter of a few months. The pledge of never going back to the IMF was broken by the new government that took office in the spring of 2008 and a very large SBA was concluded with the institution.
In terms of conditionality this was a softer arrangement; the only serious pledge made by the government was to stay within the fiscal deficit limits the Fund considered to be prudent. But the Zardari/Gilani government has found it difficult to stay within the boundaries prescribed by the Fund.
In response the Washington-based institution has decided to postpone the release of the final tranche of the large loan. Even then it allowed Pakistan $400 million as emergency assistance to take care of the additional expenditure forced upon Islamabad because of the large-scale damage to the economy and the extreme pain inflicted by the great floods of this summer. While this cycle of near-bankruptcy and rescue has taken a heavy toll on the economy, it is not clear that all decision-makers are aware of the damage that is being done. It is this cycle the donor community is asking Islamabad to break into.
This was made plain by the many speakers at the meeting of the Pakistan Development Forum in Islamabad held in mid November. That the government needs to set its house in order was vividly and depressingly demonstrated by two ministerial statements at the PDF.
On November 14, Interior Minister Rehman Malik said that Pakistan was fighting terrorism and deserved that its $50 billion foreign debt was written off. He does not seem to have realised that such a suggestion was in fact a call for default on foreign obligations, a step that would be disastrous for the country faced with so many economic problems.
Recognising that his cabinet colleague had made a serious mistake, Finance Minister Hafeez Sheikh withdrew the suggestion, using strong language. “It is a grave issue with grave consequences for future prospects”, he told the PDF a day later. “Nobody asks for it. We don’t want to be included in the list of those countries that take that route and become international pariah states.” The conclusion is clear: not only Pakistanis need to learn to live within their means, meagre though they are. The country’s leaders have also to recognise that the moral hazard approach to economic and financial management is a perilous course to take.