Will the IMF abandon Pakistan?
By Shahid Javed Burki
Monday, 06 Dec, 2010
ECONOMIES can turn quickly both ways. They can go from a situation of extreme distress to reasonable health within a matter of a few months or they can move in the opposite direction equally fast. The latter happened in the case of Pakistan in the early 2000s. From the start of the decade to mid-2007, the country’s macroeconomic performance was robust.
During the period 2000-01 to 2004-05 the country had a respectable record of growth. Real GDP grew by more than seven per cent a year while inflation also remained at seven per cent. International position improved; gross official reserves increased to $14.3 billion, sufficient to finance 3.8 months of imports.
In the period following 9/11 Pakistan received generous support from the United States and the institutions over which Washington has some influence. These include the IMF and the World Bank.
The country successfully implemented two IMF programmes, a Stand-By Arrangement (SBA) and a threeyear agreement under the Poverty Reduction and Growth Facility that provides capital to eligible borrowers on relatively easier terms – easier than the terms charged on the SBA.
The successful completion of two Fund programmes in itself was a turnaround since Islamabad had a long record of signing agreements with the Washington-based institu tions only to renege on them. The reason almost always was the same: the government’s inability to control its finance and run large and unsustainable budget deficits.
The flow of official finance was accompanied by significant debt write-offs. The result was the creation of what economists then called “fiscal space” within which the government could spend more than would have been possible otherwise.
There were also large flows of private capital that took the form of foreign direct or portfolio investment. The latter was a change for Pakistan. That foreigners were prepared to invest in the country’s stock markets was an indication of confidence in Pakistan’s economic future.
The widely read Newsweek wrote a cover story in the spring of 1985 proclaiming that Pakistan was one other Asian giant that was stirring from sleep. But that expectation turned out to be misplaced and Pakistan went back to sleep once again.
When Pakistan completed its agreements with the IMF in January 2005 it promised that it will never pick up the begging bowl again and return to the Fund for additional support. That pledge was made by the then prime minister who concurrently served as the country’s finance minister.
However, the same official presided over a significant increase in public spending. Not only that: the State Bank of Pakistan stepped in with easy money policy, flooding the economy with cheap capital.
A significant amount of the central bank’s money went into consumer finance and housing. All this was seemingly done to help President Pervez Musharraf and his political party, the Pakistan Muslim League (Q), to win the elections of December 2007. The elections were postponed by a couple of months after the assassination of Benazir Bhutto on December 27, 2007.This extension in the pre-election period gave further opportunity to the government to continue to spend freely. The result was a sharp increase in the budgetary def icit and, as is always the case, also an increase in the pressure on external resources.
Free spending by the government, however, did not win it the election held in February 2008. A new government took office in March and its finance minister de clared that he had inherited a bankrupt economy. This was a marked turn for the worse in the economy. However, relief from the donor community, including the IMF, was not immediately sought.
The country remained politically unsettled for several more months. It was only af ter the largest opposition party, Pakistan Muslim League (Nawaz), had quit the coalition government and Asif Ali Zardari had replaced Pervez Musharraf as president that Islamabad turned its attention towards managing the rapidly deteriorating eco nomic situation. One part of the strategy was to go back to the IMF for help.
The begging bowl was back in the hands of the government. In November 2008, the Fund responded with a 23 month-long Stand-By Programme for $7.6 billion, equivalent to 500 per cent quota (share) in the institution’s capital.
In return for the IMF support, the government made two promises: that it would restore macroeconomic stability and confidence through a significant tightening of fis cal and monetary policies and that adequate support would be provided to the poor.
The government promised to balance these two objectives which meant that poverty alleviation programmes would not lead to larger fiscal deficits. Islamabad indicated that it would work to reduce the fiscal deficit from 7.4 per cent of GDP estimated for 2007-08 to 4.2 per cent in 2008-09 and to only 3.3 per cent in 2009-10 while allowing for spending on social safety net.
This was an overly ambitious target to pursue; per haps an unnecessary one. In its annual report issued in June 2008, the Lahore-based Institute of Public Policy, using a macroeconomic model it had developed, determined that a fiscal deficit of 4.5 per cent of GDP was sustainable in Pakistan’s case.
The larger deficit would not produce intolerable inflation and would, at the same time, ensure that growth was not sacrificed. But the Fund prevailed and Pakistan signed on the dotted line, promising a drastic fiscal adjustment.
Apart from the impracticality of reducing the budgetary deficit by almost four percentage points in three years, the Fund’s programme was based on the assumption that a new democratic order that was beginning to take shape will have the capacity to deliver difficult structural changes. That did not happen and the targets were not achieved.
While intense discussions were taking place between Islamabad and the Fund – these were often conducted in Dubai since the Fund management was too nervous to send its staff to Islamabad as the security situation continued to worsen.
Pakistan was hit by an unprecedented flood. The floods led to a sharp deterioration in the economic outlook. The agriculture sector which accounts for 21 per cent of GDP and nearly half of employment was hard hit. There was also substantial damage to infrastructure and private property.
A combined assessment by the Asian Development Bank and the World Bank put damages and losses from the floods at about $10 billion. This could reduce the rate of economic growth by one to 1.5 per cent a year for years to come.
There was also impact on the budget. The government planned to provide $1.8 billion or one per cent of GDP in cash transfers to flood victims. Most of this money if properly delivered was likely to be spent on housing.
The Fund has kept its pressure on Islamabad in the last few months. It was not satisfied that enough effort was being made by the government in addressing the growing budgetary problem. In a statement made at the Pakistan Development Forum (PDF) on November 15, the Fund’s representative, while recognising that prior to this summer’s floods growth was picking up, “the 2009/10 budget target was missed by a significant margin and the end-2010 ceiling on government borrowing from State Bank of Pakistan was also exceeded. As a result the fifth programme review could not be completed on time.” This was the IMF’s way of saying that it was not prepared to release the next tranche to Islamabad at least not by the end of the year as was expected earlier. It continued to press for structural reforms to improve budgetary performance.
According to the IMF’s statement at the PDF: “Two areas stand out. One is the reformed general sales tax (RGST), including an effective input-crediting mechanism, reduced exemptions, and elimination of zero-rating and special rates.The other is electricity reform, where action is needed to eliminate untargeted subsidies while protecting the poor and address the problem of circular debt.” What would happen if the Fund pulled back? Would the economy take a deep plunge or would it be able to survive without too much damage to the fundamentals? I will take up these question in later articles once the results of the ongoing deliberations between Islamabad and the Fund become available.