Shaping economy in times of crises
By Shahid Javed Burki
Monday, 18 April, 2011
PAKISTAN today is passing through difficult times. With the rate of growth plunging to 2.5 per cent, there will be a significant increase in the incidence of poverty. Perhaps another six to seven million people will be added to the pool of poverty.
However, in a recent press statement, President Asif Ali Zardari said that his government had managed to stabilise the economy. As evidence in support of this view he spoke about the extraordinary increase in exports and remittances as well as the build-up in foreign exchange reserves. These developments have indeed taken place but do not signal that the economy is out of the woods.
Where will Pakistan go from here? The Institute of Public Policy at Lahore has constructed an econometric model to draw up some scenarios for its annual report to be released on April 25. Of these, two scenarios are presented here to set the stage for policymakers to contemplate adopting an approach that would help the economy move in the right direction.
In the best case scenario, Islamabad undertakes major tax reforms, starting with the budget of 2011-2012 which includes introduction of a comprehensive reformed general sales tax, the RGST. This means withdrawing all exemptions on goods and eliminating all distortions that have crept into the current system.
Wealth tax will be reintroduced and a strong effort will be made to curb tax evasion. These measures will be seen as making the system more equitable and should improve compliance. Provincial sales tax on services will be broadened and the provinces will develop their tax systems to generate more resources from within their economies, taking advantage of some of the provisions in the 7th National Finance Commission Award 2009.
On the expenditure side, the best case scenario focuses on improving working of large lossmaking enterprises, on eliminating the problem of “circular debt” that is constraining the supply of electric power from existing capacity, and a careful review of public sector development programme by placing emphasis on completion of high priority projects. These measures will bring about a significant improvement in the govern ment’s financial situation.
Within the context of monetary policy, the best case scenario assumes that the State of Bank of Pakistan will have the autonomy to order its policies with the objective of containing inflation and not meeting the fiscal deficits of the federal government. The SBP will back off from the printing press and let the government finance its operations by increasing tax revenues and by going to the market to raise additional money. The central bank will also let the market determine the exchange rate.
This package of measures will have a number of positive consequences including the resumption of tranche release by the International Monetary Fund, Pakistan’s return to international capital markets, increase in foreign direct investment, and resurgence in business confidence.
With the pick up in the rate of economic growth and increase in government revenues at the central and provincial levels, new fiscal space will be created so that there is significantly greater focus on social development and social protection policy. On the external side, there will be considerable improvement in the rate of growth in trade.
This model estimates the real GDP growth increasing from a low of 2.2 in 2010-11 to 6.5 per cent four years later; the rate of investment increasing from 12.5 to 25.1 per cent of GDP; the rate of inflation dropping from 14.2 to 9.8 per cent; and the fiscal deficit declining from 6.2 to 3.6 per cent.
The worst case scenario produces a particular ly grimmer picture of the economy. It is based on the assumption that the policymakers will not gather the political will and the required support to introduce the proposed policy changes; allow further deterioration in the quality of governance to take place, further decline in the delivery of public services to the citizenry including those provided by the large state-owned corporations, and greater economic isolation of the country. There will be haemorrhaging of foreign exchange reserves due to a sharp increase in the current account deficit.
By the end of 2012-13 foreign exchange reserves could reduce to the level equivalent to only two months of imports. There could be a serious financial crisis by the second half of 2012-13, on the eve of the next set of general elections.
According to the worst case scenario, the rate of GDP increase is only two per cent in 2011-12, increases to 3.3 the following year, only to drop to 2.8 per cent in 2014-15. The rate of investment declines from 11.5 to 8.5 per cent; the rate of inflation increases from 14.5 to 20.1 per cent; and fiscal deficit grows from seven to 7.6 per cent. Real exchange rate drops from Rs92.7 to the dollar to Rs133.2.
These illustrative scenarios raise the question of probability. What is the likelihood that the political system will have the wherewithal to introduce the reforms needed to move to the best case scenario? Or, conversely, will the policymakers, not recognising the consequences of inaction, allow the policy environment within which the economy is working to further deteriorate?
It is not likely that the stakeholders within the system will have the will or the interest to adopt the measures spelt out in the best case scenario unless they are pressured by circumstances that threaten their hold on power.
One type of pressure that could build up has brought about significant change in the structures of politics in some of the countries of the Middle East. The explosion on the streets of that part of the world happened unexpectedly; it reflected the frustrations of the citizenry with the political and economic systems under which they were kept for decades.
Some of the recent developments suggest that building blocks have been gathered that could allow the construction of a political structure that will be more responsive to the needs of the people.
The most important building block is the passage of the 18th amendment last year and the speed with which it is being implemented.
The 7th National Finance Commission award of 2009 is another part of the foundation that is being laid. If done with appropriate care, the intended devolution will bring government closer to the people.
Economists have long recognised that good governance means a government that is not too distant from the people it is intended to serve. In other words, there is much that remains to be done before the government can claim – as President Zardari did the other day – that the economy has been stabilised.
(The writer is chairman of The Institute of Public Policy, Lahore.)