High cost of the conflict


ECONOMIC costs associated with the pestering Kashmir conflict and the resultant slowdown in the rate of economic growth can be estimated by using counterfactual analyses of the type described in a previous article. This can be done by estimating the cost of the conflict and likely benefits that would have resulted had relations between the two countries been more amicable.

We can distinguish among four different costs of the conflict and than estimate the benefits that would have accrued to the economy and to the society had India and Pakistan been on better terms with each other. The four areas of likely benefit include reduced military expenditures; increase in intra-regional trade, in particular trade between India and Pakistan; a larger flow of foreign direct investment; and an investor-friendly domestic environment.

There is no doubt that in the absence of the Kashmir dispute, military expenditure as a proportion of GDP would have been lower in the case of Pakistan than for India. Small countries in the neighbourhood of large states tend to spend less on defence if relations among them are cordial. In 2002, Argentina, for instance, spent only 1.1 per cent of its GDP on defence compared to 1.6 per cent for Brazil. For Canada, the proportion was only 1.1 per cent compared to 3.4 per cent for the United States.

Even Bangladesh, that now has uneasy relations with India, the country’s much larger neighbour, spent only 1.1 per cent on defence. If Pakistan had spent 2.5 per cent on defence — a proportion roughly equivalent to that of India — it could have saved as much as three per cent of GDP a year. Compounded over this period, the amount saved is equivalent to four times the country’s gross domestic product.

What would have been the consequence if this entire amount had been invested in the economy? Assuming that the rate of return would have been the same as that realized from investments in the past, additional capital flows into the economy would have significantly added to the rate of growth of the economy. Put another way, military expenditure maintained at a level of 2.5 per cent a year with savings utilized at an incremental capital ratio of four — which means that investment equal to four per cent of GDP raises the rate of GDP growth by one per cent — would have increased the long-term GDP growth rate by as much as 0.75 per cent a year. This addition to the rate of GDP growth compounded over a period of 55 years would have meant an increase of more than 50 per cent in the size of the gross domestic product.

While a smaller amount committed to military expenditure would have directly contributed to increasing GDP growth, conflict with India also hurt Pakistan by reducing trade as a proportion of its economy. India’s initial antipathy towards Pakistan was not the result of the Kashmir dispute. The first generation of Indian leaders — in particular Jawaharlal Nehru, the country’s prime minister and Sardar Vallahbhai Patel, the powerful interior minister in the first Indian cabinet — were angry at Mohammad Ali Jinnah, and his political associates.

Jinnah and his colleagues stood in the way of the realization of the Hindu leadership’s dream of a united India. The Indian leaders were also convinced that they could get Pakistan to return to the Indian fold by increasing the economic cost of separation. It was this reason and not because of Kashmir that India launched its first trade war against Pakistan. However, Kashmir later worsened relations between the two countries and progressively loosened the strong economic links that had existed between the two parts of British India before they became independent states.

Had the two countries continued to trade at the level of the exchanges that occurred before independence, the rate of increase in international trade in the case of Pakistan would have been of the order of eight to 10 per cent a year, rather than the average six per cent achieved over the last quarter of a century. This, too, would have contributed to increasing the growth in GDP.

The World Bank maintains that growth in trade leads to an increase in GDP by a perceptible amount. It is not an exaggeration to suggest that by maintaining trade with India at the levels of the late 1940s Pakistan would have added another one-third to half a percentage point to its GDP increase. This would have meant an additional one-third increase in the current level of GDP.

The other important outcome of good relations with India would have been greater flow of foreign direct investment into the country. The contribution large FDI flows have made to the development and modernization of the economies of East Asia is now well recognized. South Asia has not benefited from the increased availability of these flows in large part because of the security problems associated with the Kashmir conflict.

There were other reasons as well, among them the less open economic policies followed by the countries in South Asia for nearly four decades. However, even when these policies were abandoned in favour of greater openness — and they were in the early 1990s — foreign capital still did not become an important component of investment for the South Asian region. This was particularly the case for Pakistan. Better relations with India and greater amounts of intra-regional trade would have brought in additional foreign direct investment into the country, adding significantly to the relatively low level of domestic savings and domestic investments. In 2002, Pakistan received $823 million FDI compared to $3 billion for India. Both countries did poorly in that area compared to those in East Asia. For instance, Malaysia received $3.2 billion, Thailand $2.4 billion, South Korea $2.0 billion, and the Philippines $1.1 billion.

Foreign investors stayed away partly because of the less open economies of the region but also because of the virtual absence of intra-regional trade and a deep concern about security. If these concerns were not there, both India and Pakistan would have attracted amounts of capital on the order of perhaps $10 billion for the former and $2 billion a year for the latter. Two billion dollars of foreign flows would be equivalent to three per cent of Pakistan’s GDP.

Pakistan has had a long history of poor domestic savings rates which translate into low rates of investment unless foreign capital is available. In the 1990s while domestic savings increased from 11 to 13 per cent — from 1990 to 2002 — gross capital formation declined by four percentage points, from 19 to 15 per cent of gross domestic product. The eight per cent savings-investment gap was covered by foreign flows in 1990; the decline in foreign flows brought investment closer to domestic savings by 2002.

Had foreign private capital been available in 2002 to the extent suggested above — in the neighbourhood of $2 billion a year — this would have brought investment back to the levels of the late 1980s. Foreign flows amounting to about three per cent of GDP would have added about 0.75 per cent to the rate of economic growth.

A serious investment gap emerged between Pakistan and India in the 1990s at the height of the insurgency in Kashmir. According to a study carried out by Ijaz Nabi and his associates at the World Bank, private investment in India and Pakistan was about the same in 1982-1991. However in 1992-2001, private investment in Pakistan was six percentage points lower than in India. A part of this gap — say about 75 per cent — can be attributed to the deterioration of the investment climate in Pakistan caused by the rise of Islamic militancy in the country which in turn was associated with the Kashmir problem.

These factors lowered investment rates in Pakistan by 4.5 percentage points compared to that in India. This implies loss in growth of at least one percentage point of GDP. Stable relations with India would have brought economic and perhaps also economic stability to Pakistan. This would have produced better investment climate in the country and contributed to higher levels of domestic savings and investment. This would have also contributed to increasing the rate of GDP growth.

By aggregating the four positive consequences for the Pakistani economy if the country had not gotten embroiled in the Kashmir dispute, it would appear that the country’s long-term growth rate could have been some two to two and a half percentage points higher than that actually achieved. A higher rate of growth of this magnitude, sustained over a period of half a century, would have increased the gross product by a factor of between 3.4 and 4.4. Pakistan’s gross domestic product could have been three and a half times larger than that in 2003-04 — $330 billion rather than $95 billion — and its income per capita would have been $2200 rather than $630 had the country been at peace with India.

This estimate, of course, is a very rough order of magnitude. It is based on a series of heroic assumptions about the efficient use of resources diverted from military to development expenditure; about a significant increase in trade with India and higher level of trade contributing to economic growth; about Pakistan becoming an attractive area for foreign direct investment; and about domestic savings and investment increasing with the presence of tranquillity in the region. Even if half of the benefits estimated above had been actually realized, they are sizable and they would have changed the economic, political and social complexion of Pakistan.

In sum a good case can be made that Pakistan, in particular, has paid a very heavy economic, social and political cost for continuing to keep the Kashmir case on the front burner. This is a good time to take a very hard look at the cost-benefit calculus of the position the country has adopted in the past over the dispute in Kashmir. The situation has begun to change largely because of the promise of peace between India and Pakistan. New investments have begun to flow into the country in particular from the Arab world; Pakistan’s own private sector has become active; the rate of economic growth has picked up perceptibly; the incidence of poverty has begun to decline; Pakistan now seems ready to join other fast growing Asian economies. It would be a pity if Kashmir is allowed to intervene once again in the form of a dispute that attracts extremist elements in both countries. They will try to derail the process on which India and Pakistan are currently engaged. Both Delhi and Islamabad must resist these attempts.