Asalam-o-Alaikum Intellectuals.

You guys have just dropped down from the sky like an angel for me. Nearly a week ago I read an article in Dawn. Generally, I am able to understand articles on economics but this one sounds complex.

Can anyone of you please make a summary of the following article.

I would be extremely grateful to him!

Regards,
Adil Memon

PS: If somebody could just point out the important points elaborately; that would be enough as well.

Truth about good financial management

By Shahid Kardar


THE debate on the contribution to the turnaround in Pakistan’s economic fortunes in recent years of better government macro-economic and financial management, of the faithful implementation of IMF conditions, of debt rescheduling and the generosity of donors after 9/11 continues to rage.

This discussion is meant to argue that the government exaggerates the contribution of its good management of the economy to push up the growth rate. It will argue that there are some key areas well within the control of the government in which achievements have been disappointing. Four such areas of policy failure are discussed below.

The first is the failure to further deregulate the economy, eliminate multiple taxes and get the government off the backs of people through reduction/removal of discretionary powers by repealing or amending many of the outdated regulatory laws and rules that unduly burden the private sector’s cost of doing business, while providing opportunities for corruption to government functionaries.

With the exception of the CBR, where policy and institutional reforms have certainly reduced the private sector’s cost of doing business in the last two years or so, the government’s other efforts (including traditionally weak areas relating to political stability and law and order) to reduce the cost of doing business have not borne much fruit. Hence, even the recent improvement in our international ranking with respect to the domestic environment for private investment does not bring much comfort since China, which ranks several notches below us on this table, attracts most of the world’s foreign direct investment.

The speed of government decision-making continues to be leisurely, compared with the pace at which changes are being made by our international competitors in maintaining their competitiveness. As usual, in a rapidly changing world, we are doing too little too late to address the growing gap between ourselves and our competitors.

In contrast with the daily rhetoric on the high quality financial management supposedly reflected in the marked reduction in the budget deficit, it is instructive that the better balancing of the books has been achieved by cutting down development expenditures, and as a result of the debt re-profiling done by our creditors after 9/11 rather than by expenditure re-prioritization and revenue enhancement.

The gap between government expenditures and its tax revenues continues to be close to seven per cent points of the GDP, the differential that existed in 1999/2000 with the tax to GDP ratio actually worsening from 13 per cent of the GDP to under 10 per cent. That a part of this gap is now being filled by non-tax revenues which are expected to decline as more profitable enterprises like PTCL are privatized cannot be a source of comfort for the future in terms of sustainability, highlighting the macro-economic management capability test of the government, particularly after the October 8 quake.

While acknowledging the major strides made by the State Bank in modernizing and strengthening the capability of the institution to perform its supervisory and regulatory functions and the independence it has shown in its periodic reviews of the economy and the government’s economic and financial management, it has singularly failed to fulfil its primary responsibility with respect to monetary policy. At a time when both the exchange rate and monetary policy were the easiest to handle, thanks to the surfeit of liquidity and the abundance of cheap money in the financial system, the central bank did not perform its principal duty of controlling inflation.

Inflation, contrary to official claims, has not been soaring simply because of the rising prices of oil and food owing to the raising of the support price of wheat. It is also soaring because of the huge increase in money supply allowed by the State Bank, well above the rate justified by the expansion in the economy. As a result, Pakistan has the dubious distinction of having the highest inflation rate in this region; India faced similar pressures but has an inflation rate hovering around the five per cent mark.

In other areas of its jurisdiction the performance of the central bank is judged by its success in controlling inflation. Here the State Bank has stoutly defended its monetary management which resulted in inflation almost reaching double digits. It takes pride in having adopted an accommodating monetary policy that stimulated economic growth by keeping interest rates lower than the rate of inflation and did not use the capital inflows from abroad to retire expensive debts. However, the pursuit of this strategy and a monetary policy that was working at cross purposes compromised its role as an independent agent mandated to keep inflation in check through an interest rate adjustment.

The monetary overhang of 27 per cent by the end of 2004 (less than five per cent of which has been absorbed to date in 2005) is keeping inflation close to nine per cent. With inflation at such levels, the catastrophe of October 8 has hit the economy. A colossal amount of money will be required for the massive relief effort and the gigantic task of reconstructing the devastated infrastructure and houses and buildings, getting the crippled economies of the affected areas up and running again and relieving the misery of what are essentially the poorest sections of the population.

These demands will keep inflation under pressure, requiring deft handling; although for some officials it may provide yet another convenient excuse on which to lay the blame for the continuing inflation. Therefore, the biggest test in recent years for the State Bank has come precisely at a time when leadership change is due at the central bank. The new situation demands that the new governor should have a sound understanding of monetary economics. Owing to poor monetary management a huge opportunity has also been lost to develop a market for low-cost housing finance, hitting the less affluent segments of society, already suffering from the ravages of inflation.

While the financial system was flushed with funds, the federal government managed its debt poorly. When it could have borrowed at low interest rates for a while it stopped issuing seven-to-10 year Pakistan Investment Bonds that could have enabled it to borrow funds at seven per cent. It chose instead to offload six month T-bills at two per cent or so when inflation had begun to climb and there was every sign that the interest rate structure would change and rates would rise sharply.

This flawed strategy cost the government and the taxpayers dearly as the debt profile got skewed in favour of short-term debt. The cost of this poor financial management has been massive — and could be as much as Rs. 100 billion over the next 10 years. While the government should have raised more long-term and relatively cheap debt, it took the bizarre decision to discontinue issuing bonds of longer-term maturities and relied more on short-term bonds.

The short-term debt instruments which were earlier being floated at low interest rates are now being replaced by expensive bonds at high interest rates. Moreover, if the Etisalat-PTCL deal does not go through then the government will have little choice but to borrow another Rs.120 billion to Rs.150 billion at 13 per cent in the form of 10-year bonds resulting in actual loss and not just in cost terms.

Similarly, international capital markets are ostensibly being tapped to diversify the government’s sources of funding and to reduce dependence on multilateral lending agencies for financing. The impressive launching of the first round of bonds, it has been argued, has facilitated Pakistan’s reappearance on the radar screens of investors for not just debt instruments but also for foreign direct investment.

With the government struggling to find ways of utilizing foreign exchange reserves, one is at a loss to understand what it wants to do with the additional mobilization that is being planned at interest rates higher than what we would have to pay for borrowing from the World Bank and the ADB.

These inflows would, at best, earn a relatively nominal return from their investment in other income earning instruments. The overall outcome of such a transaction would be a net capital outflow, since the servicing cost of the bond would be higher than the income stream from the proceeds of these bond sales.

It is not quite clear what would be achieved. The cost of such endeavours will be high since there would be a worsening of the debt profile, with more short-term expensive debt, when cheaper debt of longer-term maturity is readily available from the World Bank and the ADB. The argument that even China with its massive reserves is raising money from international financial markets through bonds of relatively shorter term maturities fails to realize:

a) that when at the turn of the century Pakistan was on the verge of defaulting on its debt obligations it was largely because of the short-term debt that it was finding impossible to service; and

b) China has close to three times Pakistan’s rate of national savings and can afford to adopt even a wrong strategy. It can make such a mistake (this is not to suggest that by raising money from international financial markets it is making such a mistake) as it can easily bear the cost of correction.

The argument that by venturing into international financial markets we can set a point of reference at which we can borrow in the future is misplaced. Our ratings are being monitored and revised continuously. Therefore, our credit rating, and the rates at which we can borrow, could be different every time we enter the market.

A faux pas was also committed in that the Islamic Sukuk bonds were issued on a floating rate at a time when the interest rate environment was changing and the rates were beginning to climb, again reflecting the poor quality of financial planning.

Finally, losses were, and continue to be, incurred on account of poor currency hedging for servicing external debt and because of the currency mismatch of assets and liabilities.

The writer is a former finance minister, Punjab

__________________
"The race is not over because I haven't won yet."

Adil Memon
Police Service of Pakistan (P.S.P)
37th Common Training Program