Battling imbalances
By SHAHID KARDAR

WHEN selecting policy instruments and the timing of interventions, a key question that bedevils decision-makers in the country is how to facilitate growth and contain inflation simultaneously.

It has been argued in these columns before that there is no single template for tackling inflation. General inflation has been high because of the combined impact of certain factors.

These include food inflation; movements in the international price of oil (given our heavy dependence on it); revisions in the administered prices of electricity and gas; domestic energy shortages jacking up imports of goods; speculation; domestic cartels; nature and structure of the economy and imported inflation aggravated by rupee depreciation.

Take food inflation. It is high because of the upswing in global commodity prices; sharp increases by the government in the support prices of wheat; structural variance between supply and demand ensuing from the increase in the size of the middle class — particularly in Punjab and Karachi — and shifting patterns of consumption. How do you address such issues in the short to medium term?

Historically, the destiny of our economy has been critically dependent on capital inflows from our benefactors because our domestic savings have been inadequate to finance the combined investments of the public and private sectors.

There has to be a net inflow of capital — either in the form of stock market investments, foreign direct investment or donor assistance — over and above the portion of deficit on the trading account not covered by remittances. There must also be outflows for capital gains made in the stock market by portfolio investors, and interest and dividend payments to finance the deficit on the external current account.

Moreover, in our case it is instructive that these inflows have financed consumption more than they have financed investment. These capital inflows had until recently propped up the rupee but the reduced inflow despite the relatively small size of the deficit on the current account has been the main factor in the steep decline in its value.

This is so especially with market sentiment taking a turn for the worse in the knowledge that the exchange reserves (itself made up of borrowed money) have fallen to a level barely able to finance one month’s imports.

The lesson that decision-makers are reluctant to accept is that the precipitous fall in the value of the rupee — the most recent indicator of the deeper malaise of the macroeconomic imbalances afflicting the economy — and its continued weakness reflects the weakness of our current account.

This is simply because the propensity for inflation and the vulnerability of our balance of payments is policy-induced and structural. The rupee can only be stable if there is macroeconomic stability — a rate of inflation no higher than that in the economies of our competitors.

You cannot run large budget deficits — with their spillover effects on the balance of payments — and have an inflation rate higher than that of our trading partners and still expect the rupee’s value to be stable. A high rate of inflation within the country with an unadjusted rupee raises the cost of production, makes imports cheaper and exports less competitive internationally, leading to a wider trade deficit.

In other words, the primary reason why we have a large external deficit in our trade of goods and services is because our exports are not competitive at the current exchange value of the rupee. And a monetary policy relying solely on the instrument of the interest rate is of little help in this matter (except through a higher interest rate supporting the exchange rate) since it has greater influence over prices of non-tradable goods and services.

Official efforts, on the other hand, end up focusing more on financing the current account deficit than on reducing its size. The reason for this is that policymakers tend to concentrate on the immediate or short-term crises in response to a public outcry — in itself the consequence of civil society’s poor understanding of the underlying, deep-seated issues. But the narrowing of the deficit requires a combination of policy decisions and structural reforms that can only be implemented in the medium term.

The inability and unwillingness of successive governments to take action needed to deal with chronic issues and the risks that were continuously building up has had negative results. The economy has settled at a substantially lower rate of growth than what is required to avoid social unrest by productively and gainfully employing the two million entering the labour force every year.

So far the postponement of fundamental structural reforms and repeated bailouts by the rest of the world was possible because of our ‘nuisance value’. This gravy train may well continue to operate until the close of 2014 when the Americans leave Afghanistan.

Meanwhile, the economic situation has deteriorated further, with imbalances having widened and the hole simply too big for anyone to fill. We may be too big a country to be allowed to fail but we are also too big a country for anyone to help.

No one has such deep pockets. With frayed relations with the international community, the window for taking key decisions and avoiding risks is becoming smaller, with markets and donors running out of patience and not prepared to wait for a political consensus to emerge.

One of the puzzles is why the liberal economic reforms of the early 1990s, despite their success, failed to create a political constituency for reform. Those promising more government intervention and social welfare benefits get more votes because advocates of reform (partly because they are too few in number to change the public narrative) have not been able to clearly articulate the links between structural vulnerabilities of the budget, inflation and the unabated pressure on the rupee.

Government finances are stretched to a breaking point with no serious effort being made to rein in expenditures. Liabilities are building up outside the government’s cash book from the annual losses of state enterprises and from the government’s commodity-related operations with respect to wheat, sugar, fertiliser etc.

The result of all this is the Pakistani state continuing to do far too much in the economy as an active player in commercial activities and in unnecessary regulation but far too little in terms of governance.

The writer is a former governor of the State Bank of Pakistan.