State and Pakistan economy: Where have we come from? Where do we go? - III

State and Pakistan economy: Where have we come from? Where do we go? - III

PARVEZ HASAN

ARTICLE (January 14 2007): The opening up of the financial and telecommunications sectors partly with the help of foreign sectors is transforming and modernising the economy in a fundamental fashion.The growth in cellular phones in Pakistan has been nothing short of phenomenal and the competition in the telecommunications sectors has pushed down prices very sharply, essentially reducing the cost of information and doing business.The liberalisation, privatisation and reforms of the financial system, a process that was started in the 1990, are providing a strong base for healthy private sector development. The largely publicly owned banking system was greatly misused by vested interests both to earn economic rents and thwart genuine entrepreneurial activity.In a very short time, the control of the banking system has moved into private hands. More than 80 per cent of the bank deposits are now with the privately owned banks. Under the leadership of the State bank of Pakistan, corporate governance in the private sector banks has improved, their capital base strengthened and the problem of non-performing loans largely resolved.After taking into account the provisioning for bad loans, the ratio of net non-performing loans to net advances has come down to around 5 per cent. Above all, the prudential regulatory capacity of the central bank has been greatly enhanced and its autonomy increased.Financial reforms have improved resource allocation by making lending follow sound economic and financial criteria. It has also improved governance by closing avenues for corrupt practices and political influence paddling.There is also evidence of financial deepening as the ratio of monetary assets to GDP has risen from 40 to 44 percent over the last five years after having been stagnant for a long period. The increased financial intermediation also generally augurs well for economic efficiency.There is also broad evidence that investment climate for the private sector is improving and the cost of doing business is going down. According to the World Bank, Pakistan was one of the top reformers in terms of doing business in 2004. It ranked 60th out of 154 countries in 2006 (India was 116th) and 74th out of 175 countries in 2007.However, employing workers, paying taxes, and enforcing contracts remained relatively very weak areas according to the 2007 survey. According to World economic Forum Global Competitiveness Reports, Pakistan's ranking improved from 75th out of 102 in 2003 to 66th out of 116 in 2005. However, Malaysia, Thailand, India, China, and Turkey were substantially ahead of Pakistan in rankings.The growing importance of private sector in Pakistan is also evident from its share in fixed investment. The share of private investment which exceeded 50 per cent of the total only in the 1990s is now approaching 75 per cent.(Table below) It is also important to note that public investment that was practically stagnant during 1997-2002 has grown strongly during the last few years. Furthermore, even though public investment as a percentage of GDP declined moderately from 5.6 per cent in 1999-2000 to 4.8 per cent in 2005-06, the composition of public investment has changed dramatically in recent years. While investment in public enterprises has dropped in absolute terms, public development outlays have grown strongly over 2001-06.This trend which is likely to continue means that public investment is increasingly concentrated in infrastructure areas which do not pose direction competition to the private sector, indeed facilitate private sector development. So not only has the share of private sector in investment increased but there are growing complementarities between private and public investment.STILL THERE ARE THREE MAJOR PROBLEM AREAS First in the power sector, which is largely in public hands, the inefficiencies and frequent breakdowns in supplies not only increase the costs for the private sector by requiring alternative generating capacity but also result in large losses for public entities which are a significant drain on public resources. It is not clear that largest scale privatisation of WAPDA's energy corporations is a quick and fully feasible answer at least in the short run.Secondly, though much progress has been made the private sector still looks too much to the government for solving its competitiveness problems by seeking tax, credit and other concessions. Rs 50 billion package demanded recently by the textile industry to cope with competitive pressures in the post MFA era is a case in point.The government on its part has not been able to resist the urge to control prices as inflationary pressures reemerged and the consumers complained. Rent seeking behaviour has not entirely disappeared and genuine entrepreneurship is still hampered though medium and small industries are faring better than before.Third, while the large foreign investment flows are providing a more balanced source of external finance, the bulk of foreign investments are taking place in areas like energy, telecomm, financial and other services which do not contribute directly to export development.Since, as discussed below, export growth remains critical for Pakistan's development a lop- sided pattern of foreign investment could prove costly in the long run.In other areas where state interventions required improvement, resource mobilisation, distribution of growth benefits, human development, and last but not least governance, progress has been more mixed.TAXATION The structure of taxation has improved, the burden of several taxes has been reduced, the move away from reliance in foreign trade taxation has continued, and serious efforts are under way to improve tax administration. It is too early to say, however, whether improvements undertaken or proposed would result in an elastic system of taxation which will automatically capture a reasonable share of GDP growth as government revenues.Also, the tax system is regressive because the rich and the well do not pay sufficient taxes and the individual income tax receipts remain very small. Finally, the present tax to GDP ratio at 10.4 per cent remains very low both in relation to needs and international norms. It should be stressed, however, that the stagnation in the tax to GDP ratio, indeed a small decline compared to 1990s, is due entirely to the liberalisation measures which have reduced import duties.It has been estimated that if the import tax reductions had not occurred and if sales tax had not been increased in partial compensation, the government revenues would have been about 11 per cent higher than otherwise in FY 2005.INCOME DISTRIBUTION, POVERTY, AND EMPLOYMENT The revival of strong growth, and doubling of real public spending over the last six years, after the stagnation of a decade, has expanded employment, resulted in some increase in real wages, and reduced poverty incidence. The extent of reduction in poverty incidence over 2001-05 is a matter of some debate but there is little disagreement that poverty has declined in recent years.This is hardly surprising considering especially the strong agricultural growth in 2004-05. The more interesting question is why has poverty reduction not shown a clear downward trend since 1990.Obviously greater progress in poverty alleviation would have been possible but for the inherent inequalities promoted by the existing power and asset structures, a tax system that does not generate sufficient revenue to fund poverty programs adequately and a labour market that has yet to fully exploit opportunities offered by labour intensive exports.Rural poverty and growing differences in income between rural and urban areas are a matter of growing concern. According to government numbers, the rural poverty incidence in 2004-05 was at 28 per cent was almost double the rate of urban poverty. Surely the high incidence of rural poverty in a bumper crop year cannot be the basis of much satisfaction.Government pro- poor spending, though still low, has increased in recent years to 4.5 per cent of GDP as fiscal space has opened up and progress on some rural programs such as rural electrification and girls' education is impressive. Increased pace of social spending has improved gross enrolment ratios and reduced gender differences.But net primary enrolment rate of 60 percent in 2004-05 means that 40 per cent of the primary school cohort were not in school. The overall education spending is still less than 2 per cent of GDP and quality and governance issues in public education remain huge. At the same time, the government must be given credit for turning its urgent attention to higher education and skills gap and developing cogent plans.Reducing poverty incidence and increasing the access of the poor to basic public services in the rural areas is, however, only one dimension of Pakistan's distribution problems which are reflected in growing income inequalities and regional differences.It seems that the current high growth is deepening inequalities more dramatically than was the case in the earlier high growth periods of 1960s and 1980s because the growth of incomes of the relatively well to do is being fuelled greatly by extraordinary booms in the real estate and stock market.There is not even a modest capture of the windfall profits because of a total absence of capital gains taxation. USA, even after the tax cuts of recent years, has a 15 per cent capital gains tax rate. More generally the income taxation of the well to do has yet to become effective.As mentioned above, the economic rents in the private sector have not disappeared. Though it is difficult to quantify the impact of this factor, it does exacerbate income disparities.Containing of income and consumption disparities as well as steady reduction in poverty especially rural poverty needs to be built in more explicitly as an integral part of the future economic strategy because clearly the issue of the distribution of growth benefits has assumed more urgency with economic liberalisation and greater role for the private sector.The distribution problems have distinct dimensions in rural and urban areas, with poverty being much more of a problem in rural areas and growing income disparities much more of a problem in urban areas. In rural areas the share of consumption of the highest quintile to the lowest quintile was only two only 2.2 in 2004-05 and had changed little since 2000-01.But as mentioned above, rural poverty is widespread and nearly 80 per cent of Pakistan's poor live rural areas. In contrast urban areas account for little over 20 per cent of the poor. But in urban areas consumption disparities are huge and growing. In 2004-05 the share of consumption of the highest quintile to the lowest quintile in urban areas was over 12 times and had grown from 10.4 in a short period of four years.Some of the ways in which Pakistan's policy approaches to the twin issues of poverty and income distribution might be strengthened are discussed in the next section.GOVERNANCE Governance is a very broad area which encompasses the delivery and effectiveness of all public services. Here again the record of last several years is very mixed.The opening of fiscal space has certainly made possible a very sharp expansion in public spending on economic and social development including more adequate pay for the civil servants. But the quality of many services including law and order and justice including enforcement of property rights remains extremely problematic.Still it appears surprising, that the perceptions about widespread corruption have not improved. The Transparency International's Corruption Perception Index (on a scale of 0 (worst0) to 10 (best)) for Pakistan stood at 2.2 in 2006 compared to 2.3 in 2001. Pakistan is now ranked 142 out of 163 as against 79 out of 91 in 2001.Is corruption in Pakistan worse than Nigeria and so much worse than China and India who with a score of 3.3 are ranked 70? In any case, Pakistan's bad score seems a little difficult to reconcile with the absence of major financial scandals linked to the top layers of government. Still perceptions matter and Pakistan's corruption problems appears to be compounded by image problems.The lack of definite progress on governance issues shows, on the one hand, the intractability of issues of institution building and lags in obtaining visible results as shown by the tax administration reform.The biggest achievement of the Musharraf Government has been the creation of a political structure consisting of 6400 new indirectly elected governments with significant participation of women. The devolution to Nazim as an elected head of district government could prove to be a revolutionary change provided other political interest do not undercut the reforms, the initiative is properly funded and is fully supported by measures to enhance local governments' capacities.The biggest disappointment is the stalling of the civil service reform. While merit now plays a greater role in recruitment and promotion, and there is an important initiatives to upgrade skills of civil servants through foreign training, the restructuring of processes and incentives to attract the best and the brightest to the top layers of governments at all levels of government are lacking.Civil service reform must go hand in hand with effective devolution and should include much improved compensation at higher levels as well more competition for these positions including hiring from the private sector.There are examples both from Pakistan's past and recent history that strong, effective, and independent public institutions can be created through autonomy, proper selection of top management and professional staff, and adequate pay.V - LOOKING AHEAD Pakistan's development and modernisation have suffered in the past either because there was not a very clear vision of the future or there were conflicting views about national identity and priorities.One hopes that that main political parties and the military leadership have learnt their lesson from history and would strive to unite the country around a broad emerging consensus about future directions. This consensus must have both economic and non-economic dimensions because social and political shocks can easily derail the economy.Some of the elements of the non-economic consensus that appear to be falling in place are: -- Need for an enlightened moderation in which narrow interpretations of Islam are not allowed to drive the societal and state agenda-- Resolution of conflicts with India, containment of military establishment and gradual reduction of defence spending as a percentage of GDP and public spending-- A determined attempt to reduce the centralisation of decision making by empowering the provinces in the spirit of the federation, hopefully making possible effective devolution of authority and resources to local governments.Decisive progress on the non economic issues is a necessary but perhaps not a sufficient condition for releasing the creative energies of the country to meet its aspiration of high growth rates to match those that are being achieved by China and India.For that a better articulation of an economic vision is necessary which encompasses concern with growth as well as broadening of the growth benefits, reducing income, regional, gender disparities, and modernisation of attitudes towards work and thrift.The Planning Commission is now working on a Vision 2030 paper. The approach paper has many good and important ideas but the longer- term economic vision needs to focus more clearly on some problem areas which have severely hampered Pakistan's development.The following goals need special attention: -- Rapid export expansion-- An elastic tax system which mobilises, at all levels of government, at least 15 per cent of the increment of GDP-- Major decentralisation of public services and accountability closer to the people-- Compact with the private sector which guarantees a liberal economic framework but requires in return proper payment of taxes and abiding by the regulatory framework-- Narrowing of gaps in incomes and access to public services that exist among households, regions and districts and between genders.The policy goals are interlinked and would reinforce each other. Rapid export expansion is necessary for sustaining high growth which must remain a central element in reducing poverty.A more effective tax system would generate the revenues necessary for expanding and improving public services and help narrowing income and regional differences. But an effective tax system would not take root unless governance improves and there is ability to tax at local and provincial governments as well and there is a better understanding with the private sector.EXPORT DEVELOPMENT Despite early promise, export growth has lagged in Pakistan. Even after the substantial export expansion of the last few years, the ratio of exports to GDP remains at 13 per cent very much below the range of 30-50 per cent of GDP in the successful East Asian economies.Even India has a greater export orientation (around 21 per cent of GDP), thanks to its IT exports, than Pakistan Failure of Pakistan to develop a large and diversified base of exports is one of the fundamental factors why it has not matched the growth and poverty reduction performance of not only the first generation of Asian tigers, South Korea, Hong Kong and Singapore but also relative late comers to the field, Thailand, Malaysia and above all China.The relatively slow growth in manufactured exports in Pakistan is highlighted by the continued very heavy reliance on cotton based exports and the failure to enter new lines of production, synthetic textiles in the 1950s, electronics in the 1970s and 1980s and information technology exports in the 1990s.Future development strategy needs to emphasise exports sufficiently and help remove, the trade policy distortions that remain. Special policy support might be needed to diversifying the export base and to develop information technology exports. Recent weakness in exports is particularly worrisome.The Planning Commission is not particularly shy in indicating export targets for 2030. It suggests raising the share of Pakistan's export in world exports from 0.2 at present to say 1 per cent over the next twenty five years.Not an impossible goal but one that will require an average real growth of 12 per cent per annum, raising Pakistan's exports from $16 billion to $270 billion, assuming the world trade grows only 5 per cent per annum.Policies and programs are not in place to achieve these ambitious targets. Diversification of exports should be a key goal. Miscellaneous manufactured goods where Pakistan has little world presence and high value agriculture products are the most promising areas.The vehicles for aggressive export development could include economic zones, targeted foreign private investment in technology and export intensive areas and major breakthrough in exports to China. Right now the large negative trade balance with China is clearly hurting industry as well as the overall balance of payments position.REVENUE MOBILIZATION AND SIZE OF GOVERNMENT Improvements in governance and further economic reforms will depend critically on management of public service personnel. But I doubt that improved governance, better delivery of public services, and a vibrant civil service can be delivered without expanding the base of government revenues.The over extension of government terms of its functions should not obscure the woeful inadequacy of its financial capacity. In Pakistan non-interest non -defence public spending, a key indicator of the size of government is only a little over 11 per cent of GDP, much lower than almost all developing countries.(See Table 4 above)Raising tax revenue is both a moral and a practical imperative. One cannot run an effective government, however circumscribed its functions, on a shoestring. But the expansion in real spending in support of social and economic development must focus on de-centralised programs supporting the important devolution initiative which remains seriously under funded. Taxation effort and authority also need to be devolved in parallel.DISTRIBUTION OF GROWTH BENEFITS Sustained growth and political stability do require a better distribution of growth benefits than in the past. Income distribution issues are not peculiar to Pakistan. Even rapidly growing economies like China have major income distribution issues notably growing rural and urban income gaps and widening regional disparities.Some of these issues arise from structural factors like concentration of labour force in agriculture and rural areas while non-rural economy grows much faster. In the long-run only increased education and out - migration from rural areas can provide a durable solution of rural poverty in Pakistan. But much more can and should be done in the medium term to alleviate both rural and urban poverty and to contain income disparities.First, the rather obvious but sometimes overlooked point, the trend in population growth would remain a major determinant of poverty. The demographic transition has begun but must be strongly reinforced by policy actions. Fertility rates have declined but still remain high.The desired family size in Pakistan is still four children compared to 2 in Bangladesh. Since rural fertility rates are much higher in rural areas, the present efforts to increase the levels of female education must be combined with making family planning services available widely and cheaply.TABLE 4 ===============================================================
Non-Interest and Non-Defence Expenditure for Selected Countries
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(Percent of GDP)
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1990 1995 2000
Argentina 9.0 13.2 12.7
Bangladesh 15.1 12.6 11.8
Chile 16.2 17.4 21.1
Egypt 20.4 24.3 19.4
India 21.0 17.8 19.8
Indonesia 14.7 12.1 13.0
Malaysia 20.5 15.9 17.5
Nepal NA 14.3 13.8
Pakistan 14.5 11.7 10.3
Philippines 11.2 12.9 14.3
Sri Lanka 20.9 19.3 15.9
Thailand 9.8 13.2 15.5
Turkey 12.2 17.3 22.2
===============================================================Source: World Bank, Pakistan Public Expenditure Management, 2004.(To be continued)
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