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

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

PARVEZ HASAN

ARTICLE (January 13 2007): Bhutto came to power in December 1971. His Pakistan People's Party (PPP) had captured the imagination of the general public with the slogan of Roti, Kapara, Makan, though Bhutto had no clear notions about socialism, he felt he had the public mandate to bring about fundamental changes in public ownership of means of production.Bhutto undertook large-scale nationalisation of industry, insurance, and banking, extending the state control of the modern sector significantly. Bhutto government also took full control of country's educational system by nationalising private educational establishments.This experiment with socialism had far-reaching and long-term consequences. Though successive governments in the next two decades attempted privatisation, large segments of banking, insurance, and industry remained with the state till the late 1990s.Apart from their negative impact on private industrial development, Bhutto's policies had adverse long-term economic consequences through increase in defence establishment, nationalisation of educational institutions, a cavalier attitude towards public spending, and, last but not least, serious erosion of the capacity and authority of public sector institutions.A great deal of the responsibility for failures in basic education, which has become an important constraint on growth, can be traced back to the decision to nationalise educational institutions in 1972.From economic point of view, Zia-ul-Haq's rule (1977-88) was the least ideological and the least innovative. Fortunately for Zia-ul-Haq, the economy showed a high and sustained growth rate helped mainly by a number of special factors both domestic and external. The completion of long gestation period Tarbela Dam project in 1977 added considerably to irrigation water availability and hydel power capacity.Fertiliser and cement investments undertaken under Bhutto contributed to industrial growth. A tremendous boost to economic activity was also provided by rising worker remittances and large external assistance for Afghan Mujahedin, channelled through Pakistan. Similarly, the narcotics trade, which gathered great momentum in the 1980s, strongly supported the service sectors of the economy.Lulled by a comfortable growth rate and a balance of payments situation greatly helped by remittances and other external factors mentioned above, Zia regime did little to deal with the serious structural problems inherited from the 1960s and 1970s: the over-extension of government, the poor climate for private sector investment, heavy dependence of exports on cotton based exports, and the inelasticity of the tax system.Indeed some structural problems were intensified. Relentless growth in public spending, a major shift in the public expenditure priorities from development to defence, and consequent rise in fiscal deficits increased debt burden sharply.There is no doubt that macroeconomic imbalances were worsening and growth was slowing down after mid 1980s. Had Zia lived, he would have had to face the consequences of his neglect of some basic economic issues. As it turned out, the responsibility for sorting out the difficulties fell to a succession of weak political democratic governments which followed Zia.These governments were both ill-equipped and disinclined to deal with the multitude of structural issues that had accumulated over time, and thus the economy has had to suffer periodic economic crises in the 1990s.Notwithstanding substantial macro-economic mismanagement over decades (less visible in the 1980s than in the 1970s and 1990s), there was a gradual process of liberalisation of the economy starting in the late 1980s notably the reduction of interventions in agricultural prices, relaxation of import and investment controls and financial sector reforms.Major agreements with the IMF and the World Bank financially supported the structural reform process which was further accelerated by the removal of foreign exchange controls and stepping up of the pace of privatisation under the first Nawaz Sharif Government in 1991-92.The policy shift towards the private sector and greater reliance on market signals rather than administered prices was influenced largely by pragmatic considerations. Policy decisions to involve the private sector in energy and infrastructure development reflected a realisation going back to 1987 that the public sector funds had become a serious constraint on development.Similarly, the drain caused by losses of public sector enterprises was a major factor in the decision to hasten privatisation of industrial assets. Efficiency considerations were also behind the drive to privatise government banks and telecommunications corporations.DEFENSE SPENDING Because relations with India deteriorated early on and Kashmir dispute has continued to simmer between the two countries, high level of defence spending has remained a key feature of state policy and strong competition between defence and development has been unavoidable.The only periods in Pakistan's history when defence spending grew less rapidly than GDP were the first half of the 1960s and the second half of the 1990s. In the former period it was the large US military assistance which made a lid on military expenditures possible. In the latter period, growing financial and fiscal crises led to an actual decline in defence outlays for a few years. (See Table 4).Between 1965 and 1990 there was an almost relentless growth in defence and related spending. Real defence expenditure almost doubled between 1960-65 and 1965-70 in the wake of the 1965 war. Under Z.A. Bhutto defence outlays increased by a further 33 percent even though the size of the country and the economy had shrunk substantially.Under Zia, real defence spending increased on average by 9 percent per annum during 1977-88 while development spending rose 3 percent per annum; by 1987-88 defence spending had overtaken development spending. For 1980s as a whole, defence spending averaged 6.5 percent of GDP. Not only was this a peak but it also contributed strongly to large fiscal deficits and a rapid build up of public debt.PUBLIC V/S PRIVATE SECTOR The notion that the state must be leading agent in economic development was also embedded deeply in early economic thinking. An important achievement of the 1950s was the increase in the rate of domestic capital formation, in absolute terms fixed investment in the then West Pakistan increased nearly fourfold in the 1950s.But there was a clear public sector bias. There was an almost sevenfold increase in the real level of public investment in the 1950s and the share of public investment in total investment increased from less than 40 percent to two-thirds over the decade.The Ayub era was an exceptionally successful period of economic management because it used panning institutions and processes effectively for economic policy co-ordination. The pace of economic decision-making was speeded up, implementation processes strengthened and sectoral planning substantially decentralised. But the public sector bias of the development policy of the 1950s continued and was compounded by the large availability of foreign assistance, which mainly financed public sector development.Private investment was expected to account for only 25 percent of total development spending (including the Indus Basin Replacement Works and the Rural Works Programme) under the revised Second Plan. In fact, private investment in West Pakistan turned out to be higher than public investment (including the Indus Basin Works). Even so, the Third Plan (1970-75) allocations for the private sector were projected at little over one-third of the total (including Indus Basin Works).Bhutto's economic policies virtually halted the growth of the modern private industrial sector and reinforced the anti-export bias of the industrial strategy. Large public investments in industry focused on import substitution and the reform of the exchange rate system failed to remove the large wedge between the average effective exchange rates for imports and exports.Even though the attitude towards the private sector improved during the Zia period and some privatised units were returned to the private sector, there was no attempt to tackle the overhang of major nationalisation of the Bhutto period. Even though major inefficiencies had already emerged in public sector enterprises, especially the nationalised commercial banks, not much thought was given to systemic solutions.The early 1990s saw the emergence of liberal economic policies and a fuller realisation that the private sector should be allowed to play a greater role in the economy. But structural reforms including financial sector liberalisation and privatisation did not go far enough, or remained in early stages.Only limited progress was made in privatisation in financial, telecommunications, and the energy sectors. The delay in privatising large state-owned banks was particularly costly because credit allocation decisions became more susceptible to political pressures under the democratically elected governments.Paradoxical though it may seem, some of the liberalisation measures, though sound in themselves, had the impact of diluting the urgency of macroeconomic adjustment. First, the ease of financing the foreign exchange gap through foreign currency deposits and portfolio investments became an excuse for not facing up to the unsustainability of large balance of payments deficits. Second, large receipts from privatisation were used to bolster public spending rather than to retire debt.III - PAKISTAN AT THE THRESHOLD OF 21ST CENTURY As I have argued elsewhere Pakistan as it approached the 21st century Pakistan was faced with not only a financial crisis but also an economic growth crisis because the per capita GDP growth had slowed down to 1 percent per annum during the 1990s from the average of around 3 percent per annum during 1960-85.It is too simplistic to lay the blame for Pakistan's economic and financial problems at the end of 20th century mainly at the governance and economic policy failures in the 1990s.The fundamental governance and growth problems had long roots and had their origins in: -- A level of defence spending that the country could ill afford-- Inability of the government after mid 1980s to collect enough revenues to cover current expenditures. This led to borrowing partly for current outlays including defence and thus sharp build up of public debt and rise in interest payments. Consequently, despite large fiscal deficits, social and development spending began to squeezed and began to fall as a percentage of GDP.-- A major neglect of human development outlays and quality of public education in face of rapid growth of population and rising needs for skills.-- A weak industrial and export structure, dominated by cotton based exports resulting from both from insufficient progress in education and trade policies which discouraged backward linkages, exports based on imported inputs and diversification-- Personalised rule, over centralised decision making, weakening public institutions and rule of law, increasing public corruption, and lack of accountability-- A pattern of development which resulted in sharply increasing inequalities and only slow reduction in poverty because it rewarded rent seeking, discouraged genuine entrepreneurship, did not promote labour intensive exports, and did not sufficiently tax the rich.By the end of 1990s, the growth and governance problems had become intertwined. Because growth benefits were not widely shared, the quality of public services especially education was deteriorating and the pace of poverty reduction was slowing, the tensions in the society had begun to erupt with increasing frequency in ethnic, sectarian and random violence. The deteriorating law and order situation in turn had become a constraint on investment and growth.Taking the second half of the twentieth century as a whole, however, it is the governance failures in Pakistan that stand out much more than growth disappointments. Pakistan no doubt missed major economic opportunities especially in exports of manufactured goods but its average GDP per capita growth rate of 2 percent per annum over 1950-2000 was about the average for developing countries and about the same as India's.Furthermore, Pakistan had to cope with a much higher growth rate of population of nearly 3 percent per annum over fifty years. If governance had not deteriorated so much and the strength public institutions not eroded over time, the resources mobilised through taxation would have been more adequate and the quality of public services especially education would not have declined so precipitously.Poor governance hurt the poor and low income groups especially as they depend relatively more on public services. The failure of the well intentioned Social Action Program in the 1990s which aimed at provision of basic education and health services and narrow the gaps in human development must basically be attributed to poor governance.Why did governance decline so sharply over time? This is a big question and the answer to which is essentially beyond the scope of this paper. But one can point to some basic factors. I believe the very high population growth rate complicated, both financially and managerially, the delivery of basic public services. The responsibility for weakening of the rule of law must be borne by the political leadership both military and civilian.Some argue that extra- judicial interventions by the military and disregard of the Constitution is a root cause of this problem. But in some respects Pakistan's military regimes were less arbitrary than some democratically elected leaders starting with Z.A. Bhutto.The weakening of bureaucracy, a decline in its competence, and increase in corruption is as much due to its steadily declining relative compensation as to the frequent political interventions in violation of rules and regulations.Governance was relatively good till the 1960s. The sanctity of public expenditure was well observed and there was not the cavalier attitude towards the use of public funds. Relatively new public entities such as WAPDA and PIDC had strong leadership and were quite effective because they had more operational freedom including ability to adjust prices. Later, the governments were either populist or weak and unsure and tended to postpone difficult decisions for the sake of short term gain.But purely from an economic policy viewpoint, the picture at end of 1990s had some important bright spots. By the sheer pressure on public resources defence spending did not increase much in real terms in the 1990s. The gradual liberalisation of imports and reduction of tariffs had by reducing foreign trade taxation substantially reduced the anti-export bias in policies, agricultural price distortions had become minimal, and the environment for private sector had become much friendlier.There was a clear recognition in the privatisation efforts and seeking of private investments in power generation that government had become overextended financially as well as administratively.IV - STATE AND ECONOMY UNDER MUSHARAFF PROGRESS AND PROBLEMS So what has changed and by how much during the last seven years? Unfortunately the views on what has happened tend to be rather polarised. The government claims broad success in putting national finances on a sound footing, reviving strong growth, improving social indicators and beginning the difficult processes of improving governance and sharing of growth benefits more widely.The sceptics point to the continuance of serious issues in governance and quality of public services, narrow base of the prosperity, only modest progress in poverty reduction, and re-emergence of heavy reliance on external flows. As often the reality is more complex. There have been some fundamental changes in macroeconomic policies, attitudes towards the private sector and size and use of public resources which have revived strong growth and improved growth prospects, enhanced the priority of social sectors including higher education, and accelerated pro-poor spending.But it also remains very much an open question whether reforms so far have put the economy on a sustainable high growth path and improved the economic model and the governance structures sufficiently to ensure a more equitable growth. This section and the next explore both the progress and the challenges that remain.MACROECONOMIC MANAGEMENT: REDUCTION OF DEFICITS AND DEBT BURDEN REDUCTION The sharp turnaround in the public and external finances of Pakistan has been a singular economic policy success of recent years.No doubt the improvement in the external and domestic finances and the large build up of foreign exchange reserves has been greatly helped by developments following 9/11 and realignment of Pakistan's relationship with the United States and other Western Countries. External grants, substantial concessionary assistance, Paris Club rescheduling, payments for logistical support to the US, and somewhat better access to external markets, all contributed strongly to the remarkable build up of external reserves over the last few years.But tough stabilisation policies aimed at restoring financial discipline, shrinking fiscal deficits, great restraint on non-concessionary external borrowing, and measures to promote exports laid the basic ground work for the much increased confidence in the stability and strength of Pakistan rupee which in turn resulted in reversal of capital flight, large increase in worker remittances, and growing interest by foreign investors.The external and public debt levels have come down very sharply since 2000. Total external debt of Pakistan grew only modestly from $32.1 billion in mid 2001 to $35.7 billion in mid 2006 cushioned in part by large increase in foreign investments inflows related partly to privatisation efforts. Meanwhile, exports and worker remittances have risen sharply.As a result, external debt, as a percentage of exports of goods, services, and transfers has dropped from around 250 percent to 115 percent over the period. Furthermore, the average terms of external debt have softened considerably because of large debt relief from the Paris club, retirement of expensive debt and substantial concessionary assistance especially from IDA.This is reflected in an even sharper drop in the ratio of external debt service payments to foreign exchange earnings from 26.5 percent in FY2002 to 9 percent in FY 2006.The public debt to GDP ratio has declined from over 90 percent (on new GDP numbers) in mid 2000 to 55 percent in mid 2006. As a proportion of government revenues, Pakistan's public debt has also declined from nearly 600 percent in mid 2000 to less than 400 percent in 2005-06. Interest payments as percentage of government revenue have come down from 33 of public expenditure in late 1990s to17.5 percent in 2005-06.But it is clearly desirable to reduce debt burden further say to a total public debt to revenue ratio of less than 300 percent and interest payments to government revenue ratio of less than 15 percent from 33 of public expenditure in late 1990s to17.5 percent in 2005-06.The sharp decline in interest payments in the budget from nearly 7 per cent of GDP in FY 2000 to 3.1 percent (as well as containing defence spending as a percentage of GDP) has opened up fiscal space, defined as non-interest and non-defence spending, while at the same time making possible a reduction in fiscal deficits.The non-interest and non-defence spending increased from a low of 8.6 percent of GDP in FY 2000 to 12.2 percent of GDP in FY 2006. Public spending including the earthquake related spending has doubled over the last six years in real terms providing a strong momentum to both growth and social development.The macroeconomic management in Pakistan is being challenged once again partly because of both external shocks and too accommodative a monetary policy in FYs 2005-06.-- The almost doubling of the international oil price between 2003-05 and 2005-06 has added $3 billion or more than 2 per cent of GDP to Pakistan's petroleum imports.-- The devastating earthquake which will cost the economy $6 billion over five years but at best only one-third will be covered by truly additional grants and highly concessionary assistance. So the budget will have to suffer a negative impact of 0.5 per cent for the next few years.-- In retrospect, the private credit expansion of more than 100 per cent between mid 2003 and 2006 was clearly excessive especially in respect of consumer credit increase.Notwithstanding major economic shocks, Pakistan has been able to avoid disruption to economic growth because of adequate level of foreign exchange reserves and large foreign investment flows related partly to rapid privatisation.However, the current account balance of payments deficits, after official transfers, to $5 billion in 2005-06 and the July-October 2006 data suggest could grow to $6.0 billion or over 4 percent of GDP in 2006-07, if the recent decline in international oil price is not sustained. Meanwhile, inflation though stable at around 7-7.5 percent is stubbornly high.Maintaining of macro stability would require further strengthening the structural position of both external and internal finances not only through fiscal and monetary policy adjustments but also through export push in non-traditional exports. Just because an economic shock is exogenous does not mean it does not need a policy response particularly if it is not self-correcting.Having said that Pakistan has much greater freedom of financial options than ever before as typified by its successful long term bond placement in the international market, the continuing strong interest from foreign investors especially from the Middle East, and continued strong support from international organisations especially the World Bank and the ADB.DEFENSE SPENDING As mentioned above, high defence spending (both in real terms and as percentage of GDP), has constrained growth and development over long periods in the past not the least because there was not the national will after 1985 to mobilise enough tax resources to meet defence needs without borrowing for current government expenditures.In the second half of the 1990s real defence spending as well as all other non- interest government spending fell as interest payments on debt absorbed a steadily rising share of public expenditures. Between 1991-92 and 1999-2000, there was virtually no increase in real defence spending and it declined as a percentage of GDP from 6.3 percent in 1991-92 to 4.8 percent in 1999-2000 - much lower than the peak of 7 percent in late 1980s under Zia-ul-Haq.However, it should be noted that real non-interest non-defence public spending declined even more sharply both in absolute terms and as a percentage of GDP, from 15.2 percent in 1991-92 to 10 percent in 1999-2000. Thus the civilian expenditure was squeezed to a greater extent than military spending under the financially strapped 1990s.(See Annex Tables 1&2) The analysis of defence spending since 2000 is complicated by two facts. First, as is the custom in many countries including India, the defence pensions were moved to the civilian budget from 2000-2001 Secondly the national income figures were revised substantially upwards and a new series introduced starting with 1999-2000. This makes historical comparisons somewhat difficult.Since 2000-01, defence spending, excluding pensions, has risen in real terms roughly in line with the growth in GDP. It actually fell in the stabilisation years 2000-2002 but has increased by 23 percent during the last three years (2003-06).Currently defence spending is around 3.2 percent of GDP and appears to be lower than the level in the 1990s even after making rough adjustments for comparability of data. Three points need to be noted, however. First the defence budget is still absorbing nearly one third of government revenue. Secondly, the current military outlays are being supported partly by payments from the US government for the fight against terrorism. If and when these payments decline, down ward adjustments in spending will be needed and if not made the history of late 1960s will repeat itself.Thirdly, it is not clear that all military purchases abroad either through foreign assistance or loans are fully reflected in the budget figures. In any case, the issue of an appropriate level of defence spending ie the choice between guns and butter remains very much alive.PRIVATE SECTOR DEVELOPMENT AND PRIVATIZATION Another important success of the Musharraf regime, not unrelated to the strengthening of the financial position and increased confidence in the currency, has been the further energising of the private sector through accelerated privatisation's and improvement of investment climate. Induction of foreign investment has becoming a promising source of future growth.During the last five years, 2001-2006, direct foreign private investment has totalled $7.3 billion, rising from $500 million in 2001-02 to $3.5 billion in 2005-06. Privatisation receipts at $2.4 billion have accounted for over one-third of direct foreign investment. The privatisation sales to the foreigner have been concentrated in banking, telecommunications and thermal power while other important foreign investment flows have been in oil and gas and telecommunications.TABLE 3 ====================================================================================================
Key Fiscal Aggregates, Public and Private Investment (as percentage of GDP)
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Years Public Fixed Private Fixed Consolidated Defence Non-interest Fiscal Tax
investment investment Public Spending Non -defence deficits Revenue
Spending Public Spending
1960s 8.2 8.8 NA 2.8(1960-65 NA 2.1 NA
4.0(1965-75)
1970s 10.3 5.6 21.5 5.61 14.0 5.3 13.8
1980s 9.2 7.8 24.9 6.5 14.5 7.1 13.4
1990s 7.5 9.1 24.1 5.6 11.7 6.9 14.0
1999-2000 6.0 8.4 23.6 4.9 10.5 6.6 12.9
New Revised National Account Series
1999-2000 5.6 10.4 18.7 4.02 7.8 5.4 10.7
2000-2001 5.7 10.2 17.2 3.2 8.0 4.3 10.6
2001-2002 4.2 11.3 18.8 3.4 8.0 4.3 10.9
2002-03 4.0 11.3 18.6 3.3 9.2 3.7 11.5
2003-04 4.0 10.9 16.7 3.2 10.0 2.4 11.0
2004-05 4.4 12.1 18.2 3.2 11.8 3.3 10.0
2005-06 4.8 13.6 17.7 3.2 11.3 4.2 10.4
====================================================================================================(To be continued)
Copyright Business Recorder, 2007