Faltering economy: a reality check

Source: http://dawn.com/2008/04/07/ebr1.htm

By Yousuf Nazar

The State Bank of Pakistan’s quarterly report covering the economic performance for the first six months (July-December 2007) of the current fiscal year confirmed what was already in the public domain. Key economic targets for the current fiscal year will be missed and the government’s finances are under pressure. But a close examination of the official data has led us to raise the following critical questions:

Is the government revealing the correct real GDP growth numbers by under-stating the rate of inflation? Is the economy growing at 6-6 per cent?

Is oil price the only or real reason for the ballooning fiscal deficit and consequently for the rapid growth in money supply and inflation?

The answer to both the questions is a no in the light of information published by the bank itself. The report begins with a rather benign view of the economy by stating, “the country’s economy continues to show resilience to domestic and international shocks. Although these have taken their toll, the economy is expected to turn in a reasonable growth performance during FY08, albeit substantially lower than target.” The SBP has revised the key targets for the full year as follows:

Two of the most important indicators, real GDP growth and inflation, if correct, would justify the SBP’s remarks about the performance and growth expectations of the economy. But are they correct even if the estimates about cotton and wheat crops turn out to be right? Remember that the wheat crop estimates were deliberately overstated last year to present a better picture of the GDP growth but the previous year’s growth numbers have still not been officially adjusted.

In simple terms, GDP (gross domestic product) is the short hand for the income of a country. The real growth rate is calculated (in lay man’s terms) by adjusting nominal growth for inflation. For example, if the income of person grows by 10 per cent from Rs100 to 110 in a year and the inflation during the year was four per cent, it can be stated that his real income grew by approximately six per cent, leaving aside mathematical complications. The key to calculating the real growth is the inflation rate. If a rate lower than the actual rate is used, real growth rate will look better or vice versa.

The government maintains that the inflation rate during the current fiscal year will be in the range of 8–9 per cent. That is, no more than 0.2 to 1.2 percentage points higher than 7.8 per cent for FY 2007. However, its own month by month data comparing inflation rate in the current fiscal year to FY 2007 does not support this as shown in the following graph. It illustrates that increase in the consumer price inflation (CPI) and wholesale price inflation (WPI) during the current year has been much higher than 1.2 per cent as the government or the SBP appears to suggest.

This graph shows for the CPI and WPI, the percentage increase in a given month in 2007 and 2008 over the corresponding month of the previous year. For 2008, this number is significantly higher than eight or nine per cent as indicated by the sharp upturn from August 2007 onwards.

During the eight months from July 2007 to February 2008, the cumulative rise in the CPI was 9.15 per cent and 11.31 per cent in the WPI. Obviously, it will be higher for the entire 12-month period. Based on the eight months’ rise, the annualised inflation rate works out to be 14.03 per cent for the CPI and 17.43 per cent for the WPI. It is important to note that much of the real GDP data is calculated using the wholesale price index (WPI). In any case, pick any inflation index using 11 or 12 per cent average inflation rate, the real GDP growth may be around 3.5 per cent or even less in FY 2008 unless the (previous) government’s economic managers can provide a robust and full explanation of the glaring inconsistencies in what are the most important set of macroeconomic indicators.

Revision of growth estimates and even that of the entire set of national income accounts is not uncommon even in the developed world. The new government may wish to do this by appointing a permanent head of the Federal Bureau of Statistics and conducting a full and independent investigation into the data to get a picture of the true state of the economy.

Coming to the budget or fiscal deficit, the SBP report candidly acknowledges, “another troubling aspect is that the fiscal deficit may be under-stated. Evidence suggests that at least a part of the subsidy on fuel prices during July-February FY08 was not financed from government account.” It goes on to explain as follows:

“Instead, in order to mitigate the financial difficulties of the various institutions (particularly the oil marketing companies) with unpaid price differential claims, the government provided guarantees against which these public and private sector institutions could borrow the amounts from financial institutions. Such a financing structure simply shifts most of the cost of the financing from the current fiscal year to the fiscal deficit in future years.”

Leaving aside the issue of understating the real level of fiscal deficit due to the non-inclusion of guarantees to the oil companies, let us take a look at the government’s revenue and expenditure for the first half of FY 2008 in the table below:

Table: Revenue and Expenditure Summary

Government officials and many others have attributed the ballooning deficit to the rise in the oil prices but the data does not fully support this contention. Against a full year’s revenue target of Rs1475 billion, the government’s revenue for the first half were Rs625.6 billion. That is, the total revenue grew by only 1.8 per cent against the target of 20 per cent (per annum) and the tax revenues grew by only four per cent against the target of 21 per cent. (per annum).

The weakness in Q2-FY08 fiscal revenues stemmed from a variety of factors. For example, direct taxes declined due to a fall in expected taxable profits of key industries (e.g. banks, cement, etc.). Similarly, the weakness in non-tax revenues mainly reflected the delayed disbursement of logistic support grant (indicated by a fall in defence receipts), and low collections of surcharges on petroleum and gas.

On the other hand, expenditures appeared to have gone out of control in an election year as summarised below:

In the backdrop of 1.8 per cent increase in the total revenues, no effort seemed to have been made to control the expenditures that grew by 25.3 per cent. While current and unexplained expenditure increased by Rs120.2 billion (18.9 per cent), development expenditure jumped by Rs77.9 billion or 52.7 per cent. The net result was a deficit of Rs356.3 billion (3.6 per cent of full year GDP) for just the first six months only against the full year target of Rs398 billion or 4.2 per cent of the GDP. At this rate, the deficit is likely to exceed six per cent of the GDP.

Contrary to the widely held view, the subsidies for oil and other commodities contributed to no more than five per cent of the total current expenditure during the first half of FY 2008. This is evident from the following table in which subsidies are included in the Economic affairs’ expenses.

Interest payments on debt, defence, payments to provinces, and expenditure other than subsidies accounted for Rs161 billion or 83 per cent of the increase in current expenditure during the half-year ended December 2007 or 86 per cent of Rs187 billion rise in the budget deficit during the period.

Here it should also be noted that the sharp rise in the oil price came only towards the end of October 2007 when it broke the $90-a-barrel level after trading in the $70-80 range during July-September 2007. The hard fact is that interest payments, defence, and payments to the provinces were the three largest items and accounted for 75 per cent of the total current expenditure.

The overall picture emerging from this analysis is that President Musharraf’s administration did not exercise any financial discipline in the election year and did not take any action to stop the politically-driven escalation in spending even when the revenue growth stalled. This came at the cost of overall higher inflation and an all-time record fiscal deficit.

The deficit was financed mostly by borrowings from the State Bank or in simple terms by printing money as illustrated in the following table:

Compared to the first half of FY2007, the deficit more than doubled to Rs356.3 billion. The worst aspect was that 64 per cent of this was financed by highly inflationary bank borrowing compared to only 18.6 per cent in the previous year.

In conclusion, the hard evidence points to some unpleasant facts. The economic growth during FY08 is probably going to be much less what the government claims and which the multilateral lenders seem to accept without much questioning. The inflation is a lot higher than what the previous economic managers have been telling us. And most importantly, low single digit growth in tax revenues, election year spending spree together with interest on past borrowings, and not the oil price or subsidies, are the principal reasons behind the record level of budget deficit during the first-half of the current fiscal year.

yousufnazar@yahoo.com