January 9, 2006	Monday	Zilhaj 8, 1426

IN its first quarter report of fiscal 2006, the State Bank of Pakistan has cautioned against celebrating high GDP growth and falling inflation without worrying about an inadequate revenue base to keep the fiscal deficit in check and attending to the sharply widening current account deficit.

This advice should be taken seriously. Here’s why. GDP growth this year will not be as high as it was last year. It will miss last year’s level of 8.4 per cent as well as the government target of seven per cent as both large-scale manufacturing and agriculture growth come in below expectations.

The SBP forecasts GDP growth of six per cent to 6.6 per cent while in its latest country update the Asian Development Bank says growth will slow to 6.5 per cent by June.

While these levels are lower, they are still above the long-term target of annual GDP growth of six per cent. But why is growth slowing? To begin with, record agriculture growth especially in the cotton crop, gave GDP growth a big push last year and as the SBP explains it, the government illogically hoped this would continue into 2005-06 as well.

Cotton and sugarcane, two major crops have shown a decline in production this year. Cotton is 13 per cent lower than last year as a result of delayed sowing, untimely rains, pest attacks and uncommonly hot weather in August and sugarcane is lower on account of the perennial dispute between sugarcane mills and growers which resulted in farmers switching from cane to other minor crops such as oilseed.

Sugar mill owners offered lower prices than government announced rates for the last two years and typically delay payments to growers as well.

The SBP says agriculture growth may still meet its 4.8 per cent growth target if the Rabi season shows a stellar performance. But this hinges on water availability which may not be as high as it was in the Kharif season when availability was above normal for the first time in six years.

What the SBP doesn’t discuss, however, is the lack of logic in how the government sets agriculture growth targets. True, a long-term average puts agriculture growth at four to 4.5 per cent. But while water availability and agriculture credit can be assessed in making projections, the reliability of projections remains weak since investments in agriculture appear not to be a serious aim for the government.

Industry slowing down: Industrial production was another major contributor to high GDP growth last year but large-scale manufacturing became the biggest contributor to the slowdown in industrial production in the first quarter of 2005-06.

The deceleration in large-scale manufacturing has been, as the SBP points out, broad-based with major sectors like textiles, petroleum, fertilizer and electric goods showing declines in production even though previously depressed sectors such as pharmaceuticals and paper picked up steam.

In the first quarter of the financial year, large-scale manufacturing grew 8.7 per cent compared to 25 per cent in the same period last year.

Services sector growth continues to be strong with financial services and telecommunications leading the growth and this will contribute generously to overall GDP growth. However, the deceleration in agriculture ad industrial growth means overall growth is sure to weaken.

And so, while growth is still robust, it is not an entirely glittering story in the economy especially since long-term GDP growth will be constrained by limited upside in agriculture growth, which in turn will be constrained by a paucity of real investment in farming.

Inflation slowing too? The other story being pushed as good news in the economy is the slowdown in the rate of inflation. Consumer price inflation has slowed from 11.1 per cent in April to 7.9 per cent in November but as the ADB says in its report, inflation still remains high.

While CPI may have slowed, core inflation, which is non-food, non-fuel inflation, remains steady at 7.6 per cent without any perceptible downward movement. CPI appears to have responded to some extent to the tightening of monetary policy by the State Bank and the relative slowdown in GDP growth has also eased the pressure on inflation.

Improved food supplies have also helped but international oil prices continue to be a wild card in the inflation equation. International oil sector analysts say oil prices will continue to rally as the commodity bull market continues over the next few years. The change in leadership at the SBP also leaves the question of whether monetary policy will continue to remain tight, helping keep CPI below eight per cent.

As the SBP points out, some short-term growth should be sacrificed to help lower the rate of inflation because if it does fall, that will provide the basis on which monetary policy could be eased to help support long-term growth. However, this will be tricky to achieve as international commodity prices rise, global inflationary pressures also rise and the upward pressure on international interest rates.

Fiscal pressures persist: While the positives of high growth and falling inflation clearly do not come without a set of problems, the negatives in the economy are looming large. The ADB points out that the fiscal deficit target could be missed on account of earthquake related spending. SBP data shows the fiscal deficit widened from 0.4 per cent in the first quarter of 2004-05 to 0.5 per cent in the first quarter of 2005-06. The SBP says this is not a matter of concern since revenue growth is strong and net lending to public sector enterprises is negative.

The State Bank also says that since the biggest growth in government spending has been on development expenditure (a growth of 58.6 per cent), there is less cause for worry. But the fiscal performance will deteriorate after the first quarter on account of earthquake related spending pressures. Even if this does not significantly affect the deficit, the question that remains is how will the government cope with higher spending, especially necessary spending on development, without a solid revenue base?

In their defense, the government would argue that the Central Board of Revenue has improved first quarter revenues by 21 per cent. But as the SBP rightly points out, international trade related revenues account for 76 per cent of the total increase in tax collection.

So what happens if trade-related revenues fall? Tax receipts will be seriously impacted by a slowdown in runaway imports. And as expenditure rises and revenue growth is unable to keep up because trade tax collection is lower, development spending will once again become the victim of an ancient vicious cycle, thereby throwing the economy back into the same old trap.

The way out, of course, lies in expanding the tax net and enforcing compliance. However, despite repeated assurance by the government that this is on the agenda and repeated pleas by economists that this is essential, no moves have been seen in this direction yet.

Current account imbalance: The current account deficit is perhaps of even greater concern at this time than the fiscal deficit which is still relatively within limits despite poor long-term revenue prospects. Rapidly rising imports, however, have thrown the trade deficit out of whack and the current account deficit has widened to alarming proportions.

In the first four months, the current account deficit has widened to $2.1 billion from $135 million in the same period last year as exports growth of 23 per cent has been unable to keep up with 54 per cent import growth. The trade deficit has ballooned to $4.6 billion from $1.8 billion in the same period last year.

What’s most worrying on the trade front is the composition of imports. Although the government’s data shows a 62 per cent increase in machinery imports, the import of automobiles actually makes up the biggest head under this category. In the first four months, car imports rose 91 per cent and the import of electrical instruments increased 73 per cent. High international oil prices contributed to rising imports too as the oil import bill climbed 68 per cent.

Meanwhile, on the export front, although textiles have performed well post-quotas, rising 28 per cent to $4 billion in the first four months, not much else has changed in the composition of export products or markets. And as the SBP indicates, it is unlikely imports will be contained to a great extent given the openness of international trade and the growth levels in the economy.

That takes us back to the old requirement that export diversification is a must. But here too, despite assurances no real strategy has been seen to be developed. Growth, although weakening will remain above the targeted six per cent and inflation, although still high, will moderate to eight per cent.

But the real issue is that in the short-term even larger deficits can be sustained but in the long-term the twin deficits can cause worrisome distortions and imbalances in the economy. And to ensure this doesn’t happen, a far deeper and stronger focus on tax reform and export diversification is the only way out.