May 22, 2006	Monday	Rabi-us-Sani 23, 1427

THE sharp turnaround in external and public finances has been a singular economic policy success of recent years. The reduction in the burdens of public and external debt was much greater than was envisaged by the Debt Committee five years ago.

But the macro-imbalances have deteriorated quite sharply during the last year or so. Admittedly, there appears no immediate danger of unravelling of the foreign exchange situation.

Indeed the government is basking in the glow of very successful long-term bond placements in the international market. Still the sharp adverse swing in the balance of payments and the pattern of government domestic borrowing raise serious issues about sustainability. It is thus necessary to understand the factors behind current macroeconomic trends and examine their implications for longer- term debt strategy and management.

The current account balance of payments during the first nine months of 2005-06 ran at the annual rate of $6 billion or nearly five per cent of GDP in sharp contrast to the large surpluses of just two years ago.

The fiscal deficit during the current fiscal year is likely to be well over four per cent of GDP (nearly double the level of previous two years) even after taking into account larger external grants.

Inflation though apparently not rising further has become stubbornly high at around eight per cent year over year. The close link with the dollar led to a significant real appreciation of the value of the rupee during 2005 and there is some danger of eroding the competitiveness of our exports if this appreciation is not reversed.

No doubt, two large negative economic shocks suffered by the country, the sharp increase in oil prices and the devastating earthquake, have weakened the underlying balance of payments position. However, several policy lapses or delayed responses have compounded the situation and are endangering the hard won macroeconomic stability.

The stringent fiscal policies of 2000-4 made possible a very accommodative monetary policy but this policy was pushed too far and too long. As inflation rose, the government resisted the market pressures to raise interest rates and in large measure discontinued the reliance on public investment bonds (PIBs) as an instrument of government borrowing.

It relied heavily instead on borrowing from the State Bank of Pakistan. This has kept the immediate cost of government borrowing low but has shortened the maturities of public debt and even more importantly fuelled very large private credit expansion. The borrowing from the central bank would have been even higher but for the very large privatization proceeds.

Finally, the government keeps making the rather unrealistic assumption that additional costs related to reconstruction of damage from earthquake can be met entirely from additional grants or very concessionary assistance so that no adjustments in other expenditure and borrowing plans are necessary.

The expansionary stance has no doubt contributed to a sharp acceleration in the level of economic activity and investment. But good growth rates are being financed excessively by foreign savings, thus increasing the vulnerability of an economy which already relies heavily on huge worker remittances, logistical support payments etc. Also, the greater self- reliance attained during the last few years could be in jeopardy.

Even assuming that the investment expansion during the current year would push up by the overall investment rate to 18 per cent, the saving – investment gap would widen to 25-30 per cent range suggesting that at least a part of current account deficit is financing consumption rather than investment.

National savings (which include the large net transfer payments from abroad including remittances) that were a little over 15 per cent of GDP in FY 2005 are likely to decline in the current year to 13-14 per cent of GDP and the domestic saving rate may dip below 10 per cent.

The safeguarding of the macro stability requires continued fiscal restraint, notwithstanding the approaching 2007 elections, a much tighter monetary policy and a competitive exchange rate. In order to prevent any possible loss of confidence in the currency, public debt reduction goals must be raised and limits of reliance on external finance, including both borrowing and foreign investment, must be clearly set.

The government can take credit for bringing the public debt to GDP ratio from 93 per cent (on new GDP numbers) in FY 2001 to 64 per cent in FY 2005. This ratio will probably decline to less than 60 per cent in the current year. Thus the goal set under the Fiscal Responsibility Law for 2010 will be met many years earlier. This means that the target under law would no longer be much of a constraint on future fiscal deficits.

It is desirable to set more stringent targets because the public debt burden remains quite high in terms of the ratio of debt to government revenues and the ratio of interest payments to total government expenditures.

As a proportion of government revenues, public debt was 480 per cent in 2004-05, much higher than any large developing and developed country. It was also substantially higher than the indicative target of 370 per cent for 2010 suggested by the Debt Committee.

Similarly, the interest payments still accounted for nearly a quarter of public expenditures in 2005-06 thus pre-empting social and development spending.

It is suggested that government adopts the goals of reducing the level of public debt burden further in relation to revenues and interest burden on expenditure by say about a third over the next five years. This would translate into a reduction in public debt as a proportion of revenues to 300 per cent of revenues and decrease in the ratio of interest payments to 15 per cent of government expenditures and bring Pakistan closer to international norms while still permitting fiscal deficits of 3-4 per cent of GDP annually.

Closely linked with the reduction in public debt burden, has been the reduction in the external debt burden. Total external debt grew only modestly from $32.1 billion in mid-2001 to $34.0 billion in mid-2005 cushioned in part by privatisation receipts. Meanwhile, exports and worker remittances have risen sharply.

As a result, external debt, as a percentage of exports of goods and services, dropped from over 300 per cent to less than 200 per cent 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 exports of goods and services from 36.7 per cent in FY2002 to 15 per cent in FY 2005. Pakistan’s external debt burden, though significantly reduced, is still higher than low debt countries that typically have external debt and debt service payments ratios to exports of 100 per cent and 10 per cent respectively.

Ideally, it would appear desirable to reduce external debt burden further significantly, say by one third, over the next five years so that Pakistan can join the rank of low debt countries like India. This would not be feasible if the average terms of new borrowing are hardening substantially (at present the average annual interest payments are less than three per cent of total debt on external debt and the average maturity exceeds 20 years).

Borrowing on hard market terms needs to be limited. In any case, the government should consider adopting specific external debt burden guidelines say to limit debt service payments to 12 per cent and total external debt to 150 per cent of exports of goods and services. These guidelines should be a part of an external debt management strategy which complements and reinforces the public debt management goals. Such a strategy is at present lacking.

Equally important it is necessary to debate and decide, at least notionally, on the extent to which Pakistan is willing to rely on foreign private investment to finance its external deficits. With greater confidence in the economy, foreign investment flows have picked up sharply and a substantial part of privatized assets have been purchased by foreign investors. According to State Bank of Pakistan’s figures, foreign investment flows (both direct and portfolio investment) during the last three years have been close to $7 billion.

Pakistan badly needs foreign investment to supplement its own resources, to upgrade technology, and to assist in expanding and diversifying its exports. I do not, however, share the view that large current balance of payments deficits financed mainly by equity flows do not matter because there are no fixed foreign exchange obligations.

Given the rapid rise in foreign investment, it is likely that profit and dividend payments, at present around $500 million annually, would more than double in the next few years and would begin to exceed the interest payments on external debt.

While it is neither desirable nor possible, in a liberal economic regime, to tightly regulate foreign private investment, the overall level of current account balance of payments deficits (foreign savings) must remain under policy scrutiny to ensure that the dependence on foreign flows does not become excessive and net inflows finance investment rather than consumption.

A rule of thumb that no more than 20-25 per cent of domestic investment should be financed from net foreign savings could be instituted as a part of an external finance strategy. This will permit the acceptable level of current account balance of payments deficit to rise as the investment rate as a percentage of GDP rises. At the same time, it will ensure that external flows do not directly or indirectly finance consumption.

This kind of limit would be in addition to the limits on external borrowing suggested above. A balance between external finance and domestic resource mobilisation would also assure that the benefits of growth accrue principally to nationals and the investment income payments, either in the form of interest or profits and dividends do not become a major burden on the balance of payments.

Maintenance of an adequate level of external reserves must be another integral part of any external finance strategy. After a spectacular rise from a low of $2 billion in mid-2000 to $12.6 billion in mid-2005, the foreign exchange reserves have levelled off. Indeed, the large current account balance of payments deficit would have eroded the reserve level sharply in the current fiscal year except for large privatisation receipts and recent market borrowing abroad.

The present level of reserves of around $13 billion can hardly be considered excessive in light of annual foreign exchange payments which are running at the annual rate of $32 billion, growing foreign investment liabilities, and uncertainty about the course of international oil prices and remittances. A build up to a level equal to six months’ imports payments would be quite justified.

To sum up, Pakistan needs a fresh dose of financial prudence. It can signal concern with the growing balance of payments deficit by tightening fiscal and monetary policies. It can also enhance confidence by revisiting and adopting more stringent public debt goals. Above all, it needs an external finance strategy which will ensure that past mistakes of excessive reliance on foreign flows and financing consumption by borrowing will not be repeated.

The author is a former chief economist of the World Bank. He chaired the Debt Committee during 2000-01.

E-mail: phasan@aol.com