Economy: challenges ahead

Published January 1, 2007

THE year 2007 may turn out to be a challenging and difficult one for Pakistan after the above six per cent average economic growth during the past three years. Specifically, there is an increasing likelihood that:

• GDP growth, though still healthy, will drop to under six per cent.

• Rupee will gradually depreciate against the dollar by end 2007 with the current account deficit rising to $9-10 billion — its highest level ever.

• Industrial growth rate will moderate mainly due to the textile sector

• Property market will see price declines in some major urban areas.

• For the first time since end-2001, the stock market will yield negative returns amid decelerating corporate earnings growth and dampening investor sentiment.

• Fiscal deficit will exceed the government’s target of 4.2 per cent of the GDP.

• Income inequalities and poverty indicators will worsen as the poor, lower income and salaried households will be hit harder because even the official statistics are now reporting double-digit inflation.

• Energy crisis will become acute and an increasingly important factor in Pakistan’s external relations.

The next year may well be an election year but it is unlikely that the political developments will have a significant impact on the economy policy or direction, barring some extraordinary developments or surprises, besides creating some noise. The country enters the new year at a time of generally sound global economic environment, hopes of a breakthrough in relations with India and growing foreign investment flows, particularly in the banking sector.

However, the economic outlook is clouded by a widening current account deficit (around six per cent of the GDP — among the highest in emerging markets), persistently high inflation, slowing textile exports growth, tight monetary policy and a looming energy crisis in the backdrop of the oil price holding above $60/barrel and reports that the natural gas reserves may not able to cope with the growing demand in another three to four years.

Moreover, the sensitive price indicator (SPI) has hit the double-digit levels from seven per cent in 2005-06. The SPI – the index that measures inflation in the prices of food items, petrol, gas, tea, cigarettes, etc. – climbed to 11.25 per cent during the five months period of July-November 2006. This will put further upward pressure on wages and production costs in the coming months with adverse implications for labour productivity and international competitiveness.

Meanwhile, the country’s stock market has been the worst performer among major emerging markets (except Turkey) during 2006 despite being ‘cheap’. It may remain cheap in 2007. Another negative signal from the capital markets is the performance of the recently issued global depository receipts (GDRs) of the Oil and Gas Development Company and the Muslim Commercial Bank. Both have not done well on the London stock exchange after their listing recently and have traded below or around their initial offering price levels. This type of post-issue performance is usually not a good omen for future equity issuances of a country.

Now why the GDP growth may slip below six per cent? Last year, the services sector, which represents about 52 per cent of the GDP, accounted for about 68 per cent of the GDP growth. This masked the rather moderate growth rates in the agriculture and industry. Agriculture, with 21.6 per cent share of the GDP, accounted for just 8.7 per cent of the overall GDP growth and the industrial sector, with 26 per cent of the GDP, accounted for 23.3 per cent.

The services sector that led the overall growth includes the following:

Sub-sector Per cent Contribution

of total to GDP

GDP growth

(Per cent)

Wholesale and

retail trade 27.9 27.8

Transport and

communication 19.2 11.2

Finance, banking

and insurance 4.2 13.9

The relatively disproportionate contribution of the finance and banking sector to the overall GDP growth was due to a heady 30 per cent yearly growth in the net domestic credit or lending during FY2004-06. With the monetary tightening underway, the banking sector assets’ growth is slowing down to around 10 per cent or less but only 2-3 per cent in real or inflation-adjusted terms.

The reduced availability of credit, not to mention the higher borrowing costs, will affect not just the banking sector but industry and trade as well. Hence, as the services sector cools down to grow at a more sustainable pace, its overall contribution will fall more in line with its size after three years of double-digit growth. The GDP growth is more than likely to be less than what the government and some other agencies project.

Let us now take the agriculture sector in which the livestock sector’s size is as large as that of major crops. This year, 3-4 per cent growth is expected in this sector compared to last year’s exceptionally high growth of eight per cent and the average of 2.5 per cent during 2002-2005. Among the major crops, the cotton output will be around 12.5 million bales, less than the earlier forecast of 12.8 million bales because the crop has been damaged by insects and disease. Although the outlook for agriculture remains generally positive for 2007-08, with the wheat production forecast to rise by 3.7 per cent to 22.5 million metric tons next year, there is little reason to believe that the agriculture’s growth rate will exceed 3-4 per cent. It may even be less depending on weather conditions.

The bottom is, Pakistan is entering a rather challenging phase of growth. The economy is cooling down after three years of above average growth produced by a combination of benign global economic environment and domestic consumption-driven economic recovery — facilitated by abundant and cheap liquidity- after the slump of the late 1990s in the aftermath of Pakistan’s nuclear explosion in 1998.

Pakistan has come a long way from a precarious state of its domestic and external finances in the late 1990s when it defaulted on its foreign currency deposits obligations. However, even after seven years of the “reforms”, its industry and trade remain heavily dependent on cash crops and low value-added textiles. While the government has managed to improve the finances, particularly through its debt and fiscal management policies, it still has no credible and comprehensive industrial and foreign trade strategy to achieve 6-8 per cent growth target in the next few years, mainly because it does not seem to have the political will or vision and perhaps both, to change the fiscal and trade policies that favour special interest groups and hinder efficient allocation of resources. The narrow industrial, exports and tax bases together with the looming energy crisis combined represent the biggest risk to its growth prospects as well as the greatest challenge for its leadership.

The challenge may have arrived sooner than the government could have expected. While the fiscal situation appears to be still under control with the government likely to achieve its revenue targets, the trade deficit for the first five months (July-November) of FY2006-07 widened to $5.4 billion — an increase of 17.9 per cent compared to a year earlier. With this development, the current account deficit is estimated to be around $5 billion for the first six months of the FY2006-07. This means the government will need an estimated $7-8 billion in foreign investments (including the privatisation proceeds) and borrowings during the next six months to maintain the current level of $10.8 billion in foreign exchange reserves (excluding gold) assuming the foreign workers’ remittances reach the level of $5 billion as being currently projected.

The government’s top economic managers maintain that given the record foreign inflows in 2006, there should be no cause for concern about Pakistan’s ability to attract more foreign investments and finance current account deficit. They continue to maintain a highly optimistic stance about the growth trends and point to the successful privatisations of a large number of companies and foreign banks’ acquisition of local banks. A note of caution is warranted here. Judging from the Latin American experience in the 1980 and 1990s, privatisation alone is not enough to produce stable or high growth nor is foreign ownership of banks an insurance against an economic collapse. Argentina went from a boom in 1997-98 to a bust in 2001 when its privatised but corruption-ridden economy collapsed despite the fact that at the time, foreign banks controlled 52 per cent of its banking system after a record number of acquisitions of the local banks by the US and European banks in the mid-late 1990s. Argentina’s corrupt political system, failure to undertake critical fiscal and trade reforms, and its currency peg were largely held responsible for the collapse.

To be fair, that the government raised over $6.1 billion through the privatisation proceeds during its seven-year tenure is an impressive achievement. But just to put things in perspective, foreign direct investment (FDI) flows into Turkey and Egypt amounted to $23 billion and $6 billion respectively in 2006 alone. Here it took seven years to raise $6.1 billion and the proceeds were concentrated in a few large transactions. Just two privatisation deals — out of nearly 40 — involving Pakistan’s largest telephone company and its biggest oil and gas exploration company, accounted for 56 per cent of this amount. The sale of stakes in two of the five largest commercial banks raised another $600 million. Pakistan has few such mega companies left to privatise.

Given the current pipeline of the privatisation transactions (the most imminent being the planned sale of a 51 per cent stake in the Pakistan State Oil with a market capitalisation of $800 million) and their values as reflected in their share prices on the stock exchange, it seems improbable — particularly during an election year — that the government will be able to raise anywhere close to $7-8 billion it needs to bridge the external financing gap in 2007.

It seems to be in a rush to sell its stakes in large oil and gas companies — a relatively easy-sell in an energy scarce world — to raise as much money as it can to finance the current account deficit. Leaving aside the seriously questionable wisdom of privatising the strategically sensitive and highly profitable oil and gas assets for a moment, this is unlikely to matter much in the short- term as these transactions take 12-18 months to complete and depend on capital market conditions. Hence, the most likely scenario is that the government will have to resort to external borrowing or cut imports sharply to maintain the current level of liquid foreign exchange reserves that represent about 4.6 months of imports.

Pakistan is among the largest recipients of World Bank financial assistance. In FY2006, World Bank support to Pakistan totalled $1.5 billion, making it the World Bank’s fourth largest borrower. Pakistan will need a much higher level of external financial assistance next year. Although there is no concrete indication yet, most of this is likely to come from the friendly oil-rich neighbours.

Flushed with petro-dollars, the oil states can become a major source of financing to the private sector in addition to buying state-owned assets and 2007 may well see a higher volume of ‘Islamic finance’ deals in Pakistan. The United Arab Emirates has been the single largest foreign investor in Pakistan so far but there has been little investment by the Saudi Arabian government in the private sector except the $98.5 million acquisition of a local bank by the Saudi government-controlled bank SAMBA.

Saudi Arabia with hundreds of billions of investible dollars can be a major source of investments into Pakistan but it is not, despite close political ties between the two countries. Meanwhile, Saudis have poured money in investments and projects within as well as outside the region. This suggests that even some of Pakistan’s closest friends do not find it as attractive an investment destination as some Pakistanis would like to believe. Another such friend is China, whose investments in Sudan alone have reached a staggering $10 billion (mainly in the oil sector) within the past five years; more than double the $4.5 billion US military and civil aid to Pakistan since 2001. In contrast, FDI flows from China have remained insignificant although it has provided invaluable official assistance in terms of loans, grants and project aid.

The government must accelerate the development of human and physical resources on a war footing on one hand and make aggressive cuts in the non-development expenditure, including defence, on the other if it wants to ensure a steady level of FDI flows necessary to sustain a 6-8 per cent growth rate.

The IMF estimates that Pakistan needs at least $5-6 billion in yearly FDI flows to sustain this growth rate for the next few years. Pakistan’s level of national savings declined from 21.9 per cent of the GDP during 2002-03 to 16.1 per cent in 2005-06. With a declining savings rate, low or negative real returns on bank deposits and continuing fiscal deficits, Pakistan’s dependence on foreign capital is likely to grow.

However, the level of FDI it needs to attract is unlikely to materialise on a sustainable basis in the absence of massive investments needed to upgrade its workforce and physical infrastructure. After all, the FDI investors look for more than just GDP growth numbers and debt ratios.

(The writer is a former head of Emerging Markets Equity Investments, of a leading international bank ).

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