October 1, 2007	Monday	Ramazan 18, 1428

A large and persistent fiscal deficit has been a major macroeconomic issue facing the country since the early 1970s. It is, therefore, important to analyse the sources of the fiscal deficit and the mode of its financing to arrive at an understanding of how it has affected the economy.

Fiscal economists use three main indicators to measure the budgetary position of a country: overall fiscal balance, revenue balance, and primary balance. Overall fiscal balance measures the difference between total revenue and total expenditure of a government and is the most commonly used indicator of the state of public finances.

Revenue balance measures the difference between total revenue and current expenditure and is an indicator of government sector saving. A high level of government saving contributes to development but this needs to be qualified by the fact that developmental impact of current and capital outlays is difficult to distinguish and the very concepts of current and capital accounts can overlap.

Primary balance is the difference between total revenue and non-interest expenditure and measures the current fiscal position by eliminating the effect of previous budgets. The first two indicators measure the impact of discretionary policy-- both past and present, while the third gauges the effect of policy in any year.

As Table 1 shows, Pakistan has been confronted with a major imbalance in its public finances since the 1970s. The overall fiscal deficit (total revenue minus total expenditure) has averaged around seven per cent of GDP. In the earlier part of this period, budget deficit has been quite large, averaging eight per cent of GDP in the 1970s, seven per cent in the 1980s, and 6.9 per cent in the 1990s. Over this period, Pakistan’s average budget deficit was twice as high as that of Asian developing countries.

Revenue deficit (total revenue minus current expenditure) also worsened in the 1990s, moving from a surplus of 0.2 per cent of GDP in the 1980s to a deficit of three per cent in the late 1990s. An increase in revenue deficit showed that government was borrowing increasingly to meet its current obligations. Public sector dissaving to the extent of three per cent of GDP obviously pulled down national savings, put a heavy strain on the country’s balance of payments and increased foreign debt. Revenue balance gradually improved and turned into surplus since 2003-04 onwards.

Primary deficit (total revenue minus non-interest expenditure) moved from an average of 3.7 per cent of GDP in the 1980s to 1.8 per cent in the first half of the 1990s and improved to a surplus of 0.3 per cent of GDP in the second half of the 1990s. Primary balance remained surplus during the period 2000-05 but turned into deficit during 2005-07. This shows that fiscal deficit in the second half of the 1990s was mainly driven by interest payments.

The genesis of the fiscal problem can be traced back to the earlier part of the 1970s. Fiscal deficit widened from 1.3 of GDP in 1970 to four per cent in 1972-73 to 6.9 in 1973-74 to 11 per cent in 1974-75. This was mainly caused by a huge surge in expenditure on subsidies, wages, public enterprises, development and defence, driven as it was by the populist policies of the regime. The deficit was financed through grants and loans from oil-exporting Arab countries.

An empirical study on the subject traces the origins of the fiscal problem to an upsurge of externally financed development spending during the mid-1970s, mainly in the form of investment by public enterprises. The public sector was unable to generate the revenues, either from taxation or from direct return on investments undertaken, to close the fiscal gap (Nadeem ul Haque and Peter J. Montiel, Fiscal Policy Choices and Macroeconomic Performance in the 1990s). What began as temporary spending to boost economic activity through a strong public sector became an intractable problem two decades later as deficits moved out of control.

The change of regime in 1977 led to a change of policy aimed at fiscal retrenchment through both expenditure cuts and revenue increases under a short-term stabilisation programme with the IMF. Expenditure cuts flowed from a de-emphasis on the role of public sector while trade taxes contributed to the bulk of the revenue gain. The fiscal deficit fell from eight in 1977 to five per cent in 1982.

However, there was a slide as 1980s moved on and the fiscal deficit again reached the level of eight per cent as expenditure growth outstripped revenue increase. Deficit in the 1980s emanated from two policy choices – an increase in pubic consumption in the face of political inability to raise commensurate revenue and a change in the financing mix from domestic bank and external financing to domestic non-bank borrowing. The outcome of these choices was confronted in the 1990s.
The deficit in the 1990s was mainly driven by a rising expenditure, mainly on interest payments and defence. Tax reforms in the early 1990s led to a reduction in deficit to six per cent by the mid-1990s, as compared to eight per cent in the late 1980s.

However, as a result of successful stabilization programme, fiscal deficit has come down to an average of 3.8 per cent of GDP during the period 2000-07. An analysis of revenue and expenditure aggregates shows that expenditure reduction mainly underlies the fiscal adjustment achieved during this period.

Overall fiscal deficit is generally indicative of an expansionary fiscal stance in relation to the rest of the economy but this needs to be tempered by an analysis of the type of financing and the structure of receipts and expenditures. The impact of fiscal deficit on the economy is determined by the way it is financed.

Table 2 shows the distribution by source of financing the budget deficits. The bulk of the financing in the 1970s was external and came in the form of grants and loans from the oil-exporting Arab countries. In the 1980s, 51 per cent of the budget deficit was financed by borrowing from the non-bank sources, 26 per cent from external sources, and the remaining 23 from banking sources.

In order to avoid inflation through monetisation of deficit and external financing, the government resorted to non-bank financing during the 1980s, resulting in a rapid growth of interest payments on domestic debt, which became the largest component of current expenditure in the 1990s. As a percentage of GDP, interest payments rose from two per cent in 1980-81 to 3.5 in 1990-91 and 6.8 in 2000-01. These averaged at 3.8 per cent of GDP in the 1980s and 6.8 per cent in the 1990s.

There was a significant change in the sources of financing during the 1990s: the share of bank financing increased to 31 per cent with a corresponding decline in non-bank financing, while external financing remained more or less at the same level. Large recourse to bank financing during the 1990s was one of the major reasons behind double-digit inflation in the country. During the period 2000-07, there was a significant increase in external financing which became the major contributor. The share of bank financing came down substantially, while privatisation proceeds contributed quite significantly.