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Crises past and present

October 13, 2017

PAKISTAN is in the early stages of experiencing, yet again, intensifying pressure on its balance of payments position. The external current account has widened sharply, and is on a trajectory of ballooning to dangerous levels in the current fiscal year. While recent trends regarding exports, worker remittances and foreign direct investment inflows are all positive, with export receipts showing a year-on-year increase in seven months out of the last nine, import growth since November 2016 has outstripped the rise in inflows by a large margin.

CPEC-related machinery imports have contributed, in part, to the surge in overall import payments over this period, combined with the fact that the country’s ever-larger energy requirements are also being met from abroad. However, non-energy and non-machinery imports have made a larger contribution to the deterioration of the external account.

While there is a growing concern in non-policy quarters regarding the direction of the external account, policy circles have shown little understanding or recognition so far of the challenges ahead. A belated move has recently been made by the Economic Coordination Committee to impose regulatory duties on the import of approximately 250 items, in combination with ensuring actual implementation of the export package announced early this year but which has mainly received lip service by the finance ministry.

A recursive history of economic boom and bust — and lessons unlearnt.

The first line of defence is shaping up to be, as always, resort to more commercial borrowing to replenish the drawdown in foreign exchange reserves. However, without addressing the fundamental flaws in the policy settings — excessive taxation of inputs, withholding of refunds, an overvalued exchange rate, uncompetitive energy pricing, indiscipline in public spending — these moves are unlikely to produce anything more than a delaying by a few months of the inevitable. The sum total will amount to too little, too late.

Without a visible, meaningful and credible course correction, the crystallising sentiment of market participants is unlikely to change; ‘bets’ will continue to be placed against the rupee, and these will become both self-fulfilling as well as self-reinforcing. Exporters will begin to delay repatriation of proceeds, while importers will front-load their purchases. Sensing the build-up of pressure on the exchange rate, other economic agents will begin buying dollars (have begun?) as a speculative hedge. Foreign equity investors will move back into dollars to avoid devaluation risk and the associated market risk, which will reverse the direction of portfolio investment flows. (A major risk factor in these circumstances, as correctly noted by the World Bank recently, is the potential for a significant portion of the invested stock of portfolio equity investment — which had touched $7.1 billion earlier this year — to ‘unhinge’ and head out, exacerbating the pressure).

The sum total of all these moves is likely to be that the incremental amount the government picks up from the international capital markets and commercial banks — which are likely to have a combined willingness to lend to Pakistan around $3-5bn maximum, in my view — to prop the reserves will not last long. With its reserves depleted, and out of options, the central bank will then be at the complete mercy of speculators and market forces.

Unfortunately, we have been here before. Not for the first time, the country has indulged in a binge of spending, afforded by borrowed short-term inflows and an overvalued exchange rate, it could ill afford. While many past balance-of-payments crises had an adverse terms-of-trade shock as an immediate cause, in each case the policy framework put in place has been similar as well as similarly flawed. From the economic boom experienced post-Korean War to the 2003-08 period, the similarities are stark. Under all manner of government — from technocrats to bureaucrats, military dictators and politicians — a policy framework has been constructed that encouraged import-based consumption subsidised by the country’s export sector via the overvalued exchange rate.

Each time the impending episode of external account pressure has been predictable — and, like in the case of each previous occurrence of balance-of-payments difficulty, was foretold by many independent economists and commentators well ahead of time. What lessons should policymakers be learning — and have yet to learn — from our now-frequent trysts with economic crises?

Past growth episodes have been short-lived, lasting an average of around four years. Pakistan’s growth experience in this regard has been unlike China, India, Vietnam or a clutch of other high-performing developing economies, where the phase of economic expansion has lasted, virtually uninterrupted, for decades. Our growth episodes have been based on import-friendly policy settings. Combined with an embedded anti-export policy bias, the spurt in economic growth and associated imports has meant that the economy has quickly come up against its old nemesis — the foreign exchange constraint.

Each government — including the technocratic set-up under Shaukat Aziz — has responded in a similar and predictable manner: by resorting to ‘over-financing’ rather than undertaking ‘adjustment’ via much-needed structural reforms. With the international capital markets and commercial banks having a ‘natural’ appetite of only a few billion dollars for Pakistan risk, governments have quickly exhausted this avenue as well.

With a need for stabilisation, compounded by a return to the IMF, the economy has then experienced a policy- as well as balance-of-payments-induced slowdown, with higher interest rates, lower public spending and increased taxation. Each time this has occurred, it has set back the country’s economic development by years, as the stabilisation policies reset the growth process virtually to ‘zero’. The gradual process of rebuilding the confidence of private investors then starts from scratch each time, taking a few years to fully restore.

Only if policymakers jettison their obsession with debt-financed and export-subsidised consumption, and instead focus on building a more sustainable policy framework based on meaningful promotion of exports and industry, can Pakistan break from this cycle of economic boom and bust.

The writer is a former economic adviser to government, and currently heads a macroeconomic consultancy based in Islamabad.

Published in Dawn, October 13th, 2017