Burning billions

January 18, 2019

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The writer is VC, Pakistan Institute of Development Economics, and a member of the Economic Advisory Council.
The writer is VC, Pakistan Institute of Development Economics, and a member of the Economic Advisory Council.

TODAY, we can find, fairly cheaply, an amazing variety of imports from all over the world in Pakistan: honey from Germany, vegetables from Brazil, and clothing from India. The government of Pakistan subsidises imports of luxuries for the elites by spending billions in foreign exchange to keep the price of the dollar low. Many different economic indicators show a pattern of consistent and maintained overvaluation of the rupee over the past several decades. In contrast, many competitors who started out behind us, like India, Bangladesh and China, have surpassed us in exports by keeping their currencies consistently undervalued.

Long-term cheap availability of imports has a well-known effect called the Dutch disease. Normally, Dutch disease strikes countries that are rich in resources (like oil). This makes it possible for them to earn foreign exchange cheaply, without learning how to manufacture world-class exports. When the exchange rate is too low, imports are cheap, and prevent the development of local industry. At the same time, exports decline because they are too expensive in the world market. The services sector enjoys a boom because services cannot be imported from foreign countries and must be provided locally. Over the past few decades, the Pakistan economy shows all the characteristic symptoms of Dutch disease, with deindustrialisation, declining exports, increasing imports, and a boom in the services sector.

The proxy war between the US and Russia in Afghanistan made massive amounts of dollars available to Pakistan, creating favourable conditions for Dutch disease. Remittances have also been a significant source of easy foreign exchange earnings. We did not have the wise leadership required to use the availability of foreign exchange to build productive capacity in the domestic economy. Instead, we fell into the trap of building a consumer-oriented economy based on cheap imports, which is attractive in the short run, but enormously costly in the long run.

There are obstacles in the path of structural change.

An agricultural country imports $6 billion worth of agricultural products, like food, raw cotton, edible oil, only because overvaluation makes it cheaper to import than to produce. The government must burn billions of dollars to maintain an overvalued rupee, enabling the wealthy to enjoy foreign luxuries. Unfortunately, the standard sources from which we used to borrow to finance our spending spree have dried up.

The future is in our hands. We can continue to borrow, from other sources, and maintain an economy driven by consumption, and by industries which make profits by using artificially cheap imports. Or we can bite the bullet and go for the structural transformation required to create productivity in the domestic economy, which is the only route to sustainable growth.

But there are serious obstacles in the path of the needed structural transformation. Currently, when we pump money into the domestic economy, it is channelled into imports because dollars are cheap. If the exchange rate were higher, people would demand domestic products.

However, currently, those domestic products do not exist. The industries which could have come into existence had imports been expensive were never born. There is no domestic capacity to fulfil the additional demand, if it is blocked from going into foreign imports. Thus, increased aggregate demand for domestic products will only lead to inflation — increased prices of domestic goods in the desirable sectors. Contrary to common belief, this type of inflation is not harmful. In fact, high prices are required to send a signal to the domestic sectors that extra production is desirable and will be profitable. If we can sustain the policy of keeping aggregate demand in domestic products high, higher prices in the desired sectors will lead to creation of extra productive capacity and stimulate domestic industry, which is exactly what is needed.

However, there are many obstacles in the path. When the subsidy of billions of dollars for imports is withdrawn, there will be a lot of rich and powerful losers. They will demand continuation of the previous policies that created huge profits for them. The potential beneficiaries of the structural change are as yet unborn, and so cannot speak in favour of the change.

The challenge facing the government is to manage the transition in a way which would minimise disturbance to the masses, and provide social support to those who need it the most. The greatest dangers come from the privileged classes, accustomed to extracting revenues without having to work. The billions pumped into supporting the rupees end up, indirectly, in their pockets. Withdrawing this subsidy will lead to loud screams by the rich and powerful, disguised to sound as if they are coming from the people. Whether the government has the courage to stay the course remains to be seen.

The writer is VC, Pakistan Institute of Development Economics, and a member of the Economic Advisory Council.

Published in Dawn, January 18th, 2019