In many developing countries, governments retain powers to set a wide range of prices across the economy.
For example, the government in Pakistan guarantees how much dealers and distributers in the oil supply chain earn per litre. The support price for sugar cane growers is another well-known example. At a macro level, the price of the rupee against the dollar receives most attention.
Such interventions are often motivated by the government’s desire to provide a specific segment of the economy with relief. At first glance, it looks like raising the support price for sugar cane will benefit farmers. Likewise, decreasing natural gas prices should apparently benefit households.
However, prices have a more important role of allocating resources across the economy. This lack of appreciation for prices as an important part of the allocative mechanism has led to significant distortions in almost every sector.
For example, a higher support price for sugar cane has increased the total area under sugar cane cultivation. This has come at the expense of a decrease in the area under cotton cultivation. Worse still, over-production from preceding years has led to a surplus stock, which is not profitable to export in the absence of a subsidy.
Similar allocative distortions are also observed in the production of wheat. The Punjab government is paying around Rs21 billion in annual interest payments on loans taken to procure wheat in preceding years. The total financial loss from 2010-11 to 2016-17 equals Rs163bn. This is again a direct consequence of support prices, which are significantly higher than the market clearing price.
It is not difficult to see that the policy of significantly higher support prices creates a perfect justification at a later stage for providing interest groups, other than farmers, with subsidies to get rid of the surplus stock.
The political cost that accompanies this is often underappreciated. Subsidies given to interest groups to get rid of the surplus stock puts a question mark on the true intention of the initial policy.
It can be argued that the government intended to benefit powerful interest groups. This can adversely affect the credibility of the government and lead to fruitless enquiries where nothing can be proved with certainty.
Higher support prices create a perfect justification at a later stage for providing interest groups with subsidies to get rid of the surplus stock
Energy is another critical sector with significant distortions. Low natural gas prices in preceding years decreased the incentive for firms to invest in gas exploration. Foreign investment in oil and gas exploration declined roughly 50 per cent between 2012 and 2017. With the depletion of gas in operational fields and limited exploration activity, the production of natural gas fell from the peak of 36.6bn cubic metres to 34.7bn cubic metres in the same period.
In contrast, higher energy prices in the United States during the last two decades played an important role in incentivising investment in exploration activity. It also played a critical role in the exploration of shale gas. These developments have decreased US dependence on imported fuel.
There are significant allocative distortions at the aggregate level as well. Keeping the price of the rupee against the dollar almost fixed between 2013-14 and 2016-17 adversely affected the production structure of the economy. The export-to-GDP ratio decreased from around 13pc to 8pc over the corresponding period.
The intended aim of the fixed exchange rate policy was to keep inflation and fiscal costs of debt servicing under control. However, as exports declined and foreign currency reserves depleted, it led to a currency crisis and ultimately higher inflation and interest rates. This is surely not what the government intended to achieve.
The government should use the fiscal space to invest in activities, which will improve the productivity of the targeted sector. For example, in the case of agriculture, this will involve increasing the farmers’ access to seeds of better quality and providing a targeted subsidy on inputs. It may also involve increasing their access to financial products, such as insurance against adverse weather conditions.
Nonetheless, caution is warranted when deregulating prices, which are already regulated. For example, the deregulation of cotton prices, while maintaining support prices for sugar cane, encouraged farmers to move away from producing cotton and towards producing sugar cane.
In addition to increasing dependence on imported cotton, it also increased fiscal costs of maintaining a higher support price for sugarcane. The ad hoc deregulation of cotton prices, therefore, exacerbated allocative distortions in the agriculture sector.
What is needed is a systematic and simultaneous review of pricing regimes across different sectors of the economy. At the same time, the government must strengthen the Competition Commission of Pakistan and make necessary regulatory changes to ensure that weaker segments are not exploited by dominant players in the economy.
The writer teaches at the University of Bristol
Published in Dawn, The Business and Finance Weekly, January 21st, 2019