Sustaining growth: the investment challenge

Updated March 20, 2019


Pakistan is not investing enough and its share of investment to GDP is one of the lowest in the world at 15 per cent, almost half of the South Asian average at 30pc. — Dawn/File
Pakistan is not investing enough and its share of investment to GDP is one of the lowest in the world at 15 per cent, almost half of the South Asian average at 30pc. — Dawn/File

Pakistan’s economy is unable to sustain high growth rates for extended periods. Every few years, the economy is faced with a balance of payments crisis as it tries to grow fast. This is unlike many other successful peer countries that are growing at higher rates for a longer time. This inability to sustain growth momentum has dented Pakistan’s ambitions to become an upper middle-income country. What is the reason for this boom and bust cycle that Pakistan experiences so often?

The fundamental cause for these short-lived growth cycles in Pakistan is that these are propelled by private and government consumption, not by higher investment. Resultantly, the country’s demand increases at a much higher pace than its supply of goods and services, prompting a need for higher imports that becomes unsustainable. Successive governments have tried to notch up growth in this way, but all of them have ended up with a balance of payments crisis.

Pakistan is not investing enough and its share of investment to GDP is one of the lowest in the world at 15 per cent, almost half of the South Asian average at 30pc. This translates into inadequate infrastructure, lack of access to sufficient levels of energy and water, poor quality of schools and hospitals.

In a new report, the World Bank takes a deep look at what Pakistan needs to do to have a better future for its people by 2047, a full century after the country’s birth. In this series, the authors provide a brief summary of key recommendations of the report.

More worryingly, private investment as a share of GDP has been declining and stands at less than 10pc in FY18. This low investment trap and declining labour productivity have reduced Pakistan’s growth potential.

The decline in economy’s growth pot­e­ntial is particularly concerning becau­­se it suggests that the country will not be able to grow at higher rates required for job creation. To correct this Pakistan needs to undertake several reforms in multiple areas to increase labour productivity and capital formation.

Foremost priority is that Pakistan must maintain macroeconomic stability. Persistent macroeconomic instability has discouraged savings and private investment in the country resulting in low-aggregate investment and fluctuating output levels. It remains one of the key reasons for low foreign investment in Pakistan, as the country’s share in overall global investment flow is low and falling. Fiscal slippages and quasi-fixed exchange rate policy has caused significant damage to the economy.

Moreover, population growth rate needs to be brought down to reduce a high dependency ratio to improve savings. Pakistan’s savings rate of 13.6pc of GDP (2012-17 average) compares poorly with that of its neighbouring countries. It is not surprising; therefore, that nearly all of Pakistan’s high-growth periods have coincided with inflows of foreign savings (in the form of external loans, grants and remittances).

Accordingly, whenever such inflows have dried up, economic growth slid back, as domestic savings and investments were never sufficient to sustain the momentum.

Public investment in key infrastructure and human capital has to increase. Public investment is important as a policy instrument to crowd in private investment and augment human capital to increase labour productivity. However, low tax revenues — a legacy of a suboptimal tax structure — leave limited space for public investments to provide public goods. Current expenditures exhibit structural rigidities due to large debt-servicing costs, significant subsidies, and salaries and wages.

Pakistan also needs to redefine its tax policy and administration to raise more revenues and improve the investment environment. The inefficient and retrogressive tax regime has discouraged the business environment and investment in productive sectors. While some sectors are taxed beyond their share in GDP, others are not taxed or only lightly taxed, creating adverse incentives.

Property transactions are taxed at of­­ficial valuations, which are only a fraction of market value. This large wedge not only provides an opportunity for lar­ge returns but also acts as a haven for un­­documented wealth. A substantial por­­tion of investable funds are diverted to this sector at the expense of other im­­portant job-creating sectors. Another ex­­­ample on how tax policy is creating disincentives for business is the design of the sales tax. A business operating in Pakis­tan must file 60 sales tax returns annually and must deal with five tax au­­tho­ri­t­ies. Effectively a bad tax design has div­ided Pakistan into four smaller markets.

Improving business environment will be necessary to tap foreign resources. Foreign direct investment (FDI) is still extremely low, even at a time when many of Pakistan’s peers are attracting large FDI inflows. This weak performance in attracting FDI is partly explained by Pakistan’s cumbersome investment climate. Given the shortage of domestic savings, the China-Pakistan Economic Corridor (CPEC) opens an important avenue for foreign investment. Nonetheless, to reap full benefits of such investments, the country needs to improve its investment environment, reduce the burden on businesses by undertaking a regulatory guillotine to cut down on redundancy, and harmonise tax laws across the federation.

Pakistan must aim to become a high middle-income country when it would be celebrating the centenary in 2047. But to achieve that goal, the country needs to take tough decisions now including regaining and maintaining macroeconomic stability, broadening its tax base and encouraging investments through tackling the structural and regulatory constraints.

Only then can Pakistan embark on a sustained high growth path and avoid boom and bust cycles, we are so painfully familiar with.

The co-authors are World Bank staff.

Published in Dawn, March 20th, 2019

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