THE new finance minister has expressed exasperation at the conditionality of the ongoing IMF programme — Pakistan’s 23rd since 1950. The main thrust of the programme is focused on achieving a primary fiscal surplus that is consistent with a sustainable path of public debt; building external account buffers, and making the power sector financially viable. Prima facie, and in a high-level ‘strategic’ sense, the conditionality appears aligned with Pakistan’s main structural weaknesses.
That these weaknesses have persisted, and indeed worsened, over a period of four decades is testament to how comfortably numb Pakistan’s elites have been despite the country lurching from crisis to crisis. The country’s elites have been cushioned by external aid flows and their disinterest and inaction conditioned by strong policy capture; hence, they have demonstrated inertia and apathy of epic proportions for a protracted period. Even during (and in between) IFI-led reform programmes, a lack of ownership as well as understanding has been compounded by political and policy instability.
Nonetheless, despite the outsized contribution of endogenous factors in Pakistan’s absent progress on a coherent reform agenda, IMF programme design flaws have also made a significant contribution. In fundamental ways, the programme design and parameters are inconsistent with Pakistan’s reform objectives. I have outlined the programme design weaknesses in several articles in the past (including an in-depth critique in this newspaper in August 2019 titled ‘Evaluating the programme’), in discussions both with the IMF as well as the Fund’s Independent Evaluation Office, and during several talks on the issue, including at a high-level seminar at the State Bank in February 2020.
Broadly, the reservations revolve around three sets of issues.
The design of the IMF programme has led to perverse incentives and unintended consequences.
The first issue concerns a fundamental misdiagnosis of the problem. Pakistan has a fiscal fault line that needs correction. This is beyond debate. But whether an out-of-whack fiscal deficit for a couple of years prior to the numerous balance-of-payments crises the country has experienced was the foremost issue that needed to be fixed by the IMF in addressing Pakistan’s external account crisis is very much moot.
Pakistan has landed repeatedly in IMF programmes not because the fiscal deficit has ballooned for a few years prior to the crisis, but because its export base is too small to pay for the surge in imports that accompanies a growth spurt. To break out of this vicious cycle, Pakistan’s export sector has to grow. It is currently at less than 10 per cent of GDP — compared to 15.3pc for Bangladesh, 23.1pc for Sri Lanka, 18.4pc for India, and a whopping 107pc for Vietnam.
In effect, Pakistan’s binding foreign exchange constraint stems from its small export base, and not from its low tax base. While this conclusion appears to run counter to the received wisdom of the twin deficits problem, a number of econometric studies for Pakistan have found no causation from the fiscal balance to the external balance in the short run (with one study published in 2010 in the Pakistan Development Review finding that higher fiscal deficits reduce the subsequent external current account deficits through a positive output shock and exchange rate effects).
The implication of this is that so far, for most of the 23 programmes that Pakistan has been in, the IMF has been addressing a public debt problem while the issue has been in the real/ productive sector of the economy (though the two are linked). The important policy implications of this misdiagnosis are discussed further below.
The second major problem with programme design stems from the disconnect between the structural nature of Pakistan’s challenges and IMF policy prescriptions that have to be fitted into a one- to two-year time frame of a front-loaded programme. The ‘need for speed’ sets up perverse incentives and negative feedback loops — leading to serious unintended consequences that undermine rather than help progress on reforms.
This finding is aptly illustrated by the lynchpin of programme conditionality — that relating to tax collection. In the current IMF programme, indicative quarterly targets on tax collection have been set. The unintended consequences? Rather than providing the incentive — and space — to innovate and change its fatally flawed model, the IMF programme design gives no bandwidth or incentive to FBR to widen the tax base or reduce administrative inefficiencies. On the contrary, FBR staff is incentivised to overtax the already documented formal sectors of the economy to meet quarterly targets. This not only leaves the large informal sector untouched (documenting which should be a key tax policy objective), but increases the ‘tax arbitrage’ between formal- and informal-sector firms, increasing the incentive for medium and small formal-sector firms to informalise.
This outcome is the exact opposite of what Pakistan’s tax reform objective dictates. Apart from the revenue leakage, informal-sector firms typically do not invest in building economies of scale, nor do they invest in training and productivity improvement of their workforce. For obvious reasons, informal-sector firms are rarely recipients of foreign direct investment as well. Hence, the wider economic consequences of IMF conditionality on the tax front include not just more strain on formal-sector firms, and an erosion of the tax base in the longer run, but worst of all, a loss of competitiveness for formal-sector firms. And this loops back to a small, and declining, export base — the primary cause of Pakistan’s balance-of-payments problem in the first instance!
A similar pernicious negative feedback loop has been established by programme conditionality in the power sector by over-reliance on tariff increases.
The third issue with programme design, related to the foregoing discussion, is that the government’s political capital is frittered on price and tariff adjustments in a ‘shock therapy’ approach without being farmed for more substantive and consequential reforms such as governance improvements in the power sector or the introduction of a modern VAT.
The implication of the foregoing is that a longer-duration programme with more back-loaded structural conditionality is likely to lead to better reform outcomes.
The writer is a former member of the prime minister’s economic advisory council, and heads a macroeconomic consultancy based in Islamabad.
Published in Dawn, May 21st, 2021