PAKISTAN’S current account balance that slipped into red in 2004-05 after posting surpluses for three consecutive years remains in deficit with the gap widening owing to hefty rise in non-oil imports fuelled by strong domestic demand.

The State Bank’s report for the second quarter rings the alarm bell on the deteriorating external balances. The report maintains that “although remittances are expected to show reasonable growth and exports are likely to remain strong, the current account deficit is expected to swell to 4.7 per cent of GDP by end-FY06.

While this deficit is not low, it is quite sustainable in the short run. In the longer run, however, large current account deficits cannot be sustained, as these would initiate a vicious circle of debt creation, exchange rate deprecation and inflation”.

On the other hand, the opinion of former US Treasury Secretary Paul O’Neill that current account deficits are rather a sign of strength of an economy than a problem has recently attracted lot of debate, for and against the argument.

William Poole, the President of the St. Louis Federal Reserve Bank argues that “current account deficits do not matter when seen in terms of the balance of payments accounting framework. Following his view, the current account deficit of the US is largely the reflection of the on-going attractiveness of the US as a harbour for international capital.

Deficits and surpluses can only show up in the sub-balances such as in the balances of goods, services, investment income, current transfers and the capital and financial account”.

Technically speaking, as a matter of accounting convention the balance of payments must be in equilibrium, excess spending implies debt accumulation or loss of ownership by domestic economy. A negative current account balance requires a positive capital and financial account and this implies that the holding of domestic assets by foreigners must increase.

In other words, when residents of a country (individuals, businesses, and government) sell more assets to foreigners than they buy from them, the capital and financial account will be positive. It is this surplus in the capital and financial account that is being used to buy additional goods and services from abroad, registered as debit in the current account.

Pakistan has a long tradition of financing current account deficit from surpluses in the capital and the financial accounts. It has an average incidence of current account deficit of 3.9—4.5 per cent of the GDP during the decade of the 1980s and the 1990s respectively. By that standard the projection of 4.7 per cent of the GDP is very high. Pakistan’s experience of the 1990s was terrible when a vicious circle of debt creation started to finance the large current account deficits.

There are two financing options for current account deficits. The first one is through non-debt creating inflows which is hardly available to developing countries and who are compelled to resort to finance current account deficits through debt creating inflows as Pakistan did in the 1990s.

The current account deficit of the current year emanates from strength of the economy rather its weakness. The financing is also coming from non-debt creating inflows like foreign direct investment (FDI) and private transfers like remittances.

FDI is preferred to debt creating flows as it not only brings capital but also technology and managerial skills to a developing country like Pakistan. Multinational corporations help promote competition by improved corporate governance standards and practices which have to be emulated by the domestic companies to stay competitive. This improves the business climate.

If the current account deficit is financed by stable non-debt creating flows such as foreign direct investment or inflow of workers’ remittances, there will be less cause of concern. It would be more reasonable to focus on the financing pattern of the current account deficit and the composition of the deficit to gauge the overall health of the external sector.

Any analysis of the current account sustainability should examine not only the composition of the deficit, but the underlying reasons and the financing sources also.

The analysis of the expected large current account deficits in 2005-06 suggests that its quality is far better than previous peaks in the 1990s. If we compare the current account deficit in 2005-06 with previous peaks witnessed in 1992-93 and 1996-97 it suggests that while the deficit in all the cases occurred due to large trade imbalance, there is a wide difference in the composition of the deficit.

While the recent rise in the trade deficit is caused by the broad-based increase in the economic activity together with the higher international commodity prices during 1990s, the merchandise deficit was largely the result of one-off policy decisions, as in 1993 due to yellow cab scheme, and subsequently during 1997, when contracts with independent power projects pushed up the import bills.

The deterioration in the current account balance was primarily due to the widening trade deficit and higher payments outflow for shipment freight charges. The growth in imports, and therefore the current account deficit, cannot be easily contained.

As one can see from the data of the balance of payments (BoP,) much of the growth in imports comprises either of capital goods or input for the growing economy. Curtailing imports through administrative or policy measures is likely to result in significant fall in the economic activity.

Growth in imports is an inevitable component of a growing economy like Pakistan because of heavy reliance on exports, industry, or even on services and imported inputs.

When public and private investment increases in anticipation of a strong surge in the economy, savings react very slowly in rising to domestic demand. As investment expenditure typically reacts more strongly on the business cycle than private saving, the current account balance deteriorates with a lag.

The output expansion generates both— an increase in tax receipts and employment opportunities. The large current account deficit can be sustained in the short-run to medium term but if it persists for long-term, it is bound to augment macroeconomic imbalances.

The policy-makers have very limited options available to them. One of the most suitable is, prioritization on the need basis, or containing the growth in aggregate demand through stringent monetary policy measures.

Yet another difficult option is promoting exports through diversification and hunt for market access. Pakistan has very narrow export base and it badly needs to diversify its exports both product-wise and trade-wise. Pakistan at present is exporting very limited number of products to very limited number of countries.

Another important option is encouraging non-debt creating inflows like FDI and workers’ remittances. Hard choice will have to be made in future years, if it continues to persist. Less desirable options would be to fund the current account deficits through a mix of privatization receipts and higher debt levels or a significant drawdown of the foreign exchange reserves.

This option is also not viable because Pakistan has earned the strong pile up of foreign exchange reserves at a cost. Now the government should learn how to tackle the problem. It has to devise a comprehensive strategy to cure the problem of current account deficit from external borrowing. Pakistan is at the cross road and hard choices have to be made in the years to come.