Political turn and the economy

Published December 31, 2007

Dr Parvez Hasan

It is not possible to predict the result of upcoming elections and their aftermath. Hopefully, political change will bring more democracy, greater pluralism and reduced violence. But the political transition could also be messy.

In any case, the new political and economic leadership would have to deal, among other things, with a set of serious economic and social challenges that have emerged.

There is clear disaffection with the distribution of growth benefits particularly as inflationary pressures have re-emerged and food and energy prices have risen sharply. However, economic concerns are not limited to issues of equity, employment and poverty. For a variety of reasons, sustained high growth and macroeconomic stability are also threatened.

The triple tasks of aggressively addressing the distribution and poverty issues, solving the structural problems hampering rapid long-term growth, and maintaining macroeconomic stability would make economic and political management very difficult. At the same time, consensus building and firm policy actions would not be easy if no party wins a clear majority.

The rest of this piece discusses nature of these challenges and possible responses to them.

The addressing of the causes of political discontent should be a top priority. But, dispassionate assessments of the extent and sources of this discontent are also necessary. For instance, the view that the benefits of growth reached only 10-12 per cent of the population, mostly in the Punjab and big cities is not supported either by the income distribution data or the real wage data for 2000-05.

Still, there is no denying the fact that the distribution of benefits of growth, a problem area since the beginning of the 1960s, has become even more of a critical issue in recent years because of increasing power of the vested interests and growing dualism in the economy that has enlarged increased income differential between the rich and the poor, urban and rural populations, and among regions.

To add to the turmoil, Pakistan’s economic and social problems are being complicated by two important worldwide developments.

First, under globalisation, improvements in total factor productivity have become increasingly important driver of both economic growth and exports. Pakistan’s growth in overall productivity has been limited and hobbled by the lags in social development because of decades of neglect of education including higher education, inadequate rates of investment, and slower adaptation of newer technologies. The loss of competitiveness and momentum in exports and the problems of the textile industry are just a few facets of this problem.

Second, the steep rise in international oil prices has raised petroleum import bill from $3 billion FY 2004 to nearly $7.5 billion in FY 2007. No relief is in sight. Even though crude oil prices are expected to decline from the present level of over $90 per barrel, the average cost of oil for Pakistan during the current fiscal year FY 2008 is likely be substantially higher than the cost of $ 63 per barrel in 2006-07.

The higher oil prices have meant a loss of terms of trade equal to about three per cent of GDP, and have put direct and immediate pressure on the real incomes of middle and lower income groups and also are threatening macroeconomic stability.

How can the model of growth be made fairer without going back on the very substantial liberalisation of the economy and much greater reliance on market forces witnessed since the early 1990s?

Four rather obvious public policy instruments for progress towards a more equitable society are: improved governance especially access of underprivileged to reasonable quality public services, fairer tax and expenditure policies, more equitable access to credit and land for both the rural and urban poor and middle classes. And last but not least tougher, more effective public regulation which reduces anti-competitive behaviour, curbs economic manipulation and guards against economic rent seeking.

Poor governance hurts the poor the most. But they cannot be helped unless they have a greater voice. The creation of political structure at the local government level with Nazim as the elected head of the district government is an important start. But the initiative is not adequately funded and provincial governments’ support to it remains generally ambivalent.

The decentralisation process needs to be pushed much harder by devolving, in the spirit of the federation, the essentially provincial functions from the centre and funding the local governments more liberally. This will not only streamline administrative processes, but also encourage healthy economic competition among provinces (A la States in India and the US), and give local governments a real chance. Fortunately, all the major parties seem agreed on this.

However, the government cannot deliver adequate and better quality public services without resources. Presence of waste, inefficiency and corruption in the public sector should not obscure the woeful inadequacy of its financial capacity especially taking into account the high expenditure on defense. In Pakistan total non-defense, non-interest public spending as a proportion of GDP, a good measure of size of government, is only around 11 per cent-- much lower than almost all major developing countries (this ratio in India is more than 20 per cent).

Raising tax revenue is a both a moral and practical imperative. But additional revenue must be raised through equitable means. By any standard, the burden of taxation on the rich and the well to do is quite light, there is no tax on income earned abroad by residents, no capital gains tax, and no estate taxation even for the very rich. Individual income tax which in most countries serves as a tool for some redistribution of incomes mobilises only about one per cent of GDP.

Meanwhile, there are few studies of the incidence of tax and expenditures.

Unless fiscal policies can be made more effective and equitable, the free market model would come under Iincreasing attacks.

The allocation of both rural and urban land is heavily tilted in favour of the already well to do. Similarly, despite progress in recent years micro-credit level remain low. Policy changes in these areas can be a very potent tool for helping the poor and the urban middle classes.

In devising a more equitable economic strategy, Pakistan should also draw on international experience and expertise. Larger gaps in incomes between the rich and poor, skilled and the unskilled labor, rural and urban areas, as well as growing regional disparities, appear to be a widespread phenomenon driven in part by globalisation.

Rapid rates of technological change and increasing openness of world economy, are increasing the rate of obsolescence, boosting the share of profits in national income, and raising the returns to education and skill development. There is thus growing recognition universally that protecting the losers from the otherwise beneficial globalisation trends requires public action.

Even with a more equitable distribution of income and opportunities, rapid long- term economic growth would remain the major source of job and income growth. Pakistan can take satisfaction in the relatively high growth rate of over seven per cent per annum during the last five years. However, the sustainability of this growth cannot be taken for granted.

The longer- term growth outlook requires a fresh look. The hubris about the rise in investment levels and very large inflows of foreign private investment needs to be tempered by a closer look at the numbers.

Gross fixed capital formation measured in current prices has risen from 17.2 per cent of GDP in FY 2000 to 22.2 per cent of GDP in 2006-07. But in constant 1999-2000 prices, the fixed investment ratio has increased only very modestly from 17.2 to 17.9 per cent over the period. This means two things: real investment has grown only at a slightly higher pace than the economy and that a substantial part of the increase in investment in nominal terms represents merely a faster rise in investment goods prices than the general price level. It is not thus surprising that that domestic capacity constraints are adding to inflationary pressures. In any case, the present investment levels are not likely to support a sustained annual growth rate to 7-8 per cent per annum.

At the same time, partly because of external shocks, Pakistan’s perennial problem, an excessive reliance on foreign resources for its development has re-emerged. The foreign savings (defined as current balance of payments deficit before official transfers) as a proportion of total investment were 23 per cent in 2006-07, roughly the same level as the average in the 1990s. This is despite the fact that worker remittances that count as national savings have risen very sharply during the last five years.

The present level of current account balance of payments deficit before official transfer (5.3 per cent of GDP in 2006-07) is not sustainable. Even running of balance of payments deficits of four per cent of GDP on a sustained basis would require steady real export growth of 10-12 per cent annum.

Unfortunately, our exports, after an impressive growth over 2000-05, have stumbled and now face serious structural problems. The weak competitive position of textile industry is likely to come under further pressure due to end of quota restrictions under safeguard measures on China, and entry of Vietnam in the WTO.

Among large developing countries, Pakistan has the least diversified pattern of manufactured exports, with the exception of Bangladesh. Heavily locked into textile and clothing exports is one of the main reasons why the country has not made major headway in international trade. The rate of expansion in the world textile and clothing trade has not been and will not be nearly as robust as the rate of the rest of world manufacturing sector exports.

Pakistan’s exports of manufactured goods other than textiles and clothing at about $2.5 billion are only a little over 0.03 per cent of world manufactured goods (excluding textiles and clothing) India’s manufactured exports in this category are nearly 25 times that of Pakistan.

The minimal presence of Pakistan in the world market in other manufactured, however, also represents a major opportunity.

It is of course a good thing that a large part of the net foreign inflows is being financed by foreign equity investment rather than by excessive run up of public debt as in the past. However, foreign investment has its costs. Investment income payments related to direct and portfolio investment have almost doubled during the last two years to $3.4 billion in 2006-07 and now far exceed interest payments on public debt.

More worrying from a dynamic growth point of view is the fact the bulk of direct foreign private investment has been in service industries and relatively little in manufacturing and exports. It is ultimately export growth that creates the base for servicing future debt and foreign investment obligations.

The most immediate need is to address macroeconomic imbalances that have worsened as a result of a sharp rise in import petroleum bill, a sharp slow down in exports, and a fiscal policy that has become very expansionary during the last year partly because of the government decision not to pass through the burden of higher oil prices.

Economic adjustment to higher oil prices (and to the more recent rise in international food prices) cannot be avoided. While some subsidies to lower income would remain necessary, the overall fiscal policies must be tightened both through selective scaling back of burgeoning public expenditures and higher revenue mobilisation, giving due attention to equity considerations. This would be a painful process.

However, there are several positive elements that can facilitate orderly transition to more self-reliant and more equitable growth. The full potential of agriculture remains far from being fully exploited and the rise in world food prices provides a great opportunity for expansion of agricultural exports provided improvements in agricultural productivity can be attained.

The lags in social development are being narrowed and larger investment in human capital would begin to pay off. The close relationship with China can play a very important role in growth and structural change in industry and export.There is substantial untapped capacity of taxation of the well to do. Last but not least, prospects for Pakistan’s access to concessionary assistance; market borrowing and private investment flows remain good. Thus a precipitous adjustment in reduced reliance on foreign inflows can be avoided.

Still, the view that mere continuation of existing policies would solve Pakistan’s major economic and social issues is likely to prove myopic.

(The author is a former Chief Economist of the World Bank. email:phasan@aol.com)

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