JUDGING from the debate in the electronic and print media in Pakistan on the US decision by the US authorities to hold back disbursements of $800 million owed to the country, there seems to be a state of panic amongst reasonably well informed people of the likely impact on the economy.
The American decision signals to the authorities in Pakistan that they cannot – in fact should not – rely on a regular flow of funds from the United States. Telephone calls from the news media for comments on the American decision came to me while President Barack Obama was giving a live press conference on the state of his discussions with the leaders of the Republican Party about getting from the US Congress an increase in the country’s debt ceiling.
Without such an agreement, the United States would have reached the legally authorised debt limit on August 2 and will have to default on which ever foreign or domestic obligation that had to be honored that day.
America had never defaulted before and if it did no body was prepared to guess what would be the implications for the global economy not to mention the consequences for the US economy. Given the importance of the matter the American president was discussing with the press, it was interesting to note that the TV channels found the news about the likely cut in US aid to Pakistan to be important enough to run it on the moving sticker at the bottom of the screen. This raises the obvious question: should the policymakers in Pakistan panic?
The simple answer is no and that is for two reasons. First, let us put the $800 million that was being put on hold in context. Pakistan is currently running a fiscal deficit of 6- 7 per cent of its GDP of some $170 billion. This means that it needs to find some $10-12 billion this financial year to close the gap between government expenditures and government revenues. This is a large amount but $800 million is in the neighbourhood of seven per cent of the expected deficit. Keeping that from coming to Pakistan won’t break the back of the economy.
The second deficit to be concerned about is in the current account. This is the gap between what the country pays for the import of goods and services and for servicing foreign debt and what it earns from abroad. This year the gap is estimated at about five per cent of GDP or about $8.5 billion. If the entire amount put on hold by the United States was used for closing this second gap, it would be equivalent to a bit less than 10 per cent. This amount not becoming available won’t break the economy’s back either.
The other thing worth noting about this amount is that it is strictly not economic assistance. A part of it is for payment for the services the Pakistan military has already provided to the American and NATO forces operating in Afghanistan and part of its is to pay for the equipment the military would like to purchase from the United States. Legally the United States cannot hold back the amount which has been spent as a part of a binding agreement. Of the $800 million not being paid, significant amount cannot be held back for long. The other bit is for military purchases. There are reports that the Pakistanis no longer want to acquire some of this equipment, not sure whether its availability would not be interrupted at some day. They may be turning to the Chinese as the more reliable source of supply.
For the moment, it does not seem that the Americans are putting a hold on economic assistance being provided under the Kerry-Lugar bill approved by Congress in 2009. This committed $7.5 billion of grants to Pakistan over a five year period, is for financial years 2009 to 2014.
Congressional commitments, under the US law, do not mean actual disbursements. This only happens when a particular item gets included in the budget for the year. Given the American unhappiness with Pakistan these days, it would not be surprising if these get excluded or significantly reduced under the annual budgeting process.
Since both the administration and Congress are working on reducing government expenditure and since there is not a powerful constituency for foreign aid in the American legislature, it would be a miracle if Pakistan is given the promised amount. To bank on the receipt of this money year after year would not be prudent for the people managing Pakistan’s finance.
If the assistance from the US does begin to flow it should be treated as a wind-fall gain rather than as a component of normal revenue availability to run the government and get the economy moving again.
However the financial flow that matters for the health of the economy is the one promised by the IMF. The amount was $11 billion to be disbursed over a period of two years starting in late 2008. More than $7 billion was released; leaving $4 billion that got stalled. It was stopped since Pakistan did not fulfill one of the more important conditions imposed by the Fund. Islamabad promised to raise the woefully low tax-to-GDP ratio by reforming the fiscal system. Since bringing more tax payers into the system would have proven politically problematic, both sides – Pakistan and IMF—agreed to tax consumption.
Ideally this should have taken the form of a value-added tax, the VAT. But the tax acquired a bad name in the country. Its purpose and the method of collecting it were both poorly explained and deliberately distorted. The government settled instead for what it called the General Sales Tax which got transformed into RGST or reformed general sales tax. The “reform” appellation referred to the elimination of some loopholes, elimination of some exemptions, and extending the tax to the serve sector.
But RGST also proved to be politically difficult to impose. Most of the opposition to the tax was due to the impression that that it would add to the rate of inflation which was already very high. There was also opposition from the provinces that saw the sales tax as a provincial levy and not a tax that could be legitimately collected by the federal government. These problems meant that Pakistan continued to miss the deadlines laid down by the IMF which has refused to start releasing funds from the blocked account.
It would be wiser for the government and the citizenry not to worry about the American threat to slow down the flow of funds to Pakistan. They should worry much more about the policy failure that has led to the freezing of disbursements from the IMF. Since these are tied to the reform of the tax system, politicians should have both the wisdom and the l nerve to convince the voters that without a fundamental restructuring of the tax system and the tax code, Pakistan cannot put its economy on a trajectory that would take it towards sustainable high rates of GDP growth.
The Fund had offered an opportunity for doing precisely that but the country let it pass. Instead of putting its effort where it is needed the most, both the government and the people are prepared to heap blame on Washington for the poor performance of the economy. Not mobilising resources from within the economy and continuing to blame foreigners may be politically expedient but is a short-sighted strategy for producing economic growth.