Pakistan’s new government had barely enjoyed its honeymoon when it announced a gaping hole in the country’s public finances. Meanwhile external imbalances, oil and food price shocks and soaring inflation further threaten its search for economic stability
Pakistan’s political landscape changed dramatically following February’s parliamentary election, which saw allies of embattled president Pervez Musharraf purged from power.
Riding a wave of sympathy following the December assassination of its former leader Benazir Bhutto, the Pakistan People’s Party (PPP) formed a coalition government with the party of former prime minister Nawaz Sharif of the Pakistan Muslim League (PML-N), whose leaders remain bitterly hostile to the incumbent president.
The result, though vindication for Pakistan’s long-disenfranchized political parties, has raised the prospect of a prolonged confrontation between the unpopular Musharraf, a major US security ally, and the new government, which could drag out the political uncertainty in the nuclear-armed country.
But the political troubles – which have been brewing since early last year when Musharraf mounted a botched attack on the country’s judiciary – have also blighted Pakistan’s much-vaunted economic success story: infrastructure constraints are prevalent, public finances are in disarray and foreign investment remains uncertain.
Pakistan’s economic growth roared to new heights after the 9/11 attacks, buoyed by international aid and renewed investor confidence in the country’s widely-praised economic management. Despite simmering domestic anger at Musharraf’s US alliance, consumption, investment and American aid fuelled the economy and boosted a rapidly expanding financial system. The result was strong investment, unprecedented external inflows and a low interest rate environment, which combined to push growth to an average 7% of GDP since 2002.
Fast forward to 2008: as Pakistan’s political axis has swung, the much-trumped economic victories now look hollow, while food and energy price shocks have pushed inflation to perilously high levels.
Moreover revelations about the extent of the budget deficit have left observers stunned: new data shows that in the fiscal year ending December 2007, the budget deficit far exceeded the budgeted figures. “No one beyond the government knew how grave the fiscal deficit was; this surprised everyone,” says Sakib Sherani, chief economist at ABN Amro in Islamabad.
Double trouble
The post-election euphoria was quickly dampened as both the extent and implications of the adverse fiscal and external balances became clear to the incoming government.
The country’s new finance minister Ishaq Dar previously headed the ministry in 1999, under then prime minister Nawaz Sharif. While the antagonism between Dar and Sharif’s PML-N party against the president has yet to play out, Dar has already revealed the extent of alleged economic mismanagement by the previous administration.
At an April press briefing Dar accused the old guard of manipulating the accounts and hiding the true extent of the fiscal hole. “There is evidence of understatement and fudging in economic projects by the previous government. We have to revise all our economic targets,” he told journalists in Islamabad. “For the first eight months ending February 29, 2008 the fiscal deficit should have been 2.7% while it is actually 4.7% of GDP.”
The central bank now forecasts the deficit will increase to 6% of GDP at the end of this fiscal year, compared with an initial target of 4.8%.
Dar also signalled that belt-tightening measures are needed to shore up Pakistan’s defence against domestic and external headwinds. “We have given you the hard fact sheet; all these things [the previous government’s economic targets] are not achievable; we are telling you in a very frank manner,” he said.
In the 2007 election year, the then government splurged 14.5 billion rupees ($232 million) a month on food and energy subsidies against an initial budgetary estimate of $800 million for the fiscal year July 2007 to end-June 2008, according to Deutsche Bank. This has stretched government finances to breaking point, further bruised by stagnant revenue collection, which is up by just 1.8% year-on-year.
“The fact the [previous] government did not pass on higher fuel prices has put significant pressure on the public finances and balance of payments and is not sustainable,” says Henri Lorie, the IMF’s senior representative in Pakistan.
The government’s newly-revealed budgetary weakness has also coincided with deteriorating terms of trade as the current account deficit now stands at 5%, increasing the country’s vulnerability to external shocks. Says Lorie: “A rising current account deficit and deterioration in the public finances is clearly a worrying situation.”
The IMF estimates that from July 2007 to March 2008, Pakistan’s net portfolio inflows were nil while foreign direct investment (FDI) stood at $3 billion. This compares with $3.9 billion of FDI and $1 billion of portfolio inflows the previous year.
“We had expected financing for the budget and current account to be financed externally, including by portfolio investments and FDI, but this has not been on the scale that we had expected because of the political situation leading to the election,” adds Lorie.
Bank bailout
To finance its populist adventure, the previous government placed Treasury bills directly with the central bank, accounting for 38% of all net funding raised in the first half of the present fiscal year, according to Deutsche Bank. This borrowing has led to substantial monetization and also contributed to asset and consumer price inflation, which the central bank forecasts may accelerate to 9% this fiscal year above the 6.5% target.
In previous interviews with Emerging Markets, State Bank of Pakistan (SBP) governor Shamshad Akhtar explained there were clear tensions when she attempted to enforce ceilings on the former government’s quarterly borrowings in August last year.
Dar has already publicly said the government will no longer sanction relentless calls on the SBP’s resources in order to give the central bank some breathing room to sterilize capital inflows and help stabilize inflation. But the near-term economic and political hurdles to achieve fiscal prudence are stark.
The government could raise roughly $3.5 billion by selling shares in state-owned institutions including Kot Adu Power, Habib Bank and the National Bank of Pakistan. But some argue that borrowing from the central bank “could persist well into the end of the current financial year”, says former IMF economist Taimur Baig, now at Deutsche Bank. “The new regime will have many other challenges to deal with before tackling the politically tricky issue of selling off state-owned assets,” he says.
Others disagree. “Most members of the coalition when they were previously in power were in favour of the privatization programme. We should expect a slow start, but the pace of reform will then quicken,” says Nasim Beg, ceo of Arif Habib Investments, an investment fund with $617 million under management.
The IMF’s Lorie says a new Fund programme had not been necessary, following the end of the last one in 2004, especially with Pakistan’s reserves building up to $13 billion, according to the central bank.
Says Sherani: “There is a negative stigma attached to accessing the IMF; it’s seen as a sign of desperate times. It also reduces government’s policy autonomy and forces it to pursue unpopular measures.”
But resources are now urgently needed to bridge the budget deficit. Even with a $750 million to $1 billion global bond expected later this spring, Lorie says unpopular belt-tightening is necessary. In particular, “the development budget has increased dramatically over the last couple of years, and so there is scope for curtailing this,” he says.
Professor Abdul Nayyar at the Sustainable Development Policy Institute in Islamabad says cutting back health and education spending could sow further seeds of domestic discontent. He highlights how “the edifice of the Pakistani government’s economic policy is on precarious grounds since the state of public finances rests on international money.”
Tax reform
Observers also note that Pakistan’s tax-to-GDP ratio is among the lowest in developing countries – reflecting vested interests and sustained neglect by successive governments. A serious tax reform will have to be high on the priority list of the new administration.
Averting a financing crunch and arresting external imbalances are tasks made even more daunting given the potentially fractious nature of the new coalition, further complicated by its power struggle with the president.
In November the ratings agency Standard and Poor’s revised the B+ rated sovereign’s outlook to negative in light of rising political tensions. But Sherani warns that “the current difficult external environment combined with the political situation will lower the appetite for reform.”