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Emerging Markets

Too big to fail

Although Pakistan’s economic prospects have brightened, the country needs a sustainable growth model – fast. But security concerns are putting the economic policy debate on the back burner

Although Pakistan’s economic prospects have brightened, the country needs a sustainable growth model – fast. But security concerns are putting the economic policy debate on the back burner.

For years, Pakistan’s growth model – heavily reliant on foreign cash to finance its deficit – provided the space for hefty government spending, fuelled by easy global credit, amid a domestic consumption boom.

This arrangement helped turbo-charge the country’s economy, which experienced an average annual growth of 5.8% in the five-year period between 2002 and 2007. But robust growth masked structural inefficiencies, including the country’s reliance on small-scale and low-value textiles and a mounting trade deficit. Moreover, as privatization proceeds dried up, the government began to draw increasingly on unsterilized (and inflationary) central bank borrowings as well as foreign portfolio inflows to finance the current account deficit.

Then came last year’s oil and food price shocks, which led to massive unbudgeted subsidies and a gaping fiscal deficit of 7.4% of GDP in 2008 – the highest in nine years. This was followed by domestic political turmoil and a global economic meltdown – together with the widespread withdrawal of foreign capital.

Just in time

Last November the IMF stepped in to save Pakistan from the brink of bankruptcy with a $7.6 billion loan, to be spent over two years. And in recent months, Pakistan’s economic prospects have started to brighten. “Things are looking up,” says Faisal Potrik, portfolio manager at KASB Funds in Karachi. “Economic indicators have improved, and the international community realizes Pakistan needs economic support.”

Recent foreign bilateral aid reflects mounting western concern that an economic meltdown in the nuclear-armed nation could imperil its fight against radicalism and boost support for militant groups.

The US has pledged a $7.5 billion aid package for the next five years, and in mid-April international donors pledged another $5.28 billion. But there is concern that even though the funds are intended for “economic purposes”, some of the cash could be diverted to the war against the Taliban and Al Qaeda rather than supporting economic development.

Even after a recent Friends of Pakistan donor conference, US special envoy Richard Holbrooke expressed concern that the aid deal itself may not be enough to bolster the state, given the country’s tortuous struggle for political stability. “The terrorists in western Pakistan are planning other attacks around the world... so we need to work hard to strengthen the government of Pakistan,” he said.

Nevertheless, aid and less public spending will help shore up public finances this year, while helping stabilize the currency and boost foreign exchange reserves. But growing unemployment, higher energy costs, declining remittances and divestment will further fuel social instability as the economy slows. The IMF forecasts 2.5% annualized growth by June 30 – the slowest pace in eight years. The Fund programme also requires a fiscal deficit of 4.2% this year and 3.3% in 2010.

Too tough?

Although many concede stabilization measures are a necessary evil to anchor a flagging economy, concerns are growing that IMF-imposed austerity will further imperil targeted social programmes – despite the Fund plans widening the social safety net by 0.6% of GDP – as well as much needed investment in the energy sector.

Similar austerity programmes, enforced by western creditors after the 1997 Asia crisis, have been accused of undermining East Asia’s long-term growth potential by cutting government-funded development and employment projects. “There are a large number of economists who take the view that now is not the right time to cut spending, given its negative impact on social cohesion and Pakistan’s huge development needs,” says Basharat Ullah, chief investment officer at Arif Habib Investments, one of the country’s largest fund managers.

Whatever the case, vanishing private-sector credit and reduced government spending threaten to be a significant drag on growth, even with lower interest rates.

Bank aid

The World Bank has committed $2 billion to Pakistan this year, while the ADB has a $4.4 billion country assistance programme for 2009–13. And in recent months emergency cash from external creditors, as well as lower oil prices and declining imports, have reduced Pakistan’s economic vulnerabilities.

But the nation urgently needs to revamp “its fiscal and monetary policy mix to address the structural weaknesses” that have left the country vulnerable to boom and bust cycles, says Sakib Sherani, chief economist at RBS in Islamabad.

Now, more than ever, Pakistan needs a more sustainable growth model. The ADB estimates that once growth drops to 5%, Pakistan could face a balance-of-payments crisis, given the current account gap and unstable financing sources.

“The pace of progress has been slow over the years, and I see this continuing,” says Ullah at Arif Habib Investments. He says public finances are in such a structurally weak position due to the country’s low tax-to-GDP at 10%. In principle, this forces governments to either borrow abroad or from domestic non-bank sources.

The IMF agreement forces the government to curb its practice of raiding central bank resources, but Sherani argues that what’s needed is a legislative commitment to phase out both direct budget financing and pro-cyclical public spending. To drive the transition from a domestically driven economy to an externally competitive regional player, productive investment in high-value exports would improve the trade balance while agricultural reforms would boost income levels and employment.

But even after the recent reconciliation between the governing People’s Power Party (PPP), led by president Asif Ali Zardari, and the Pakistan Muslim League (PML-N), the largest opposition party, Pakistan’s political climate is still beset by instability. And as a result, deep structural reform faces the prospect of further neglect.

Warns Sherani: “The security situation is putting the economic policy debate on the back burner.”


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