Between 2000 and 2007 Pakistan was one of the fastest growing economies in Asia. Economic growth of 7% a year had resulted in its external debt being halved, comfortable foreign exchange reserves were propping up the country’s exchange rate and international investor confidence had returned.
Then it all went wrong. The onset of global financial turmoil, the astonishing rise of oil and commodity prices and political instability sent the economy reeling.
By the end of its 2007–08 fiscal year Pakistan was facing four major challenges: a drop off in growth; rising inflation; widening of fiscal and current account deficits; and rapidly depleting foreign exchange reserves.
The worsening fiscal and current account balances were largely the results of external shocks of extraordinary proportions accompanied by policy inaction during most of the year. The growing fiscal and external imbalances were financed by unprecedented borrowing from the central bank and drawing down of foreign exchange reserves.
Gross foreign exchange reserves at the central bank slid from $14.2 billion in October 2007 to $8.6 billion in June 2008 and further to $3.4 billion (less than one month of imports) by October 2008. Worsening macroeconomic imbalances had resulted in a decline of foreign exchange reserves from $14.2 billion to $3.4 billion – a loss of $10.8 billion in just one year.
So why did deterioration on such a large scale take place in such a short period of time?
There are three reasons. First, the speed and dimension of both domestic and external shocks were of extraordinary proportions. Second, political expediency prevented the previous regime from taking corrective measures to address external shocks.
Third, the incoming government that took charge in March 2008 was initially inept at addressing economic problems in general, and external shocks in particular.
While the rest of the world was taking corrective measures and adjusting to higher food and fuel prices, Pakistan lurched from one crisis to another. Despite a peaceful election and a smooth transition to a new government, political instability persisted. For protracted periods there were no finance, commerce, petroleum and natural resources and health ministers in the country. The government lost six precious months in finding its feet. It gave the impression of having little sense of direction and purpose. A crisis of confidence intensified as investors and development partners started to walk away: the stock market nose dived, capital flight set in, foreign exchange reserves plummeted and the Pakistani rupee slumped in value by a third.
Pakistan’s macroeconomic vulnerability had grown unbearable. It had no option but to return to the IMF for a bailout package.
MISTAKEN ASSUMPTIONS
The IMF approved a $7.6 billion standby arrangement last November spread over seven quarters, ending in June 2010. The IMF programme had two major objectives: to restore macroeconomic stability and investor confidence through a tightening of macroeconomic policies, and to do so in a manner that ensured social stability and adequate support for the poor during the adjustment process.
The IMF programme appears to have been finalized in haste as its methodology is inconsistent with its objectives. For example, one key objective was to restore macroeconomic stability and investors’ confidence through tightening macroeconomic policies. Tight monetary policy was to be pursued to curb aggregate demand so as to slow down import growth and thus reduce trade and current account deficits.The IMF was apparently unaware that over 40% of tax revenues originate from imports; any policy that curtails import growth would also hurt revenue collection!
Likewise, overall economic growth was targeted at a low level of 3% for the year. Against this backdrop, raising the revenue collection target by Rs110 billion – from Rs1,250 billion to Rs1,360 billion – was simply inconsistent with the policy design. Accordingly, the 2008–09 financial year ended with revenues of Rs1,157 billion, meaning a Rs203 billion slippage from the IMF target.
In line with the IMF programme, Pakistan pursued tight fiscal and monetary policies in 2008–09 with a view to reducing macroeconomic imbalances. Such a policy stance was necessary to address the challenges of high fiscal and current account deficits.
These policies paid handsome dividends. The fiscal deficit was reduced from 7.4% of GDP a year ago to 5.2% and the current account deficit to 5.1% of GDP from 8.4% a year ago. Inflationary pressures also eased. Pakistan succeeded in minimizing macroeconomic imbalances in 2008–09 by pursuing tight macroeconomic policies.
Prudence demanded that Pakistan should have continued with the same policy stance in the current year (2009–10) as well. Tight macroeconomic policies were needed to consolidate macroeconomic gains.
But the government lost its patience and embarked on an expansionary fiscal policy and a relatively easy monetary policy with a view to reviving economic growth, creating employment opportunities and reducing poverty. Such a policy stance is not viable – at all – in the face of high fiscal and current account deficits as well as the rising price of oil.
Furthermore, growth cannot be revived on a sustained basis by creating more macroeconomic imbalances.
Because Pakistan is pursuing an expansionary fiscal policy this fiscal year, finding the financing to do so has become a source of anxiety and a major risk to this year’s budget. Over 43% of this year’s budget deficit is to be financed from external sources – the bulk of which is expected to come from the pledged resources of donors at this April’s conference in Tokyo.
IMF STEPS IN
Donors have pledged $5.7 billion to Pakistan over three years. Pakistan has received little or no money so far from the Tokyo pledges, and it approached the IMF for additional resources of $3.2 billion to fund priority spending. The IMF has approved the additional funding as a bridge financing until the Tokyo-pledged resources are made available.
So why has Pakistan undertaken such massive spending based on borrowed resources from the IMF?
It is also strange that the IMF has allowed its resources to be used for budgetary reasons instead of balance-of-payments support. This is a major departure from the past – it is as if the IMF has changed its religion. On this logic, the Fund ought to tell member countries that inflation everywhere is a fiscal phenomenon and that policy-makers should now learn the fiscal rather than monetary approach to balance of payments.
The total resources approved by the IMF for Pakistan amounted to almost $11 billion for the two years up to the end of 2010. This means that the IMF has emerged as a major source of external financing. Despite this the programme itself has been extraordinarily benign — asking for little reforms and with a generous waiver for non-observance of performance criteria.
Major reforms should have looked at three areas — tax system and tax administration reform; power sector reform including resolution of the sector’s recurring inter-corporate circular debt; and enhancing the central bank’s enforcement powers in banking supervision.
The introduction of a broad-based VAT regime by mid-2010 is a key pillar of tax system reform. The progress thus far is not up to the mark. Pakistan has also promised to improve tax administration. Political support to boost the tax system and tax administration reform is vital. If the IMF programme continues to remain benign, the chances of the success of the reform agenda remain bleak.Pakistan should have pursued tight fiscal and monetary policy for another two years with a view to consolidating the macroeconomic gains. Minimizing the macroeconomic imbalances should have been the policy thrust of the government. Macroeconomic stability is increasingly recognized as being critical for sustained economic growth and poverty reduction.
The government has become impatient while the IMF has also forgotten its own lesson of a sound fiscal position, so vital for achieving macroeconomic stability.
Ashfaque Khan is professor and dean of the Business School at the National University of Sciences & Technology, Islamabad. He was economic adviser to Pakistan’s Ministry of Finance from 1998 to 2009