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Tuesday, October 18, 2011

Impending Economic Crisis

PAKISTAN’S economy stands on the edge of an impending economic crisis, which like that of 2008 could threaten Pakistan’s ability to service its external debt putting it in default. Even today the economy is failing, causing untold misery and losses but its impact remains domestic.

Last year’s hike in export prices and acceleration in remittances have insulated foreign exchange reserves from declining so far, but a stagnant economy and inflation are taking a severe toll on domestic employment, incomes and the purchasing power of the poor in particular. Since the latter have not yet translated into political and social strife, present economic conditions have not triggered the urgent response that these warrant, either from the civilian government or other stakeholders.

Persistent and growing budget deficits are at the root of macroeconomic imbalances which afflict Pakistan’s economy contributing to rigidities and risks across the economy. While reducing the deficit is critical to recovery, the democratically elected federal and provincial governments have made no credible attempt at revenue mobilisation and expenditure control.

Important fiscal reforms are hostage to short-sighted political compulsions and corruption. The government response to rising unemployment, economic stagnation and persistent inflation has been over-employment in state-run enterprises, untargeted subsidies and mushrooming development projects. The latter contribute to more losses in PSEs, circular debt and greater fiscal deficits that contribute further to inflation and economic stagnation, perpetuating a vicious cycle of worsening government finances.

Instead of facilitating growth and employment in the private sector and focusing on its basic role of service delivery, the government tried to become the source of employment, both unjustified and unsustainable. With local government systems on hold there can be no effective improvement in service delivery. Meanwhile, the large infrastructure development agenda and social sector needs of Pakistan remain neglected.

Management of macroeconomic stabilisation and governance has been complicated by the new NFC award and the 18th Amendment which dealt with important fiscal assignment issues superficially. As a result, the federal government is further handicapped in ensuring macroeconomic stability without cooperation from the provinces that remain fiscally irresponsible behind a dangerous parochial rhetoric.

Large persistent budget deficits financed by borrowing over the last three years have increased the burden of public debt, now over 64 per cent of GDP. New debt is from more expensive domestic sources on increasingly shorter term. Cheaper longer-term foreign funding has declined and the share of floating domestic debt has increased, reflecting the lack of support for the government’s economic management.

The resultant increase in government exposure to roll over and interest rate risk is worrisome as domestic creditors’ appetite for treasury bills will soon decline amidst the potential downgrading of Pakistan’s public debt as happened in the larger European economies. Markets are also watching the rising burden of debt servicing as it reaches alarming proportions casting doubt on the government’s ability to repay its domestic debt.

The government has few alternatives. Visits at the highest level to traditionally friendly countries have yielded no concessionary loans. In any case, the remedy is not more financing, it is tough fiscal reforms. Borrowing again from the State Bank to finance budget deficits will result in further acceleration of inflation. The public tolerance for more inflation is doubtful, especially as we approach elections.

Double-digit inflation has stubbornly persisted for more than four years now. More recently, the budget deficit has been increasingly financed by borrowing from commercial banks, which is less inflationary but has crowded out private-sector borrowers with serious consequences for growth. During the last two years, banks have lent over 80 per cent of their new lending to the government thus giving up financial intermediation. The increase in banking-sector credit to private fixed investment in FY11 was less than Rs10bn for the entire economy, an indicator of the dismal state of the economy and an alarming decline in private-sector activity.

Industry in Pakistan has been ground to a halt by power shortages, high interest rates, lack of credit and loss of competitiveness of nearly 15 per cent over the last three years. Pakistani producers face higher inflation of costs than their trading competitors disadvantaging exports and domestic industries against imports. With the energy crisis continuing mainly due to financial mismanagement by this government it is no surprise that large segments of industry have shut down across Pakistan.

The impact of all this on growth in national income is inevitable. Growth in GDP has slowed to an average of 2.5 per cent annually during the last four years. Prospects for revival in growth are poor due to declining investment especially private investment. Forecasts of four per cent growth in FY12 is another false hope offered by incompetent policy managers.

Contrary to government claims, the surplus in the external current account in FY11 reflects a collapsing domestic economy as declining national savings exceeded more rapidly decreasing total investment. The sharp increase in exports reflected buoyant prices not increasing market shares or higher volumes, hence susceptible to reversal with international prices.

The recent increase in remittances is not policy-induced hence risky to rely on; the decline in September 2011 is worrisome.

The current account is likely to be in deficit again in 2012, while the surplus on the financial account may decline further resulting in a large decline in official reserves. Foreign direct investment (FDI) was already lower in 2011, and will continue to decline in view of the economic crisis, killings in Karachi and the unjust fate meted out to Pakistan’s largest single FDI in Reko Diq.

The official capital inflows will be lower too unless the government can present a credible programme to the IMF and get support from other multilateral and bilateral partners. With weak fundamentals, an accumulation of reserves of over $17bn has created a false sense of economic security encouraging further delay in important reforms across the economy.

An economic crisis is inevitable with this government in power. Economic imbalances cannot decline unless the budget deficit is reduced through tough fiscal measures. The government is unlikely to undertake tough measures or refrain from its compulsive corrupt practices as polls approach. Without fiscal adjustment the IMF is unlikely to endorse the government’s economic programme which will also restrain other donors from providing support, so Pakistan is likely to be in a serious foreign exchange crisis early 2012.Time will tell whether the economy will survive till the elections.

By Mohammad Zubair Khan: http://www.columnspk.com/impending-economic-crisis-by-mohammad-zubair-khan/