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Pakistan

Briefing Notes for the Launch in Islamabad, March 2008

Strong growth continues but genuine concern for inflation

  • Pakistan’s economy maintained its momentum in 2007, growing by 7%, slightly more than the 6.6% for 2006. Agricultural sector growth recovered sharply, from 1.6% in 2006 to 5% in 2007, while the manufacturing sector growth continued at 8.4% in 2007, slightly more moderate than the 10% for 2006. Services grew at 8% in 2007, down from 9.6% in 2006. But exports were sluggish in 2007, with economic growth largely driven by strong domestic demand. Investment overtook consumption, helped by a surge in domestic private investment and record foreign direct investment (FDI) flows. In 2007, investment in real terms increased by over 20%.
  • Supported by all sectors, Pakistan’s economic growth is expected to remain strong at 6.5% in 2008. In just a few years, sound macroeconomic policies have transformed Pakistan’s consumption-led growth impetus to one in which investment-led growth can assume a more important role. But recent political violence and uncertainty about the future could slow the economy.
  • Pakistan’s inflation in 2007 remained virtually unchanged from the 2006 rate, standing at 7.8%. Food inflation was even higher, at 10.3%, affecting people living on low and fixed incomes. The inflation was fuelled by global increases in some commodity prices, higher utility tariffs, and by local supply- and demand-driven factors. To contain food inflation, Pakistan’s government expanded the public-sector utility-store network, extending it even into rural areas. Through the network the government provides large subsidies for the sale of essential edibles. The central bank responded to high inflation by tightening monetary policy: it simultaneously raised the discount rate, the cash requirement on demand deposits and the statutory liquidity requirement of demand and time deposits. However, the problem of inflation can not be tackled without addressing the large budget deficit. Inflation in 2008 is expected to remain around last year level.
  • Pakistan’s government has maintained an expansionary fiscal stance, seeking to promote more investment for growth and more pro-poor spending. In recent years development expenditure has become a higher proportion of overall expenditure. The central government’s budget deficit in 2007 remained at 4.2% of GDP, unchanged from 2006. Budget deficit in 2008 is again expected to remain large and becoming a major concern of the economy.
  • Growth in Pakistan’s exports and imports slowed sharply in 2007: the rate for exports fell to 3.4%, for imports to 6.9%. A huge trade deficit was partly covered by remittances from migrant workers abroad, which rose in 2007 to a record amount of $5.5 billion. The country’s current account deficit further widened to about 5% of GDP. Net inflows of foreign investment almost doubled from 2006 to 2007, reaching $8.4 billion. Pakistan’s rising foreign exchange reserves were over $16 billion in November 2007. However, there has been a significant decrease in those reserves in recent months.
  • The main challenge for countries in South Asia is to sustain their growth momentum in the face of high oil prices. Should oil prices remain very high, this could undermine economic growth while putting pressure on budgets, inflation rates and the balance of payments in countries throughout the sub-region. Measures need to taken to hedge the risk of continued high oil prices and, more importantly, to contain oil imports through selective energy conservation measures.
  • The current account deficit is already a serious problem in some South Asian countries. The abolition of the Multi-Fiber Arrangement (MFA) regime at the end of 2004 had a mixed effect on countries in the sub-region. The MFA abolition might have further adverse medium-term effects as quota restrictions on Chinese exports are lifted in 2008, creating stiff competition from Chinese exports. To reduce the risk of depending too heavily on a single sector, export diversification should remain an important part of government strategies.

Fiscal deficit and public debt sustainability in South Asia

  • Despite improvements in recent years, public debt remains a serious problem for most countries in South Asia, including Pakistan. While domestic public debt is becoming a larger component of total public debt, it has received relatively less attention despite its serious economic and social implications. Excessive reliance on debt, whether domestic or external, carries macroeconomic risks that can hinder economic and social development. High domestic public debt pushes up interest rates and crowds out private investment, which is much needed to promote economic growth.
  • When most government revenues are devoted to debt servicing, fiscal policy cannot be used to provide basic services, such as education, health, safe drinking water and housing. When public debt level reaches a very high level, a larger fiscal deficit becomes unavoidable. As a result, inflation starts climbing, pushing domestic interest rates and the cost of debt servicing further up. Therefore, countries should pursue vigorous macroeconomic policies to contain public debt, including domestic public debt before they become totally unmanageable.
  • In Pakistan, public debt growth during the 1990s was unprecedented. A credible debt reduction strategy and fast economic growth cut the public debt burden from 84% of GDP in 2000 to 57% in 2006. Pakistan reduced its external debt burden through rescheduling, a debt swap for social spending, debt cancellation and prepayment of expensive debt. The real burden of public debt is in its servicing. The debt service ratio has substantially declined in Pakistan over 2000-2006, though about 30% of government revenues remain allocated to debt servicing.
  • An International Monetary Fund (IMF) debt sustainability analysis shows that if Pakistan follows its historical growth path, its debt-to-GDP ratio will continue to decline over the next five years. But an upsurge in the primary deficit would slow the reduction. Because of a growing budget deficit, the improvement in the ratio of domestic public debt to GDP since 2001 appears to have bottomed out. The country is likely to face a higher external debt-servicing burden as repayments of the rescheduled non-ODA Paris Club stock resume in 2008 and some foreign currency bonds mature. A sustained high current account deficit could also hurt the external debt-to-GDP ratio, which may start rising in the medium term.
  • By reducing public debt, more resources can be made available for development expenditures. Pakistan increased its development expenditure from about 2% of GDP in 2001 to about 5% of GDP in recent years, mainly after the Government reduced its debt burden, partly due to external debt relief. An ESCAP secretariat analysis shows that a further 20% decrease in the public debt service to government revenue ratio could increase development spending by 24%.
  • There are some lessons that policymakers would find useful in their efforts to contain public debt. The sustainability of debt is crucially dependent on the size of the economy. Moreover, past experience suggests that it is difficult to bring public debt ratios down without robust economic growth. Therefore, policies promoting GDP growth should be vigorously pursued.
  • As budget deficits are a major cause of public debt, every effort should be made to maintain a primary surplus in the budget. A high budget deficit in Pakistan in recent years is a cause for concern. Therefore, the pace of government revenue growth through the strengthening of tax administration and broadening of the tax base must continue to rise so that the country’s debt-carrying capacity can increase. Debt sustainability becomes an issue of growing concern when the growth of government interest payments exceeds that of government revenues.
  • Strengthening tax administration is crucial. Tax rates are not low in South Asia, but inefficient tax systems and corruption keep revenues low. A simpler tax system, with fewer exemptions, less discretion and better compliance, should be a focus. Improving documentation of the economy will also help. Greater use of information technology could strengthen tax administration.
  • Widespread poverty and lack of basic services mean that demand for public spending is high. The challenge for governments is to contain wasteful public spending and orient it towards priority sectors. Public expenditure should promote pro-poor growth; basic services, such as education, health, sanitation and housing, should be a priority.

Addressing the neglect of agriculture – two-pronged approach needed

  • The rural poor account for around 70% of the poor in the Asia-Pacific region, and agriculture is their main livelihood. Another worrisome trend is the widening gap between the rich and the poor because the benefits of growth are not shared equally by different sectors, regions or income groups. Agriculture appears neglected, even though it still provides jobs for 60% of the working population and generates about a quarter of the region’s GDP. Growth and productivity in agriculture are slowing, and the green revolution has bypassed millions. In South Asia, growth in agriculture output dropped from 3.6% in the 1980s to 3.0% in 2000-2003.
  • Agricultural labour productivity has a significant impact on poverty reduction. ESCAP estimates show that a 1% increase in agricultural productivity would lead to a 0.37% drop in poverty in the Asia-Pacific region. Given the large agriculture productivity gaps among countries in the region, the potential gains appear substantial. Raising the region’s average agricultural productivity to that in Thailand can take 218 million people out of poverty, roughly a third of total poor in the region. Large gains in poverty are also possible through comprehensive liberalization of global agriculture trade, which could lift another 48 million people out of poverty in the region.
  • Therefore, a policy priority should be to revitalize agriculture. Revitalizing agriculture requires connecting the poor to markets by improving rural infrastructure, improving availability and management of water, improving agricultural technology, increasing the capacity to adapt technologies, and speeding diversification and commercialization. It also requires improving the distribution of land and the access to agricultural credit and extension - and making macroeconomic policy friendlier to agriculture, all enabling the poor to make a dent on poverty by themselves.
  • While agriculture growth will help in reducing poverty particularly in rural areas, yet some poor will shift from agriculture to industry and services, which offer them a better chance of escaping poverty. Policies should be put in place to make this transformation easy. Public policy could thus adopt a two-pronged approach, taking both aspects into account; revitalizing agriculture while facilitating the migration of excess labour from agriculture to industry and services. Farmers can leave agriculture for non-farm activities in rural areas or for work in urban areas. This requires creating opportunities in the non-farm sector as well as urban planning. Both require better opportunities for skills development and strategies for raising overall economic growth.