By Dr. Nayyer Ali

06 June , 2008

Severe Challenges Face Pakistan’s Economy

Three months since the landmark elections ushering back in a democratic Pakistan, the economy is coming under heavier and heavier stress. There are major problems that must be tackled in the next 12 months to put things back on a sound footing, but so far the politicians have been mostly bickering and accomplishing nothing.
The single biggest challenge is of course surging inflation.  While inflation accelerated to over 5% in the 2006, it was still under 8% when Aziz handed over control of the government to a caretaker regime in November.  Since then, and especially since February, the inflation rate has surged to 17% year over year.  Linked to this is the electricity shortfall, the plunge in the foreign exchange reserves, the loss of value in the rupee to an all-time low, the obvious reduction in economic growth rate, and the loss of international confidence as the rating agencies have downgraded the country due to ongoing political turmoil.  None of these challenges are insurmountable, but will require clearheaded economic policies and some political will to implement them.  Neither appears to be available at present in Islamabad.
This fiscal year, which is ending on June 30, will show economic growth of only 5.5%.  This would have been a great figure by the standards of the 1990’s, but after five years of 7%, it represents a significant decline. The decline in growth means less tax revenues than planned and a larger budget deficit.
Meanwhile, the State Bank of Pakistan has raised the discount rate to 12% from 10.5% in an attempt to slow inflation.  While a welcome move (although the bankers and businessmen have been screaming bloody murder over it), even 12% interest is still not tight enough, and the State Bank has been acting in a slothful manner during this inflationary surge. Unfortunately, to really squelch inflation it will take a significant tightening above current levels and a slowing of the economy.  Is this government willing to pay that short-term price?
The second major challenge is electricity. Electricity issue is mainly one of a short-term demand/supply imbalance.  There needs to be several gigawatts of new capacity brought online, but fortunately much of that is already in the pipeline. Between the new capacity and the slowing economy that will dampen demand growth, the electricity shortfall should evaporate in the next 12-18 months.
The third challenge is the trade and current account deficit.  The rapidly rising deficits are causing a drop in foreign exchange reserves.  Even at their height last year of 16 billion dollars, they were still quite small compared to other major Asian nations, and now have dropped to below 12 billion. Many think they will drop below 10 billion by year-end.  Attempts to build reserves by selling bonds on the open market have had to be abandoned to declines in Pakistan’s credit rating since the democratic government took over. Last year, Aziz was able to sell 750 million dollars of sovereign bonds at a spread of only 150 basis points over the comparable US government debt, but now the spread is over 500 points, and there is little or no demand out there for fresh debt from Pakistan. This is creating strong pressure on the rupee, which has plunged to an all time low against the dollar.  That is doubly remarkable as the dollar itself is plunging to new lows against the other major global currencies, which means the rupee is in fact very weak. Much of this is being driven by the cost of oil imports, but this is a problem that all oil importers face, not just Pakistan.
The new government has made some noises about setting a growth target of 7% for the next year in the budget.  This is irresponsible nonsense, and it will mean the country will face significant budget problems as projections based on such growth rates turn out to be wrong.  Meanwhile, because of politics, Pakistan has no Finance Minister, even as budget preparations should be in full swing.  It is not inconceivable that further mismanagement and deterioration in the current account and exchange  rates may lead to a sharp depletion of the forex reserves.  The end result will be a balance of payments crisis, and the PPP-led government will be back to familiar ground as it turns over Pakistan to the IMF.  Already the PPP has shelved several of the privatization transactions that were in the pipeline, presumably because Pakistanis are so good at building socialist nirvanas.
It is a sad comment on how little we expect from the politicians that there has been no real concern or serious discussion about Pakistan’s economic policies and the ridiculous spectacle of having no one in charge of the Finance Ministry.  For a while they may be able to dupe the gullible with cries of how these issues are the fault of their predecessors, but that will eventually wear thin.  What will happen then? Are the politicians already on the road to discrediting democracy in Pakistan a third time?  And does anyone care?  
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