August 01, 2008
Economic Crisis in Pakistan
There is a genuine economic crisis going on in Pakistan, some of it homegrown and some due to global issues. Currently, the stock market has crashed over 40% from 16,000 to 10,000, with investors now rioting around the KSE.
In tandem, forex reserves have crumbled from 16 billion to around 10 billion dollars, the rupee has dropped from 60 to 70 to the dollar, and inflation, which was running 9% last fall, has now accelerated to over 20% year over year, with the bulk of this due to food and fuel prices that have surged, hitting the poorer segments especially hard. The Economist now forecasts growth to be only 3% this year and 4% next.
This level is equivalent to a recession in advanced economies, as Pakistan needs a growth rate of at least 6% to absorb the annual increase in the labor force, otherwise unemployment goes up. After the boom of the last 5 years, there is the dual pain of both stagnant economic activity and galloping inflation, a combination known in the US in the 1970’s as “stagflation”. What should or could be done at this point?
There are two sets of issues, the first short-term, and the second structural and long-term. The inflation problem began in the extreme boom year of 2004-2005 when growth surged to 9% and the economy overheated taking the inflation rate to 7%. The government then believed wrongly that they could bring this down without having to tighten monetary policy excessively, which in hindsight was an error, and allowed inflation to become embedded into the economy.
Over the next two years, the inflation rate stayed about 7%, which was much higher than ideal, but not too onerous in the context of an overall economic boom. Meanwhile, inflation began to creep into the US, the EU, and the major emerging markets. Everywhere the culprit was the same - excessively loose monetary policy in an attempt to keep growth at a high level or cushion the blow of popping asset bubbles. This created worldwide excess demand, particularly for food and fuel, and in the last 12 months has seen inflation take off throughout the world. To unwind this it will take global corrective action. There will need to be a general tightening of the monetary policy as all central banks will need to raise rates. In China, it will also mean that the Chinese will have to allow the yuan to revalue against the dollar, and pass through oil costs. The effect will be to shutter a significant part of the low-cost export industries of China, and they will need a new home. Pakistan should position itself to grab as much of that as possible.
Third World countries will also need to dismantle fuel subsidies that are artificially keeping a floor under demand. In India, for example, the government is shelling out 50 billion dollars to subsidize crude oil imports. Aziz did not unwind Pakistan’s fuel subsidies last fall when crude was at 70 dollars per barrel; at 140 dollars the subsidies are even worse for the government’s finances and more inflationary, and the current government will have to bring prices in line with the market.
Milton Friedman explained 30 years ago that inflation is always a monetary phenomenon, meaning that at its root it is due to excessive money creation by central banks. For Pakistan to end this wave of inflation, it needs to make interest rates higher than the inflation rate. This implies that the State Bank has a long way to go before it has a chance of really solving the problem. But make no mistake, this degree of tightening will cause real pain, and put the economy into a recession for 18 months. When Paul Volcker finally tackled inflation in the US in 1981, he put short-term interest rates up to 21%, and threw the country into its worst recession since the Great Depression in the 30’s.
The electricity issue, which is of uppermost importance to average people because of its direct and immediate impact on their lives, is really a short-term problem. There developed a mismatch between capacity and demand over the last 7 years that manifested itself beginning January of this year, and will probably abate over the next 12 months as 2-3 gigawatts of new capacity come online. Meanwhile, the slowing of the economy will dampen demand growth that will also allow supply a chance to catch up. It’s a moving target, but the government should always maintain some supply cushion, which it did not over the last few years.
The long-term structural issues are in better shape. Overall the economy is in good shape and structurally sound. The banks are healthy. The nation’s debt burden is the lowest it has been in 20 years, and will drop this year, despite the high budget deficit of 5% of GDP (although the deficit is large, the total economy will grow 25% in nominal terms due to the high inflation, so the rupee debt will actually shrink as a proportion of the size of the economy - this is “inflating away the debt”). The main structural issues are the current account deficit and privatization. Pakistan runs a current account deficit of 7% of GDP, which is very high and is basically being financed by the high rate of remittances and the inflow of FDI, which hit 6 billion dollars in 2006-2007. But FDI is dropping due to politics and terrorism issues, and this has caused the forex reserves to be used up, and put pressure on the rupee. What is needed is a reduction of the trade deficit by increasing exports, while also reducing import costs. Saudi Arabia has just decided to help out by allowing Pakistan to defer payments on 7 billion dollars of oil imports over the next 6 months. It is possible that the Saudis may eventually waive that oil cost, which they have done in the past. But the Saudi largesse will come with a price tag that has yet to be revealed. Pakistan at present cannot borrow in dollars internationally as its credit has been damaged.
The other long-term challenge is human development. It is disgraceful that infant mortality and educational standards are so dismal in Pakistan. Current spending on education amounts to 2.8% of GDP, compared with 6% in the US. Pakistan needs to spend another 1% of GDP each on primary and secondary education. It also needs to build one or two world-class research universities to give the 1500 PhD’s studying abroad under the HEC a real place to continue their work when they complete their programs.
Economics is not that complicated. It basically boils down to the idea that there is no such thing as a free lunch, all actions have costs and consequences, and the unintended consequences of policies can often undo the intended result. A good example is laws meant to protect jobs by making it difficult to fire people. In reality this results in an extreme reluctance to hire workers, and boosts overall unemployment, while benefiting the lucky portion that has protected jobs. The ongoing quest for “pro-poor” policies often veers into these sorts of populist acts that actually worsen the fate of the poor. No nation in Europe or the US ended material want by instituting “pro-poor” policies, they did it by economic growth. The proper role of the government is to provide public health and public education, infrastructure, a minimum welfare benefit in line with its resources, and justice. Which is why the other major structural reform that remains unfinished is privatization. Communism failed for a reason, and the watered down version practiced in Pakistan is no better.
If Pakistan can overcome its short-term challenges, bring inflation under control, reduce the current account deficit, bring electricity supply and demand back into balance, it will hopefully be able to resume high rates of growth and invest appropriately in human development. To do all this will require 18-24 months of hard economic policies, with real pain for many Pakistanis. Does the current government have the stomach, or the expertise, to do this?
