an analysis of pakistan's macroeconomic situation and prospects

7/27/2019 An Analysis of Pakistan's Macroeconomic Situation and Prospects

1/64

ADB EconomicsWorking Paper Series

An Analysis of Pakistans MacroeconomicSituation and Prospects

Jesus Felipe and Joseph Lim

No. 136 | December 2008


2/64


3/64

ADB Economics Working Paper Series No. 136

An Analysis o Pakistans MacroeconomicSituation and Prospects

Jesus Felipe and Joseph Lim

December 2008

J esus Felipe is Principal Economist in the Central and West Asia Department, Asian Development Bank;J oseph Lim is Professor at the Ateneo de Manila University. Mel Espina provided excellent researchassistance. The authors are grateful to participants in a workshop organized by the Central and West Asia

Department for their comments and suggestions.


4/64

Asian Development Bank6 ADB Avenue, Mandaluyong City1550 Metro Manila, Philippineswww.adb.org/economics

2008 by Asian Development BankDecember 2008ISSN 1655-5252Publication Stock No.: _______

The views expressed in this paperare those of the author(s) and do notnecessarily reect the views or policiesof the Asian Development Bank.

The ADB Economics Working Paper Series is a forum for stimulating discussion and

eliciting feedback on ongoing and recently completed research and policy studies

undertaken by the Asian Development Bank (ADB) staff, consultants, or resource

persons. The series deals with key economic and development problems, particularly

those facing the Asia and Pacic region; as well as conceptual, analytical, or

methodological issues relating to project/program economic analysis, and statistical

data and measurement. The series aims to enhance the knowledge on Asias

development and policy challenges; strengthen analytical rigor and quality of ADBs

country partnership strategies, and its subregional and country operations; and improve

the quality and availability of statistical data and development indicators for monitoring

development effectiveness.

The ADB Economics Working Paper Series is a quick-disseminating, informal

publication whose titles could subsequently be revised for publication as articles in

professional journals or chapters in books. The series is maintained by the Economics

and Research Department.


5/64


6/64


7/64

Abstract

During the latter part of 2007 and early 2008, it became obvious that Pakistans

macroeconomic situation was deteriorating rapidly, and that unless immediate

measures were taken, the country may slip into a balance of payments crisis.

This paper analyzes Pakistans current macroeconomic economic situation, in

particular the sizeable budget and current account decits t also discusses

the effects of the surge in food and oil prices. The paper also evaluates the

governments response to the deteriorating conditions and proposes a number of

policy measures.


8/64


9/64

I. Pakistans Macroeconomic Situation

This paper was written during the second half of 2008 and before Pakistans authorities

had to ask the nternational onetary und () for nancial assistance t provides

an analysis of the deteriorating macroeconomic situation in the country, and proposes a

number of policy measures.

Pakistans economy experienced relatively fast growth during the 1970s, 1980s, and the

early 1990s (Figure 1). There have been three distinct phases. First, between the early1970s and the early 1980s, gross domestic product (GDP) growth showed an upward

trend, reaching almost 9% in 1980. The rest of the decade and until the early 1990s, the

trend attened and growth uctuated between 5% and 75% inally, between the early

and late 1990s, growth displayed a downward trend. During this period, the economy

suffered two major slowdowns, rst in 99 and then in 997

Figure 1: GDP Growth Rate

1954 58 62 66 70 74 78 82 86 90 94 98 2002 06

15

13

11

9

7

5

3

1

1

3

5

Source: International Financial Statistics online (IMF 2008).

After the 1997 setback, growth started to recover, but again in 2001 it decreased

signicantly Since 2002, it recovered, and especially between 2004 and 2007 the

economy registered high growth. The growth episode since 2002 is marked by the

following salient features:


10/64

(i) Contributionofexportstooverallgrowthhasdeclined,whilethatof

investmentandconsumptionhasincreased

During 20012003 (a period of moderate growth) the contribution of export growth to

GDP growth was signicant This changed during 20042007 (period of high growth),as consumption (private and government) and gross xed capital formation (the latter

especially in 2007) became the main drivers of growth (Figure 2). These changes are

the result of increased workers remittances (which amounted to $5.3 billion dollars

in 2006/07 and to $6.5 billion dollars in 2007/08) and foreign investment, as well as

government pump-priming, fueled by cheap credit. This change in growth strategy

has proven fragile as it has run into resource constraints (i.e., the productive capacity

of the economy has not increased and power and water shortages are becoming an

acute concern) This has led to serious macroeconomic imbalances and to inationary

pressures.

Figure 2: Real GDP by Expenditure Category and Contributionto Growth (percentage points)

2000 01 02 03 04 05 06 07

14

12

10

8

6

4

2

0

2

4

6

Private consumption

Gross xed capital formation

Imports of G&S

Government consumption

Exports of G&S

GDP

G&S = good and services.Source: Authors computations based on data rom Key Indicators 2007(ADB 2007).

(ii) Servicesarethemajorcontributortooutputgrowth

From the point of view of the sectors contribution to overall growth, services (mainlytrade, transportation, communications, nance, government and private services)

contribute over 50% (Figure 3). This outcome runs against what was envisaged in the

Medium Term Development Framework 20052010, which assumed that growth would

emanate from agriculture and industry (i.e., the commodity producing sectors). An

important drawback of this growth model is the lack of employment creation.1

The all in the unemployment rate between 2005/06 and 2006/07 rom 6.2% to 5.3% (the unemployment rate o

2006/07 is only provisional and may change) hides two problems. First, underemployment is very high. The State

| ADB Economics Working Paper Series No. 136


11/64

Figure 3: Real GDP by Sector and Contribution to Growth

(percentage points)

2000 01 02 03 04 05 06 07

9

8

7

6

5

4

3

2

1

0

1

Agriculture Industry Services Real GDP

Source: Authors computations based on data from Key Indicators 2007(ADB 2007).

(iii) Macroeconomicimbalances:defcitsintheprivate,fscal,andexternal

accounts

The subperiod 20042007 has been marked by deteriorating decits in the private, public,

and external current account sectors. Figure 4 shows these macroeconomic imbalances.Figure 4a shows that during the last few years, private savings have been unable to

keep up with growing private investment. Figure 4b shows that the tax revenue effort

has stagnated while government spending has increased (partly spurring the current

high growth episode) This has led to the scal decit These two decits imply a large

external current account decit, which igure 4c shows Exports plus net factor income

from abroad (the latter made up mostly of remittances from overseas workers less

interest payments on foreign debt) have fallen (as a percentage of gross national product

[GNP]) in recent years, while imports have increased substantially as a result of the

countrys high growth. Note that the positions of all three sectors have deteriorated with

respect to those in earlier years, when they registered either surpluses or lower decits

Bank o Pakistan (2006) reported that in scal year 2003/04, the percentage o the employed and the percentageo the labor orce working less than 35 hours were 4% and 2.9%, respectively. This gure or underemployment

is quite conservative since it does not include those working more than 35 hours but who want additionalemployment. Lubna et al. (2008) report that 88.03% o the unpaid amily workers are in agriculture, 6.97% in

retail trade, 3.73% in manuacturing, 0.65% in personal services, 0.58% in construction, and 0.54% in nance

and business services. The second problem is the increasingly larger percentage o employed people under thecategory unpaid amily workers. This percentage increased rom 20.8% o total employed in 200/02, to 26.9% in

2005/06.

An Analysis of Pakistans Macroeconomic Situation and Prospects | 3


12/64

This deterioration in the position of the three sectors is symptomatic of Pakistans growth

pattern (during the high-growth periods in the 1980s and early 1990s, there were also

signicant private, public, and external current account decits)

Figure 4: Macroeconomic Imbalances(percent of GNP)

Figure 4a: Private saving and investment Figure 4b: Tax eort and government expenditure

Figure 4c: (Exports + net factor income from abroad) and Imports

25

20

15

10

5

0

Private investments

Percent

25

20

15

10

5

0

Percent

25

20

15

10

5

0

Percent

Private savings

1989 91 93 95 97 99 2001 03 05 07 1989 91 93 95 97 99 2001 03 05 07

1989 91 93 95 97 99 2001 03 05 07

Government consumption + Government Investment

Tax eort

Imports

Exports + Net factor income from abroad

Source: Key Indicators 2007 (ADB 2007).



13/64

Figure 5 shows gross national savings and gross capital formation (investment). The

gure shows the signicant savings decit in 2006 and 2007, similar to the ones

experienced in the 960s, 970s, and 990s The decits are due to signicantly

increased investment rates together with reduced savings rates.

Figure 5: Gross National Savings and Gross Capital

Formation (percent of GNP)

1960 64 68 72 76 80 84 88 92 96 2000 04 08

25

20

15

10

5

0

Gross national savings

Gross capital formation

Source: International Financial Statistics (IMF various years).

(iv) Deterioratingtradeandcurrentaccounts

Figure 6 shows the recent deterioration in the external accounts, consistent with the

lower contribution of export growth to overall growth discussed above. The situation is

similar to that in earlier high-growth periods when high growth rates were accompanied

by signicant trade and current account decits n scal years 2005/06 and 2006/07, the

trade decit surpassed 7% of GDP, as imports increased faster than exports (partly due

to high oil prices, and partly due to high overall growth) n scal year 2007/08 it reached

$20.70 billion dollars.2 The current account decit reached more than 5% in 2005/06 and

2006/07, and in scal year 2007/08 it reached 84% of GDP (over $4 billion dollars)

Fortunately, current transfers and remittances made by overseas Pakistani workers are

helping the current account decit not to deteriorate further (in fact, the current accountwas in surplus during 20022004).

2 Imports amounted to $39.70 billion (out o which $.3 billion were oil and $4.2 billion ood) and exports to $9

billion.

An Analysis of Pakistans Macroeconomic Situation and Prospects |


14/64

Figure 6: Exports, Imports, Trade Balances and Current

Account Balance, 19762007 (percent of GDP)

1976

1977

1978

1979

1980

198

1

198

2

198

3

1984

1985

25

20

15

10

5

0

Percent

Good exports: F.O.B.

Trade balance

Good imports: F.O.B.

Current account, N.I.E.

198

6

1987

198

8

1989

1990

199

1

1992

1993

1994

1995

199

6

1997

1998

1999

2000

200

1

2002

2003

2004

2005

2006

2007

Source: International Financial Statistics Online (IMF 2008).

The current account decit has led to an excessive and risky dependence on external

nancing This poses a serious problem due to the high volatility of the external capital

account The share of total investment nanced by external resources was 42% in

2000/0 (hence about 96% was nanced by domestic sources) This increased to

8.4% in 2004/05; to 20% in 2005/06; to 22% in 2006/07; and to 38% in 2007/08 (i.e.,62% was nanced by domestic resources) n 2000/0, foreign direct investment (D)

represented 2.3% of total investment and 55.7% of external resources. In 2007/08, FDI

represented 10.6% of total investment and 27.5% of external resources. This implies that

the proportion of D in external resources has declined signicantly Now Pakistan relies

more on other capital inows, ie, borrowing, and this entails a higher risk Net capital

ows were negative between 998 (the Asian nancial crisis) and 2004 as debt payments

outpaced new loans However, net capital ows turned positive during 20052007 as D

increased substantially and net portfolio investments, as well as net other investments

(mainly loans net of payments) turned positive (Figure 7).

6 | ADB Economics Working Paper Series No. 136


15/64

Figure 7: External Financial (Capital) Account, 19762007

(percent of GDP)

8

6

4

2

0

2

4

6

Percent

FDI

Net other investments

Net portfolio investments

Financial account, N.I.E.

1976

1977

1978

1979

1980

198

1

198

2

198

3

1984

1985

1986

1987

198

8

1989

1990

1991

1992

1993

1994

1995

199

6

1997

1998

1999

2000

200

1

2002

200

3

2004

2005

2006

2007

Source: International Financial Statistics Online (IMF June 2008).

The net positive capital inows in recent years have allowed Pakistan not to have a

balance of payments crisis. In fact, Pakistans international foreign exchange reserves

grew until 2007 (Figure 8).

Figure 8: Foreign Exchange Reserves, 19992007End Period (US$ million)

1999 2000 01 02 03 04 05 06 07

18000

16000

14000

12000

10000

8000

6000

4000

2000

0

Net reserves with SBP Net reser ves with banks

Real GDP

Source: State Bank o Pakistan.



16/64

s Pakistans current account decit (nanced by inows of capital and loans) a problem?

Decits reect underlying economic trends, which may be desirable (and therefore not

necessarily bad) or undesirable for a country at a particular point in time. A current

account decit reects the fact that a country is building up liabilities to the rest of the

world that are nanced by ows in the nancial account Eventually, these need to bepaid back. If a country spends its borrowed foreign funds on spending that yields no long-

term productive gains, then its ability to repay might come into question, as the country

must be able to eventually generate sufcient current account surpluses to repay what

it has borrowed Therefore, the key is whether the borrowing nances investment that

has a higher marginal product than the interest rate (or rate or return) that the country

has to pay on its foreign liabilities oreover, a large decit means that an economy

and its currency may struggle if foreign capital inows suddenly dry up n the case of

Pakistan, the current account decit reects low export growth (see next section) and,

ultimately, export competitiveness problems Pakistans persistent current account decit

does not reect a highly productive economy ndeed, there are doubts about the quality

of the project portfolio under the Public Sector Development Program (i.e., projectsof questionable economic value, as well as noncivilian spending registered under this

Program, such as the construction of so-called strategic highways. For example, a major

portion of the strategic Makran Coastal Highway was built at least twice). Finally, the

current account decit also reects poor scal policy (see analysis of the scal situation)

(v) Poorexport per formance

The fundamental reason that explains Pakistans growing trade and current account

decits, especially during high-growth years, is its poor export performance Tables and

2 compare Pakistans export performance with that of selected countries in East, Central,

and South Asia. Table 1 shows the annual growth rate of merchandise exports fordifferent periods. Pakistans performance is clearly sub-standard, with only Afghanistan,

Kyrgyz Republic, Mongolia, Sri Lanka, Turkmenistan, and Uzbekistan having lower export

growth rates. In 2006 and 2007 Pakistans export growth collapsed to below 5%. Analysis

at a highly disaggregated level indicates that key exports shrank. For example, in 2007,

Pakistans largest single export product (representing over 20% of total exports), Linens

and other furnishings art (of textile), suffered a decline of 7.45%.3

3 Something similar happened to other major categories such as Undergarments knitted, not elastic, nor rubbered

(share o 8.58%, negative growth rate o 6.63%); Other cotton abrics, woven, bleached, dyed, etc. (share o0.77, negative growth rate o 6.25%); Womens, girls, and inants outer garments, not knitted(share o 3.37%,

negative growth rate o 6.32%). In total, major export products (with at least % export share) representing 53%

o Pakistans total exports, registered negative growth in 2007. at the same time, other major export categoriesregistered very small positive growth, e.g., Outer garments knitted, not elastic, nor rubberd with a share o 8.9%

registered a growth rate o only 4.92%.



17/64

Table 2 shows the export to GDP ratio. In 2006, only Afghanistan, Georgia and Nepal had

lower export-to-GDP ratios than Pakistan. It is also worth noting that even if Pakistan has

a similar export-to-GDP ratio as a country like India, the latter is a much larger economy,

and its export-to-GDP ratio has improved considerably over the years, while Pakistans

has remained stagnant.

What explains Pakistans poor export performance? ne possible reason is overvaluation

of the exchange rate. Figure 9 shows the real effective exchange rate of selected

countries since 2000.4 The gure shows that Pakistans rupee is the weakest among the

countries in the gure Therefore, currency overvaluation has to be ruled out as the main

reason underlying Pakistans weak export performance.5

A more plausible reason that explains Pakistans weak export performance is the lack of

export sophistication. Throughout the years, Pakistan has not been able to upgrade its

export structure, heavily concentrated on the low end of textiles and garments.6 Figure

10 shows the elasticity of Pakistans exports with respect to the GDP of the industrialcountries (i.e., by what percentage Pakistans exports change when the GDP of the

industrial countries increases why one percentage point) since the fourth quarter of 1985.

This variable is a proxy for the nonprice competitiveness of Pakistans exports (i.e., the

quality attribute) The gure shows that this elasticity is low, taking an average value of

for the whole period of 0.87. Upgrading the export package will take time but measures in

the form of a coherent plan must be taken as soon as possible.

4 The choice o the base year is critical, but Pakistans comparatively weak currency is robust. I we use 997 (the start

o the Asian crisis) as base year, Pakistans rupee was the second weakest ater the Malaysian ringgit in February2008. I one uses 980 as base year, Pakistans rupee is the second weakest ater the PRCs renminbi (also in

February 2008).5 Regression analysis indicates that exports are relatively sensitive to currency depreciations.6 In another paper we show that Pakistans export sophistication is lower than that o the successul Asian

economies, and the level o sophistication has actually deteriorated over the years (Felipe 2007).



18/64


19/64

Figure 9: Real Eective Exchange Rate of Selected

Asian Economies

140

130

120

110

100

90

80

70

Armenia

Pakistan

PRC

Philippines

Malaysia

Ja

n

Fe

b

M

ar

Apr

May

Ju

n

J

ul

Au

g

Se

p

O

ct

Nov

Dec

Ja

n

Fe

b

M

ar

Apr

May

Ju

n

J

ul

Au

g

Se

p

O

ct

Nov

Dec

Ja

n

Fe

b

M

ar

Apr

May

Ju

n

J

ul

Au

g

Se

p

O

ct

Nov

Dec

Ja

n

Fe

b

M

ar

Apr

May

Ju

n

J

ul

Au

g

Se

p

O

ct

Nov

Dec

Ja

n

Fe

b

M

ar

Apr

May

Ju

n

J

ul

Au

g

Se

p

O

ct

Nov

Dec

Ja

n

Fe

b

M

ar

Apr

May

Ju

n

J

ul

Au

g

Se

p

O

ct

Nov

Dec

Ja

n

Fe

b

M

ar

Apr

May

Ju

n

J

ul

Au

g

Se

p

O

ct

Nov

Dec

Ja

n

Fe

b

M

ar

Apr

May

Ju

n

J

ul

Au

g

Se

p

O

ct

Nov

Dec

Ja

n

Fe

b

2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: International Financial Statistics (IMF various years).

6

5

4

3

2

1

0

Figure 10: Elasticity of Exports with Respect to GDP

of Industrial Countries

Source: Stas estimations; recursive estimation or the period 982Q42007Q4.



20/64

(vi) Continuingfscaldefcits

The latest growth period 20042007 is also marked by increasing decits in the scal

position, as Figure 11 shows. Since 2006, the low tax effort and revenue-generating

capacity has eroded the countrys macroeconomic stability. While total expendituresincreased (which certainly contributed to overall growth), the tax effort did not improve

signicantly so that the scal decit increased to 5% of GDP during 20052007 or the

rst half of the 2008 scal year (ie, JulyDecember 2007) the scal decit reached 6%

of GDP, only 0.4 percentage point below the target set for the whole year (4%). The

major reasons for the decit are expenditure overruns before the elections, energy-related

subsidies, and disruptions to revenue collection. A comparison with the previous J uly

December decit indicates that this one has increased by % or the total scal year

ending 0 June 2008, the scal decit amounted to 65% of GDP n the speech given by

the Finance Minister during the Budget Session of the National Assembly

( June 2008, tem no 9 (5)), he argued that the budget decit was mainly due to the

phenomenal buildup in subsidies in the budget totaling Rs.407 bn. including petroleum,Rs. 175 billion; electricity, Rs. 133 billion; wheat Rs.40 billion and textiles and fertilizers,

Rs. $48 billion. The Rs. $407 billion total subsidies far exceed the Rs. 114 billion (which)

was provided in the (original) budget. The structure of the budget is shown in detail in

Table 3.

The increase in expenditures between scal years 2006/07 and 2007/08 was mostly due

to the increase in current expenditures, where most subsidies (fuel, energy, and food)

are recorded. The other large component of expenditures, development spending, saw a

decline.

Figure 11: Consolidated Government Revenue,Expenditure and Decit, 19892007 (percent of GDP)

30

25

20

15

10

5

0

5

10

15

Percent

Total revenues

Total expenditures

Tax revenues

Overall budgetary surplus/decit

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Source: Key Indicators 2007(ADB 2007).



21/64


22/64

According to Table 3, while external and domestic sources contributed about the same

to the nancing of the decit in scal year 2007/08, the government estimates that about

90% of the decit will be nanced through external sources in scal year 2008/09 This

will be very difcult and will depend on donors disbursements

t is important to emphasize that a government can always potentially nance its budget

decit if it were nanced in domestic currency n Pakistan the shares of domestic

currency and foreign currency are about the same (see Table 4). Pakistans current

account decit is a more serious and pressing problem (because the country needs to

earn dollars to pay for its imports). But it is important to emphasize that the composition

of expenditures in the budget needs to be reassessed to make sure that spending

is conducive to the full employment of Pakistans resources This way, superuous

categories should be eliminated The budget decit will be inationary once the economy

reaches full employment.

As a consequence of the widening imbalances, government borrowing has increasedsharply, which most likely will lead to an increase in public debt in scal year 2007/2008

(Tables 4 and 5 show data until March 2008), with the consequent increase in interest

payments. Pakistans total external debt has increased in absolute terms, but it has been

declining as a percentage of GDP (Table 5) the total debt-to-GDP ratio declined from

75% in 2002/03 to 55.2% in 2006/07; and the external debt to GDP ratio from 36.6% to

254% We expect that this trend will be reversed when gures for the complete scal

year are released. External debt is mostly public (the private component is very small),

used to nance the governments scal decits A signicant portion of the decit was

nanced via monetization, a route the government has used since 2005 (a total of

almost $10 billion since 2005) in order to avoid the increase in interest payments. During

scal year ending 0 June 2008, about 70% of the increase in domestic public debt hascome from borrowing from the central bank This increase in the decit led in scal year

2007/08 to a breach of two provisions of the Fiscal Responsibility and Debt Limitation Act

2005: (i) the budget will record a revenue decit (revenue minus current expenditures);

and (ii) public debt will not decline by at least of 2.5 percentage points of GDP for the

second consecutive year. This jeopardizes the gains achieved between 1999 and 2007

when the public debt-to-GDP ratio declined from about 79% in scal year 999/2000 to

about 55% in scal year 2006/07 (see Box )



23/64


24/64


25/64

Box 1: Fiscal Responsibility and Debt Limitation Act 2005

The key targets in this Act are as follows:

(i) educe the revenue decit of the federal government to zero not later than June 2008and thereafter maintain a revenue surplus. According to the Fiscal Policy Statement of theDebt fce, the budget carried a revenue decit of 06% of GDP during the last 4 years(2002/03 to 2005/06), and at 0.9% of GDP in 2006/07. However, as mentioned earlier,the primary decits become surpluses if current expenditure is reduced by the amount ofunidentied expenditure shortfall

(ii) Ensure that by 30 June 2013, the total public debt does not exceed 60% of GDP andthereafter remains below this level According to the Debt fce this target has alreadybeen met in 2005/06. At the end of 2006/07, it stood at 55.2%.

(iii) Ensure that in every nancial year from 200/04 to 202/, the public debt is reduced byno less than 2.5% of GDP, provided that social and poverty alleviation-related expendituresare not reduced below 4.5% percent of GDP; and that the budgetary allocation foreducation and health is doubled in terms of percentage of GDP in the next 10 years. Theoverall poverty alleviation expenditures were 5.7% of GDP in 2006/07, but it is not clear ifthe target for education and health will be met.

(iv) Not issue new guarantees for any amount exceeding 2% of GDP. In 2006/07, thegovernment issued guarantees of 0.8% of GDP.

Summing up, Pakistans high-growth episode of 20042007 was the result of a growth

model that aimed at achieving a high growth rate through misguided policies Both inows

of capital and workers remittances, together with government pump-priming not matched

by an increase in the tax effort (which led to the scal decit) led to high growth ratesHowever, these were not accompanied by a concomitant increase in the productive

capacity of the economy. High growth prompted an increase in imports (which led to

the trade decit) and in consumption The current account decit resulted from imports

increasing faster than exports (where the latter suffer from a structural competitiveness

problem), which led to a dependence on inows of overseas remittances, D, portfolio

investment, and loans. Increased government spending, together with an increase in

business condence, crowded in the private sector, with investment running ahead

of savings. This growth model could perhaps have been sustained longer, as long as

capital inows exceeded the current account decit (leading also to a build-up of foreign

exchange reserves) But as the external decit has continued increasing, the situation has

become riskier This is indeed what we observe in 2008 as inows of capital have starteddecelerating. Moreover, as a model of long-run growth and sustainable development, it

poses a number of questions.



26/64


27/64

the moderate rates that have prevailed in recent times has any signicant harmful effects

on output, employment, growth, or the distribution of income. Box 2 summarizes this

evidence and the Appendix provides empirical evidence.

Box 2: Ination and Growth: What does the Empirical Evidence Say?

A number of authors have analyzed the relationship between ination and growth Bruno (995)found that ination and growth are positively related up to 5% ination, and then diminishingreturns to ination set in Both variables are negatively related once ination rises above 0%Barro (997) found that these two variables are unrelated when ination is below 200%Bruno and Easterly (998) found that there is no evidence that ination rates below 40% haveadverse effects on growth They argue that the negative inationgrowth correlation is onlypresent with high-frequency data, and that there is no cross-sectional correlation between thesetwo variables using (averages) long-run data.

Dornbusch (2000) cites a study by the World Bank according to which truly damaging inationdoes not start until about 40% Dornbusch argued that: Countries with 5 percent ination

per month must stabilize with urgent priority: nothing is likely to be more important. On theother hand, countries with 5 percent ination per year certainly should not belittle inationThey denitely should attempt, on average, to bring ination down But they must see this asone of a number of priorities, and they should view it as a process of ve or even more years(Dornbusch 2000, 52). He refers to the example of Chile: Chiles policymakers recognizethat strong growth, modernization, and integration in the world economy are not held backby 6, 0, or even 5 percent ination, but could be seriously hampered if overambitiousdisination created a macroeconomic problem (Dornbusch 2000, 5) These results have beencorroborated recently Pollin and Zhu (2006), who have found that higher ination is associatedwith moderate gains in GDP growth up to an ination threshold of about 58%1 Stiglitz et al.(2006, Table 2.1) have examined growth in several countries (Argentina, Brazil, Chile, Israel,Poland, and Turkey) that have experienced episodes of low, moderate, and hyper ination Theirdata show that (i) low ination is not associated in general with high growth; (ii) hyperination

in general is associated with low growth; and (ii) moderate rates of ination, 200% per year,have been associated with rapid growth quite often.

The conclusion is that while ination has potentially damaging effects (and for this reason oneshould analyze and monitor what is happening today), the empirical evidence indicates that thethreshold after which its damaging effects show up is way above the ination rates observedtoday. Overall, there is no support for the claim that a necessary condition for faster growth isthat ination should be as low as possible Likewise, there is neither theoretical nor statisticalsupport for the popular notion that ination has a built-in tendency to accelerate and that it isself-perpetuating And nally, there is no empirical evidence that ination, should it increaseslightly, cannot be reversed at a relatively minor cost (Blinder 1987, Eisner 1995, Stiglitz et al.2006).

What is truly damaging for an economy is unpredictable, unexpected, and volatile ination, butnot steady and predictable ination (Blinder 987, chapter 2) t is difcult, therefore, not to beconcerned with the likely sacrices being made by many developing countries across Asia interms of output loses (and, consequently, employment) as a result of trying to maintain very lowination rates t is also true that the impact of ination upon different groups of society differswith the type of ination, eg, food ination probably, though not always, has a larger impact onthe urban poor. See the Appendix.

Dornbusch (2000) also reers to another study by the IMF where the threshold is set at a much lower level, 8%. Khan andSenhadji (200) estimated the threshold ater which infation hurts growth at -3% or developed countries and atabout 7-% or developing countries.



28/64

n 2008 high food prices and rising fuel prices brought ination to double digits igure

shows the year-on-year ination rates for the latest 2 months until June n June

2007/08, ination reached 25% nation is caused primarily by increases in food

prices, which represent 40% of the CP basket n June 2008, food ination surpassed

0% What is worrisome is that core ination (ie, excluding food and fuel ination) ison the rise. There are fears that this may lead to a wage-price spiral. Table 6 shows

the percentage contribution to core ination of its different components Although the

largest contribution is provided by house rent, its share has declined, and in J une 2008

it contributed slightly less than 45% to total core ination n the other hand, during the

last few months, the contribution of transport fare/charges has risen signicantly This

reects the pass-through to consumers of higher petroleum prices The contribution of

doctors fees, drugs and medicines, and washing soap and detergents to core ination

has also increased. Whether these increases are leading to workers demands for higherwages, which then feed into higher price increases is difcult to know as Pakistansstatistical ofces do not provide data on wages Without precise data on wages and labor

productivity it is impossible to assess the question.

Figure 13: CPI Ination, Year-on-Year (percent)

Jun

07

Jul

07

Aug

07

Sep

07

Oct

07

Nov

07

Dec

07

Jan

08

Feb

08

Mar

08

Apr

08

May

08

Jun

08

Jul

08

Overall Food Nonfood Core ination

35

30

25

20

15

10

5

0




29/64

Table 6: Contribution to Core Ination (percentage points)July

2006

July

2007

January

2008

February

2008

March

2008

April

2008

May

2008

June

2008Cotton cloth 0.2 0.4 0.2 0.2 0.27 0.32 0.37 0.39

House rent 3.70 3.28 4.58 4.80 5.07 5.45 5.74 5.84

Transport are/charges 0.43 0.08 0.0 0. 0.8 0.85 0.92 0.97

Tuition ee 0.37 0.36 0.23 0.6 0.6 0.23 0.40 0.40

Washing soap and detergent 0.06 0.2 0.28 0.33 0.48 0.55 0.58 0.59

Jewlellery 0.27 0.04 0.24 0.27 0.35 0.29 0.3 0.33

Drugs and medicare 0.03 0.0 0.02 0.03 0.03 0.04 0. 0.2

Doctors ee 0.4 0.55 0.27 0.27 0.2 0.25 0.44 0.43

All others .38 .35 .88 .9 2.53 2.83 3.44 3.83

Core ination (percent) 6.5 6.0 7.8 8.1 9.3 10.8 12.3 13.0

igure 4 provides the month-to-month ination rate t shows that with the exception of

February 2008, all months have seen price increases (this is consistent with Figure 13,

which shows that year-to-year ination started to exceed 0% in January 2008, andaccelerated starting in arch 2008) igures and 4 indicate that nonfood ination is so far below food and core ination This may change when with the new scal year(starting J uly 2008) fuel subsidies should disappear. Box 3 provides additional informationon ination

Figure 14: Monthly Ination Rate, June 2007June 2008

Jun

07

Jul

07

Aug

07

Sep

07

Oct

07

Nov

07

Dec

07

Jan

08

Feb

08

Mar

08

Apr

08

May

08

Jun

08

Overall Food Nonfood Core ination

6

5

4

3

2

1

0

1

Percent




30/64

Box 3: Impact o Food and Fuel Price Increases in Pakistan

The recent increase in domestic prices in Pakistan has come from a few commodities, mainlywheat our, rice, vegetable ghee, and fresh milk n June 2008, their prices increased by

75%, 93.4%, 54.3%, and 22.7%, respectively, on a year-on-year basis. Box Table 3.1 showsthe contribution of each product category in the ination basket to the overall ination ratefor J une 2006/07 and for J une 2007/08. During J une 2007/08, food prices and transport andcommunication contributed 60% and 8.5%, respectively.

Box Table 3.1: Percentage Point Contribution to

Ination by Category (year-on-year)

Items June 07 June 08

Food 3.90 12.93

Wheat Flour 0.35 3.83

Rice 0.65 .25

Vegetable Ghee .02 .45

Milk Fresh 0.85 .5

Others .03 4.89Transport and Communication 0.22 1.82

Petrol 0.2 0.7

All Others 3.32 6.78

Overall Ination (percent) 7.00 21.53

Source: Sta estimates.

Regarding fuel, on 1 March 2008, the government started adjusting upward the administeredprice of key fuel items, thereby partially passing on the impact of higher prices to consumers.

The price that consumers pay equals the import price of oil minus price differential claim (PDC)paid by the government; plus the margins of the oil marketing companies and of dealers;plus inland freight and taxes (excise duty, petroleum development levy [PDL], and sales tax).

The price differential claim is the direct subsidy paid by the government on the import price

of kerosene oil and light diesel oil (LDO). This is paid directly by the government to the oilmarketing companies. In addition, government provides implicit subsidy in the form of reductionin PDL to stabilize the domestic price of kerosene and LDO. In the case of high octane blendingcomponent (HOBC) and gasoline, the PDC subsidy was introduced in J une 2008 but it waseliminated on both products as of 1 J uly 2008, and the only implicit subsidy on these twoproducts has been in the form of a reduction in the PDL.

The upper part of Box Table 3.2 shows the absolute levels of import and domestic prices ofkerosene, LDO, and HOBC. The middle part of the table shows the PDC in absolute termsand as percentage of the total import price. In absolute terms, subsidies on kerosene andLDO increased until J uly 2008, but then sharply fell in August 2008 as the government startedreducing PDC following the decline in international oil prices. As percentage of the total importprice, the subsidies on kerosene and LD have continued to decline and registered a signicant

fall in August 2008.

The bottom part of the table provides the ratio of domestic to total import prices, a proxy for thepass-through, that is, how much of the increase in prices is passed on to consumers. Thesegures indicate that the government continues to subsidize kerosene and LD or example,in J uly 2008, the domestic price of kerosene was 75% of the total import price, and similarly forLDO. This means that the subsidy represented 25% of the total import price. In the case of

continued.



31/64

Box3:continued.

the HOBC and gasoline, there are no subsidies (the ratio is greater than unity). For example,in J uly, the government charged 145% of the import price on HOBC. In August 2008, following

a decrease in international oil prices, the ratio increased for kerosene and LDO, signifying areduction in subsidy on these items.

Box Table 3.2: Oil Subsidies and Pass-through to Consumers

Kerosene (Rs./liter) LDO (Rs./liter) HOBC (Rs./liter) Gasoline (Rs./liter)

TotalImport

Price

DomesticPrice

TotalImport

Price

DomesticPrice

TotalImport

Price

DomesticPrice

TotalImport

Price

DomesticPrice

07-Jul 33.45 35.23 30.84 32.57 35.05 64.88 34.22 53.708-Jan 43.27 35.23 40.86 32.57 43.23 64.88 42.26 53.708-May 62.63 4.44 58.7 44.59 52.76 80.77 5.63 68.808-Jun 70.58 49.73 66.73 49.05 6.25 88.85 59.98 75.69

08-Jul 77.69 58.37 73.07 56.5 66.48 96.08 65. 86.6608-Aug 66.23 58.37 6.57 56.5 55.8 96.08 50.27 86.66

Price Diferential Claims

Rs./liter As Percent o TotalImport Price

Kerosene LDO* Kerosene LDO 07-Jul 5.33 5.58 5.9 908-Jan 7.9 6.3 4.4 70.6

08-May 32.4 23.86 5.3 05.408-Jun 33.57 29.04 47.6 90.708-Jul 33.93 29.4 48. 9.708-Aug 8.47 6.82 23.8 42.2* Light diesel oil.

Ratio o Domestic Price to Total Import Price (percent)

Kerosene LDO HOBC Gasoline07-Jul 05 06 85 57

08-Jan 8 80 50 2708-May 66 77 53 3308-Jun 70 74 45 2608-Jul 75 77 45 33

08-Aug 88 92 72 72

Source: Sta estimates.

B. Declining Foreign Exchange Reserves

As a consequence of political uncertainty and economic deterioration (increasing externaldecits and reduced capital inows), foreign exchange reserves, which had been rising

since 2001 (see Figure 8), started declining in November 2007 (Figure 15), and the

deterioration in the overall reserve position has accelerated in recent months. From a

total of $16 billion (in liquid foreign reserves) in October 2007, reserves fell to $10.83

billion on 12 J uly 2008 (a fall of more than 30%). The deterioration has been caused by



32/64

rising imports of fuel and food products, increased outows of portfolio investment, and

use of foreign exchange reserves to defend the rupee nows of overseas remittances

are still holding and helping counterbalance the trade decit D is lower but is still

signicantly positive t amounted to $88 billion during the rst months of 2007/08, as

against $4.52 billion in 2006/07. The decline is not excessive given that last years FDIwas extraordinary (Ministry of Finance 2008).

Figure 15: Foreign Exchange Reserves, End of month:

July 2007 to May 2008

18000

16000

14000

12000

10000

8000

6000

4000

2000

0

Net reserves with SBP Net reserves with banks

Total liquid reserves

Source: State Bank of Pakistan.

US$Million

Jul07

Aug07

Sep07

Oct07

Nov07

Dec07

Jan08

Feb08

Mar08

Apr08

May08

C. Downgrade o Debt Rating

As noted above, the consolidated government decit has also deteriorated signicantly

from an already high 5% of GDP in 2005-2007 to 6.5% of GDP in 2007/08. In recent

years, scal decits have been nanced signicantly through borrowings from the State

Bank of Pakistan (SBP) Both the SBP and the international nancial markets believe

that this monetization of the decit contributes to inationary pressures, although the

empirical evidence is scant. Nevertheless, this is inconsistent with the SBPs efforts to

ght ination

The political instability of the coalition government; increasing ination; as well as

the large trade, current account, and scal decits led Standard and Poors (S&P) to

downgrade Pakistans debt rating on 15 May 2008 from B+ to B, and its long-term local

currency rating from BB to BB-. The outlook is negative. In tandem with the lowering of

sovereign credit rating, S&P also lowered the Transfer and Convertibility Assessment



33/64

rating on Pakistan to BB- from BB (Business Recorder2008). Moodys followed suit on

2 ay 2008 Pakistans credit rating was cut for the rst time in 9 years by oodys

Investors Service, which cited growing economic imbalances and renewed political

difculties Pakistans foreign-currency sovereign rating was lowered from B to B2, even

below Turkmenistans. The ranking of locally issued debt was also reduced to B2 (TheNation 2008) S&P and oodys have termed Pakistan a highly speculative country for

bond investment.

This pessimistic view from the international nancial markets is reected in igure 6,

which shows Pakistans sovereign credit spread (between the yield of the sovereign bond

and the US Treasury bond of equivalent maturity) being not only much higher than of

other emerging markets but also on a rising trend since May 2007. On 19 August 2008,

the spread of Pakistani sovereign bonds had a risk premium of 912 basis points, more

than twice that of Viet Nam, whose ination rate is above 20%

Figure 16: JP Morgan EMBI Sovereign Stripped Spreads

(basis points)

1000

900

800

700

600

500

400

300

200

100

0

Source: Bloomberg.

1-Jan

07

18-Feb

07

7-Apr0

7

25-Ma

y07

12-Jul

07

29-Au

g07

16-Oc

t07

3-Dec07

20-Jan

08

8-Mar0

8

25-Ap

r08

12-Jun

08

30-Jul

08

Pakistan

912

365

355

268

156

Viet Nam

Indonesia

Philippines

Malaysia

Capital account liberalization has made it more difcult today for high ination (above

20%) and high economic growth to coexist (as it did in the past in Chile, for example).

Today, international nancial markets and credit rating agencies exert signicant inuence

on economic outcomes High ination quickly brings in credit downgrades, loss of

condence, capital outows, and reductions in capital inows

http://www.silobreaker.com/View360.aspx?Item=11_81046http://www.silobreaker.com/View360.aspx?Item=11_81046


34/64

D. Depreciation o the Rupee

In late May and early J une 2008 (during the period right after the credit downgrade and

the announcement that ination had reached 20%) the rupee fell fast from around 66

to the dollar to almost 70. The exchange rate only recovered when the SBP intervenedin the foreign exchange market and raised its discount rate by 150 basis points. In

early J uly the rupee touched 73 to the dollar, a 14% drop since the start of 2008. This

prompted the SBP to issue a statement indicating that it would support the currency to

ensure exchange rate stability While defending the rupee will control imported ination,

the SBP is using its reserves and thus contributing to their depletion. Finally, the SBP has

issued a temporary suspension of forward booking for all imports t is difcult to assess

the impact of this measure and how the private sector will react.

III. Government Response to the Deteriorating

Macroeconomic SituationThe governments response since May 2008 to the quickly deteriorating conditions can be

summarized as follows:

(i) The SBP reacted to the increasing ination and to the depreciation of the rupee by

raising the discount rate by 150 basis points to 12% on May 23. It also increased

the cash reserve requirement for all deposits up to 1 year maturity. In addition,

the statutory liquidity requirement was increased by 100 basis points to 19% of

total time and demand deposits. The SBP also enacted stricter rules on foreign

exchange convertibility to end speculative foreign exchange trading (Dawn Internet

2008).

(ii) The government has tried to show a more realistic stance by scaling down its

GDP growth forecast to 55% for scal year 2008/09 This is still seen as too

optimistic by some experts. The International Monetary Fund, for example, is

projecting a 34% growth rate for 2008/09. The government also scaled up its

projected ination rate for 2008/09 to %

(iii) The government has committed itself to during scal year 2008/09 to:

(a) reducing the scal decit to 47%

(b) increasing the investment-to-GDP ratio to 21.5%

(c) reducing the current account decit to 6% of GDP

(d) increasing foreign exchange reserves to $12 billion from the current level

below ($11 billion)



35/64


36/64


37/64


38/64

and this way set the basis for a successful recovery; at the same time it is trying to deal

with the ination problem n our view, while some measures in the budget appear to be

sensible (eg, the reduction in across-the-board subsidies), it will be difcult to achieve

the target budget decit This could be achieved only by implementing signicantly more

drastic cuts (beyond subsidies). The elimination of certain subsidies is necessary but thishas to be done by keeping in mind the social repercussions. The increase in the price

of fuel has to be implemented gradually. At the same time, the most vulnerable groups

need social protection. It will be of paramount importance to ensure (perhaps by law) that

social and health expenditures are not curtailed. Moreover, in the current situation, we

believe that the government will most likely not be able to raise tax revenues by 25%.

Likewise, privatization will be difcult The government also plans to increase import

duties of nonessential and luxury items to 3035% from the current 1525%. If the

objective is to discourage imports of these goods, the tax rate has to be much higher to

have any serious impact.8 Given Pakistans already high interest rates, the country will

need nancial assistance t has been announced that Pakistan will receive US defense-

related grant inows Saudi Arabia will also provide relief support through an oil creditfacility.9 The World Bank and Asian Development Bank (ADB) will also provide budget

support.

t is difcult to ascertain whether the measures contained in the new budget result in the

stabilization of the economy and can deal with the effects of the increase in food and

fuel prices, as now the macroeconomic imbalances and the ination problem reinforce

each other ur view is that the government will not be able to achieve its budget decit

target unless it cuts drastically spending on social services (education, health, etc.) and

development expenditures. However, if this is done, it will have serious repercussion for

Pakistans future. A better strategy would be to negotiate with the multilateral agencies a

program that have would allow the country to reduce the decit at a slower pace until itreaches a more manageable level. During this time, the structure of spending should be

analyzed, and a realistic program to increase direct taxation should be devised.

IV. Policy Recommendations

The impact and extent of the current economic and political uncertainty will depend

upon: (i) how the economic response of the new government develops gradually during

the next few months; (ii) on whether the government will not fall or not fall apart; (iii) onwhether external conditions (rising food and fuel prices, world economic slowdown) will

continue deteriorating, or whether they will improve; and (iv) on how people respond to

the removal of food and fuel subsidies.

8 Imports o ancy mobile phones and vehicles take $2 billion annually.9 This takes the orm o a 3-year deerred payment. The details o the agreement have not been disclosed.



39/64

What seems to be beyond dispute is that the economic slowdown and strong inationary

pressures will remain throughout 2008 and 2009. The strong monetary contraction and

increased interest rates, as well as weaker business condence, will dampen privateinvestment t will be difcult for the government to achieve the target investment-to-GDP

ratio of 21.5% (private investment declines as a share of GDP in 2007/08). Second,

high food and fuel prices, as well as increased taxes, will dampen private consumption.

And the removal of the food and fuel subsidies will aggravate the already high ination

Therefore, achieving 55% growth in 2008/09 and an ination rate of % will be very

difcult ur view is that growth will be at about 5% and ination at about %

With a current account decit above 8%, a budget decit of 65%, and ination in June

2008 (year-on-year) above 20% (with food ination exceeding 0%), Pakistans economic

situation is risky The major risk is that the country is vulnerable to a sudden outow of

capital Table 8 provides a summary of current account and budget decits, interest rates,as well as ination in a number of emerging markets t shows that Pakistans situation is

among the most problematic.

Table 8: Potential Economic RiskCurrent

Account

(percent oGDP)

Budget

Balance

(percent oGDP)

Interest Rates (percent) Ination

3 month 10-yearGovernment

Bond

Latest2008

2008

China, Peoples Rep. o +8.6 2007 0.5 4.32 4.85 +6.3 Jul +6.6Czech Republic 2.7 Jun .8 3.8 4.42 +6.9 Jul +6.6Hungary 5.9 Q 4.0 8.55 7.80 +6.7 Jul +6.5

Poland 4.9 Jun .9 6.54 6.2 +4.8 Jul +4.2Russia +6.0 Q2 3.6 .00 7.04 +6.2 Jun +3.9Turkey 6.4 Jun 2.7 8. 7.00* +2. Jul +.0India 3.0 Q 3.4 9.2 9.66 +7.7 Jun +7.

Indonesia +2.8 Q 2.0 9.84 7.25* +.9 Jul +9.9Malaysia +3.9 Q 3. 3.70 4.45* +7.7 Jun +5.4Pakistan 8.6 Q 6.4 3.26 2.22* +2.5 Jun +7.6Philippines +2.9 Q .5 8 6.88 .4 Jun 6.8Korea, Rep. o 2.5 Jun .5 5.78 5.77 +5.9 Jul +4.2

Taipei,China +5.3 Q .9 2.75 2.64 +3.7 May +3.Thailand 0.4 Jun 3.0 3.78 4.69 +9.2 Jul +8.5Argentina +2.9 Q .7 3.88 na +9. Jul +9.7Brazil .3 Jun .6 2.9 6.6* +6.4 Jul +6.

Mexico 0.8 Q 0. 8.8 8.79 +5.4 Jul +4.8

South Arica 8.0 Q 0.4 2.25 9.25 +2.2 Jun +9.6* Dollar-denominated bonds. The Economistpoll or Economist Intelligence Unit estimate/orecast.Source: The Economist(622 August 2008, 856); Philippines current account, budget balance, interest rates, and actual infation are

rom Philippine sources.



40/64

Although it is impossible to predict all possible outcomes, it is possible to dene broadly best-

case and worst-case scenarios for 2008/09:10

(i) Best-Case Scenario (soft landing): There is no unrest and disorder as a

consequence of the removal of food and fuel subsidies, and global conditionsimprove. The government stands by its announced policies and achieves most of

the economic targets Economic condence returns ecession or major economic

slowdown as well as high ination are avoided

(ii) Worst-Case Scenario (hard landing): The country sees itself immersed in unrest

and discontent due to the removal of food and fuel subsidies, rising ination,

increased taxes, and rising unemployment. The global conditions continue

deteriorating, therefore aggravating the stagation problem The shaky coalition

government cannot withstand the pressures and backtracks on its announced

policies; or worse, the coalition government falls apart due to disunity and discord,

and political instability follows Business condence is badly eroded Capitalight takes place, a possible freefall of the rupee may occur; and a balance of

payments, nancial, and economic crisis may ensue

In our view, and despite the looming risks, the country is not on the verge of a major

collapse, provided sensible economic policies are put in place right away, and the political

bickering stops. While serious measures must be taken, this does not imply that the

country has to be subjected to an austerity program that leads to a recession. Fiscal

discipline acts as a deationary force as it induces excess capacity and unemployment

The experience of the Asian nancial crisis from a decade ago proved that this is not

the way to solve the problems aficting Pakistan onetary and scal policies affect

both short- and long-run trends in unemployment. Pakistans policy makers must aim atmaintaining strong aggregate demand.

The new government has to avoid at all costs setting overly optimistic GDP growth

targets, as well as implementing populist economic policies. Its credibility is at stake.

During 2007 and the rst few months of 2008, it became clear that inationary pressures,

limited job creation, and the highly skewed nature of the income gains during the last few

years led to the change in government. The main opposition parties (Pakistan Peoples

Party and Pakistan Muslim League-N) ran economic platforms during the elections that

emphasized full employment and inclusive growth. These objectives must remain in

sight.11

The government also needs to nd a delicate balance between measures aimed at

alleviating the impact of food and fuel ination, and economic policies aimed at gradually

redressing the macroeconomic imbalances. The government is aware of this. At the

same time, it needs to devise and implement a long-term growth model that leads to the0 Certainly these are two extremes and in between there is a range o scenarios. Pakistans Vision 2030 states the ollowing (p. XVI): Make employment and employability the central theme in

economic and social policies.



41/64

transformation of the economic base from an agricultural and textile-dependent economy

into a modern industrial and service economy. Furthermore, during the last few years, FDI

inows have concentrated on the service sector Efforts must be made to attract D into

commodity-producing and export-oriented sectors. This transformation should also lead

to the creation of productive and decent employment. This model requires an in-depthanalysis of the possibilities of structural change and diversication in Pakistan12 The

years 2008 and 2009 have to be dedicated to setting the foundations of this model, in

which both private and public sectors must understand the role that they have to play.

A. On Ination and the Role o Monetary Policy

onetary tightening to control ination may not be as effective as desired unless it

causes a major recession and collapse in aggregate demand. This is because the

combination of low growth and high ination seen today is caused by supply-side factors

How to control supply-side ination is a major challenge, and depends a great deal

on external factors. In this sense, it is important to recognize that a substantial shareof Pakistans macroeconomic problem has to do with the international situation. This

means that although domestic measures must be taken, Pakistan depends on global and

regional cooperative efforts to tackle the food and oil price ination and the subprime-

related (world) economic slowdown.

There are two important questions regarding the role of monetary policy. First, how

sensitive is the real economy to interest rates movements? During depressive conditions,

this option has little proven effects activating an economy. In bad times lower interest

rates do not inspire consumer expenditure. Likewise, lower interest rates do not induce

more investment (by making borrowing cheaper) as during these periods there tends to

be excess capacity, and output is not being sold. Empirical evidence suggests that theinterest elasticity of investment is nonlinear and asymmetric. While an increase in interest

rates is likely to reduce investment during economic booms (the economy is on or above

capacity), the reverse is not true. In general, it is the quantity of credit, rather than its

price, that inuences investment or this reason, the volume of credit in developing

countries is a more effective instrument of monetary policy than the price or credit. What

is true is that tight monetary policy resulting from an increase in interest rates will also

be associated with increased credit tightening. Under these circumstances it may be

reasonable to assume that there will be some effect on aggregate demand.

Second, what is the impact of interest rates on ination? ncreases in interest rates

might be effective when ination is caused by demand pressures13 Increases in interest

2 This is a very important point, not developed in this paper. ADB is already working with the Government oPakistan on the development o this model.

3 And even in this case the impact is not entirely clear. Consumer borrowing is not very sensitive to interest rates

increases. And, as indicated earlier, the eects o interest rates on investment are nonlinear and asymmetric. Thehome mortgage market is probably somewhat more elastic. But evidence indicates that what people care about

when taking a mortgage is the total monthly payments and not interest payments.



42/64

rates will probably have a more signicant impact in preventing the depreciation of

the rupee than in controlling ination This way, imported ination will not worsen due

to the currency depreciation. The down side is that higher interest rates may dampen

investment prospects and the higher value of the rupee may negatively affect exports.

Likewise, higher interest rates will increase costs and thus induce higher prices. Finally,it is well-known that there are long lags in monetary policy. This route, therefore, may

be detrimental to growth. Pakistans monetary authorities have increased the discount

rate four times between J anuaryJ une 2007 and J ulyDecember 2008, from 9.50%

to 13%. These increases have led to rises in the Karachi Interbank Offered Rate and,

consequently, in the bank lending rate; and during this period ination has increased

Should the SBP decide to continue increasing interest rates, it should monitor closely the

impact on investment and exports.

Box 4 further emphasizes the potentially negative effects of restrictive monetary policies

and proposes the use of income policies to deal with income ination and ination

expectations.

Box 4: Ination, Monetary Policy, and Income Policies

nation caused by supply shocks (eg, increase in oil prices, bad crop due to adverseweather conditions) cannot be averted by increases in interest rates. On the contrary, thesewill most likely aggravate the problem. If policy makers depend excessively on higher interestrates to stabilize prices, rms will become reluctant to use debt nancing and will tend torely more heavily on self-nancing Capital, which is so scarce in developing countries, willbe allocated less efciently in the short run, and growth will be hampered in the long run1estrictive monetary policies may have been appropriate for combating hyperination

episodes (at least in the hundreds percent) in some developing countries (e.g., in Latin Americain the 1980s). But this is hardly Pakistans situation today (and countries in Asia have rarelyexperienced hyperination) oreover, it is known that unless interest rates are changeddrastically, it takes a long time for monetary policy to impact the economy, especially inationIt is known that a major reason for Pakistans central bank interest rate tightening is to tryto restrict by law government borrowing from the SBP A more efcient way to achieve thisobjective is to limit by law the amount that the government can borrow from the SBP. And amore effective policy to control current ination is to use scal policy (combined with moderateincreases in interest rates). The government should try to identify and eliminate programs thatinduce an inationary bias to the economy 2

There is fear that ination may lead to a wage-price spiral by increasing workers inationexpectations (although this is a very poorly understood question), and therefore push upfurther the price level. In fact, effective 1 J uly 2008, the government increased across-the-

continued.

Interest rates policies have both allocative and distributional eects. Sometimes the latter can be substantially larger.Indeed, a signicant increase in interest rates may not induce a decrease in speculative investment in real estate, but mayhurt small- and medium-size rms trying to obtain working capital.

2 As Stiglitz et al. (2006, 24) argue: .reducing aggregate demand when the economy aces infation by reducinggovernment expenditures is oten alleged to be better or growth than doing so by increasing interest rates, since thelatter leads to reduced investment. But whether this is the case depends on which government expenditures are cut back:i its high return investments in inrastructure, growth would have been enhanced by using monetary policy rather than acontraction in government investment.



43/64


44/64

standard rate of return to the historically observed rate of prot, which may have been high dueto high growth While prot ination is caused by high demand, it is not necessarily caused byexcess demand since utilization rates may be below unity Also, rms may decide to increasemarkups as a result of higher interest costs; or as a result of changes in the perception ofcompetitive pressures from abroad. Again, this is not caused by excess demand. This meansthat oligopolistic pricing can set off an inationary cycle independent of the monetary policy

This inationary conict may be addressed by developing mechanisms for cooperation betweenworkers and rms (the way these exist in countries like Sweden) with a view to preventing aninstitutional power struggle for higher incomes. The key is restraint on both sides. Both partiescan walk to the negotiating table with a clear understanding of what is at stake, namely, that theincome distribution struggle leads to temporary winners, but to a no-win game in the aggregate;and, therefore, they need to work together. This way, it is possible to minimize, if not neutralize,the effects of prot and wage ination ne possible way to implement this mechanism isthrough an incomes policy (see below).

What is the role of the central bank in this context? n general, the monetary authoritiesvalidate this process (i.e., the increase in prices as a result of increases in nominal wagesabove increases in labor productivity) through the monetary expansion (i.e., the money supplyincreases) n this case, monetary policy to curb ination by, for example, increasing interestrates, is not only ineffective but may also have perverse effects if increases in interest ratesraise the cost of capital, which would justify an increase in prices thereafter (i.e., interest ratesand prices can move together) Today, some central banks avoid inationary wage and protdemands by not validating workers and rms claims How is this done? By preventing thatthe demand-determined actual level of output gets too close to the supply-determined levelof potential output (i.e., by ensuring a lack of effective demand). This is achieved by targetingination through the manipulation of short-term interest rates The result is the preclusion of fullemployment, i.e., a policy of stability at the cost of growth.

However, income ination and ination expectations can also be tackled in other ways Adeliberately announced incomes policy, that is, a policy that constrains workers and rmsfrom demanding increases in nominal wages that exceed labor productivity, can bevery useful in holding back ination expectations (Davidson 2006) ne possibility isto penalize the largest domestic rms in the economy when they agree to wage rateincreases in excess of some national productivity improvement standard as well as forincreasing excessively their markups. It is also important to monitor price increases of industriesthat operate under monopolistic/oligoplistic regimes (e.g., fuel products) so that the pass-thoughto consumers does not exceed the increase in the international prices. In the case of foodproducts, hoarding should be penalized. This policy has to be permanent and it has to be only apenalty for those rms that infringe the system and not a reward for those that comply with it

A different but related proposal is that of Vickrey (1992). He proposed to establish a market inrights to raise prices (and obligations to lower them) Each rm is given a certain number ofwarrants to gross markups, based on past performance These allow rms to raise prices, in ananalogous way to the markets in rights to emit air pollution. The initial allocation of the warrantsensures a predictable rate of ination and adjustments in warrants issued in subsequent periodsresult from changes in investment and hiring in the previous period.

f a rm wishes to increase its price above what is allowed, it has to buy the rights from anotherrm (these transactions are conducted freely) that is seeking and willing to lower its price by asimilar amount This system ensures a stable overall price level f a rm fails to abide by thesystem (ie, if a rms gross markup exceeds its warrants) it will have to pay a penalty

Box 4: continued.



45/64

A major concern is the possible contractionary impact of the monetary tightening that

has occurred during the rst half of 2008 and that, most likely, will continue throughoutthe rest of the year. Figure 17 shows the growth of M2 and of domestic credit and thatof the CP ination rate The gure shows that periods of growth in Pakistan have been

accompanied by high growth in 2 and in domestic credit above the ination rate14

Figure 17: Growth Domestic Credit, M2 and Ination, 196

35

30

25

20

15

10

5

0

5

10

196119

6319

6519

6719

691971

197319751977197919811983198519871989199119931995

199719992001200320052007

Growth of domestic credit

Growth rate of M2 (percent)

CPI ination rate

Table 9 shows the latest available growth rate gures of domestic credit, 2, and ination

for the period J anuaryMay for 2006, 2007, and 2008. In real terms, the growth rates

of both domestic credit (which grew by almost 0% during the rst ve months of 2008)

and of M2 were negative during J anuaryMay 2008. Therefore, in real terms, there has

been a decline in domestic credit and liquidity (i.e., lower purchasing power of the funds

borrowed declined). This implies that fall in broad money (M2) in real terms may lead to

a slowdown in consumption spending, while the fall in domestic credit in real terms may

signal slowdown or decline in investment and consumption.

4 This lax monetary policy may have contributed to the high growth, but it does not imply that the high monetary

growth led to infation.

Source: International Financial Statistics online (IMF, July 2008).



46/64


47/64

Figure 18: Ination and Discount Rates, 19612007

30

25

20

15

10

5

0

519

6119

6319

6519

6719

691971

197319751977197919811983198519871989199119931995

199719992001200320052007

CPI ination rate

Discount rate (end of period)


Figure 19: Ination and Discount Rate, Q1 2007 to May 2008

25

20

15

10

5

0Discount rate (end of period)

CPI ination rate




48/64


49/64

(vi) n Pakistan, food accounts for 40% of the weight in the CP This source of ination is notconsidered by T models, which assume that ination is caused by excess demand T,

therefore, cannot solve cost-push ination

(vii) The SBP does not have a good model to forecast ination

(viii) The IT models assume that monetary policy affects actual output only in the short run withactual output moving to the natural rate of unemployment in the long run. However, mayeconomists believe that monetary policy is not neutral and that the conduct of monetarypolicy may have effects on output in both the short and long run.

(ix) When the central bank manipulates interest rates to adjust current output relative topotential output, its actions affect both actual and potential output.

(x) The model needs an estimate of potential output. However, calculating it is extremelycomplicated.

(xi) What is the natural real interest rate? As in the case of potential output, policies derivedfrom the IT model depend on this rate.

(xii) Risks of IT: (a) monetary authorities may be forced to increase interest rates whenination increases, even though there is a wide perception that price increases are one-off, not an inationary episode (b) The proper adjustment to disturbances to the economyassociated with higher aggregate demand is not an increase in interest rates. IT may behighly inefcient

(xiii) T models make scant, if any, reference to scal policy This is due to the belief that thispolicy is ineffective (if not inationary) for the purposes of achieving the goals of economicpolicy, i.e., price stabilization.

(xvi) Little is known about the costs of IT on potential output, employment, poverty, and income

distribution Akbari and ankaduwa (2006) estimate an output-ination trade-off model(the sacrice ratio) and nd out that: a one percent decline in ination rate caused bya permanent reduction in monetary growth rate would result in a cumulative output (GDP)decline of 0.87 percent below its potential level [] if monetary policy were to target theination rate of 4 percent, the resulting cumulative decline in output below its potentiallevel (trend) would be about 5.1 percent (Akbari and Rankaduwa 2006, 185).

(xvii) What ination targeting regime will Pakistan choose, a point target or a range?

(xviii) Chaudhry and Chouhdary (2006, 207) argue that Pakistans economy is operating ata very horizontal portion of the supply curve. This conclusion corroborates Krieslerand Lavoies (2007) argument that for a large range of capacity utilization prices do notincrease; and Eisners (1995) empirical work for the US.

Summing up, before a nal decision is made the SBP should consider all these factors andprovide clear answers. While monetary targeting is problematic due to the instability of themoney demand function, the SBP has to consider the issues raised above. The doctrine thatthe central banks role is (exclusively) to consumer prices within a narrow range is a legacyof Monetarism. Historically, central banks developed in order to secure the stability of credit.nation need not be the only objective of monetary policy

Box 5: continued.



50/64

B. On the Exchange Rate

As mentioned earlier, monetary tightening may help contain the depreciation of the

rupee, which is facing tremendous pressures as a result of the macroeconomic and

political instability. Figure 9 above showed that the rupee is not overvalued. Currencydepreciation may aggravate ination and lead to further loss in condence, so there

are reasons to try to moderate it. The government has tried to do this by: (i) intervening

in the foreign exchange market and (ii) increasing interest rates and reserve ratios

and monetary tightening. However, the lessons of the Asian crisis a decade ago are

such that desperately defending the currency may lead to the depletion of international

reserves, and the situation may worsen leading to a full-edged balance of payments

crisis. Increasing interest rates and unduly reducing money and credit may deteriorate

rms balance sheets and lead to nancial defaults and a nancial crisis (as happened

during the East Asian crisis of 19971998). In the current situation, the best way to tame

pressures for currency depreciation is to lower political instability. Without a return of

political condence and certainty, using monetary tightening in excess may prove futileand ultimately damaging to the economy.

Maintaining a competitive exchange rate is fundamental for Pakistan and is a desirable

target policy. Real exchange rate overvaluation is bad for growth, while undervaluation is

good. Moreover, a competitive real exchange rate contributes to employment generation

through a number of channels The rst is through its impact on the level of aggregate

demand (the macroeconomic channel). The second is through its impact on the cost of

labor relative to other goods and, thereby, affecting the amount of labor hired per unit of

output (the labor intensity channel). The third one is through its impact on investment and

growth (the development channel). In an economy characterized by vastly underutilized

resources, there are growth-related externalities derived from a policy of maintaining acompetitive exchange rate, as the higher demand for exports, as well as the increasing

production of import-competitive goods, can spill over into demand for nontradables as a

result of higher income in sectors that produce tradables.

C. On Subsidies

The new government needs to analyze the impact of the subsidy burden on the budget

and decide what is crucial to guarantee a minimum living standard to the disadvantaged

groups (this calls for well-designed targeted programs); and what has to be passed on to

consumers. However, it must be clear that if increases in oil prices are directly passed on

to consumers, the overall price level will increase (ie, ination) and the country will be

subject to credit downgrades and losses of condence from the international community

due to its high ination rate

There is a ne line between maintaining sensible subsidies and populist measures

Knowing the difference is fundamental. The targeting of poor households will be crucial



51/64

to the success of the governments program. Since coming up with an objective targeting

mechanism will take time (a good survey or data gathering and monitoring system at the

local levels), it may be good to suggest that nongovernment organizations and United

Nations agencies be active in the cash transfer and targeting programs to ensure that

these end up in the hands of poor households. An objective targeting system to identifypoor households can be put in place through the so-called proxy means testing system.

In this method, key household characteristics such as lack of ownership of television

sets, refrigerators, water pipes, or water-sealed toilets, as well as very low electricity bills

serves as easy ways for identifying poor households. Furthermore, to make the target

system more effective, a co-responsibility system can be adopted: households availing

cash transfers and subsidies will be required to continue sending their children to school,

allowing them to receive immunization and health services, and entering livelihood

programs. This program has delivered positive results in the Philippines. Likewise,

mechanisms can be devised to identify poor groups for purposes of providing fuel

subsidies (e.g., giving discounts to public transport vehicles catering more to the lower

income classes in the gasoline stations).

D. On the Budget Decit

Pakistans scal decit is the result of a low revenue-generating capacity, more than

scal proigacy Nevertheless, the government has to analyze the structure of spending,

eliminate all superuous categories (including subsidies) and projects with questionable

benets, and get rid of unprotable state-owned enterprises As noted in Box , these

measures will also help address the ination problem Likewise, the law should limit (eg,

through the Fiscal Responsibility and Debt Limitation Act 2005) the maximum amount that

the government can borrow from the SBP.

t is important to note that budget decits are not sins if they are well understood and

adequately managed oreov

an analysis of pakistan's macroeconomic situation and prospects

Documents