Need for Fiscal Reforms
June 15, 2012
Not surprisingly, the yearly consumer price index inflation has increased to 12.3 percent in May 2012. A noteworthy aspect of inflation behavior is its persistence at this high level alongside slack economic activity. A probable explanation of this persistence is that the expansionary effect of the fiscal position is offsetting the weak private demand, especially investment demand. SBP is not expecting a sharp increase in inflation but its continuation around current levels in FY13. The issue is not just aggregate demand pressures but also people’s expectations. Therefore, limiting and retiring budgetary borrowings from the banking system and implementation of consistent and credible policies would help in moving away from this undesirable equilibrium.
The sheer volume of borrowing from the banking system and expectations that this trend will continue, in the absence of fiscal reforms, has made banks complacent. They are simply channeling the economy’s incremental deposits, raised at 7.0 percent on average, to government securities that give an average return of approximately 12 percent across different maturities. Specifically, the scheduled banks perceive the government as a captive borrower and can afford to avoid the private sector without taking a hit on their profits.
The real issue is the structural gap between fiscal revenues and expenditures of the fiscal authority. This gap cannot be narrowed without fiscal reforms. In particular, it would be difficult to reduce the scale of borrowings from the scheduled banks and adhere to the legal requirements of limiting and retiring borrowings from the SBP without generating additional revenues.
Falling private investment-to-GDP ratio to 12.5 percent in FY12 according to provisional data, also echoes the need for fiscal reforms. Absence of an enabling business environment due to persistent energy shortages and precarious law and order conditions has dampened the demand for fresh private credit. Therefore, urgent energy sector reforms are required to boost business confidence and arrest the declining investment-to-GDP ratio.
As for the developments in the external sector, the issue is not the size of the external current account deficit but lack of sufficient external inflows to finance it. Cushioned by robust worker remittances of $10.9 billion, the current account deficit was $3.4 billion during the first ten months of fiscal year 12. After incorporating the estimated deficit for the remaining two months, it is likely to remain around 1.7 percent of GDP for fiscal year 12, which is not large for a developing country like Pakistan. The net flows in the capital and financial account, on the other hand, were only $1.4 billion during the same period. Accounting for repayments of the International Monetary Fund (IMF) loans during the year, SBP’s net liquid foreign exchange reserves have declined to $11.3 billion by end-May 2012 compared to $14.8 billion at end-June 2011.
For fiscal year 13, the size of the external current account deficit as percentage of GDP is projected to be approximately the same as in FY12. However, due to anticipated rise in debt payments in fiscal year 13, the economy would need substantial external inflows to preserve our foreign exchange reserves. Further, the problems in the Eurozone have increased uncertainty in the global economy.
Being a safe haven for investors, the US dollar has strengthened significantly in the past few weeks against almost all currencies, especially the euro, and Pakistan rupee was no exception. Appreciation of the US dollar in international markets is probably one explanation why oil prices have eased somewhat, declining from a peak of $130 per barrel (Saudi Arabian Light) on April 3, 2012 to $97 per barrel on June 1, 2012. This, together with expected global slowdown may keep the oil prices softer compared to earlier projections. Given that almost one third of Pakistan’s total import bill is due to oil payments, this would be a positive development. For instance, with the current quantum of petroleum products and crude imports at 21 million metric ton, a decline of $5 per barrel in international oil prices could save up to $700 million in import payments in fiscal year 13.
Analysts say the root-cause of Pakistan's economic ills is a ballooning fiscal deficit, projected to be around 7% of GDP this year.
The government says it aims to reduce the deficit to 4.7%, although many analysts are unclear how the government intends to go about achieving this.
Most analysts agree that the lack of structural reform and poor governance, and an apparent policy paralysis, has hampered the country's economic potential. Pakistan is sometimes referred to as the 'sick man' of South Asia.
"Unless Pakistan changes course and corrects its structural imbalances, we will have to go back to the IMF," says DrHafeezPasha according to various media reports.
And the sooner the better, he believes. "That way, we'll able to avoid a full blown crisis."
After all, as experts point out, Pakistan's track record in implementing IMF conditions is not particularly good.
The last time the IMF bailed out Pakistan, with $11.3bn (£7.3bn), was in 2008. That programme ended when Prime Minister YousufRazaGilani's government rejected demands for reform and walked out of the arrangement prematurely.
"This time, the conditions are likely to be even tougher and harsher," says Dr Pasha.
"For that reason, I don't see the present government negotiating with the Fund and implementing its conditions before to the elections.
"They appear to be on course to leave a big economic mess behind which the next government will to grapple with," he said.