Notes for the finance minister

We have multiple distress signals coming out of the mismanaged economy of Pakistan. A shrinking base of direct taxation and expanding underground economy, rising prices, stagnating output, widening income inequality, mounting circular debt, growing losses of public sector enterprises, recurring loadshedding and recently appearing shortage of petroleum products are not isolated problems.
They are interlinked and basically reflect the macroeconomic mismanagement that has been happening for a long time. These problems cannot be resolved durably without the formulation and implementation of a coherent macroeconomic policy framework.
With the State Bank of Pakistan having been given off to incompetent hands and the Planning Commission sidelined, currently the Ministry of Finance is calling all the macroeconomic policy shots without professional input from other vital economic institutions and with no checks and balances on what it does or does not do. Any outside advice that is listened to comes from vested interest groups of the business and landlord communities that benefit from the existing policies and from the IMF that has its own axe to grind in Pakistan.
Within the Ministry of Finance policies are being driven by what the finance minister thinks and dictates, with the bureaucrats carrying out his instructions rather than having the courage – and risk – of giving him professionally sound contrasting policy advice. In the circumstances, it is imperative for independent economists and analysts to remind the finance minister to think deeply about policy inter-linkages, and in a long-term perspective, to lift the economy out of its quagmire.
The two critical areas of policy reforms relate to the budget and the balance of payments. In the columns of this newspaper, I have tried to highlight the structural budgetary problems hoping that the finance minister will focus on the fundamental issues of tax reforms. It is equally important that the structural problems of the balance of payments are properly understood and addressed with a focus on acceleration in exports.
The finance minister has repeatedly mentioned three ‘achievements’ under his economic stewardship relating to the external sector. First, that he has built up foreign exchange reserves to $15 billion. Second, that he has stabilised the nominal exchange rate around $1=Rs100. Third, that he has made inroads into the world private capital markets through successful sale of Eurobond and Sukkuk.
These outwardly positive developments hide behind them troubling problems in the external sector. The foreign exchange reserves of the SBP, excluding compulsory deposits of commercial banks held with it as a reserve requirement on foreign currency deposits, are about $8 billion – and not $15 billion. The government and the SBP include in what they call ‘liquid foreign exchange reserves’ an amount of about $7 billion of foreign currency assets of commercial banks – partly counted in the reserves of the SBP because those are deposited there to meet the reserve requirements – that are fully matched by a corresponding amount of foreign exchange liabilities of commercial banks to private sector depositors.
The FE Circular 25 of 1998 issued by the SBP, under which the new foreign currency scheme was allowed, clearly stipulates that “the banks accepting the funds would not be required to surrender the same to the State Bank”.
Moreover, the modest increase in proper reserves of the SBP itself has been achieved by larger foreign borrowing, whose servicing and repayment will add to the long-term foreign exchange difficulties of the country. For example, about $3 billion of those reserves represent recent government borrowing from the world capital markets at above market rates. Building up reserves by indiscriminate foreign borrowing is not a sustainable or a wise policy. The reserves must be built by improving the trade account, attracting direct foreign investment and diverting home remittances from financing of trade deficit to increasing reserves.
The nominal effective exchange rate stood appreciated by 10 percent in one year ended on November 14, 2014. As inflation in Pakistan has been running higher than in the trading partner countries, the real effective exchange rate appreciated by some 14 percent in the same period.
In a country that has a wide trade deficit and where exports have been on the decline, no government that understands economics will boast about appreciation of their currency as an economic achievement. In fact, simultaneous coexistence of falling exports, a wide trade deficit and a stable nominal exchange rate are proof of poor economic management.
An access to the world capital markets is a good thing as it establishes credit rating for the country to enable the private sector to borrow from the world capital markets. But it is a bad omen if the government is forced to borrow from the world capital markets excessively at exorbitant rates of interest to finance the budget and balance of payments deficits. It only adds to long-term economic vulnerability and a rising burden of external debt which would take the country towards an external debt trap and more internal monetary instability.
A saving grace for the balance of payments has been the increasing inflow of home remittances – they are rising at a healthy rate of about 15 percent per year. But three aspects of home remittances must be kept in mind. First, a steady rise in remittances has nothing to do with economic policies of the government. In fact, it reflects shrinking employment opportunities and deteriorating economic conditions at home leading to large-scale migration of the working force abroad in order to financially support their families at home.
Second, remittances are being used to finance the trade gap by the government and consumption by the recipients. Both are hurtful for growth. The domestic savings rate being low, and on the decline, foreign savings should not be wasted in financing consumption. Third, a likely decline in remittances will prove disastrous for the country if it continues to run a huge trade deficit.
The balance of trade remains in perpetual deficit and is being financed by home remittances and net capital inflows. During the last three fiscal years, imports averaged about $41 billion per year and exports about $24 billion leaving a trade deficit of $17 billion. If exports and imports increase at the same rate, the absolute trade gap widens simply because the import base is about twice as big as export base. For this deficit to be narrowed in absolute terms, exports must rise at a rate much faster than imports. But in reality, exports have been stagnating in the last three years and in the first half of FY15 they actually declined.
The real solution of the trade deficit lies in steady export expansion. It requires a change in development strategy to encourage production of exportable commodities, particularly in high value-added category, and active use of exchange rate to improve and maintain export competitiveness.
At present, the government is paying no attention to the structure of exports and adopting no measures to expand the production and export of high value-added items. More than 50 percent of exports consist of textiles, mainly raw cotton, cotton yarn and low value-added cotton cloth, knit work and bed wear. The government’s focus needs to shift from building motorways to improving the production base of high-value-added exportable goods to be exported aggressively through an appropriate exchange-rate policy.
The writer is a former governor of the State Bank of Pakistan.

Email: doctoryaqub@hotmail.com