While paying for grocery at a shop the other day, the electricity went off and it took a few minutes before backup generators took over. After a few moments of inertia, the cashier rejoined rather apologetically, “Twelve hour a day loadshedding is back, sir,” and continued, “Look what they have done to Pak Rupee. We can’t trust anyone who comes to power in this country.”
His remarks urged me to respond to his discomfiture. “We are still under the caretaker setup. Let’s give the newly-elected government some time. These problems did not appear over-night. International crude oil prices are higher. We must control money printing even if that means reduction in payments for covering inefficiencies in electricity supply chain. Above all, there is an interrelated and ongoing currency problem. Wait till the CPEC power projects come online.”
I realised before I uttered these words that it was futile convincing him as his views did not change. It seems there is a general lack of awareness that the newly-formed government is bound to confront a myriad of economic challenges that must be addressed promptly and would entail taking unpopular measures until the underlying causes of economic melt-down are addressed.
The most pressing economic challenge facing the government is the balance of payments (BoP) problem — disequilibrium in external receipts and payments. Other than the BoP problem, the newly elected government has to fulfill its manifesto of creating a welfare state amid problems on the fiscal front such as already prevailing high and somewhat downward sticky expenditures and dismal tax revenues. The government will have to carry out massive restructuring on the fiscal side, and simultaneously, create equally important supplementary market-based arrangements for enhancing the provision of education, health and housing.
There are many pathways to creating a welfare state, but these will have to take a back stage for now to be furnished later. More importantly, the government will have to address the competitiveness issues in the industry, resuscitate the ailing small and medium enterprises (SME) sector and encourage entrepreneurship for innovative new firm creation for a strong, diversified economy with healthy employment generation.
Finally, the business of loss-making state-owned enterprises will have to be taken care of on an emergency footing. The main causes of the ongoing BoP problem appear to be: a fixed Pak Rupee exchange rate for a long time which caused an overvaluation in real exchange rate in the presence of a high budget deficit and its inflationary financing from the central bank; an expansionary monetary policy, and weaknesses in our export sector.
Contrary to common perception, CPEC related activities do not seem to have hitherto put any significant ‘direct’ pressure on BoP, although with the resultant massive and rapid increase in external debt, the sustainability of Pakistan’s debt has been put into question. Consequently, foreign investors, doubting future repayment capacity of the country, appear to have taken a cautious stance. Lack of transparency on CPEC in such a situation leads to a ‘lack of information’ discount by foreign investors.
As per the available data, Pak Rupee had accumulated approximately 20 per cent overvaluation in real terms as of the first quarter of FY18. This eroded the competitiveness of our “non-differentiated price sensitive” commodity exports while imports became relatively cheaper. Trade deficit, therefore, bore the brunt of overvalued real exchange rate and excessive concomitant consumption-based domestic demand.
It seems that under these conditions, the free trade agreement with China further intensified the pressure on trade deficit. Perhaps the country cannot afford to have even mild overvaluations in the real exchange rate in the presence of both a lack of competitiveness of our exports as well as a free trade agreement.
A massive deterioration in trade deficit coupled with insufficient financial inflows led to a steady loss in international reserves. Increased vulnerability of BoP, with an increase in international crude oil prices contributed to reserves depletion at a rapid pace and consequently to an increase in speculative dollarization within the economy.
As part of the remedial measures, Pak Rupee exchange rate has already been devalued by a total of slightly above 20 per cent since the beginning of FY17. This would correct the detrimental real appreciation of the currency. Regulatory duty has been imposed on selected imports, and monetary policy has been somewhat tightened. Although it can be argued that monetary policy is still not tight enough given trends in core inflation, further increase in inflation due to devaluation and overall macroeconomic/monetary conditions is expected. Devaluation and monetary policy tightening will do their part but only in preventing further drainage of foreign exchange reserves going forward.
However, it is important to note that the damage has already been done; the country has critically low levels of foreign exchange reserves and some international loans repayments will soon become due. In addition, the BoP remains somewhat vulnerable to certain uncontrollable economic shocks, particularly to a further spike in international energy prices or international economic slowdown.
Against this backdrop, arms-length foreign investors will continue to demand a higher risk premium or would adopt a more cautious stance in investing in the country – excluding our key strategic partner, China. The key challenge is then what can the new government do to address the BoP quagmire in the short run? There is no denying that we immediately need larger inflows of foreign exchange from abroad either as FDI or loans from friendly countries, and / or from IMF.
But perhaps more important is that the house needs to be put in order via controlling fiscal slippages through expenditure controls and taxation measures, curbing excessive monetary financing of fiscal deficits, greater flexibility in exchange rate, and careful monitoring and controlling of resultant excessive domestic demand. IMF loan under a suitable programme would be preferred as this would immediately signal international investors and other creditors that the necessary steps to put the house in order would be undertaken more efficiently as part of the conditionalities.
Restoring and enhancing export competitiveness is a slightly longer-term issue and can be addressed while carrying out reforms to increase industrial competitiveness, SME resuscitation and encouraging innovative new firm creation. Fast tracking restructuring of loss-making public sector entities which are a heavy drain on country’s resources and contribute to fiscal deficit, introducing proper incentives structures within such entities and eventually selling these restructured entities via capital markets will not only control fiscal slippages but also generate much needed resources.
However, such restructurings and privatisations are not only difficult to push through but also take some time. The creation of the wealth fund, however, is a step in the right direction; partly correcting the incentives at the top level while giving control in the hands of accomplished private sector experts.
The ground reality is that ‘almost’ all these short-term adjustments for restoring economic stability, whether entirely carried out by the government itself while simultaneously taking out loans from ‘friendly’ countries or carried out as part of an IMF programme, will be highly unpopular as the burden of say higher interest rates, high electricity tariffs (at least until power sector inefficiencies are resolved), and perhaps a mild economic crunch will all be borne by the public as usual.
However, it is also important to note that economic challenges faced by the country today did not build up overnight. Therefore, the public needs to be urgently made aware about the key underlying economic realities in a way that is summarised, factual and free from economic theory jargon. The unpopular burden of economic crisis related policy adjustments should be publicly shared.
This economy awareness objective can be achieved by improving and increasing the coverage of Ministry of Finance and State Bank of Pakistan’s publications along the lines mentioned above. In addition, effective mechanisms need to be put in place that permit constructive debate and consensus building on tough economic crisis resolution policies among all the concerned parties.
Public disclosure, increased awareness, and economic crisis policies developed and implemented on consensus would create conducive environment for the government to focus on and move ahead with other long-term challenges for creating an inclusive, stable, and dynamic economy.