The economy and the paradox of thrift

Having registered a healthy growth of 5.8 percent last year (FY18), the highest over the past one decade, coupled with a low inflation rate of 3.9 percent, the economy is sinking into stagflation: an unenviable combination of contracting growth and rising prices. The World Bank, the Asian Development Bank (ADB), and the IMF have downward revised projected growth of the Pakistan economy to 3.4 percent from 4.7 percent, 3.9 percent from 4.8 percent, and 2.9 percent from 5.2 percent respectively.

The United Nations Economic and Social Commission for Asia and the Pacific has forecast 4.2 percent economic growth for Pakistan during the current calendar year. The State Bank’s latest projections put economic growth for the current financial year at 3.5 percent. What are the factors that are pushing the economy into a hole?

Central to Keynesian economics is the paradox of thrift. Formulated by John Maynard Keynes, it states that the desire to save more by cutting back on consumption drives down the aggregate demand and thus puts the brakes on economic growth. As a result, incomes fall and people end up saving less.

An analogy may be drawn between the paradox of thrift and the economic management by the PTI government. From the very outset, the architects of Naya Pakistan were set on stabilizing the economy, which is a euphemism for pursuing contractionary policies: hike in taxes (mainly indirect) and interest rates and cuts in public (particularly development) spending. But their attempts to stabilize the economy are actually destabilizing it through growth deceleration and upward movement of the general price level.

Large-scale Manufacturing (LSM), which makes up 75 percent of total manufacturing, declined by 2.3 percent during the first seven months of the current financial year – against the 7.2 percent growth recorded in last year’s corresponding period. By the same token, during FY19 (July-February), average inflation reached 6.5 percent compared with 3.8 percent during last year’s corresponding period. In February 2019, on a year-on-year basis, inflation was recorded at 8.2 percent, which represents the highest general price level increase over last five years. According to the SBP, FY19 is likely to close with 6.5 to 7.5 percent average inflation rate.

Inflation is either demand-pull or supply-push. The current inflation is supply-side, as it is accompanied by growth contraction. Much of the inflation is the fallout of fiscal and exchange rate adjustments, which have been the mainstay of the PTI government’s economic policies.

The PTI assumed power in August 2018, less than two months after the last financial year had ended up with high fiscal (Rs2.3 trillion), current account ($19.89 billion) and trade deficits ($37.6 billion). The PTI put down the country’s macro-economic problems, particularly the record trade deficit, to an overvalued exchange rate. It was argued that the previous government (the PML-N’s) had, by keeping the rupee higher viz-a-viz other currencies, created distortions in the exchange rate regime. According to this theory, that action by the previous government made imports cheaper and exports expensive, contrary to what would have happened had market forces been allowed a free hand. Not only did this usher in massive trade deficit as imports scaled up and exports remained stagnant, it also stifled the domestic industry, which found it difficult to compete with cheaper imports.

The argument is not wholly devoid of substance – empirically at least. In the face of an overvalued exchange rate, the trade and current account deficits racked up from $22.16 billion and $3.12 billion respectively in FY15 to $23.9 billion and $5.45 billion respectively in FY16, to $32.48 billion and $13.13 billion respectively in FY17 and to $37.6 billion and $19.89 billion respectively in FY18.

Be that as it may, the exchange rate is only one of the factors that bear upon the external sector performance, which goes awry when the economy spends (imports of goods and services) far more than it produces (exports of goods and services). Thus, a massive trade deficit is undergirded primarily by low productive capacity – not by exchange rate distortions.

Pakistan’s productivity constraints are well brought out by the composition of exports and their respective share in the world market. In 2017, the total size of the export basket was $21.87 billion. This included $12.42 billion for textiles and garments, $1.75 billion for rice, $0.631 billion for leather articles, $0.511 billion for sugar, $0.410 billion for precision, medical and surgical equipment, $0.406 billion for fish, $0.385 billion for cement, $0.382 billion for beverages, $0.353 billion for fruits, $0.335 billion for raw hides and skins, $0.271 billion for plastics, and $0.258 billion for petroleum products. Cumulatively, these products account for nearly 83 percent of the total export revenue.

Thus Pakistan’s export basket is laden with primary products, semi-processed products, and low value-added goods. A sustained increase in exports will remain a pie in the sky in the face of such a commodity-based export basket, because not only do commodity prices fluctuate rapidly, there is also a long-term decline in non-oil commodity prices. Besides, as a rule, commodities lack product differentiation and sophistication, which is a prerequisite if exports are to bound ahead. Not surprisingly, for non-oil commodity exporting countries like Pakistan, trade deficit is a perennial problem.

Not only this, even in most of the above mentioned low value-added products, Pakistan’s share in the global market is exceedingly low. By and large, Pakistan’s garments are sold to the low end of the market, which partly accounts for relatively low export revenue.

Like the export basket, the import punnett is dominated by a few products: petroleum products, machinery and appliances, chemicals and pharmaceuticals, metals, vehicles, and industrial raw materials. The import of these goods is essential for keeping the wheels of the economy moving. Thus, for a substantial part of imports, Pakistan does not have a credible import competing industries.

It follows that Pakistan’s foreign trade problems are productivity-based: a narrow manufacturing and export base, reliance on primary and low-value added products, lack of skilled labour and low marginal productivity of labour due to shortage of capital. The industry is also deficient in product differentiation. The exchange rate management did not cause these problems, so by itself it is not their panacea. Hence, despite steep depreciation of the rupee since December 2017, Pakistan’s exports grew only 1.8 percent on a year-on-year basis from $14.8 billion in July-February 2017-18 to $15.3 billion in July-February 2018-19. On the other hand, the sharp depreciation of the rupee put upward pressures on price movement.

To bring down the fiscal deficit, the government relied on raising the prices of gas and electricity as well as indirect taxes, such as regulatory duties on imports. Despite all the austerity measures – some of which were foppish, such as the sale of the PM Office’s buffaloes and cars – fiscal deficit reached 2.7 percent of GDP during the first half of FY19 compared with 2.3 percent for the same period of the preceding year mainly due to revenue shortfalls. When an economy slows down, tax revenue comes down. The current financial year is projected by the central bank to close with 4.9 percent fiscal deficit.

Since the interest rate is a function of inflation, in the face of creeping inflation, the SBP has been jacking up interest rates over the last one year. From 6 percent in February-March 2018, the interest rate has gone up to 10.75 percent for April-May 2019. This shows that exchange rate management, which has allowed the domestic currency to depreciate, and monetary policy, which aims at driving up the domestic currency value through higher interest rates, are working at cross purposes. Hence, monetary policy induced possible reduction in inflation has been offset by depreciation induced spike in inflation. As always, a contractionary monetary policy put the skids under real output expansion.

The lower output and higher prices which stagflation entails feed on each other. Fall in output drives up prices, which in turn drives down aggregate demand and thus puts the brakes on investment and growth. That’s the reason stagflation stumps even the most astute of policymakers. Let’s hope the PTI’s economic wizards will wave a magic wand and pull the economy out of the morass.

The writer is an Islamabad-based columnist.

Email: hussainhzaidi@gmail.com

Twitter: @hussainhzaidi