An unwarranted assumption

Shaukat Tareen is the fourth finance minister in the PTI government that came to power in August 2018. A banker of considerable distinction who earlier led the finance ministry during the PPP regime (2008-13), Tareen will now spearhead the government’s efforts for putting the economy back on track.

This is an arduous task, which stumped his two predecessors – Hammad Azhar who had the shortest stint as finance minister was only a stop-gap arrangement – each of whom was well-versed in economic matters. So, the important question is: can Tareen hit the bull’s eye where his equally illustrious predecessors had come a cropper?

Without the slightest of intentions to put the credentials of the new finance minister under question, one may point out the fundamental flaw in the thinking behind the latest reshuffle in the cabinet: if a team is performing below par, change the captain or other members without taking into account the objective factors undergirding their performance.

The objective factors in the matter on hand are the chronic structural constraints, which keep the economy pass through cycles of consumption-induced growth bubble and austerity-induced stagflation (recession coupled with high prices). Such constraints include premature deindustrialization, a narrow manufacturing base, declining productivity in agriculture, too much dependence on primary products and low value-added manufactures for generating export revenue, a corporate sector which is remarkably deficient in entrepreneurship and markedly short on competitiveness and which thrives on subsidies and rent seeking, an inefficient public sector, and widespread tax evasion.

The short periods of relatively high growth generate the impression that the economy is out of the woods once and for all and that the country is well on the road to development. But not long before this impression turns out to be an illusion. An analogy may be drawn between this growth illusion and money illusion.

Popularized by the eminent economist John M Keynes, the notion rests on the disparity between the nominal and real value of the currency. Money is valued not for its own sake but for the goods and services that it can buy. An increase in income, which puts more money at the disposal of households, leads many to believe that they are better off. That may actually be so. But if at the same time prices also go up, households find to their dismay that their purchasing power or real income has not improved; it may even go down in case price increase outpaces that of income. The salaried class is typically prone to this illusion.

By the same token, an economy may see its total output go up for a few years, which may lead the residents into believing that good days have finally arrived. This may be the case if the growth is undergirded by an uptick in some of the key economic fundamentals, such as an increase in the productivity of land or labour, an improvement in entrepreneurship, higher domestic savings, or growing competitiveness of enterprises.

However, if the growth is due to such factors as monetary expansion or debt-creating foreign capital inflows, it will ramp up domestic demand without shoring up the productivity of the economy. Imports will increase while exports will remain stagnant, resulting in large trade and current account deficits. Because of quick returns, the increased capital inflows will find their way into speculative channels, ballooning up asset prices and creating a growth bubble or illusion.

Over the years, Pakistan has been prone to such growth bubbles. During FY2004-2008, the economy registered robust average annual growth of 7 percent. The following five years (FY2009-2013) saw the annual average growth rate plummet to 2.8 percent. During FY2014-FY2018, the economy regained its growth momentum and grew on average by 4.8 percent. However, during FY2019, the growth receded by 1.9 percent before contracting by 0.4 percent during FY2020.

Economic management during periods of a growth bubble has had some common characteristics. One, an expansionary monetary policy is pursued to keep interest rates low. The avowed purpose is to curtail the cost of doing business and encourage investment. However, monetary expansion ends up encouraging consumer borrowing and investment in real estate and stock market at the cost of real sector investment.

In case of speculative investment, wealth is not created; it only changes hands. Movement of stocks or sale and purchase of land may multiply the wealth of some people and turn others into paupers, but there are no net gains to the economy. Star performance of the stock and property markets create a growth bubble, which bursts after it has run its course.

Two, in the presence of a fragile domestic production capacity, the increased domestic consumption is met largely through imports, thus fueling trade and current account deficits. To finance the deficit, the government is forced to resort to massive borrowing, thus accumulating debt.

Three, the domestic currency exhibits relative stability but in fact is overvalued, which allows cheaper imports but discourages exports. A country running increasing trade deficit normally sees its domestic currency go down as the demand for foreign currency well exceeds its supply. The only way to keep an otherwise overvalued currency stable is to pump hard foreign exchange into the market, thus running down foreign exchange reserves.

This policy, however, is not sustainable and a stage soon comes when it is no longer possible to keep an overvalued exchange rate. When left to market forces, the domestic currency nosedives in keeping with its real value; just as it happened in 2008 and 2018. By that time, the external balance position has become so fragile that the country has to go back to the IMF for multi-billion dollar assistance. This happened in 2008, and in 2018 – on each occasion immediately after national elections and induction of a new government.

An IMF-sponsored programme is a bailout and not a development package. The purpose is to help the country service its debt, make payment for imports, and build up its foreign exchange reserves. The reserves build-up from the IMF assistance improves the country’s credit rating and brings some measure of stability to the exchange rate.

However, an IMF programme is not without its costs. It makes the government put the brakes on economic growth in a bid to slash the external deficit. Not only that, the IMF programme by itself doesn’t offer a credible solution to the chronic economic problems. Take trade and fiscal deficits.

As in case of most other petroleum importing developing countries, trade deficit has been a perennial feature of the Pakistan economy. The economy needs to import a lot of capital equipment and industrial raw materials to maintain or accelerate the growth momentum. Culturally, the people are strongly inclined towards imitating the lifestyle in vogue in rich countries, despite lacking the corresponding productive capacity, which encourages the import of luxury goods. On the other hand, because of severe supply side constraints coupled with a relatively large population, exports can’t keep pace with imports.

As for fiscal deficit, it is difficult to contain on both revenue and expenditure sides. When the growth rate shrinks, the tax revenue is bound to fall. However, even in periods of relative prosperity, the direct tax revenue fails to go up significantly, partly because of a culture of tax evasion and partly because of a large informal sector, which by definition is difficult to tax. On the other hand, the autonomous expenditure (debt servicing, defence, pays and pensions and general administrative spending) which is independent of the output level, and has to be incurred whether the growth rate shrinks or accelerates, accounts for more than 75 percent of the total public spending. That is why in FY2019, despite a 1.9 percent growth rate, fiscal deficit ballooned up to 9.1 percent of the GDP.

Addressing the structural economic constraints is the only recipe for sustained and healthy economic growth. Mere change in faces is likely to be of little consequence here.

The writer is an Islamabad-based columnist.

Email: hussainhzaidi@gmail.com

Twitter: @hussainhzaidi