Friday June 21, 2024

An ‘over-heated’ economy

By Hussain H Zaidi
June 11, 2022

Over the years, Pakistan’s economy has been confronted with a dilemma it has not been able to overcome: In the event that it registers lackluster growth, it will not be able to create enough jobs for its massive (more than 65 million) and growing labour force, thus remaining stuck in low income-low-employment-low living standards vicious cycle.

In case the economy grows at a moderately healthy rate of five per cent or above, the growth pace will exacerbate external imbalances mainly in the form of galloping imports, and drive up prices exorbitantly, making economic expansion difficult to sustain. As a result, stabilization (read: growth compression) measures will have to be instituted to cool down the ‘over-heated’ economy.

In the latest manifestation of this dilemma, the National Economic Council, the apex government body for economic matters, has targeted a five per cent growth rate for the upcoming financial year, because a higher growth rate would have become problematic (read: unsustainable) in the face of the state of the economy and IMF conditionalities. When an economy is liable to overheating at growth rate exceeding five per cent, it’s obvious that its edifice rests on flawed fundamentals.

The, to put it euphemistically, growth-stabilization dilemma is rooted in elementary economics. The total demand in an economy can be met either by domestic output or through foreign goods or services (imports). When on the back of a relatively robust economic growth rate, the domestic demand shores up, local and foreign products will compete to satisfy it.

As a rule, the lower the capacity of the local industry to cater to the heightened domestic demand, the wider space will be available to foreign products to rack up their presence in farms, factories, offices, and at homes. Characteristically, in the case of Pakistan, an uptick in domestic demand drives up imports, as local supplies lag well behind the increased ability and willingness to buy in the economy.

One obvious objection to the foregoing reasoning is that it disregards the ‘fact’ that acceleration of economic growth is accompanied by an increase in the scale of domestic output. The answer to this objection consists in the distinction between short-term economic growth and long-term or potential economic growth. Short-term growth, as opposed to the potential growth, is undergirded only by an increase in total demand without a corresponding increase in the productive capacity of the economy. An example seems in order here.

Suppose an economy can produce 100 million shirts and 100,000 cellphones annually. This output is the maximum attainable, given the resource base and productivity levels. Cost-saving and profit-maximizing businesses in either industry will not necessarily produce to their capacity. The actual number of shirts and cellphones manufactured each year will depend on their projected demand. In a typical year, 75 million shirts and 80,000 cellphones are manufactured.

Suddenly, because of the induction of a charismatic leader in power or for some other reason, the economy receives great amounts of remittances from the patriotic expatriates residing across the globe. Anticipating an increase in demand, garment factories and cellphone manufacturing units will jack up their production to 80 million pieces and 85,000 units respectively. The increase in production and sale of the two products will be duly reflected in the expansion of the country’s total output or the GDP.

The increase in remittance inflows keeps on increasing and with it the number of shirts and cellphones produced, and the size of the GDP remains on an upward trajectory until in five years the demand for shirts rises to 100 million and that for cellphones reaches 100,000 units.

Everyone now seems better off. Consumers, by and large, have more shirts to wear and more smartphones to use. Factories are hiring more labour and buying an increased volume of raw materials and components and racking in higher revenues. The government has a cause for boasting that its pro-growth policies have been consequential.

This scenario does have a fly in the ointment. During all these years, the productive capacity of the economy has remained stuck at 100 million shirts and 100,000 cellphones, because no new investment has been made in either industry; nor has the productivity of the workforce gone up. This means that the short-term growth has not translated into long-term or potential growth. As the actual shirt, as well as cellphone, output has already reached the maximum capacity, a further increase in demand on the back of ever-increasing capital inflows can only be met by imports.

Imports are not bad per se; import of raw materials, components and capital goods may be necessary for keeping the wheels of the economy turning. Likewise, export of certain consumer goods, such as food and pharmaceuticals, is unavoidable. However, when exports become stagnant or their growth lags well behind import growth, it becomes a cause for concern: foreign exchange reserves dry up, the domestic currency takes a pounding, and external deficit balloons up. Soon the euphoria generated by the short-run growth fizzles out and the government has no alternative to swallowing the bitter pill of cooling down the economy and reversing the much-trumpeted pro-growth policies. All of a sudden, the need for undertaking the painful but eventually fruitful reforms becomes the talk of the town.

Be that as it may, growth compression policies are not sustainable either. It may be a tautology, but undeniably a developing economy must keep growing, especially one that has a relatively high population growth rate. Politically, no elected government would like to leave its office with economic stagnation mocking its balance sheet. People want jobs, which can be generated only when the economy expands. Businesses are keen to sell more, which is possible only when consumers have rising incomes and better job prospects. The creditors, which are looking to get their capital back along with the mark-up, would like the debtor country to jack up its earnings. So soon after surviving the meltdown, the economy is back on the growth track – jerrybuilt, though it may be. Somberness, again, gives way to euphoria and economic reforms are put on the backburner.

Pakistan goes through this economic cycle every four or five years, coinciding with the election cycle. The malady is all too familiar but has proved a hard nut to crack. At 15.2 per cent, Pakistan’s investment-to-GDP ratio is among the lowest in the world, which needs to significantly go up. Not only that, we need the type of investment that raises the productive capacity of the economy. This entails diversion of scarce funds from quick yielding speculative investment – in stocks and plots – to the real sector (manufacturing, agriculture, and value-added services), with the right tax and other incentives or disincentives, as the case may be. As in the past, such a move may come a cropper in the face of stiff resistance from the powerful realty sector. Anyway, an increase in productive capacity of the real sector is essential for easing supply-side constraints and putting the country on a long-term economic growth trajectory.

The quality of output is as important as its scale. Production of sub-standard products, even if on a massive scale, can’t provide a secure basis for long-term growth. In Pakistan, quality is widely regarded as the most negotiable feature of goods and services. Likewise, businesses are geared more towards keeping wages down than towards ratcheting up the productivity of labour. Because the domestic industry is heavily protected, it can conveniently sell low-quality products at home. However, the same enterprises are either shy of entering foreign markets or find it arduous to compete therein. As a result, export growth is stifled and can’t match import growth, with all its adverse implications. This calls for putting in place a proper regulatory-cum-facilitatory framework to protect consumers and encourage the domestic industry to become competitive.

A market economy needs entrepreneurs to pilot its ship. Entrepreneurs are a special breed among businesses, taking abnormal risks and venturing into new areas or new ways of doing business. As family-based well-entrenched but risk-averse business houses have held sway over the corporate landscape and both governments and banks have been reluctant to support startups for their risky ventures, Pakistan has remained remarkably short on entrepreneurship, which has impaired long-term growth prospects. Through preferential credit and taxation and simplified incorporation procedure, entrepreneurship needs to be supported.


Twitter: @hussainhzaidi

The writer is an Islamabad-based columnist.