Asad Umar and the IMF – An Unpopular Opinion

Picture taken from DAWN's website

Perhaps the economic team under Asad Umar could have done better in communicating their economic policies. But what Asad’s team did do will make the IMF program relatively less painful.

One reason for which Asad had been criticised during his tenure was for taking too long in striking a deal with the IMF. The argument goes that markets do not like uncertainty. Higher policy uncertainty forces firms to delay their investment decisions thus depressing growth. Moreover, expecting depreciation, individuals may convert their savings to dollars. Likewise, exporters may temporarily park their foreign currency earnings overseas.

While these arguments have obvious merits, the core thesis ignores the other side of the story. Specifically, it ignores the cost of entering an early IMF program. This is mostly done out of convenience. It is much harder to predict how the economy would have turned out had we made different decisions in the past.

Before proceeding further, let us get an important point of confusion out of the way. There is not much you can negotiate when you are seemingly negotiating with the IMF. A favourable deal is easier to achieve through using your international relations rather than forwarding competing economic arguments.

It is also important to appreciate where the country stood at the time when Asad took charge. First, the consumption led growth model had once again brought the country at the verge of a balance of payment crisis. At 5.7 percent of GDP, current account deficit was almost three times bigger than in FY13. Second, foreign currency reserves had depleted in the process of financing the import bill and defending the overvalued exchange rate. Third, the build-up of circular debt due to factors including unfunded subsidies required a Rs3.82 per unit increase in price of electricity as proposed by NEPRA. Fourth, a new phenomenon of circular debt in the gas sector had emerged after the outgoing government dragged her feet on increasing gas prices during preceding years. At one point, OGRA had proposed a 300 percent increase in gas prices for domestic consumers. Fifth, the budget presented by the outgoing government pushed a significant proportion of salaried class out of the tax net. Sixth, the collection of advance tax during previous fiscal year to artificially shore up revenue collection, blocked refunds and Supreme Court’s ruling against tax on mobile cards further depleted revenue sources. In short, everything was in a mess!

Considering these challenges, the question was never about what steps had to be taken. The economy had to be slowed down to contain imports; exchange rate could no longer be defended; electricity prices had to go up to contain circular debt; gas prices had to increase to prevent the supply-chain in the gas sector from collapsing; the tax base had to be restored; the process of refund had to start to resolve financing problems of exporters; finally, tax exemptions and unfunded subsidies had to be withdrawn.

Instead, the only relevant question was how and when. The economic managers under Asad had to decide if they would do this at once or gradually in phases. To their bad luck, the IMF came down hard demanding a rather immediate adjustment across all these dimensions. Commentators at the time were of the view that the government may be better off entering an IMF program at once. The argument went that the new government should expose the economy they had inherited; enter an IMF program; and, start with a clean slate.

The argument had its merits. But, perhaps, most commentators did not fully appreciate the implication of what they were proposing: a front-loaded adjustment program. Imagine if the government would have entered an IMF program right after coming to power. What would have happened? First, exchange rate would have been left to free float. As a result, exchange devaluation would have been much steeper and much bigger. Second, electricity prices would have increased by close to Rs3.8 per unit. Third, average gas prices would have more than doubled. Fourth, tax exemptions would have been withdrawn and new taxes would have been imposed.

All this would have led to a much higher rate of inflation and, consequently, a much higher interest rate. The growth rate, as a result, would have been much lower than the 3.3 percent achieved during fiscal year 2019. Perhaps, in our counterfactual world, the commentators would have been criticising the government at an even higher pitch. 

We now also know what steps the IMF was demanding when the government first started discussions with the IMF: a prior increase of 600 basis points in interest rates; an average increase of 94 percent in gas prices; an average increase of 50 percent in power tariffs; an increase in tax-to-GDP ratio to 13.2 percent; and, a shift to a free floating exchange rate regime. All these actions would have lead to an inflation rate at 19 percent and, consequently, an interest rate at 21 percent. What would have happened to the GDP growth rate is not even worth asking.

Instead, Asad’s economic team continued to ‘negotiate’ with the IMF while undertaking gradual adjustment. Despite some mismanagement, exchange rate was allowed to adjust in several steps. Electricity prices were increased by one-third of the recommended amount. Likewise, gas prices were increased by an average of 35 percent. This was contrary to the initial proposal of increasing gas prices by three times the actual increase. The tax concessions were partially reversed. A mechanism was designed to start the process of refunds. The interest rate was increased but by less than what the IMF wanted.

These steps did increase inflation and slowed down economic growth. However, by delaying the IMF program, Asad and his economic team effectively spread the adjustment process over a longer period than what the IMF would have allowed. Now that almost half of the adjustment has already been made, a similar IMF program will be less painful as the magnitude of required adjustments will be less than it would have been.

Yes, there were episodes of economic mismanagement during this time. Yes, the economic climate is not going to get better any sooner. However, the pain would have been much greater had Asad conceded to a front-loaded IMF program right after taking charge.

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Ahmed Jamal Pirzada has PhD in Economics. He teaches at the University of Bristol and is also a visiting fellow at the SDPI. He tweets at @ajpirzada

Bilal Lakhani is a Fulbright Scholar and alum of Columbia University’s Graduate School of Journalism. He tweets at @MBilalLakhani

How to escape the BoP crises?

Every time the economy collapses, policymakers turn towards restoring the growth rate. Most often, this is achieved by encouraging domestic consumption.

For example, during growth years of the Musharraf government, contribution of total consumption (public and private) towards GDP growth increased from 0.9 percent points in fiscal year 2003 to 9.4 in FY05. A similar trend can be seen since the 2008 financial crisis. Contribution of total consumption increased from 0.66 percentage points in FY09 to 7.92 percentage points in FY17.

This has unintended consequences. An increase in domestic demand encourages firms to produce for the domestic market. In other words, resources shift away from export sector towards non-export sector. Moreover, demand for imported goods increase as well. Both, the dismal performance of export sector and an increase in imports, worsen the trade deficit.

To be clear, persistent trade deficit is of limited concern in case of most advanced economies. This is due to developed financial markets; high degree of substitutability across their currencies; and, significant capital inflows due to their status of ‘safe asset’ providers etc. None of these conditions exist when it comes to developing economies.

A typical policy response to meet foreign currency shortfall in developing economies, therefore, relies on a mix of foreign aid, international loans (including IMF) and remittances. At first, this may appear harmless or even beneficial. However, empirical evidence shows that, in absence of adequate policy response, such inflows have similar adverse implications: resources shift away from export sector towards non-export sector.

The reason is similar to famous ‘Dutch disease.’ These inflows lead to an appreciation of real effective exchange rate (REER) thus adversely affecting competitiveness of domestic goods in the international market. An obvious implication is that the country continues to suffer from persistent trade deficit and, consequently, weak balance-of-payments (BoP).

Pakistan has also relied on a combination of similar measures when dealing with BoP crises over last two decades. Consequently, Pakistan’s export base has shrunk from 17 percent of GDP in FY03 to only 8 percent in FY17. The decline during last five years has been most significant. Excessive reliance on external loans to maintain a stable exchange rate, in addition to meeting foreign currency shortfall, caused REER to appreciate from 104 in FY13 to 125 in FY17. In absence of adequate policy response, share of exports in GDP fell from more than 13 percent to less than 8 percent.

The recent move to allow rupee to depreciate has been successful in reversing the declining trend in exports. SBP data shows that REER has depreciated from the peak of 127 in April 2017 to 111 in April 2018. This is exactly the period during which exports started to recover.

However, adjustments in REER alone have remained insufficient to contain the trade deficit. It is often argued that the upward trend in import bill is due to CPEC related imports and increasing oil prices. While this does explain part of the story, it does not fully explain the broad-based increase in import bill supported by SBP data. Demand for imported goods continues to grow across most regions and commodity groups.

The key to explaining observed trend in trade deficit is the implicit growth model which is based on growth in non-export sector. Let’s take CPEC as an example. Except for limited investment in Gwadar port, almost all CPEC related inflows have so far been directed towards projects which do not make any distinction between the export sector and the non-export sector.

This apparent neutrality of CPEC projects between export and non-export sector may appear reasonable. However, since the prevailing economic landscape is already unfavourable for export-sector, all inflows continue to move towards non-export sector in order to benefit from higher returns relative to export sector.

A litmus test of the preceding statement is the difficulty in recalling even a single major corporate group expanding her business under CPEC to cater to growing demand in the regional market. Instead all major investment projects, motivated by CPEC, aim to cater to growing demand in the domestic market.

It is, therefore, not difficult to see why strong growth in real economy during last two years once again weakened country’s BoP. Continuous flow of resources away from export sector has made sure that country’s export base remains dismal.

There is no reason why the same cycle will not get repeated in future. This can only change if policymakers undertake series of reforms aimed at shifting growth paradigm away from non-export sector towards export sector.

Some key measures include adopting correct exchange rate policy; implementing VAT to facilitate a transparent tax refund mechanism for exporters; and, undertake structural reforms aimed at streamlining processes involved in cross-border trade etc.

However, this requires conceptual clarity on part of policymakers and political backing against perverse incentives from the incoming government.

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p.s. I wrote this article in July 2018 during my stay at the SDPI. 

Complexity of #CPEC Cost-Benefit Analysis

Provincial Share (approx.) Under Signed Agreements:-
Punjab ($12.45bn), Sindh ($9.25bn),
KPK ($2.72bn), and Balochistan ($1.21bn)
source: tribune.com.pk

An honest assessment of CPEC must, therefore, carefully evaluate its impact on real economic activity

The transformation which the China-Pakistan Economic Corridor (CPEC) will bring forth may be exaggerated but it surely has expanded the national discourse by introducing elements of economic development to it. Before I proceed, two general points must be made. First, hypothetically speaking, even if CPEC is only a passageway for the Chinese goods, there are significant positive externalities – developmental and geopolitical – associated with trade routes. Second, such projects have long lasting distributional consequences which could be easily managed at the conception stage.

Here I will focus on the effects of the CPEC on the Balance of Payments (BoP) of Pakistan. To fully appreciate the impact which CPEC may have on the BoP, a simple explanation and a brief history is necessary. BoP includes the Current Account (CA). Pakistan’s CA is largely driven by movements in the trade balance and remittances. Any deficit in the CA is mostly financed by foreign investment, State Bank of Pakistan (SBP) reserves and/or loans from the international market – mainly IMF.

Recall that following an increase in commodity prices in the world market, Pakistan’s trade balance worsened from -$13.8bn in fiscal year (FY) 2007 to -$21.4bn in FY2008, according to the SBP data. With no significant change in remittances, CA deficit increased from $6.8bn in FY2007 to $13.8bn in FY2008. Over the same time, foreign investments decreased from $10bn to $8.1bn. With CA deficit higher than total foreign investment, remaining deficit had to be financed from SBP reserves. Consequently, SBP gross reserves decreased from $15bn in FY2007 to $9.5bn in FY2008. Dwindling reserves lead to currency speculation thus forcing the then incoming government to negotiate a $7.6bn bailout package with the IMF in 2008. A similar episode was repeated between FY2011 and FY2013 but also coupled with the repayments of IMF loan. SBP gross reserves fell from the peak of $16.6bn in FY2011 to only $7.2bn in FY2013. Another bailout agreement of $6.6bn was signed with the IMF by the current government in 2013.

Against this backdrop, $46bn of Chinese investment expected over a decade or more under CPEC appears refreshing. It must, however, be noted that $35-37bn of this investment is in the energy sector having a significant import component in the form of power plants and project consultancy. Therefore, the dollar inflow will be significantly less than the size of the total portfolio. Another aspect of the energy projects is also the consequent repatriation of profits. Crude estimates from my discussions with the Planning Commission (PC) sources suggest profit repatriation of $10bn annually once all the energy projects are complete. A cursory analysis of the CPEC, therefore, suggests dollar inflows during the medium term followed by dollar outflows over the longer horizon.

Large dollar inflows during the implementation of the CPEC can also have significant consequences for the CA. It will appreciate the Rupee thus making our exports less competitive in the international market. An honest assessment of CPEC must, therefore, carefully evaluate its impact on real economic activity rather than focusing on its magnitude alone. Given the sheer size of the energy sector in total investment, one would have expected part of the investment to also focus on improving the efficiency of the electricity transmission network. With current line losses – a major cause of the circular debt – at close to 20%, it is intuitive to note that pouring more water in a bucket with a hole is surely not an optimal investment strategy.

It must also be considered how investing billions of dollars in an already established eastern trade route may further contribute towards growth? What are the opportunity costs? Could there have been alternate projects which would improve our trade linkages and open new markets for our exporters? We know that the development of the highway network in Balochistan aimed at linking Gwadar with the Central Asian markets via Quetta as well as with the national trade route via Ratedero faces financial starvation. As per PC documents, at the rate of FY2015 PSDP allocation, N-85 widening & improvement project will take another 4-5 years to complete. Also there is no indication of any work on the 549km Hoshab-Khuzdar section of the M-8. Since PC is expected to meet Pakistan’s part of the financing of CPEC projects, the completion of the above projects may be further delayed especially when tax targets for FY2016 are revised downwards.

Overall, the direct effect of CPEC on the BoP maybe short lived but potential indirect benefits through an improvement in the real economic activity could be substantial. However, much depends on the architecture of CPEC. Is it designed as a set of scattered projects largely intended to achieve immediate political objectives with economic returns as a by-product? Or is each project seen as a part of whole aimed at transforming Pakistan into a regional trade hub? I want to be optimistic.

Falling oil prices and window of opportunity

FALLING oil prices decrease the marginal cost of production for firms. In the ‘general equilibrium’ framework, this encourages firms to increase their output, capital and hire more labour.

While this may have been good news for Pakistan, it is constrained by supply-side bottlenecks to fully benefit from the falling oil prices. In other words, given the energy — electricity and gas — shortfall, firms cannot increase their output following a favourable decrease in their cost of production.

Since the output cannot be increased, the market clears at the point where firms charge prices significantly higher than their marginal costs. I will call this ‘constrained equilibrium’. If the constraint is strictly binding, the economy experiences no change in employment, GDP and prices. But whenever the constraint is removed, firms will increase their output, shifting the economy to higher employment, higher GDP and lower prices.

This has implications for monetary policy. Since monetary policy only affects the demand side of the economy, any change in demand will only affect the price level under the assumption that the energy constraint is strictly binding all across the economy. I will relax this assumption later. Moreover, any fiscal policy not focused on removing the energy constraint will also suffer a similar consequence.

The State Bank of Pakistan (SBP) and Pakistan Bureau of Statistics data confirm the proposition. Immediately after coming to power, the PML-N government cleared the energy sector’s circular debt. This removed the constraint. There was an immediate growth in large scale manufacturing (LSM), and it grew 6.3pc during the first quarter of FY14.

This was achieved despite the increases in domestic oil and electricity prices during the same period. This spurt in growth suggests that the economy was in a ‘constrained equilibrium’.

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Given the energy constraints, a purely expansionary monetary policy will only work towards stabilising inflation, while providing limited gains to GDP

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However, since the government financed the clearing of the circular debt by borrowing from the SBP, the increase in the money supply triggered an increase in inflation. A 3.3pc month-on-month (MoM) growth in the broad money supply (M2) in June 2013 was followed by 1.5pc MoM non-food non-energy (NFNE) inflation in July 2013. This was much higher than the monthly 0.3pc and 0.4pc NFNE inflation reported for May and June 2013 respectively.

The LSM growth rate declined to only 2pc for the first quarter of FY15. This is not surprising, even though the earlier increase in oil prices during the first half of FY14 had mostly been reversed in the fourth quarter of that fiscal. There is little evidence to suggest any adverse change in demand which might have slowed the LSM growth.

The primary cause for this slowdown is the circular debt, which was reported to have risen to around Rs400bn by the first quarter of FY15 — only a little less than the Rs480bn that was cleared a year before.

The economy will grow faster in response to falling oil prices since the energy constraint is not strictly binding all across the economy. The agriculture and services sectors are not as dependent on energy (electricity and gas) as the manufacturing sector. Declining oil prices will, therefore, work towards increasing GDP by raising production in sectors of the economy that are less dependent on electricity and gas.

However, there is little reason to believe that the government will be able to meet its GDP growth target of 5.1pc for FY15 while the energy constraint persists. The World Bank, IMF and ADB have all projected the GDP growth rate to remain below 4.5pc. With returns and growth of the production sector constrained, it is no wonder that banks find it preferable to invest in government securities rather than in high-risk private investments.

But it’s not all doom and gloom. The SBP is on its way to adopting an expansionary monetary policy following downward inflation trends. Monthly NFNE inflation declined to 0pc and 0.1pc in February and March respectively.

However, given the energy constraints, a purely expansionary monetary policy will only work towards stabilising inflation, while providing limited gains to GDP. There is little hope that the private sector alone will be willing to fill in the investment vacuum in the energy sector, given the deep-rooted governance, transparency and capacity issues.

Nonetheless, we are presented with a window of opportunity where the SBP can direct funds towards government investment for solving supply-side bottlenecks — transmission lines, distribution networks etc — without fearing inflationary consequences.

Published in Dawn, Economic & Business, April 27th, 2015: http://www.dawn.com/news/1178362

PTI: Imran Khan's delicate stitch!

I have often participated in heated ideological debates on the issue related to the foundational principles on which Pakistan was established and how it should be governed. But why is it when it comes to supporting PTI and its political slogan of 'Naya Pakistan' many of the very same people are seen standing side by side despite their inherently contradictory ideological orientations? What makes these ideological fissures - on which traditional political parties have time and again built their political strategies - appear to be secondary in importance if not disappear altogether? Will such a unity outlive Imran Khan's own life? Or will we see a repeat of post-Jinnah ideological debates where each group attempts to drag the focal personality to its own ideological block without realizing that such an attitude is only leading to increased polarization? 

Unfortunately, the answers are not simple. Every narrative has a life of its own. A certain narrative may continue to live if the competing narrative shares no commonality. There is little incentive for any person supporting these contrasting narratives to concede. Facts, evidences and observations offer little help. Two dots can be connected to form a straight line as well as any other possible shape one can conceive. What scientific yardstick is there to declare one better than the other? More often than not, the apparent internal contradictions in the 'facts, evidences and observations' allow every person to assign specific weights to these data/information points such that the end narrative for any person is always somewhat different from the other.

Taking this understanding back to where I started, Khan has knowingly or unknowingly managed to craft an alternative narrative which maybe more suited to our time. By 'suited' I not only mean its desirability but more specifically its offering enough incentive to varying factions that they may put aside their old narratives for a better one. This hypothesis is at odds with a recent article which argues that the politics of ideology is dead such that today's politicised youth is 'non-ideological.' Since the author confines the term 'ideology' to merely indicating the right-left divide, the obvious fallout is the overemphasis of 'credibility, rhetoric and charm of top leaders' as the key driving factors. Had this been the case, what stopped Khan from generating mass appeal in the recent past? On the contrary, a movement which was largely concentrated to the youth at its initial stage is increasingly generating appeal across other age groups as well. Surely it is difficult to explain away this shift purely on the grounds of 'credibility, rhetoric and charm of top leader' and/or generational effect.

It is difficult to concede that an ideological person will be attracted to something less than a better ideology. Ultimately the puzzle depends on how one define terminologies. If ideology is defined as a narrative worth exerting for then there is little difference between the movement led by Khan and the earlier ideologically driven movements. The only key difference is that Khan has somehow managed to detach the political narrative from that of left & right and linked it to governance/institutions. There is no better evidence for this than the appearance of both the liberals and the conservatives under the PTI umbrella. Take PTI out of the picture and everyone will return to where they were. In other words, minus the new narrative/ideological shift, a liberal will be a liberal and a conservative will be a conservative with little mutual harmony. Any improvement in the perceived credibility of the house of Sharifs and that of Bhuttos will still have little to no attraction for the liberals and the conservatives, respectively.

The new political ideology is no longer that of left & right but of governance and institutional reforms. The idea of 'change' is no longer linked to the specific mode of governance but with solving peoples problems. The old guards selling the religious or secular mode of governance are increasingly finding fewer and fewer buyers. The complementary narrative of democracy & dictatorship is likewise failing to hold for long with the countrymen and women. Khan has raised the narrative to a level which runs counter to the incentives of the existing ruling elite. He is no longer selling democracy as an alternate to dictatorship but he is selling accountability, power and freedom. He is not selling reduced inflation, less crime and no bomb blast but he is selling institutional professionalism achieved through zero political interference. He is no longer selling the Shariah of the right and the Secularism* of the left, rather he has taken the game to the desired objectives of any of these governing systems - equality, justice and freedom! He is selling the morality/values of the religious east and the equality/justice of the secular west. He is shaping himself as a focal point of national unity. In short, Khan is playing Jinnah!

The more the people buy what Khan is selling, the more difficult it becomes for the ruling elite to compete. The public agitation has forced people to reconsider what they really want. Do they want what Khan is selling? or do they want to stick with the old basket of goods? Khan knows this. He has realised that it is not the resignation which should be the prime objective but rather it should be the selling of this new narrative to as many as possible. The more he convinces this nation that the existing exchange between the rulers and the ruled stands redundant, the more electoral capital he accumulates for the final assault. However, PTI must not forget that only the one sitting on a high wall risks a great fall.

It is no less imperative to emphasise that this carefully knit alliance on the fault lines of old ideological contradictions is only held together by Imran Khan's delicate stitch of new ideological narrative.  Any desire by one of the ideological blocks within the PTI to drag the movement towards their side will lead to a catastrophic implosion. The mystery of unity is always an intellectual puzzle with no precise answer. Treat it as holy and a one-off blessing from God, The Benevolent!


*I have not used the term 'secularism' in an athiestic and purely non-religious sense