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’.

---

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

---

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