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.