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.

------------------------------------------------------

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

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

Budgetary Comparison (Static): Development Strategies of Punjab & KPK

The political competition between the two provincial governments (Punjab & KPK) has expectedly or unexpectedly resulted in an apparent convergence across the two budget papers. At the aggregate level there does appear to be certain differences, however, they do not stand much ground when accounting adjustments are made for a consistent comparison. The first impression is that of an uncomfortable similarity. Nonetheless, there are major priority differences at the micro level - distinctly reflecting respective party manifestos - which can only be inferred through a careful analysis of the allocations under annual development expenditure.

Table 1: The %ages have been calculated using corresponding tables (on General Revenue and Expenditure 2014-15) in both the budget documents (given at the end).

Two key adjustments are to be noted when looking at Table 1. Firstly, the apparent difference across the two provinces under the heading of General Public Services (GPS) and Education Affairs & Services (EA) is only due to how the district level education expenditure is treated. Punjab government has divided the education expense into provincial (82bn) and district level (181bn). I infer that the Punjab government has recorded all of the district level expenditure under the GPS since this is where 236bn worth of transfers are made to 'the district government.'  This is contrary to the KPK who appear to have recorded the corresponding expense under the EA. Therefore, I have taken this out of the GPS and placed it under EA to ensure consistency and facilitate comparison. An identical adjustment has been made for health. 37bn of the health related district level spending is taken out of the GPS and moved under 'Health.' Secondly, the entry for Punjab under 'B' has been adjusted by eliminating the double counting (related to state trading + repayment of commercial bank loan) - in line with the KPK format. 

After the aforementioned adjustments, the only difference at the aggregate level is the negligible allocation for 'social protection' by the Punjab government arguably compensated by relatively higher spending under health. Other than this, higher level of Development expenditure (C) in KPK is mostly due to a relatively higher proportion of foreign assistance (most of which is grants). With these points in mind, the potential difference across the two provinces can therefore only be observed in how the annual development expenditure (ADE) is allocated.

In what follows, I start with a breakdown and cross-comparison of Education and Health. I then move on to the breakdown of the annual development expenditure (ADE) which is where the respective development strategies are reflecting themselves.

1) EDUCATION & HEALTH

Note that there are two primary heads under which the sectoral expenditures fall: Current expenditure (CE) in the form of salaries etc; and, annual development expenditure (ADE). I give estimates for each of these to allow you for self-reflection.

Punjab

i) CE: Allocation of 228bn for education (20.8% of the Budget) and 91bn for health (8.3% of the Budget).  

ii) ADE: Allocation of 45bn* for education (13% of total ADE and 4.1% of the Budget) and 31bn for health (9% of total ADE and 3.6% of the Budget). 

*I have taken out the 2.9bn for 'Sports and Youth' from education to stay consistent with the KPK allocation.

Summary: Total allocation of 24.9% and 11.1% (of the budget) for education and health, respectively.

KPK

i) CE: Allocation of 87bn for education (21.6% of the Budget) and 21bn for health (5.2% of the Budget).  

ii) ADE: Allocation of 25bn for education (18% of total ADE and 6.1% of the Budget) and 11bn for health (8% of total ADE and 2.7% of the Budget). 

Summary: Total allocation of 27.7% and 7.9% (of the budget) for education and health, respectively.

2) ADE: PRIORITY BREAKDOWN

While there is little difference at the aggregate level, some significant differences can be observed in the development strategies of the two provinces. 

i) One of the contributing factor (education) has already been pointed out. Education has a share of 18% in ADE for KPK whereas it is 13% for Punjab. 

ii) Industry & commerce gets an allocation of 3.7% by KPK. For Punjab it is 2% of the ADE.

iii) 13.4% of the ADE in KPK is going to district/regional development. For Punjab it is only 5.3%. 
iv) Water & Senitation gets 7.6% and 5% (of ADE) in KPK and Punjab, respectively.
v) Infrastructure development gets a major 43% of the ADE in Punjab. For KPK it is only 24%

   a) Roads: 9.2% of ADE for Punjab; 12.4% of ADE for KPK.

   b) Irrigation: 10% of ADE for Punjab; None

   c) Energy: 9% of ADE for Punjab; 4% for KPK

   d) Buildings: 2.3% of ADE for Punjab; 1% for KPK

   e) Urban Development: 12.2% of ADE for Punjab; 6.3% for KPK

vi) For Punjab, 9.5% of the ADE is going the 'Special Initiatives.' For KPK, an almost similar heading of 'Pro-poor initiatives' has an allocation of 5.7% of the ADE. KPK has explained these pro-poor initiatives to include 'health insureance scheme, insulin for life, mother and child health programme and nursing training programme' (Dawn, 17/06/2014). For Punjab, it is less clear as to what these initiatives are.
vii) Lastly, KPK also has a significant allocation of 8.9% going to 'Home' and 'Finance.' I am uncertain about their explanation.

The above breakdown (plus health) accounts for around 90% of the total ADE for both the KPK and Punjab. The higher spending by Punjab under v) and vi) can explain all of the spending difference between the two provinces under i), ii), iii), iv) and vi). 

CONCLUSION

The difference between the two development strategies can be adequately attributed to the varying priorities across Social Development Spending and Infrastructure Development Spending. While KPK is more focused on education and district level social spending in an attempt to directly target the middle and lower-middle class, Punjab has its emphasis on large scale infrastructure projects in both energy and road network. Which one is better? It is a subjective question. In the end what matters without any ambiguity is the institutional mechanism through which the funding is directed.

Source material: I have used the following two documents for my analysis.

http://www.financekpp.gov.pk/FD/attachments/article/251/White%20Paper%202014-15.pdf

http://www.finance.punjab.gov.pk/system/files/WP2014_15.pdf

Note: It is very difficult to compare the two documents since the divisions and sub divisions are not consistent. Unlike Punjab, KPK seems not to have followed the layout of Federal Budget which makes comparison very difficult. 

Simplified: Budgetary Accounting and What to Expect (2014-2015)

In this post, I have simplified all the statistics in the budgetary paper uploaded by the Finance Ministry. I do not intend to get into what the Govt. plans to spend the money on. Here i only concern myself with past year's performance and how the government plans to finance the expenditure for the coming year. The objective is to predict the potential short falls and the probable measures Govt. will resort to, using previous years behaviour of the PML-N's Govt. as a predictor. Moreover, the analysis has been kept free from any economic or political inclination except as a guideline. Now let us turn to the task at hand:

BUDGETARY ADJUSTMENTS IN 2013-14

The point of this section is to understand how ad-hoc measures are taken to meet the ends when the revenue targets are missed. Looking at past years performance will make us better acquainted with what to expect in the coming year. 

In 2013-14 there were no major revisions/adjustments seen on the expenditure side as per the document. However, there were significant adjustments carried out over the year to meet the financing needs. The govt started with 75.5% of the total expenditure being financed with internal and external resources while the remaining 24.5% of the financing was put under the head of bank borrowing. Over the period, bank borrowing was only used to finance 9.3% of the expenditure. To get a feel of it, bank borrowing was reduced by 600bn (from the planned amount of 974bn to only 374bn). This was achieved by raising an additional 670bn of the resources generated internally and externally. 

An approximate breakdown of the 670bn

Each sub-heading provides further breakdown in the respective category:

1)   106.8 billion was raised under the Net Capital Receipts:

i)    Recovery of loans was revised down by around 116 billion

ii)   Public Accounts head was also revised down by 77.3 billion

iii) To make up for the downward revision and also raise 106.8 billion of additional resources, government increased the borrowing from the public by 264.4 billion. This was further aided by a reduction of around 35 billion in disbursements.

2)    137.7 billion were raised from external resources:

i)   External grants declined by 70 billion (from expected 108.9 billion to actual of 38.8 billion)

ii)  To make up for it, government borrowed an addition of 207.9 billion externally (total of 675.3 billion)

3)    Provinces contributed an additional of 159.9 billion in surplus

4)    266 billion came from the increase tax and non-tax revenues. This is interesting. lets have a look in detail:

i)   Taxes collected by FBR saw a 200 billion shortfall. FBR seems to have missed the targets under all the headings and sub-headings of direct and indirect taxes.

ii)  This shortfall was primarily overcome by using ad-hoc taxation measures and increasing non-tax revenue. Under ad-hoc taxation measures:

a) While petroleum levy was decreased by 12 billion

b) Gas Infrastructure Dev. Cess was increased by 50 billion, and

c) Natural Gas Dev. Surcharge was increased by around 4.6 billion.
There were various revision in the non-tax revenue. Most of them cancel each other. The few significant ones are:
a) Increase of roughly 45 billion under 'Mark up (PSEs & Others)' and unexpected 67.6 billions under Other Profits. I dont know what any of these represent.

b) Further there was an additional: 60 billion of profits from SBP; 6 billion under defence services; and, 6 billion under General Administration Receipts.

c) Most important of all the contributions is the additional 174 billion under the foreign grants (possibly the $1.5 billion from Saudi Arabia). 

Summary of adjustments

To make up for the missed targets and to reduce bank borrowing by 600 billions, there was heavy reliance on: 

i)   public borrowing (264 billion); 

ii)  external borrowing (207.9 billion); 

iii) provincial contribution (159.9 billion); 

iv) ad-hoc taxation (42.5 billion); and, 

v)  334.6 billion increase in non-tax revenue. It can be safely understood that 50% of this was the grant from Saudi Arabia; 17.6% due to increased profits from SBP; 34% contributed by 'other profits' and 'mark up (PSEs & others).' 

Key point

What you should get out of it (for future reference) is that the major shocks coming from the ambitious targets set by the federal govt are absorbed via all sorts of borrowing measures, ad-hoc unplanned taxation, provincial sacrifices and one off good luck shocks.

BUDGET 2014-2015: ALL YOU NEED TO KNOW

As mentioned before, my focus in this post is on the revenue side due to significant uncertainty surrounding the estimates. However, for the sake of completeness, I start with the expenditure side giving a brief overview of the notable differences vis-a-vis previous budget:

Expenditure brief 2014-2015

Total Expenditure is expected to be Rs. 4.3 trillion.

Otherwise, there is not much happening on the expenditure side. Also any breach on the expenditure side is often internally adjusted by cutting the development expenditure (PSDP primarily). Nonetheless, few noteworthy points are: 

i)   allocation for subsidies have been reduced from 323 bn to 203 bn. All of this reduction is coming from less subsidy for both WAPDA/PEPCO and KESC. This will be a challenging task. 

ii)  Grants to provinces is expected to decrease from 53.8 billion to 24.3 billion. What is surprising is that the Grants under other various heads have been increased from 282 billion to 338 billion. 

iii)  Allocation for BISP has been increased from 70 billion to 97 billion which is very pleasing to me personally.
iv)  138 billion were spent in the settlement of the circular debt during 2013-14. However, nothing has been allocated for 2014-15. This is surprising since no significant energy sector reform has been carried out in the recent memory which could have possibly eliminated this problem. At the same time, it has already been reported to have risen to significant levels. Recently government was reported to have borrowed 30 billion from the banking sector in an attempt to clear some of the circular debt (and push the problem further into the future as before).

Planned Financing for 2014-2015

Following is the breakdown of financing sources for the planned expenditure:

i) 16% will be financed by Net Capital Receipts. All of this will be government borrowing from the public in the form of bonds and national savings etc. The two other items (loan recovery and disbursements) cancel each other out.

ii) 20% will be financed by External Receipts. 72% of these (external receipts) will be external borrowing while the remaining will be in the form of grants and privatization receipts.

iii) 6.7% will be via provincial surplus.

iv) 5.3% will be financed by the bank borrowing.

v) 51.7% will be financed by tax and non tax revenue.

What to Expect Over 2014-2015

Lets now focus on some of the revenue targets which were missed last year. As we have already seen, most important of them are:

i)    FBR's tax collection target of 2.8 trillion which is 25% more than this year's revised target. It is most likely to be revised downward by a big margin. Tax collection target was revised several times in 2012-2013 from the target of 2.38 trillion to 2 trillion whereas for 2013-14 it was revised down to 2.27 trillion from 2.47 trillion. Without legal action against tax evaders, it is no exaggeration that the tax target will be missed by somewhat 200 billions. 

In case - which is most likely - FBR misses the target, there is little room for ad-hoc taxation measures since Gas related taxes have already been increased in the proposed budget by 64 billion. This is in addition to a 15 billion increase in the petroleum levy. 

ii)   Privatization receipt of 198 billion under external resources. This roughly equals $2 billion of foreign investment from privatization alone. Nonetheless, its an ambitious but an achievable target. However, there is a possibility of significant political roadblocks in the process towards privatization.

Potential panics

Any shortfall on the revenue side, as has been the case in the past year, will force the government to domestic and international bond markets. The government already plans to borrow another 100 billion from the international market (50 bn via euro bond and 50 bn via sukuk bonds). It is likely, following last year's example, that the govt may resort to borrowing from the international market more than what she plans. Domestic bank borrowing - which is proposed to be kept at 227.9 billion for 2013-14 - may also be breached. Since International donors have already been fully engaged, the third source is borrowing money from the public through savings schemes. All these options will push up the interest rates and crowd out investment especially when the govt is only borrowing to meet the expenses rather than to invest.

(the unit of currency is Pak. rupee unless otherwise stated)

Pillars of an Islamic Welfare State!

Finding an Answer to Iqbal’s Question – in the Footsteps of Jinnah

In my previous article I pointed out that Iqbal had noted in his letter (dated 28^th May 1937) to Jinnah: “The atheistic socialism of Jawaharlal is not likely to receive much response from the Muslims. The question therefore is how is it possible to solve the problem of Muslim poverty? And the whole future of the League depends on the League’s activity to solve this question.” With this in mind I went on to say that the Muslim League’s future was therefore only till what they had managed to answer and was destined to see its end when the time for the next question came – a course which the coming years had taken and are now a part of League’s history.

The Planning Committee which Jinnah had formed in 1943 with the aim to chart out a five year plan for the socio-economic uplift of Pakistan could not complete its objective due to the turn of events in the short span of time. Taking lead from Jinnah’s advice that in any such plan ‘our ideals should not be capitalistic but Islamic,’ we must return to completing this work initiated by Jinnah so as to find the answer to Iqbal’s question.

Saleena Karim in her book ‘Secular Jinnah’ (2010) attributes the usage of the term ‘Islamic socialism’ to Jinnah himself ‘as well as the early leaders of Pakistan.’ Furthermore, she states: ‘Liaquat Ali Khan considered the abolition of landlordism a necessary step towards establishing this Islamic Socialism.’ But the certainty in the need of abolishing ‘landlordism’ is not enough unless one comes up with an alternate which is consistent with the ideological foundations of the country and thus the constitution. Similar is the case in dealing with every other economic malaise – which will not go away unless a more feasible and consistent alternative is put forward.

UNDERLYING FRAMEWORK of ‘ISLAMIC WELFARE STATE’

The concept of ‘Islamic socialism’ or more recently ‘Islamic welfare state’ (IWS) has often resurfaced and mostly as a campaign mantra of the political parties. However, its specific pillars largely remain undefined. A stop gap measure has often been Islamicizing the welfare model of Scandinavian countries by introducing zakat and other such Islamic features to it. But doing this is largely plagiarizing what may look similar but is distinctly different from the principles of IWS which evolved during the time of the Prophet, peace be upon him and his family, and on which the earliest Muslim Caliphate was based.

As the term suggests, a simple but technical definition of a welfare state is where State manages the economy so as to maximize the overall welfare of the society with the objective to fulfill the basic needs of its citizens and ensure an equitable distribution of wealth.  The ‘Islamic welfare state,’ as understood from the hadith literature, is explicitly different from the ‘modern welfare state’ in that it is extremely market based – forbidding majority of government interventions in the market mechanism except regulatory and what has been declared illegal by the religious law. For example, the fundament pillars of IWS do not allow for either minimum support prices or minimum wages which must be determined by the market. However, this presumes a competitive market mechanism rather than a monopoly/monopsony – not to be allowed by the State.

State intervention, with respect to achieving its welfare goals, takes the form of lump-sum transfer – in the form of social security (via zakat and taxes) and providing for the needs of basic health, education and public goods (via taxes and interest free borrowing) – only after market has allocated the resources. Furthermore, nationalization of all sorts of private property (eg. farms and industry) and similarly privatization of all public property (eg. parks, natural resources and dams) is discouraged and not allowed unless under special circumstances and at the discretion of the head of the state. Thus the state has no role in directly intervening in the markets and running businesses unless the social returns are greater than private returns in which case the entity should be run as a public service with no profit/loss orientation.

REGULATORY REGIME

Land and Agriculture: While there is almost no state intervention in the markets, there is strong underlying regulatory framework which surfaces after a closer look. For example, with respect to land reforms, in an IWS any state land can be utilized by anyone of the citizens for agriculture without any formal permission - although State can formalize this if it wants to. More importantly, if the land remains un-utilized for 2 years (or 3) then the state is required to take it away and give it to others for cultivation or keep it to itself. Much emphasis is also laid on the appropriate distribution of farm income between land owner and farmer – from 1/3 to 1/2 going to the famer depending on who provides the water etc. Similarly, towards the revenue side, the farm output is taxed from a minimum of 5 to 10% of the output depending on if the water is provided through rain or irrigation, respectively.

Corporate Finance and Banking: Other such regulations include that any CEO or Board members of the company – who make business decisions – have to be shareholders at the same time. Simultaneously, such decision makers (who are also shareholders and thus have their incentives aligned) must be given autonomy in their decision making. Moreover, forward buying and selling are considered against the Islamic principles which do not allow an object to be sold as long it is not in the possession of the seller. Similar is the case about Options pricing. Both these transactions are viewed as a transfer of risk such that one person’s benefit is other’s loss and thus equivalent to gambling. By the same principle applicable to forward buying and selling, banking practices of fractional reserve banking where an X amount of cash deposit is made to lend a total of roughly 10X, given a reserve ratio of 10%, also requires considerable review.  In all likelihood, an X amount can only be used to make a total loan of X amount under the Islamic framework.

Other Interventions and State Finances: Last but not least, State is expected to assist the poor in paying back their loans if they fail despite all efforts. In this regard, if the State decides to pay off the loans itself, it is to be paid back in full irrespective of the interest payment. It is beyond the State’s jurisdictions to get any part of the loan written off unless voluntarily undertaken by the lender. Although the State itself is not allowed to fund its expenses from the interest based borrowing, it can raise revenue through taxation before undertaking the intended project. Other sources of government finances are income from natural resources etc and interest free borrowing primarily from its Central Bank and from the public through non-interest bearing prize bond schemes.

ECONOMIC PROFESSION and the ISW PILLARS

These are just some of the key pillars of ISW, based on the extensive hadith literature, expressed in the language of modern economics. Many of the theoretical economic foundations of these pillars are well known and agreed upon by the majority while others remain disputed between the academic circles, eg. economics of minimum wages. Few on the other hand, such as interest free financing of government expenditure, are too alien to even be considered in the economics profession such that I do not expect any serious research on this subject in any near future. However, the intention is not to replicate the West or the East but to innovate our own system so as find an answer to Iqbal’s question of ‘Muslim Poverty’ based on Jinnah’s words: ‘our ideals should not be capitalistic but Islamic.’

note: picture from lyndit.com

Economic Logic and Falling Inflation: Why the Recent Trend Makes Sense?

In the article I wrote earlier, I made an attempt to track the trends in inflation figures choosing 2008 as my starting year. Using data from the State Bank inflation reports, I finally concluded that ‘most of the fluctuations in various inflation indexes can be traced back either to the global trends in commodity prices or domestic shocks such as due to floods, energy shortages or elimination of subsides.’ Furthermore, I also pointed to the increase in the minimum support price of major agricultural commodities (eg. wheat) which consequently increased the prices of other crops as well.

The above analysis had direct policy implications. Firstly, any policy which aggressively attempts to control spurts in inflation – when exogenous shocks are the primary reason – will be counterproductive. Therefore, monetary policy must take a cautionary approach. Secondly, inflation will gradually decline as different shocks finally dissipate in the economy. Both the implications were based on the observation that excess demand is unlikely to be the driving force underlying inflation trends. This observation flows from the fact that growth rates of the past few years have been below the potential. In technical terms used in macroeconomic models, ‘output gap’ have been negative.

There is indeed evidence that the economy has not experienced any major price shock in the previous months thus allowing the inflation to converge to the level consistent with the prevailing output gap. In addition, recent cut in the prices of CNG by Rs. 30 has increased the pace of this downward convergence. However, there are two strong arguments which question the declining trends: one is excessive government borrowing from the banking system which makes decline in overall inflation to look paradoxical; and, the other is how much time (time lag) it may take for the shocks to dissipate in the economy. Both the arguments are interlinked as is everything in economics and they equally strengthen the notion that government must have manipulated the numbers to suit their political needs. However, to me the recent inflation trend appears to follow a pattern which is dictated by economic logic rather than political motives.

Most economic models are tuned to considering the shock processes as exogenous. Endogenous shocks have only recently begun to penetrate in the mainstream models. Therefore, I must accept that I do not have a sound research study to support the following analysis but this in itself is not a valid reason to stop me from doing so. Although most of the shocks are considered to be exogenous but some of them could very well be endogenous at least in some special circumstances.

The first argument of increase in the government borrowing has two parts in it. Government may borrow from the commercial banks or from the State Bank. It is only the latter which significantly contributes towards inflation by resulting in an increase in the money supply as a direct consequence of State Bank printing money. This increase in the money supply is a shock and is mostly treated as exogenous in macroeconomic models. However for Pakistan, in the special case of last few years, money supply shock was endogenous to other exogenous shock processes such as floods, military operation, IDPs, global energy prices which resulted in rising fiscal needs. It will, therefore, be illogical to analyze its effects independent of the exogenous shock processes thus overestimating the consequences and justifying an aggressive monetary policy stance.

The second argument of the ‘time lag’ is less generic and varies from region to region. The time lag itself depends on the degree of inflation persistence and also the dynamics (autocorrelation) of it. Inflation persistence determines the time it takes for any price shock to dissipate. Knowing inflation persistence is vital for conducting monetary policy optimally as it guides the monetary authority (State Bank) on how to adjust the policy instruments in response to shocks (or deviation from the steady state) so as to achieve the desired targets. Lack of inflation persistence implies that the impact of monetary policy response to price shocks will be immediate rather than delayed and gradual.

Recent study by the State Bank showed that aggregate inflation persistence in Pakistan has only been 0.19 for the period of 1959-2011 which has become statistically insignificant for the most recent period of 2001-2011. This means that the impact of the previous shocks has already been felt at the aggregate level and thus the recent fall in the aggregate inflation level to 7.66% is justified. On the other hand, inflation persistence in the core inflation is significant at 0.69 which is why core inflation, which stands at 10.8%, has still not come down significantly and will take more time given no bad news hits the economy in the coming months.

Gold, Fiat Money and the Monetary Management

Having read most of the articles which followed the debate in the US on going back to the Gold standard, I was put off by simplistic arguments being made by both the sides. The primary arguments revolve around the role of Gold in controlling inflation on one hand and how it limits governments’ ability in managing business cycles on the other.  In this article I attempt to discuss both the sides in as much brevity as possible without choosing one over the other.

Both the primary arguments are strong enough to support either side’s point of view. Let me start with the role of Gold in controlling inflation. Stability in the purchasing power of a unit of currency – which is a store of value – plays a critical role in the efficient working of a market economy. This stability is threatened by the change in the price level (i.e. Inflation) within the economy. Inflation has been established as a monetary phenomenon such that any change in the units of currency in circulation (money supply) results in the change in the purchasing power of a single unit in the opposite direction. It is the inability of the government to change money supply in an economy with Gold as a unit of currency which is argued as a factor contributing towards the desired stability. David Ricardo makes a similar point by saying, "Experience shows that neither a State nor a Bank ever have had the unrestricted power of issuing paper money, without abusing that power.”

The argument that changing price levels is not only a characteristic of Fiat era is incomplete. Inflation episodes during past centuries, when Gold standard was in place, can be traced back to three main reasons: increase in the production of Gold (eg. 1848-1873); periods of government printing notes to fund war expenses etc. (eg. 1782-1814); and, decrease in the reserve ratios or other factor leading to increase in banking credit (eg. 1914-1920). The last two factors have explicit involvement of the government. The first factor, although important, plays a role in a way which does not lead to abrupt changes in the prices due to physical limitations eg. production capacity. Instead the change in price level is rather gradual. Data for the 19^th century also shows that on average, annual increase in gold production have been roughly equal to the annual increase in demand (around 3%) necessary to keep the prices stable.

I now step on the other side of the fence. The most important reason to me for not supporting ‘return to gold’ is the ability of the government to manage business cycles. Although money is neutral in the long run, nominal rigidities in the form of price, wage and information stickiness do allow significant room to central banks such that they can alter the money supply to stabilize the economy in response to shocks. Now one may argue that the volatility of business cycles is actually a causal effect of such government interventions to start with eg. boom (created lets say through cheap credit) must be followed by a bust. This latter argument does hold some ground but still this does not strip the central bank of all its ability to effectively stabilize the economy. So in a perfect world where government is benevolent, ability to alter money supply can decrease the volatility and stabilize the economy.

One may ask, and rightly so, that is the government really benevolent? Not really. There is always a chance that short term objectives will result in policies which will lead to inflation. However, it can be argued that the misadventures during the past centuries were undertaken in the absence of a proper economic theory such that the consequences could not be fully perceived. Similarly, during the 1950s and 60s, policy decisions were led by incomplete economic theory of a permanent trade-off between inflation and output. There is significant support for the argument that the monetary policy of the 80s and onwards (in addition to other factors like improved inventory management) in the US, with greater focus on the stabilization, was indeed successful in reducing the volatility of business cycles while the institutional framework (independence on central banks) allowed limited room for any monetary misadventures.

There may actually be a solution to the respective problems in both the regimes. Under Gold standard, monetary authority can regulate the banking credit to effectively alter the money supply to achieve the desired objectives. While under the Fiat system, it can adopt the price level targeting rule that can help in stabilizing the value of currency.

Ultimately it boils down to an empirical question. Are the benefits from the ability to stabilize greater than the costs associated with possible monetary misadventures? I do not know, as yet!

Fight against corruption

EVERY year up to $1.8 trillion in illicit funds derived from corruption, tax evasion and organised crime circle the globe, according to a Transparency International report 2010. The figure is much larger than the funds allocated for the Millennium Development Goals.

In another study by Ernst & Young, half of those surveyed estimated that corruption raised project cost by at least 10 per cent.

Apart from the direct monetary losses due to misappropriation of scarce resources, corruption not only distorts markets and creates unfair competition but also weakens institutions by nurturing and sustaining the corrupt government officials and politicians through bribery.

In a similar Ernst & Young survey, almost a fifth of more than 1000 executives claimed to have lost business due to a competitor paying bribes.

However, corruption, which takes advantage of shortcomings in transparency, internal governance and lack of oversight, is not limited to government-led businesses and institutions. Corruption within private enterprises is increasingly becoming an important subject in policy circles, especially after the 2008 recession. It constitutes: executives giving generous payouts to themselves; majority shareholders trying to influence corporate strategy at the cost of long-term profitability; and, staff abusing power entrusted to them for personal gains.

Corruption decreases FDI while FDI decreases corruption: Past studies have spent significant energies in understanding effect of corruption on FDI and mechanism with which such an effect materialises. However, only few have made an attempt to explore the possible effect of FDI on corruption and have found the relationship to be negative and statistically significant. The two main studies in this regard are Pinto and Zhu (2011) and Larrain and Tavares (2004). Larrain and Tavares (2004) use FDI inflows as a measure of openness to access the effect of openness to FDI on corruption after accounting for trade intensity. They find the relation to be significant and negative.

Mechanism of this effect: Due to limited research, the mechanism of how FDI may lower corruption also remains less understood. One way to understand this is to look at the restrictions placed on FDI inflows. With the help of a theoretical model, Krueger (1974) shows how trade restrictions are used ‘as originators of rent’. She emphasises on the role of competition for import licences as an inducement to corruption.

Moreover Ades and DiTella (1999) emphasise high level of corruption in countries where local firms have limited exposure to foreign competition. Deriving inference from trade openness, one may argue that foregoing protectionist policies towards FDI inflows will lower the avenues of corruption exploited by the agents for their individual gains.

Second, FDI itself brings positive spill-over effects through improvement in technology, better management practices and transparency in corporate governance. The increasing role being played by the multinationals in the transfer of technology has been talked about for a long time now.

Findlay (1978) was one of the first few to show this in his ‘explicit analytical model of technological diffusion’. Findlay highlighted the role of major corporations with higher level of efficiency in enabling the less developed countries to better adopt the new technologies. This higher level of efficiency of major corporations further results in the transferring of advanced management skills to domestic firms. In a case study on Russia, Braguinsky and Mityakov (2012) show that domestic firms which interact with foreign corporations in Moscow are twice as transparent as other domestic firms.

Word of Caution: Pinto and Zhu (2011) also discuss the negative consequences of FDI if domestic characteristics are not fully understood. They find FDI to be associated with high levels of corruption in less developed economies and in autocracies. This is mainly due to non-competitive markets, high custom duties (lowering the degree of openness) etc in the less developed economies.

TI report has argued that in the absence of competitive markets, FDI may very well lead to increase in corruption as foreign firms bribe the officials to gain unfair foothold in the host economy. On the bright side, this gives less developed countries a promising starting point: strengthen their competition commissions, gradually lower the custom duties, and move away from protectionist policies.

Policy Implications: As it is not in the benefit for those in power to increase transparency and accountability, increasing demand to fight corruption has often led to a stand-off between governments and people. Under such conditions, FDI as an additional tool can play an important role in a gradual advancement of a country away from corruption. By this I do not mean to say that fighting corruption should be replaced with encouraging FDI rather this mechanism must be used to augment the fight against corruption.

First Published in Dawn (3rd September 2012)

http://dawn.com/2012/09/03/fight-against-corruption/