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

Solving the puzzle: The clue lies with Iqbal, not Jinnah!

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.’ However the subsequent social and political developments lead to a constitution which clearly intended to be based in the ‘Islamic ideals’ as understood by Iqbal and Jinnah but was at the same time inconsistent. No wonder, she says, the opposition leaders of the time ‘raised some legitimate criticisms’ on the then proposed constitutional framework so as to promote their notion of ‘modern democratic state’ – the term falsely attributed to Jinnah in Justice Munir’s book ‘From Jinnah to Zia’ (1979).

Why was it then that the intentions could not result in the necessary actions required to innovate a new socio-political and economic system of governance based on the ‘Islamic ideals’ for which Pakistan was created? Part of the answer is the early death of the ideological fathers of Pakistan thus leaving an intellectual gap which was not filled. But this does not do justice with the immense significance of the question and is only a way of avoiding it by pretending to having answered it.

Jinnah had abhorred the ‘modern democratic form of Government’ in his address to the Hostel Parliament of Ismail Yusuf College (dated 1^st Feb 1943) while demanding ‘a true democracy in accordance with Islam and not a Parliamentary Government of the Western or Congress type.’ Later in the same year, Jinnah said in his Presidential address at the Muslim League’s Annual Session (dated 24^th April 1943), “I have no doubt that a large body of us visualise Pakistan as a people’s government.… The constitution of Pakistan can only be framed by the millat and the people.”

The using of the words ‘large body of us’ makes it clear that ideology of Pakistan was well understood by the Leaguers’ and the notion of Jinnah’s death leaving behind an intellectual gap is overemphasised. The intellectual clarity of the ‘large body of us’ which Jinnah left behind can be depicted by their debates with the opposition during the first Constituent Assembly and unanimity on drafting of the constitution by the ‘people’s government’ in ‘accordance with Islam.’ This brings us back to the above question to which the answer, in fact, lies not with Jinnah but with Iqbal.

In one of the letter to Jinnah (dated 28^th May 1937), Iqbal wrote, “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 Iqbal’s death, all the energies of the League shifted towards manoeuvring the realities of the time so as to achieve their political objective. The 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.

While the Leaguers’ knew what they did not want for Pakistan – Secular Capitalistic Democracy of the West and Atheistic Socialist Communism of the East – they had not yet answered Iqbal’s crucial question. This is apparent from Jinnah’s address at the Opening Ceremony of State Bank of Pakistan. Jinnah categorically refuted the notion of adopting the ‘economic system of the west’ which ‘created insoluble problems for humanity’ and propagated for ‘evolving banking practices compatible with Islamic ideas of social and economic life’ and hence the term ‘Islamic socialism.’ However, nowhere in the Leaguers’ speeches does one find what these ‘practices’ or principles were except in broader terms of equality, freedom and socio-economic justice as embedded in Islam.

In fact, Jinnah had formed a Planning Committee in 1943 to chart out a five year plan for the socio-economic uplift of Pakistan. The Committee – consisting of economics, engineering and other professionals – held its first meeting in September 1944 and was advised by Jinnah in the following words: ‘Our ideals should not be capitalistic but Islamic.’ However, the Committee could not complete the second phase of its objective of focusing primarily on Pakistan specific areas due to the turn of events in the short span of time.

It is my understanding that the success of Pakistan lies in returning to completing the work initiated by Jinnah so as to find the answer to Iqbal’s question. However, it is highly unlikely to escape the shackles of both ‘capitalism’ and ‘socialism’ in our pursuit towards reaching our destiny without having understood the Islamic socio-economic view. And for this goal of applying ‘Islamic ideals’ to create our distinct socio-economic system promising justice and mutual wellbeing, the starting point is to study their first hand application by the very person who introduced such ‘Ideals.’

 

Note: Quotations used have been taken from Saleena Karim’s book ‘Secular Jinnah’ (2010).

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!