Pakistan’s Economy: Sinking or swimming along the Indus?

Islamabad has received considerable economic assistance for its role in the 'anti-terror' frontline, but the debt trap is deep and production is in the doldrums. Temporary external gains can only buy time for structural change.

In the last five months, Pakistan's economy has been portrayed in the international media as a star performer among the world's emerging economies. Propped up by debt relief and enhanced foreign aid flows in return for its role as a frontline state in America's war in Afghanistan, Islamabad's financial performance has shot to the forefront of South Asia's economic achievements since 11 September. Moody's Investors Service has upgraded Pakistan's credit rating and foreign investors have come back to Pakistani shores. Beneath the surface, however, the country's endemic economic troubles continue to run deep. Agricultural output is faltering on account of a persistent water crisis, industrial growth remains negligible, and domestic investors keep away, wary of political uncertainties and inconsistency in government policy.

The pluses

Still, it cannot be ignored that the economy has returned from the brink of bankruptcy and possible default on sovereign debt to a position of stability and liquidity. Indeed, in the last three months, the Karachi Stock Exchange benchmark index of 100 shares has climbed almost 30 percent to a two-year high on the back of both local and foreign demand. As cash has begun to flow into the real estate market, property prices have shot up. And foreign investors — both direct and portfolio — who have long shunned a country plagued with political strife, law and order problems and bureaucratic hurdles, have taken renewed interest in Pakistan. Foreign portfolio investors have poured USD 20 million into the Karachi stock market in the last two months, compared to a net outflow of foreign funds last year. And foreign direct investment between July and December 2001 amounted to USD 205 million, 39 percent higher than in the corresponding period the previous year.

Pakistan's first big break came post-11 September, when President General Pervez Musharraf negotiated with Washington a lifting of the economic sanctions imposed after the May 1998 nuclear tests. This led to an agreement with the Paris Club for the restructuring of USD 12.5 billion of external debt. In turn, this led to the resumption of a USD 596 million standby arrangement with the International Monetary Fund (IMF) which, after being completed in December, and to a long-term USD 1.3 billion poverty reduction and growth facility loan.

The debt rescheduling amounts to savings of USD 1.1 billion this year, USD 0.9 billion next year and USD 0.8 billion in 2004, however, although this relief is welcome, two-thirds of the debt rescheduled under the agreement relate to concessional loans and not to the more expensive and burdensome commercial credits on which payments will still need to be made. More importantly, the move to reschedule a portion of external debt should not be seen as anything more than a first step towards a long-haul extrication from a deep debt trap. Pakistan's stock of public debt as a percentage of revenues is over 600 percent and annual debt service payments on external debt amount to USD 6-7 billion a year, consuming more than two-thirds of export earnings.

The second big stride for the Pakistan economy has been the appreciation in the value of the rupee, which in the open currency market has climbed to Rs 60 to the dollar currently as against Rs 67 last summer. In fact, had the central bank not been intervening in the market to prop up the dollar for the benefit of exporters, the rupee is likely to have risen to Rs 55. Meanwhile, the US crackdown on the hundi system of money transfer, part of Washington's strategy to curb terrorist activity, has led to a surge in remittances coming into Pakistan through banking channels. In the first eight months of the current fiscal year, workers remittances have crossed the USD 1.3 billion, more than 100 percent higher than in the previous year. And this figure is expected to continue rising as portions of the estimated USD 10 billion that come through unofficial channels are routed through above-ground banking channels instead. This inflow has, for the first time, given Pakistan the cushion of more than USD 5 billion in foreign exchange reserves.

On the import front too, the country has gained from lower international oil prices, which have kept a cap on the oil import bill and allowed the economy to record a historic balance of payments surplus of USD 1.2 billion in the first six months of the current fiscal year. Indeed, low international oil prices have also helped keep year-on-year inflation under 3 percent, according to figures from the State Bank of Pakistan, the central bank.

The minuses

But even on the external account, it has not been all good news. Cancelled export orders after 11 September, particularly in the textile sector, the global recession and the threat of war with India are expected to cumulatively cost Pakistan about USD 100 million a month. This means the country's export target for the year, of USD 10 billion, will be missed by at least USD 1 billion.

The trouble is that improvements on the external front and the resumption of aid flows are far from enough to spur growth in the real economy which is the key to generating income to pay down debt. Perhaps one of the weakest areas of government remains revenue collection. In a country where just 1.2 million people pay taxes out of a population of 140 million, restructuring the Central Board of Revenue (CBR), the country's central tax collecting body, should have been among the government's top priorities. But the CBR remains corrupt, inefficient and ineffective. Although the government has managed to meet IMF conditions and impose a general sales tax on retail trade, it is not expected to yield much.

The government will miss its tax collection target of 430 billion rupees, a target that was set after two downward revisions on the plea of lower customs duty collection because of sagging imports. Not just that, but total tax collection will come in below last year's levels, and the government will then once more be squeezed by its inability to meet IMF conditions. Revenues have also not been forthcoming through the privatisation of state assets. The government was unable to meet its target of raising USD 1 billion last year through privatisation because unstable conditions kept foreign investors away. This year, Islamabad may succeed in selling off 26 percent of the state owned telecom monopoly Pakistan Telecommuncations Company, and the United Bank, but it is unlikely to meet the ambitious goal of living off Habib Bank and the debt-ridden Karachi Electric Supply Corporation, among others.

Meanwhile, mounting defense expenditure, in particular the massive cost of deploying forces along the border with India, is still not accounted for and is likely to lead to a larger-than-expected fiscal deficit.

Even more troubling, perhaps, has been the economy's slack response to favourable external conditions. A water shortage of crisis proportions throughout the country has meant that the increase in agriculture output will not be higher than 2.5 percent for the fiscal year. Cotton and wheat may perform along lines seen last year but will still miss government targets, while sugar may fare slightly better. Rice production, on the other hand, will be disappointing.

Large-scale manufacturing has languished. This sector grew by an impressive 6.7 percent last year but is unlikely to top 3 percent by the close of this year in June with major industries – textiles, food, beverages and tobacco leading the declining trend. Textile exports – which account for abut 60 percent of Pakistan's total exports – have declined 3 percent from last year's levels and continue to remain weak with cancelled export orders leading to factory shutdowns and layoffs in the industry. This will not improve substantially in the rest of 2002, since world growth will remain contained at 2.5 percent and declining growth in Pakistan's main markets, the US, Germany and the UK, will keep demand low. Indications are that there has been no noticeable pickup in demand, and performance may deteriorate further by the end of the fiscal year since the textile industry has largely retreated into the shadows, wary and unwilling to make fresh investments. This is especially troublesome because the industry is in desperate need of new inputs of modern machinery in order to compete with India, Sri Lanka, China and Thailand when textile quotas are phased out under World Trade Organisation rules in 2005.

Domestic investment remains virtually nonexistent despite external improvements and is likely to suppress growth through the end of the calendar year. Credit demand in the first half of the fiscal year was 50 percent lower than last year, strongly indicating investor reluctance. Indeed, it seems investors will wait until general elections, scheduled for October 2002, are over and a smooth transition has hopefully been achieved. Only then will they take the plunge. And that means the real economy will remain sluggish until the early days of 2003 at best.

The central bank has taken advantage of the strong currency and brought interest rates down significantly in the last six months in a bid to support the real economy. But despite a reduction in the discount rate from 12 percent to 9 percent, banks have so far been shy to follow through with reductions in lending rates which have dipped only slightly and currently hover around the 14 percent mark. With government national savings schemes offering deposit rates as high as 14 percent, banks are unable to compete with the government for customer deposits. Moreover, despite significant progress in reform of the banking sector, non-performing loans amounting to Rs 308 billion continue to be a substantial drag on the national economy.

Pakistan will close the fiscal year with a GDP growth rate of no higher than 3 percent. But a troubled textile sector and further export declines will exert significant pressure on growth. And unless Islamabad aggressively focuses on restructuring the CBR and improving tax collection and emphasises sectoral reform, it will be difficult to truly separate temporary external gains from actual structural improvements in the economy.