A risky Budget - I

MACROECONOMIC BACKDROP TO THE BUDGET: The Federal Budget of 2008-09 comes at a time when macroeconomic conditions have substantially deteriorated with the inflation rate at an all-time peak and people's expectations are high about relief from the newly elected coalition government.
The question is, how grave is the current macroeconomic situation? Pakistan is, in fact, facing serious economic challenges in terms of high inflation, unsustainable fiscal and current account deficits and a declining growth rate.
The revised estimate of fiscal deficit for 2007-08 is 7 percent of GDP as revealed by the Ministry of Finance in the budget documents, in relation to the target deficit of 4 percent of GDP. The higher deficit has been financed largely by borrowing from SBP which has put pressure on monetary policy, resulting in higher growth in monetary aggregates.
This monetary expansion together with higher international oil and food prices has already translated into high double-digit inflation. Moreover, the projected estimate of current account deficit for 2007-08 has crossed 8 percent of GDP, soaking up foreign savings and resulting in depletion of foreign exchange reserves and increase in foreign debt.
These deficits and the alarming level of inflation have affected the pace of economic growth. GDP growth is 5.8 percent in 2007-08, below the year's target and less than last year.
It appears that our present economic predicament is due to a combination of domestic and external factors, of a short and long term nature. The GDP growth rate tapered- off following the peak of 9 percent attained in 2004-05. Both agriculture and manufacturing have demonstrated a gradual decline in the growth rate since that year.
Inflation has been threatening the economy since 2004-05. Cumulative inflation from 2004-05 to 2006-07 has been 27 percent in the overall CPI and 33 percent in food prices. In recent months the inflation rate has spiralled, with the overall rate of inflation rising to 19 percent and in food prices to 29 percent on a year-to-year basis.
On the fiscal side, the government did a good job of fiscal stabilisation up to 2003-04. Thereafter, the deficit started increasing as public expenditure built up once again with rising PSDP and higher non-interest current expenditure. Revenues did not respond with corresponding buoyancy, and remained stagnant at around 10-11 percent of the GDP. By 2006-07, revenue and primary deficits had emerged, indicating that the government was borrowing to sustain its day-to-day operations.
As far as the balance of payments is concerned, we witness a transformation from surpluses on the current account between 2001-02 to 2003-04 to a deficit of over 8 percent of GDP in the out-going fiscal year. Strong growth in aggregate demand, liberalisation of imports due to falling tariffs, declining interest rates and emergence of consumer financing increased demand for imported consumer durables, and private investment (mostly with imported machinery) resulted in an unprecedented growth in imports.
Non-oil, non- food imports increased by over 30 per cent in 2004-05 and 2005-06 respectively. To finance these rising imports, exports responded up to 2005-06. Thereafter, exports began to falter. The result is pressure both on the foreign exchange reserves, which have declined by US $6.3 billion in the last 7 months, and the exchange rate, which has depreciated by 6.4 per cent in 2007-08 upto the end of April.
THE FISCAL OUTCOME IN 2007-08: The year started with a budgeted deficit of Rs 398.8 billion, which was projected at 4 per cent of the GDP. The budgeted net revenue receipts of the federal government were 902 billion while the current expenditure projection was Rs 993 billion.
Three-quarters into the fiscal year, the then Finance Minister, Mr Ishaq Dar, informed the nation that current expenditure was likely to exceed the budgeted target by as much as Rs 521 billion, thereby enhancing the budget deficit to Rs 956 billion, equivalent to 9.5 percent of the GDP.
As compared to this, the deficit for 2007-08 revealed in the budget documents is Rs 734 billion, or 7 per cent of GDP. How was such a large adjustment of 2.5 per cent of GDP achieved in only three months, during the last quarter of the fiscal year? It appears that there was a Rs 51 billion additional inflow of non-tax receipts due to higher profits of SBP and larger defence receipts. Also, the PSDP has been cut back by Rs 50 billion or so.
In addition, a decline of Rs 100 billion approximately is reported in current expenditure in relation to the estimate made in early April 2008, by excluding the additional defence expenditure of 75 billion incurred on military operations in the North and a lower outlay on research and development support to the textile sector by Rs 24 billion. Clearly, either the expenditure estimates of April were overstated or the more recent estimates in the budget documents understate the expenditure in 2007-08.
Despite the above adjustments made in the last three months, the fiscal outcome for 2007-08 indicates a high and unsustainable fiscal deficit of 7 percent of the GDP. The jump of 3 percent of GDP in relation to the target for 2007-08 is due to massive overruns in current expenditure, especially on subsidies and interest payments.
FISCAL POLICY OBJECTIVES IN THE BUDGET Given the macroeconomic backdrop and the burgeoning fiscal deficit, the fiscal policy objectives in the 2008-09 budget are as follows:
1) MACROECONOMIC STABILIZATION: The fiscal deficit has to be brought down from the current high level in line with the requirements of the Fiscal Responsibility Act and to preserve the sustainability of the debt burden. The containment of aggregate demand through contractionary fiscal policy should also have a favourable impact on the external balance of payments.
2) CONTAIN INFLATION: Fiscal policy has to reinforce the recent monetary measures introduced by the State Bank of Pakistan. In a precipitate set of actions, it has moved to tighten monetary policy. This represents a reversal of the growth-oriented monetary policy over the last five years, whereby money supply continued to expand rapidly, increasing by as much as 19 percent in 2006-07. To curb inflation and contain aggregate demand, SBP has opted to raise interest rates sharply in the economy.
Whether this will contain aggregate demand hinges crucially on the nature of fiscal policy measures in the federal budget of 2008-09. If the fiscal deficit is brought down sharply and less reliance placed on borrowing from the Central Bank then monetary and fiscal policies could reinforce each other not only in restoring confidence but also in containing inflation.
3) SUSTAIN MEDIUM-TERM GROWTH: The contractionary monetary and fiscal policies required for stabilisation can temporarily at least imply some loss of growth. The process of adjustment, should, to the extent feasible, rely on measures that do not suffocate growth due, for example, to sharp increases in tax rates or a precipitous fall in the level of development expenditure. Also, the fiscal deficit has to be financed in a way that does not significantly 'crowd-out' the private sector.
4) ACHIEVE REDISTRIBUTION: Recent research on poverty consequences of the current economic situation shows that whatever gains in poverty reduction were achieved in the earlier part of the decade have largely been washed out. The evidence shows that after a decline in poverty during the period, 2000-01 to 2005-06, the poverty levels have increased to neutralise the earlier gains, as food inflation accelerated and GDP growth declined. The central policy lesson of the economic performance during the last eight years is that poverty levels increased in spite of high GDP growth in later years because of the fact that growth was heavily tilted in favour of the rich and high food inflation was not controlled. The analysis highlights the importance of controlling food inflation and at the same time bringing about the institutional changes necessary for pro-poor growth.
As the process of adjustment continues, vulnerable groups are likely to be further burdened. Therefore along with achieving stabilisation, the budget for 2008-09 will also have to focus on a package of relief for the poor. There is need to ensure that the aggregate demand management of the economy and the withdrawal of subsidies does not lead to a sharp rise in poverty. Strong social safety nets will have to be put in place to ensure that there is adjustment with a human face.
In particular, food security of the poor will have to be protected to avoid a big fall in nutrition levels. This can best be achieved by a combination of various types of social safety nets so that different categories of vulnerable groups are adequately targeted. Currently, Pakistan is spending only about 0.1 percent of GDP on various social safety net programs. There clearly is a strong case for increasing this proportion manifold.
THE FISCAL OUTLOOK FOR 2008-09: Turning to the budget of 2008-09, the sharp reduction in the fiscal deficit to 4.7 percent of GDP is predicated on a reduction in current expenditure of 4 percent and a big jump in net revenue receipts of 18 percent. Consequently, even with the large deficit reduction, there appears to be scope for increasing the overall PSDP of the federal and provincial governments combined by almost 20 percent.
One of the major failures of the Budget is the lack of quantification and setting of targets for savings in non-salary expenditure of ministries, divisions and departments. This is a major area where economy could be exercised especially in light of the extravagance and waste that has characterised public spending during the last five years when significant 'fiscal space' emerged in the Budget.
The Finance Minister has indicated that the government proposes to ban the purchase of motorcars, air conditioners and other office equipment. Also, freezing of non-development, non-salary expenditure will take place at the 2007-08 level. It is indeed unfortunate that the Finance Minister had to indicate that this policy could not be reflected in the preparation of the Pink Book (relating to the demand for grants and appropriations).
As presented currently, no government entity has followed the example set by the Prime Minister of taking a cut of 40 percent in the costs of his Secretariat. The government must try to achieve a minimum saving of Rs 50 billion in non-salary expenditure in 2008-09 from the estimates currently presented in the budget if a true commitment to 'austerity' is to be demonstrated to the people.
Beyond this, we believe that the budget estimates from 2008-09 include same overstatement of revenues and a substantial understatement of expenditure, as follows:
TAX REVENUES: Budget estimates show a high growth rate of 25 percent. This does not include normally the impact of taxation proposals. However, the tax-to-GDP ratio has largely remained constant during the last few years. Therefore, the normal growth in tax revenues would be about 17.5 percent in line with the expected growth of nominal GDP next year. We attribute the higher growth to the additional revenue likely to be generated from the taxation measures announced by the Finance Minister.
INTEREST PAYMENTS: Interest payments are expected to increase from Rs 502 billion to Rs 523 billion, showing a modest growth of only 4 percent. As in the last two years, there is the likelihood of a significant understatement of this expenditure, especially since domestic debt is likely to increase by over 20 percent this year in view of the large fiscal deficit. Also, interest rates are on the rise and the return on national savings schemes has been enhanced. The hump of maturity of Defence Savings Certificates continues next year. Overall, we estimate that interest payments in 2007-08 may be underestimated by least Rs 60 billion in 2008-09.
SALARY INCREASE: The Finance Minister has announced the following increases in pay and allowances of government employees:
a) A 20 percent increase in basic pay is proposed to all Federal Government employees with a similar increase also for defence services.
b) A 20 percent increase in net pension is proposed for all civilian and defence pensioners.
c) Minimum pension increased from Rs 300 to Rs 2000/-.
d) 100 percent increase in conveyance allowance, for government employees from BS-1 to BS-19.
e) Medical allowance for BS-1 to BS-16 increased from Rs 425/- to Rs 500/- per month.
f) Increase in minimum wages level from Rs 4600/- to Rs 6000 per month.
The impact of these increases in pay and allowances has not been incorporated in the current expenditure estimates for 2008-09. Based on the figures contained in the Demand for Grants and Appropriations we estimate that the pension and salary hike will add about Rs 15 billion to defence expenditure and Rs 20 billion on the civilian side at the federal level. The additional cost to the four provincial governments could approach Rs 30 billion, thereby reducing the provincial surplus accordingly.
PSDP: The combined PSDP of the four provincial governments has been projected at Rs 150 billion. But the provincial governments of Punjab, Sindh and NWFP have already announced PSDPs of Rs 160 billion, Rs 77 billion and Rs 41 billion respectively. Therefore, the combined PSDP of the four provinces could exceed Rs 290 billion, which is Rs 140 billion more than the size mentioned in the budget documents.
SUBSIDIES: The budget proposes a significant reduction in the subsidy bill from Rs 407 billion in 2007-08 to Rs 302 billion in 2008-09. There are limits to the extent to which the subsidy, especially on oil and wheat, can be reduced in the short run. As such, we project that the cost of subsidies could be almost Rs 100 billion higher and approach the level attained in 2007-08. Also, if the R&D support to the textile sector is restored then this would involve an additional outlay of up to Rs 45 billion.
Overall, we believe that the level of expenditure, current and development, could exceed the budget estimates for 2008-09 by almost Rs 360 billion. This implies that the fiscal deficit in 2008-09 could rise substantially beyond the projected level of 4.7 percent of the GDP to almost 7.5 percent of the GDP. In this scenario, there will be no fiscal adjustment and the fiscal deficit will remain very high. Of course, in this case, efforts will be made to scale down the PSDP to the budgeted size.
(The authors are Vice Chairman and Director of Research of the Institute of Public Policy, Beaconhouse National University, Lahore)
(To be concluded)