Macroeconomic stability - measures taken to restore higher and sustainable economic growth

Pakistan is now at a cross-road as slippages in fiscal discipline and unprecedented rise in oil and food prices have disrupted the hard gained macroeconomic stability. Both these factors resulted in doubling the fiscal and external current account deficits during the past 3-4 years.
Despite vibrant growth in the services sector, output contracted as the productive sectors' performance remained subdued due to political distractions and rise in the cost of doing business in coping with the escalation in prices of both inputs and utilities. To contain high inflationary pressures, monetary tightening was intensified in May 2008. Protracted political uncertainties compounded these complications, and delays in the real sector structural reforms impeded the ability of firms to launch capacity enhancement programs.
Restoring macroeconomic stability is a prerequisite for reverting to the above 7 percent economic growth - average growth rate realised during FY04 - FY07. Backed by a democratic government, an economic policy package has been launched to infuse a degree of economic discipline as we enter into fiscal year 2008-2009.
Leading the way to restore stability, State Bank of Pakistan (SBP) advanced its monetary policy (normally due at end-July every year) in wake of rising inflationary pressures in direct response to both the food price hike and growing recourse of the government to central bank financing. Despite the controversy generated by few segments of industry regarding the SBP policy rate rise, there is a wide acknowledgement in both international and domestic economic community that the hike in SBP policy rate coupled with the rise of 100 basis points in both the Cash Reserve and Statutory Reserve Requirements, were the first round of concrete policy measures that not only helped stabilise the short term economic challenges, but infused confidence in markets and public.
Besides this, SBP also introduced a minimum interest rate on PLS deposits to encourage banks for deposit mobilisation. This will help reduce growth in currency in circulation (now growing at about 17.7% and constituting 22.7% of the total liabilities). This in turn would allow banks to serve the private sector credit requirements as well as invest in government papers, thereby offloading at least a part of the stock of the government borrowings from the central bank.
Recognising that the monetary sector of the economy is intricately linked to the fiscal and external sectors, SBP included some additional steps in the monetary policy:
-- First, the central bank has worked over the years to raise the level and quality of the communication of monetary policy to help the government and public better understand the effects of fiscal and external sector developments on the monetary module, which ends up subsuming all the shocks. These translate into a rise in reserve money growth that in turn drives the broad money supply growth, manifesting the rising demand pressures in the economy which has adverse inflationary consequences.
-- Second, the central bank has now communicated both through interim monetary policy and other communications that the government needs to cease its reliance on the central bank. The government, however, has a twofold problem. On one hand, there is the excessively high stock of gross borrowings from SBP which has more than doubled during FY08: rising from Rs 452.1 billion at end-June FY07 to an astonishing Rs 1,028 billion by June 24, FY08.
On the other hand, there is a flow problem which refers to the incremental fresh borrowings for FY09. Encouraging sign, however, is that for the first time the budget recognises that borrowings from the central bank have reached an unacceptable level. Specifically, the Finance Minister has stated: "With more money and no new production, only prices are likely to increase, which is what is happening. We have to stop this process otherwise inflation will be running much higher than what it is at present."
-- Third, recognising the stress of central bank borrowing, the Government plans to diversify the sources of borrowing. To mobilise resources through the National Savings Scheme, the Government has raised returns on these instruments by 200 bps and will be revising these rates on a quarterly basis. The Government also plans to mobilise resources through new Islamic products and commercial paper.
-- Fourth, to ensure effective compliance with this policy stance, SBP has advocated that a policy position on Government's recourse to borrowings needs be adopted and legislated. SBP has recommended to the Government to include in the Fiscal Responsibility and Debt Limitation Act, 2005, provisions to bar Government's recourse to the central bank and, as a step in this direction, to impose limits on central bank borrowings.
In line with the best international practice, the central bank has underscored the need for fiscal and monetary co-ordination which involves ensuring that both the government and SBP agree on a mutually acceptable roadmap for lowering the stock of borrowings from the central bank (currently at 9.8% of GDP).
In general, governments do not borrow from central banks as this is inflationary. Even the governments that allow for reliance on central bank borrowing impose stringent limits to ensure that fiscal discipline prevails.
-- Fifth, the interim monetary policy included measures which recognise the demand pressures coming from the external current account deficit which has risen to 7.8% of GDP during Jul-May FY08 (relative to 5% of GDP in Jul-May FY07). Since export growth has risen by 15.9% in Jul-May FY08 - close to the last five years' average, and remittances by 18.2% during the same period, the external current account deficit has risen exclusively from the steep growth of 30.2% in imports. Almost 31% increase in imports is on account of oil (reflecting largely the international oil price impact), 11.2% from food imports, and remaining due to other imports.
With the growth in foreign inflows declining as the foreign portfolio inflows (net) fell by $1.7 billion and foreign direct investment lowered by $639 million of the FY07 level, the external current account deficit has resulted in the drawdown of reserves by $4 billion by June 27, 2008. Registering some fresh inflows in the last six weeks, in wake of the spillover of multilateral inflows to the next fiscal year, the end-year FX reserve level will be close to $11.20 billion.
Impact of macroeconomic distress of FY08 has filtered and permeated into the economy. Pakistan has to take steps to defuse the negative impact and consequences of last year's fiscal deterioration and slide. At the same time it has to position itself to deal with the rising global inflation which is likely to be stronger as international oil prices are likely to be steeper. These factors, combined with the weakening global economic scenario and rising inflationary expectations, have complicated Pakistan's medium term economic projections and outlook.
Recognising these concerns, the Government has proposed to bring down the fiscal deficit/GDP ratio to 4.7% of GDP for FY09. This involves a downward adjustment of 2.3% of GDP assuming that the FY08 outcome is close to 7% of GDP. While the fiscal adjustment is significant, deficit at 4.7% of GDP is high compared with the average fiscal deficit of the last five years.
Adherence to this fiscal deficit would require a strong political commitment, determination, and capacity to rigorously monitor the fiscal position and resist temptation to seek refuge in central bank financing. The fiscal projections are quite tenuous but have been prepared under difficult circumstances and have involved a delicate balancing act. On a positive note, the budget proposes:
-- Normal buoyancy of taxes and new tax measures to yield increase in tax/GDP ratio by 0.7% to 10.2%. While the additional tax measures would yield Rs 86.4 billion, the net revenue impact is low, about Rs 30.4 billion, after deducting the impact of a host of relief measures (ranging from income support for the poor to relief for government employees) that involve expenditures of around Rs 56 billion.
-- Stringency in recurrent spending as the budget assumes a decline in nominal terms in the current expenditures by 1.5% -- this has been achieved through reduction in subsidies from Rs 378 billion in FY08 to Rs 260 billion in FY09 which would be realised by scaling subsidies on POL products and energy.
-- A degree of realignment of development expenditures - though the level of investment envisaged is higher than a realistic resource envelope. The budget incorporates strategic emphasis on promoting productive sectors. In the agriculture sector, to enhance food production, the government has decided to review the support prices for agriculture products on timely basis, and withdraw tariffs on agricultural inputs.
Other measures include: allowing duty free import of agriculture implements, doubling subsidy on DAP to Rs 1,000/50kg bag that would offset the impact of rising DAP prices, exempting fertilisers and pesticides from general sales tax to boost demand for urea and DAP, abolishing 5 percent excise duty on crop insurance to encourage crop insurance scheme and help farmers to switch towards high cost edible oil crops. Withdrawal of 10% duty on import of rice seed is likely to enhance the use of better seeds and help improve rice yield.
For the industrial sector, measures have been taken to promote demand and reduce costs of production. For instance, the removal of GST on all fertilisers and increase in DAP subsidy is likely to increase the demand for fertilisers. The production capacity of the country in producing DAP has already been increased through BMR. This, coupled with increase in wheat support price is likely to spur fertiliser demand. Similarly, while the prospects of export demand for cement remain strong, a 6% higher Public Sector Development Program in FY09 will provide a boost to the domestic demand for cement.
To promote industrial sectors, tariffs on chemicals, pharmaceutical ingredients and packaging materials have been reduced from 10 to 5%. Similarly, duty cut on major inputs like caustic soda, PSF and buckram may lower the production cost of the textile sector. Duty on Polyester Staple Fiber (PSF) has also been reduced from 6.5 to 4.5%. The Textile industry, especially the fabrics and garments sectors, is expected to benefit from this relief.
In the consumer durable industry, measures have been taken to protect the local industry from imports. Increase in import duty on CBU of major electronics items is likely to have a positive impact on local electronics assemblers. Furthermore, the import duty on CKD automobiles has been reduced to 32.5% and duty on CBU imports increased by 10%. The impact of the latter, however, on auto production will be partly offset by increase in car prices following the imposition of Federal Excise Duty on car sales.
Realising the build-up of inflationary pressures, the Government has announced a few budgetary measures for the social uplift of the country, even with the limited fiscal space. The government is committed to adhere to the poverty reduction strategy of the Fiscal Responsibility and Debt Limitation Act (2005) by allocating higher than the minimum level of 4.5% of GDP for poverty reduction, PSDP budget allocation for earthquake program of Rs 27 billion, for Income Support Fund (Rs 34 billion) and People Work Programs (Rs 28 billion). For the poorest segment of society, Rs 4.7 billion has been allocated for Social Protection Fund depicting an increase of 27% as compared to last year's budget allocation.
Economic stability now requires the government to launch an aggressive domestic resource mobilisation effort directed at raising the investment/GDP ratio. It is now incremental productive capacity, along with the swift facilitation of investment through institutional and governance reforms and resolution of sector inefficiencies, which will be the key driver of growth.
Thus far, the financial system has helped stimulate real sector growth, but ability of the banking system to finance the real sector now depends on its absorptive capacity which will have to be nurtured by both an effective incentive regime, as well as proper and ethical policy, legal and regulatory environment.
A DYNAMIC LEADER:
Dr Shamshad Akhtar took over as Governor, State Bank of Pakistan on 2nd January, 2006 for a three-year term. Dr Akhtar, who is the first woman and the 14th Governor of the State Bank since its inception in July, 1948 brings rich experience, both national and international, to her new assignment.
Prior to her appointment as SBP Governor, Dr Akhtar has been serving the Asian Development Bank (ADB) as its Director General, Southeast Asia Department since January, 2004. Earlier, she was Deputy Director General of the Department. She also held the position of Director, Governance, Finance and Trade Division for East and Central Asia Department of ADB.
Dr Akhtar began her career in ADB in 1990 and rose to the position of Manager in 1998 after serving as Senior and Principal Financial Sector Specialist. She has been ADB's Co-ordinator for Apec Finance Ministers Group from 1998-2001 and has served on a number of ADB committees including the Reorganisation Committee, Appeals Committee and Oversight Committee etc.
She has interfaced and represented the Asian Development Bank at the Bank for International Settlements and the International Organisation of Securities Commissions (IOSCO). She has developed a broad regional expertise in financial and economic matters of Central Asian Republics & Southeast Asia including the People's Republic of China.
Before joining the ADB, Dr Akhtar worked for 10 years as an Economist in the World Bank's Resident Mission in Pakistan. In Pakistan, she also worked briefly with the Planning Offices of both the Federal and Sindh Governments. She dealt with wide ranging subjects which covered analysis of macroeconomic situation, finance and money and structural reforms of key sectors including industry and agriculture. Her work included papers on taxation system of Pakistan, state of inter-governmental fiscal relations, poverty incidence & its dimensions and foreign direct investment etc.
Dr Akhtar also contributed to the development of diversification of financial markets including the analysis of monetary policy and state of banking industry (at the World Bank) and restructuring of the Securities & Exchange Commission, Insurance Commission and worked closely with the private sector including the stock exchanges of Pakistan.
She has been advising the central banks on reforms of financial markets. Dr Akhtar has also been dealing with the banking sector's legal, regulatory and institutional reforms while advising on diversification of the industry to exploit long term funding through development of bond market.
Born in Hyderabad, Dr Akhtar had her earlier education at Karachi and Islamabad. She has had an excellent academic record. She graduated from the University of Punjab with a B. A. Economics degree in 1974. Dr Shamshad Akhtar has an M.Sc. in Economics from the Quaid-e-Azam University, Islamabad, an M.A. in Development Economics from the University of Sussex in 1977 and a Ph.D. in Economics from the UK's Paisley College of Technology in 1980. She is a post-doctoral fellowship Fulbright Scholar and was a visiting fellow at the Department of Economics, Harvard University in 1987.
Dr Akhtar has presented numerous papers on economics and finance at international conferences/seminars/symposia. Her research interests are on Monetary and Fiscal Policy, Banking and Capital Market, International Finance Architecture, Regulation and Supervision, and Industrial & Corporate Restructuring.