Growth rate has increased but...

The economy has shown sharply divergent symptoms and indicators in 2017-18. According to the estimates by the Pakistan Bureau of Statistics, the GDP growth rate has been rising consistently since 2012-13 reaching a peak of 5.8% by 2017-18. This is the highest growth rate since 2005-06 in an environment of low inflation. However, an attempt is made below to check the validity of the growth and inflation estimates.
As opposed to these claims, the underlying official economic data reflects contrasting signs. The 'twin' deficits have been steadily worsening since 2015-16. From a low of 5% of the GDP, after excluding one-off receipts, in 2015-16, the fiscal deficit is likely to reach 6% of the GDP or more in 2017-18. Similarly, the current account deficit, which was only 1.7% of the GDP in 2015-16, is soaring, and likely to exceed 5% of the GDP, leading to a substantial drawing down of the foreign exchange reserves of the country.
What explains the simultaneous presence of both positive and negative trends in the economy? Part of explanation lies in the strong expansionary fiscal and monetary policies that fueled the growth process feeding the sharp jump in import demand leading to a larger trade and current account deficit, without a concomitant increase in export earnings to finance the enhanced import bill. It is only recently that a much needed improvement is being witnessed in exports after a major fall since 2013-14.
The objective of this state of the economy review is to make an assessment primarily of how long the growth process can be sustained in the presence of the large deficits. Answering this question is especially important in the context of the Annual Plan for 2018-19 which aims to raise the GDP growth rate further to 6.2%.
The first part of the review describes the principal features of the economic growth in 2017-18. Since elections are forthcoming shortly and the rate of growth is a prime indicator of performance of the incumbent Government, there is need to assess if the PBS has biased it upwards or not. There is evidence that this was the case in the last two years.
The second section focuses on the level of investment in 2017-18, the third reviews the trend in employment and the fourth analyses the causes of the exceptionally low rate of inflation this year. The next two sections project the magnitude of the fiscal and current account deficits by end-June 2018. The last section analyses the relationship between stabilization and growth and identifies the contours of the appropriate strategy in the medium run.
1. GROWTH The economy apparently has come very close to achieving the ambitious growth target in the Annual Plan of 2017-18 of 6%. The divergence is only 0.2 percentage points. All sectors seem to have exhibited relatively fast growth. Agriculture achieved a growth rate of 3.8%, the highest since 2005-06. Industry experienced a growth of 5.8%. This was the highest rate since 2007-08. The services sector also exhibited exceptional dynamism with a growth rate of 6.4% and contributed over 67% of the increase in GDP in 2017-18.
The major crop sector has apparently shown a high growth rate of 3.6%. This is not substantiated by the derivation of the weighted growth rate of individual crops. Further a high growth is unlikely with a fall in fertilizer off-take in nutrient tons in 2017-18 of 4% and a big decline in water availability in the Rabi season.
Turning to the nearly 4% growth rate in the livestock sector it is in sharp contrast to the declining or unchanged trend in per capita consumption of major livestock products like milk, meat and beef. These products account for 60% of the value of output in the sector.
The growth in large-scale manufacturing at over 6% has apparently been achieved in a situation where electricity consumption in the sector has actually fallen by 2%, according to the information in the Pakistan Economic Survey on energy. To say the least, this is extremely unlikely.
Further, the top 10 industries in terms of value added have a combined growth rate of 4%. These industries account for almost two-thirds of value added in the sector. It is beyond the realm of possibility that the relatively small industries could show a combined growth rate of over 10%.
There is also likelihood that the growth rate of large-scale manufacturing will be lower in the last quarter of 2017-18. This will be due to the on-going heavy load shedding in Karachi. Over 30% of industry is located in this city.
A high growth rate is shown in the construction sector of over 9 %. This is probably based on the double-digit growth rate in industries producing construction inputs like cement. However, construction activity linked to the execution of development projects has slowed down with a decline in the real PSDP expenditure of over 5% in 2017-18, according to the budget documents. Further, real investment in housing has increased by only 4% in 2017-18.
The high growth rate of 7.5% in the wholesale and retail trade sector will need to be adjusted downwards in line with the lower growth rates in the commodity-producing sectors. The finance and insurance sector is shown as recording a growth rate of over 6% in 2016-17. In the presence of very low interest rates, the SBP estimates that nominal profits of commercial banks collectively have witnessed a downturn. This implies that the value added in the sector is unlikely to have been augmented significantly.
The last two other sectors where the growth appears to be exaggerated are Government services and private services respectively. In the latter case, the budget documents enable a computation of the public expenditure growth rate, which is somewhat lower than that reported by the PBS. Finally, private services are unlikely to be buoyant with a combined growth rate of over 6% in a situation where employment in the sector has been growing in recent years by less than 1%, as reported by the Labor Force Surveys.
Overall, our estimates of the growth rates are 2.8% in agriculture, 4.9% in industry and 5.6% in services. This leads to an estimate of the overall GDP growth rate in 2017-18 of 4.9%, which is significantly lower than the PBS estimate of 5.8%. A similar discrepancy was revealed by us in 2016-17. The estimate of the GDP growth rate by the PBS for the year was 5.4%, whereas our estimate was 4.4%.
The conclusion is that the growth rate has no doubt increased annually since 2012-13, but not as fast as indicated by the PBS. We look forward to an interaction with the PBS to discuss the divergence in the growth estimates.
2. INVESTMENT All indications were there that there would be an upsurge in investment, both private and public, in 2017-18. Interest rates are exceptionally low along with the availability of ample credit. There has been apparent removal of the electricity supply constraint along with a greatly improved security environment and CPEC on-going projects.
Unfortunately, the resulting level of investment is unlikely to be as high as anticipated. The Annual Plan had set a target for gross domestic capital formation at 15.6% of the GDP in 2017-18. According to the PBS, the actual level will be 14.8% of the GDP. Private investment is estimated at 9.8% of the GDP as compared to 10% of the GDP in 2016-17. It has fallen annually from the level of 10.4% of the GDP attained in 2014-15.
However, public investment has apparently shown some recovery. It is likely to reach 5% of the GDP this year. From 2013-14 to 2015-16 it remained significantly constrained during the tenure of the IMF Program at below 4% of the GDP.
The disappointing response of the private sector needs to be understood in the presence of very favorable conditions. Machinery import has actually fallen by 3% in the first nine months and there has been little or no growth in credit off-take by the private sector.
An analysis of the sectoral distribution of private sector investment reveals that four sectors, viz., agriculture, large-scale manufacturing, transport and communications and housing, account for bulk of the investment with share of 26%, 13%, 17% and 23% respectively.
Private investment in real terms in industry has actually fallen by 2%. This may be a reflection of the presence of excess capacity in industry, especially in textiles, following the downturn in exports. It has also declined in transport and communications. The latter sub-sector experienced major expansion in earlier years but has reached a mature stage of development. However, it is heartening to note that investment in agriculture has grown in excess of 5%.
Turning to public investment, PBS estimates a big jump of 17% in 2017-18. Much of the upsurge is in government investment from budgetary sources of as much as 21%. Unfortunately, the budgetary documents belie this estimate. According to the latest MOF publication, Budget in Brief, development spending from the PSDP of the Federal and Provincial Governments has fallen in nominal terms by 2%, implying a decline in real terms of almost 6%.
As such, the level of public investment in 2017-18 has been overstated by 0.9% of the GDP. Overall, it appears that the overall level of fixed investment is actually close to 13.9% of the GDP as compared to the PBS estimate of 14.8% for 2017-18. The revised estimate indicates that there has been a fall in the rate of fixed capital formation by 0.6% of the GDP from the level attained in 2016-17. Clearly, the process of faster growth has not been investment-led. This raises doubts about the ability of the economy to remain on a higher growth path.
3. EMPLOYMENT The Pakistan Economic Survey for 2017-18 gives information on the labor force and employment only upto 2014-15. A more recent source of data up to 2015-16 is the Household Integrated Economic Survey (HIES) by PBS. The labor force of Pakistan is expanding at a relatively fast rate of 3% in presence of the 'youth bulge'. It is estimated at almost 67 million in 2017-18.
The unemployment rate that emerges from the HIES of 2015-16 is almost 9 percent. It is significantly higher than the estimate of 6% from the Labor Force Survey of 2014-15 by the PBS. In 2011-12, the unemployment rate was somewhat lower at 8.5%.
The level of unemployment is especially high in urban areas and among female or highly educated workers. For example, workers with a degree or postgraduate qualification currently face an unemployment rate of almost 20%.
4. INFLATION One of the most positive elements of the economic picture is the low rate inflation since 2014-15. The rate of increase in the Consumer Price Index is only 3.8% in the first nine months of 2017-18. It is even lower in the case of the food prices at 2%. This has cushioned low income families from falling below the poverty line. However, the 'core' rate is close to 5.5%.
There is a tendency here also for the PBS to somewhat bias the estimate of the rate of inflation downwards. In particular, the housing rent price index is reported to have increased by 6% while the HIES estimates it at 11%. As such, the rate of inflation in the CPI is close to 5%.
Two factors have contributed to the relatively less pressure on prices. First, since June 2014 international commodity prices, especially of oil, have fallen cumulatively by 38%. Second, the policy of deliberately maintaining the nominal value of the exchange rate has limited the rate of inflation. However, the recent depreciation of the rupee and the upsurge in oil prices do not auger well for inflation in coming months.
We turn now to the trend in the magnitude of the two deficits.
5. PUBLIC FINANCES The MOF skillfully targeted for a big reduction in the fiscal deficit of 5.8% of the GDP in 2016-17 to 4.1% of the GDP in 2017-18. This was achieved by making bloated revenue and understated expenditure projections. Revenues were shown as growing by as much as 17% while the level of current expenditure was actually projected to show a decrease of 1%.
The Finance Minister has indicated that there have been significant slippages in relation to the targets and that the fiscal deficit will be 5.5% of the GDP in 2017-18. Actually, the budget documents reveal that it will be closer to 5.8% of the GDP. This is the same level of deficit as last year. As such, there has been no fiscal consolidation.
Further, there is the likelihood that the deficit could have been larger. The Provinces are unlikely to generate a significant cash surplus. This will raise the deficit estimated by the MOF by almost 0.8% of the GDP. FBR revenues are expected to fall short by an additional Rs 75 billion, equivalent to 0.2% of the GDP. Therefore, despite a big cut in the federal PSDP of Rs 251 billion and of Rs 312 billion in the combined Provincial PSDP, the consolidated fiscal deficit is likely to approach 6.8% of the GDP in 2017-18. This is even higher than the fiscal deficit in the last year, 2012-13, of the PPP Government of 6.6% of the GDP, excluding the retirement of the circular debt in the power sector.
6. BALANCE OF PAYMENTS The outcome of the balance of payments in 2017-18 is of critical importance. Reserves are being depleted at a rapid rate and by end-March 2018 had come down to below $11 billion, not even enough to provide import cover of two months. In fact, if the 'swap' funds with the SBP are excluded the reserves fall to only $4 billion.
The Annual Plan projects the current account deficit at $13.7 billion in 2017-18. Already, by March 2018, the deficit had reached $12 billion, representing a growth of 50% over the level in the corresponding period of 2016-17. In the last quarter of 2016-17 the deficit was $4.6 billion. As such, even if the deficit in the on-going quarter of 2017-18 remains the same as last year, the annual current account deficit will approach $16.6 billion in 2017-18, equivalent to 5.2% of the GDP. This is $2.9 billion higher than the official projection in the Annual Plan.
The difference is due primarily to underestimation of the projected level of imports in 2017-18. The Annual Plan implies that these will be close to $52 billion. By end-March imports had already touched $40.6 billion. With little or no growth over the last year's imports in the fourth quarter, they could come close to $55 billion in 2017-18.
How will the current deficit be financed in the last quarter? The estimate is that the net inflow of external borrowing will be $2 billion. Non-debt creating inflows, including FDI, will be less than $1 billion. Therefore, there could be further bleeding of reserves, which could fall to about $9.5 billion by end-June 2018. The Finance Minister has however, assured that reserves will be unchanged at the present level of close to $11 billion at the end of the financial year. We pray for his success.
7. STABILIZATION VERSUS GROWTH We take up the crucial issue of the appropriate policy stance in 2018-19. Should expansionary fiscal and monetary policies be continued to provide stimulus for achievement of a GDP growth rate above 6% or should restraint be exercised to enable a major reduction in the deficits, especially in the current account deficit?
The Annual Plan for 2018-19 clearly adopts an expansionary posture. The MOF has proposed in the Budget that the fiscal deficit should be brought down, more or less, sharply to below 5% of the GDP. However, this is based once again on favorable projections as in 2017-18. In particular, the size of the national PSDP has perhaps been restricted too much while current expenditure will continue to rise at a double-digit rate.
The Annual Plan projects that the current account deficit will be brought down to $12.5 billion in 2018-19 from the likely level of over $16 billion this year. This is to be achieved by restricting import growth to only 6% and achieving over 11% increase in exports. But with 6.2% growth rate there will be a strong demand for higher imports. Further, oil prices are on the rise and could add as much as $2.5 billion to the import bill in 2018-19. Also, CPEC imports could reach a peak next year.
The more likely level of imports is $61 billion, almost $6 billion higher than the projection in the Annual Plan. Special measures will need to be taken to control imports and further stimulate exports, including possibly a significant depreciation of the rupee. In the event, imports could be restricted to $58 billion and the current account deficit to $15 billion. This is close to the level projected by the IMF for 2018-19.
There is need to emphasize that one neglected dimension of policy is the need to raise the level of national savings. It has fallen from 14.7% of the GDP in 2014-15 to 11.4% in 2017-18. A larger investment-savings gap has put pressure on the current account deficit. Clearly, the emphasis in 2018-19 must be to enhance savings by various measures including higher real rates of return on financial assets.
The fundamental question is how a current account deficit approaching $15 billion will be financed in 2018-19? The MOF has projected that gross external financing of close to $10 billion will be available next year. But this includes $2 billion flotation of Euro/Sukuk bonds and $3 billion of commercial borrowing. Even if these flows materialize the net inflow will be limited to $3.4 billion in the presence of $6.6 billion of fast growing debt servicing liabilities. Next year a bond of $1 billion matures and a big annual repayment starts of the EFF loan to the IMF.
Non-debt creating inflows in 2018-19 are unlikely to exceed $3 billion. Altogether, at the maximum, only $6.4 billion will be available to finance the current account deficit of $15 billion. It could be down to $4.4 billion if there is failure in floating the bond, especially if FATF puts Pakistan off the 'grey' list.
Therefore, the pressure on reserves could be to the extent of over $10 billion, more than the likely level of reserves at the start of 2018-19. There appears to be no option but to go back to the IMF soon after the induction of the new Government for a Standby Facility, given the size of the balance of payments problem.
This will be predicated on resort to strong contractionary fiscal and monetary policies and to even draconian measures to curtail imports. These steps will be necessary even in the presence of a Fund program as the level of available funding is unlikely to exceed $6 billion over a two- to three-year period, given the size of the SDR quota of Pakistan with the IMF.
The bottom line is that we need to have contingency plans against all possible scenarios. There are no grounds for complacency at this time. The recently presented Budget for 2018-19 may be inappropriately conveying too many positive signals, with a multitude of tax breaks and promises of a rosier tomorrow.
(The writer is Professor Emeritus at BNU and former Federal Minister)