Reducing the primary deficit

Contrary to the practice in previous IMF Programs with Pakistan, the emphasis in stabilization of public finances this time will not be on reduction in the overall budget deficit but on containment of the primary deficit. The objective will be the transformation over the tenure of the prospective Program to a primary surplus of a sufficiently large magnitude. As such, the primary deficit is expected to be reduced, according to the IMF press statement, to 0.6 percent of the GDP in 2019-20, the first year, and rise by 2021-22 to a big primary surplus of perhaps over 1 percent to the GDP.
What is the primary deficit? How large is it likely to be in 2018-19? What is the significance of conversion of a big primary deficit into a large surplus? What are the implications of a target of big primary deficit reduction on the overall state of public finances in the country? Is it likely that such a big reduction in the primary deficit next year will imply a severe 'fiscal squeeze' on public expenditure?
The primary deficit arises when the total revenues are less than total public expenditure, excluding interest payments on public debt. The level of the primary deficit as a percentage of the GDP is a key determinant of the rise or fall in the public debt to GDP ratio. If it is significantly negative then there is a high probability that the ratio will rise. One the other hand, if there is a relatively large primary surplus then this will tend to indicate a falling public debt to GDP ratio.
The likely level of the primary deficit in the combined budgets of the Federal and Provincial Governments in 2018-19 can be projected from the data on fiscal operations for the first nine months released recently by the Ministry of Finance. There are three critical magnitudes for derivation of the primary deficit. The first is total revenues, tax and non-tax revenues. The second is total expenditure, both current and development, and the third is interest cost of debt servicing.
The projected level of revenues in 2018-19 is Rs 5280 billion: with a growth rate of only 1 percent. Consequently, the revenues-to-GDP ratio will fall sharply to 13.6 percent of the GDP from 15.2 percent in 2017-18. Total expenditure is estimated at Rs 8250 billion, equivalent to 21.2 percent of the GDP. Interest payments are expected to rise sharply to almost Rs 2000 billion in 2018-19, due to the big hike in interest rates during the year. They are likely to approach 5.2 percent of the GDP, with a growth rate of 33 percent. Overall, the primary deficit may be as large as 2.4 percent of the GDP, even larger than the deficit of 2.2 percent of the GDP last year.
The magnitude of front loading of the process of stabilization can be judged by the fact that a quantum reduction is targeted for in the primary deficit in the first year, 2019-20, of the Program. The deficit is proposed to be reduced from the anticipated 2.4 percent of the GDP in 2018-19 to 0.6 percent of the GDP in 2019-20.
What are the implications of such a big deficit reduction? These are derived for three scenarios in 2019-20. The variation among the scenarios is largely a reflection of the growth rate in tax revenues. The understanding reached with the IMF is that as much as Rs 700 billion will be raised through additional taxation measures in 2019-20, over and above any normal growth. Consequently, the success or failure in achieving this extremely ambitious target will determine the performance of tax revenues in 2019-20. Non-tax revenues are expected to fall somewhat from 2.2 percent of the GDP in 2018-19.
The three scenarios are based on growth rates of 15 percent, 20 percent and 25 percent respectively in tax revenues in 2019-20. Development spending, which remained low in 2018-19, is projected to rise by 0.2 percent of the GDP in line with IMF exhortation to protect essential spending and raise outlay on social protection. Interest payments will continue to grow rapidly due to the recent jump in the policy rate by 150 basis points and possibly more increases in 2019-20. They are likely to approach 5.4 percent of the GDP in 2019-20.
The likely outcomes in the three scenarios are presented in Table 1. It is very clear that bulk of the adjustment has to be made in non-debt servicing current expenditure of the Federal and Provincial Governments combined. In the event of a growth rate of 15 percent in revenues, this expenditure is projected at Rs4884 billion, as compared to Rs 4871 billion in 2018-19. This implies a near zero growth in Federal current expenditure, excluding debt servicing, in the first scenario.
The second scenario, with higher growth of 20 percent in revenues, leads to a projected level of non-interest current expenditure in 2019-20 of Rs 4975 billion, indicating a growth rate of 2 percent only. As opposed to this, the growth rate of such expenditure in the third scenario is higher but still remains single digit at just 6.5 percent.
The impact of inflation on current expenditure plus the annual increment in salaries and allowances will imply a normal growth rate in non-interest related current spending of approximately 5 percent. As such, the first two scenarios will imply a significant cutback even in the nominal level of such spending.
There is another dimension to the likely 'fiscal squeeze' in 2019-20. If federal tax revenues increase, more or less, rapidly by 15 percent to 25 percent in 2019-20, then divisible pool transfers will be rise accordingly. This will motivate the provincial governments to target for double-digit growth rates in their spending, including that on the current account. Consequently, there will be need for a further cutback in current expenditure, excluding interest payments, by the federal government.
The non-interest current expenditure of the federal government consists of the largest outlay on defense services, followed by costs of civil administration, pensions, subsidies, grants and expenditure on the provision of services in areas under its jurisdiction. IMF appears to be skillfully and insidiously targeting for a real cut in defense spending by Pakistan. This can be interpreted as a violation of national security and must be resisted at all costs, especially at a time when there is tension on the borders and acts of terrorism are on the rise once again.
The solutions to the targeted 'fiscal squeeze' are to be found, first, in the economic team renegotiating for less frontloading of the primary deficit reduction, second, by resort to pruning of development spending to somewhat below 3.4 percent of the GDP next year and thereby highlighting the direct tradeoff between security and development. Third, understanding will need to be reached with the Provincial Governments that they will generate a combined cash surplus of at least 1 percent of the GDP in 2019-20. Otherwise, there is the likelihood of the IMF Program aborting even before or soon after its start in view of the infeasible magnitude of the likely 'fiscal squeeze' in 2019-20.

==================================================================================

Scenario for Public Finances in 2019-20

==================================================================================

(% of GDP)

==================================================================================

                           2018-19    Scenario(I)    Scenario(II)    Scenario(III)

==================================================================================

Tax Revenues                  13.6           13.4            13.9             14.5

Total Expenditure             21.2           19.4            19.9             20.5

Current Expenditure

(excluding debt servicing)    12.6           10.8            11.0             11.5

Debt Servicing                 5.2            5.4             5.4              5.4

Development Expenditure        3.4            3.4             3.5              3.6

Primary Deficit               -2.4           -0.6            -0.6             -0.6

==================================================================================