The government needs to impose regulatory duties and cash margins on opening of letters of credit for non-essential import items in order to tide over the pressure on country''s foreign exchange reserves.
Failure to do so would result in imports rising to $28 billion in the current financial year and the current account deficit to reach $6 billion in FY06, widening it further to $7.5 billion in FY07, says the research unit of ABN Amro Bank (Pakistan).
It is widely recognised, the report says, that Pakistan''s external imbalance is growing, and on current trends it is potentially unstable.
ESSENTIALLY, THE POLICY MAKERS FACE THREE CHOICES: 1) Finance or adjust; 2) within adjustment, use expenditure-reduction or expenditure-switching policies; or 3) within expenditures-switching policies, use devaluation of currency or commercial policy (raising duties on certain imports, imposing cash margins on import L/Cs, etc).
So far, policy makers have found it difficult to resist the temptation to ''finance their way through'' since imbalances are not likely to self-correct without painful consequences. This course of action basically boils down to placing increasing reliance upon capital inflows from abroad, either as borrowing from the international capital markets or as direct investment (FDI).
The report points out that global markets are at their most liquid levels in recent history. International investors--especially those investing in emerging markets--have pushed the risk envelope outward in their search for yield. As a result, the spread compression in the EM universe has been dramatic, with the spread on J.P. Morgan''s EMBI+ falling from 550 bps (over US Treasury) in June 2003, to 179 bps currently. In conjunction with improving credit fundamentals, excess global liquidity remains a prime driver of the strong interest exhibited in Pakistan''s international bond offerings so far.
However, with a turn in global liquidity conditions appearing to be under way and concern regarding the sustainability of the external imbalance growing, Pakistan''s financing options will prove finite. A saving grace could be rising foreign investment inflows from the Middle East. So far, foreign direct investment (FDI) from the cash-rich region has amounted to almost $1 billion in FY06 (excluding partial payment for PTCL shares by UAE-based Etisalat).
According to reports, interest from Middle Eastern investors in Pakistan''s privatisation programme remains strong, in addition to large investments planned in real estate development, leisure and physical infrastructure.
Given the choice, says the study, policymakers around the world would rather ''over-finance'' and ''under-adjust'' (to use terminology borrowed from Paul Krugman). Nonetheless, a fundamental reason for erring on the side of ''adjustment'' in the financing-adjustment policy mix in the case of Pakistan is the fact that the surge in imports is not transient. Strong economic growth, stimulatory policy settings and reverse capital flight have catalysed aggregate demand in a near-unprecedented fashion.
The resultant overheating in the economy, if allowed to persist, can undermine the economic gains of the past several years; hence, the need for adjustment.
Within adjustment policies, there are ''hard choices'' to be made, as spelled out by the central bank recently. To contain aggregate demand (''AD'') would involve slowing the economy through either the use of a counter-cyclical fiscal policy and/or a tighter monetary stance. To apply this remedy, at a time when the economy is just beginning to attract foreign as well as domestic investment and has begun to add jobs, is a difficult choice for any government--more so for one that faces a general election in slightly over a year.
On the other hand, expenditure-switching policies entail increasing exports and reducing imports via devaluation of the currency. Commercial policy can also be used to curtail imports in a supposedly ''less painful'' way. However, the downside in both cases (ie, resorting to a devaluation or using commercial policy) is higher inflation. This outcome can eventually derail the initial benefits of a devaluation and is thus not regarded as first-best.
Keen to avoid the downside risks, associated with either of the two policy choices (expenditure reduction vs expenditure switching), the central bank has proposed to increase exports through reduction in business costs facing the export sector.
There are at least three problems with this approach.
First, improving the competitiveness of Pakistan''s exports by lowering inflation or undertaking measures such as removing infrastructural bottlenecks may work best in the longer term--leaving a widening external imbalance to address in the interim. Second, it is uncertain how ''elastic'' the response of exports would be to a reduction in inflation, especially given the concentration of overall exports in T&C and the China factor previously mentioned.
Third, reducing inflation would require a tighter monetary or fiscal policy in the first instance. Controlling inflationary pressures in an overheated economy through the use of administrative and supply-side measures alone is wishful.
Hence, it is clear from the aforementioned that the common denominator in what the SBP is proposing and the approach that is required is a tighter monetary policy and/or a contractionary fiscal policy. Since political compulsions make any ''adverse'' change to fiscal policy impractical, the burden of adjustment needs to necessarily fall upon monetary policy.
Over the past few weeks, the central bank has begun a fairly aggressive phase of liquidity withdrawal from the interbank market. This is a positive change, and, if continued, should result in a slowdown in bank credit growth in addition to a lessening of import demand at the margin.
COMMERCIAL POLICY: A word is in order regarding the appropriateness, or otherwise, of commercial policy. Commercial policy involves the use of quotas, import duties and tariffs, or other measures, to curb specific categories of imports, rather than a broad application to all imports, as in the case of an exchange rate adjustment. The government''s recent imposition of regulatory duty on wheat imports is an example of the use of commercial policy.
In fact, regulatory duties on certain categories of imports and/or the imposition of cash margins on opening of import letters of credit have been used fairly extensively by Pakistan''s policymakers during the 1990s, and have generally worked well as a short-term measure. The limitation of commercial policy resides in the fact that administrative constraints and opportunity for rent seeking can arise, raising the cost of this policy.
The immediate reaction to considering the use of commercial policy, even as an option, is adverse. Policymakers cringe at blocking the operation of a ''free market'', yet they had no qualms in the recent past in inter alia setting price ceilings on cement in addition to banning its export, imposing a regulatory duty on wheat import, conducting direct interventions to influence the prices of crops to generate favourable returns to farmers, and banning the inter-provincial movement of wheat, etc.
In addition, the meltdown in the domestic equity markets in March 2005 was met with a near-forced participation of large financial institutions in bailing out a handful of market participants engaged in speculation - hardly an example of the principle of ''market forces'' at work.
It will be useful to recall that the US and EU have employed a wide range of trade-restrictive practices either to gain an advantage for their exporters or to discourage imports of a particular commodity or from a specific country/region. The imposition of ceilings and quotas in response to the surge in imports of textile and apparel products from China in 2005 is a glaring example of the use of commercial policy even by the world''s largest trading nations - otherwise the champions of laissez faire.
It will also be useful to remember that China and India have only recently allowed unbridled ''consumerism'' to take hold, after well over a decade of robust economic growth in which the emphasis was upon promoting investment as opposed to consumer spending. Against this backdrop, the brushing aside by Pakistan''s policy makers of the use of commercial policy to dampen import demand, especially for consumer goods, needs reconsideration.
As widely recognised by now, Pakistan''s external imbalance is growing, and on current trends is potentially unsustainable. Underpinned by high domestic demand and combined with possibly non-transient factors such as rising import penetration and deteriorating terms of trade, rapid import growth is threatening the stability of the balance of payments. Exacerbating the problem is the ''quality'' of imports: a large portion is consumer goods, while the overwhelming majority is not destined for the export sector.
While the external account is well funded in the near term, without corrective action, the adequacy of foreign exchange reserves may become a binding constraint to Pakistan''s development path--not unlike the 1990s. To forestall such an eventuality, aggregate demand must be curtailed. Even though this will entail an inevitable slowing of the economy, this policy course will ensure greater durability of the current economic expansion, advocates the report.
In addition, managing agents'' expectations and perceptions of economic management, particularly of those in the financial markets, will become increasingly important.
To avert a portfolio shift into dollars and a self-fulfilling depreciation of the currency, policymakers need to ensure that confidence in their ability to avert macroeconomic instability is not eroded, concludes the report.
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