Fiscal discipline is the key

The State Bank of Pakistan (SBP) is certain that most of the present problems of the economy are rooted in the widening fiscal deficit of the country. According to its second quarterly report for the year 2007-08 released on 31st March, the fiscal deficit during July-December, 2007 is estimated to be as high as 3.6 percent of the estimated annual GDP or nearly twice the figures for the last two years.
This had troubling implications for vital areas of the economy. "Support to aggregate demand due to fiscal deficit contributed directly to a rise in monetary aggregates, raising inflationary pressures, complicating monetary management, and stoking the growth of the current account deficit. International credit rating agencies have already cited the growth of the fiscal deficit as a key negative indicator for Pakistan's sovereign credit rating".
The combination of rising fiscal deficit and weak external receipts has pushed government borrowings from the State Bank to a record Rs 359.3 billion during July-March, 2008 as compared to only Rs 25.6 billion in the corresponding period of last year. This has been instrumental in sustaining the growth in money supply at around 17.6 percent, significantly offsetting the central bank's efforts to tighten monetary policy.
The inflationary impact of widening fiscal deficit and government's increasing reliance on State Bank's lending was aggravated by an unanticipated strength of international commodity prices, anti-competitive market structures and practices in the domestic market, as well as supply disruptions. The State Bank has projected inflation rate to be in the range of 8.0-9.0 percent for FY08 as against the target of 6.5 percent for the year. It is of the view that "the government has limited options to ease inflationary pressures.
Efforts to reduce government subsidies on fuel will raise inflation in the short-run. Further, given limited fiscal space, any subsidies need to be carefully targeted and should be limited in scope". Also, policy actions should not distort price signals as these were essential to ensure investment and productivity increases needed to remove shortages and modulate consumption in future.
The government's desire to reduce current cost pressures in the domestic economy through a subsidy on fuel prices has the unintended consequence of supporting the widening of the current account deficit, as demand was not rationalised to reflect the higher international prices. The State Bank has also made a poignant remark about the size of the fiscal deficit by observing that the actual deficit at 3.6 percent may be understated as a part of the subsidy on fuel prices during July-February, 2008 was not financed from government account.
The impact of strong domestic demand (emanating mainly from growing fiscal deficit) and higher international commodity prices was also reflected in the deteriorating external imbalances during FY08. As a consequence of rising import growth and slow growth in textile exports, the current account deficit may reach around 6.0 percent of GDP. According to the State Bank, "the growth of current account deficit indicates that the exceptional fiscal expansion supported aggregate demand in the economy".
In the past, Pakistan was able to sustain current account deficits by encouraging non-debt creating financial inflows but, with the change in investment conditions, sustained external sector deficits could pose risks to the macro-economic stability. Reflecting a sharp increase in current account deficit, overall foreign exchange reserves declined to $14.0 billion at the end of February, 2008 from $15.6 billion at the close of June, 2007 while Pak rupee depreciated against US dollar by 3.5 percent during this period. An area where the State Bank does not feel very much disconcerted is the growth rate of the economy.
Although domestic and international shocks have taken their toll, the economy was expected to turn in a reasonable growth performance during FY08, albeit substantially lower than the target. The principal drag on this year's growth was the outcome of Kharif harvests and slowdown in LSM growth but the services sector was set to show a good performance for the sixth consecutive year.
We feel that the State Bank's prognosis of the economy is quite appropriate to the situation and there is no confusion about the message of the second quarterly report. After following a prudent fiscal strategy for a number of years and enacting FRDL Act, 2005 with all the good intentions, the previous government could not stick to the predetermined fiscal strategy due to political expediency in the election year.
Exogenous shocks like abnormal increases in the international oil prices were not passed on to the domestic market, expenditure of the government continued to increase at a fast rate and tax mobilisation efforts were not up to the mark. Relaxed attitude of the government to the evolving situation led to a sharp growth in fiscal deficit which was financed largely by increased reliance on State Bank's lending. This has resulted in a steep increase in liquidity in the economy, fuelled inflationary pressures and worsened the current account deficit.
If the fiscal deficit is not contained in the near future, new problems like further depletion of foreign exchange reserves, depreciation of the rupee rate, contraction of imports of raw materials and other industrial inputs, downgrading of credit rating of the country and loss of confidence in the country's solvency will be added to the list. Strangely, fiscal managers of the country have excluded Rs 54.6 billion of contingent liabilities of the government from the fiscal deficit probably on the ground that financial transactions involved in the process were between the public sector enterprises and the banks.
However, since the guarantees provided by the government are likely to be invoked due to the continued precarious position of the borrowing organisations, the truth cannot be masked for long and its implications would be as serious as those of a normal fiscal deficit.
Statistical trickery cannot hide the fact that it is absolutely essential at this juncture to estimate the budget outcome in an honest and transparent manner with a view to reducing the fiscal deficit to the target of four percent of GDP during the current year and maintain it at a level in future which is consistent with the objective of monetary stability. We know that the task is highly challenging but there is no alternative for the country if it is to be saved from the emerging downside risks.
We are happy that the State Bank has managed to convey the right message at the right time. Since the State Bank's report is essentially meant for parliamentarians, the new members of the National Assembly as well as various ministries will be less tempted to put up their financial demands for their constituencies and burden the exchequer further after going through the contents of the SBP report.
In fact, after getting a cue from the Governor's earlier statements and speeches, many top notch leaders of the political parties were already prepared to make the right moves. In this context, it was gratifying to note that in his first speech to the parliament, the Prime Minister announced a sharp reduction of expenditure for the PM House, instructed the ministers not to use cars of more than 1600 CC and discontinued spending on the renovation of government buildings and residences. Although overall budgetary impact of these measures will not be very significant, yet it shows the commitment of the government for austerity and would send the right signals to the bureaucracy and other stakeholders.
The State Bank has also made a strong case against the provision of subsidies and has indirectly linked it to the creation of additional fiscal space. New ministers are also crying hoarse that they have inherited an empty public kitty, suggesting indirectly that relief measures cannot be announced at this stage. All of this augurs well for the enforcement a strict financial discipline which is the key to improving macro-economic indicators and rehabilitating the economy.
The contribution of the State Bank in highlighting the basic problem of the economy and goading the government in the right direction needs to be appreciated. However, we cannot understand the reason behind the confidence of the State Bank in the resilience of the economy. There are clear signs that this year's growth rate will be driven mainly by the services sector. If the agriculture and LSM sectors continue to falter, as is the case in the current year, it will not take too long for the services sector to change its course and have a negative impact on the growth rate of the economy.