In a free market economy like Pakistan's, economic management including economic development is conducted through the use of and co-ordination of three policies, namely fiscal policy, monetary policy and exchange rate policy.
Generally, economic policy objectives in a developing country are to promote economic growth with relative price stability and keep the macro-economic imbalances ie fiscal deficit and balance-of-payment deficit at a modest, manageable level. Economic challenges emerge and, not infrequently, become deeply entrenched because imbalances are unsustainably large, whereas savings and investment are too low to generate a respectable growth rate that should result in an improvement in per capita income.
FISCAL POLICY
Public sector investment takes place largely in the areas of social and physical infrastructure and, at times, in mega debt projects that require lumpy capital as well as long gestation periods because the private sector is reluctant to go in these areas.
To finance these activities a government (treasury/ministry of finance) needs to generate enough resources to have surplus in the revenue budget, which, together with some borrowing from various sources should enable the government to finance its expenditure in the aforementioned areas.
However, the reality on ground is that over the decades, various governments failed to take requisite measures and/or introduce fiscal reforms to put the fiscal affairs in order. Among others, a major reason for this timidity has been to earn cheap popularity with the electorate at the expense of long-term health of the economy. The result is that the tax-to-GDP ratio in Pakistan at 9.5 - 10, is one of the lowest in the world.
MONETARY POLICY
It is obvious that with this tax-to-GDP ratio the government cannot meet both the revenue and development expenditure. Consequently, governments at various times depended on bank borrowing, borrowing from the public, borrowing through national savings schemes (NSS), and also on loans and grants from abroad.
Generally, the governments at various times found it convenient to borrow from the banking system, both from the State Bank of Pakistan and from the scheduled banks, to meet their budget deficit. This has added a burden to monetary policy, particularly when such borrowing became excessive and the incidence of this borrowing was on credit availability for the private sector.
There is nothing wrong with such borrowing, provided this is at a modest level and does not become a regular feature. Regrettably, in the case of Pakistan, various governments became somewhat addicted to borrowing from the banking system, particularly when the State Bank of Pakistan showed virtually unqualified co-operation and let the government borrow to meet the budgetary deficit.
At times, most of the total bank credit went to the government, leaving the private sector, the main generator of national income and engine of growth, high and dry. The graph here shows that during FY11, 86.7 percent of the total bank credit of Rs 586.86 billion went to the government. This, against the average of 51.8 percent since 1990 and the average of 80.3 percent during the past 3 years, shows the growing fiscal burden. If we take into account the quasi budget deficit, then the problem becomes all the more challenging.
Repayment and/or retirement of these loans have been so low, if not meagre compared with additional borrowing. The domestic public debt, which the government of Pakistan owes to banks and non-bank sectors, has been constantly rising; it now stands at Rs 5.817 trillion rupees or 33.2 percent of the GDP. Of this amount, borrowing from the banking system is Rs 2.601 trillion. During 2010, the government paid about Rs 900 billion towards debt servicing including Rs 577 billion as interest on domestic debt alone.
Thus, instead of reducing the size of the budget deficit to a sustainable level, both by improving the tax-to-GDP ratio and by reducing the non-development expenditure, the authorities have opted to shift this burden to monetary policy by way of borrowing from the banking system. This borrowing has been the principal cause of unsustainably high inflation in the country.
The high rate of inflation with all its adverse impact on balance-of-payments, pressure on exchange rate, implications for income distribution and generating inflationary expectations among economic agents is just one of the undesirable effects of the heavy borrowing from the banking system to finance the deficit and conveniently postpone the requisite structural changes that would stop further deterioration in the fiscal situation and reduce the fiscal deficit to a modest, manageable level. This also means that the burden of debt is being passed on to the country's future generations.
As stated earlier, this heavy bank borrowing by the government means squeezing credit for the private sector, which generates a preponderant percentage of GDP of the country. The cost of servicing the public debt, including external debt - which has accumulated to $56 billion essentially because of external borrowing to finance balance-of-payment deficit - as well as development budget, is estimated at Rs 750 billion for the year 2011-12; albeit it was close to Rs 900 billion during the preceding year.
This level of debt servicing, together with expenditure on defence and administration, cumulatively exceed the total tax revenue. The result is that for a long time various governments have been borrowing to meet a part of non-development expenditure (public consumption) and to finance their development expenditure.
The burden of this borrowing falls mainly on bank borrowing. Also, very frequently, when the size of the fiscal deficit exceeds budget estimates because of underestimation of expenditure and optimistic revenue estimates, it is virtually impossible to mobilise additional resources required through non-bank borrowing at a short notice. Under such circumstances, bank borrowing is the only answer.
Virtually all governments over the decades got used to treating bank borrowing as an easy source of financing, and till 1992 a highly subsidised source of financing the budget deficit. More specifically, before the introduction of financial reforms in 1992, the government used to borrow from the banking system at a highly subsidised rate, by way of ad-hoc treasury bills at 0.5 percent from the State Bank and at a fixed rate of 6 percent (on tap) from commercial banks.
When in 1992, the government was required to borrow at market rates, entailing the introduction of market oriented monetary policy, it meant a huge burden for the government. But it hardly served as a deterrent to reduce reliance on bank borrowing.
One major factor of this process of passing the fiscal burden to the monetary policy has been the inability of the State Bank of Pakistan to take a principled stand against government borrowing when it exceeded the estimates provided in the budget or otherwise posed a serious threat to price situation in the country.
I faintly recall that once in 1989 or thereabout, a section officer in the Finance Division addressed a letter to the Executive Director concerned in the State Bank conveying the government's wish that State Bank should ensure that the government account with the State Bank of Pakistan should never go into red.
Implications of such a wish are obvious. Also, in one case, a certain governor of the State Bank never wrote a single letter to the government during his entire tenure to contain the bank borrowing. Under such circumstances, the monetary policy has been taken for a ride. The government has dominated the State Bank so much that its governors who were not pliant were sent home or left their positions on their own, finding that their role was not effective in realising the objectives of monetary policy because of the government's interference.
FINDING THE POLITICAL WILL It is too obvious to repeat as to what needs to be done under the prevailing economic situation in the country. Various aspects of the needed policy changes have been discussed threadbare both in the print and the electronic media.
What is lacking is the political will to take corrective measures which could be unpopular with the electorate. Vested interests and tax evaders in a corruption-infested economy have become deeply entrenched over the years.
There is no realisation among those at the helm of affairs that unless emergency measures are taken to set the fiscal house in order and revive economic growth, the situation could deteriorate further, necessitating even more radical measures to put the economy back on the track. Any sense of complacency at this stage could have serious consequences in a not very distant future.
Improvement in the government's fiscal position is indisputably the most important challenge facing the government. This priority area has remained unaddressed for too long a period. Had the incumbent government taken some unpopular measures at the beginning of their five-year term, by this time they would have achieved some positive results, which could improve their image and credibility. Unfortunately, this has not happened and problems have become all the more intractable.
The writer is the former Deputy Governor (Policy), and Chief Economic Advisor of the State Bank of Pakistan. Among other research work, he is the author of History of the State Bank of Pakistan Volume-III (1977-88) and Volume-IV (1988-2003). He can be reached at ashraf.janjua@iobm.edu.pk Note: The article was written on July 20, 2011, and therefore does not reflect latest borrowing numbers that were updated on July 30. The revision of numbers, however, does not change the writer's argument.
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