Inflation: a ticking time bomb

A time bomb facing the Imran Khan administration is the continuing inflationary spiral.

The Prime Minister and his coterie of ministers/advisers insist that prices are rising mainly due to decades-long supply side dynamics - the outcome of market imperfections, particularly collusion reflecting elite capture of supplies of most commodities - value-added items and perishables. The opposition cites government's incompetence as a major factor contributing to supply side inflation by arguing that during their tenures they faced the same flawed market conditions but dealt with them through negotiations rather than accusations, threats and warnings that, three years into the tenure, have yet to bear fruit.

Independent economists acknowledge the veracity of the claims made by the government as collusion has long been evident in this country including in commodities that in other countries operate under perfect market conditions (sugar, cement, perishables) as the number of suppliers and buyers is simply too large to make collusion possible. However, in Pakistan this has been made possible as senior leadership of the three major national parties are heavily engaged in such industries/productive activities as well as own large landholdings (barring Imran Khan though many of his cabinet members source their wealth to such activities) and exert influence to a point where they dictate policy decisions pertaining to their sub-sector of operation.

Be that as it may, windfall profits should attract rather than deter new entrants who could well challenge the existing 'collusion' - tacit or otherwise - of existing market players.

So why have new entrants been so few in large scale manufacturing industry in Pakistan? Rukhsana Kalim argued in an article that appeared in Pakistan Economic and Social Review (winter 2001) that: "there is convincing evidence that overall capital intensity in the manufacturing sector increased and substitution of capital for labour had been taking place. Some industries such as wood and cork products, furniture and fixture, industrial chemicals, nonmetallic minerals and iron and steel are highly capital intensive industries in terms of both high capital-labour (K/L) and capital-value-added ratios (K/V). According to the end use, the intermediate goods industries on average are found to be the highest capital-intensive ones in terms of K/L and K/V ratios...increasing capital-labour ratios may be due to many factors such as the changes in relative factor prices and the increased use of imported technology."

Three observations are in order. First, in 2020 as per the State Bank of Pakistan website machinery imports were around 14 percent of total imports - supported by successive administrations as a prelude to higher future output (with negative implications for the absorption capacity of our youth entering the labour market).

Second, import of machinery especially with an eroding rupee vis-a-vis the dollar requires either: (i) adequate personal capital with entrepreneurs in general preferring to invest as little of their own equity as is necessary; and/or (ii) borrowing from banks. In Pakistan, credit has been mainly disbursed to (i) existing market players operating in large scale manufacturing sector (LSM) considered less risky as far as the banks are concerned which could be a factor in deterring new local entrants; and (ii) an IMF study 2020 reports domestic credit to private sector by banks is by far the lowest in Pakistan at 17 percent (barring Afghanistan at 3 percent) though last year it rose to 33 percent yet it remains too low compared to other regional countries including India's 55.3 percent, Bangladesh's 45.1 percent, Sri Lanka's 49.7 percent, Bhutan's 68.9 percent and Nepal's 87.8 percent.

Clearly, Pakistani banks prefer to lend to the government which raised its reliance on domestic borrowing from 16.5 trillion rupees in 2018 to over 25 trillion rupees today.

Pakistani governments traditionally encourage new entrants through policy revisions say in the automobile sector yet those taking advantage are mainly foreign companies that remit a large part of their profits, and have yet to implement the indigenization originally agreed.

The Khan administration has announced special credit package for small scale industries in the budget: (i) refinance and credit guarantee scheme for collateral free lending to SMEs at 1.19 billion rupees and (ii) SME risk sharing facility earmarked 5 billion rupees. These amounts are small and unlikely to make too much of a difference.

The poor farmers' generational reliance on aarthis to provide financial support - from sowing to marketing their output - is regarded as the reason for the discrepancy in the cost and sale price of perishables though seasonal factors also impact on the price. Here too the government has budgeted 100 million rupees for credit to small farmers but time will tell if this amount is sufficient to break the hold of the aarthis.

And finally, there have been increases in factor prices attributable to the conditions agreed with the International Monetary Fund (IMF) specifically with respect to utility prices (electricity). The newly-appointed finance minister Shaukat Tarin has refused to raise the base price of electricity as agreed with the Fund in February 2021 however this does not include passing on the fuel adjustment charges or the quarterly adjustments in electricity rates. Other input costs are also rising, mainly due to higher transport costs, which cannot entirely be laid at the doorstep of external factors as petroleum and products are heavily taxed (in the current year the government has budgeted 610 billion rupees as petroleum levy plus sales tax).

Budget deficits have been unsustainable since the Khan administration's tenure began, consistently above 7 percent, a highly inflationary policy. Add the recent inexplicable erosion of the rupee post-May 2021 - from 152 rupees to the dollar to over 161 rupees to the dollar today in spite of reported record foreign exchange reserves (though half of these are sourced to debt and swap arrangements), record high remittance inflows and a highly sustainable current account deficit of less than 2 billion dollars (as opposed to 20 billion dollars inherited by this government) and one has a couple of more reasons for the sustained rise in prices.

To conclude, fiscal and monetary policies coupled with periodic accusations and warnings to the colluders have failed to arrest inflation. And the post-June 2021 erosion of the rupee has not generated any concern from the Prime Minister or the Ministry of Finance though it has without doubt made the carefully calibrated budgeted deficit figure redundant.

Copyright Business Recorder, 2021