Approaching or landed in deflation?

I wrote an article in this newspaper on February 17, 2015, stating clearly that Pakistan's economy is heading towards deflation. Some economists thought that it was too early to pass the judgement and at least one senior economist totally disagreed with my assessment. Six months have passed since then and new numbers, as released by the government, lend further support to my views of February, 2015. This article shed more light on whether we are approaching or landed in deflation.
What is deflation? Deflation, as opposed to inflation, is defined as the persistent decline in general price level. Deflation occurs when the country's inflation rate continuously declines and falls below zero percent (a negative inflation rate).Inflation rate, as measured by the changes in Wholesale Price Index (WPI) was 6.6 percent in July 2014 and within four months, it decline to zero percent (November). It turned negative (-0.9%) in December and remained negative for the last eight months in a row (-2.9% in July 2015). Adjusting for food and energy, the inflation rate is in negative for the last ten months in a row.
The CPI-based inflation appears to react with a time lag viz. WPI- based inflation. It was 7.9 percent in July 2014 and continued to exhibit a declining trend, reaching as low as 1.8 percent in July 2015. The government and its ministers took credit for bringing inflation to a historic row. Ignorance is bliss. Such a low level of inflation in a developing country like Pakistan is not a good sign for the economy. Inflation is like grease, necessary to run the machine. Some level of inflation is absolutely necessary to run the machine of the economy.
What is the optimum level of inflation for a developing country like Pakistan? The IMF and the SBP have estimated it to be in the range of 7-9 percent. For me, if inflation remains in the range of 5-6 percent, I will not worry for inflation. The CPI-based inflation has remained below 4 percent since January 2015 - seven months in a row and continuously falling, reaching as low as 1.8 percent in July 2015. Should we celebrate or be concerned of falling prices? Chairperson of the Federal Reserves of the US, Governors of the Central Bank of Japan and China are worried and they are taking measures to take the inflation above 2.0 percent. What should we be doing?
What has brought Pakistan's economy into deflation? The answer is simple. Pakistan is pursuing 'stabilisation first' or austerity program for the last seven/eight years in a row. Such a prolonged period of austerity has suffocated the economy and severely constrained the country's growth potential. Pakistan's economy has grown at an average rate of 3.2 percent per annum in the last seven years. With country's population growing by 2.2 percent per annum during the period, the real per capita income has grown at an average rate of 1.0 percent per annum.
This level of growth in per capita income is neither here nor there. Such a low increase in real per capita income has pushed the country into a deficient demand mode. The deficient demand has caused deficient supply. Consequently, Pakistan's growth is now stuck in the range of 3.0 - 4.0 percent - a 'new normal' for Pakistan.
Deflation is a rare phenomenon that does not occur in the course of a normal economic cycle. Investors (local and foreigners) recognise it as a sign that something has severely gone wrong with the state of the economy. In deflation, economic activity slows considerably, domestic demand weaken, unemployment and poverty rise, private sector is shy in expanding its businesses, therefore, they borrow less from commercial banks, foreign investors also become nervous and prefer to exit from the country, manufacturing activity slows in the country, and most importantly, it breeds civil unrest, social chaos, break down of law and order, and weakens the state's authority.
Do we see all these happenings in Pakistan? The pursuance of tight fiscal and tight monetary policy under the so called austerity program of the IMF for such a long period has contributed significantly in taking the economy into deflation. Once deflation has shown its ugly head, it becomes very difficult to break the cycle of deflation. Japan and Europe are the classic examples of recent times. The easy monetary policy pursued by the SBP during the last one year (3.0 percentage point cut in discount rate) has failed to make any dent in reviving investor's confidence.
Weak domestic demand is well reflected by the collection of sales tax at domestic stage. Domestic demand serves as tax base for sales tax at domestic stage which has simply collapsed in 2014-15, growing by almost one percent in nominal term. Adjusting for inflation, this tax has registered a negative growth - a clear reflection of collapse in domestic demand.
Weaker domestic demand have discouraged private sector to expand their businesses. This is reflected by lesser borrowing of private sector from banking system. Private sector borrowing from commercial banks was almost one - half in 2014-15 as compared with last year's (2013-14) level. Investment, particularly private investment, is on the decline since 2007-08 - down from 19.2 percent of GDP to 15.1 percent in 2014-15 and 12.8 percent to 9.7 percent, respectively. In fact, private investment in large-scale manufacturing adjusted for inflation was down by 13 percent in 2014-15. The growth in large-scale manufacturing accordingly remained subdued over the last seven years, growing at an average rate of 1.1 percent per annum. It grew by 2.4 percent in 2014-15.
Exports and most importantly, manufactured exports are on the decline as well. Overall exports were down by 3.8 percent and textile and other manufacturers posted negative growth of 1.0 percent and 1.6 percent, respectively.
Based on the above, it is clear that Pakistan's economic growth has slowed, domestic demand has weakened, private sector is shy and not borrowing enough to expand their businesses, manufacturing activities are stagnant, exports are falling, and foreign investors are exiting. Consequently, unemployment and particularly youth unemployment is on the rise (see my July 29 article) and the labour force participation rate has also declined, suggesting that less people are now looking for a job. These developments are breeding civil unrest, social chaos, breakdown of law and order and weakening the state authority.
Do we still need more evidence to prove that Pakistan's economy has either landed in deflation or approaching fast towards deflation? Once we recognise the problem only then we will take corrective measures. Time has come to change our policy stance. Too much fixation on deficit reduction has seriously damaged the economy and landed Pakistan into deflation. We have to strike a balance between stabilisation and growth. Pakistan badly needs growth stimulus policy and reforms. Lest! We will remain stuck with 'new normal' growth (3-4%) with all its socio-economic consequences for years to come.
(The writer is Principal and Dean at NUST School of Social Sciences & Humanities, Islamabad)