'Strong incentives to remain undocumented in Pakistan,' Chief Economist, DFID

Stefan Dercon is the Professor of Economic Policy at the Oxford University and the Director of the Centre for Study of African Economies at Oxford University. He is a development economist and advises the United Kingdom's Department for International Development (DFID) as their chief economist. His interest is in applying microeconomics and statistics to problems of development. He has worked on risk and poverty, agriculture and rural institutions, political economy, childhood poverty, social and geographic mobility, micro-insurance, and measurement issues related to poverty and vulnerability.
BR Research's conversation with Stefan revolved around his assessment of Pakistan's economic issues and his advice for robust economic development. Below are edited excerpts of the interview.
BR Research: What responsibilities does your role as Chief Economist of the UK's Department for International Development (DFID) include? Stefan Dercon: DFID is responsible for spending aid budgets amounting to almost 12 billion pounds. It also implements the UK's aid policy. I advise DFID on these matters and focus on the use of evidence to improve the quality of development policy design and evaluation across a wide range of development issues.
BRR: How does DFID view Pakistan's development and which areas are of primary importance in its strategy? SD: Pakistan is still a very important country for the UK with long-standing relations extending not just to development but its people and economy as well. It is a big country with lots of poverty. But at the same it is also an emerging economy with a lot of potential.
The problems with security and stability in the neighbourhood are of global importance, and therefore important to the UK as well. We are very interested in economic growth of the country and the inclusiveness of that growth. Other areas include the role of accountability and the role of sensible economic reform to support the broader stability agenda in Pakistan. We are focusing more on the growth and inclusion part currently.
BRR: Pakistan's economy is growing at a decent pace with burgeoning domestic demand and the CPEC, but there are risks as well such as the rising current account deficit. In your view how robust is Pakistan's economic growth and what are the challenges it needs to overcome?
SD: Pakistan's story is not unlike a lot of other countries in the broader neighbourhood that have been doing very well. Poverty has been coming down and human development indicators are increasing. However, it is underperforming relative to its peers in the region and definitely against the broader progress in Asia.
It is growing at a decent rate, but it is yet to achieve a consistently high growth rate that changes a country fundamentally in its growth and living standards. Michael Spence chaired a Growth Commission with the World Bank, which basically came to the conclusion that 25 years of 8 percent growth is the road to success. Pakistan has barely ever reached these kinds of growth levels. So it is underperforming relative to actually being on this trajectory of fundamental and long-lasting change towards a higher income economy.
At the same time let's not be too critical of the 5.3 percent growth rate, which is quite decent. On this visit, I have heard about the deep-rooted problems involving the relationships between business and state, as well as issues of stability and security and their impact on people. Then there are the forms of exclusion of different groups in society and the instability in certain regions. Therefore, even though achieving 5.3 percent under these circumstances is pretty good, but keep in mind that you are underperforming relative to your potential.
One of the things that often happen in countries is that they go through periods of economic crisis and are then bailed out. Pakistan has gone through 17 International Monetary Fund (IMF) programs so far. But Pakistan has not capitalised on the progress achieved under those programs.
BRR: What kind of progress has been missing?
SD: Pakistan has completed two programs out of 17 with one them ending recently. However, merely completing it is not enough. You need to grasp the dividend from going through the review because it has been costly and it is only the first step. Stabilising an economy is not the same as structurally addressing your economy in a way that you want to. It is great to be able to do that once you are out of the program. That should be the moment where you consolidate the progress by sensible structural changes and reforms.
Then there is the issue of taxation. It includes the small taxpaying base, which is a result of the broader group of population and businesses avoiding taxation. There are strong incentives to remain undocumented and it will be tricky to address this issue. Without creating a more transparent, simpler and leaner system, meaningful progress cannot be achieved.
Another main challenge is competitiveness, as this is still a remarkably closed economy in my observation. It still has substantial input barriers and a low export base. I saw some amazing export success stories in Sialkot in my visit. Despite the relative unevenness of economic structures in the country, the firms there are pockets of success. Why can't the whole of Pakistan be like Sialkot? Granted it will be difficult to replicate in areas like Baluchistan at the moment, but the same success can be achieved by other parts of the country.
One other red flag is that this is an economy where the business community very quickly looks for support from the state to protect their own positions. It wants to consolidate and is really worried about competition. For an individual firm, it is a perfectly natural incentive. However, from a policy point of view it is not good for the economy. Therefore, you should keep encouraging reforms that help with competitiveness.
These are tricky things to implement and there isn't some magic formula. The aim is to embrace more competition and not simply be happy with supplying the growing domestic consumer market but actually realising that the global market is much larger.
BRR: Primarily, Pakistan's exports have been textile-based for a long time whereas you see other countries like South Korea progressing to technology- and service-related exports. Do you see any new exporting areas where Pakistan can excel?
SD: Finding new areas has entirely to do with knowing the technology and doing something different. I have a strong belief that pushing the frontier is not about picking a particular sector or commodity. Instead, it is about having a team that actually wants to learn and is recognisant of emerging trends to cater to. This will require Pakistanis making the right connections overseas and knowing the international market.
Another factor at play is Pakistan's fundamentally strong history as a trader's economy. Sometimes successful manufacturing is undertaken by traders who were initially buying these products from overseas but then realise they can add this value locally. Imagine it as a perpetual climb of the value-added ladder rather than a specific sector or product. The focus then should be on incentivising entrepreneurs to go to that next little step on the ladder.
Again, a good learning example is Sialkot because the entrepreneurs there seem to have done this. They were learning while they were selling; they were learning about how market trends were evolving while moving up the quality ladder at the same time. I wish there was more encouragement and active policy to make these kinds of connections. This will require a strong outward investment agency that makes these connections and that uses intelligence to do this.
BRR: Do you think Pakistan's managed float currency system has an adverse impact on exports?
SD: If you look at IMF statistics, they suggest that the real effective exchange rate is overvalued. Even though it may be very attractive because your imports will remain cheaper, which might be good for some parts of the economy, but an overvalued exchange rate is not particularly helping Pakistan. This is not in itself a point about the managed exchange float but rather how you manage these kinds of transitions. However, you do want to guard yourself against overvaluation of the exchange rate.
BRR: Do you think that Pakistan's inward FDI will pick up to supplement the rising domestic demand given the high returns available? How can it be utilized to increase exports?
SD: It is a bit of a catch-22 situation. Even though there is a part of the economy that is clearly outward focused, this is still an economy that is very much focused on the domestic market. But the current account deficit cannot be maintained indefinitely. You have been able to keep your balance of payments in check with lots of remittances and these days maybe with a bit of debt as well. However, in the long run it could prove to be unsustainable.
FDI comes in and where it sees there is an opportunity. If the structure of your economy is focused on the domestic market, which it currently is, then the FDI that comes in is going to focus on those products and services that are supplying the domestic market. Do not blame the FDI for that. You should welcome it. But think carefully about directing the spillovers gradually towards increasing competitiveness and hence exports.
BRR: What kind of alignment does Pakistan need to make the existing incentive structure for spurring both exports and FDI?
SD: You have to realise that tax systems and incentive structures are negotiated and evolve over time. They are part of political arrangements in the country as well as social sustainability. I am not going to say big shock therapy is either feasible or desirable in a narrow sense. But from an economic point of view, Pakistan needs to benefit from being exposed to the productivity function internationally because otherwise you will keep on risking staying behind the growth.
Therefore, you would want to structure incentives in such a way that they encourage sectors where the value-addition ladder can be climbed much more effectively. They should also aid sectors where there is a scope of productivity improvement. It should not be manufacturing versus services but rather where the productivity frontier is higher.
However, you do not want to use trade policy instruments because they are discriminatory and distorted in nature rather than being incentives. Similarly, punitive tax structures and bad incentives or subsidies should be avoided. It is more the lens where the discussions should actually lie. You test your incentive structure through a lens where you view Pakistan as being part of a global economy.
BRR: How do you view the CPEC's economic impact on the domestic industry in Pakistan?
SD: Even though CPEC has enormous potential, I think people could be worried about how exactly it will play out. But I do understand from the way these things work that it is in the power of Pakistan to give it the right direction rather than making it costly.
The domestic industry should not be afraid of competition. They should slowly focus on building up their infrastructure. This will allow them the time to analyze and transform in an informed manner. The possibilities for growth and a bit of creative destruction coupled with Pakistan businesses adopting a more outward approach is what are required.
I believe it is in the power of politics and business here to make CPEC a success. At the same time, clarity is required, and it needs to be owned across the board. It cannot be a small group of people capturing all the benefits from the initiative.
BRR: What message would you give to Pakistan on economic development?
SD: The UK aims to be supportive and does not believe in dictating policy. The most important advice is seeing through economic reforms on accountability and inclusion, which have already been started.