Emerging trends

The key macroeconomic variables of the national economy are beginning to show sharply divergent trends from those observed earlier since June 2019. This includes developments in the real economy, monetary sector, inflation, public finances and the balance of payments.

These sharp changes in trends are primarily attributable to Covid-19. The consequences of this pandemic are both global and domestic in character. World trade has begun to fall sharply, commodity prices (especially of oil) have experienced big declines and there has been a large outflow of funds from developing countries, including Pakistan, to safer havens.

Pakistan has seen the spread of Covid-19 from March, 2020. There have been attempts with varying levels of a lockdown to limit the spread. More recently, both the SBP and the Ministry of Finance have announced and implemented relief packages with significant implications on the conduct of monetary and fiscal policies.

The first set of developments relate to the unfortunate transition from positive to negative growth in the real economy. Prior to Covid-19 pandemic, the GDP growth rate was expected to be close to 2 percent in 2019-20. Three primary sources of negative growth have since emerged. First, exports have fallen by 8 percent in March and by as much as 54 percent in April. This is probably due both to demand and supply factors. Orders have either been postponed or cancelled by major importers in the USA, the EU, China and the Middle East. On the supply-side there has been a build-up of containers due to limited operations at Karachi Port. The big decline in exports is expected to persist.

Second, private investment has started plummeting due to increasing shyness of investors in a risky and uncertain environment. Up to February 20, private investment, as measured by the import of capital goods, had fallen in the first eight months of 2019-20 by 5 percent. But in March, import of machinery declined by as much as 25 percent. It remains to be seen if the more recent big cut in interest rates will lead to a fundamental change in investor perceptions of future profitability.

The third indicator of contraction in the real economy is the negative growth in tax revenues of FBR successively in the last two months. The fall in March was 10 percent and almost 14 percent in April. Prior to this, there had been a steady growth rate of 17 percent, due primarily to relative buoyancy of almost 25 percent in taxes levied on domestic tax bases. This buoyancy has clearly vanished and explains the precipitate fall in tax revenues. It implies that even the domestic tax bases are also now showing negative growth.

The next set of changes is in the monetary sector, with broader implications on the economy. First, there is a faster rate of monetary expansion, as measured by M2. It grew by 4.9 percent up to February and has reached 8.3 percent by the last week of April. This compares with the growth rate of only 3.4 percent in the corresponding period of last year. The faster increase is due largely to a jump in Net Foreign Assets as compared to a big decline last year.

Second, a perhaps not so visible and recognized trend is the move away from bank deposits to currency in circulation. From mid-March onwards currency in circulation has increased by Rs 336 billion while bank deposits have actually fallen by Rs 175 billion. This may be due to heightened liquidity concerns of households due to the lockdown. Also, the big fall in interest rates may have been behind the exodus from the banking system. This has happened when the SBP has brought schemes for credit expansion to sustain employment in business operations and a larger deposit base is required.

Third, there has been a sizeable increase in Government borrowing from the banking system in recent weeks. Up to end-February, the cumulative increase in borrowing during the current financial year had been Rs 35 billion only. It now stands, as of the latest estimates of 24th April by the SBP, at Rs 540 billion. Clearly, this is attributable to the big shortfall in revenues and the need to make funds available for the relief packages. It will not be surprising if by end-June bank borrowing by the Government even exceeds the record level in 2018-19 of over Rs 2.2 trillion. With a lag, this monetary expansion will exert upward pressure on the price level.

Meanwhile, the rate of inflation has moderated substantially. From a peak of 14.6 percent in January 20, it has fallen successively to 12.4 percent in February, 10.2 percent in March and 8.5 percent in April. There is, however, a difference in factors contributing to the fall in the rate of inflation in February and March versus April. The former two months saw big decline in food prices, especially in perishable items. Almost 85 percent of the 4.4 percentage point drop in the rate of inflation from January to March was due to the fall in food prices. But in April, almost half the 1.7 percentage point dip in the rate of inflation is due to fall in prices of non-food items, especially in petroleum products. The further decrease in prices of motor spirit and HSD oil on the 1st of May should contribute further to lowering the rate of inflation, beyond the seasonal jump during the month of Ramadan. This is perhaps the only positive impact of Covid-19.

There is need also to recognize that the fall in the rate of inflation in non-food items is also due to lower levels of consumer demand due to rising unemployment and poverty. For example, the rate of inflation in the prices of items like cloth, washing soap, drugs and medicines, household equipment and appliances, etc., have fallen between January and April.

The above-mentioned shortfall in revenues and the costs of the relief package by the government are likely to take the budget deficit to an unprecedented level. This is unfortunate since the conduct of fiscal operations had been successful in restricting the deficit to 3.6 percent of the GDP in the first three quarters of 2019-20 as compared to 5 percent of the GDP in the corresponding period last year. It will not be surprising if the last quarter of the year witnesses a huge deficit approaching 6 percent of the GDP. The indication that this is beginning to happen is highlighted by the recent jump in government borrowing from the banking sector.

There are two other developments which need to be highlighted on the public finance front. First, Provincial Governments are beginning to see a reduction in their cash surpluses. Federal transfers increased by only 12 percent in the first nine months despite a 17 percent jump in revenues from Federal taxes in the divisible pool. Probably there has been some withholding of transfers by the Federal Government. Now with the likely huge shortfall in both federal and provincial tax revenues there is the likelihood that the four provincial governments combined will actually have a large cash deficit by end-June in excess of Rs 200 billion perhaps for the first time. No doubt, this will also contribute to a larger consolidated fiscal deficit.

Second, the mix of borrowing to finance the deficit is also beginning to diverge substantially from the budget estimates for 2019-20. Net external borrowing was Rs 692 billion in the first nine months. In fact, in the third quarter net external inflow into the Government account was only Rs 170 billion. The expectation in the federal budget was an average quarterly inflow of Rs 300 billion. This highlights the growing shortage of sources of international borrowing following Covid-19.

We come next to the important developments on the balance of payments front. The extremely good news is that in the month of March there was virtually no deficit on the current account, thanks to a big fall in the trade deficit both in goods and in services and continued growth in home remittances. But the big question is why despite this big improvement the overall balance of payments was actually in deficit in March?

The answer lies in developments in the financial account of the balance of payments. The balance of this account actually turned negative perhaps for the first time in many months. There was an outflow of $1627 million from this account as compared to an inflow of $3412 million in March 2019.

There are two reasons for this negative development. First, the onset of Covid-19 led to an unanticipated exit of $1830 million of the 'hot money' invested in short-term treasury bills. Second, there was also a net outflow of $778 billion from the General Government account. This was primarily due to a big increase in external debt repayment of 40 percent and a marginal inflow of newly borrowed funds of only $152 million. Interestingly, here again the original budget expectation was of a gross inflow of borrowing of $1667 million monthly. This again confirms how Covid-19 is leading to bigger outflows and lower inflows. If this trend persists for sometime then Pakistan's balance of payments position could become more fragile.

Fortunately, the month of April has seen an inflow of $1.4 billion from the rapid financing facility of the IMF. This has, more or less, sustained the level of foreign exchange reserves. But there is a big question mark about the future of the IMF program with Pakistan from the Extended Fund Facility.

Most of the emerging developments are unfortunately in the negative direction. If they persist then the real GDP, exports and private investment will continue falling, while the budgetary position and the balance of payments will deteriorate substantially. The Covid-19 has exposed the relatively more fragile nature of Pakistan's economy. We hope and sincerely pray that we will emerge from the pandemic without too loss of 'lives and livelihoods'.

(The writer is Professor Emeritus at BNU and former Federal Minister)