The Annual Report released by the State Bank of Pakistan on 2nd December gives a fairly objective assessment of the economic situation during 2005-06 and contains lots of advice of the right kind, for the policy makers of the country to deal properly with the emerging weaknesses of the economy.
In order to highlight the contents of the Report and put them into proper perspective, the State Bank Governor, unlike the previous practice, also briefed the newsmen in person at a press conference scheduled for the purpose. This was probably considered necessary to help the press to understand the linkages between various sectors and avoid misrepresentation of the facts.
Pakistan's economy, according to the Report, turned in a strong performance for yet another year in FY06 with real GDP growth of 6.6 percent remaining higher than the desired long-term average of six percent. The sustained high growth was achieved despite the many adverse developments, such as unexpectedly weak harvests of some key crops during FY06, an unprecedented rise in oil prices and the October 2005 earthquake.
This, in large measure, was made possible "by strong growth in exports and private investment that probably contributed to a further reduction in poverty". The use of the word "probably" in the context of reduction of poverty was perhaps meant to convey that the State Bank did not have total faith in the government's measurement of poverty level often publicised to give a rosy picture.
While eulogising the continued growth of the economy, the State Bank also added another caveat at almost the very beginning of the Report by saying that "sustained strong growth has contributed to increased stresses because of (i) a relatively narrow growth base, (ii) persisting high inflation (iii) pressures in fiscal deficit in the backdrop of a nearly stagnant tax base which has kept the tax/GDP ratio in the 10 and 11 percent range for over a decade; (iv) widening of the external current account deficit.
Sustainability of economic growth rates of over six percent in years ahead requires continued vigilance to ensure macroeconomic stability". These words indicate slippage's of policy and performance in these major areas of the economy at the moment, though the rationale of the State Bank to link these weaknesses with sustained high growth is not understandable.
Performance in some of the other key areas of the economy was, however, not impressive. Although national savings rose by 16.5 percent during FY06, their ratio to GDP dropped by 0.1 percentage point to 16.4 percent, the lowest level since FY01, due to a comparatively higher rise in nominal GDP.
The reasons for this unhealthy performance include negative real returns on deposits, smaller than expected rise in NSS rates, and continued consumption boom in the economy. Total investment to GDP ratio, however, rose from 18.1 percent to 20.0 percent.
Fiscal deficit widened to 4.2 percent of GDP as compared to the previous year's 3.3 percent. The Report notes that there remain structural weaknesses in the fiscal system, including a narrow tax base and over-reliance on import related taxes. Provinces have tremendous scope for tapping the revenue potential given that the taxation of major sectors of the economy (agriculture and services) rests with the provinces, but their revenue mobilisation efforts are extremely poor.
SBP continued to follow a tight monetary policy and, for the first time in six years, the growth in broad money dropped below that of nominal GDP. Although CPI witnessed a deceleration from a peak of 9.3 percent in FY05 to 7.9 percent during FY06, inflationary pressures continue to persist in the economy and inflation during 2006-07 may well be in the range of 6.5-7.5 percent, a little above the annual target of 6.5 percent.
Given (1) high levels of CPI inflation and core inflation, (2) resilience in non-food inflation, and (3) a low inflation target of 6.5 percent for the current year, SBP is likely to continue with its tight monetary policy in the months ahead. On the external front, the country witnessed the highest ever current account deficit of $5.0 billion during FY06 as compared to a deficit of $1.5 billion in the previous year.
According to the prognosis of the State Bank, policy environment is likely to be more challenging during FY07. Monetary policy is required to support a lower inflation target as well as higher real GDP growth. The large external current account deficit driven by a rapid expansion in trade deficit would also require continued adherence to tight monetary policy.
The expansionary fiscal policy in FY07 has further compounded the risks to the economy. If necessary growth in expenditures is not matched by a commensurate increase in revenues, the hard-won fiscal space gained in recent years would be lost. Over the medium term, expansion in tax coverage by bringing exempted or lightly taxed sectors in the tax net (including agriculture and the services sectors) and leveraging more provincial and local taxes, is the key to fiscal sustainability.
The Report warns that sustained large external-imbalances typically introduce vulnerabilities in the economy. It would be preferable to finance external deficits principally from stable non-debt sources, rather than taking on additional debt.
Looking forward, the SBP projections suggest that real GDP would be close to the seven percent annual target in FY07 but inflation may exceed the projection of 6.5 percent. Stronger fiscal stimulus and a widening current account deficit together with the risk of an above-target inflation outcome serve to highlight the need for a continuation of a tight monetary posture in FY07.
In doing so, however, the Central Bank would be mindful of the inherent danger of excessive tightening hurting the growth momentum. The widening of current account deficit could be controlled by substantially increasing interest rates (to reduce aggregate demand), or encouraging a depreciation of the rupee (raising the demand for domestic goods relative to imports).
However, given the prevailing tight monetary policy, further sharp rise in interest rates could slow down the growth momentum of the economy and a "sharp rupee depreciation could lead to self-fulfilling expectations that could de-stabilise the economy".
The State Bank, in our view, deserves praise for producing an analytical and comprehensive Report that depicts a true picture of the economy. The broad message of the Report which is loud and clear is that although high growth rate is still intact, problems in other key areas are getting worse.
Inflation continues to be a concern, growth is narrowly based, saving rate is not only declining but is clearly insufficient to finance the necessary investment, current account deficit is widening to dangerous levels, and weakening fiscal deficit is raising the spectre of frittering away of the hard-won fiscal space.
To tell the truth, the economy is now delicately poised. If these problems are properly addressed by the relevant authorities, the economy could witness further growth with stability. Otherwise, the economic prospects of the country would be bleak. It is sad to note that the government functionaries, including the President and the Prime Minister, are busy propagating about the sound health of the economy with the promise to pass its beneficial effects to the common man, without paying enough attention to the emerging weaknesses of the economy.
This could be counter-productive in the long-term as the harsh measures needed to correct the emerging imbalances would be difficult to undertake if the people at large are not informed properly and in time about the impending problems. The State Bank, we feel, has done a service to the nation by revealing the real facts and at the same time by listing the policy alternatives necessary to correct the situation.
The raising of awareness level about the true state of the economy is the only thing that the State Bank can do. It is mostly up to the government to devise appropriate policies and mechanisms to reverse the deteriorating trends in the specified areas to pave the way for a sustained and stable growth which is the only reasonable guarantee to ensure a better economic future for the majority of our people.
The malaise of complacency and the belief within the government that the economy is now strong and resilient enough to withstand severe pressures and grow automatically, surely needs to be discarded.
While we do not take issue with most of the analysis and policy prescriptions given in the Report, there are some aspects of monetary policy which need to be reviewed. It took a long time for the State Bank to realise that monetary policy stance needs to be tightened. A delayed action on the part of the State Bank resulted in high growth of money supply for a number of years and accelerated the pace of inflation.
Thankfully, the rate of inflation has now moderated and the State Bank seems to be more prepared to attune its monetary stance to the unfolding conditions. However, at various places in the Report, the State Bank seems to be highly concerned about the impact of its policies on the growth rate which, gives the impression that the Central Bank is laying equal emphasis on price stability and the growth objective.
This, in our view, should not be the approach of a Central Bank which must concentrate primarily on containment of inflation and design its monetary policy accordingly. In fact, these two objectives should not be considered as mutually exclusive since chances of achieving a sustained high growth are generally better in an environment of price stability.
The case for adopting such a strategy is even more compelling in Pakistan where almost one third of the population lives below the poverty line and there are no safety nets. These poor people do not have capital, fixed assets or savings to absorb the adverse impact of inflationary cycles, and they suffer the most.
The increasing cases of severe depression, suicides and robberies are manifestations of a hopeless situation resulting from unemployment and inflation.
Another omission of the State Bank which we have been pointing out repeatedly was the measly returns on deposits leading to financial repression, low saving rates in the economy and diversion of savings to speculative and unproductive sectors of the economy. It also resulted in transferring of resources abroad to take advantage of higher returns in real terms as against the possibility of depreciation of the Pak rupee.
The State Bank, after waiting for a long time, has finally decided to act in the larger interest of the country. At the press conference, the Governor confirmed the fact of fleecing of the bank depositors in Pakistan beyond any doubt with the help of relevant data and then warned the financial institutions to rectify the situation failing which the banks would be taken to task. We hope that the threat would work. If it doesn't, the State Bank should not feel any hesitation in carrying out its threat.