There is a proposal from the World Bank to extend cash withholding tax on withdrawals from foreign currency accounts. This suggestion has been, reportedly, laid at the doorstep of the Federal Board of Revenue (FBR). The rationale behind this move is fairly evident. As FBR comes under increasing pressure from the government to generate revenue commensurate to the economic activity in the country, FBR should begin to look at short-term measures to raise tax revenues.
A 2004 International Monetary Fund study on Foreign Currency Deposits (FCDs) in Pakistan argued that "the policy makers thought that the FCDs might be the answer to the low level of savings and investment in the economy, because these deposits could help mobilise both domestic and external savings.
However, the increase in potential savings from the FCDs did not result in a boom in investment, but instead these short-term foreign liabilities helped finance large fiscal and external account deficits for a somewhat longer period than would have been possible otherwise. The end result was that the country was saddled with a debt overhang problem, which severely constrained long term growth prospects."
The report adds that Pakistan's experience demonstrates the importance of public debt sustainability for maintaining economic stability and growth and underlines the problems borrowing governments face in assessing the appropriate debt levels. Regulations that governed the FCDs required commercial banks to surrender it to the State Bank, which provided rupees at the prevailing rate. The commercial banks used the rupees to lend to private and public sector, and meeting their own reserve and liquidity requirements.
The IMF report states that "the commercial banks closed their open forex positions by purchasing forward cover from the State Bank, which was sold at subsidised rates (the rate of depreciation of the rupee exceeded the cost of forward cover) for almost all years...thus the FCDs were a highly profitable proposition for the commercial banks that were more interested in mobilising FCDs than deposits denominated in rupees."
It is rumoured that in response to the severe foreign exchange reserve crisis that was faced last year the SBP was continuing to implement this regulation. FCDs from non-resident and resident Pakistanis peaked in 1996-97 (4.35 million dollars and 5.49 million dollars respectively.) FCDs plummeted as a consequence of the decision taken in the post nuclear blast scenario by the Nawaz Sharif government to freeze all foreign currency accounts and never ever reached the same highs.
In 2003-04 the total foreign currency accounts were only 221 million dollars, a tiny percentage of the pre-nuclear blast position. It is heartening to learn that the FBR has convinced the World Bank, for the time being at least, that such taxation would be counter productive to the economic objectives as these accounts serve to boost the dwindling foreign currency reserves of the country.
It is, however, pertinent to note that the protection given by the Sharif government to such accounts pre-nuclear blast, which overrode all other related legislation, continues to be debated, off and on, by the State Bank and the FBR as a prelude to generating revenue from these accounts. With a burgeoning budget deficit what policy options must the government consider with respect to the FCDs?
IMF argues that international reserve targets must be set in relation to variations in the volumes of foreign trade as well as growth in the short-term liabilities like FCDs. It also urges the government to enact measures to enhance international liquidity, including measures that would make domestic currency denominated assets more attractive to hold.
Lower inflation, adequate rates of return on domestic currency deposits, or in other words with a positive real rate of return, would lead to sustained lowering of reliance on FCDs and the dollarisation of the economy. Be that as it may, these conditions do not apply to the economy today; however, one would hope that the government would follow prudent policies in this regard by seeking to attract FCDs without taxing them and at the same time not use these accounts to strengthen its external account position.