The external balance of payments of Pakistan worsened in 2016/17crossing $12 billion, from a relatively safe level of below $5 billion in 2015-16. The year, 2017-18 saw a further deterioration and the current account deficit rose further to $18 billion, equivalent to 5.8 percent of the GDP. This puts us in the list of countries vulnerable to complications in discharging external debt obligations. Countries like Egypt and Turkey also have current deficits in the range of 5.5 to 6.5 percent of their GDP. These countries have witnessed substantial depreciation in the value of their respective currencies, ranging from 50 percent to 60 percent, over the last two years.
Why has the current account deficit become so large? And has this deficit acquired a deeper, protracted and structural character? There are a number of explanations for its growing level. First, the policy preference from 2014 onwards was to maintain the nominal value of the rupee. This resulted in the appreciation of the real effective exchange rate (REER), by as much as 24 percent by mid-2017. This rise in the value of the currency affected the competitiveness of our exports and made imports cheap relative to domestically produced goods. Consequently, exports plummeted by 12 percent between 2013-14 and 2016-17, while imports continued to grow at an accelerated rate.
Secondly, the IMF Program bound us to further liberalize the trade regime, requiring the scaling down of the import tariff walls, resulting in the maximum tariff being brought down from 30 percent to 20 percent. The lower tariff slabs were also cascaded down accordingly.
Thirdly, a number of other special factors were also in operation. The launching of power generation and other infrastructure projects under CPEC induced a sharp increase in imports of machinery by almost 23 percent between 2015-16 and 2017-18. Furthermore, the oil price which had fallen to below US$ 50 per barrel in 2015 started rising, especially in 2016-17. As a result, from 2015-16 to 2017-18 the oil import bill increased by 59 percent.
Exports have also been rendered more uncompetitive by some other factors. The zero-rating of exports should have implied, more or less, automatic payment of refunds. But this has not transpired. Currently, over Rs 200 billion of outstanding refund claims have piled up, adversely affecting the liquidity of exporters.
The cost disadvantage of exporters has been worsened by the relatively high price of electricity in Pakistan, partly owing to large inefficiencies in generation, transmission and distribution, partly to a continuing low recovery rate of bills and theft. System losses approach 30 percent. Also, until recently there was heavy dependence on a relatively expensive fuel source, furnace oil.
Our vulnerability to a financial crisis is highlighted by the perilously low level of foreign exchange reserves with the SBP. Currently, they stand at just above $10 billion, not even enough to provide an import cover of two months. Further, if the 'swap' funds with the SBP are excluded net reserves are down to a precarious level of less than $ 4 billion.
1. FACTORS AFFECTING COMPETITIVENESS
In the last five years, the competitiveness of the real sectors in particular and the economy in general has been increasingly compromised. Two inextricably linked policy distortions and poor governance have impacted the competitiveness of the economy, creating and reinforcing potentially grim challenges in the not too distant future to the financing of our external bills.
These relate to:
a) An increasingly slanted tax structure conjoined with the unpredictable interpretation of the governing laws that incentivizes movement of investable funds into either unproductive sectors of the economy (like real estate, speculative activities, etc.) or sub-sectors of a 'rentier' nature involving heavy protection against global competitors. The complex system has simultaneously raised for all businesses the cost of compliance with tax regulations;
b) As mentioned above an overvalued exchange rate and other policies pertaining to taxation in general, and long delays in processing tax refunds, in particular of exported products and higher input costs due to relatively large energy tariffs and transportation costs (owing to a heavy reliance on taxes on diesel for tax revenues-the mainstay of industry, transport and agriculture). This is the consequence of complex and high rates of import duties on raw materials and intermediate goods used in manufacturing and a dysfunctional system for GST and customs duty refunds. These factors induced a higher rate of our domestic inflation compared with our competitors or trading partners, gravely impairing the competitiveness of the economy.
c) Since we have been running large budget deficits (with their spill-over effects on the balance of payments) and a higher rate of inflation than our trading partners it has been difficult to ensure stability in the value of the rupee. A high rate of inflation within the country with an un-adjusted rupee raises the cost of production, making imports cheaper and exports less competitive internationally.
Furthermore, we have to compete in a global trading system where increasingly stringent requirements apply with regard to product quality, safety, health and environmental impact. Hence, exporters need certificates from internationally recognized institutions that their products conform to these requirements.
Today, non-tariff trade costs (freight, insurance, and other cross-border-related fees) tend to be much larger than any remaining import tariffs. Those trade costs also have a more intangible dimension that encompasses information costs, non-monetary barriers (regulation, licensing, and so on), insecure contracts, and weak trade governance leading to uncertainty.
The discussion above underscores the complexity of designing trade policy, since it requires grappling with a large array of overlapping objectives, in a system where policymaking is highly fragmented. In Pakistan historically, the destiny of our economy has been critically dependent upon external capital inflows because the level of our domestic savings has been inadequate to finance the combined investments of the public and private sectors.
Hitherto our style of governance has been to look towards the international community for handouts to pay our bills, as if we have an open-ended license fiscal profligacy, and to mismanage our affairs. Official efforts have been geared to simply winkle the next tranche from the granted loans rather than as temporary relief measures, as efforts are launched for fiscal rectitude and encourage and solicit domestic and foreign investment to drive growth. And foreign investors follow a boom, they cannot create a boom. Foreign investment only supplements and complements domestic investment. The experiences of SE Asia and China bear testimony to this. Foreign investment in China is high because domestic investment is high and not vice versa. There are no examples in the world of accelerated economic growth based largely on foreign capital.
Therefore, going forward we will have to look at domestic sources to meet our growing investment requirement, since international capital flows are destined to become more volatile, while the poor country image and the fragility of the external account will make it more difficult to access such funds at affordable rates. This will require more savings, both 'public' and private, which will have to be anchored in fundamental structural reforms.
2. REFORMS
While acknowledging that the structural vulnerabilities of the external account can be dealt with comprehensively only in the medium-term (there being no quick fixes) some strong multiple actions are needed urgently on both the export and import fronts because, as already argued above, the foundations of our balance of payments are wobbly and the foreign exchange reserves are under severe stress.
These measures should be aimed at bringing the current account deficit down to around 2.5 percent of GDP, corresponding to a gap that can be financed from normal and regular capital flows. Some of these transitional interventions will have to be phased out in the medium to long term to address the structural issues affecting our competitiveness.
Emergency provisions of GATT may also have to be invoked by introducing a regime of minimum import prices (admittedly a non-tariff barrier) not entirely because of balance of payment financing reasons but for administrative reasons as well, to check under-invoicing.
The import bill could also be controlled by a wider system of cash margins for various categories of imported items. The cash margin could range from 10 percent to 100 percent, depending on the nature of the good imported.
For reducing the high cost of doing business for exports we propose the following measures:
a) Removal of regulatory duties on all raw materials to reduce the high cost of domestic production to compete with imports and help exports.
b) Levy of import duties on machinery and spare parts to 5% and removal of GST on machinery, whether imported by manufacturer or commercial importers, to reduce the cost of investment for modernization and to keep up with new trends in the export market. Simultaneously, There is need to minimize the number of SROs.
b) Five exporting sectors zero rated by FBR should also be zero rated for power surcharges on energy to bring the tariff in line with regional competitors. The export incentive scheme should be extended to cover more emerging exports.
c) As starting points for achieving timely refunds, FBR revenue targets should be set in gross terms to reduce the incentive to withhold refunds and the previous system of automatic refunds is reintroduced for matching transactions/invoices filed by the seller and buyer.
d) A mechanism needs to be put in place to provide duty drawbacks on locally manufactured raw materials to support the entire value chain.
e) Indirect exports should be made eligible for support under the LTFF scheme.
f) The LTFF facility should also cover investment on infrastructure of garment plants.
g) Manufacturers-cum-Exporters who do not have composite units but get the work done by vendors are not allowed facilitation under the DTRE scheme. The facility of import of yarn, fabric and other raw materials under the DTRE scheme is only allowed to composite units. It should be extended to Manufacturers-cum-Exporters who do not have composite units are now allowed.
h) To improve the liquidity of exporters and reduce their cost of doing business we should consider an Indian type instrument (its Merchandize Exports from India Scheme) whereby Duty Credit Scrip's are issued automatically against actual export receipts (as a percentage of the FOB value), which can then be used for paying customs duties and GST, instead of the present system of processing these claims through long winded procedures lacking transparency.
i) Alternatively, a cash incentive type scheme followed by Bangladesh may be adopted. This will require payment of the export rebate/duty drawback along with the export receipts by commercial banks and reimbursement by the SBP.
Furthermore, whilst the bigger exporters in the country have the resources to participate in these regional chains and replace say the Chinese suppliers as the move up the up the value chain, the SME sector, which provides jobs to 80 percent of the manufacturing labor force, will need government support to benefit from such opportunities. Recommendations on credit to SME exporters are:
a) More than 70 percent of the credit lines under the EFS are utilized by the 100 largest exporters. Hence a separate and dedicated component of EFS and LTTF financing should be established for SMEs.
b) Since energy is a key issue, the government can help SMEs by conducting and subsidizing their energy audits to make their processes more energy efficient;
c) Existing vocational and technical training centers for sub-sectors in which we have a comparative advantage should be transferred to a foreign partner to produce internationally certified skilled workers. Bilateral donors can be persuaded to divert their funding for setting up state of the art institutions and become partners in financing technical assistance and managing such centers-because their present grants tend to be relatively small and thinly spread across different agencies and programs, with limited societal and economic impact.
Moreover, with the change in currency of power - from 'hard' to 'soft' other opportunities are being generated with creative industries becoming an important source of not just the badly needed 'soft image' of the country but also a source of growth and trade. Our bright young designers, singers and musicians (many of whom are women) can help change the country image. They should be supported to enable them to realize their potential. This will not require large volumes of funds.
3. MEETING THE FINANCING REQUIREMENT
As highlighted above, there is the risk that the external financing requirement could reach an even higher level of $29 billion in 2018-19. Last year, even with a significantly lower requirement of $24 billion, almost $6.3 billion of reserves were consumed to finance the gap. And this year such a cushion of reserves does not exist, presenting a more formidable challenge.
There are two potential options. If we enter into negotiations with the IMF and unacceptable non-economic conditions are imposed then several strong domestic measures will have to be implemented to achieve a measure of self-reliance.
This will involve reducing imports by over 5 percent in relation to last year's imports of $56 billion to achieve which there will be a need to simultaneously apply a variety of reforms to contain imports. This will include a general enhancement in import tariffs (and possible tariff quotas on competitive imports from China), across-the-board application of cash margins up to 30 percent and significant further depreciation of the rupee (such that the REER is brought down from 111 to 100).
The pressure on the rupee and the foreign exchange reserves is not likely to subside anytime soon following the initiation of 'global currency wars' as one outcome of the trade wars. This depreciation (along with the increase in interest rates-see below) will address the issue of creeping speculation against the rupee, while discouraging imports and improving the competitiveness of our exports.
Direct attempts to narrow the trade deficit will have to be supported by fiscal and monetary policies so as to manage the overall level of aggregate demand in the economy, thereby restricting the volume of import.
This will include a reduction in the size the PSDP by up to Rs 200 billion. The policy rate of the SBP (hitherto benign in nature) may have to reach a double-digit rate and government borrowing from the SBP will have to be limited to below 1.5 percent of the GDP to ensure relatively low growth in money supply.
On the fiscal policy front, the proposals contained in the earlier articles on the agenda of tax reforms and on economy in expenditure will need to be implemented. The fiscal deficit for 2018/19 will have to be brought down to near 5 percent of GDP.
The above set of measures should halve the deficit of 2017/18 of $18 billion to $9 billion in 2018-19. With external debt repayments of around $9 billion this year, the gross financing requirement will be $18 billion following the stabilization measures mentioned above.
The problem is that even with this lower requirement the financing of such a gap will be tough. With less than two months import cover of reserves, multilaterals like the World Bank and ADB may slow down, if not stop, the flow of funds to Pakistan. Also, it will not be possible to float bonds internationally except at interest rates carrying a high risk premium. The country will then have to rely on increased support from friendly countries like China and Saudi Arabia and place hope on increased investment by the diaspora.
Based on the above referred measures to stabilize the economy, without an IMF Programme, the BNU Macro Econometric Model makes the following projections for 2018-19:
Current Account Deficit:--$ 9 billion
GDP Growth Rate: --4.4 %
Private Investment Growth Rate: ---5.5%
Increase in Employment:----less than 1/4th of the
--annual addition to
--labour force
Rate of Inflation:--10.5%
Budget Deficit: --5.2% of the GDP
Therefore 2018-19 is likely to be a year characterized by a decline in the growth rate from 5.8% in 2017-18 to 4.4%, a rise in the rate of inflation from about 4% to over 10% and a nominal increase in employment opportunities.
The slowing down of the growth rate following the squeezing of imports can be less harsh as a consequence of CPEC related investments and a faster rate of growth of exports, assisted by timely payments of duty drawbacks and tax and GST refunds at the time of export receipts.
The inflationary impact of the measures can partly be moderated by the utilization of cheaper sources of energy through an improvement in the fuel mix and by adjusting downward the support and procurement prices of sugar and wheat to reflect the decline in international commodity prices.
From the discussion above, however, it should be apparent that no amount of external flows from friendly countries and bonds taken up by our diaspora will be able to meet the financing requirement of this year, suggesting that an IMF program may be unavoidable.
Contrary to common perceptions, entering into a Program with the IMF will ease the pain of correction; it will actually provide some 'breathing space' to the process of reduction in the current account deficit. This can then be spread over two to three years. Perhaps surprisingly, this should be the chosen path if the Fund behaves as the global lender of the last resort and no non-economic conditions are introduced, since it will enable a gradual and less painful path for undertaking the long delayed essential external and internal adjustments.
Entry into a Program with the IMF will mean that a current account deficit of up to $12 billion can be financed, more or less, comfortably in 2018-19. First, the IMF could make available up to $4 billion in the first year of the Program. Also, the multilateral agencies will be back to support Pakistan and it will also be possible then to float Euro/Sukuk bonds. The second and third year of the Program should witness the completion of structural reforms to put the country back on the path of high and sustainable growth.
The external financing requirements and potential financing in 2018-19 under the two scenarios - 'Without IMF' and 'With IMF' - respectively, are presented in the Table below:
EXTERNAL FINANCING REQUIREMENTS AND SOURCES OF FINANCING
($ billion)
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EXTERNAL FINANCING REQUIREMENTS AND SOURCES OF FINANCINGa
($ billion)
Without IMF With IMF
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A. External Financing Requirements 18.0 23.5
Current Account Deficit 9.0b 12.0c
External Debt Repayment 9.0 9.0
Build up of FE Reserves - 2.5d
B. Financing 18.0 23.5
FDI/FPI 2.5 3.0
Government Borrowing 10.0 13.0
Bilateralse 3.0 2.5
Multilaterals 1.5f 3.5g
Bonds - 2.5
Commercial Loans 4.0 3.0
Other Support 1.5h 1.5h
Private Borrowing 3.0 3.5
Higher Support from Friendly Count 2.5 -
From IMFj - 4.0
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