From Aid-Fuelled Growth to Volatility

Zia’s regime represented the second episode of aid-fuelled growth after Pakistan became a ‘front-line’ state with the Soviet invasion of Afghanistan in 1979.

His economic policies were otherwise unremarkable and devoid of any bold initiatives. The economy was kept on a stable path thanks to the ultra-conservative approach of the inimitable Ghulam Ishaq Khan who, as the country’s financial kingpin, had an aversion to changing the economic status quo and little time or patience to hear about IMF/World Bank recommendations of freer markets, privatisation, exchange rate flexibility and a bigger role for the private sector.

In a World 188Bank document outlining the conditionality of a Structural Adjustment Loan for Pakistan he wrote succinctly by hand, ‘I am not prepared to hand over the management of the Pakistan economy to the World Bank for $250 million’. That was the end of that discussion.

While foreign aid once again was the main driver of growth, it cannot be said that the aid Pakistan received during these years was well spent. Indeed, as we know now, much of the aid was diverted to the military. Zia had other things on his mind and left much of the economic management to his Finance Minister who was content to keep a steady hand on the levers of economic policy. It must have been a blow to a hugely stubborn and proud man when Pakistan was forced to enter into a three-year arrangement with the IMF (an Extended Fund Facility) because of balance of payments difficulties.

The program was treated as a secret document with only one copy of the program conditionality kept under lock and key. Even secretaries of ministries and divisions were not called to the meetings with the IMF so they could not present their views, had no idea of what had been agreed to or what they had to implement. In any event, the IMF program was abandoned without completing it or undertaking any economic reforms of substance (apart from minor tinkering with the trade and import tariff regime and some cosmetic steps towards restructuring the public enterprise sector), one of the many IMF programs that would meet the same fate.

The first signs of macroeconomic volatility seem to have started with the Benazir government. Her first tenure was labelled a ‘comedy of errors’. There was some truth to that unflattering label despite the steadying hand of her experienced and able Advisor of Finance whom she, sadly, did not listen to often enough. Once again in economic distress, Pakistan entered into a major IMF program at the inception of her government. On a visit to Washington DC, the Managing Director of the IMF was so taken by her that he added $100 million with his own pen to the $1.2 billion the IMF staff had recommended for Pakistan. This was done on the understanding of cutting trade protection by 30 per cent while meeting a fiscal deficit target of 5 per cent of GDP. In the budget that followed, she did neither, bringing the IMF program to an ignominious halt.

Following much discussion and new commitments, the IMF program was re-started. Even then, economic growth was lackluster and volatile, fiscal 189slippages were routine and inflation picked up. Despite IMF resources there was constant pressure on the external accounts as manifest by the (growing) disparity between the parallel market for foreign exchange (or the ‘hundi’ rate) and the official market rate. This was because the budget was subject to extreme spending pressures since her weak mandate meant she had to please everyone. Budget supplmentaries (approvals for more spending not provided for in the original budget) became commonplace.

The disparity between the official and ‘hundi’ rate was also widening, as the Prime Minister would give instructions to the State Bank not to move the exchange rate because it gave her a bad press and suggested economic failure. She was always concerned about ‘my forex position’ as she called it. But to her credit must go two accomplishments. She granted the State Bank of Pakistan a degree of autonomy (even if it was under IMF pressure and was part of a ‘prior action’ in the IMF program meaning an action to be taken before the program was approved) taking it out of the grip of the Ministry of Finance. Pakistan’s tax- to-GDP ratio hit a short-lived peak during her twenty months in power in her first tenure in office. Once convinced, and that was never easy because she was opinionated and liked to argue, she showed a capacity to take bold measures and accept the political backlash. This was sustained and well- orchestrated with Nawaz Sharif and his ‘bazaar-power’ snapping at her heels from the Punjab asking his supporters not to pay taxes. Clandestine efforts were also made to spread panic in the foreign exchange market by planted rumours of massive capital flight. Pakistan’s foreign exchange reserves took a frightening dip as the contrived rumours turned into a self-fulfilling prophecy. However, the situation stabilised quickly thereafter.

Sharif’s ‘Far-Reaching’ Reforms

Nawaz Sharif is widely regarded as bringing about an economic revolution in Pakistan with his ‘far-reaching’ economic reforms. His ’no­ questions-asked’ foreign currency deposits (FCDs) were a haven for tax evaders and under-filers—the scourge of Pakistan’s economy—that could now ‘whiten’ their ill-gotten income with no taxation and no fear of detection. With no foreign exchange reserve cover to back them up, these deposits quickly swelled to close to $12 billion, of which 80 per cent belonged to resident Pakistanis who had converted their ill-gotten wealth into dollar accounts with no fear of questions as to the source of this income. To add insult to injury to those who did pay taxes, these FCDs were handsomely 190remunerated at above-market rates, guaranteed against exchange risk and allowed unrestricted withdrawal facilities. These features and capital gains from exchange rate depreciation made the scheme a highly attractive instrument. Since this was an age before concerns about ‘money laundering’ were openly talked about the IMF gave muted approval to this ‘far-reaching’ reform. However, as the IMF cautioned, an ‘open capital account’ (which incidentally inverted the sequence of external liberalisation since the current account should have been opened first) meant that economic policies would have to be especially disciplined so as not to shake the confidence of these holders of foreign exchange. The IMF also warned that the overhang of such foreign exchange demand liabilities, unmatched by parallel reserve accumulation, heightened the economy’s vulnerability to downside risks and that bad policies or an adverse exogenous shock would quickly manifest itself in capital flight and bring the economy to its knees.

But many feel the Fund was not forceful enough. As the Fund’s Independent Evaluation Office report on Pakistan noted, ‘at the authorities request, the FCDs owned by residents were reported in the balance of payments “above the line” as part of private transfers (like workers’ remittances) and even FCDs held by non-residents were not included in the stock of external debt’. Furthermore, FCDs held by residents, even though they represented a liquid claim on the central bank’s foreign exchange holdings and generated a large ‘open’ position for the central bank, were not netted out for the purpose of program monitoring of net international reserves, or NIR (where changes in NIR are an important part of program conditionality).

The benefit to government of these resident FCDs was that it had access to foreign exchange that could be used to finance the external current account deficit. It also allowed the Sharif government (including, to be sure, successive governments) to postpone taking the necessary but difficult policy measures to address the fundamental disequilibrium in the balance of payments. However, by encouraging rapid ‘dollarisation’ of the economy it eroded confidence in the rupee, reduced the tax base, caused huge losses to the State Bank because of the exchange risk guarantee and immunity from enquiry, legalised capital flight and promoted the growth of the underground economy. Finally, at a policy level, the rising proportion of resident FCDs in total money supply constrained monetary policy management. Controlling 191domestic liquidity became more difficult and behavioural relationships between reserve money (operational target) broad money (intermediate target) and inflation (ultimate objective) became more complex.

Despite the economy’s new vulnerability and the need to foster an environment of macroeconomic stability and low inflation, the government embarked on a number of grandiose schemes, the most notable of which were motorways and airports (all financed by non- concessional external borrowing) with the piece de resistance being the yellow cab scheme. In short order, as rows of yellow cabs filled the parking lots at the Karachi Port, Pakistan’s foreign exchange reserves started to dwindle with alarming speed until there was only $150 million left in the kitty (equivalent to about a day’s worth of imports) against foreign exchange demand liabilities of $12 billion. Once again Pakistan turned to the IMF to bail it out.

Shifting Sands

General Musharraf acknowledged that he did not know economics. But he was a good listener, loved long-winded, coloured power-point presentations and he learnt well. As usual, given the precarious state of the economy with low foreign exchange reserves, Pakistan entered into an IMF program, which took the shape of a three-year highly concessional Poverty Reduction and Growth Facility (PRGF) with high access. Despite the arrangement, foreign exchange reserves initially continued to hover at the very low level of $1-1.7 billion. This changed dramatically after 9/11 reflecting the reverse flow of capital and re-flow of workers’ remittances into the official market, both of which occurred in response to fears of possible investigation of transactions in the money-changer market. Debt relief from the Paris Club, increased disbursements of foreign assistance by the US after Pakistan’s cooperation in Afghanistan, also contributed to the reserve build-up. In one year alone, foreign exchange reserves surged by more than $4 billion, boosting confidence, stabilising the exchange rate and reducing the disparity between the official and parallel market rate for foreign exchange. Indeed at one point the parallel market rate was less depreciated than the official exchange rate.

In a remarkable first, the government actually completed the three- year PRGF. Whether this was done with a sleight of hand or not remains 192a mystery. Pakistan had earlier confessed to cooking the fiscal books and showing a lower fiscal deficit than the true one. Without taking the Office of Executive Director in the IMF into confidence beforehand, which may have allowed the matter of misreporting to be handled quietly, the new Finance Minister stunned the IMF with a letter of admission of misreporting of the fiscal deficit. An IMF mission was sent to Pakistan to investigate the matter and submitted a report to the IMF Executive Board. Pakistan was fined millions of SDRs (the IMF’s synthetic unit of account) for this indiscretion and had to return money to the IMF since it had been accessed (drawn on) in the context of an IMF program and therefore under false pretences (IMF News Brief No. 00/23). Whether this practice of massaging the data to meet targets continued under the PRGF remains unknown. With a few exceptions, Pakistan’s national accounts are poor and bear only a passing resemblance to the reality on the ground. This is especially so with regards to the fiscal accounts where an unknown but certainly large amount of spending, particularly US-funded military spending, is undertaken off-budget. The fiscal accounts, typically the cornerstone of an IMF program are a tempting target for discreet and deft manipulation.

With the IMF program completed, there was much rejoicing and backslapping over having broken the ‘begging bowl’ and regaining our ’economic sovereignty’. To more sober and thoughtful minds, and especially in the light of our past experience, many hearts sank since such boastful declarations usually signal the beginning of another end. And so it was this time as well. Now unconstrained in its decision-making, the government embarked on a hasty and ill-conceived dash for growth taking comfort from a significant level of foreign exchange reserves, sharply rising workers’ remittances, up-grades by rating agencies, large inflows of foreign private direct and portfolio investment, new bond flotation, and plentiful aid. The principal instrument to further the government’s growth objective was to use monetary policy to finance consumption, a bizarre strategy in a savings- constrained economy with a large savings-investment gap (which was mirrored on the external side by the large disparity between imports and exports). To ‘kick-start’ the economy, interest rates were cut sharply to below inflation which meant that they were negative in inflation-adjusted terms flooding the economy with cheap money and excess liquidity. In the initial period, with some ‘slack’ in the economy (as reflected in underutilised labour 193and capital and a negative output-gap) growth did pick up and inflation stayed low. However, this slack was quickly taken up and the economy moved to above its ‘potential growth’ limit, defined as the maximum speed at which an economy can grow-given labour and capital resources and the shape of the technical progress function—without igniting inflationary pressures or straining macroeconomic imbalances.

The underlying trend of inflation is always a good indicator of resources pressure in an economy. Inflation was unusually low in the aftermath of September 11 at around 2 per cent per annum but started to pick- up. By the time inflation had reached 5-6 per cent per annum there was no cause for undue alarm since that is Pakistan’s long-term ‘steady-state’ rate of inflation and one could argue that inflation had reverted to its long-term trend. There would have been even less cause for concern on the inflation front if the growth upswing had been accompanied by improvements in economy- wide Total Factor Productivity (TFP) that would augment the economy’s potential non-inflationary growth limit. While a pick-up in TFP typically occurs in the initial phase of an economic upturn (as output grows faster than the existing stock of inputs of labour, capital and technology), the growth of TFP should reflect a permanent structural shift in the production function that is sustained and can therefore support the higher non-inflationary growth potential of the economy. There is no evidence to suggest that TFP growth following an initial pick-up was either permanent, structural or was sustained. To a discerning economic observer it should have been clear that the economy had started to ‘overheat’ as aggregate demand raced ahead of the economy’s aggregate supply potential largely fuelled by consumption. In addition to the loose and highly accommodative monetary policy stance of negative real interest rates, the fiscal deficit instead of serving as a counter- cyclical tool and attenuating demand pressures on the up-swing (as it normally should) was becoming dangerously pro­cyclical. Thus, both fiscal and monetary policy was imparting a strong expansionary impulse, pushing up inflation and spilling over into the external sector leading to surging imports while ‘crowding out’ exports when economic policy should have been aiming to do the reverse.

The fact that the exchange rate was appreciating in real effective terms (a ‘stable’ nominal exchange rate set against a background of rising domestic inflation) made matters worse as export profitability was squeezed and the export-to-GDP ratio fell. As the external deficit widened 194there was sustained downward pressure on the country’s foreign exchange reserves. This is always an unambiguous sign of an economy under stress. A paper prepared by the Social Policy and Development Center as early as 2005 presented some striking numbers all pointing towards economic overheating. Economic growth was a solid 8.4 per cent, the highest in the world. But growth was not being driven by investment and net exports. It was being led by consumption and imports rather than the more sustainable route of investment and exports. In 2005 real private consumption rose by 17 per cent (double the rate of the previous year), imports by 44 per cent, exports by only 8 per cent (the large difference between imports and exports or net exports shaved off as much as 5 per cent from growth), private fixed investment rose by a modest 4.8 per cent, public investment fell 5 per cent and inflation accelerated into double-digits. Despite these numbers, which denoted an economy under stress, the 2005-06 budget took on an ominously expansionary and pro-cyclical stance.

Apologists for General Musharraf’s regime argue that once it had become clear that the economy was overheating, the State Bank of Pakistan moved into a tightening phase and raised its policy interest rate to cool the economy. If that was the case the State Bank was hopelessly behind the policy-making curve. This is because it takes twelve to fifteen months for a change in the policy interest rate to start to affect outcomes. In view of these long lags, the State Bank should have acted pre-emptively at the first unmistakable signs of economic overheating (of which there were many) to dampen demand pressures and subdue inflation, which had now developed a worryingly unstoppable dimension.

With speculative bubbles developing in consumption, the real estate sector, the stock market and commodities such as gold, and accelerating inflation, all that was needed to tip an overheated economy with heightened vulnerability over the edge was a small unanticipated exogenous domestic or external shock.

This came in the form of the large ’twin global shocks’, the first of which was the surge in the global price of oil and other commodities; and the second the worst global financial crisis since the Great Depression.

The former pushed Pakistan’s fiscal deficit to beyond 8 per cent of GDP as the higher price of oil was absorbed into the budget as subsidies and was not passed through; correspondingly the higher imported cost of oil and commodities swelled the external current account deficit to in excess of 8 per 195cent of GDP.

The ‘Great Global Recession’ also hurt the demand for Pakistan’s exports at a time when import volume and unit values were rising strongly. The new government inherited an economy in growing disarray as the lags from the deeply flawed policies of the previous government worked themselves out. Instead of quickly taking stock of the rapidly deteriorating economic situation and implementing strong corrective measures, the government seemed stupefied. A new concoction named ‘Friends of Democratic Pakistan’ (FoDP) pledged fresh assistance to Pakistan at a conference held in Tokyo, Japan but it was clear—or should have been clear—that translating these pledges into actual inflows that would help the budget and/or the balance of payments would take time. The Finance Minister informed the people that he had a ‘Plan A’, a ‘Plan B’ and a ‘Plan C’ in mind when it should have been clear to him that the only game in town was Plan F—the IMF.

Countries that are in economic distress are reluctant to turn to the IMF for assistance, since doing so is an admission of economic failure and of a loss of control.

Articles in the Pakistan press about ‘fiscal servitude’ and the ‘social holocaust’ an IMF program will bring in its wake, whether contrived or spontaneous, did not help the government make up its mind.

However, delaying, prevaricating and hoping that someone would come to Pakistan’s rescue only made the task of economic adjustment more painful. It is self-evident that the wrenching pain of adjustment and the strength of the corrective measures that would be needed to put the economy back on track would have been smaller and the costs in terms of lost output, employment and poverty less if Pakistan had turned to the IMF earlier rather than later.

As domestic and external deficits widened and inflation continued to climb, confidence was lost and there ensued unprecedented capital flight amid a rupee/dollar exchange rate in virtual free-fall.

The stock market collapsed as private portfolio investment fled to safer heavens, bubbles popped and our foreign exchange reserves, in a painful repeat of the past, started to disappear with astonishing speed, at one time declining $700 million in a single week. In the end, Pakistan had no recourse except to turn once again to the IMF for ’exceptional financing’. It is highly likely that the FoDP made their support conditional on Pakistan engaging with the IMF.

196In hindsight it is true that the twin external exogenous shocks served as the tipping point for the economy. But these shocks were neither the precipitating nor the initiating force behind Pakistan’s latest economic crisis; they exacerbated it but did not cause it. The root cause of the crisis was the short-sighted and heedless pursuit of unsustainable policies, both fiscal and monetary, that produced an illusion of consumption-led growth and prosperity for a while but was bound to self-destruct With a little bit of foresight, attention to the build-up of pressures and carefully-calibrated pre-emptive steps to cool the economy, the economy would have made a ‘soft landing’ and Pakistan could have been as well-placed to cope with the twin exogenous shocks as other developing countries were. The economy could have continued on a less spectacular but more sustainable growth path with macroeconomic imbalances tending towards correction and inflationary pressure easing. Other developing countries had room to use their fiscal position as a counter-cyclical tool and ease monetary policy to cushion the turbulent downburst arising from ‘The Great Global Recession’ since their starting position was stronger.

Pakistan had to do the reverse. It had to tighten its macroeconomic policy stance, curb the fiscal deficit and push up interest rates in an effort to dampen demand pressures and inflation and forestall a full­blown balance of payments crisis and debt-default. The people of Pakistan were once again put through a painful exercise of economic readjustment. As economic growth slowed amid soaring inflation which hit an unprecedented headline rate of 26 per cent (core inflation which strips out the volatile components of inflation such as food and oil and is an unambiguous reflection of the underlying stance of macro­economic policies also hit an unprecedented high of 18 per cent), the economy was trapped in the grips of stagflation. Unemployment rose and millions of households were pushed back into poverty as high inflation cruelly eroded their living standards.

Was the IMF Culpable?

It has been argued that the genesis of the crisis as described here is exaggerated because the IMF—the ever-watchful guardian of fiscal and 197monetary rectitude—would have said something. However, the truth of the matter is that with the IMF program having been completed, it had no leverage over the conduct and direction of Pakistan’s economic policies. The annual obligatory Article IV Consultation discussion which the IMF holds with all member-countries (advanced and developing) is, compared to program negotiations, a relaxed affair and is taken lightly. This is unfortunate because IMF ‘surveillance’ over member’s policies (whether they have an IMF program or not) goes to the heart of the IMF’s mandate. The IMF is duty-bound to point out emerging risks and unsustainable policies and make recommendations for timely corrective action. How it should convey the message and what kind of language it should use has been the subject of much debate amongst IMF staff, management and the Executive Board. There is always the risk that strong words may rattle markets and precipitate a crisis when there was not one to begin with. On the other hand, the IMF can be too nuanced and subtle in its language (sometimes dubbed as ‘Fund- speak’) in glossing over fault lines. It has happened in South America and most infamously in the Asian Crisis of the 90s as well as in Mexico and Russia. Critical turning points can be missed, the language in staff reports to the Executive Board is insufficiently forthright and the IMF is caught off- guard when the crisis erupts.

Were the Pakistani authorities warned of the unsustainable nature of their policies or the economy’s heightened vulnerability to shocks, and impending disaster? There is reason to believe they were, but only in private. These warnings were rebuffed with the Bushism that, ‘You are either with us or against us’. In one case a critical report on the performance of the Pakistan economy was re-written, toning down the language and the Mission Chief’s name was removed from the document. Obviously, neither the Pakistani authorities nor the JMF’s Executive Board read the original unexpurgated report. That report presented in stark hard- hitting terms the escalating risks of an impending crisis and urged urgent corrective action in the fiscal, monetary, structural and exchange rate areas. Is the IMF therefore culpable in Pakistan’s most recent crisis? To an extent it was. The IMF is a professional organisation with some of the best macroeconomists under one roof but it is neither clairvoyant nor omnipotent. The IMF has also made mistakes and some very grievous ones. In Pakistan’s case, the IMF has not been the overbearing, rigid and inflexible detractor that it is made out to be. It has not had a profound and deep impact on policy- 198making in Pakistan. Its influence has been intermittent, if not marginal. Those in Pakistan deeply committed to reforms lament the fact that the IMF has been insufficiently tough on Pakistan laying itself open to the charge that its policies serve to perpetuate Pakistan’s corrupt ruling elites. Time and again Pakistan has been left off the proverbial hook when economic adversity and a need for exceptional financing from the IMF to stave off a financial crisis would have been the best time to push through deep seated and lasting reform. These remarks apply to other multilateral lending agencies as well—the World Bank (WB) and Asian Development Bank (ADB).