Ownership of Reforms

Pakistan needs many macroeconomic and structural reforms.

These have been unfulfilled even after 63 years and many failed IMF programs.

Pakistan’s record of taking reform steps and then rolling them back had earned it the sobriquet of ‘stop-start adjustment’.

An IMF program gets some reforms implemented as part of its conditionality. But as soon as the program is over or ended by the authorities themselves mid-way, all the reforms are rolled back.

Tax exemptions and concessions are a case in point. The IMF will insist that these exemptions and concessions be removed since they fragment the tax base and reduce revenue, are wasteful and ineffective. They are removed only to be put back once the IMF program is over.

At the next program—and there always is another IMF program lurking down the road—the charade is repeated. Selective tax concessions and/or exemptions are doled out again to the politically powerful, the budget is burdened with ill-targeted subsidies which accrue largely to the rich and crowd-out much needed investment in social and physical infrastructure, and import protection is raised for specific products and sectors.

Tax revenues fail to keep up with even the nominal growth of the economy because of poor compliance, corruption and insufficiently vigorous audits of tax under-filers.

The phenomenon of reforms being rolled-back and vitiating any good that may have been done is a striking manifestation of a lack of ‘program ownership’. Pakistan needs to ‘own’ reforms not only under­ take them, haltingly and grudgingly, or with a sleight of hand, under IMF duress. Program conditionality cannot substitute for ownership. The Fund has erred in this respect hoping that tighter conditionality can make up for a lack of ownership. The view so often heard that there can be no reforms because of powerful ‘vested interests’ has some weight but is not entirely 199persuasive. There are vested interests in other countries as well, whether in Brazil or India or Indonesia. Yet these countries have implemented reforms, they manage to keep their macro economy on a stable low inflation track, they anticipate and implement corrective measures promptly when risks emerge, they take bold decisions, and they do not turn to the IMF to bail them out every few years because they have mismanaged their economy and run out of foreign exchange reserves.

At the technical level, Pakistan has the talent of bright economic minds even if the best and the brightest had fled from the country to greener pastures in the Bank and the IMF around 1970. The talent of those who are still in Pakistan needs to be harnessed and their voices heard so they can convince the political leadership that reforms, which make for a more efficient and egalitarian economy and make inroads into poverty, are in their interest. These people have the skill to develop an economic and financial strategy of growth and poverty alleviation, which is underpinned by well-articulated policy measures and structural reforms. Even if the IMF needs to be called in, it should be Pakistan’s program, and not what the IMF gives us, to which we react. Other countries do this. They present their own program to the IMF and treat the associated financial assistance as a reward of their belated display of virtue. This is the only way to ensure ‘ownership’, the most critical ingredient in successful and lasting reform implementation.

This is not to suggest that only economists can solve our economic problems and save the day. Pakistan has had the good fortune to produce some of the finest civil servants, who have served with distinction in key economic ministries and the central bank. Many of them have a deep and abiding commitment to reforms, listen to advice, understand the issues and know the art of the possible. Even economists know, or should know, that the ideal textbook solution to an economic problem is not always possible or doable. They must then work with second-best alternatives keeping in mind ‘ground realities’ and administrative and technical absorptive capacity.

The 2008 twenty-two-month IMF SBA has produced some positive results although the economic situation remains—to use a much-loved IMF word—‘fragile’. Pakistan’s external deficit is sharply down with most of it due to lower international prices for our imports but also due to 200macroeconomic adjustment taking root. Foreign exchange reserves have reached more comfortable levels; growth is picking up despite the strong headwinds associated with power shortages and a difficult security situation; asset markets have stabilised and the announcement of fresh inflows of US assistance following the ‘Strategic’ talks led to an appreciation of the rupee versus the US dollar. Market confidence is returning, interest rate spreads denoting country risk are narrowing and the international rating agencicfappear to be close to up-grading our debt. Yet, despite these positive developments, risks abound.

Fiscal slippages, especially on the spending side related to defence and security cloud the economic picture. Government borrowing from the central bank, which injects ‘high-powered’ money into the economic system and is therefore highly inflationary, has been in excess of prudent limits and inconsistent with the need to control inflation. The phenomenal, but not well- understood, rise in workers’ remittances despite the turmoil in the Gulf countries, notably Dubai, shows signs of slowing down. This could portend the unwinding of a prolonged ‘stock adjustment’ process which when completed may see workers’ remittances fall off sharply and weaken the external current account. Inflation appears to be making an unwelcome comeback suggesting that the process of monetary easing may have to be halted, or reversed, which will hurt growth.

Given these extant and emerging risks, it is well that the budget for 2010-11 attempts at another year of macroeconomic stabilisation. This would be good for inflation, which needs to come down further even if the end-of-period inflation target of 9.5 per cent per annum is disappointingly unambitious. The relatively tight stance of macro policies should also ensure that the external deficit, a key source of vulnerability in the Pakistan economy and always a binding constraint, is kept in check and gross foreign exchange reserves stay at comfortable levels despite an anticipated pick-up in import volumes and prices as the domestic and global economic recovery gathers strength. Much of the debate on the fiscal measures in the budget has been overshadowed by a vigorous—if ill-informed—debate on Pakistan’s commitment to the IMF to transition from the present GST (which operates in VAT-like-mode) to a full-fledged VAT. Some of the concerns and criticism are self-serving like that which comes from the wealthy with business interests in the National Assembly (dubbed as the centre of conflict of interest) who probably fear that the 201VAT will trap them in a seamless chain of value-addition, force them to document and pay some taxes for a change. Having successfully corrupted the GST through ‘fake and flying invoices’, or fake refund claims, they would have to start afresh to corrupt the VAT regime which would take time and effort and where success is not guaranteed. Some concerns are valid, especially the lack of education of all stakeholders on what VAT means and entails. In most other countries which moved to a VAT regime, the process of education is started eighteen months or more in advance.

There is concern about the impact of VAT on inflation. This seems to be over-stated since the present GST rate can vary from 17-27 per cent. Moving to a single 15 per cent standard rate should actually reduce taxes and hence prices across a broad range of commodities, an outcome which the Competition Commission of Pakistan needs to ensure and enforce. A high VAT threshold means that economic activity which is valued at below the threshold (Rs. 7.5 million) is exempt from VAT altogether.

Neither the IMF nor the Government of Pakistan should be taxing or want to tax every ‘khoka’ or ‘ghara’ (small one-man retail shops and hand-driven cart retailer respectively) down the street. There are a limited list of exemptions, such as food, health services, education and medicines that are VAT-exempt, which impart some progressivity in the VAT regime. One would have hoped that private health and education institutions would not be exempted from VAT. Yet the VAT is an indirect tax and the budget regrettably took no measures to bring back progressive taxes such as the wealth tax, gift tax or inheritance tax which should never have been removed in the first place.

Most importantly, with the VAT not in place by 1 July 2010, Pakistan would have missed a ‘performance criterion’ under the on-going GoP-IMF SBA program. This would, technically-speaking, bring the program .to a halt and no further drawings can be made on IMF resources until Pakistan requests and receives a ‘waiver’ for non-compliance from the IMF’s Executive Board. In the meantime, there is much discussion about a ‘reformed’ GST (instead of the VAT) although it is not clear what that means and, if feasible, raises the question: why was the GST not reformed a decade ago?

Whatever the final outcome, the question remains whether the Executive Board will grant the request for a waiver and whether Executive Directors will ‘buy into’ the ‘reformed’ GST as an equivalent, if not superior, substitute for the pure VAT. The US as the largest shareholder in the IMF is being lobbied intensely to soften its own stand and soften up other Executive Directors (especially those representing other G-7 countries) on the IMF Executive Board.

Pakistan plays politics with the IMF while also complaining that the IMF is a political—and not a professional—institution serving the interests of the same G-7.

If the waiver is granted (and there could be more than one request for waivers as there appears to be a breach of another ‘performance criterion’, namely, zero net borrowing from the central bank at end quarter), the SBA program can be restarted.

It would be in Pakistan’s interest to do so and not allow the momentum of the adjustment program to stall. The task of stabilisation is unfinished and the critical transition to a higher growth path is on hand. Provided infrastructure constraints can be eased (such as in the energy sector) and the security situation improves for the better, there is no reason why the economy cannot post a growth rate of GDP of around 5–5.5 per cent in 2010–11 and move closer to potential of 6.0–6.5 per cent GDP growth the following year.

Once the SBA is over at end-2010, it would be surprising if the US and the other G-7 countries do not ask that Pakistan stay engaged with the IMF, since a stable macroeconomic environment strengthens the odds that aid inflows will be used wisely and well. Indeed, the grant of waivers for non-compliance of performance criteria mentioned earlier could well be given subject to Pakistan’s commitment to a follow-on IMF program. The major donors know our undistinguished record of economic mismanagement and ‘stop-start-rollback’ record of adjustment.

An IMF arrangement disciplines the conduct of our economic policies. Pakistan should use the IMF as a political flack-jacket to push through deep-seated reforms. The IMF is used to playing that role and can take the flack. Many countries, both developing and advanced, use that ploy as well to good effect, the latest example being Greece where deep public-sector pay and pension cuts and fiscal austerity have been fiercely resisted but will go through as a condition for IMF and Euro-loans. Greece has no choice and the Euro-countries led by Germany and France would not want to see the Euro currency fail. Removing the IMF’s disciplining force, no matter how much it is disliked and criticized could 203cause us to revert to the all-too-familiar paradigm of unconstrained decision- making which time and again has got us into trouble.

There are several possibilities of further IMF engagement. One possibility would be to ask the IMF for a ‘precautionary’ follow-on SBA (and not draw on relatively expensive SBA resources and exacerbate our external debt). One could also think of a looser arrangement, a sort of ‘shadow’ program that mimics an actual IMF arrangement but does not entail request for IMF resources. However, given the size of Pakistan’s outstanding debt to the IMF, which exceeds 100 per cent of its quota, Pakistan may have no choice anyway but to submit to ‘Post-Program Monitoring’ with six monthly reviews that are published, implying a close watch over the conduct of our macroeconomic policies.

Whatever Pakistan’s relations with the IMF in the immediate term, Pakistan needs to abjure the temptation to resort to overly-expansionary macroeconomic policies that only create the all-too-familiar cycle of boom, bubbles and bust. Pakistan’s political leadership and policymakers need to recognise that there is an asymmetry between good and bad policies and their outcomes.

Bad policies will quickly lead to bad outcomes from which there may be no turning back as negative dynamics take hold in a cumulative and circular self-fulfilling downturn. The rewards of implementing good policies takes a frustratingly long time to be felt because confidence of economic agents once lost is difficult to regain; moreover those who suffer from reform recognise their losses quickly and want to offset them rapidly while the beneficiaries either fail to appreciate their ‘gains’ or take a much longer time to do so.

All governments are impatient to show results and want to be seen as responsive to the expectations of the people. But experience should teach that there is little to be gained by policy-induced distortions of macroeconomic policy instruments, such as interest rates that are close to zero or negative after adjusting for inflation encouraging excessive consumption and imports, imprudent borrowing, building up debt and discouraging savings.

This creates a mirage of prosperity and a short-term burst in growth but eventually self-destructs. Nor is there anything to be gained by hastily conceived unviable spending initiatives that crowd-out more essential spending on education, health and other physical and social infrastructure which are critical to boosting the economy’s medium-term growth potential.

Ensuring macroeconomic stability and low inflation is a non-starter unless governance issues are addressed first.

Good governance is inextricably linked with good economic policies and vice versa.

The subject of good governance encompasses a daunting and vast field but by any calculus Pakistan ranks poorly when compared to other developing countries. No doubt, bad governance as manifest in mismanagement, deep-seated corruption and a flaunting of the rule of law, extracts a heavy toll in all sections of Pakistan society and creates the kind of economic instability and wrenching crisis that Pakistan has witnessed so many times before.