Postscript: The Great Flood of 2010

The Great Flood in the summer of 2010 caused widespread damage to the economy, especially to major and minor crops and the livestock sector. Irrigation, transport and power sectors were also badly hurt. Manufacturing was for the most part spared by the ferocity of the flood. The World Bank and Asian Development Bank’s estimate of the flood damage was around $10 billion. What all this means for the economy going forward is difficult to tell but a plausible scenario can be sketched out.

In the very short-term (perhaps the first two quarters of 2010-11), real GDP is likely to contract by about 1.5 per cent amidst a spike in inflation, especially food inflation trapping the economy in stagflation from which it 211emerged only recently. Both the domestic and external deficits will come under strain.

In the former case this would be because of the need to spend vast sums on rehabilitation and rebuilding damaged/destroyed physical and social infrastructure as well as pay one-time compensation to those affected or displaced by the flood. Externally, exports could falter—especially of traditional items such as textiles and leather. Import demand will be strong- led by food, raw cotton and the import content of replacement capital investment. Nevertheless, the external side need not come under undue pressure. Workers’ remittances could see a significant further rise as families ask for larger transfers to cope with their needs for food, clothing, shelter, medicines and buying of livestock and other agricultural inputs lost in the floods.

Foreign aid inflows (including reimbursement from the US Coalition Support Funds), additional IMF financing under their low-conditionality natural disasters facility ($451 million), as well as further drawings under the ongoing SBA arrangement should help keep foreign exchange reserves at a comfortable level with a ‘cover’ of five to seven months of projected imports. The government announced new ‘measures’ in a revised budget for 2010–11 to reflect post-flood realities. On the revenue side, it tabled before Parliament the Reformed GST (RGST) with a single rate of tax of 15 per cent along with a sweeping elimination of exemptions as well as bringing the hitherto untaxed services sector under the RGST net.

Since the old GST tax rates varied from 17 per cent to 25 per cent, a single 15 per cent rate of tax under the RGST could imply price reductions across a broad range of items. In Autumn 2010 the authorities announced a temporary flood surcharge on incomes above a certain exemption threshold in addition to a doubling of the Special Excise Tax on selected non-essential imports to 2 per cent. Fears of a renewed bout of inflation resulting from these measures appeared to be overblown.

Nevertheless, the Competition Commission of Pakistan (CCP) will have to be vigilant to ensure that price reductions do take place where taxes have been cut while being watchful about cases of price-gouging or other anti-competitive abuse in the new tax environment. The CCP’s excellent track record of enforcement gives confidence that they will help to protect the interest of the Pakistani consumer. On the spending side, non-interest non-defence expenditures at the federal level have been frozen in nominal terms, whilst the public sector 212development program has undergone a drastic cut in size with new projects put on hold and implementation of ongoing, externally-financed projects and programs being accelerated.

Along with the cut, there was significant reprioritising of the development program, shifting resources to sectors directly helpful to and related to post-flood reconstruction. The provinces have also been asked to pare down their overly ambitious development program to bring them more in line with their technical and administrative capacity to implement them. This would reduce their presently large deficit budgets. Taken together, these revenue and expenditure-saving measures at the federal and provincial levels are expected to yield a consolidated (federal plus provincial) overall fiscal deficit of around 4.7 per cent of GDP in 2010–11, which by all accounts has the begrudging blessings of the IMF who would have wanted the pre-flood end-year deficit target to remain unchanged at 4 per cent of GDP. However, even with this upward revision in the deficit target, Pakistan should be in a position to secure the next tranche under the continuing SBA, provided the Executive Board of the IMF approves requests for waivers for non-compliance of performance criterion, since the measures taken now have been delayed and the performance criterion set earlier were breached.

The government did not take advantage of the crisis to push through more radical—and highly desirable—measures, such as imposing a 10 per cent tax on the market value of all immoveable properties (residential and commercial) in the major cities, along with insisting that the provinces tax agricultural income above a certain threshold from land not affected by the floods. To many, a deep flaw in the recent National Finance Commission (NFC) award—which saw a significant shift of resources devolve to the provinces—is the lack of any conditionality. Fiscal devolution should have been accompanied by a clear understanding that, should the provinces fail to raise their own revenues, releases from the NFC award would be withheld by the amount of the tax revenues foregone. There has not been any hint of bringing back more progressive forms of taxation, such as the wealth tax or gift tax, which would not only be revenue-enhancing but would also impart greater progressivity to the tax system. However that may be, if the authorities are able to achieve a consolidated fiscal out-turn of 4.7 per cent of GDP in 2010–11, aggregate demand pressures in the economy would be reduced, government borrowing and hence interest rates would decrease, the private sector would be ‘crowded-in’ and inflation could start to subside 213quickly, thus enabling the central bank to cut its policy rate of interest and boost growth.

The Great Flood has caused widespread hardship and misery— displacing some twenty million people who were already poor and vulnerable—and significant capital destruction. However, the task of rebuilding the capital stock presents a unique opportunity for Pakistan to build a new and invest in new-vintage technologies that would raise productive efficiency and boost Total Factor Productivity. Once the relief phase is complete, the task of rebuilding could result in a sustained surge in domestic demand led by new investment. Provided this phase is handled in the context of an overall macroeconomic framework that is prudent and fully-financed by non-inflationary methods, real GDP growth could rebound in a V-shaped recovery accompanied by significant gains in employment, wages and poverty reduction with the demand stimulus lasting for three or four years. After contracting in the first two quarters, real year-on-year GDP growth in 2010–11 could be in the region of 2–3 per cent—an estimated outcome that is in line with the central bank’s most recently published report on the economy. Such an outcome could be said to be satisfactory, given the dire starting circumstances. Once economic recovery takes hold, Pakistan’s policy-makers should take the opportunity to start the process of implementing the macroeconomic and structural reform agenda sketched out in the main body of this chapter with far- reaching structural reforms making the economy resilient, more efficient and self-sustaining.