Pakistan's economy - I

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Alongsides is the first part of a three-part series by an economist who has reflected on his more than half a century involvement with the country's economy. Pakistan has had a chequered economic and political history. The periods of rapid growth in the 1960s, the first half of the eighties, and 2002-07 have been followed by periods of sharp economic slowdowns.

Sustained economic growth has been elusive, there has been no real deepening of structure of the economy, and social and distribution issues have become increasingly troublesome. Yet Pakistan has somehow managed to attain an annual average GDP growth rate of 5.2 percent and a per capita income growth of 2.5 percent over the last half century (1960-2010) that has resulted in more than trebling of the average living standards over the period. The distribution of gains from growth has undoubtedly not been equitable. However, the economic record, though of course not at all matching that of East Asia especially China and more recently India, seems to compare favourably with the average for developing countries. This is not a mean achievement considering a great deal of political instability and long periods of military rule which had relatively good governance but entailed a high cost in terms of defence spending, continued tensions with India, and weakening of institutional authority.

However, the past economic performance is also somewhat misleading because the growth of output, investment, and employment have very seriously slowed down during the last four years and economic revival has become uncertain. GDP growth averaged less than 3 percent per annum over 2008-2012. Gross fixed capital formation dropped more than 20 percent in real terms over 2008-12 and the ratio of fixed investment to GDP at around 11 percent in FY 2012 was at the lowest level in three decades. Public finances have deteriorated very significantly and external finances are largely being kept afloat as a result of very large worker remittances, both through official channels and money market companies: consequently GNP growth has averaged to be 3.6 percent per annum or 0.7 percent higher per annum than the GDP growth during the last four years (2008-12)

In looking for lessons from Pakistan's development experience one cannot and must not overlook at the factors that made fairly respectable growth rates possible for long periods despite many odds. But the more important questions relate to the many missed opportunities by Pakistan and many policy missteps that have kept it from attaining its fairly widely heralded economic promise in the 1960s. Most urgently, a look at the Pakistan's development experience is essential to try to learn lessons on how to break out from the economic stagnation that now threatens not only the economic well being of large masses but also the political future of the country.

Salient aspects of economic history

But before drawing the lessons from Pakistan's development experience, it is necessary to provide at least a thumbnail sketch of the major economic periods. When the idea of Pakistan was first put forward in the 1940s, doubts had continually been put thrown on its economic and financial viability. Despite the turmoil caused by the Partition, early development of tensions with India, and frequent changes in what were weak governments without a strong public mandate the basis, the 1950s saw rapid industrialisation and the decade did lay down the basis of future growth by sharply increasing investment both in physical and human capital and creating strong economic institutions, notably State Bank of Pakistan, WAPDA, PIDC, and PICIC. By 1959-60 fixed investment In West Pakistan (now Pakistan) had risen to 11.5 percent of GDP from 4.1 percent in 1949-50 with public investment playing a dominant role accounting for nearly two-thirds of the capital formation. (Hasan, 1998) It may seem surprising but education was not neglected in the 1950s. Gross primary enrolment grew by 10 percent per annum though the girls' enrolment accounted for only 22 percent of the increment.

The financing of investment, however, relied already in the early years excessively on external flows, a pattern that was to become endemic. While private investment especially in the rapidly growing textile sector relied mainly on reinvesting of burgeoning profits under strong protection, the more than six fold increase in real public investment in the 1950s relied on foreign assistance and money creation.

I believe that apart from foreign assistance, there were three main drivers of growth in the early years, a competent, committed ,and honest bureaucracy with strong economic leaders such as, Ghulam Mohammad, Chaudhry Mohammad Ali, Ghulam Faruque, Zahid Hussain, a large number of migrants consisting of well educated professionals that played a vital role in strengthening civil services and financial sector, and last but not least private sector entrepreneurs led mainly by members of Bohra, Memon, and Khoja communities that migrated from India but settled in Karachi making it the premier industrial city.

Economic growth rate that had been a little over 3 percent per annum in the 1950s shot up to nearly 7 percent in the 1960s and in the heyday of Ayub era in the mid 1960s, Pakistan's development efforts were hailed as a rare success story. The transformation in economic performance compared to the previous decade was the result of both massive increase in foreign aid and investment, economic liberalisation, technological breakthroughs in agriculture, and exceptionally well co-ordinated economic policies and speedy decision making supported by strong planning processes. A less well known fact is that real defence spending from Pakistan's own resources grew little over 1960-65, the size of the army was kept strictly under control, and all of the incremental expenditure on weapons and equipment were financed from substantial US military assistance. Public investment and aid flows were specially stimulated by large expenditures under the Indus Basin Water Treaty signed with India in 1960 with the help of the World Bank. Including the expenditure for Indus Basin Replacement works of about $1.2 billion, water and power investments totalled $2.5 billion (about 3.6 percent of GDP) during the 1960s and accounted for more than 50 percent of total public spending. Fixed investment reached an all time peak of 20.8 percent of GDP in 1964-65, more than 50 percent financed by external assistance. The massive long term investment in infrastructure was critical in sustaining agricultural growth through mid 1990s.

The 1965 war with India had the disastrous consequences of a decline in aid flows and upsetting the balance between defence and development, and set in motion currents that led to separation of East Pakistan in December 1971. The near doubling of defence spending between the first half and the second half of the 1970s was also major setback for education; additional primary school enrolments during 1965-70 was one third less than in 1960-65. Based on an imperfect knowledge of the level and the rate of growth of population, the Third Plan had set an ambitious 70 percent enrolment target for 1969-70 - the actual result was only 40 percent enrolment.

Had not been for the exceptional agricultural growth rate of 5 percent in agriculture made possible both by speedy private tube well development and the very successful exploitation of the green revolution in wheat and rice production, the economic activity would have slowed down very seriously in the second half of the 1960s. Even so, the fixed investment to GDP ratio had come down to 14.3 percent by 1969-70. More importantly, exchange rate and trade policies that were initially supported by large influx of aid flows began to cause progressively distorting effects on the economy. The large supplies of long -term credit for industry through PICIC and Industrial Development Bank at gross overvalued exchange rate led to wasteful and unviable investments. The multiple exchange rate regime that had been put into place under the export bonus scheme in 1959 caused an effective subsidy to manufactured exports of over 100 percent for textiles while taxing agricultural exports very substantially. This setback the development of a really competitive diversified manufactured export base while aggressively promoting low value added cotton yarn exports.

Z.A. Bhutto's five and a half-year rule encompassed a wide-range of economic policy initiatives and state interventions. While Bhutto did not have a grand design for the economy and an ambivalent belief in socialism, he felt that he had a popular mandate to curb the power of the industrialists and bureaucrats and improving the lot of the poor. He, therefore, vastly expanded the state role in economic activity by nationalising education, banking, insurance, and a number of heavy industries. While he did not nationalise light industry, the Punjab government under PPP invested in several sugar and textile mills. Including the large and not very economic steel mill and other investments in cement, fertilisers, and heavy industries, public sector industrial investment grew tenfold in real terms while large scale private industrial sector essentially shrivelled because of perceived hostility to the 22 families.

It is not an exaggeration that Bhutto's economic policies virtually halted the growth of the modern industrial sector and reinforced the anti-export bias of the industrial strategy. Labour and other regulations adopted have continued to provide strong disincentives to the growth of large-scale industry to this day.

Other Bhutto policies that have had a negative impact on long term growth are the large increase in defence establishment (when the country was halved), nationalisation of educational institutions, a cavalier attitude towards public spending (that his nemesis Ziaul Haq eagerly replicated), and last but not least serious erosion of capacity and authority of public institutions especially those responsible for planning. A great deal of responsibility for failures in basic education, which remains an important constraint on growth, can also be traced back to the decision to nationalise educational institutions in 1972. As a direct consequence of this decision, the management capacity of the government was extended, the competition for resources within the education sector deepened the urban bias of education and thus the development of basic education and literacy slowed down.

In terms of Bhutto's short-term policies, three points stand out. On the positive side, following his populist instincts his decision to greatly relax passport controls did a great deal to help migrant workers and initiate a stream of remittances that for a while became a flood in the first half of the 1980s.The same populist instinct led Bhutto to postpone energy price adjustments that became necessary after the first oil shock at the end of 1973. Through grants and loans from friendly Arab countries consumers were protected and it was only after the second oil shock in 1979-80 that the painful adjustment of energy prices was undertaken in General Ziaul Haq's time. But in the meanwhile, well functioning public entity Wapda had become a loss-making enterprise.

Finally, the loss of fiscal and monetary discipline in Bhutto years had the consequence of triggering strong inflationary pressures (consumer prices doubled between 1972 and 1976) that wiped out a good part of the gains accruing to labour through increase in nominal wages.

The GDP growth in Bhutto period, though a respectable 4.9 percent per annum suffered from the fact floods and poor harvests adversely affected agricultural growth which also suffered from the fact that the availability of large irrigation water from Tarbela dam was delayed by two years due to technical problems. That was a lucky break for General Ziaul Haq.

Compared to other Pakistan's rulers General Ziaul Haq took relatively little interest in the economy at least partly because it performed quite well through most of his period as a result of a number of exogenous factors. Agricultural growth recovered to nearly 4 percent per annum during 1977-88 from a dismal 2 percent during 1972-77. A good deal of this agricultural expansion was not related to the price policies but rather to the huge addition to water supplies from Tarbela and private tube wells, and the breakthrough in cotton productivity in the mid 1980s. The five fold jump in worker remittances between 1976-77 and 1982-83 to the peak of nearly $3 billion or 10 percent of GDP was another strong boost to economic activity. At the same time, external assistance for Afghan Mujahedin, estimated at $5-7 billion in the first half of the 1980s that was channeled through Pakistan also helped the economy.

But lulled by high economic growth and a comfortable foreign exchange position, Zia's regime, with Ghulam Ishaque Khan as finance minister, made economic decisions and policy choices that were to have serious long -term consequences. First, under Zia, the defence budget, which had already expanded significantly during Bhutto, increased more than a two hand a half times in real terms or at an average rate of 9 percent per annum. The consequence was a sharp rise in public expenditure and sizable fiscal deficits as there was only a marginal improvement in the tax GDP ratio. At the same time, the development outlays were squeezed, rising only 3 percent per annum over 1977-88 in real terms: by 1987-88 defence spending had overtaken development spending.

The shift in priorities and the way the budget deficits were financed had two results: they led to slowing down of investment and a sharp rise in public debt. Rise in national savings as a result of large inflow of remittances made possible the financing of the large deficits mainly from non- bank borrowing especially as government saving schemes offered highly favourable tax free interests rates. This kept inflation low but the large pre-emption of savings by the public sector crowded out the private sector and dampened private investment. This combined with the slowing public development expenditures resulted in essentially stagnant investment to GDP ratio that had negative consequences for long-run growth. Although economic policies became more market friendly, Zia did not do much to dismantle the nationalizations of the Bhutto period. Ghulam Ishaque Khan had an instinctive distrust of the private sector and the bureaucracy had quickly also quickly come to appreciate the power and the privilege that an extended public sector afforded it.

Finally, the important two major structural problems, high population growth and the serious lag in education were neglected and the two policy problems inherited from the 1960s and 1970s - the inelasticity of the tax system and the strong anti- export bias of the trade policy - actually worsened because of increasing reliance on foreign trade taxation.

The succession of weak political governments that followed Zia found it difficult to deal with the worsening macroeconomic balances and the build of debt. There were, however, major efforts, starting with the first Nawaz Sharif Government in the early 1990s, to liberalise the economy, to expand the role of private sector, and to redress the imbalances in social services. Investment controls on both domestic and foreign investors were greatly relaxed , the foreign exchange regime was made virtually free, high tariffs began to be dismantled and heavy reliance on foreign trade taxation was reduced, private sector involvement in infrastructure ,especially energy was greatly encouraged and prices of both agricultural outputs and inputs were aligned more closely to international prices. At the same time, the interest rates were substantially liberalised and credit subsidies were reduced. A start was made to privatise public sector assets not only in industry but also in banking, telecommunications, and energy.

The privatisation efforts and the shift towards the private sector were influenced largely by pragmatic considerations. The losses of public sector enterprises hastened the decision to divest industrial assets. The policy decision to involve the private sector in energy and infrastructure development reflected the realisation going back to 1987 that public sector funds had become a major constraint on development.

However, for a number of reasons, the reforms did not succeed in avoiding an economic slowdown and an external debt crisis by the end of 1990s. The biggest factor was the failure to reduce macroeconomic imbalances: large deficits financed through credit creation led to a big spurt in inflation and a loss of competitiveness as exchange rate adjustment lagged. The attraction of large foreign currency deposits with a large implicit interest rate subsidy sustained consumption and imports at a high level but sowed the seeds of a future foreign exchange crisis. There were also a general deterioration in the effectiveness of resource use in the public sector; a well intentioned Social Action Programme to expand and improve primary education, basic health care, family planning , and rural water supply and sanitation services did not deliver because of leakages; among other things ghost schools and phantom teachers. Finally, the growing abuses in the largely public sector controlled financial system led to siphoning off of valuable resources.

The result was that per capita GDP growth slowed down to 1 percent per annum in the 1990s compared to the average of over 3 percent per annum during 1960-90 and the rate of investment declined significantly. Overall, the Musharraf era did deliver high growth for a few years, partly as a result of good management and partly as a result of good luck. There were a few really shining years, when it appeared that perhaps there would be a new economic dawn. But the return of old-style politics after the 2002 elections and the increasing compromises made by Musharraf in order to stay in power led to policy mistakes. When adverse exogenous shocks struck, the government in its hubris ignored the need for adjustments, hoping to ride the tide on a mistaken assumption of wide public approval.

As a result, the deepening of structural reforms was put on the backburner and, thus, in terms of fundamentals, Pakistan's economy found itself in 2008 in a not much better shape than it was at the end of the 1990s. However, credit must be given to Musharraf for giving a greater voice given to women, local bodies, and the media, the initiatives which in the long run would benefit governance considerably.

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