Policies For Growth & Stability of Pakistan Â S Economy

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Policies For Growth
&
Stability of Pakistans Economy

May 29, 2011

Author: Muhammad Ali Nisar

Committee: Economics

Dossier # 001

Version # 001

Nature of Document: Plan

IRW
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Committee on Economics Policies for Growth & Stability of Pakistans Economy
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Table of Contents

Introduction 04
Overview of Pakistans Economy 04
Price Instability 4-5
Unemployment 5-6
Production (output) Growth 6-7
Twin Deficits (Fiscal & Balance of Payment 7-8
Financial Instability 8-9
Recommendations/Suggestions 9-11
Bibliography 12

Policies for
Growth &
Stability of
Pakistans
Economy

Introduction
Economic growth and stability are the basic
objectives of any government. Macroeconomic
policies are formulated to achieve these
economic objectives. Performance of
political administration can be easily gauged by
their success in achievement of the following
economy objectives:
Price stability & Inflation control
Employment
Growth in National Production
Balance of Payment Equilibrium
Stability in Financial Sector

Financial sector plays an important role in
t he development of all other sectors of t he
economy. After the recent financial crisis (2008-
2009), the stability of t h e financial sector
has gained almost the same weight on
government priorities list as any other area of
concern. The crisis started from t he burst of
housing market bubble caused by t he
subprime mortgage markets and ended in a
deepest recession since the great depression
of the 1930s.
To achieve the economic growth and stability
economics policies are used as tools. These
are Fiscal policies, Monetary policies and
Trade policies or direct control policies like
tariffing, quotas etc. In most countries
monetary policy is formulated by Central
Banks, fiscal policy by Treasury or Ministry of
Finance and direct policies by Ministry of
Commerce. Similarly in Pakistan monetary
policy is t he responsibility of State Bank of
Pakistan (SBP), Fiscal policy is formulated by
t h e Ministry of Finance and direct control
policies are formulated by the Ministry of
Commerce.
Overview of Pakistans Economy
Pakistan has been categorized as
impoverished and an underdeveloped
country by the CIA World Fact (2010). The
total volume of Pakistans GDP according to
CIA statistics (2010) was $ 174.8 Billion with
the per capita income of $ 1049 (IMF: 2010)
which is quite low. The population has
reached to 170 Millions (approx) and big
proportion of population about 24% (2005-06)
is living below poverty line. Public debt has
reached to $ 58 billion in 2010. The debt to
GDP ratio is 49.9 % therefore a huge
proportion of total government budget goes to
serve the cost of debt. The performance of
Pakistani economic policies could be easily
judged by the unsuccessful story of economic
objectives achievement in the following
paragraphs.
Price Instability
The role of price stability has mostly been
considered t o be t he responsibility of
monetary authority. In his recent speech to
the Federation of Chamber of Commerce
and Industry, Governor of the State Bank of
Pakistan (SBP) declared price stability as a
fundamental objective of monetary policy
(Kardar: 2010). It seems State Bank of
Pakistan has not been very successful to
control inflation in t he past few years. One
of the major problems faced by the Pakistani
economy is t h e h i g h rate of inflation. A
dire part of inflation is food inflation, wh i c h
is more prominent than non-food items. Food
groups consist of 40% of t he consumer price
index (CPI) and prices of food group items
have been increased by 86% from June 2007
to October 2010 (Kardar: 2010).
Consumer Price Index (CPI)
FY General Food Non-Food
2008 12.0 17.6 7.9
2009 20.8 23.7 18.4
2010 11.7 12.5 11.1

Source: State Bank of Pakistan (SBP)
The inflation statistics of Federal Bureau of
Statistics (FBS) from January to January
each year tells the worsening situation.

Source: - Federal Bureau of Statistics (2011)
In countries like t he U.K monetary authority
sets an inflation target e.g. inflation target of
Bank of England is CPI at 2%. If inflation
goes above or below the target by 1% the
Governor of the Bank of Engl and has to
write a letter to the exchequer explaining
reasons for not meeting the target. Although
the recent rate of inflation was 4% the Bank
of England is consistent with its easy
monetary policy and all time low rate of
interest at 0.5%. The stance of fiscal authority
has been tight therefore it is expected to bring
down i nfl ati on by fiscal measures.
Particularly speaking about inflation in
Pakistan, although the discount rate has been
high at 14% since November 2010, but it
was a failed attempt to control inflation by
curtailing the growth of money supply. The
causes of inflation in general as
acknowledged by SBP in governors speech
(Kardar: 2010) were output gap, inflation
expectation and cost-push. Moreover over it
was also accepted that the high interest
rates and government spending and deficit
has crowded out the private sector
investment and growth. But the excuse given
for tight monetary policy was that as the
energy crises and law and order conditions
ar e not ver y f avor abl e i t i s l ess l i kel y
t h a t t he pr i vat e s ec t or woul d be
encouraged by the low interest rates. In very
mild language the governments trade policy
(support price of wheat) was also criticized.
An interesting point here is although the SBP
agrees that tight monetary policy is harmful for
economic growth lead by private investment
and reason of inflation is not growth in money
supply, yet the bank is persistent on its
contractionary stance. In a latest statement
made by t he SBP (2011) structural deficit
and excessive government borrowing from
SBP w e r e s t a t e d as reasons for high
inflation and external account imbalance.
On empirical grounds analyzing money
supply behavior in Pakistan, Ahmad & Ahmed
(2006) discouraged the idea of active
monetary policy and recommended unisons
with other intuitions. Considering all these
factors, tight stance of monetary policy
cannot be justified. The recent academic
research in t h e role of fiscal policy to
control inflation also urges to use fiscal
measure for price stability. Research on
French and British economic policies by Creel
et al. (2009) showed that fiscal policy may
dominate the monetary policy without having
any negative influence. It seems that poor
fiscal discipline in Pakistan has resulted in a
NASH between fiscal and monetary authority,
which is causing economic instability.
Unemployment
Creation of employment opportunities is
expected from elected governments. Although
full employment does not exist because of a
natural rate of unemployment, which is the
level at which the demand of labour is at
equilibrium with t he supply of labour.
However the average rate of unemployment
in Pakistan from 1990 to 2009 has been
5.88% (Federal Bureau of Statistics), which is
quite high. Moreover unlike developed
countries there is no job seeker support or
allowance for the unemployed in Pakistan. In
present situation the rate of unemployment is
very high reflected by the following statistics:
Rate of Unemployment (2003- 2011)
Year Unemployment Rate
(%)
Change
(%)
2003 7.80
2004 7.70 (1.28)
2005 8.30 7.79
2006 6.60 (20.48)
2007 6.50 (1.52)
2008 5.60 (13.85)
2009 7.40 32.14
2010 14.00 89.14
2011 15.00 7.14

Source: CIA World Fact book
Unemployment has increased by 168% since
2008. There are various reasons for high
unemployment rate in Pakistan; low
investment, low savings, energy crisis, low
industrial growth, and use of machinery in
agriculture sector, poor law and order situation,
unfriendly environment for Small and Medium
Enterprises (SMEs). Last years devastating
floods are another major cause of high
unemployment in affected areas of Pakistan.
Most of the factors are correlated with each
other; industry could not grow without
investment, uninterrupted energy supply at low
cost and easy availability of factors of
production including capital. The very high
interest rates in this regard discourage private
sector investment decision.
Production (output) Growth
Pakistan is a developing country and in
nominal GDP ranking it is at 47 position in
the world. The GDP growth had been very
slow in the last few years.
Gross Domestic Product (GDP)
Constant Prices
Year GDP Growth (%)
2003 4.86
2004 7.38
2005 7.67
2006 6.15
2007 5.64
2008 1.64
2009 3.37
2010 4.79

Source: IMF World Economic Outlook (2010)

The period of moderate growth from 2004-07
did not last long and growth slumped in 2008.
Increasing population also fads away the
economic growths impact on society. If we
decompose the GDP, services (including
public sector and defense services)
contributed more than half of total towards
national income.
Pakistan Gross Domestic Production
(Sector wise)

Agriculture
Industry
Services

Agriculture (21.8%) - Industry (23.6%) - Services
(54.6%)
Global financial crises and sluggish growth may
have contributed to the deterioration of
Pakistans economic growth; however, as
compared to the other developing and
emerging economies in the region e.g. India
and China, Pakistans performance has been
very poor.
A country like Pakistan where there are plenty
of resources available, contribution of
agriculture and industry is highly insignificant.

Slow growth and poor contribution of
agriculture and industry to the national income
also results in poor contribution to tax revenues
and exports. It further results in twin deficits
i.e. fiscal and balance of payment.
Twin Deficits (Fiscal & Balance of
Payment
Pakistan is running a deficit in its both
balance of payment and fiscal account. The
debt to GDP has risen to 49.9% with $ 58
billion of external debt. The statistics
released by SBP (2011) showed that deficit
commitment at the beginning of fiscal year
was 4% of GDP (Rs. 685 billion) after t h e
floods to 4.7% of GDP (Rs. 812 billion).
Moreover the deficit in current account was
$ 3.9 billion in 2010.
The trade imbalance (exports minus imports)
was $ 11.5 billion, which has made significant
contribution towards the current account
deficit.
A major positive contribution was remittances
of $ 8.9 billion, which absorbed the trade
imbalance to some extent. It is worth
mentioning here that in Coalition Support Fund
( CSF) only $ 0.743 billion were realized.
Exports growth had been faster (2.9%) than
imports which declined by -1.7 %.
If we look on the balance of payment account
it is very clear that major reason of deficit is
trade imbalance, imports are well above the
exports. Therefore, even the huge
remittances could not fully balance the trade.
It i s usef ul t o ment i on here that the
remittances are less volatile than other
elements of balance of payment account as
overseas Pakistanis consistently make
contribution. Therefore we need to focus more
on trade imbalances.
The credit availed by the private sector during
2nd quarter of FY- 2011 increased to Rs211
billion which was Rs199 billion in the
corresponding period last year. It could be a
positive sign if it had been due to easy and
cheap availability of capital. But it was an
increased cost of production (including
expensive imports), which compelled private
sector to borrow at high cost of capital. The
credit for working capital rose to 97% in t h e
first half of FY-2011 as compared to the
same period in previous year, but the credit
for fixed investment declined from Rs. 43.4
billions to Rs. 6.7 billion. Another problem
visible in t he banking sector is the decline in
credit to deposit ratio although the deposits in
banking sector increased. Most probably it has
been due to the high level of nonperforming
loans whi ch reached close to Rs 500 in t he
first quarter of the current financial year
(SBP: 2011), which discouraged banks to
lend to private sector. Moreover, the high
demands of public sector enterprises also
limited the availability of credit to the private
sector.
Alarmingly the government borrowing from
SBP increased to 1500 billion in mid
December (SBP: 2011). This shows a huge
disproportion between public and private
sector borrowing, which indicates that tight
monetary policy, is discouraging private
sector to contribute to national i ncome and
j ob creat i on. Although t he private sector is
more efficient and innovative than public
sector but the motivation is profit. High cost
of production and energy crisis adversely
effects private sector initiatives and results in
huge trade imbalances
In future the governments intention to reduce
its deficit, which could ease the inflation
pressure, seems unrealistic. The reforms on
general sales tax (GST) have been postponed,
moreover continuous subsidy on energy and
legal restrictions on government borrowing
limit have not been implemented. It clearly
shows that the government is not going
further with its own plans due to its credibility
and political unpopularity.

Source: SBP Monetary Policy Statement (2011)

Government ambition to increase tax
revenue seems impractical because of high
level of tax evasion, Rs. 796 billion according
to t he World Bank reports. This amounts to
huge tax avoidance, approximately equal to
the annual budget deficit. In this scenario
increasing taxes or introduction of new taxes
would discourage current taxpayers. In the 1
st

and 2
nd
quarter of t he current financial year
the revenue growth was 11.2% and 15%
whereas the target was 26% annual growth.
The total target of revenue collection was Rs.
1667 billion but FBR collected onl y Rs. 661
b illion in t he first half of the year (SBP:
2011). On the expenditure side there had
been considerable reductions made in
development heads. However there had been
huge subsidies given in energy, food and
transfers. The reduction in development
budget would negatively affect future
prospect of t he economy. According to SBP
(2011) subsidies could result in further losses
of RS 25 to Rs. 35 billion by the end of fiscal
term. There has been no progress made in
the plan to raise Rs. 55 billion from t he
issuance of new technology license to mobile
companies. This situation has created a
huge fiscal imbalance, which is growing
consistently and in future could be a major
problem for the Pakistani economy.
Financial Instability
After t h e recent banking crisis (2008-09) in
major economies of the world started by the
financial services industry. The role of the
financial sector in economic growth and
stability cannot be neglected. As a r e s u l t
economic stability is now associated with
financial stability.
The banking sector i n P a k i s t a n is
supervised and regulated by t h e State
Bank of Pakistan (SBP). There are 41
scheduled banks, 6 development finance
intuitions, and 2 micro finance banks
operating in Pakistan. Banks are to maintain
minimum paid up capital level of Rs.1 Billion
and reserve requirement ration of 5%. This
seems quite reasonable to encourage
lending. According to SBP (2011), in banking
sector the non performing loans (NPLs) have
reached near to level of Rs. 500 billions. Due
to high discount rate, law and order situation,
energy crisis and mostly importantly political
influence, the banking sector could not
provide substantial capital support to the
production sector (agriculture & industry). At
present, the government borrowing from July
2010 - Jan 2011 has been Rs. 355.2 billion,
which contributed about 78% in monetary
expansion. The government has not only
become a major user of banking resources
but also causing inflationary pressure by
excessive borrowing.
The dream of Islamic banking in Pakistan is as
old as Pakistan itself. Even in the constitution
of the Islamic Republic of Pakistan article
38(f) states that: The State shall eliminate
riba as early as possible. In 1980s efforts
were made to introduce Islamic banking in
Pakistan but the model failed due to certain
reasons whi ch cannot be covered under
t he scope of this paper. However in January
2002 new license was issued to Al-Meezan
Investment Bank Ltd to open a fully
operational Meezan Islamic Bank. At present
there are 6 licensed Islamic Banks (IBs) and
12 conventional banks whi c h have licenses
to operate Islamic banking branches (IBBs).
According to SBP
1
the total assets of the
Islamic banking industry are over Rs. 225
billion as of 30th June 2008, which accounts
for a market share of 4.5% of t h e total
banking industry assets. Total branch
network of the industry comprises more than
330 branches with presence in over 50 cities
and towns covering all the four provinces of
the country and AJK. The development of
Islamic banking in Pakistan is appreciable;
however there is a lot more this sector can
contribute to the economy in future.
The Small & Medium Enterprises (SMEs)
play an important role in economic
development; Taiwan, Korea and China are
prime examples of the role of SMEs in the
development of these counties. In Pakistan
unfortunately t h e financial sector has not
played significant role to improve SMEs
culture. There had been two institutions
established SMEDA and SME Bank, however
poor condition of SMEs reflects performance of
these institutions. Although there are some
measures SBP is considering taking e. g.
dr af t pr udent i al regulations for the SMEs,
consideration of the credit information bureau
and urging banks to lend to the SMEs;
however no efforts have been made practical.
Together wi t h the energy crisis, law and
order situation, high inflation and limited
avai l abi l i ty of low cost capital to the SMEs,
there are no signs of development in this
sector.
There are three stock markets in Pakistan;
Karachi Stock Exchange is the largest with
total capitalization of Rs. 3, 388, 801, 907 .65
and 655 listed companies. However the

1
http://www.sbp.org.pk/departments/pdf/Strategic
PlanPDF/Strategy%20Paper-Final.pdf
volatility of market is very high KSE-100 index
has declined from 15500 points in April to
2008 to below 5000 points in January
2009, although it has significantly
recovered in January 2011(Bloomberg: 2011)
2
.
This level of volatility discourages investors;
poor law and order situation, sluggish
industrial growth and insiders trading are
major problems for Pakistani stock markets.
Tight monetary pol icy (high interest rates)
also negatively affects stock markets by
announcement and credit channels. Moreover
the discounted value of future profits also
decreases, which discourages investment in
the equity markets. These effects are
prominent in Pakistani markets since the SBP
tightened its stance
3
.
Recommendations
Considering the present situation of the
Pakistani economy. The author would like to
make the following recommendations.
Monetary Policy
1) The State Bank must abandon its tight
monetary policy to support economic growth
and development. As it is acknowledged by
the SBP that the inflation is not due to
excessive monetary growth but other factors
e.g. fiscal deficit, energy crisis and supply
shock. There is no reason to adopt a tight
monetary stance. It is important to mention
here that interest payment leaves less money
for tax deductions, therefore high interest rates
also results in less revenue for the treasury.
2) Banking sector should be encouraged to
supply liquidity to the production sector
(agriculture & industry) and investment
activities. Interest rates must be dropped
significantly to enable banking sector to
perform its role. Economic growth by these
measures would stabilize economy by
decreasing output gap and bringing down
prices by matching demand.

2
http://www.bloomberg.com/apps/quote?ticker=K
SE100:IND
3
http://www.bloomberg.com/apps/news?pid=news
archive&sid=aDFkw4sRLuk8&refer=world_indic
es
3) Particularly for the development of SMEs
and industry in rural areas, SBP should
provide loans to t he banking sector at low
discount rates. Banks must be bound to use
these funds for SMEs and industry
development. Moreover, SMEs applying for
loans should be registered with the credit
rating agencies and their credit history
maintained.
Fiscal Policy
4) There should be a government spending
review to analyze each head of expenditure,
and efforts must be made to minimize
wasteful spending. Austerity measures should
be adopted at each level.
5) Tax evasion must be reduced; it would not
only overcome the deficit of budget but also
bring down inflation. The empirical research
also supports even prefers the role of the fiscal
policy in inflation control instead of tight
monetary policy.
Trade Policy
6) The subsidies e.g. wheat price support puts
huge pressure on the exchequer as the rich
class does not pay any tax and the salaried
class bear the burden. Therefore, subsidies
should be gradually eliminated. To keep low
prices, export and smuggling of these items
should not be allowed. Moreover, imports
from the international markets must be
allowed either at low tariff or no tariff to
match the demand and keep the price at
equilibrium. Best example is the sugar crisis
when artificial supply shock surged the prices
to record high levels.
7) The stance of t h e government has been
to cut the demand to keep the prices low,
which is against the concept of welfare. The
supply should be increased to keep the prices
low; an example could be allowing import of
foods items and issuance of license to open
new sugar mills.
8) In the automobile industry, there must be no
restriction on automobile imports. Government
can generate huge amount of revenues by
putting tariffs on automobile and their part
imports. Moreover road tax particularly on
vehicles would contribute to increasing
revenue.
9) In Information Technology, gaming is a big
industry, investment in professional education
to develop a work force specialized in game
software development would be very useful.
Furthermore, financial support to software
houses would also help to develop and grow
this industry.
Islamic Banking
10) To shift more towards Islamic banking, the
current Islamic banks should be facilitated.
Banks are advised and allowed to open new
branches particularly in rural area. Islamic
and conventional banking could go side by side
to contribute in economic growth. It would not
only creates jobs but also provide liquidity
es pec i al l y in those area where
conventional banking does not due to the
religious aspect.
Development Projects
11) Infrastructure projects should be started in
partnership with the private sector, particularly
in t h e energy and development sector. It
could be in the form of shared equity, to
initiate the project and when the revenues
are realized the private partner could
gradually return the public sector investment.
12) Pakistan must use each and every
source of energy production i.e. Solar,
Nuclear, Wind, Coal, Thermal etc. to produce
more energy than its domestic requirement. It
is important to mention here that Pakistan has
t h e potential to produce energy from almost
every source and importantly there is an
increasing need of electricity in India in future
(approx 950,000 MW
4
).

4
http://www.monstersandcritics.com/news/energ
ywatch/news/article_1184013.php/India_envisa
ges_about_9500
00_MW_power_requirement_by_2030
Financial Stability
13) The role of Pakistans Security & Exchange
Commission (SEC) should be enhanced to
control the financial and corporate sector
instability. There should be an additional
department in SBP to work as a market
watchdog so that insider trading and illegal
activities could be monitored.
14) As part of privatization, IPOs of public
sectors enterprises should be issued to
promote investment culture in Pakistan.
About the Author
The author is an economist by profession. He is
a graduate of BA Economics, MBA Finance,
MSc Finance, PHD Macroeconomic Policies
Interaction & Effects on Financial & Economic
Stability. He has 10 years professional work
experience in the field of economic and finance.
[E-mail: ali_paf2002@yahoo.com]

Bibliogrpahy
Ahmad, N. & Ahmed, F. (2006) The Long-run
and Short-run Endogeneity of Money Supply in
Pakistan: An Empirical Investigation, SBP-
Research Bulletin, Volume 2, and Number 1.
Creel, J. Veroni, P.M., and Saraceno, F.
(2009) Fiscal policy is back in France and the
United Kingdom!, Journal of Post Keynesian
Economics / Summer , Vol. 31, No. 4 645.
Kardar, S. H (2010), Understanding Inflation
and SBPs Monetary Policy Stance, Address
at the Federation of Pakistan Chamber of
Commerce and Industry, 13
th
December.
State Bank of Pakistan (2011), Monetary
Policy Statement, January.

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