Institute of banking and finance

REVIEW ON ARTICLES
MACRO ECONOMICS

SUBMITTED TO
Ma’am Javeria Masood

SUBMITTED BY
Atia Khalid
BBFE-17-32
BBA (IBF)
4th semester
Evening

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SAVINGS AND ECONOMIC GROWTH IN PAKISTAN: AN
ISSUE OF CAUSALITY
G. M. SAJID and MUDASSIRA SARFRAZ*

The objective of the paper is to investigate causal relationship between savings and output in
Pakistan for the period of 1973 to 2003. The relationship between savings and economic growth
is not only an important but also a controversial issue for both academicians and policy makers.
Many internationally reputed economists have analyzed this phenomenon as cause and effect
relationship. A group of economists favours capital fundamentalists point of view that savings
cause growth but others are in favour of Keynesian theory that savings depend upon the level of
output.

The co-integration and the vector error correction techniques are used to explore causal
relationship between savings and economic growth. The results suggest bi-directional or mutual
long run relationship between savings and output level. The results of ADF test show that all
measures of savings and level of output are integrated of order one. It means that these variables
are stationary at their first differences. Once it is found that all the variables used in the analysis
are integrated of the same order whether the variables have long run relationship.

The results of the co-integration test show that there is long run equilibrium relationship between
different measures of savings and level of output. The residuals obtained from these co-
integrating vectors are also stationary at their levels.

The results of the VECM suggest a long run bi-directional relationship between different
measures of savings and level of output. However there is unidirectional long run causality from
public savings to both measures of output (GNP and GDP) and from private savings to GNP
only. The speed of adjustment in case of savings is stronger than that of level of output. There is
mutual short run causality between gross domestic product (GDP) and domestic savings. The
unidirectional short run causality runs from output (GNP) to national and domestic savings and
from GDP to private savings. Only the national savings causes the GDP in the short run.

The results also indicate unidirectional short run causality from gross national product (GNP) to
national and domestic savings; and from gross domestic product (GDP) to public savings. The
short run causality runs only from national savings to gross domestic product (GDP). So overall
short run results favour Keynesian point of view that savings depend upon level of output.

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How do CFOs make capital budgeting and capital structure
decisions?
John R. Graham & Campbell R. Harvey

This paper summarizes the findings of the authors' recent survey of 392 CFOs about the current
practice of corporate finance, with main focus on the areas of capital budgeting and capital
structure. The findings of the survey are predictable in some respects but surprising in others. For
example, although the discounted cash flow method taught in our business schools is much more
widely used as a project evaluation method than it was ten or 20 years ago, the popularity of the
payback method continues despite shortcomings that have been pointed out for years. In setting
capital structure policy, CFOs appear to place less emphasis on formal leverage targets that
reflect the trade-off between the costs and benefits of debt than on “informal” criteria such as
credit ratings and financial flexibility. And despite the efforts of academics to demonstrate that
EPS dilution per se should be irrelevant to stock valuation, avoiding dilution of EPS was the
most cited reason for company’s reluctance to issue equity. But despite such apparent
contradictions between theory and practice, finance theory does seem to be gaining ground. For
example, large companies were much more likely than their smaller counterparts to use DCF and
NPV techniques, while small firms still tended to rely heavily on the payback criterion. And a
majority of the CFOs of the large companies said they had “strict” or “somewhat strict” target
debt ratios, whereas only a third of small firms claimed to have such targets. What does the
future hold? On the one hand, the authors suggest that we are likely to see greater corporate
acceptance of certain aspects of financial theory, including the use of real options techniques for
evaluating corporate investments. But we are also likely to see further modifications and
refinements of the theory, particularly with respect to smaller companies that have limited access
to capital markets.

Executives use the mainline techniques that business schools have taught for years, IRR and
NPV, to value projects. Interestingly, financial executives are much less likely to follow the
academically proscribed factors and theories when determining capital structure. Perhaps the
relatively weak support for many capital structure theories indicates that it is time to critically
reevaluate the assumptions and implications of these mainline theories. Alternatively, perhaps
the theories are valid descriptions of what firms should do - but corporations ignore the
theoretical advice. Possibility is that business schools might be better at teaching capital
budgeting than at teaching capital structure and therefore firms do not follow academic guidance
about capital structure. Moreover, perhaps IRR and NPV are more widely understood than
capital structure theories because they are more straightforward and have been accepted as
mainstream views for longer. Additional research is needed to investigate these issues. It will
help to strengthen the link between the theory and practice of corporate finance.

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An Analysis of Pakistan’s Macroeconomic Situation and Prospects
Jesus Felipe and Joseph Lim

During the latter part of 2007 and early 2008, it became obvious that Pakistan’s macroeconomic
situation was deteriorating rapidly, and that unless immediate measures were taken, the country
may slip into a balance of payments crisis. This paper analyzes Pakistan’s current
macroeconomic economic situation, in particular the sizeable budget and current account
deficits. It also discusses the effects of the surge in food and oil prices. The paper also evaluates
the government’s response to the deteriorating conditions and proposes a number of policy
measures.

Pakistan’s economy experienced relatively fast growth during the 1970s, 1980s, and in early
1990s. Pakistan’s latest growth experience during 2003–2007 was the result of short-sighted
policies driven by high remittances of overseas workers, FDI, “hot money” and loan inflows, as
well as some government pump-priming.

The main problems afflicting the Pakistani economy:

 A crisis of confidence in the political order and a strong perception of a weak

government, unable to undertake strong economic measures, such as improving revenue
collection, switching from price subsidies to income subsidies, and solving the power and
water shortages
 A neglect of the supply side of the economy (i.e., productive capacity, technological
upgrade of the economy)
 Inability to address the increasing fiscal and current account deficits. Like other
developing countries that have implemented questionable domestic policies, external
shocks have put Pakistan in a very difficult situation.

Some solution to Pakistan’s problems will have to consider:

(i) A coherent economic program that tackles macroeconomic imbalances, as well asa long-term
program that leads to the modernization of the economy.

(ii) On the fiscal front, the government must have enough political muscle to:

 Implement progressive direct taxes to generate more revenue

 Analysis of Pakistan’s Macroeconomic Situation and Prospects from price subsidies to
income subsidies with clear targeting mechanisms for poor households
 protect vital social and economic services when poverty is Increasing
 allot funds to address the power and water shortages.

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(iii) To address the external deficit and the fall in international reserves, it will be unavoidable to
look for grants and concessional loans. But over and beyond this the government should be
aggressive in upgrading and diversifying the country’s export basket.

(iv) To address the increase in prices, a combination of moderate monetary policies, elimination
in the budget of the programs with a strong inflationary bias, and a program of incomes policies
to prevent inflation expectations should be put in place.

The American economic

THE COST OF CAPITAL, CORPORATION FINANCE AND THE
THEORY OF INVESTMIENT
By FRANCO MODIGLIAN1 AND MERTON H. MILLER*

The "cost of capital" to a firm in a world in which funds is used to acquire assets whose yields
are uncertain; and in which capital can be obtained by many different media, ranging from pure
debt instruments, representing money-fixed claims, to pure equity issues.

There are three classes of economists:

(1) The corporation finance specialist concerned with the techniques of financing firms so as to
ensure their survival and growth

(2) The managerial economist concerned with capital budgeting

(3) The economic theorist concerned with explaining investment behavior at both the micro and
macro levels.

In much of his formal analysis, the economic theorist at least has tended to side-step the essence
of this cost-of-capital problem by proceeding as though physical assets-like bonds-could be
regarded as yielding known, sure streams. Given this assumption, the theorist has concluded that
the cost of capital to the owners of a firm is simply the rate of interest on bonds; and has derived
the familiar proposition that the firm, acting rationally, will tend to push investment to the point
where the marginal yield on physical assets is equal to the market rate of interest. This
proposition can be shown to follow from either of two criteria of rational decision-making which
are equivalent under certainty, namely (1) the maximization of profits and (2) the maximization
of market value.

The operational definition of the cost of capital and how that concept can be used in turn as a
basis for rational investment decision-making within the firm. Needless to say, however, much
remains to be done before the cost of capital can be put away on the shelf among the solved
problems. According to static, partial equilibrium analysis it has assumed among other things a
state of atomistic competition in the capital markets and an ease of access to those markets which
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only a relatively small important group of firms even come close to possessing. These and other
drastic simplifications have been necessary in order to come to grips with the problem at all.
Having served their purpose they can now be relaxed in the direction of greater realism and
relevance, a task in which we hope others interested in this area will wish to share.

ECONOMY OF PAKISTAN: PAST, PRESENT AND FUTURE

Ishrat Husain

This article explains the economy of Pakistan. This article is divided into six sections:

The first section deals with the past achievements and failures of Pakistan’s economy. Pakistan
was one of the few developing countries that had achieved an average growth rate of over 5
percent over a four decade period ending 1988-89. Consequently, the incidence of poverty had
declined from 40 percent to 18 percent by the end of the 1980s. An average Pakistani earns about
$500 in 2003 compared to less than $100 in 1947. Agriculture production has risen five times
with cotton attaining a level of more than 10 million bales compared to 1 million bales in 1947.
Five decades later, the manufacturing industries production index is 12,000 with the base of 100
in 1947. Per capita electricity generation in 2003 was 10,160 kwh compared to 100 in 1947. The
road and highway network in Pakistan spans 250,000 km – more than five times the length
inherited in 1947. Natural gas was discovered in the country in the 1950s. These achievements in
income, consumption, agriculture and industrial production are extremely impressive and have
lifted millions of people out of poverty levels.

The second section presents a synopsis of economic performance during 1999-2003 – a

period of intensive restructuring and reforms of the economy. It was at this stage that the military
government under General Pervez Musharraf assumed power in October 1999. A stand-by IMF
programmed was put in place in November 2000, which was successfully implemented followed
by a three-year Poverty Reduction and Growth Facility (PRGP), which will expire in November
2004. Monetary aggregates have been contained and inflation rate is below 4 percent. External
debt burden has been reduced in absolute terms from $38 to $35 billion and as a proportion of
GDP from 62.5% to 46%.The Musharraf Government actively pursued an aggressive and
transparent privatization plan whose thrust was sale of assets in the oil and gas industry as well
as in the banking, telecommunications and energy sectors, to strategic investors, with foreign
investors encouraged to participate in the 10 privatization process. Prices of petroleum products,
gas, energy, agricultural commodities and other key inputs are determined by market. The
markets do not always function effectively. Despite this movement towards a liberalized and
deregulated regime. Then taxes are reform. To produce good governance they reduce the power
of local government and use accountability process to reduce the corruption.

The third section distils the policy lessons learnt from the historical and most recent
experience of Pakistan’s economic management. They have to do central planning has been a

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failure as it leads to low productivity, lack of innovation, lack of incentives, poor quality goods
and services and low investment in human resources. Licensing to open, operate, expand, and
close business by the government. Import substitution behind high tariffs not only protects a few
thousand inefficient producers. Over regulation, controls and inspection of all kinds on the
private sector. High tax rates on individuals and corporate. Subsidies on inputs such as fertilizers,
seeds, electricity, water, gas, petroleum, etc. incur heavy budgetary costs but benefit the well-to-
do classes and highly influential individuals rather than those for whom the subsidies are
intended. Foreign investment and multinational corporations are not evils that should be shunned
but are the most important conduits for transfer of technology, managerial skills, organizational
innovation in addition to much needed capital and foreign exchange.

The fourth Section attempts to lay down the contours of the future direction of Pakistan’s
economy based on the lessons learnt and development experience gained from in-country and
cross country record. They have to do Outward-looking strategy. Private sector is the main
vehicle for producing and exchanging goods and services. Public sector enterprises and
government trading houses should be privatized. Pakistan will continue to have a liberal foreign
exchange and low tariff regime. The value of Pakistani currency in relation to other foreign
currencies will be determined. The Central Bank or the Government no longer controls interest
rates on government securities, corporate borrowing, deposits, etc. Foreign companies,
individuals, multinational corporations can own 100 percent shares in locally incorporated or
unincorporated firms. Consumers have choices to purchase foreign goods or domestically
produced goods.

The fifth Section assesses as to how the attempts to introduce Islamic economic model in the
country, if successful, will impact upon this future direction. Islamization, if adopted and
practiced in its true form, at any time in the future will strengthen the economy particularly
income distribution and poverty alleviation which have proved elusive under the present
economic model. This will, in fact, eliminate the sources of instability, violence and propensity
towards terrorism arising from a sense of deprivation.

The final section provides insights into the economic prospects of Pakistan in the medium term.
A comprehensive package of educational sector reforms, a medium term health strategy, fiscal
restructuring and devolution of administrative and financial powers to local government, public-
private partnership in delivery of social services, community involvement and participation are
some of the ways that need to be put in practice with full commitment.

The above survey of Pakistan’s past, present and future should reassure the Western Community
that if and when Islamization of the economy takes place it will not pose a threat to Pakistan’s
journey towards stability, growth and poverty reduction. Along with good policies, good
governance and good luck it will create conditions that are conducive for growth and poverty
reduction Pakistan is very much and will remain integrated into the world economy and fully
utilize the opportunities thrown open by globalization to benefit its population.