By Waqar Masood Khan
In an all-encompassing article on the state of the economy Dr Asad Zaman (author’s teacher and PhD thesis advisor) has painted an optimistic scenario and has advised that there is no truth in the proposition that the ‘sky is falling’. We are in full agreement with his assessment that Pakistan’s economy is in an expansive phase, that during such a phase it is inevitable to have the twin-deficits of fiscal and external account; that the external debt is not touching the dangerous heights; and, that the potential of Pakistan is significantly bigger compared to our present level of development. Beyond these agreements, we have some disagreements.
At the outset, it may be noted that Dr Asad Zaman is a member of one of the most important bodies charged with policy-making in the country, i.e., Monetary Policy Committee of the Central Bank. This fact is important as there is no precedence yet of a member of MPC voicing his views publicly. Even though the central bank has started publishing the minutes of the MPC but so far they largely comprise the experts’ views of the Bank’s staff and a small summary of MPC discussions, without attributing the discussion to individual members or their voting pattern. Clearly, whether intended or not, the article is an indication of the views held by Dr. Zaman and the manner in which he would be voting on the important decisions of monetary policy.
Second, the article has given a carte blanche to economic managers that whatever they are doing is just right and there is no cause for concern and views expressed to the contrary are not worthy of taking heed.
Third, in his view, loss of reserves is no sign of economic weakness or worry and even if more reserves are lost it would be good for the economy. He has qualified that such use of reserves should be for productive purposes, but has not suggested how to ensure that these reserves are used for productive purposes. He has assumed that this must already be the case.
Fourth, he suggests that the fiscal deficit should also not be a cause for concern as all of it would be going in making investments which are necessary for accelerated growth. Incidentally, the fiscal deficit at 5.8% was larger than the combined development spending of federal and provincial governments at 5.3%, indicating that even some part of the current expenditure was also met from borrowing.
These views are in sharp contrast to the established orthodoxy on economic management whether of the IMF or the World Bank, or the Chicago School. More importantly, the article has missed the fundamental point that is being debated, namely the sustainability of the twin-deficits. Clearly, if the basic proposition of the article is that this is not an issue to be concerned about or that no policy measures are required to correct them, then in our view the proposition is not tenable.
We make the following five submissions in support of the above view:
First, as agreed by Dr Zaman, both deficits are fundamentally harmful if not contained within certain limits. Let’s first look at the fiscal deficit. There is a very well defined mathematical rule that establishes that a persistent “primary deficit” (after excluding interest payments from fiscal deficit) would produce an explosive growth in public debt. Accordingly, so long as there is a primary surplus some debt may be retired even after paying for interest payments and growth of debt would not be explosive. In the alternative (primary deficit) we may be borrowing even to make interest payments. During the three fiscal years ending June 30, 2014, 2015 and 2016, the primary deficit was close to zero (a major correction from an average of 3.4% of GDP in the fiscal years 2011, 2012 and 2013). Unfortunately, the primary deficit has resurfaced significantly in the fiscal year 2017 being 1.6% of GDP. Thus, the conditions under which this deficit may be helpful are not being met and hence extreme caution by the policymakers is warranted.
Second, the current account deficit must be financed by foreign exchange resources, and in its absence, it cannot be sustained. Dr Zaman is cognizant of this limitation. However, in his view, there is no harm if the financing gap is met by drawing down on reserves. Three important issues would ensue from such a prescription, noted below as sub-points:
One, these reserves have been raised through a painstaking process of collecting revenues from divestment of public sector shares, sale of spectrum licenses, proceeds of concessional lending by the IMF, the World Bank, ADB, Coalition Support Fund (CSF), grant assistance from friendly countries and costly issuance of Euro Bonds and Sukuk from the international capital market. In majority of the cases, particularly for loans, we justified their use on account of accumulation of reserves to give strong signals to local and foreign investors to engage confidently in the economy of Pakistan.
Two, each of the above sources of inflows were termed ‘adjustors’ under the IMF program, meaning thereby that official reserves must stay above the level of their accumulated sum. Accordingly, if a Fund program were to be in operation, we would have breached the performance criterion for reserves accumulation (the single most important goal) by a whopping $5-6 billion, the amount of reserves we have lost during the last twelve months (Oct to Oct).
Three, the IMF program would have required that the SBP, on an active basis, must be a net-purchaser of at least as many dollars from the inter-bank market as it would want to provide for financing the current account deficit. It is obvious that such a major demand from the central bank in the inter-bank market would have forced a major adjustment in the exchange rate. Therefore, it turns out that we have used reserves, not to help boost development related imports, but to artificially support the exchange rate. Just as it would happen in the case of any product or commodity, setting a price below its market clearing level would induce more demand and less supply. The use of reserves is simply providing more supply to meet ‘excess demand’, which cannot be done indefinitely as the SBP would soon run out of its ability to use reserves for this purpose.
Third, until such time that we make fundamental departures from current practices in economic management, it is the duty of the central bank to do whatever it can, within the regulatory constraints, to limit monetization of deficit. Unfortunately, another major reform, achieved earlier, has been undone in a major way i.e., central bank, financing for budgetary support (on which, more in a separate article). Last year, as much as Rs 907 billion were provided as deficit financing (monetization of deficit or printing of notes) by the central bank, nearly 50% of the fiscal deficit. This is in sharp contrast to a retirement of nearly Rs.1 trillion achieved during the fiscal years 2014-2016. The country should be bracing for inflationary pressures that are likely to ensue with a lagged effect. Here again, nothing explains this development except the fear that not doing so would have led to increase in market interest rates. No one can recommend setting these rates on the basis of anything other than market forces and not to accommodate an expansionary fiscal policy based on deficit financing.
Fourth, the central bank has been given the exclusive responsibility under Section-9A(b) of the SBP Act, 1956 for reserves management. There is no role of the Ministry of Finance in this area. Accordingly, the burden of bringing order and creating a sustainable environment in the external account devolves on the central bank exclusively, including exchange rate management. Here again, the need for caution is all too obvious.
Finally, we must note, and as is evident from the above discussion, that the twin deficits have returned with vengeance, just as the Fund program has come to a close. What kind of signal are we sending to our international development partners: we comply with your prescription, not out of any belief on their efficacy but only under compulsion and that we return to our familiar ways as soon as we can. Well, the time may soon be coming, despite Dr Zaman’s hope to the contrary, that we may be left with no option but to seek a new program from the Fund. Clearly, in that event, we would be facing significant credibility gaps; the Fund would require that almost all reforms in a new program be delivered upfront, including a massive adjustment in the exchange rate. What is worse, we may be doing so at a time when the security environment surrounding us may demand that we steer-clear of such vulnerabilities.