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Map of Asia |
CIAO DATE: 2/00
Pakistan: A Fragile Economy
The South Asia Monitor
Number 11
July 1, 1999
Sanctions imposed on Pakistan following last year’s nuclear tests precipitated a balance-of-payments crisis and a near default on its external debt. The Pakistani economy, unlike India’s, faced an immediate foreign debt crisis. A U.S.$1.56 billion loan from the International Monetary Fund (IMF) helped stave off default and stabilize the country’s external financing position. It also aimed to provide a window of opportunity for the politically tough measures needed to shape up the economy.
The 1999–2000 budget, announced this month, unfortunately does little to address the country’s severe fiscal imbalance. Output growth is depressed, and exports and foreign investment have fallen steeply. Prospects for growth are also limited by the economy’s narrow industrial and export base and huge debt burden. Moreover, the conflict with India over Kashmir is likely to further strain budgetary resources and deter foreign investment. Meanwhile, with development spending taking the brunt of budget cuts, long-standing goals of reducing illiteracy and slowing population growth will continue to take a back seat. This precarious situation is likely to continue until the government is willing to take the political risks involved in serious reform.
A slow economy:
Pakistan’s economy is in the midst of a recession. Output growth has slowed from 4.3 percent in 1997–1998 to 3.1 percent in 1998–1999, and exports and investment have fallen steeply. The slowdown in growth mainly reflects poor performance in the agriculture and manufacturing sectors.
The economy is dominated by agriculture, which accounts for 25 percent of GDP and about 60 percent of employment. Growth in agriculture slowed sharply from 3.8 percent in 1997–1998 to 0.4 percent in 1998–1999, mainly because of below target production in cotton and wheat, the main crops. Cotton is a mainstay of the economy: cotton textiles are Pakistan’s leading industry and main export. Successive crop failures in recent years have thus had a large impact on the economy, hurting growth and exports. Crop failures have in turn largely reflected structural constraints, including farmers’ lack of access to quality pesticides, fertilizers, and certified seeds, as well as bottlenecks in input distribution. More generally, dependence of the economy on a narrow agricultural base has made it highly vulnerable to vagaries in agricultural performance.
Manufacturing accounts for 18 percent of GDP. Growth in manufacturing has also slowed steeply over the last year, from 7.9 percent to 2.7 percent. The sector has suffered on account of the tight lending policies adopted by banks in the face of mounting bad loans, declining foreign and domestic investment arising from weak investor confidence, and lower export demand. More generally the sector continues to suffer from technological constraints, and has remained concentrated in low-value-added cotton-based textile industries. Pakistan’s inability to develop a well-diversified industrial base has severely limited its options for growth.
Problems in the banking sector have contributed to the downturn. The sector has been progressively weakened by politically motivated lending and loan defaults by politically influential groups. Banks are burdened with a large portfolio of non-performing loans, estimated at more than Pakistani rupees (PR) 150 billion (U.S.$2.9 billion). Mounting bad loans have led banks to tighten their lending policies, further exacerbating the current slowdown.
Fiscal imbalances:
The government managed to cut the budget deficit from 7.1 percent of GDP in 1995–1996 to 4.7 percent in 1998–1999. Although the reduction in the budget deficit is encouraging, it has been achieved mostly through draconian cuts in development spending, rather than through increases in tax revenue.
Two weaknesses characterize the fiscal side: low tax revenues and an unbalanced structure of budgetary expenditures. High budgetary outlays on defense and debt servicing expenditures, along with low tax revenues, have squeezed the capital and social expenditures required for higher growth and social development.
Pakistan’s tax to GDP ratio is around 13 percent. Less than one percent of the population is effectively subject to income tax. Low tax revenues reflect a narrow tax base and a weak tax administration system. Agriculture, the largest component of GDP, is virtually untaxed. Taxpayers often evade paying taxes in collusion with tax officials.
Higher tax revenues are, however, crucial to generating the budgetary resources for capital and social investment. Tax reform has been a central policy condition for the many IMF loans to Pakistan, including the present one. Successive governments have dodged the required changes, due to opposition from powerful business and landowning groups. The budget for 1999–2000 fails to address problems related to the tax system and to the composition of budgetary expenditures. Approximately two-thirds of budgetary expenditures for 1999–2000 are devoted to defense and debt servicing, while total expenditure on development is to be less than half of that for debt servicing. This structure of budgetary expenditures is, however, unlikely to prove sustainable or to be consistent with rapid economic growth. The squeeze on fixed investment will unfavorably affect prospects for a recovery in industry.
Tax revenues over the past years have consistently failed to reach the required target. Last year’s tax revenues, estimated at PR 300 billion (U.S.$5.8 billion), fell short of the target of PR 354 billion (U.S.$6.8 billion). Under the circumstances, the government’s tax collection target of PR 356 billion (U.S.$6.9 billion) for the next fiscal year is a stiff one. A domestic slump and lower customs revenues due to declining imports will dampen tax receipts. More importantly, the proposed tax schemes fail to broaden the narrow tax base, by reducing exemptions for the agriculture sector, and to impose a flat-rate general sales tax (GST) on utilities and services. A mandatory GST is central to raising tax revenues in a nation with a high incidence of tax evasion. Additionally, the budget scrapped the unpopular “zilla” or municipal tax; it is not certain, however, whether revenues from other taxes will offset the losses from the termination of the zilla tax, estimated to contribute annually PR 20 billion (U.S.$388 million). The success of the tax schemes proposed in the budget will be heavily contingent upon voluntary tax compliance.
The government’s budget deficit target of 3.3 percent of GDP for 1999–2000 is unlikely to be achieved if the stipulated tax revenue target is not met. Failure to extend the scope of the GST, as initially agreed with the IMF, has raised concerns about the government’s commitment to the terms of the loan.
A difficult external environment:
Although the IMF loan has enabled the country to reschedule U.S.$3.3 billion of its short-term bilateral debt with the Paris Club of official creditors, the country’s external financial position remains vulnerable. With declining foreign remittances and foreign exchange earnings, Pakistan is vitally dependent on debt rescheduling agreements to meet its external payment obligations. At present, the government is seeking to reschedule about U.S.$800 million in commercial debt with the London Club of commercial creditors and U.S.$520 million in offshore trade debt with a group of commercial foreign banks.
Foreign direct investment fell over the last year from U.S$436 million to U.S$296 million, and portfolio investment from U.S$204 million to U.S$4.7 million. Foreign investor confidence has been badly shaken by the government’s dispute with the independent power producer, Hubco, over domestic electricity tariff rates, as well as by tax harassment of foreign companies, and by the freeze on foreign currency accounts. Limited foreign investor interest has led to delays in the privatization program. Foreign investment is unlikely to pick up under the prevailing political and economic instability and until the government restores its credibility.
The current account deficit has shrunk to U.S$1.92 billion because of a fall in exports and a sharper decline in imports. Exports fell by almost 12 percent, and imports by 17 percent, during the first nine months of 1998–1999 over the same period the year before.
Notwithstanding the improvement in the current account, Pakistan’s external position remains vulnerable. The fall in imports, particularly of oil, is the result of a short-term domestic slump and the demand for oil imports, upon which the economy is highly dependent, is expected to pick up as the economy revives.
The erosion in Pakistan’s export performance, however, reflects more fundamental weaknesses in its export base. Cotton textile exports, Pakistan’s main export, fell by 15 percent last year, in the face of weak external demand, particularly in Asia, and an overvalued exchange rate. Over the medium-term, the country will need to widen its export and manufacturing base and diversify into higher value-added exports, especially in view of the weaknesses in the capital account and rising oil prices.
Looking ahead:
The prerequisites for sustainable growth are investments in industry, agriculture, and education. The ongoing fiscal consolidation, coupled with low tax revenues, has put tremendous pressure on social expenditures; development expenditures have declined from 4.3 percent of GDP in 1995–1996 to 3.2 percent in 1997–1998. The provinces’ dependence on federal transfers has meant that expenditure cuts at the federal level have particularly affected the provision of services at the provincial level.
Increased investment in social development is, however, vital to the country’s growth prospects. Pakistan’s literacy rate (36 percent) is one of the regions’ lowest, and its population growth rate (2.6 percent per annum) one of the highest. Despite an average growth rate of 5–6 percent a year since 1947, poverty remains widespread; 34 percent of the population live in absolute poverty. Given this context, budgetary reform, focused on broadening the tax revenue base and reallocating resources, becomes imperative.
We will be featuring shortly a special report on the latest conflict in Kashmir and its implications for both India and Pakistan.
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