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Tuesday, July 21, 2009

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Engine of economic growth

Dr Ashfaque H Khan Economic growth is essential for job creation and poverty alleviation. Studies have shown that capital accumulation by the private sector drives growth. It is also acknowledged that privatesector investment is highly influenced by the prevailing macroeconomic environment. Macroeconomic stability is therefore one of the critical elements of promoting private-sector investment which, in turn, is the main drivers of growth. Empirical evidence shows that private investment is significantly and negatively influenced by uncertainty and macroeconomic instability. The experiences of Pakistan during the 1990s and over the last two years are in line with empirical evidence. A key objective of the countrys macroeconomic policies should be to establish conditions that facilitate private investment. A substantially large proportion of Pakistans economic activity is in the hands of the private sector. It employs 90 percent of Pakistans labour force. The private sector in Pakistan is not only the main engine of growth but also the main source of employment generation. How to promote private sector investment by improving investment climate is a major challenge for the government over the medium term. What constitutes a good investment climate? There are three broad and interrelated elements that shape good investment climate. These are macroeconomic stability, good governance and strong physical and human infrastructure. As regards the first element, a stable macroeconomic environment is characterised by low and stable inflation, low budget and current account deficits; low realinterest rates, a stable and predictable exchange rate, and comfortable foreign-exchange reserves. A stable macroeconomic environment must be accompanied by wide-ranging structural reform which will make up one crucial set of ingredient for spurring investment and growth. Pakistan maintained a stable macroeconomic environment for a fairly long period in this decade when inflation averaged 5.8 percent, budget and current-account deficits averaged 3.8 percent and 0.7 percent, respectively, foreign-exchange reserves surged from $2.1 billion in 1999-2000 to $16.4 billion in October 2007; and the exchange rate moved in the range of Rs58.4 to Rs60.6 against the dollar. The stable macroeconomic environment was accompanied by wide-ranging structural reforms in various sectors of the economy. What have been the outcomes of stable environment and structural reforms? Quite naturally, domestic investment surged from 17.2 percent to 22.5 percent of the GDP during 2000-07 an increase of 5.3 percentage point of the GDP. The surge in domestic investment was led by private-sector investment, which increased from 10.2 percent to 15.4 percent of the GDP. In other words, private-sector investment contributed 98 percent to the overall increase in investment. The confidence of foreign private investment is also influenced by stable macroeconomic environment. During 2000-07, foreign private investment increased more than eight folds from approximately $1 billion to over $8 billion. The surge in domestic and foreign investment resulted in sharp acceleration of economic growth which averaged almost 7 percent per annum during 2002-07; real per-capita income grew by 4.7 percent per annum; over 13 million jobs were created, thus reducing unemployment from 8.3 percent to 5.3 percent and poverty was reduced to one half from 34.5 percent to 17.2 percent. A worsening of macroeconomic environment over the last two years have adversely affected investment and growth. Investment is down to 19.7 percent from 22.5 percent of the GDP and

economic growth has slowed to 2.0 percent. Consequently, unemployment and poverty have increased and will continue to worsen as long as the macroeconomic environment is not improved. The government, therefore, must concentrate on improving macroeconomic environments, that is, bring inflation to low single-digit, bring budget and current account deficits to around 3 percent and 2-2.5 percent of the GDP, respectively, maintain stability in the exchange rate and build foreign-exchange reserves to provide a cushion against adverse external shocks over the next three years. Unfortunately, the government has decided to revive growth by creating more imbalances in the economy. We may not see a revival of economic growth but widening of budget and current account deficits. As regards good governance, the government must restore confidence which is vital for promoting private-sector investment and growth. The government must concentrate on reforming the tax system and tax administration, merit-based appointments, appointments of right people in right places, ensuring access of the private sector to key economic ministers, improving communication with domestic and foreign investors and markets; ensuring transparency in economic policy making, maintaining consistency and continuity in policies and most importantly getting rid of apna admi Culture. Unless and until the government moves in this direction and is seen as making efforts to improve governance, we may not see investment and growth accelerating in the near future. As regards the third element of the investment climate, the government must assign top priority to strengthening the countrys infrastructure. The government must be seen as improving the supply of power and gas; and making efforts to improve roads, rail, water availability, telecommunication network and modernising ports. The capacity of power generation is not an issue in the short run. The country has the capacity to produce over 19,000 MW of electricity but it is currently producing only 13,000 MW. Power generation can improve in the short-run if the government resolves the issues of circular debt. The prime minister must set up a high-level committee under his chairmanship for improving the investment climate. The committee should meet every month to monitor progress. Needless to say, that a strong investment climate benefits both the formal and informal sectors, and it is the latter where the poor often have the best chance of finding jobs. The writer is dean and professor at NUST Business School, Islamabad. Email: ahkhan @nims.edu.pk