An Analysis of Pakistan's Macroeconomic Situation and Prospects

ADB Economics
Working Paper Series

An Analysis of Pakistans Macroeconomic
Situation and Prospects
Jesus Felipe and Joseph Lim
No. 136 | December 2008
ADB Economics Working Paper Series No. 136
An Analysis of Pakistans Macroeconomic
Situation and Prospects
Jesus Felipe and Joseph Lim
December 2008
J esus Felipe is Principal Economist in the Central and West Asia Department, Asian Development Bank;
J oseph Lim is Professor at the Ateneo de Manila University. Mel Espina provided excellent research
assistance. The authors are grateful to participants in a workshop organized by the Central and West Asia
Department for their comments and suggestions.
Asian Development Bank
6 ADB Avenue, Mandaluyong City
1550 Metro Manila, Philippines
www.adb.org/economics
2008 by Asian Development Bank
December 2008
ISSN 1655-5252
Publication Stock No.: _______
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are those of the author(s) and do not
necessarily refect the views or policies
of the Asian Development Bank.
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Contents
I. Pakistans Macroeconomic Situation 1
II. Deteriorating Global and Macro Conditions in 2008 18
A uel and ood nfation A uel and ood nfation 8
B. Declining Foreign Exchange Reserves 23
C. Downgrade of Debt Rating 24
D. Depreciation of the Rupee 26
III. Government Response to the Deteriorating Macroeconomic Situation 26
IV. Policy Recommendations 30
A n nfation and the ole of onetary Policy A n nfation and the ole of onetary Policy 3
B. On the Exchange Rate 42
C. On Subsidies 42
D n the Budget Defcit 43
E n the Current Account Defcit 44
n the Cost of ighting nfation 44
V. Conclusions 45
Appendix: The elationship between nfation, Growth, and nequality 47
References 54
Abstract
During the latter part of 2007 and early 2008, it became obvious that Pakistans
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 Pakistans current macroeconomic economic situation, in
particular the sizeable budget and current account defcits t also discusses
the effects of the surge in food and oil prices. The paper also evaluates the
governments response to the deteriorating conditions and proposes a number of
policy measures.
I. Pakistans Macroeconomic Situation
This paper was written during the second half of 2008 and before Pakistans authorities
had to ask the nternational onetary und () for fnancial assistance t provides
an analysis of the deteriorating macroeconomic situation in the country, and proposes a
number of policy measures.
Pakistans economy experienced relatively fast growth during the 1970s, 1980s, and the
early 1990s (Figure 1). There have been three distinct phases. First, between the early
1970s and the early 1980s, gross domestic product (GDP) growth showed an upward
trend, reaching almost 9% in 1980. The rest of the decade and until the early 1990s, the
trend fattened and growth fuctuated between 5% and 75% inally, between the early
and late 1990s, growth displayed a downward trend. During this period, the economy
suffered two major slowdowns, frst in 99 and then in 997
Figure 1: GDP Growth Rate
1954 58 62 66 70 74 78 82 86 90 94 98 2002 06
15
13
11
9
7
5
3
1
1
3
5
Source: International Financial Statistics online (IMF 2008).
After the 1997 setback, growth started to recover, but again in 2001 it decreased
signifcantly Since 2002, it recovered, and especially between 2004 and 2007 the
economy registered high growth. The growth episode since 2002 is marked by the
following salient features:
(i) Contributionofexportstooverallgrowthhasdeclined,whilethatof
investmentandconsumptionhasincreased
During 20012003 (a period of moderate growth) the contribution of export growth to
GDP growth was signifcant This changed during 20042007 (period of high growth),
as consumption (private and government) and gross fxed capital formation (the latter
especially in 2007) became the main drivers of growth (Figure 2). These changes are
the result of increased workers remittances (which amounted to $5.3 billion dollars
in 2006/07 and to $6.5 billion dollars in 2007/08) and foreign investment, as well as
government pump-priming, fueled by cheap credit. This change in growth strategy
has proven fragile as it has run into resource constraints (i.e., the productive capacity
of the economy has not increased and power and water shortages are becoming an
acute concern) This has led to serious macroeconomic imbalances and to infationary
pressures.
Figure 2: Real GDP by Expenditure Category and Contribution
to Growth (percentage points)
2000 01 02 03 04 05 06 07
14
12
10
8
6
4
2
0
2
4
6
Private consumption
Gross xed capital formation
Imports of G&S
Government consumption
Exports of G&S
GDP
G&S = good and services.
Source: Authors computations based on data from Key Indicators 2007 (ADB 2007).
(ii) Servicesarethemajorcontributortooutputgrowth
From the point of view of the sectors contribution to overall growth, services (mainly
trade, transportation, communications, fnance, government and private services)
contribute over 50% (Figure 3). This outcome runs against what was envisaged in the
Medium Term Development Framework 20052010, which assumed that growth would
emanate from agriculture and industry (i.e., the commodity producing sectors). An
important drawback of this growth model is the lack of employment creation.
1
The fall in the unemployment rate between 2005/06 and 2006/07 from 6.2% to 5.3% (the unemployment rate of
2006/07 is only provisional and may change) hides two problems. First, underemployment is very high. The State
2 | AD8 Lconomics Working Paper Series No. !J6
Figure 3: Real GDP by Sector and Contribution to Growth
(percentage points)
2000 01 02 03 04 05 06 07
9
8
7
6
5
4
3
2
1
0
1
Agriculture Industry Services Real GDP
Source: Authors computations based on data from Key Indicators 2007 (ADB 2007).
(iii) Macroeconomicimbalances:defcitsintheprivate,fscal,andexternal
accounts
The subperiod 20042007 has been marked by deteriorating defcits in the private, public,
and external current account sectors. Figure 4 shows these macroeconomic imbalances.
Figure 4a shows that during the last few years, private savings have been unable to
keep up with growing private investment. Figure 4b shows that the tax revenue effort
has stagnated while government spending has increased (partly spurring the current
high growth episode) This has led to the fscal defcit These two defcits imply a large
external current account defcit, which igure 4c shows Exports plus net factor income
from abroad (the latter made up mostly of remittances from overseas workers less
interest payments on foreign debt) have fallen (as a percentage of gross national product
[GNP]) in recent years, while imports have increased substantially as a result of the
countrys high growth. Note that the positions of all three sectors have deteriorated with
respect to those in earlier years, when they registered either surpluses or lower defcits
Bank of Pakistan (2006) reported that in fscal year 2003/04, the percentage of the employed and the percentage
of the labor force working less than 35 hours were 4% and 2.9%, respectively. This fgure for underemployment
is quite conservative since it does not include those working more than 35 hours but who want additional
employment. Lubna et al. (2008) report that 88.03% of the unpaid family workers are in agriculture, 6.97% in
retail trade, 3.73% in manufacturing, 0.65% in personal services, 0.58% in construction, and 0.54% in fnance
and business services. The second problem is the increasingly larger percentage of employed people under the
category unpaid family workers. This percentage increased from 20.8% of total employed in 200/02, to 26.9% in
2005/06.
An Analysis o PakisIans Macroeconomic SiIuaIion and ProspecIs | J
This deterioration in the position of the three sectors is symptomatic of Pakistans growth
pattern (during the high-growth periods in the 1980s and early 1990s, there were also
signifcant private, public, and external current account defcits)
Figure 4: Macroeconomic Imbalances
(percent of GNP)
Figure 4a: Private saving and investment Figure 4b: Tax eort and government expenditure
Figure 4c: (Exports + net factor income from abroad) and Imports
25
20
15
10
5
0
Private investments
P
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Private savings
1989 91 93 95 97 99 2001 03 05 07 1989 91 93 95 97 99 2001 03 05 07
1989 91 93 95 97 99 2001 03 05 07
Government consumption + Government Investment
Tax eort
Imports
Exports + Net factor income from abroad
Source: Key Indicators 2007 (ADB 2007).
Figure 5 shows gross national savings and gross capital formation (investment). The
fgure shows the signifcant savings defcit in 2006 and 2007, similar to the ones
experienced in the 960s, 970s, and 990s The defcits are due to signifcantly
increased investment rates together with reduced savings rates.
Figure 5: Gross National Savings and Gross Capital
Formation (percent of GNP)
1960 64 68 72 76 80 84 88 92 96 2000 04 08
25
20
15
10
5
0
Gross national savings
Gross capital formation
Source: International Financial Statistics (IMF various years).
(iv) Deterioratingtradeandcurrentaccounts
Figure 6 shows the recent deterioration in the external accounts, consistent with the
lower contribution of export growth to overall growth discussed above. The situation is
similar to that in earlier high-growth periods when high growth rates were accompanied
by signifcant trade and current account defcits n fscal years 2005/06 and 2006/07, the
trade defcit surpassed 7% of GDP, as imports increased faster than exports (partly due
to high oil prices, and partly due to high overall growth) n fscal year 2007/08 it reached
$20.70 billion dollars.
2
The current account defcit reached more than 5% in 2005/06 and
2006/07, and in fscal year 2007/08 it reached 84% of GDP (over $4 billion dollars)
Fortunately, current transfers and remittances made by overseas Pakistani workers are
helping the current account defcit not to deteriorate further (in fact, the current account
was in surplus during 20022004).
2
Imports amounted to $39.70 billion (out of which $.3 billion were oil and $4.2 billion food) and exports to $9
billion.
An Analysis o PakisIans Macroeconomic SiIuaIion and ProspecIs | 5
Figure 6: Exports, Imports, Trade Balances and Current
Account Balance, 19762007 (percent of GDP)
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Good exports: F.O.B.
Trade balance
Good imports: F.O.B.
Current account, N.I.E.
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Source: International Financial Statistics Online (IMF 2008).
The current account defcit has led to an excessive and risky dependence on external
fnancing This poses a serious problem due to the high volatility of the external capital
account The share of total investment fnanced by external resources was 42% in
2000/0 (hence about 96% was fnanced by domestic sources) This increased to
8.4% in 2004/05; to 20% in 2005/06; to 22% in 2006/07; and to 38% in 2007/08 (i.e.,
62% was fnanced by domestic resources) n 2000/0, foreign direct investment (D)
represented 2.3% of total investment and 55.7% of external resources. In 2007/08, FDI
represented 10.6% of total investment and 27.5% of external resources. This implies that
the proportion of D in external resources has declined signifcantly Now Pakistan relies
more on other capital infows, ie, borrowing, and this entails a higher risk Net capital
fows were negative between 998 (the Asian fnancial crisis) and 2004 as debt payments
outpaced new loans However, net capital fows turned positive during 20052007 as D
increased substantially and net portfolio investments, as well as net other investments
(mainly loans net of payments) turned positive (Figure 7).
Figure 7: External Financial (Capital) Account, 19762007
(percent of GDP)
8
6
4
2
0
2
4
6
P
e
r
c
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t
FDI
Net other investments
Net portfolio investments
Financial account, N.I.E.
1
9
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Source: International Financial Statistics Online (IMF June 2008).
The net positive capital infows in recent years have allowed Pakistan not to have a
balance of payments crisis. In fact, Pakistans international foreign exchange reserves
grew until 2007 (Figure 8).
Figure 8: Foreign Exchange Reserves, 19992007
End Period (US$ million)
1999 2000 01 02 03 04 05 06 07
18000
16000
14000
12000
10000
8000
6000
4000
2000
0
Net reserves with SBP Net reserves with banks
Real GDP
Source: State Bank of Pakistan.
s Pakistans current account defcit (fnanced by infows of capital and loans) a problem?
Defcits refect underlying economic trends, which may be desirable (and therefore not
necessarily bad) or undesirable for a country at a particular point in time. A current
account defcit refects the fact that a country is building up liabilities to the rest of the
world that are fnanced by fows in the fnancial account Eventually, these need to be
paid back. If a country spends its borrowed foreign funds on spending that yields no long-
term productive gains, then its ability to repay might come into question, as the country
must be able to eventually generate suffcient current account surpluses to repay what
it has borrowed Therefore, the key is whether the borrowing fnances investment that
has a higher marginal product than the interest rate (or rate or return) that the country
has to pay on its foreign liabilities oreover, a large defcit means that an economy
and its currency may struggle if foreign capital infows suddenly dry up n the case of
Pakistan, the current account defcit refects low export growth (see next section) and,
ultimately, export competitiveness problems Pakistans persistent current account defcit
does not refect a highly productive economy ndeed, there are doubts about the quality
of the project portfolio under the Public Sector Development Program (i.e., projects
of questionable economic value, as well as noncivilian spending registered under this
Program, such as the construction of so-called strategic highways. For example, a major
portion of the strategic Makran Coastal Highway was built at least twice). Finally, the
current account defcit also refects poor fscal policy (see analysis of the fscal situation)
(v) Poorexportperformance
The fundamental reason that explains Pakistans growing trade and current account
defcits, especially during high-growth years, is its poor export performance Tables and
2 compare Pakistans export performance with that of selected countries in East, Central,
and South Asia. Table 1 shows the annual growth rate of merchandise exports for
different periods. Pakistans performance is clearly sub-standard, with only Afghanistan,
Kyrgyz Republic, Mongolia, Sri Lanka, Turkmenistan, and Uzbekistan having lower export
growth rates. In 2006 and 2007 Pakistans export growth collapsed to below 5%. Analysis
at a highly disaggregated level indicates that key exports shrank. For example, in 2007,
Pakistans largest single export product (representing over 20% of total exports), Linens
and other furnishings art (of textile), suffered a decline of 7.45%.
3
3
Something similar happened to other major categories such as Undergarments knitted, not elastic, nor rubbered
(share of 8.58%, negative growth rate of 6.63%); Other cotton fabrics, woven, bleached, dyed, etc. (share of
0.77, negative growth rate of 6.25%); Womens, girls, and infants outer garments, not knitted(share of 3.37%,
negative growth rate of 6.32%). In total, major export products (with at least % export share) representing 53%
of Pakistans total exports, registered negative growth in 2007. at the same time, other major export categories
registered very small positive growth, e.g., Outer garments knitted, not elastic, nor rubberd with a share of 8.9%
registered a growth rate of only 4.92%.
Table 2 shows the export to GDP ratio. In 2006, only Afghanistan, Georgia and Nepal had
lower export-to-GDP ratios than Pakistan. It is also worth noting that even if Pakistan has
a similar export-to-GDP ratio as a country like India, the latter is a much larger economy,
and its export-to-GDP ratio has improved considerably over the years, while Pakistans
has remained stagnant.
What explains Pakistans poor export performance? ne possible reason is overvaluation
of the exchange rate. Figure 9 shows the real effective exchange rate of selected
countries since 2000.
4
The fgure shows that Pakistans rupee is the weakest among the
countries in the fgure Therefore, currency overvaluation has to be ruled out as the main
reason underlying Pakistans weak export performance.
5
A more plausible reason that explains Pakistans weak export performance is the lack of
export sophistication. Throughout the years, Pakistan has not been able to upgrade its
export structure, heavily concentrated on the low end of textiles and garments.
6
Figure
10 shows the elasticity of Pakistans exports with respect to the GDP of the industrial
countries (i.e., by what percentage Pakistans exports change when the GDP of the
industrial countries increases why one percentage point) since the fourth quarter of 1985.
This variable is a proxy for the nonprice competitiveness of Pakistans exports (i.e., the
quality attribute) The fgure shows that this elasticity is low, taking an average value of
for the whole period of 0.87. Upgrading the export package will take time but measures in
the form of a coherent plan must be taken as soon as possible.
4
The choice of the base year is critical, but Pakistans comparatively weak currency is robust. If we use 997 (the start
of the Asian crisis) as base year, Pakistans rupee was the second weakest after the Malaysian ringgit in February
2008. If one uses 980 as base year, Pakistans rupee is the second weakest after the PRCs renminbi (also in
February 2008).
5
Regression analysis indicates that exports are relatively sensitive to currency depreciations.
6
In another paper we show that Pakistans export sophistication is lower than that of the successful Asian
economies, and the level of sophistication has actually deteriorated over the years (Felipe 2007).
Table 1: Annual Growth Rate of Merchandise Exports, Selected Economies
19602006 19601970 19701980 19801990 19902000 20002006
Afghanistan 4.79 5.57 22.79 9.94 2.37 5.09
Armenia* 3.66 5.27 40.27
Azerbaijan* 20.88 7.74 44.9
Bangladesh** .87 4.3 8.2 4.35 0.77
Bhutan*** 2.34 5.20 3.94 22.6
Cambodia 9.07 5.68 8.52 8.3 32.07 8.26
China, Peoples Rep. of 3.76 .08 22.87 3.2 4.9 25.40
Georgia* 6.74 3.02 34.55
Hong Kong, China 4.30 3.83 23.24 5.02 9.42 8.06
India 0.28 4.29 5.53 7.66 8.96 8.98
Indonesia .03 2.80 34.77 .60 9.80 7.95
Kazakhstan* 23.45 8.20 59.88
Korea, Rep. 22.2 38.58 35.55 4.02 0.23 .9
Kyrgyz Republic* 7.34 6.82 9.59
Lao PDR 6.3 23. 4.55 0.93 5.37 7.63
Mongolia*** 5.30 5.07 2.07 9.27
Nepal 8.6 9.58 6.54 9.8 4.70 0.93
Pakistan 8.48 1.15 19.29 7.93 4.86 11.05
Philippines 9.85 5.25 8.62 3.52 7.23 2.83
Sri Lanka 6.47 .8 2.07 6.0 .00 4.04
Tajikistan* 9.4 8.7 3.04
Thailand 3.35 5.62 24.79 3.49 .59 .23
Turkmenistan* 7.76 2.63 8.32
Uzbekistan* 6.80 .67 6.57
*Data starts in 994, **data starts in 974, ***data starts in 980.
Annual growth rate is estimated by F(T) = F(0) (+ r)
T
where F(T) is the fnal value, F(0) is the initial value, r is the annual growth
rate, and T is the number of years. This leads to r = [F(T)/F(0)]
/T
- .
Source: World Development Indicators.
Table 2: Merchandise exports, Selected Countries (percent of GDP)
1960 1970 1980 1990 1995 2000 2006
Afghanistan 4.3 4.92 8.40 5.2
Armenia 8.46 5.38 5.72
Azerbaijan 20.80 33.0 32.0
Bangladesh 4.9 5.55 9.23 3.57 9.07
Bhutan 2.30 23.05 33.55 23.02 37.6
Cambodia 0.99 5.43 7.72 24.85 38.0 52.36
China, Peoples Rep. of 4.9 2.52 9.6 7.5 20.44 20.79 36.64
Georgia 5.6 0.56 2.82
Hong Kong, China 52.5 66.22 70.52 07.6 20.55 9.84 70.0
India 3.64 3.3 4.67 5.66 8.60 9.2 3.9
Indonesia .47 28.08 22.44 22.47 39.63 28.37
Kazakhstan 25.77 48.7 49.96
Korea, Rep. 0.82 9.39 27.43 24.65 24.8 33.67 36.65
Kyrgyz Republic 24.62 36.87 28.23
Lao PDR 9.3 7.64 9.02 25.43
Mongolia 3.58 38.56 49.2 49.25
Nepal 3.29 4.90 4. 5.62 7.84 4.63 8.50
Pakistan 10.79 4.47 11.05 14.03 13.24 12.21 13.35
Philippines 8.99 5.56 7.69 8.32 23.6 52.4 40.0
Sri Lanka 27.09 4.87 26.5 23.80 29.5 33.25 25.54
Tajikistan 60.90 80.0 49.76
Thailand 4.89 0.02 20. 27.03 33.62 56.27 63.39
Turkmenistan 75.74 86.28 50.
Uzbekistan 25.69 20.47 32.70
Source: World Development Indicators.
!0 | AD8 Lconomics Working Paper Series No. !J6
Figure 9: Real Eective Exchange Rate of Selected
Asian Economies
140
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90
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70
Armenia
Pakistan
PRC
Philippines
Malaysia
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2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: International Financial Statistics (IMF various years).
6
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Figure 10: Elasticity of Exports with Respect to GDP
of Industrial Countries
Source: Stafs estimations; recursive estimation for the period 982Q42007Q4.
An Analysis o PakisIans Macroeconomic SiIuaIion and ProspecIs | !!
(vi) Continuingfscaldefcits
The latest growth period 20042007 is also marked by increasing defcits in the fscal
position, as Figure 11 shows. Since 2006, the low tax effort and revenue-generating
capacity has eroded the countrys macroeconomic stability. While total expenditures
increased (which certainly contributed to overall growth), the tax effort did not improve
signifcantly so that the fscal defcit increased to 5% of GDP during 20052007 or the
frst half of the 2008 fscal year (ie, JulyDecember 2007) the fscal defcit reached 6%
of GDP, only 0.4 percentage point below the target set for the whole year (4%). The
major reasons for the defcit are expenditure overruns before the elections, energy-related
subsidies, and disruptions to revenue collection. A comparison with the previous J uly
December defcit indicates that this one has increased by % or the total fscal year
ending 0 June 2008, the fscal defcit amounted to 65% of GDP n the speech given by
the Finance Minister during the Budget Session of the National Assembly
( June 2008, tem no 9 (5)), he argued that the budget defcit was mainly due to the
phenomenal buildup in subsidies in the budget totaling Rs.407 bn. including petroleum,
Rs. 175 billion; electricity, Rs. 133 billion; wheat Rs.40 billion and textiles and fertilizers,
Rs. $48 billion. The Rs. $407 billion total subsidies far exceed the Rs. 114 billion (which)
was provided in the (original) budget. The structure of the budget is shown in detail in
Table 3.
The increase in expenditures between fscal years 2006/07 and 2007/08 was mostly due
to the increase in current expenditures, where most subsidies (fuel, energy, and food)
are recorded. The other large component of expenditures, development spending, saw a
decline.
Figure 11: Consolidated Government Revenue,
Expenditure and Decit, 19892007 (percent of GDP)
30
25
20
15
10
5
0
5
10
15
P
e
r
c
e
n
t

Total revenues
Total expenditures
Tax revenues
Overall budgetary surplus/decit
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
Source: Key Indicators 2007 (ADB 2007).
T
a
b
l
e

3
:

S
u
m
m
a
r
y

o
f

C
o
n
s
o
l
i
d
a
t
e
d

F
e
d
e
r
a
l

a
n
d

P
r
o
v
i
n
c
i
a
l

B
u
d
g
e
t
a
r
y

O
p
e
r
a
t
i
o
n
s
,
1
9
9
8
2
0
0
9

(
m
i
l
l
i
o
n

R
u
p
e
e
s
)
F
Y

9
8
F
Y

9
9
F
Y

0
0
F
Y

0
1
F
Y

0
2
F
Y

0
3
F
Y

0
4
F
Y

0
5
F
Y

0
6
F
Y

0
7
P
r
e
l
i
m
i
n
a
r
y

F
Y

0
8
2
0
0
8
/
0
9

B
u
d
g
e
t
T
o
t
a
l

R
e
v
e
n
u
e

4
2
9
,
4
5
4

4
6
8
,
6
0
1

5
1
2
,
5
0
0

5
5
3
,
0
0
0

6
2
4
,
1
0
0

7
2
0
,
8
0
0

7
9
4
,
0
0
0

9
0
0
,
0
1
4

1
,
0
7
6
,
6
0
0

1
,
2
9
7
,
9
5
7

1
,
4
9
9
,
3
7
9

1
,
6
7
9
,
2
3
8

T
a
x

r
e
v
e
n
u
e

3
5
4
,
7
5
4

3
9
0
,
7
2
6

4
0
5
,
6
0
0

4
4
,
6
0
0

4
7
8
,
0
0

5
5
5
,
8
0
0

6
,
0
0
0

6
5
9
,
4
0

8
0
3
,
7
0
0

8
8
9
,
6
8
5

,
0
5
0
,
6
9
4

,
2
5
,
4
6
2

F
e
d
e
r
a
l

3
3
8
,
0
4
2

3
7
5
,
0
7
8

3
8
6
,
8
0
0

4
2
2
,
5
0
0

4
5
9
,
3
0
0

5
3
4
,
0
0
0

5
8
3
,
0
0
0

6
2
4
,
7
0
0

7
6
6
,
9
0
0

8
5
2
,
8
6
6

,
0
0
9
,
9
0
2

P
r
o
v
i
n
c
i
a
l

6
,
7
5
,
6
4
8

8
,
8
0
0

9
,
0
0

8
,
8
0
0

2
,
8
0
0

2
8
,
0
0
0

3
4
,
7
0

3
6
,
8
0
0

3
6
,
8
9

4
0
,
7
9
2

N
o
n
t
a
x

r
e
v
e
n
u
e

7
4
,
7
0
0

7
7
,
8
7
5

0
6
,
9
0
0

,
4
0
0

4
6
,
0
0
0

6
5
,
0
0
0

8
3
,
0
0
0

2
4
0
,
6
0
4

2
7
2
,
9
0
0

4
0
8
,
2
7
2

4
4
8
,
6
8
5

4
2
7
,
7
7
6

F
e
d
e
r
a
l

6
2
,
4
0
0

5
4
,
6
3

9
0
,
8
0
0

9
,
5
0
0

2
4
,
7
0
0

3
9
,
6
0
0

5
8
,
0
0
0

2
8
,
2
0
0

2
2
5
,
3
0
0

3
6
2
,
8
6
4

3
7
0
,
6
9
8

P
r
o
v
i
n
c
i
a
l

2
,
3
0
0

2
3
,
2
6
2

6
,
0
0

9
,
9
0
0

2
,
3
0
0

2
5
,
4
0
0

2
5
,
0
0
0

2
2
,
4
0
4

4
7
,
6
0
0

4
5
,
4
0
8

7
7
,
9
8
7

T
o
t
a
l

e
x
p
e
n
d
i
t
u
r
e

6
3
4
,
0
4

6
4
7
,
7
7
8

7
0
9
,
0
0

7
7
,
9
0
0

8
2
6
,
2
5
0

8
9
8
,
2
0
0

9
5
6
,
0
0
0

6
,
9
8
,
4
0
,
9
0
0

,
7
9
9
,
9
6
8

2
,
2
7
6
,
5
4
8

2
,
0
0
9
,
8
1
2

C
u
r
r
e
n
t

5
2
9
,
9
9

5
4
7
,
2
7
9

6
2
6
,
4
0
0

6
4
5
,
7
0
0

7
0
0
,
2
0
0

7
9
,
7
0
0

7
7
5
,
0
0
0

8
6
4
,
5
0
0

,
0
3
4
,
7
0
0

,
3
7
5
,
3
4
5

,
8
5
7
,
5
7
,
4
9
3
,
8
3

F
e
d
e
r
a
l

4
0
7
,
2
9

4
2
4
,
4
4
3

4
7
7
,
9
0
0

4
7
9
,
0
0
0

5
2
4
,
6
0
0

5
9
9
,
8
0
0

5
5
7
,
0
0
0

6
6
4
,
2
0
0

7
8
9
,
0
0

9
7
3
,
3
0

,
4
2
0
,
4
3
9

P
r
o
v
i
n
c
i
a
l

2
2
,
7
0
0

2
2
,
8
3
6

4
8
,
5
0
0

6
6
,
7
0
0

7
5
,
6
0
0

,
9
0
0

2
8
,
0
0
0

2
0
0
,
3
0
0

2
4
5
,
6
0
0

4
0
2
,
2
5

4
3
7
,
3
2

D
e
v
e
l
o
p
m
e
n
t

0
4
,
0
9
5

9
8
,
2
8
6

9
5
,
6
0
0

8
9
,
8
0
0

2
6
,
2
5
0

2
9
,
2
0
0

,
0
0
0

2
2
7
,
7
8

3
6
5
,
0
0

4
3
3
,
6
5
8

4
5
,
8
9
5

5
6
,
6
2
9

N
e
t

l
e
n
d
i
n
g

2
,
2
3

(
2
,
9
0
0
)

(
7
,
6
0
0
)

(
2
0
0
)

(
2
2
,
7
0
0
)

2
0
,
0
0
0

2
4
,
7
6
3

2
,
0
0

(
9
,
0
3
5
)

(
2
8
,
4
9
4
)

S
t
a
t
i
s
t
i
c
a
l

d
i
s
c
r
e
p
a
n
c
y

9
,
7
0
0

4
,
8
0
0

(
,
7
0
0
)

3
,
2
0
0

(
3
2
,
0
0
0
)

(
8
6
,
3
0
7
)

(
2
4
,
5
0
)

(
4
,
4
2
4
)
B
u
d
g
e
t

d
e
f
c
i
t
(
2
0
4
,
5
6
0
)
(
1
7
9
,
1
7
7
)
(
2
0
6
,
3
0
0
)
(
1
7
9
,
7
0
0
)
(
1
9
0
,
4
5
0
)
(
1
8
0
,
6
0
0
)
(
1
3
0
,
0
0
0
)
(
2
1
6
,
9
6
7
)
(
3
2
5
,
3
0
0
)
(
3
7
7
,
5
0
1
)

(
7
7
7
,
1
6
9
)

(
3
3
0
,
5
7
4
)
F
i
n
a
n
c
i
n
g

2
0
4
,
9
9
2

1
7
9
,
1
7
8

2
0
6
,
3
0
0

1
7
9
,
7
0
0

1
9
0
,
4
5
0

1
8
0
,
6
0
0

1
3
0
,
0
0
0

2
1
6
,
9
8
8

3
2
5
,
2
0
0

3
7
7
,
5
0
1

7
7
7
,
1
6
9

3
3
0
,
5
7
5

E
x
t
e
r
n
a
l

3
8
,
7
6

9
7
,
0
7
0

6
9
,
7
0
0

2
0
,
7
0
0

8
3
,
0
0

3
,
0
0
0

(
5
,
9
0
0
)

2
0
,
4
3
2

4
8
,
9
0
0

4
7
,
5
0

,
3

3
0
0
,
6
9

D
o
m
e
s
t
i
c

6
6
,
2
3

8
2
,
0
8

3
6
,
6
0
0

5
9
,
0
0
0

0
7
,
3
5
0

6
7
,
6
0
0

3
5
,
9
0
0

9
6
,
5
5
6

7
6
,
3
0
0

2
3
0
,
3
5

6
2
5
,
8
5
8

3
0
,
4
0
6

N
o
n
b
a
n
k

8
,
2
0
2

5
5
,
9
9

9
6
,
7
0
0

9
2
,
0
0
0

8
5
,
0
0
0

9
,
5
0
0

6
,
0
0
0

8
,
0
5
0

8
,
0
0

5
6
,
9
0
5

0
5
,
9
5

B
a
n
k

4
8
,
0
2
9

(
7
3
,
8
)

3
9
,
9
0
0

(
3
3
,
0
0
0
)

4
,
0
0
0

(
5
5
,
6
0
0
)

6
3
,
6
9
0

6
0
,
7
9

7
0
,
9
0
0

,
9
8
2

5
9
,
9
0
7

P
r
i
v
a
t
i
z
a
t
i
o
n

p
r
o
c
e
e
d
s

8
,
3
5
0

3
,
7
0
0

,
2
0

2
8
,
3
2
7

9
7
,
3
0
0

7
,
4
6
4

G
D
P
,

c
u
r
r
e
n
t

p
r
i
c
e
s
,

R
s

b
i
l
l
i
o
n
2
6
7
8
2
9
3
8
3
8
2
6
4
2
0
4
4
5
3
4
8
7
6

5
,
6
4

6
,
5
0
0

7
,
6
2
3

8
,
7
2
3

0
,
4
7
8

A
s

%

o
f

G
D
P

*
T
o
t
a
l

R
e
v
e
n
u
e

6
.
0

5
.
9

3
.
4

3
.
4
.
0

4
.
8

4
.
3
.
8

4
.
4
.
9

4
.
3

T
a
x

r
e
v
e
n
u
e

3
.
2

3
.
3

0
.
6

0
.
5

0
.
7

.
4

0
.
8

0
.
0
.
5

0
.
2

0
.
0

N
o
n
t
a
x

r
e
v
e
n
u
e

2
.
6

2
.
8

0
.
0
.
0

0
.
3

.
0

0
.
3

9
.
6

0
.

9
.
8

9
.
6

T
o
t
a
l

e
x
p
e
n
d
i
t
u
r
e

2
3
.
7

2
2
.
0

1
8
.
5

1
7
.
1

1
8
.
6

1
8
.
4

1
6
.
9

1
7
.
2

1
8
.
4

2
0
.
6

2
1
.
7

C
u
r
r
e
n
t

9
.
8

8
.
6

6
.
4

5
.
3

5
.
7

6
.
2

3
.
7

3
.
3

3
.
6

5
.
8

7
.
7

D
e
v
e
l
o
p
m
e
n
t

3
.
9

3
.
3

2
.
5

2
.

2
.
8

2
.
6

2
.
9

3
.
5

4
.
8

5
.
0

4
.
3

B
u
d
g
e
t

d
e
f
c
i
t

(
7
.
6
)

(
6
.
1
)

(
5
.
4
)

(
4
.
3
)

(
4
.
3
)

(
3
.
7
)

(
2
.
3
)

(
3
.
3
)

(
4
.
3
)

(
4
.
3
)

(
7
.
4
)
*
B
e
g
i
n
n
i
n
g

f
r
o
m

9
9
9
2
0
0
0
,

P
a
k
i
s
t
a
n
s

G
D
P

w
a
s

r
e
b
a
s
e
d

a
t

9
9
/
2
0
0
0

p
r
i
c
e
s
.

W
h
e
r
e
v
e
r

G
D
P

a
p
p
e
a
r
s

i
n

d
e
n
o
m
i
n
a
t
o
r

t
h
e

n
u
m
b
e
r

o
f

p
r
i
o
r

t
o

9
9
/
2
0
0
0

a
r
e

n
o
t

c
o
m
p
a
r
a
b
l
e
.
S
o
u
r
c
e
:

B
u
d
g
e
t

W
i
n
g
,

F
i
n
a
n
c
e

D
i
v
i
s
i
o
n
,

P
a
k
i
s
t
a
n
.
An Analysis o PakisIans Macroeconomic SiIuaIion and ProspecIs | !J
According to Table 3, while external and domestic sources contributed about the same
to the fnancing of the defcit in fscal year 2007/08, the government estimates that about
90% of the defcit will be fnanced through external sources in fscal year 2008/09 This
will be very diffcult and will depend on donors disbursements
t is important to emphasize that a government can always potentially fnance its budget
defcit if it were fnanced in domestic currency n Pakistan the shares of domestic
currency and foreign currency are about the same (see Table 4). Pakistans current
account defcit is a more serious and pressing problem (because the country needs to
earn dollars to pay for its imports). But it is important to emphasize that the composition
of expenditures in the budget needs to be reassessed to make sure that spending
is conducive to the full employment of Pakistans resources This way, superfuous
categories should be eliminated The budget defcit will be infationary once the economy
reaches full employment.
As a consequence of the widening imbalances, government borrowing has increased
sharply, which most likely will lead to an increase in public debt in fscal year 2007/2008
(Tables 4 and 5 show data until March 2008), with the consequent increase in interest
payments. Pakistans total external debt has increased in absolute terms, but it has been
declining as a percentage of GDP (Table 5) the total debt-to-GDP ratio declined from
75% in 2002/03 to 55.2% in 2006/07; and the external debt to GDP ratio from 36.6% to
254% We expect that this trend will be reversed when fgures for the complete fscal
year are released. External debt is mostly public (the private component is very small),
used to fnance the governments fscal defcits A signifcant portion of the defcit was
fnanced via monetization, a route the government has used since 2005 (a total of
almost $10 billion since 2005) in order to avoid the increase in interest payments. During
fscal year ending 0 June 2008, about 70% of the increase in domestic public debt has
come from borrowing from the central bank This increase in the defcit led in fscal year
2007/08 to a breach of two provisions of the Fiscal Responsibility and Debt Limitation Act
2005: (i) the budget will record a revenue defcit (revenue minus current expenditures);
and (ii) public debt will not decline by at least of 2.5 percentage points of GDP for the
second consecutive year. This jeopardizes the gains achieved between 1999 and 2007
when the public debt-to-GDP ratio declined from about 79% in fscal year 999/2000 to
about 55% in fscal year 2006/07 (see Box )
Table 4. Pakistan: Public Debt Outstanding, FY2000/08 (JulyMarch)
FY 00 FY 01 FY 02 FY 03 FY 04 FY 05 FY 06 FY 07 FY 08
(Mar)
In Rs billion
Domestic currency debt 576 728 75 852 979 252 2322 260 302
Foreign currency debt 442 76 795 766 80 93 204 223 2593
Total public debt 308 3489 350 368 3789 4065 4363 484 5605
As percent of GDP
Domestic currency debt 41.2 41.5 39.0 38.4 35.1 33.1 30.5 29.8 28.7
Foreign currency debt 37.7 42.3 40.8 36.6 32.1 29.4 26.8 25.4 24.7
Total public debt 78.9 83.8 79.7 75.0 67.2 62.5 57.2 55.2 53.5
As percent of revenue
Domestic currency debt 307 32 275 257 246 239 22 200 95
Foreign currency debt 28 38 288 245 225 23 86 70 68
Total public debt 588 63 563 502 470 452 398 37 363
As percent of total debt
Domestic currency debt 52.2 49.5 48.9 51.2 52.2 52.9 53.2 54.0 53.7
Foreign currency debt 47.8 50.5 51.1 48.8 47.8 47.1 46.8 46.0 46.3
Memo Items:
Foreign currency debt
($billion)
27.5 27.8 29.9 30.6 3.3 32. 33.9 36.5 4.3
Exchange rate
(Rs/US$, end of period)
52.5 63.4 60. 57.7 57.9 59.7 60.2 60.6 62.8
GDP (Rs billion) 3826 463 4402 4823 564 6500 7623 8723 0478
Total revenue (Rs billion) 53 553 624 72 806 900 095 298 546
Source: Various economic surveys, Budget Wing, Ministry of Finance.
An Analysis o PakisIans Macroeconomic SiIuaIion and ProspecIs | !5
Table 5: Pakistans External Debt and Liabilities
FY 02 FY 03 FY 04 FY 05 FY 06 FY 07 FY 08*
In US$ billion
. Public and public-guaranteed debt 29.23 29.9 29.93 3.09 32.9 35.35 40.69
A. Medium and long term (> year) 29.05 29.00 29.9 30.82 32.74 35.32 40.08
Paris club 2.52 2.59 3.63 3.0 2.79 2.69 4.53
Multilateral 4.33 4.95 4.35 5.36 6.82 8.69 2.52
Other bilateral 0.43 0.47 0.69 0.8 0.92 .00 .8
Euro bond/Sandak bonds 0.64 0.48 0.82 .27 .9 2.7 2.68
Military debt 0.82 0.26 0.20 0.9 0.3 0.08 0.05
Commerical loans/credits 0.3 0.25 0.22 0.8 0.7 0.5 0.2
B. Short term (< year) 0.8 0.9 0.02 0.27 0.7 0.03 0.6
IDB 0.8 0.9 0.02 0.27 0.7 0.03 0.6
2. Private nonguaranteed debt 2.23 2.03 .67 .34 .59 2.25 2.49
3. IMF .94 2.09 .76 .6 .49 .4 .4
Total external debt (1+2+3) 33.40 33.31 33.36 34.04 35.99 39.01 44.59
of which: public debt 29.90 30.60 31.30 32.10 33.90 36.50 41.30
4. Foreign exchange liabilities 3.3 2.2 .95 .80 .59 .47 .33
Total external debt and liabilities
(1+2+3+4)
36.53 35.43 35.31 35.84 37.58 40.48 45.92
of which: public debt 29.90 30.60 31.30 32.10 33.90 36.50 41.30
Ofcial liquid reserves 4.34 9.53 0.56 9.8 0.77 3.35 3.37
As percent of GDP
. Public and public-guaranteed debt 40.8 35.4 30.5 28.4 25.8 24.6 23.8
A. Medium and long term (> year) 40.5 35.2 30.5 28. 25.7 24.5 23.5
B. Short term (< year) 0.3 0.2 0.0 0.2 0. 0.0 0.4
2. Private nonguaranteed debt 3. 2.5 .7 .2 .2 .6 .5
3. IMF 2.7 2.5 .8 .5 .2 .0 0.8
Total external debt (1+2+3) 46.6 40.4 34.0 31.1 28.2 27.1 26.1
4. Foreign exchange liabilities 4.4 3.0 2.7 2.5 2.2 2. .9
Total external debt and liabilities
(1+2+3+4)
50.9 43.0 36.0 32.7 29.5 28.1 26.9
* End March.
Box 1: Fiscal Responsibility and Debt Limitation Act 2005
The key targets in this Act are as follows:
(i) educe the revenue defcit of the federal government to zero not later than June 2008
and thereafter maintain a revenue surplus. According to the Fiscal Policy Statement of the
Debt ffce, the budget carried a revenue defcit of 06% of GDP during the last 4 years
(2002/03 to 2005/06), and at 0.9% of GDP in 2006/07. However, as mentioned earlier,
the primary defcits become surpluses if current expenditure is reduced by the amount of
unidentifed expenditure shortfall
(ii) Ensure that by 30 J une 2013, the total public debt does not exceed 60% of GDP and
thereafter remains below this level According to the Debt ffce this target has already
been met in 2005/06. At the end of 2006/07, it stood at 55.2%.
(iii) Ensure that in every fnancial year from 200/04 to 202/, the public debt is reduced by
no less than 2.5% of GDP, provided that social and poverty alleviation-related expenditures
are not reduced below 4.5% percent of GDP; and that the budgetary allocation for
education and health is doubled in terms of percentage of GDP in the next 10 years. The
overall poverty alleviation expenditures were 5.7% of GDP in 2006/07, but it is not clear if
the target for education and health will be met.
(iv) Not issue new guarantees for any amount exceeding 2% of GDP. In 2006/07, the
government issued guarantees of 0.8% of GDP.
Summing up, Pakistans high-growth episode of 20042007 was the result of a growth
model that aimed at achieving a high growth rate through misguided policies Both infows
of capital and workers remittances, together with government pump-priming not matched
by an increase in the tax effort (which led to the fscal defcit) led to high growth rates
However, these were not accompanied by a concomitant increase in the productive
capacity of the economy. High growth prompted an increase in imports (which led to
the trade defcit) and in consumption The current account defcit resulted from imports
increasing faster than exports (where the latter suffer from a structural competitiveness
problem), which led to a dependence on infows of overseas remittances, D, portfolio
investment, and loans. Increased government spending, together with an increase in
business confdence, crowded in the private sector, with investment running ahead
of savings. This growth model could perhaps have been sustained longer, as long as
capital infows exceeded the current account defcit (leading also to a build-up of foreign
exchange reserves) But as the external defcit has continued increasing, the situation has
become riskier This is indeed what we observe in 2008 as infows of capital have started
decelerating. Moreover, as a model of long-run growth and sustainable development, it
poses a number of questions.
II. Deteriorating Global and Macro Conditions in 2008
During the second half of 2007 and the early months of 2008, global and macroeconomic
conditions have deteriorated signifcantly, frst, as a result of the global economic
slowdown caused by the subprime crisis in the US; and second, as a consequence of the
worldwide food shortages, which have led to high food prices globally and have fueled
food price infation At the same time, world fuel prices accelerated at an unprecedented
pace in 2008.
A. Fuel and Food Infation
These global events have contributed to the worsening of Pakistans macroeconomic
situation n the infation front, igure 2 shows that between fscal years 997/98 and
2006/07, Pakistan was able to maintain the infation rate below 0% Pakistan only
experienced moderate-high infation in the mid-970s, over 25%, when the frst oil price
shock caused stagfation throughout the world The fgure shows that in fscal year
2007/08, consumer price index (CP) infation breached the 0% level and reached 2%
7
Figure 12: CPI Ination Rate, 19782008
14
12
10
8
6
4
2
0
P
e
r
c
e
n
t
,

1978 80 82 84 86 88 90 92 94 96 98 02 04 06 08 2000
Source: International Financial Statistics Online (IMF, June 2008).
ne may ask if the empirical evidence on the relationship between infation and growth is
conclusive, ie, that higher infation is associated with lower growth This is not the case
The empirical evidence available tends to indicate that it is high infation signifcantly
higher than the one experienced today, which undermines growth and social stability.
While there is no doubt that infation, in particular food infation, is a tax on the poor (and
for this reason it should be addressed), there is no (historical) evidence that infation at
7
At the beginning of the paper it was argued that in the growth model that Pakistan implemented during the last
few years, productive capacity did not keep up with demand, which led to the build-up of infationary pressures.
Despite this, the 0% infation rate was not reached and passed until fscal year 2007/08. In our view, the major
driver of infation in Pakistan is fuel and food, i.e., it is supply-driven.
the moderate rates that have prevailed in recent times has any signifcant harmful effects
on output, employment, growth, or the distribution of income. Box 2 summarizes this
evidence and the Appendix provides empirical evidence.
Box 2: Infation and Growth: What does the Empirical Evidence Say?
A number of authors have analyzed the relationship between infation and growth Bruno (995)
found that infation and growth are positively related up to 5% infation, and then diminishing
returns to infation set in Both variables are negatively related once infation rises above 0%
Barro (997) found that these two variables are unrelated when infation is below 200%
Bruno and Easterly (998) found that there is no evidence that infation rates below 40% have
adverse effects on growth They argue that the negative infationgrowth correlation is only
present with high-frequency data, and that there is no cross-sectional correlation between these
two variables using (averages) long-run data.
Dornbusch (2000) cites a study by the World Bank according to which truly damaging infation
does not start until about 40% Dornbusch argued that: Countries with 5 percent infation
per month must stabilize with urgent priority: nothing is likely to be more important. On the
other hand, countries with 5 percent infation per year certainly should not belittle infation
They defnitely should attempt, on average, to bring infation down But they must see this as
one of a number of priorities, and they should view it as a process of fve or even more years
(Dornbusch 2000, 52). He refers to the example of Chile: Chiles policymakers recognize
that strong growth, modernization, and integration in the world economy are not held back
by 6, 0, or even 5 percent infation, but could be seriously hampered if overambitious
disinfation created a macroeconomic problem (Dornbusch 2000, 5) These results have been
corroborated recently Pollin and Zhu (2006), who have found that higher infation is associated
with moderate gains in GDP growth up to an infation threshold of about 58%
1
Stiglitz et al.
(2006, Table 2.1) have examined growth in several countries (Argentina, Brazil, Chile, Israel,
Poland, and Turkey) that have experienced episodes of low, moderate, and hyper infation Their
data show that (i) low infation is not associated in general with high growth; (ii) hyperinfation
in general is associated with low growth; and (ii) moderate rates of infation, 200% per year,
have been associated with rapid growth quite often.
The conclusion is that while infation has potentially damaging effects (and for this reason one
should analyze and monitor what is happening today), the empirical evidence indicates that the
threshold after which its damaging effects show up is way above the infation rates observed
today. Overall, there is no support for the claim that a necessary condition for faster growth is
that infation should be as low as possible Likewise, there is neither theoretical nor statistical
support for the popular notion that infation has a built-in tendency to accelerate and that it is
self-perpetuating And fnally, there is no empirical evidence that infation, should it increase
slightly, cannot be reversed at a relatively minor cost (Blinder 1987, Eisner 1995, Stiglitz et al.
2006).
What is truly damaging for an economy is unpredictable, unexpected, and volatile infation, but
not steady and predictable infation (Blinder 987, chapter 2) t is diffcult, therefore, not to be
concerned with the likely sacrifces being made by many developing countries across Asia in
terms of output loses (and, consequently, employment) as a result of trying to maintain very low
infation rates t is also true that the impact of infation upon different groups of society differs
with the type of infation, eg, food infation probably, though not always, has a larger impact on
the urban poor. See the Appendix.
Dornbusch (2000) also refers to another study by the IMF where the threshold is set at a much lower level, 8%. Khan and
Senhadji (200) estimated the threshold after which infation hurts growth at -3% for developed countries and at
about 7-% for developing countries.
n 2008 high food prices and rising fuel prices brought infation to double digits igure
shows the year-on-year infation rates for the latest 2 months until June n June
2007/08, infation reached 25% nfation is caused primarily by increases in food
prices, which represent 40% of the CP basket n June 2008, food infation surpassed
0% What is worrisome is that core infation (ie, excluding food and fuel infation) is
on the rise. There are fears that this may lead to a wage-price spiral. Table 6 shows
the percentage contribution to core infation of its different components Although the
largest contribution is provided by house rent, its share has declined, and in J une 2008
it contributed slightly less than 45% to total core infation n the other hand, during the
last few months, the contribution of transport fare/charges has risen signifcantly This
refects the pass-through to consumers of higher petroleum prices The contribution of
doctors fees, drugs and medicines, and washing soap and detergents to core infation
has also increased. Whether these increases are leading to workers demands for higher
wages, which then feed into higher price increases is diffcult to know as Pakistans
statistical offces do not provide data on wages Without precise data on wages and labor
productivity it is impossible to assess the question.
Figure 13: CPI Ination, Year-on-Year (percent)
Jun
07
Jul
07
Aug
07
Sep
07
Oct
07
Nov
07
Dec
07
Jan
08
Feb
08
Mar
08
Apr
08
May
08
Jun
08
Jul
08
Overall Food Nonfood Core ination
35
30
25
20
15
10
5
0
Table 6: Contribution to Core Infation (percentage points)
July
2006
July
2007
January
2008
February
2008
March
2008
April
2008
May
2008
June
2008
Cotton cloth 0.2 0.4 0.2 0.2 0.27 0.32 0.37 0.39
House rent 3.70 3.28 4.58 4.80 5.07 5.45 5.74 5.84
Transport fare/charges 0.43 0.08 0.0 0. 0.8 0.85 0.92 0.97
Tuition fee 0.37 0.36 0.23 0.6 0.6 0.23 0.40 0.40
Washing soap and detergent 0.06 0.2 0.28 0.33 0.48 0.55 0.58 0.59
Jewlellery 0.27 0.04 0.24 0.27 0.35 0.29 0.3 0.33
Drugs and medicare 0.03 0.0 0.02 0.03 0.03 0.04 0. 0.2
Doctors fee 0.4 0.55 0.27 0.27 0.2 0.25 0.44 0.43
All others .38 .35 .88 .9 2.53 2.83 3.44 3.83
Core infation (percent) 6.5 6.0 7.8 8.1 9.3 10.8 12.3 13.0
igure 4 provides the month-to-month infation rate t shows that with the exception of
February 2008, all months have seen price increases (this is consistent with Figure 13,
which shows that year-to-year infation started to exceed 0% in January 2008, and
accelerated starting in arch 2008) igures and 4 indicate that nonfood infation
is so far below food and core infation This may change when with the new fscal year
(starting J uly 2008) fuel subsidies should disappear. Box 3 provides additional information
on infation
Figure 14: Monthly Ination Rate, June 2007June 2008
Jun
07
Jul
07
Aug
07
Sep
07
Oct
07
Nov
07
Dec
07
Jan
08
Feb
08
Mar
08
Apr
08
May
08
Jun
08
Overall Food Nonfood Core ination
6
5
4
3
2
1
0
1
P
e
r
c
e
n
t
An Analysis o PakisIans Macroeconomic SiIuaIion and ProspecIs | 2!
Box 3: Impact of Food and Fuel Price Increases in Pakistan
The recent increase in domestic prices in Pakistan has come from a few commodities, mainly
wheat four, rice, vegetable ghee, and fresh milk n June 2008, their prices increased by
75%, 93.4%, 54.3%, and 22.7%, respectively, on a year-on-year basis. Box Table 3.1 shows
the contribution of each product category in the infation basket to the overall infation rate
for J une 2006/07 and for J une 2007/08. During J une 2007/08, food prices and transport and
communication contributed 60% and 8.5%, respectively.
Box Table 3.1: Percentage Point Contribution to
Infation by Category (year-on-year)
Items June 07 June 08
Food 3.90 12.93
Wheat Flour 0.35 3.83
Rice 0.65 .25
Vegetable Ghee .02 .45
Milk Fresh 0.85 .5
Others .03 4.89
Transport and Communication 0.22 1.82
Petrol 0.2 0.7
All Others 3.32 6.78
Overall Infation (percent) 7.00 21.53
Source: Staf estimates.
Regarding fuel, on 1 March 2008, the government started adjusting upward the administered
price of key fuel items, thereby partially passing on the impact of higher prices to consumers.
The price that consumers pay equals the import price of oil minus price differential claim (PDC)
paid by the government; plus the margins of the oil marketing companies and of dealers;
plus inland freight and taxes (excise duty, petroleum development levy [PDL], and sales tax).
The price differential claim is the direct subsidy paid by the government on the import price
of kerosene oil and light diesel oil (LDO). This is paid directly by the government to the oil
marketing companies. In addition, government provides implicit subsidy in the form of reduction
in PDL to stabilize the domestic price of kerosene and LDO. In the case of high octane blending
component (HOBC) and gasoline, the PDC subsidy was introduced in J une 2008 but it was
eliminated on both products as of 1 J uly 2008, and the only implicit subsidy on these two
products has been in the form of a reduction in the PDL.
The upper part of Box Table 3.2 shows the absolute levels of import and domestic prices of
kerosene, LDO, and HOBC. The middle part of the table shows the PDC in absolute terms
and as percentage of the total import price. In absolute terms, subsidies on kerosene and
LDO increased until J uly 2008, but then sharply fell in August 2008 as the government started
reducing PDC following the decline in international oil prices. As percentage of the total import
price, the subsidies on kerosene and LD have continued to decline and registered a signifcant
fall in August 2008.
The bottom part of the table provides the ratio of domestic to total import prices, a proxy for the
pass-through, that is, how much of the increase in prices is passed on to consumers. These
fgures indicate that the government continues to subsidize kerosene and LD or example,
in J uly 2008, the domestic price of kerosene was 75% of the total import price, and similarly for
LDO. This means that the subsidy represented 25% of the total import price. In the case of
continued.
Box3:continued.
the HOBC and gasoline, there are no subsidies (the ratio is greater than unity). For example,
in J uly, the government charged 145% of the import price on HOBC. In August 2008, following
a decrease in international oil prices, the ratio increased for kerosene and LDO, signifying a
reduction in subsidy on these items.
Box Table 3.2: Oil Subsidies and Pass-through to Consumers
Kerosene (Rs./liter) LDO (Rs./liter) HOBC (Rs./liter) Gasoline (Rs./liter)
Total
Import
Price
Domestic
Price
Total
Import
Price
Domestic
Price
Total
Import
Price
Domestic
Price
Total
Import
Price
Domestic
Price
07-Jul 33.45 35.23 30.84 32.57 35.05 64.88 34.22 53.7
08-Jan 43.27 35.23 40.86 32.57 43.23 64.88 42.26 53.7
08-May 62.63 4.44 58.7 44.59 52.76 80.77 5.63 68.8
08-Jun 70.58 49.73 66.73 49.05 6.25 88.85 59.98 75.69
08-Jul 77.69 58.37 73.07 56.5 66.48 96.08 65. 86.66
08-Aug 66.23 58.37 6.57 56.5 55.8 96.08 50.27 86.66
Price Diferential Claims
Rs./liter As Percent of Total
Import Price

Kerosene LDO* Kerosene LDO
07-Jul 5.33 5.58 5.9 9
08-Jan 7.9 6.3 4.4 70.6
08-May 32.4 23.86 5.3 05.4
08-Jun 33.57 29.04 47.6 90.7
08-Jul 33.93 29.4 48. 9.7
08-Aug 8.47 6.82 23.8 42.2
* Light diesel oil.

Ratio of Domestic Price to Total Import Price (percent)
Kerosene LDO HOBC Gasoline
07-Jul 05 06 85 57
08-Jan 8 80 50 27
08-May 66 77 53 33
08-Jun 70 74 45 26
08-Jul 75 77 45 33
08-Aug 88 92 72 72
Source: Staf estimates.
B. Declining Foreign Exchange Reserves
As a consequence of political uncertainty and economic deterioration (increasing external
defcits and reduced capital infows), foreign exchange reserves, which had been rising
since 2001 (see Figure 8), started declining in November 2007 (Figure 15), and the
deterioration in the overall reserve position has accelerated in recent months. From a
total of $16 billion (in liquid foreign reserves) in October 2007, reserves fell to $10.83
billion on 12 J uly 2008 (a fall of more than 30%). The deterioration has been caused by
An Analysis o PakisIans Macroeconomic SiIuaIion and ProspecIs | 2J
rising imports of fuel and food products, increased outfows of portfolio investment, and
use of foreign exchange reserves to defend the rupee nfows of overseas remittances
are still holding and helping counterbalance the trade defcit D is lower but is still
signifcantly positive t amounted to $88 billion during the frst months of 2007/08, as
against $4.52 billion in 2006/07. The decline is not excessive given that last years FDI
was extraordinary (Ministry of Finance 2008).
Figure 15: Foreign Exchange Reserves, End of month:
July 2007 to May 2008
18000
16000
14000
12000
10000
8000
6000
4000
2000
0
Net reserves with SBP Net reserves with banks
Total liquid reserves
U
S
$
M
i
l
l
i
o
n
Jul
07
Aug
07
Sep
07
Oct
07
Nov
07
Dec
07
Jan
08
Feb
08
Mar
08
Apr
08
May
08
C. Downgrade of Debt Rating
As noted above, the consolidated government defcit has also deteriorated signifcantly
from an already high 5% of GDP in 2005-2007 to 6.5% of GDP in 2007/08. In recent
years, fscal defcits have been fnanced signifcantly through borrowings from the State
Bank of Pakistan (SBP) Both the SBP and the international fnancial markets believe
that this monetization of the defcit contributes to infationary pressures, although the
empirical evidence is scant. Nevertheless, this is inconsistent with the SBPs efforts to
fght infation
The political instability of the coalition government; increasing infation; as well as
the large trade, current account, and fscal defcits led Standard and Poors (S&P) to
downgrade Pakistans debt rating on 15 May 2008 from B+to B, and its long-term local
currency rating from BB to BB-. The outlook is negative. In tandem with the lowering of
sovereign credit rating, S&P also lowered the Transfer and Convertibility Assessment
rating on Pakistan to BB- from BB (Business Recorder 2008). Moodys followed suit on
2 ay 2008 Pakistans credit rating was cut for the frst time in 9 years by oodys
Investors Service, which cited growing economic imbalances and renewed political
diffculties Pakistans foreign-currency sovereign rating was lowered from B to B2, even
below Turkmenistans. The ranking of locally issued debt was also reduced to B2 (The
Nation 2008) S&P and oodys have termed Pakistan a highly speculative country for
bond investment.
This pessimistic view from the international fnancial markets is refected in igure 6,
which shows Pakistans sovereign credit spread (between the yield of the sovereign bond
and the US Treasury bond of equivalent maturity) being not only much higher than of
other emerging markets but also on a rising trend since May 2007. On 19 August 2008,
the spread of Pakistani sovereign bonds had a risk premium of 912 basis points, more
than twice that of Viet Nam, whose infation rate is above 20%
Figure 16: JP Morgan EMBI Sovereign Stripped Spreads
(basis points)
1000
900
800
700
600
500
400
300
200
100
0
Source: Bloomberg.
1
-
J
a
n
0
7
1
8
-
F
e
b
0
7
7
-
A
p
r
0
7
2
5
-
M
a
y
0
7
1
2
-
J
u
l
0
7
2
9
-
A
u
g
0
7
1
6
-
O
c
t
0
7
3
-
D
e
c
0
7
2
0
-
J
a
n
0
8
8
-
M
a
r
0
8
2
5
-
A
p
r
0
8
1
2
-
J
u
n
0
8
3
0
-
J
u
l
0
8
Pakistan
912
365
355
268
156
Viet Nam
Indonesia
Philippines
Malaysia
Capital account liberalization has made it more diffcult today for high infation (above
20%) and high economic growth to coexist (as it did in the past in Chile, for example).
Today, international fnancial markets and credit rating agencies exert signifcant infuence
on economic outcomes High infation quickly brings in credit downgrades, loss of
confdence, capital outfows, and reductions in capital infows
D. Depreciation of the Rupee
In late May and early J une 2008 (during the period right after the credit downgrade and
the announcement that infation had reached 20%) the rupee fell fast from around 66
to the dollar to almost 70. The exchange rate only recovered when the SBP intervened
in the foreign exchange market and raised its discount rate by 150 basis points. In
early J uly the rupee touched 73 to the dollar, a 14% drop since the start of 2008. This
prompted the SBP to issue a statement indicating that it would support the currency to
ensure exchange rate stability While defending the rupee will control imported infation,
the SBP is using its reserves and thus contributing to their depletion. Finally, the SBP has
issued a temporary suspension of forward booking for all imports t is diffcult to assess
the impact of this measure and how the private sector will react.
III. Government Response to the Deteriorating
Macroeconomic Situation
The governments response since May 2008 to the quickly deteriorating conditions can be
summarized as follows:
(i) The SBP reacted to the increasing infation and to the depreciation of the rupee by
raising the discount rate by 150 basis points to 12% on May 23. It also increased
the cash reserve requirement for all deposits up to 1 year maturity. In addition,
the statutory liquidity requirement was increased by 100 basis points to 19% of
total time and demand deposits. The SBP also enacted stricter rules on foreign
exchange convertibility to end speculative foreign exchange trading (Dawn Internet
2008).
(ii) The government has tried to show a more realistic stance by scaling down its
GDP growth forecast to 55% for fscal year 2008/09 This is still seen as too
optimistic by some experts. The International Monetary Fund, for example, is
projecting a 34% growth rate for 2008/09. The government also scaled up its
projected infation rate for 2008/09 to %
(iii) The government has committed itself to during fscal year 2008/09 to:
(a) reducing the fscal defcit to 47%
(b) increasing the investment-to-GDP ratio to 21.5%
(c) reducing the current account defcit to 6% of GDP
(d) increasing foreign exchange reserves to $12 billion from the current level
below ($11 billion)
(e) reducing the tariff rates of imported inputs of agricultural products, textile,
pharmaceutical products, and other industrial products
The governments response has failed so far to convince the credit agencies to reverse
the countrys credit downgrade. The mood is still rather pessimistic as it is not clear
how people will react once food subsidies are removed during fscal year 2008/09, and
consequently prices go further up.
A major aspect of the governments response to the current diffculties is the federal
budget item changes from fscal year 2007/08 to fscal year 2008/09 Table 7 provides a
summary of the estimated federal government budget items of 2007/08 and in 2008/09.
Key to this budget is a proposed increase in revenues by 20% and an increase in
expenditures by only 7%. Table 7 indicates that there will be a major reduction in
expenditures on Economic Affairs, mainly reduction in subsidies. Overall, these changes
are expected to lead to a reduction of 40% in the defcit
Table 7: Revenues and Expenditures of the Federal Government, 2007/08 and 2008/09
(Rs. million)
Revised Budget
FY 2007/08
Projected Budget
FY 2008/09
Growth Rate
(percent)
I. Revenues 1398918 1679238 20.0
A. Tax Revenues 005569 25462 24.5
Direct taxes 388250 496000 27.8
2 Indirect taxes 6739 755462 22.4
3 Surcharges/others
B. Nontax Revenues 393349 427776 8.8
Of which: Interest income 56152 39659 29.4
Privatization Proceeds 1650 25106 1421.6
II. Expenditures 2405233 2578150 7.2
A. Federal Expenditure 1948031 2009812 3.2
. Current 56262 49383 1.5
a. General Public Service 88657 929522 5.4
of which: Debt Servicing 502471 523172 4.1
b. Defense Afairs and Services 277265 296077 6.8
c. Public Order and Safety Afairs 2606 26770 2.5
d. Economic Afairs 293442 205 31.5
e. Environment Protection 83 20 14.8
f. Housing and Community Amenities 46 359 18.6
g. Health Services 5287 5490 3.8
h. Recreation, Culture and Religion 33 39 1.9
i. Education Afairs and Services 24280 24622 1.4
j. Social Protection 3765 479 27.3
2. Development Expenditure (PSDP) 458283 549709 19.9
Estimated Operational Shortfall
(PSDP)
63200 77000 21.8
Other Development Expenditure 36686 43920 19.7
Memo item: Subsidies 407485 295204 27.6
B. Transfers to Provinces 457202 568338 24.3
III. Budget Defcit 5493 330574 39.8
Note: Subsidies refers to all subsidies, including food, fuel, and fertilizers.
Source: Annual Budget Statement 2008-2009 (Ministry of Finance 2008).
The budget contains the following salient features.
One, it is assumed that tax revenues will increase by almost 25%, with direct taxes
rising by about 28% and indirect taxes by about 22%. Some of the major tax measures
proposed to achieve this are:
i) increase import duties on about 300 nonessential and luxury items from the
current 15%25% range to 30%35% range
ii) increase in sales tax rates from 15% to 16%
iii) increase in the excise (value-added tax mode) duty on telecommunication services
from 15% to 21%
iv) increase in the federal excise duty on banking, insurance, and franchise services
from 5% to 10%
v) elimination of 35 items subject to income tax exemptions
vi) introduction of an investment tax scheme wherein taxpayers will have to declare
past business, investments, and assets acquired, and pay 2% of their market
value
vii) introduction of a more transparent uniform income tax of 2% for commercial as
industrial importer, instead of the current variable rate, ranging from 1% to 5%,
depending on the import stage (raw materials, intermediate inputs, or fnal gods)
viii) introduction of an advanced 10% tax on electricity bills exceeding Rs. 20,000
per month, adjustable against their fnal tax liability, to be paid by industrial and
commercial consumers of electricity
ix) introduction of progressive withholding tax rates on high income groups, from 5%
to 15%, depending on the income bracket
x) introduction of Rs. 100 per square yard tax on developed plots sold during the
year, and a minimum tax of Rs. 50 per square foot on the sale of constructed
property, to be paid by developers and builders
xi) imposition of a revised excise duty on cigarettes
Two, on the expenditure side, there will be a freeze on nonpersonnel, nondevelopment
expenditure spending and a ban on new purchases of physical assets such as cars, air-
conditioners, and other offce equipment
Three, there will be a 28% decrease in subsidies (mostly classifed under economic
affairs). The decline in subsidies will affect mostly fuel and food (the largest subsidies
are on wheat and edible oil). The government is committed to eliminating all subsidies on
fuel by 31 December 2008. To reduce food subsidies and give farmers better farm gate
prices, the wheat support price will be raised from Rs. 510 to Rs. 625 per
40 kilograms. This support price will be reviewed again in the next cropping season of
AugustSeptember depending on the input costs then, and on the prevailing international
prices. On the other hand, fertilizer subsidies and funds for social protection programs
(cash subsidies to targeted poor families) will be increased.
Four, development expenditure under the Public Sector Development Programme will
increase to help pump-prime the economy. Development expenditure will increase by 20%
from Rs. 458,283 million in 2007/08 to Rs. 549,709 million in 2008/09. Public investment
will be undertaken to reduce power and water shortages. Other investments will consist
of building roads, railways, ports, and terminals; and establishing industrial estates and
export processing zones in poor provinces such as in Baluchistan and the NWFP. It must
be pointed out that the fertilizer subsidies are classifed under development expenditure
The total available for fertilizer subsidies amounts to Rs. 32 billion, increasing the subsidy
per bag from Rs. 470 to Rs. 1,000. Other agricultural funds will also be provided:
Rs. 30 billion will be available for agricultural credit, Rs. 75 billion for water availability,
s 5 billion for livestock projects, s billion for fsheries; and additional support will
be provided for the national seed commercial production program (especially for Bt cotton
varieties).
ive, the domestic fnancing of the fscal defcit will shift from the SBP to the issuance
of government bonds and securities to commercial banks at market rates. External
fnancing will be the dominant form of fnancing in 2008/09 (see Table ) Since Pakistans
sovereign spread is very high, the country will have to source the external fnance from
concessional loans from multilateral agencies and bilateral donors.
Six, the social protection program, which is supposed to cushion the impact of the
removal of subsidies, will consist of cash transfers to poor families, amounting to
Rs. 34 billion, and later to be increased to Rs. 50 billion. This program is called the
Benazir Income Support Program, and is expected to start in September 2008. The
program also contemplates cash grants of Rs. 1000 per month, to be given to targeted
poor households using the computerized National Database and Registration Authority
database and the Computerized National Identity Card system, including other welfare
services, like employment, skill development training for family youth, medical insurance,
and food subsidies t is not clear, however, how the identifcation and targeting of the
poor households will be undertaken.
Summing up, what is the new government doing to deal with the current situation? As
discussed above, it is trying to implement a series of measures to stabilize the economy
and this way set the basis for a successful recovery; at the same time it is trying to deal
with the infation problem n our view, while some measures in the budget appear to be
sensible (eg, the reduction in across-the-board subsidies), it will be diffcult to achieve
the target budget defcit This could be achieved only by implementing signifcantly more
drastic cuts (beyond subsidies). The elimination of certain subsidies is necessary but this
has to be done by keeping in mind the social repercussions. The increase in the price
of fuel has to be implemented gradually. At the same time, the most vulnerable groups
need social protection. It will be of paramount importance to ensure (perhaps by law) that
social and health expenditures are not curtailed. Moreover, in the current situation, we
believe that the government will most likely not be able to raise tax revenues by 25%.
Likewise, privatization will be diffcult The government also plans to increase import
duties of nonessential and luxury items to 3035% from the current 1525%. If the
objective is to discourage imports of these goods, the tax rate has to be much higher to
have any serious impact.
8
Given Pakistans already high interest rates, the country will
need fnancial assistance t has been announced that Pakistan will receive US defense-
related grant infows Saudi Arabia will also provide relief support through an oil credit
facility.
9
The World Bank and Asian Development Bank (ADB) will also provide budget
support.
t is diffcult to ascertain whether the measures contained in the new budget result in the
stabilization of the economy and can deal with the effects of the increase in food and
fuel prices, as now the macroeconomic imbalances and the infation problem reinforce
each other ur view is that the government will not be able to achieve its budget defcit
target unless it cuts drastically spending on social services (education, health, etc.) and
development expenditures. However, if this is done, it will have serious repercussion for
Pakistans future. A better strategy would be to negotiate with the multilateral agencies a
program that have would allow the country to reduce the defcit at a slower pace until it
reaches a more manageable level. During this time, the structure of spending should be
analyzed, and a realistic program to increase direct taxation should be devised.
IV. Policy Recommendations
The impact and extent of the current economic and political uncertainty will depend
upon: (i) how the economic response of the new government develops gradually during
the next few months; (ii) on whether the government will not fall or not fall apart; (iii) on
whether external conditions (rising food and fuel prices, world economic slowdown) will
continue deteriorating, or whether they will improve; and (iv) on how people respond to
the removal of food and fuel subsidies.
8
Imports of fancy mobile phones and vehicles take $2 billion annually.
9
This takes the form of a 3-year deferred payment. The details of the agreement have not been disclosed.
J0 | AD8 Lconomics Working Paper Series No. !J6
What seems to be beyond dispute is that the economic slowdown and strong infationary
pressures will remain throughout 2008 and 2009. The strong monetary contraction and
increased interest rates, as well as weaker business confdence, will dampen private
investment t will be diffcult for the government to achieve the target investment-to-GDP
ratio of 21.5% (private investment declines as a share of GDP in 2007/08). Second,
high food and fuel prices, as well as increased taxes, will dampen private consumption.
And the removal of the food and fuel subsidies will aggravate the already high infation
Therefore, achieving 55% growth in 2008/09 and an infation rate of % will be very
diffcult ur view is that growth will be at about 5% and infation at about %
With a current account defcit above 8%, a budget defcit of 65%, and infation in June
2008 (year-on-year) above 20% (with food infation exceeding 0%), Pakistans economic
situation is risky The major risk is that the country is vulnerable to a sudden outfow of
capital Table 8 provides a summary of current account and budget defcits, interest rates,
as well as infation in a number of emerging markets t shows that Pakistans situation is
among the most problematic.
Table 8: Potential Economic Risk
Current
Account
(percent of
GDP)
Budget
Balance
(percent of
GDP)
Interest Rates (percent) Infation
3 month 10-year
Government
Bond
Latest
2008
2008
China, Peoples Rep. of +8.6 2007 0.5 4.32 4.85 +6.3 Jul +6.6
Czech Republic 2.7 Jun .8 3.8 4.42 +6.9 Jul +6.6
Hungary 5.9 Q 4.0 8.55 7.80 +6.7 Jul +6.5
Poland 4.9 Jun .9 6.54 6.2 +4.8 Jul +4.2
Russia +6.0 Q2 3.6 .00 7.04 +6.2 Jun +3.9
Turkey 6.4 Jun 2.7 8. 7.00* +2. Jul +.0
India 3.0 Q 3.4 9.2 9.66 +7.7 Jun +7.
Indonesia +2.8 Q 2.0 9.84 7.25* +.9 Jul +9.9
Malaysia +3.9 Q 3. 3.70 4.45* +7.7 Jun +5.4
Pakistan 8.6 Q 6.4 3.26 2.22* +2.5 Jun +7.6
Philippines +2.9 Q .5 8 6.88 .4 Jun 6.8
Korea, Rep. of 2.5 Jun .5 5.78 5.77 +5.9 Jul +4.2
Taipei,China +5.3 Q .9 2.75 2.64 +3.7 May +3.
Thailand 0.4 Jun 3.0 3.78 4.69 +9.2 Jul +8.5
Argentina +2.9 Q .7 3.88 na +9. Jul +9.7
Brazil .3 Jun .6 2.9 6.6* +6.4 Jul +6.
Mexico 0.8 Q 0. 8.8 8.79 +5.4 Jul +4.8
South Africa 8.0 Q 0.4 2.25 9.25 +2.2 Jun +9.6
* Dollar-denominated bonds.

The Economist poll or Economist Intelligence Unit estimate/forecast.
Source: The Economist (622 August 2008, 856); Philippines current account, budget balance, interest rates, and actual infation are
from Philippine sources.
An Analysis o PakisIans Macroeconomic SiIuaIion and ProspecIs | J!
Although it is impossible to predict all possible outcomes, it is possible to defne broadly best-
case and worst-case scenarios for 2008/09:
10
(i) Best-Case Scenario (soft landing): There is no unrest and disorder as a
consequence of the removal of food and fuel subsidies, and global conditions
improve. The government stands by its announced policies and achieves most of
the economic targets Economic confdence returns ecession or major economic
slowdown as well as high infation are avoided
(ii) Worst-Case Scenario (hard landing): The country sees itself immersed in unrest
and discontent due to the removal of food and fuel subsidies, rising infation,
increased taxes, and rising unemployment. The global conditions continue
deteriorating, therefore aggravating the stagfation problem The shaky coalition
government cannot withstand the pressures and backtracks on its announced
policies; or worse, the coalition government falls apart due to disunity and discord,
and political instability follows Business confdence is badly eroded Capital
fight takes place, a possible freefall of the rupee may occur; and a balance of
payments, fnancial, and economic crisis may ensue
In our view, and despite the looming risks, the country is not on the verge of a major
collapse, provided sensible economic policies are put in place right away, and the political
bickering stops. While serious measures must be taken, this does not imply that the
country has to be subjected to an austerity program that leads to a recession. Fiscal
discipline acts as a defationary force as it induces excess capacity and unemployment
The experience of the Asian fnancial crisis from a decade ago proved that this is not
the way to solve the problems afficting Pakistan onetary and fscal policies affect
both short- and long-run trends in unemployment. Pakistans policy makers must aim at
maintaining strong aggregate demand.
The new government has to avoid at all costs setting overly optimistic GDP growth
targets, as well as implementing populist economic policies. Its credibility is at stake.
During 2007 and the frst few months of 2008, it became clear that infationary pressures,
limited job creation, and the highly skewed nature of the income gains during the last few
years led to the change in government. The main opposition parties (Pakistan Peoples
Party and Pakistan Muslim League-N) ran economic platforms during the elections that
emphasized full employment and inclusive growth. These objectives must remain in
sight.
11
The government also needs to fnd a delicate balance between measures aimed at
alleviating the impact of food and fuel infation, and economic policies aimed at gradually
redressing the macroeconomic imbalances. The government is aware of this. At the
same time, it needs to devise and implement a long-term growth model that leads to the
0
Certainly these are two extremes and in between there is a range of scenarios.
Pakistans Vision 2030 states the following (p. XVI): Make employment and employability the central theme in
economic and social policies.
transformation of the economic base from an agricultural and textile-dependent economy
into a modern industrial and service economy. Furthermore, during the last few years, FDI
infows have concentrated on the service sector Efforts must be made to attract D into
commodity-producing and export-oriented sectors. This transformation should also lead
to the creation of productive and decent employment. This model requires an in-depth
analysis of the possibilities of structural change and diversifcation in Pakistan
12
The
years 2008 and 2009 have to be dedicated to setting the foundations of this model, in
which both private and public sectors must understand the role that they have to play.
A. On Infation and the Role of Monetary Policy
onetary tightening to control infation may not be as effective as desired unless it
causes a major recession and collapse in aggregate demand. This is because the
combination of low growth and high infation seen today is caused by supply-side factors
How to control supply-side infation is a major challenge, and depends a great deal
on external factors. In this sense, it is important to recognize that a substantial share
of Pakistans macroeconomic problem has to do with the international situation. This
means that although domestic measures must be taken, Pakistan depends on global and
regional cooperative efforts to tackle the food and oil price infation and the subprime-
related (world) economic slowdown.
There are two important questions regarding the role of monetary policy. First, how
sensitive is the real economy to interest rates movements? During depressive conditions,
this option has little proven effects activating an economy. In bad times lower interest
rates do not inspire consumer expenditure. Likewise, lower interest rates do not induce
more investment (by making borrowing cheaper) as during these periods there tends to
be excess capacity, and output is not being sold. Empirical evidence suggests that the
interest elasticity of investment is nonlinear and asymmetric. While an increase in interest
rates is likely to reduce investment during economic booms (the economy is on or above
capacity), the reverse is not true. In general, it is the quantity of credit, rather than its
price, that infuences investment or this reason, the volume of credit in developing
countries is a more effective instrument of monetary policy than the price or credit. What
is true is that tight monetary policy resulting from an increase in interest rates will also
be associated with increased credit tightening. Under these circumstances it may be
reasonable to assume that there will be some effect on aggregate demand.
Second, what is the impact of interest rates on infation? ncreases in interest rates
might be effective when infation is caused by demand pressures
13
Increases in interest
2
This is a very important point, not developed in this paper. ADB is already working with the Government of
Pakistan on the development of this model.
3
And even in this case the impact is not entirely clear. Consumer borrowing is not very sensitive to interest rates
increases. And, as indicated earlier, the efects of interest rates on investment are nonlinear and asymmetric. The
home mortgage market is probably somewhat more elastic. But evidence indicates that what people care about
when taking a mortgage is the total monthly payments and not interest payments.
An Analysis o PakisIans Macroeconomic SiIuaIion and ProspecIs | JJ
rates will probably have a more signifcant impact in preventing the depreciation of
the rupee than in controlling infation This way, imported infation will not worsen due
to the currency depreciation. The down side is that higher interest rates may dampen
investment prospects and the higher value of the rupee may negatively affect exports.
Likewise, higher interest rates will increase costs and thus induce higher prices. Finally,
it is well-known that there are long lags in monetary policy. This route, therefore, may
be detrimental to growth. Pakistans monetary authorities have increased the discount
rate four times between J anuaryJ une 2007 and J ulyDecember 2008, from 9.50%
to 13%. These increases have led to rises in the Karachi Interbank Offered Rate and,
consequently, in the bank lending rate; and during this period infation has increased
Should the SBP decide to continue increasing interest rates, it should monitor closely the
impact on investment and exports.
Box 4 further emphasizes the potentially negative effects of restrictive monetary policies
and proposes the use of income policies to deal with income infation and infation
expectations.
Box 4: Infation, Monetary Policy, and Income Policies
nfation caused by supply shocks (eg, increase in oil prices, bad crop due to adverse
weather conditions) cannot be averted by increases in interest rates. On the contrary, these
will most likely aggravate the problem. If policy makers depend excessively on higher interest
rates to stabilize prices, frms will become reluctant to use debt fnancing and will tend to
rely more heavily on self-fnancing Capital, which is so scarce in developing countries, will
be allocated less effciently in the short run, and growth will be hampered in the long run
1

estrictive monetary policies may have been appropriate for combating hyperinfation
episodes (at least in the hundreds percent) in some developing countries (e.g., in Latin America
in the 1980s). But this is hardly Pakistans situation today (and countries in Asia have rarely
experienced hyperinfation) oreover, it is known that unless interest rates are changed
drastically, it takes a long time for monetary policy to impact the economy, especially infation
It is known that a major reason for Pakistans central bank interest rate tightening is to try
to restrict by law government borrowing from the SBP A more effcient way to achieve this
objective is to limit by law the amount that the government can borrow from the SBP. And a
more effective policy to control current infation is to use fscal policy (combined with moderate
increases in interest rates). The government should try to identify and eliminate programs that
induce an infationary bias to the economy
2
There is fear that infation may lead to a wage-price spiral by increasing workers infation
expectations (although this is a very poorly understood question), and therefore push up
further the price level. In fact, effective 1 J uly 2008, the government increased across-the-
continued.

Interest rates policies have both allocative and distributional efects. Sometimes the latter can be substantially larger.
Indeed, a signifcant increase in interest rates may not induce a decrease in speculative investment in real estate, but may
hurt small- and medium-size frms trying to obtain working capital.

2
As Stiglitz et al. (2006, 24) argue: .reducing aggregate demand when the economy faces infation by reducing
government expenditures is often alleged to be better for growth than doing so by increasing interest rates, since the
latter leads to reduced investment. But whether this is the case depends on which government expenditures are cut back:
if its high return investments in infrastructure, growth would have been enhanced by using monetary policy rather than a
contraction in government investment.
Box 4: continued.
board the salary of civil servants by 20%, and set the minimum wage at Rs. 6000 per month to
compensate for the rise in prices. These wage increases raise the cost of production and create
a feedback loop whereby infation may lead to further wage increases, and so on While this
may not be good, it does not lead to a reduction in peoples real purchasing power.
Can infation expectations be anchored through increases in interest rates? We argue in this
document that this is diffcult because the impact on interest rates on an economy like that of
Pakistan is unclear and because the measure could potentially have a depressive effect.
There are other mechanisms to control infation expectations more effectively than with an
increase in interest rates. One such mechanism is the implementation of policies that restrain
changes in frms gross proft margins (markups) and in nominal wages relative to labor
productivity, through tripartite agreements among frms, workers, and government n a context
where the latter strives to achieve full employment, each self-interested worker, union, and
business entrepreneur has little fear that their demand for higher prices and money income will
result in lost sales and unemployment.
3
As long as the government accepts the responsibility for creating suffcient aggregate effective
demand to maintain the economy close to full employment, there will be no market incentive to
stop this recurring struggle over the distribution of income. The implication is that a policy of full
employment that is not backed by an incomes policy will potentially eliminate unemployment,
but will generate (income) infation n the fnal analysis, infationary pressures arise whenever
the recipients of money income (wages, profts, rents) seek to increase their own share of real
income at the expense of others That is, infation is a symptom of social confict This struggle
for income distribution is never neutral, as it always affects relative prices nfation arises from
conficting views about the distribution of income
Wage infation will have an impact on infation when the increase in nominal wages is above that
of labor productivity ncreases in nominal wages can lead to infation before full employment
or full capacity is reached arkup or proft infation is associated with an increase in proft
margins, often as a result of market power due to monopolistic/ oligopolistic situations,
rather pervasiveness in developing countries. These are the two essential components of the
bargaining process between frms and workers n one hand, workers try to get an increasing
share of the product through wage increases above labor productivity (i.e., the wage setting
process). Certainly the scarcity of labor can trigger wage increases, but this tends to be more a
sectoral issue rather than a generalized one. In most developing countries there are millions of
people unemployed/underemployed. In a situation approaching full employment, there will be a
spontaneous tendency for nominal wages to increase, which will lead to an increase in prices,
and to a secondary rise in wages, and so on.
As long as the increase in wages is less than or equal to the increase in labor productivity, the
wageprice spiral will not occur. But problems will occur if nominal wages increase above the
productivity of labor The irony of this, however, is that this differential would be refected in
higher prices so that the increase in money wages will be offset.
n the other hand, frms try to appropriate a higher share of the overall product by increasing
their markups (ie, price setting process) t is important to stress that proft infation need not
be the result of excess demand, at last the way this is understood in a monetarist explanation.
ndeed, frms may decide at one point to increase their markups in an attempt to adjust the

3
See Asia Economic Monitor (ADB 2008, 6), which notes that the key to anchoring infation expectations lies in frms
moderating the rise in prices and workers not asking for excessively high increases in wages. What we propose here is a
mechanism to ensure that this indeed happens.
continued.
An Analysis o PakisIans Macroeconomic SiIuaIion and ProspecIs | J5
standard rate of return to the historically observed rate of proft, which may have been high due
to high growth While proft infation is caused by high demand, it is not necessarily caused by
excess demand since utilization rates may be below unity Also, frms may decide to increase
markups as a result of higher interest costs; or as a result of changes in the perception of
competitive pressures from abroad. Again, this is not caused by excess demand. This means
that oligopolistic pricing can set off an infationary cycle independent of the monetary policy
This infationary confict may be addressed by developing mechanisms for cooperation between
workers and frms (the way these exist in countries like Sweden) with a view to preventing an
institutional power struggle for higher incomes. The key is restraint on both sides. Both parties
can walk to the negotiating table with a clear understanding of what is at stake, namely, that the
income distribution struggle leads to temporary winners, but to a no-win game in the aggregate;
and, therefore, they need to work together. This way, it is possible to minimize, if not neutralize,
the effects of proft and wage infation ne possible way to implement this mechanism is
through an incomes policy (see below).
What is the role of the central bank in this context? n general, the monetary authorities
validate this process (i.e., the increase in prices as a result of increases in nominal wages
above increases in labor productivity) through the monetary expansion (i.e., the money supply
increases) n this case, monetary policy to curb infation by, for example, increasing interest
rates, is not only ineffective but may also have perverse effects if increases in interest rates
raise the cost of capital, which would justify an increase in prices thereafter (i.e., interest rates
and prices can move together) Today, some central banks avoid infationary wage and proft
demands by not validating workers and frms claims How is this done? By preventing that
the demand-determined actual level of output gets too close to the supply-determined level
of potential output (i.e., by ensuring a lack of effective demand). This is achieved by targeting
infation through the manipulation of short-term interest rates The result is the preclusion of full
employment, i.e., a policy of stability at the cost of growth.
However, income infation and infation expectations can also be tackled in other ways A
deliberately announced incomes policy, that is, a policy that constrains workers and frms
from demanding increases in nominal wages that exceed labor productivity, can be
very useful in holding back infation expectations (Davidson 2006) ne possibility is
to penalize the largest domestic frms in the economy when they agree to wage rate
increases in excess of some national productivity improvement standard as well as for
increasing excessively their markups. It is also important to monitor price increases of industries
that operate under monopolistic/oligoplistic regimes (e.g., fuel products) so that the pass-though
to consumers does not exceed the increase in the international prices. In the case of food
products, hoarding should be penalized. This policy has to be permanent and it has to be only a
penalty for those frms that infringe the system and not a reward for those that comply with it
A different but related proposal is that of Vickrey (1992). He proposed to establish a market in
rights to raise prices (and obligations to lower them) Each frm is given a certain number of
warrants to gross markups, based on past performance These allow frms to raise prices, in an
analogous way to the markets in rights to emit air pollution. The initial allocation of the warrants
ensures a predictable rate of infation and adjustments in warrants issued in subsequent periods
result from changes in investment and hiring in the previous period.
f a frm wishes to increase its price above what is allowed, it has to buy the rights from another
frm (these transactions are conducted freely) that is seeking and willing to lower its price by a
similar amount This system ensures a stable overall price level f a frm fails to abide by the
system (ie, if a frms gross markup exceeds its warrants) it will have to pay a penalty
Box 4: continued.
A major concern is the possible contractionary impact of the monetary tightening that
has occurred during the frst half of 2008 and that, most likely, will continue throughout
the rest of the year. Figure 17 shows the growth of M2 and of domestic credit and that
of the CP infation rate The fgure shows that periods of growth in Pakistan have been
accompanied by high growth in 2 and in domestic credit above the infation rate
14
Figure 17: Growth Domestic Credit, M2 and Ination, 19612007
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CPI ination rate
Table 9 shows the latest available growth rate fgures of domestic credit, 2, and infation
for the period J anuaryMay for 2006, 2007, and 2008. In real terms, the growth rates
of both domestic credit (which grew by almost 0% during the frst fve months of 2008)
and of M2 were negative during J anuaryMay 2008. Therefore, in real terms, there has
been a decline in domestic credit and liquidity (i.e., lower purchasing power of the funds
borrowed declined). This implies that fall in broad money (M2) in real terms may lead to
a slowdown in consumption spending, while the fall in domestic credit in real terms may
signal slowdown or decline in investment and consumption.
4
This lax monetary policy may have contributed to the high growth, but it does not imply that the high monetary
growth led to infation.
Source: International Financial Statistics online (IMF, July 2008).
Table 9: Growth Rate of Nominal and Real Domestc Credit and M2
JanMay
2006
JanMay
2007
JanMay
2008
Growth rate of domestic
credit 2.76 6.62 9.50
M2 3.92 5.88 .89
CPI 3.28 .88 .69
Growth rate of
real domestic credit 0.52 4.73 2.9
Real M2 0.64 3.99 9.80
Source: Calculations based on IFS Online (July 2008).
All this indicates that the monetary authorities must exercise a great deal of caution as
they tighten monetary policy. This is to ensure that investment and consumption are not
excessively adversely affected so as to cause a major economic slowdown or recession.
igure 8 shows the CP infation rate and the discount rate The fgure indicates that,
in general, the discount rate has been above the infation rate, except during the high
infation periods in the mid-970s and early 980s igure 9 shows that as infation has
hit double digits in 2008, the real interest rate has become negative. This indicates that
most likely interest rates will increase and there will be further monetary contraction.
This must be moderated (as indicated above, domestic credit and broad money [M2]
are declining in real terms). We cannot stop emphasizing that any further interest rate
increase as well as monetary contraction will have to be carefully considered. Often, a
collapse in credit cannot be reversed and the consequences linger for a long time.
The SBP has been studying the possibility of shifting from the current system of monetary
targeting to infation targeting (T), where the central bank announces infation targets,
coupled with a credible and accountable commitment on the part of government policy
authorities to the achievement of these targets. While IT has some advantages, the SBP
must take into account that the theoretical model underlying T presumes that infation is
exclusively a demand-driven phenomenon (the gap between actual and potential output).
Second, the tool that monetary authorities use to bring the growth of current and potential
outputs in line is short-term nominal interest rate. This requires an effective transmission
mechanism from the short-term interest rate to infation Box 5 discusses the pros and
cons of IT as a monetary policy regime.
Figure 18: Ination and Discount Rates, 19612007
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Figure 19: Ination and Discount Rate, Q1 2007 to May 2008
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Box 5: Infation Targeting
nfation targeting is a monetary regime where the central bank announces publicly an infation
target, coupled with a credible and accountable commitment on the part of government policy
authorities to the achievement of these targets. The central banks primary (and in most cases
only) mandate is to maintain price stability at the lowest possible rate of infation n most cases,
no attention is paid to asset prices, exchange rates, credit quality, or unemployment. IT is based
on the proposition that monetary policy is fundamentally about controlling the price level.
What is the rationale for T? irst, it is the belief that price stability is a precondition for sustained
growth and employment (i.e., economies grow as a direct result of sound monetary policies
directed at lowering the infation rate), and that high infation damages the economy in the
long run.In this context, price stability is thought to deliver better allocation of resources and
improved planning for the private sector and hence real gains for the economy. The idea is to
anchor price expectations so as to allow better monetary policy in the medium term. Second,
the SBP currently pursues monetary aggregate targeting. This assumes that the money demand
function is stable and that there exists a predictable relationship between monetary aggregates
and infation However, empirical work indicates that Pakistans money demand function us
unstable (Moinuddin 2007), which seems to make IT a possible choice of monetary regime.
Third, some authors claim that T countries have experienced low and stable infation rates, with
no apparent sacrifce in growth
The literature indicates that IT has a number of advantages (Bernanke et al. 1999). Among
them are that it provides a nominal anchor for policy (ie, to stabilize infation and price
expectations) Second, that it is easy to understand and is fexible, transparent, and amenable
to accountability. Third, central banks gain credibility. Fourth, since New Zealand adopted it in
990, it has helped create global awareness of the costs of infation inally, it is claimed that
the countries that have adopted it have performed better These, however, are not suffcient
conditions for Pakistan to adopt T as a monetary regime The key questions are, frst, whether
Pakistan is ready for it, as there are a number of requirements to be met for the IT regime to
be a sensible option as a monetary regime; and second, whether the SBP has considered
the full implications of shifting to IT, in particular how this monetary regime will contribute to
other objectives of the country such as growth, employment creation, and poverty reduction.
Although in theory IT does not preclude central banks from pursuing other goals (e.g., output
stabilization), it clear that IT is an institutional commitment to price stability as the primary goal of
monetary policy, to which other goals are subordinated. Thus, shifting to IT, despite its possible
advantages, entails not only a full understanding of the theoretical basis (including the difference
between developed and developing economies), but also of the unavoidable trade-offs involved.
Some of issues that need to be considered are as follows (Felipe 2007):
(i) The evidence of the superiority of IT is, at best, partial.
(ii) The effect of monetary policy on infation is small and insignifcant
(iii) The possibility that the economy may face a defcient aggregate demand is not
contemplated.
(iv) It is claimed that the IT framework leads to greater accountability on the part of the central
bank. However, it is not clear that this is necessarily true.
(v) n practice, infation targets are missed very often, about 40% of the time, for prolonged
periods, and by wide margins.
continued.
(vi) n Pakistan, food accounts for 40% of the weight in the CP This source of infation is not
considered by T models, which assume that infation is caused by excess demand T,
therefore, cannot solve cost-push infation
(vii) The SBP does not have a good model to forecast infation
(viii) The IT models assume that monetary policy affects actual output only in the short run with
actual output moving to the natural rate of unemployment in the long run. However, may
economists believe that monetary policy is not neutral and that the conduct of monetary
policy may have effects on output in both the short and long run.
(ix) When the central bank manipulates interest rates to adjust current output relative to
potential output, its actions affect both actual and potential output.
(x) The model needs an estimate of potential output. However, calculating it is extremely
complicated.
(xi) What is the natural real interest rate? As in the case of potential output, policies derived
from the IT model depend on this rate.
(xii) Risks of IT: (a) monetary authorities may be forced to increase interest rates when
infation increases, even though there is a wide perception that price increases are one-
off, not an infationary episode (b) The proper adjustment to disturbances to the economy
associated with higher aggregate demand is not an increase in interest rates. IT may be
highly ineffcient
(xiii) T models make scant, if any, reference to fscal policy This is due to the belief that this
policy is ineffective (if not infationary) for the purposes of achieving the goals of economic
policy, i.e., price stabilization.
(xvi) Little is known about the costs of IT on potential output, employment, poverty, and income
distribution Akbari and ankaduwa (2006) estimate an output-infation trade-off model
(the sacrifce ratio) and fnd out that: a one percent decline in infation rate caused by
a permanent reduction in monetary growth rate would result in a cumulative output (GDP)
decline of 0.87 percent below its potential level [] if monetary policy were to target the
infation rate of 4 percent, the resulting cumulative decline in output below its potential
level (trend) would be about 5.1 percent (Akbari and Rankaduwa 2006, 185).
(xvii) What infation targeting regime will Pakistan choose, a point target or a range?
(xviii) Chaudhry and Chouhdary (2006, 207) argue that Pakistans economy is operating at
a very horizontal portion of the supply curve. This conclusion corroborates Kriesler
and Lavoies (2007) argument that for a large range of capacity utilization prices do not
increase; and Eisners (1995) empirical work for the US.
Summing up, before a fnal decision is made the SBP should consider all these factors and
provide clear answers. While monetary targeting is problematic due to the instability of the
money demand function, the SBP has to consider the issues raised above. The doctrine that
the central banks role is (exclusively) to consumer prices within a narrow range is a legacy
of Monetarism. Historically, central banks developed in order to secure the stability of credit.
nfation need not be the only objective of monetary policy
Box 5: continued.
B. On the Exchange Rate
As mentioned earlier, monetary tightening may help contain the depreciation of the
rupee, which is facing tremendous pressures as a result of the macroeconomic and
political instability. Figure 9 above showed that the rupee is not overvalued. Currency
depreciation may aggravate infation and lead to further loss in confdence, so there
are reasons to try to moderate it. The government has tried to do this by: (i) intervening
in the foreign exchange market and (ii) increasing interest rates and reserve ratios
and monetary tightening. However, the lessons of the Asian crisis a decade ago are
such that desperately defending the currency may lead to the depletion of international
reserves, and the situation may worsen leading to a full-fedged balance of payments
crisis. Increasing interest rates and unduly reducing money and credit may deteriorate
frms balance sheets and lead to fnancial defaults and a fnancial crisis (as happened
during the East Asian crisis of 19971998). In the current situation, the best way to tame
pressures for currency depreciation is to lower political instability. Without a return of
political confdence and certainty, using monetary tightening in excess may prove futile
and ultimately damaging to the economy.
Maintaining a competitive exchange rate is fundamental for Pakistan and is a desirable
target policy. Real exchange rate overvaluation is bad for growth, while undervaluation is
good. Moreover, a competitive real exchange rate contributes to employment generation
through a number of channels The frst is through its impact on the level of aggregate
demand (the macroeconomic channel). The second is through its impact on the cost of
labor relative to other goods and, thereby, affecting the amount of labor hired per unit of
output (the labor intensity channel). The third one is through its impact on investment and
growth (the development channel). In an economy characterized by vastly underutilized
resources, there are growth-related externalities derived from a policy of maintaining a
competitive exchange rate, as the higher demand for exports, as well as the increasing
production of import-competitive goods, can spill over into demand for nontradables as a
result of higher income in sectors that produce tradables.
C. On Subsidies
The new government needs to analyze the impact of the subsidy burden on the budget
and decide what is crucial to guarantee a minimum living standard to the disadvantaged
groups (this calls for well-designed targeted programs); and what has to be passed on to
consumers. However, it must be clear that if increases in oil prices are directly passed on
to consumers, the overall price level will increase (ie, infation) and the country will be
subject to credit downgrades and losses of confdence from the international community
due to its high infation rate
There is a fne line between maintaining sensible subsidies and populist measures
Knowing the difference is fundamental. The targeting of poor households will be crucial
to the success of the governments program. Since coming up with an objective targeting
mechanism will take time (a good survey or data gathering and monitoring system at the
local levels), it may be good to suggest that nongovernment organizations and United
Nations agencies be active in the cash transfer and targeting programs to ensure that
these end up in the hands of poor households. An objective targeting system to identify
poor households can be put in place through the so-called proxy means testing system.
In this method, key household characteristics such as lack of ownership of television
sets, refrigerators, water pipes, or water-sealed toilets, as well as very low electricity bills
serves as easy ways for identifying poor households. Furthermore, to make the target
system more effective, a co-responsibility system can be adopted: households availing
cash transfers and subsidies will be required to continue sending their children to school,
allowing them to receive immunization and health services, and entering livelihood
programs. This program has delivered positive results in the Philippines. Likewise,
mechanisms can be devised to identify poor groups for purposes of providing fuel
subsidies (e.g., giving discounts to public transport vehicles catering more to the lower
income classes in the gasoline stations).
D. On the Budget Defcit
Pakistans fscal defcit is the result of a low revenue-generating capacity, more than
fscal profigacy Nevertheless, the government has to analyze the structure of spending,
eliminate all superfuous categories (including subsidies) and projects with questionable
benefts, and get rid of unproftable state-owned enterprises As noted in Box , these
measures will also help address the infation problem Likewise, the law should limit (eg,
through the Fiscal Responsibility and Debt Limitation Act 2005) the maximum amount that
the government can borrow from the SBP.
t is important to note that budget defcits are not sins if they are well understood and
adequately managed oreover, they need not always refect loose fscal stance, but may
signal stagnation in a destabilized economy Government expenditure and fscal policy in
general should be seen from the point of view of how to keep the total spending in the
economy at the rate that would buy all the goods that is possible to produce. Fiscal policy
should be conceived as a mechanism that balances the system, exogenously increasing
aggregate demand (e.g., by injecting expenditures) whenever private sector spending falls
short of a full employment level of effective demand.
Studies for the Organisation for Economic Co-operation and Development countries
show that fscal tightening achieved by increasing taxes and cutting public investment
tends to be contractionary and unsustainable. In the case of developing countries, the
empirical evidence indicates that expenditure composition is critical. While increases
in spending on government wages and salaries tend to have a negative impact on
growth, expenditures on other goods and services and capital projects tend to raise the
growth rate signifcantly Therefore, fscal policy has to be tailored to country-specifc
conditions to foster growth n other words, the quality of the fscal defcit (ie, the use
of expenditures) is a key issue. Fiscal responsibility is not about permanent balanced
budgets but about the quality of the defcits, and whether the public debt accumulated is
sustainable.
Revenue collection should be enhanced by, for example, introducing a tax on real
estate transactions. Likewise, the tax base should widen so that direct taxes, rather than
indirect, contribute more to government revenues. Also, a higher share of taxes should
be extracted from the service sector, given that it represents over 50% of GDP but
contributes only a quarter to total tax revenue.
E. On the Current Account Defcit
How to reduce the current account defcit poses another dilemma (the government
envisages import growth in the range of 6.5% and export growth at around 15% for
2008/09). Reduction in growth will lead to a decline in import growth. However, oil
imports will remain high if the price of oil does not decline.
15
On the other hand, export
growth may not pick up in the short term given the current international scenario. For
this reason, the 2008/09 export target, set at $22.1 billion, may not be achieved. It is
crucial, therefore, to put in place policies to improve export growth Diversifcation and
quality improvement are essential to make Pakistan less dependent on exports of textiles.
Likewise, efforts must be made toward attracting FDI in the commodity-producing sectors
of the economy.
F. On the Cost of Fighting Infation
ood infation most likely damages Pakistans urban poor, and for this reason it has to
be fought (see Appendix) However, fghting infation always entails costs and most often
these are in terms of higher unemployment (especially unskilled workers), at least in the
short run, and lower growth in the medium term Available estimates of the sacrifce
ratio should make policy makers aware of the substantial trade-off between the reduction
in infation and the loss output that effort entails
While high infation lowers the effciency of the economy, using tight monetary policy to
fght it can be damaging, as the experience of ussia during 99998 shows (barter
transactions increased). Moreover, higher interest rates make the cost of funds more
expensive. This discourages investment and limits growth. And if interest rates become
highly variable, frms will become more reluctant to use debt fnancing and use more
internal funds Therefore, high and variable interest rates impair the effciency of capital
markets.
5
After peaking at about $50 per barrel in July 2008, the price of oil declined to below $50 in December 2008.
inally, and as stressed above, currency appreciation may help contain imported infation,
but attention must be paid to the effect on exports.
V. Conclusions
Pakistans latest growth experience during 20032007 was the result of short-sighted
policies driven by high remittances of overseas workers, FDI, hot money and loan
infows, as well as some government pump-priming While initially this led to high growth,
it has now become clear that this growth model failed to address the main problems
afficting the Pakistani economy: (i) a crisis of confdence 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; (ii) a neglect of the supply side of the
economy (i.e., productive capacity, technological upgrade of the economy); and
(iii) inability to address the increasing fscal and current account defcits
Like other developing countries that have implemented questionable domestic policies,
external shocks have put Pakistan in a very diffcult situation However, inducing a
reduction in aggregate demand through recessionary policies to cure problems that have
strong supply-side causes (i.e., the oil and food price shocks and poor infrastructure)
will not help Pakistan. Often international institutions have been excessively preoccupied
with fears of infation Excessive austerity has forced countries to cut unnecessarily
on high-return public investments, and has led to higher unemployment and to larger
gaps between actual and potential output. All this has ended up harming growth. The
very painful lessons of the East Asian crisis (although it had different roots), and of
the subsequent Turkish and Argentine economic collapses (as a result of the shock
treatment approach), have led some economists to recommend more heterodox
economic policies in periods of crises. Achieving political stability is a key piece of the
solution Austerity measures in the monetary and fscal fronts will not bring back, on their
own, much-needed confdence Likewise, the situation requires a coordinated effort at the
international level.
With this in mind, any sensible solution to Pakistans problems will have to consider:
(i) A coherent economic program that tackles macroeconomic imbalances, as well as
a long-term program that leads to the modernization of the economy.
(ii) n the fscal front, the government must have enough political muscle to:
(a) implement progressive direct taxes to generate more revenue; (b) switch
from price subsidies to income subsidies with clear targeting mechanisms for
poor households; (c) protect vital social and economic services when poverty is
increasing; and (d) allot funds to address the power and water shortages.
(iii) To address the external defcit 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 countrys
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 infationary bias, and a
program of incomes policies to prevent infation expectations should be put in
place.
Appendix: The Relationship between Infation, Growth,
and Inequality
t is often claimed that infation is harmful to the economy because it affects growth negatively
However, the link between these two variables, as well as with other real variables is signifcantly
weaker than usually assumed.
ighting infation should be a top priority when it becomes hyperinfation, in the hundreds percent
and above, as this has large economic costs Very high infation creates uncertainty and impacts
the effciency with which resources are used But under moderate infation (50%), these costs
are much lower. Since the 1990s, most developed and developing countries have experienced low
or moderate infation, below 0% At these levels, the efforts to reduce it may derive lower benefts
and incur higher costs, especially when traditional contractionary monetary policy is the main
instrument to fght it The result is that this may dampen employment in the short term and growth
in the long run.
As discussed in Box 2, there is little evidence that moderate infation has a signifcantly adverse
impact on growth. And likewise, there is little theory or evidence too on the contention that once
infation starts it is very diffcult to stop it Stiglitz et al (2006, 9) summarize the infation and
growth rates for Argentina, Brazil, Chile, Israel, Poland, and Turkey for different subperiods. Their
table is reproduced here for convenience as Appendix Table The authors refer to low infation
up to about 0%; moderate infation up to about 0%; and high/hyperinfation from about 70% to
2000%. They argue that omitting footnotes:
Very high infation and hyperinfation have been generally associated with low growth or open
economic recession, although there are some exceptions to the rule, as in Israel in 197985. On
the contrary, moderate rates of infation (of the order of 20 or 0 percent per year) have been
accompanied by rapid economic growth quite often [] The view that low infation facilitates
economic growth is not valid as a general proposition [] cross country-regressions, although
imperfect, suggest that infation is not closely related to growth, so long as infation is not too
highbelow a threshold of some 20 to 30 percent (Stiglitz et al. 2006, 19-20).
Appendix Table 1. Economies where Infation has not Impeded Growth
Years Low Infation Moderate Infation High/Hyperinfation
Infation Growth Infation Growth Infation Growth
Argentina 96574 30.5 5.
97587 259.4 0.9
98890 92.2 4.2
9993 69. 0.
9940 0.7 .4
200204 2.2 .6
Brazil 96580 36.2 7.9
9886 50.4 2.2
98795 87.8 2.0
99603 8.5 .7
Chile 9657 25.7 4.6
97277 269.9 -0.6
97885 26.9 3.5
98694 8.9 7.4
99503 4.8 4.5
Israel 96570 4.7 8.0
9778 30.3 5.5
97985 8.5 4.0
98696 7.9 5.4
99703 3.8 2.2
Poland 9887 3.2 .0
9889 233.8 -3.7
99298 27.2 5.4
99903 5. 3.5
Turkey 96870 5.4 4.7
9777 7.5 6.
97880 7.4 0.5
9887 37.9 5.8
9880 72.8 2.8
200203 35. 6.9
Source: Table 2. in Stiglitz et al. (2006, 9).
Since the last subperiod considered by Stiglitz et al. (2006) ends in 2004, we have checked the
subperiod 20042006 (2006 is the last year available). Appendix Figure 1 shows the average
growth and infation rates for 20042006 for 62 countries
16

The graph shows that during this period, the highest infation rate was 2665%, corresponding
to Angola, which also registered one of the highest growth rates during this period, 16.78%. The
regression line between the two variables displays a positive and statistically signifcant coeffcient
The graph also shows that that there were many countries in the world that achieved low infation
but also low growth during the period under consideration. Given that this is just a correlation,
we do not want to infer any causality. But certainly this result serves to question the view that
higher infation is associated with lower growth Appendix Table 2 ranks the countries according
to their infation rate, and shows no relationship between a countrys infation rate and whether its
predicted growth rate is higher or lower than the actual rate.
Appendix Figure 1: Growth versus Ination, 20042006
25
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Others, including non-Asian countries
ADB developing member countries
A
v
e
r
a
g
e

G
D
P

G
r
o
w
t
h
Average Ination
Azerbaijan
Pakistan
0 10 20 30
Note: Average GDP growth = 4.44 + 0.22 Average ination
(11.27) (4.08)
No. of Observations: 162; R
2
=0.09
6
This excludes Zimbabwe, with negative growth and an average infation rate of almost 600%.
Appendix Table 2. Infation, Actual Growth, and Predicted Growth
Infation
Rate
Actual
Growth Rate
Predicted
Growth Rate
Angola 26.66 6.79 0.39
Dominican Republic 2.07 7.3 9.4
Haiti 7.20 0.9 8.28
Venezuela, RB 7.2 2.98 8.26
Zambia 5.0 5.60 7.8
Yemen, Rep. 5.05 3.95 7.80
Madagascar 4.37 4.9 7.64
Nigeria 3.70 6.3 7.49
Malawi 3.60 5.28 7.47
Iran, Islamic Rep. 3.38 4.66 7.42
Serbia 2.95 6.79 7.33
Ghana 2.89 5.90 7.3
Congo, Dem. Rep. 2.66 6.06 7.26
Costa Rica 2.53 6.2 7.23
Jamaica 2.50 .79 7.23
Moldova 2.42 6.29 7.2
Kenya 2.3 5.64 7.4
Sierra Leone .93 7.34 7.0
Belarus .83 0.28 7.08
Myanmar .30 4.00 6.96
Russian Federation .07 6.75 6.9
Mozambique .02 8.08 6.90
Sri Lanka 0.97 6.28 6.89
Ukraine 0.54 7.30 6.79
Suriname 0.43 6.45 6.76
Turkey 0.4 7.47 6.76
Rwanda 0.05 5.08 6.68
Indonesia 9.94 5.40 6.65
Mauritania 9.58 7.44 6.57
Ethiopia 9.50 0.77 6.56
Qatar 9.5 3.46 6.48
Romania 9.5 6.73 6.48
Nicaragua 9.07 4.45 6.46
Botswana 9.04 4.09 6.45
Burundi 9.0 3.62 6.45
Azerbaijan 8.89 23.63 6.42
Gambia, The 8.69 4.87 6.38
Mongolia 8.68 8.8 6.38
Tonga 8.58 .69 6.35
Argentina 8.32 8.89 6.29
Lao PDR 8.4 7.02 6.25
Pakistan 8.4 7.32 6.25
Sudan 8.00 8.50 6.22
Egypt, Arab Rep. 7.93 5.4 6.2
Viet Nam 7.92 8.3 6.20
Kazakhstan 7.69 0.00 6.5
Bangladesh 7.66 6.29 6.5
Honduras 7.50 5.04 6.
Guatemala 7.42 3.47 6.09
continued.
Appendix Table 2. continued.
Infation
Rate
Actual
Growth Rate
Predicted
Growth Rate
Solomon Islands 7.4 6.37 6.09
Samoa 7.32 3.63 6.07
Syrian Arab Republic 7.23 5.4 6.05
Georgia 6.97 8.28 5.99
Paraguay 6.9 3.78 5.98
Uruguay 6.75 8.48 5.94
Philippines 6.6 5.57 5.9
Latvia 6.50 0.40 5.89
Trinidad and Tobago 6.3 9.58 5.84
Bulgaria 6.22 6.33 5.82
Mauritius 6.9 4.27 5.82
Uganda 6.08 5.85 5.79
Guyana 6.06 .95 5.79
Brazil 5.88 4. 5.75
Nepal 5.74 3.53 5.72
Colombia 5.08 5.46 5.57
Tanzania 5.03 6.49 5.56
Bhutan 4.96 7.44 5.54
Slovak Republic 4.9 6.57 5.53
Lesotho 4.84 4.72 5.52
Cambodia 4.77 .44 5.50
Hungary 4.74 4.28 5.49
Bolivia 4.7 4.28 5.49
Kyrgyz Republic 4.68 3.8 5.48
India 4.60 8.92 5.46
Iceland 4.55 5.79 5.45
Swaziland 4.5 2.7 5.44
El Salvador 4.39 3.04 5.42
Jordan 4.37 7.02 5.4
Equatorial Guinea 4.23 .6 5.38
Mexico 4.0 3.92 5.35
Thailand 3.98 5.26 5.33
Estonia 3.86 9.98 5.30
Namibia 3.82 4.75 5.29
Belize 3.66 4.44 5.25
Chad 3.52 4.02 5.22
Macao, China 3.5 7.30 5.22
Armenia 3.50 2.57 5.22
Maldives 3.46 9.96 5.2
Tunisia 3.38 5.5 5.9
Benin 3.34 3.37 5.8
Spain 3.3 3.54 5.7
Congo, Rep. 3.25 5.90 5.6
St. Vincent and the
Grenadines
3.24 3.84 5.6
West Bank and Gaza 3.24 4.64 5.6
Greece 3.22 4.27 5.5
continued.
Infation
Rate
Actual
Growth Rate
Predicted
Growth Rate
Grenada 3.9 2.06 5.5
South Africa 3.4 4.97 5.4
Togo 3.4 2.78 5.4
United States 3.0 3.35 5.3
United Kingdom 3.00 2.65 5.
New Zealand 2.90 2.53 5.08
Korea, Rep. of 2.86 4.64 5.08
Croatia 2.86 4.44 5.07
Malta 2.86 2.29 5.07
Ireland 2.86 5.8 5.07
Australia 2.85 2.66 5.07
Slovenia 2.84 4.55 5.07
Kuwait 2.82 7.35 5.07
Burkina Faso 2.78 6.04 5.06
Ecuador 2.73 5.97 5.05
Niger 2.70 3.80 5.04
Malaysia 2.70 5.90 5.04
Cote dIvoire 2.60 .28 5.02
Algeria 2.58 4.50 5.0
St. Lucia 2.57 6.9 5.0
Lithuania 2.56 7.64 5.0
Fiji 2.56 3.20 5.0
Chile 2.50 5.22 4.99
Portugal 2.46 .04 4.99
Luxembourg 2.46 4.60 4.99
Cameroon 2.45 3.7 4.98
Cyprus 2.45 4.06 4.98
Peru 2.43 6.47 4.98
Czech Republic 2.40 5.7 4.97
Peoples Republic of China 2.39 0.40 4.97
Albania 2.34 5.47 4.96
Bahrain 2.32 6.70 4.95
Poland 2.27 5.03 4.94
Belgium 2.22 2.40 4.93
Dominica 2.9 0.86 4.93
Italy 2.09 .05 4.90
Guinea-Bissau 2.06 3.30 4.90
St. Kitts and Nevis 2.05 6.70 4.89
Papua New Guinea 2.05 2.87 4.89
Canada 2.02 3.0 4.89
Oman .94 5.56 4.87
Austria .94 2.53 4.87
Morocco .92 5.20 4.87
Panama .92 7.52 4.86
France .85 2.06 4.85
Germany .78 .64 4.83
continued.
Infation
Rate
Actual
Growth Rate
Predicted
Growth Rate
Denmark .62 2.80 4.80
Mali .6 4.52 4.80
Vanuatu .5 6.40 4.77
Gabon .49 .85 4.77
Macedonia, FYR .47 3.74 4.76
Seychelles .46 .22 4.76
Senegal .44 4.60 4.76
Norway .44 3.5 4.76
Netherlands .36 2. 4.74
Cape Verde .30 5.76 4.73
Saudi Arabia .08 5.2 4.68
Libya .06 5.63 4.67
Singapore 1.04 7.77 4.67
Switzerland .0 2.47 4.66
Israel .0 5.04 4.66
Finland 0.87 4.04 4.63
Hong Kong, China 0.85 7.45 4.63
Sweden 0.73 3.74 4.60
Brunei Darussalam 0.73 2.0 4.60
Central African Republic 0.4 2.54 4.53
Japan -0.0 2.28 4.43
Source: Authors calculations.
What about the impact of infation on inequality? Stiglitz et al (2006, 24) also point out that
the evidence on the relationship between these two variables is ambiguous as to whompoor
or richinfation hurts more The impact of infation on inequality depends on social and market
institutions, as well as on the level of indexation of the economy. Wealthy individuals tend to hold
fnancial assets, so infation has a negative impact on them People in the middle-income groups
are likely to hold most of their assets in housing, so infation benefts them n many developed
countries, senior citizens pensions are indexed, so they are protected. On the other hand,
the level of social security, pensions, and social protection in general is extremely low in most
developing countries This means that infation affects them negatively The effect of infation on
workers depends on whether their ages adjust. Again, in most developing countries this is not
the case Therefore, the effect to which infation affects wages depends on whether frms pay
effciency wages to maintain workers productivity Likewise, the impact of infation differs across
sectors of the economy n the case of food infation, most likely the most affected group is the
urban poor, although not always.
In a recent study for Pakistan, Chaudhry and Chaudhry (2008) analyze the effects of rising food
and fuel costs on poverty in Pakistan. They conclude that, in the short run, the impact of food price
increases on poverty is greater than the impact of energy price increases. Second, that the impact
of food price infation on poverty levels is higher for rural populations than for urban populations
The rural poverty head count is 45.7%, and a 10% (20%) increase in food prices pushes the
poverty head count to 50.6% (55.3%). For urban areas, the poverty head count is 22.1%, and a
10% (20%) increase in food prices pushes the poverty head count to 24.5% (27.1%).
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About the Paper
Jesus Felipe and Joseph Lim analyze Pakistans macroeconomic developments during the
last few years. The increasing budget and current account defcits led to a situation of near
bankruptcy.
About the Asian Development Bank
ADB's vision is an Asia and Pacifc region free of poverty. Its mission is to help its developing
member countries substantially reduce poverty and improve the quality of life of their
people. Despite the region's many successes, i t remains home to two thirds of the world's
poor. Six hundred million people in the region live on $1 a day or less. ADB is committed to
reducing poverty through inclusive economic growth, environmentally sustainable growth,
and regional integration.
Based in Manila, ADB is owned by 67 members, including 48 from the region. Its main
instruments for helping its developing member countries are policy dialogue, loans, equity
investments, guarantees, grants, and technical assistance. In 2007, it approved $10.1 billion
of loans, $673 million of grant projects, and technical assistance amounting to $243 million.
Asian Development Bank
6 ADB Avenue, Mandaluyong City
1550 Metro Manila, Philippines
www.adb.org/economics
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