Q.1 a. Why Governments may find it necessary to intervene in the working of Price Mechanism?

Intervention in the market The government may choose to intervene in the price mechanism largely on the grounds of wanting to change the allocation of resources and achieve what they perceive to be an improvement in economic and social welfare. All governments of every political persuasion intervene in the economy to influence the allocation of scarce resources among competing uses What are the main reasons for government intervention? The main reasons for policy intervention are:

To correct for market failure To achieve a more equitable distribution of income and wealth To improve the performance of the economy

Options for government intervention in markets There are many ways in which intervention can take place some examples are given below Government Legislation and Regulation Parliament can pass laws that for example prohibit the sale of cigarettes to children, or ban smoking in the workplace. The laws of competition policy act against examples of price-fixing cartels or other forms of anti-competitive behaviour by firms within markets. Employment laws may offer some legal protection for workers by setting maximum working hours or by providing a price-floor in the labour market through the setting of a minimum wage.

The economy operates with a huge and growing amount of regulation. The government appointed regulators who can impose price controls in most of the main utilities such as telecommunications, electricity, gas and rail transport. Free market economists criticise the scale of regulation in the economy arguing that it creates an unnecessary burden of costs for businesses with a huge amount of red tape damaging the competitiveness of businesses. Regulation may be used to introduce fresh competition into a market for example breaking up the existing monopoly power of a service provider. A good example of this is the attempt to introduce more competition for British Telecom. This is known as market liberalization. Direct State Provision of Goods and Services Because of privatization, the state-owned sector of the economy is much smaller than it was twenty years ago. The main state-owned businesses in the UK are the Royal Mail and Network Rail. State funding can also be used to provide merit goods and services and public goods directly to the population e.g. the government pays private sector firms to carry out operations for NHS patients to reduce waiting lists or it pays private businesses to operate prisons and maintain our road network. Fiscal Policy Intervention Fiscal policy can be used to alter the level of demand for different products and also the pattern of demand within the economy. (a) Indirect taxes can be used to raise the price of de-merit goods and products with negative externalities designed to increase the opportunity cost of consumption and thereby reduce consumer demand towards a socially optimal level (b) Subsidies to consumers will lower the price of merit goods. They are designed to boost consumption and output of products with positive externalities remember that a

subsidy causes an increase in market supply and leads to a lower equilibrium price (c) Tax relief: The government may offer financial assistance such as tax credits for business investment in research and development. Or a reduction in corporation tax (a tax on company profits) designed to promote new capital investment and extra employment (d) Changes to taxation and welfare payments can be used to influence the overall distribution of income and wealth for example higher direct tax rates on rich households or an increase in the value of welfare benefits for the poor to make the tax and benefit system more progressive Intervention designed to close the information gap Often market failure results from consumers suffering from a lack of information about the costs and benefits of the products available in the market place. Government action can have a role inimproving information to help consumers and producers value the true cost and/or benefit of a good or service. Examples might include:

Compulsory labelling on cigarette packages with health warnings to reduce smoking Improved nutritional information on foods to counter the risks of growing obesity Anti speeding television advertising to reduce road accidents and advertising campaigns to raise awareness of the risks of drink-driving Advertising health screening programmes / information campaigns on the dangers of addiction

These programmes are really designed to change the perceived costs and benefits of consumption for the consumer. They dont have any direct effect on market prices, but they seek to influence demand and therefore output and consumption in the long run. Of course it is difficult to identify accurately the effects of any single government information campaign, be it the campaign to raise awareness on the Aids issue or to encourage people to give up smoking. Increasingly adverts are becoming more hardhitting in a bid to have an effect on consumers.

The effects of government intervention One important point to bear in mind is that the effects of different forms of government intervention in markets are never neutral financial support given by the government to one set of producers rather than another will always create winners and losers. Taxing one product more than another will similarly have different effects on different groups of consumers. The law of unintended consequences Government intervention does not always work in the way in which it was intended or the way in which economic theory predicts it should. Part of the fascination of studying Economics is that the law of unintended consequences often comes into play events can affect a particular policy, and consumers and businesses rarely behave precisely in the way in which the government might want! We will consider this in more detail when we consider government failure. Judging the effects of intervention a useful check list To help your evaluation of government intervention it may be helpful to consider these questions: Efficiency of a policy: i.e. does a particular intervention lead to a better use of scarce resources among competing ends? E.g. does it improve allocative, productive and dynamic efficiency? For example - would introducing indirect taxes on high fat foods be an efficient way of reducing some of the external costs linked to the growing problem of obesity? Effectiveness of a policy: i.e. which government policy is most likely to meet a specific economic or social objective? For example which policies are likely to be most effective in reducing road congestion? Which policies are more effective in preventing firms from exploiting their monopoly power and damaging consumer welfare? Evaluation can also consider which policies are likely to have an impact in the short term when a quick

response from consumers and producers is desired. And which policies will be most costeffective in the longer term? Equity effects of intervention: i.e. is a policy thought of as fair or does one group in society gain more than another? For example it is equitable for the government to offer educational maintenance allowances (payments) for 16-18 year olds in low income households to stay on in education after GCSEs? Would it be equitable for the government to increase the top rate of income tax to 50 per cent in a bid to make the distribution of income more equal? Sustainability of a policy: i.e. does a policy reduce the ability of future generations to engage in economic activity? Inter-generational equity is an important issue in many current policy topics for example decisions on which sources of energy we rely on in future years.

b. What Economic factors business firms would evaluate before entering into new market? Discuss. There is always some risk involved when you decide to expand your business into a new market. You need to lay the groundwork to make sure that your product is viable and your timing is right before you enter the new market "ring." Here are 10 questions you need to have answered before you take the leap: Key Economic Factors before entering into Local Market 1. Does your product actually fill a need in the market? 2. Do you have enough money to make your venture into a new market a success? Make sure that you incorporate a "fudge factor" into your calculations. Typically speaking, people tend to be over-optimistic about revenues and sales and underestimate costs. In addition, it is important to have enough capital in the event that you are not able to introduce your product as quickly as you planned.

3. Are you on top of market research news? You have to have a thorough understanding of your competition, their market approach and their pricing. Understanding this will help you decide about how you are going to position your product in the marketplace. 4. Do you know how the competition reacted to other new product introductions in the past? This information will also help you strategize how the competition will react to your product and how you will respond. 5. Do you truly understand your potential customer base? You will want to know which clients are healthy financially, who might be interested in your product immediately and who would be long-term targets. 6. At what point is the lifecycle of the market of your product? If the market is mature, you may be chasing after diminishing returns unless you can position yourself at the high price/niche end. If the market is new, you will have to shoulder all of the costs of developing the market. 7. Do you have the personnel to handle and support a new product? You have to have people to handle more supplies coming in and more products going out the door. 8. How much time will it take to train existing personnel as well as any new people that you hire to bring them up to speed on the product? 9. Does your new product fit within your current product line? It is easier to sell complementary products than it is to sell a widget to one market and a bunch of gadgets in a completely different market using the same sales staff. 10. How will you distribute the product? Will you sell directly to end users or go through distributors? How does this fit with your current organization distribution plan? Knowing how to market a product and how to develop an effective marketing plan can make all the difference in having a successful product launch into a new market. Key Economic Factors before entering into Global Market

Factor 1: Get company-wide commitment. Every employee should be a vital member of your international team, from the executive suite to customer service through engineering, purchasing, production and shipping. You're all in it for the long haul. Factor 2: Define your business plan for accessing global markets. An international business plan is important in order to define your company's present status and internal goals and commitment, but it's also necessary if you plan to measure your results. Factor 3: Determine how much you can afford to invest in your international expansion efforts. Will it be based on ten percent of your domestic business profits or on a pay-as-you-can-afford process? Factor 4: Plan at least a two-year lead-time for world market penetration. It takes time and patience to build a great, enduring global enterprise, so be patient and plan for the long haul. Factor 5: Build a website and implement your international plan sensibly. Many companies offer affordable packages for building a website, but you must decide in what language you'll communicate. English is unarguably the most important language in the world, but only 28 percent of the European population can read it. That percentage is even lower in South America and Asia. Over time, it would be best to slowly build a site that communicates sensibly and effectively with the world. Factor 6: Pick a product or service to take overseas. You can't be all things to all people. Decide on something. Then stick with it. Factor 7: Conduct market research to identify your prime target markets. You want to find out where in the world your product will be in greatest demand. Market research is a powerful tool for exploring and identifying the fastest-growing, most penetrable market for your product. Factor 8: Search out the data you need to predict how your product will sell in a specific geographic location. Do you want to sell a few units to a customer in Australia

or ten 40-foot containers on a monthly basis to retailers in France? Doing your homework will enable you to find out how much you'll be able to sell over a specific period of time. Factor 9: Prepare your product for export. You should expect to adapt your product to some degree for sale outside your domestic markets before you make your first sale. Packaging plays a vital role in enabling international connections. Make yours the best in its class, and you'll be able to sell it anywhere in the world. Factor 10: Find cross-border customers. There is no business overseas for you unless you can locate customers first. Factor 11: Establish a direct or indirect method of export. It all boils down to export strategy and how much control you wish to exercise over your ventures. On the other hand, readiness to seize an opportunity is more important than having your whole strategy nailed down beforehand. Factor 12: Hire a good lawyer, a savvy banker, a knowledgeable accountant and a seasoned transport specialist, each of whom specializes in international transactions. You may feel you can't afford these professional services, but you really can't afford to do without them. Factor 13: Prepare pricing and determine your landed costs. Be ready to test out your price on your customer. See what reaction you get and then negotiate from there. Factor 14: Set up terms, conditions and other financing options. Agree on terms of payment in advance, and never, ever sell on open account to a brand new customer. No ifs, ands or buts. Just don't. Factor 15: Brush up on your documentation and export licensing procedures. If you find it too time consuming, hire a freight forwarder who can fill you in on the spot. Ask a lot of questions. Use their expertise to your advantage. Factor 16: Implement an extraordinary after-sales service plan. The relationship between your company and your overseas customer shouldn't end when a sales is made.

If anything, it should be just the start of a long relationship which requires more of your attention. The "care and feeding" of your customers will determine if they keep coming back for more. Factor 17: Make personal contact with your new targets, armed with culturespecific information and courtesies, professionalism and consistency. Your goal should be to enter a different culture, adapt to it and make it your own. Factor 18: Investigate international business travel tips. The practical aspects of international business can make or break the success of your trip. In preparing to go boldly where you've never gone before, plan accordingly. Factor 19: Explore cross-border alliances and partnerships. In charting your global strategy, consider joining forces with another company of similar size and market presence that's located in a foreign country where you're already doing business, or would like to. Gauge your readiness-or willingness-to take on a 50/50 partnership and what it can and cannot do for you. Factor 20: Enjoy the journey. Never forget that you are the most important and valuable business asset you have, and that the human touch is even more precious in our age of advanced technology. Take the best possible care of yourself, your employees, your suppliers and your customers, and your future will be bright, prosperous and happy.

Q- 2 a- Unemployment Rate is a key and most watched indicator of the economy. Therefore, it is important to understand how it is defined and determined, explain? The unemployment rate is expressed as a percentage, and is calculated as follows: Unemployment rate = Unemployed Workers Total labour force As defined by the International Labour Organization, "unemployed workers" are those who are currently not working but are willing and able to work for pay, currently available to work, and have actively searched for work. Individuals who are actively seeking job placement must make the effort to: be in contact with an employer, have job interviews, contact job placement agencies, send out resumes, submit applications, respond to advertisements, or some other means of active job searching within the prior four weeks. Simply looking at advertisements and not responding will not count as actively seeking job placement. Since not all unemployment may be "open" and counted by government agencies, official statistics on unemployment may not be accurate. The ILO describes 4 different methods to calculate the unemployment rate:

Labour Force Sample Surveys are the most preferred method of unemployment

rate calculation since they give the most comprehensive results and enables calculation of unemployment by different group categories such as race and gender. This method is the most internationally comparable.

Official Estimates are determined by a combination of information from one or

more of the other three methods. The use of this method has been declining in favor of Labour Surveys.

Social Insurance Statistics such as unemployment benefits are computed base on

the number of persons insured representing the total labour force and the number of

persons who are insured that are collecting benefits. This method has been heavily criticized due to the expiration of benefits before the person finds work.

Employment Office Statistics are the least effective being that they only include

a monthly tally of unemployed persons who enter employment offices. This method also includes unemployed who are not unemployed per the ILO definition. The primary measure of unemployment, U3, allows for comparisons between countries. Unemployment differs from country to country and across different time periods. For example, during the 1990s and 2000s, the United States had lower unemployment levels than many countries in the European Union, which had significant internal variation, with countries like the UK and Denmark outperforming Italy andFrance. However, large economic events such as the Great Depression can lead to similar unemployment rates across the globe. Calculating Unemployment

The unemployment rate is commonly considered one of the most important measures of economic health. The greater proportion of people that don't have jobs, the worse the economy is likely to be doing. The basic calculation used to find the unemployment rate is the total amount of people who are out of work but seeking employment, divided by the total amount of people in the labor force. The labor force is defined as anyone who is either currently working at a job, or actively seeking a job. People that do not have jobs (yet are not trying to get one) are not part of the labor force, and are not technically considered unemployed. Often seeking a job within the past month is used as qualification for being considered in the labor force.

Gathering Data

Calculating the unemployment rate relies heavily upon gathering data about the work force. While the calculation of unemployment in and of itself is simple, getting correct numbers for the total amount of people in the labor force--and the total amount of people looking for jobs--requires constant surveying. Every

month, the Bureau of Labor Statistics conducts a survey of households, known as the Current Population Survey, which is used as a sample for the overall population. It would be impractical to survey every household and keep track of every unemployed person each month. Sufficiently large sample groups are used to make statistically accurate approximations for the size of the labor force and those without jobs. Shortcomings of Unemployment Data

The unemployment rate is a useful calculation, but it has several shortcomings. Since a worker must be actively looking for employment to be considered in the labor force and counted as unemployed, workers that are discouraged and not actively seeking a job because there are none to be had are not counted as unemployed, even if they would want to work if ample jobs were available. There are also a large amount of workers that do not work at traditional jobs, such as contractor and freelancers who may be considered employed if they are doing work occasionally, but the amount of work they are doing may be far less than a traditionally employed worker.

b. Discuss different types of inflation and develop concept to understand consumer price index (CPI) and how it is calculated? There are four main types of inflation. The various types of inflation are briefed below. Wage Inflation: Wage inflation is also called as demand-pull or excess demand inflation. This type of inflation occurs when total demand for goods and services in an economy exceeds the supply of the same. When the supply is less, the prices of these goods and services would rise, leading to a situation called as demand-pull inflation. This type of inflation affects the market economy adversely during the wartime. Cost-push Inflation: As the name suggests, if there is increase in the cost of production of goods and services, there is likely to be a forceful increase in the prices of finished

goods and services. For instance, a rise in the wages of laborers would raise the unit costs of production and this would lead to rise in prices for the related end product. This type of inflation may or may not occur in conjunction with demand-pull inflation. Pricing Power Inflation: Pricing power inflation is more often called as administered price inflation. This type of inflation occurs when the business houses and industries decide to increase the price of their respective goods and services to increase their profit margins. A point noteworthy is pricing power inflation does not occur at the time of financial crises and economic depression, or when there is a downturn in the economy. This type of inflation is also called as oligopolistic inflation because oligopolies have the power of pricing their goods and services. Sectoral Inflation: This is the fourth major type of inflation. The sectoral inflation takes place when there is an increase in the price of the goods and services produced by a certain sector of industries. For instance, an increase in the cost of crude oil would directly affect all the other sectors, which are directly related to the oil industry. Thus, the ever-increasing price of fuel has become an important issue related to the economy all over the world. Take the example of aviation industry. When the price of oil increases, the ticket fares would also go up. Discuss different types of inflation and develop concept to understand Consumer Price Index (CPI) and how it is calculated? A consumer price index (CPI) measures changes in the price level of consumer goods and services purchased by households. The CPI is defined by the United States Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services." The CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically. Sub-indexes and sub-sub-indexes are computed for different categories and sub-categories of goods and services, being combined to produce the overall index with weights reflecting their shares in the total of

the consumer expenditures covered by the index. It is one of several price indices calculated by most national statistical agencies. The annual percentage change in a CPI is used as a measure ofinflation. A CPI can be used to index (i.e., adjust for the effect of inflation) the real value of wages, salaries, pensions, for regulating prices and for deflating monetary magnitudes to show changes in real values. In most countries, the CPI is, along with the population census and the USA National Income and Product Accounts, one of the most closely watched national economic statistics. Calculating the CPI for a single item

Where 1 is usually the comparison year and CPI1 is usually an index of 100.

Alternatively, the CPI can be performed as . The "updated cost" (i.e. the price of an item at a given year, e.g.: the price of bread in 1982) is divided by the initial year (the price of bread in 1970), then multiplied by one hundred.[2] Calculating the CPI for multiple items Example: The prices of 95,000 items from 22,000 stores, and 35,000 rental units are added together and averaged. They are weighted this way: Housing: 41.4%, Food and Beverage: 17.4%, Transport: 17.0%, Medical Care: 6.9%, Other: 6.9%, Apparel: 6.0%, Entertainment: 4.4%. Taxes (43%) are not included in CPI computation.[3]

Q3. You have been asked to work as a part of a team appointed by the government to carry out a cost benefit analysis of the building of an additional runaway at the international airport.? a. Explain the term Cost Benefit Analysis? 1. Definition Cost-benefit analysis (CBA or COBA) is a major tool employed to evaluate projects. It provides the researcher or the planner with a set of values that are useful to determine the feasibility of a project from and economic standpoint. Conceptually simple, its results are easy for decision makers to comprehend, and therefore enjoys a great deal of favor in project assessments. The end product of the procedure is a benefit/cost ratio that compares the total expected benefits to the total predicted costs. In practice CBA is quite complex, because it raises a number of assumptions about the scope of the assessment, the time-frame, as well as technical issues involved in measuring the benefits and costs. Before any meaningful analysis can be pursued, it is essential that an appropriate framework be specified. An extremely important issue is to define the spatial scope of the assessment. Transport projects tend to have negative impacts over short distances from the site, and broader benefits over wider areas. Thus extending a runway may impact severely on local residents through noise generation, and if the evaluation is based on such a narrowly defined area, the costs could easily outweigh any benefits. On the other hand defining an area that is too broad could lead to spurious benefits. The aim of the study area definition should be to include all parts of the transport network which are likely to include significant changes in flow, cost or time as a result of the project (UN 2003, 17). Because transport projects have long term effects, and because the analysis is carried out on a real term basis, the benefits and costs must be assessed using specific and predetermined parameters. For example: when is the project start date, when will it be

completed, over what period of time will the appraisal run, and what discount rate will be used to depreciate the value of the costs and benefits over the appraisal period? These and other parameters must be agreed upon. Costs and benefits are presented in nominal values, i.e. monetary values of the start year and discounted for inflation over the project period. Because most transport projects are assessed for a 30 year period employing different discount rates may influence greatly the outcomes. 2. Costs and Benefits Costs associated with the project are usually easier to define and measure than benefits. They include both investment and operating costs. Investment costs include the planning costs incurred in the design and planning, the land and property costs in acquiring the site(s) for the project, and construction costs, including materials, labor, etc. Operating costs typically involve the annual maintenance costs of the project, but may include additional operating costs incurred, as for example the costs of operating a new light rail system. Benefits are much more difficult to measure, particularly for transport projects, since they are likely to be diffuse and extensive. Safety is a benefit that needs to be assessed, and while there are complex issues involved, many CBA studies use standard measures of property savings per accident avoided, financial implications for reductions in bodily injury or deaths for accidents involving people. For example, Transport Canada uses $1.5 million in 1991 dollars for each fatality saved. One of the most important sets of benefits are efficiency gains as a result of the project. These gains might be assessed by estimating the time savings or increased capacity made possible by the project. Many other elements relating to social impacts, aesthetics, health and the environment are more difficult to assess. The latter, in particular, is a major factor in contemporary project assessment, and usually separate environmental impact analyses are required. Where possible these factors must be considered in CBA, and a variety of measures are used as surrogates for environmental benefits and costs. For example, the commercial losses of habitat destruction and property damage can be estimated. For example, the difference in

the values of properties adjacent to airports and those further away are used to assess the costs of noise. 3. Results and Biases Three separate measures are usually obtained from CBA to aid decision making:

Net Present Value (NPV): This is obtained by subtracting the discounted costs and negative effects from the discounted benefits. A negative NPV suggests that the project should be rejected because society would be worse off.

Benefit-cost ratio: This is derived by dividing the discounted costs by the discounted benefits. A value greater than 1 would indicate a useful project. Internal rate of return (IRR): The average rate of return on investment costs over the life of the project.

The first two are broadly similar, though with significant differences. A project may have a high B/C ratio but still generate a smaller NPV. The results should be subjected to a sensitivity analysis. This would include considering the robustness of the predictions of costs and benefits, and usually involves the identification of aspects that would introduce uncertainty into the predictions. If certain elements are shown to be subject to variations (inflation, higher fuel charges etc.) various scenarios would be prepared, and the cost/benefit values re-evaluated. Results in cost / benefit analyses tend to be notoriously inaccurate, as large infrastructure projects systematically have high cost overruns. An enduring bias concerns the underestimation of costs and the exaggeration of benefits, which questions the usefulness and relevance of cost / benefit analysis. A major factor behind this bias is the inherent propensity for infrastructure promoters to portray projects as highly beneficial for the costs involved in order to secure approval and funding. To make matters worst, the projects that have the most exaggerated benefits and the highest cost overruns tend to generate much lower benefits than expected. Problem that might be encountered in carrying out this analysis?

There are several objections to the use of CBA for environmental impact assessment: 1. Problems in attaching valuations to costs and benefits: Some costs are easy to value such as the running costs (e.g. staff costs) + capital costs (new equipment). Other costs are more difficult not least when a project has a significant impact on the environment. The value attached to the destruction of a habitat is to some priceless and to others worthless. Costs are also subject to change over time I.e. the construction costs of a new bridge over a river or the introduction of electronic road pricing 2. The CBA may not cover everyone affected (i.e. all third parties) inevitably with major construction projects such as a new airport or a new road, there are a huge number of potential stakeholders who stand to be affected (positively or negatively) by the decision. COBA cannot hope to include all stakeholders there is a risk that some groups might be left out of the decision process a. Future generations are they included in the analysis? b. What of non-human stakeholders? 1. Distributional consequences: Costs and benefits mean different things to different income groups - benefits to the poor are usually worth more (or are they?). Those receiving benefits and those burdened with the costs of a project may not be the same. Are the losers to be compensated? To many economists, the equity issue is as important as the efficiency argument. 2. Social welfare is not the same as individual welfare - What we want individually may not be what we want collectively. Do we attach a different value to those who feel passionately about something (for example the building of new housing on greenfield sites) contrasted with those who are more ambivalent? 3. Valuing the environment: How are we to place a value on public goods such as the environment where there is no market established for the valuation of property rights over environmental resources? How does one value nuisance and aesthetic values?

4. Valuing human life: Some measurements of benefits require the valuation of human life many people are intrinsically opposed to any attempt to do this. This objection can be partly overcome if we focus instead on the probability of a project reducing the risk of death and there are insurance markets in existence which tell us something about how much people value their health and life when they take out insurance policies. 5. Attitudes to risk e.g. a cost benefit analysis of the effects of genetically modified foods a. Precautionary Principle: Assume toxicity until proven safe 1. If in doubt, then regulate b. Free Market Principle: Assume it is safe until a hazard is identified 1. If in doubt, do not regulate. Despite these problems, most economists argue that CBA is better than other ways of including the environment in project appraisal.

Q5. Critically write about the present economic situation of Pakistan and how do you see the future of Pakistan? A careful analysis of Pakistans current economic conditions reveals a mixed situation. Led by strong export earnings and robust growth in remittances, the external current account position has surpassed all earlier projections. This has helped the SBP in building foreign exchange reserves and accumulating Net Foreign Assets (NFA), which contributed in keeping the foreign exchange market stable and provided rupee liquidity in the system. However, key challenges remain in the shape of persistent inflation, weak economic growth and private investment, and a large budget deficit. In such circumstances, SBP is endeavouring to strike a delicate balance to address the multiplicity of considerations in formulating the monetary policy stance such as containing inflation, promoting private productive economic activity, and keeping financial markets stable. The remarkable improvement in the external current account, a surplus of $748 million during July-April, FY11, has been a major positive development. Given the turmoil in global economic conditions, especially in the export-destination and remittance-generating economies, there were expectations of an external current account deficit. However, a spectacular rise in international cotton prices has boosted exports, which are expected to exceed $25 billion in FY11. This together with consistently rising flow of remittances helped neutralize import and other payments. More importantly, despite falling financial account inflows, $0.5 billion during July-April, FY11 compared to $3.7 billion in the corresponding period of last year, SBPs foreign exchange reserves have increased to $13.7 billion by 18th May 2011 and are expected to increase further by end-June 2011. Nevertheless, caution needs to be exercised while assessing the outlook of the overall balance of payment position. The main reasons for this prudence include the sharp

decline in international cotton prices in the last two months, likely continuation of oil prices at around $100 per barrel, and debt obligations that are due in FY12. Barring any unforeseen developments, these factors together with the continued suspension of IMFs Stand-By Arrangement (SBA), which has implications for other financial inflows, imply that the stellar performance of the external account may be difficult to sustain. Therefore, maintaining the current upward trajectory of SBPs foreign exchange reserves would be a challenging task. The repercussions of uncertain foreign inflows may not be limited to the external sector. Deviations in the baseline estimates could affect the net external budgetary financing as well as the monetary projections. A similar scenario did play out in this fiscal year with implications for monetary management. For instance, government borrowings from the banking system have increased significantly, partly due to the shortfall in external financing and partly due to the increase in the fiscal deficit on account of security spending, the impact of unprecedented floods and the recent one-off adjustment of Rs120 billion to address the issue of old stock of the circular debt of the power sector. During 1st July 7th May, FY11 incremental government borrowing from the banking system, including SBP, for budgetary support was Rs614 billion; a year-onyear growth of 28.3 percent. The borrowings from SBP explain almost 80 percent of the expansion in reserve money while total banking system budgetary borrowings explain 95 percent of the expansion in M2. Demonstrating its commitment the government retired its borrowings from the SBP in Q3-FY11 and by end-March 2011 the stock of these borrowings (on cash basis) had come down to Rs1155 billion. The recent increase in these borrowings is temporary and a reflection of the governments efforts to internalize the growing quasi-fiscal expense related to the circular debt of the energy sector. The SBP has already shifted a portion of this borrowing, Rs61 billion, to the market through an outright Open Market Operation (OMO) and expects that government borrowing will soon converge to the endSeptember 2010 level, Rs1290 billion, as committed by the government. The year-on-year growth in both reserve money and M2 remains close to 15.5

percent and may increase further by the end of FY11, which would be higher than SBPs earlier projections. The magnitude of such borrowings poses a challenge for effective liquidity management with implications for inflation in FY12. Though the CPI inflation of 13 percent in April 2011 is lower than the flood-induced peak of 15.7 percent in September 2010, its persistence is a source of concern. The 12-month moving average of 20-percent trimmed measure of core inflation has continued to move between 11.5 and 12.5 percent in the last one year. Nonetheless, the average CPI inflation for FY11 is likely to remain between 14 and 14.5 percent, which is lower than SBPs earlier projections. Another consequence of governments growing borrowing needs, both current and expected, is that the private sector credit has been squeezed out in terms of banks allocation of systems deposits. By 7th May 2011, the year-on-year growth in private sector credit, which was mostly due to working capital needs, was 3.2 percent and that of total deposits was 15.3 percent. The basic intermediation function of scheduled banks is being constrained as the fiscal deficit and the commodity operations of the government are financed by deposits at the cost of declining private sector investment. The recently released provisional National Income Accounts reveal that real private investment expenditure registered a decline of 3.1 percent while real private consumption growth was 7 percent, leading to a growth of 5.9 percent in total domestic demand. These developments highlight a predicament faced by the economy. The rising total debt, Rs11.2 trillion by end-March 2011, and its servicing is demanding an increasing portion of fiscal revenues. At the same time, the GDP growth rate of below 4 percent over the past four years appears to be highly correlated with declining real private investment expenditures and driven by consumption demand. This coupled with severe energy shortages is negatively affecting the utilization and expansion of the economys productive capacity. This implies that the output gap the difference between aggregate domestic demand and the supply is perhaps widening again, making it difficult to bring inflation down. Thus, along with rising debt the economy seems to have settled at a lowgrowth-high inflation equilibrium.

The solution to these outcomes rests with wide-ranging fiscal reforms that restore the economy back towards the requirements of the Fiscal Responsibility and Debt Limitation Act (2005). In particular, there is an urgent need to address the issue of the falling and single-digit tax to GDP ratio. The Federal Board of Revenues (FBR) tax collection was Rs1156 billion during July-April, FY11 and it is confident that it will realize additional revenues from the measures announced in March 2011. Plans to consolidate them are being considered along with the announcement of new measures in the forthcoming budget. However, because of the recent adjustment of old dues reflected in the stock of the circular debt of the power sector, the fiscal deficit for FY11 is likely to increase by approximately 0.7 percent of GDP over the revised deficit target of 5.5 percent. The final outcome will depend upon the realization of the targets of FBR revenues and provincial surpluses. For a sustainable fiscal path revenue-enhancing measures need to be complemented with renewed efforts to stem the leakages in the tax system, bring a wider range of incomes in the tax net, and effective expenditure control measures, especially the removal of untargeted and distortionary subsidies. These initiatives will be critical for reducing the stress on the fiscal position and to encourage entrepreneurship in the economy. In conclusion, for the economy to grow on sustainable basis, the debt burden to become manageable and inflation to come down to single digits, the private productive activity and investment will have to increase considerably and quickly. This will require government borrowings from the banking system to subside to create space for private sector credit, which in turn would need satisfactory implementation of the aforementioned fiscal reforms. The government is mindful of fiscal pressures and has expressed its resolve to address these issues, especially the containment of the fiscal deficit. The budget for FY12 is expected to reflect this commitment. In this context and after incorporating the improved external position SBP has decided to keep the policy rate unchanged at 14 percent for another two months. Source: State bank of Pakistan, Monetary Policy Decision 21st May 2011

How do you see the future of Pakistan? Pakistans past economic history suggests that rapid economic growth has been associated with poverty reduction. Once GDP growth rate persists over 6 percent per annum over a long period of time the incidence of poverty begins to decline. GDP growth rate is projected to rise to 7 percent in the current fiscal year with inflation rate hovering around 7 percent. The next five years plan envisages an average GDP growth of 7 percent reaching a level of 8 percent in 2010 and inflation contained to average 5 percent. With the population growth rate declining to 1.5 percent, this growth rate will translate into 6.5 percent rise in per capita incomes which should double at this rate in the next 10 to 11 years. Empirical studies indicate that the best way to achieve higher rates of economic growth is to raise investment and to improve the quality of institutions. An increase in investment ratio by 5-6 percentage points over the next 5 years and improving the quality of institutions could result in the postulated increase in the per capita growth. What are the prospects for raising investment? The successful implementation of Debt Management Strategy in the last five years has not only brought the debt burden down to sustainable levels in the future, but also reduced interest payment out of the budget significantly. The public sector investment programme that was constrained due to these high interest payments is now expanding. As a result, development expenditure will continue to rise both in absolute terms and as a ratio of GDP pushing up the overall investment rate for Pakistan. As the private sector is able to obtain the infrastructure services and the social services it needs, the cost of production will become lower for capacity expansion or investment in new areas of business. The recent experience suggests that investment rate will rise and productivity of investment will improve, making it possible to attain 6 to 7 percent GDP growth rates. Pakistan has committed itself to bringing the incidence of poverty down to 16 percent by

2015 under the Millennium Development Goals (MDGs). Other MDGs for Pakistan are: (i) Literacy rate of 86 percent and Gross enrolment ratio of 100 percent; (ii) Ratio of literate females to males reaching 0.93; (iii) Infant mortality rate down to 40 with under five mentality to 52 and more than 90 percent of children fully immunized (iv) 100 percent coverage by lady health workers of target population (v) Sustainable access to safe water available to 93 percent of population with 55 percent having access to sanitation. These goals have been incorporated in the Poverty Reduction Strategy Paper (PRSP) as well form part of the next five year plan. The achievement of per capita growth targets and Millennium development goals will very much depend upon political stability, sound leadership committed to growth and poverty reduction and to the extent the challenges facing us are tackled successfully by the government, private sector and the civil society together. These challenges though formidable are by no means insurmountable. Challenges for the Future: Despite the impressive studies made on several fronts in the recent past Pakistan has a number of challenges to reduce incidence of poverty to half its current level by 2015. This will require sustained GDP growth rates of 7 to 8 percent per annum, targeted poverty interventions and accelerated investment in human development. Some of these challenges are listed below: 1. Diversification of Export Base: Two thirds of Pakistani exports are based on Cotton textiles while in the world market textiles are not a dynamic commodity. Technological base of Pakistani exports is low and the share of engineering goods is almost negligible. Not only the share of engineering goods in the world market is almost 50 percent but is rate of growth is above average. Thus the need for diversifying away from textiles to medium technology exports is quite obvious. diversification. Greater emphases on technical and vocational education as well as integration into world supply chains are critical for this Reliance on a single commodity based exports is neither desirable nor beneficial in the long run and is prone to serious risks.

2. Development of Human Resources:

It has been well established and there is a

broad consensus that among all the factors that will make a difference to Pakistans economic and social goals is the extent to which we are able to step up investment in human development. Indeed this is the single most dominating factor that has kept the country below its potential. High population growth has given rise to a young dependent population and increased unemployment among the youth. The average years of schooling of labor force (3 years) remains quite low making it difficult to impart new skills to the burgeoning labour force. Raising this by 1 - 2 years could have raised real per capita economic growth rate by about percentage points per year. Investment in higher education, science and research, vocational and technical education, female education thus should be the highest priority for the next ten years. This can only be achieved if there is a strong public private community partnership in the governance and provisioning of education and health. Investing in human development through better education and health care benefits the poor directly but these should be well targeted. 3. Investment in infrastructure: Higher economic growth rates can be sustained on a long term time horizon only if the bottlenecks, shortages, disruptions and breakdown in supplies, in power, gas, oil pipelines, ports, railways, and congestion in roads and highways are removed. This requires huge investment in each of these areas. Public Sector development program can finance only one half of the annual requirements of US $ 3 billion. The remaining requirements will have to be filled in by the private sector. 4. Regional Hub: Another reason for large investment in physical infrastructure is to exploit the potential of Pakistans strategic location as a regional hub for the Middle East, Central Asia and Western China and South Asia. Gwadar port is being developed to take advantage of this potential but developing a network of highways, warehouses and terminals, oil and gas pipelines, power generation plants, facilitation of cross border trade, harmonization of tariffs and duties are some of the ingredients that will pave the way for meeting this objective. Peaceful relations with the neighboring countries and greater cooperation in areas of trade and transit will lay the solid foundations.

5. Productivity Increase in Agriculture and Industry:

Compared to the countries in

East Asia and China that should serve as the benchmark for Pakistans competitiveness we lag behind in total factor productivity as well as productivity gains in commodity producing sectors. Although the yields per hectare of major crops have raised over time these are still lower than those in Indian Punjab and Haryana. Except for export industries the productivity levels in manufacturing are sub optimal. On-the-job training and injection of new skilled workers are some of the short term measures that can help but in the long term, emphasis on technical and vocational education rather then producing graduates with generalized education will yield the desired results. 6. Judicial and Legal Reforms: It is believed that the financial sector and real sector of the economy will benefit immensely if land titles were clear, coded, actively traded, mortgaged and exchanged without much hassle; if the court system is unclogged and the enforcement of contracts is much quicker with low transaction costs and if the poor have equal access to the Police and the judiciary for redressing wrongs done to them. In Pakistan, the slow and cumbersome legal system combined with unequal access to the poor to the system have to be put right both for efficiency gains as well as for attaining a just and equitable distribution. 7. Widening the Tax Base: The tax administration that has been practiced in Pakistan has deployed indirect means, presumptive assessment and compulsory withholding taxes to collect most of the taxes. This system has not only kept the tax GDP ratio stagnant but also restricted the growth of tax base and tax payers. The recent reforms of the Central Board of Revenue give some hope that tax base will be widened so that tax GDP ratio can rise and a more equitable incidence of burden takes place. A natural corollary of this widening of tax base is that the tax rates particularly for individual income tax and corporate tax can be reduced gradually and thus discourage the incentives to evade taxes. Tax collection in Pakistan has been much higher when the rates are low supporting the supply side hypothesis. Risks to the Future Outlook

Several observers of Pakistan economy appear to be overly obsessed with the political risk arguing that the country may end up with a situation in which the Islamic extremist parties or their sympathizers in the Army wrest control over the countrys nuclear arms. The victory of the MMA in the NWFP and Balochistan and their apparent anti-American stance have fortified the beliefs of these observers mostly in the western think tanks and the media. Both the main components of the Alliance Jamaat-e-Islami and Jamiat Ulema Islam have no history or links with religious extremist groups who have created violence in the country. This risk is also highly exaggerated as more than 88 percent of Pakistani population voted for the mainstream moderate political parties at the most recent elections. Pakistan Army is a highly disciplined, organized and modern force and the support for the extremist parties in the ranks of Army is almost non-existent. These western observers have very little familiarity with the strength and resilience of Pakistans polity. Pakistans nuclear assets will remain safe as country has developed an effective command and control system. The geopolitical risks facing Pakistan have also been mitigated as a composite dialogue has been opened with India and the relations with the Karzai government in Afghanistan have been normalized and strengthened. The first democratic elections in Afghanistan took place peacefully reflecting the cooperation and support of Pakistan government. The intensity in exchange of people, cultural troupes, sporting teams, media representatives between India and Pakistan has brought about a new atmosphere of harmony and goodwill in the two countries. Although the political and geopolitical risks remain paramount in the minds of the western observes there are residual risks that can possibly slow down the trajectory of high economic growth and poverty reduction. First, it is assumed above that the country will continue to face a benign external environment and will remain free from major upheavals and unanticipated exogenous shocks. In case the external environment becomes hostile or some other major internal disturbance takes place, it is unlikely that the high growth momentum can be maintained. Second, the implementation capacity and weakness of institutions are still major obstacles. The need to inculcate professionalism, expertise, competence and systems to make the civil services meet the realities of the 21st century is being met through reforms but will take some time. In the meanwhile, the nature of the government has dramatically changed; public expectations have heightened while

implementation capacity of government policies, programs and projects as well as the delivery of public services has been seriously impaired. Sound policies can see the light of day only if the institutional capacity is strengthened and reoriented. Public-privatecommunity partnership provides a way forward to mitigate this risk. The reform of civil service is on the agenda but needs to be expedited. Third, the legal and judicial system is out-of-sync with the requirements of modern business practices. Contract enforcement, sanctity of property rights and dispute resolution mechanisms leave much to be desired. Congestion of courts, cumbersome and time-consuming procedures, inadequate training of judges in commercial and banking laws and physical infrastructure facilities are some of the constraints for the present state of affairs. Reforms of laws and judiciary have to be given priority attention by political leaders. The Asian Development Bank (ADB) is assisting the government through its Access to Justice programme. Fourth, the most important missing link in Pakistans competitive edge and what is posing as a serious threat to its economic progress are the poor indicators of human development. Adult literacy and the skill level of the labour force are low, health status is precarious with low productivity, high absenteeism and gender disparities are large. The country has to devote more attention and resources to invest in education, health, nutrition and gender programmes to equip the labour force to excel in its area of specialization. Finally, Pakistan has embarked on a program to devolve administrative functional and financial powers to local tiers of government. This experiment is extremely critical for providing essential public services at the doorsteps of the poor people. The teething problems and legal snags confronting the local governments if unresolved, could create a potential difficulty in reaching out to the poor. These risks, except those arising out of adverse or unanticipated exogenous shocks, can be mitigated through a series of reforms. Institutional capacity can be strengthened, judicial and legal processes can be revamped, human development can be accelerated and devolution of powers can be expedited. The balance of risks therefore suggests that given a benign global economy and domestic political stability, Pakistan can move forward in its march towards meeting its economic and social goals.