Cover Story 
 

Cover Story

Banking on the IMF

The 7th NFC Award and the subsequent 18th Constitutional Amendment in 2010 resulted in a significant fiscal and administrative decentralization which left the resulting fiscal federal structure unbalanced and posed macroeconomic and political challenges.

By DR. MOHAMMAD ZUBAIR KHAN | April 2023


Pakistan stands on the brink of default with inflation at a record 40%, growing unemployment, the exchange rate in an unending slide as exports decline by nearly 20% and industry and businesses are shutting down. Macroeconomic imbalances have destabilised the economy, aggravating the existing sufferings of its people due to unaddressed long term developmental issues. While the country’s economic woes are rooted in its own inept policies, the government remains engaged with the IMF continuing to pursue the same policies that failed to rein in the economic meltdown, and possibly contributed to it. A fresh approach to address the economic crisis is hampered amid a democratic transition of government stalled by political polarization, institutional disorder and constitutional standoff.

Pakistan is not destined to suffer such economic conditions. “In the first 20 years after independence in 1947, Pakistan had the highest growth rate in South Asia. In 1965 it exported more manufactures than Indonesia, Malaysia, Philippines, Thailand, and Turkey combined. It would have made anyone’s list of the Asian countries most likely to enjoy miracle level growth rates over the ensuing decades. This did not happen” says the World Bank Development Policy Review of 2002.

Pakistan’s exports failed to provide the sustained contribution to the country’s GDP growth and to finance the import needs of a growing economy exposing the country to greater risk of balance of payments vulnerability fuelled by chronic fiscal deficits. In the following decades Pakistan could not achieve the world market share gains made by its comparator economies largely because of import substitution policies the country adopted throughout the period and the inadequate responses to changes in market trends and global trading rules. While adoption of import substitution policies was not unusual in the 60s but as other countries shunned “inward looking policies” early, Pakistan continues import substitution policies even today, with a strong anti-export bias.

Economic development in Pakistan suffered as a result of several policy mistakes and wrong priorities but growth was most often disrupted by short-term macroeconomic mismanagement. Throughout the development experience of the country, chronic fiscal deficits fed into mounting debt and rising interest payments, contributing to excessive domestic demand spilling over into external imbalances and loss of reserves.

With a weak performance of exports, Pakistan experienced persistent balance of payments crises as a result. The foreign exchange crisis Pakistan faces today is also linked to fiscal imbalances as this support domestic demand and import growth, but importantly for Pakistan, external pressures are also linked to the poor performance of exports and the surge in imports due to the loss of competitiveness of the economy.

Competitiveness is no longer about exports’ competitiveness in isolation; increasingly, it is recognized that measures to strengthen competitiveness should be economy-wide to support exports and the domestic businesses because of strong interdependencies between the domestic economy and exports and to encourage exports diversification. Policies have overlooked that businesses create jobs and wealth, not governments. Financing of persistent and rising budget deficits by borrowing from the banks have crowded out the private sector in Pakistan, while government efforts to address fiscal imbalances with rising taxes on businesses, over-valuation of the currency and placing the burden of energy sector inefficiencies on businesses resulted in loss of competitiveness of both exports and domestic sectors.

Since the 1990s there have been fundamental changes in global trading rules and market trends with important implications for the competitiveness of countries which have not received adequate policy attention in Pakistan. Apart from “border” issues like the exchange rate, taxes on inputs and trade facilitation, the ability to deliver on time and conformance with international standards have become sources of comparative advantage which require a range of “behind the border” policy and infrastructure support.


Consequently economic performance of Pakistan has been episodic; periods of high growth (when GDP grew by over 5% for three years or more) were interspersed with low growth periods, each the outcome of a range of factors from policy changes to internal and external shocks. The most recent high growth period was 2003-2008 when the growth rate averaged 6.2% per annum. But subsequently the economy experienced the longest low growth period continuing till now during which the growth rate averaged around 3% and sporadic recovery in particular years remained fragile.

Fiscal deficits which are at the root of Pakistan’s macroeconomic problems have been aggravated in recent years by a number of policy decisions and fiscal federal resource distribution. Most significantly, the 7th NFC Award and the subsequent 18th Constitutional Amendment in 2010 resulted in a significant fiscal and administrative decentralization which left the resulting fiscal federal structure unbalanced and posed macroeconomic and political challenges. The 7th NFC Award transferred an unprecedentedly large share of the divisible pool 57.9% and other resources to the provinces from the federation without the re-assignment of additional expenditure responsibilities to the provinces. This contributed to substantial vertical fiscal asymmetry creating a significant structural deficit at the federal level with serious macroeconomic effects. Apart from the larger share in the divisible pool, the provinces now have exclusive tax jurisdiction over agriculture and services which account for 80 percent of Pakistan’s GDP. With most of tax revenues going to the provinces, federal efforts to raise revenue for the federal budget needed to be substantially larger. This has resulted in an increase of tax burden on existing taxpayers and businesses with adverse consequences for tax compliance and loss of competitiveness contributing to the severe balance of payments crisis.

The 7th NFC does not address the issue of sharing the burden of financing joint responsibilities which remain with the federation, in particular public debt service of loans used for national projects. The dominance of fiscal revenue consideration in tax policy measures was evident at the cost of competitiveness of exports and the domestic economy. Fiscal problems also reflected continued loss-making in Public Sector Enterprises (PSEs).

The second most significant drain on fiscal resources contributing to fiscal deficits and the ensuing macroeconomic imbalances and foreign exchange crises has been the interest rate policy of the State Bank of Pakistan (SBP) mostly driven by the dictates of the IMF. The IMF’s dogmatic reliance on higher interest rates to contain inflation and attracting capital inflows to build reserves has proved unsuccessful because private sector spending in Pakistan unlike more developed economies is not driven by credit, while short term inflows are unstable for Pakistan with long term external liabilities. In addition to that, high interest rates have crippled industry and increased the burden on the budget claiming Rs. 5.2 trillion, over 60% of all tax revenues.

While globally, post 2008 financial crisis, countries have pursued financial repression keeping interest rates low in response to accumulation of debt, the IMF has prescribed ever increasing interest rates in Pakistan, rising from 11% to 20% over three years, further contributing to increase public debt to over 80% of GDP. Despite high interest rates, inflation has steadily risen, raising the cost of doing business, and dampened investment and exports.

The IMF prescription to protect interest incomes of banks and creditors from the erosion of inflation has rewarded the rich while failing to protect the poor from the burden of inflation. The most recent increase in interest rates of 300 basis points to 20% has drained Rs600 billion from budgetary resources that the Fund prescribes to be offset by an increase in sales tax, a burden borne by the poor.

But most significantly, Pakistan’s economic crisis has been aggravated by the design of the IMF’s stabilisation programmes. As Pakistan experienced persistent foreign exchange crises, the country sought IMF supported stabilisation programmes. Each time the IMF programmes built reserves with borrowed funds, paying previous debts with new loans, arranging financing for foreign exchange shortfalls from various sources. Programmes were approved if creditors could be repaid, not necessarily if Pakistan would be able to stand on its feet.

But inevitably crises re-emerged soon after programmes ended because the fundamental issue of increasing foreign exchange earnings for its import needs remained unaddressed or aggravated. The programmes failed to recognize that competitiveness is more than the real effective exchange rate in the post-WTO trading world.

Furthermore, in its narrow focus on reducing fiscal imbalances through revenue measures of every kind, fund programmes paid little heed to the impact of tax measures on investment, resource allocation, economic activity, export promotion and income distribution. As a result, exports remained stagnant, investment rates low and SMEs collapsed in recent years with rampant unemployment. Increasing allocations for income support programmes are neither sustainable nor a substitute for policies to support robust growth of SMEs and agriculture.

The government and the opposition have no clue or plan to pull Pakistan out of the economic quagmire but are entangled in a deadly power struggle. To avoid an imminent economic catastrophe it is imperative that the political parties adhere to the Constitution and the rule of law. All sides are looking to the IMF and bilateral creditors to lend more to the heavily indebted country as a way out, but it is obvious the approach is flawed.

Even if Pakistan reaches agreement with the IMF to avoid an imminent default before June 2023 the economic crisis would have been postponed, not overcome. Looking ahead Pakistan will need another IMF programme in July but it must be a stronger home-grown adjustment programme or restructure its debt.

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