Economic decisions ahead of general election

A lot has been said and written about the state of the economy in the last few years. Independent economists and domestic and international professional organisations like the State Bank of Pakistan (SBP), the International Monetary Fund (IMF), the World Bank (IBRD) and the Asian Development Bank (ADB) have warned the present government of the dangers ahead if the direction of economic policies is not changed.
But there appears to be no realisation on the part of the economic team and the political leadership of the gravity of the economic situation or their insensitivity reflects different priorities and agenda that have not much to do with national interests.
It appears that the present government would like to get through the elections without any difficult economic policy decisions. Given the track record of the present government, it is easy to predict as to what will happen in the next 12-15 months. The government is not likely to take any fundamental policy decisions to arrest the underlying deterioration of the economy. If anything, its election year actions will intensify the fundamental economic problems. The most likely approach of the government will be to indulge in extravagance in expenditure and hiring of more people in the public sector without any resource mobilisation effort. The public sector expenditure will balloon for a number of reasons.
First, debt servicing will rise faster than tax revenue and consume a larger share of revenue. Second, there may be a temptation to increase public sector salaries and hire more people in the public sector on political considerations. Third, the government being in an election mold will spend more on subsidies and on programmes like Benazir Income Support Programme.
Fourth, the public sector enterprises will remain unstructured and their rising losses will be taken over by the government at different points in time either directly or indirectly through their loan guarantees. Fifth, in order to ensure fuller utilisation of installed electricity generation capacity, and minimise loadshedding in an election period, the government will want to make sure that the private power companies get paid regularly. Accordingly, the deficit in the electricity sector taking the shape of floating debt will be absorbed in government guaranteed bank loans or issuance of special treasury bills.
Sixth, provinces will end up with deficits in their budgets even with larger share in revenue which will be met by their borrowing from the banking system or delay in payments to the private sector. At the same time, the federal government will not lower its expenditure on activities that have been transferred to the provinces under the 18th Amendment. Seventh, the government will not give up its wasteful spending habits and may in fact expand such expenditures in an election period. All these factors will sharply increase the public sector requirements for borrowing. Unfortunately, it will happen in a period of declining external budgetary support.
With foreign budgetary support on the decline, the only source of financing of rising public sector expenditure will be borrowing from the State Bank of Pakistan (SBP) and from commercial banks. Accordingly, in the next 12-15 months government borrowing from the banking sector would increase enormously. Additionally, the government may indulge in expensive external borrowing from the private market. What it will do to the economy in the long run would not seem to be much of a concern to the present government.
In the absence of any prospects for the adoption of a sound budget management approach, it may be worthwhile to enlist the areas of vulnerabilities in the economy in the order of their gravity that the next government will need to address on a war footing, anchored on a mutually consistent strong macroeconomic framework.
---- The most vulnerable sector is the balance of payment over which the government has no control. At present, imports are rising faster than exports and the country is incurring an annual deficit in the trade account of the order of $10-11 billion. Home remittances finance about one half of the trade deficit as the remaining amount is used up in financing external interest payments and profit remittances by foreign-owned businesses. A net annual inflow of about $5 billion in the capital account, representing mainly borrowing, is needed to balance the external accounts without loss of reserves. Recently, there has been a sharp decline in the net capital account inflows and the unfilled current account gap is now depleting the foreign exchange reserves of the country. If these trends continue and there is no bail out by foreign creditors, foreign exchange reserves of the SBP will fall to the range of $9-10 billion by the beginning of the next fiscal year and to $2-4 billion by the end of FY2012/13.(The so-called "reserves" held by commercial banks are in fact foreign currency deposits to be paid on demand by banks and therefore are of no relevance for the financing of the balance of payments deficit.)
---- When the SBP reserves reach the level below $9-10 billion, it will trigger a panic in the market. If the SBP begins to defend the depreciating exchange rate, it will begin to lose reserves at a fast pace and face the threat of external debt default and trade disruption earlier than expected. If it lets the exchange rate take the hit, rupee-dollar parity may tend towards the $1=Rs 100 landmark by the end of FY2012/13.
---- When reserves reach the range of $2-3 billion, the country will either have to enter into another standby arrangement with the IMF or face the threat of an external debt default. Both will carry a high price tag with it in terms of economic hardship and difficult economic policy decisions.
---- By the time the new government takes office, the external payment situation will be characterised by depreciating exchange rate, declining reserves, large repayment obligations to the IMF and other external creditors and a potential of an external debt default. The government will be in an unenviable situation confronted with difficult economic policy decisions that may collide with their election campaign promises.
---- The second trigger point is the rate of inflation and the associated inflationary expectations. The country is in the grip of demand-pull inflation. During the last four years, money supply has increased at about six times the rate of growth of the economy. Government borrowing for commodity operations, budgetary support and meeting the deficit of loss making public sector enterprises will go up sharply in the remainder of FY2011/12 and FY2012/13 inflating the economy at an accelerating rate. A part of it will find its way in the depreciation of the exchange rate and in the depletion of foreign exchange reserves of the SBP. But a large part of it will put pressure on domestic prices which will steadily rise to levels not experienced before. Rising electricity, gas and oil product prices and depreciating exchange rate will give further boost to demand-pull inflation. The rising level of prices will test the limit of patience of the people and may trigger unrest that may have severe social and political implications. The consequences of economic mismanagement of the previous five years will have to be faced by the new government.
---- The investment level will remain depressed. There will be virtually no inflow of direct foreign investment and the domestic private sector will be reluctant to make any new investment in an environment of political uncertainty, deteriorating law and order situation, shortages of inputs and electricity and gas. The domestic saving rate will remain low and nominal interest rates high leading to continuation of a low rate of economic growth.
---- Low growth, high inflation and rising population will add to the level of unemployment and economic disparity. The islands of prosperity seen in an ocean of poverty will become socially less tolerable and a class war is a real possibility in a situation of despair. Increasing poverty will fuel inter-provincial discord and threaten national unity. The country will become increasingly more ungovernable and economic, social and political situation more chaotic. The frustrated majority of the population, which is in slumber at present, may wake up to shake the foundations of the government and indeed of the country.
The only viable option for the new government will be to be truthful to the people, to lay bare the economic realities, and work out its long term plan of policy reforms with the promise that its implementation will show some light at the end of the tunnel in a time span of 3-4 years. Empty promises or quick fixes will only accentuate the already difficult underlying situation. Whichever political party expects to win the elections and form the next government should begin to seriously review its options and likely solutions to arrest the deteriorating economic situation.
(The writer is former Governor State Bank of Pakistan)