State of the economy

The first six months of 2022-23 have witnessed considerable uncertainty about country’s economic prospects. Foreign exchange reserves have dwindled sharply from $9.8 billion in end-June 2022 to only $5.6 billion by end-December 2022.

The large negative impact of the 2022 floods with continued higher international commodity prices, devaluation of the rupee and physical restrictions on imports have ushered in a period of high stagflation. The inflation rate has risen to historical peak levels, especially of food prices, and there has been negative growth of the GDP.

The objective of this article is to highlight the trends observed in sectoral growth, investment, inflation, public finances, balance of payments in the first half of 2022-23.

The impact of the floods on output of the agricultural sector has been very large. The kharif crops have been badly affected. The largest decline is likely to be of cotton, with arrivals falling by 40% and rice by over 15%. Minor crops, especially vegetables, are also in short supply. This is demonstrated by the fourfold increase in the price of onion. Overall, the loss of output in the Kharif season is likely to be of the order of almost 10%.

The large-scale manufacturing sector is also experiencing a decline in output. The latest data on the Quantum Index of Manufacturing (QIM) is for November 2022. The QIM fell by 3.5% over the five-month period, July to November, and by 5.5% in November.

A number of major industries have contracted, including cotton yarn, cotton cloth, petroleum products, chemicals, fertilizers, pharmaceuticals, cement and iron and steel products, with declines ranging from 2 to 25%. A major factor contributing to the fall in many of these industries is the shortage of imported intermediate inputs and raw materials due to the controls imposed on the LCs for import.

Other indicators of a fall in the GDP are the decline in petroleum products consumption in the transport sector according to the OCAC of 20% and lower power generation by 5%. The banking sector is seeing a decline in deposits of over 8%. The fall in output of the cement and iron and steel industries clearly highlights the stagnation in construction activities. Overall, the GDP growth rate in the first six months of 2022-23 is likely to have been in the range of negative 4 to 5 percent. This has seldom been the case.

The loss of growth momentum coupled with the escalation in the policy rate of the SBP from 13.75% in May 2022 to 16% in November 2022 have inevitably impacted on the level of private investment. There has been only a modest growth of 4% in bank credit to the private sector. Imports of machinery have tumbled by as much as 45%, including a drop in textile machinery of 44%. This will inevitably restrict the potential future growth in textile exports.

Investment by the public sector is showing somewhat mixed trends. The level of federal development spending was down by almost 48%, while the development expenditure by provincial governments has remained unchanged in the first quarter of 2022-23. Overall, the investment-to-GDP ratio of Pakistan which had shown a big jump in 2021-22, is likely to fall sharply in 2022-23.

Turning to the rate of inflation, Pakistan is experiencing currently one of its highest ever rates of inflation of 25%, in the first six months of 2022-23, as compared to under 10% in the corresponding period of 2021-22. A number of factors have contributed to this including significantly higher international commodity prices, devaluation of the rupee by 32% and big supply shortages that have emerged after the floods and the physical restrictions placed on imports.

One of the most worrying developments is the big upsurge in food prices. The food price index has gone up by 31% in the urban areas and by 34% in the rural areas in the first six months of 2022-23.

A glaring example of the extreme impact of the supply shortage is the over fourfold increase in the price of onion. Similarly, the price of the staple food, wheat flour, is up by over 40%, while the price of imported items like tea and vegetable ghee have increased by 63% and 31%, respectively.

Turning to the position regarding the balance of payments and the public finances, there has been a deterioration on both fronts. The overall position of the external balance of payments from July to December 2022 is a deficit of $4.3 billion. This has happened even after a big reduction in the size of the current account deficit to $3.7 billion from $9.1 billion in the corresponding period of 2021-22.

The improvement in the current account deficit position has been neutralized by a severe worsening of the financial account. It has gone into a deficit of $1.2 billion as compared to a big surplus of $10.1 billion from July to December 2021-22. In fact, the financial account has turned negative for the first time in many years.

The primary reasons for this unprecedented happening are, first, that the disbursement of loans to government has fallen short of the amortization payments on external debt. This is the root cause of the fundamental deterioration in the financial position of Pakistan and the hemorrhaging of foreign exchange reserves. Second, foreign investment, both direct and portfolio, has plummeted to negative levels.

There is need also to understand the reasons for the almost 60% reduction in the size of the current account deficit. This is primarily due to a big fall in imports, of 6% in the first quarter and almost 30% in the second quarter. The latter is clearly due to the administrative control exercised by the SBP on import LCs.

The contradiction is that from October onwards an overvalued rupee was maintained which increased the demand for imports while this demand was physically suppressed by the SBP through control over the LCs. Presumably, the target was to control the rate of inflation but what was perhaps not realized was that supply shortages due to containment of imports by almost $4.5 billion will also lead to more inflation.

The SBP has also restricted the payments for imported services like information technology, airlines, and banking. Profit repatriation by MNCs (multinational corporations) operating in Pakistan has also been reduced. Further, the large gap between the inter-bank exchange rate and the black-market rate of the rupee has led to an estimated diversion of remittances and exports of almost $1.5 billion to the hundi market.

The position of federal and provincial finances has also worsened in the first half of 2022-23. This is despite the ambitious target of budget deficit reduction from 7.9% of the GDP in 2021-22 to only 4.9% of the GDP during the current financial year. First estimates are that the consolidated budget deficit has actually risen to 2.4% of the GDP, from 2.0% of the GDP last year, in the first six months of 2022-23. This renders impossible the achievement of the target for the full year.

There are a number of reasons for the worsening of the state of public finances. First, this is due to the additional expenditures for relief and rehabilitation after the floods of over Rs 500 billion. Second, the growth rate in FBR revenues is 13%, in the face of target rate of 22%, due primarily to the contraction of the import tax base and negative growth in the large-scale manufacturing sector.

Third, the policy rate has been pushed up by the SBP leading to an escalation in the domestic borrowing cost of the federal government. Now with the recent further escalation of the policy rate to 17%, there is the likelihood that the cost of debt servicing may be as much as Rs 1 trillion higher. Some of this cost may be compensated for by a big cut in the size of the federal PSDP. The final risk factor is that the provincial governments may miss by a big margin the targeted cash surplus of Rs 750 billion.

Overall, it will not be surprising, given current trends, to see in 2022-23 a consolidated budget deficit of close to 6.5% of the GDP, higher by more than 1.5% of the GDP in relation to the target deficit.

The economic outcome in the first six months of 2022-23 is very worrying. We have seen negative GDP growth combined with rate of inflation operating at close to 25%, with an even bigger upsurge in food prices. This is the worst form of ‘stagflation’ we have ever seen, due partly to the biggest natural disaster. There is likely also to have been a big jump in the number of unemployed and the population below the poverty line.

Copyright Business Recorder, 2023