Trade with India could increase 18-fold: WB

Pakistan's spending on its military detracts from how much it can spend on other development priorities, with fewer resources available to meet its development needs than peer countries, says the World Bank (WB). The WB in its latest report "Pakistan@100: Shaping The Future" released here on Monday states that the smaller size of its economy vis-a-vis India's (and the growing gap) means that, although as a share of GDP military spending is significantly higher than India's, in absolute terms it is vastly outspent by India. Pakistan spends almost 70 percent of its revenue on military and interest spending.
Strained regional relations affect trade, opportunities for regional cooperation and countries' domestic policies. Strained relations have affected trade and investment volumes, but also countries' ability to use regional cooperation to address issues that would benefit from regional coordination, such as security and climate change. Strained relations also affect domestic policies. Pakistan has allocated a large amount of resources to developing and maintaining strong military capabilities, according to the report.
The origin of Pakistan's frequent and recurring macroeconomic crises is structural, not cyclical, and avoiding future crises requires appropriate medium-term responses. Pakistan@100 seeks to focus on policy changes that can address the country's medium-term challenges, while also bearing in mind that macroeconomic imbalances often press the brakes in Pakistan's development trajectory.
Pakistan's macroeconomic challenges are not cyclical, insofar as they are not caused by the business cycle, or a domestic or external shock. Pakistan's macroeconomic challenges are structural: a revenue system that is unable to meet the government's financing needs and consumption-led growth that relies on external flows (remittances, aid) for its sustainability and is therefore very vulnerable to changes in flows. Failure to address these structural, medium-term challenges, while stabilising the macroeconomic imbalances, just means that the next crisis is another 4 to 5 years away. The proverbial can is constantly being kicked down the Pakistani road.
Today, Pakistan's economy is relatively closed to global and regional markets, limiting its ability to benefit from its pivotal geographical situation. Average tariffs and tariff escalation are relatively high, and it is not well integrated in global value chains, limiting access to newest technologies and the opportunity to use increased competition and specialisation for structural transformation.
Trade with India, an economy with over 1 billion people and which may be one of the world's largest economies by mid-century, is negligible. Regional tensions affect domestic policy choices, with an increasing share of limited public resources being used for defence. Increasing regional integration within South Asia could expand Pakistan's economy by 30 percent by 2047.
The report states stronger regional relations can support Pakistan's economic transformation and security objectives, increasing its leverage to resolve disputes with its neighbours and freeing resources for public investment in economic and human development.
Pakistan has failed to reap the benefits of trade and regional integration. Pakistan's trade-to-GDP ratio was close to that of its South Asian neighbours in the early 2000s, but then fell behind as Pakistan failed to fully leverage export trade as an engine of growth. From 2005 to 2017, India's exports of goods and services increased by 216 percent, Bangladesh's by 250 percent, and Vietnam's by 519 percent.
In comparison, Pakistan's exports increased by only 50 percent, from US $19.1 billion to US $28.7 billion. In addition, access to international markets has helped firms in South Asia grow and become more productive. There are many channels through which trade has promoted productivity growth: competition, knowledge spillover, and access to better technology and quality inputs. Bangladesh's garment industry and India's auto industry are some of the well-known success stories. But Pakistani firms have not been able to fully leverage the potential of trade because of trade policy constraints, logistical issues and limited regional integration.
Trade with the region could more than triple. Pakistan's share of exports to India is less than 2 percent of its total exports, while India's imports from Pakistan account for less than 0.5 percent of its total imports. Trade with India could increase 18-fold, with exports growing 45 times over their 2015 value and imports growing 15 times over the same period.
In addition, due to the proximity and size of the Indian economy, predicted exports to India are 3.5 times higher than those predicted for China. Overall, liberalisation of trade in goods with the region could result in the economy growing by 30 percent by 2047.
Weak governance is a cross-cutting constraint that affects Pakistan's ability to transform its economy. Most constraints to economic activity reported by Pakistani firms can be traced back to issues related to governance (corruption, electricity, taxation). Weak governance makes it easier for powerful groups with narrow interests, such as politically connected firms, to exert undue influence over policy.
Pakistan's average economic growth rate has been declining over the past 30 to 40 years, with periods of accelerating growth usually followed by a crisis. Growth has declined because the country is not investing enough in either physical or human capital, and because misguided economic policies mean that limited resources are not used in the most productive way.
The state has often been undermined by rent seeking behaviour and a complex security situation, particularly over the past 40 years. Well-connected industries and firms are often protected from foreign and domestic competition in a variety of ways, limiting the positive impact that increased competition has on productivity. Productivity is also affected by weak public services provision-whether it be energy, livable cities, a healthy and educated population, or security. Frequent macroeconomic crises affect the country's growth trajectory. This report identifies the key choices that Pakistan will need to make if it is to be able to invest more, and invest more efficiently, in both human and physical capital, and allow markets to allocate resources to where they are put to the most productive use.
There are four elements to a growth strategy for Pakistan, namely (i) accumulation, (ii) allocation, (iii) sustainability, (iv) and governance. That is: (i) accumulation of physical and human capital, which will require both increasing public and private investment; (ii) allocation of resources to their most productive use, through structural transformation and openness to trade and investment; (iii) environmental and social sustainability, to ensure that the unsustainable use of finite resources does not constrain growth in the future, and that everybody can benefit from and contribute to growth; and (iv) a governance environment that supports growth and the successful implementation of necessary reforms. Pakistan has had no shortage of technical assistance to inform policies or support for reforms from the international community. But many of the necessary policies have not been thoroughly implemented, or they have been reversed. A governance environment that supports making tough policy choices and then following through with those choices will be crucial if Pakistan is to follow the type of transformative path being suggested.
The set of reforms needed to transform Pakistan is large and varied and as such it needs to be prioritised into a more manageable set of immediate interventions, taking into account capacity and financing constraints.
A prioritised set of interventions that addresses the binding constraints to growth can have a significant and sustainable impact on growth. Higher government revenues will contribute to increasing investment rates, directly, by increasing public investment, and indirectly, by reducing the likelihood of macroeconomic crises and reducing crowding out of private sector borrowing.
Higher revenues will also create the necessary fiscal space to address other constraints to growth such as weak human capital. An improved business environment and a more open economy to both regional and global trade and investment will unshackle the private sector and contribute to quickly accelerate productivity growth. Some measures may only contribute to growth in the medium term, but inaction today will have an irreversible and prolonged impact.
Pakistan's youth bulge can be turned into a demographic dividend, providing an additional boost to growth in the medium-term, if dependency rates decline and people have the necessary skills. Lowering fertility and investing in early childhood development, which is the basis for future learning and skills development, are key to ensure that Pakistan's large population becomes an engine for growth. Finally, improving water management, using water more efficiently in the agriculture sector but also releasing water for other sectors in the economy, will be necessary for the sustainability of growth.
A first priority for Pakistan is to make the best use of its greatest asset, its people. The three immediate interventions for human capital investments are: (i) programmes to reduce fertility; (ii) improving spending patterns to use existing resources more efficiently; and (iii) early childhood development programs.
With just 1.5 million registered taxpayers, the tax base needs to be expanded, while also reducing exemptions, preferential treatments to some sectors, and outdated property valuation tables. A broadening of the tax net should include the agriculture sector, which accounts for over 20 percent of Gross Domestic Product (GDP) but generates a meagre 0.22 percent of total direct tax revenue.
The tax system is also riddled with legal loopholes that facilitate tax evasion and need to be rectified. There are multiple taxes and jurisdictional overlaps between the federal government and provinces, which increase compliance and administrative costs, and provide opportunities for rent-seeking.
Increased fiscal space will also reduce the likelihood of macroeconomic crises, often the result of fiscal imbalances, and reduce the government's borrowing needs, freeing up resources for private sector investment. Domestic revenue mobilisation efforts will need to be combined with reforms in the financial sector to deepen financial intermediation and facilitate access to finance by small and medium-sized enterprises (SMEs).
Creating a governance environment that is conducive to reforms requires realigning the incentives of political leaders and public officials with the needs of citizens. This includes increased transparency - transparent and accessible information on politicians' track-records of reform and service delivery, and increased accountability - the provision of levers for citizens to sanction public officials and political leaders when policy and service delivery do not meet their expectations.
Accountability will also be supported by furthering the devolution process, as it allows local leaders to tailor service delivery to local needs, and facilitates monitoring and sanctioning by voters based on service delivery performance. Currently, local governments are deprived of the authority to direct service delivery, undermining accountability, as it deprives voters of the ability to closely monitor the leaders responsible for providing public services.
To accelerate and sustain growth over the next 30 years, Pakistan needs to invest more and let market forces allocate production factors. Countries that have embarked on profound and often difficult reform processes have had a clear goal to guide the reforms.
In Pakistan, reforms efforts should be guided by the need to increase investment levels, both in physical and human capital, as well as efforts to allow market forces to allocate labour and capital to its most productive use. Successful reforms will significantly increase investment levels and productivity for Pakistan to become a stable and confident upper middle-income country by 2047.
Putting Pakistan on a path to upper middle-income status requires significant increases in investment and productivity growth. To better understand the magnitude of the changes necessary for Pakistan to move toward upper middle-income status, a dynamic growth framework is used to simulate how reforms that improve factor accumulation and Total Factor Productivity (TFP) affect growth.
Simulation results drawn from the framework suggest that Pakistan can gradually accelerate growth and reach upper middle-income status by its centenary under three key assumptions: First, this can be achieved if Pakistan were to gradually increase investment from 15 to 25 percent of GDP. An investment rate of 25 percent is still below the regional average, with India, Bangladesh and Sri Lanka all investing above 25 percent of GDP.
Second, accelerating growth requires enhancing TFP growth from 1 to 2 percent per year. Third, achieving upper middle-income status requires a gradual deceleration of population growth rates, from currently above 2 percent to around 1 percent by 2045, consistent with population growth rates in other South Asian countries that currently lie around 1.1 percent.
Good governance will be crucial in implementing the reforms needed to transform Pakistan. In a governance environment that is conducive to reform, citizens hold policymakers accountable to ensure that policies are consistent with their demands. This can be presented as a triangular relationship between political leaders, public officials and citizens.
Capture by powerful elites and "clientelism" means that the triangular relationship that defines a functioning political system fails, undermining a country's ability to implement crucial reforms. The government failure occurs when leaders are selected based on their provision of private goods to select special interest groups, rather than their ability to provide public goods.
There is a growing sentiment that Pakistan's political economy is not conducive to reforms. Over the past decades, crucial reforms with seemingly broad support have nonetheless stalled. For example, reforms in the agriculture and water sectors, and to the tax and SOE systems, have been attempted but not successfully implemented.
Complex tax administration and poor tax policy design undermine the business environment. Complex tax administration results in some sectors being very lightly taxed (e.g., the real estate sector), which can divert investments from more productive sectors to those with lower tax rates. Paying taxes is consistently identified by the private sector as a key constraint, not only because of the time it takes but also because of widespread perceived corruption at the federal and provincial revenue boards.
A key constraint to structural transformation is the persistence of market distortions, resulting from government failures. Government intervention can introduce market distortions that prevent resources from being allocated to the most productive uses.
A distortionary tax system provides strong incentives for firms to remain in the informal sector and thus delays structural transformation. Political favoritism generates an uneven playing field that allows unproductive firms to survive longer than if they were in competitive environments.
Financial support to underperforming SOEs is a major driver of the fiscal deficit and a source of substantial fiscal risks. In FY16, subsidies, loans and grants to support federal SOEs accounted for 32.7 percent of the budget deficit and 1.5 percent of GDP.
At the same time, public guarantees for SOEs pose significant fiscal risks, as they accumulate contingent liabilities for the federal government, reaching almost 3 percent of GDP in FY17. This is particularly problematic in the power sector, where shortcomings in the operations of DISCOs and the tariff-setting mechanism are direct and major causes of Rs 1 trillion of public debt.