Pakistan’s Current Account Deficit: Tackling the Sustainability Issue

Does the current account deficit represent a risk to our economic well-being in the near term or in the longer term? To answer this question, it is needed to identify the underlying causes.

 

Abstract

 

[The magnitude of the recent increases in the current account deficit (CAD), both in relation to GDP as well as in absolute dollar size, has raised considerable concern. There is nothing inherently bad about CAD, however, the concern about the deficit centers on a specific issue: Does the current account deficit represent a risk to our economic well-being in the near term or in the longer term? To answer this question, it is needed to need to identify the underlying causes of the deficit. What developments during the past two or three years in the domestic economy and in the world have led us to purchase dramatically more goods and services from abroad? Furthermore, can the Pakistan economy sustain a deficit of this magnitude for some years? And, if not, what are the likely implications of this for the Pakistan economy? Can there be a way out of this quagmire? – Author ]

 

Introduction

The current account (CA) balance is a key indicator of the strength of an economy’s fundamentals. Fluctuations in this variable are deeply intertwined and convey information about the actions and expectations of all economic agents in an open economy; movements in the current account balance provide useful insights about shifts in the macroeconomic policy and responsiveness to autonomous shocks.

 

A long-term review of the current account may require looking at structural features of the economy, such as levels of economic development, demographic profiles and structures of consumption and production. These factors have a role in determining the savings rate and, hence, the current account balance. As countries move to the next stage of development, they typically import capital and, therefore, run current account deficits.

 

In the 1990s, Pakistan’s Current Account Deficit (CAD) averaged 5.0 percent of GDP, which declined substantially after 9/11 and even Pakistan saw surpluses for three consecutive years. The frequent devaluations of the 1990s were replaced with appreciation of Pakistani rupee in this period. However, CAD started to re-emerge in last two/three fiscal years and has now reached the alarming levels. The major driver was the widening trade imbalance in both goods and services. The easy monetary policy in the initial phase and expansionary fiscal policy during the last five years since FY04 have contributed to kick-start the spike in demand for imported goods, especially consumer durables. Consumption has attained new heights in recent years, although SBP was marginally successful in bringing it down through a tightening of the monetary policy. Real growth in consumption stood at 8.5 percent in FY08, far higher than the real GDP growth of 5.8 percent. The contribution of consumption to GDP growth was 118 percent.

 

Like most transitional economies, Pakistan has to rely on the current account deficit because it has been an important factor for its current higher economic growth. However, the deficit’s sustainability is a major issue that should be analyzed.

 

The current growth momentum is based upon demand for durables, mostly imported, and expansion in the financial and the telecom sectors. These were, collectively, important drivers of inflows and thus the current account deficit.

 

Inflationary pressures furthered the depreciation of the rupee that jeopardized ineffectiveness of demand management policies in Pakistan. It is a Herculean task for policymakers to prevent the population clustering around the poverty line from falling below it. To prevent these masses from falling to a very low standard of living, it is essential that the current growth momentum be sustained. Only a higher growth trajectory could alleviate poverty or — at least prevent it from rising further—and put additional weight to the adverse effects of such policy in a country like Pakistan.

 

Earlier, Pakistan did see a period of a current account surplus (FY01–FY03). It was characterized by lower economic growth, which reinforces the notion that a current account deficit often leads to higher economic growth in the initial phase. However, when there is a prolonged period of high current account deficits, economic growth tends to shrink because of problems caused by imprudent financing. In other words, current account deficits support growth to some extent but eventually the economy has to stabilize itself.

 

The case of Pakistan is different in that higher current account deficits, even in the short run, normally lead to worsening of the debt trap and exchange rate volatility.

 

The recent deterioration of the current account is multifaceted and has been caused by both domestic and external factors. On the domestic side, five years of strong economic growth, strengthening of the domestic demand, and the consequent pickup in investment spending have led to a massive surge in imports. The problem of rising imports is further aggravated by the unprecedented rise in oil prices in the international market. An unexpected rise in commodity prices in recent years has also contributed to the surge in the import bill.

 

 

 

On the external front, the global economy continued its strong and broad-based expansion, with growth reaching close to 5 percent. This helped Pakistan’s export growth to expand after a period of dismal growth during the 1990s. However, Pakistan’s foreign trade sector is being affected by structural rigidities and cyclical factors. During the last five years (FY03–FY08), the country’s exports grew at an average rate of 13.3 percent per annum whereas imports continued to expand at an average rate of 23 percent per annum. The mismatch between import and export growth has resulted in a massive rise in the trade imbalance. Pakistan’s size of trade had risen substantially from 25.8 percent of GDP in FY00 to 35.5 percent of GDP in FY06; however, it nosedived to 28.9 percent of GDP in FY08 (Figure 1).

 

CAD remained supportive in the initial phase of recovery; however, with a marked slowdown in exports in FY04, it started to deteriorate. It maintained a surplus of 2 percent of GDP during the period FY00–FY02. However, despite relatively high GDP growth in both nominal and real terms (5–7 percent in real terms) since FY04, the current account developed an imbalance that worsened from 1.5 percent of GDP to 5 percent of GDP during FY04–FY07. This deficit reached a new height of 7.5 percent of GDP in FY08.

 

Of course, the worsening of the CA deficit would have not been possible without proper financing arrangements. The orthodox financing arrangements were not properly managed to make the financing of the current account sustainable. The non-structural inflows, defined as potentially non-repeating flows that are not principally driven by developments in the economy, slowed drastically after FY04, widening the current account deficit. These inflows included the Saudi oil facility and receipts for logistic support provided to Coalition Forces operating in Afghanistan. The Saudi oil facility was abandoned in FY04, while receipts for logistic support to the US-led coalition in Afghanistan declined substantially. The Coalition Forces also used receipts as pressure tactics against Pakistan for extracting too much out of unstable political environment.

 

Greater reliance on foreign savings and a current account deficit to finance domestic investment leads to greater accumulation of external debt. The tremendous rise in the accumulation of external debt during the last one and a half year (FY07 and FY08) bears great similarity to what happened in Pakistan in the 1990s. Large fiscal and current account deficits led to the accumulation of both public and external debt, increasing the country’s vulnerability to external shocks, reducing the investment rate, and consequently slowing economic growth.

 

As happened in most developing countries in recent years, the deficit came as a consequence of large inflows of easy foreign capital. In the case of Pakistan, prior to the 9/11 fiasco, most of the CA deficit was financed by external borrowing (mainly through grants and loans), whereas, starting from 2002, the financial account took over the primary role of the financing of the current account deficit. Foreign direct investments (FDI) along with other inflows started to become increasingly important and it was assumed that FDI inflows would continue to remain buoyant in the long run. However, there was a sudden slowdown in FDI inflows during FY08, which played havoc with the sustainability of the CA deficit and exposed flaws in the complacent policy, under which 4.5 percent of GDP’s worth of current account deficit was being financed through mainly non-debt creating inflows like FDI.

 

Pakistan’s overall balance of payments remained surplus for the period FY01–FY07 mainly because of the persistence of non-debt creating inflows. Private transfers continued to rise and enabled the current account balance to remain sustainable for this period. Workers’ remittances, which accounted for more than 90 percent of the private transfers, remained buoyant. (This upbeat mood of the non-resident Pakistanis was not the result of any conscious policy of the government; if anything, it was there in spite of the adverse situation in the country — non-resident Pakistanis were forced to shift their savings to their homeland in the aftermath of the 9/11 fiasco. However, the government failed utterly to capitalize on the opportunity and properly channel these inflows to productive sectors.) The above-the-line private transfers helped the current account balance to remain either in surplus or modestly in deficit, which helped in generating overall surpluses in the balance of payments, and these were added to the overall reserves of the country (Figure 4). Although private transfers remained buoyant in FY08, the overall balance turned into a deficit with the result that reserves had to be drawn down.

 

The current account deficit continued to widen with even more vigor. Unfortunately, official circles had no Plan B for the eventuality that inflows might suddenly stop or be reduced to a minimal level. When inflows became inadequate in the first three quarters of the current fiscal year (FY08), there was excessive borrowing from SBP and a massive rise in external borrowing, which complicated the already difficult task of monetary management. The massive influx of non-debt-creating inflows had provided much needed exchange rate stability to the economy in the past. However, the abrupt fall in these inflows not only put pressure on the debt stock but also fuelled the free fall of the rupee against all major currencies. This implies that preventing or limiting foreign capital inflows could prove to be a costly policy vendetta to reduce the CA deficit in terms of economic growth.

 

In the last quarter of FY08, prospects for the current account or fiscal account deficits were not very good; even the private sector was not generating enough surpluses to provide ample support. Higher energy costs, falling purchasing power of consumers, social unrest, an unexpectedly high price level, poor governance, massive corruption and, above all, lack of an enabling environment pose serious threats to the hard-earned macroeconomic stability of the country. In this situation, the question of sustainability of the current account becomes very important and especially warrants serious policy attention.

The Question of Sustainability

The sustainability of the current account deficit is frequently analyzed in terms of sustainability of external debt. Two years ago, the sustainability of Pakistan’s current account deficit was not a major issue since abundant non-debt-creating inflows were available to finance it and no additional strain needed to be placed on the external debt stock (which was already too high by any standards). For the last one and half years or so, however, non-debt-creating inflows have been absent or very low, leading to addition to the existing stock of external debt and drawing down of accumulated foreign exchange reserves.

 

Notably, during the last few years, there has been an unprecedented rise in capital inflows in developing countries, sparking an academic debate throughout the developing world about the judiciousness of relying on this trend. A cautious approach was advocated towards external inflows on account of their potential to disrupt an otherwise smooth balance of payments. However, this concern was not evident in Pakistan while non-debt-creating inflows were pouring into the country; nobody seemed to be worried about the inflows’ sustainability or long-term implications.

 

Pakistan’s current account deficit, at above 5 percent of GDP, is very high and unsustainable. In the last 30 years, only small industrial countries have had current account deficits in excess of 5 percent of GDP that were sustained for some years. These economies include Australia, Austria, Denmark, Finland, Greece, Iceland, Ireland, Malta, New Zealand, Norway and Portugal. What is even more striking is that very few countries, whether industrial or emerging, have had high current account deficits that lasted for more than five years. Over the years, a number of authors have argued that a worsening of a current account balance that stems from an increase in investment is very different from one that results from a decline in national savings. Some have gone as far as arguing that very large deficits in the current account “don’t matter” as long as they are originating from higher (private sector) investment (Corden 1994). In the case of Pakistan, the current account deficit averaged over 5 percent of GDP in the 1980s and the country paid the price in the 1990s when economic growth was hemorrhaged by the unsustainability of the twin (budget and trade) deficits.

 

Studying the dynamics of twin deficits, Dudley and McKelvey (2004) maintain that the two are intertwined. Chronic budget deficits create a shortfall of domestic savings. This leads to higher interest rates, a stronger local currency, and foreign capital inflows. In this way, the initial budget deficit becomes transformed into twin budget and trade deficits.

 

In Pakistan, the tolerance for higher fiscal deficits that began in FY05 and attained new heights in FY08 has led to the situation where the expansionary fiscal policy is more than neutralizing the highly positive impact of a tight monetary policy. Persistent upward adjustments of interest rates by SBP since April 2005 proved to be counterproductive and private sector investment in the productive sectors shrank considerably, with serious implications for job creation. The competitiveness of the manufacturing sector went down and the agriculture sectors faced severe shortages of affordable credit disbursement.

 

 

 

 

 

Freund (2000) and Mann (1999) concluded from their studies of the experiences of other industrial countries that pressure for correction often arises when external deficits are in the range of 4 to 5 percent of GDP. Experiences reviewed by Freund (2000) suggest that growth does slow in most countries undergoing external adjustment and exchange rate depreciation. However, these experiences reflect a range of policies interacting with a range of economic and financial conditions. In FY08, Pakistan also faced a slowdown in economic growth and depreciation of the rupee versus major currencies.

 

 

A very interesting feature about Pakistan is that its current account is driven either by a slowdown in exports growth or a rise in GDP growth (Figure 2). Normally, higher export growth is the ultimate result of higher economic growth because a growing economy generates an exportable surplus in normal conditions. However, Pakistan’s consumers prefer imported items whenever their incomes are rising, leading to the unique phenomenon that increase in GDP growth and deceleration of exports go side by side in the country’s economy.

 

This implies that GDP growth originates from the services sector rather than the production sector. There was a structural imbalance between the growth of tradable and non-tradable goods and services.

 

Another relatively qualitative measure of CAD sustainability concerns external competitiveness, which plays a major role in determining whether a country’s assets are dearer to the outside world or the deficit is driven by a consumption bonanza. One of the indicators frequently used by economists and researchers to identify an increase or decrease in the competitiveness of the economy is the terms of trade index. Pakistan’s terms of trade index has deteriorated at a faster pace since FY98, the major contributor being rising import prices rather than falling export prices. In fact, export prices have risen at a healthy pace but import prices rose even more sharply (Figure 3). The unit value of imports has risen substantially while unit value of exports has risen modestly during the last decade. The real culprit is Pakistan’s captive imports and exports basket and this deterioration in the terms of trade reinforces the need to diversify the country’s trade quantum[N1] .

 

 

 

Milesi-Ferretti and Razin (1996) define a CAD as sustainable if it is not going to provoke any drastic policy shift. This is not likely to happen as long as a country’s inter-temporal solvency is not violated. In addition, a country’s willingness to repay debts and foreign investors’ willingness to lend must not be jeopardized. Milesi-Ferretti and Razin provide a very useful theoretical framework. Unfortunately, lack of data and the complicated task of structuring the future [N2] prevented the use of its principal solvency equations. Nevertheless, the unsustainability of Pakistan’s CAD is clear from the recent currency depreciation, which has demanded frequent policy interventions, and the fact that the trade policy is also under severe pressure. The country has to make adjustments in the balance of payments — the sooner the better[N3] .

 

 

 

Economic theory suggests that large external capital inflows have the potential to cause real exchange rate appreciation. This is an inherent risk in overdependence on external inflows to finance the current account deficit, which policymakers have to manage. Appreciation in the real exchange rate could cause a loss of competitiveness and further structural worsening of the trade balance, which, in most developing economies like Pakistan, has been the major driver of the current account deficit. If the source of the trade deficit is structural in nature, it is likely that the resultant current account deficit will be unsustainable. Roubini and Wachtel (1998) observed that, although the current account deficit mainly emanates from a savings-investment gap, if it is accompanied by a real appreciation of the effective exchange rate, the deficit could become less sustainable. When the real exchange rate appreciation is viewed in the context of its relationship with the current account balance dynamics in Pakistan, it emerges that movements in the real effective exchange rate (REER) in Pakistan have tracked both trade balance and current account balance fluctuations consistently. [N4]

 

 

 

 

After [N5] the re-emergence of a trade deficit-driven current account deficit since FY04, the appreciation of the real exchange rate has consistently driven trade deficits and current account deficits in Pakistan. These periods of appreciating real exchange rate coincide with periods of massive external capital inflows into the Pakistan economy. The appreciation of the REER has persistently driven trade deficits, which in turn has driven current account deficits in Pakistan.

 

 

 

 

Since September 2007, the REER started depreciating as the nominal exchange rate started losing ground against major currencies. With the start of the last quarter of FY08, the nominal exchange rate started free-falling. The REER followed suit. One positive aspect of the depreciation of the rupee may be an increase in the competitiveness of Pakistan’s exports. Such tremendous depreciation has boosted the probability of the narrowing of the trade deficit but, still, exports or imports are not responsive. Even with low elasticities of imports and exports, Pakistan would be able to narrow the trade deficits to some extent.

 

Conventionally, it is expected that a current account deficit resulting from low domestic savings is likely to be more unsustainable than one resulting from high investment. Obviously, high investment has the potential of increasing production capacity and, thus, future output and trade surpluses.

 

Review of the Current Account Balance

Table 1 shows that Pakistan’s trade balance was in deficit even when the current account balance was in surplus for three years (FY01 to FY04). In this period, economic growth was lower than its level in more recent years, i.e. from FY05 to FY08. It is worth noting that an extraordinary focus on narrowing the gap in the trade deficit can be counterproductive for developing countries, as they have to import capital goods and intermediate inputs for domestic production which help them produce an exportable surplus as well. Pakistan’s imports as well as exports increased substantially for the period FY01–FY05 but fell significantly in FY06–FY08 and the deceleration of exports growth was much sharper than the deceleration of imports growth, which led to widening of the trade imbalance. This may be because generation of an exportable surplus hinges upon imported raw material, or could have been the ultimate outcome of the demand management policies of SBP, mainly its revision of policy rates and the signals it sent to the money market.

 

The growth of exports slowed significantly in FY07 but picked up in FY08, offsetting a significant decline in import growth during FY07 in response to a deceleration in credit to the private sector, or monetary tightening. SBP was able to shave off some demand for imports but, certainly, at a cost. However, imports growth bounced back amidst rising commodity and oil prices in FY08 and the differential between imports growth and exports growth widened significantly. The current account deficit reached 5.2 percent of GDP (US$7.5 billion) in FY07, one percentage point higher than in FY06. It had already reached 7.6 percent of GDP during July-May of FY08. The irony was that no effective policy response came from official circles.

 

 

 

 

 

 

 

 

 

 

 

Policies to shave off aggregate demand from the economy may not hurt higher living standards and may also not necessarily lower a CAD. For the last two years, Pakistan’s fiscal and monetary policies have been at loggerheads. Fiscal profligacy has more than offset the impact of monetary tightening; even then, some fall in the aggregate demand in the market has occurred, which is commendable. Poor quality government spending and problems of low productivity are concentrated in non-tradables which are likely to result in raising the real exchange rate, reducing the competitiveness of domestic industries exposed to international competition. This may further exacerbate the already worse CAD.

 

One of the manifestations of the conflict in monetary tightening and fiscal expansion is that the CAD reached 7.6 percent of GDP or US$13.0 billion in the first eleven months of the current fiscal year (July-May FY08). The increase in CAD has given rise to suspicions about a sharp contraction of economic growth, consumption and, consequently, imports, coupled with major depreciation in the exchange rate against the currencies of main trading partners. The Pakistani rupee has already depreciated by 7.0 percent, moving from Rs.60.5 per dollar in July 2007 to Rs.68.8 per dollar in May 2008. SBP has taken some measures to bridle the rupee’s free float against the dollar but has only succeeded in reducing the velocity of depreciation. The government has thwarted all measures to bring foreign inflows for maintaining exchange rate stability in the country.

 

Exports: Deceleration in exports growth is very crucial because it is a manifestation of the poor sequencing of reforms and failure of targeted policies. In recent years, the composition of imports underwent substantial changes while the structure of exports remains more or less the same. All claims of export diversification proved to be mere rhetoric; exports remained narrowly based in terms of both products and destinations[N6] .

 

The share of the textile sector in overall exports has declined in the post-quota liberalization period by almost 5 percentage points and the share of other items has gone up by more or less the same amount. Over the years, the textile sector has been nurtured by undue official patronage leading to poor industrial base in the country. The sector has been heavily subsidized and lacks competitiveness. The government allowed tremendous concessional financing facilities to it but it proved to be a disaster, and most of the investment was done in the spinning sub-sector, which was less export-intensive.

 

Pakistan’s exports suffer from serious structural issues which need to be addressed, primarily by the industry itself, with the government playing the role of facilitator. Structural weaknesses in the textile sector, for example, include: (i) low value added and poor quality products fetching low international prices; (ii) considerable depreciation of machinery installed in recent years relative to Pakistan’s competitors; (iii) use of machines that are power-intensive, less productive and entail high maintenance costs; (iv) augmented wastage of inputs adding to the cost of production; (v) little or no efforts on the part of industry to improve workers’ skills; (vi) low spending by industry on research and development; and (vii) lack of capacity of export houses to meet bulk orders as well as requirements of consumers in terms of fashion, design and delivery schedules. For these reasons, wasting further resources to boost textile exports would prove to be a doomed strategy. The Federal Budget 2008–09 has rightly brushed aside pressure from the powerful textile lobby and does not offer any new incentives to the sector. The depreciation of the Pakistani rupee might be a blessing in disguise for the textile sector.

 

 

 

 

 

During the first eleven months of FY08 (July–May), exports growth was driven completely by non-conventional, non-textile products. However, export of technology-based products was still almost non-existent. Exported products ranged from crude items like sports goods and clinical and surgical items to some negligible software exports. A value added or knowledge-based component was largely missing.

 

Another failure of Pakistan’s export sector lies in not locating enough markets for its products. The export base is limited, with only four countries accounting for more than 50 percent of exports. Trade diplomacy has been ineffective: Pakistan could have bargained for more market access in the post-9/11 situation but this did not seem to be a policy priority. In fact, the country has lost many opportunities in the past where it could have use its political clout to bargain for concessions and market access. The posting of trade or commerce staff in embassies across the globe is based on political or military connections rather than merit and thus Pakistan’s diplomats has failed to deliver when it comes to trade promotion.

 

Imports: Importantly, in order to reduce the trade deficit and still accelerate economic growth, it is not necessary to restrain imports—this could adversely affect domestic production as well as growth in exports. Hence, the import of necessary inputs for production should continue to be encouraged, and exports will simultaneously be expanded. More than three-fifths of Pakistan’s basket of merchandised exports include textile items that have low prices and income elasticity of demand, while its import basket includes manufactured goods that have high prices and income elasticity in demand. Therefore, the trade deficit will inevitably be widened unless reductions in domestic demand drive a decrease in imports. As mentioned earlier, periods of high economic growth are associated with periods of large trade deficits in Pakistan, as well as a current account deficit (Figure 2). This is a reminder of the important theory that reductions in the trade deficit due to limiting or decreasing imports will constrain economic growth, as has happened in most developing countries[N7] .

 

 

 

 

 

 

 

Like exports, Pakistan’s imports are also highly concentrated in a few items, namely, machinery, petroleum and petroleum products, chemicals, transport equipments, edible oil, iron and steel, fertilizer and tea. These eight categories of imports accounted for 85 percent of total imports during the first eleven months (July–May) of FY08. Pakistan’s imports are also highly concentrated in terms of the origin. The USA, Japan, Kuwait, Saudi Arabia, Germany, the UK and Malaysia have been major sources of imports for the last ten years. Over 40 percent [N8] of Pakistan’s imports continue to originate from these seven countries. Saudi Arabia, followed by USA and Japan, remain major suppliers of imports.

 

The composition of Pakistan’s imports has undergone a substantial change in recent years. The share of petroleum imports declined between FY01 and FY05 but bounced back with much intensity — rising by almost 10 percentage points — during the last three fiscal years. The more alarming change is the trend of decline in the machinery group and the raw material group  by around 10 percentages points[N9] ; this decline is more than offset by a rise in the “others” category, which includes non-traditional items like mobile phones and other luxuries. The slowdown in the import of machinery and raw materials implies a slowdown in the economy. While SBP might be pleased that the share of consumer durables in the import basket is finally stabilizing, its monetary tightening might have had a deeper effect on the investment cycle than on consumer demand.

 

Pakistan’s imports grew at an average rate of 29 percent per annum during FY03–FY06 on the back of strong economic growth that triggered a consequential growth in investment and imports. Import growth slowed to a normal level in FY07 but registered a sharp pickup once again in FY08 on account of an unprecedented rise in oil import bills and some one-off elements in the shape of imports of wheat and fertilizer. As a result, Pakistan’s trade and current account deficits have widened substantially in this year, contributing to serious macroeconomic imbalances. Correction of imbalances through shaving off of aggregate demand by appropriate policies should be the topmost priority of the government.

 

 

 

During the first eleven months of FY08, imports grew by 29.6 percent to $35.9 billion with an extraordinary surge in the import of petroleum products as well as imports of the food group and raw material. Non-oil imports were up by 22.4 percent and non-oil and non-food imports surged by 18.5 percent during the same period. Imports of the food group were up by 51.3 percent in the current fiscal year, mainly on account of unanticipated imports of wheat, amounting to $860 million, and an extraordinary surge (71.5 percent) in the imports of edible oil due to the sky-rocketing price of palm oil in the international market. Imports of food group accounted for 11 percent of total imports but contributed 16.0 percent in the overall growth of imports in the current fiscal year[N10] .

 

Imports of machinery posted a modest increase of 11.0 percent in the first eleven months of FY08, reaching $5.2 billion. Within the machinery group, imports of power generating machines, construction and mining machines, and other machinery showed a substantial increase of 38.2 percent, 33.1 percent and 9.9 percent, respectively. The rise in the import of these different categories of machines is attributed to ongoing work on various power and construction projects in the country. The machinery group accounts for 14.5 percent of total imports but contributed only 6.3 percent in the overall import growth of this year.

 

Table-4: Major Contributors to Increase in Imports

 

Imports of the petroleum group witnessed an extraordinary surge of 52.2 percent, amounting to $10.1 billion. The petroleum group accounts for 28.1 percent of total imports but contributed 42.2 percent in the overall import growth for the year. The surge in imports of petroleum group has been the result of an extraordinary increase in the prices of Petroleum, Oil and Lubricants’ (POL) products.

 

Unlike previous years, imports of consumer durables registered a decline of 3.9 percent in the first eleven months of FY08. The share of consumer durables in total imports stood at 7.2 while its contribution to import growth has been negative 1.3 percent.

 

 

Imports of raw material, accounting for 8.1 percent of total imports, grew by 6.5 percent in the first eleven months of FY08. Fertilizers, plastic material, iron, steel and scrap, accounting for 45 percent of total raw material imports, grew respectively by 193.1 percent, 12.3 percent and 74 percent. The extraordinary increase in the import of fertilizer was surprising at a time when the price of fertilizer in the international market was up by almost 50 percent. As against 1.2 million tons last year, Pakistan imported almost 2 million tons in the first eleven months of FY08, registering a growth of 58 percent. Why such large quantities of fertilizer were imported when its off-take within the country did not grow compared to last year is not clear. The country had to pay an additional $490 million in imports on account of the extraordinary increase in the import of fertilizer, which cannot be explained by looking at the performance of this year’s agricultural crops. Imports of raw material contributed 2.2 percent to the overall growth of imports this year.

 

Unlike the trend in the recent past, imports of telecom remained more or less at last year’s level of $2.1 billion, suggesting that the expansion phase of various cellular companies has saturated for the time being. Imports of telecom accounts for 5.9 percent of total imports but contributed only marginally (0.3 percent) to this year’s overall imports growth.

 

It is important to note that the surge in imports during 2003–06 had been driven by strong economic growth which strengthened the domestic demand and increased investment. In contrast, the surge in this year’s import is not due to any structural shift in demand but because of rising international commodity prices, such as crude oil and palm oil, and one-off increases in the import of wheat and fertilizer. Imports of petroleum products and edible oil alone contributed 47 percent to the rise of this year’s import. An additional 18.7 percent contribution came from the import of wheat and fertilizer. Together, these four items accounted for two-thirds of growth in this year’s imports.

 

Services Trade: Imbalances on services trade have grown at a much faster pace than imbalances on merchandize trade during the last four years. Liberalization in the areas of major services during the last eight years may be the main culprit. The main drivers are transportation and travel services, insurance and freight payments and more travel expenses by Pakistanis to travel abroad. This is a new phenomenon in Pakistan’s current account deficit and warrants an immediate policy response.

 

Pakistan was unfairly placed by the foreign shipping companies in the post-9/11 situation, which imposed extraordinary insurance and risk premiums on all cargo originating from or destined to the country. Pakistan could not negotiate properly with its allies in the so-called war on terror regarding this unfair treatment, which has been a major contributing factor in the rising current account deficit. The volume of expenditure on freight and insurance is rising constantly; the difference between Federal Bureau of Statistics (FBS) trade data and SBP data is also widening because the difference between the two is expenditure on these counts.

 

Income Account: On the income account [N11] side, the balance was almost stagnant in absolute terms but declined in relation to GDP in the six out of eight years since FY00. However, in the last three fiscal years (FY06–FY08), the deficit, even in relative terms, was explosive. The amount includes mainly income from investment, both in the form of direct portfolio or other investment, income being generated in non-conventional means or profits and dividends on investments. The outflow on account of direct investment or equity increased from $1.2 billion in FY04 to $2.8 billion in FY07, while outflow on account of portfolio investment increased from $0.2 billion to $0.6 billion in the same period. The outflow on account of income on equity has already touched $2.3 billion in Jul–Mar FY08. The deficit on the income account increased from $2.2 billion in FY04 to $3.6 billion in FY07. Among the implications of the way the financing of the current account was arranged in the most recent past will be rising interest payments and remittance of profits and dividends by investors in Pakistan in the near future.

 

Current Transfers: The deterioration in the current account deficit in the last three years mainly emanated from the sharply rising trade deficit, along with increase in net outflows from the services and income account. The strong growth in current transfers[N12] , caused by impressive growth in remittances, almost entirely offset the deficit in the services and income account, leaving the trade deficit as the fundamental source of expansion in the current account deficit. Current transfers witnessed an impressive increase of 16.4 percent during Jul–April FY08 due to strong growth in private transfers. Notwithstanding this surge in recent years, the quantum of current transfers fluctuated in the $8–10 billion range. Worker’s remittances have depicted a high double-digit growth but official transfers fluctuated a great deal.

 

The future sustainability of the current account deficit hinges on the implications of financing items. The foreign exchange gap was filled by foreign financial resources during the last eight years, including both debt-creating and non-debt-creating flows. The composition of capital flows has changed significantly over the years. Dependence on aid has almost vanished; foreign direct investment, foreign portfolio inflows, external borrowing on commercial terms, mostly from multilateral agencies like World Bank and Asian Development Bank (ADB), and workers’ remittances have accounted for the lion’s share in foreign exchange inflows. The proportion of non-debt-creating flows has gone up substantially.

 

 

 

 

 

 

 

Table-5: Pakistan’s   Balance of Payments
(Million US Dollars)
I  T  E  M	FY05			FY06			FY07			FY08 (Jul-Mar)
	Credit	Debit	Net Credit	Credit	Debit	Net Credit	Credit	Debit	Net Credit	Credit	Debit	Net Credit
1.Current Account	27,006	28,540	-1,534	31,761	36,751	-4,990	32,772	39,866	-7,094	26,835	36,601	-9,766
A.   Goods and services	17,801	25,608	-7,807	20,322	33,193	-12,871	21,202	35,289	-14,087	16,584	32,509	-15,925
a.   Goods	14,482	18,996	-4,514	16,553	24,994	-8,441	17,080	27,024	-9,944	14,156	25,312	-11,156
1.   General merchandise	14,401	18,753	-4,352	16,388	24,624	-8,236	16,924	26,652	-9,728	14,000	25,016	-11,016
b.   Services	3,319	6,612	-3,293	3,769	8,199	-4,430	4,122	8,265	-4,143	2,428	7,197	-4,769
1.   Transportation	1,062	2,280	-1,218	1,080	2,863	-1,783	1,092	3,135	-2,043	751	2,590	-1,839
1.1   Freight	112	1,617	-1,505	124	2,083	-1,959	157	2,225	-2,068	124	2,066	-1,942
2.   Travel	177	1,172	-995	216	1,411	-1,195	275	1,625	-1,350	205	1,191	-986
3.   Other Services	2,080	3,160	-1,080	2,473	3,925	-1,452	2,755	3,505	-750	1,472	3,416	-1,944
B.   Income	437	2,823	-2,386	784	3,451	-2,667	934	4,503	-3,569	1,316	3,991	-2,675
1.   Compensation of employees	2	1	1	6	1	5	7	–	7	6	0	6
2.   Investment income	435	2,822	-2,387	778	3,450	-2,672	927	4,503	-3,576	1,310	3,991	-2,681
2.1   Direct investment	18	1,640	-1,622	39	2,115	-2,076	31	2,837	-2,806	42	2,272	-2,230
2.1.1   Income on equity	18	1,640	-1,622	39	2,115	-2,076	31	2,837	-2,806	42	2,272	-2,230
C.   Current transfers	8,768	109	8,659	10,655	107	10,548	10,636	74	10,562	8,935	101	8,834
1.   General government	266	16	250	715	34	681	528	24	504	542	37	505
2.   Other sectors	8,502	93	8,409	9,940	73	9,867	10,108	50	10,058	8,393	64	8,329
2.Capital & Financial  Account	5,890	4,294	1,596	8,486	3,694	4,792	13,085	6,476	6,609	11,352	2,393	8,959
A.   Capital account	693	8	685	250	9	241	340	5	335	37		31
B.   Financial account	5,197	4,286	911	8,236	3,685	4,551	12,745	6,471	6,274	11,315	2,387	8,928
Source: SBP

However, the surge in external capital inflows has not been matched by a commensurate rise in the absorptive capacity of the economy. The principal reason is the persistent deterioration in the competitiveness in the industrial sector of Pakistan, mainly because of rising energy prices, higher overheads, uncertainty and ill-directed incentives.

 

In the one and a half year from July 2006 to March 2008, most of the net inflows of foreign capital into Pakistan have been in the form of debt to be repaid by future generations. The country has added almost $9 billion to its external debt stock in this relatively short period. Not only has this mounting indebtedness increased the stock of income-producing capital [N13] but the country’s spendthrift bureaucracy, with the collusion of corrupt, establishment-hatched politicians, has entirely wasted this massive inflow. It may be said that the capital was shortsightedly and irresponsibly spent in an orgy of unbridled consumption.

 

The accretion of foreign exchange reserves was given undue importance over the last eight years. Most of the inflows were added to the foreign exchange reserves of the SBP. The capital inflows intermediated through commercial banks resulted in credit expansion which, instead of stimulating investment, triggered a consumption boom with a strong import bias in the country during FY02–FY06. SBP had tried to manage commercial banks’ intermediation at low level but even though it has helped in tremendous rise in imports or higher production of consumer durables. SBP had done proper sterilization of the inflows to check unplanned expansion of money supply. It never seemed successful for keeping M2 growth below nominal GDP growth for the last four years. However, the resultant monetary overhangs are adding to the inflation miseries of the population at large.

 

With US$15 billion in foreign exchange reserves (FER) and a current account deficit of $7 billion in FY07, Pakistan can expect to finance its current account deficit for two years in the absence of any kind of inflow. However, if the trade deficit continues to widen during this period and the gap is not bridged by proper [N14] financial resources, the minimum amount of foreign exchange required to achieve targeted growth rates will not be available and economic growth will be constrained by the balance of payments. Pakistan’s total foreign exchange reserves stood at $12.3 billion at end-April 2008 — significantly lower than the end-June 2007 level of $15.6 billion. Reserves peaked to $16.4 billion at end-October 2007 but showed a significant depletion of $4.1 billion during November–April FY08. During July–October 2007, reserves improved by 5.1 percent due to the relatively lower current account deficit and substantial inflows in the financial account. However, from October onwards, net outflows from portfolio investment and a steep rise in the current account deficit led to a sharp decline in the foreign exchange reserves of the country. Two other important reasons for the lack of improvement in the foreign exchange reserve were the sudden stoppage of many inflows and a financing orgy over imports in FY08.

Macroeconomic Perspective

In the macroeconomic perspective, a current account deficit may refer to excess of gross investment over national savings (comprised of public, corporate and household savings). A current account deficit thus reflects the inadequacy of a country’s national savings to finance its investment needs and that country’s need to resort to the savings of foreigners. Capital-starved countries like Pakistan have more investment opportunities than they can afford to undertake with low levels of domestic saving. Resources acquired to fill this gap have the potential to spur faster output growth and economic development. However, the experience of Pakistan negates this notion as external inflows have failed to spur growth.

 

 

 

The investment level tells little about the adequacy of incomes or the productivity of spending on non-tradables compared to spending on tradables. The current account deficit is determined through developments in business saving, government saving, investment, exports, imports, and a host of other factors. All these variables are endogenous according to standard macroeconomic theory. This means that their values are simultaneously determined by more fundamental considerations. A high saving rate cannot cause a low investment rate or a low CAD. Instead, the levels of investment and saving depend diversely on the underlying causative factors, such as preferences, new technologies, taxes, government spending and regulatory environment, and terms of trade. As a result, any observed correlation might be positive, negative, or zero depending on the nature of the dominant joint causes during the observation period. This might explain the growth and investment nexus in Pakistan’s case.

 

 

 

 

As Figure 7 s[N15] hows, the recent deterioration of Pakistan’s current account has largely been the result of a decline in national savings, in particular, the public and household component of national savings. A simple implication of this trend is that an improvement in Pakistan’s current account situation will not only imply a REER adjustment, it will also require an increase in the national savings ratio, in particular, in household savings. The government has remained a major dissaver in the last few years, with the exception of FY04 when it generated a minor surplus. The current account deficit during the last three years also emanates from a fall in private surpluses which turned into deficits in the last two years.

 

As can be seen in Figure 7, since FY04, the increase in the current account deficit has reflected mostly a decline in both public and private sector saving because of the growing fiscal deficit and a further decline in already low household savings rates. Private investment, despite its welcome pickup since FY00, remains below its levels in the mid-1980s. The surplus of private savings over private investment has been shrinking for the last four years starting from FY 04 to FY 07 [N16] and this is the period during which the CAD has grown. FY08 has been an exceptional year but the deterioration of the current account deficit was equally supported by deterioration in both public and private saving-investment gaps. The public savings-investment deficit has also started worsening in this period and the collective deterioration has contributed collectively to widening of the CAD. The expansionary fiscal policy is the main culprit. Reckless public investment has not yielded dividends; it has worsened the external debt burden[N17] .

 

 

 

It is an undisputed fact that the larger part of government spending in Pakistan is wasteful. The poor quality of government expenditure is not necessarily wasteful from the point of view of politicians, who are spending money to attract votes or considering only the point of view of the beneficiaries of the expenditure. Owing to lack of fiscal discipline and accountability, the ruling elite enjoy substantial discretionary powers and the favored constituencies are protected. When the government is spending without serious examination of overall value-for-money considerations, it is to be expected that the scale of the waste would be of economy-wide significance.

 

There is also much — well-justified — disquiet about the quality of the government’s regulations and institutions. [N18] No significant productivity gains from recent increases in social sector and development expenditures are observed, which are mainly funded by foreign borrowings. The costs and delays in getting infrastructure projects under way are a pervasive concern. The widespread acknowledgement of the poor quality of the regulatory mechanism, even in official circles, has led to a weakening of the investment, growth and employment nexus [N19] in Pakistan. Consequently, even when a higher level of investment is being experienced, it is not accompanied by commensurate generation of jobs or expansion of productive capacity in the economy. This also explains the captivity of exports in some sectors and some regions.

 

Pakistan has experienced a tremendous surge in FDI inflows, which have increased more than tenfold in the last six years and reached well above US$5 billion in FY07. A surge in FDI flows (excluding privatization proceeds) and portfolio inflows resulted in a record-high surplus in the financial account in FY06 and FY07. During the first ten months of FY08, the euphoria of FDI inflows dissipated; nevertheless, the inflows have shown great resilience and managed to remain at $3.6 billion, which may seem low compared to the unprecedented inflows of the previous year but augurs well given that average inflows were at $300–500 million in the 1990s. This development reflects the anticipation of foreign investors of improved macroeconomic stability, and responsiveness to progress in liberalization and investor protection regulations. The [N20] current mode of reckless and directionless inflows of foreign investment will not serve any purpose, be it job creation, technological up-gradation or financing of the current account deficit through non-debt creating inflows.

 

More than 80 percent of FDI inflows are in four sectors of the economy, namely, power, telecommunications, oil and gas, and financial businesses. Since none of these sectors is employment-intensive, the contribution to growth has been jobless and joyless. The remittance of profits and dividends in these sectors is enormous and prompt. This is visible from the massive growth of remittance of profits and dividends during FY07. The trend is likely to persist in the years to come and thus likely to cause great problems for exchange rate stability and sustainability of the current account deficit.

Sustainability Outlook

The current account deficit, in its present shape, is unsustainable by all standards. Even without the aid of sophisticated econometric models, it is possible to assess that the prevalent practices do not augur well for CAD sustainability. The following indications support this conclusion:

 

v  The increasing external debt-to-GDP ratio is an indication of unsustainability. This implies that a current account balance that leads to increasing external liabilities is an indication of un-sustainability of the deficit.[N21] In Pakistan’s case, until now, the current account deficit has not provoked an increase in the external debt-to-GDP ratio. However, Pakistan was hardly able to maintain this ratio during July 2007-March 2008. This ratio is likely to explode [N22] by end-June 2008 [N23] and thus may break the condition of sustainability.

 

v  According to Summers (1996), a CAD-to-GDP ratio higher than 5 percent sends a strong signal for an evaluation of sustainability and a review of strategy. Pakistan’s current account deficit had already breached that level by the end of FY07. However, a careful evaluation of the sources of the higher deficit must be undertaken: a deficit driven by investment growth is more likely to be sustainable than a deficit driven mainly by falling national savings (or higher budget deficits). In Pakistan’s case, only in FY07 was the CAD driven by rising investment; otherwise, for most part of its history, it has been driven by falling national savings.

 

v  A fall in national savings is problematic for CAD sustainability. Inasmuch as a fall in the public component of national savings is associated with a higher budget deficit, trends in the fiscal deficit become an automatic indicator of the sustainability of the CAD. In Pakistan, CAD is driven by public dissavings. National savings in Pakistan declined substantially from 18 percent of GDP [N24] to as low as 13 percent of GDP in FY08. The budget deficit has also increased to 7 percent of the GDP.

 

v  The current account deficit may broadly be decomposed into trade deficit and net factor income. The composition of the current account deficit is very crucial in determining its sustainability. A current account deficit may be less sustainable if it is being driven by a large trade deficit than by a large negative net factor income (Roubini and Wachtel 1998). Persistently large trade deficits are indicative of structural competitiveness problems whereas large negative factor incomes may be due to a fall out of higher external debt profile. Higher trade deficits are normally associated with countries where the trade-to-GDP ratios are low. So the size of the overall trade in relation to the GDP may be a good indicator of competitiveness but the level of the exports-to-GDP ratio is an even more accurate[N25] indicator of structural competitiveness. Furthermore, the real effective exchange rate could be used as a measure of structural competitiveness and, thus, the sustainability or otherwise of deficits.

 

Pakistan has been passing through structural problems in promoting its export base. Its overall trade-to-GDP ratio as well as exports-to-GDP ratio have been falling for the last two fiscal years (FY07–FY08). The country’s REER was appreciating for FY06, FY07 and the first half of the FY08. However, sharp nominal depreciation in the second half of FY08 led to depreciation of the REER as well.

v  In the aftermath of the East Asian Currency turmoil of 1997, gross international reserves have been given much importance and regarded as an important tool in external sector stability. A higher level of foreign exchange reserves is widely used to measure the sustainability of current account deficits. A higher ratio of gross international reserves to debt stock is also regarded as indicative of sustainability of current accounts. Gross foreign exchange reserves are also regarded as a cushion for a number of weeks of imports; specifically, forex reserves in excess of 16 weeks of imports are normally considered to imply the sustainability of a current account deficit.

 

In the case of Pakistan, foreign exchange reserves have not only been falling in terms of cover for weeks of imports in FY07 and FY08 but they have also declined substantially in absolute value from as high as $17 billion to just under $12 billion by the end of April 2008.

 

v  The sustainability of current account deficits is believed to be contingent upon a sound and stable domestic financial system that includes strong supervision and regulation. This has been lacking in Pakistan in recent months — during FY07 and FY08, the vigilance of the State Bank of Pakistan came under furious attack on various counts and its vulnerability was exposed more than once.

 

v  The current account deficit is basically a financing gap and some part of it has to be filled by foreign capital inflows, which are very sensitive to the state of political stability and the predictability of economic policies. These two factors, in turn, ultimately hinge on the continuity of the system of governance and confidence of investors. Unfortunately, during FY08, Pakistan scored very poorly on creditworthiness; its credit ratings were downgraded several times. Scarcity of foreign inflows has created many problems in FY08, including monetary financing and very significant exchange rate depreciation. Massive creation of debt to finance the current account deficit has generated a future stream of payments that might create problems for current account sustainability.

 

v  The role of debt-creating and non-debt-creating capital inflows has changed substantially during the last few years. The composition, size and direction of such inflows have become crucial. Short-term inflows are more dangerous in financing the current account deficits than long-term inflows; however, the latter may enhance current account vulnerability in the long run. These inflows are expected to have real effects as the real exchange rate would tend to appreciate and compromise the competitiveness of the economy and, consequently, re-introduce structural trade deficits, which would worsen the initial current account deficit, making it more unsustainable.

Policy Recommendations

 

Pakistan needs an extensive external sector adjustment in the medium term because the current high level of the current account deficit is exerting pressures on external borrowing. From July 2007 to end-March 2008, Pakistan added around $5.4 billion to its stock of external debt—the highest ever addition made in a single year. This is generating a future stream of repayments which is likely to exert tremendous pressure on the balance of payments.

 

The origins of the exceptional size of the current account deficit should be analyzed in more detail and it should be determined whether:

1. Domestic investment is too high and/or national saving is too low;
2. Total domestic spending is too high and/or total domestic income is too low; and
3. Domestic spending on tradables is too high and/or domestic production of tradables is too low.

 

A current account deficit is a norm rather than an exception in developing countries like Pakistan. What is expected is that it be kept at a tolerable level and that it not force abrupt policy adjustments that may distort the economy’s growth momentum. The threshold level in the given structural rigidities and potential of the economy is around 4 percent of the GDP, and that too should come from rising investment rather than falling national savings. The persistence of a high current account deficit over an extended period of time has serious implications, such as haphazard fluctuations in the exchange rate; accumulation of external debt beyond a sustainable level; and development of undue concerns about the vulnerability of the economy towards external shocks. A higher external debt burden constitutes a serious constraint to development because debt repayments absorb resources that could be channeled into domestic investment and development efforts.  High external debt burdens discourage foreign investment because they create a high-risk environment in which there is exchange rate depreciation, capital flight, uncertainty among potential foreign investors about the possibility of profit repatriation, and higher taxes to service debts.

 

Pakistan is facing a double problem of depreciation because the Pak rupee is depreciating against the US dollar and the US dollar is depreciating against major currencies. In July–March FY08, Pakistan’s external debt went up by $5.4 billion but the disbursement effect was only US$1.2 billion, while $4.2 billion was translation effect emanating from the depreciation of the dollar against major currencies like the Euro, Japanese yen and others. If Pakistan’s rupee depreciates by Rs.1, it means Rs.46 billion are added to the foreign currency payable debt in rupee terms. Pakistan has to take depreciation seriously and should diversify its currency basket by engaging in professionally executed currency hedging.

 

Pakistan faced all sorts of problems in FY08 owing to widening of the current account deficit beyond unsustainable limits. The country’s problem is structural in nature and rigidity of exports and imports, external debt servicing commitments, volatile external inflows and, above all, a complacent economic policy have provided very little room for its management.

 

Pakistan has to make arrangements for non-structural financing, like the Saudi Oil Facility, by using its leverage and importance on a sustained basis.

 

The structure of trade has to be reviewed in detail. The structure of imports was driven by food and petroleum in FY08, the combined impact of which was explosive growth in imports by 58 percent. Clearly, Pakistan needs to reduce its reliance on imported food and energy. The import substitution strategy of the 1960s has to be revised and a task force should be formed to look into viable options for resorting to alternative food and energy sources. The world has made much progress in identifying alternative energy resources and Pakistan is bestowed with enormous wind, solar and water energy potential. The task that awaits is the capitalization of these options. Similarly, reliance on domestically produced edible oil has to be extended and farmers should be provided incentives to diversify their low-yielding crops with cultivation of edible oilseeds. Pakistani farmers need price incentives as well as technical support, especially improved seeds, for growing alternative edible oil. The current poor management of water resources, which is causing enormous loss in potential agricultural output, is another key issue to be addressed.

 

Pakistan’s imports still include a large concentration of luxury items, tariffs upon which have been substantially lowered in recent years. It may be pertinent to review the tariff structure for such items, including cars and cell phones.

 

Exports, which are captive in terms of both regions and products, have to be diversified, and non-conventional products need to be marketed to non-conventional markets. Knowledge-based exports are crucially missing from the country’s export basket, while its neighbor, India, is earning billions of dollars through export of high-tech or knowledge-based products. Pakistan has to develop a sound production base with state-of-the-art application of technology and quality standards. To build a high-tech industrial base, trained manpower and investment in human capital are needed. Quality education and skill enhancement should be emphasized.

 

In addition, the traditional focus on merchandize exports needs to be broadened; there is potential to enhance foreign exchange earnings by boosting services exports. Pakistan has a comparative advantage in information technology services and tourism, and there should be emphasis on obtaining outsourced contracts from the industrialized world. Remittances can be boosted as well by negotiating labor market opportunities in the East Asian economies and the Middle East countries. In this regard, the productivity of Pakistani labor should be enhanced by imparting quality training and apprenticeships.

 

The combination of these actions would narrow the country’s trade imbalance and help restore the sustainability of its current account deficit.

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