Will Pakistan's Latest Near Crisis Persuade It to Tackle Reform?

December 4, 2019 9:30 AM
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REUTERS/Akhtar Soomro

Pakistan recently averted yet another potential balance of payments and fiscal crisis under a lending program with the International Monetary Fund (IMF). This is Pakistan’s 22nd program since 1958, making it one of the most frequent borrowers from the IMF. Demonstrable good results have been achieved, including a turnaround of the current account deterioration by allowing the exchange rate to be more determined by markets. Government revenues have also increased slightly.

But Pakistan needs to undertake more basic reforms to escape its repeated cycles of macroeconomic instability. In recent decades, Pakistan’s programs with the Fund have aimed at addressing problems similar to the ones underpinning the most recent near crisis: large fiscal deficits and balance of payments pressures. Structural reforms are called for to address the sources of these problems: low growth, poverty, badly managed budget policies including profligate spending and low taxation, and an overvalued exchange rate.

Political Economy Factors Prolonging Macroeconomic Instability

What are the political economy factors and incentives that induce repeated cycles of macroeconomic instability in Pakistan?

  • A large, omnipresent state with powerful stakeholders. A state defined by a politically powerful army, influential business interests, and a government exerts considerable control over the allocation of resources and rents, including a tacit willingness to permit tax avoidance by business interests (e.g., presidential decrees exempting specific individuals and entities from taxation). This entrenched political economy configuration has for decades prevented the formulation of a clear strategy focused on growth and poverty reduction.[1]
  • Economic institutions that lack independence and allow widespread rent-seeking. Neither do these institutions prevent violations of norms and regulations put in place to keep budgets under control (e.g., violations of Pakistan’s Fiscal Responsibility and Debt Limitation Act (FRDL), or disregard for regulations governing energy tariffs, leading to large arrears to electricity companies, which eventually have to be paid by the government).
  • Overreliance on external assistance. Due to its geopolitical position as a so-called frontline state in a hostile region, Pakistan has traditionally considered itself too strategically important to fail. This is evidenced by the considerable aid it has received from various countries, including China, the Persian Gulf countries, and the United States, and international financial institutions.[2] This overreliance on aid has distorted policymakers’ incentives away from sustainable policies in the expectation that they will be bailed out by the international community in the event of economic difficulties.

Despite recent gains, Pakistan’s economic performance remains anemic (growth in fiscal year 2019–20 is expected to be only 2.4 percent, according to IMF data), and its outlook is risky. The country requires large capital inflows to meet its financing needs, at least partly because of its large budget deficit (7.4 percent of GDP in 2019–20) and public debt (76.7 percent of GDP).

What Can Be Done?

Pakistan can implement certain reforms without major changes in its political-economic DNA—for example, greater transparency in government expenditures, as well as better regulation and enforcement in the energy sector to eliminate its financial burden on the budget and to bolster economic growth. A more independent central bank can play a critical role in avoiding budget financing and maintaining a flexible exchange rate.

But Pakistan’s political structures and practices need more fundamental changes to formulate and implement a way forward for equitable economic growth. For decades, achieving such a unified vision has been hindered by political instability, wars with India, and uneasy relations with neighbors. Arriving at such a vision is a task for the Pakistani people, and not for the IMF, which is designed mainly for assisting countries in short-term macroeconomic difficulties—the situation in which Pakistan has found itself time and time again.

Long-lasting structural transformation and modernization of the Pakistani economy needs a substantially reduced role for the state, a smaller and better-trained bureaucracy, a simplified and better enforced regulatory framework; greater attention to the role the nation could play in the global and regional value chains; and moving away from rent seeking and import substitution. These are long-term goals and can most likely be achieved from bottom up, through public pressure. It is also necessary that Pakistan enhance its potential to achieve a stable economic future by improving relations with India, spurring increased trade and growth and reducing defense spending. India and Pakistan have for too long been heavily invested in maintaining their conflict, which is draining considerable resources and creating significant uncertainty for long-term investors.

Pakistan must also be more realistic in its expectations of international financial support. These are not promising times for countries needing international financial assistance. The economies of affluent countries have weakened, and the desire to solve international problems through multilateral approaches is at a low.

Moreover, the drawdown of US involvement in Afghanistan has altered Pakistan’s geopolitical position. For example, Pakistan has been an ally of the United States as long as Russia was the enemy, and Washington did not mind its close relationship with China to help in the balance of power in South Asia. But today Washington is increasingly wary of China’s ambitions to develop its economic sphere of influence in Asia. The United States is concerned that Pakistan has become the largest component and beneficiary so far of China’s ambitious Belt and Road initiative, which aims to build a giant infrastructure of roads, harbors, and connections enhancing China’s regional influence. Washington is questioning the wisdom of supporting Pakistan financially if it is felt that the authorities in Pakistan could use those resources to repay debt to China. In addition, Pakistan’s traditional supporters in the Persian Gulf, especially Saudi Arabia, are now confronting their own problems, including lower oil revenues. Therefore, the external resources available to Pakistan are likely to diminish considerably.

These developments should help push Pakistan along an innovative path toward a new economy, dismantling old vested interests and breaking repetitive cycles of instability and bailouts. Whether Pakistan will get on such a path will become clear in the next few years.

Notes

1. See Nadeem Ul Haque, Looking Back: How Pakistan Became an Asian Tiger in 2050 (Kitab, 2017).

2. For a discussion of the politics of aid to Pakistan, including by the IMF, see Ehtesham Ahmad and Azizali Mohammed, “Pakistan, the United States, and the Bretton Woods Institutions (BWIs): A Continuing Great Game?” in Routledge Handbook of Contemporary Pakistan, ed. Aparna Pande (2017).

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Adnan Mazarei Senior Research Staff

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