How good is the economy?

Pakistan has done what many IMF creditors do - good enough to keep the program going while avoiding painful reform

How good is the economy?
The IMF issued a glowing account of Pakistan’s economy last month, in its Sixth Review of the Extended Fund arrangement. That account, which has been extensively quoted in the national press, as well as in The Economist, has come at a particularly good time for the current government – a month before it presents its third budget, and just a few months after it has weathered a serious political crisis. We could all do with the good news. But is it really all good?

The IMF’s report is notable for its mixed messages. In almost every section, it first credits the government for improvement in certain indicators, and then puts in explanations which point to the fact that policy implementation had little to do with the improvements. Even more interesting, the report is replete with caveats, wherein the Fund seems to be giving itself space to backtrack from its rosy account. All these shenanigans make for interesting reading, but leave the reader somewhat baffled. To give just a few examples:

The very first sentence of the report is that “the macroeconomic picture is improving.” The paragraph then goes on to say that this is predicated on significant growth in agriculture and construction. The Fund may have called it too soon – the wheat crop has suffered due to untimely rains in March and April. Earlier, the State Bank’s Overview of the first quarter of the current fiscal year had warned that floods in Punjab in August/September 2015 are likely to have an impact on agricultural output. In fact, that overview specifically said that although cotton was sown over a larger area this year, production is expected to remain below target. It is thus not clear what the IMF’s optimism is based on. As far as construction is concerned, the sector’s share in Pakistan’s GDP is around 2.5%. A construction boom can have a very positive fallout, because the sector has many backward and forward linkages with the services sector, but there is little evidence that Pakistan is experiencing the sort of unprecedented surge in construction activity that would significantly boost the economy.
The government hasn't stopped borrowing, it has just shifted to another source

Embedded somewhere in the same paragraph is the information that exports have weakened due to lower cotton prices, and an appreciation of the real exchange rate. At the same time, improvement in the capital account can be attributed to multilateral inflows, continued growth in remittances and the one-time launch of the Sukuk bonds. The one positive element is that the dip in international oil prices has resulted in a lower import bill and an improvement in the trade balance, in addition to helping bring about a fall in headline inflation. But even this improvement is not unequivocal – the government has passed on a good measure of the fall in prices to the consumers, but has taken a revenue hit in the process.

The IMF’s assessment of the government’s fiscal performance is again couched in positive terms, but does not hold up to scrutiny. The Fund says that the budget deficit has been restricted, but acknowledges that this was done by restraining development expenditure. The indicative target of federal tax collection was missed in the second quarter, because of the reduced collection from tax on petroleum products, and because the government has had to face legal challenges to its plans to get industry and CNG stations to pay a Gas Infrastructure Development Cess over and above the existing Gas Development Surcharge it takes from exploration companies. Matters are desperate enough that the authorities were considering raising the rate of sales tax on petroleum products, and levying regulatory duties on a range of products midway through the fiscal year. These measures are almost bound to go through in the next budget. Industry sources are also alleging that the revenue shortfall would be higher if the government had not delayed refunds on income and sales tax to industry. The government of course denies this, and says in fact that it is going to put into place a plan to speed up the refund process by mid June 2015.

One area where the government has made definite progress is improving tax compliance and enforcement. The Federal Board of Revenue has issued notices to more than 150,000 non tax filers in the first six months of the current fiscal year and has worked hard to put together information on potential taxpayers from a variety of sources. They have also successfully linked evidence of tax filing to concessions on regulatory fees paid for a range of services.

The IMF hasn’t said much about government borrowing from the banking sector, which was a major issue in past reports. This is because there is a substantive change on this front. Government borrowing from the central bank has fallen such that an outstanding credit of Rs 2.2 trillion in March 2014, was reduced to one of Rs 1.7 trillion in March 2015. This, combined with the drop in oil prices, has obviously had a positive effect on inflation. In fact, inflation has dipped to the low single digits, and the State Bank has twice, in the last six months, reduced its discount rate. But the government’s borrowing habit has not abated – it is just shifted to another source. Outstanding credit extended to the government by the commercial banks amounted to Rs 4.9 trillion in March 2015, compared to Rs 3.7 trillion in March 2014. The State Bank’s statement of monetary policy in March 2015 said that private sector credit had remained subdued, and its not difficult to see why, if the government is going to mop up all the available funds. On the other hand, the IMF’s report says that private sector credit uptake has increased by a healthy 10% in the last year. This is an increase from a very low base, which is the only way that the two contradictory statements would reconcile.

There is little doubt that the macroeconomic indicators have shown positive movement. The trade balance has improved due to the fall in the import bill, mainly on account of falling prices of petroleum products. The net reserves with the State Bank have risen due to multilateral flows and sustained remittances. The fiscal deficit is likely to have shrunk to about 5% of GDP compared to 8% two years ago. Inflation has fallen sharply. All of this is good news.

Not much of this, however, is due to sustained policy reform. Falling international oil prices have helped the balance of payments and inflation, but have also caused an over-valuation of the exchange rate which is hurting exports and will therefore have to be corrected in the longer run. The deficit has been controlled by sharp cuts in development expenditure which has long term implications. Government borrowing from the central bank has decreased, but the government has shifted to commercial banks as a source of funds, thus squeezing private sector credit offtake. In short, the Government of Pakistan has done what many IMF creditors do. It has done just enough to keep the program going and tranches flowing, but has managed to avoid painful reform that would hurt the interests of its entrenched elites. The IMF would have done well to recognize this.