International Monetary Fund (IMF) and Pakistan recently agreed on terms for a $6bn bailout package, which would be disbursed over a period of more than three years. The deal followed months of negotiations by Pakistani officials with the IMF, and comes with some tough conditions. Ailia Zehra sits down with economist and dean of Information Technology University Dr Akmal Hussain to talk about the program and its implications for the country. This is the first of a series of interviews with economic experts about the bailout package.
Ailia Zehra: It is said the IMF bailout package will put unprecedented economic pressure on the common man and curb the growth rate. How do you think will it affect the ordinary citizens?
Dr Akmal Hussain: The basic conceptual framework of the IMF “stabilization” program aims to achieve stabilization in the exchange rate through a substantial reduction in the Balance of Trade deficit. This, they imagine, can be done by reducing import expenditures through a contraction of the aggregate demand which involves a slowdown in the GDP growth rate. The four main policy instruments the IMF uses in the pursuit of its aim are:
1. Devaluation of the exchange rate
The devaluation, by making imports more expensive in rupee terms, reduces import demand. Devaluation is erroneously thought by the IMF to reduce the Dollar price of exportables, substantially raise export demand thereby leading to increased export earnings. In the case of Pakistan, while devaluation has reduced import expenditures, it has failed to significantly increase export earnings. The reason is that there are three necessary conditions for devaluation to lead to an improvement in the Balance of Trade and none of these is met in Pakistan’s case:
(a) According to the Marshall-Lerner condition, the sum of the price elasticities of demand for exports and imports has to be equal to or greater than one.
In simple terms, this means that import demand has to be highly responsive to an increase in the rupee price following devaluation.
At the same time, export demand has to be highly responsive to a reduction in the Dollar price, following devaluation. Only then will a substantial reduction in the import expenditures and increase in foreign exchange earnings from exports be possible.
However, most of Pakistan’s imports are necessities (such as, oil, fertilizer, industrial machinery and spare parts) whose volumes cannot be substantially reduced even if rupee prices rise sharply. At the same time, Pakistan’s exports are mainly primary or related goods (such as cotton, cotton yarn, grey cloth and other low value added textiles) whose demand does not rise enough to raise foreign exchange earnings following a reduction in the Dollar price.
Thus, no significant improvement in the Balance of Trade can be expected through devaluation. This has in fact been the case over the last nine months when a sharp devaluation in the exchange rate occurred.
This has also been the historical experience of Pakistan whenever devaluation has been attempted under a dozen IMF programs.
https://www.youtube.com/watch?v=gu50D_ixLKc
(b) Domestic inflation has to be brought under control before devaluation so that an increase in the rupee prices of exportables does not neutralize the effect of devaluation on the Dollar prices of exportables. In Pakistan’s case the required sequence of policy was not followed.
In any case, immediately after devaluation, inflation accelerated because the domestically manufactured goods use oil, electricity and whole range of industrial inputs whose prices rise with devaluation.
(c) Even if the Dollar price of exportables falls after devaluation, for an increase in export sales, it is necessary to have underutilized capacity so that export orders can be quickly supplied. In Pakistan’s case 50% of production units in the textiles industry (the largest industry), are paralyzed due to acute cash flow problems and the remaining about 50% of the production units are running at full capacity.
It is clear therefore, that devaluation in Pakistan, while it will not significantly improve the Balance of Payments, it will certainly generate inflation.
2. A drastic reduction in the fiscal deficit from the present 9% of GDP to 3.5% of GDP.
Given the fact that a large increase in revenues through an increase in Tax/GDP ratio has not been possible so far, meeting the IMF budget deficit target means a reduction in development expenditure, with cuts in health and education expenditures as well as reduction in expenditure on infrastructure. So IMF programs typically slow down GDP growth and consequently increase unemployment and poverty. That is why Dr. Mahbub-Ul-Haq wisely observed: “It is short sighted to balance budgets by unbalancing the lives of people”.
3. Sharp increase in prices of electricity and gas
Pursuant to their objective of a drastic reduction in the fiscal deficit, the IMF requires withdrawal of subsidies including those on utilities. This means a sharp increase in the prices of electricity and gas. Consequently the inflation that was induced by devaluation is further reinforced by an increase in the electricity and gas tariffs.
4. Increase in the interest rate
The fourth conditionality of the IMF program is an increase in the interest rate. This would raise the cost of borrowing for entrepreneurs and thereby reduce private sector investment and hence slowdown GDP growth. Thus, the interest rate increase reinforces the slowdown in GDP growth induced by a reduction in public sector development expenditure.
The purpose of interest rate increase in the IMF conceptual framework is to control inflation by tightening the money supply. While this policy works in the highly developed countries, it does not in an underdeveloped country like Pakistan. This is because inflation in Pakistan is structural. The four main triggers to inflation in Pakistan are: (i) fuel prices; (ii) prices of electricity and gas; (iii) food prices; (iv) prices of imported industrial inputs. As the present galloping inflation has demonstrated, all four of these structural triggers are turned by policies within the IMF framework.
It is apparent that while the IMF program, given the structure of Pakistan’s economy, is unlikely to achieve a sustainable improvement in the Balance of Trade, it will certainly add a dreadful burden on ordinary citizens by increasing inflation, poverty and unemployment.
William Easterly (2005) conducted research on countries (including Pakistan) where IMF programmes have been repeatedly adopted. On the basis of evidence from the top 20 recipients (including Pakistan) of repeated IMF Adjustment Lending, concluded “If the original objective was adjustment with growth, there is not much evidence that structural adjustment lending generated either adjustment or growth”.
AZ: The PTI government agreed to such a high increase in revenues unlike previous governments which appeared to have resisted the strict conditions. Do you think the deal could have been negotiated better?
AH: Although details are yet to emerge, judging from the stipulated policy measures prior to finalization of the IMF program by the Board of Governors, it appears that this time the conditionalities will be severer than in the previous 12 programs.
The difference between the earlier programs and this one, is that previously, the Pakistan government was “the most allied ally” to the US, and was playing a strategic military role for the US: starting from the Ayub period when Pakistan joined SEATO and CENTO pacts to help cover the Southern flank of the Soviet Union; then General Zia-Ul-Haq whose government played a key role in the US covert war against the Soviet Union in Afghanistan. Then the governments of General Musharraf and successive civilian governments, in supporting the US in the “war against terrorism”, sacrificed precious lives, billions of Dollars of war damages to the economy and allowed a destabilization of society through the rise of militant extremism.
By contrast, in the case of the present government, there is a trust deficit with the US and a transactional relationship with them prevails.
So this time around the US is using the IMF to pressurize Pakistan to fall in line with their strategic objectives in South Asia and the Middle East.
AZ: What, in your opinion, are the five main structural problems with Pakistan’s economy that force us to keep going back to the IMF?
AH: The essential reason for Pakistan’s repeated dependence on foreign loans is the failure so far to build an economic structure which would enable sustained economic growth through the development of the capabilities of all its people rather than a few. This requires an institutional structure that provides equality of opportunity to all citizens to develop their human potential for creativity and innovation. When human capabilities of a society are developed and brought to bear in the sphere of the economy, then a broad base for enterprise, innovation and productivity increase can generate sustained, self-reliant economic growth. Recent research first by Professor Aghion on Endogenous Growth and later by Professor Atif Mian shows that the long term growth requires a base within the country for innovation and productivity increase.
So, it can be argued that there are five main structural features of Pakistan’s economy that underlie its incapacity to achieve sustained long term economic growth and perennial loan dependence:
1. Rent-based institutional structure
Such a system systematically generates rents for the elite coalition. This is done by restricting high quality education, health and denying equal access over productive resources, markets, economic and political competition and governance.
Such an elite-oriented institutional structure by restricting competition induces inefficiency, allows hiring based on nepotism, has disincentives for hard work, lack of innovation and productivity increase. Consequently, such an economy cannot sustain high long term growth in per capita income; is unable to generate export earnings high enough to finance the import requirements of a high growth trajectory; has inadequate revenues for the government to build infrastructure through its own financial strength.
Consequently every spurt of growth in such an economy soon comes to a halt due to an unmanageable Balance of Payments deficit and a fiscal deficit.
2. Elite-dominated society
Inherent to such a rent based, elite dominated society is the phenomenon of high interpersonal and inter-regional inequality. The failure to sustain growth combined with inequality has led to persistent mass poverty, food insecurity, high death rates amongst young mothers and child malnutrition. Consequently, a large proportion of the population is excluded from the opportunity to save, invest and innovate for self-reliant economic growth.
3. Governments’ failure to provide basic facilities to citizens
The third structural problem with Pakistan's economy is the failure to provide high quality health, education and basic services to all citizens. Consequently, a large proportion of the population is suffering from illness and is unable to engage in critical thinking and hence original thought due to poor quality of education.
It is not surprising therefore that productivity in Pakistan is so low and the country is dependent on the IMF not only for finance but also for its policy thinking.
4. A centralized governance structure
The governance structure excluding all but the elites from the process of decision making, is unable to bring to bear in governance, the traditional wisdom and values of compassion which the poor possess in plenty.
5. A bureaucracy that has not bought into the vision of the political leadership
Bureaucracy in Pakistan lacks motivation and is demoralized by interference of politicians for their personal gain. Most important, apart from a few exceptions the bureaucracy has inadequate professional capability to even understand the problems they are dealing with, let alone design policy to overcome them.
Ailia Zehra: It is said the IMF bailout package will put unprecedented economic pressure on the common man and curb the growth rate. How do you think will it affect the ordinary citizens?
Dr Akmal Hussain: The basic conceptual framework of the IMF “stabilization” program aims to achieve stabilization in the exchange rate through a substantial reduction in the Balance of Trade deficit. This, they imagine, can be done by reducing import expenditures through a contraction of the aggregate demand which involves a slowdown in the GDP growth rate. The four main policy instruments the IMF uses in the pursuit of its aim are:
1. Devaluation of the exchange rate
The devaluation, by making imports more expensive in rupee terms, reduces import demand. Devaluation is erroneously thought by the IMF to reduce the Dollar price of exportables, substantially raise export demand thereby leading to increased export earnings. In the case of Pakistan, while devaluation has reduced import expenditures, it has failed to significantly increase export earnings. The reason is that there are three necessary conditions for devaluation to lead to an improvement in the Balance of Trade and none of these is met in Pakistan’s case:
(a) According to the Marshall-Lerner condition, the sum of the price elasticities of demand for exports and imports has to be equal to or greater than one.
In simple terms, this means that import demand has to be highly responsive to an increase in the rupee price following devaluation.
At the same time, export demand has to be highly responsive to a reduction in the Dollar price, following devaluation. Only then will a substantial reduction in the import expenditures and increase in foreign exchange earnings from exports be possible.
However, most of Pakistan’s imports are necessities (such as, oil, fertilizer, industrial machinery and spare parts) whose volumes cannot be substantially reduced even if rupee prices rise sharply. At the same time, Pakistan’s exports are mainly primary or related goods (such as cotton, cotton yarn, grey cloth and other low value added textiles) whose demand does not rise enough to raise foreign exchange earnings following a reduction in the Dollar price.
Thus, no significant improvement in the Balance of Trade can be expected through devaluation. This has in fact been the case over the last nine months when a sharp devaluation in the exchange rate occurred.
This has also been the historical experience of Pakistan whenever devaluation has been attempted under a dozen IMF programs.
https://www.youtube.com/watch?v=gu50D_ixLKc
(b) Domestic inflation has to be brought under control before devaluation so that an increase in the rupee prices of exportables does not neutralize the effect of devaluation on the Dollar prices of exportables. In Pakistan’s case the required sequence of policy was not followed.
In any case, immediately after devaluation, inflation accelerated because the domestically manufactured goods use oil, electricity and whole range of industrial inputs whose prices rise with devaluation.
(c) Even if the Dollar price of exportables falls after devaluation, for an increase in export sales, it is necessary to have underutilized capacity so that export orders can be quickly supplied. In Pakistan’s case 50% of production units in the textiles industry (the largest industry), are paralyzed due to acute cash flow problems and the remaining about 50% of the production units are running at full capacity.
It is clear therefore, that devaluation in Pakistan, while it will not significantly improve the Balance of Payments, it will certainly generate inflation.
2. A drastic reduction in the fiscal deficit from the present 9% of GDP to 3.5% of GDP.
Given the fact that a large increase in revenues through an increase in Tax/GDP ratio has not been possible so far, meeting the IMF budget deficit target means a reduction in development expenditure, with cuts in health and education expenditures as well as reduction in expenditure on infrastructure. So IMF programs typically slow down GDP growth and consequently increase unemployment and poverty. That is why Dr. Mahbub-Ul-Haq wisely observed: “It is short sighted to balance budgets by unbalancing the lives of people”.
3. Sharp increase in prices of electricity and gas
Pursuant to their objective of a drastic reduction in the fiscal deficit, the IMF requires withdrawal of subsidies including those on utilities. This means a sharp increase in the prices of electricity and gas. Consequently the inflation that was induced by devaluation is further reinforced by an increase in the electricity and gas tariffs.
4. Increase in the interest rate
The fourth conditionality of the IMF program is an increase in the interest rate. This would raise the cost of borrowing for entrepreneurs and thereby reduce private sector investment and hence slowdown GDP growth. Thus, the interest rate increase reinforces the slowdown in GDP growth induced by a reduction in public sector development expenditure.
The purpose of interest rate increase in the IMF conceptual framework is to control inflation by tightening the money supply. While this policy works in the highly developed countries, it does not in an underdeveloped country like Pakistan. This is because inflation in Pakistan is structural. The four main triggers to inflation in Pakistan are: (i) fuel prices; (ii) prices of electricity and gas; (iii) food prices; (iv) prices of imported industrial inputs. As the present galloping inflation has demonstrated, all four of these structural triggers are turned by policies within the IMF framework.
It is apparent that while the IMF program, given the structure of Pakistan’s economy, is unlikely to achieve a sustainable improvement in the Balance of Trade, it will certainly add a dreadful burden on ordinary citizens by increasing inflation, poverty and unemployment.
William Easterly (2005) conducted research on countries (including Pakistan) where IMF programmes have been repeatedly adopted. On the basis of evidence from the top 20 recipients (including Pakistan) of repeated IMF Adjustment Lending, concluded “If the original objective was adjustment with growth, there is not much evidence that structural adjustment lending generated either adjustment or growth”.
AZ: The PTI government agreed to such a high increase in revenues unlike previous governments which appeared to have resisted the strict conditions. Do you think the deal could have been negotiated better?
AH: Although details are yet to emerge, judging from the stipulated policy measures prior to finalization of the IMF program by the Board of Governors, it appears that this time the conditionalities will be severer than in the previous 12 programs.
The difference between the earlier programs and this one, is that previously, the Pakistan government was “the most allied ally” to the US, and was playing a strategic military role for the US: starting from the Ayub period when Pakistan joined SEATO and CENTO pacts to help cover the Southern flank of the Soviet Union; then General Zia-Ul-Haq whose government played a key role in the US covert war against the Soviet Union in Afghanistan. Then the governments of General Musharraf and successive civilian governments, in supporting the US in the “war against terrorism”, sacrificed precious lives, billions of Dollars of war damages to the economy and allowed a destabilization of society through the rise of militant extremism.
By contrast, in the case of the present government, there is a trust deficit with the US and a transactional relationship with them prevails.
So this time around the US is using the IMF to pressurize Pakistan to fall in line with their strategic objectives in South Asia and the Middle East.
AZ: What, in your opinion, are the five main structural problems with Pakistan’s economy that force us to keep going back to the IMF?
AH: The essential reason for Pakistan’s repeated dependence on foreign loans is the failure so far to build an economic structure which would enable sustained economic growth through the development of the capabilities of all its people rather than a few. This requires an institutional structure that provides equality of opportunity to all citizens to develop their human potential for creativity and innovation. When human capabilities of a society are developed and brought to bear in the sphere of the economy, then a broad base for enterprise, innovation and productivity increase can generate sustained, self-reliant economic growth. Recent research first by Professor Aghion on Endogenous Growth and later by Professor Atif Mian shows that the long term growth requires a base within the country for innovation and productivity increase.
So, it can be argued that there are five main structural features of Pakistan’s economy that underlie its incapacity to achieve sustained long term economic growth and perennial loan dependence:
1. Rent-based institutional structure
Such a system systematically generates rents for the elite coalition. This is done by restricting high quality education, health and denying equal access over productive resources, markets, economic and political competition and governance.
Such an elite-oriented institutional structure by restricting competition induces inefficiency, allows hiring based on nepotism, has disincentives for hard work, lack of innovation and productivity increase. Consequently, such an economy cannot sustain high long term growth in per capita income; is unable to generate export earnings high enough to finance the import requirements of a high growth trajectory; has inadequate revenues for the government to build infrastructure through its own financial strength.
Consequently every spurt of growth in such an economy soon comes to a halt due to an unmanageable Balance of Payments deficit and a fiscal deficit.
2. Elite-dominated society
Inherent to such a rent based, elite dominated society is the phenomenon of high interpersonal and inter-regional inequality. The failure to sustain growth combined with inequality has led to persistent mass poverty, food insecurity, high death rates amongst young mothers and child malnutrition. Consequently, a large proportion of the population is excluded from the opportunity to save, invest and innovate for self-reliant economic growth.
3. Governments’ failure to provide basic facilities to citizens
The third structural problem with Pakistan's economy is the failure to provide high quality health, education and basic services to all citizens. Consequently, a large proportion of the population is suffering from illness and is unable to engage in critical thinking and hence original thought due to poor quality of education.
It is not surprising therefore that productivity in Pakistan is so low and the country is dependent on the IMF not only for finance but also for its policy thinking.
4. A centralized governance structure
The governance structure excluding all but the elites from the process of decision making, is unable to bring to bear in governance, the traditional wisdom and values of compassion which the poor possess in plenty.
5. A bureaucracy that has not bought into the vision of the political leadership
Bureaucracy in Pakistan lacks motivation and is demoralized by interference of politicians for their personal gain. Most important, apart from a few exceptions the bureaucracy has inadequate professional capability to even understand the problems they are dealing with, let alone design policy to overcome them.