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Untitled Document
The Knife Edge of Fiscal Space
Dr. Akmal Hussain
Newspaper: The Daily Times
Dated: Thursday, 22nd January 2004

The history of economic policy in Pakistan shows that economic disasters have befallen the hapless citizenry due to sins of commission as much as by sins of omission. We will show in this article that there was a time over a decade ago when incorrect sequencing of the Structural Adjustment Programme led to disastrous economic consequences. That was a sin of commission. Today we may be about to commit a sin of omission: The failure to translate the over 10 billion dollars State Bank reserves into increased GDP growth and poverty reduction could lead to continuing and unnecessary increase in the misery of the people, and an erosion of the reserves themselves.

Successive governments stricken by the discreet charms of the IMF sought to reduce the budget deficit, regardless of the cost in terms of rising poverty and declining growth. That elusive symbol of economic health is now at hand. After a decade of stringent restrictions on development expenditure and more recently a sharp reduction in the debt-servicing burden (following debt restructuring), the fiscal deficit as a percentage of GDP has fallen from 8.8 percent in 1990-91 to 4.5 percent in 2002-03, while State Bank reserves are at an all time high level of over 10 billion dollars. Two questions emerge at such a juncture:

  1. What are the likely consequences of conserving this fiscal space rather than utilizing it?

  2. Can this fiscal space be productively utilized for economic growth and poverty alleviation?

Since both the above questions refer to the problem of sequencing economic policy, let us begin by revealing a policy disaster that occurred in the late 1980s because the government, the World Bank and the IMF got the sequencing wrong. Dr. Rashid Amjad, an eminent Pakistani economist, has shown in a recent paper how the government decision to sharply increase interest rates in 1987-88 was part of the Structural Adjustment Programme and a specific part of the financial sector reform programme associated with the Banking Sector Adjustment loan from the World Bank. In terms of economic logic it is clear that an increase in interest rates should follow and not precede a reduction in the budget deficit, so that the government would not have to borrow at extremely high interest rates. Amjad argues that this incorrect sequencing of economic policy was a policy “disaster”. It certainly was, because the resultant increase in the government’s debt servicing burden forced such a sharp reduction in development expenditure (to meet the IMF budget deficit reduction targets) that GDP growth slowed down and poverty increased to historically unprecedented levels. Development expenditure as a percentage of GDP, which was over 7 percent in the 1970s fell to less than 3 percent in the late 1990s. Development expenditure has historically played a significant role in generating GDP growth both directly as well as indirectly by stimulating private sector investment. Thus GDP growth fell from a historical trend rate of over 6 percent to about 3 percent in the late 1990s while poverty doubled from 17% of the population in 1987-88 to about 34 percent by the end of the 1990s.

The government policy in the late 1980s of increasing interest rates before reducing the budget deficit was a monumental policy disaster. More important the cost was paid by the poor in terms of untold suffering. Every third household in Pakistan today is hungry; 65 percent of the poor are suffering from disease; about 40 percent of the children are stunted in body and mind due to mal nutrition and large numbers of parents unable to bear such misery are committing suicide. Was any body held accountable for this policy decision in the government, the IMF or the World Bank?

We shall not here engage in the debate on whether or not the Structural Adjustment Programme was correctly designed. Economists like Nobel Laureate Stiglitz have argued that it was not. The point here is that the human cost in terms of hunger and disease could have been lesser if the IMF, the World Bank and the government had managed the Programme better, and sequenced its policy elements correctly.

Here we are today having finally achieved “macro economic stability” at a terrible cost in human suffering. The government and multi lateral agencies owe it to the people who have paid this cost to ponder on the strategic policy choice that has now emerged. The choice is clear: (a) Either the government at the behest of the IMF further reduces the budget deficit from 4.5 percent today to 3.5 percent next year in the pursuit of strengthening the “macro economic stability”, or (b) Use the existing fiscal space to undertake bold new initiatives in the public sector for poverty alleviation and accelerating growth. The increase in the GDP growth rate must not be marginal but a quantum leap to a new growth path of over 7.5%, which would make a substantial dent into the poverty problem.

Economic analysis leads us to an important proposition in the context of the above choice: If the government persists in simply conserving or further enlarging the fiscal space, and does not use it immediately, then this misplaced fiscal conservatism will lead to a loss of the fiscal space itself in the foreseeable future. Consider. If the large State Bank reserves do not get translated into high growth through public sector expenditure, then Pakistan’s exchange rate would appreciate. In such a case, ceteris paribus, export growth would slow down, with a consequent increase in the balance of payments deficit, thereby leading to an erosion of State Bank reserves. This is already beginning to happen in the Indian case which is why the Vajpayee government in its election year is envisaging a huge public sector development programme to stimulate their high growth to even higher levels and to maintain the competitiveness of Indian exports by preventing further appreciation in the exchange rate.

It is clear that fiscal conservatism in Pakistan in a situation of continuing low levels of private sector fixed investment means, that GDP growth will remain inadequate, poverty will increase and the very fiscal space that the government seeks to conserve will be constricted.

Let us now consider the alternative policy option that is available. The government can launch a set of major targeted programmes for the poor aimed at generating employment through rural infrastructure development, filling the food deficit gap of the poorest, providing safe drinking water and preventive health care.

Such targeted programmes would change the nature of the policy challenge. The issue would no more be, how to reduce the budget deficit further. A new range of issues will then emerge: (a) How to undertake a civil service reform. (b) How to improve the institutional efficiency of public sector development programmes. (c) How to accurately identify the poorest of the poor who are to be the beneficiaries of some of the targeted programmes. (d) How to conduct impact analysis of the government’s poverty programmes, and to independently monitor and evaluate these programmes. (e) How to transfer resources to district governments, currently starved of finances. (f) How to strengthen the institutional capability of local governments to design, implement and monitor projects for income generation, infrastructure, health and education.

Those in favour of fiscal conservatism point to the “limited absorptive capacity” for development funds in Pakistan. The fact is that due to over a decade of drastic cuts in development expenditure, there has been an erosion of even the weak institutional structure for public sector development that existed in the 1980s. It is only when a much higher order of development expenditure is allocated, that the financing and the management expertise necessary for reconstructing institutions, will come into play, as an integral element of resource allocation.

The argument for utilizing the existing fiscal space and aiming for high growth and poverty reduction does not mean losing macro economic stability. On the contrary I would argue that Pakistan’s economy is on a knife-edge. If the existing fiscal space is not quickly utilized for catapulting the economy on to a growth path of over 7.5% and for making its structure pro poor, then the economy will fall off the knife-edge. In such an event the prospect of sustaining macro economic stability will fall away as the economy slips into relatively slow growth and increased poverty. Thus the very fiscal space that is sought to be preserved will be lost. We cannot tarry too long on the knife-edge.

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