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Untitled Document
What Determines Investment?
Dr. Akmal Hussain
Newspaper: The Daily Times
Dated: Thursday, September 18, 2003

Inspite of the government’s claims of an economic turn around, the fact is that growth continues to persist at a level inconsistent with economic revival, while poverty continues to increase. As I have argued (see for example the UNDP, National Human Development Report, Chapter 2), the key factors that will determine economic revival and poverty reduction in Pakistan are the level and composition of investment. Over the last decade (1993 to 2003), investment as a percentage of GDP has continued to stagnate at a low level, and its composition has been such that the resultant poor quality of GDP growth has benefited the few at the expense of the many. Therefore the government needs to come to grips with the problem of investment, which lies at the heart of Pakistan’s current economic malaise. In this article I will briefly indicate some of the empirical and theoretical issues that would need to be considered in the context of an investment policy.

Let us start with the two economic indicators the government is using as a basis for its claim that it has achieved an economic turn around: (1) The State Bank reserves have increased to a historically unprecedented level. (2) The budget deficit has been significantly reduced.

It is true that the State Bank reserves have risen above 10 billion dollars, yet unless they are used to finance new investment they will wither on the vine. After all the reserves are kept mainly in US treasury bonds at about half percent interest rate, which means that in terms of opportunity cost, the government is actually losing money by keeping it in the form of State Bank reserves. The challenge is to achieve a sharp increase in productive investment (government plus private) so as to make a quantum leap in the GDP growth rate to over 7 percent. Such a growth rate must be achieved quickly and then maintained. This high growth trajectory is necessary if Pakistan is to overcome its serious economic problems of poverty, inadequate social and economic infrastructure and the resultant severe pressures on society and state.

While the budget deficit has been reduced, this achievement can at best be expected to induce stability in the government’s finances. It certainly cannot be expected to stimulate economic growth. On the contrary reduction in public expenditure would in itself, tend to reduce the GDP growth rate. What both the IMF and the government have failed to understand is that it is not just the level of the budget deficit that needs to be addressed, but more importantly the composition of the budget deficit with respect to development and non development expenditure. On October 27, 1991 when the Managing Director of the IMF, Mr. Michel Camdessus was in Lahore for a seminar with independent economists, I had pointed out to him that the IMF’s single-minded emphasis on budget deficit reduction was likely to prove counterproductive in Pakistan’s case. My argument was that the government would reduce development expenditure rather than non-development expenditure in its attempt to meet the public expenditure targets stipulated by the IMF. This was likely to slow down growth and the resultant low government revenues would generate the same budget deficits in the future. I also argued that the IMF policy package at the time was infeasible since it did not take into account issues of GDP growth and poverty. (reported in the Frontier Post, October 28, 1991). Ten years later this criticism has proven true. The development expenditure as a percentage of the GDP was reduced from over 6 percent in the late 1980s to about 3 percent in the year 2000. At the same time GDP growth fell sharply and poverty increased dramatically. Mr. Camdessus during the Lahore debate (1991) of course pointed out that “IMF was not in the business of GDP growth”, since it was only responsible for doing “battlefield surgery” on countries in crisis.

In the last two years in Pakistan the budget deficit has been reduced essentially because of a sharply reduced debt-servicing burden resulting from the debt rescheduling following Pakistan’s sagacious decision to join the war against terrorism. Nevertheless it is important to recognize that the fiscal space afforded by the debt rescheduling is not enough to enable an increase in development expenditure large enough to jumpstart the economy. Thus, inspite of the government’s claims of a “historically unprecedented increase in development expenditure” this year, as a percentage of GDP, it is still only 4.1 percent, which is far below the 7 percent level of the 1970s.

For Pakistan to reach the GDP growth rate consistent with substantial poverty reduction (over 7 percent), a much higher scale of development expenditure is required. This is necessary if urgently needed construction of infrastructure projects such as, water reservoirs, highways, port facilities, health and education projects are to be undertaken. These would not only directly accelerate GDP growth through an increase in public sector investment but would also do so indirectly, by stimulating private sector investment.

The government’s policy of inducing an increase in private sector investment is fragmented, and lacks a sound theoretical basis. For the last three years the government’s economic managers have believed that if they could somehow reduce interest rates and stabilize the exchange rate, that private sector investment would increase. They have reduced the interest rates substantially and stabilized the exchange rate (at least for the present), yet total investment as a percentage of GDP continues to stagnate at about 14 percent. The question is why?

It can be argued that the government’s theoretical proposition that a lowered interest rate would increase investment, is fallacious. A lowered interest rate would marginally reduce the cost of investment projects. However this consideration does not determine investment and comes into play only after the entrepreneur decides to take the risk of investment. In the same way a stable exchange rate enables reliable cost estimates to be made (with respect to imported inputs) by a prospective investor. This may be a facilitating factor, but cannot determine his investment decision. It is not surprising therefore that in a situation where private investors in Pakistan are not willing to take long run risks associated with new projects, they are putting their money into real estate and speculative operations in the stock market. The key to an investment decision is the investor’s judgment that the likelihood of an acceptably high, income stream in the future is greater than the risk of losing his money. This brings us to the issue of historical time and uncertainty in the context of economic theory.

Alfred Marshall, the 19th century economist points out in the preface of his Principles of Political Economy, “The element of Time is the center of the chief difficulty of almost every economic problem”. Keynes, in his General Theory (1936) attempts to explain the functioning of the modern economy by working out the implications of the uncertainty generated by historical time. The issue of time and uncertainty became important for Keynes because of his paradigmatic proposition that it is investment that determines the level of output and employment. His analysis is based on the fact that we live in the movement of time, and therefore objective and subjective changes that occur at any moment in time, feedback to alter our future investment behaviour. Rather than investment being governed by savings as in the orthodox neo classical model, Keynesians like Michal Kalecki (1966) argued that investment in part generates the profits necessary to finance itself.

While expectations of profits in the future determine the amount of investment that will be undertaken today, this expected return cannot be determined simply in terms of present interest rates. This is because the future is inherently unknowable. Professor Joan Robinson, my teacher at Cambridge, during my first year as an undergraduate, explained to me the role of future expectations in present investment decisions. She pointed out in October 1969 during a lunch of bread and cheese, at the Anchor, a pub beside the River Cam, “investment decisions are made in the present where the past is irrevocable, and the future is unknown”. This remark echoed the importance of what Keynes had called “animal spirits” of the entrepreneurs in the investment process and the independence of investment from savings decisions.

In an econometric study on the constraints to private investment in Pakistan, Dr. Ali Cheema and Dr. Faisal Bari of LUMS, (2003), have shown that governance variables such as tax administration, law and order, and contract enforcement are major constraints to investment in Pakistan.

In conclusion it can be suggested that investment in Pakistan today depends upon a variety of factors, which go into investors’ expectations of the future: These include not just interest rates and exchange rates that impact present costs of production, but also infrastructure, law and order conditions, relations with India (which could affect future security), and the establishment of institutions such as a free judiciary and representative government. All these factors together could influence the functioning of markets, costs and profits in the future. Such factors related with economic, social and political conditions come into play to varying degrees for entrepreneurs who invest today, on the basis of their individual assessment of what the future holds for them. Given these determinants, the government can lead the investment process from the front by undertaking the necessary investment in infrastructure, pursuing peace with India, and establishing the institutional conditions for the rule of law and representative government. Only then can entrepreneurs start put the fear of the past behind them and invest in a better future.

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