By A.B. Shahid
In August 02, a series of three scholarly articles by Dr Ishrat Husain appeared on the opinion pages of this newspaper. The articles explained, at length, the rationale behind the current policy on maintenance of foreign exchange reserves, to the policy’s critics as well as the uninitiated readers who were likely to be misled by the criticism of the policy.
One year seems a fair time lag to examine whether the policy was founded on credible bases.
The single most interesting aspect of the analytical exercise was the absence of a reference to the policy’s sociological impact, although the articles admitted that it had a direct impact on the monetary policy and therefore the economy as a whole. The author cannot be blamed for this striking gap in the analysis.
Economists around the world still don’t deem it fit to include this all-important variable in the macroeconomic models they design, which has been the reason for their failure in resolving macroeconomic problems.
In Pakistan, failure of economic planners (in which they are ably assisted by tactless and often corrupt politicians) throughout the past three decades has led to a sustained rise in the level of poverty. Yet, they are not prepared to accommodate the social aspect in their planning models. Instead, they make it a point to belittle the critics who point out this serious shortcoming. They pity their critics as if the social aspect is an alien variable that could distort their models.
The culture of belittling policy critics is gaining momentum as economies come under firmer control of academics that are used to postulating outcomes while assuming that environment will not react in certain ways. This club of “like-minded” people, who tend to follow, often unimaginatively, what their counter-parts do elsewhere, places incompetent and gullible politicians on the wrong track. These articles too cited a Reuter story about growth in Asian forex reserves and recommended duplication of that model in Pakistan suggesting that, “ for the country to be free from the influence of the IMF there is no other better option to assert our economic sovereignty than to accumulate these reserves.”
The same clan of advisors (quoted in Reuter story) failed to predict “sudden change in market sentiment” that left many Asian economies vulnerable to the 1997 crisis. Now they insist that developing countries become more cautious by increasing savings at the expense of increasing misery, realizing little that such a doctrine will lead to a more serious crisis - a social upheaval that could rapidly lead to unmanageable chaos. Signs thereof (poverty and deprivation-driven crime and terrorism) are already clearly visible.
Towards the end of the last article in the series, the basis of the policy favouring accumulation of foreign exchange reserves was aptly summed by saying “there is an inherent trade-off in the short run between debt reduction strategy and public sector-led growth acceleration strategy. As the country was under a heavy debt burden and faced with an acute liquidity shortage, it was decided to reduce this vulnerability and secure the external sector of the economy.” This implied downgrading all other priorities in favour of supporting the external sector. Admittedly, there was a need for this policy shift but not carrying it on for nearly four years has, undeniably, been detrimental for the economy.
The rationale behind this momentous decision needs examination i.e. the inherent trade-off between debt reduction and growth. The pre-fix “public sector” seems superfluous because critics of the policy on foreign exchange reserves did not advocate public “sector” led growth. Instead, what they advocated was government investment in maintaining the physical and social infrastructure, which was essential for any kind of growth led either by public or private sector. It is undeniable that Pakistan’s infrastructure is falling apart.
It was viewed too casually during the last two decades. The havoc caused by this year’s monsoon rains will shatter it even more. Postponing action any further on repairing it will cause long-term damage to the economy, with or without foreign exchange reserves.
A dispassionate look at the infrastructure reveals the following painful realities:
* large dams suffer from the effects of silting, and can no longer store quantities of water that the provinces require to sustain agriculture; the conflict led to serious inter-provincial differences that threatened the unity of the State;
* irrigation system has degenerated because river banks were not repaired for decades; land erosion and salinity have left vast tracts of arable land unusable;
* power generation and transmission systems are virtually falling apart forcing people to switch to expensive and environment unfriendly alternatives;
* railway system has become so archaic that practically every component thereof needs replacement;
* roads, especially in big cities (look at Karachi’s roads), are in a terrible state; condition of bridges is no better;
* fuel oil storage capacity is capable of holding just 75-day buffer stocks; God alone will help us in an emergency;
* state-run schools, colleges and universities, which account for almost 75 per cent of educational institutions are grossly under-funded, ill-managed and produce half-educated, unskilled young men and women who can’t find jobs;
* state-run hospitals, which account for almost 80 per cent of the healthcare services are grossly under-funded, ill-managed and wholly incapable of delivering even essential healthcare services; controlling spread of epidemics is impossible;
* emergency services are virtually zero when compared with the country’s size and population spread; their response to natural calamities and disasters in the recent past should leave no one in doubt about their gross inadequacy;
* besides being inherently corrupt, law enforcement agencies lack modern forensic and surveillance equipment;
* the legal system is seriously handicapped by the incompatibility between its size and mounting demands thereon, which is a reflection of the fast deteriorating social conditions.
Overlooking the neglect of the development aspect, the first article in the series faulted critics for their opposition to the policy’s obsession with building reserves by saying: “The second group [of critics] consists of those who consider foreign reserves to be ‘irrelevant’ as this has not helped the conditions of common man. They confuse the domestic budgetary resources with external resources and are not perhaps fully aware of the distinction between the fiscal and external accounts.
Foreign reserves belong to the whole nation - the government and private sector - while budgetary resources belong to the government alone. In theory, these reserves can be transferred to the government by the SBP in form of loans.
“ The government can then use these resources in a variety of ways: (a) to increase its development expenditure and thus boost the declining investment level; (b) to insulate the general public from hikes in petroleum prices, electricity and gas prices by providing subsidies; (c) to devise special schemes such as Housing, Yellow Cab, Yellow tractor; (d) to set up programmes for direct employment creation; (e) to extend concessional loans at low rates of interest to agriculture, exports, SME and IT sectors. What will be the consequences of this policy? The reserves will be exhausted in less than two years, the government’s domestic debt will increase by Rs420 billion and debt-servicing component of the budget will create additional annual budgetary outlays of Rs40 billion every year and inflation will most likely be in double digits.”
It is undeniable that building exchange reserves by withholding vitally needed expenditure on sustaining the country’s dwindling infrastructure, has dampened the investment climate, halted creation of large new businesses and jobs, and multiplied social problems that the State now seems hard put to resolve. It is an accepted fact that, until an under-developed economy reaches a take-off stage (Pakistan is far from it), the State remains the biggest “business” that could boost growth. To fault those who advocate (a) increasing outlay on development expenditure, was unfair.
Reservations about (b) public expenditure for minimizing (not “insulating” the public from) the impact of price hike in utilities are also flawed. There is a critical “trade-off” between the policy on sustaining residual incomes and demand creation if economic growth is to be maintained at a level commensurate with the rise in population and the issues that it give rise to.
The implied disapproval of (c) devising special [financing] schemes (not the “Yellow Cab” or the “Yellow Tractor” types) to promote housing too was mistimed. Aren’t both the central bank and the State now encouraging banks to launch such schemes? Does it not prove that (claims about containing inflation aside) purchasing power is being diluted by steeply rising utility and fuel costs, and reducing consumer demand as a consequence thereof?
A for the reference to (d) setting up employment programmes, the use of the pre-fix “direct” requires explanation. If the implication is “without merit” the reference was wrong; no critic ever asked for lowering merit because it will eventually lead to worsening of an already inefficient bureaucratic set-up, and increase waste.
What the critics certainly asked for was creation of employment opportunities (not arbitrarily but) as a logical consequence of increase in development expenditure and initiation of projects to sustain the physical and social infrastructure.
Finally, (e) are we not extending loans at low interest rates to agriculture, export, IT and SME sectors, though it is yet to be established credibly whether SME sector too is benefiting from this policy?
As for the dangerous scenario (painted in the articles) that could emerge if all these policy initiatives were taken, it has yet to unfold. For the present, there are no signs of the reserves being exhausted in less than “two” years even if outlay on development expenditure was increased by another Rs. 60 billion to bridge some of the yawning gaps in the country’s infrastructure cited above.
Neither do we see the signs of government’s domestic debt rising by Rs420 billion nor is inflation in double digits, not, at least, according to official sources.
All signs are that the government could do a lot more than it has opted to do in the area of improving the vital but dilapidated components of the country’s infrastructure.
Accumulating reserves while openly disregarding other vital aspects of the economy was ill advised. That’s what the critics have been pointing out.
The assertion that the “strategy to draw down reserves and allow the government to pump the domestic economy will prove short-sighted, expose Pakistan once again to the enhanced risk of default on its external debt and liabilities in the future, and generate uncertainties and turbulence in the markets,” was grossly unfair because no critic ever suggested that the State should overlook maintaining a balance between meeting its commitments to foreign lenders and pressing development needs.
This comment was a classic example of how academics sometimes choose to belittle their critics.
Admittedly, the policy of accumulating foreign exchange reserves contributed its “share” in stabilizing the exchange rate, reversing [the] flight of capital, arresting dollarization of the economy, lowering inflation (?), reducing interest rates, and lowering debt ratios. But it is unfair for the central bank to claim credit for all these achievements. The assertion that inward remittances flow has been inspired by central bank’s action in restoring confidence in Pakistan’s banking channels is exaggerated. 9/11 had a great deal to do with it. Similarly, flight of capital could hardly be induced by falling rates of profit on deposits in Pakistani banks, and the weak investment sentiment. Once again 9/11 deserves credit for limiting the flight of capital.
The benefit of lower interest rates, which went entirely to business and industry, has not been recycled to consumers even partially. Proof thereof is the amazing rise in the 2002-profits of the large end of the corporate sector.
What comes out, though, as a stark reality, is the fact that while businesses have benefited from drop in interest rates, saving deposit holders continue to get a negative real rate of return, which is pushing up poverty. And there is precious little proof of low inflation having benefited the lower income groups.
The only significant benefits of the current policy on foreign exchange reserves have been lower external debt ratios and low country risk associated with Pakistan but weak investment sentiment prevents benefiting therefrom.
The belief that offering concessions to business and industry through lower interest rates and extraordinarily easy borrowing terms alone will boost growth, has backfired because infrastructure deficiencies continue to discourage investment.
The disastrous consequence of pursuing this policy will be that Pakistan will stay dangerously unprepared for the scenario after January 2005. The country could be flooded with cheaper imported goods rather than produce them locally.
In the end, it would be less than fair not to admit that criticism of the policy of accumulating foreign reserves has been flawed in as much as some critics faulted open market purchases of foreign exchange by the central bank. It betrays their lack of knowledge about the flaws in the banking system that led, over time, to remittances being transacted in the open market.
To bring that inflow back into to the official domain was not something that should have been criticised, especially because it was followed by squeezing of these parallel banking channels; what needed scrutiny was the manner in which the central bank went about buying foreign exchange from the open market. Surely, there would be instances of excesses that deserved punitive or remedial action by the central bank.
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