‘Not a panacea’- Inflation, private investment and growth in the new Budget 2011-12

Published in the Friday Times, June 10, 2011 in their issue on the budget. 

Current GDP growth estimates for Pakistan are at 2.4%. A figure insufficient to create jobs for the 2 million strong that join the labour force every year. According to IMF estimates an annual growth figure of 8% is needed to absorb the labour force while our target is 4.2%. Inflation, the evil twin of growth, is likely to increase with soaring oil and food prices threatening the current account into deficit. And then with the sad state of our finances, what of foreign donor confidence and private investment?

The budget has come under heat from major economists. Syed Akbar Zaidi for one said that “the finance minister’s speech yesterday was empty and disappointing. It was devoid of merit and failed to identify or address any of Pakistan’s numerous problems.” He went on to say that the budget panders to politicians due to its proximity to the election. Former Finance Minister Shahid Javed Burki was of the view that Hafeez Shaikh’s team consisted of brilliant minds, yet didn’t do much with the budget. Burki is of the opinion Hafeez Shaikh did well with the privatisation portfolio under Pervez Musharraf’s government and should have used his experience to hand over some of the poor performing public sector corporations. “Where will this budget take the economy over the next financial year? Not very far. It will not revive economic growth, not reduce the dependence on foreign flows, not reduce the incidence of poverty, nor integrate the economy with rest of the world.” But as Finance Minister Hafeez Shaikh says, it’s a budget not a panacea.

Key problems identified in the current Economic Survey released by the State Bank are persistent and high inflation, low growth, low revenue collection leading to a high fiscal deficit that continues to add to the overall debt, and a dramatic fall in the investment rate. As Dr Sohail Zafar, Dean of the Business School at the Lahore School of Economics put it, “It’s a gloom and doom scenario, and all attempts to be consciously optimistic are not supported by sane logic and data.”

Of deficits, inflation and other sins: Consider the 4.2% growth target for instance, not impossible to achieve, not enough for our needs and yet a bit ambitious considering last year’s performance. Other targets like decreasing inflation to 9% seem too optimistic. The idea here is that the smaller deficit target will reduce the printing of money and reduce inflation. All this requires strict fiscal discipline, and actually meeting the 4% fiscal deficit target which we bounded over last year.

The central bank has the same view, that the government tightening its belt will decrease inflation, reduce borrowing costs and encourage consumer demand. However, government borrowings have increased 55% since the end of the last fiscal year. In an interview with Bloomberg (June 4), director of the monetary policy department, Hamza Ali Malik said that further tightening would be difficult, “Low growth, high inflation, rising debt. It’s a nightmare for any economy.” Furthermore, Dr Sohail Zafar says that expectations about foreign resources to meet the deficit seem are not likely to be realized.

The core problem facing Pakistan that affects the situation of government expenditures is of taxation and revenues. The tax policy has been somewhat contradictory. On the one hand the finance minister said that only 1.5 million people have filed their tax returns this year, only half of those who are registered and over 70,000 have been given notices. On the other hand the budget raises the taxable income level by Rs 50,000 to give relief. Then there’s a 15% pay increase for government employees, above the 50% increase given last year. How’s that for fiscal discipline?

The one percent decrease in the GST rate, from 17% to 16% will hardy impact inflation. As Irfan Hussain writes in Dawn (7 June), “If international prices of sugar are rising in Chicago, not even a Supreme Court suo motu notice will keep them down in retail outlets across Pakistan. Artificially low prices enforced by the state will only succeed in driving stocks underground, and encourage the creation of a black market.” Which brings us to the issue of subsidies and price control.

Does subsidy removal cause inflation? The decrease in GST is to offset the effect of the withdrawal of exemptions in fertilisers, pesticides, tractors, leather, surgical items, sports goods, carpets and some other sectors. There has been much hue and cry over this cut that this would cause inflation. Speaking at a post-budget press conference on 4th June, Dr Hafeez Shaikh said this would not happen because the subsidies would be made more targeted so they were not misused by wealthy people.

Subsidy removal, without spending the associated savings, may increase poverty due to the rise in input costs relative to the selling prices of products sold by most firms and farms. But the government’s fiscal policy will ultimately determine the effects. Inflation resulting from subsidy removal can be reduced with a conservative fiscal policy. Inflation comes from two sources: the initial increase in general prices due to the higher cost of inputs and more spending by the government as funds are freed up. Therefore, if their goal is to reduce the inflationary effect, the government has to keep spending to a minimum, focusing only on areas that can increase the country’s productive capacity. Our focus is defence (Rs 495 billion) and interest payments (Rs791 billion).

Even with an expansionary policy, to keep inflation low, government spending of associated savings needs to increase purchasing power and raise production. Wasteful public projects which do not add much to the country’s productive capacity should be avoided and private production encouraged. The new growth strategy by the Planning Commission of Pakistan focuses solely on the private sector as an engine of growth.

Pakistan and the private sector: Private investment in Pakistan has been shrinking for some time. Investment in the large-scale manufacturing has declined by 32% (compared to 17% last year). The investment-to-GDP ratio dropped to below 17% last year because of decreasing private investment. The manufacturing sector has been hit the hardest.

An improvement in electricity generation will also have a large impact on production levels and costs in the country. It should kept in mind, however, that such investments may take years to materialise.

It seems that some efforts have been made in this budget to aid private sector growth by reducing some taxes and duties, but they may be too lean. All special excise duties have been abolished. Regulatory duty on 392 items have been abolished. It is now limited to luxury vehicles, cigarettes, arms and ammunition, betel nuts and sanitary ware. Federal excise duty on cement will be phased out in three years. The federal excise on beverages has also been reduced from 12% to 6%. The tax rate on interest income from government securities will be 10% with no tax return requirement. The finance minister also announced on June 4 a five-year tax holiday on loan-free equity investments.

It is unclear whether this budget will do well for industry. Dr Zafar is of the view that there is a disconnect between monetary policy and the fiscal policy embodied in the budget. “Interest rates may be low theoretically, but are too high practically to push the private sector. New investments in the industry are not likely to show improvement during the next year.” But at least no new taxes were imposed to hurt investment.

Saadia Gardezi is a political economist

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