A stronger trade policy

The first four months of 2017-18 have witnessed a further deterioration in the balance of payments position. The trade deficit has risen by 41 percent to $ 9.7 billion. Exports have started increasing after long time, with a growth rate of 11 percent. But this has not been adequate to compensate for the continued rapid growth of imports of 26 percent. Remittances have been, more or less, flat. The resulting current account deficit for the period, July to October, 2017, has exceeded $5 billion, showing a very big jump of 122 percent over the level in the corresponding period of 2016.

How far has this current account deficit been financed? The combined inflow into the financial and capital accounts is $2.5 billion. As such, about half the deficit has been covered. The gap would have been even larger if commercial short-run borrowings had not been resorted to of $1 billion. The resulting decline in foreign exchange reserves is $ 2.5 billion, equivalent to 16 percent of the level at the start of 2017-18.

The bottom line is that the balance of payments position is becoming increasingly precarious. Within the next six months, if current trends continue, reserves may not be adequate to provide import cover of even two months. The time has come to formulate a much stronger and more strategic Trade Policy to bring down the current account deficit which can be financed by normal sources like FDI, FPI and long term concessional borrowing. Otherwise, if there continues to be resort to large bond flotation and/ or commercial borrowing then the external debt position of Pakistan will become completely unsustainable in the not so distant future.

The government does have an existing Strategic Trade Policy Framework, which is effective from 2015 to 2018. This aims to achieve the target for exports of $35 billion by June, 2018. Clearly, this policy has failed because there may be shortfall in relation to the target of over $12 billion. The primary reason is the lack of strong, tangible and adequate measures for promoting exports in the policy. Little priority also has been attached in the policy for enhancing import substitution and thereby limiting the growth of imports.

There are potentially a number of policy instruments for influencing the growth of exports and imports and thereby limiting the size of the trade deficit. Some countries like Turkey, a model for us, have used depreciation of the exchange rate as the principal instrument. Other countries like Bangladesh have chosen a regime of large cash export incentives to boost exports. On the import front, many countries including Egypt and Brazil have imposed a wall of relatively high import tariffs. Countries like India have opted for non-tariff barriers as a means of regulating imports. In the case of Pakistan, during the last two episodes of falling reserves in 2008 and 2013 the rupee was depreciated cumulatively by 29 percent and 15 percent respectively despite no visible signs of significant overvaluation.

Where does Pakistan stand in terms of its actual trade policy in the last few years? Since 2013-14 a, more or less, stable nominal exchange rate has been maintained. Currently, the rupee is overvalued, according to the SBP, by over 21 percent. Few export incentives had been put in place, besides concessionary finance and a low presumptive income tax on exports.

The tariff policy on imports indicates a move towards trade liberalization under the umbrella of the last IMF programme. Consequently, the number of slabs has been set at five and the maximum import tariff at 20 percent. In 2012-13, the number of slabs was seven and the maximum rate, 30 percent.

The presence of a substantially overvalued exchange rate and lower import tariffs has clearly contributed to the substantial widening of the trade deficit. Somewhat belatedly, the Government has taken some steps since January 2017. These include the export incentive scheme offering duty drawbacks ranging from 5 percent to 7 percent on a number of key export items. This was made subject to achieving a growth rate in exports of at least 10 percent. Recently this condition has been partially relaxed.

On the import front, a regime of regulatory duties has been introduced. This was initially made applicable on a number of non-essential import items. Recently, this list has been expanded to 731 items. There are as many as 15 slabs of regulatory duty ranging from 2 percent to 80 percent. The logic behind the setting of the rates of regulatory duty on different products is very unclear.

Given the large and growing size of the trade deficit, it is immediately obvious that the steps taken to date are inadequate. There is great urgency, given the plummeting of reserves, to adopt a greatly strengthened and more strategic trade policy. The big question is what should be the key components of such a policy?

The fundamental issue relates to the issue whether the rupee should be depreciated or not in the presence of substantial overvaluation. The Government probably fears that it will lead to a spike in the domestic price level and increase the size of the public debt in rupee terms in the election year. The experience historically is that a10 percent devaluation leads to a 3 percent rise in exports and 7 percent decrease in imports in dollar terms, thereby contributing significantly to reduction in the trade deficit. However, the domestic price level increases by 3 percent.

The first best option is to bring down the rupee in two steps of 10 percent each, one step soon and one in early 2018-19. The other option is to largely preserve the nominal stability of the rupee. But the risk with the latter policy is that in the event of a fall in reserves to a precariously low level a very large devaluation may become necessary in the presence of large-scale hedging and speculation. Almost certainly, if Pakistan goes to IMF in the second half of 2018, a big depreciation will be required as a prior action.

With or without immediate depreciation of the currency, the following additional measures are required to strengthen the trade policy.

(i) Payment of the export incentive should be made through the banking system to an exporter along with the export receipts. Payment of refunds through FBR should stop. Outstanding refunds should be used by exporters for discharging their existing or future tax liabilities with FBR, especially on local sales/income tax. This will require designing a scheme like the Duty Scrip scheme in the 2015 MEIS scheme of India.

(ii) There is need to enhance the export incentive rate on emerging and SME exports. Also, the presumptive income tax of 1 percent on exports should be withdrawn. The facility may also be extended to ‘deemed’ exporters. Exporters who show an annual growth rate of 20 percent or more may receive an additional two percentage points.

(iii) Some imports are likely to be subject to under-invoicing in the presence of high regulatory duties. In such case minimum import prices may be introduced. Product groups of imports which need to be examined from this viewpoint are iron and steel, plastic materials, rubber tyres and tubes, paper and paper board, art silk yarn, etc. These imports have entered Pakistan at significantly lower prices since June 2016.

(iv) Extension of the cash margins at rates of 10 percent to 35 percent on all imports, with the exception of products like basic food items, POL, agricultural inputs, pharmaceuticals, etc. In effect, this will tantamount to reintroducing the BPRD Circular No.33 of the SBP.

(v) An additional two percentage points may be levied on the presumptive income tax charged on commercial importers. The additional revenues should be used to reducetaxes like GIDC and sales tax on fuel inputs into electricity generation to the extent possible.

(vi) Investment incentives may be increased by doubling the accelerated depreciation allowance and the tax credit for BMR. In addition banks may be given a tax credit for the increase in credit to SMEs.

(vii) Following negotiation with China on the FTA, application of the SRO 570(1)/2017 giving further duty concession on 1446 items may be deferred.

The above set of measures may be seen as ‘overkill’. But if the Trade Policy is not greatly strengthened then Pakistan may find itself facing a financial crisis in its external transactions. A few days ago, Bloomberg Markets has identified ten countries, including Pakistan, as prone to a technical default in the foreseeable future As such, implementation of vigorous and wide ranging measures is required if severe dislocation of economic activity and heavy costs on the people of Pakistan are to be avoided.

(The author is Professor Emeritus and former Federal Minister)