What’s Pakistan’s fiscal problem?

Pakistan’s provinces where much of the welfare and infrastructure lies are all running balanced budget as required by the constitution – thank the Almighty. The federal government has obligations to smaller regions that it administers such as the Fata, GB, AJK but these are not more even 1% of GDP. Much maligned defence is about 3% of GDP which given the war on terror which has killed 50,000 people and destroyed many cities may not be too large.

Running of the federal government is only about 1.5% of GDP. Debt service is the largest amount about 4% of GDP. All in all, the federal government does not appear to be a huge spendthrift locked up in huge administrative and defence expenditures that cannot be reversed. Where then is the problem?

The federal deficit borders on about 8 to 9% of GDP. Our revenue is only about 9% of GDP. Adding up the above mentioned items, our expenditure commitments are only about 9.5% of GDP. Our deficit should then be about 1% of GDP at most rounding out errors.

Where does the rest come from?

PSDP

Well, the government wants a public invest programme the PSDP of about 3% of GDP. Can this be contained? Used more wisely? Absolutely.

For years this has been used as a slush fund by all political factions, the politicians, dictators, defence establishment, and the bureaucracy. There is a rush for development without purpose. Indeed much if it is brick and mortar with a low rate of return and oftentimes developed for non-economic ends.

PSDP has also created assets which if used well could return funds to it so that development could be self-sustaining. The Malaysian Khazana or the Singapore Tamasek model come to mind. But in the current governance structure such institutional innovation would be anathema.

But in the current model PSDP spending provides only a small short term stimulus (.07% for every 1% increase in PSDP see Pasha et al at PC) to the economy. In the long run studies such as Ghani and Muslehuddin have shown that the PSDP has no positive impact on growth. If PSDP operation is cleaned up it could easily result in an annual gain of about 1% per annum in economic growth.

PSEs

But the other major drain from the budget is the PSEs especially the energy sector. Over the years, the PSEs have been enmeshed in the administrative bureaucracy which has often used these for their own slush funds and repositories of perks. The DMG gets positions in boards and often even as executive heads of the PSEs. The rules if business make the secretary the principal accounting officer (PAO) of the PSE. This status allows the PAO to raid the PSE for vehicles and real estate.

This parasitic or symbiotic relationship between the administrative bureaucracy has for years prevented a clear financial position of PSEs to emerge. Often timely audited balance sheets are not available. Management is frequently not in control of staffing, investment, maintenance, pricing and other strategic decisions. The result is that we really do not have separate organisations. Nor are we able to anticipate financial flows. Debts build up as a by-product of our institutional arrangements.

For the last 5 years we have continuously been surprised by the frequent build-up of losses in the PSEs despite sporadic pay-downs. And it should be noted that since many PSEs are in control of essential services like energy, railways and airlines, they can force payments as services are shut down. Meanwhile an economy of shortages develops. Growth and productivity decline and hence employment opportunities are curtailed.

Without reform we can expect that the PSEs are likely to lose 3 to 4% of GDP growth annually.

Commodities

For some reason despite devolution that has made agriculture being a provincial subject, the federal government for its own political needs wishes to intervene in agriculture markets. It subsidises fertiliser and chooses to set the procurement price with a commitment to buy for wheat. While the fiscal cost of these commodity operations is only about .5% of GDP, they do involve large and expensive government guarantees (almost 2% of GDP worth of bank credit is used. In addition they distort the agricultural market. Cleaning out this operation ie, rescinding government involvement is expected to increase GDP growth by about .5% annually.

The net result

Summing up these figures we can see that our fiscal deficit of about 7-8% comes from PSE losses, PSDP and commodity operations.

Careful and well articulated reform in these areas could not only make the budget manageable but have the additional payoff of increase in annual economic growth of about 5 to 6%. The quick fix of arbitrary taxes and chasing false revenue numbers is a bad strategy that is exacerbating the ailment of poor governance and low growth not fixing it.

We would be remiss if we did not add the cost of our maladministration. The loss of capacity in government as well as the weakening of governance procedures in pursuit of austerity has contributed to the adoption of hurried and flawed policies that are costing the government much. For example the guarantees to various sectors of industry (IPPs, cars, fertilisers etc) slow down investment and frequently operate like call options on government.

Arbitrary expenditure cuts in interests of austerity have taught the rulers to disrespect the budget. Hence throughout the year, the cabinet and the ECC are entertained off budget expenditure items in contravention of rules and fiscal policy. For example, when sugar prices were going up in 2009, government imported sugar and when there was an abundance of sugar in 2012, government bought sugar from sugar mills to save them. Both acts were off budget and the result of poor procedures and lack of process and human capital in the finance ministry.

Understanding the budget in this fashion shows clearly hat there are no quick fixes. The deficit is structural and really a product of the underlying institutions of governance. A durable fiscal adjustment will require fixing the governance institutions -detailed civil service reform, development of expenditure management, change in the rules of business, innovation in PSDP management and realignment of the role of government.

All roads lead to Rome: reform leads to growth and fiscal sustainability

The good news is that if we do this right not only do we address the fiscal situation; we also regenerate growth and productivity.

Changing the model from austerity to growth is win-win.

As shown in the earlier austerity articles, tax revenues can be increase through deep reform such as elimination if SROs, perks/plot culture, and better use of government assets. It is the same reforms that will help the expenditure side. The same reform increases growth.

This in essence was the Planning Commission Framework of Economic Growth which was passed by the National Economic Council. Time to take it seriously.