Pakistan’s Economic Challenges

Published October 6, 2022

Vibes of Ishaq Dar’s return started as soon as he assumed office

Mr. Miftah Ismail started his speech on a candid note and said that talks of Ishaq Dar’s returning to Pakistan started circulating within two weeks of his becoming the finance minister. He candidly joked that he was never sure whether he would remain the Finance minister for the subsequent two weeks or not.

Pakistan’s approach to economic governance is akin to gambling

Mr. Miftah Ismail said that Pakistan’s governance and approach towards the economic policy is too short-term focused. We tend to live and spend as much as we can today, without thinking about tomorrow. We gamble with our future and go through a boom-bust cycle. He compared this to a joke that he narrated as follows:

“When I was a boy, my dad gave me money to go downtown and pay the electricity bill. But instead, I bought raffle tickets for a chance to win a new truck. I told my dad when I got home, and he beat me. The next morning, however, there was a brand-new truck in the driveway. We all held each other and cried, especially me because it was the truck from the electric company there to turn off the lights. My dad beat me again.”

The recent cuts in fuel taxes are without IMF’s nod

Mr. Miftah said that the IMF was sure that Pakistan will stop increasing taxes as soon as it will receive the IMF tranche. He assured IMF that it will be different this time and he will increase the taxes as committed. However, right after Mr. Ishaq Dar assumed office as a finance minister, the government skipped the due increase in taxes that it had promised with the IMF, thus living up to the expectations.

We often discuss that we need to reduce energy imports. According to economic principles, the best way to reduce energy consumption is to increase the price. He further mentioned that despite his reluctance, and upon the insistence of the Prime Minister, he reached out to the Managing Director of the IMF, to consult about freezing taxes at current levels for the next three months in view of floods. No response had come from the IMF yet. However, the government unilaterally froze the taxes.

Pakistan’s fiscal situation is not sustainable

Pakistan has a grave fiscal issue. Federal government spending is estimated at roughly PKR 9,000 billion for FY23. Tax collection is estimated at PKR 7,500 billion plus an additional PKR 650 billion in PDL. Roughly PKR 4,000 billion out of the revenues go to the provinces. Hence the deficit would likely be more than PKR 4,000 billion in FY23 i.e more than 7.0% of GDP. Such a large fiscal deficit is causing the debt to rise at a faster pace than the nominal GDP and this is not sustainable.

World’s appetite to lend money to Pakistan is very limited

On the external front, the appetite to lend money to Pakistan is now very limited. There is no appetite amongst commercial lenders. But even the bilateral appetite is very limited

During the recent visit from the representatives of the UAE government, the SBP governor had requested the finance minister to request the UAE to roll over USD 450mn in loans given to Pakistan in 1996-97 and request additional loans. While the UAE representative agreed to take up rollover of the old loans with the higher authorities, he referred to our inability to pay back a 25-year-old loan as a reason to excuse from giving any new loans.

Pakistan’s privatization laws are too restrictive; and so is our mindset towards privatization

As an alternative to loans, the UAE government offered to buy 10% shares in listed SOEs with a buy-back agreement at a fixed profit rate ranging between 5-6%. This was a very good deal. However, this became very controversial in the media. Our current laws also do not allow such a transaction. According to our existing laws, if everything goes perfectly well, it takes a minimum of 461 days to complete a privatization transaction.

SME bank has been losing money since 2007 and is on the active list of privatizations since 2008 and is likely to be shut down now. Roosevelt hotel has been on the active list of privatizations since 1997. Roosevelt hotel is estimated to be a USD 1.0 billion asset and costs the national exchequer USD 5-10 million every year in severance and union-related litigation. The day we privatize this, the media spaces will flood with talks of corruption and theft.

Pakistan’s growth model needs to shift from Import Substitution to Export Promotion

The growth model of Pakistan has always been that of Import substitution. There are a lot of incentives through protection and import duties, which makes it unviable for foreign companies to sell in Pakistan and there is no incentive for companies to become efficient. 80% of manufacturing in Pakistan sells to Pakistan. Textile is the only industry in Pakistan that exports. 2/3 of exports is textile.

Imports is the main source of taxes due to low tax compliance, but it makes the economy very inefficient

Tax collection in Pakistan is very low. Marginal tax rates are very high and there is a huge incentive to evade tax. Almost 52% of the tax collection is at the import stage and the bulk of the remaining tax collection is also linked to imports. For eg if Candyland imports a certain quantity of flavor, the tax machinery is able to collect sales tax on the equivalent quantity of candies that can be produced by using that flavor. High taxes at the import stage makes the market very inefficient.

Due to the domestically focused industrial sector, Pakistan oscillates between a boom-bust cycle and none of the governments during the last 15 years have managed to fix this

When the economy slows down, the only stimulus policy we know is to incentivize large industry to expand. The most recent example is TERF. In case of TERF the government gave loans of billions of Rupees to large business in hopes that the new plants and factories set up would generate employment. By the time the new plant and machinery is imported, the imports had risen so much that the government now needs to slow down the economy. The jobs that were supposed to be created through TERF are now offset by the job losses occurring due to slow down of the economy.

Globally, economies have developed and progressed through export promotion policies rather than import substitution policies. In the 1960s, the South Korean Martial Law administrator forced Korean businesses to export. Hyundai’s construction business was asked to win construction projects in other far eastern economies.

During the last 15 years, every government left the economy with a high Current Account Deficit (CAD). General Musharraf left the economy with a CAD of USD 11.3 billion or 8.1% of GDP in 2008. PML-N left at 6.0% or USD 19.0 billion in 2018. PTI left it at USD 17.5 billion. Every government follows the policy of giving unnecessary stimulus ahead of elections without thinking about the subsequent consequences. When the new government comes in, it must slow down the economy in the first few years but then goes on to repeat the cycle. Pakistan needs to overcome this boom-bust cycle.

Pakistan’s Current Account Deficit of 5.0% of GDP is unsustainable as it is being used to fund consumption

It is common sense that one’s expenses should be equal to or lesser than one’s income, otherwise one would go bankrupt. The same applies to the economy. If we have imports of USD80 billion and exports of USD30 billion, and USD 30 billion in remittance, there is a USD 20 billion shortfall, known as Current Account Deficit (CAD). This trend cannot continue for long. The world won’t finance a CAD of USD 20 billion, which is 5.0% of GDP.

A good responsible country shouldn’t have a CAD of more than 1.5 to 2.0% of GDP. CAD means that foreigners are giving their savings to us to fund it. A country can use the borrowed savings from foreigners to either invest or consume it. We borrowed heavily from foreigners to double our electricity production by setting up new plants. But our exports did not rise. We did not use this additional electricity to produce more exportable goods. Instead, we ended up consuming it in households. We put up marriage halls. And we do this every time. We borrow when we incur current account deficit, and we use this debt to increase our consumption.

Considering our high debt levels; Pakistan needs to tighten its belt in the near term

Considering our high debt levels, until and unless we increase our resources (Exports of USD 30 billion + Remittances of USD 30 billion = USD 60 billion) we would need to restrict our imports to USD 60 billion. That’s why he followed the strategy of limiting imports through import curbs. A lot of imports we do are essential items, such as energy, food, and raw materials for re-export. This leaves very few items that we can restrict, including luxury items, and even industrial machinery. This may sound unwise at the first instance, but consider it from an eg of a business group. A business group may want to put up a large plant but may not have the funds for it, so they won’t set up the plant. Similarly, Pakistan does not have the money to invest in plant and machinery for domestic consumption. Ideally, we should only allow / assign preference to export-oriented industrial machinery for now.

Reducing loadshedding requires running inefficient plants or consuming expensive fuel but it substantially increases cost of electricity

This year Pakistan went directly from winter to summer. There was no spring season. There were record high temperatures in May. Every 1 degree centigrade rise in temperature results in 800 MW increase in electricity demand in Punjab. Despite generating 25,000 to 26,000 MW of electricity, Pakistan still had shortages as high as 5,000 MW. Pakistan cannot make more than 25,000 – 26,000 MW in May. This resulted in 6 to 7 hours of loadshedding and even higher in some areas.

There was a lot of pressure to run all plants. We even ran the plant in Jamshoro that has a variable cost of PKR 59/unit. But there is more to it. Since line losses are 20%, effective cost of this PKR 59/unit electricity becomes PKR72/unit and since 10% of the electricity bills are never paid, the real effective cost of this plant was PKR 80/unit. This was the marginal cost in May-22. Even the average cost of electricity is now around PKR 40/unit, and we are selling it at PKR 30-35/unit which is very high. But we can’t do anything about it in the short term.

For LNG we are now competing with Europe. One spot cargo now costs USD 140 million which reduces daily loadshedding by 1 hour for a month. Under our existing long-term arrangements, one cargo costs USD 30-35mn. So extra importing LNG under spot contracts is a very difficult choice.

Energy Sector is Pakistan’s biggest challenge and put our survival at risk

Just putting up factories through incentives like TERF won’t cut it unless we provide utilities such as electricity and gas for these factories. There are businesses that have set up factories, in export-oriented sectors, but the factories are shut because there is no gas and electricity being supplied to these factories. Pakistan has this issue about power and gas. Power division was given PKR 1,072 billion last year by the federal government. The consumer paid an additional PKR 1600 – PKR 1700 billion in the form of electricity bills. Despite this, there was an addition of PKR 300-400 billion in circular debt. This is how inefficient our energy system is. This amounts to a total cost of PKR 29-30/ unit of electricity. This is probably the most inefficient electricity generation and distribution system in the world.

Pakistan needs to take urgent steps to reform its energy sector

Something has to be done about our Energy sector soon. This includes privatization of distribution and generation companies, coming up with a wholesale market for electricity, and introducing a more rational and nimble power regulator. Since currently there is huge pressure from IMF and World Bank to pass on the cost to the consumer, so we are essentially passing on even our inefficiencies to the consumer

In Pakistan, generation is not that inefficient if we shut down old furnace oil-based power plants. However, when you account for the recent increase in fuel prices, overall cost of electricity is very high. With higher fuel prices, solar is now much cheaper than fossil fuel-based electricity sources so you can substitute some thermal oil based generation with solar.

At least 10% of the industry in Pakistan remain shut because of lack of supply of gas and electricity. Gas supply is a main concern of Pakistani businesses, and it shouldn’t be this way. Industries should get gas. Mr. Miftah Ismail said that he had an unpopular view that we should increase the gas supply to Industry by 50 mmcfd but this would increase daily loadshedding by 40 minutes.

Power sector will sink our economy if it is not fixed

Nothing is more important than the power sector. Power sector is sinking our economy and it will sink it for good if we don’t fix it. We won’t be able to grow or increase our exports unless we really bring in an iron hand to reform this. People will raise a lot of hue and cry because there are large, vested interest. But if we don’t reform the power sector, that is like gambling with your future. Reducing the tariff for a month or three months won’t cut it, not passing on the fuel adjustment charges won’t cut it, but that’s just like kicking the can down the road and we are really mortgaging our future by doing this.

To recap, in order to grow, Pakistan needs to get its federal budget in line, sort our power and gas sector and come up with an export promotion model rather than import substitution.

Privatizing SOEs will increase the efficiency of the state and help Pakistan achieve higher GDP growth rates

The world has changed and there is no point in governments to run businesses i.e State Owned Enterprises like PSO, PIA, Steel Mills, SSGC, SNGPL, Power Distribution Companies, Power Generation Companies, even E&Ps. These are big issues in Pakistan’s economic efficiency.

Pakistan runs into a Current Account Deficit as soon as we increase our GDP growth rate above 4.0%. There was a time when India couldn’t grow at more than 4.0% GDP growth. World Bank and IMF started referring to it as Hindu rate of growth. It was believed that due to India’s democracy and its complicated structure, it cannot grow by more than 4.0% every year. But this changed when India implemented economic reforms in the 1990’s and their growth rate substantially increased. So, these limits and thresholds change if you make the economy efficient.

A key reason behind Pakistan’s inability to sustainably achieve a GDP growth rate of more than 4.0% is the inefficiency of the state including the SOEs. If we make the state nimble and efficient, Pakistan can achieve higher GDP growth rates.

Privatization / shutting down SOEs will result in job losses but holding these entities in government ownership makes no sense

Job losses are a key concern in shutting down SOEs, but we can shift the senior management and other staff in a surplus pool and use them somewhere else or give them a golden handshake or a severance package. But running these SOEs doesn’t make any sense.

Mr. Miftah Ismail quoted some examples from his previous tenure as Finance Minister. Civil Aviation in their budgets assumed that PIA would not pay their dues. Similarly, PIA doesn’t pay its dues to PSO. Finance minister once had to intervene to stop the FBR chairman from getting an FIR registered against PIA’s CFO for nonpayment of its due taxes to the FBR. Similarly, virtually every SOE is late in paying their dues to their suppliers and state authorities. There is no point in keeping these SOE’s in government ownership. Privatizing these SOEs will also help in reducing the size of the government and make it efficient.

Pakistan also has inefficiencies through duplication of ministries at federal and provincial level

Since the federal government has limited resources due to low tax collection and more than half of those taxes being transferred to the provinces, the federal government should reduce its expenses. After 18^th amendment, many state responsibilities, such as health and education, were transferred to the provinces. However, the ministries were renamed, and the bureaucrats remained. For eg although agriculture is a provincial subject, federal government still has a Ministry of Food Security which is effectively doing the job of provincial agricultural ministry. This is doubling of resources and expenses.  Similarly, Ministry of Environment has now become Ministry of Climate Change. We need to abandon these ministries.

Pakistan needs to reexamine the NFC award and the 18^th amendment

Pakistan can’t avoid revisiting the NFC award and the 18^th amendment as the federal government is running huge deficits and provinces have increased their payroll by 400% during the last 10 years. On the flipside, the entire revenue collection is being done by the federal government and provincial tax collection is very little.

NFC award and the 18^th amendment needs to revisited according to the following yardsticks:

• The responsibilities that need to be devolved to the provinces should effectively be devolved to the provinces and the federal government should stop taking those responsibilities and shut those ministries.
• If it not suitable to devolve certain functions of the government then the federal government should take it back from the provinces and the provinces shouldn’t have those ministries.
• Furthermore, although provinces are the champion of devolution, there has been no devolution of power further down to the local /city governments, which is against the spirit of public finance theory, spirit of devolution and the spirit of 18^th The real effectiveness of federalism only comes when the power is devolved to the lowest level that is the local governments.

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