An amazing article by none other than SHAHID KARDAR
http://www.dawn.com/2012/01/03/structural-imbalances.html
Structural imbalances
A WIDE array of commentators has arraigned the government for poor financial management and for allowing the budget deficit to reach such alarming levels that it has compromised not only the monetary policy but also prospects for growth by crowding out the private sector from the banking system.
While essentially agreeing with them this writer is of the view that the macroeconomic imbalances that we are witnessing in the shape of a budget deficit of six per cent plus of GDP, a low growth rate of the economy, persistent double-digit inflation and continuing pressure on the rupee have structural characteristics and that we will have to learn to live with these unless fundamental changes are ushered in quickly.
After the recent NFC Award a significantly increased share of national revenues is being provided to the provinces, e.g.
against the projected tax revenues of Rs1.9tr more than Rs1.2tr will go to the provinces (also signifying that net tax revenues accruing to Islamabad will not be enough to even finance its debt-servicing commitments).
This arrangement has, at least for the next two years, diluted the political and economic incentives to raise additional revenues. Since most of the sectors/activities and tax bases (e.g. agricultural incomes, properties, economic services) that continue to be either exempted or are under-taxed lie in the provincial domain under the constitution, why would any government take the political risk of going out on a limb by taxing hitherto un- or under-taxed groups?
That the political system protects habitual tax defaulters only compounds the problem of low collections owing to rampant evasion in collusion with the administrative machinery.
Next, all major expenditures, defence (absorbing in excess of Rs800bn when we consolidate expenditures reflected under different heads), debt servicing of close to Rs800bn (including loans that financed physical infrastructure in provincial use), subsidies on fertiliser and energy and an oversized civil bureaucracy (even after the 18th Amendment under which several state functions have been transferred to the provinces) are still being borne by the federal government. And this with no prioritisation of functions that the state should retain and pay from the public purse.
It is also intriguing that whereas the provinces refuse to levy or collect agriculture income tax, Islamabad is hell-bent on continuing to subsidise imported fertiliser used by the same farmers — whereas it should be insisting that the provinces pick up this tab.
The federal budget has overestimated revenues from the State Bank, the Americans against the Coalition Support Fund (for reimbursement of the war-on-terror expenditures), the auction of 3-G licences, Eitasalat or external inflows from the World Bank, ADB and bilaterals like USAID, the Department for International Development, etc. It has also under-provided for expenditures. This has worsened the environment for the budget deficit, monetary policy, inflation and, therefore, for the value of the rupee.
To appreciate how far out the expenditure estimates in the budget are, take the following examples. The fertiliser subsidy bill will cross Rs50bn for the year whereas the budget allocates nothing for it. The cost of the power subsidy is building up at an astounding average rate of Rs7 lakh a minute, Rs1bn a day compared with the budgeted amount of Rs50bn for the entire year! Islamabad will also have to cough up a subsidy on cotton and sugar of a figure in excess of Rs10bn (with nothing earmarked in the budget for these expenditures) to please powerful lobbies. (The government is seriously contemplating buying sugar and cotton at prices higher than those prevailing in the market.)
And lest we forget, there will be additional bailout packages for Railways, Steel Mills and PIA. Therefore, for the reasons articulated, and battered by weak governance we will have to learn to live with budget deficits that are likely to be in excess of six per cent of GDP in the foreseeable future.
With the government seeking more funds from the banks to meet its spending obligations it will crowd out the private sector, in particular the more labour-intensive small- and medium-sized enterprises already struggling to survive without adequate supplies of reliable energy at affordable rates.
With the sovereign queuing up for money, the risk-averse banking sector will understandably lend to the government rather than to private businesses. It is startling that since 2008 the share of the private sector in bank credit has declined from 61 per cent to below 47 per cent.
That this private sector is also unwilling to dilute its ownership or does not have the market credibility to raise funds from non-banking sources (it is note-worthy that Rs1.6tr, 35 per cent of deposits, is currency in circulation) only serves to worsen the conditions for investment and production, which provides one of the explanations why we are seeing economic growth settling at a low-level equilibrium.
The banking system will be unable to fund the bulk of the budget deficit, if for a variety of reasons — ranging from tense ties with the US to the failure to stay the course on the IMF programme — inflows from abroad are not enough to finance the bulk of this requirement, and those holding cash are unwilling to part with it. (In the latter case, cash holders would be earning returns — from speculative or other activities — that are higher than those offered by financial instruments after the 200 basis point reduction in interest rates.) Resultantly, a substantial share of the financing of such large budget deficits would require the State Bank to print money.
This will have its own inflationary consequences. Hence my argument that a significant proportion of the inflation that we will experience going forward will be for structural reasons.
With our inflation likely to be higher than that of our trading partners our manufacturing sector, already struggling to maintain production volumes faced with acute energy shortages, will find it difficult to compete internationally with a rising cost curve, making imports cheaper at the prevailing exchange rate, at least in the short term.
This will widen the trade deficit, whose financing and narrowing will not be sustainable without an adjustment in the value of the rupee. This continuing pressure on the rupee will, therefore, also be an outcome of the imbalances requiring structural adjustments for pushing the economy onto a higher growth path and thereafter nourishing it so that it can accommodate the burgeoning population of youth looking for gainful employment opportunities.
The writer is a former governor of the State Bank of Pakistan.
