metadata: authors: 0: author: Ahmed,Sadiq
count: Pakistan
docna: 0: docna: Explaining Pakistan's high growth
            performance over the past two decades : can it be sustained?
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,Industrial Economics,Construction Industry,Common Carriers Industry,Food & Beverage Industry,General Manufacturing,Pulp & Paper Industry,Plastics & Rubber Industry,International Trade and Trade Rules,Economic Growth,Inflation,Macroeconomic Management,Business Cycles and Stabilization Policies
teratopic: Poverty Reduction
abstracts: cdata!: Using standard statistical growth
            analysis, the author shows that Pakistan's growth is
            the result of: (a) rapid capital accumulation.
            Pakistan's investment rate was relatively low but its
            fixed investment rate grew steadily in the 1970s,
            stabilizing at about 17 percent of the Gross Domestic
            Product (GDP) in the mid-1980s; (b) growth of the labor
            force, which offset a tendency toward capital intensity of
            production; (c) more competition from external trade; and,
            (d) a policy of economic liberalization since 1978. Pakistan
            was able to sustain high growth and avoid a financial crisis
            - despite large deficits - because real interest rates on
            debts were substantially negative in the 1970s, so
            debt-to-GDP ratios continued to decline. But real interest
            rates turned positive in the 1980s. If Pakistan continues to
            have fiscal deficits of the same magnitude as in the past, a
            financial crisis will quickly emerge. Pakistan cannot avoid
            a debt crisis by creating money. Higher inflation will hurt
            resource allocation and income distribution. To guard
            against reduced growth, weakened export performance, and
            higher real interest rates, Pakistan should reduce its
            fiscal deficit to below 4.5-5 percent of GDP and phase out
            quasi-fiscal deficits. Pakistan needs more balanced use of
            fiscal, monetary and exchange rate policies. Putting the
            burden of external adjustment fully on the real exchange
            rate, as Pakistan tried to do in the past, is inconsistent
            with improvements in external balance. Real exchange rate
            depreciation imposes capital losses on the stock of external
            debt. The real exchange rate should be set at an appropriate
            level, and monetary and fiscal policies should be used to
            adjust demand. A substantial adjustment effort will be
            needed to increase domestic savings and investment rates.
            National savings should increase from 14 percent of GDP to
            20-22 percent of GDP. Raising public revenues and reducing
            public investment should focus on areas (such as physical
            infrastructure and human development) that promote private
            investment, economic growth, and equity. To contain the
            fiscal cost of domestic borrowing, Pakistan has pursued a
            policy of financial repression, which has repressed the
            private credit and investment needed for long-term growth.
            Also needed is more rapid progress in human capital
            development, especially investments in women's health
            and education. To complete internationally in manufacturing
            requires more skilled production and a better educated
            workforce than Pakistan has had.
geo_reg_key: 517198,517212,517191
repnme: repnme: Explaining Pakistan's high growth
            performance over the past two decades : can it be sustained ?
display_title: Explaining Pakistan's high
            growth performance over the past two decades : can it be
            sustained : Explaining Pakistan's high growth
            performance over the past two decades : can it be sustained
listing_relative_url: /research/1994/08/698089/explaining-pakistans-high-growth-performance-over-past-two-decades-can-sustained-explaining-pakistans-high-growth-performance-over-past-two-decades-can-sustained
topicv3: Economic Growth m1326241 471,Current Account m1326278 1135,Manufacturing Sectors m1326521 1281,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Poverty Reduction
origu: Development Economics and Chief Economist
no_of_pages: 56
author_keys: 0: author_key: 91273
model_extractions: POLICY **RESEARCH WORKING** PAPER 1341

# Summary findings

Using standard statistical growth analysis, Ahmed shows that Pakisran's growth is the result of:

- Rapid capital accumulation. Pakistan's investment rate was relatively low but its fixed investment rate grew steadily in the 1970s, stabilizing at about 17 percent of GDP in the mid-1980s.

* Growth of the labor force, which offset a tendency toward capital intensity of production.

* More competition from external trade.

* A policy of economic liberalization since 1978.

Pakistan was able to sustain high growth and avoid a financial crisis - despite large deficits - because real inLeres **r** ates on debts were substantially negative in the 1970s, so debc-to-GDP ratios continued to decline. But real interest rates turned positive in the 1980s. If Pakistan continues to have fiscal deficits of the same mnagnitude as in the past, a financial crisis will quickly emerge. Pakistan cannot avoid a debt crisis by creating money. Higher inflation wiil hurt resource allocation and income distribution.

To guard againsr reduced growth, weakened export performance, and higher real interest rates, Pakistan shou)'l reduce its fiscal deficit to below 4.5-5 percent of GDP and phase out quasi-fiscal deficits.

Pakistan needs more balanced use of fiscal, monetary, and exchange rate policies. Putting the burden of external adjustment fully on the real exchange rate, as Pakistan tried to do in the past, is inconsistent with improvements in external balance. Real exchange rate depreciation imposes capital losses on the srack of external debt. The real exchange rate should be set at an apprqpriate level, and monetary and fiscal policies shoufd bc used to adjust demand.

A substantial adjustment effort will be needed to increase domestic savings and investment rates. National savings should increase from 14 percent of GDP to 2022 percent of GDP. Raising public revenues and reducing public consumption will achieve public savings of 3-4 percent of GDP (savings are negative now). Public investmenr should focus on areas (such as physical infrastructure and human development) that promote private investment, economic growth, and equity.

To contain the fiscal cost of domestic borrowing, Pak-istan has pursued a policy of financial repression, which has repressed the private credit and investment needed for long-term growth. Also needed is more rapid progress in human capital development, especially investnents in womcn's health and education. To compete intemationally in manufacturing requires more skilled production and a better-cducated workforce than Pakismn has had.

- - This paper a product of the Office of the Director, South Asia Country Department Ill is parr of a larger effort in the department to analyze the nature and extent of the adjustment challenges faced by Pakistan in the 1990s. Copies of the paper are available free from the World Bank-, 1818 H Street NW, Washington, DC 20433. Please contact Ann Bhalla, room D10-071, extnsion 84440 (47 pages). August 1994.

_Tbe Policy Reerch Working Paper Scres dssmnwates the findngs of uwork_ M _progress_ **_to_** _ncourage the exchnge of ideas about deuetopment issues. An objective of the serie is toget thefindigs outickly, eavn if the prestationsarc less thanfuily polisbed The papers_ **_cay_** _the names of theauthors and should be usedand ced accordigly. The fndings, interpretatsons, and conclusionsare th authors' own and should not e attributed to tbh World Bank, its Executive Board of Directors, orany of its rember-countries._ Produced by the Policy Research Dissemination Center
# **EXPLAING** PAKISTAN'S **HIGH GROWVTH** PERFORMANCE **OVER THE** PAST TWO **DECADES: CAN If** BE **SUSTAED?**

# By

**SADIQ AHMED** *

* I am grazeu to Fan Xu (summer intem) for research assistance and to Ann Bballa (senior staff assistant) for help with processing this documenL The initial draft was widely circulated and commemted upon. Ihe present version was revised in light of those conmms. I am **grateful** in paEicular to Paul Isenman. Gobind Nankani, Ishrat Husain, Mohamed ElErian. Nadeem ul Haquc. Akbar Noman and Rui Coutinho for yer helpful conmnents.
# Table of Contents

|||Page No.|
|---|---|---|
|SUN|MARY.....**.....**..............................|i|
|1.|INTRODUCTION.|I|
|[I.|PAKISTAN'S DEVELOPMENT PERFORMANCE OVER THE PAST<br>TWO DECADES--AN INTERNATIONAL COMPARISON .1||
||Economic Growth .1||
||Social Development.|2|
||Macro-baances..................................|...4|
||Saving and Investment ..|_5_|
|III.|EXPLAINING PAKISTAN'S PAST GROWTH PERFORMANCE.|8|
||Overview<br>.8||
||Statistical Analysis .8||
||<br>Interpretation of the Regression Results.|9|
|IV.|CAN PAST HIGH GROWTH RATES BE SUSTAINED IN THE<br>MEDIUM-TO-LONGER TERM? .13||
||Fiscal Deficits and their Inplications for Sustained Growth .13||
||Fiscal Deficits andExernalBalance .......................|13|
||Fiscal Deficits and Internal Balance .21||
||Sustinable Current Account and Fiscal Deficits-<br>mplications<br>for the 1990s .-------------------------|26|
||Financing High Growth: The Saving-Investnent Challenge .31<br>Human Capital Formation and Implications for Pakistan's||
||Growth Performance .34||
|V.|SUMMARY AND CONCLUSIONS .37||
|REFE|RENCES .41||
|ANN|EX TABLES .44||

!
# SUMMARY

Pakistan's 6.0% p.a. growth rate over the past two decades has been considered by some as a "development puzzle" because this growth performance has been accompanied by three major disconcerting factors-high fiscal and current account deficits, relatively low savings and investment rates, and poor human capital formation. What factors explain Pakistan's rapid growth? And, can Pakistan sustain this high rate of growth in the future without first addressing the three disconcerting factors noted above?

Using a standard statistical growdt analysis, the paper shows that, consistent with the predictions of economic theory, the main determinants of growdt have been: a rapid pace of physical capital accumulation, the positive contribution of labor force growth, greater competition from external trade, and a policy of economic liberalization since 1978. Although Pakistan's invrestment rate remains low by international standards, the fLxed investment rate grew steadily during the 1970s and then stabilized at around 17% of GDP p.a. since the mid-1980s. This allowed the capital stock, economy-wide and in the manufactring sector, to expand fairly rapidly which in tmrn supported a substantial increase in the capital labor ratios and average labor productivity. Although a rapidly growing population with low skills coupled with a tendency towards greater capital intensity of production weakened the contnbution of labor in explaining growth especially in the manufactrng sector, the expansion of labor force remained a significant determinant of overall output growth. The growth impact of these traditional factors was augmented by improvements in total factor productivity resulting from greater trade and other economic hiberalizaton that has happened in Pakistan since 1978.

The sustainability of this high growth performance over the medim-to-longer term in the fature is, however, doubtfil. In the past, the main reason why Pakistan was able to sustain high growth and avoid a fmiaucial crisis in the face of large fiscal and balance of payments defLeits Was ta the real inrest rates on both external and domestic debts were substantially negative during the 1970s. As a result, debt to GDP ratios continued to decline despite large fiscal and current account deficits. However, real interest rates tued positive during the 1980s. So, even though on average fiscal and current account deficits were lower in the 1980s, the interest burden of the domestic and external debts have increased significandy. The oudook for the 1990s is that both foreign and domestic real intest rates will remain significanly positive. In this situation, if Paldstan were to continue to run fiscal deficits of the same magnitude as in the past, a financial crisis is likely to emerge pretty rapidly.

It is not possible to avoid a "debt crisis" by funding large fiscal deficits through money creation. The analysis of this paper shows that Padistan's inflation target of 5% p.a. is consistent with "inflation tax revenue" in the 2-2.5 % of GDP range. The revenue would reach a maximum of 3-3.2% of GDP with an inflation rate of 20% p.a. A further -acceleration of inflation will cut the "inflatior, tax base" (real money balances) pretty rapidly so that the revenue proceeds from inflation will actually fall. Even trying to generate the maxinmm revenue of 3-3.2% of GDP from higher inflation tax (20%) is unwise. The adverse effects of this higher inflation on resource allocation and income distribution can be quite severe.

Using a macroeconomic consistency framework, the paper derives estimates of sustainable current account deficits (i.e. deficits that do not worsen external creditworthiness) in the range of
3% of GDP p.a. Consistent with this and the Government's inflation target of 5% p.a., the sustainable fiscal deficits are in the range of 4.5-5% of GDP p.a. (Note that the definition of fiscal deficit corresponds to overall public sector borrowing requirement and not the central government budget deficits). It is important to note that the fiscal deficits in the 4.5-5% of GDP range are sustainable in the sense that such deficits are consistent with other macroeconomic targets/variables (GDP growth, export growth, real interest rate and inflation). If these targets/variables change, the level of sustainable fiscal deficit will also change. In particular, external shocks could reduce growth, weaken export perfonnance and raise real interest rates. To guard against these risks, a prudent policy stance would be to aim for an even lower fiscal deficit than 4.5-5.0% of GDP. The paper also emphasizes the need to phase out "quasi-fiscal deficits", resulting from State Bank of Pakistan's transactions with the private sector, in order to ensure that revenes from seignorage are actually available to fmance the ordinary fiscal deficits and avoid additional domestic borrowing.

The paper suggests the need for a more balanced use of fiscal, monetary and exchange rate policies. Patting the burden of external adjustment filly on the real exchange rate, as Paldstan has attempted since the mid-1980s, is inconsistent with improvements in external and internal balance. This is not only because fiscal deficits continme **to** put pressure on internal and external deficits but also because a real exchange rate depreciation imposes capital losses on the stock of external debt A balanced policy stance involves setting the real exchange rate at its appropriate level and using monetary and fiscal policies to adjust aggregate demand.

Given the need to reduce macroeconomic imbalances, the paper also concludes that a substantial adjustment effort will be needed to raise domestic saving and investment in order to ensure the consistency of these macroeconomic targets with the growth target. The need, particularly is to raise the national saving rate from 14% of GDP presently to 20-22 % of GDP. This, in turn, wil require a substantial fiscal adjustment which will raise public revenues and reduce public consumption to achieve a public saving rate of 3-4% of GDP, as compared with negative savings presently. A similar adjustment in public capital spending will be necessary to ensure that public investment is focussed on areas that promote private investment, economic growth and equity-e.g. physical infrasnucture and human development.

Lower fiscal deficits will also help reconcile the need for greater financial resource mobilization with the objective of stimulatng private investment. A large part of the domestic financing of the fiscal deficits has come from borrowing from the private sector. To contain the fiscal cost of domestic borrowings, Pakistan has followed a policy of financial repression for a fairly long period. The opportunity cost of this policy has been reduced financial resource mobilizaton and repressed private credit and investment As Pakistan proceeds **with** financial liberalization to facilitate stronger fmancial intermediation and inproved fimancial resource a:location, the reduction of fiscal deficits will help contain the increase in real interest rates and minimize the disincentive effects of higher real interest rates for private investment.

Fmnally, the paper argues that Paldstan's ability to sustain high growth rates over the longer terms will also depend upon rapid progress with huiman capital development. In the first place, human resource development, particularly investment in female education and health, is essential to reduce the high populatLon growth rate. Secondly, the sources of future growth, in terms of types of econonic activity, will need **to** change substanfally, as compared with the past, which will require
- iii -

substantially stronger human capital input. In particular, the reliance on a diversified and dynamic manufactring sector, which can compete effectively in the international markets, wili have to increase. This, in turn, will require a much higher skill-intensity of production and a generaly better educated labor force than in the past. The international evidence on the importance of human capital formation for sustained growth performance is indisputable. Pakistan's recent shift in emphasis on this subject, as reflected in the Social Action Program, is evidence that this reality has dawned upon the policy makers. Speedy and effective implementation of this program, however, remains a challenge.
# **I.** INTRODUCTION

1. At 6% p.a., Pakistan's growth performance over the past two decades has been very impressive as compared with most of the developing world, except the high performing economies of the East Asia Region. Although less impressive, this cc.npares favorably in per capita terms as well, even after allowing for Pakistan's very rapid population expansion. Pakistan's growth performance has been considered as a "development puzzle" by some in view of a munber of disconcerting factors that has prevailed along with rapid growth. These include: first, despite the high growth rate, Pakistan's social indicators remain strikingly poor -- Pakistan is among the countries with the highest adult illiteracy rate and lowest primary school enrollment ratio; second, while Pakistan has been able to avoid high inflation, its fiscal and balance of payments deficits have been pretty large, contnbuting to a fairly rapid increase in its domestic and external debt burden; third, notwithstanding progress in mobilizing domestic saving and raising the rate of investment, the saving and investment efforts remain at a relatively low level as compared with most uoher developing countries of the world; the domestic saving rate, in particular. is strikingly low, falling below the average saving rate for the Africa Region.

2. What factors explain Pakistan's rapid growth? And can Pakistan sustain this high growth performance in the next 10-20 years without first addressing the three disconcerting factors mentioned above? The objective of this paper is to try to provide some light on these two very mportant questions. The paper is organized as follows: Section II reviews Paldstan's development performance over the past two decades in terms of a number of key indicators and compares this performance with other developing countries. Section HI analyzes statistically the factors that explain Pakistan's past growth performance using a commonly used growth-related analytical framewort Section IV focuses on the question of sustainability of the past growth performance. Considerable atenon is given to this question as Pakistan's rapid growth has generated some controversy about the importance of paying attention to the prevailing macroeconomic imbalances. Finally, Section V provides summary and conclusions. A list of cited work is included and selected background data are presented in the Annex.

# I. PAKISTAN'S DEVELOPMENT PERFOORMANCE OVER THE PAST TWO DECADES - AN 1NTERNATIONAL COMPARISON

# Economic Growth

3. The trend ia the expansion of total and per capita GDP in Paistan over the past two decades -is illustrated in Graph 1. Although the growth path exhibits considerable variation-partly reflecting the flucmatons of agricultural production but also showing the _*ffects_ of frequent political disturbances-the trend growth for total GDP is estimated at 6.0% per annm, which is a stikingly healthy performance by international standards (see Table 1). A large part of this high output growth, however, is spent simply on sustaining a very high pace of population expansion (3.1% p.a.). Even so, at around 3% p.a., Pakistan's per capita income growth compares favorably with most other developmg countries of the world (see Table 2).
-2 -

Graph I Pakistan **--** Growth of GDP and Per Capita GDP <!-- Start of picture text --> pa<br>r . .. . . .. . . . .. . . . ...... .. . . . . . . . . . . . .. . . . . . . . . . . . .<br>B 8 .... ' ' ' ' 't......................... ...................... f i .. _<br>D<br>p /<br>d<br>S<br>0<br>r<br>tW<br>r<br>a 4 t I I I I I I I I I I I I I. I<br>* 72 r 74 76 7778 79 80 81 82 83 84 8S 86 87 88 89 90 91 92<br><!-- End of picture text --> <!-- Start of picture text -->
-PFr  Capita  QDP  -+I-DP  growth  rat<br><!-- End of picture text -->

# Social Development

4. The significant grow in per capita income coupled with iflows of remittances enabled a modest growth in per capita conmption (see Table 3). This in turn allowed a reduction in the xmmber of people living in absolute poverty as measured in income terms (see Maik (1994)1.

_5._ High growth, however, did not translate into sharp improvements in the quality of life. There is also a concern that the income distribution may have worsened.' Thus, along with high growth, an equally striking result is the rather dismal performance in terms of social indicators.

There i substnial debace on thc quesfion of the incince of porerty and its regional distnuton. Furdter work is undergoing in the Bank tO try to resolve some of the debate arising from data and methodology. Few, however, doubt the conclusion tat absolute poverty measued in income terms **has** been declining in Pakistan.

**2** See Economic Survey. 1992-93. Minis"ry of Fnance (1993).
-3-

# T'able 1. Growth in Pakistan's GDP - An Intemational CompariRon

||1970-80|1980-91|
|---|---|---|
|Pakistan|4.9|6.1|
|India|3.4|5.4|
|Bangladesh|2.3|4.3|
|Nepal a/|2.1|4.7|
|Sri Lanka|4.1|4.0|
|South Asia|3.5|5.4|
|East Asia and Pacific|6.6|7.7|
|Latin America and the Caribbean|_5.5_|1.7|
|Middle East and Norh Africa|5.2|2. L|
|Sub-Saharan Africa|4.0|2.1|
|World|_3.5_|3.0|

a/ Estimated from World Tables 1993.

Source: WDR, 1993.

Table 2. Growth in Pakistan's GDP Per CaDia - An International Comparison

||1970-80|1980-91|
|---|---|---|
|Pakistan|1.8|3.0|
|India|1.1|3.3|
|Bangladesh|-0.4|2.1|
|Nepal<br>l|-0.2|2.2|
|Sri Lanka_|2.4|2.6|
|South Asia|1.1|3.2|
|EastAsia and Pacific|4.8|6.1|
|LatinAmerica and the Caribbean|2.2|-0.3|
|MiddleEastand North Africa|1.7|-1.1|
|Sub-Saharan Africa|0.9|-1.0|
|World|1.6|1.3|

a/ Estimated friom World Tables 1993.

Source: WDR. 1993.
-4 -

Table 3. Growth in Pakistan's Per CaDim ConsuTmtion - An International Comparison

||1970-80|1980-91<br>m|
|---|---|---|
|Pakistan|__1.1|1.6|
|Idia|0.6|3.2|
|Bangladesh|_0_4<br>._.1.4|.|
|Nepal at|3.2|2.2|
|Sri Lanka|||
|South Asia|0.6|2.9|
|East Asia and Pacific|3.9|4.9|
|Latin America and the Caribbean|3.1<br>-|0.6|
|Middle East and North Africa|-<br>_||
|Sub-Saharan Africa|2.3|-2.4|
|World|1.6|1.3|

a/ Estimated from World Tables 1993.

Source: WDRP 1993.

Although some progress was made in raising life expectancy, reducing infant mortality, and increasing adult literacy, Pakistan's performance stll compares poorly widt other developing countries (see Table 4). For example, the infant mortality rate remains above the average for all other regions of the developing world except Africa. Pakistan's adult illiteracy rate is amongst the highest in the world, exceeding the average in all other regions. Perhaps the most disappointing situation is regarding schooling achievement. Pakistan's primary school enrollment ratio is substantially below the average for any other region in the world. Moreover, there is substantal discrimination against female education.

# Macro-balances

6. Pakistn faced significant inflationary pressures in thie 1970s, but succeeded in reducing these pressures in the 1980s. Indeed, its average inflation rate during the 1980's was amongst the lowest in the developing countries, only bettered by the East Asia and Pacific Region (see Table 5). Pakistan, however, ran substantial fiscal deficits while the current account balance of payments deficits have also been sizeable. As explained later, while initially these deficits did not pose a financial problem because of negative international and domestic real interest rates, more recently in the 1980 the effects of these fiscal and current account balance of payments deficits have shown up in terms of a growing debt burden. External debt as a share of GDP, for example, grew from 37% in 1981 to 50% in 1992. Domestic debt (excluding transactions with the Central Bank) expanded from 13% in 1981 to 31% in 1992.
_-5-_ Table 4. Paistan's Social Indicators - An International Comparison

||Life exp<br>at b|ectancy<br>irth|Inf<br>mor|ant<br>taliy|Ad<br>Illite|ult<br>racy|Prim<br>enrol|ary<br>lment|Seco<br>enrol|ndary<br>lnent|
|---|---|---|---|---|---|---|---|---|---|---|
|-|1970|1991|1970|_1991_|1975|1991|1970|1990|1970|1990|
|Pakistan|46|59|142|97|79|65|40|37 at|13|22|
|India|47|60|137|90<br>|.64|52|73|97|26|44|
|Bangladsh|45|_51_|140|103|78|65|54|73|-|17|
|Nepal|41|53|157|101|Bi|74|26|86|10|30|
|SriLanka|64|71|53|18|17|12|99|107|47|74|
|South Asia|49|59|138|92|-|54|67|88|25|39|
|East AsiaandPacific|59|_68_|76|42|-|24|88|127|24|49|
|Latin America and the<br>Caribbean|61|68|82|44|-|.16|95|107|28|49|
|Middle East and North<br>Africa|53|64|135|60|-|45|68|97|24|36|
|Sub-Saharan Afiica|43|51|144|104|-|50|46|68|6|17|
|World<br>||<br>58<br>||<br>66||<br>8S|5<br>S3|-|35|83|104|15|39|

_ = Not available.

a/ There is some controversy surrounding ihis number. Other esdmates suggest an improvement in the primary enrolhnent ratio over 1970.

Source: 1) WDR 1993, 1979 2) World Tables, 1997

# SavinEs and Investments

7. - A rapidly expanding economy is usually assciated with a high rate of saving and investment. In the case of Pakistan, both saving and investment rates have increased noticeably. For example, the domestic saving rate grew from an average of 7.3% in 1973-76 to 11.5% in 1988-91, while the toal investment rae expanded from 14.9% to 18.6% over the same period (see Table 6). Nevertheless, a stiking result is that both the saving and investment rates are below the average found in other developing regions except Sub-Saharan Africa. The saving rate is also below that found in Sub-Sabaran Africa.
-6-

Table 5. Pakistan's Macroeconomic Balances - An International Comparison

||Inflation|rare at|Govt.'s bud<br>bl|get deficit<br>|Current<br>Derci|Account<br>tbi ct|Exteria<br>toExp|l Debt<br>onrsd|Extena<br>toG|l Debt<br>NPdi|
|---|---|---|---|---|---|---|---|---|---|---|
||1971-H0|1981-91|1971-80|1981-91|1971-80|1981-91|1980|1991|1980|1991|
|Pakistan|13.4|7.0|7.9 el|7.0|5.5|4.0|208.8|244.9|42.4|50.1|
|India|8.4|8.2|4.8_ft_|7.7 g/|0.5|2.3|136.2|295.3|11.9|29.3|
|Nepal|8.5|9.1|2.5|7.2|2.7|8.0|_85.5_|370.0|10.4|53.5|
|Bangladesh|20.8|9.3|-0.2 ft|0.4 hl|7.8|7.5|345.3|443.7|31.3|56.0|
|Sri Lanka|12.3|11.2|10.4|9.5|5.4|9.2|123.4|211.0|46.1|72.6|
|Indonesia|21.5|8.5|2.6|1.2|1.3|3.3|94.2|223.2|28.0|66.4|
|Malaysia|7.3|1.7|6.0|6.4 It|0.6|4.0|144.6|53.7|28.0|47.6|
|lhailand|9.2|3.7|3.4|-0.2|4.2|4.9|96.8|94.9|26.0|39.0|
|Mexico|18.1|66.5|3.2|8.7gl|5.7|1.3|259.2|224.1|30.5|36.9|
|Ienva|10.1|9.2|4.7|4.7|94|8.4|167.3|318.4|49.0|89.6|
|Ghana|352|40.0|6.5|3.7|1.8|5.9|116.0|384.5|31.8|66.9|
|Nigeria|15.2|18.1|5.3|6.4|-0.9|3.8|32.2|257.1|10.1|108.8|
|Sub-Sabaun<br>Africa,|13.9|_1A_|-|-|-|-|96.6|329.4|28.6|107.9|
|**_Somud_**Asia|9.7|8.3|_|_|_|_|160.4|287.1|17.0|35.6|
|East Asia &<br>Pacific|9.1|6.3|_|_|||89.8|96.2|16.9|28.2|
||MiddleEastand<br>North Africa|18.8|8.6|_|_|_|_|114.4|185.8|31.0|_58.8_|
|Latin America<br>andCaribbean|43.1|208.2|_|_|_|-|195.5|256.0|35.1|41.3|
|Severely<br>indebecd||30.1|189.6|||_|-|176.6|285.9|34.0|46.4|

2a Period average (% p.a.) _bi_ Period avcrage (% of GDP) - Defined narrowly as ihe deficit of the Cenual Government el Current **account** before official transfers

**d/** End of ped: **toal** exports including hear services el 1973-80 f 1974-80

1 1981-90 h/ 1081-89 Source: WDR 1993 and World Tables 1993, 1991
-7-

Table 6. Pakistan's Saving Investment Trends - An Intemational Comparison

|-|T|1973-76|||1980-83|||1988-91||
|---|---|---|---|---|---|---|---|---|---|
||Sa|ving|Total<br>Invest-<br>ment|Sav|ing|Total<br>Invest-<br>ment|Sav|ing|Total<br>Invest-<br>ment|
||Dom.|NaL||Dom.|Nat||Dom.|Nat.||
|Pakistan|7.3|6.1|14.9|8.3|9.9|18.8|11.5|13.8|18.6|
|India|19.6|20.0|19.9|20.6|21.8|23.6|22.1|22.0|24.3|
|Nepal|7.7|7.8|11.9|10.1|_10.5_|18.2|8.1|10.2|20.2|
|Bangladesh|0.0|0.0|8.2|2.0|_1.6_|14.9|2.6|2.0|11.7|
|Sri Lankcz|10.7|9.9|15.3|12.0|15.0|18.8|12.6|10.7|22.1|
|Indonesia|25.7|23.9|22.0|30.4|27.3|27.5|36.1|31.5|34.6|
|Malaysia|30.4|26.5|27.1|30.6|25.8|29.6|33.3|28.2|30.9|
|Thailand|23.4|23.7|25.9|20.1|19.1|34.3|29.5|28.2|34.3|
|Mexico|18.7|14.9|21.3|26.9|23.2|24.6|21.0|17.6|21.7|
|Kenya|19.4|14.3|22.5|19.0|16.8|24.9|18.8|15.6|23.5|
|Ghana|11.5|10.4|10.9|3.3|1.8|4.3|7.6|9.0|15.6|
|Nigeria|26.0|22.9|20.7|16.2|13.1|17.2|22.3|15.1|14.6|
|Sub-Saharan Africa|20.2|-|19.8|14.2|_|17.9|13.1|-|16.2|
|South Asia|16.6|-|18.6|17.7||_22-_<br>25|19.3|-|22.8|
|EastAsia&Piaific|27.6|-|27.7|29.2|-|29.7|38.4|-|37.5|
|LatinAmcrica&<br>Caribbean|22.0|-|23.2|22.1|_|21.9|22.7|-|20.3|
|MikdeEast &<br>North Africa|29.6|-|25.6|26.1||27.2|20.5|_|21.7|

Source: World Tables 1993
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# II. EXPLAINING PAKISTAN'S PAST GROWTH PERFORMANCE

# Overview

8. There is a large volume of literature, many of recent origin, that seeks to explain the growth performance of countries using statistical models. Much of the statistical investigation is focussed on explaining differences in per capita growth across countries. The analytical foundation of these studies is usually centered around the debate whether growth can be explained by the neo-classical model that assumes diminishing returns to capital so that economies with low capital to labor ratio will tend to grow fastcr and per capita income across countries would tend to equalize over time, or whether growth is 'endogenous' in the sense that there are constant or increasing retmrns to capital allowing rich economies to continue to grow faster than the poorer economies. (See, for example, Rebelo (1991), Barro (1989; 1991), Mankiw, Romer and Weil (1992); Romer (1986); Lucas (1988)).Both models, however, suggest that countries that are accumulating capital and labor at a faster pace will grow more rapidly. And second, they both agree that the pace of accumulation of labor and capital cannot explain all the differences in output growth. The empirical investigation has largely focussed on explaining this residual growth that cannot be axounted for by the rate of expansion of labor and capital. The choice of other explanatory variables has included a measure of 'human capital' and a variety of proxies to represent the influence of government policies (measures of fiscal, monetary, trade, financial and exchange rate policies) and institutional factors including political climate (see, for example, Elias (1990); Barro and Lee (1993), Levine and Renelt (1991); Maddison(1987)). Among the interesting findings are: first, a strong positive role of human capital in explaining growth; and second, a significant relationship between trade policy and growth-

# Statistical Analysis

9. In the case of Paldstan, we used a simple relationship that expressed the GDP growth rate as a function of the rate of growth of physical capital, growth of labor, a measure of trade policy and a dummy variable to capture the impact of economic liberalization since 1978. The role of human capital could not be investigated due to the lack of an appropriate time series indicator of human capital. This relationship was estimated with aggregate data over the period 1974-1992 using overall GDP growth rate and the growth rate in the manufacturing sector alternatively as a dependent variable. The best estimates are shown in Tables 7 and 8. Data used for the regressions are contained in the Annex Tables Al and A2.

Table 7. Determinants of Pakistan's GDP Growth Rate. 19741992

|l___________|Constant Tenn|**Growth**of<br>Capital Stock|Growth of<br>Labor|**Measue**of**trade**<br>policy|**Structural**change<br>dummy|
|---|---|---|---|---|---|
||C|GK|GL(-l)**a1**|**(X+MIGDP)-1**at|D|
|Value of coefficient|-3513|2.50|0.49|0.43|8.00|
|t-stuistic|(-324)|(3.79)|**(1.89)**|(2.6D)|(3.35)|
|**Adjusted R;**=**0.40**||||**AR(1)p **=0.|396(l.84)|

a/ **The** best **estimates for** labor and trade variable appeared with a one period lag.
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Table 8. Determinants of Pakistan's Manufacturin, Growth Rate. 1974-1992

||Constant Term|Growth of<br>Capital Stock|Growth of<br>Labor|Measure of trade<br>policyr|Structural change<br>Summary|
|---|---|---|---|---|---|
||C|GMK(-2)al|GML(-I) bl/|(X+M/GDP)-I bh|D|
|Value of coefficient|-9.64|0.31|0.16|0.25|6.27|
|t-statistic|(-1.31)|a-36)|(1.41)|(1.23)|(3.82)|
||A|djustedR2=0.65;|D.W. = 1|.89||

31 The best estimates of capital appeared with a two-period lag. bf The best estirnates of labor and trade variable appeared with a one-period lag.

10. The main results of the statisdcal analysis are as follows:

- Physical capital accumulation played a very important role in Pakistan's growth performance-overall and in the manufacturing sector-over the past two decades.

- :Labor's contibution to overall growth showed up with the right sign and was also statistically significant at the _5%_ level. However, in the case of manufacturing, the coefficient was 'significant only at the 20% level.

- Trade policy, as measured by the ratio of total value of exports and import to GDP, came up with the right sign and a significaht coefficient (at the 5% level) in the case of overall GDP; however, the variable was significant at only the 25 % level in the case of growth of maTnfacturing output.

- The strctural change dummy, included to captare the impact of the change in the policy regime m Pakistan from the socialist-orientation of the 1972-77 period to the market-oriented economy since 1978, came up with a significant coefficient in both theequations.

# Interoretation of the Regression Results

11. The results of the regression analysis are intaitively appealig and consistent with the predictions,of economic analysis. Although Pakistan's investment rate remains low, by ipternational standards, the t&tal and fiked invesunent rates grew stadily during the 1970s and then stabilized at around 19% and 17% of GDP respectively in the mid-1980s (see Graph 2). This allowed the capital stock, economy-wide and 'in the manufactring sector, to expand fairly rapidly, which in turn supported a substantial increase in the capital labor ratios and labor productivity (see Table 9).

> 3 This measure of die openness of trade policy has been frequendy used in regression analysis, despite its limitations because of the ease of consruction. More sophisticated indicators, such as the one used by Leaner (1988), are aLw problematic. See Harrison (1992) fbr a critical rview of the literature on openness and growth.
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Graph 2 Pakislan -- Trend in Tolal and Fixed InvesIment Rate <!-- Start of picture text --> 20<br>O ~~~~~~................................................... . . . . . . . . . . . . . . .<br>r _...................................................................................................<br>72 73 74 75 75 77 7 8 7 9 8 D 81 8 2 B3 8 4 8 5 86 87 8 8 89 90 91 92<br>-Tolal Investment -+Fixed Investment<br><!-- End of picture text --> 12. The relatively weakter statistical significance of the labor coefficient, especialy in the maufrIng growth equation, partly reflec= the growing capital intensity of prodchltion.<sup>But it</sup> is also an indication that, coloris paribuis, population growth is too fast in Paldstan. Labor markets cann Ot productively absorb such a rapid growth in population, particularly with Pakistan's very low skill leveles. The increase in capital inte nsity could be the effect of two forces at work- First, Palistan's macrocemoomic policies have generaly favored greater capital intensity of produotn, resulting from under-priced capual unports through over-vbalued exchange rate (well unt the mid 1980s), low interet rts and other imentives. Seconxd, extemal migra:tion of skilled an d se misldlled labor in the 1970s and early 1980s tedd to raise real wages (see Irfan and Ahmed (19B81).

13. The positive impact of greater openness to itraonltrade and external compeiition on aggregate growth is a very important r-c;ult. Again, this is intLiitively appealing and consistent with the findings of other research (see, for example, the East Asia Mirale Study (1993)). The lower statistical significance of the trade variable in the mauimwregresion is ralher difficult to explain as, a priori, a large part of the effec of greater efficiency resultmg from increased openness should have come frnom the mariX sector.
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Table 9. Pakistan: Caital-Output and Capital-Labor Ratios and Per Capim Output. 1972-92 (000' Rs., 1987 prices)

||KIGDP|Overll<br>Economy<br>KIL|ODP/L|MKIMGDP|Manulacmnng<br>MKIML|MGDPIML|
|---|---|---|---|---|---|---|
|1972|-|-|-|-|-|12.4|
|1973|1.37|17.7|12.9|1.33|17.4|13.0|
|1974|1.42|18.4|13.0|1.33|17.7|13.4|
|1975|1.47|19.3|13.3|1.46|18.6|12.7|
|1976|1.53|20.3|13.4|1.70|20.9|12.3|
|1977|1.61|21.3|13.4|1.89|23.7|12.5|
|1978|1.61|22.0|13.8|2.01|26.5|13.1|
|1979|1.67|22.7|13.8|2.13|2B.8|13.5|
|1980|1.64|24.0|14.8|2.18|32.4|14.9|
|1981|1.62|25.0|15.3|2.34|35.1|IS.0|
|1982|1.62|26.0|_15.8_|2.19|37.3|17.0|
|1983|1.62|27.2|16.8|2.18|39.7|1B.2|
|1984|1.64|28.4|17.1|2.15|41.D|19.0|
|1985|1.63|29.6|18.2|2.10|41.7|19.9|
|1986|1.65.|31.6|19.2|2.07|45.7|22.0|
|1987|1.66|32.0|19.6|2.03|42.7|21.13|
|1988|1.63|33.7|20.6|1.94|40.3|25.4|
|1989|I.66|34.9|21.0|2.00|51.0|25.5|
|19900|1.70|36.0|21.2|1.97|53.0|27.1|
|1991|1.71|37.1|22.4|2.00|6.0|27.9|
|1992|1.70|38.7|23.5|-|_|.|

Source: Annex Tables Al and A2.

Table 10. Contribution of Total Factor Productivity Change to Pakistan's Economic Growth (% p.a.)

||Average<br>growth of<br>GDP|Average<br>Growth of<br>Capital|Average<br>Growth<br>of<br>Labor|Average<br>TFP<br>change|
|---|---|---|---|---|
|1973-1977|4.8|8.4|3.5|-1.2|
|1978-1992|6.4|6.8|2.6|1.6|

Source: Growth of labor capikal and output are estimated from Anne Table Al. To estmate TBP change, the she of capital was assumed at 0.52 and die share of labor 0.48. These are based on dxe numbers repored in Bumey (1986); an average of the 1969-70-1979-80 period is used.
- 12 -

14: The strong significance of the structural change dummy variable is explained by the major improvement in efficiency resulting from the change in the policy regime from one of intervention during the 1972-77 period toward a more w.Arket-oriented one in the following years. The 1972-77 period was marked by a heavily interventionist policy framework with a substantial nationalization of the economy and, numerous controls that distorted incentives and reduced efficiency. Many of these distortions were reduced gradually in the subsequent years. A simple growth accounting shows negative total factor productivity (TFP) change during the 1973-77 period as compared with the positive contribution of TFP change to growth in the later periods (see Table 10)4. Similar results are also reported by Papanek (1992)).

_15._ The rather low values of adjusted<sup>2</sup> suggests tht a significant part of the variation in overal and manufacturing growth rates remain unexplained indicating the possibility of missing variables. It could also reflect the uneven quality of the data used in the regression analysis; (see also Box 1). One obvious missing variable is human capital. There is considerable empirical evidence from crosscountry analysis that growth and human capital are positively and significandy correlated. However, measuring the impact of this in a time series analysis is not easy as a good proxy to capture the quality aspects of education is not available for Pakistan. The large variance of the growth path, however, also -implies that a number of exogenous factors including changes in wealth, political disturbances, external shocks etc., could have played important roles in individual years. While it is possible in principle to capture these effects through dummy variables, this is not done here as the policy implications of these dummy variables is not obvious.

> 'B OX -- ' Pakista's Bladkconomy-Explaning Pakista: s growth;performance is: comlicatedby' the presence: of what s niere any aTblick ecoomy. Teamcivties that feed-into t hi undrgr ecnmyainclu the raandsmuggling:of goods.- There isnoir data on the size of this economy, although-estiiates have been mi the range exceeding US40bllo=%r vr9 of GDP.- Uneial, a lagblack cnycreats-: difficulties for measuing the true sizeof theluerlydng -econom-ic- varables- GD savings, lavestinent, exports amL imports. Therels may- wel be underestim b h offiialdat. I paticlar saing an inestmen_t raesmihtbe higher-m taimlied by official datHow ldoes thiscompic ate thgrowth analysis? T- main* imli is h domesticcaptlfoationcould d~~~~~raiou i d;: so te ;s -besm coefficient oh--e cpiOf ftl-Svariablewu---..

**' Therc is little evidec of a higher incidence of external shocks or political disturbances** in **dhe 1972-1977 period that could accoumt for the diffrnce in productivity.**
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## IV. CAN PAST **HIGH** GROWTH **RATES** BE SUSTAINED IN THE MEDIUM-TO-LONGER TERM?

16. The prevalence of the three disconcerting factors mentioned at the beginning of the paper -- large fiscal deficits, relatively low saving and invesanent rates, and poor human development indicators-has raised doubts whether past growth rates can be sustained in the medium to longerterm without substantially reversing these adverse factors. Let us examine the main concerns in some greater detail.

# Fiscal Deficits and Their Imulications for Sustained Growti

17. The adverse implications of large fiscal deficits for macroeconomic balances and, therefore, for sustained high rate of economic growth are well known and there is a large body of empirical research that supports these conclusions (see, for example, Buiter and Patel (1992); Easterly and Schmidt-Hebbel (1993); Fischer and Easterly (1990); Sweder van Wijnbergen (1989)). Put in simple language, on the domestic side, large fiscal deficits tend to push up the inflation rate, raise interest rates, and discourage saving and private investment; on the external side, they tend to raise the current account deficit and external indebtedness. These developments in turn constrain the growth performance over the longer turn. Needless to say, none of the results are automatic and how fiscal deficits transmit their effects through the economy depends upon the specific circumstances of the country concerned and the behavior of other policy variables.

# Fiscal Deficits and External Balances

18. Pakistan has a long history of running large fiscal deficits. Two obvious consequences of the deficits have been:

- a large increase in the ratio of domestic debt to GDP since 1974 (see Graph 3); and

- a sharp increase in the interest cost of the budget (see Graph 4)

19. A less obvious but important consequence has been the contribution of these deficits to external imbalances. The relationship between fiscal and current account deficits is indicated in Graph 5, which suggests a strong positive correlation. Statistical investigation also supports the conclusion that fiscal deficits have a strong adverse consequence for deficits in the current account of the balance of payments (results are reported in Table 11).

> 5 It is **important** to note **that in** this paper fiscal deficit is defined broadly to correspond to **the** public sector bormwing requirement. **The** Government of Pakistan's definition of 'budget **deficit'** is a subset of this broader definition.
- 14 -

Graph 3 Pakistan -- Domestic Debt to GDP **(%X** <!-- Start of picture text --> 35<br>*3 0 _ . ......... .. ... .... .. . .. ...... ... .. I. ... .. ... ., ,.... . . . ..<br>0 I I I I I I t I I- -<br>72 73 74 75 76 77 78 79 80 81 82 83 8. 86 88 87 88 89 90 91 92<br>-- Domestic Debt/IGOP %<br><!-- End of picture text -->
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Graph 4 Pakistan -- Government Interest Payments as a Percent of GDP <!-- Start of picture text --> S<br>4 ................ v<br>4 . .. . . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . . ........................<br>2. ....................................... .....................<br>2 .. . . . . . . . . . . . . .. . . . . . . .........................................-<br>~~~~~~~~~~~~~~~~... .... . ........ ....... ...................................................<br>72 73 74 76 78 77 78 79 80 81 82 83 84 86 86 87 SB 89 90 91 92<br>=In1ereat as S of GDP<br><!-- End of picture text -->
- 16 -

Graph 5 Pakistan -- Trend in Fiscal and Current Account Deficits (% of GDP) <!-- Start of picture text --> 14<br>2 .................... t Z. _... ......... . ...... . .<br>t O . . /fi..... .... ........................^. ..... ..<br>8 < 1 ~~~~~............ <....... ......... ....... .. .. .<br>72 74 74 7- 76 7l8 7 0 8 2 8 5 6 7 8 9 9 1 9<br>4 ...........<br>72 73 74 75 J8 77 78 79 80 81 82 E9 84 8C 88 87 88 89 9OL 01 92<br>--'t-urrent Account 4-Flecal<br><!-- End of picture text -->
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Table 11. Pakistan: Determinant of Current Account Deficits<sup>6</sup> . 1972-92

|l____________|Terms of Trade<br>(TOT)|Real Exchange Rate<br>(RER)|Fiscal Balance as a<br>share of GDP<br>(FBGDP)|Time Trend<br>(T)|
|---|---|---|---|---|
|Coefficients|0.077|-0.651|0.767|0.403|
|T-Statistic|(3.59)|(-3.47)|(5.71)|(3.60)|
||Adjusted_Rt_=0.63|D.W.- 2.25|||

20. What has been the impact on external debt? The trend in external debt to GDP is shown in Graph 6. The graph reveals an interesting pattern. The external debt declined as a share of GDP well upto 1981, but the trend has been sharply reversed since then, rising from a low of around 37 % of GDP in 1981 to over 53 _%_ in 1991. What explains this pattern? The answer lies in the dynamics of the debt (See Sweder van Wijnbergen (1989)). It can be shown that:

- The equation estimated took the form:

CABDGP = f(F BGDP, RER. TOT. FRIR. GWI. T) where: CABGDP = current account balance as a percentage of GDP FBGDP = fiscal balance as a share of GDP TOT = External tenns of trade RER = real exchange rate FRIR - foreign real intest rate GWI = growth of industrial countries GDP T time trend This specification follows Khan and Knight (1983). A priori, we expect TOT, FBGDP, and GWI to be positively related to the current account balance. while RER and FRIR should be negatively related to CURBAL. The full regression, including GWI and SUiR yielded the foDowing results: CURBAL = 0.062 TOT + 0.722 FBGDP + 0.21 GW[ - 0.619 RER - 0.0164 FRM + 0.389 T (2.27) (4.88) (0.95) (-2.54) (-0.31) (2.56) Adjusted R<sup>2</sup> =0.53. D.W.=2.11 All coefficients have the right signs but GWI and FRIR failed to show a significant relationship (as indicated by the t- statistic in parenthesis). So, the equation was reestiunated widtout GWI and FRIR and the results are reported in the Table 11 above.
-18 -

Graph 6 Pakistan **--** Trend In External Debt as a Percent of GDP <!-- Start of picture text --> so t ................................................................................................<br>70<br>40 _ 9 .. .... I .. . . .... . . . .................<br>10<br>72 73 74 76 78 77 78 79 80 81 82 83 84 86 86 87 88 89 90 91 92<br>- Ext.D*bt to GDP (SI<br>Ad= (r-g) d-v4 ALd (1)<br>e<br>where d = debt-output ratio<br>A = change in the debt-output ratio<br>r = real interest rate on extrnal debt<br>v = non-interest current account balance as a percentage of GDP.<br>e real exchange rate<br>Ae = rate of change of real exchange rate<br>e<br>g = real rate of economic growth<br><!-- End of picture text -->
-1 9-

Equation (1) states that the change in the external debt to GDP ratio can be traced to three factors: (i) the growth in the ratio due to the excess of the foreign real interest rate over the real growth of GDP _((r-g)d);_ (ii) te non-interest current account balance (v); and (iii) the capital loss on external debt due to real exchange rate depreciation ( A@) . The contribution of the three factors to the change in the external debt-GDP ratio is shown in Table 12. The main results are as follow:

# Table 12. Pakistan: Determinants of External Debt-GDP Ratio. 1973-1991 (%6)

||_Ad_|_(r-g)d _||Aed|
|---|---|---|---|---|
|1973-191|-28.4|-64.8|.40.3|_-39_|
|1981-1991|16.1|-26.8|-19.3|23.6|

Source: Own estimates.

- Between 1973 and 1981, Palistan experienced substantial non-interest current account deficits. By itself, this should have contributed sipificantly to raising the external debtGDP ratio. However, the ratio declined noticeably because the adverse implication of these deficits was more than offset by the contributions of a large negative external interest rate and the high GDP growth rate<sup>7</sup> . The appreciation of the real exchangc rate (see Graph 7) also contributed to reducing the external debt-GDP ratio by causing a capitl gain on the stock of real debt, although it tended to raise the ratio on the flow side by worsening the current balance.

- In sharp contrast to the earlier period, between 1981 and 1991, the external debt-GDP ratio increased noticeably, even though the level of non-interest current balance was on average less negative than during 1973-81 and the average' growth of GDP was somewhat higher than in the previous period. The external debt to GDP ratio increased partly because the foreign real interest rate turned positive and, as a result, the cushion provided by the large negative "dynamic debt component"-(r-g)d-was weakened in this penod. Furthermore, while the depreciation of the real exchange rate helped reduce the non-interest current deficits, it also had a substantial offsetting rising impact on the external debt-GDP ratio through its direct effect on capital losses on the stock of debt.

**T** he interest rate is defined as the average inteu rate and is derived as the rado of interest payments to total exteral debt. The main reason why average nominal inerest rates were so low in this period is because of the dominance of official concessional loans in the external debt portfolio.
Graph 7 Pakislan Real and Nominal Exchange Rate aI <!-- Start of picture text --> 30<br>25 .,;<br>R p25 .... . . . . . . . . . ..............I .... ........................ . . . . . . . . .<br>e<br>e p 20<br>S e 2F - _........ ...... ............................... ....<br>S<br>S _ ....................................................<br>72 73 14 75 76 77 78 7a 80 81 82 83 84 85 80 sa 88 89 90 91 92<br>-Nom. exchange rate I+Real exchange rate<br><!-- End of picture text -->

**a!** Note **that exchange fate is delined** as Rupees per **snir ol** USS. **So** up means a depreciatIon.

21. These results, especially the role of international real interest rate, is very importnt and has strong mplications for the sustinable level of current account deficit for the future. For example, if real interest rates in the 1973-81 period were even barely positive (close to zero) the exrnal debtGDP ratio would have risen by 6 percentage points ever the period instd of declining by 28 percentage points. Given the current outlook for intenational real interest rates (2-3% in real tams), runing non-interest curent deficits as in the past would quickly put considerable pressure on the external debt-GIP ratio. If real intest rates were to exceed the growth of real GDP for a significant period, the county would mov.e towards external insolvency.

22. The role of real exchange rate changes in the external debt-GIP ratio also merits special attention. The substantial adverse direct effect of the real exchange rate depreciation on extemal debt-GDP ratio over the 1981-91 period should not be i ted as a case against real depreciation. The real depreciation was necessitated by the need to improve export competitiveness. As noted from the results of Table 11, the RER has a positive impact ofrtlie current accounflblance, working through both exports and imports. Therefore, the posiive efficts of the real exchange depreciation on exports and economic growth needs to be taken ito account along with the capital loss on the stock of debt. However, the important message here is the need to avoid shifting the full burden of extnal adjustment on the real exchange rate, which is what Pakistan appears to have been doing over the.past decade, and balance the exchange rate management wit fiscal adjustment
- 21 -

# Fiscal Deficits and Internal Balance

23. Pakistan's relatively low rate of inflation despite high rates of fiscal deficits has led some to believe that prevailing fiscal deficits, although higher than desirable, are still manageable. Let us examine this argument in some greater detail. We first turn to the dynamics of fiscal deficit, total government debt and money creation, which can conveniently be summarized by the following expression (see Easterly and Fischer (1990)).

_Atd=-z-u+(r-g) td_ (2)

- where Atd = change in total (domestic plus external) government debt as a share of GDP

- _r_ = real interest rate on total government debt g = real growth rate of GDP z = primary budget balance as a percentage of GDP a = seignorage revenue as a share of GDP

24. The intaition behind this expression can be seen as follows. The change in total government debt as a percentage of GDP can be explained by three factors.' First, other dtings remaining unchanged, the non-interest fiscal deficit (primary deficit) will increase the debt to GDP ratio. Second, the non-interest fiscal deficit can be fianced through money creation-this is the role of seignorage as a share of GDP. Third, to the extent that money creation falls short of the primary deficit, this gap will need to be financed through new debt which in turn will generate interest obligations. However, the denominator of the debt ratio is GDP, so the debt ratio will decline with real growth. So far as real growth of the economy is less than the real interest rate on public debt, the contribution of this third factor to the debt-GDP ratio will be negative.

25. The third component-(r-g)td-shows the dynamics of the debt through the interplay of real interest rate and real economic growth. Suppose the government were runnng primary deficits that exceed the amount of resources mobilized through the seignorage. Then, the government will need to borrow (domestically and/or externally). Now if the real interest rate on this borrowing exceeds the real growth of the economy, then the numerator of the debt to GDP ratio wilU grow faster dtan the denominator, causing the debt to GDP ratio to grow without limit. At some point, the government will find in impossible to borrow any further as confidence problems take over.

26. What would prevent the government from financing its entire non-interest deficit through money creation and avoid the instability of the debt dynamics component? The answer lies in the implications of money creation for inflation and the feedback of this high inflation for the

- t Note that **the** impact of real exchange **rate** changes on **extrnal** debt in ignored in this **formTula.**
- 22 -

susmainability of.growth. The relationship between seignorage (or inflation tax)C and the demand for real balances can be shown as follows (see Box 2).

# Box 2

Money and Inflation in the Long Run <!-- Start of picture text --> In steady'state, the rate of inflation will equal. the rate of growth of money less the real rate<br>of growth of the:economy.<br>- .: r ~ = m-g M- -(i)<br>where: :rr ---. ; AP.IP .- ;the:rate%of inflation..-%<br>= .- - -M-- -;therate.of growth of monery<br>g - -.- AyIy -;the rate of growthof output<br>:e inflatio xtat. is. defined ..as the real valueaof the: base- money<br>-= ~ MIP @ i. a-<br>... ....... T , . . .. .... ..... .<br>------. tiiFcarrbe. earrangeu1ro .yield. .............-.-., .--: . :.. . . - ....:. - :: . -. .. ................. ---- :-..:.-.----:-. .<br>See' ~ ~ ~ ~ ~~~~ ......<br>.-. *.*-,. -4VXX =l-'Z.--. .. .-.. (a e~ --..<br>g _ 9'~~~~~7_ '-+g _'(3') '<br>where T = AM/p the inflation tax<br>T- = domestir- rte of inflation<br>g =real GDP growth rate<br>M = base or "high-powered' noney<br>P = domestic price level<br>MIP = real base money--<br><!-- End of picture text --> 9 A disDncdot is often drawn between seigi2orage and inflation tax. We use these concepts inter-changeably inthis pape-
-23 -

Expression (3) indicates that the amount of resources that could be mobilized though money creation depends on three factors - the rate of inflation, the growth of the economy, and people's willingness to hold real money balances. If the demand for real balances were invariant with respect to inflation, the government could in principle mobilize large amounts of resources though money creation. The problem, however, is that empirical evidence shows that the demand for real money balances is a negative function of inflation and this sensitivity increases with the pace of inflation. So, other things remaining unchanged, more money creation would cause a more rapid pace of inflation which will reduce the demand for real money balances. Therefore, the impact of inflation on seignorage will depend upon the relative strengths of the two opposing forces--with high inflation the inflation tax rate (sr) goes up, but the tax base (MIP) falls.1<sup>0</sup> 27. Let us now apply these concepts to Pakistan's case. Table 13 shows the government's total debt, interest payments, primary deficit and seignorage, all expressed as a percentage of GDP. A number of important points should be noted. First, in calculating domestic debt, the Government's obligations to the State Bank of Pakistan (SBP) are excluded as these are simply the counterpart of a large component of the seignorage. Second, it is assumed that the Government does not pay interest on the SBP's holding of T-bills. Examination of the SBP profit and loss accounts suggest this is a reasonable assumption. Third, seignorage revenues are broken down by the actual beneficiaries. A significant share of the seignorage revenues are returned back to the private sector through SBP rediscounts to commercial bank at below market rates." The profile of total debt shows the same pattern as external debt, declining upto 1981 and then a large increase to over 84% of GDP by 1991. Decomposing the change in total debt-GDP ratio into its determinants yields the following results (see Table 14).

- Pakistan ran large budget deficits between 1973 and 1981; other things rening unchanged, the associated primary deficits would alone have added 77 percentage points to the total debt-GDP ratio over the period. The effect of these large deficits was, however, more than offset by a combination of revenues from seignorage, negative interest rates, rapid economic growth and an appreciation of the real exchange rate. So, despite large fiscal deficits, the total debt-GDP ratio actually declined.

During 1981-1991, the total debt-GDP ratio changed gear and grew rapidly, expanding by 38 percentage points over the period. What caused this worsening? First, of course, was the role of fiscal deficits-although primary deficits were lower on average than during the previous decade, they remained significantly large. In fact, other things remaining unchanged, pnmary deficits alone would have added 52 percentage points to the total debt-GDP ratio. A second factor that added to the debt-

- D This relationship between inflation and seignorage tkes the form of a bell-shaped curve. Seignorage initially ises with inflation, then reaches a uaximum **before** declining. The classic work is due to Cagan (1956). also modified by Friedman (1971) to **bring in the** role of income growdt in seignorage, and by Bailey (1962) to show the impact of **welfare** costs of inflation. Friedman's modification **is** especiaUy important for low inflationi countries, where higher economic growth by itself will yield non-inflationary means of budget financing through moderate money creation.

- The correct definition of seignorage revenues **for the** Treasury requires **one** further adjusrmenL **Iterest earned** by SBP on **the rediscounts** kss interest paid by SBP on comnercial bank required reserves should be added back. **Unavailabiliy** of the required **data** presented this adjusbuent.
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GDP ratio was the depreciation of the real exchange rate. As noted earlier, although real exchange rate contributed to improving external creditworthiness by increasing exports, it nevertheless. raised the debt-GDP ratio through its impact on capital loss on the stock of external debt. The less rapid increase in the total debt-GDP ratio was partly due to the revenues from seignorage, which Mnded to offset almost a tird of the impact of the primary deficits. Moreover, the debt dynamics component continued to dampen the adverse effects of high deficits because of Pakistan's strong growth performance, even though interest rates turned positive in real terms.

Table 13: Pakistan: Trends in Debt. Interest Payments, Primary Balance and Seignorage as percentage of GDP

|Year|TDGDP|GINTGDP|PBGDP|SENGDP|Treasury use of<br>SENGDP|
|---|---|---|---|---|---|
|1972|72.5|1.8|- 4.1|3.6|2.6|
|1973|79.3|1.7|- 6.5|2.2|0.3|
|1974|67.4|1.7|- 7.0|4.8|-2.3|
|1975|59.6|1.5|-11.4|2.0|0.7|
|1976|60.9|1.9|-11.0|2.3|1.6|
|1977|61.6|_1.9_|- 9-0|2.8|3.0|
|1978|595|_1.9_|- 8.1|2.2|2.1|
|1979|_582_|2.0|- 9.6|3.6|2.6|
|1980|_55.2_|2.2|- 8.2|2.4|0.7|
|1981|49.8|2.0|- 6.5|1.2'|-0.6|
|1982|_55.4_|2.2|- _6.5_|2.3|2.3|
|1983|_.59.7_|2.9|-8.2|1.9|0.9|
|1984|57.6|3.4|- 6.5|2.2|2.2|
|1985|63.9|3.5|- 5.2|1.2|0.4|
|1986|76.0|3.8|- 4.3|2.8|1.7|
|1987|84.4|4.2|- 4.0|3.0|1.3|
|1988|76.0|4.9|- 3.6|1.6|1.0|
|1989|80.4<br>.|_5.0_|- 2.7|2.5|1.8|
|1990|83.9|_5.5_|- 1.0|2.5|2.0|
|1991|84.3|_5.0_|- 3.8|4.1|3.3|
|1992|80.6|5.3|- 2.2|1.4|0.7|

Source: Estimatedfromdataavailable inEconomicSurvey, Ministry of Fmance(various issues); International FmancialStatstics (IFS) of DIF and the Monthly Bulletin of the State Bank of Pakistan (SBP). See also Annex Table A3.
- 25 -

Table 14: Pakistan Factors Underlvinz the Changes in the Total Debt-GDP Ratio. 1973-1991 (%)

|Year<br>1973-1981|Atd<br>-29.5|z<br>-77.1|ii<br>8.1|(r-g)zd<br>-94.6|e<br>_d_<br>-3.9|
|---|---|---|---|---|---|
|198 1-1991|34.5|-52.3|16.3|-25.1|23.6|

Source: Own estimates

- Although the debt dynamics component remained favorable, it is inportant to note the substantial difference in the impact over the two periods. Indeed, the differential effects of. the debt dynamics component on the total debt-GDP ratio over the past two decades is. a key result that needs emphasis. The reason that Pakistan has avoided'an explosive debt sitation in the face of large fiscal deficits over the past twenty years is largely explained by the fact that real interest rates have been negative for a substntial period. However, the interest rate on both external and domestic debt has been turning positive. Continued high growth of the economy has helped absorb the adverse effect of this change. But unlike the 1970s, this cushior is weakening. Indeed, if real interest rates had been positive-say 3 % in real terms over the past twenty years-the total debt-toGDP ratio would have expanded by an additional 40.5 percentage points between 1973 and 1991, reaching 125% in 1991.

28. Can Pakistan run large fiscal deficits as in the past and avoid a debt crisis by financing these deficits through seignorage or inflation tax? In order to estimate the relationship between seignorage and inflation, we first need to estimate the demand for real money balances. The following specification was used to esfimate the demand function: where Ln = natural log _A_ = constant _BM_ Base or high-powered money _P_ = price level y = real income X = inflaton rate The specification allows the elasticity of demand for real balances to vary along the demand curve. The estimated results are shown in Table 15. The coefficients are of the right sign. The long-term elasticity of real balances with respect to real income is close to one.
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# Table 15: Pakistan: Demand for Real Money Balances. 1973-1992

|Variable|**LnA**<br>Lny||r|_Ln_(Bp )-|
|---|---|---|---|
|Coefficient value|-0.376<br>0.256|-0.011|0.757|
|t-mtio|C-Oil)<br>(1.70)|**(-3.34)**|(6.06)|
||D.W.=**2A1,**AdjustedIt=|0.98||

Using these results and expression (3), the relationship between seignorage and inflation is shown in Graph 8. The graph suggests that in Pakistan the demand for real balances is pretty sensitive to inflation. Seignorage grows noticeably with inflation reaching a maximum of about 3.2% of GDP at an inflation rate of 20%, and then falls as higher inflation cuts into the base of the inflation tax and reduces revenue despite the higher tax rate. During the past two decades, Pakistan mobilized some 2% of CGDP p.a. on average as inflation tax, running an average inflation rate at below 10% p.a. While there is some scope to mobilize higher revenues from inflation tax, the price will need to be an acceleration of inflation in the 15-20% range with adverse consequences for other economic variables. But most importantly, even if the Government were to accelerate inflation to the 15-20% range, on average it would mobilize only an additional 1.2% of GDP from seigcorage. So, with positive real interest rates, the end result of the large fiscal deficits will be a continuously rising debt to GDP ratio which cannot be sustined in the long runt<sup>2</sup> .

# Sustinable Current Account and Fiscal Deficits-Implications **for** the 1990s

29. We now have all the elements of the analytical framework to pull together the various threads and draw the mplications for sustainable current account and fiscal deficits for Pakistan in the 1990s. Let us first examine what constitutes sustainable current **account** deficits.

30. Sustinable current account deficits: Estinating sustairable current account deficits involves determining Paldstan's room for additional external borrowing. This is turn involves two considerations: solvency and creditworhiness. It can be shown that solvency requires that = **Note also dcat the relationship between seignorage and inflation is not a static one. Pakistan seems to be an oudier** in terms **of its ability to generate higher than average revenue from seignorage than other countries at comparable inflation raes.** For **example, Easterly and Schmidt-Hebbel (1993) show that over nearly 20 years across 51 countries,** three **quarers of anumal observations of inflation tax revenues were less than 2% of GDP. One important reason for the higher seignorage revenue yield in Pakistan is the high rate of economic growth. Another reason is the large ratio of base money, particularly currency, to GDP resulting frin the low financial depdt of the Pakistni economy. So, with greater financial deepening, the ability to raise seignorage revenue is likely to fal even with similar GDP growth rate and inflation.**
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Graph 8 Pakistan **--** Seignorage as a Functlon Inflation <!-- Start of picture text --> 3.5<br>S3 .. .. .. . =.... ........... . .. .. .. .. . . . . . . . . . .<br>n<br>0 j 2. 0 . . . ................................ ...... ..................................<br>r<br>a<br>0 ...............................................................................<br>a<br>0<br>D<br>3 _, , ...,. .. . . .,,,,,,,,,...,,,,,,,,,,,,,,.............................................................................. ,, .,l<br>p<br>c 5 10 15 20 25 30 36 40 46 S0 65 B0<br>Inflation Rate (S)<br>V 2C r-n) b --- (4)<br><!-- End of picture text --> which states that the non-interest current surplus must at least equal the initial debt times the difference between real interest cost of foreign debt and real outW growth rate.'<sup>3</sup> So long as the real interest rate is lower than the real growth of the economy, Pakistan can continme to run current account deficits without becoming insolvent. The need to maintain solvency of its external payments obligaton alone sets some strict limits on Paldstan's future current account deficits. Thus, given Paldstan's growth target of 6 % p.a. and given the oudook for international real interest rate of 2-3 % per annu in the next 5 years, Pakistan can run non-interest current deficits of about 1.5-2% of GDP which implies a current account deficit of about 3-3.5 % of GDP p.a. The higher the real interest rate, the lower the non-interest deficit that will maintain solvency. Indeed, if real interest rates 13 See Sweder van Wijnbergen (1989).
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exceed the growth rate of the economy, the non-interest current balance would need to go into surplus to maintain solvency.

31. Solvency consideration alone is often not enough to enable a country's continued access to external finance. The lenders perception of a country's "creditworthiness" is what counts. Lenders look at various indicators, particularly the economy's capacity to service the debt. In practice, various measures of this capacity are used-including the debt-service racio, the debt/exports ratio and the debt/GDP ratio. Commercial lenders pay particular attention to the debt-service and the debt to export ratios, as they represent direct measures of the economy's ability to service debt in the short run. Over the longer term, appropriate policy changes can allow a diversion of resources from most tradeables to tradeables. So, the debt to GDP ratio is a better measure of a country's capacity to service its debt over the longer-term. As suggested by Daniel Cohen (1985, 1988), an appropriate measure of a country's creditworthiness is the 'debt-resource' ratio, which is calculated as a weighted average of debt to GDP and debt to exports ratios. Another useful result from Cohen's work is that if a country has not defaulted, then maintning a constant debt to resource ratio constitutes a better debt strategy than forcing the country to reduce this ratio.'<sup>4</sup> Using these results, Pakistan's sustainable current account deficits are indicated in Table 16. The table suggests that higher the GDP growth rate and/or the higher the export growth rate, the higher the level of sustainable current account deficits. Thus, given Pakistan's medium-term target of achieving 6 percent growth in GDP and the projected real export growth of 6-7% p.a. (the same level as over the past 20 years), the maximum levels of current account deficit that are sustainable (maintmins a constant debt to resource ratio) is around 3 percent per annum. If export growth can be accelerated tfrther to say, 8% p.a. and the GDP growth is boosted to 7% p.a. the level of sustainable current account deficit can be raised by another half percentage point.

Table 16. Pakistan: Prudent Levels of Foreign Borrowing-Sustainable Current Account Deficits (% of GDP)

|GDP Growdi Rate||_Growth||Rate of|Exports|||
|---|---|---|---|---|---|---|---|
||2|3|4|_5_|6|7|8|
|2|1.0|1.3|13|1.8|2.0|2.3|2.6|
|3|1.2|1.5|1.7|2.0|2.2|2.5|2.8|
|4|1.4|1.7|1.9|2.2|2.4|2.7|3.0|
|5|1.6|1.9|2.1|2.4|2.6|2.9|3.2|
|6|1.8|2.1|2.3|2.6|2.8|3.1|3.4|
|7|2.0|2.3|_2.5_|2.8|3.0|3.3|3.6|

ouc:Own estinmats 4 A counry that has been current in servicing its debt should not be required to reduce the debt-resource ratio because the transition cost could resuk in lower creditworthiness. If. however, this reduction rakes place as a result of a surge in exports, a strong GDP growth and strong domestic resource mobilization, that would be fine. The issue here is to avoid an extra degree of constraint.
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32. Sustainable fiscal deficits. Sustainable current account deficits impose significant restrictions on sustainable fiscal deficits. The intuition underlying this can best be seen from the fundamental budgetary constraint that fiscal deficits need to be financed through external borrowing, domestic borrowing or money creation. The level of external borrowing is determined by sustainable current account deficit (as above); the level of domestic borrowing is determined by the need to avoid a domestic debt explosion and crowding out of the private sector: while the level of money creation depends upon the level of inflation. So, for any given growth. external balance and inflation targets, there is a particular level of fiscal deficit that is consistent with these targets. Thus. given Pakistan's growth target of 6 percent p.a. and the sustainable level of current deficit that is consistent with this target (defined in Table 16)'5, the sustainable levels of fiscal deficits is illustrated in Table 17 as a function of the rate of inflation.'<sup>6</sup> For domestic borrowing, we assume zero additional domestic borrowing. The rationale for this assumption is quite simple. With greater financial liberalization currently underway in Pakistan, the real interest rate on government domestic borrowings has been turning significantly positive, reaching about 3 % in 1993. As fmancial sector distortions are further reduced, GOP is likely to face the full market cost of domestic borrowing which is expected to be around 5-6% in real terms. In this situation, it will be imprudent for Paldstan to continue to increase its domestic debt because, as explained in para 25, the debt dynamics interplay-(r-g)dt-could lead 7 towards financial insolvency'.

33. The results of Table 17 are quite revealing. First, Given Paldstan's growth target of 6% p.a., an inflation target of 5% (by 1996),"8 and assuming an export growdt rate of 7% p.a., consistency of the external target (creditworthiness) requires that fiscal deficits are reduced to around 4.5-5% of GDP p.a. This is much below the 8% average of the past decade and the 9.7% reached in 1992193. Second, adding another half percentage pomt to the fiscal deficit will require, in the absence of bigher borrowing, an acceleration in the inflation rate to 15-20% p.a. This suggests that the inflationary consequences of higher fiscal deficits are substantial. Third, financing even further increases in fiscal deficits will require higher external or domestic borrowing because running higher inflation will be counter- productive for revenues. Given the trend towards increasing real interest rates, these higher borrowing will result in a serious debt problem; this in turn will jeopardize Palistan's ability to maintain growth rates at 6% p.a.

- I We assumre a growth rate of 6% p.az and export growth of 7% p.a., which yields a sustainable current account deficit of 3.1% of GDP. Roughly 70% of this is available for the public sector.

- 16 Note that this is a somewhat simplistic presentation as it ignores the general equilibrium effects of inflation on growth and current account deficits. Also, the real exchange rate is assumed to remain constant.

17 It is possible to argue that Pakistan is moving towards a more open economy. including greater international capital mobility. This means Pakistan could end up aligning its financial policies with the international market so that domestic and international interest rates are fully aligned. Even in this extreme case of perfect capital mobility, real interest rates in Pakistan are likely to be higher than in the international markets due to country creditworthiness risk considerations. Depending upon the risk premium, a divergence of one to two percentage points between international and Pakistan interest rates would still lead domestic real interest rates in the 4-5% range. With real interest rates very close to real GDP growth rate, and given the already large interest cost of domestic debt, it would be prudent to avoid any further increase in domestice debL

- ' As described in the 1993194-1995/96 PFP.
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34. It is important to note that fiscal deficits in the 4.5-5% of GDP range are sustainable in the sense that such deficits are consistent with other macroeconomic targets/variables (GDP growth rate, export growth rate, inflation rate, real interest rate). If these targets/variables change, the level of sustainable fiscal deficit will also change. [n particular, external shocks could reduce economic growth, weaken export performance and raise real interest rate. For example, if a sustained external shock were to reduce medium-term export growth to 4% p.a., and GDP were to falter to 3-4% p.a., sustainable fiscal deficit will fall below 4% of GDP. Similarly, as noted in footnote 12, GOP's ability to mobilize 2.6% of GDP in terms of seignorage revenue at 5% inflation rate could be reduced with the greater monetization of the economy and improvements in financial services. This is very likely, as suggested by the experience of more financially developed economies where the ratio of base money to GDP is much lower. To guard against these risks and uncertainties, a prudent policy stance would be to aiqn for an even lower fiscal deficit than 4.5-5 % of GDP.

35. Seipnora2e and Ouasi-Fiscal Deficits: The arguments underlying the result of Table 17 is based on the key assumption that the full amount of seignorage revenues are available for financing the fiscal deficit. However, as noted, this has not been the case in the past. A part of the seignorage revenue has been used to finance "quasi fiscal deficits" resulting from transactions between the State Bank of Pakistan and the private sector. There are three sources of quasi fiscal deficits: (1) subsidized credit schemes funded by the SBP; (ii) exchange -ate losses resulting from SBP forward cover operations; and (iii) write-off on loans that are not recovered. The cost of these transactions are estimated at around 1.3 % of GDP in 199019l. The diversion of seignorage revenues to finance quasi fiscal deficits has required additional domestic borrowing to finance the ordinary fiscal deficits. Apart from the resource misallocation implications of the quasi-fiscal deficits, their macroeconomic implications in terms of additional domestic borrowing needed to fiance the ordinary fiscal deficits suggests an urgent need to review and rapidly phase out these quasi-fiscal tansactions. Without this policy change, financing of fiscal deficits even in the 4.5-5 % range would require positive net domestic borrowing with adverse financial consequences.

Table 17. Pakistan: Sustainable Fiscal Deficits as a Function of Inflation Rate (% of GDP)

|Inflation Rate<br>.<br>____________|**Seignorage**<br>_______________|Net**External**<br>Borrwing|**Net**Domestic<br>Borrowing|**Sustainable Fsal**<br>Deficits|
|---|---|---|---|---|
|_5_|2.6|**2.2**|0|4.8|
|10|3.0|**2.2**|0|5.2|
|15|3-1|2.2|0|5.3|
|20|3.2|2.2|**0**|**5.4**|
|**25**|3.0|**220**||5.2|
|30|2.8|2.2|0|5.0|

Source: Own **esdma**
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# Financing High Growth: The Saving-Investment Challenge.

36. The previous section focused on the consistency of fiscal policy given growth, inflation and sustainable current deficit targets. The relationship between fiscal deficit and growth was not examined directly. How does fiscal policy affect growth? One key link is through the implications of fiscal policy for saving and investmenL Maintaining high growth will require an adequate investment effort. Empirical evidence from Pakistan suggests that the rate of capital accumulation is a major determinant of economic growth. What constitutes an adequate investment effort? Over the past 20 years, Pakistan's average fixed investment rate has been around 17% of GDP. which, given the rate of growth of the economy, yielded a net capital output ratio of 2.75 and a gross capitl-output ratio of 3.14. So, assuming unchanged efficiency, a 6% growth trget will require a gross fixed investment effort of about 19% of GDP p.a., which is higher than the past average rate. However, this ignores an important factor: the need to build up the economic and social infrastructare which appears to have been neglected in the past. Evidence from fast-growing economies show that their investment efforts have been in the range of 24-30% of GDP p.a. Therefore, it is reasonable to expect that Palistan would need to accelerate its investment effort to the 21-22% of GDP range in order to sustain the growth rate of 6% p.a. This corresponds to a gross ICOR of about 3.5.

37. The financig of this investment effort, however, will present a major challenge. Table 18 shows the trend in investment fiance broken down by its components-foreign and national saving. The patter shows a fairly strong dependence on foreign saving-about a quarter of the investment effort is financed through foreign saving. We saw in the previous section that the level of sustainable current account deficits (foreign saving) is around 3% of GDP--much lower than the 5% of the past. At the same time, it was noted above that the fixed investment rate will need to be raised from 17% of GDP to around 21-22%. Adding the two yields a total required increase in national saving effort of 6-7% of GDP. This is an indication of the magnitude of internal adjustment necessary to ensure the consistency of growth with macroeconomic stability.

Table 18. Paldstan - Saving-Investment Balance, 1972-92 (% of GDP)

|____________________<br>||Average<br> 1972-80|Average<br>1980-85|1986|1987|19B8|1989|1990|1991|1992|
|---|---|---|---|---|---|---|---|---|---|
|Invesbflent||||||||||
|- Gross Fixed Ilnvesunent|16.7|16.8|17.0|17.5|16.5|17.3|17.3|17.1|17.2|
|- Change m stocks|4.3|1.8|1.8|1.6|15|1.6|1.6|1.6|1.4|
|- Gross Invesuient|_16A_|18.6|18.8|19.1|18.0|18.9|18.9|18.7|18.6|
|Financed by:||||||||||
|- Foreign Saving|5.5|4.0|3.9|2.2|4.4|4.8|4.2|4.8|3.0|
|- National Saving|10.9|14.6|14.9|16.6|13.6|14.1|14.2|13.9|13.4|

Source: World Tables 1993 and Minislly of Finance
- 32 -

J 38. Expanding the saving effort by this large magnitude is not an easy task: it is not an impossible challenge either. As shown in Table 6 earlier, there are many countries where the national saving effort is in the range of 20% of GDP or above (e.g. India, Indonesia, Thailand, Malaysia). Efforts will be needed to raise both the private and the public saving rate. In Pakistan, special emphasis needs to be placed on public saving, which brings us to fiscal policy once again.

39.. Avoiding a Crunch on the Private Sector: The 'crowding out' effect of fiscal policy can be best understood by looking at another accounting identity: fiscal deficit is simply equal to the sum of foreign saving (current account deficit) and net private saving (difference between private saving and invesunent). So, given sustainable current account deficits (foreign saving), higher fiscal deficits must be financed trough a private net surplus. Table 19 illustrates the 'crowding out' impact of Pakistan's large fiscal deficits on the private sector.

40. Running negative.public saving implies that a part of the investible surplus is being use,d to finance public consumption. Private sector saving has been mnobilized for the public sector part,y through the inflation tax but mostly through domestic borrowing. To contain the fiscal cdst of: domestic borrowing, Pakistan has followed a policy of financial repression for a fairly long period. (see Graph 9 for movements in interest rates). While fmnancial repression allowed the Government to mobilize resources for the budget deficit at below coSt, the oppormnity cost of this policy was reduced fnancial resource mobilization and repressed4private credit and investment. For example, bank deposits and private credit as a share of GDP has been muchlower in Pakistan than in countries' with more liberalized financial policies. Both fnancial variables show signs of relative decline or stagnation, unlike other high performing economies which exhibit considerable financial djnamism **_-_** (see Table 20, see also Box 3).

41 Financial liberalization inevitably results in. a rising interest cost of fiscal deficits. Indeed, evidence that this has been happening in Pakistan was presented earlier. It was also pointed out that the dynamics of borrowing (expression 2) could evetually lead to a major financial crisis for the public sector. Rising real interest rate is also of concem to the private sector, as this tends to have an adverse effect onincentive for investment. The challenge for policy is to develop an appropri,e combination pf macroeconomic policies that prevents financial repression but also avoids'high real interest rates. Fiscal policy has a very imporant role here. As Paldstan proceeds with fiurther financial liberalization to facilitate stronger financial intermediation and improved financial resource allocation, this should be combined with fiscal adjustment to prevent a crowding out of the private sector through high interest rates, while also preventing a public sector financing crisis.
**-** 33 -

> Table 19: Pakistan--Private Sector Pinancing of Public Tnvestmen: A/ (S of GDP)

||m<br>Average<br>1972-80|m_<br>Average<br>1980-85|-<br>1986<br>|1987|19B8|1989|1990|1991|1992|
|---|---|---|---|---|---|---|---|---|---|
|Public Investment|11.2|9.3|9.3|9.7|3.8|<br>9.0|8.3|<br>8.2|7.7|
|Flinced By:||||||||||
|- Foreign Savingsh/|5,0|3.6|1.7|1.9|3.3|4.0|S.I|3.2|2.1|
|-Public<br>Saving|1.3|0.6|-0.4|-1,8|-1.6|-1.4|0.1|-2.2|-0.3|
|- Private Net Surplus|4.9|_5.1_|8.0|9.6|7.1|6.4|_5.1_|7.2|5.9|
|Private Investment|_5.2_|9.3|9.5|9.4|9.2|9.9|10.6|_10.5_|<br>10.9|
|Private National Saving|9.6|14.0|15.3|18.7|15.2|_15.5_|14.1|16.1|13.7|
|Private Foreign Saving|_0.5_|**0.4**|**2.2**|0.3|1.1|**0.8**|**1.1**|1.6|0.9|

**al** Stock changes are assumed to be financed by the private sector. h/ Defined as public sector's share of current account deficit.

Source: Ministry of Finance Table 20: Financial Develonment in Pakistan Relative to Selected Countrie A/

||1|972|1|980|1|985|1|990|1|992|
|---|---|---|---|---|---|---|---|---|---|---|
||D|PC<br>GDP|D<br>GDP|PC<br>GDP||D<br>GDP|PC<br>**GDP**|D<br>**GDP**|PC<br>**GDP**|D<br>**GDP**|PC<br>**GDP**|
|Pakistn|31.9|27.9|27.5|24.0|281|31.0|24.1|27.5|28.8|26.7|
|Indonesia|||-12.0|_.5_|18.1|18.2|38.2|50.2|47.6|_55.0_|
|Malaysia|39.7|21.1|40.2|38.3|53.9|61.7|57.1|72.2|-||
|Thailand|25.9|_19.5_|31.2|30.6|54.3|49.5|78.2|79.3|-|-|
|Chile|19.6|9.7|21A4|43A|27.0|70.1|33.5|50.2|36.8|51.2|

**a/ D = Total** bank deposits; PC **=** private credit; GDP **-** gross domestic prodi.t. **Source: International Fiaial Sctdstics**

42. Not all public spending is at the expense of private spending. Public investment can and should play an important role in supporting private investment and economic growth. There is adequate empirical evidene which suggests that public spending in physical infrastructure and human capital play an important role in raising the productivity of private investment and increasing economic growth. Baffes and Shah (1993), for example, using cross-country data, found a strong positive response of GDP growth to human capital and infastructure investment for a large number of counties including Pakistan. As noted in para 34, there is a concern that Pakistan will need to
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Graph 9 Pakistan -- Movements in Real Interest Rates <!-- Start of picture text --> 5 ....................... .............<br>RD<br>na<br>d .. .. . ... .. .. ... .. .. ... .. .. .. ... .. .. ... .. .. ... .. .. ..<br>RL<br>R _ ,\S/,............... ... ... ....... . . ...................................... ....<br>-25 ~ ~ I t I a I I I I I I I I I I I I I<br>72 78 74 75 76 77 78 79 80 81 82 88 84 86 86 87 88 89 90 91 92<br>- Real deposit rate + -Real lending rate<br><!-- End of picture text --> invest quite heavily in basic economic and social infrastructure to increase labor productivity and reduce the cost of production. So, another major challenge for fiscal policy is to ensure that the composition of the public investment program is consistent with Pakistan's development objectives and priorities. We now return to the role of public spending on human resource development in some greater detail in the next section.

# Human Capital Formation and Implications for Pakistan's Growth Performance

43. One of the key findings of the East Asian Miracle stmdy is that the high performing East Asian economies invested very heavily in human capital formation. Quantitative analysis suggest that human capital was a key factor explaining the better growth performance of these economies. There is similar evidence of a very strong role of human capital in explaining growth performance across
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# Box 3 Costs of Financial Repression

The-costs of.financial repression-can.be substantal. Mexico's experience illustrates the effects of financial repression under. rising inflation. Financial controls intensified after. 1981 as.inflation soared, and the ratio of private credit to GDP dropped below already low -: levels. Foliowing fiiancial liberalintion in 1990, the ratio- doubled in two years; In Ghana,;.. private crditiwas ata. very low level in the. late: 1980s, reflecting years of financial. repression. Countries that abstined from. repressive interest rate:-controls, such as. Chile and..;:: Thailand,.and.Indonesia:(after ..1983) had very high levels of private credit which may. partially explain their superior investment and- growth performance. in the 1980s. ..

Source: Willia Easterly andm Klms Schmidt-Hebbel. (1993) countries from a number of other studies (see for example Barro (1991); Barro and Lee (1993)). What are the implications of this result for Pakistan that has grown fairly rapidly but without commensurate progress in improving its human capital"?

44. One obvious implication of the relative neglect of human development has been the high rate of population growth in Pakistan. So, even with a growth rate over the past ten years that has been the highest in the South Asia Region, PakSlant'a per capita GDP growth has been below the region's average. Therefore, over the medium-to-long term, a major pay-off to substantial investnent in human capital, especially female education, would be a sharp reduction in the population growth rate.

_45._ The fact that Pakistan has sustained an average growth of 6.0% p.a. over the past twenty years even with the neglect of human capital formation has emerged as a development puzzle. One needs to look a bit more deeply at the sectoral sources of growth to understand this phenomenon While there is some positive evidence of structural change happening in. Pakistan over the past 20 years, especially in terms of the share of manufacturing exports in total exports, the picture does not suggest the making of a dynamic economy. The share of manufactming in GDP remains relatively small. Moreover, there is a strong dependence of the manufacturing sector on a small number of agriculture-related industies (cotton, foodstff). Given the relatively tiin manufacturing base, it is not surprising that skldls have not yet emerged on a major consraint on the rate of economic growth. Moreover, fim level analysis suggests that on-die-job traimng has been playing an miportan role in skill formation, making up for some of the deficiencies resulting from weak formal education In agriculture, where growth was also fairly robust (4.2% p.a.), a large part of the output expansion " See **Behnman** and Schneider (1991) for a compartive analysis of invesmen in human capital in **Pakistan** and **odier** developing **countries.**
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came from area expansion supported by heavily subsidized water and fertilizer. Except for cotton and. wheat, productivity improvements have not been very significant. In the services sector, activities that have dominated include construction, trade and informal sector services. Given the limited nature of the skills required, learning-by-doing seems to have been the main basis for acquiring the skills needed to perform these functions.

46. The real question boils down to whether the past economic activities will continue to provide the basis for growth in the future? The hypothesis of this paper is that this will be very difficult. Take agriculture, which as noted has grown at the healthy pace of over 4% p.a. over the past two decades. Continued strong agricultural growth rate would be critical to sustainfing high overaU GDP growth. As noted, although there have been some improvements in productivity, expansion of area under cultivation supported by heavily subsidized water and fertilizer has played a critical role in supporting past agricultural growth.<sup>20</sup> Evidence suggests that there is a substantial productivity gap, even with available technology, between potential yields per hectare and what is actually achieved for most major crops including wheat. For the futare, much more reliance will need to be put on productivity improvements than in the past to support a healthy agricultural growth rate as land and water have become increasingly scarce. Also, with rising cost of farm production resulting from cutbacks in subsidies on fertilizer, increases in water O&M charges and reduction of interest subsidies for mechanized inputs, improvements in farm productivity will be essential to maintain incentives. A further change that will be necessary is to diversify farm production away from heavy reliance on three major crops-rice, cotton and wheat-to higher-value production such as fruits and vegetbles. Apart from rising cost of farm inputs, domestic demand for food crops (rice, wheat) is likely to expand. less rapidly with the slowdown in population growth rate and given .the relatively low income elasticity of these products. On the other hand, the higher income elasticity of other farm products- (fruits, vegetables, meat) is likely to raise their prices. Improvements in farm productivity and diversification towards higher value crops will require considerable improvements in farmer education and research and extension services.

47. In manufacturing, growth has proceeded at an average pace of about 7.4% p.a. The sector remains heavily dominated by two main activites: textles and food and beverages. Again, demand constraints for textiles at the interational level will limit ability to expand at the same pace as in the past. A more diversified manufactuing base geared to the world markets will be needed to sustain continued rapid growth of the manufactring sector. A more matured and diversified industrial base will be much more skill intensive than at present This is fully borne out by the experience of the fast growing economies of East Asia. Secondly, the correction of policy distortions currently underway and/or necessary for the fiuture-especially trade policy reform--wili reduce the rents derived from trade and other protection. Greater competitive pressure at both home and abroad will require substantial improvements in labor productivity in the manufacturing sector. Again, a better educated and trained labor force wiUl be necessary to raise labor productivity.

20 For example, **torl cropped** area expanded from 16.6 million hectares in **1972** to 21.35 million hecaires in 1992: water availablitw increased from 71 MAF in 1972 to 124 MAF in 1992; fertlizer off-take grew from **379** thousand NIT in 1972 **to** 2068 thousand NIT in **1?92.**
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48. Even in the services sector, skill requirements are changing. The reduction of the government's economic role in infrastructure and services and the growing role of the private sector is associated with greater competition in the provision of quality services at competitive prices. Again, productivity improvements will need to play a key role in supporting growth rates of 6-7% p.a., calling for a more skilled labor force.

49. It is hard to predict with any degree of certainty how quickly the structural transformation in growth will need to take place and therefore when the skills constraint will begin to bite in. Experience of other countries unequivocally suggest that this is a reality that will need to be faced sooner or later. Therefore, it is in Pakistan's interest to accelerate efforts to improve human capital formation. Fortunately, there is some evidence that this is now well recognized, as indicated by the formulation of the Social Action Program. The implementation tasks ahead, however, remain formidable.

# V. SUMMARY AND CONCLUSIONS

50. Pakistan's rapid growth rate over the past two decades has attracted considerable attention and debate, with some regarding this growth performance as a "development puzzle" in view of a number of disconcerting factors that has prevailed along with rapid growth. These include: high fiscal and current account deficits, a low saving and investment effort, and a neglect of human capital formation. This paper sought to address two questions: What factors explain Palistan's rapid growth? Can Pakistan sustain high economic growdt over the next 10-20 years without first addressing the three disconcertng factors mentioned above?

_51._ What are the determinants of the past growth performance? Using a standard statistical framework, the paper concludes that:

- Physical capital accumulation played a very important role in Pakistan's growth performance-overall and in the manufacturing sector. Although Pakistan's investment rate remains low by mternational standards, the fixed investment rate grew steadily during the 1970s and then stabilized at around 17% of GDP in the mid-1980s. This allowed the capital stock, economy-wide and in the manufacuarng sector, to expand fairly rapidly which in turn supported a substantial increase in the capital labor ratios and labor productivity.

- Accumulation of labor also played a signifcant role in overall economic growth, although the statistical significance of labor in explaining growth in the manufactring sector came out as rather low. The relatively weaker statistical significance of the labor coefficient, especially in the manacturnng growth equation, reflects the growing captial intensity of production. But it is also an indication that, colons paribus, population growth is too fast. Labor markets cannot absorb such a rapid growth in population, particularly with Pakistan's very low skills level. The increase in capital intensity could be the efferct of two forces at work. First, Pakistan's macroeconomic policies have generally favored greater capital intensity of production, resulting from under-priced caphal imports due to over-valued exchange rate (well upto the mid-1980s), low interest
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rates and other incentives. Second, external migration of skilled and semi-skilled labor in the 1970s and early 1980s that tended to raise real wages.

- Greater trade liberalization, as measured by the increase in the ratio of total value of exports and imports to GDP, had a strong positive impact on Pakistan's growth performance. Once again, however, the statistical significance of trade policy surprisingly was reduced in the case of manufacturing sector. Nevertheless, the strong positive role of greater trade openness suggests that Pakistan needs to continue with further trade reforms to enhance competition and economic efficiency.

- The structural change dummy variable included to capture the impact of the change in the policy regime in Pakdstan from the interventionist policy regime of the 1972-77 period to the market-oriented economy since 1978 came up with a significant coefficient in the case of both aggregate and manufacturing sector growth equations- This result is explained by the major improvement in efficiency resulting from the reduction in controls and bureaucratic interventions. Estimates of total factor productivity (TFP) confirm this finding as well-TIP change was negative in the first period as compared with the positive contribution of TIP change to growth in the later period. Once again, this reinforces the importance of further progress with economic liberalization.

_52._ Can past growth rates be sustained in the medium-to longer term? The paper examined each of the three disconcerting factors in some depth. A key conclusion is that past growth rates winl be difficult to sustain without substantial progress in addressing these concerns. The analysis of consistency of macroeconomic policies of the past-especially fiscal policy was examined on the basis of a quantitative framework developed by Sweder van Wijnbergen (1988) and others. The key conclusions of this analysis are as follows:

- The main reason that Pakistan was- able to sustain high growth and avoid a fiancial crisis in the face of large fiscal deficits was that the real interest rates on both external and domestic debt were substanially negative during the 1970s. Mainly because of this factor, debt to GDP ratios continued to decline even though Pakistan ran substantial fiscal and current account deficits in the 1970s.

- lHowever, real intrest rates have been uning positive during the 1980s. This development has already impacted, as expected, quite adversely on Paldstan's debt situation. As a result, notwithstanding some reduction in fiscal and current account deficits, the interest burden of the domestic and external debt has been increasing significandy in the 1980s.

- The outlook is that both foreign and domestic real interest rates will become significantly positive in the 1990s. In this situation, if Palcistan were to ran fiscal and current account deficits of the same magnitude as in the past, a fnancial crisis is likely to emerge pretty rapidly.

- It is not possible to avoid a debt crisis by fimding larger fiscal deficits through money creation. The analysis shows that Pakistan's inflation target of 5% p.a. is consistent
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with 'inflation tax' of about 2-2.5% of GDP. This tax will reach a maximum of 3- 3.2% of GDP with an inflation rate of 20%. A further acceleration of inflation will cut the 'iMflation tax base' (real money balances) pretty rapidly so that the revenue proceeds from inflation will actually fall. Even trying to generate the maximum revenue of 3- 3.2% of GDP from higher inflation tax (20%) is unwise. The adverse effects of this higher inflation on resource allocation and income distribution can be quite severe.

Estimates of sustainable current account deficit (e.g. deficits that do not worsen external creditworthiness) suggest a value of about 3% of GDP p.a. Consistent with this and the inflation target of 5 %, sustainable fiscal deficits are in the range of 4.5-5 % of GDP per annum. It is important to note that these fiscal deficits are sustanable in the sense that they are consistent with other macroeconomic targets/variables (GDP growth, export growth, real interest rate and inflation). If these targets/variables change, the level of sustinable fiscal deficit will also change. In particular, external shocks could reduce growth, weaken export performance and raise real interest rates. To guard against these risks, a prudent policy stance would be to aim for an even lower fiscal deficit than 4.5-5.0% of GDP.

Fiscal prudence calls for avoiding any net addition to domestic debt, given its high and growing financial cost. It is therefore important to ensure that revenues from seignorage (that are consistent with the 5% inflation target) are fully available for financing the ordinary fiscal deficits. This will require a rapid phase out of "quasifiscal deficits" resulting from the transactions between the State Bank of Palistan and the private sector.

The paper also suggests the need for a balanced use of fiscal, monetary and exchange rate policies. Patting the burden of external adjustment fully on the real exchange rate, as Pakistan seems to have done in the past, is inconsistent with improvements in external and internal balance not only because fiscal deficits will continue to put pressure on the external and internal debt but also because a real exchange depreciation will impose capital loss on the stock of external debt A balanced policy stance involves setting the real exchange rate at its appropriate level and using monetary and fiscal policies to manage aggregate demand and stabilize the real exchange rate.

53. Regarding the implications of the low saving-investnent effort, the paper concludes that a substntial adjustment will be needed to raise national saving and investment in order to ensure the consistency of the growth target with the need to reduce macroeconomic imbalances, while financing the acumulation of physical and human capital required to support high growth. The need particularly is to raise the national saving rate from the curent low level of 14% of GDP to around 20-22% of GDP. This, in turn, will require a substantial fiscal adjustment which will raise publc revenues and reduce public consumption tO achieve a public saving rate of 3-4% of GDP, as compared with negative savings presendy. A similar adjustnent in public capital spending will be needed **to** ensure that public investment is focused on areas that promote private sector investment and growth-e.g. physical and human infras .
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54. Lower fiscal deficits will also help reconcile the need for greater financial resource mobilization with the objective of stimulating private investment. A large part of the domestic financing of the fiscal deficit has come from borrowing from the private sector. To contain the fiscal cost of domestic borrowing, Pakistan has followed a policy of financial repression for a fairly long period. While financial repression allowed the Govermnent to mobilize resources for the budget at below cost, the opportunity cost of this policy was reduced financial resource mobilization and repressed private credit and investnent. For examnple, bank deposits and private credit as a share of GDP have been much lower in Pakistan than in countries with more liberalized fmancial policies. Both indicators show signs of stagnation or even decline from relatively low levels, unlike other high performing economies which exhibit considerable financial dynamism. Financial liberalization, however, inevitably results in an increase in real interest rates which tends to have an adverse effect on incentive for private investment. The challenge for policy, therefore, is to develop an appropriate combination of macroeconomic policies that prevents financial repression but also avoids high real interest rates. Fiscal policy has a very important role here. As Pakistan proceeds with financial liberalization to facilitate stronger financial intermediation and improved resource allocation, this should be combined with fiscal adjustment to prevent a crowding out of the private sector through high real interest rates.

_55._ Finally, the paper argues that Pakistan's ability to sustain high growth rates in the medium-tolong term will also depend upon rapid progress with human capital formation. In the first place, the ability to reduce population growth rate will depend critically upon human resource development, especially education of women. Moreover, the sources of growth in the future wiU change substantially, as compared with the past. A diversified manufacturing sector wiU need to lead the way, supported by improved agricultural productivity and more efficient services. These in turn will require a much higher skdll intensity of production than in the past. The international evidence on the importance of human capital formation for sustained growth performance is indisputable. Paldstan's recent shift in emphasis on this subject, as reflected in the Social Action Program, is evidence that this reality has dawned upon the policy-makers. Speedy implementation of this program however, remains a challenge.