Special Edition-07.pdf - Lahore School of Economics
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<strong>Special</strong> <strong>Edition</strong> ISSN 1811-5438<br />
THE LAHORE JOURNAL<br />
OF<br />
ECONOMICS<br />
<strong>Lahore</strong> <strong>School</strong> <strong>of</strong> <strong>Economics</strong><br />
Papers presented at<br />
The Third Annual Conference on<br />
Management <strong>of</strong> the Pakistan Economy<br />
Economic Reforms: The Road Ahead (2007 -2010)<br />
2nd May to 3rd May, 2007<br />
<strong>Lahore</strong> <strong>School</strong> <strong>of</strong> <strong>Economics</strong>, <strong>Lahore</strong>, Pakistan.<br />
Ishrat Husain<br />
Reforming the Government in<br />
Pakistan: Rationale, Principles and<br />
Proposed Approach<br />
A. R. Kemal<br />
Industrial Competitiveness <strong>of</strong><br />
Pakistan (2000-10)<br />
Shamyla Chaudry<br />
Increasing Global Competitiveness: A<br />
Case for the Pakistan Economy<br />
Shahid Kardar<br />
Monetary and Fiscal Policies<br />
Shakil Faruqi<br />
Pakistan Financial System - The Post-<br />
Reform Era - Maintaining Stability<br />
and Growth<br />
Muhammad Arshad Khan & Sajawal<br />
Khan<br />
Financial Sector Restructuring in<br />
Pakistan<br />
M. Ashraf Janjua<br />
Pakistan’s External Trade: Does<br />
Exchange Rate Misalignment Matter<br />
for Pakistan?<br />
Naheed Zia Khan<br />
Doha Round Baggage: Implications<br />
for Economic Reforms in Pakistan<br />
and other Southern Countries<br />
Samina Shabir & Reema Kazmi<br />
Economic Effects <strong>of</strong> the Recently<br />
Signed Pak-China Free Trade<br />
Agreement<br />
Mehak Ejaz<br />
Determinants <strong>of</strong> Female Labor Force<br />
Participation in Pakistan<br />
An Empirical Analysis <strong>of</strong> PSLM (2004-<br />
05) Micro Data<br />
September, 2007
THE LAHORE JOURNAL<br />
OF<br />
ECONOMICS<br />
Editors<br />
Dr. Azam Chaudhry, Editor<br />
Dr. Theresa Thompson Chaudhry, Editor<br />
Ms. Nina Gera, Co-Editor<br />
Editorial Advisory Board<br />
Dr. A. Mushfiq Mobarak<br />
Dr. A. R. Kemal<br />
Dr. Ahmed Kamaly<br />
Dr. Ahmed M. Khalid<br />
Dr. Ajaz Hussain<br />
Dr. Akmal Husain<br />
Dr. Anwar Shah<br />
Dr. Ashish Narain<br />
Dr. Aslam Chaudhry<br />
Dr. Baoyun Qiao<br />
Dr. Gwendolyn A. Tedeschi<br />
Dr. Inayat Ullah Mangla<br />
Dr. Irfan ul Haque<br />
Dr. Jamshed Y. Uppal<br />
Dr. Jan Warner<br />
Dr. Javier Arze del Granado<br />
Dr. Kaiser Bengali<br />
Dr. Kamal Munir<br />
Dr. Khalid Aftab<br />
Dr. Khalid Nadvi<br />
Dr. Lennart Erickson<br />
Dr. Mathew Andrews<br />
Dr. Michal Jerzmanowski<br />
Dr. Moazam Mehmood<br />
Dr. Munir Ahmad<br />
Dr. Nasim Hasan Shah<br />
Dr. Naved Hamid<br />
Dr. Nuzhat Ahmad<br />
Dr. Pervez Tahir<br />
Dr. Phillip Garner<br />
Dr. Rashid Amjad<br />
Dr. Saleem Khan<br />
Dr. Salman Ahmad<br />
Dr. Sarfraz Qureshi<br />
Dr. Sarwat Jahan<br />
Dr. Sean Corcoran<br />
Dr. Sebastian Eckardt<br />
Dr. Serkan Bahceci<br />
Dr. Shahid Amjad Chaudhry<br />
Dr. Shahrukh Rafi Khan<br />
Dr. Sohail Zafar<br />
Dr. Tariq Siddiqui<br />
Dr. Umar Serajuddin<br />
Pr<strong>of</strong>. Robert Neild<br />
Pr<strong>of</strong>. Viqar Ahmed<br />
Editorial Staff: Tele. No: 0092 – 42 - 5874385<br />
Telefax: 0092 - 42 - 5714936<br />
E-mail:<br />
nina@lahoreschool.edu.pk<br />
Publisher: <strong>Lahore</strong> <strong>School</strong> <strong>of</strong> <strong>Economics</strong>, <strong>Lahore</strong>, Pakistan.<br />
Correspondence relating to subscriptions and changes <strong>of</strong> address should be sent to The<br />
<strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong>, 105-C-2, Gulberg III, <strong>Lahore</strong> - 54660 - Pakistan<br />
Instructions to authors can be found at the end <strong>of</strong> this issue. No responsibility for the views<br />
expressed by authors and reviewers in The <strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong> is assumed by the<br />
Editors, the Associate Editor and the Publisher.<br />
Copyright by:<br />
<strong>Lahore</strong> <strong>School</strong> <strong>of</strong> <strong>Economics</strong><br />
<strong>Special</strong> <strong>Edition</strong>2007
THE LAHORE JOURNAL OF ECONOMICS<br />
Contents 2007<br />
Editors’ Introduction<br />
i<br />
Reforming the Government in Pakistan: Rationale,<br />
Principles and Proposed Approach<br />
Ishrat Husain 1<br />
Industrial Competitiveness <strong>of</strong> Pakistan (2000-10)<br />
A. R. Kemal 17<br />
Increasing Global Competitiveness:<br />
A Case for the Pakistan Economy<br />
Shamyla Chaudry 31<br />
Monetary and Fiscal Policies<br />
Shahid Kardar 43<br />
Pakistan Financial System - The Post-Reform Era<br />
Maintaining Stability and Growth<br />
Shakil Faruqi 67<br />
Financial Sector Restructuring in Pakistan<br />
Muhammad Arshad Khan and Sajawal Khan 97<br />
Pakistan’s External Trade: Does Exchange Rate<br />
Misalignment Matter for Pakistan?<br />
M. Ashraf Janjua 125<br />
Doha Round Baggage: Implications for Economic<br />
Reforms in Pakistan and other Southern Countries<br />
Naheed Zia Khan 153<br />
Economic Effects <strong>of</strong> the Recently Signed Pak-China<br />
Free Trade Agreement<br />
Samina Shabir and Reema Kazmi 173<br />
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan<br />
An Empirical Analysis <strong>of</strong> PSLM (2004-05) Micro Data<br />
Mehak Ejaz 203
Editors’ Introduction<br />
The <strong>Lahore</strong> <strong>School</strong>’s Third Annual Conference on the Management <strong>of</strong> the Pakistan<br />
Economy, in May 2007, reflected on the economic reforms that have been<br />
implemented since the 1990s and on the prospects for additional reforms in both<br />
the near and long-term. A number <strong>of</strong> respected economists and other experts<br />
provided evaluations <strong>of</strong> the government’s past efforts, and <strong>of</strong>fered advice on the<br />
direction that future reform efforts should take. The Conference focused on a few<br />
key areas which included Governance Reforms, Industrial Competitiveness,<br />
Monetary, Fiscal and Financial Sector Policies, Exchange Rate and Trade Policies,<br />
and Female Labor Force Participation. The key findings <strong>of</strong> the papers were as<br />
follows:<br />
Governance Reforms: Ishrat Husain presented a view <strong>of</strong> long-term governmental<br />
reform in Pakistan to take place over a period <strong>of</strong> 10 to 20 years. The need for<br />
such reform is great, given the demands <strong>of</strong> the “globalized world” that all<br />
economies, including Pakistan, increasingly face. He drew lessons from other<br />
developing countries that have been successful in their modernization efforts. He<br />
also reviewed recent developments in Pakistan that highlighted the need for<br />
change, including: i) the lack <strong>of</strong> equitable distribution <strong>of</strong> the benefits <strong>of</strong> economic<br />
growth and dysfunction in the delivery <strong>of</strong> public services, ii) the implications <strong>of</strong><br />
public enterprise privatization for government ministries, iii) the devolution <strong>of</strong><br />
powers and public finances to the provinces and districts, iv) the shift in the<br />
responsibilities <strong>of</strong> federal ministries toward policy making and monitoring and<br />
evaluation, v) the burgeoning <strong>of</strong> public-private and public-NGO partnerships, vi)<br />
uncertainty about the future <strong>of</strong> the civil service, and vii) developments in e-<br />
government. Mr. Husain discussed the broad principles that should underpin<br />
reforms in the civil service, the structures <strong>of</strong> federal, provincial and district<br />
government, and business process re-engineering. He concluded with suggestions<br />
regarding the timing and sequencing <strong>of</strong> reforms that would be most conducive to<br />
long-term change.<br />
Industrial Competitiveness: A.R. Kemal began by pointing out that Pakistan is<br />
currently internationally competitive in only a few products, demonstrating the<br />
need for dramatic improvements. He continued by examining in detail Pakistan’s<br />
performance in the various dimensions <strong>of</strong> the Global Competitiveness Index, in<br />
addition to a brief analysis <strong>of</strong> total factor productivity measures. Dr. Kemal<br />
concluded with suggestions on how Pakistan can increase its productivity and<br />
therefore competitiveness, in particular by attracting investment via a more<br />
favorable business environment, adapting and adopting new technologies, using<br />
industrial clusters to foster technological up-gradation, improving education,<br />
streamlining business regulation and dispute resolution mechanisms, and improving<br />
infrastructure (especially transport).<br />
Shamyla Chaudry also examined the ratings <strong>of</strong> Pakistan in various surveys <strong>of</strong> global<br />
competitiveness and compared Pakistan’s position in these rankings to that <strong>of</strong> India<br />
and China, two neighbors and competitors. She found that Pakistan has stagnated<br />
by most measures <strong>of</strong> industrial competitiveness, and is particularly weak in health<br />
and education and human capital development.
Monetary, Fiscal and Financial Sector Policies: Shahid Kardar evaluated Pakistan’s<br />
recent performance in monetary and fiscal management <strong>of</strong> the economy. While<br />
admitting that macroeconomic stability has been maintained, he argued that the<br />
situation remains precarious, given the level <strong>of</strong> inflation, current account deficit,<br />
and fiscal deficit. The economy has benefited from inflows from donors post-9/11,<br />
increased remittances <strong>of</strong> overseas Pakistanis, and privatization receipts, but the<br />
country may not be able to rely on these sources indefinitely. More recently, the<br />
government tightened monetary policy. Mr. Kardar also looked at the fiscal<br />
policies <strong>of</strong> the government. The government had been financing expenditures<br />
through borrowing from the State Bank, but changes were needed in order to<br />
reduce the inflationary pressures that this borrowing had created. With this view,<br />
the article presented suggestions for reforming both government expenditures and<br />
revenues.<br />
Shakil Faruqi began with a summary <strong>of</strong> the financial reform efforts that began in<br />
Pakistan in the early 1990s, in particular the privatization and consolidation <strong>of</strong> the<br />
banking sector. He assessed the current state <strong>of</strong> the banking system with regards<br />
to soundness, non-performing loans, intermediation costs and efficiency (spreads),<br />
pr<strong>of</strong>itability, banking and exchange rate risks, and sensitivity to shocks. Despite an<br />
impressive performance in several areas, he noted that shortcomings remain; among<br />
these is lack <strong>of</strong> credit access for large segments <strong>of</strong> the population, and lagging<br />
levels <strong>of</strong> financial intermediation as compared to other countries at similar stages <strong>of</strong><br />
development.<br />
Muhammad Arshad Khan and Sajawal Khan also looked at financial sector reforms.<br />
The paper begins with a framework for the three major stages <strong>of</strong> financial sector<br />
reform. They divided Pakistan’s past reform efforts into three phases, starting in<br />
the late 1980s. They evaluated the effects <strong>of</strong> these sustained reform efforts by<br />
looking at the impacts on interest rates, bank solvency, credit and indicators <strong>of</strong><br />
financial deepening, bank pr<strong>of</strong>itability, privatization, and corporate governance.<br />
Suggestions for a second generation <strong>of</strong> reforms were given, including a focus on<br />
macro-stability, governance, institutional capacity building and property rights,<br />
development <strong>of</strong> venture capital and private equity, and the legal infrastructure for<br />
finance.<br />
Exchange Rate and Trade Policies: M. Ashraf Janjua analyzed trends in Pakistan’s<br />
real exchange rate (REER) over the period 1978 to the present, and identified the<br />
domestic policies and events in the external environment that contributed to REER<br />
movements. The article also included an econometric analysis <strong>of</strong> the equilibrium<br />
real exchange rate (ERER), based on macroeconomic fundamentals. The estimated<br />
equilibrium real exchange rate was then compared to the actual REER to identify<br />
exchange rate misalignments over the last three decades.<br />
Naheed Zia Khan turned the discussion to international trade, by providing a<br />
detailed overview <strong>of</strong> the history <strong>of</strong> trade negotiations through GATT and the WTO.<br />
Given the current (stalled) round <strong>of</strong> trade negotiations in Doha, she paid particular<br />
attention to the issue <strong>of</strong> agriculture, focusing on Pakistan’s modest support policies<br />
toward agriculture and contrasting them with the strong agricultural support<br />
<strong>of</strong>fered by the US, EU and other developed nations.<br />
Samina Shabir and Reema Kazmi gave a detailed account <strong>of</strong> the history <strong>of</strong> economic<br />
cooperation between Pakistan and China, describing the many agreements signed
since 2001 by the two countries on tariff reductions, investment, defense, energy,<br />
infrastructure, and other areas. These agreements (and future planned agreements)<br />
are intended to create a free trade area between Pakistan and China. The paper<br />
also took a detailed look at Pakistan’s exports and its trade deficit with China, and<br />
examined the recent performance <strong>of</strong> some key sectors <strong>of</strong> the Pakistani economy<br />
that will continue to receive protection under the FTA, including textiles,<br />
garments, engineering, automobiles, and consumer durables.<br />
Female Labor Force Participation: In the last paper <strong>of</strong> the special edition, Mehak<br />
Ejaz used recent data from the Pakistan Social and Living Standards Measurement<br />
Survey (PSLM) to conduct an empirical analysis <strong>of</strong> the determinants <strong>of</strong> female labor<br />
force participation. Using a limited dependent variable approach, she found that<br />
women were more likely to work outside the home when they belonged to a<br />
nuclear family, had greater education, were unmarried, and had access to a vehicle,<br />
and were less likely to work when there were a large number <strong>of</strong> children in the<br />
household and had access to home appliances.<br />
This <strong>Special</strong> <strong>Edition</strong> <strong>of</strong> the <strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong> has been compiled from the<br />
papers presented at the Third Annual Conference on Management <strong>of</strong> the Pakistan<br />
Economy. This <strong>Special</strong> <strong>Edition</strong> is meant to disseminate the findings <strong>of</strong> this conference<br />
more widely at both the national and international levels.
The <strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong><br />
<strong>Special</strong> <strong>Edition</strong> (September 2007)<br />
Reforming the Government in Pakistan: Rationale, Principles<br />
and Proposed Approach<br />
Ishrat Husain *<br />
Abstract<br />
Though government reforms are viewed as important for most<br />
developing countries, the rationale for these reforms must be clearly<br />
understood if they are to be correctly designed and implemented. From an<br />
international perspective, government reforms in Pakistan must be developed<br />
to integrate Pakistan into a larger global economy and should be based on<br />
the lessons learned from other developing countries. From the domestic<br />
perspective, reforms are necessary for the Pakistani government to adapt to<br />
the changing domestic environment. The reforms must focus broadly on the<br />
Federal, Provincial and District governments, on civil service reform and on<br />
business process re-engineering. This paper details the rationale for<br />
government reform in Pakistan, focuses on critical areas <strong>of</strong> reform, and<br />
provides a framework for the proposed reform approach.<br />
INTRODUCTION<br />
A legitimate question that is <strong>of</strong>ten raised by those working for the<br />
government in Pakistan but not by outsiders is: Why reform the<br />
Government? Most <strong>of</strong> them believe that things are going well and the costs<br />
<strong>of</strong> bringing about these reforms will prove to be disruptive for the economy<br />
as well as for administration. We had inherited a strong, robust system from<br />
the British that has been tried and tested over time and there is hardly any<br />
compelling reason to bring about any major structural changes. In order to<br />
address this question we have to provide the rationale for bringing about<br />
reforms in the government which is done in Section I. Having established<br />
the business case for reforms, Section II lays down the principles that would<br />
underpin these reforms. Finally, the proposed approach to design the<br />
reforms will be discussed in Section III.<br />
* Chairman, National Commission for Government Reform, and Former Governor, State<br />
Bank <strong>of</strong> Pakistan.
2<br />
Ishrat Husain<br />
SECTION I<br />
Rationale for Reforms<br />
It must be conceded at the outset that the time horizon for the<br />
consummation and impact <strong>of</strong> the proposed reforms is long term – the next<br />
10 to 20 years and not immediate or short term. The rationale for this plan<br />
should therefore be viewed in the context <strong>of</strong> the long term vision <strong>of</strong><br />
Pakistan, the external environment in which Pakistan will be operating as a<br />
country, the lessons learnt from other successful developing countries, the<br />
diagnostic studies including public opinion polls about government<br />
performance in Pakistan and the growing expectations <strong>of</strong> the public at large.<br />
(A) Long Term Vision and External Environment<br />
Vision 2030 prepared by the Planning Commission in consultation<br />
with the private sector, academia, civil society organizations, etc. envisages<br />
Pakistan to be a developed, industrialized, just and prosperous nation at the<br />
end <strong>of</strong> the next 20-25 years. This vision is to be achieved through rapid and<br />
sustainable development in a resource constrained economy by deploying<br />
knowledge inputs. The transition for achieving this objective is proposed to<br />
be managed by an intelligent and efficient exploitation <strong>of</strong> globalization<br />
through competitiveness. Pakistan is therefore opting to become an active<br />
participant in the globalized economy for goods, labor, capital, technology<br />
and services, and this option has serious consequences for the future<br />
governance <strong>of</strong> the country.<br />
The imperative <strong>of</strong> integrating Pakistan in the larger global economy<br />
places certain essential demands and one <strong>of</strong> these demands is that the<br />
structures <strong>of</strong> the state and instruments <strong>of</strong> the government have to be<br />
redesigned to use knowledge and technology inputs to create opportunities<br />
for increased productivity and competitiveness within the constraints<br />
imposed by depleting resources. Among the 180 nations <strong>of</strong> the world which<br />
are Pakistan’s competitors for capturing market share in the ever expanding<br />
global economy, only those will survive that remain agile and adapt<br />
themselves to the changing demand patterns, supply value chain and<br />
technological upgradation. The main actors in a country that will together<br />
impinge upon its competitiveness and productivity are the state, market and<br />
civil society. The respective roles <strong>of</strong> these main actors and their<br />
interrelationships have therefore to be redefined and re-calibrated.<br />
Structural economic reforms to improve Pakistan’s prospects for<br />
competing in the globalized economy require stable, functioning, competent
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 3<br />
and responsive institutions for implementation. But unfortunately, we are at<br />
present caught in a difficult logjam. While the economic reforms themselves<br />
create dislocation and displacement in the transition period, strong working<br />
institutions provide the wherewithal and armory to withstand these shocks<br />
thus minimizing the costs <strong>of</strong> adjustment and maximizing the benefits to the<br />
poor and neglected. The urgency to build strong institutions to implement<br />
these structural reforms is therefore quite obvious.<br />
Following this logical sequence the various organs <strong>of</strong> the State –<br />
executive, judiciary and legislature – have to be assessed and evaluated to<br />
determine whether they are capable <strong>of</strong> meeting this new challenge or<br />
whether they need to be re-vamped to develop new capabilities and build<br />
up new response capacity. The task assigned to the National Commission for<br />
Government Reforms (NCGR) is limited to a review and examination <strong>of</strong> one<br />
<strong>of</strong> the organs <strong>of</strong> the State i.e. the Executive branch. The Commission has<br />
been asked to assess whether the government, its structures, processes and<br />
human resources can keep up with these new demands or need modification<br />
or alteration.<br />
(B) Lessons from other Developing Countries<br />
The role and limitations <strong>of</strong> governments in various developing<br />
countries have been analyzed at great length. The majority view is that<br />
governments should do what they are capable <strong>of</strong> doing better than in the<br />
past. A strong and effective government is needed rather than a weak and<br />
expansive government. The all wide-encompassing government has become<br />
too cumbersome and centralized with overlapping and competing interests,<br />
inefficient and unresponsive to the emerging needs <strong>of</strong> the public. Civil<br />
servants are poorly trained, sub-optimally utilized, badly motivated and<br />
ingrained with attitudes <strong>of</strong> indifference and inertia. It has been argued by<br />
development economists 1 that effective government in developing countries<br />
is not only necessary due to abundant market failures but possibly even<br />
sufficient to achieve economic development.<br />
A number <strong>of</strong> developing countries have successfully reformed their<br />
governments and tackled the market failures as well as achieved rapid<br />
economic development. How have they been able to transform the expansive<br />
government into a well focused, well functioning and result oriented<br />
effective government? The interpretation <strong>of</strong> the success <strong>of</strong> East Asian<br />
countries such as the Newly Industrializing Countries (NICs), ASEAN<br />
countries and China is a matter <strong>of</strong> serious debate among development<br />
economists. Neoclassical economists attribute the success to market friendly,<br />
private led growth and openness to trade with the governments providing
4<br />
Ishrat Husain<br />
macroeconomic stability, security <strong>of</strong> person and property, infrastructure<br />
services, promoting research and development, investing in education,<br />
health, science and technical training. Others such as Wade (1990) and<br />
Amsden (1989) have argued that an interventionist state which guided and<br />
steered a proactive industrial policy and picked the winners, was largely<br />
responsible for their success. By now, there is some consensus that if the<br />
labels and ideologies are set aside, the evidence suggests that countries that<br />
have tended to promote competition and avoided monopolies or oligopolies,<br />
ensured a level playing field and entry for new comers in the market, made<br />
privatized firms face competition, exercised regulatory vigilance (but<br />
eliminated inefficient and outdated regulations), opened up the economy to<br />
international trade, provided the way for judicial independence, provided<br />
dispute resolution mechanisms and enforced contracts, promoted<br />
transparency, observed the rule <strong>of</strong> law, have been relatively successful. In<br />
short, the government provided an enabling environment for private<br />
businesses to carry out production, distribution, trade <strong>of</strong> goods and services<br />
but did not indulge itself in these activities directly.<br />
The other piece <strong>of</strong> empirical evidence that is beginning to gain wide<br />
acceptance is that decentralization and greater devolution <strong>of</strong> power,<br />
authority and resources to lower tiers <strong>of</strong> government also makes a difference<br />
through better allocation and a more efficient utilization <strong>of</strong> resources.<br />
Devolution also helps in moving towards a relatively more egalitarian<br />
outcome in the provision <strong>of</strong> basic public goods services.<br />
Another way to promote human development and deliver social<br />
services to the poor segments <strong>of</strong> the population that has worked is through<br />
the wider participation <strong>of</strong> the private sector, communities and civil society<br />
organizations. Participation, besides being considered a means to further<br />
human capabilities a la Sen 3 is also a way <strong>of</strong> choosing the right kind <strong>of</strong><br />
projects and ensuring that development funds are used more judiciously.<br />
Private–public partnerships and public–NGO or Civil Society Organization<br />
partnerships are being successfully used in many countries for the provision<br />
<strong>of</strong> infrastructure, education, health and other social services. These<br />
partnerships not only supplement the limited public resources and counter<br />
the governance issues through monitoring, evaluation and corrective actions<br />
but also enable local communities to participate in decision making through<br />
their organizations. The reduced efficiency <strong>of</strong> public sector expenditure can<br />
also be corrected through these partnerships.
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 5<br />
(C) Changes in Pakistani Scene<br />
We now turn to the diagnostic studies and the changes that have<br />
taken place in the landscape in Pakistan in the past several years and are<br />
likely to affect the functioning <strong>of</strong> the government in the future. A number<br />
<strong>of</strong> commissions, committees, task forces, and working groups have examined<br />
and made recommendations about the changes in our administrative system.<br />
These recommendations and studies have been scanned and sifted and the<br />
proposals that are still relevant and useful will form part <strong>of</strong> the NCGR’s<br />
recommendations. But in addition to the historical reasons there have been<br />
at least seven new developments in the last few years that clearly point to<br />
the need for reforms in the structure, processes and human resource<br />
management policies and practices.<br />
First, it is becoming increasingly apparent that the benefits <strong>of</strong><br />
economic growth have not been distributed equitably among the lower<br />
income groups, backward districts, rural areas and women. Although the<br />
government has used the channels <strong>of</strong> devolution and poverty targeted<br />
interventions to spread these benefits, the results have been less than<br />
satisfactory. Almost all studies point out that the institutions <strong>of</strong> governance<br />
i.e. the governmental machinery at the Federal, Provincial and Local<br />
Governments have become largely dysfunctional due to the protracted<br />
neglect <strong>of</strong> our institutions. Almost all comparative country rankings,<br />
whether originating from the World Bank* or Global Competitiveness<br />
Report <strong>of</strong> the World Economic Forum or other think tanks and institutions<br />
consistently rate Pakistan quite low in Public Sector Management,<br />
Institutions and Governance. Along with the low Human Development<br />
Indicators this weak institutional dimension makes the task <strong>of</strong> poverty<br />
reduction, income distribution and delivery <strong>of</strong> public services quite difficult.<br />
The impact <strong>of</strong> good economic policies upon the lower strata <strong>of</strong> our society,<br />
particularly those who are illiterate and are not well connected, thus gets<br />
muted. The widespread hue and cry about the absence <strong>of</strong> a trickle down<br />
effect <strong>of</strong> good economic policies is a manifestation <strong>of</strong> the dysfunctional<br />
nature <strong>of</strong> our public sector governance. Government institutions have to be<br />
strengthened to meet this challenge.<br />
Second, the responsibilities <strong>of</strong> the government in the field <strong>of</strong><br />
owning, managing and operating public enterprises and corporations have<br />
undergone significant change both in the thinking as well as action during<br />
the last sixteen years. A large number <strong>of</strong> government owned corporations,<br />
businesses, industrial units, banks and financial institutions and service<br />
providers have either been privatized or are in the process <strong>of</strong> privatization.<br />
This will reduce the burden on the administrative apparatus at all levels <strong>of</strong>
6<br />
Ishrat Husain<br />
government. The shedding <strong>of</strong> these activities by the government has serious<br />
repercussions for the oversight function <strong>of</strong> the Ministries/ Departments in<br />
the post privatization period.<br />
Third, the devolution <strong>of</strong> administrative, operational and financial<br />
powers to local governments since 2001 has introduced a completely new<br />
element in the governance structure that will require suitable modifications<br />
in other tiers <strong>of</strong> the government. The Federal Government is seriously<br />
considering the transfer <strong>of</strong> some functions listed in the concurrent list <strong>of</strong><br />
the constitution to the Provincial Governments. The projected increased<br />
award <strong>of</strong> financial resources to the provinces under the National Finance<br />
Commission should provide some fiscal space to them for carrying out<br />
essential public services directly or through the District Governments. This<br />
implies a reallocation <strong>of</strong> administrative resources and the strengthening <strong>of</strong><br />
capacity at the local government level.<br />
Fourth, the unbundling <strong>of</strong> the policy, regulatory and operational<br />
responsibilities <strong>of</strong> the Federal ministries has shifted the focus on the policy<br />
making, monitoring and evaluation functions. But this transition has been<br />
incomplete, uneven and mixed across the ministries and needs to be firmly<br />
rooted. The lack <strong>of</strong> adequate competence and knowledge <strong>of</strong> regulatory<br />
functions would demand the development <strong>of</strong> expertise in this field as well as<br />
in policy formulation, implementation and evaluation.<br />
Fifth, some limited success has been achieved by fostering private –<br />
public partnerships in the fields <strong>of</strong> infrastructure, education and health. But<br />
these partnerships can only be nurtured if the government departments and<br />
ministries have the adequate skills to design concession agreements, B.O.T<br />
or contractual arrangements, monitoring and evaluation tools and legal<br />
recourse to enforce the obligations and stipulations agreed by the private<br />
sector partners. Similarly, the NGOs and community organizations such as<br />
Rural Support Programs have been actively engaged in the delivery <strong>of</strong> public<br />
services in the fields <strong>of</strong> education, health, water supply etc. The government<br />
departments and ministries have to be reconfigured to develop the capacity<br />
to design and operate these partnerships.<br />
Sixth, there is a great deal <strong>of</strong> uncertainty and anxiety among the<br />
members <strong>of</strong> the civil services <strong>of</strong> the country about their future career<br />
prospects. Those specialists serving in ex-cadre jobs such as scientists,<br />
engineers, medical doctors, accountants, etc. are demoralized because they<br />
have limited opportunities for career progression. They also feel that they<br />
are not treated at par with the cadre service <strong>of</strong>ficers in matters <strong>of</strong> promotion<br />
and advancement.
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 7<br />
Seventh, the switch over from manual to automated processes and<br />
the government’s commitment to move towards E-Government would<br />
require a look at the skill mix and training requirements <strong>of</strong> the existing and<br />
future civil servants throughout the entire hierarchy. E-Government will<br />
itself flatten the hierarchical texture and make apparent the redundancies in<br />
the system. At the same time it will involve basic computer literacy at all<br />
levels and grades, digital archiving, storage and retrieval <strong>of</strong> all files and<br />
documents. Consequently, only a few <strong>of</strong> the clerical and subordinate staff<br />
positions can be utilized in the future government organization.<br />
(D) Expectations-Delivery Gap<br />
The recent political history <strong>of</strong> South Asia clearly points to the failure<br />
<strong>of</strong> successive governments to live up to the expectations <strong>of</strong> the majority <strong>of</strong><br />
their population. This trend has become even more acute in the last decade<br />
or so with the advent and spread <strong>of</strong> the electronic media. Although all the<br />
countries in the region have performed well and attained respectable rates<br />
<strong>of</strong> economic growth, yet every incumbent government has been voted out <strong>of</strong><br />
power at the time <strong>of</strong> elections. The benefits <strong>of</strong> growth may have filtered<br />
down but the speed and their distribution have not been able to satisfy the<br />
electorate. The ICT (Information Communication Technology) revolution<br />
that has touched even the remote areas <strong>of</strong> these countries has, in fact,<br />
tended to exaggerate the disparities and contributed to higher expectations<br />
<strong>of</strong> government. On the one hand, the capacity <strong>of</strong> the government<br />
institutions responsible for the delivery <strong>of</strong> public goods and services has<br />
rapidly eroded and is in a debilitating and feeble state, while a large variety<br />
<strong>of</strong> goods and services available, advertised and visually observed on the<br />
electronic media has whetted their appetite. They believe that the means<br />
through which they can acquire these goods and services for themselves and<br />
their children is through public sector employment, education and training<br />
and government transfers. In actual practice, the allocation <strong>of</strong> public goods,<br />
services, employment and subsidies is rationed by access to the government<br />
functionaries or by paying bribes. As these groups have neither the access<br />
nor the money to pay the bribes, they suffer from a relative sense <strong>of</strong><br />
deprivation while observing that the influential and well-to-do segments <strong>of</strong><br />
the population are preempting and enjoying the benefits <strong>of</strong> government<br />
jobs, contracts, permits, land, etc. Large, untaxed incomes are also accruing<br />
to the same privileged groups and individuals. The resentment <strong>of</strong> this poor<br />
and unconnected population is conveyed through the only instrument they<br />
possess i.e. the vote at the time <strong>of</strong> elections. This gap between expectations<br />
and delivery is one <strong>of</strong> the biggest challenges for Pakistan too.
8<br />
Ishrat Husain<br />
The popular perceptions as expressed in public opinion polls, media<br />
commentaries and editorials, articles and papers, seminars and discussions,<br />
observations <strong>of</strong> politicians and civil society actors, all convey with a few<br />
honorable exceptions, a negative image <strong>of</strong> the civil servants in Pakistan and<br />
a high level <strong>of</strong> dissatisfaction with the functioning <strong>of</strong> the Ministries,<br />
Departments, Corporations and Agencies <strong>of</strong> the different tiers <strong>of</strong> the<br />
government. These perceptions are in contrast to the views <strong>of</strong> the civil<br />
servants themselves who see themselves as poorly paid, highly demoralized<br />
and stressed out individuals. They feel that they have been unfairly treated<br />
by their political bosses and unappreciated by the general public. Empirical<br />
studies and casual observations show that the root cause <strong>of</strong> this<br />
disenchantment <strong>of</strong> civil society and the disillusionment <strong>of</strong> the civil servants<br />
can be traced to structural, procedural and motivational deficiencies in the<br />
overall system <strong>of</strong> governance. Any attempts to treat the symptoms in an<br />
isolated manner without coming to grips with the root causes will be<br />
counterproductive. The reform package should be comprehensive with a<br />
clear blueprint, but the introduction <strong>of</strong> each set <strong>of</strong> reforms could be phased<br />
and sequenced. The methodology adopted by the NCGR therefore follows<br />
with logic.<br />
SECTION II<br />
Broad Principles Underpinning the Reforms<br />
In order to lay down the direction in which the reforms will be<br />
undertaken, it is essential that the broad principles that will underpin these<br />
reforms are clearly defined. The following broad principles are outlined<br />
under each area <strong>of</strong> the reforms.<br />
Civil Services<br />
i) Open, transparent merit–based recruitment to all levels and grades<br />
<strong>of</strong> public services with regional representation as laid down in the<br />
Constitution.<br />
ii) Performance–based promotions and career progression for all public<br />
sector employees with compulsory training at post-induction, midcareer<br />
and senior management levels.<br />
iii) Equality <strong>of</strong> opportunities for career advancement to all employees<br />
without preferences or reservations for any particular class.
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 9<br />
iv) Replacement <strong>of</strong> the concept <strong>of</strong> Superior Services by equality among<br />
all cadres and non-cadres <strong>of</strong> public servants.<br />
v) Grant <strong>of</strong> a living wage and compensation package including decent<br />
retirement benefits to all civil servants.<br />
vi) Strict observance <strong>of</strong> security <strong>of</strong> tenure <strong>of</strong> <strong>of</strong>fice for a specified period<br />
<strong>of</strong> time.<br />
vii) Separate cadre <strong>of</strong> regular Civil Services at the Federal, Provincial and<br />
District levels co-existing with contractual appointments.<br />
viii) Creation <strong>of</strong> an All Pakistan National Executive Service (NES) for<br />
senior management positions drawn through a competitive process<br />
from the Federal, Provincial and District level Civil Servants and<br />
outside pr<strong>of</strong>essionals.<br />
ix) Introduction <strong>of</strong> four specialized cadres under the NES for Economic<br />
Management, Regulatory, Social Sector Management and General<br />
Management.<br />
Structure <strong>of</strong> Federal, Provincial and District Governments<br />
a) Devolution <strong>of</strong> powers, responsibilities and resources from the<br />
Federal to the Provincial governments.<br />
b) Establishing inter-governmental structures with adequate authority<br />
and powers to formulate and monitor policy formulation.<br />
c) Clear separation <strong>of</strong> policy making, regulatory and operational<br />
responsibilities <strong>of</strong> the Ministries/Provincial departments.<br />
d) Making each Ministry/Provincial department fully empowered,<br />
adequately resourced to take decisions and accountable for results.<br />
e) Streamline, rationalize and transform the attached departments/<br />
autonomous bodies/ subordinate <strong>of</strong>fices/field <strong>of</strong>fices, etc. into fully<br />
functional arms <strong>of</strong> the Ministries for performing operational and<br />
executive functions.<br />
f) Reduce the number <strong>of</strong> layers in the hierarchy <strong>of</strong> each Ministry/<br />
Provincial department.
10<br />
Ishrat Husain<br />
g) Cabinet Secretary to perform the main coordinating role among the<br />
Federal Secretaries on the lines <strong>of</strong> the Chief Secretary in the<br />
Provinces.<br />
h) Revival and strengthening <strong>of</strong> the Secretaries Committee at the<br />
Federal/ Provincial governments to become the main vehicle for<br />
inter-ministerial coordination and dispute resolution among various<br />
ministries.<br />
i) District level <strong>of</strong>ficers interacting with the general public in day-today<br />
affairs should enjoy adequate powers, authority, status and<br />
privileges to be able to resolve the problems and redress the<br />
grievances <strong>of</strong> the citizens.<br />
j) Police, Revenue, Education, Water Supply, and Health are the<br />
departments which are highly relevant for the day-to-day lives <strong>of</strong> the<br />
ordinary citizen <strong>of</strong> this country. The internal governance structures<br />
<strong>of</strong> these departments, public grievance redressal systems against<br />
these departments and checks and balances on the discretionary<br />
powers <strong>of</strong> the <strong>of</strong>ficials have to be introduced.<br />
Business Process Re-Engineering<br />
i) All laws, rules, regulations, circulars, and guidelines issued by any<br />
government ministry/department/agency should be available in its<br />
most up dated version to the general public free <strong>of</strong> cost in a userfriendly<br />
manner on the web page and in electronic and print forms<br />
at public places.<br />
ii) Service standards with timelines for each type <strong>of</strong> service rendered at<br />
the District, Thana and Union level should be developed, widely<br />
disseminated and posted at public places in each department.<br />
iii) Rules <strong>of</strong> business <strong>of</strong> the Federal, Provincial and District government<br />
should be revised to make them simple and comprehensible,<br />
empowering the Secretaries/Heads <strong>of</strong> Departments/District<br />
Coordination Officers to take decisions without multiple references,<br />
clearances and back and forth movement <strong>of</strong> files. Post-audit <strong>of</strong> the<br />
decisions taken should be used to ensure accountability rather than<br />
prior clearances.<br />
iv) Delegation <strong>of</strong> financial, administrative, procurement, human<br />
resource management powers should be revisited and adequate
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 11<br />
powers commensurate with the authority should be delegated at<br />
each tier <strong>of</strong> the hierarchy.<br />
v) Estacode, Financial Rules, Accounting and Audit Rules, Fundamental<br />
Rules and all other rules in force should be reviewed systematically<br />
and revised to bring them in line with modern management<br />
practices.<br />
vi) E-Government should be gradually introduced in a phased manner.<br />
Technological solutions, hardware and s<strong>of</strong>tware applications are easy<br />
parts <strong>of</strong> the process, but the most difficult aspect is the training and<br />
change in the culture, attitude and practices. E-Government should<br />
be driven by business needs rather than crafted as an elegant<br />
technical solution.<br />
SECTION III<br />
Proposed Approach<br />
There are several ways to approach the task assigned to this<br />
Commission. One option is to spend several years in preparing a<br />
comprehensive blueprint and plan for bringing about the desired changes<br />
covering all aspects <strong>of</strong> the structure, processes and human resource policies<br />
<strong>of</strong> government. This option has the disadvantage that by the time the report<br />
is ready, ground realities might have changed. Political support for reforms<br />
under this approach is most likely to wane as high costs are incurred<br />
upfront in pushing through complex, unpopular and difficult decisions, but<br />
the benefits <strong>of</strong> the reforms do not become visible in the lifecycle <strong>of</strong> the<br />
political regime in power. The advantage <strong>of</strong> this option is that all<br />
deficiencies and weaknesses are addressed simultaneously in a comprehensive<br />
manner.<br />
The second option is to prepare a long term vision and direction in<br />
which reforms should aim and move, but combine this with an<br />
opportunistic approach whereby easy to implement changes are taken up<br />
first and the more difficult reforms are taken up later. The disadvantage <strong>of</strong><br />
this option is that the changes introduced may be imperceptible and the<br />
time taken for the whole process to complete may be too long. But the<br />
advantage is that incremental changes that create a win-win situation for all<br />
the stakeholders including politicians have a much better chance <strong>of</strong> being<br />
accepted and implemented. It is suggested that the Commission may<br />
propose the second option as the modus operandi for its working.
12<br />
Ishrat Husain<br />
The preference for this option which is less elegant and imperfect<br />
lies in a dispassionate reading <strong>of</strong> the past history <strong>of</strong> reforms in this country.<br />
A large number <strong>of</strong> erudite Commissions and Committees have spent virtually<br />
thousands <strong>of</strong> man years in seeking out views and opinions from a diverse set<br />
<strong>of</strong> opinion makers and public at large, prepared elaborate diagnostic studies<br />
and presented a very sensible set <strong>of</strong> recommendations. But except for some<br />
tinkering here and there most <strong>of</strong> the recommendations were not<br />
implemented because <strong>of</strong> lack <strong>of</strong> political will and courage. The two<br />
exceptions to this trend are:<br />
(a) The Civil Service Act. <strong>of</strong> 1973 which under the leadership <strong>of</strong> Mr.<br />
Z.A. Bhutto brought an end to the historical covenant between the<br />
government and higher civil servants.<br />
(b) The Devolution Plan <strong>of</strong> 2001 under the leadership <strong>of</strong> President<br />
Musharraf which devolved powers from the Province to Districts.<br />
These radical reforms uprooted the existing structures, processes and<br />
relationships but the transition period for their replacement by the new<br />
structures, processes and relationships has been quite long. In both these<br />
cases there was strong political will, but fierce resistance to these changes<br />
was equally strong. Learning from these two examples the second option<br />
appears more pragmatic. We have, at present, strong political leadership for<br />
the reform <strong>of</strong> the government and we need to develop a long term<br />
framework in which the direction <strong>of</strong> the reforms is clearly laid down. The<br />
movement towards the ultimate goal post will be more nuanced – by<br />
applying acceleration when the opportunity presents itself, through a brake<br />
or temporary reversal when the resistance is fierce, through second or third<br />
gears when the opposition is neutralized and the results achieved pacify the<br />
opponents.<br />
The sequencing, phasing and timing <strong>of</strong> the various reforms and their<br />
implementation will be guided by the speed at which consensus is built<br />
among the stakeholders and the decisions are made by the top policy<br />
makers, but it is important to lay down the overall direction in which these<br />
reforms will move.<br />
While the comprehensive reforms will be implemented<br />
incrementally, a second track will also be followed in which some quick win<br />
reforms will be implemented from time to time as an opportunity presents<br />
itself. For this purpose, the Commission will follow a more flexible route.<br />
For example, it has decided to focus on four major areas where the
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 13<br />
interaction between the ordinary citizen and administrative machinery <strong>of</strong> the<br />
government is most intense. These four areas are:<br />
1. Police and Enforcement <strong>of</strong> Laws.<br />
2. Land Revenue Administration<br />
3. Education<br />
4. Health<br />
The Commission has formed four sub-committees to review and<br />
examine the efforts being made by the government, private sector and civil<br />
society in each <strong>of</strong> these areas and come up with solutions that will make the<br />
existing system more efficient and responsive to the needs <strong>of</strong> the public in<br />
the immediate or short run. The Commission has also formed another subcommittee<br />
to recommend revision in the Rules <strong>of</strong> Business for removing<br />
impediments in the functioning <strong>of</strong> the government departments/ministries/<br />
agencies and empowering the heads <strong>of</strong> the departments to deliver results.<br />
The preliminary recommendations <strong>of</strong> the sub-committees will be<br />
presented to focus groups <strong>of</strong> stakeholders drawn from diverse segments <strong>of</strong><br />
society – secretaries, committees, political leaders, businessmen, NGOs,<br />
academically refined civil servants, etc. – to solicit their feedback and views.<br />
Once this feedback is incorporated, the sub-committees will finalize their<br />
recommendations which will then be discussed by the Commission and then<br />
presented for consideration and decisions by the Steering Committee. The<br />
high powered Steering Committee is co-chaired by the President and Prime<br />
Minister and consists <strong>of</strong> the four Chief Ministers. The Committee has<br />
decided to provide a legal cover to the Commission so that the<br />
recommendations approved by the Steering Committee are implemented by<br />
the Federal and Provincial governments without further reviews.<br />
The Commission will also act as a facilitator and conduit for the<br />
reforms formulated by the Federal Ministries/Provincial Governments and<br />
table them, after its own analysis for the decisions by the Steering<br />
Committee.<br />
To conclude, those who agree that there is a need for these<br />
reforms have serious reservations about their implementation. They<br />
contend that these reforms cannot be implemented in the real sense<br />
unless we insulate bureaucratic actions from political interference.<br />
According to this school <strong>of</strong> thought, the problem <strong>of</strong> maladministration
14<br />
Ishrat Husain<br />
and poor governance stems from this interference. It must be recognized<br />
that in democratic forms <strong>of</strong> governance, elected leaders will have to<br />
respond to their political constituents and the associated vested interests.<br />
The accountability for results rests largely on these politicians and not on<br />
the civil servants. If the interference <strong>of</strong> the politicians is aimed at serving<br />
the narrow parochial interests <strong>of</strong> a few individuals or groups rather than<br />
the broader collective interests <strong>of</strong> their constituencies, they may end up<br />
paying a heavy price at the time <strong>of</strong> the next elections. Their opponents,<br />
the opposition parties and the media scrutiny will keep a watch on their<br />
actions and expose them before their constituents. The alignment <strong>of</strong> the<br />
civil servants with their political bosses in violating or circumventing laid<br />
down laws, rules, regulations and procedures would prove to be myopic as<br />
these civil servants will also become tainted and suffer in their career<br />
advancement. If the successive civil servants appointed to key positions<br />
refuse to carry out illegal, unlawful or irregular orders, how many times<br />
can a minster get them transferred or how many <strong>of</strong> them could be<br />
appointed as OSDs? The strong temptation to indulge in immediate<br />
gratification by keeping the political bosses happy and either ignore or go<br />
along with them is indeed the crux <strong>of</strong> the problem. The long term<br />
consequences <strong>of</strong> succumbing to such temptations should always be kept in<br />
mind by this category <strong>of</strong> civil servants. There is no substitute for personal<br />
integrity and character in public service.<br />
However, to expect that we will be able to induct angels in the civil<br />
services is also unrealistic. The thrust <strong>of</strong> the proposed reforms is to limit the<br />
discretionary powers <strong>of</strong> the decision makers, simplify the cumbersome<br />
procedures and processes and make them transparent and realign the<br />
incentives <strong>of</strong> the individual civil servants with those <strong>of</strong> the organization. It is<br />
proposed, therefore, that the Commission should remain as a permanent<br />
body responsible for changed management in the government, but limit the<br />
term <strong>of</strong> the <strong>of</strong>fice <strong>of</strong> the Chairman and members to two years only.
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 15<br />
References<br />
Amsden A, 1989, Asia’s Next Giant: South Korea and Late Industrialization<br />
Oxford: Oxford University Press.<br />
Government <strong>of</strong> Pakistan, 2007, Vision 2030 Draft, Planning Commission,<br />
Islamabad.<br />
Husain I, 1999, The Economy <strong>of</strong> an Elitist State, Oxford: Oxford University<br />
Press.<br />
Kaufmann D and Mastruzzi M, 2005, “Governance Matters IV,” World<br />
Bank.<br />
Leipzeiger D, 1997, Lessons from East Asia, Ann Arbor: University <strong>of</strong><br />
Michigan Press.<br />
National Commission for Government Reforms, Concept paper (website<br />
www.ncgr.ov.pk 2006.<br />
Sen. A.K. 1999, Development as Freedom, Oxford: Oxford University Press.<br />
Stiglitz J and Yusuf S, 2001, Rethinking the East Asia Miracle, Oxford<br />
University Press. Bradhan P and Mookherjee D, 2001,<br />
“Decentralization Corruption and Government Accountability: An<br />
Overview” in Susan Rose-Ackerman, Handbook <strong>of</strong> Economic<br />
Corruption, Cheltenham: Edward Elgar.<br />
Todaro, M.P and Smith, S.C, 2004, Economic Development, Pearson.<br />
UNDP, 2003, Pakistan National Human Development Report.<br />
Wade R, 1990, Governing the Market: Economic Theory and the Role <strong>of</strong><br />
Government, Princeton: Princeton University Press.<br />
World Bank, 1993, The East Asia Miracle: Economic Growth and Public<br />
Policy, Oxford University Press.<br />
World Development Report 2000/2001, New York: Oxford University Press.
The <strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong><br />
<strong>Special</strong> <strong>Edition</strong> (September 2007)<br />
Industrial Competitiveness <strong>of</strong> Pakistan (2000-10)<br />
A. R. Kemal *<br />
Abstract<br />
Though Pakistan’s exports have increased significantly, analyses have<br />
shown that Pakistan’s industrial competitiveness is limited to a narrow<br />
range <strong>of</strong> products. This paper looks at the factors affecting Pakistan’s<br />
competitiveness ranking and relates these various factors to trends in<br />
Pakistan’s total factor productivity. In addition to looking at the<br />
components <strong>of</strong> Pakistan’s competitiveness ranking, this paper details the<br />
steps required for Pakistan to increase its global industrial competitiveness.<br />
I. Introduction<br />
Whereas Pakistan’s exports have increased from $8 billion to $ 18<br />
billion over the last few years, the level <strong>of</strong> exports is still just a fraction <strong>of</strong><br />
the exports <strong>of</strong> various South East Asian countries 1 . The low levels <strong>of</strong><br />
Pakistan’s exports may be attributed to its competitive edge in a few<br />
products and that, too, in low end technology products. Since the growth<br />
rate <strong>of</strong> exports has fallen to around 5% during 2006-07 following the double<br />
digit but falling growth rates over the 2003-06 period, the formulation <strong>of</strong> a<br />
strategy for the growth <strong>of</strong> exports over the medium and long run has<br />
assumed great significance. It needs to be underscored that just the<br />
provision <strong>of</strong> subsidies or devaluation <strong>of</strong> the rupee can hardly result in a<br />
continuous increase in the export level. If the country has to be a major<br />
player in international trade it must enhance its competitiveness through<br />
improved levels <strong>of</strong> total factor productivity.<br />
David Ricardo a couple <strong>of</strong> centuries back on the basis <strong>of</strong> a 2-country,<br />
2-product and 1-production factor model had suggested that even if a<br />
country is inefficient in the production <strong>of</strong> both the goods, it would be able<br />
to compete in the world market as long as it specializes in accordance with<br />
its comparative advantage. The inefficiencies in production, however, would<br />
be counterbalanced by the low wage rates and the cost <strong>of</strong> production <strong>of</strong> the<br />
* Former Director Pakistan Institute <strong>of</strong> Development <strong>Economics</strong> (PIDE), Islamabad.<br />
1 A few decades back their exports were lower than that <strong>of</strong> Pakistan.
18<br />
A. R. Kemal<br />
export product would be lower than that in the importing country. If the<br />
country improves the productivity levels, wages would rise without<br />
increasing the cost <strong>of</strong> production and jeopardizing the competitiveness.<br />
Heckhsher-Ohlin suggests that the country would specialize in the<br />
activities that intensively use the abundant factor. They assumed the free<br />
availability <strong>of</strong> technology and no factor reversals but in practice neither is<br />
technology freely available nor is it the same across all the countries, and<br />
factor reversals do take place which may invalidate the theory. As the theory<br />
is based on factor endowments, any change in factor endowment would<br />
result in changes in comparative advantage over time. Moreover, in a<br />
seminal contribution, Pr<strong>of</strong>essor Porter suggested that competitiveness may<br />
be derived from human resources and technological development resulting<br />
in innovation and reduction in the cost <strong>of</strong> production.<br />
In recent years, a number <strong>of</strong> international agencies have ranked the<br />
competitiveness <strong>of</strong> each country on the basis <strong>of</strong> various indicators. The most<br />
important and <strong>of</strong>t quoted is the rankings by the Global Competitiveness<br />
Report <strong>of</strong> the World Economic Forum. For the last four years, it has also<br />
reported the competitiveness ranking <strong>of</strong> Pakistan, which falls below the<br />
median in most <strong>of</strong> the competitive indicators, indicating that Pakistan has to<br />
travel a long distance even to reach the average <strong>of</strong> the competitiveness<br />
indicators..<br />
The Asian Development Bank and the World Bank have examined<br />
Pakistan’s industrial competitiveness. The Asian Development Bank Report on<br />
industrial competitiveness prepared by Lall and Weiss (2004) examines various<br />
technology indices and classifies exports and value added in accordance with<br />
them. They conclude that Pakistan’s competitiveness is not only restricted to a<br />
few products but that its competitiveness has also eroded over time. On the<br />
other hand, the World Bank’s Report (2006) on growth and export<br />
competitiveness suggests that, despite some improvements, the country can<br />
attain an average growth rate <strong>of</strong> 8% only if there are improvements in almost<br />
all the competitive indicators including institutions, human resource<br />
development and technology. It also suggests policy measures through value<br />
chain analysis for the various export products <strong>of</strong> Pakistan.<br />
Kemal, Muslehuddin, and Qadir (2002) examined the Revealed<br />
Comparative Advantage <strong>of</strong> Pakistan and found that it has a comparative<br />
advantage in only a small number <strong>of</strong> products that are resource based, or at<br />
the lower end <strong>of</strong> technology. Similarly, Kemal, Mahmood and Ahmad (1994)<br />
found Pakistan’s comparative advantage in a narrow band <strong>of</strong> products, on<br />
the basis <strong>of</strong> Domestic Resource Cost.
Industrial Competitiveness <strong>of</strong> Pakistan (2000-10) 19<br />
The country needs to improve its competitiveness in a large number<br />
<strong>of</strong> products and the present study examines the possibilities <strong>of</strong> enhancing<br />
competitiveness and the policies required for that. The plan <strong>of</strong> the paper is<br />
as follows: After this Introductory Section, the determinants <strong>of</strong><br />
competitiveness and Pakistan’s competitiveness ranking are reported in<br />
Section 2. The significance <strong>of</strong> total factor productivity and its growth in<br />
Pakistan is analyzed in Section 3. The measures required for improving the<br />
competitiveness are discussed in Section 4. Major conclusions and policy<br />
recommendations are summarized in the concluding section <strong>of</strong> the paper.<br />
II. Determinants <strong>of</strong> Competitiveness and Pakistan’s Competitive Ranking<br />
Porter suggests that a country can develop competitiveness through<br />
the development <strong>of</strong> human resource activities including education, health,<br />
skills and technological development. The competitiveness is the ability <strong>of</strong><br />
firms to compete with international firms <strong>of</strong> best practice. No doubt firms<br />
formulate and implement strategies to reduce the cost <strong>of</strong> production and<br />
improve the quality <strong>of</strong> products. However, due to market failures in<br />
various activities relating to competitiveness, government intervention<br />
becomes necessary. “The essence <strong>of</strong> a competitiveness strategy is to<br />
promote in-firms learning, skill development and technological effort,<br />
improve the supply <strong>of</strong> information, and coordinate collective learning<br />
processes that involve different firms in the same industry, or across<br />
related industries popularly known as ‘clusters’, geographic or activitywise”<br />
(See ADB, (2004)).<br />
Competitiveness and comparative advantage do change over time due<br />
to various factors which include among others “rapid technical change,<br />
shrinking economic distance, technical progress in information processing,<br />
changes in the form <strong>of</strong> industrial organizations, development <strong>of</strong> value<br />
chains, development <strong>of</strong> clusters.” The countries that develop technologies,<br />
access the markets, absorb and adapt the new technologies, and have an<br />
atmosphere that allows firms to move up the technological scale enhancing<br />
their competitiveness.<br />
Pakistan ranks 91 st in the competitive index out <strong>of</strong> 125 countries<br />
included in the Global Competitive index and its score is 3.7 on the scale<br />
from 1 for the poorest rank to 10 for the highest rank. While Pakistan’s<br />
score is poor, it is encouraging to note that the score has improved from<br />
3.5 to 3.7 and the ranking from 94 th to 91 st .<br />
There are three sub-sectors <strong>of</strong> the Global Competitiveness Index, viz.<br />
basic requirements, efficiency enhancers and innovation factors. In all the
20<br />
A. R. Kemal<br />
three indicators, Pakistan lags behind the median except for the indicator<br />
measuring innovation factors where it is around the median (See Table-1). It<br />
suggests that Pakistan is far behind in competitiveness and if Pakistan has to<br />
grow at a rate <strong>of</strong> 8% on average as envisaged in the Medium Term<br />
Development Framework (MTDF), its score in almost all the indicators must<br />
improve significantly and it should be among the top 25 countries <strong>of</strong> the<br />
world (See World Bank (2006)).<br />
Table-1: Global Competitiveness Index for Pakistan<br />
Rank Score<br />
2006-07 91 3.7<br />
2005-06 94 3.5<br />
Basic Req. 93 4<br />
1st pillar: Institutions 79 3.5<br />
2nd pillar: Infrastructure 67 3.4<br />
3rd pillar: macroeconomy 86 4.2<br />
4th pillar: Health and Primary Education 108 4.8<br />
Efficiency Enhancers 91 3.3<br />
5th pillar: Higher Education and Training 104 2.8<br />
6th pillar: Market Efficiency 54 4.2<br />
7th pillar: Technological Readiness 89 2.8<br />
Innovation Factors 60 3.7<br />
8th pillar: Business Sophistication 66 4<br />
9th pillar: Innovation 60 3.3<br />
Source: Global Competitiveness Report 2006-07<br />
Institutions are crucial for the growth process and Pakistan lags<br />
behind considerably in all the indicators relating to institutional<br />
development (See Table-2). While the institutions are also important for the<br />
indigenous investors, they are crucial for foreign private investment<br />
especially for the manufacturing sector. The government intends to<br />
implement second generation reforms but so far an improvement in this<br />
direction has been quite limited. Efforts in this direction shall have to be<br />
enhanced considerably.<br />
Table-2: Institutions
Industrial Competitiveness <strong>of</strong> Pakistan (2000-10) 21<br />
Rank<br />
Score<br />
Efficiency <strong>of</strong> corporate boards 123 3.5<br />
Business cost <strong>of</strong> terrorism 122 3.1<br />
Property rights 95 3.7<br />
Reliability <strong>of</strong> police services 85 3.5<br />
Ethical behavior <strong>of</strong> firms 82 3.8<br />
Judicial independence 80 3.3<br />
Business cost <strong>of</strong> crime and violence 76 3.8<br />
Source: Global Competitiveness Report 2006-07<br />
Inadequate and poor quality infrastructure increases transaction costs<br />
and erodes the competitive edge <strong>of</strong> industries. Over recent years there have<br />
been considerable improvements in infrastructure especially in the<br />
telecommunications sector, but that seems to not have found its way so far<br />
into the Global Development Report. Teledensity has improved considerably<br />
than that reported in Table-3, as it is now around 30 per 100 persons.<br />
Incorporating these developments would improve the ranking <strong>of</strong> Pakistan<br />
further; Pakistan has a reasonably good ranking in railroads, ports and air<br />
travel. However, it is the power supplies that pull down the ranking <strong>of</strong><br />
Pakistan in terms <strong>of</strong> infrastructure.<br />
Table-3: Infrastructure<br />
Rank Score<br />
Overall infrastructure quality 67 3.4<br />
Railroad infrastructure development 39 3.6<br />
Quality <strong>of</strong> port Infrastructure 52 3.8<br />
Quality <strong>of</strong> airport structures 59 4.6<br />
Telephone lines 101 3<br />
Quality <strong>of</strong> electricity supply 87 3.5<br />
Source: Global Competitiveness Report 2006-07<br />
Pakistan has done better in some indicators <strong>of</strong> market efficiency<br />
including number <strong>of</strong> days required to set up businesses, hiring and firing<br />
practices and taxation and loans. Moreover, even though its score in easy<br />
access to loans has been low, its ranking is quite good. But despite its score<br />
around 5 in ownership restrictions <strong>of</strong> foreign firms and soundness <strong>of</strong> banks,<br />
its rank is low. In other indicators Pakistan ranks poorly (See Table-4).<br />
Table-4: Market Efficiency
22<br />
A. R. Kemal<br />
Rank Score<br />
Efficiency <strong>of</strong> legal framework 91 3<br />
Hiring and firing practices 26 4.6<br />
Cooperation in labor-employer relations 77 4.4<br />
Intensity <strong>of</strong> local competition 73 4.6<br />
Brain drain 73 2.9<br />
Foreign ownership restrictions 72 4.9<br />
No. <strong>of</strong> procedures require to start a new business 70 11 procedures<br />
Time required to start a business 30 24 days<br />
Extent and effect <strong>of</strong> taxation 33 3.9<br />
Soundness <strong>of</strong> banks 84 5<br />
Ease <strong>of</strong> access to loans 42 3.8<br />
Source: Global Competitiveness Report 2006-07<br />
Technological capabilities are determined by education, training,<br />
scientific and technological infrastructure and they are reflected in the<br />
innovations and patents. Table-5 shows various aspects <strong>of</strong> technological<br />
preparedness. The net enrolment rates at the primary and tertiary levels <strong>of</strong><br />
education are 66.2% and 3.0% respectively, the poor quality <strong>of</strong> education<br />
and, except for market sophistication like value chains and local supplies,<br />
Pakistan ranks poorly in terms <strong>of</strong> technological development.
Industrial Competitiveness <strong>of</strong> Pakistan (2000-10) 23<br />
Table-5: Education and Technical Capabilities<br />
Rank<br />
Score<br />
Primary enrolment 112 66.2<br />
Tertiary enrolment 106 3<br />
Extent <strong>of</strong> staff training 91 3.1<br />
Quality <strong>of</strong> math and science education 85 3.4<br />
Local availability <strong>of</strong> research and training services 83 3.4<br />
Quality <strong>of</strong> the educational system 74 3.2<br />
Cellular telephones 115 3.3<br />
Personal computers 113 0.4/100<br />
Internet users 107 131.1/100000<br />
Technological readiness 77 3.4<br />
FDI and technology transfer 75 4.8<br />
Firm level technology absorption 85 4.4<br />
Value chain presence 47 4<br />
Local supplier Quantity 61 4.7<br />
Local supplier Quality 66 4.2<br />
Production process Sophisticate 59 3.6<br />
Nature <strong>of</strong> Competitive Adv. 54 3.5<br />
Availability <strong>of</strong> scientists and engineers 78 4.2<br />
Utility patents 78 -<br />
Capacity for innovation 38 3.7<br />
Govt. procurement <strong>of</strong> technology products 47 3.9<br />
Secondary Event 112 27.2<br />
Quality <strong>of</strong> public schools 79 29.2<br />
Source: Global Competitiveness Report 2006-07<br />
III. Trends in Total Factor Productivity in Pakistan<br />
It is generally believed that total factor productivity (TFP) in Pakistan<br />
has been small, but it has accounted for one-third <strong>of</strong> the growth for the<br />
period 1964-65 to 2000-01. TFP has grown at a rate <strong>of</strong> 1.66% for the entire<br />
economy, only 0.37% for agriculture but 3.21% for the manufacturing<br />
sector, accounting for about half <strong>of</strong> the growth in the sector. Nevertheless,
24<br />
A. R. Kemal<br />
while productivity growth is quite encouraging it needs to be noted that it<br />
reflects rather poor levels <strong>of</strong> productivity levels in the base year and has<br />
been just catching up through learning by doing. There has been hardly any<br />
growth in productivity arising from technological development and human<br />
resource development.<br />
Table-6: Trends in Total Factor Productivity<br />
(%age Growth Rates)<br />
Sector<br />
Contribution <strong>of</strong><br />
GDP*<br />
Capital Labour TFP<br />
Overall 5.31 2.48 1.17 1.66<br />
Agriculture 3.89 2.70 0.82 0.37<br />
Manufacturing 6.39 2.23 0.94 3.21<br />
Contribution to<br />
Aggregate Growth 46.62 22.12 31.26<br />
Agriculture Growth 69.33 21.11 9.57<br />
Manufacturing Growth 34.99 14.74 50.27<br />
Source: Kemal, Muslehuddin and Qadir (2002)<br />
TFP growth in the manufacturing sector has shown wide variations.<br />
It has accounted for almost a 3% increase in output per annum in the 1960s<br />
and 1980s, but it was quite low in the 1970s and in the 1990s. In the<br />
1990s it was just 0.78%. However, in the manufacturing sector it was<br />
1.64%.<br />
Table-7: Trends in Total Factor Productivity during 1990s (%)<br />
Sector<br />
Growth Rates<br />
GDP Capital Labour Residual<br />
Overall 4.41 2.38 1.25 0.78<br />
Agriculture 4.54 2.21 0.81 1.52<br />
Manufacturing 3.99 2.09 0.25 1.64<br />
Contribution to<br />
Overall Aggregate Growth 53.97 28.25 17.78<br />
Agriculture Growth 48.63 17.83 33.55<br />
Manufacturing Growth 52.54 6.26 41.20<br />
Source: Kemal, Muslehuddin and Qadir (2002).
Industrial Competitiveness <strong>of</strong> Pakistan (2000-10) 25<br />
IV. Preparing for Technological Capabilities and Competitiveness<br />
The Medium Term Development Framework (MTDF) 2005-10 calls<br />
for a growth rate <strong>of</strong> 8.2% in 2010, with an average growth rate <strong>of</strong> 7.6%<br />
over the 5 year period. It emphasizes improvements in the productivity<br />
levels by deploying knowledge inputs rather than focusing only on the<br />
accumulation <strong>of</strong> inputs. However, the MTDF neither provides for sufficient<br />
investment levels, nor for skill development and improvements in<br />
technological capabilities required to achieve the high growth rates<br />
envisaged in the MTDF.<br />
Pakistan can realize the envisaged growth rates provided investment<br />
levels increase to 30% <strong>of</strong> GDP and total factor productivity increases<br />
through technological development and/or the adoption, adaptation and<br />
diffusion <strong>of</strong> new techniques. For an increase in investment and technological<br />
change the institutions, regulations, education, and technological personnel<br />
would have to increase and special efforts shall have to be mounted. A<br />
business friendly environment would foster both domestic and foreign<br />
investments resulting in both export competitiveness and diversification.<br />
The World Bank (2006) suggests that if the quality <strong>of</strong> the investment<br />
environment in Pakistan matches that <strong>of</strong> the Shanghai investment climate,<br />
then the average productivity <strong>of</strong> Pakistan’s textile firms operating in Karachi<br />
would improve by 81%, the rate <strong>of</strong> return to capital would increase by 36%,<br />
and wages would rise by 23%. The increased pr<strong>of</strong>itability would encourage<br />
more investment and further improvement in competitiveness 2 .<br />
Technological capabilities develop slowly but once the process starts, it gains<br />
momentum and a virtual circle <strong>of</strong> growth, competitiveness and investment<br />
in new capabilities take place. This in turn helps in further technological<br />
capabilities and growth. On the other hand, if the economy is stuck in a<br />
low level equilibrium trap and is unable to fund technological development,<br />
it is caught in a vicious circle. However, it can break out <strong>of</strong> this circle<br />
through a concerted strategy by improving the human capital and<br />
technological base and improving the institutions and infrastructure.<br />
The essence <strong>of</strong> the competitiveness strategy is to improve the supply<br />
<strong>of</strong> information, skills and technology and encourage firms to make an effort<br />
at the learning <strong>of</strong> skills and the adoption and adaptation <strong>of</strong> technology. Over<br />
the last couple <strong>of</strong> decades there have been rapid technological changes<br />
2 It also suggests that reforms carried out by Pakistan have been mainly responsible for<br />
the high growth rate <strong>of</strong> per capita incomes in Pakistan in recent years.
26<br />
A. R. Kemal<br />
across the globe which has rendered the old technologies obsolete even in<br />
the low wage economies 3 .<br />
New technologies are not just new products and processes, but<br />
involve the firms supply chain, human resource development, technology<br />
linkages etc. It amounts to building new capabilities and promoting<br />
structural change in the production patterns, the upgrading <strong>of</strong> technologies<br />
in activities including finding new markets and marketing niches. Various<br />
industries may need to access, adapt, and add new technologies to remain<br />
competitive. Industrial leaders have to invest in technological innovations<br />
while the followers invest in absorbing and adopting the technology.<br />
Contrary to the general impression that the latter is easy, it needs to be<br />
noted that it is a complex process and involves the development <strong>of</strong> skills and<br />
technological personnel. The technical change affects all industries though<br />
they are more important in innovation-based industries 4 .<br />
While technological development is absolutely necessary the capacity<br />
development for technological change is slow, costly and a risky learning<br />
process. The critical factor is not just addition to capacities but the ability<br />
to understand how to operate these at the optimum levels given local<br />
conditions and factor endowments and to upgrade the technologies to lower<br />
the cost <strong>of</strong> production and evolve new products.<br />
It also needs to be noted that the competitiveness <strong>of</strong> a country<br />
undergoes changes in response to innovation and the relocation <strong>of</strong> processes<br />
or functions. The improvements in productivity do not necessarily involve<br />
innovation, but could involve the efficient use <strong>of</strong> existing technologies. The<br />
reduction in the dispersion <strong>of</strong> the use <strong>of</strong> technology across different firms<br />
through the diffusion <strong>of</strong> technology helps in improving the productivity<br />
levels <strong>of</strong> an industry. However, it may involve large amounts <strong>of</strong> investment,<br />
effort, time, risk and constrained interaction with other actors with whom<br />
information and skills are shared.<br />
In most developing countries, firms are not aware <strong>of</strong> how to upgrade<br />
their technologies to the best practice levels. In general they fail to<br />
understand what new skills, technical knowledge and organizational<br />
techniques are generally available and how these can be accessed.<br />
Cooperation with other firms or institutions requires efforts in over-coming<br />
problems <strong>of</strong> linkage. Cluster development can be useful in this direction.<br />
3 The enterprises had to use new technology to remain viable.<br />
4 Such industries have grown at double the rate compared to the other industries.
Industrial Competitiveness <strong>of</strong> Pakistan (2000-10) 27<br />
Lack <strong>of</strong> skilled manpower is a major constraint to business activities<br />
in Pakistan and is critical to improving the productivity and competitiveness<br />
<strong>of</strong> Pakistani firms. With a view to improving education and skills, merely<br />
higher allocations to education and skill activities would not be sufficient,<br />
though it is absolutely necessary. Governance needs to be improved through<br />
the strengthening and ensuring <strong>of</strong> more effective recruitment, management<br />
and performance <strong>of</strong> teachers keeping in mind their competencies and<br />
absenteeism. It would help in the completion <strong>of</strong> education. Similarly, skill<br />
development calls for improved syllabi, teachers and laboratories and all the<br />
governance issues discussed in terms <strong>of</strong> education. Moreover, it needs to be<br />
ensured that intermediate and secondary education is more purposeful and<br />
linked to the economy and the changing needs <strong>of</strong> the labor market and<br />
careers. It also implies an upgradation and expansion <strong>of</strong> vocational and<br />
technical education capacity to train individuals who are completing<br />
matriculation, drop outs and the unemployed.<br />
Whereas there have been significant improvements in the cost <strong>of</strong><br />
doing business indicators over the last few years, the cost is still quite high.<br />
Corruption continues to be very high. The regulatory environment leaves<br />
much to be desired in all aspects <strong>of</strong> commercial laws and regulations. There<br />
is a need for operational rules, procedures and a monitoring system which<br />
are universally implemented. There is a need to develop a dispute resolution<br />
system for commercial adjudication outside courts. The infrastructure leaves<br />
much to be desired. In the power sector there are difficulties in obtaining<br />
electricity connections and the supply is unreliable, thus placing an<br />
enormous burden on business. The financial sector reforms need to be<br />
consolidated and expanded. The legal framework and judicial processes need<br />
to be improved.<br />
Despite improvements in recent years, major problems in transport<br />
logistics remain. Long standing problems include the old and depleted<br />
conditions <strong>of</strong> the transport fleet, serious overloading <strong>of</strong> trucks, restrictions<br />
on the provision <strong>of</strong> bonded transport and the high cost for less than<br />
container load shipments. Pakistan Railways do not operate on a commercial<br />
basis and gives priority to passengers rather than cargo. The main problem<br />
at the ports is the congestion at the terminals and the turnaround time <strong>of</strong><br />
ships is quite high. Pakistan lacks a coherent strategy for quality and SPS<br />
management in relation to its trade. Pakistan needs to better define and<br />
demarcate the role and responsibilities <strong>of</strong> different agencies, strengthen<br />
existing technical capacities for administrating science based SPS measures,<br />
and institutionalize and early warning or surveillance system for pest and<br />
disease contaminants etc.
28<br />
A. R. Kemal<br />
V. Conclusions<br />
Pakistan’s exports, despite a sharp increase in recent years, are just a<br />
fraction <strong>of</strong> the exports <strong>of</strong> various South East Asian countries and the main<br />
factor behind the low level <strong>of</strong> exports is the lack <strong>of</strong> competitiveness and<br />
comparative advantage in limited products the demand for which is growing<br />
slowly in the world market. Exporters are once again asking for more<br />
subsidies and devaluation <strong>of</strong> the rupee rather than enhancing their<br />
competitiveness through improvement in total factor productivity.<br />
Competitiveness may be enhanced through the development <strong>of</strong> human<br />
resources including skills and technological development. If Pakistan wants<br />
to accelerate its GDP growth rate to around 8%, it will have to improve its<br />
ranking from 91 st in the world.<br />
Whereas total factor productivity over the long run in the industrial<br />
sector has contributed one-half to the growth, its contribution has fallen in<br />
the 1990s to just 0.8%. Moreover, improvements reflect low levels <strong>of</strong><br />
productivity in the base year and they reflect just catching up through<br />
learning by doing and there has hardly been any growth in productivity<br />
arising from technological development and human resource development.<br />
Efforts need to be mounted to improve the skills and technological<br />
infrastructure in the country as has been suggested in the MTDF - that<br />
growth would be realized by deploying knowledge inputs.<br />
Whereas there have been significant improvements in the cost <strong>of</strong><br />
doing business indicators over the last few years, the cost is still quite high.<br />
Corruption continues to be very high. The regulatory environment leaves<br />
much to be desired in all aspects <strong>of</strong> commercial laws and regulations. The<br />
infrastructure leaves much to be desired. In the power sector there are<br />
difficulties in obtaining electricity connections and the supply is unreliable,<br />
thus placing an enormous burden on the business sector. Financial sector<br />
reforms needs to be consolidated and expanded. The legal framework and<br />
judicial processes need to be improved.
Industrial Competitiveness <strong>of</strong> Pakistan (2000-10) 29<br />
References<br />
Kemal, A. R., Musleh-ud Din, Kalbe Abbas and Usman Qadir, 2002, “A Plan<br />
to Strengthen Regional Trade Cooperation in South Asia” in T. N.<br />
Srinivasan (ed.) Trade Finance and Investment in South Asia, Social<br />
Science Press, New Delhi,<br />
Kemal, A.R., 2002, “Productivity Growth during the 1990s in Pakistan,”<br />
Asian Productivity Organization, Japan.<br />
Kemal, A.R., Muslehuddin and Usman Qadir, 2005, “Exports and Economic<br />
Growth in South Asia” in Mohsin Khan (ed.) Economic Development<br />
in South Asia, New Delhi: Tata McGraw-Hill Publishing Company<br />
Ltd.<br />
Kemal, A.R., Zafar Mahmood and Athar Maqsood Ahmad, 1994, Structure <strong>of</strong><br />
Protection, Efficiency, and Pr<strong>of</strong>itability. Islamabad, Study prepared<br />
for the Resource Mobilization and Tax Reforms Commission,<br />
Karachi.<br />
Lall, Sanjay A. and Jonh Weiss, 2004, Industiral Competitiveness: The<br />
Challenge for Pakistan, ADB, Islamabad.<br />
World Bank, Pakistan: Growth and Export Competitiveness, 2006.<br />
World Economic Forum, The Global Competitive Report 2006-07, Geneva.
The <strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong><br />
<strong>Special</strong> <strong>Edition</strong> (September 2007)<br />
Increasing Global Competitiveness: A Case for the<br />
Pakistan Economy<br />
Shamyla Chaudry *<br />
Abstract<br />
The issue <strong>of</strong> global competitiveness is critical for developing<br />
countries. This paper looks at the drivers that influence industrial<br />
competitiveness and provides a comparison <strong>of</strong> these drivers for Pakistan,<br />
India and China. The analysis shows that Pakistan lags behind China and<br />
India in most <strong>of</strong> the main components <strong>of</strong> the industrial competitiveness<br />
index. The analysis also presents a series <strong>of</strong> micro and macro level policy<br />
recommendations aimed at increasing Pakistan’s industrial<br />
competitiveness.<br />
I. Introduction<br />
The aim <strong>of</strong> this paper is to explain global competitiveness and its<br />
implications for Pakistan. The paper examines international data on global<br />
competitiveness and tries to develop an analysis to help improve strategies for<br />
today. The paper’s focus is on the empirical literature on competitiveness<br />
using different composite indices. These include the following:<br />
1. United Nations Industrial Development Organizations; World<br />
Industrial Development report (2002-2003)<br />
2. World Economic Forums Global Competitiveness Report (up to WEF<br />
2005-2006)<br />
The principal objective <strong>of</strong> this study is to analyze factors that affect<br />
productivity and hence competitiveness and also to identify areas where<br />
Pakistan can strengthen its competitiveness so as to contribute to the overall<br />
growth performance. In order to do such an analysis, comparisons have been<br />
made with Pakistan’s neighbours, India and China, and their success in<br />
international standings has been evaluated. A question which probably<br />
* Assistant Pr<strong>of</strong>essor, The <strong>Lahore</strong> <strong>School</strong> <strong>of</strong> <strong>Economics</strong>, <strong>Lahore</strong>
32<br />
Shamyla Chaudry<br />
comes to everyone’s mind is why India and China, which enjoy the same<br />
geographic region with Pakistan, are well ahead <strong>of</strong> Pakistan in all aspects <strong>of</strong><br />
competitiveness.<br />
II.<br />
Global Competitiveness Today<br />
The theme <strong>of</strong> competitiveness has remained the same; that is lower<br />
domestic costs hence lower the prices <strong>of</strong> goods. But ways to achieve this<br />
have changed over the years: from a pricing approach, that is the end user<br />
approach, there has been a shift to a costing approach, that is, the firm<br />
micro-level approach.<br />
Competitiveness can be defined as sustainable growth in productivity<br />
that benefits the average person. Today, competitiveness in a global<br />
economy should not be confused with abundance <strong>of</strong> natural resources or<br />
cheap labor or continued exchange rate depreciations or, for that matter,<br />
protectionist policies to support local industries. Though these bring short<br />
term advantages, they do not facilitate the making <strong>of</strong> a dynamic economy.<br />
Pr<strong>of</strong>essor Porter’s model for competitiveness is created by a stable macro<br />
economic, political, legal and social environment and also a continuous yet<br />
proactive stance to improve the micro economic environment in which local<br />
firms are taken to the forefront and strategies are developed to foster an<br />
environment for local competition.<br />
A recent study in the Industrial Development Report attempts to<br />
explain the “drivers” that seem to influence a country’s ability to influence<br />
competitive industrial performance (CIP). Skills measured by the level <strong>of</strong><br />
tertiary enrollment in technical subjects, research and development (R&D)<br />
which is financed by productive enterprises, foreign direct investment (FDI)<br />
which includes total FDI investment with no distinction between exportoriented<br />
or domestic-oriented flows in manufacturing, royalties and<br />
technical fees which include fees paid to imported technology, and lastly<br />
modern infrastructure (ICT) by the use <strong>of</strong> telephone mainlines, are the five<br />
“drivers.”<br />
• CIP Score = 27.017 + 0.277 skills + 0. 036 R&D + 0. 009 ICT+<br />
0.021royalties + 0.008 FDI.<br />
The equation shows the drivers that enhance the CIP- competitive<br />
industrial performance index (based on a data base <strong>of</strong> 51 countries for the<br />
year 2000). A 1% enhancement in skills, namely enrollment in technical<br />
subjects such as science, mathematics, computing, and engineering, will<br />
increase the CIP by 0.3. Not all the drivers are significant. R&D, FDI and
Increasing Global Competitiveness: A Case for the Pakistan Economy 33<br />
royalties achieve consistent significance whereas skills and ICT fail to do so<br />
as skills are highly correlated with R&D. What this confirms is that<br />
technological efforts are positively related to the CIP, which are the bases<br />
for industrial success. FDI driven production and the export <strong>of</strong> high tech<br />
products affects competitive industrial performance positively. Royalties and<br />
technical fees are also positively related with industrial performance.<br />
Table-I<br />
Country Rank CIP Index Change in Rank for<br />
(2000) (2000) 1990-2000 1980-1990 1980-2000<br />
Pakistan 49 0.235 -2 6 4<br />
India 40 0.275 -4 2 -2<br />
China 24 0.379 2 3 15<br />
Source: UNIDO scoreboard <strong>of</strong> core sample database)<br />
Starting with a CIP score <strong>of</strong> 0.192 (rank 53) in the 1980s to 0.219<br />
(rank 47) in the 1990s to 0.235 (rank 49) in the 2000s, Pakistan has lost<br />
ground mainly due to exogenous shocks, political instability, poor macro<br />
management, policy liberalization and an over reliance on primary products.<br />
China started <strong>of</strong>f with a score <strong>of</strong> 0.240 (rank 39) in the 1980s to 0.323 (rank<br />
26) in the 1990s to a score <strong>of</strong> 0.379 (rank 24) in the 2000s showing a<br />
sustained improvement in each decade as there have been rapid rises in<br />
manufactured exports and a significant upgrading <strong>of</strong> technological structure <strong>of</strong><br />
exports. But again policy liberalization has slowed the process <strong>of</strong> improvement<br />
in China’s global competitiveness. A number <strong>of</strong> studies conclude that China’s<br />
growth would have been relatively higher had policy liberalization not been<br />
forced on China. India’s performance amounted to a CIP score <strong>of</strong> .243 (rank<br />
38) in the 1980s to 0.262 (rank 36) in the 1990s to 0.275 (rank 40) in the<br />
2000s showing that it has upgraded its technology structure from a relatively<br />
low level and has a medium share <strong>of</strong> manufactured goods with a low per<br />
capita export value. The reason for the stagnation <strong>of</strong> Indian competitiveness<br />
can be attributed to slow medium and high technology (MHT) sector growth<br />
in the1990s which was a result <strong>of</strong> policy liberalization in the form <strong>of</strong> increased<br />
advertising budgets at the cost <strong>of</strong> R&D budgets. The small slip in the index<br />
also implies that the neighbouring country, namely China, has been doing<br />
better.<br />
The World Economic Forum defines competitiveness as a set <strong>of</strong><br />
factors, institutions and policies that underline the level <strong>of</strong> productivity; if one<br />
wants to increase productivity, hence competitiveness, one has to
34<br />
Shamyla Chaudry<br />
make better use <strong>of</strong> the available resources. The Global Competitiveness Index<br />
(GCI) incorporates nine factors that lead to increased productivity and<br />
competitiveness. The GCI incorporates the concept <strong>of</strong> stages <strong>of</strong> development,<br />
attaches different weights to different sub-indices and provides individual<br />
countries with a useful tool to identify the barriers to competitiveness. The<br />
pillars are divided into three broad categories, those being the basic<br />
requirements, efficiency enhancers and innovation and sophistication factors.<br />
These are then further sub-divided into the nine pillars, that is, institutions,<br />
infrastructure, macro economy, health and primary education, higher education<br />
and training, market efficiency (goods, labor, financial), technological readiness,<br />
business sophistication and innovation. Pakistan, India and China are classified<br />
as factor driven economies with a GDP per capita <strong>of</strong> less than $2000. For such<br />
economies the basic requirement sub-index is the most important as it has the<br />
highest weight attached to it in constructing the GCI. Economies with GDP<br />
per capita ranging from $3000 to $9000 are classified as efficiency driven<br />
economies, whereas countries with GDP per capita greater than $17,000 are<br />
classified as innovation driven economies. Naturally all three categories assign<br />
different weights to the three sub indices. Using the three weights the GCI<br />
has been constructed for Pakistan, India and China.<br />
Table-II<br />
Weights Pakistan India China<br />
Factor driven 3.66 4.44 4.24<br />
Efficiency driven 3.585 3.56 4.125<br />
Innovation driven 3.594 4.461 4.029<br />
Equal weights 3.629 4.47 4.067<br />
Source: GCI index 2005-2006)<br />
Using different weights we can see that for all the countries the GCI<br />
score deteriorates as we move from factor driven weights to innovation<br />
driven weights and only in the case <strong>of</strong> equal weights, does India show a<br />
minor improvement <strong>of</strong> 0.03 where as Pakistan and China both lose ground.<br />
This contradicts the report on the state <strong>of</strong> Pakistan’s competitiveness that<br />
asserted that by assigning equal weights to the sub-indices Pakistan’s score<br />
could have been relatively higher.<br />
Referring to the Table-III one can see a stark contrast between the<br />
three economies that have been classified as factor driven economies.<br />
Analysis has been provided for such differences. Under the first four pillars
Increasing Global Competitiveness: A Case for the Pakistan Economy 35<br />
which make up the basic requirement category, except for infrastructure,<br />
health and education, Pakistan’s ranking has fallen. The fifth, sixth and<br />
seventh pillars that fall under the efficiency enhancer’s category have shown<br />
stagnation.<br />
Considering the eighth and the ninth pillar that come under<br />
innovative factors, Pakistan has slid under the eighth pillar but has shown<br />
considerable improvement in the ninth pillar. Factor driven economies such<br />
as Pakistan define competition based on factor endowments such as<br />
unskilled labor and natural resources.<br />
Today Pakistan lags behind in all the categories <strong>of</strong> the GCI index.<br />
Though the figures show an improvement in Pakistan’s rank from 98th to<br />
91st, this does not indicate any improvement but merely the fact that more<br />
countries have been included in the index. Health and education when<br />
compared to India (5.9) and China (6.44) are weak areas for Pakistan (4.79).<br />
Human capital development is the weakest in Pakistan as indicated by the<br />
higher education and training (fifth pillar). Pakistan is a low wage, labor<br />
surplus economy with low productivity. However, firm-level comparisons<br />
suggest that while wages in Pakistan are low by international standards, they<br />
are <strong>of</strong>ten significantly higher than those in the Sub-continent. Slow growth<br />
in private investment in the large scale manufacturing sector has dampened<br />
Pakistan’s economic growth. Pakistan has liberalized trade but highly<br />
protected domestic markets have reduced the incentives to exports. Also<br />
high costs and poor functioning <strong>of</strong> infrastructure are considered to be<br />
harmful impediments for Pakistan’s growth.
36<br />
Shamyla Chaudry<br />
Table-III: Global Competitiveness Indexes: Cross-Country Comparisons<br />
2006 – 2007)<br />
China India Pakistan<br />
Rank Score Rank Score Rank Score<br />
Basic Requirements 44 4.8 60 4.51 93 3.96<br />
Institutions 80 3.51 34 4.55 79 3.51<br />
Infrastructure 60 3.54 62 3.50 67 3.36<br />
Macro economy 6 5.72 88 4.12 86 4.19<br />
Health & Primary Education 55 6.44 93 5.90 108 4.79<br />
Efficiency Enhancers 71 3.66 41 4.32 91 3.27<br />
Higher Education & Training 77 3.68 49 4.35 104 2.82<br />
Market efficiency (goods, labor,<br />
financial)<br />
56 4.22 21 5.07 54 4.23<br />
Technological Readiness 75 3.07 55 3.52 89 2.77<br />
Innovation & Sophistication<br />
Factors<br />
57 3.75 26 4.60 60 3.66<br />
Business Sophistication 65 4.05 25 5.06 66 4.05<br />
Innovation 46 3.44 26 4.14 60 3.27<br />
Overall Index 54 4.24 43 4.44 91 3.66<br />
(Source: Global Competitiveness Report (2005-2006))<br />
India ranked 43rd overall with excellent scores in the capacity for<br />
innovation and sophistication <strong>of</strong> firm operations. Firm use <strong>of</strong> technology<br />
and rates <strong>of</strong> technology transfer are high, although penetration rates <strong>of</strong><br />
the latest technologies are still quite low which reflects India's low levels<br />
<strong>of</strong> per capita income and high level <strong>of</strong> poverty. A lack <strong>of</strong> adequate health<br />
services and education as well as a poor infrastructure are limiting a more<br />
equitable distribution <strong>of</strong> the benefits <strong>of</strong> India’s high growth rates. When<br />
comparing the infrastructure pillar, India and China have very close figures<br />
which is highly debatable. Indian governments have been ineffective in<br />
reducing the public sector deficit, which is one <strong>of</strong> the highest in the<br />
world, and that would seem to cause their rankings to slide in the macro<br />
economy pillar.<br />
China’s ranking has fallen form 48 to 54, characterized by<br />
heterogeneous performance. On the positive side, China’s growth rates<br />
coupled with low inflation, one <strong>of</strong> the highest savings rate in the world,<br />
and hence investment and manageable levels <strong>of</strong> public debt have boosted<br />
China’s ranking on the macro economy pillar <strong>of</strong> the GCI to 6th place.<br />
However, a number <strong>of</strong> structural weaknesses have arisen, including in the
Increasing Global Competitiveness: A Case for the Pakistan Economy 37<br />
banking sector that is mainly controlled by the State. China has low<br />
penetration rates for the latest technologies (mobile telephones, internet,<br />
personal computers), and secondary and tertiary school enrolment rates<br />
are still relatively low. There has been a drop in the quality <strong>of</strong> the<br />
institutional environment, a slide in the rankings from 60 to 80 in 2006,<br />
with poor results across all 15 institutional indicators, spanning both<br />
public and private institutions. China has created a much more<br />
competitive environment than India or Pakistan considering the tax<br />
structure, infrastructure, capital costs and labor legislation. China is well<br />
known for the low costs <strong>of</strong> its workforce and its investment rate which is<br />
one <strong>of</strong> the highest in the world. China invests enormously in education,<br />
infrastructure and technology, yet people mistake China’s competitiveness<br />
as a result <strong>of</strong> cheap labor and piracy. China’s competition is felt<br />
particularly in some sectors requiring a great deal <strong>of</strong> manual labor such as<br />
footwear, textiles and small appliances. But in the next five years China’s<br />
auto industry will pose to be a looming threat for other car manufacturing<br />
industries across the world. In China, local firms are gaining ground over<br />
foreign competitors. These companies are receiving a boost from<br />
government policies that require at lease 70% <strong>of</strong> new machines to be<br />
made at home in sectors such as energy. Such incentives are likely to<br />
increase its growth.<br />
III.<br />
Conclusion and Recommendations<br />
Pakistan started out a poor nation at independence with<br />
dependency on agriculture. The economy has seen ups and downs which<br />
have discouraged Pakistan’s growth. In the 60s there was major investment<br />
in infrastructure, huge sugar mills and textile industries, and import<br />
substitution was implemented. It was at this time that Pakistan was<br />
considered to be an economic player <strong>of</strong> the Sub–continent. By the 70s<br />
political hurdles dissuaded Pakistan’s progress and the nationalization <strong>of</strong><br />
industry brought growth to a stand-still. In the next era <strong>of</strong> the military<br />
regime there was a heavy inflow <strong>of</strong> US aid and spending by the public<br />
sector was seen to be on the rise. The next decade, that is the 90s, can<br />
broadly be classified as a decade <strong>of</strong> lost opportunities with heavy<br />
borrowing both in the public and private sector that has resulted in being<br />
a burden on the economy today. Therefore, today prudence in economic<br />
management is crucial. But the trick that needs to be learned is to find<br />
means to support and accelerate rather than hinder enterprise<br />
development. For global competitiveness today is more reliant on the<br />
micro environment as opposed to the macro environment. A number <strong>of</strong><br />
recommendations are being cited here with reference to the two<br />
neighbouring countries that have done better than Pakistan.
38<br />
Shamyla Chaudry<br />
Competitiveness today requires a strong base <strong>of</strong> human and technological<br />
resources. However, in Pakistan per capita R&D spending is amongst the<br />
lowest. Among the high growth newly industrialized economies, there<br />
have been substantial national variances in the way exports were<br />
promoted. The challenge for Pakistani governments will be to provide<br />
support, not direction, for the private sector. Also Pakistan needs to<br />
establish alliances with countries that have technological capabilities in<br />
sectors operating at lower technological levels. The essence <strong>of</strong><br />
competitiveness is to promote in-firm learning, skill development and<br />
technological effort and to coordinate the collective learning process. To<br />
compete, Pakistani enterprises must adopt new technologies and<br />
organizational methods and link themselves to the global value chain.<br />
Coping with new technologies calls for new skills, innovative production<br />
structures, improved infrastructure and institutions. Today,<br />
competitiveness will involve the upgrading <strong>of</strong> technologies in all activities<br />
building new capabilities and finding new markets and market niches.<br />
Pakistan needs to reevaluate its exports, and even with Pakistan’s cotton<br />
resources and upgrading <strong>of</strong> textile facilities, will it remain a major player<br />
in textile and apparel market, where Pakistan has lost market share to<br />
countries like China, India, and recently to Bangladesh and Sri Lanka? In<br />
the long run export diversification is necessary. Pakistan’s wage rates are<br />
comparable those <strong>of</strong> India and China but its export structure is biased<br />
towards low technology products. Therefore, Pakistan’s scores are<br />
relatively low on export sophistication. That means that Pakistan<br />
specializes in the low value added section <strong>of</strong> the textile industry.<br />
Unfortunately, Pakistan is highly dependent on apparel products that are<br />
considered to be one <strong>of</strong> the most non dynamic exports; with sliding<br />
market shares and entry from other countries, that makes Pakistan’s<br />
position vulnerable. It also faces competition from China and India who<br />
are investing heavily in new technology, designs and skills which may outperform<br />
Pakistan. Therefore specializing in textile and clothing is not<br />
recommended in the future. It needs to diversify into other sectors where<br />
it has a competitive edge. Should Pakistan switch its production from low<br />
tech goods to primary products? At this point we are not saying that<br />
Pakistan should never produce high tech products, but build on its<br />
capabilities to develop goods that provide value addition.<br />
What should Pakistan do in the meantime? Recent examples <strong>of</strong><br />
exports <strong>of</strong> various citrus fruit varieties, mangoes, flowers, dairy products and<br />
a number <strong>of</strong> other such products will provide the diversification needed to<br />
strengthen exports. Also a study conducted by the World Bank indicates the<br />
potential for more trade with India, especially light manufactured products<br />
such as bicycle components and fans. Pakistan has to reevaluate its stance on
Increasing Global Competitiveness: A Case for the Pakistan Economy 39<br />
its medical instruments product categories, one <strong>of</strong> its most dynamic exports,<br />
where Pakistan has been losing its world market share.<br />
With low ranks in the basic requirements sub-index, Pakistan has to<br />
improve at the macro level so that an environment can be fostered for the<br />
individual firm. Pakistan has to improve in areas <strong>of</strong> health and primary<br />
education and also improve the higher education and training pillar. The<br />
investment climate, coupled with the uncertain national and regional<br />
situation, has kept foreign direct investment (FDI) inflows less than those <strong>of</strong><br />
China. For competitiveness today a country requires adequate infrastructure,<br />
cheap labor and liberal economic policies. Therefore Pakistan requires<br />
export diversification, firm level technological upgrading and the<br />
development <strong>of</strong> clusters.<br />
However, why are some industries in Pakistan doing well despite a<br />
low competitive rating? Are these the results <strong>of</strong> some ingenious ways <strong>of</strong><br />
doing business? Is the Pakistani entrepreneur really proactive? Further<br />
research needs to be directed in this area. The Business Competitiveness<br />
Index addresses firm level operations and the national business environment<br />
with relatively higher weights given to the latter. Pakistan’s performance has<br />
improved over the years from 77th to 67th place where China stands at<br />
57th and India is currently at 31st place. When these ranks are compared<br />
with other countries in the region, Pakistan has to strive hard to develop<br />
not only a strong national business environment, but also try to capture<br />
firm level ingenuity.<br />
Certain high priority areas have been identified by a study<br />
conducted by the World Bank for accelerating Pakistan’s growth and hence<br />
its global competitiveness. Some <strong>of</strong> these measures require quick decisions<br />
whereas others require long term efforts. The measures include:<br />
• Strengthening the macroeconomic framework (long term)<br />
• Analyzing electricity pricing and structural issues<br />
• Improving SME’s access to financing<br />
• Serious commitment to human capital development and to increase<br />
the supply <strong>of</strong> skilled labor (long term)<br />
• Improvements in the efficiency <strong>of</strong> the duty–drawback and sales tax<br />
rebates systems for new or small exporters and new exporting<br />
activities
40<br />
Shamyla Chaudry<br />
• Improvements in transport and trade logistics (long term)<br />
• Enhancing food and safety standards
Increasing Global Competitiveness: A Case for the Pakistan Economy 41<br />
References<br />
ADB Institute-Pakistan Resident Mission Seminar Paper, 2004, “Industrial<br />
Competitiveness: The Challenge for Pakistan”, ADB Institute, Asian<br />
Development Bank.<br />
Ansari. Javed A., 2005, “Pakistan’s Industrial Competitiveness”, College <strong>of</strong><br />
management Science, PAF-Karachi Institute <strong>of</strong> <strong>Economics</strong> and<br />
Technology.<br />
Aw, Bee Yan; Chung, Sukkyun and Roberts mark J., 2000, “Productivity and<br />
Turnover in the Export Market: Micro-Level Evidence from the<br />
Republic <strong>of</strong> Korea and Taiwan (China)”, The World Bank Economic<br />
Review, Vol. 14, No. 1, pp. 65 – 90.<br />
Balduf, Artur; Carvens, David W. and Wagner, Udo, 2000, “Examining<br />
Determinants <strong>of</strong> Export Performance in Small Open Economies”,<br />
Journal <strong>of</strong> World Business, Vol. 35, No. 1.<br />
Britto, Jorge and Janeiro, Rio de Janeiro, “Industrial Competitiveness and<br />
Inter-Firm Co-operation: An Analysis <strong>of</strong> Stylized Models <strong>of</strong> Inter-Firm<br />
Networks”.<br />
“Global Competitiveness Report 2003 / 2004”, World Economic Forum.<br />
“Global Competitiveness Report 2004 / 2005”, World Economic Forum.<br />
“Global Competitiveness Report 2004 / 2006”, World Economic Forum.<br />
“Global Competitiveness Report 2006 / 2007”, World Economic Forum.<br />
Government <strong>of</strong> Pakistan, Finance Division; “Pakistan Economic Survey 2005<br />
- 2006”.<br />
Katsikeas, Constantine S. and Leonidou, Leonidas C., 1996, “Export Market<br />
Expansion Strategy: Differences Between Market Concentration and<br />
Market Spreading”, Journal <strong>of</strong> Marketing Management, Vol. 12, pp.<br />
113 – 134.<br />
Khan, Mehmood – Ul- Hassan, “Exports in 2006: A Critical Review”,<br />
Business & Finance Review, the News International, Monday,<br />
January 8th 2007.
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Shamyla Chaudry<br />
Khan, Mehmood, Shazia; “Good Economic Indicators Pointing towards<br />
Sustainable Development”, Business and Finance Review, The News<br />
International, Monday, October 16th 2006.<br />
Maskell, Peter and Malmberg, Anders, 1995, “Localized Learning and<br />
Industrial Competitiveness”, Ministry <strong>of</strong> Finance, Government <strong>of</strong><br />
Pakistan, and USAID.<br />
Nazar, Yousaf; “Economy: Challenges Ahead”, Economic and Business<br />
Review, the Dawn News, 1-7th January, 2007.<br />
Omar, Kaleem, “The Ups and Downs <strong>of</strong> Pakistan’s Economic Scenario: A<br />
Review” Business and Finance Review, The News International,<br />
Monday, January 8th 2007.<br />
Oral, Muhittin and Ozkan Alev O., Apr., 1986, “An Empirical Study on<br />
Measuring Industrial Competitiveness”, The Journal <strong>of</strong> the<br />
Operational Research Society, Vol. 37, No. 4, pp. 345-356.<br />
Paulo, Sao; “barzils’, China’s Economies Compete”, Business and Finance<br />
Review, The Daily Times, Tuesday, April 3rd, 2007.<br />
Porter, Michael, E.; ed, “Competition in Global Industries”, Harvard<br />
Business <strong>School</strong> Press, Boston<br />
“UNIDO Industrial Development Report 2002 – 2003”, United Nations<br />
Industrial Development Organization.<br />
Wignaraja, Ganeshan and Joiner, David, 2004, “Measuring Competitiveness<br />
in the Worlds Smallest Economies: Introducing the SSMECI”,<br />
Economic and Research Department Paper Series, N0.60.<br />
World Bank Documents, 2006, “Pakistan Growth and Export<br />
Competitiveness”, Report No. 35499-PK, World Bank.
The <strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong><br />
<strong>Special</strong> <strong>Edition</strong> (September 2007)<br />
Monetary and Fiscal Policies<br />
Shahid Kardar *<br />
Abstract<br />
Though the Pakistani economy had recently achieved some level <strong>of</strong><br />
macroeconomic stability, at present there are fears that this stability could be<br />
threatened. This paper looks at monetary and fiscal reforms over the last<br />
decade and focuses on the areas that need to be addressed on both fronts. In<br />
particular, the paper looks at how present monetary policy needs greater<br />
clarity and how fiscal policy needs to focus on raising public savings and<br />
diversifying the sources <strong>of</strong> borrowing.<br />
Introduction<br />
With inflation still hovering around 8%-despite the monetary<br />
tightening over the last two years, a fiscal deficit threatening to cross 4.2%<br />
<strong>of</strong> GDP and the reversal <strong>of</strong> the current account surplus into a large deficit<br />
that could touch 5.5% <strong>of</strong> GDP, there are understandably fears that the<br />
macroeconomic stability achieved after a long and hard struggle, with a fair<br />
sprinkling <strong>of</strong> luck thrown in by the events <strong>of</strong> 9/11, has been lost. These<br />
macroeconomic imbalances are inducing pressures and new challenges for<br />
sustaining the present healthy rates <strong>of</strong> economic growth.<br />
At a time when monetary policy was the easiest to handle, thanks to<br />
the surfeit <strong>of</strong> liquidity and the abundance <strong>of</strong> cheap money in the financial<br />
system (from donors in the form <strong>of</strong> aid and from overseas Pakistanis in the<br />
form <strong>of</strong> remittances), the State Bank did not perform its principal duty <strong>of</strong><br />
controlling inflation with distinction. Inflation soared not simply because <strong>of</strong><br />
the oil and food price inflation but largely because <strong>of</strong> a loose monetary<br />
policy 5 . The State Bank allowed a huge increase in money supply, well above<br />
the rate justified by the expansion in the economy. Resultantly, Pakistan has<br />
the dubious distinction <strong>of</strong> having the highest inflation rate in this region;<br />
inflation has also been outpacing that <strong>of</strong> its trading partners and<br />
* Former Finance Minister, Government <strong>of</strong> the Punjab.<br />
5 See Khan and Schimmelpfennig (2006) and Qayyum (2006).
44<br />
Shahid Kardar<br />
competitors. A good part <strong>of</strong> the problem <strong>of</strong> inflation has been fuelled by the<br />
consumption (private and public consumption) and investment boom <strong>of</strong><br />
recent years, well beyond the production capacity <strong>of</strong> the economy (a gap <strong>of</strong><br />
almost 4% <strong>of</strong> the GDP). The widening current account deficit is a classic<br />
sign <strong>of</strong> overheating and excessive demand build-up as domestic output fails<br />
to keep pace with surging demand facilitated by easier availability <strong>of</strong> credit,<br />
especially in the form <strong>of</strong> consumer financing.<br />
The gap between government expenditures and its tax revenues<br />
continues to be close to 7 percentage points <strong>of</strong> the GDP, the differential<br />
that existed in 1999/2000 with the tax to GDP ratio actually worsening<br />
from 13% <strong>of</strong> GDP in the early 1990s to under 11%. That some <strong>of</strong> this gap is<br />
presently being filled by non-tax revenues which are expected to decline as<br />
the more pr<strong>of</strong>itable enterprises are privatized, cannot be a source <strong>of</strong> comfort<br />
for the future in terms <strong>of</strong> sustainability.<br />
Another worrying feature is the growing savings-investment gap.<br />
This is presently being financed through remittances and non-secure sources<br />
<strong>of</strong> funding such as FDI (largely as privatization proceeds), external financing<br />
from Eurobonds, GDRs, donors and remittances, which also enabled the<br />
government to keep bank borrowings lower than what they might have<br />
been otherwise. Maintaining this large and widening gap will not be<br />
possible over a longer period.<br />
The scope <strong>of</strong> this paper is, however, limited to an examination <strong>of</strong><br />
monetary and fiscal polices to date and to propose a strategy for the future.<br />
Financial Sector and Monetary Policy Reforms<br />
The key measures that lay at the heart <strong>of</strong> the financial sector reforms<br />
initiated in the early 1990s included the enhancement <strong>of</strong> competitiveness in<br />
the banking sector through the privatization <strong>of</strong> financial institutions (FIs) and<br />
the easing <strong>of</strong> market entry <strong>of</strong> new FIs, improvements in their capital adequacy,<br />
reduction in the fragmentation <strong>of</strong> financial markets through the deregulation<br />
<strong>of</strong> interest rates on deposits and loans, a partial switch over to indirect<br />
marked-based instruments for monetary management 6 , the gradual<br />
dismantling <strong>of</strong> the system <strong>of</strong> directed and concessional credit schemes,<br />
facilitating the flotation <strong>of</strong> new securities through legal, policy and other<br />
procedural and regulatory reforms, strengthening the health <strong>of</strong> the banking<br />
6 The State Bank continues to buy government paper and use primary auctions for<br />
monetary management.
Monetary and Fiscal Policies 45<br />
system through Prudential Regulations (PRs), and by strengthening the<br />
capability <strong>of</strong> the SBP to fulfill its functional obligations.<br />
In the realm <strong>of</strong> monetary policy the benefits <strong>of</strong> the financial sector<br />
reforms are visible in the development <strong>of</strong> a somewhat competitive money<br />
market for government paper (reflected in the dealers’ market operating on<br />
narrow spreads between the bid and <strong>of</strong>fer rates) 7 , and a well functioning<br />
secondary market for treasury bills, while the market for corporate debt,<br />
although thin, presently (owing to the lack <strong>of</strong> liquidity in the market and<br />
the time it takes to settle transactions) is beginning to show promise.<br />
Success has also been achieved in resource allocation by making lending<br />
based on sound economic and financial criteria, creating more developed<br />
money and capital markets that are mobilizing savings and making them<br />
available to the most efficient users, through appropriate incentive systems<br />
instead <strong>of</strong> discriminatory direct controls.<br />
However, the bulk <strong>of</strong> the intermediary functions <strong>of</strong> the financial<br />
sector and the State Bank <strong>of</strong> Pakistan’s monetary stabilization efforts are<br />
performed for the government or essentially dictated by the government’s<br />
financing requirements. Even after the grant <strong>of</strong> autonomy to the State Bank,<br />
its principal activity has been to raise financing for the government. Since<br />
its monetary management is virtually driven by the borrowing needs <strong>of</strong> the<br />
government, 88% <strong>of</strong> its Net Domestic Assets (DNA) and 39% <strong>of</strong> total assets<br />
comprise advances to the government. In fact, in FY06, the SBP claims on<br />
the government increased by more than total government borrowings from<br />
banks-the main factor behind the increase in reserve money. Similarly, the<br />
banks hold close to 40% <strong>of</strong> their assets in the form <strong>of</strong> cash with the SBP,<br />
government securities or advances to it for commodity financing. Add to it<br />
the savings in the National Savings Schemes (at Rs. 860 billion, 11% <strong>of</strong><br />
GDP) and we get an idea <strong>of</strong> the scale <strong>of</strong> the economy’s financial savings<br />
mopped up by the government<br />
Moreover, the direct financing arrangements between the GoP and<br />
the SBP, whereby there is an automatic replenishment <strong>of</strong> the Government’s<br />
account with the SBP without any limit, by issuing treasury bills, has not<br />
been substantially altered. The SBP appears to be lending money to the<br />
government against securities, which it then <strong>of</strong>floads in the market.<br />
Although the potential inflationary impact <strong>of</strong> such government borrowings<br />
7 Although the rate is being forced through the State bank’s intervention and its statutory<br />
liquidity requirements.
46<br />
Shahid Kardar<br />
becomes sterilized, the legal and practical autonomy <strong>of</strong> the SBP to apply its<br />
monetary management policies independently is compromised 8 .<br />
It is also interesting to note that the State Bank’s prudential<br />
regulations with respect to capital adequacy requirements for commercial<br />
banks have also reinforced and strengthened the role <strong>of</strong> the banks in<br />
holding government securities. All commercial banks are required to<br />
maintain a minimum capital to total risk-weighted assets ratio <strong>of</strong> 8% 9 .<br />
Resultantly, along with having to bear the cost <strong>of</strong> funds for holding<br />
government securities, banks are also required to carry the burden <strong>of</strong> an<br />
additional charge on their activities, which in turn depends upon the<br />
categories <strong>of</strong> assets held in accordance with the risk-weights assigned to<br />
each. Presently, the risk weights assumed are zero for investments in<br />
government securities and 100% for practically all categories <strong>of</strong> loans<br />
including those to the most credit worthy corporations and businesses; even<br />
the balances held with scheduled banks are assigned a risk-weightage <strong>of</strong><br />
20%. With this difference in relative capital costs owing to these risk weights,<br />
the manner in which the capital adequacy norms are being applied has also<br />
created an incentive for banks in favor <strong>of</strong> investments in government<br />
guaranteed securities. In other words, the large sums invested by the banks in<br />
government paper are simply the natural outcome <strong>of</strong> these policies.<br />
The author is aware that the State Bank is moving towards a<br />
refinement <strong>of</strong> these norms. However, even if these norms are changed, as<br />
they must be, it does not follow that when the commercial banks reduce<br />
their investment in government securities they will necessarily increase their<br />
loan portfolio at the same pace. As other financial institutions pick up these<br />
securities there would be a flow <strong>of</strong> household savings to them, resulting in a<br />
shrinking in the deposit base <strong>of</strong> banks with, perhaps, only a marginal<br />
increase in the total value <strong>of</strong> loans and advances made by them.<br />
While some indicators, especially those pertaining to the availability<br />
<strong>of</strong> different products, efficiency and customer satisfaction have improved,<br />
other features depict less than satisfactory development. For instance, the<br />
money (M 2 ) to GDP ratio, which is supposed to signify financial deepening,<br />
has risen by just 4 percentage points, from 40% to 44% between 1985 and<br />
8 In India there is an agreement between the government and the Reserve bank <strong>of</strong> India<br />
that there will be no automatic replenishment as a result <strong>of</strong> which the central bank has<br />
acquired a semblance <strong>of</strong> independence.<br />
9 The State Bank also has to sterilize large remittance inflows selling government<br />
securities in the absence <strong>of</strong> other paper for such activities. Thus the banks end up holding<br />
more government securities than what they would have if they had simply followed the<br />
requirements <strong>of</strong> the Prudential Regulations.
Monetary and Fiscal Policies 47<br />
2006 (suggesting that a major part <strong>of</strong> the economy is still non-monetized). It<br />
is not clear how much <strong>of</strong> this increase can be attributed to the reforms.<br />
Similarly, although deposits as a percentage <strong>of</strong> GDP have declined from<br />
42.4% in 1997 to under 39% in 2006 this is largely because <strong>of</strong> the GDP<br />
rebasing effect. In comparison with the ratio for 2002 it has increased by 4<br />
percentage points 10 .<br />
To eliminate the monetary overhang <strong>of</strong> the previous six years and to<br />
curb demand, the SBP has been following a tighter monetary policy in the<br />
last two years (only in FY06 was the growth in broad money less than the<br />
nominal growth in the GDP) to curb demand. The banking system which<br />
was flushed with funds provided consumer finance liberally resulting in a<br />
further increase in money supply. This contributed to the fuelling <strong>of</strong><br />
inflation (Figure 1) 11 and forced the SBP to intervene through open market<br />
operations to squeeze money supply, although it did so with an inordinate<br />
delay. This strong monetary growth reflected largely in the abrupt increase<br />
in private sector credit, has sharply raised the general price level and prices<br />
<strong>of</strong> assets - land and equities.<br />
30.0<br />
Money Supply Growth, Domestic Credit<br />
Growth and Inflation<br />
12<br />
percent<br />
25.0<br />
20.0<br />
15.0<br />
10.0<br />
5.0<br />
0.0<br />
-5.0<br />
1996-<br />
97<br />
1997-<br />
98<br />
1998-<br />
99<br />
1999-<br />
00<br />
2000-<br />
01<br />
2001-<br />
02<br />
2002-<br />
03<br />
2003-<br />
04<br />
2004-<br />
05<br />
2005-<br />
06<br />
10<br />
8<br />
6<br />
4<br />
2<br />
0<br />
MSG DCG Inflation<br />
Figure 1: (right hand axis is for inflation and the left hand axis is for MSG<br />
and DCG)<br />
To curb the stubbornly high inflation through a tighter monetary<br />
policy, the SBP raised the Reserve Requirements <strong>of</strong> banks from 5% to 7%<br />
10 The low deposit to GDP ratio also raises questions about the efficiency <strong>of</strong> the banking<br />
system and the level <strong>of</strong> transaction costs that could be serving as a disincentive to the use<br />
and growth <strong>of</strong> the banking sector.<br />
11 I am grateful to Wasim Shahid <strong>of</strong> PIDE for preparing all the graphs used in this report.
48<br />
Shahid Kardar<br />
and the Statutory Liquidity Requirement on time and demand liabilities<br />
from 15% to 18% and the discount rate by 50 basis points, which while<br />
achieving the objective <strong>of</strong> a tighter monetary policy also made government<br />
borrowing cheaper than it might have been otherwise if only the discount<br />
rate had been raised. Presently, however, real interest rates on deposits are<br />
negative (the high rate <strong>of</strong> inflation keeping them negative) which, following<br />
the recent decision to permit institutions to invest in NSS instruments, is<br />
likely to encourage disintermediation, thereby forcing banks to compete for<br />
deposits by raising rates, especially for the longer tenor ones. Interestingly,<br />
the spread between the average deposit and lending rates continues to be<br />
high, having widened since the huge inflow <strong>of</strong> remittances and the notable<br />
growth in the economy, reflecting poorly on the efficiency and competitive<br />
environment in the banking sector.<br />
In conclusion, however, it could be argued that in view <strong>of</strong> some <strong>of</strong><br />
the trade-<strong>of</strong>fs there is admittedly a need to strike a delicate balance, but<br />
only in the short-term, between the excessive tightening for demand<br />
management reasons and the momentum in economic growth. However, the<br />
question remains if these should be the concerns <strong>of</strong> the State Bank or<br />
should it merely focus on controlling monetary growth to restrain inflation,<br />
since empirical research has shown that low and stable inflation is conducive<br />
to economic growth, partly by ensuring that the expected rate <strong>of</strong> inflation<br />
<strong>of</strong> the general price level ceases to be a factor in business decisions 12 .<br />
Lack <strong>of</strong> Clarity on Objectives <strong>of</strong> Monetary Policy 13<br />
A conundrum is the lack <strong>of</strong> clarity on the objectives <strong>of</strong> the present<br />
monetary policy. In the absence <strong>of</strong> the clarity <strong>of</strong> signals one should be<br />
excused from assuming that the State Bank is still trying to keep interest<br />
rates low as well as maintain, if not fix, the exchange rate, although basic<br />
economics inform us that you can cannot fix both simultaneously over a<br />
long stretch <strong>of</strong> time.<br />
In other jurisdictions the performance <strong>of</strong> the central bank is judged<br />
by its success in controlling inflation. In Pakistan, the State Bank’s previous<br />
leadership stoutly defended its monetary management aimed at pump<br />
priming <strong>of</strong> the economy resulting in inflation almost reaching double digits.<br />
It justified adopting an accommodating monetary policy that stimulated<br />
economic growth by keeping interest rates lower than the rate <strong>of</strong> inflation<br />
8 See Feldstein (1997), Goldstein (1995), and Mishkin (1997).<br />
13 This section <strong>of</strong> the paper has benefited enormously from discussions with Dr. Nadeemul-Haque.
Monetary and Fiscal Policies 49<br />
(especially hurting depositors in the process) and did not use the capital<br />
inflows from abroad to retire expensive debt. The pursuit <strong>of</strong> this strategy<br />
and a monetary policy that was working at cross purposes, however,<br />
compromised its role as an independent agent mandated to keep inflation in<br />
check through interest rate adjustment.<br />
Loose monetary policy, partly owing to the fiscal dominance in<br />
influencing this policy (see below) has fuelled the rate <strong>of</strong> inflation as well as<br />
the recent widening <strong>of</strong> the trade deficit. Simple, well-known, economic<br />
propositions inform us that monetary expansion or contraction leads to an<br />
increase or decrease respectively <strong>of</strong> aggregate demand which in turn directly<br />
impacts on import demand. In other words, monetary contraction will reduce<br />
overall demand and import demand and facilitate the trimming <strong>of</strong> the trade<br />
deficit. In most cases monetary tightening does not affect exports since these<br />
normally respond to external demand. Contrary to claims that monetary<br />
contraction will raise interest rates and adversely affect export competitiveness<br />
if monetary tightening lowers the rate <strong>of</strong> inflation and thereby the cost <strong>of</strong><br />
production, exports could actually increase. Therefore, monetary contraction<br />
should be the appropriate policy to reduce the trade deficit.<br />
A contractionary monetary policy that reduces aggregate demand will<br />
tend to depress growth. But this is a price that will have to be paid to<br />
return to macroeconomic stability. However, the likelihood <strong>of</strong> its<br />
recessionary impact tends to get overstated. Empirical studies have shown<br />
that the interest elasticity <strong>of</strong> investment and GDP growth may not be that<br />
strong; it is issues such as poor governance, policy uncertainty and slow<br />
structural reforms that pose more fundamental problems. Even the Pakistani<br />
case shows lack <strong>of</strong> any significant increase in investment despite interest<br />
rates being negative in real terms for a significant period.<br />
Allowing monetary policy to inflate the economy has long-term<br />
consequences as economic actors factor in inflationary expectations into their<br />
actions to address the uncertainty induced by decision makers. The State Bank<br />
has to earn for itself the credibility <strong>of</strong> a responsible monetary manager, which<br />
it lost through the footloose expansion that it had permitted earlier.<br />
The State Bank can use a combination <strong>of</strong> interest and exchange rates<br />
to manage aggregate demand. The exchange rate policy facilitates switching<br />
<strong>of</strong> demand from foreign goods to domestic goods, with an undervaluation<br />
making domestic goods cheaper relative to foreign goods, thereby improving<br />
the external balance.
50<br />
Shahid Kardar<br />
Depreciation will also reduce the domestic cost <strong>of</strong> production and<br />
have a favorable impact on the trade balance. Hence to deal with a trade<br />
problem, depreciation is always a real policy choice. In any case,<br />
depreciation becomes necessary after a period <strong>of</strong> monetary expansion.<br />
During a longish period <strong>of</strong> monetary expansion, domestic inflation grows<br />
at a faster pace than inflation among our trading partners and<br />
competitors. This inflation differential will eventually have to be bridged<br />
by currency depreciation. Of course, a depreciation in the exchange rate<br />
will have an impact on the rate on inflation to the extent <strong>of</strong> the share <strong>of</strong><br />
traded goods in the economy.<br />
The rupee is currently overvalued. The standard, and hackneyed,<br />
argument <strong>of</strong> policy makers that the price <strong>of</strong> the rupee is no longer determined<br />
by the government but by the market and since capital inflows, most <strong>of</strong> which<br />
are non-debt creating in nature (foreign remittances, privatization receipts,<br />
donor grants and direct foreign investment) are largely financing the deficit on<br />
the external trade account, the value <strong>of</strong> the rupee continues to be steady.<br />
Even if their contention that the market is determining the value <strong>of</strong> the rupee<br />
were to be accepted, the question is whether allowing foreign exchange<br />
inflows (most <strong>of</strong> which are non-secure in nature) to keep the value <strong>of</strong> the<br />
rupee artificially higher (while also requiring monetary management to be<br />
more stringent) than it would be otherwise is a good strategy for the<br />
pr<strong>of</strong>itability <strong>of</strong> our exports, especially considering that our domestic rate <strong>of</strong><br />
inflation is significantly higher than that <strong>of</strong> our trading partners and<br />
competitors. The lowering <strong>of</strong> the pr<strong>of</strong>itability rates and levels in the export<br />
and modern sectors <strong>of</strong> the economy is acting as a disincentive to invest in<br />
these sectors. Hence the movement into other activities like real estate and<br />
the stock exchanges, and to some extent in manufacturing for the domestic<br />
market in the more protected industries.<br />
If China were to follow this advice, the value <strong>of</strong> the Yuan would be<br />
appreciating (since it has a huge trade surplus with the rest <strong>of</strong> the world and<br />
is also experiencing large capital inflows). China, by not choosing to sharply<br />
revalue its currency upwards and maintaining a highly competitive currency,<br />
has not only made it exceedingly difficult for the competitiveness <strong>of</strong> our<br />
exports, but has also kept pr<strong>of</strong>itability and investment high in its exporting<br />
industries. So, who is suffering on account <strong>of</strong> this reality? If, when we find<br />
our strategy unsustainable (especially when there are no privatization<br />
proceeds to finance part <strong>of</strong> the trade deficit), we decide to adjust the value<br />
<strong>of</strong> the rupee, some <strong>of</strong> our export markets would have been lost, having been<br />
captured by others, and our re-entry in these markets is bound to be<br />
awkward, if not impossible.
Monetary and Fiscal Policies 51<br />
The responsibility <strong>of</strong> the State Bank is to develop a credible<br />
monetary policy that neither inflates nor deflates the economy. This requires<br />
patient research and handling. Without a credible monetary policy, which<br />
lowers inflationary expectations, we could be supporting a vicious circle <strong>of</strong><br />
exchange depreciation and inflation. In other words, a devaluation <strong>of</strong> the<br />
rupee will also have to be backed by a reasonably tight monetary policy to<br />
deal with a trade deficit/inflation problem.<br />
In general, interest rates move slowly in response to changes in<br />
liquidity. According to the SBP Annual Review <strong>of</strong> the Economy, 2005/6<br />
recent research on transmission lags suggests that monetary tightening<br />
impacts significantly on inflationary pressures over a 28 month period. If<br />
interest rates are to become a policy variable then the government should<br />
become neutral to them. And it will become neutral only if it reduces its<br />
borrowings considerably. This means that the fiscal deficit must come down<br />
for credit markets to function smoothly.<br />
Fiscal Policy<br />
As mentioned above in the introduction, the overall fiscal deficit has<br />
been rising 14 (Figure 2). This expansionary fiscal stance <strong>of</strong> the government,<br />
given weak domestic resource mobilization, has not been consistent with<br />
the SBP’s tight demand management posture and has induced risks through<br />
the stoking <strong>of</strong> inflationary pressures and the stress it brings to bear on<br />
interest rates for managing demand. The degree <strong>of</strong> impact also depends<br />
upon the manner in which the government finances its fiscal deficit - its<br />
present monetization through heavy borrowings from the SBP directly<br />
rather than from the financial system.<br />
14 However, to give the government its due, part <strong>of</strong> the borrowing was prompted by the<br />
expenditure requirements for earthquake relief and rehabilitation operations, which have<br />
contributed just under 1% <strong>of</strong> the GDP to the fiscal deficit
52<br />
Shahid Kardar<br />
9<br />
Fiscal Deficit as a percent <strong>of</strong> GDP<br />
7<br />
percent<br />
5<br />
3<br />
1<br />
1990-91<br />
1991-92<br />
1992-93<br />
1993-94<br />
1994-95<br />
1995-96<br />
1996-97<br />
1997-98<br />
1998-99<br />
1999-00<br />
2000-01<br />
2001-02<br />
2002-03<br />
2003-04<br />
2004-05<br />
2005-06<br />
Figure 2:<br />
In my view there has been an overemphasis on the revenue side <strong>of</strong><br />
the equation and little has been said or examined about the level and<br />
efficiency <strong>of</strong> government expenditures, with good governance associated<br />
with transparency and accountability as the key drivers for improving the<br />
productivity and efficiency <strong>of</strong> government expenditures.<br />
There have been no significant reforms in government spending and<br />
a huge problem lies unaddressed on the expenditure side. It is a big black<br />
hole and a great deal <strong>of</strong> adjustment needs to be made both in terms <strong>of</strong> the<br />
structure and the efficiency <strong>of</strong> public expenditures, particularly with respect<br />
to defence related expenditures; while absorbing a third <strong>of</strong> government<br />
revenues 15 , they are characterized by complete lack <strong>of</strong> transparency (it being<br />
reflected as a single line item in the budget). Despite our nuclear deterrent<br />
and the peace overtures to India there is no let up on defence expenditures.<br />
The current strategy is seemingly adamant that defence policy and its<br />
effectiveness cannot be compromised, whatever the costs. Confronted with<br />
such a hypothesis, it is difficult to have a meaningful debate even when our<br />
distorted priorities have resulted in 6 soldiers per doctor and 1 teacher for<br />
every soldier.<br />
15 The expenditure is higher because military pensions, which are in excess <strong>of</strong> Rs. 30<br />
billion per annum, are under civilian pensions, and expenditure supported by US military<br />
aid <strong>of</strong> more than US $700 million per annum for the fight against terrorism has also not<br />
been factored in.
Monetary and Fiscal Policies 53<br />
The composition <strong>of</strong> public expenditure has also become unbalanced<br />
because <strong>of</strong> inflexible expenditure commitments. Resultantly, much <strong>of</strong> the<br />
fiscal space created by the recent rescheduling and re-pr<strong>of</strong>iling <strong>of</strong> debt has<br />
been absorbed by the rigidities in non-development expenditures –<br />
particularly salaries <strong>of</strong> a bloated civil service with few relevant skills required<br />
to manage a modern economy in a highly globalized world.<br />
This author is <strong>of</strong> the opinion that there is a need to downsize the<br />
government by means <strong>of</strong> its steady withdrawal, especially that <strong>of</strong> the<br />
federal government, from many <strong>of</strong> the functional responsibilities that it<br />
has taken upon itself. The functions so relinquished should either be<br />
organized by the private sector or should be hived <strong>of</strong>f to lower formations<br />
<strong>of</strong> government by reducing the multiplicity <strong>of</strong> agencies engaged in similar<br />
activities. In particular, the government continues to devote a<br />
disproportionate share <strong>of</strong> its resources to activities that would be more<br />
efficiently provided by the private sector. All this, combined with endemic<br />
governance issues, has resulted in accumulated losses <strong>of</strong> public sector<br />
enterprises crossing Rs. 250 billion with an annual addition in excess <strong>of</strong><br />
1% <strong>of</strong> GDP 16 . Although some public sector enterprises and the CBR have<br />
been performing relatively better than other public sector entities, the<br />
woes <strong>of</strong> PIA, WAPDA, Railways, KESC (even after privatization based on<br />
written agreements with the private owner and operator) etc. continue to<br />
dog the contribution <strong>of</strong> the public sector to national savings, which are<br />
adding to the rapid growth in the quasi-fiscal deficit. In other words,<br />
there are hidden deficits because <strong>of</strong> losses <strong>of</strong> public sector enterprises that<br />
have not been accounted for in the fiscal deficit. Such “creative<br />
accounting” has resulted in lower fiscal deficits. The fiscal deficit would<br />
also be higher if the desirable amounts <strong>of</strong> funding were to be made<br />
available for improving service delivery in the social sectors.<br />
Another persistent issue concerns the low efficiency <strong>of</strong> public sector<br />
expenditures in terms <strong>of</strong> the higher costs per unit <strong>of</strong> public sector<br />
construction projects because <strong>of</strong> corruption, poor competence <strong>of</strong> the<br />
government and other leakages. There is evidence that it would cost the<br />
government at least 50% less to fund schooling through privately managed<br />
institutions (and that too <strong>of</strong> better quality) instead <strong>of</strong> delivering education<br />
through the publicly run schools. 17<br />
16 These are estimates obtained from various reliable sources since the government does<br />
not report the financial results <strong>of</strong> public sector corporations regularly reflecting poorly on<br />
its claims <strong>of</strong> transparency.<br />
17 The Punjab Education Foundation is funding private schools by providing Rs.300 per<br />
child enrolled (compared with more than Rs. 450 per child per month that it costs the
54<br />
Shahid Kardar<br />
To check the growth in the fiscal deficit and the level <strong>of</strong> debt, the<br />
GoP has adopted legal ceilings (as a percentage <strong>of</strong> GDP) for advances to the<br />
government through the Fiscal Responsibility and Debt Limitation Act.<br />
However, the legislation aimed at reducing the fiscal deficit has several<br />
weaknesses. Some <strong>of</strong> these are discussed below.<br />
Whereas it proposes to pare the deficit on the revenue account, such<br />
a reduction and the lowering <strong>of</strong> the debt to GDP ratio could be achieved by<br />
different compositions <strong>of</strong> budgetary expenditures with sharply different<br />
outcomes. For instance, the same level <strong>of</strong> revenue deficit can be realized by<br />
cutting back much needed expenditure on the repairs and maintenance <strong>of</strong><br />
installed infrastructure (as is happening in Sindh which claims that its<br />
overdraft with the State Bank has turned into a positive cash balance). This<br />
lowering <strong>of</strong> expenditure, and the resulting deferred maintenance, would<br />
eventually get reflected as development projects in future years- a strategy<br />
that successive governments have been guilty <strong>of</strong> adopting in the past. Such<br />
an outcome, obviously, cannot be the objective <strong>of</strong> the proposed enactment.<br />
While the government has been able to lower the debt to GDP ratio<br />
to 60%, a target set for 2013 under the Fiscal Responsibility Act, and has<br />
also succeeded in sharply bringing down the ratio <strong>of</strong> interest payments to<br />
GDP from 6.9% in FY00 to just over 3% in FY06, the reduction can be<br />
achieved by the government cutting back on priority investment<br />
expenditures and on social safety nets (as is the case today, being barely<br />
0.3% <strong>of</strong> the GDP) rather than raise taxes or rationalize user charges (as has<br />
been happening in recent years), with all its implications for economic<br />
activity in general. There would be little economic justification for<br />
restructuring government investment that could have a high social return,<br />
since there are externalities <strong>of</strong> some investments that need not contribute<br />
directly to government revenues.<br />
Furthermore, although the stock <strong>of</strong> debt to GDP ratio has fallen<br />
dramatically, the debt pr<strong>of</strong>ile has not improved to the extent that it should<br />
have, given that the financial system was flushed with funds, suggesting that<br />
the Federal Government has managed its debt poorly. When it could have<br />
borrowed long at low interest rates, for a while it stopped issuing 7 to 10<br />
year Pakistan Investment Bonds. It chose instead to <strong>of</strong>fload 6 month T-bills<br />
at 2% or so when inflation had begun to climb and there was every sign<br />
that the interest rate structure would change and rates would rise sharply.<br />
government to educate a child in a government run institution) and running half-yearly<br />
quality assurance tests to ensure that assisted schools are providing a minimum<br />
acceptable level <strong>of</strong> education in terms <strong>of</strong> student learning outcomes.
Monetary and Fiscal Policies 55<br />
This flawed strategy cost the government and the tax payers dearly as the<br />
debt pr<strong>of</strong>ile became skewed in favor <strong>of</strong> short-term debt. The opportunity<br />
cost <strong>of</strong> this poor financial management has been massive – it could be as<br />
much as Rs.100 billion over the next 10 years. While the government<br />
would, and should, have raised more long-term relatively cheap debt, it took<br />
the bizarre decision to discontinue issuing bonds <strong>of</strong> longer term maturities<br />
and relied more on short-term bonds 18 .<br />
Moreover, there is also a need to distinguish between the structural<br />
and cyclical components <strong>of</strong> the deficit, a need to improve the cost<br />
effectiveness <strong>of</strong> government expenditures and to raise the tax to GDP ratio<br />
over time. Without a stipulation separating the structural from the cyclical<br />
components <strong>of</strong> a deficit, the present government would not have been able<br />
to undertake the kind <strong>of</strong> capital restructuring <strong>of</strong> KESC, WAPDA and PIA<br />
that have been, or will be, forced upon it, which, in the past pushed the<br />
fiscal deficit beyond the targeted level.<br />
Treasury bills and other government bonds held by the State Bank<br />
essentially serve the purposes <strong>of</strong> a monetary policy. This holding may<br />
increase or decrease based on open market operations conducted by the<br />
SBP 19 . Since one <strong>of</strong> the implicit aims <strong>of</strong> the proposed legislation is to<br />
grant greater independence to the SBP to conduct its monetary policy,<br />
then the SBP’s holdings <strong>of</strong> such government securities should be excluded<br />
from the purview <strong>of</strong> this legislation. This is because these bonds would<br />
not, in the true sense <strong>of</strong> the term, constitute a part <strong>of</strong> the government’s<br />
debt, since the SBP is in itself a part <strong>of</strong> the government and if a<br />
consolidated balance sheet were to be prepared, this debt would be<br />
cancelled as a contra item. This writer would, therefore, propose that, in<br />
keeping with the spirit <strong>of</strong> the Act, only that part <strong>of</strong> government debt held<br />
by households, companies, and financial intermediaries/institutions should<br />
be regarded as public debt, since the servicing <strong>of</strong> only this debt would<br />
generate a flow <strong>of</strong> funds (in the form <strong>of</strong> payments) from the government<br />
to the private sector <strong>of</strong> the economy.<br />
Revenue Mobilization and Taxation Structure<br />
18 As a result <strong>of</strong> poor monetary and debt management a huge opportunity has also been<br />
lost to develop a market for low cost housing finance, hitting the less affluent segments<br />
<strong>of</strong> society, already suffering from the ravages <strong>of</strong> inflation, even more.<br />
19 Ideally this legislation should also prevent the government (on the basis <strong>of</strong> a phased<br />
program) from accessing the SBP for financing. Under the latter arrangement, the SBP<br />
would only function as an agent <strong>of</strong> the government in financial markets.
56<br />
Shahid Kardar<br />
Largely owing to the recent rebasing <strong>of</strong> Pakistan’s national income,<br />
the inclusion <strong>of</strong> new sectors to reflect the changing structure <strong>of</strong> the<br />
economy and the revision in the contribution <strong>of</strong> some sectors to this<br />
emerging pattern, Pakistan’s revenue performance now seems to be out <strong>of</strong><br />
line with the tax efforts <strong>of</strong> other countries with similar per capita GDPs. An<br />
IMF cross-country comparison shows that:<br />
a) Pakistan’s revenues from taxation are still hovering at under 11% <strong>of</strong><br />
GDP (Figure 3), the lowest among regional countries, being at least<br />
2 percentage points lower than the average for its South Asian<br />
counterparts Bangladesh, India, Nepal and Sri Lanka; and<br />
b) The tax to GDP ratios <strong>of</strong> other comparator economies (such as<br />
Bolivia, Egypt, Indonesia, etc.) is 7 to 8 percentage points higher.<br />
11.5<br />
Total Tax as a percent <strong>of</strong> GDP<br />
11.4<br />
11.0<br />
10.9<br />
10.8 10.8<br />
10.6 10.6<br />
10.8<br />
10.8<br />
10.7<br />
10.5<br />
10.0<br />
10.0<br />
9.5<br />
9.0<br />
1996-97<br />
1997-98<br />
1998-99<br />
1999-00<br />
2000-01<br />
2001-02<br />
2002-03<br />
2003-04<br />
2004-05<br />
2005-06<br />
Figure 3:<br />
A positive feature has been the reduced reliance on revenues from<br />
the taxation <strong>of</strong> foreign trade. However, since customs duty reductions to<br />
improve efficiency in production and trade were introduced at a rate faster<br />
than the corresponding reforms in GST and direct income tax, there was a<br />
loss <strong>of</strong> revenues as increased revenue from reforms in GST and direct taxes<br />
did not materialize at the projected pace. Resultantly, so far we have a<br />
narrow and concentrated tax base, almost half <strong>of</strong> the tax revenues are<br />
contributed by imports, and domestic taxes to GDP ratio continue to be<br />
below 5%. Even in the latter case just 6 items, particularly<br />
telecommunications, fuel and energy, motor vehicles and iron and steel,<br />
account for more than half <strong>of</strong> indirect tax collection.
Monetary and Fiscal Policies 57<br />
While tax revenues have increased sharply in rupee terms in recent<br />
years, this growth has barely kept pace with the growth in the economy.<br />
The tax to GDP ratio has remained flat, if not having declined, partly<br />
because <strong>of</strong> continued tax reliefs (e.g <strong>of</strong> agriculture from income tax and <strong>of</strong><br />
freight and services such as railway fares, pr<strong>of</strong>essionals - lawyers, doctors,<br />
accountants, architects, engineers and tax and other consultants - from<br />
GST) and additional exemptions. The buoyancy in tax revenues has been<br />
substandard 20 , reflecting on the tax structure riddled with exemptions and<br />
administrative weaknesses in the collection machinery and compliance<br />
systems and procedures- the latter partly owing to express government<br />
policy to reduce the cost <strong>of</strong> doing business. In my opinion, the<br />
mobilization <strong>of</strong> tax revenues is also difficult because <strong>of</strong> the lack <strong>of</strong> faith <strong>of</strong><br />
people that the government will honor its social contract to deliver basic<br />
services and utilize resources judiciously and prudently following generally<br />
accepted principles <strong>of</strong> propriety (as should be expected from a trustee <strong>of</strong><br />
public funds) and not used to finance luxuries and junkets <strong>of</strong> the rulers<br />
and their cronies.<br />
However, despite the narrow base, one key factor underlying the<br />
high cost <strong>of</strong> doing business in Pakistan is the system <strong>of</strong> taxes. Not only is<br />
the system characterized by both multiple taxation and agencies (e.g. GST<br />
on Services, pr<strong>of</strong>essional tax by provinces and pr<strong>of</strong>essional fees by district<br />
governments) and high rates <strong>of</strong> corporate and, until recently, personal<br />
income taxes, taxpayers have to contend with complex rules, procedures and<br />
mechanisms employed to implement tax policies, although much has<br />
improved since the institution <strong>of</strong> the new tax laws and the introduction <strong>of</strong> a<br />
universal self-assessment scheme.<br />
As mentioned above, although we have a lower tax to GDP ratio,<br />
our income tax rates are, at 35%, higher than those <strong>of</strong> comparator countries<br />
and some OECD and ASEAN countries- where they range from 20% to 30%<br />
(although personal income tax rates are higher in Europe), indicating the<br />
need to broaden the narrow tax base by eliminating exemptions, lowering<br />
some <strong>of</strong> the tax rates and related charges (e.g. commercialization rates) and<br />
revising the tariff structures, and ensuring better documentation <strong>of</strong><br />
transactions and improving administrative efficiencies. As illustrations <strong>of</strong><br />
tariff structure revisions, we need to withdraw the exemption for capital<br />
gains on the trading <strong>of</strong> shares <strong>of</strong> listed companies 21 , extend the scope <strong>of</strong><br />
20 According to the SBP, although the tax buoyancy has improved from 0.8% in FY05 to<br />
1.2% in FY06 it is still low compared with the average <strong>of</strong> 1.33% for other economies in<br />
the region.<br />
21 Just in the last 2 years, the stock market index has jumped from around 6,000 to over<br />
11,000 this month (April/May 2007) with market capitalization shooting up from Rs.1.7
58<br />
Shahid Kardar<br />
GST on services 22 , make rental income taxable in the same way as income<br />
from other sources 23 , consider taxing gifts and introducing an inheritance<br />
tax and lowering the high import tariffs to protect the assemblers <strong>of</strong> motor<br />
cars and motorcycles which results in these enterprises collecting, as<br />
corporate pr<strong>of</strong>its, what would have been tax revenues.<br />
Moreover, countries with tax to GDP ratios <strong>of</strong> 20% and above,<br />
unlike Pakistan, run and manage social welfare systems for their populations;<br />
the mismatch is stark in the visible returns that developed societies and<br />
citizens obtain from the state on the taxes they pay.<br />
Thirdly is the issue <strong>of</strong> multiple taxes, which raises the effective rate<br />
<strong>of</strong> tax even further. For instance, the manufacturing sector pays an<br />
additional 5% tax on pr<strong>of</strong>it as a contribution to the Workers Pr<strong>of</strong>it<br />
Participation Fund, a 2% tax on account <strong>of</strong> Workers Welfare Fund, a 5%<br />
levy on the wage bill for EOBI, a 7% levy for social security, one month’s<br />
salary as bonus for workers, excise duty (in the case <strong>of</strong> some industries), an<br />
Education Cess <strong>of</strong> Rs.100 per worker, a provincial pr<strong>of</strong>essional tax and a<br />
district government pr<strong>of</strong>essional fee over and above the GST on its<br />
products/services.<br />
Furthermore, bonus shares/stock dividends and realized capital gains<br />
from trading in shares, debt instruments and property related transactions<br />
(unless these represent business income) continue to be exempt from tax,<br />
discouraging investment in the productive and real sectors all <strong>of</strong> which are<br />
taxable. This discriminatory fiscal treatment creates distortions by<br />
introducing a bias in favor <strong>of</strong> investment in certain instruments and sectors.<br />
Therefore, the existing structure should be replaced with one that<br />
has lower rates - at most 30% for the corporate sector - but with very few<br />
trillion to Rs.3 trillion indicating that a capital gain <strong>of</strong> more than a trillion rupees<br />
accruing to holders <strong>of</strong> listed shares escaped taxation because <strong>of</strong> a specific tax exemption<br />
for capital gains arising from trading in listed securities.<br />
22 Under the Constitution, the GST on Services is a provincial subject and the Federal<br />
Government is reluctant to extend the scope <strong>of</strong> this tax to include in its ambit powerful<br />
lobbies like lawyers and other pr<strong>of</strong>essionals and take political flak for no return, as the<br />
entire proceeds, except for a 2% percent collection charge would go to the provinces. To<br />
improve the incentive for the Federal Government to levy this tax which could contribute<br />
significantly to revenues (since services now have the largest share in the GDP) it is time<br />
to amend the Constitution accordingly so that the GST on Services becomes a part <strong>of</strong> the<br />
divisible pool to be shared in the same ratio as other taxes under the NFC Award.<br />
23 A withholding tax at 5% represents full and final settlement <strong>of</strong> the tax liability from<br />
rental income instead <strong>of</strong> it being treated as a tax credit in determining the gross taxable<br />
income and accordingly the tax liability <strong>of</strong> the taxpayer.
Monetary and Fiscal Policies 59<br />
exceptions (to check discretion), remembering that the principle <strong>of</strong><br />
horizontal equity is violated through both exemptions and defective<br />
definitions <strong>of</strong> ‘taxable income’. To this end, therefore, the personal income<br />
tax structure can be further simplified by having just a handful <strong>of</strong> rates<br />
(ideally just two as proposed by the Kelkar Commission in India) to<br />
minimize the impact <strong>of</strong> ‘bracket creep’ as tax payers enter higher marginal<br />
tax brackets because <strong>of</strong> the inflationary increase in incomes (unless the tax<br />
slabs are also indexed). The structure should link the progression in tax<br />
rates with the standard exemption limit <strong>of</strong> income, which should be fixed at<br />
a level that would ensure a balance being struck between revenue<br />
considerations and the capability <strong>of</strong> the administrative machinery to exploit<br />
the full potential <strong>of</strong> the revenue base. Personal income tax should,<br />
therefore, be built around at most three rates (compared with more than 15<br />
slabs today) with a higher exemption threshold, while ensuring that all<br />
realized capital gains and receipts as wages and salaries, benefits in kind<br />
(perquisites), interests, dividends, income from agricultural activities and<br />
rent earned on property form part <strong>of</strong> the base to be taxed.<br />
In the budget for this year (FY07), the rates <strong>of</strong> income tax were<br />
reduced after the inclusion <strong>of</strong> perquisites in calculating taxable income.<br />
While it was a step in the right direction, the main beneficiaries are again<br />
the higher paid executives. Their tax liabilities have actually declined<br />
substantially, by as much as 23%, from the tax reliefs announced, since<br />
under the existing tax regime limits on the tax exemptions on salary related<br />
allowances were already operational and hence being taxed.<br />
There is also a need for more effective audit systems rather than<br />
dependence on voluntary compliance, in view <strong>of</strong> the high degree <strong>of</strong> tax<br />
evasion, corruption and filing <strong>of</strong> fake claims for GST refunds in the country.<br />
Through taxation, the state reduces the spending capacity <strong>of</strong> its<br />
citizens. Therefore, any effort to raise tax revenues evokes criticism and<br />
protest, even resistance. What is less important is the inherent merit <strong>of</strong> any<br />
proposal. It is its voter, and media, acceptability which carries more weight,<br />
since tax reform cannot benefit all citizens. The more vocal the losers the<br />
less likely will it be for a proposal to be accepted unless the overall package<br />
distributes the burden fairly and equitably. The government has lost much<br />
<strong>of</strong> the moral high ground for simplifying the system because <strong>of</strong> its failure to<br />
understand the imperatives <strong>of</strong> the political economy <strong>of</strong> tax reform. A good<br />
example <strong>of</strong> the weakness in the strategy is the decision to continue to treat<br />
government employees as a special group. The tax exemption that they<br />
continue to enjoy on their allowances results in the loss <strong>of</strong> moral legitimacy<br />
<strong>of</strong> the underlying conceptual framework to correct the distortions and the
60<br />
Shahid Kardar<br />
potential for abuse (their perquisites being exempted from tax on the plea<br />
that their salaries were not market driven). This matter should either be<br />
treated separately or the decision not to tax the perquisites <strong>of</strong> government<br />
employees should be explained in a more transparent manner. A better<br />
policy would be to monetize the entitlement <strong>of</strong> government employees to<br />
perquisites and benefits.<br />
Since the rules for allowing tax deductions for certain expenses are<br />
much more stringent when it comes to salary incomes than for incomes<br />
from other sources, especially with regard to verification issues, a better<br />
alternative is to raise the standard/threshold income to be exempted from<br />
taxation. There is also a desperate need to bring some conceptual clarity<br />
between the deductions or exemptions that would be allowed for reasons <strong>of</strong><br />
horizontal equity or would be treated as critical components <strong>of</strong> an incentive<br />
framework. An example <strong>of</strong> the latter case would be the deduction for<br />
medical insurance or medical treatment. These contributions should<br />
continue to be allowed since it is a cost <strong>of</strong> being healthy and fit so as to be<br />
able to earn – i.e., a cost to earn or to maintain human capital. Medical<br />
expenses are permitted up to certain specified limits in Italy, Japan,<br />
Netherlands, USA and Malaysia.<br />
Moreover, much more needs to be done to enhance transparency<br />
and reduce taxpayer compliance costs by making judgments <strong>of</strong> income tax<br />
tribunals and higher courts more freely available on the internet, thereby<br />
reducing the role <strong>of</strong> the intermediaries, tax practitioners, who charge clients<br />
for what should be public information.<br />
Moving on to another major revenue instrument, the customs/<br />
import tariff, its structure remains complex and unwieldy even after several<br />
efforts to reform it since 1991. In almost every chapter there are multiple<br />
rates, several exemptions and several conditions and lists spread over<br />
hundred <strong>of</strong> pages <strong>of</strong> the book on tariff code/customs valuation. Then there<br />
are sector-specific or use-based exemptions, for which to avail <strong>of</strong>, necessitate<br />
queries <strong>of</strong> appraisers for literature and certificates, thereby not just<br />
providing an opportunity for exercising discretion but also slowing down the<br />
clearance <strong>of</strong> goods.<br />
On the face <strong>of</strong> it, the division <strong>of</strong> all goods into three categories (raw<br />
materials, intermediate and finished goods) that has been made for<br />
developing the customs tariff looks good in theory. It is, however, difficult<br />
to implement in practice. The concept that raw materials should be liable<br />
for a lower rate is impossible to implement practically since a large<br />
proportion <strong>of</strong> goods, e.g., chemicals, are both finished goods as well as raw
Monetary and Fiscal Policies 61<br />
materials. A similar problem arises when it comes to identifying<br />
intermediate goods that supposedly attract a lower rate than finished goods.<br />
In addition to the problem <strong>of</strong> dual use, it is also difficult to draw a line<br />
between the final, finished, consumer good and its sub-assemblies. A better<br />
alternative would be One – Chapter One – rate that would address<br />
considerations <strong>of</strong> revenue, the need for giving only reasonable protection 24<br />
to domestic industry and the need for simplification.<br />
A few easily identifiable consumer goods such as air conditioners,<br />
expensive motor car brands, tobacco, liquor, generally viewed as goods for<br />
conspicuous consumption, could also be identified separately and made<br />
liable for a higher rate.<br />
The import duty exemptions should be phased out quickly. Unless<br />
exemptions are withdrawn it will be difficult to achieve the objectives <strong>of</strong><br />
simplification and the speedy clearance <strong>of</strong> imports. Only life-saving goods,<br />
goods <strong>of</strong> strategic interest and security or those for charitable purposes or<br />
those satisfying international obligations should be exempt from import<br />
duties. Otherwise, relief should be granted as a support through a budgetary<br />
allocation. This will have the added advantage <strong>of</strong> being transparent, being<br />
open and subject to parliamentary and public scrutiny. However, the free<br />
flow <strong>of</strong> goods should be permitted, with a focus on intelligence gathering<br />
and valuation checks to deter import duty evasion.<br />
Finally, lest we forget, a computerized system <strong>of</strong> customs valuation<br />
can be user-friendly only when the tariff is computer-friendly. Automation<br />
alone cannot improve matters unless the tariff structures are decongested <strong>of</strong><br />
numerous exemptions, conditions and lists.<br />
Admittedly however, the reality is that there are no quick fixes.<br />
Exercises to simplify tax laws and ensure effective enforcement can take<br />
several years, as the experience <strong>of</strong> even developed countries shows – for<br />
instance, it took Canada 10 years to implement the proposals <strong>of</strong> the Carter<br />
Commission.<br />
Conclusions<br />
The primary objective <strong>of</strong> the State Bank should be the maintenance<br />
<strong>of</strong> price stability as a major policy contribution to sustained economic<br />
growth. Hence, tighter monetary and fiscal policies (especially since the<br />
24 Rather than the high levels <strong>of</strong> protection provided to assemblers <strong>of</strong> motorcycles and<br />
motor cars that enable them to pocket, as private pr<strong>of</strong>its, what would have been tax<br />
revenues from a more rational import tariff structure.
62<br />
Shahid Kardar<br />
primary surplus <strong>of</strong> 1.7% <strong>of</strong> GDP in FY04 has become a deficit <strong>of</strong> around<br />
0.5% <strong>of</strong> GDP in FY06) will be required over the medium-term. However,<br />
the domestic and external debt situation, despite the high debt to revenue<br />
and debt to export ratios (essentially because <strong>of</strong> low revenues and exports),<br />
will remain favorable, as will the interest rate and exchange rate risk (again<br />
despite the rupee being overvalued, by 10% according to the IMF and<br />
around 18% by the World Bank compared with the <strong>of</strong>ficial admission <strong>of</strong> a<br />
misalignment by only 2-4%). The State Bank should clearly spell out its<br />
monetary policy and related objectives today to achieve its inflation target <strong>of</strong><br />
around 5% over the next 8-12 months.<br />
There is a need to not only to raise public savings through higher<br />
revenues and better expenditure control, there is also a need to diversify<br />
sources <strong>of</strong> borrowing, in particular, as argued above, to improve the mix <strong>of</strong><br />
short-term and long-term borrowings. Moreover, unfortunately even when it<br />
decided to resort to long-term non-bank borrowings, the government chose<br />
to do so through NSS instruments by allowing institutional investors to opt<br />
for NSS, reversing an earlier decision that had closed this option for them.<br />
This has adversely affected the development <strong>of</strong> a capital market for longterm<br />
debt, critically required to evolve a robust housing finance system and<br />
draw private sector investment into long gestation infrastructure projects.<br />
In conclusion I would like to emphasize that apart from<br />
macroeconomic stability, governance mechanisms, institutions and the<br />
institutional environment such as the rule <strong>of</strong> law, societal norms and values,<br />
work ethics, enforcement and related costs <strong>of</strong> property and contractual<br />
rights are important for facilitating economic growth and influencing<br />
economic efficiency.<br />
Ratio to GDP FY02 FY06<br />
Investment 16.8% 20%<br />
National savings 18.6% 16.1%<br />
Domestic Savings 17.0% 14.7%
Monetary and Fiscal Policies 63<br />
Tax Revenues 10.9 10.5<br />
Total Revenues 14.2 14<br />
Expenditure 18.5 18.2<br />
Development Expenditure 2.9 4.2<br />
Current Expenditure 15.9 13.6<br />
Overall Deficit 4.3 4.2<br />
Growth % FY02 FY03 FY04 FY05 FY06<br />
Monetary (M2) 15.4 18.0 19.6 19.3 15.2<br />
Private Credit 4.8 18.9 29.8 34.4 23.5<br />
Sources: IMF, December 2006 and State Bank Annual Report, 2005/06<br />
30<br />
Growth in Money Supply and Domestic Credit<br />
25<br />
20<br />
15<br />
10<br />
5<br />
0<br />
-5<br />
1996-97<br />
1997-98<br />
1998-99<br />
1999-00<br />
2000-01<br />
2001-02<br />
2002-03<br />
2003-04<br />
2004-05<br />
2005-06<br />
MSG<br />
DCG
64<br />
Shahid Kardar<br />
5.5<br />
5.0<br />
Total Revenue as percent <strong>of</strong> GDP<br />
4.8<br />
4.9<br />
4.5<br />
4.0<br />
4.1 4.1<br />
4.0<br />
3.4<br />
3.5<br />
3.1<br />
3.2<br />
3.0<br />
13.0<br />
3.0<br />
2.5<br />
2.0<br />
1.5<br />
996-97 997-98 998-99 999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06
Monetary and Fiscal Policies 65<br />
References<br />
Feldstein, M, 1997. “The Cost and Benefits <strong>of</strong> Going from Low Inflation to<br />
Price Stability,” National Bureau <strong>of</strong> Economic Research paper 5469.<br />
Goldstein, M., 1995. “Acquiring and Maintaining Credibility for Low<br />
inflation, The US Experience”, in L. Leiderman and Lars Svenensson<br />
(ed.) “Inflation Targets”, Centre for Economic Policy Research,<br />
London.<br />
Khan, Mohsin and Schimmelpfennig, Alex, 2006. Pakistan Development<br />
Review, 45(2): 185-202.<br />
Mishkin, F., 1997. “Strategies for Controlling Inflation,” in P. Lowe (ed.),<br />
“Monetary Policy Inflation Targeting,” Proceedings <strong>of</strong> a Conference,<br />
Reserve Bank <strong>of</strong> Australia, Sydney.<br />
Qayyum, Abdul, 2006. “Money, Inflation and Growth in Pakistan,” Pakistan<br />
Development Review, 45(2): 203-212.<br />
State Bank <strong>of</strong> Pakistan, 2006. State Bank Annual Report, 2005/06.
The <strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong><br />
<strong>Special</strong> <strong>Edition</strong> (September 2007)<br />
Pakistan Financial System - The Post-Reform Era<br />
Maintaining Stability and Growth<br />
Shakil Faruqi *<br />
Abstract<br />
The financial system <strong>of</strong> Pakistan has undergone a sea-change owing<br />
to reforms which were implemented over a period <strong>of</strong> a decade and a half,<br />
1992-2006. The financial system has moved towards promoting the<br />
efficiency <strong>of</strong> financial intermediation while maintaining stability and<br />
fostering growth <strong>of</strong> the economy. Financial repression <strong>of</strong> the previous<br />
decades has receded though it has not been eliminated. Now a shift is<br />
warranted for the reform and restructuring <strong>of</strong> sectoral or sub-sectoral finance<br />
which has to be activity based, not institution based. Pakistan’s financial<br />
system has entered the post-reform era with all its potentials, complexities<br />
and challenges. How well the financial system performs in this era depends<br />
on how sustainable the financial regime is and how resilient it is in coping<br />
with change and financial shocks, both domestic and global.<br />
I. Leading Concerns<br />
The financial system <strong>of</strong> Pakistan has undergone a sea-change owing<br />
to reforms that were initiated in the early 1990s rather gingerly, but<br />
subsequently gathered momentum, culminating in accelerated change in the<br />
structure <strong>of</strong> the financial system and a revamping <strong>of</strong> the policy and incentive<br />
regime that governed its operations. The reform era lasted for nearly a<br />
decade and a half, 1992-2006. A great deal has been accomplished during<br />
this period as summarized in this paper. There has been a paradigm shift in<br />
the financial policy regime that prevailed prior to the reform era and also<br />
during the early 1990s. These achievements have occurred amidst powerful<br />
economic and financial constraints that have persisted for many years and<br />
unprecedented events that have occurred in-between, both domestic and<br />
foreign. The financial system has moved towards promoting the efficiency <strong>of</strong><br />
financial intermediation while maintaining stability and fostering growth <strong>of</strong><br />
the economy. It is an enviable record <strong>of</strong> accomplishments by any standard.<br />
* Pr<strong>of</strong>essor, The <strong>Lahore</strong> <strong>School</strong> <strong>of</strong> <strong>Economics</strong>, <strong>Lahore</strong>.
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Currently, the financial system in its structure, functions and policy<br />
regime that governs it is drastically different from what it was a decade ago.<br />
With deregulation <strong>of</strong> the financial regime, financial repression <strong>of</strong> the<br />
previous decades has receded though it has not been eliminated. Purely<br />
solvency concerns that dominated much <strong>of</strong> the 1990s have yielded to<br />
concerns <strong>of</strong> efficiency <strong>of</strong> financial intermediation and stability <strong>of</strong> the<br />
financial system in the background <strong>of</strong> a structural shift as well as operational<br />
shift discussed below.<br />
A Shift <strong>of</strong> Focus<br />
In this sense, the task <strong>of</strong> macro financial reforms is over, almost, but<br />
the task <strong>of</strong> financial system development is not over and this phase will be no<br />
less demanding than the previous phase. Therefore, now a shift is warranted<br />
to reforms and restructuring <strong>of</strong> sectoral or sub-sectoral finance which has to<br />
be activity based not institution based. Front line reforms have been the<br />
centre <strong>of</strong> attention <strong>of</strong> policy makers in the past. The focus now has to be on<br />
financial system development under the reformed policy regime and new rules<br />
<strong>of</strong> the game in an environment vastly different from what prevailed before.<br />
This shift in focus is also needed because Pakistan’s financial system has<br />
entered the post-reform era with all its potentials, complexities and<br />
challenges. How well the financial system performs in this era depends on how<br />
sustainable the financial regime is and how resilient it is in coping with<br />
change and financial shocks, both domestic and global; and how good and<br />
forward looking is the management <strong>of</strong> the financial system.<br />
There are two powerful implications concerning the functions and the<br />
operations <strong>of</strong> the financial system. One has to do with the efficiency <strong>of</strong><br />
transfer <strong>of</strong> financial resources between suppliers and users within the<br />
economy. How well this transfer occurs and on what terms and how efficiently<br />
it is performed by the financial system is <strong>of</strong> immense significance to everyone,<br />
be they households, large corporate or small and medium size businesses, or<br />
the government and its entities. The second set <strong>of</strong> implications concern a<br />
distorted distribution <strong>of</strong> resources between various segments <strong>of</strong> the society<br />
resulting from the operations <strong>of</strong> the financial system, thereby aggravating<br />
income distribution patterns that are already stacked against the poorer<br />
segments <strong>of</strong> the society. The mechanisms <strong>of</strong> resource transfer by themselves<br />
are not neutral to the social implications <strong>of</strong> the transfer.<br />
Challenges in the Post Reform Era – Stability and Solvency<br />
In managing the financial system during the post-reform era, the<br />
main challenge will be that <strong>of</strong> maintaining stability and sustaining high
The Post-Reform Era Maintaining Stability and Growth 69<br />
levels <strong>of</strong> economic growth both over the short run and the long run and<br />
sustaining solvency. Short term stability is to be interpreted rather broadly<br />
to mean both financial system stability as well as economic stability though<br />
both are intrinsically intertwined. Financial system stability encompasses a<br />
viable, market-based interest rate structure free <strong>of</strong> volatile movements,<br />
strength and resilience <strong>of</strong> financial institutions to withstand market swings<br />
and external shocks, and stable financial markets free <strong>of</strong> asset bubbles and<br />
gyrations in share prices. Economic stability is largely interpreted as price<br />
stability with acceptable levels <strong>of</strong> inflation, in addition to interest rate and<br />
exchange rate stability. It is difficult to argue which one <strong>of</strong> these is more<br />
important and peg the sequencing <strong>of</strong> corrective actions, though clearly it is<br />
difficult to think <strong>of</strong> economic stability in the face <strong>of</strong> unstable money and<br />
capital markets, or in the face <strong>of</strong> widespread distress among financial<br />
institutions, or both.<br />
Generally, stability <strong>of</strong> the financial system is largely understood as<br />
stability <strong>of</strong> the banking system only, and seldom does it cross over to concerns<br />
<strong>of</strong> stability <strong>of</strong> financial markets. Perhaps one <strong>of</strong> the reasons is that while<br />
something can be done to maintain stability <strong>of</strong> the banking system, and to<br />
some extent stability <strong>of</strong> money and short term debt markets, hardly anything<br />
can be done to ensure that capital markets remain stable beyond creating the<br />
necessary conditions with routine monetary management, if that.<br />
This is true <strong>of</strong> nearly all countries across the spectrum, not just<br />
developing countries. Monetary authorities find themselves saddled with<br />
their mainline responsibilities, and stay away from encroaching upon the<br />
operations <strong>of</strong> capital markets, known to be notoriously fickle and having a<br />
mind-set <strong>of</strong> their own. Further, with all the information flow, their<br />
analytical and predictive capabilities, computing prowess for risk and<br />
returns, sophisticated derivatives and hedge instruments, capital market<br />
participants everywhere find themselves upstaged time and again with large<br />
equity price corrections, exploding bubbles, and massive portfolio value<br />
losses. They have yet to discover ways to simply foresee market trends,<br />
much less devise ways to ensure stability.<br />
The comparative experience demonstrates that in the post-reform<br />
era, among newly opened and liberalized financial systems with enhanced<br />
exposure to market-based forces, both domestic and foreign, sooner or later<br />
both the banking system and financial markets have faced the onset <strong>of</strong><br />
instabilities that eventually degenerated into financial crises with a rapidity<br />
and severity that surprised everyone. The history <strong>of</strong> the past three decades<br />
<strong>of</strong> the post-reform era among many developing countries that have gone<br />
through reform processes, is replete with banking crises or foreign liquidity
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crises, or both. The resolution costs <strong>of</strong> these crises have been<br />
unprecedented in the annals <strong>of</strong> financial systems. However, this is not to<br />
suggest that Pakistan’s financial system is ripe for a similar crisis.<br />
Are Reforms Reversible?<br />
Ordinarily, this would be a moot question, but in the light <strong>of</strong><br />
historical processes, one can not be so sure. It is possible though unlikely. It<br />
is possible because there is a history <strong>of</strong> system reversals and grand reversals<br />
<strong>of</strong> unprecedented scale in Pakistan. In the 1970s, the government was<br />
nationalizing financial institutions including the State Bank <strong>of</strong> Pakistan<br />
(SBP), and ruthlessly rooting out every vestige <strong>of</strong> private corporation down<br />
to puny rice husking and cotton ginning shacks in remote rural areas in the<br />
name <strong>of</strong> socialism. Nearly three decades later, private corporations are being<br />
lionized and now the expectation is that they will conduct their business as<br />
per international norms <strong>of</strong> transparency and corporate governance. There<br />
remains a sense <strong>of</strong> uncertainty with investment and business decisions and<br />
there is not much commitment to enduring change.<br />
Reversal is unlikely and does not seem to be in the cards given what<br />
has transpired and what has been accomplished thus far. It is difficult to<br />
think <strong>of</strong> a return to state intervention and ownership; control and allocation<br />
<strong>of</strong> financial resources that held sway up until the end <strong>of</strong> 1990s; or that the<br />
openness <strong>of</strong> foreign finance with increasing global linkages will be<br />
smothered; or that the structure and apparatus <strong>of</strong> market-based finance<br />
together with a regulatory and supervisory framework and its infrastructure<br />
created with such great efforts, will all be bundled up. Yet, an ominous<br />
development is the transplanting <strong>of</strong> centuries old and obsolete modes <strong>of</strong><br />
finance, reminiscent <strong>of</strong> barter trade, amidst a modernized system <strong>of</strong> finance<br />
and heralding this as progress. Only time well tell.<br />
II. Banking System and NBFIs--Evolving Structure in the Post Reform Era<br />
There have been significant structural changes at the system level in<br />
ownership, organization and operations <strong>of</strong> the banking system and Non-<br />
Bank Financial Institutions (NBFIs) such that the current system hardly bears<br />
resemblance to what it was nearly a decade ago. This happened primarily<br />
due to deregulation and restructuring not only <strong>of</strong> the financial system but<br />
also <strong>of</strong> the leading sectors <strong>of</strong> the economy, restructuring <strong>of</strong> public sector<br />
enterprises (PSEs), the rationalization <strong>of</strong> prices, interest rates and the<br />
exchange rate, and opening up <strong>of</strong> foreign trade and capital accounts.
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At the system level, changes in the structure <strong>of</strong> the financial system<br />
occurred mainly due to the privatization <strong>of</strong> financial institutions as reflected<br />
in the asset holdings <strong>of</strong> the public and private sectors over the CY90-05<br />
period; the entry <strong>of</strong> new commercial banks, both domestic and foreign, new<br />
micro-finance banks, and Islamic finance institutions. Simultaneously,<br />
reforms and restructuring occurred among the clients <strong>of</strong> the banking<br />
system, mostly PSEs, which facilitated changes in the financial system.<br />
Changes in the operations occurred due to the revamping <strong>of</strong> the policy and<br />
regulatory regime governing financial intermediation and deregulation. The<br />
directed credit system that prevailed until the mid-1990s with layered<br />
allocative targets for specific sectors, sub-sectors or priority categories has<br />
been replaced by a market based credit system, and the role <strong>of</strong> DFIs and<br />
specialized financial institutions has been greatly reduced. The interest rate<br />
structure and foreign exchange regimes have been liberalized and are<br />
market-based, more or less.<br />
Privatization and Deregulation<br />
The dimensions <strong>of</strong> structural transformation owing to privatization<br />
can be gauged from changes in the ownership structure <strong>of</strong> assets together<br />
with changes in the patterns <strong>of</strong> financial intermediation and the<br />
participation <strong>of</strong> public and private sector financial institutions. At the system<br />
level, in CY90 the share <strong>of</strong> assets owned by public sector institutions, both<br />
banks and NBFIs in the total financial system assets was about 80%, and it<br />
dropped dramatically to about 26% in CY06. The converse holds true for<br />
the share <strong>of</strong> the ownership <strong>of</strong> private sector banks and private NBFIs over<br />
these years. Since the banking system is predominant in the financial<br />
system, this shift in the ownership structure was slightly more pronounced,<br />
but closely followed this pattern <strong>of</strong> change.<br />
While the structure <strong>of</strong> asset ownership thus shifted towards the<br />
private sector, the share <strong>of</strong> the public sector in the use <strong>of</strong> total financial<br />
resources mobilized in the country did not decrease, and this is not<br />
reflected by the share <strong>of</strong> the public sector in banking credit or banking<br />
assets alone. The reason is that nearly half <strong>of</strong> the annual flows <strong>of</strong> financial<br />
resources – the annual flows <strong>of</strong> financial savings, are being channeled to the<br />
public sector. This is being done through public sector borrowings from the<br />
financial system, NSS operations which are outside <strong>of</strong> the banking system<br />
but are a part <strong>of</strong> financial system flows, currency seignorage, and the<br />
inflation tax through their own modalities and mechanisms. Consequently,<br />
the public sector is still able to garner a hefty share <strong>of</strong> total financial<br />
resources generated in the country through the operations <strong>of</strong> the financial
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system. The crowding out <strong>of</strong> the private sector has been mitigated, but only<br />
in banking credit, not for resources at the macro financial level.<br />
Privatization, by itself, cannot be successful unless it is accompanied<br />
by major initiatives that have to be undertaken in parallel as part and parcel<br />
<strong>of</strong> the financial system reforms. The most important is deregulation<br />
involving the elimination <strong>of</strong> the system <strong>of</strong> directed credit to market based<br />
credit and liberalization <strong>of</strong> the interest rate and exchange rate regimes as<br />
happened in Pakistan during the reform period. To ensure that privatization<br />
succeeds, the government undertook the restructuring <strong>of</strong> financial<br />
institutions prior to their privatization, underwrote the massive costs <strong>of</strong><br />
their restructuring embedded in asset revaluation and employee severance;<br />
cleaned up the balance sheet <strong>of</strong> the dead weight <strong>of</strong> non-performing loans<br />
and other assets <strong>of</strong> dubious value through massive loan write-<strong>of</strong>fs and<br />
provisioning for the NPLs. The government also had to undertake legal<br />
reforms, enact new laws or modify the existing laws <strong>of</strong> exit and entry.<br />
In the glow <strong>of</strong> the deregulated environment, there is a swing to the<br />
other extreme, where deregulation is being interpreted by some bankers as<br />
a state <strong>of</strong> free-for-all. This has made the task <strong>of</strong> the SBP more difficult. If<br />
anything, a deregulated regime has to be more stringent and elaborate in<br />
the body structure <strong>of</strong> its laws, regulations, directives and stipulations than a<br />
controlled regime for the reason that the task <strong>of</strong> maintaining order and<br />
stability in an open market environment and free <strong>of</strong> financial distress is<br />
more difficult. The rules <strong>of</strong> the game have to be charted out over and over<br />
in an iterative fashion in an ever-changing environment until they come to<br />
grips with market realities. A delicate balance has to be struck between lack<br />
<strong>of</strong> rules and over-regulation. It is a delicate and complex task.<br />
Consolidation or Fragmentation?<br />
The number <strong>of</strong> bank and non-bank financial institutions is still large<br />
even though there have been some buy-outs and mergers and the entry <strong>of</strong><br />
new banks has become more difficult given substantially increased minimum<br />
capital requirements discussed below. The number <strong>of</strong> banks is roughly the<br />
same it was five years ago. In 2005, the banking system comprised 44<br />
institutions. Among these, 35 were commercial banks including 4 stateowned<br />
banks, 20 local private banks, and 11 foreign banks. In addition,<br />
there were 5 micro-finance banks and 4 specialized banking institutions,<br />
ZTBL being the largest. The number <strong>of</strong> NBFIs, is much larger, 160 as <strong>of</strong><br />
last count, and their number has increased over the past five years in spite<br />
<strong>of</strong> closures, mergers and buy-outs. These include five Development Financial<br />
Institutions (DFIs), 8 investment banks, 20 leasing companies, 31
The Post-Reform Era Maintaining Stability and Growth 73<br />
modarebas, 40 mutual funds, 52 insurance companies including 48 domestic<br />
owned and 4 foreign owned, 3 housing finance companies, 3 venture capital<br />
companies, 3 discount houses and more than 400 brokers.<br />
The sheer number <strong>of</strong> financial institutions, therefore, remains<br />
unwieldy and it is not healthy for the structure since it has led to the<br />
fragmentation <strong>of</strong> the banking system and NBFIs. Entry into NBFIs continues<br />
unabated, such as the new banks or finance companies which are ensconced<br />
in their niche markets, providing housing finance, consumer finance or<br />
Islamic finance. These new and old entrants, together, are marginal players<br />
in the financial system given the size <strong>of</strong> their operations relative to the<br />
mainline banking institutions as discussed below. They have ended up<br />
enhancing fragmentation because they perform similar services to existing<br />
institutions, just more inefficiently, and have a potential for mismanagement<br />
or overexposure to various risks which may cause serious financial losses and<br />
ultimately become a source <strong>of</strong> instability at the system level.<br />
Currently, the entry <strong>of</strong> Islamic finance and micro-finance<br />
institutions is being heralded as the start <strong>of</strong> a new era in Pakistani banking<br />
and in some ways it is, given that their entry is driven by societal<br />
preferences <strong>of</strong> one kind or the other. But it is not going to help with the<br />
diversification <strong>of</strong> the banking system given that they are likely to remain<br />
appendages <strong>of</strong> financial intermediation for a long time to come.<br />
Diversification does not occur just because the number <strong>of</strong> financial<br />
institutions has increased, rather it occurs primarily when new institutions<br />
or old ones launch new business operations, introduce new products such<br />
as term lending, and begin to cover new segments <strong>of</strong> clientele. Therefore,<br />
in open financial systems, what matters is activity-based rather than<br />
institution-based diversification.<br />
Concentration or Competition?<br />
A look at business shares shows that banking is concentrated among<br />
the top five commercial banks who dominate the banking system in every<br />
category while the remaining banks are small players. Four <strong>of</strong> these are:<br />
NBP, HBL, UBL, MCB. The fifth one was ABL until recently and has now<br />
been displaced from fifth position by Alfalah Bank. The dominance <strong>of</strong> these<br />
five banks has diminished over the past years; yet, their combined assets are<br />
slightly more than half <strong>of</strong> the assets <strong>of</strong> the banking system; so are the<br />
proportions <strong>of</strong> their deposits and advances in the banking system. But the<br />
combined NPLs <strong>of</strong> the original five banks were higher, about three fourths<br />
<strong>of</strong> total NPLs <strong>of</strong> the banking system until a couple <strong>of</strong> years ago.
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The financial strength <strong>of</strong> the banking system, therefore, is closely<br />
tied to the financial fortunes <strong>of</strong> these large five banks. They are the price<br />
setters; while at the same time in the past, many <strong>of</strong> them were loss leaders<br />
as well. Their pr<strong>of</strong>itability and solvency is <strong>of</strong> systemic significance to the<br />
banking system and hinges upon the efficiency <strong>of</strong> their operations and cost<br />
effectiveness, risk management, credit outreach and their business<br />
diversification. Impetus for future improvements will come from institutionspecific<br />
initiatives concerning meaningful capacity building and change<br />
management. This will happen mainly owing to pressures <strong>of</strong> pr<strong>of</strong>itability and<br />
efforts to maintain their relative market shares. A direct role <strong>of</strong> the SBP or<br />
the government in this arena is no longer material as it was in the past.<br />
Financial Intermediation – Structural Change and Growth<br />
The core function <strong>of</strong> financial intermediation in Pakistan remains<br />
with the commercial banks, not the NBFIs, and this is unlikely to change in<br />
the future. The assets <strong>of</strong> the NBFIs, both state-owned and private, as a<br />
proportion <strong>of</strong> total assets <strong>of</strong> the financial system steadily declined from 24%<br />
in 1990 to 11% in 1995, mainly owing to the closure or privatization <strong>of</strong><br />
DFIs, or because <strong>of</strong> a much faster growth <strong>of</strong> private banks as a group as<br />
compared to the growth <strong>of</strong> private NBFIs as a group, regardless <strong>of</strong> the<br />
spectacular growth <strong>of</strong> some segments <strong>of</strong> the NBFIs such as leasing companies<br />
or Islamic finance companies.<br />
This decline in the asset share <strong>of</strong> the NBFIs is reflective <strong>of</strong> a faster<br />
decrease in the share <strong>of</strong> advances, since loans outstanding are the largest<br />
part <strong>of</strong> assets <strong>of</strong> a financial institution any time. In 1990, advances <strong>of</strong> the<br />
NBFIs were 27% <strong>of</strong> financial system advances, and declined to 7% last year.<br />
If we add Islamic finance, this proportion increases slightly. Currently,<br />
deposits <strong>of</strong> the NBFIs as a group are a minuscule proportion <strong>of</strong> the total<br />
financial system deposits, at about 2%. If we add the deposits <strong>of</strong> Islamic<br />
finance, this proportion increases to about 3%. For these reasons, the focus<br />
has to be on the operations <strong>of</strong> the banking system. The role <strong>of</strong> NBFIs has<br />
been marginalized no matter what indicator is used and they are not<br />
significant for the future <strong>of</strong> the financial system <strong>of</strong> Pakistan.<br />
The deregulation <strong>of</strong> the interest rate structure occurred gradually<br />
and the regime has undergone a significant change during the reforms from<br />
administered rates to market-based rates. This transition was not smooth as<br />
there was periodic volatility in interest rates but not destabilizing<br />
movements. This is a considerable achievement <strong>of</strong> the monetary authority,<br />
the SBP, when observed in the light <strong>of</strong> comparative experiences <strong>of</strong> financial<br />
reforms in similar phases in other countries. The SBP discount rate has now
The Post-Reform Era Maintaining Stability and Growth 75<br />
firmly established itself as the anchor rate for the banking system after<br />
several iterations and fine tuning <strong>of</strong> auction mechanisms during the 1997-<br />
2002 period.<br />
As regards the long term trend <strong>of</strong> interest rates on the lending side,<br />
the weighted average lending rate <strong>of</strong> commercial banks was rising<br />
throughout much <strong>of</strong> the 1990s and reached a peak <strong>of</strong> about 16-17% in the<br />
late 1990s, though this weighted average hides a significant variation <strong>of</strong> up<br />
to 20-22% on the high side. Thereafter, these rates began to decline and<br />
reached their lowest point <strong>of</strong> about 7-8% by CY04. Since then, lending rates<br />
began to rise again and currently they range between 10-12% for<br />
mainstream borrowers and 15-17% for fringe borrowers.<br />
The trend <strong>of</strong> interest rate changes on the deposit side is similar.<br />
There was significant volatility over the reform period. The weighted<br />
average deposit rate through much <strong>of</strong> the 1990s ranged around 8%. Towards<br />
1999, a slide <strong>of</strong> major proportions occurred and the weighted average<br />
deposit rate fell drastically to about 2% by 2004. Since then deposit rates<br />
have recovered to about 4% currently. Deposit rates <strong>of</strong> NSS have also fallen<br />
from 14% to 10% for long term mainline instruments over the same period<br />
and are about 9% currently.<br />
Thus far, the banking system has withstood volatility <strong>of</strong> interest rates<br />
and has emerged with stronger earnings and pr<strong>of</strong>itability through managing<br />
associated interest rate risks. As for lending, it is unclear how much <strong>of</strong> the<br />
banking system loan portfolio has been rebalanced with the current<br />
structure <strong>of</strong> interest rates – the financial liability related turnover <strong>of</strong> credit,<br />
because borrowers effectively recycle the shorter loan maturities relatively<br />
easily than their medium to long term maturities, which are a small<br />
proportion <strong>of</strong> the commercial banks’ portfolio.<br />
There has been a strong growth <strong>of</strong> deposit mobilization by the<br />
financial system, inclusive <strong>of</strong> NSS during 1995-2005 averaging at about 15%<br />
per year. The rate <strong>of</strong> growth <strong>of</strong> deposits during CY90-CY00 was 12%. Later<br />
on, during CY00-05, this rate slowed down to 11%. In part, this growth<br />
occurred because <strong>of</strong> phenomenal growth <strong>of</strong> NSS deposits at an average<br />
annual rate <strong>of</strong> 24%. As it was, banking system deposits also increased at the<br />
rate <strong>of</strong> 9% annually over the CY95-00 period. Subsequently, this situation<br />
reversed; during CY00-CY06 the annual growth rate <strong>of</strong> banking system<br />
deposits nearly doubled to 16% while that <strong>of</strong> NSS dropped to 7%. If NSS<br />
deposits are set aside, then practically deposit mobilization by the banking<br />
system is all that matters at the financial system level while shares <strong>of</strong> NBFIs<br />
and Islamic banks remain at about 3% and are inconsequential. Deposit
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taking activities <strong>of</strong> fringe segments such as finance companies, Islamic banks,<br />
micro-finance banks and NBFIs do not hold much potential for bringing<br />
about structural changes at the system level.<br />
One could argue that NSS operations are not financial<br />
intermediation, NSS instruments are not deposit instruments, and deposits<br />
mobilized by the NSS are a part <strong>of</strong> government operations <strong>of</strong> unfunded<br />
debt, not deposit mobilization as such, and these deposits are an expensive<br />
way <strong>of</strong> debt financing. That is largely the case because as the SBP estimates<br />
show, if the government had borrowed Rs. 230 billion through the financial<br />
market instead <strong>of</strong> NSS during FY02, it would have saved about Rs 11 billion<br />
in borrowing costs per year. The NSS, therefore, is neither a low cost<br />
borrowing source, nor a debt management system but has led to distortions<br />
in savings mobilization because <strong>of</strong> its negative impact on banking system<br />
deposits, though institutional depositors are now banned from investing in<br />
NSS instruments.<br />
There has been significant growth <strong>of</strong> financial system credit<br />
throughout the reform period, accompanied by structural changes in the<br />
sources <strong>of</strong> credit along the privatization patterns. During much <strong>of</strong> the<br />
1990s, the rate <strong>of</strong> growth <strong>of</strong> credit remained fairly stable at around 9% per<br />
year, but during CY00-05, this rate increased to about 12% per year with<br />
significant volatility from year to year. This expansion <strong>of</strong> credit at the<br />
financial system level mirrored patterns <strong>of</strong> growth <strong>of</strong> banking credit but in<br />
an accentuated pattern in the late reform period. The average annual<br />
growth <strong>of</strong> banking credit during the decade <strong>of</strong> CY90-00 was about 11%, and<br />
thereafter rose to about 16% during CY00-05. Lately, there are signs <strong>of</strong> a<br />
slowing down <strong>of</strong> credit expansion amidst rising interest rates. Nonetheless<br />
credit expansion is occurring at a record rate <strong>of</strong> growth. The issue is<br />
whether these spectacular increases in banking credit can be sustained, and<br />
if so, does it represent an exception to the trend, or is it the vanguard <strong>of</strong> a<br />
structural change in bank lending that was the expected outcome <strong>of</strong> decade<br />
long financial reforms and dissipation <strong>of</strong> financial repression.<br />
There has been a reversal both in the sources <strong>of</strong> credit and<br />
allocation <strong>of</strong> credit between the public sector and the private sector owing<br />
to privatization, deregulation and the elimination <strong>of</strong> a layered system <strong>of</strong><br />
credit allocation that prevailed earlier. At the start <strong>of</strong> reforms, in CY90 the<br />
proportion <strong>of</strong> credit extended by public sector banks was 86%, while the<br />
share <strong>of</strong> credit extended by private sector banks was only 14%. Later on, the<br />
share <strong>of</strong> private sector banks began to rise and by CY00 it was about 42%,<br />
and then it jumped to about 80% in CY06 in the wake <strong>of</strong> the privatization<br />
<strong>of</strong> UBL and HBL. There was a corresponding decrease in the share <strong>of</strong> credit
The Post-Reform Era Maintaining Stability and Growth 77<br />
extended by public sector banks over the same period. As regards allocation<br />
and use <strong>of</strong> credit, the share <strong>of</strong> private sector borrowings from the financial<br />
system was 55% in CY90, and slowly rose to about 60% in CY00, and then<br />
jumped to 71% by CY06, representing a significant change in uses <strong>of</strong> credit<br />
over the patterns that prevailed before.<br />
A major issue concerning the credit system is overdraft lending<br />
which is preponderant with short term maturities, and there is not much<br />
term lending in the system. One could argue that overdraft lending with<br />
variable interest rates is effectively term lending given the perpetual rollover<br />
<strong>of</strong> loan maturities at call, but that is stretching the point. Overdraft<br />
borrowing has a higher repayment flow than contractual term-borrowing<br />
with or without variable interest rates. Hence, term lending is more<br />
conducive for promoting longer term investments. This is the same rationale<br />
that underpinned the DFIs’ era in Pakistan in the 1950s and 1960s and also<br />
in other developing countries.<br />
Overdraft lending creates a bias in favor <strong>of</strong> large, well-heeled<br />
corporate borrowers – the premium borrowers with substantial cash flow<br />
potential. Almost all banks prefer premium borrowers to extend large loans,<br />
thereby keeping their banking risks and cost fairly low, and are averse to<br />
diversifying their client base in favor <strong>of</strong> small and struggling new borrowers<br />
who are left high and dry. This is why SME lending, or micro-credit has not<br />
made significant inroads in the mainline banking system, not only in<br />
Pakistan but in many developing countries as well. This has forced the<br />
authorities to revive SME banks, and <strong>of</strong>fer incentives for the establishment<br />
<strong>of</strong> micro-finance institutions and to revive housing finance. These are issues<br />
<strong>of</strong> sectoral finance which need an in-depth evaluation.<br />
As a result <strong>of</strong> the above, there is loan concentration since the large<br />
amounts <strong>of</strong> credit flow to premium borrowers, though it has diminished<br />
somewhat with the drive to bring in new borrowers whose number has<br />
increased substantially. By implication, the amount <strong>of</strong> banking credit<br />
extended to medium and small borrowers is fairly low. In this regard,<br />
lending practices <strong>of</strong> banks in Pakistan are similar to those in other<br />
countries. There is also sectoral concentration <strong>of</strong> banking credit which has<br />
always persisted both in the pre-reform and post-reform period. The textile<br />
sector is the major borrower as traditionally it has been, and its share in<br />
total banking system credit has ranged between 25-31%, followed by<br />
consumer credit whose share was about 10%. In contrast, the share <strong>of</strong><br />
agriculture sector credit has been less than 10%, and the share <strong>of</strong> trade<br />
credit to exports and imports about 8% in recent years.
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In spite <strong>of</strong> attention given to housing finance, the proportion <strong>of</strong><br />
house building finance remains an insignificant fraction at only about 2% <strong>of</strong><br />
banking system credit as compared to 12-18% in Asian countries and 25-<br />
35% in advanced countries. Until some years ago, the housing sector was<br />
classified by many commercial banks as an unproductive sector, even though<br />
there are roughly 38 industries whose growth is directly linked to housing<br />
construction and is a leading indicator in advanced countries to gauge the<br />
performance <strong>of</strong> the economy over the short term. Mortgage lending is beset<br />
by two issues: the prime one is the bankability <strong>of</strong> property collateral<br />
tendered and the mismatch in the maturity structure <strong>of</strong> bank funding and<br />
house building loans <strong>of</strong> long term maturities.<br />
III.<br />
Post Reform Era – Management <strong>of</strong> Financial System<br />
The objectives <strong>of</strong> managing the financial system are to maintain<br />
stability, growth, soundness and solvency which boils down to maintaining the<br />
sustainability <strong>of</strong> the financial system. These issues have been front line<br />
concerns <strong>of</strong> the SBP and form the core <strong>of</strong> its strategic objectives. These are:<br />
maintaining price stability with growth, broadening the access <strong>of</strong> borrowers to<br />
banking credit and the provision <strong>of</strong> financial services, ensuring the soundness<br />
<strong>of</strong> the financial system, exchange rate and foreign exchange reserve<br />
management, and the strengthening <strong>of</strong> the payments system. Stability is the<br />
prime focus <strong>of</strong> monetary management, while soundness and solvency are the<br />
prime focus <strong>of</strong> banking supervision and regulation, though there is no hard<br />
and fast division as such. The practice turns out to be that way.<br />
Review and analysis <strong>of</strong> financial reforms in Pakistan and their impact<br />
has already been done in an exhaustive fashion in the series <strong>of</strong> the Financial<br />
Sector Assessment (FSA) reports and Banking System Review (BSR) reports<br />
launched by the SBP nearly five years ago. These two annual series are<br />
unique in that hardly any central bank among developing countries has<br />
undertaken this task as systematically as the SBP has done over the past five<br />
years. At the start, the focus was on the impact <strong>of</strong> reforms on the financial<br />
system. It has now shifted to maintain the soundness <strong>of</strong> the banking system<br />
as viewed through CAMEL indicators, and the evaluation <strong>of</strong> improvements<br />
in the system <strong>of</strong> banking supervision and regulation.<br />
The focus <strong>of</strong> maintaining soundness and solvency centers around<br />
what the banking system does, given that on the intermediation side its role<br />
is overwhelmingly significant. The front line issue is how the banking system<br />
has fared thus far regarding soundness and solvency, and what are the<br />
prospects in the post-reform era? In this sense, managing a financial system
The Post-Reform Era Maintaining Stability and Growth 79<br />
is more than simply monetary management, though it is a critical element<br />
in maintaining stability and fostering the growth <strong>of</strong> the economy.<br />
For maintaining stability and fostering growth, the foremost issue is<br />
what are the remaining distortions or weaknesses in the financial system,<br />
how significant they are, and where do they originate from? The issue for<br />
the policymakers is what is the nature <strong>of</strong> future interventions, and how to<br />
balance them with economic and social priorities? What are the intervention<br />
points, and how effectively can those be managed in fast moving financial<br />
markets, both domestic and global. The complexity <strong>of</strong> these issues will<br />
grow, not diminish, as the financial system progresses and becomes more<br />
sophisticated in a fairly open and liberalized financial regime.<br />
On the financial markets side, the main objective is to keep money<br />
and capital markets stable and avoid volatility, swings and market<br />
corrections, if that can be achieved, though markets have a way <strong>of</strong><br />
surprising everyone. Financial market behavior is notoriously unpredictable<br />
and there is not much that can be done to avoid periodic episodes <strong>of</strong> swings<br />
or even volatility in financial market prices and transactions. Therefore,<br />
maintaining the stability <strong>of</strong> interest rates, prices and exchange rates is<br />
regarded as a necessary condition for the stability <strong>of</strong> financial markets; that<br />
is the role <strong>of</strong> the SBP, while maintaining orderliness, participation,<br />
transparency and the integrity <strong>of</strong> financial market operations is the role <strong>of</strong><br />
the SECP at a time <strong>of</strong> open capital accounts and FDI inflows.<br />
Financial Deepening and Growth<br />
A widely used indicator <strong>of</strong> financial system growth is the M2/GDP<br />
ratio because M2 is a reflection <strong>of</strong> resource mobilization <strong>of</strong> the financial<br />
system, and are liabilities <strong>of</strong> the financial system. After all, M2 is basically<br />
currency, a statutory but non-binding liability <strong>of</strong> a central bank while<br />
deposits are liabilities <strong>of</strong> the banking system. The larger the M2, the larger<br />
is the magnitude <strong>of</strong> macro-financial resources mobilized. Conversely, in<br />
repressed financial regimes with relatively low levels <strong>of</strong> financial deepening<br />
roughly at one third <strong>of</strong> GDP, economic growth would be stifled compared<br />
to what it would have been otherwise. This is the prevailing view <strong>of</strong><br />
financial deepening.<br />
During the second half <strong>of</strong> the 1990s, the M2/GDP ratio in Pakistan<br />
was nearly stagnant at about 37%, then jumped to around 44% during the<br />
last five years. This is a reflection <strong>of</strong> the extraordinary growth <strong>of</strong> deposits<br />
over the last six years. This seven point move <strong>of</strong> the M2/GDP ratio within a<br />
relatively short period <strong>of</strong> five to six years does not imply that a structural
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change <strong>of</strong> this magnitude has erupted from within the economy. For one, a<br />
good deal <strong>of</strong> increase in this ratio owes to expansion <strong>of</strong> net foreign assets<br />
and a large part <strong>of</strong> the economy still remains undocumented and operates<br />
outside the financial system.<br />
Currently, Pakistan’s M2/GDP ratio is much lower than that<br />
prevailing in other Asian countries. In 2005, this ratio in India was 67%; in<br />
the Philippines 53%; in Thailand 96%, and in Malaysia, 106%. Therefore,<br />
there is ample room for further increase in the M2/GDP ratio and growth.<br />
This shows that the necessary conditions for future development <strong>of</strong> the<br />
financial system have largely been taken care <strong>of</strong> and now is the time to<br />
tackle sufficient conditions through diversification and consolidation <strong>of</strong> the<br />
banking system, restructuring <strong>of</strong> priority sector financing at the sectoral<br />
level, capacity building, and corporate governance <strong>of</strong> financial institutions.<br />
The reliance on the M2/GDP ratio to gauge the depth <strong>of</strong> financial<br />
intermediation is weak and may be supplemented by looking at the trends<br />
on the asset side, the asset/GDP ratio, which has increased from 54% in the<br />
mid-1990s to about 62% currently. This ratio also reconfirms that financial<br />
deepening has a long way to go to reach levels observed in many countries<br />
where it exceeds 100%.<br />
Monetary Management – Stability<br />
It is in this background that we need to have a look at monetary<br />
management in Pakistan. Overall, the SBP has been very successful at<br />
monetary management over the past years and has been attuned to the<br />
needs <strong>of</strong> maintaining stability at a time <strong>of</strong> transformation within the banking<br />
system and volatility in financial markets. The SBP has achieved a skillful<br />
switch-over from a system <strong>of</strong> direct monetary controls that prevailed until<br />
the late 1990s to the deployment and calibration <strong>of</strong> indirect monetary<br />
instruments in a liberalized environment such as cash reserve requirements<br />
(CRR), statutory liquidity requirements (SLR), SBP discount rates, and open<br />
market operations. More importantly, reserve money has finally acquired the<br />
backing <strong>of</strong> large foreign exchange reserves, which was not the case some<br />
years ago. The role <strong>of</strong> the interest rate has been enhanced after the<br />
withdrawal <strong>of</strong> the Credit Deposit Ratio (CDR) as the leading instrument <strong>of</strong><br />
credit control. Therein lies the shift from a direct to indirect system <strong>of</strong><br />
monetary management.<br />
The SBP has also been quite successful in steering a tight or easy<br />
monetary policy stance during the past four years as warranted by short<br />
term trends and has established good operational mechanisms. The<br />
movements in the structure <strong>of</strong> interest rates has followed a monetary policy
The Post-Reform Era Maintaining Stability and Growth 81<br />
stance over the past years, by and large, led by the SBP discount rate which<br />
has always been a powerful tool <strong>of</strong> monetary management. The banking<br />
system is responsive to signals conveyed by the monetary authority though<br />
there is periodic slack in the speed <strong>of</strong> adjustments and there are rigidities.<br />
These elements have helped to keep inflation under control and<br />
maintain price stability over previous years, though the price level has been<br />
under severe pressure for the past couple <strong>of</strong> years. The rate <strong>of</strong> inflation<br />
declined steadily from about 13% in FY95 to about 3%, then to 9.3% in<br />
FY05. Since then, there has been some moderation in the levels <strong>of</strong> inflation<br />
but it remains a major concern as inflation currently is about 7%.<br />
Historically, inflationary pressures originated mainly from fiscal deficits and<br />
the consequent monetary expansion by the then banking system to meet<br />
public sector borrowing needs, and the same pattern prevails today given<br />
soaring levels <strong>of</strong> fiscal deficits from Rs 134 billion in FY04 to Rs 325 billion<br />
in FY06.<br />
A good part <strong>of</strong> inflation during the 1990s occurred from imported<br />
inflation and steady depreciation <strong>of</strong> the exchange rate. These pressures<br />
were mitigated over the past few years but now have re-emerged as fiscal<br />
deficits and current account deficits have continued to rise substantially.<br />
The issue is: what are the threats to price stability and how serious are<br />
they? And how far will monetary policy be able to cope with these<br />
pressures in the future? In such circumstances, the SBP had no option but<br />
to pursue a tight monetary policy, which it has over the past couple <strong>of</strong><br />
years, though the SBP realizes that it has to strike a balance between<br />
inflation and growth; has to moderate pressures on the exchange rate<br />
while keeping interest rates stable. However, in times <strong>of</strong> swiftly rising<br />
fiscal deficits and large inflows <strong>of</strong> FDI, a restrictive monetary stance can go<br />
only so far in maintaining short term price stability, together with<br />
exchange rate and interest rate stability.<br />
In spite <strong>of</strong> an open foreign trade regime, liberal incentives for<br />
export, a market determined exchange rate and a large foreign exchange<br />
reserve position, current account deficits have returned with a vehemence<br />
that is reminiscent <strong>of</strong> the old days, to a record level <strong>of</strong> $5 billion in FY06<br />
and is likely to be higher in FY07, since the trade deficit in the first nine<br />
months <strong>of</strong> this fiscal year is approaching nearly $9 billion. The silver lining<br />
is that foreign exchange reserves <strong>of</strong> about U$13 billion are sufficient for<br />
nearly a year <strong>of</strong> imports rather than for just a few weeks as in the past.<br />
The SBP has been successful in maintaining exchange rate stability,<br />
over the past five years together with a strong foreign exchange reserve
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position which began building up from a modest level <strong>of</strong> US$ 1.35 billion in<br />
CY00, to around US$ 13 billion currently under the free floating foreign<br />
exchange rate and inter-bank foreign exchange market. There have been<br />
periodic ups and downs but in a narrow band. Recently, there has been a<br />
noticeable increase in the inflows <strong>of</strong> FDI, but nearly a third <strong>of</strong> it is in onetime<br />
foreign exchange privatization proceeds which will not recur. There is<br />
also growth <strong>of</strong> portfolio investment, but nowhere near the levels that<br />
occurred in East Asian or Latin American countries, whose abrupt return<br />
became the cause <strong>of</strong> a full blown crisis for them. There are no FDI induced<br />
bubbles to cause worry, though the capital market boom is beginning to<br />
look like a bubble situation.<br />
Comparative experience has demonstrated that attempts to stabilize<br />
or to maintain some targeted level <strong>of</strong> the exchange rate by central banks<br />
have been unsuccessful. Some <strong>of</strong> the spectacular failures were in the early<br />
1990s when the Bank <strong>of</strong> England tried to maintain the parity <strong>of</strong> the British<br />
pound and then had to withdraw after staggering losses within a matter <strong>of</strong> a<br />
few days. Subsequently, Bank Negara Malaysia tried to do the same, and<br />
suffered heavy losses with stunning rapidity. It is now firmly understood that<br />
foreign currency trading to corner the global currency market is suicidal<br />
which has a turnover approaching two trillion dollars per day. Therefore,<br />
maintaining the stability <strong>of</strong> the exchange rate through currency market<br />
manipulation when the Pakistani rupee is being traded actively is not an<br />
option available to the SBP except in a narrow band and for short duration.<br />
This perception <strong>of</strong> monetary policy management amidst conflicting<br />
objectives is familiar among countries at similar stages <strong>of</strong> financial reforms.<br />
After the era <strong>of</strong> the control regime is over and the external sector is<br />
liberalized, the monetary authorities can pursue either domestic price<br />
stability or exchange rate stability, but not both with the same degree <strong>of</strong><br />
success. Once the financial system is liberalized and financial markets begin<br />
to assert their role, and large inflows from overseas begin to occur with<br />
open trade and capital accounts, be they remittances or FDI, price and<br />
exchange rate stability then become difficult to maintain simultaneously,<br />
because the opening <strong>of</strong> capital accounts reduces the influence <strong>of</strong> the<br />
monetary authorities on interest rates and hence its capacity to affect<br />
aggregate spending.<br />
If the authorities pursue exchange rate stability to stabilize foreign<br />
exchange inflows and keep the current account balance intact, the domestic<br />
interest rate and price stability comes under pressure because <strong>of</strong> the<br />
sterilization <strong>of</strong> FDI and other foreign currency inflows, no matter how it is<br />
done. Conversely, if they shift to maintain interest rate and price stability,
The Post-Reform Era Maintaining Stability and Growth 83<br />
sooner or later the exchange rate comes under pressure. For example, in<br />
times <strong>of</strong> inflation, if the monetary authority were to raise interest rates and<br />
they become higher than the international rates, it will encourage capital<br />
inflows and will depress the real exchange rates.<br />
Banking Regulation and Supervision - Solvency<br />
Improvements in the system <strong>of</strong> banking regulations and supervision<br />
at the SBP has been one <strong>of</strong> the leading items from the start <strong>of</strong> the reform<br />
period and it has paid rich dividends. Since then it has undergone a<br />
significant transformation and the system that prevails today is far superior<br />
than it was at the start <strong>of</strong> the reforms. Its procedures and practices have<br />
been modernized and these are as sophisticated as one would expect to find<br />
anywhere among the leading countries. The process is supported by the<br />
installation <strong>of</strong> an upgraded payments system, IT facilities at the SBP as well<br />
as at leading banks, thereby significantly improving the speed and accuracy<br />
<strong>of</strong> financial information flow so vital for banking supervision.<br />
A major change from the old to the new is transparency in the<br />
processes <strong>of</strong> supervision and regulation as to what is being regulated and<br />
why and by whom. There hardly was any meaningful information flow in the<br />
public arena concerning the operations <strong>of</strong> financial institutions, much less<br />
on the state <strong>of</strong> their financial health or their relative standing with regard to<br />
impaired capital and other systemic weaknesses that were at the root <strong>of</strong><br />
their financial distress. This information flow, together with the analysis and<br />
evaluation <strong>of</strong> financial institutions, started with the launching <strong>of</strong> annual<br />
series <strong>of</strong> FSA and BSR reports. This transparency is critical in the postreform<br />
era if stability, soundness and solvency <strong>of</strong> the financial system are to<br />
be achieved.<br />
Nearly all banking and financial crises that have erupted during the<br />
previous decades, occurred in countries which had a well established system<br />
<strong>of</strong> supervision and a full awareness <strong>of</strong> the potential for crisis. It seems that<br />
no amount <strong>of</strong> banking supervision is sufficient enough to prevent the<br />
emergence <strong>of</strong> crises, and that is a sobering thought. In times <strong>of</strong> financial<br />
distress, banks and quasi-banking institutions have a way <strong>of</strong> going belly-up,<br />
not because <strong>of</strong> any lack <strong>of</strong> supervision, but mainly because <strong>of</strong> excesses <strong>of</strong><br />
placements, untenable risk exposure, and herd behavior in garnering golden<br />
opportunities <strong>of</strong> pr<strong>of</strong>it or large capital gains in a red-hot market, be it the<br />
loan market, financial market, exchange market, or real estate market. That<br />
is why there is such rapidity in the onset <strong>of</strong> the crises and its monumental<br />
dimensions, once it unravels. This has happened in developed countries such<br />
as Japan and the US during the 1990s when a few large commercial banks
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became insolvent and before any remedial action could be taken, they had<br />
folded up, in spite <strong>of</strong> an enviable system <strong>of</strong> information flow and a modern<br />
supervision system.<br />
Similarly, the Mexican crisis <strong>of</strong> the mid-1990s and East Asian crisis<br />
<strong>of</strong> the late 1990s happened even though their banking supervision and<br />
regulation systems and the sophistication <strong>of</strong> bankers and financiers and<br />
their expertise in handling capital inflows was regarded at par with<br />
international standards. They also had the knowledge and experience <strong>of</strong><br />
similar crises that erupted previously. What went wrong and why so<br />
swiftly? The post-crisis diagnosis reveals that one <strong>of</strong> the common elements<br />
is herd behavior and overexposure <strong>of</strong> a speculative variety in a few sectors<br />
in anticipation <strong>of</strong> more than normal market returns. As soon as the inflow<br />
began to dry out, the specter <strong>of</strong> foreign exchange illiquidity loomed large,<br />
and investors wanted to exit before imminent devaluation <strong>of</strong> the Mexican<br />
peso in the face <strong>of</strong> foreign currency illiquidity. This mass exit <strong>of</strong> foreign<br />
capital, the reverse flow, is akin to a bank run domestically. There is no<br />
safeguard against it, much the same way as there is no safeguard against a<br />
bank-run on any given day.<br />
Further, good bankers have been known to become bad bankers,<br />
and this process unfolds right under the nose <strong>of</strong> bank examiners and<br />
supervisors. Spotting this trend is difficult; it is a matter <strong>of</strong> experience and<br />
ultimately it is a judgment call. This has happened time and again in<br />
developed and developing countries alike. How it happens is explained<br />
briefly below. Why it happens boils down to the inability <strong>of</strong> bankers or<br />
financiers to keep a lid on acceptable business risks, and tame these risks<br />
when they get out <strong>of</strong> line, but well before they are beyond any reprieve.<br />
This is a precarious rope walk. There is always an unwillingness to close<br />
losing operations, take early losses and quit in the early stages when these<br />
losses are still smaller than later on when the crisis erupts full scale.<br />
The instinct <strong>of</strong> the bankers is to keep the borrowers alive through<br />
recycling and renewals <strong>of</strong> bad loans into loans, a window dressing exercise;<br />
or worse yet, advancing additional fresh loans to effectively insolvent<br />
borrowers to tide over what is perceived as cash flow problems and<br />
imminent illiquidity, thereby getting deeper into financial distress. In this<br />
sense, insolvency occurs first, illiquidity follows later. The borrowers are<br />
already in deep distress by then, and they are well past the stage <strong>of</strong> routine<br />
rescue operations because their illiquidity originates not from their routine<br />
business turnover and cash flows, but rather from structural weaknesses in<br />
their operations. The same occurred in the nationalized banking era in<br />
Pakistan when banks kept bailing out insolvent PSEs, lending more
The Post-Reform Era Maintaining Stability and Growth 85<br />
intentionally because <strong>of</strong> collusion or bad judgment, or on government<br />
directives, then writing <strong>of</strong>f the loans while the banking supervision outfit<br />
was alive to these perils.<br />
Soundness and Solvency – the Banking System<br />
Maintaining soundness and solvency <strong>of</strong> the financial system has been<br />
the uppermost concern <strong>of</strong> the SBP. The BSR reports <strong>of</strong> SBP are focused on<br />
the latest developments in the leading indicators <strong>of</strong> soundness <strong>of</strong> the<br />
banking system, based on timely reporting by financial institutions, required<br />
under disclosure laws and regulations. The analytical approach is the<br />
CAMEL framework which is a rating system <strong>of</strong> financial institutions. The<br />
evaluation <strong>of</strong> the banking system’s soundness, as given in the SBP reports,<br />
clearly shows that financial strength and soundness <strong>of</strong> the banking system<br />
has considerably improved as evidenced by various soundness indicators at<br />
the system level, and its capability is fairly strong to withstand various types<br />
<strong>of</strong> shocks within plausible limits. It may, however, face difficulties in<br />
extreme situations, the probability <strong>of</strong> occurrence <strong>of</strong> which is largely remote.<br />
Among the soundness indicators, the first one is capital adequacy<br />
inclusive <strong>of</strong> minimum capital requirements and an assessment <strong>of</strong> the ratio <strong>of</strong><br />
capital to risk weighted assets. For years, the minimum paid up capital<br />
requirement was fairly low at around Rs. 500 million, and was raised to Rs.<br />
1 billion in 2002 and again to Rs. 2 billion in 2004. This increase in paidup<br />
capital together with cleaning up <strong>of</strong> the loan portfolio was the main<br />
element in reducing the risk factor in assets, and has led to a significant<br />
improvement in the risk weighted capital adequacy ratio, a statutory<br />
obligation for all banks regardless <strong>of</strong> their ownership.<br />
Since the time the SBP began publishing soundness indicators in its<br />
FSA and BSR reports covering the period CY97-05, the data shows a<br />
significant improvement in the Capital Adequacy Ratio (CAR). In 1997, it was<br />
4.5% for all banks, and jumped to 11% within a year, and since then has<br />
stayed at around the same level, though there have been variations from year<br />
to year. For state owned banks, private banks and foreign banks, the same<br />
pattern prevailed. There were annual variations in between, but the ratio<br />
remained fairly high and was not a cause for concern. In contrast, this ratio<br />
for specialized banks has never recovered from negative levels.<br />
As part <strong>of</strong> the Basel II implementation, the banks are required to<br />
further increase their paid-up capital by Rs one billion per year until they<br />
reached Rs 6 billion by the end <strong>of</strong> 2009 by all banks and DFIs. This is an<br />
unprecedented increase in base capital. After the increase materializes by
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2009, the CAR for banks will range from 8% to 14%. The shift to such<br />
levels <strong>of</strong> capital adequacy is the first insurance against the insolvency <strong>of</strong><br />
financial institutions, and once the range is reached, solvency at the system<br />
level is assured. A swift rise <strong>of</strong> minimum capital requirements to such levels,<br />
however, would be a powerful barrier to entry for new banks seeking<br />
incorporation, though not for non-bank entities which are incorporated<br />
under the companies charter. These requirements will discourage not only<br />
the entry <strong>of</strong> new banks, but will also hurt competition, and will encourage<br />
non-bank companies to enter the NBFIs group which is likely to add to the<br />
fragmentation <strong>of</strong> the financial system.<br />
Burden <strong>of</strong> NPLs - Asset Quality<br />
The asset quality indicator revolves around the proportion <strong>of</strong> risk<br />
weighted assets or the proportion <strong>of</strong> non-performing loans (NPLs) in total<br />
assets. These ratios indicate that there are no threats to solvency <strong>of</strong> the<br />
banking system that loomed large during much <strong>of</strong> the 1990s mainly due to<br />
the rise <strong>of</strong> NPLs. The management <strong>of</strong> NPLs by the banking system has<br />
considerably improved over the past years, and the burden <strong>of</strong> NPLs does not<br />
pose a threat to the solvency <strong>of</strong> the banking system, large though it is.<br />
There has been a reduction in NPLs from an all time high <strong>of</strong> Rs 244 billion<br />
in CY01 to Rs 184 billion in CY06 largely because <strong>of</strong> the resolution <strong>of</strong> loan<br />
defaults, loan write-<strong>of</strong>fs and several recovery drives. The proportion <strong>of</strong> NPLs<br />
in the total loans <strong>of</strong> the banking system has fallen from about 24% to about<br />
8% in CY06. A great deal <strong>of</strong> provisioning has been done by the banks since<br />
the early 1990s and the total amount is estimated at Rs 139 billion in<br />
CY06. The amount <strong>of</strong> net NPLs, therefore, has decreased from Rs 92 billion<br />
in CY97 to Rs. 45 billion in CY06; their proportion in banking credit has<br />
likewise decreased significantly.<br />
Hence, NPLs are no longer a systemic risk as they were in the<br />
1990s. The solvency risk has been mitigated, though NPLs remain a drag on<br />
the pr<strong>of</strong>itability <strong>of</strong> leading banks and this situation will persist in the future.<br />
The resolution <strong>of</strong> problem banks, likewise, is no longer a pressing issue as it<br />
was during the 1990s when a large part <strong>of</strong> the banking system was in<br />
financial distress. There are now only three problem banks and they do not<br />
pose a systemic threat. Private banks are likely to impose a much tighter<br />
discipline on lending practices to prevent the incidence <strong>of</strong> loan defaults, but<br />
how far new NPLs will be contained remains a concern given the recently<br />
reported rise <strong>of</strong> defaults. The culture <strong>of</strong> default may have been weaned but<br />
has not disappeared. It will take a long time before good borrowing<br />
behavior is restored coupled with good lending behavior as well.
The Post-Reform Era Maintaining Stability and Growth 87<br />
Intermediation Costs and Spreads - Efficiency<br />
The intermediation cost is not a CAMEL indictor, but it reflects the<br />
operating efficiency <strong>of</strong> banks though only on the funding side since it is the<br />
ratio <strong>of</strong> administrative expenses to the average amount <strong>of</strong> deposits and<br />
borrowings <strong>of</strong> a financial institution. BSR estimates show that intermediation<br />
costs during the late 1990s was about 3.5%, and then began to decline and<br />
is currently around 2.7%. This suggests that banking efficiency improved at<br />
least on the funding side over the late reform period, but still it is above<br />
the cost range prevailing in comparator countries at around 2.0%, and is<br />
much higher than the range <strong>of</strong> 1.5 to 2.0% observed in leading countries.<br />
These intermediation costs are exclusive <strong>of</strong> provisioning costs for<br />
NPLs. Provisioning for NPLs adds close to one percent to banking<br />
intermediation costs over and above the current level <strong>of</strong> 2.7%. This is a<br />
major reason for high intermediation costs, especially for the recently<br />
privatized large banks. Part <strong>of</strong> the cost <strong>of</strong> provisioning and equity<br />
replenishments have been assimilated and recycled into the balance sheets <strong>of</strong><br />
financial institutions thereby raising the costs <strong>of</strong> operations and thus<br />
intermediation costs, which refuse to be compressed beyond current levels.<br />
Banking spreads have remained around 7% during most <strong>of</strong> the 1990s<br />
and have remained around the same over the recent period, even higher, at<br />
around 8%. This is not surprising because structural changes in the credit<br />
system occurred concurrently to significant volatility, both in the deposit<br />
rates and lending rates over the reform period discussed earlier. The<br />
concern that banking spreads are high is valid, but in a deregulated system<br />
there is hardly much that the monetary authority, the SBP, can do to help<br />
reduce the spread since it is embedded into the bank funding structure on<br />
one side, and into lending operations and investments on the other.<br />
Pr<strong>of</strong>itability – Banking System<br />
Recently, commercial banks have returned to pr<strong>of</strong>itability after<br />
persistent losses for many years, though specialized banks are still<br />
unpr<strong>of</strong>itable. There has been an astounding increase in pr<strong>of</strong>itability which<br />
has mitigated but has not eliminated the specter <strong>of</strong> insolvency at the system<br />
level, though not at the institutional level. Nothing prevents a single<br />
financial institution becoming insolvent while the rest <strong>of</strong> the banking system<br />
is doing well and is pr<strong>of</strong>itable.<br />
Pr<strong>of</strong>itability may be gauged through the return on asset (ROA) both<br />
before and after tax, or return on equity (ROE) before and after tax, or the
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ratio <strong>of</strong> net interest income to gross income, or the cost income ratio. All<br />
these indicators unanimously show a marked improvement during the CY97-<br />
05 period in the pr<strong>of</strong>itability <strong>of</strong> the banking system in Pakistan. After tax<br />
ROA for the banking system was negative until CY01 and then turned<br />
positive and swiftly rose to the current levels <strong>of</strong> about 2%, ahead <strong>of</strong><br />
international benchmarks. After tax ROE likewise was negative until CY01,<br />
but thereafter it became positive and shot up to 26% in CY05. This jump is<br />
a one time phenomenon and is unlikely to be replicated in the future,<br />
though it is a broad indicator <strong>of</strong> a trend towards pr<strong>of</strong>itability. Net interest<br />
income as a proportion <strong>of</strong> gross income showed a remarkable increase from<br />
49% in CY97 to 72% in CY05, owing to the scissor like pattern <strong>of</strong> interest<br />
rates on deposits and lending over this period discussed earlier.<br />
A number <strong>of</strong> factors have contributed to enhanced pr<strong>of</strong>itability.<br />
Banks were able to lower their interest expenses faster than the decline in<br />
their interest income owing to low borrowing needs, re-pricing <strong>of</strong> their<br />
interest bearing liabilities and a large growth in non-interest income from<br />
investments and other assets over the past few years. In addition, improved<br />
operating and business practices and financial services, restructuring and<br />
reorganization and downsizing, staff reduction, branch closures, tightened<br />
internal costs, and controls on administrative expenses have helped to<br />
reduce their operating costs. Above all, a decline in the corporate taxes on<br />
banking business from 56% to 42% have improved after tax pr<strong>of</strong>its, and will<br />
get a further boost when the tax rate is lowered to 35%. <strong>Special</strong>ized banks<br />
have continued to suffer heavy losses throughout this period and their<br />
pr<strong>of</strong>itability indicators never returned positive. Lately, their losses have<br />
narrowed down but pr<strong>of</strong>itability remains as elusive as ever.<br />
Managing Banking Risks<br />
In the above context, the issue is how well the banks are able to<br />
manage banking risks with market-based interest rates, floating exchange<br />
rates and exposure in the foreign exchange reserve position, open external<br />
accounts, increased participation in FDI and capital inflows. The pattern <strong>of</strong><br />
credit risk in routine bank lending to sectors <strong>of</strong> the economy has not<br />
changed much. If anything, it has increased owing to a move to new lines <strong>of</strong><br />
lending such as consumer credit; but as long as exposure <strong>of</strong> the banks<br />
remains concentrated towards prime borrowers, this shift in the pr<strong>of</strong>ile <strong>of</strong><br />
credit risk will be manageable. If credit risk is not managed properly it<br />
eventually shows up in NPLs, or the concentration <strong>of</strong> banking credit in a<br />
few sectors <strong>of</strong> the economy, or in a few segment <strong>of</strong> borrowers, or a rising<br />
proportion <strong>of</strong> riskier loans in its portfolio during times <strong>of</strong> rapid expansion <strong>of</strong><br />
banking credit.
The Post-Reform Era Maintaining Stability and Growth 89<br />
Exchange rate risk concerns the exposure <strong>of</strong> banks on their foreign<br />
exchange liabilities. The banking system was shielded from exchange rate<br />
risk in the past owing to a number <strong>of</strong> explicit and implicit safeguards<br />
extended to them by the SBP in return for their surrendering their foreign<br />
exchange inflows, be they on FCAs, remittances, or export earnings. All this<br />
has changed since then in the new foreign exchange regime whereby<br />
commercial banks are practically on their own with regard to foreign<br />
exchange risks on their reserves, exporters’ balances, foreign currency<br />
deposits, foreign exchange loans extended to the foreign companies or<br />
customers, and on their portfolio related operations in the foreign exchange<br />
markets.<br />
The impact <strong>of</strong> interest rate risk is on the portfolio <strong>of</strong> the bank, both<br />
investment portfolio and loan portfolio, and is central to asset/liability<br />
management at the institutional level. The impact <strong>of</strong> interest rate changes is<br />
severe if there is a serious mismatch <strong>of</strong> maturity structure between the loan<br />
portfolio and deposit portfolio because <strong>of</strong> a significant divergence in interest<br />
rates associated with these maturities. Unless the bank is able to compensate<br />
on both the asset and liability sides <strong>of</strong> its balance sheet, it is likely to suffer<br />
a loss. Interest rates were falling during most <strong>of</strong> the CY95-03 period, and<br />
then they stabilized. During this period, the overall pr<strong>of</strong>itability <strong>of</strong> banks<br />
was not compromised. Thereafter, when interest rates began to rise over the<br />
past two years, this was accompanied by a significant growth in banking<br />
pr<strong>of</strong>its to record levels. This indicates that during both periods, banks were<br />
able to absorb the impact <strong>of</strong> interest rates on their portfolio, be it the<br />
investment portfolio or loan portfolio.<br />
Likewise, banks have been able to manage the equity price risk over<br />
this period. The sustained fast growth <strong>of</strong> stock market and equity prices<br />
continues unabated, and it has further accelerated this year. The SBP placed<br />
a cap on the direct exposure <strong>of</strong> banks in stock market placements estimated<br />
at about Rs. 35 billion in CY05, though it has grown further since then.<br />
This exposure <strong>of</strong> the banking system in equity investment is not a cause for<br />
concern, because the share <strong>of</strong> direct exposure in total investments held by<br />
the banking system remains small. The indirect exposure through carry-overtransactions,<br />
badla financing, was about Rs. 8 billion in CY05, and since<br />
then it has decreased further owing to restrictions placed on badla<br />
financing. In view <strong>of</strong> this structure <strong>of</strong> the banking system’s exposure in the<br />
equity market, the degree <strong>of</strong> equity price risk is not a major concern.<br />
From the point <strong>of</strong> view <strong>of</strong> soundness, the proposition that banks<br />
become insolvent first and illiquid later is likely to generate much debate<br />
among bankers and financiers. No matter how one perceives it, liquidity
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Shakil Faruqi<br />
risk has to be managed well. Since the observance <strong>of</strong> liquidity levels is a<br />
statutory obligation, and the SLR is closely monitored by the SBP, the<br />
banking system has to keep adequate liquidity levels all times in<br />
compliance <strong>of</strong> the SLR. Observance <strong>of</strong> the SLR by itself does not eliminate<br />
liquidity risk which has emerged for the banking system partly from<br />
inflation, and partly from the rapid growth <strong>of</strong> banking credit. Currently,<br />
liquid assets are nearly one third <strong>of</strong> total assets, and this is a reasonably<br />
comfortable position for the banks; their liquidity position is in excess <strong>of</strong><br />
the statutory requirement.<br />
Banking System - Sensitivity to Shocks and Stress<br />
The crux <strong>of</strong> the management <strong>of</strong> the soundness and solvency <strong>of</strong> the<br />
banking system, to the extent that it can be system analyzed, is to enhance<br />
its resilience so that it can successfully absorb moderate levels <strong>of</strong> financial<br />
system shocks and moderate levels <strong>of</strong> economic instability, while operating<br />
in the market environment with open capital accounts and a vibrant<br />
external sector. To assess the resilience <strong>of</strong> the banking system, the SBP<br />
conducted its own stress tests as reported in the BSR05 involving 12 largest<br />
banks. The exercise covered all three market risks, namely the interest rate,<br />
the exchange rate and equity price risks, and a fourth one as well, the<br />
liquidity risk. Four stress scenarios were developed for each <strong>of</strong> these risks<br />
and their impact was estimated on the combined pr<strong>of</strong>itability and capital <strong>of</strong><br />
these banks as an approximation to the impact at the system level. The<br />
results show that among these four risks, the liquidity risk is relatively more<br />
worrisome and the impact <strong>of</strong> a shock is more severe because liquidity<br />
margins are thin if the liquid assets exclude near-liquid government<br />
securities. If these are included, the amounts <strong>of</strong> liquid assets with the banks<br />
increase and consequently liquidity shocks are not so severe.<br />
Stress tests <strong>of</strong> credit risk shocks show that the degeneration <strong>of</strong><br />
position <strong>of</strong> NPLs is not a material threat to their solvency; it is manageable<br />
and banks will be able to withstand a degeneration <strong>of</strong> their portfolio quality<br />
except for extreme situations which are unlikely to occur. The impairment<br />
<strong>of</strong> the quality <strong>of</strong> the portfolio is exhibited in rising levels <strong>of</strong> NPLs. Test<br />
results show that the capital adequacy <strong>of</strong> these banks will be unimpaired and<br />
they will be able to tolerate a 10% increase in their NPLs together with a<br />
50% degeneration <strong>of</strong> their loan portfolio into classified loans. Further, if the<br />
ratio <strong>of</strong> NPLs to loans currently estimated at 6.7% were to degenerate to as<br />
much as 33.5%, only then will it wipe out the capital <strong>of</strong> these banks,<br />
meaning that banks are fairly strong and their solvency will be at stake only<br />
in extreme cases <strong>of</strong> far-out shocks.
The Post-Reform Era Maintaining Stability and Growth 91<br />
Similarly, the impact <strong>of</strong> shocks <strong>of</strong> upward interest rate movements<br />
together with parallel shifts <strong>of</strong> the yield curve on the value <strong>of</strong> the bank’s<br />
portfolio is tolerable, except for a large shock in the case when interest rate<br />
increases by 100 basis points or 200 basis points and there is a parallel shift<br />
and flattening <strong>of</strong> the yield curve. The impact on gross income is more<br />
pronounced and the percentage loss is substantial. The shock <strong>of</strong> a decrease<br />
in equity prices, that is, a fall in the stock price index in the range <strong>of</strong> 20-<br />
40% will also not have much <strong>of</strong> a negative impact on the banks, and banks<br />
will be able to ride out these adverse movements.<br />
The shock <strong>of</strong> exchange rate movements is more manageable because<br />
the foreign assets <strong>of</strong> banks are larger than their foreign currency liabilities.<br />
Therefore, a depreciation <strong>of</strong> the exchange rate <strong>of</strong> as much as 25% does not<br />
have any negative impact on their capital; in fact their CAR appreciates.<br />
Their borrowers, however, will face difficulties in loan servicing <strong>of</strong> foreign<br />
credits; therefore the value <strong>of</strong> their foreign currency loan portfolio will<br />
decrease. If there were to be an appreciation <strong>of</strong> the exchange rate by 20%,<br />
it will lower the rupee value <strong>of</strong> their assets and their CAR will decline but<br />
only slightly. It seems that banks are resilient enough to absorb shocks <strong>of</strong><br />
any combination <strong>of</strong> exchange rate movements within these ranges together<br />
with the counterpart impact <strong>of</strong> exchange rate changes on their clients.<br />
There is a corroboration <strong>of</strong> the central conclusion <strong>of</strong> these SBP tests with<br />
those <strong>of</strong> the IMF-WB FSA05 report based on its own sensitivity and stress<br />
tests. Their results show that Pakistan’s financial system is resilient enough<br />
to absorb various types <strong>of</strong> moderate shocks and there is no imminent threat,<br />
except in situations where several types <strong>of</strong> shocks may occur simultaneously<br />
and in combination, though the report does not elaborate upon the<br />
combination or their severity.<br />
Looking Ahead<br />
The future <strong>of</strong> financial system development will in good part depend<br />
on capacity building and improved corporate governance. Capacity building<br />
needs priority attention because it is not a once for all activity, rather it is a<br />
continuous process. As soon as one threshold is scaled, another one looms on<br />
the horizon owing to fast moving changes in the business world and also in<br />
the financial system owing to increasing global linkages. Hence, the need for<br />
continuous revival and rejuvenation from within at the institutional level will<br />
always be there if the dynamism <strong>of</strong> modern banking is to be internalized.<br />
Further gains in efficiency and improvements in the operations <strong>of</strong><br />
the banking system simply can not be achieved without adequate investment<br />
and efforts at capacity building. Frontline institutions have already gone
92<br />
Shakil Faruqi<br />
through a few rounds <strong>of</strong> their capacity building led by the SBP, which<br />
embarked on this process some years ago with considerable success. Many<br />
small private banks and foreign banks went through capacity building efforts<br />
<strong>of</strong> their own and completed their transition earlier on during the late<br />
1990s. Recently, privatized large banks embarked on their capacity building<br />
a few years ago and they are in the midst <strong>of</strong> catching up to their fast<br />
growing needs.<br />
There are three main elements to capacity building. These are:<br />
improvements in management orientations and dynamism, investment in<br />
training, and investment in infrastructure such as IT facilities in parallel<br />
with IT training if this investment is to yield dividends. All the three<br />
elements are a relatively recent experience for Pakistani banks, but these are<br />
not unfamiliar or new to them. Investment in training, unfortunately is still<br />
regarded as an administrative expense rather than investment in human<br />
capital. That mind-set has not changed. Currently, most institutions spend<br />
only a fraction <strong>of</strong> their routine administrative budget on training, perhaps<br />
no more than 3% <strong>of</strong> their annual administrative outlays and it is not<br />
considered as investment in human capital.<br />
Further, training is widely interpreted as improving basic skills or is<br />
regarded as improving abilities in procedures as compared with functional<br />
training. For example, training a branch manager is not the same as training<br />
a banker; or for that matter, training a central banker, say, in currency<br />
regulations is not the same thing as preparing someone to become a central<br />
banker. This involves the enhancement <strong>of</strong> capabilities, re-orientation <strong>of</strong> the<br />
mind-set and attitudes which are much harder to come by. Functional<br />
training was not needed in a nationalized system, directed as it was from the<br />
centre, or so it seems. That is why training came to a grinding halt and<br />
with it the culture <strong>of</strong> self-improvement at the institutional level disappeared.<br />
In the current business environment financial institutions cannot prosper<br />
without sustained efforts at capacity building.
The Post-Reform Era Maintaining Stability and Growth 93<br />
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Hunter Caprio and Leipziger (eds.), Preventing Bank Crises: Lessons<br />
from Recent Global Failures, Federal Reserve Bank, Chicago,<br />
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Leipziger (eds.), Preventing Bank Crises: Lessons from Recent Global<br />
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Development Studies, pp 243-260.<br />
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in Hunter Caprio and Leipziger (eds.), Preventing Bank Crises:<br />
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Diaz-Alejandro, Carlos, 1985, Goodbye Financial Repression, Hello Financial<br />
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Frankel, Jeffrey, Preventing Banking Crises, in Hunter Caprio and Leipziger<br />
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The <strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong><br />
<strong>Special</strong> <strong>Edition</strong> (September 2007)<br />
Financial Sector Restructuring in Pakistan<br />
Muhammad Arshad Khan and Sajawal Khan *<br />
Abstract<br />
In this paper an attempt has been made to review the financial<br />
restructuring process and its importance for economic growth and<br />
macroeconomic stability. The main focus is on the financial restructuring<br />
efforts undertaken by the government <strong>of</strong> Pakistan since 1990. We also<br />
analyze the impact <strong>of</strong> financial restructuring by using various financial<br />
indicators. The overall results suggest that the financial industry in<br />
Pakistan is showing remarkable and unprecedented growth. Unlike 1990,<br />
the performance <strong>of</strong> the financial sector is much better today. After the<br />
successful completion <strong>of</strong> first generation reforms, the introduction <strong>of</strong> second<br />
generation reforms is required, which will help to further strengthen the<br />
financial system and transfer the benefits <strong>of</strong> the first generation reforms to<br />
society.<br />
I. Introduction<br />
In a modern economy, an efficient financial system is essential to<br />
facilitate economic transactions, specialize in production, and establish<br />
investor-friendly institutions and competitive markets. A stable and efficient<br />
financial system not only reduces uncertainty and the cost <strong>of</strong> transactions but<br />
also improves overall economic efficiency through the efficient allocation <strong>of</strong><br />
resources. A more balanced and vibrant financial system will contribute to<br />
economic growth and the stability <strong>of</strong> the economy. In contrast, regulated<br />
financial systems lead to underdeveloped and incompetitive markets, with a<br />
financial sector dominated by government owned financial institutions that<br />
impose constraints on economic growth. It is now widely recognized that<br />
weak and inefficient financial systems are more vulnerable to contagion, less<br />
able to cope with volatile capital flows and exchange market pressures, and<br />
more likely to propagate and magnify the effects <strong>of</strong> financial crises. This<br />
* The authors are respectively Associate Pr<strong>of</strong>essor Government Post-graduate College<br />
Muzaffarabad (Azad Kashmir) and Lecturer Government Degree College Ghazi, Haripur<br />
(NWFP) and both are currently working as Research Associates, Pakistan Institute <strong>of</strong><br />
Development <strong>Economics</strong>, Islamabad.
98<br />
Muhammad Arshad Khan and Sajawal Khan<br />
recognition has highlighted the need for the global adoption <strong>of</strong> strengthened<br />
standards for banking supervision (IMF, 1996). The appropriate sequencing <strong>of</strong><br />
financial sector restructuring and supervision policies have also become<br />
pressing issues in many LDCs, where a large part <strong>of</strong> the banking system is<br />
undercapitalized and insolvent, reflecting major macroeconomic shocks, large<br />
structural changes and weak banking supervision. The resulting distress in the<br />
financial system has, in turn, complicated monetary management and affected<br />
the effectiveness <strong>of</strong> stabilization policies (Sundararajan, 1996).<br />
Since the early 1990s, many developing countries have started to<br />
restructure their financial sector as a part <strong>of</strong> broader Structural Adjustment<br />
Programs (SAP) which includes fiscal consolidation, reforms <strong>of</strong> the trade and<br />
exchange rate systems, price liberalization, deregulation <strong>of</strong> financial sector<br />
activities and other wide-ranging measures to enhance efficiency and supply<br />
responsiveness <strong>of</strong> the economy. These reforms were expected to bring about<br />
significant economic benefits, particularly through a more effective<br />
mobilization <strong>of</strong> domestic savings and efficient allocation <strong>of</strong> resources. Policies<br />
for restructuring the domestic financial system are aimed at strengthening the<br />
role <strong>of</strong> market forces and competition through liberalization <strong>of</strong> interest rates,<br />
adoption <strong>of</strong> indirect monetary instruments, strengthening <strong>of</strong> prudential<br />
supervision and related market information systems in order to deal effectively<br />
with interest rate and exchange rate risks and other banking risks, particularly<br />
in the context <strong>of</strong> capital account liberalization by enhancing banks’ soundness<br />
and by promoting equity markets (IMF, 1995). Moreover, the liberalization <strong>of</strong><br />
current and capital account transactions are aimed at better integrating the<br />
domestic financial system into world financial markets.<br />
During the pre-reform period, the financial sector in Pakistan mainly<br />
accommodated the financing needs <strong>of</strong> the government, public enterprises<br />
and priority sectors. Private sector investment remained modest, and efforts<br />
to mobilize savings lacked the dynamism <strong>of</strong> a competitive financial system.<br />
Financial intermediaries were insulated from competition in the domestic<br />
market through oligopolistic practices and barriers to entry in the sector,<br />
and from outside competition through tight restrictions on current and<br />
capital accounts transactions (Khan, 1995).<br />
In such an environment, which was typical <strong>of</strong> many pre-reform<br />
situations, distortions were widespread, interest rates were generally<br />
negative in real terms, incentives were provided to inefficient investment,<br />
credit was rationedon the basis <strong>of</strong> government determined priorities and<br />
excessive regulations hindered the activities <strong>of</strong> financial intermediation.<br />
Consequently, economic efficiency remained low and growth suffered from<br />
relatively low savings and investment rates in the private sector.
Financial Sector Restructuring in Pakistan 99<br />
Like many other developing countries, Pakistan undertook the<br />
process <strong>of</strong> financial restructuring through reforms in the early 1990s to<br />
establish a more market-based system <strong>of</strong> financial intermediation and<br />
government financing, conduct monetary policy more efficiently through<br />
greater reliance on indirect instruments and contribute to the rapid<br />
development <strong>of</strong> the stock markets. These reforms were primarily designed to<br />
correct the distortions implicit in the administered structure <strong>of</strong> rates <strong>of</strong><br />
returns on various financial instruments, to abolish the directed and<br />
subsidized credit schemes, to allow the free entry <strong>of</strong> private banks in the<br />
financial sector in order to enhance competition and efficiency in the<br />
financial sector and to strengthen the State Bank <strong>of</strong> Pakistan’s (SBP)<br />
supervision.<br />
The main objective <strong>of</strong> this paper is to examine the financial<br />
restructuring efforts undertaken by the government <strong>of</strong> Pakistan to gain<br />
efficiency in the financial sector. Moreover, the study also examines the<br />
outcomes resulting from financial restructuring and suggests further<br />
improvement in this regard. The rest <strong>of</strong> the study is structured as follows:<br />
Section 2 discusses the theoretical rationale <strong>of</strong> financial restructuring.<br />
Section 3 describes the financial restructuring process carried out so far in<br />
Pakistan, while Section 4 assesses the results <strong>of</strong> restructuring in Pakistan.<br />
Some concluding remarks are given in Section 5.<br />
II.<br />
Theoretical Rationale <strong>of</strong> Financial Sector Restructuring<br />
The theoretical support for financial restructuring as a policy goal<br />
can be traced back to the fundamental theorem in welfare economics and<br />
the efficient market hypothesis. The fundamental theorem suggests that<br />
competitive markets lead to Pareto optimal equilibria, while the efficient<br />
market hypothesis argues that the financial sector uses market information<br />
efficiently. A combination <strong>of</strong> these two ensures the efficiency in the financial<br />
sector. The reform <strong>of</strong> the financial system removes market distortions that<br />
impede free market conditions (Eatwell, 1996; Mavrotas and Kelly, 2001).<br />
Mckinnon (1973) and Shaw (1973) argued that financial deepening is an<br />
essential ingredient to the process <strong>of</strong> capital accumulation, which in turn<br />
enhances economic growth through savings and investment. They further<br />
stated that financially repressed economies remain below its market clearing<br />
values thereby generating less than the optimal amount <strong>of</strong> savings and thus<br />
detracting from the pool available for investment. The policy message is that<br />
both financial and real sector development requires a comprehensive<br />
package <strong>of</strong> financial restructuring that frees up interest rates to their<br />
market-clearing levels and eliminates administratively-determined selective<br />
credit allocation (Chowdhury, 2000).
100<br />
Muhammad Arshad Khan and Sajawal Khan<br />
There is now general agreement among economists that<br />
inappropriate regulatory and supervisory policies not only retard long-term<br />
economic growth but also increase the likelihood <strong>of</strong> a financial crisis that<br />
could spread beyond the country’s own borders. Table-1 provides the<br />
importance <strong>of</strong> prudential and related regulations in the efficient<br />
management <strong>of</strong> the financial system.<br />
Table-1: Types <strong>of</strong> Financial Regulation: Objectives and Key Policy<br />
Instruments<br />
Type <strong>of</strong><br />
Regulation<br />
Macroeconomic<br />
Allocative<br />
Structural<br />
Prudential<br />
Objectives<br />
-To maintain control over<br />
aggregate economic activity.<br />
-To maintain internal and<br />
external balance<br />
-To influence the allocation<br />
<strong>of</strong> financial resources in<br />
favour <strong>of</strong> priority activities.<br />
-To control the possible<br />
abuse <strong>of</strong> monopoly power<br />
by dominant firms.<br />
-To preserve the safety and<br />
soundness <strong>of</strong> individual<br />
financial institutions and<br />
sustain public confidence in<br />
systemic stability.<br />
Organizational -To ensure smooth<br />
functioning and integrity <strong>of</strong><br />
financial markets and<br />
information exchanges<br />
Protective<br />
Source: Vittas (1992, p. 63)<br />
-To provide protection to<br />
users <strong>of</strong> financial services,<br />
especially consumers and<br />
non-pr<strong>of</strong>essional investors.<br />
Key Policy Instruments<br />
Reserve requirements, direct<br />
credit and deposit ceilings,<br />
interest rate controls,<br />
restrictions on foreign capital<br />
Selective credit allocation,<br />
compulsory investment<br />
requirements, preferential<br />
interest rates.<br />
Entry and merger controls,<br />
geographic and functional<br />
restrictions.<br />
Authorization criteria,<br />
minimum capital<br />
requirements, limits on the<br />
concentration <strong>of</strong> risks,<br />
reporting requirements.<br />
Disclosure <strong>of</strong> market<br />
information, minimum<br />
technical standards, rule <strong>of</strong><br />
market making and<br />
participation.<br />
Information disclosure to<br />
consumers, compensation<br />
funds, ombudsmen to<br />
investigate and resolve<br />
disputes.
Financial Sector Restructuring in Pakistan 101<br />
It is clear from Table-1 that the debate relating to liberalization has<br />
focused on the allocative aspect <strong>of</strong> the financial sector rather than<br />
prudential, organizational and protective regulations because <strong>of</strong> information<br />
problems. Barth, et. al. (1998) suggest that the following initial steps should<br />
be taken to reduce the likelihood <strong>of</strong> a financial crisis:<br />
• Develop and improve legal systems and information disclosure;<br />
• Impose rate ceilings on bank deposits;<br />
• Establish limits on the rate at which banks can expand credit or on<br />
the rate <strong>of</strong> increase in their exposure to certain sectors, such as real<br />
estate;<br />
• Required greater diversification <strong>of</strong> bank portfolios; and<br />
• Reduce the restrictions on the range <strong>of</strong> activities in which banks can<br />
engage.<br />
They maintain that it is not possible to determine a priori which<br />
combination is most appropriate for individual countries because <strong>of</strong> the<br />
different stages <strong>of</strong> development. Despite this, it would be essential to<br />
maintain that the central purpose <strong>of</strong> prudential and organizational<br />
regulations is to deal with failures associated with moral hazard while<br />
protective regulations focus on the need to design a fair financial system<br />
that protects the interests <strong>of</strong> the users <strong>of</strong> financial services.<br />
Sheng (1996) defined financial restructuring as “the package or<br />
macroeconomic, microeconomic, institutional and regulatory measures taken<br />
to restore problem banking system to financial solvency and health”. The<br />
problem banking system may be defined in terms <strong>of</strong> non-performing loans<br />
(NPLs) and shortfall <strong>of</strong> credit requirements. Sheng states that “as a rule <strong>of</strong><br />
thumb, banking distress is likely to become systemic when NPLs, net <strong>of</strong><br />
provisions reached roughly 15% <strong>of</strong> the total loans”. The Narasimham<br />
Committee on Banking Sector Reforms (1998) defines that “a weak bank<br />
should be one whose accumulated losses and net NPLs exceed its net worth<br />
or one whose operating pr<strong>of</strong>its less its income on recapitalization bonds is<br />
negative for three consecutive years”. Practically, financial restructuring is a<br />
complex process but it strengthens the balance sheet structure <strong>of</strong> banks and<br />
non-bank financial intermediaries (NBFIs). It can be argued that appropriate<br />
efforts are necessary to reverse the insolvency and poor pr<strong>of</strong>itability <strong>of</strong><br />
banks. Moreover, the regulatory environment and supervisory institutions<br />
must be modernized and restructured (Hoelscher, 1998). These steps are
102<br />
Muhammad Arshad Khan and Sajawal Khan<br />
necessary to ensure that banking failure does not jeopardize the stability <strong>of</strong><br />
financial institutions. The process <strong>of</strong> financial restructuring consists <strong>of</strong> four<br />
phases i.e. diagnosis, damage control, loss allocation and rebuilding<br />
pr<strong>of</strong>itability and creating the right incentives. If the diagnosis is done<br />
correctly, it would help the banks to know the extent and causes <strong>of</strong> loss by<br />
applying uniform accounting and auditing standards ─ especially loan<br />
classifications and interest accrual standards ─ for all banks. Damage control<br />
is basically intended to stop the flow <strong>of</strong> future losses either by liquidating,<br />
enforcing hard budget constraints, changing management, etc. Loss<br />
allocation among different parties 25 is the most difficult part <strong>of</strong> financial<br />
restructuring and successful restructuring depends on the loss allocation.<br />
Finally, rebuilding pr<strong>of</strong>itability and creating the right incentives requires<br />
good policies, reliable and efficient management and a strong institutional<br />
framework.<br />
There are two types <strong>of</strong> restructuring mechanism: one is market<br />
based solutions such as shareholder capital injection, sale or merger,<br />
liquidation without deposit compensation, etc. and the other involves<br />
government intervention such as liquidation with deposit insurance,<br />
formation <strong>of</strong> asset recovery trust, supply side solutions, etc 26 . Dziobek and<br />
Pazarbasioughu (1988) propose two types <strong>of</strong> restructuring mechanisms:<br />
financial and operational restructuring. According to them, the aim <strong>of</strong> the<br />
restructuring program is to restore the solvency and pr<strong>of</strong>itability <strong>of</strong> the<br />
banks. Bank solvency would emanate from shorter-term financial<br />
restructuring measures such as capital injection, long-term loans, swapping<br />
bonds for NPLs, etc. While a return to pr<strong>of</strong>itability requires more difficult<br />
and longer-term operational restructuring such as improved cost<br />
effectiveness, better internal governance, effective risk management, etc.<br />
Hence, bank insolvency is dealt with by financial restructuring, while poor<br />
pr<strong>of</strong>itability is caused by some combination <strong>of</strong> NPLs and high operating<br />
costs. These problems are dealt with through operational restructuring.<br />
Mishkin (1996) has noted that “a non-linear disruption to financial<br />
markets in which adverse selection and moral hazard problems become much<br />
worse, so that the financial markets are unable to efficiently channel funds to<br />
economic agents who have the most productive investment opportunities”.<br />
There are four factors promoting a financial crisis: increases in interest rates,<br />
increases in uncertainty, asset market effects on balance sheets, and bank<br />
panics. Hence, a strong regulatory and supervisory system is necessary to cope<br />
with a financial crisis and promote the efficient functioning <strong>of</strong> financial<br />
25 Such as, owners, borrowers, depositors, regulators and government.<br />
26 See Sheng (1996), p. 36.
Financial Sector Restructuring in Pakistan 103<br />
markets. Caprio and Klingebiel (1997) showed that a mixture <strong>of</strong> bad policies<br />
and bad banking causes bank insolvency. Furthermore, excessive expansion <strong>of</strong><br />
credit is also one <strong>of</strong> the main causes <strong>of</strong> insolvency. Besides bad banking and<br />
excessive credit expansion, there are many causes which are cited in the<br />
literature such as asset-liability mismatches, insufficient diversification,<br />
directed lending, fraud, etc. Therefore, the challenge is to devise an<br />
appropriate regulatory framework that enables the banking system to be more<br />
resilient to insolvency. In addition, timing, sequencing, and speed <strong>of</strong><br />
restructuring measures are very important for successful restructuring<br />
(Khatkhate, 1998 and Alawode and Ikhide, 1997).<br />
The experiences <strong>of</strong> economies in transition illustrate that the<br />
sequencing <strong>of</strong> bank restructuring and supervision policies have had a great<br />
impact on macroeconomic performance and financial market development.<br />
In Eastern and Central Europe, bank restructuring policies-recapitalization<br />
with government funds (Hungary, Czechoslovakia, Poland), carving out bad<br />
loans (Poland, Czech Republic), conversion <strong>of</strong> enterprise debt-to-equity<br />
(Bulgaria and Croatia) - were implemented in varying degrees since 1991<br />
(Sundararajan, 1996). The effectiveness <strong>of</strong> financial restructuring requires<br />
sustained efforts towards stabilization and proper design and the<br />
enforcement <strong>of</strong> bank restructuring and prudential supervision policies in<br />
order to avoid major disruption to growth and stability.<br />
The sequencing <strong>of</strong> financial restructuring and prudential supervision<br />
policies may be divided into three stages (Sundararajan, 1994 and Alexander<br />
et al, 1995). These three stages (Table-2) can provide guidelines for every<br />
country, pursuing restructuring and financial liberalization policies.<br />
Table-2: Financial Restructuring during the Various Stages <strong>of</strong> Financial<br />
Sector Reform<br />
The preparatory stage include:<br />
Stage 1: Preparatory<br />
Introduction <strong>of</strong> a minimal program <strong>of</strong> financial restructuring<br />
policies to deal with fixed rate loans, selected nonperforming<br />
loans, capital adequacy and subsidized selective credit.<br />
Review <strong>of</strong> legal and organizational arrangements for banking<br />
supervision.<br />
Strengthen the licensing and entry regulations. Put in place a<br />
framework for orderly intervention and liquidation <strong>of</strong> banks.
104<br />
Muhammad Arshad Khan and Sajawal Khan<br />
Stage 2: Initiating Market Development<br />
This stage includes the following measures:<br />
Phase in the reform <strong>of</strong> commercial bank accounting and bank<br />
reporting systems, help to enforce prudential norms and facilitate<br />
monetary analysis.<br />
Phase in the prudential regulations, particularly loan classification<br />
and provision, credit concentration limits, credit appraisal<br />
guidelines and foreign exchange exposure rules based on new<br />
accounting standards.<br />
Strengthen and phase in the capital adequacy norms in line with<br />
bank restructuring strategy.<br />
Introduction <strong>of</strong> a strategy to combine <strong>of</strong>f-site, on-site, and<br />
external audit, and the balance among the components such as<br />
the availability <strong>of</strong> resources and technical assistance.<br />
Active pursuit <strong>of</strong> institutional development <strong>of</strong> banks.<br />
Formulation <strong>of</strong> a comprehensive program <strong>of</strong> bank restructuring,<br />
bank liquidations, loan recovery and loan workout arrangements.<br />
Implementation <strong>of</strong> simple financial restructuring policies for banks<br />
- supported by enterprise financial restructuring (e.g. policies to<br />
reduce debt-equity ratio <strong>of</strong> non-financial firms and recapitalize<br />
banks through portfolio restructuring) as a part <strong>of</strong> this program.<br />
Stage 3: Strengthening Financial Markets<br />
During this stage the following steps are needed:<br />
Continuation <strong>of</strong> comprehensive reforms to foster bank and<br />
enterprise restructuring systematically in line with the program<br />
designed in stage 2.<br />
Promotion <strong>of</strong> well-capitalized and well-supervised dealers in<br />
government securities (and money market instruments) as part <strong>of</strong><br />
strengthening security market regulations and supervision.<br />
Completion <strong>of</strong> reforms <strong>of</strong> bank accounting and prudential standards.<br />
Strengthen financial risk management in payment systems.<br />
Strengthen supervision <strong>of</strong> asset-liability management (interest rate<br />
risks, liquidity management), internal controls, and management<br />
systems <strong>of</strong> banks.
Financial Sector Restructuring in Pakistan 105<br />
Achievement <strong>of</strong> appropriate balance between <strong>of</strong>f-site supervision,<br />
on-site inspection and external audit through technical assistance<br />
and training.<br />
Close monitoring <strong>of</strong> risk implications <strong>of</strong> financial innovations and<br />
internationalization.<br />
III.<br />
Financial Restructuring in Pakistan<br />
In Pakistan, banking sector reforms were launched in the early<br />
1990s. The objective <strong>of</strong> these reforms was to make the financial industry<br />
more competitive and transparent by privatizing formerly nationalized<br />
commercial banks, liberalizing interest rates and credit ceilings,<br />
strengthening the supervisory capacity <strong>of</strong> the central bank and standardized<br />
accounting and auditing systems (Iimi, 2004).<br />
Prior to the 1990s, the financial sector in Pakistan remained heavily<br />
controlled 27 . Interest rates were set administratively and usually remained<br />
negative in real terms. Monetary policy was conducted primarily through the<br />
direct allocation <strong>of</strong> credit. The money market was under-developed, and<br />
bond and equity markets were virtually nonexistent. Commercial banks<br />
<strong>of</strong>ten had to lend priority sectors with little concern for the borrowing<br />
firm’s pr<strong>of</strong>itability. Despite the opening <strong>of</strong> the non-bank financial sector for<br />
private investment in the mid-1980s, state-owned financial institutions held<br />
almost 93.8 % <strong>of</strong> the total assets <strong>of</strong> the entire financial sector at the end <strong>of</strong><br />
the 1980s. Moreover, the status <strong>of</strong> financial institutions was precarious due<br />
to, inter alia, high intermediation costs resulting from overstaffing, a large<br />
number <strong>of</strong> loss-incurring branches, poor governance with low quality<br />
banking services, accumulation <strong>of</strong> non-performing loans and inadequate<br />
market capitalization. These inefficiencies and distortions caused severe<br />
macroeconomic difficulties in the late 1970s and 1980s and distorted<br />
economic growth. In order to remove these distortions and spur economic<br />
growth, the Government <strong>of</strong> Pakistan undertook a wide range <strong>of</strong> reforms in<br />
the early 1990s to strengthen its financial system and to provide an<br />
adequate macroeconomic environment.<br />
The financial sector reforms included: (i) the liberalization <strong>of</strong> interest<br />
rates by switching from an administrated interest rate setting to a market<br />
based interest rate determination; (ii) the reduction <strong>of</strong> controls on credit by<br />
27 All commercial banks were nationalized in January, 1974, with the aim <strong>of</strong> making<br />
credit availability to high priority sectors <strong>of</strong> the economy which previously had limited<br />
access to investable funds (see Haque and Kardar, 1993 for a detailed account).
106<br />
Muhammad Arshad Khan and Sajawal Khan<br />
gradually eliminating directed and subsidized credit schemes, (iii) the<br />
creation and encouragement <strong>of</strong> the development <strong>of</strong> a secondary market for<br />
government securities, (iv) strengthening the health and competition <strong>of</strong> the<br />
banking system by recapitalizing and restructuring the nationalized<br />
commercial banks (NCBs) increasing their autonomy and accountability, (v)<br />
improving the prudential regulations and supervision <strong>of</strong> all financial<br />
institutions, and (vi) allowing free entry <strong>of</strong> private banks in the financial<br />
market.<br />
The financial sector reforms which were launched in the early 1990s<br />
can be classified in three phases. These three phases <strong>of</strong> financial sector<br />
reforms can be termed as the first generation <strong>of</strong> reforms.<br />
III.A. First Phase <strong>of</strong> Financial Reforms (1988 –1996)<br />
The first phase reforms were aimed at creating an efficient,<br />
productive, and enabling environment for operational flexibility and<br />
functional autonomy. The first phase <strong>of</strong> financial reforms 28 included: first,<br />
the government liberalized the market entry <strong>of</strong> private and foreign banks 29<br />
in order to gain efficiency and enhance competition within the financial<br />
sector. Secondly, two <strong>of</strong> the state-owned commercial banks, i.e. Muslim<br />
Commercial Bank (MCB) and Allied Bank Limited (ABL), were partially<br />
privatized between 1991 and 1993. Thirdly, major state-owned<br />
commercial banks and DFIs were downsized in terms <strong>of</strong> branches and<br />
employees. Fourthly, credit ceiling as an instrument <strong>of</strong> credit control was<br />
abolished, the Credit Deposit Ratio (CDR) was also abolished and open<br />
market operations is now an instrument <strong>of</strong> monetary policy and the State<br />
Bank <strong>of</strong> Pakistan (SBP) at regular intervals has conducted auctions <strong>of</strong><br />
government securities. Fifthly, the loan recovery process was strengthened<br />
by establishing banking courts and standardizing loan classification and<br />
accounting rules. Finally, the State Bank <strong>of</strong> Pakistan was granted full<br />
autonomy. However, the segmentation <strong>of</strong> financial markets continued<br />
owing to continuing controls on interest rates on government debts and<br />
specialized credit programs.<br />
28 The early phase <strong>of</strong> financial reforms as a part <strong>of</strong> financial restructuring policies started<br />
in the late 1980s to early 1990s.<br />
29 Ten new private banks started their operations in 1991 and 23 private domestic banks<br />
operating in the country including HBL, ABL, MCB and UBL. The process <strong>of</strong><br />
liberalization started in the early 1990s and except NBP, more than 50 % shares <strong>of</strong> the<br />
public sector have been privatized. There are about 14 foreign banks that have been<br />
operating in the country.
Financial Sector Restructuring in Pakistan 107<br />
III.B. Second Phase <strong>of</strong> Financial Reforms (1997-2001)<br />
In late 1996 the financial sector was on the verge <strong>of</strong> collapse<br />
(Table-3) with about one-third <strong>of</strong> banking assets stuck in the form <strong>of</strong> Non<br />
Performing Loans (NPLs). Liquidity problems had begun to emerge as<br />
disintermediation spread and banking losses increased. Most cases <strong>of</strong> loan<br />
defaults remained unresolved because <strong>of</strong> the ineffective judicial system.<br />
These problems were rooted in a failure <strong>of</strong> governance and lack <strong>of</strong><br />
financial discipline. Political interference had vitiated the financial<br />
intermediation function <strong>of</strong> the banking system and the borrowers expected<br />
not to repay loans they took, especially from National Commercial Banks<br />
(NCBs) and Development Finance Institutions (DFIs). NCBs and DFIs were<br />
the main loss makers because over 90% <strong>of</strong> their loans were in default.<br />
Excess manpower, large branch network and undue interference by labor<br />
unions resulted in large operating losses. Poor disclosure standards and<br />
corruption were widespread. These serious problems created a demand for<br />
further reforms. As a result, the second phase <strong>of</strong> banking sector reforms 30<br />
was introduced in early 1997. These reforms addressed the fundamental<br />
causes <strong>of</strong> crisis and corruption and strengthened corporate governance and<br />
financial discipline. In this regard, the cost structure <strong>of</strong> banks was first<br />
restructured through capital maintenance and increased by public funds.<br />
Secondly, partially privatized commercial banks were privatized<br />
completely. Thirdly, bank branches were fully liberalized which allowed<br />
private banks to grow faster and increase their market share. Fourthly,<br />
loan collateral foreclosure was facilitated and strengthened to reduce<br />
default costs and to expand lending to lower tier markets, including<br />
consumer banking. Fifthly, national savings schemes were reformed so as<br />
to integrate with the financial market. Sixthly, the mandatory placement<br />
<strong>of</strong> foreign currency deposits was withdrawn. Lastly, the SBP was<br />
strengthened to play a more effective role as regulator and guardian <strong>of</strong> the<br />
banking sector and phase out the direct and concessional credit programs<br />
to promote market integration.<br />
30 The second phase <strong>of</strong> banking sector reforms started from 1997 to 2001.
108<br />
Muhammad Arshad Khan and Sajawal Khan<br />
Table-3: Selected Indicators <strong>of</strong> Vulnerability in Pakistan<br />
(Period ended 1996)<br />
Macro Indicator<br />
Inflation > 5% 10.7<br />
Fiscal Deficit > 2% <strong>of</strong> GDP 6.5<br />
Public Debt > 50% <strong>of</strong> GDP<br />
Current Account Deficit > 5% <strong>of</strong> GDP 7.4<br />
Short-term Flows > 50% <strong>of</strong> the Current Account Deficit<br />
Capital Inflows > 5% <strong>of</strong> GDP<br />
Ratio <strong>of</strong> Short-term Debt to International Reserves >1<br />
Financial Sector Indicators<br />
Recent Financial Sector Liberalization<br />
Recent Capital Account Liberalization<br />
Credit to the Private Sector > 100% <strong>of</strong> GDP 17.1%<br />
Credit to the Private Sector (real growth) > 20%<br />
Emphasis on Collateral when making loans<br />
Estimated Share <strong>of</strong> Bank Lending to the Real Estate Sector>20%<br />
Stock <strong>of</strong> Non-performing Loans > 10 % <strong>of</strong> Total Loans<br />
Stock Market Capitalization as %age <strong>of</strong> GDP 20.11%<br />
Source: Lindgren et al (1999), p. 11<br />
III.C. Third Phase <strong>of</strong> Financial Sector Reforms (2002-2004)<br />
In this phase there were several major changes and significant<br />
positive shifts in the regulatory atmosphere to strengthen the financial<br />
system and introduce structural improvements. Some <strong>of</strong> the more important<br />
developments have been seen in the following areas:<br />
Consolidation, Privatization and Regulation: During the 1990s,<br />
mushroom growth in commercial banks and non-bank financial institutions<br />
has been witnessed, a few <strong>of</strong> which have low capitalization,<br />
inadequate/inappropriate staffing, poor risk management practices and a<br />
marginal portfolio quality. The central bank sought out to consolidate the<br />
Yes<br />
Yes<br />
Yes<br />
Yes<br />
Yes<br />
No<br />
No<br />
Yes<br />
No<br />
Yes
Financial Sector Restructuring in Pakistan 109<br />
banking sector by raising the minimum capital requirement. The minimum<br />
capital requirement was 1 billion for 2003, 1.5 billion for 2004 and was set<br />
at 2 billion for 2005. There have been 17 mergers and acquisitions and<br />
there are several in the pipeline. Weak entities have been eliminated. The<br />
average capital base <strong>of</strong> a commercial bank has risen from 1.8 billion in 2000<br />
to 3.7 billion in 2003. Now all banks are required to maintain at least 8% <strong>of</strong><br />
the risk weighted assets as capital requirement.<br />
The regulatory oversight for a sizeable chunk <strong>of</strong> the financial system<br />
(such as leasing companies, modarabas, investment banks, mutual funds and<br />
insurance companies) has been moved to the Securities and Exchange<br />
Commission (SECP), but SECP failed to build capacity in order to handle<br />
this inflow. The SECP lacks on-site inspection capability.<br />
Universal and Consumer Banking: Banks are allowed to form separate<br />
subsidiaries to function as mutual funds, asset management companies,<br />
venture capital, foreign exchange companies, etc. Furthermore, banks are<br />
encouraged to expand their lending operations to middle and lower income<br />
groups. A large range <strong>of</strong> consumer asset products such as credit cards, auto<br />
loans, clean installment loans, housing finance, etc., are being marketed<br />
aggressively. The NPLs in this sector are significantly lower than that <strong>of</strong> the<br />
corporate sector. Similarly, Small and Medium Enterprise (SME) financing<br />
has also become part <strong>of</strong> the lending toolkit. However, several banks shy<br />
away from this sector because <strong>of</strong> high-risk perception.<br />
Automation and Prudential Regulations: ATM coverage is relatively low<br />
and on-line banking is <strong>of</strong>fered by most <strong>of</strong> the banks. The Central Bank itself<br />
is making significant progress in this area. Credit information data and<br />
credit rating agencies data are now available on line.<br />
Similarly, the Central Bank has been steadily moving away from its<br />
tradition <strong>of</strong> intrusive regulation and directed lending. Unlike the late 1980s,<br />
a much more permissive regulatory atmosphere prevails today. The Central<br />
Bank also modernized and revised prudential regulations for corporate and<br />
commercial banking, SME financing, micr<strong>of</strong>inance institutions and consumer<br />
financing.<br />
Banking Audit, Supervision and Corporate Governance: The<br />
SBP’s compliance with the Basle Core Principles is generally high. The SBP<br />
now conducts comprehensive on-site inspections using a standardized
110<br />
Muhammad Arshad Khan and Sajawal Khan<br />
CAMELSS 31 for rating the overall condition <strong>of</strong> a bank. The SBP is also<br />
developing an early warning system called IRAF 32 . For corporate<br />
governance, both the SBP and SECP issued codes <strong>of</strong> corporate governance.<br />
Corporate disclosure standards have improved. However, there is a need to<br />
reform the taxation structure and the tax collecting institutions.<br />
Out-<strong>of</strong>-Court Settlement <strong>of</strong> NPLs: Two thirds <strong>of</strong> the stock <strong>of</strong><br />
NPL involve a single lender. Recovery <strong>of</strong> NPLs involves internal and<br />
external hurdles. The pressure from influential borrowers is <strong>of</strong>ten exerted<br />
through the government. To reduce the level <strong>of</strong> NPLs, the government<br />
and the SBP established the committee for the revival <strong>of</strong> sick industrial<br />
units (CRSIU) and corporate and industrial restructuring corporation<br />
(CIRC). The committee claims that it has revived 172 industrial units<br />
involving outstanding NPLs <strong>of</strong> Rs. 46 billion. However, the World Bank<br />
concluded, regarding the assessment <strong>of</strong> CIRSU, that “in the absence <strong>of</strong><br />
operational analysis, there would generally appear little increment in the<br />
value <strong>of</strong> the project. Future viability and renewed distress <strong>of</strong> these projects<br />
are <strong>of</strong> concern. No track is kept <strong>of</strong> financial or operational details <strong>of</strong> the<br />
projects after revival.” In 2002 because <strong>of</strong> growing NPLs and the failure <strong>of</strong><br />
CIRC, the National Accountability Bureau (NAB) and CIRSU, the SBP<br />
issued guidelines whereby banks are actively encouraged to settle NPLs<br />
with borrowers at the Fore Sale Value (FSV) <strong>of</strong> the underlying collateral.<br />
Under this scheme, borrowers were required to deposit 10% down<br />
payment at the time <strong>of</strong> signing the settlement agreement and repay the<br />
remaining amount in 12 quarterly installments. This scheme encourages a<br />
lot <strong>of</strong> defaulters to come forward and settle their long-standing liabilities.<br />
Similarly, under the debt recovery program, EDR (Excess Debt Recovery)<br />
had a write-<strong>of</strong>f efficiency ratio <strong>of</strong> 5:1(i.e. for each <strong>of</strong> the provisions<br />
written <strong>of</strong>f it would generate a cash recovery <strong>of</strong> Rs. 5). Under these<br />
guidelines Rs. 52 billion <strong>of</strong> NPL have been settled at the cost <strong>of</strong> around<br />
Rs. 35 billions.<br />
IV. Results <strong>of</strong> the Financial Restructuring<br />
The objectives <strong>of</strong> financial restructuring policies were to forestall a<br />
collapse <strong>of</strong> the generalized banking system and to establish a viable banking<br />
system in the country. It was expected that financial and operational<br />
restructuring policies strengthened the microeconomic foundations <strong>of</strong> the<br />
banking system. However, commercial banks have been slow to mobilize<br />
31 CAMELSS indicate Capital, Assets, Management, Earnings, Liquidity, and Sensitivity<br />
to Market Risk, Systems.<br />
32 IRAF indicate Institutional Risk Assessment Framework.
Financial Sector Restructuring in Pakistan 111<br />
deposits, which play a significant role in financial intermediation. As Akhtar<br />
(2007) pointed out, the successful transformation and restructuring <strong>of</strong> the<br />
financial industry depends on some critical factors such as: (i) promoting a<br />
higher degree <strong>of</strong> depth and efficiency in the financial intermediation process<br />
by effective resource mobilization and channeling these resources to<br />
promote economic growth, (ii) improving the financial performance and<br />
strengthening the soundness <strong>of</strong> financial institutions, and (iii) extending the<br />
outreach <strong>of</strong> financial services to the poor segment <strong>of</strong> society.<br />
We therefore, briefly discuss the impact <strong>of</strong> the financial sector<br />
reforms under the following headings:<br />
IV.A. Interest Rate Policies<br />
Interest rates directly affect business conditions and economic<br />
activities and thus represent a powerful policy instrument. In Pakistan,<br />
before financial reforms, interest rates were set administratively and were<br />
<strong>of</strong>ten negative in real terms. For example, deposits were paid negative real<br />
return, thus discouraging savings in the country. Ceilings on interest rates<br />
were imposed with the desire to provide low-cost financing to encourage<br />
investment, particularly in the priority sectors. However, restrictions on<br />
interest rates led to financial disintermediation, as savers and investors<br />
sought alternative outlets outside the formal financial system. Consequently,<br />
financial deepening was hindered, and financial resources were not directed<br />
into productive activities.<br />
After liberalization, the price <strong>of</strong> financial services was intended to be<br />
determined by the banks on a competitive basis, with little intervention<br />
from the SBP. To achieve the twin objectives <strong>of</strong> reducing the government’s<br />
cost <strong>of</strong> borrowing on domestic debt and encouraging private sector credit<br />
expansion, the SBP had been pursuing a relatively easy monetary policy from<br />
July 1995 to July 2000. The weighted average lending rate gradually came<br />
down from 15.6% in 1998 to 8.81% 33 in June 2005, but the real interest<br />
rate increased from 3.6% in 1996 to 10.9% in 2000 and then following a<br />
declining trend, reached –0.49% in June 2005 (see Table-4). This reduction<br />
in the lending rate indicates little improvement in the pr<strong>of</strong>itability <strong>of</strong> the<br />
banks but is purely ad hoc and not in the line with liberalization. Similarly,<br />
the weighted average deposit rate declined from 6.8% in 1998 to 1.37% in<br />
June 2005; the real deposit rate remained negative except for the period<br />
1999-2002. This reduction in the deposit rate will reduce savings even<br />
further.<br />
33 Although in 2004 the rate fell to 7.28 %.
112<br />
Muhammad Arshad Khan and Sajawal Khan<br />
Year<br />
Inflation<br />
Rate<br />
Table-4: Interest Rate Behavior in Pakistan<br />
Weighted average<br />
Lending Rate<br />
Weighted average<br />
Deposit Rate<br />
Interest Rate<br />
Spread<br />
Nominal Real Nominal Real Nominal Real<br />
1990-95 10.57 12.55 1.98 6.53 -4.05 6.02 5.95<br />
1996 10.8 14.4 3.6 6.4 -4.4 8.00 8.00<br />
1997 11.8 14.6 2.8 6.8 -5.0 7.8 7.8<br />
1998 7.8 15.6 7.8 6.8 -1.0 8.8 8.8<br />
1999 5.7 14.8 9.1 6.5 0.8 8.3 8.3<br />
2000 3.6 13.52 10.9 5.47 1.9 8.05 9.00<br />
2001 4.4 13.61 9.21 5.27 0.87 8.34 8.34<br />
2002 3.5 13.19 9.69 3.61 0.11 9.58 9.58<br />
2003 3.1 9.40 6.3 1.61 -1.49 7.79 7.79<br />
2004 4.6 7.28 2.68 0.95 -3.65 6.33 6.33<br />
2005 9.3 8.81 -0.49 1.37 -7.93 7.44 7.44<br />
Source: SBP Annual Reports (various issues).<br />
The interest rate spread 34 is an important indicator for the financial<br />
sector’s competitiveness, pr<strong>of</strong>itability and efficiency. Spread typically declines<br />
when competition among banks increases to access the financial market to<br />
increase their customer’s base. But in Pakistan, the high lending rate and low<br />
deposit rate have generated a large spread 35 nearing 7.44% in June 2005 as<br />
against 6.33% in 2004. The high lending rate will increase the cost <strong>of</strong><br />
borrowing and hence discourage investment. The low deposit rates discourage<br />
savings, resulting in a high debt/GDP ratio, deterioration <strong>of</strong> the banks balance<br />
sheets, lowering economic growth, and increasing poverty. Furthermore, the<br />
large spread also reflects a perceived sovereign risk (Khan, 2003).<br />
However, the efforts <strong>of</strong> the SBP to enhance competition helped to<br />
narrow the spread to 6.33% in 2004. But this trend was reversed and the<br />
spread rose again to 7.44% by the end <strong>of</strong> June 2005 and the commercial<br />
34 Interest Rate Spread = (Average Lending Rate – Average Deposit Rate).<br />
35 High interest rate spread is generated by factors such as high administrative costs,<br />
overstaffing and unavoidable burden <strong>of</strong> non-performing loans (for further detail, See<br />
SBP’s financial sector assessment 2003-2004).
Financial Sector Restructuring in Pakistan 113<br />
banks re-priced their loans in line with the upward adjustment in the SBP<br />
repo rate in the wake <strong>of</strong> high inflation without any rise in deposit rates.<br />
Hence, measures should be taken to bring down the interest rate spread close<br />
to zero in order to enhance both savings and investment in the country.<br />
IV.B. Performance and Efficiency <strong>of</strong> Financial Institutions<br />
The performance and efficiency <strong>of</strong> a financial institution involves two<br />
aspects, namely, solvency and sustainable pr<strong>of</strong>itability. Solvency improving<br />
measures affect the bank's balance sheet while pr<strong>of</strong>itability measures affect<br />
the bank's income. The improvement in the banking performance emanates<br />
from financial restructuring operations. NPLs can be used as an indicator to<br />
measure the performance <strong>of</strong> financial institutions. In Pakistan, the NCBs and<br />
the DFIs have been facing the problem <strong>of</strong> NPLs, which increased from Rs.<br />
25 billion in 1989 to Rs. 128 billion in June 1998, or 4% <strong>of</strong> GDP.<br />
Moreover, the NPLs increased from Rs. 230.7 billion in December 1999 to<br />
Rs. 240.1 billion in December 2000. However, some significant efforts were<br />
made by the government to recover default loans. As a result, NPLs, in<br />
gross as well as net terms have followed a declining trend since 2001<br />
showing an improvement in loan appraisal standards and market discipline.<br />
Furthermore, as the banking sector registered a growth in advances, the<br />
ratio <strong>of</strong> NPLs to advances showed a sharp declining trend (Table-5).<br />
Table-5: Non-performing Loans <strong>of</strong> the Banking System<br />
Year<br />
NPL’s (in<br />
Billions)<br />
Gross NPLs to<br />
Advances (in %)<br />
Provisions to<br />
NPLs (in %)<br />
Net NPL to Net<br />
Advances (in %)<br />
1997<br />
173.0<br />
23.5<br />
46.6<br />
-<br />
1998<br />
183.0<br />
23.1<br />
58.6<br />
11.1<br />
1999<br />
230.7<br />
25.9<br />
48.6<br />
15.3<br />
2000<br />
240.1<br />
23.5<br />
55.0<br />
12.2<br />
2001<br />
244.1<br />
23.4<br />
54.7<br />
12.1<br />
2002<br />
231.5<br />
21.8<br />
60.6<br />
9.9<br />
2003<br />
222.7<br />
17.0<br />
63.9<br />
6.9<br />
2004<br />
211.2<br />
11.6<br />
70.4<br />
3.8<br />
2005<br />
177.3<br />
8.3<br />
76.7<br />
2.1<br />
Source: SBP Annual report (various issues)
114<br />
Muhammad Arshad Khan and Sajawal Khan<br />
The financial institutions succeeded in bringing down NPLs from<br />
25.9% to 8.3% <strong>of</strong> the total advances <strong>of</strong> the banks and DFIs at the end <strong>of</strong><br />
2005. The net NPLs (net loan ratio), which is a more appropriate measure,<br />
was still about 2.1%. These indicators reveal a very impressive performance<br />
by the banking sector because in late 1996, the banking system was on the<br />
verge <strong>of</strong> a crisis with about one-third <strong>of</strong> its assets stuck in the form <strong>of</strong><br />
default and NPLs.<br />
IV.C. Money and Credit Policies<br />
In the late 1980s and early 1990s, Pakistan conducted its monetary<br />
policy through direct control on credit and interest rates. The banking<br />
system was not generally competitive and major banks were owned by the<br />
state. In addition, banks and other financial institutions were required to<br />
hold part <strong>of</strong> their portfolios in government debt at below market rates. The<br />
government directed bank loans to state owned-enterprises. The range <strong>of</strong><br />
financial instruments available to banks and the public was intended to be<br />
narrow with maturity structures and yields unrelated to risk and liquidity.<br />
In recent years, Pakistan has started to reform its monetary policy by<br />
using indirect or market-based instruments to achieve macroeconomic<br />
stability. In 1995, the SBP shifted the emphasis from direct to indirect<br />
instruments i.e. open market operations including a rediscount window,<br />
liquidity auctions, repurchase agreements and overdraft facility. The<br />
monetary authorities have sought to reduce direct government intervention<br />
and strengthen the role <strong>of</strong> market forces in allocating financial resources in<br />
order to improve the capacity <strong>of</strong> institutions to mobilize domestic savings,<br />
improve the effectiveness <strong>of</strong> monetary policy, enhance competition among<br />
banks and strengthen the banks’ financial soundness.<br />
To measure the improvement in the financial intermediation<br />
capacity <strong>of</strong> the banking system following the financial restructuring process,<br />
the standard indicators used in this paper include the ratios <strong>of</strong> currency to<br />
broad money (M2), ratio <strong>of</strong> currency to GDP, M2/GDP, M3/GDP, M1/M2,<br />
the ratio <strong>of</strong> private sector credit to GDP and market capitalization 36 . Table-5<br />
presents the entire situation after the introduction <strong>of</strong> financial sector<br />
reforms.<br />
36 M1 is the currency in circulation plus demand deposits. M2 is M1 plus time deposit,<br />
foreign currency deposits. M3 is M2 plus other type <strong>of</strong> deposits, as well as short-term<br />
money market instruments such as certificates <strong>of</strong> deposits. In the case <strong>of</strong> Pakistan M3<br />
includes M2 plus NSS, NBFIs.
Financial Sector Restructuring in Pakistan 115<br />
The ratio <strong>of</strong> currency to broad money (M2) would tend to fall in the<br />
financial environment where market forces dominate, where there are<br />
alternative saving investment instruments (stocks, bonds, mutual funds etc.)<br />
that raise the real rate <strong>of</strong> return, where there is confidence in the banking<br />
system and where access to the banking system has expanded. The ratio fell<br />
from 37.56% in 1990 to 23% in 2005. This implies the dominance <strong>of</strong><br />
market forces and retains the confidence <strong>of</strong> the customer in the banking<br />
system. Furthermore, the low ratio <strong>of</strong> currency to money mainly reflects<br />
advancement in the payment system, which heavily relies on credit cards,<br />
the development <strong>of</strong> the banking system and that money can be transferred<br />
between checking and savings accounts easily without any significant cost.<br />
Table:- Indicators <strong>of</strong> Financial Deepening (in %)<br />
Indicators 1961-70 1971-80 1981-90 1990 2000 2001 2002 2003 2004 2005<br />
Currency/M 2 45.13 32.29 32.28 37.56 27.80 26.02 25.30 25.04 23.99 23.00<br />
Currency/GDP 16.06 13.53 13.29 14.73 10.82 10.31 11.08 11.77 11.84 11.18<br />
Broad Money<br />
(M2)/GDP<br />
34.03 33.90 41.24 39.24 38.93 39.64 43.80 46.99 49.36 48.61<br />
M3/GDP - - 51.60 60.63 57.98 55.90 60.8 64.36<br />
M1/M2 - - 67.10 76.01 59.32 58.48 58.01 61.23 61.78 72.48<br />
Private Sector<br />
Credit/GDP<br />
Stock market<br />
capitalization/<br />
GDP<br />
19.60 19.24 21.45 19.92 22.33 22.02 21.92 24.87 29.30 28.44<br />
8.42 4.08 3.75 4.68 10.24 8.15 9.26 15.48 24.05 30.95<br />
Sources: Calculated by authors using IFS and SBP data<br />
During the financial restructuring process, the ratio <strong>of</strong> M2 to GDP<br />
tends to rise as access to banking and saving instruments spreads. But as<br />
markets mature, the ratio M2/GDP tends to decline as other financial<br />
instruments outside the M2 aggregate become available. The ratio M2/GDP<br />
which was 39.24% in 1999, touched 48.61% at the end <strong>of</strong> 2005. This is<br />
mainly due to the improvement <strong>of</strong> the domestic financial system.<br />
The ratio <strong>of</strong> currency to GDP has decrease from 14.73% in 1990 to<br />
11.18% in 2005 implying that the banking system is relatively developed.<br />
There are significant foreign currency deposits in the banking system and<br />
substantial real rates <strong>of</strong> interest on saving accounts in domestic currency.
116<br />
Muhammad Arshad Khan and Sajawal Khan<br />
The ratio <strong>of</strong> M1/M2 provides a proxy for the extent to which the<br />
financial system <strong>of</strong> a country has succeeded in mobilizing savings. In 1990,<br />
the ratio was 76.01, which came down to 58.01% in 2003. This is mainly<br />
due to the development <strong>of</strong> the banking sector, a significant increase in<br />
foreign currency deposits and substantial real interest rate on savings. It<br />
started increasing from 58.01% from 2003 and touched 72.48% at the end<br />
<strong>of</strong> 2005. This implies a reduction <strong>of</strong> savings due to the negative real rate<br />
returns on deposits.<br />
The share <strong>of</strong> private sector credit to GDP is one <strong>of</strong> the important<br />
indicators <strong>of</strong> allocative efficiency when compared with that <strong>of</strong> the<br />
government sector. Credit to the private sector would be expected to<br />
expand when banks are successfully restructured. In addition, this ratio also<br />
reflects whether the private sector receives sufficient resources to carry out<br />
its economic activities. It has fuelled economic activity, revived and<br />
enhanced industrial capacity and supported steady growth in the services<br />
sector, the contribution <strong>of</strong> which to GDP is nearly 52.3%. The ratio <strong>of</strong><br />
private-sector credit to GDP increased from 19.92% in 1990 to 28.44% in<br />
2005. In addition, fiscal adjustment efforts, privatization <strong>of</strong> some public<br />
enterprises and the liberalization <strong>of</strong> interest rates had all clearly enhanced<br />
the private sector's access to the banking system.<br />
Stock market capitalization, which was 4.68 % <strong>of</strong> GDP in 1990, is<br />
30.95 % <strong>of</strong> the GDP in 2005. This indicates the promotion <strong>of</strong> trading<br />
activities. However, the secondary market is not yet operating efficiently and<br />
remains very thin and bank financing remains the main source <strong>of</strong> funds for<br />
productive investment. Furthermore, foreign access to the stock market is<br />
limited because <strong>of</strong> a number <strong>of</strong> factors including macroeconomic<br />
weaknesses, inadequate transparency and accounting standards and a<br />
cumbersome and opaque regulation environment. In addition, there are<br />
some restrictions on the capital movements for non-residents and also<br />
ceilings on non-residents’ shares in companies’ equity. Moreover, bond<br />
markets barely constitute 5-7% <strong>of</strong> GDP and there is low pension and<br />
insurance coverage.<br />
IV.D. Pr<strong>of</strong>itability and Financial Soundness<br />
After years <strong>of</strong> poor pr<strong>of</strong>itability, the returns on assets and equity are<br />
beginning to increase. Net interest income decreased from 69% in 2001 to<br />
58.2% in 2003. This reduction <strong>of</strong> net interest income is mainly due to a<br />
contraction in interest margin. As a result, the share <strong>of</strong> net interest income<br />
in gross income declined to 58.2% (Table-6).
Financial Sector Restructuring in Pakistan 117<br />
Table-6: Banking Sector Earnings and Pr<strong>of</strong>itability.<br />
Earning and Pr<strong>of</strong>itability 1999 2000 2001 2002 2003<br />
Return on assets after tax -0.2 -0.2 -0.5 0.1 1.0<br />
Return on equity after tax -6.2 -0.3 -0.3 13.8 22.1<br />
Net interest income to gross income 54.3 61.2 68.9 67.4 58.2<br />
Non-interest expenses to gross income 76.9 71.6 62.7 57.3 50.4<br />
Personnel expenses to non-interest<br />
expenses<br />
57.0 54.3 52.6 51.4 50.1<br />
Non-interest income to total income 17.6 16.5 14.5 18.1 30.9<br />
Source: State Bank <strong>of</strong> Pakistan<br />
Akhtar (2007) has pointed out that the pr<strong>of</strong>its <strong>of</strong> commercial banks<br />
crossed over $1 billion for the first three quarters <strong>of</strong> 2006. She further noted<br />
that from 2000-2006, the returns on assets <strong>of</strong> banks rose from -0.2% to 2.1%<br />
and return on equity from -3.5% to 26.1%. This increase in pr<strong>of</strong>it may be<br />
attributed to many factors such as: (i) a rise in earning assets <strong>of</strong> commercial<br />
banks to 85% in September 2006 which is significantly above the pre-reform<br />
period and a rise in advances to total assets from 49.1% in 2000 to 55.1% in<br />
September 2006, (ii) a decline in total and operating expenses, (iii) a rise in<br />
the SME, consumer finance and agriculture sector lending which constitutes<br />
over one third <strong>of</strong> total outstanding advances, (iv) a high share <strong>of</strong> non-interest<br />
bearing deposits and declining share <strong>of</strong> fixed deposits, and (v) a growth <strong>of</strong><br />
service charges by the use <strong>of</strong> electronic banking. Furthermore, it can be<br />
argued that the privatization <strong>of</strong> the financial industry has had a distinct impact<br />
on the pr<strong>of</strong>itability <strong>of</strong> the banking sector, though its impact on efficiency is<br />
relatively weak 37 . However, it is expected that over a period <strong>of</strong> time there will<br />
be more progress in these areas.<br />
IV.E. Privatization Policy<br />
The structure <strong>of</strong> the financial sector in Pakistan has substantially<br />
changed following privatization <strong>of</strong> the state-owned commercial banks. In<br />
1990, the financial system was fully dominated by five state-owned<br />
commercial banks. During the first round <strong>of</strong> financial sector reforms, two<br />
state-owned commercial banks ─Muslim Commercial Bank (MCB) and Allied<br />
Bank Limited (ABL) ─were privatized between 1991 and 1993. The reform<br />
process was subsequently delayed for several years and again resumed in the<br />
37 State Bank <strong>of</strong> Pakistan (2005).
118<br />
Muhammad Arshad Khan and Sajawal Khan<br />
early 2000s. With the privatization <strong>of</strong> the third largest commercial bank,<br />
United Bank Limited (UBL), in 2002, the domination <strong>of</strong> the state-owned<br />
commercial banks was ended. As <strong>of</strong> September 2003, the asset share <strong>of</strong><br />
domestic private banks and public sector commercial banks was 47% and<br />
41% respectively. Furthermore, when the privatization <strong>of</strong> Habib Bank<br />
Limited (HBL) was completed in 2004, the share <strong>of</strong> the assets <strong>of</strong> the<br />
banking system held by public sector commercial banks decreased to less<br />
than 25%. Today, the National Bank <strong>of</strong> Pakistan (NBP) is the only stateowned<br />
commercial bank with a market share <strong>of</strong> approximately 20%.<br />
The privatization <strong>of</strong> nationalized commercial banks and DFIs poses a<br />
serious challenge to the government. The government facilitated bank<br />
restructuring process by recapitalization <strong>of</strong> banks through (i) equity injection<br />
<strong>of</strong> Rs. 46 billion in some <strong>of</strong> the public sector banks and write <strong>of</strong>fs equivalent<br />
to Rs. 51 billion, (ii) lay-<strong>of</strong>f <strong>of</strong> close to 35,000 employees in two phases 38 from<br />
public banks, and (iii) the closing <strong>of</strong> over 2000 loss incurring bank branches.<br />
IV.F. Corporate Governance<br />
The efforts <strong>of</strong> SBP helped in bringing a positive change in the<br />
corporate governance standards <strong>of</strong> banks. Banks and other financial<br />
institutions are now managed by a better cadre <strong>of</strong> pr<strong>of</strong>essionals and<br />
stakeholders now play an active role in the affairs <strong>of</strong> banks. Regular board<br />
meetings, financial reporting standards, disclosure and transparency helped<br />
to improve corporate governance. Improvement in corporate governance<br />
helped to ensure a high degree <strong>of</strong> financial stability.<br />
From December 2002 to December 2005, the balance sheet <strong>of</strong> the<br />
banking system has recorded a growth <strong>of</strong> 64.5%, which is quite significant.<br />
Since 2002, the deposits <strong>of</strong> the banking system registered a growth <strong>of</strong> 69%.<br />
Returns on assets after tax increased from 0.1% in 2002 to 1.9% in 2005<br />
and further increased to 2.1% by the end <strong>of</strong> September 2006. The loan<br />
portfolio <strong>of</strong> the banking system doubled in the last three years. Credit<br />
growth is now fairly diversified. All these achievements have resulted owing<br />
to good governance policies.<br />
On the basis <strong>of</strong> the above analysis, we reached the following conclusions:<br />
• Financial markets have now become more competitive and relatively<br />
efficient but still remain shallow. There are many financial<br />
38 In 1997 almost 24000 employees were laid <strong>of</strong>f and in the second phase around 11,700<br />
employees were relieved (Akhtar, 2007).
Financial Sector Restructuring in Pakistan 119<br />
instruments available for transactions but the evolution <strong>of</strong> new<br />
instruments has to remain on track.<br />
• Although financial infrastructure has been strengthened, the legal<br />
system is still complicated, time consuming and costly for ordinary<br />
customers. Furthermore, the regulatory environment has been<br />
improved and the monitoring system is much better today but<br />
enforcement and corrective capabilities need to be further<br />
strengthened.<br />
• The further development <strong>of</strong> long-term bond markets, further<br />
improvements <strong>of</strong> corporate governance, reinforcement <strong>of</strong> regulatory<br />
and supervisory arrangements, the expansion <strong>of</strong> investors’ base,<br />
improvement <strong>of</strong> equity market infrastructure, revaluation <strong>of</strong> market<br />
volatility-controlling mechanisms and sequencing the reforms also<br />
need to be enhanced.<br />
The Second Generation <strong>of</strong> Reforms<br />
The first generation <strong>of</strong> reforms launched in the early 1990s gained<br />
roots and the financial industry in Pakistan is now ready to shift its focus to a<br />
second generation <strong>of</strong> reforms. The second generation reforms will not only<br />
help in achieving macroeconomic stability but also create an enabling<br />
environment for sustainable economic growth. Institutional strengthening,<br />
macroeconomic stability, protection <strong>of</strong> property rights, and legal and financial<br />
infrastructure development should be the main pillars <strong>of</strong> the second generation<br />
<strong>of</strong> reforms. The main ingredients <strong>of</strong> second generation <strong>of</strong> reforms include:<br />
(i) Macroeconomic Stability<br />
It can be thought that the banking system could easily be weakened<br />
by high and volatile real interest rates, owing to inappropriate fiscal policies<br />
that entail excessive borrowing from the commercial banks, inefficiencies in<br />
the payment system that encourage fraud, and loss-incurring banks. In order<br />
to maintain stability within the liberalized financial system, it is necessary to<br />
ensure that the fiscal position should be sound, banks should be well<br />
capitalized, and the payment systems should be modernized. To achieve these<br />
objectives the authorities should ensure stable and enabling macroeconomic<br />
conditions because it is inadequate to promote financial liberalization when<br />
the structural and macroeconomic problems remain unresolved.<br />
(ii) Improvement in Governance<br />
An improvement in governance would ensure greater transparency<br />
and accountability, a more secure and predictable environment for domestic
120<br />
Muhammad Arshad Khan and Sajawal Khan<br />
and foreign investment, and promote greater ownership <strong>of</strong> the reform<br />
efforts. In Pakistan there is still a need to clarify rules related to governance.<br />
Hence, attention should be paid to clarification and rules should be<br />
conformed so that they are consistent with international standard.<br />
(iii) Strengthen Institutional Capacity and Protection <strong>of</strong> Property Rights.<br />
For economic stabilization and sustainable economic growth,<br />
institutional strengthening and the risk taking ability <strong>of</strong> economic agents is<br />
necessary. Macroeconomic stabilization requires strong institutional<br />
coordination between the monetary and fiscal authorities. Strong institutions<br />
and protection and simplification <strong>of</strong> property rights should be given an<br />
important place in the second generation reform agenda. Furthermore, upgradation<br />
and the encouragement <strong>of</strong> institutions such as SMEs,<br />
micr<strong>of</strong>inance, consumer finance, housing finance and rural banking will<br />
accelerate the momentum <strong>of</strong> the financial industry because <strong>of</strong> the access <strong>of</strong><br />
the vast majority <strong>of</strong> the population to financial services. Hence, there is an<br />
urgent need to further develop and strengthen these institutions.<br />
(iv) Streamline Venture Capital Funds and Private Equity Funds<br />
Venture capital and private equity funds, private pension and<br />
provident funds and insurance companies are the most effective means for<br />
financing innovative firms in the economy. The authorities should<br />
streamline these funds and encourage their growth.<br />
(v) Strengthen the Legal and Financial Infrastructure<br />
The accountability and enforcement <strong>of</strong> financial contracts requires<br />
that we have a legal system that dispenses justice quickly and inexpensively.<br />
But our legal procedure is too lengthy. There is a need to review banking<br />
laws and procedures to make them simple and less abrupt. Hence, this area<br />
needs special attention.<br />
V. Conclusions<br />
Financial restructuring is a continuous process not an event. Prior to<br />
1990, the financial sector in Pakistan was characterized by weakness in<br />
banking and corporate governance, weak accounting standards, lack <strong>of</strong> market<br />
discipline, weak prudential regulations and poor legal infrastructure. These<br />
problems increased the exposure <strong>of</strong> financial institutions to a variety <strong>of</strong><br />
external threats, including a decline in the values <strong>of</strong> assets, market contagion,<br />
speculative attacks, exchange rate devaluation, and a reversal <strong>of</strong> capital flows.<br />
Furthermore, capital flight and disrupted credit allocation further caused a
Financial Sector Restructuring in Pakistan 121<br />
deterioration in the efficiency <strong>of</strong> the banking sector. In the background <strong>of</strong> the<br />
arising situations <strong>of</strong> the financial sector in Pakistan, a number <strong>of</strong> restructuring<br />
measures were undertaken since 1990 with a view to restore financial<br />
discipline and improve the operational efficiency <strong>of</strong> the financial sector. The<br />
financial sector restructuring program was instituted in 1990 and was<br />
concluded in 2004. In response to financial restructuring measures, financial<br />
discipline and operational efficiency shows significant improvement today as<br />
compared to pre-1990. Pakistan has made considerable progress during the<br />
past one and half decades in reforming its financial sector. Financial<br />
restructuring and privatization have changed the landscape <strong>of</strong> the financial<br />
industry in Pakistan. However, the secondary market is relatively thin and as<br />
such the supply <strong>of</strong> corporate securities remains small but the change is more<br />
fundamental in banking relative to equity markets. The development <strong>of</strong> the<br />
capital market is related to a range <strong>of</strong> economic, financial, institutional and<br />
legal factors that need to be addressed properly.<br />
Furthermore, the legal infrastructure must be developed for financial<br />
supervision, bankruptcy and foreclosure. Bank secrecy laws should be<br />
improved to enhance transparency and a deposit insurance scheme is needed<br />
to maintain confidence in the financial system. An early warning system and<br />
prompt corrective actions are needed. The study further concludes that<br />
without further improvement <strong>of</strong> corporate governance and expansion <strong>of</strong> the<br />
investor's base, capital markets cannot be developed. Moreover, until the<br />
equity markets are strengthened, the capital market cannot function well to<br />
complement the banking sector. More openness, together with more<br />
transparency and the disclosure <strong>of</strong> information, should contribute<br />
significantly to the financial restructuring <strong>of</strong> the economy and integration<br />
into the global economy. Although Pakistan restructured its financial sector<br />
successfully within a very short period, the sustainability and performance <strong>of</strong><br />
financial sector reforms are required (Akhtar, 2007):<br />
• Macroeconomic stability,<br />
• A greater degree <strong>of</strong> consolidation should be necessary for strong and<br />
robust banking,<br />
• Prudent regulatory and supervisory framework,<br />
• Maturity and reorientation <strong>of</strong> financial industry,<br />
• A well diversified and competitive financial system is still needed,<br />
• Strong corporate governance, effective risk management system and<br />
mitigation, and
122<br />
Muhammad Arshad Khan and Sajawal Khan<br />
• The financial system should be socially inclusive and should facilitate<br />
access to financial services.<br />
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The <strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong><br />
<strong>Special</strong> <strong>Edition</strong> (September 2007)<br />
Pakistan’s External Trade: Does Exchange Rate Misalignment<br />
Matter for Pakistan?<br />
M. Ashraf Janjua *<br />
Abstract<br />
This paper is primarily aimed at assessing the significance <strong>of</strong> the<br />
exchange rate on Pakistan’s foreign trade. It estimates the Equilibrium Real<br />
Effective Exchange Rate (ERER) and exchange rate misalignment for<br />
Pakistan using annual data from FY78 to FY06. The Engle Granger cointegration<br />
technique is used for the estimation <strong>of</strong> ERER depending upon<br />
various macroeconomic fundamentals as recommended by Edwards (1994).<br />
The results <strong>of</strong> the study are also used for the forecasting <strong>of</strong> ERER and<br />
misalignment up to the year 2010. The results <strong>of</strong> the study reveal that<br />
ERER is determined by variables such as: a) terms <strong>of</strong> trade, b) trade<br />
openness, c) net capital inflows, d) relative productivity differential, e)<br />
government consumption, and f) workers’ remittances.<br />
The error correction term points to the gradual convergence <strong>of</strong> the<br />
real exchange rate towards the long-run equilibrium level which suggests<br />
that the prevailing Pak Rupee exchange rate has not deviated from the<br />
ERER and captures economic fundamental trends. Moreover, Pakistan’s<br />
foreign trade would depend significantly upon the state <strong>of</strong> economic<br />
fundamentals in the future. Improved economic fundamentals are likely to<br />
support trade besides paving the way for enhanced inflows <strong>of</strong> capital and<br />
financial receipts.<br />
I. Introduction<br />
The economic literature recognizes that exchange rate policy<br />
influences various parts <strong>of</strong> the balance <strong>of</strong> payments. It affects the balance <strong>of</strong><br />
trade <strong>of</strong> a country mainly through improving international competitiveness<br />
which affects the supply and demand for exports and imports (i.e. the<br />
elasticities <strong>of</strong> supply and demand for exports and imports). In fact, exchange<br />
* Dean, College <strong>of</strong> Business Management, Karachi, and Former Deputy Governor, State<br />
Bank <strong>of</strong> Pakistan.
126<br />
M. Ashraf Janjua<br />
rate policy affects the international competitiveness <strong>of</strong> domestic products as:<br />
a) changes in the cost <strong>of</strong> production may raise the domestic price level; b)<br />
changes in domestic price may also affect production costs if changes in<br />
wages are in line with the changes in cost <strong>of</strong> living when imports become<br />
more expensive with depreciation; and c) if a large country depreciates its<br />
currency, the exports from small countries to the concerned country may be<br />
reduced. Keeping in view its significance, every government needs an<br />
exchange rate policy and has to make a strategic choice between a fixed<br />
exchange rate regime, a flexible exchange rate regime, or one <strong>of</strong> various inbetween<br />
options. Each policy has its own advantages and disadvantages, and<br />
each country’s circumstances are different. Although many countries have<br />
pegged their exchange rates with hard currencies, there is a clear trend<br />
towards greater flexibility in exchange rate policy. Moreover, a central bank<br />
that is independent <strong>of</strong> the government is committed to maintaining low<br />
inflation and full employment does not finance budget deficits and <strong>of</strong>ten<br />
prefers a flexible exchange rate.<br />
Historically, Pakistan pursued a policy <strong>of</strong> export-led growth, with the<br />
objective <strong>of</strong> achieving viability in her balance <strong>of</strong> payments. With a view to<br />
achieving this objective, the country had to adopt various exchange rate<br />
regimes at different times. A fixed exchange rate regime was followed from<br />
1947 to 7 th January, 1982. During the early 1980s, the dollar started<br />
appreciating in terms <strong>of</strong> the major currencies and as the Rupee was linked<br />
to the U.S. dollar, this affected the competitiveness <strong>of</strong> Pakistani products in<br />
international markets. Thus, with a view to maintaining the competitiveness<br />
<strong>of</strong> exports and thereby to bring a sustainable balance between the country's<br />
current receipts and current payments, it was decided to adopt the managed<br />
floating exchange rate system w.e.f. 8 th January, 1982. Under this system the<br />
value <strong>of</strong> the Pak-Rupee was reviewed daily with reference to a trade<br />
weighted basket <strong>of</strong> currencies <strong>of</strong> the country's major trading<br />
partners/competitors. Necessary adjustments in the value <strong>of</strong> the Pak-Rupee<br />
were made as and when circumstances indicated a need for such an<br />
adjustment, keeping in view the relative changes in exchange rates and the<br />
prices <strong>of</strong> the country's major trading partners/competitors as well as major<br />
macro-economic indicators <strong>of</strong> Pakistan. The managed float continued to<br />
operate successfully till 21st July, 1998. In the wake <strong>of</strong> economic sanctions<br />
by major donors and the restraining stance adopted by multilateral financial<br />
institutions as a reaction to the nuclear tests on May 28, 1998, Pakistan had<br />
to take a number <strong>of</strong> measures to face the challenge. As a part <strong>of</strong> this<br />
strategy, the State Bank <strong>of</strong> Pakistan (SBP) introduced a New Exchange Rate<br />
Mechanism (NERM) on 22 nd July, 1998, replacing the managed-floatingexchange-rate<br />
system. The underlying philosophy <strong>of</strong> the dual exchange rate<br />
was to pass on the advantages <strong>of</strong> devaluation to exporters, expatriate workers
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 127<br />
wishing to remit money to Pakistan and to compress non-essential imports.<br />
It was also intended to contain the cost <strong>of</strong> devaluation in terms <strong>of</strong><br />
containing price increases <strong>of</strong> essential imports and repayments <strong>of</strong> the<br />
external debt thereby limiting the impact <strong>of</strong> inflation and the overall fiscal<br />
deficit <strong>of</strong> the government. The adoption <strong>of</strong> NERM was tantamount to a<br />
multiple currency practice. The multiple exchange rate system discriminated<br />
among different exporters and importers and led to a misallocation <strong>of</strong><br />
resources with an adverse impact on output and growth. Further, under the<br />
I.M.F's Articles <strong>of</strong> Agreement, a member is not allowed, except temporarily,<br />
to engage in multiple currency practice. The two-tier exchange rate system<br />
was replaced with a market- based unified exchange rate system w. e. f. May<br />
19, 1999. Under the unified exchange rate system, a floating inter-bank rate<br />
was applied to all foreign exchange receipts and payments both in the public<br />
and private sectors. However, the State Bank could intervene in the market<br />
for the sale and purchase <strong>of</strong> foreign exchange on its own account at rates<br />
and timing <strong>of</strong> its choice. On 20 th July 2000, Pakistan set the Pak rupee on a<br />
free float.<br />
Since the free float <strong>of</strong> the Pak rupee, monetary policy has played a<br />
dominant role in stabilizing the exchange rate in Pakistan. Significant ups<br />
and down in forex rates are now being monitored through effective<br />
instruments <strong>of</strong> monetary policy. Similarly, whenever speculative activities are<br />
observed in the market, they are tackled with proactive monetary policy<br />
measures <strong>of</strong> the State Bank. The Bank uses the instrument <strong>of</strong> the discount<br />
rate to control undue pressure on the exchange rate while Cash Reserve<br />
Requirements (CRR) or mopping up <strong>of</strong> excessive liquidity through purchases<br />
from the kerb market, to curb speculative activities in the forex market. The<br />
recent level <strong>of</strong> the nominal exchange rate appears to be controversial from<br />
the monetary policy angle. Although the SBP considers the current level <strong>of</strong><br />
the exchange rate suitable for foreign trade, the IMF and other institutions<br />
have shown their concern recently over its suitability which is based on<br />
continuous deterioration <strong>of</strong> Pakistan’s external trade, particularly the current<br />
account.<br />
One viewpoint is that the appreciation <strong>of</strong> the Pak rupee is the result<br />
<strong>of</strong> a host <strong>of</strong> other factors, thus it is difficult to assess the creditability <strong>of</strong> the<br />
recent level <strong>of</strong> the nominal exchange rate from a monetary point <strong>of</strong> view.<br />
The reason is that monetary policy simply helped exchange rate stabilization<br />
at a specific level. It is, therefore, difficult to say that the recent level <strong>of</strong> the<br />
exchange rate is close to the equilibrium level.<br />
The prime objective <strong>of</strong> the current study is to evaluate the<br />
suitability <strong>of</strong> existing exchange rate policy for Pakistan’s external trade. It
128<br />
M. Ashraf Janjua<br />
will particularly pinpoint the magnitude if the exchange rate has deviated<br />
significantly from its equilibrium level. For this purpose, the paper is<br />
organized in the following way. The second section is about the history <strong>of</strong><br />
exchange rate regimes and its significance for Pakistan’s external trade. The<br />
third section discusses the methodology used for assessing the deviation <strong>of</strong><br />
the exchange rate from its equilibrium level. The fourth section pertains to<br />
concluding remarks.<br />
II. Exchange Rate Regimes and Pakistan Foreign Trade<br />
Pakistan pursued different exchange rate regimes in its history<br />
spreading over 60 years. Initially, the Pak rupee was pegged to the Pound<br />
Sterling. The Pak rupee was then pegged to the US dollar in 1971 and the<br />
new exchange rate parity was fixed at Rs.4.76 per US $. After the separation<br />
<strong>of</strong> erstwhile East Pakistan (now Bangladesh) in December 1971, Pakistan had<br />
problems in absorbing the surplus products which earlier used to be sent to<br />
former East Pakistan. Large amounts <strong>of</strong> raw cotton piled up during fiscal<br />
year 1971/72. Since its introduction on 15 th January 1959, the Export Bonus<br />
Scheme (EBS) had become increasingly complex with all the adverse<br />
consequences <strong>of</strong> multiple exchange rates for resource allocation. Also,<br />
Pakistan experienced a high rate <strong>of</strong> inflation during this period. These<br />
events convinced policy makers to rationalize the exchange rate through<br />
adjustment. As a result, the Rupee was depreciated on 11 th May, 1972 and<br />
the new exchange rate was set at Rs.11.00 per US Dollar.<br />
Pakistan's Foreign Trade and Rupee/$ Parity<br />
50,000<br />
70<br />
Million US $<br />
40,000<br />
30,000<br />
20,000<br />
10,000<br />
0<br />
FY79<br />
FY81<br />
FY83<br />
FY85<br />
FY87<br />
FY89<br />
Trade (LHS)<br />
FY91<br />
FY93<br />
FY95<br />
FY97<br />
Exchange rate<br />
FY99<br />
FY01<br />
FY03<br />
FY05<br />
FY07t<br />
60<br />
50<br />
40<br />
30<br />
20<br />
10<br />
0<br />
Rupees
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 129<br />
The new exchange rate was viewed by some people as excessive<br />
devaluation <strong>of</strong> the Rupee 39 . However, when the US$ was devalued by 10% in<br />
February 1973, the Pak Rupee, being linked with US$, automatically<br />
appreciated by 10% and the new exchange rate was the Pak Rupee 9.90 per<br />
US dollar. This exchange rate continued till 8 th January 1982, when the<br />
fixed exchange rate was discarded, and the State Bank <strong>of</strong> Pakistan adopted a<br />
managed float based on a basket <strong>of</strong> 16 currencies <strong>of</strong> Pakistan’s trade<br />
partners.<br />
Following the worldwide trend <strong>of</strong> deregulation <strong>of</strong> economies and<br />
exchange rates, Pakistan opted out <strong>of</strong> the fixed exchange rate regime and<br />
floated the value <strong>of</strong> the rupee against a basket <strong>of</strong> sixteen currencies under<br />
a managed exchange rate regime on 8 th January 1982. As a result, the<br />
value <strong>of</strong> the rupee depreciated quite significantly after the adoption <strong>of</strong> the<br />
managed floating regime. During the 1990s, the value <strong>of</strong> the rupee was<br />
generally set in line with the inflation differential. In other words, the<br />
rupee had to be devalued to <strong>of</strong>fset the adverse effect <strong>of</strong> domestic inflation<br />
on the real exchange rate. For the last decade, however, exchange rate<br />
depreciation has been undertaken more as a desperate attempt to control<br />
the rising Current Account Deficit (CAD) than to follow the Purchasing<br />
Power Parity (PPP) rule. The cumulative current account deficit during the<br />
period 1992/98 stood at about US$23-30 billion which was financed by<br />
the entire amount <strong>of</strong> US$11.0 billion <strong>of</strong> foreign currency deposits besides<br />
government’s additional external borrowings. Accumulation <strong>of</strong> large shortterm<br />
liabilities in the absence <strong>of</strong> an equal rise in foreign exchange reserves<br />
was bound to lead to a crisis in a period <strong>of</strong> economic or political<br />
uncertainties. The economic crisis occurred when Pakistan exploded the<br />
nuclear bomb on May 28, 1998.<br />
During the fixed exchange rate regime from FY73-82, the actual<br />
Real Effective Exchange Rate (REER) moved in tandem with the price<br />
differential and the movement <strong>of</strong> the US Dollar vis-à-vis major currencies.<br />
The Rupee regained competitiveness in real terms during 1976–79, because<br />
<strong>of</strong> the continued lower inflation differential and US Dollar depreciation visà-vis<br />
major currencies. During the early 1980s, the REER appreciated<br />
substantially due to the appreciation <strong>of</strong> the US Dollar against major<br />
currencies and higher domestic inflation as compared to its trading partners.<br />
Keeping in view this sharp appreciation, Pakistan adopted the managed<br />
floating exchange rate system on January 8, 1982. The period thereafter was<br />
39 For details <strong>of</strong> discussion among the policy makers which led to new exchange rate,<br />
please see Janjua, “The History <strong>of</strong> State Bank <strong>of</strong> Pakistan, Volume-III, (1977-88),” pp<br />
409 – 413.
130<br />
M. Ashraf Janjua<br />
characterized by more frequent and small adjustments in the Rupee against<br />
the US Dollar, keeping in view the relative changes in exchange rates and<br />
the prices <strong>of</strong> the country's major trading partners/competitors as well as the<br />
various macroeconomic indicators <strong>of</strong> Pakistan.<br />
With the transformation <strong>of</strong> the economy from a semi-closed to a<br />
more open or market-oriented economy in the beginning <strong>of</strong> the 1990s, the<br />
exchange rate saw a much larger devaluation in nominal terms, which was<br />
just <strong>of</strong>fset by a higher level <strong>of</strong> inflation in Pakistan as compared to its<br />
trading partners. The imposition <strong>of</strong> economic sanctions following the<br />
nuclear tests in May 1998 created a crisis-like situation and the State Bank<br />
<strong>of</strong> Pakistan introduced a number <strong>of</strong> measures including the implementation<br />
<strong>of</strong> a two-tier exchange rate system 40 among others, from 22 nd July 1998, to<br />
steer the economy out <strong>of</strong> the crisis. On May 19, 1999, the SBP moved from<br />
multiple exchange rates to the dirty float by defending the exchange rate<br />
within a narrow band up to 20 th July 2000 by channeling the foreign<br />
exchange from the kerb market to the inter-bank market through kerb<br />
purchases. In July 2000, the SBP moved away from the managed exchange<br />
rate to a floating exchange rate regime.<br />
Trend in Nominal and Real Effective Exchange Rates<br />
250<br />
230<br />
210<br />
190<br />
170<br />
150<br />
130<br />
110<br />
90<br />
70<br />
50<br />
App/Dep in REER (RHS) NEER REER<br />
FY-78<br />
FY-7 9<br />
FY-8 0<br />
FY-81<br />
FY-8 2<br />
FY-83<br />
FY-84<br />
FY-85<br />
FY-86<br />
FY-87<br />
FY-88<br />
FY-89<br />
FY-90<br />
FY-91<br />
FY-92<br />
FY-93<br />
FY-94<br />
FY-95<br />
FY-96<br />
FY-97<br />
FY-9 8<br />
FY-99<br />
FY-0 0<br />
FY-01<br />
FY-02<br />
FY-03<br />
FY-04<br />
FY-05<br />
12<br />
9<br />
6<br />
3<br />
0<br />
-3<br />
-6<br />
-9<br />
-12<br />
-15<br />
-18<br />
percent<br />
40 The new mechanism was based on: a) <strong>of</strong>ficial exchange rate, b) floating inter-bank exchange<br />
rate, and c) composite rate.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 131<br />
Bilateral RER (2000:100)<br />
140.00<br />
120.00<br />
100.00<br />
80.00<br />
60.00<br />
40.00<br />
20.00<br />
1972<br />
1974<br />
1976<br />
1978<br />
1980<br />
1982<br />
1984<br />
1986<br />
1988<br />
1990<br />
1992<br />
1994<br />
1996<br />
1998<br />
2000<br />
2002<br />
2004<br />
2006<br />
RS/yen<br />
RS/PSt<br />
Initially, the rupee dollar parity witnessed a sharp nominal<br />
depreciation <strong>of</strong> 18.5% during Fiscal Year 2001, which shows the market<br />
correction <strong>of</strong> the cumulative overvaluation that took place during Fiscal Year<br />
1999 and Fiscal Year 2000. In the new exchange rate regime, monetary<br />
instruments act as a nominal anchor to curb the anticipated high volatility<br />
<strong>of</strong> the exchange rate. This, coupled with the build-up <strong>of</strong> forex reserves, led<br />
to stability in the nominal exchange rate after the sharp depreciation in<br />
Fiscal Year 2001. The substantial surge in workers’ remittances in the interbank<br />
market following the international crackdown on informal channels<br />
after the September 11, 2001 incident reversed the downward trend in the<br />
exchange rate. The excess liquidity in the foreign exchange market,<br />
following the post September 11, 2001 surge in workers’ remittances in the<br />
formal banking channel, induced the SBP to purchase US$ 8.2 billion from<br />
October 2001 to March 2004 to preserve the competitiveness <strong>of</strong> exports<br />
from abrupt exchange rate appreciation. The increased demand <strong>of</strong> foreign<br />
exchange from importers dried up excess liquidity in the inter-bank market,<br />
which not only prompted the SBP to scale down its purchases from the<br />
inter-bank market; SBP also had to start providing market support by<br />
financing lumpy oil payments. Interestingly, in real terms, the Rupee<br />
continued to maintain the compositeness due to the fact that the basket <strong>of</strong><br />
currencies appreciated against the Dollar more than the Rupee and relatively<br />
higher inflation compared to that <strong>of</strong> trading partners.
132<br />
M. Ashraf Janjua<br />
Exchange Rate<br />
Date / Period Exchange Rate Regime<br />
(Pak Rupee per US App(+)/<br />
Dollar) Dep(-)<br />
Prior to August,1955 3.31<br />
8/1/1955 (i) Fixed Exchange Rate 4.76 -30.46<br />
5/11/1972 from 14-8-1947 to 07-01-1982 11 -56.73<br />
13-Feb-73 9.9 11.11<br />
8-Jan-82 10.1 -1.98<br />
1981-82 10.5535 -4.30<br />
1982-83 12.7063 -16.94<br />
1983-84 13.4838 -5.77<br />
1984-85 15.1668 -11.10<br />
1985-86 16.1391 -6.02<br />
1986-87 17.1795 -6.06<br />
1987-88 17.5994 -2.39<br />
1988-89 19.2154 -8.41<br />
1989-90 (ii) Managed Float 21.4453 -10.40<br />
1990-91 from 8th Jan. 1982 to 21st July 1998 22.4228 -4.36<br />
1991-92 24.8441 -9.75<br />
1992-93 25.9598 -4.30<br />
1993-94 30.1638 -13.94<br />
1994-95 30.8507 -2.23<br />
1995-96 33.5684 -8.10<br />
1996-97 38.9936 -13.91<br />
1997-98 43.1958 -9.73<br />
1998-99 - (iii) Two tier Exchange Rate System 50.0546 46.7904 -13.70<br />
(Multiple Exchang Rate)<br />
from 22nd July 1998 to 18th May 1999<br />
1999-00 - (iv) Dirty Float: SBP defending the 51.7709 -3.32<br />
exchange rate within a narrow band<br />
from 19th May 99 to 20th Jul 2000<br />
2000-01 (v)from Managed Float to Floating 58.4378 -11.41<br />
2001-02 Exchange Rate regime 61.42580 -4.86<br />
2002-03 Since July 20, 2000 58.49950 5.00<br />
2003-04 57.57450 1.61<br />
2004-05 59.35760 -3.00<br />
2005-06 59.85660 -0.83
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 133<br />
1) The two-tier exchange rate system was introduced on July 22, 1998.<br />
The new mechanism was based on: a) <strong>of</strong>ficial exchange rate, b)<br />
floating inter-bank exchange rate, and c) composite rate.<br />
2) The exchange rate system was unified on May 19, 1999.<br />
Since the free float <strong>of</strong> the rupee, the monetary policy has played a<br />
dominant role in stabilizing the exchange rate in Pakistan. Significant ups<br />
and downs in forex rates are now being monitored through effective<br />
instruments <strong>of</strong> monetary policy. Similarly, whenever speculative activities are<br />
observed in the market, they are tackled with proactive monetary policy<br />
measures taken by the State Bank. The Bank uses the instrument <strong>of</strong><br />
discount rate to control undue pressure on the exchange rate while the CRR<br />
or mopping up <strong>of</strong> excessive liquidity through purchases from the kerb<br />
market are used to curb speculative activities in the forex market.<br />
According to the SBP, the following considerations are generally taken into<br />
account while looking at the level <strong>of</strong> the exchange rate from the monetary<br />
policy side:<br />
1. The existing level <strong>of</strong> the exchange rate has helped improve the<br />
build-up <strong>of</strong> forex reserves. There is a continuous increase in forex<br />
reserves, which is also a positive sign for the economic stability <strong>of</strong><br />
the country.<br />
2. The existing exchange rate level has sufficiently discouraged<br />
speculative activities in the forex market.<br />
3. The rate has also helped discourage inflows <strong>of</strong> foreign remittances<br />
from illegitimate channels. Now there are less incentives for<br />
remitters to transmit their money through Hundi or other illegal<br />
channels.<br />
4. The rate has helped strengthen the role <strong>of</strong> the inter-bank market.<br />
The two forex markets are expected to integrate if the existing rate<br />
prevails for a longer period.<br />
5. The existing level <strong>of</strong> the exchange rate has smaller pass-through,<br />
which is evident from the lower inflation rate.<br />
6. The rate is also providing an incentive to capital inflows. Some<br />
positive developments are also witnessed on the private foreign<br />
investment front.
134<br />
M. Ashraf Janjua<br />
Like other economies, the September 11, 2001, incident had<br />
significant consequences for the Pakistani economy. The process <strong>of</strong><br />
appreciation <strong>of</strong> Rupee-Dollar parity not only started but quickened primarily<br />
during the month <strong>of</strong> October 2001 in the wake <strong>of</strong> increasing capital inflows<br />
from the international community and donor agencies and easing <strong>of</strong> quota<br />
restrictions imposed on some Pakistani exportables to the Euro zone and the<br />
United States. The strengthening <strong>of</strong> the Rupee resulted from a variety <strong>of</strong><br />
factors, these included the lifting <strong>of</strong> US sanctions, easing <strong>of</strong> quota<br />
restrictions by the European community, rescheduling <strong>of</strong> external debt, a<br />
positive response by the IMF in terms <strong>of</strong> approval <strong>of</strong> credit lines, an increase<br />
in foreign exchange reserves and diversion <strong>of</strong> investment funds from the<br />
currency market to the stock market.<br />
Pakistan's Exports and Rupee App/Dep<br />
Million US$<br />
20,000<br />
18,000<br />
16,000<br />
14,000<br />
12,000<br />
10,000<br />
8,000<br />
6,000<br />
4,000<br />
2,000<br />
0<br />
FY79<br />
FY81<br />
FY83<br />
FY85<br />
FY87<br />
FY89<br />
FY91<br />
App/Dep<br />
FY93<br />
FY95<br />
FY97<br />
FY99<br />
Exports<br />
FY01<br />
FY03<br />
FY05<br />
FY07t<br />
10<br />
5<br />
0<br />
-5<br />
-10<br />
-15<br />
-20<br />
In Percent<br />
As regards Pakistan’s exports, it may be noted that Pakistan’s export<br />
structure has a very narrow base, both in terms <strong>of</strong> products and markets,<br />
and most <strong>of</strong> the exportable items are <strong>of</strong> low value addition. The composition<br />
<strong>of</strong> exports mainly consists <strong>of</strong> textile manufactures and food items, largely<br />
originating from the agricultural sector where the incidence <strong>of</strong> uncertainty<br />
is quite high and the market is highly competitive. Although, the textile<br />
sector constitutes over 65% <strong>of</strong> our total exports, its production and exports<br />
have attained almost maximum capacity and there is a need to shift the<br />
focus to other exportable items. The external shocks taking the form <strong>of</strong><br />
depressed demand and decreasing price <strong>of</strong> export products in the<br />
international market have made the external sector most vulnerable. As for<br />
the destination <strong>of</strong> Pakistan’s exports, about 70% <strong>of</strong> exports are directed to
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 135<br />
only 13 countries including the USA, UK, Hong Kong, Germany, Dubai,<br />
France, Japan, South Korea and Canada, etc.<br />
The structure <strong>of</strong> the country’s exports calls for a policy shift to<br />
diversify exports across different products and also to move towards higher<br />
value-added items. The objective <strong>of</strong> diversification and value addition can be<br />
achieved through consistent and well-defined strategies. Due to limited<br />
resources, a piece-meal strategy should be adopted to enhance the export<br />
base. Initially, there is a need to explore the products in which the country<br />
has a comparative advantage and certain low cost measures will help boost<br />
the exports, thereby enhancing productivity. In spite <strong>of</strong> the fact that fruits,<br />
vegetables and fish are produced in abundance in Pakistan, the processing<br />
industry is not developed. One <strong>of</strong> the major reasons for Pakistan's poor<br />
performance in this field is a lack <strong>of</strong> storage and canning facilities. Nontraditional<br />
agro-based products such as fruits, vegetables, dairy products and<br />
fish <strong>of</strong>fer vast scope in augmenting domestic production and exports<br />
through crop substitution, the introduction <strong>of</strong> modern technology for<br />
storage, processing and packing, etc. The Export Promotion Bureau should<br />
plan cold storage houses at different points in the fruit growing areas to<br />
handle farm products for export purposes. These storage houses should also<br />
serve as places where training for the packaging <strong>of</strong> fruits, vegetables and fish<br />
for export should be imparted to the exporters.<br />
The textile sector, which is the single largest contributor to the<br />
nation’s export earnings, has remained concentrated in the relatively low<br />
value-added segment <strong>of</strong> the market, which has retarded the realization <strong>of</strong><br />
Pakistan’s true potential in textile exports. Thus, the need is both to<br />
diversify exports across different product categories and also to move to<br />
higher value-added textile exports. The slowdown in exports from this sector<br />
exerts a dampening effect on the overall export growth. For export<br />
diversification through higher value added products, there is a need to<br />
upgrade technology, which involves: 1) tailoring the existing technology and<br />
processes to specific production requirements; 2) improving processes within<br />
the existing technology design; 3) improving the quality <strong>of</strong> textile products.<br />
Information Technology and other hi-tech sectors also require special<br />
attention for development according to potential. Due to the economic<br />
recession in major industrial economies and enhanced competition, the<br />
country may also explore new markets for its products, particularly in the<br />
Central Asian Republics, East Asian countries and the African region.<br />
In a changing international environment, Pakistan also needs to<br />
diversify exports towards its industrial base. This objective can be achieved<br />
by attracting Foreign Development Investment (FDI) selectively in such
136<br />
M. Ashraf Janjua<br />
export-oriented industries that correspond to and utilize the dynamic<br />
comparative advantage <strong>of</strong> the country. This will proactively create linkages<br />
between domestic firms and Transnational Corporations (TNCs), enabling<br />
local firms to tap the technological expertise <strong>of</strong> TNCs and move into<br />
integrated international production systems, as indirect or direct exporters.<br />
III. Exchange Rate Misalignment and Future Outlook<br />
In 1994, John Williamson observed that he “cannot see how the<br />
Fund could be expected to play a central role in the international monetary<br />
system without the analytical capacity to judge whether exchange rates were<br />
consistent with satisfactory macro-economic outcomes.” Propounding the<br />
concept <strong>of</strong> the Fundamental Equilibrium Exchange Rate (FEER), he defined<br />
it as the real effective exchange rate that is consistent with macro-economic<br />
balance (which requires the simultaneous attainment <strong>of</strong> both the internal<br />
and external balance).<br />
To make the Real Effective Exchange Rate (REER) based assessments<br />
comparable with other variants <strong>of</strong> equilibrium, the behavior <strong>of</strong> REER is<br />
decomposed into permanent and temporary components and the movements<br />
in each is explained in terms <strong>of</strong> certain determinants. Some studies try to<br />
explain the REER appreciation / depreciation through certain identifiable<br />
fundamental determinants and any movement in REER that remains<br />
unexplained by the fundamentals is ascribed to cyclical / temporary shocks<br />
(both internal and external) and interpreted as misalignment. Deviation <strong>of</strong><br />
the actual REER (based on observed inflation rates) from the equilibrium<br />
REER (derived on the basis <strong>of</strong> fundamental determinants) – the sign <strong>of</strong><br />
misalignment – is not easy to identify. This is because there could be two<br />
types <strong>of</strong> real exchange rate misalignment. Macroeconomic induced<br />
misalignments occur mainly due to inconsistent macro polices (particularly<br />
monetary policy). On the other hand, structural misalignment results when<br />
changes in real determinants (such as technical progress and shifts in terms<br />
<strong>of</strong> trade) alter the equilibrium REER, but the actual REER does not change<br />
(Edwards, 1992). Sachs, Tornell and Velasco (1996) <strong>of</strong>fered two reasons to<br />
explain why the market agents also take into account the leading<br />
information embodied in the REER.<br />
a) Firstly, the higher the degree <strong>of</strong> appreciation <strong>of</strong> the REER and the<br />
lower the extent to which tradables respond to REER depreciation,<br />
the market receives the signal that a large REER depreciation may<br />
be necessary to restore external balance, and accordingly initiates<br />
action to ensure a sharp fall in the nominal exchange rate.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 137<br />
b) Secondly, the more vulnerable an economy is to sudden and large<br />
demand compression when demand management measures are<br />
instituted to correct the external imbalance, the market perceives<br />
that the authorities may prefer depreciation to recession and such<br />
market perceptions <strong>of</strong>ten trigger the attack. Besides relating to the<br />
construction <strong>of</strong> REER and fixing a benchmark equilibrium level,<br />
several operational issues constrain any explicit policy<br />
pronouncement on REER.<br />
Misalignment generally refers to deviation <strong>of</strong> the actual exchange rate<br />
from a path that is consistent with the economic fundamentals. Exact<br />
identification <strong>of</strong> the path that could reflect economic fundamentals has,<br />
however, proved elusive. The complexity <strong>of</strong> the issue has spawned an<br />
enormous volume <strong>of</strong> literature, each trying to <strong>of</strong>fer an alternative<br />
approximation. For the purpose <strong>of</strong> identifying misalignment, various<br />
determinants <strong>of</strong> the exchange rate have been used in the literature. The<br />
earliest attempt on the subject dates back to 1945 when Ragnar Nurkse<br />
defined the equilibrium exchange rate as one that could give rise to an<br />
equilibrium in the balance <strong>of</strong> payments subject to:<br />
1. the absence <strong>of</strong> any undue restrictions in trade flows,<br />
2. the absence <strong>of</strong> special incentives to encourage inflow and measures<br />
to discourage outflows, and<br />
3. the absence <strong>of</strong> excessive unemployment.<br />
The recent theoretical and empirical literature on the determinants <strong>of</strong><br />
the Equilibrium Real Exchange Rate (ERER) in developing countries include<br />
Bartolini et al (1994), Edwards (1994), Elbadawi (1994), Guerguil and<br />
Kaufman (1998) and Chinn (1998). Edwards (1994) constructed the ERER<br />
based on a theoretical model that features a sustainable long-run equilibrium<br />
in the nontraded goods and the external sector. The model recognizes the fact<br />
that the short-term and long-term determinants <strong>of</strong> the ERER may differ, and<br />
more specifically, only real factors determine the long-run behavior <strong>of</strong> the real<br />
exchange rate whereas both nominal and real factors influence short-run<br />
behavior. The model is very similar to Williamson's seminal work (Williamson<br />
1985) except that it is constructed for a small, open economy, which is unable<br />
to influence its terms <strong>of</strong> trade. The construction <strong>of</strong> the ex-post ERER involves<br />
the estimation <strong>of</strong> the real exchange rate that preserves the internal and the<br />
external equilibria.
138<br />
M. Ashraf Janjua<br />
Here, we applied the Johansen’s full-information maximum-likelihood<br />
methodology <strong>of</strong> cointegrated systems (Johansen 1988) to estimate the ex-post<br />
ERER for Pakistan as pinpointing the factors that resulted in the misalignment<br />
<strong>of</strong> the real exchange rate in Pakistan, and could help investigating the aspects<br />
<strong>of</strong> current account sustainability and the appropriateness <strong>of</strong> exchange rate<br />
policies in Pakistan. The estimation procedure is very convenient since it<br />
incorporates the cointegration relation to show how the "fundamentals"<br />
influence the real exchange rate in the long run and derives the ERER as well<br />
as the error correction mechanism to model the short-run adjustment process.<br />
The explanatory variables used in the model capture fundamentals such as the<br />
fiscal stance, degree <strong>of</strong> economic openness, international terms <strong>of</strong> trade, and<br />
net capital flows.<br />
The current study uses Engle Granger cointegration technique to<br />
estimate the ERER, based on various macroeconomic fundamentals<br />
suggested in the economic literature.<br />
Empirical Framework<br />
The methodology adopted in this paper has earlier been used by<br />
Hyder, Zulfiqar and Adil Mahboob (2006). The study has updated the<br />
estimates <strong>of</strong> their study and made forecasts 41 <strong>of</strong> misalignment upto 2010.<br />
The paper estimates the degree <strong>of</strong> real exchange rate misalignment based on<br />
the model developed by Edwards (1988, 1989, 1994), Elbadawi (1994), and<br />
Montiel (1997). The reduced form REER equation is given as follows:<br />
lreer= f ( ltrop, ltot, lgovc, lrigdp, lremg, capinf, tfpd/t)<br />
(-) (+/-) (+/-) (-) (+) (-) (+)<br />
The variables included in the analysis are: the real effective exchange<br />
rate index (reer), trade openness (trop), terms <strong>of</strong> trade (tot), real investment<br />
to GDP ratio (rigdp), government consumption as % <strong>of</strong> GDP (govc), workers’<br />
remittances as % <strong>of</strong> GDP (remg), long-term capital to gross domestic<br />
product (capinf), and total factor productivity differentials (tfpd) or time<br />
trend (t) representing the Harrod-Balassa Samuelson effect. All variables,<br />
except capinf and tfpd, are expressed in natural logs. The signs for each<br />
fundamental variable in determining the behavior <strong>of</strong> REER are explained<br />
below:<br />
41 The forecasts are made under the assumption <strong>of</strong> the prevalence <strong>of</strong> a static environment in<br />
Pakistan which is likely to remain unchanged up to 2010 and we do not foresee the reversal <strong>of</strong><br />
significant changes in the external economic front <strong>of</strong> the Pakistani economy during the period.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 139<br />
• Trade openness depreciates REER because trade liberalization and<br />
trade opening makes future consumption <strong>of</strong> importables very cheap<br />
which in turn makes consumers substitute non-tradable for tradable<br />
goods.<br />
• The impact <strong>of</strong> terms <strong>of</strong> trade on REER is ambiguous and can take<br />
either sign depending on the substitution and income effects.<br />
• The impact <strong>of</strong> government consumption on REER depends not only<br />
on the government inter-temporal budget constraints but also on the<br />
composition <strong>of</strong> government consumption. If government consumption<br />
contains a larger share <strong>of</strong> tradable goods, then the increase in<br />
government consumption will worsen the current account, and thus<br />
lead to a depreciation <strong>of</strong> REER.<br />
• The sign <strong>of</strong> rigdp would be negative as the rise in rigdp means higher<br />
spending on tradables (imported machinery and raw materials).<br />
• The sign <strong>of</strong> workers’ remittances to GDP ratio on the real exchange<br />
rate is positive which reflects that the rise in workers’ remittances to<br />
GDP ratio, remg, leads to appreciation <strong>of</strong> the real exchange rate.<br />
• The impact <strong>of</strong> net capital inflows on REER depends on the magnitude<br />
<strong>of</strong> capital flows. The capital inflows over and above the current<br />
account deficit will lead to appreciation <strong>of</strong> the REER while the capital<br />
inflows matching or lower than the current account result in the<br />
depreciation <strong>of</strong> the REER.<br />
• The inclusion <strong>of</strong> the tfpd or time trend (t) in the REER equation<br />
represents the well-known Balassa-Samuelson effect, which contends<br />
that productivity improvements will be generally concentrated in the<br />
tradable sector and thus lead to an appreciation <strong>of</strong> the REER.<br />
The Engle-Granger two-step cointegration approach has been used<br />
to estimate a single equation REER model for Pakistan. The coefficients<br />
from the estimated models and sustainable values <strong>of</strong> the economic<br />
fundamentals are then used to compute the ERER, while the misalignments<br />
<strong>of</strong> the exchange rate are computed by taking the %age deviations <strong>of</strong> the<br />
actual REER from the ERER. Annual data from Fiscal Year 1978 to Fiscal<br />
Year 2006 have been used. The IMF trade-weighted REER index has been<br />
used for Pakistan while the rest <strong>of</strong> the data are taken from the SBP’s
140<br />
M. Ashraf Janjua<br />
Statistical Bulletin, Economic Survey, and Economic Report <strong>of</strong> the<br />
President on the US economy for the year 2006.<br />
Results Interpretation<br />
Firstly, the time series properties <strong>of</strong> data have been checked by<br />
testing the stationarity <strong>of</strong> the fundamental variables. The augmented<br />
Dickey-Fuller (ADF) criterion has been applied for unit root and the<br />
results <strong>of</strong> the ADF test suggest that all the variables are integrated <strong>of</strong><br />
order one, i.e. I(1), which fulfills the criteria for estimating any long run<br />
relations.<br />
The Ordinary Least Square (OLS) has been applied for the estimation<br />
<strong>of</strong> the results. The results are quite encouraging as coefficients and signs in<br />
all regressions except rigdp coincide with the earlier empirical studies. In<br />
the regression equation, five macroeconomic fundamentals [trade openness<br />
(trop), current government consumption to GDP ratio (govc), net capital<br />
inflows as % <strong>of</strong> GDP, real investment to real GDP ratio (rigdp), and total<br />
factor productivity differential (tfpd)] determine the REER. Trop, and the<br />
increase in govc and capinf caused depreciation in the REER while an<br />
increase in rigdp leads to appreciation <strong>of</strong> the REER. The improvement in<br />
tfpd leads to REER appreciation. The coefficient <strong>of</strong> tfpd is small in all three<br />
regressions, which is in line with the recent empirical work. In Pakistan’s<br />
case, workers’ remittances are an important source <strong>of</strong> foreign exchange<br />
earnings and finance a large portion <strong>of</strong> trade and services deficits in the<br />
current account balance.<br />
Workers’ remittances turn out to be significant and have a positive<br />
sign, which reflects that the increase in the remittance inflows cause<br />
appreciation <strong>of</strong> the real exchange rate. Furthermore, the inclusion <strong>of</strong> the<br />
relevant variable, remg, positively affects the overall performance <strong>of</strong> the<br />
regression and causes tot (an important macroeconomic fundamental) to<br />
significantly explain the real exchange rate. The positive sign <strong>of</strong> tot shows<br />
that the improvement <strong>of</strong> tot leads to appreciation <strong>of</strong> the real exchange rate.<br />
However, rigap becomes insignificant with the inclusion <strong>of</strong> remg and the<br />
Wald Test supports the exclusion <strong>of</strong> rigdp.<br />
The residuals generated from these regressions are tested for unit root to<br />
establish a long-run cointegrating relationship. These residuals are<br />
stationary, as reflected by the results <strong>of</strong> the unit root test reported,<br />
confirming that the above regression is showing a long-run cointegrating<br />
relationship between the REER and economic fundamentals.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 141<br />
LRERR = 7.7 - 0.61* LTROP - 0.94* LGOVC + 0.17* LREMG-<br />
(8.71) (-4.63) (-7.61) (5.91)<br />
0.03*CAPINF1 + 0.34* LTOT + 0.03*TFPD (1)<br />
(-3.34) (3.49) (5.73)<br />
R 2 = 0.96<br />
Adj R 2 = 0.94<br />
S.E Regression = 0.07<br />
D.W Statistics= 1.60<br />
Following are the major results <strong>of</strong> the regression:<br />
• As trade openness increases by one %age point <strong>of</strong> GDP, this leads to<br />
real depreciation <strong>of</strong> 0.61% <strong>of</strong> the Pak rupee against the basket <strong>of</strong><br />
currencies<br />
• An improvement in terms <strong>of</strong> trade by one percent causes 0.34% real<br />
appreciation <strong>of</strong> the Pak rupee vis-à-vis the basket <strong>of</strong> currencies.<br />
• An increase in government expenditure <strong>of</strong> one percentage point <strong>of</strong><br />
GDP is associated with 0.94% real <strong>of</strong> depreciation <strong>of</strong> the Pak rupee<br />
against the basket <strong>of</strong> currencies.<br />
• An increase in net capital inflows <strong>of</strong> one percentage point <strong>of</strong> GDP<br />
causes 0.03% real depreciation <strong>of</strong> the REER.<br />
• An increase in workers’ remittances <strong>of</strong> one percentage point <strong>of</strong> GDP<br />
leads to a 0.17% real appreciation <strong>of</strong> the Pak rupee against the<br />
basket <strong>of</strong> currencies.<br />
• A one unit reduction in total factor productivity differential relative<br />
to trading partners (i.e. US) causes a 0.03% real appreciation <strong>of</strong> the<br />
Pak rupee against the basket <strong>of</strong> currencies.<br />
The estimated regressions also satisfied the diagnostic tests.
142<br />
M. Ashraf Janjua<br />
Actual Vs Equilibrium Real Effective Exchnage Rates (1992=100)<br />
Actual REER<br />
EREER3<br />
200.0<br />
185.0<br />
170.0<br />
155.0<br />
140.0<br />
125.0<br />
110.0<br />
95.0<br />
80.0<br />
FY78<br />
FY79<br />
FY80<br />
FY81<br />
FY82<br />
FY83<br />
FY84<br />
FY85<br />
FY86<br />
FY87<br />
FY88<br />
FY89<br />
FY90<br />
FY91<br />
FY92<br />
FY93<br />
FY94<br />
FY95<br />
FY96<br />
FY97<br />
FY98<br />
FY99<br />
FY00<br />
FY01<br />
FY02<br />
FY03<br />
FY04<br />
FY05<br />
FY06<br />
FY07<br />
FY08<br />
FY09<br />
FY10<br />
The above long-term relationships can be used to compute the<br />
ERERs by evaluating these coefficients at sustainable values <strong>of</strong><br />
macroeconomic fundamentals. The rationale <strong>of</strong> using sustainable economic<br />
fundamentals is to eliminate short run fluctuations in the explanatory<br />
variables and only use long-term equilibrium values <strong>of</strong> the variables. The<br />
Hodrick-Prescott (HP) filter is used to remove the short-term variations from<br />
the explanatory variables.<br />
The Figure (above) presents the actual REER and the ERER derived<br />
by evaluating the coefficients at the HP filter series <strong>of</strong> economic<br />
fundamentals. The estimated ERER reflects a divergence in both directions<br />
from the actual REER in the first part <strong>of</strong> the sample while the behavior <strong>of</strong><br />
the actual REER remained close in the latter part <strong>of</strong> the sample. More<br />
specifically, the rupee remained overvalued from 1978 to 1980 relative to<br />
the ERER due to a lower price differential and real depreciation <strong>of</strong> the US<br />
dollar against the major currencies. During the period 1981-86, the trend <strong>of</strong><br />
the actual REER and ERER reveals that the rupee remained undervalued due<br />
to the real appreciation <strong>of</strong> the US dollar against hard currencies. This figure<br />
also reflects that the actual REER appears to have been close to its estimated<br />
equilibrium REER during the last five years. However, the spread between<br />
the forecasts <strong>of</strong> the REER and ERER appears to have widened during the<br />
period up to 2010 mainly on account <strong>of</strong> real appreciation <strong>of</strong> the Pak rupee<br />
against trading partners and competitors currencies.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 143<br />
Short-term dynamics <strong>of</strong> the REER are examined through the<br />
estimation <strong>of</strong> error correction models (ECMs) which show that some <strong>of</strong> the<br />
long-term fundamentals such as trop, capinf, and govc are statistically<br />
significant and affect the short-run dynamics <strong>of</strong> the real exchange rate in the<br />
same direction as the variables did in the case <strong>of</strong> the long run. The<br />
estimated regressions also satisfied the post-diagnostic tests such as <strong>of</strong> no<br />
autocorrelation, homoskedasticity, normality <strong>of</strong> the residuals and stability <strong>of</strong><br />
parameters.<br />
As described in the economic literature, macroeconomics policies such<br />
as the exchange rate policy, fiscal policy and monetary policy may impact the<br />
REER in the short run. We investigated the impact <strong>of</strong> macroeconomic polices<br />
and found that excess domestic credit was insignificant while a rise in fiscal<br />
deficit as a percentage <strong>of</strong> GDP and depreciation <strong>of</strong> the nominal exchange rate<br />
(ndev) led to depreciation <strong>of</strong> the REER in the short run. Monetary policy is<br />
statistically insignificant in all the short-run regressions which may reinforce<br />
the established view that monetary policy in Pakistan was subservient to fiscal<br />
policy. Since monetary policy remained subservient to fiscal policy due to the<br />
heavy reliance <strong>of</strong> the government on financing the fiscal deficit from the<br />
banking system, the direct impact <strong>of</strong> monetary policy in the short term is<br />
statistically insignificant. The impact <strong>of</strong> net devaluation on the ERER turned<br />
out to be negative as expected which indicates that nominal<br />
devaluation/depreciation <strong>of</strong> the Pak Rupee against the US $ depreciates the<br />
REER. As the coefficient <strong>of</strong> the error correction term is negative and has<br />
absolute values smaller than one, this not only indicates the stability in the<br />
long-term ERER but also reflects the gradual convergence <strong>of</strong> the exchange<br />
rate towards long-run equilibrium.
144<br />
M. Ashraf Janjua<br />
We have also derived a misalignment <strong>of</strong> the exchange rate which is<br />
percentage deviations <strong>of</strong> the actual REER from its equilibrium level. The<br />
misalignment is based on the model <strong>of</strong> the ERER. Negative and positive<br />
deviations reflect real appreciation/ depreciation <strong>of</strong> the actual REER from its<br />
equilibrium level.<br />
25.0<br />
Misalignment (in percent)<br />
Mis1<br />
20.0<br />
15.0<br />
10.0<br />
5.0<br />
0.0<br />
-5.0<br />
-10.0<br />
-15.0<br />
FY78<br />
FY79<br />
FY80<br />
FY81<br />
FY82<br />
FY83<br />
FY84<br />
FY85<br />
FY86<br />
FY87<br />
FY88<br />
FY89<br />
FY90<br />
FY91<br />
FY92<br />
FY93<br />
FY94<br />
FY95<br />
FY96<br />
FY97<br />
FY98<br />
FY99<br />
FY00<br />
FY01<br />
FY02<br />
FY03<br />
FY04<br />
FY05<br />
FY06<br />
FY07<br />
FY08<br />
FY09<br />
FY10<br />
The exchange rate misalignment ranged between -12.1% to 25.2%<br />
with zero reversion mean during the year 1978 and 2006. Furthermore,<br />
the actual REER in 2006 reflects an appreciation <strong>of</strong> the REER relative to<br />
the ERER. This suggests that the current exchange rate is away from the<br />
ERER.<br />
These results yield the following important policy implications for<br />
exchange rate policy in Pakistan:<br />
a) ERER is not fixed and is subject to variability as a result <strong>of</strong> changes<br />
in economic fundamentals.<br />
b) Fiscal policy is crucial to exchange rate stability in Pakistan.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 145<br />
c) The appreciation <strong>of</strong> the actual REER due to higher price differentials<br />
relative to the ERER would lead to exchange rate misalignment.<br />
d) A flexible exchange rate regime responds better in case <strong>of</strong> real<br />
shocks more than other exchange rate regimes. This suggests that<br />
the SBP should continue with its current stance <strong>of</strong> a flexible<br />
exchange rate regime and intervene in the interbank market only to<br />
smooth unwarranted movements in the exchange rate by keeping in<br />
view the ERER and exchange rate misalignment.<br />
To strengthen the viewpoint on exchange rate policy, bi-lateral<br />
REER and ERRER has been computed for Yen and Pound Sterling. Both the<br />
estimates <strong>of</strong> ERRER exhibit a completely different picture. The bi-lateral<br />
REER and ERRER and computed misalignment against both the currencies<br />
is given in the Appendix.<br />
IV. Where do we go from here?<br />
1. There has to be identification <strong>of</strong> and emphasis on the indicators <strong>of</strong><br />
fundamental equilibrium in the medium term.<br />
2. Policy has to be a more flexible exchange rate to maintain a<br />
competitive position in the world market.<br />
3. Policy measures should be identified and if needed, should be<br />
introduced immediately to correct any actual or even potential<br />
misalignments <strong>of</strong> the exchange rate.<br />
V. Policies and Ground Realities<br />
Apart from a theoretical approach there is a need for greater (and<br />
more intensive) coordination among the stakeholders: the SBP and the<br />
government, the latter Comprising Finance, Commence, Export Promotion<br />
Bureau, Board <strong>of</strong> Investment and Planning Commission.<br />
Constraining policy hurdles should be removed at the macro and<br />
micro level:<br />
- Export industries<br />
- Meeting the requirements <strong>of</strong> SMEs (fisheries, no bank credit, fishers,<br />
do not have any collateral) – the case <strong>of</strong> tiles.
146<br />
M. Ashraf Janjua<br />
- Availability <strong>of</strong> specific facilities at the Federal, Provincial and Local<br />
level. There is a need for improvement in the quality <strong>of</strong> imports: all<br />
those factors which are related to productivity. It is not too early to<br />
talk <strong>of</strong> a knowledge based economy – The role model is Singapore’s<br />
medium and long term issues.<br />
- The SBP should restrict its role to financial flows and price stability:<br />
there should be adequate credit facilities to make full use <strong>of</strong> the<br />
export potential.<br />
- The government should provide incentives to help maintain<br />
competitiveness.<br />
- Diversification <strong>of</strong> exports.<br />
Concentration <strong>of</strong> exports in commodities: textiles, carpets, leather<br />
products, sports goods, surgical instruments, rice etc. There is a need for<br />
diversification towards services including I.T., dairy products, cottage<br />
industry products, plants and machinery and jewelry.<br />
We must also expand inter-regional trade with India, Bangladesh, Sri<br />
Lanka, and China. With over 25% <strong>of</strong> our exports going to the U.S.A. we<br />
have become extremely vulnerable. Any sanction could spell disaster for us.<br />
VI. Concluding Remarks<br />
1. Information about the causes <strong>of</strong> fluctuations in the real exchange<br />
rate is important for central banks, as some fluctuations may require<br />
immediate corrective actions by them while others may not require<br />
this. It is essential to know what kind <strong>of</strong> movements in the real<br />
exchange rate signal a loss in the external competitiveness <strong>of</strong> the<br />
economy. If appreciation <strong>of</strong> the real exchange rate is due to an<br />
improvement in the “fundamentals” such as an increase in the rate<br />
<strong>of</strong> productivity growth in the tradable goods sector <strong>of</strong> an economy,<br />
the central banks in this case need not take any corrective action.<br />
However, if the real exchange rate deviates significantly from its<br />
equilibrium level, also known as a “misalignment”, the competitive<br />
stance <strong>of</strong> the Pak economy would be jeopardized and require<br />
immediate “corrective action” by the SBP.<br />
2. The real exchange rate responds to real as well as nominal<br />
(monetary) variables. At any given moment, the real exchange rate<br />
depends on economic fundamentals (e.g. tariffs, international prices,
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 147<br />
real interest rates, etc.) and aggregate macroeconomic pressures,<br />
generated by an excess supply <strong>of</strong> money or a fiscal deficit or both.<br />
3. In order to achieve sustainable macroeconomic equilibrium,<br />
monetary and fiscal policies must be consistent with the chosen<br />
nominal exchange rate regime. Further, the misalignments in the<br />
real exchange rate can be used as a guideline for policy interventions<br />
by the SBP.<br />
4. Pakistan’s Balance <strong>of</strong> Payments (BoP) is characterized by persistent<br />
large external financing needs with weak economic activity in the<br />
country. This has cast doubt on the possibility <strong>of</strong> exchange rate<br />
misalignment in Pakistan.<br />
5. The CPI-based REER index suggests that the Pak. rupee has been<br />
depreciating over the period <strong>of</strong> the study. However, the rate <strong>of</strong> real<br />
depreciation <strong>of</strong> the Pak rupee was lower than the actual need which<br />
is evident by the widening <strong>of</strong> Pakistan’s trade deficit. Moreover,<br />
Pakistan’s export base remained stagnant and did show significant<br />
diversification in the last decades, which is reflected in a constant<br />
export market share and deteriorating trade balances.<br />
6. There are some signs <strong>of</strong> external financial vulnerability and the<br />
country’s real exchange rate appears to be somewhat overvalued, a<br />
situation that could be best addressed through increased fiscal<br />
discipline.<br />
7. The BOP statistics show that despite continued devaluation, the<br />
Current Account Deficit (CAD) in Pakistan has deteriorated. This<br />
does not necessarily mean that the exchange rate polices do not<br />
work. The exchange rate policy in Pakistan failed due to a number <strong>of</strong><br />
factors. The most important reason is that devaluation was<br />
accompanied by poor monetary management. In particular a<br />
continued growth in money supply resulted in a high inflation rate<br />
which neutralized the favorable affects <strong>of</strong> devaluation on the real<br />
exchange rate and Pakistan could not achieve any competitive<br />
advantage from devaluation. What really matters is to improve the<br />
BOP position through adjustment in the real exchange rate. To<br />
influence the real exchange rate through devaluation, Pakistan<br />
should have adopted a tight monetary policy. Thus, except for the<br />
intervention in the foreign exchange market the State Bank <strong>of</strong><br />
Pakistan should have held tight control on money supply.
148<br />
M. Ashraf Janjua<br />
8. In a changing international environment, Pakistan also needs to<br />
diversify exports towards its industrial base. This objective can be<br />
achieved by attracting FDI selectively into such export-oriented<br />
industries that correspond to and utilize the dynamic comparative<br />
advantages <strong>of</strong> the country. This will proactively create linkages<br />
between domestic firms and Transnational Corporations (TNCs),<br />
enabling local firms to tap the technological expertise <strong>of</strong> TNCs and<br />
move into integrated international production systems, as indirect or<br />
direct exporters.<br />
9. The structure <strong>of</strong> the country’s exports suggests the need for a<br />
policy shift, to diversify exports across different products and also<br />
to move towards higher value-added items. The objective <strong>of</strong><br />
diversification and value addition can be achieved through<br />
consistent and well-defined strategies. Due to limited resources, a<br />
piece-meal strategy should be adopted to enhance the exports base.<br />
Initially, there is a need to explore the products in which the<br />
country has a comparative advantage and certain low cost measures<br />
will help boost exports, thereby enhancing productivity. In spite <strong>of</strong><br />
the fact that fruits, vegetables and fish are produced in abundance<br />
in Pakistan, the processing industry is not developed. One <strong>of</strong> the<br />
major reasons for Pakistan's poor performance in this field is lack<br />
<strong>of</strong> a storage and canning facility. Non-traditional agro-based<br />
products like fruits, vegetables, dairy products and fish <strong>of</strong>fer vast<br />
scope to augment domestic production and exports through crop<br />
substitution, the introduction <strong>of</strong> modern technology for storage,<br />
processing and packing, etc. The Trade Development Authority <strong>of</strong><br />
Pakistan (TDAP), formerly the Export Promotion Bureau, should<br />
plan cold storage houses at different points in the fruit growing<br />
areas to handle farm products for export purposes. These storage<br />
houses should also serve as places where training for the packaging<br />
<strong>of</strong> fruits, vegetables and fish for export should be imparted to the<br />
exporters.<br />
10. The variables such as trade openness, government consumption<br />
and capital inflows lead to depreciation <strong>of</strong> the REER index, while<br />
workers’ remittances, terms <strong>of</strong> trade, and total factor productivity<br />
vis-à-vis trading partners lead to an appreciation <strong>of</strong> the REER<br />
index.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 149<br />
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Saygili, M., G. Sahinbeyoglu and P. Ozbay, 1998, “Competitiveness<br />
Indicators and the Equilibrium Real Exchange Rate Dynamics in<br />
Turkey”, in Macroeconomic Analysis <strong>of</strong> Turkey: Essays on Current<br />
Issues, Research Department, The Central Bank <strong>of</strong> The Republic <strong>of</strong><br />
Turkey.<br />
Williamson, J., 1985, “The Exchange Rate System” Policy Analyses in<br />
International <strong>Economics</strong> 5, Institute <strong>of</strong> International <strong>Economics</strong>,<br />
Washington, D.C.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 151<br />
Appendix<br />
Bilateral Misalignment<br />
Bilateral Actual and Equilibrium RER vis a vis Pound Sterling<br />
Actual BRER<br />
EBRER<br />
140.0<br />
120.0<br />
100.0<br />
80.0<br />
60.0<br />
40.0<br />
20.0<br />
1978<br />
1979<br />
1980<br />
1981<br />
1982<br />
1983<br />
1984<br />
1985<br />
1986<br />
1987<br />
1988<br />
1989<br />
1990<br />
1991<br />
1992<br />
1993<br />
1994<br />
1995<br />
1996<br />
1997<br />
1998<br />
1999<br />
2000<br />
2001<br />
2002<br />
2003<br />
2004<br />
2005<br />
2006<br />
Misalignment (in percent)<br />
30.0<br />
20.0<br />
Depreciation<br />
10.0<br />
0.0<br />
-10.0<br />
Appreciation<br />
-20.0<br />
-30.0<br />
1978<br />
1979<br />
1980<br />
1981<br />
1982<br />
1983<br />
1984<br />
1985<br />
1986<br />
1987<br />
1988<br />
1989<br />
1990<br />
1991<br />
1992<br />
1993<br />
1994<br />
1995<br />
1996<br />
1997<br />
1998<br />
1999<br />
2000<br />
2001<br />
2002<br />
2003<br />
2004<br />
2005<br />
2006
152<br />
M. Ashraf Janjua<br />
Bilateral Actual and Equilibrium RER vis a vis Yen<br />
Actual BRER<br />
EBRER<br />
110.0<br />
100.0<br />
90.0<br />
80.0<br />
70.0<br />
60.0<br />
50.0<br />
40.0<br />
30.0<br />
20.0<br />
1978<br />
1979<br />
1980<br />
1981<br />
1982<br />
1983<br />
1984<br />
1985<br />
1986<br />
1987<br />
1988<br />
1989<br />
1990<br />
1991<br />
1992<br />
1993<br />
1994<br />
1995<br />
1996<br />
1997<br />
1998<br />
1999<br />
2000<br />
2001<br />
2002<br />
2003<br />
2004<br />
2005<br />
2006<br />
Misalignment (in percent)<br />
40.0<br />
30.0<br />
20.0<br />
Depreciation<br />
10.0<br />
0.0<br />
-10.0<br />
-20.0<br />
-30.0<br />
Appreciation<br />
1978<br />
1979<br />
1980<br />
1981<br />
1982<br />
1983<br />
1984<br />
1985<br />
1986<br />
1987<br />
1988<br />
1989<br />
1990<br />
1991<br />
1992<br />
1993<br />
1994<br />
1995<br />
1996<br />
1997<br />
1998<br />
1999<br />
2000<br />
2001<br />
2002<br />
2003<br />
2004<br />
2005<br />
2006
The <strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong><br />
<strong>Special</strong> <strong>Edition</strong> (September 2007)<br />
Doha Round Baggage: Implications for Economic Reforms in<br />
Pakistan and other Southern Countries<br />
Naheed Zia Khan *<br />
Abstract<br />
This study is based on the premise that agriculture remains the key<br />
issue in all reform efforts <strong>of</strong> Pakistan and the Doha Round <strong>of</strong> trade talks has<br />
strategic significance for the second round <strong>of</strong> the country’s farm sector<br />
reforms. It is argued that although there are differences among the individual<br />
developing countries, the majority have a comparative advantage in<br />
agricultural production and removing farm sector export subsidies and tradedistorting,<br />
domestic subsidies is their common concern. Evidence is provided<br />
to support the view that the Uruguay Round negotiations on agricultural<br />
subsidies are not a done deal, because although signed by the members, the<br />
Agreement on Agriculture is not ‘ratified’ by the recent farm bills <strong>of</strong> the<br />
developed countries which continue to defy economic logic and the WTO<br />
(World Trade Organization). On the other hand, the evidence provided from<br />
Pakistan shows that the governments <strong>of</strong> developing countries are not fighting<br />
the farmers’ cause since they are poorly managing agricultural policy and<br />
have been overly compliant with respect to the Uruguay Round ruling on<br />
reducing farm subsidies and increasing trade liberalization. The analysis<br />
shows that although the developed countries stand to gain far more from the<br />
liberalization <strong>of</strong> trade in agricultural commodities than the developing<br />
countries, the handful <strong>of</strong> farmers in developed countries are the stumbling<br />
block to the regeneration <strong>of</strong> world trade. It is argued that to alleviate world<br />
poverty, the developed countries need to demonstrate their willingness to<br />
gradually remove both the absolute value <strong>of</strong> subsidies provided to their<br />
farmers and the tariff and non-tariff barriers that protect agriculture.<br />
Finally, the author maintains that at world trade forums, the developing<br />
countries have exhibited poor representation due to lack <strong>of</strong> leadership.<br />
Introduction<br />
The external sector is a fundamental policy concern <strong>of</strong> both the<br />
first and second generation economic reforms in Pakistan. In an economic<br />
* Pr<strong>of</strong>essor <strong>of</strong> <strong>Economics</strong>, Fatima Jinnah Women University, Rawalpindi.
154<br />
Naheed Zia Khan<br />
world dominated by trade, the rules <strong>of</strong> the World Trade Organization<br />
(WTO) prevail. These rules are the outcome <strong>of</strong> the Uruguay Round (UR)<br />
<strong>of</strong> trade talks. The UR began in 1986 and culminated in converting the<br />
‘interim’ Secretariat <strong>of</strong> the General Agreement on Tariffs and Trade<br />
(GATT) into the WTO. The UR was the eighth round <strong>of</strong> GATT and it<br />
included agriculture and services in the trade talks for the first time. 1<br />
With 150 member countries in January 2007, the WTO enforces the<br />
1993 UR agreement; the Agreement on Agriculture (AoA), the General<br />
Agreement on Trade in Services (GATS), the agreement on Trade Related<br />
Intellectual Property Rights (TRIPs) and Trade Related Investment<br />
Measures (TRIMs). The members are required to abide by the WTO rules<br />
which are prolific, running into thousands <strong>of</strong> pages. Following an aborted<br />
attempt in Seattle in late 1999, the Ministerial Meeting <strong>of</strong> the WTO in<br />
Doha, the capital city <strong>of</strong> Qatar, launched the next comprehensive round<br />
<strong>of</strong> multilateral trade negotiations in November 2001. The Doha Round<br />
aims at reducing tariffs, subsidies and other barriers to global commerce<br />
in order to boost progress, apparently, in the underdeveloped parts <strong>of</strong> the<br />
world. Like its predecessor, the UR, agricultural subsidies remain the<br />
sticking point also in the Doha Round <strong>of</strong> trade talks, causing the<br />
suspension <strong>of</strong> the process in July 2006, as the multilateral negotiation on<br />
this thorny issue failed to reach agreement even after a five-year effort.<br />
There is a broad range <strong>of</strong> issues that are <strong>of</strong> important concern for<br />
economic reforms in developing countries such as Pakistan. One key issue<br />
relates to the extent to which they have so far benefited from the UR<br />
reforms, most notably the commitments to liberalize trade in agriculture.<br />
In the wake <strong>of</strong> the break down <strong>of</strong> the trade talks in July 2006, this study<br />
takes a hard look at developments in agricultural policies since the UR<br />
agreement. The analysis is divided into four parts. Part 1 discusses the<br />
importance <strong>of</strong> agriculture in Pakistan’s economy relative to the economies<br />
<strong>of</strong> selected Asian and African countries. Part II presents the estimates,<br />
found in the literature, <strong>of</strong> the welfare gains from removing trade barriers<br />
globally. Pakistan’s performance in reforming its agricultural sector is also<br />
discussed in this part. Part III analyzes the size and significance <strong>of</strong> the<br />
developed countries’ farm subsidies in the Post-UR agreement period.<br />
Finally, before presenting the conclusion <strong>of</strong> this study, Part IV discusses<br />
the factors relating to agricultural subsidies hindering the reform efforts in<br />
developing countries.<br />
Part I<br />
1 The earlier Rounds were Geneva 1947; Annecy 1948; Torquay 1950; Geneva 1956;<br />
Dillon 1960-61; Kennedy 1964-67; and Tokyo 1973-79.
Implications for Economic Reforms in Pakistan and other Southern Countries 155<br />
During the first reform period, Pakistan’s economic performance<br />
compared favorably with most <strong>of</strong> its Asian counterparts. This is supported by<br />
the last century’s scenario presented in Table-1. The figures listed in Tables-1<br />
show that Pakistan fared well in comparison against the averages <strong>of</strong> low<br />
income/ middle income countries and the world, and also with the individual<br />
countries included in the list. However, many <strong>of</strong> its counterparts, both in Asia<br />
and Africa, are much ahead on the literacy front where Pakistan lags behind<br />
even the low income countries and markedly behind the middle income<br />
countries.<br />
Table-1: Economic and Social Indicators <strong>of</strong> Selected Developing<br />
Countries (Asia and Africa)<br />
Category<br />
National Income<br />
(growth rate)<br />
1965-99 (% per annum)<br />
GDP<br />
GDP<br />
Per Capita<br />
Life Expectancy<br />
(years)<br />
Social Indicators<br />
1999<br />
Adult Illiteracy<br />
Rate (%)<br />
1. Country<br />
Bangladesh 3.8 1.3 61 59<br />
Egypt 5.6 3.3 67 45<br />
Kenya 4.7 1.2 48 29<br />
India 4.6 2.4 63 44<br />
Indonesia 6.9 4.8 66 5<br />
Iran 1.7 -1.0 71 24<br />
Malaysia 7.0 4.3 72 13<br />
Mauritius 5.2 3.9 71 16<br />
Oman 9.5 5.0 73 30<br />
Pakistan 5.6 2.7 63 55<br />
Singapore 8.3 6.3 78 8<br />
South Africa 2.3 0.0 48 15<br />
Sri Lanka 4.6 3.0 73 9<br />
Thailand 7.3 5.1 69 5<br />
2. Country Group<br />
Low Income 4.1 1.8 59 39<br />
Middle Income 4.2 2.4 70 15<br />
3. World 3.3 1.6 66 n.a.<br />
Source: World Bank (2001a).
156<br />
Naheed Zia Khan<br />
Pakistan’s economic performance is mainly dependent on the<br />
performance <strong>of</strong> its agricultural sector, the lifeline <strong>of</strong> the country. Table-2<br />
presents the contribution <strong>of</strong> Pakistan’s agricultural sector in its economy<br />
relative to the developing countries included in the comparisons listed in<br />
Table-1. All countries included in the list had overwhelmingly agrarian<br />
economic structures about two generations ago. However, the drive for<br />
modernization and industrialization which began in the later half <strong>of</strong> the 20 th<br />
century has varyingly affected different countries. The indicators listed in<br />
Table-2 show the relative importance <strong>of</strong> agriculture in the countries’<br />
economies during the part <strong>of</strong> the first reform period <strong>of</strong> the 20 th century.<br />
Table-2: Agriculture’s Contribution to the Internal and External Sectors<br />
<strong>of</strong> the Economy<br />
(Selected Developing Countries <strong>of</strong> Asia and Africa)<br />
Country Agricultural internal<br />
sector shares and<br />
Grain<br />
selfsufficiency<br />
Agricultural external sector<br />
indicators<br />
Merchandise Indices (1995-99)<br />
growth rate (%)<br />
Labor GDP Growth<br />
(%) exports Comparative Net<br />
force 1999 rate<br />
1995-99 (% share) advantage export<br />
1990 1965-99<br />
1995-99 index index <br />
Bangladesh 66 25 2.1 88 11 1.07 -0.49<br />
Egypt 39 17 2.8 110 15 1.45 -0.78<br />
Kenya 19 23 3.4 85 64 6.06 0.46<br />
India 69 28 2.8 99 20 1.88 0.28<br />
Indonesia 56 19 3.8 89 17 1.56 0.20<br />
Iran 26 21 4.5 130 6 0.70 -0.49<br />
Malaysia 26 11 2.9 27 13 1.26 0.36<br />
Mauritius 16 6 0.3 0 28 2.63 0.08<br />
Oman 45 3 n.a. n.a. 5 0.44 -0.50<br />
Pakistan 51 27 4.1 101 72 1.39 -0.33<br />
Singapore 1 0.2 -1.5 0.00 4 -1.00 -1.00<br />
South Africa 14 4 2.0 146 14 1.33 0.27<br />
Sri Lanka 48 21 2.7 59 23 2.18 0.40<br />
Thailand 64 11 3.9 142 23 2.15 0.45<br />
Source: World Bank (2001a) and FAO (2001).<br />
<br />
Agriculture’s share <strong>of</strong> the country’s exports relative to its share <strong>of</strong> global<br />
merchandise exports.<br />
<br />
Agricultural exports minus imports as a ratio <strong>of</strong> agricultural exports plus<br />
imports.
Implications for Economic Reforms in Pakistan and other Southern Countries 157<br />
The comparisons show that during the first reform period<br />
agriculture played a very important role in Pakistan’s economy, both in the<br />
internal and external sectors. Two <strong>of</strong> the three components <strong>of</strong> internal<br />
balance are full employment and economic growth. It is normal for<br />
agriculture’s contribution to production and employment to decline in<br />
relative importance as an economy grows. However, the process is slow in<br />
labor abundant countries such as Pakistan, starting from a low industrial<br />
base and facing the acute shortage <strong>of</strong> both human and physical capital.<br />
Table-2 suggests that for the upkeep <strong>of</strong> the internal balance <strong>of</strong> Pakistan’s<br />
economy, agriculture appears to remain the most important sector also<br />
during the second reform period; more than half <strong>of</strong> the country’s labor force<br />
is still engaged in agriculture and the sector’s contribution to Gross<br />
Domestic Product (GDP) is well above a quarter <strong>of</strong> the total. 2 Thus,<br />
agriculture remains the major source <strong>of</strong> Pakistan’s economic growth. More<br />
importantly, the agricultural sector is also to be credited with achieving the<br />
strategic target <strong>of</strong> grain self-sufficiency which must be maintained in the<br />
future, as it is one <strong>of</strong> the prerequisites for sustainable development.<br />
Although the history <strong>of</strong> Pakistan’s external balance happens to be a<br />
sorry affair, agriculture has always provided it a saving grace through the<br />
farm sector’s huge direct and indirect contribution to the country’s<br />
merchandise export earnings. 3 During the first reform period, a low<br />
comparative advantage index <strong>of</strong> Pakistan in agriculture, relative to<br />
Thailand, Sri Lanka and Kenya, must be adjusted for the huge share <strong>of</strong> its<br />
textiles sector in export earnings which largely depends on the raw cotton<br />
produced in the country. 4 Another index, registered in the final column <strong>of</strong><br />
Table-2, accounts for the imports <strong>of</strong> agricultural products. It ranges<br />
between -1 and +1, for net importers and exporters respectively. The sign<br />
and the size <strong>of</strong> Pakistan’s index, -0.33, indicates that during the first<br />
reform period the country has been fairly open in the domestic market to<br />
competition from the rest <strong>of</strong> the world. The same cannot be maintained<br />
for Iran and Oman whose economies are largely dependent on the<br />
2 The agricultural share <strong>of</strong> labor force declined to 48.42 percent in 2002 (see, Pakistan<br />
Economic Survey, 2002-03, Statistical Appendix, Table 12.11, p. 121).<br />
3 The indirect contribution <strong>of</strong> agriculture to export earnings comes from the textile sector<br />
which contributed about 60 percent <strong>of</strong> the export earnings during 1978-94. Pakistan is<br />
the fifth largest cotton producer in the world and most <strong>of</strong> its textile export earnings<br />
depend on the raw cotton produced in the country (see Khan, 1998).<br />
4 The agricultural competitiveness listed in Table 2 is based on the computation <strong>of</strong><br />
Balassa’s index <strong>of</strong> ‘revealed’ comparative advantage, which is agriculture’s share <strong>of</strong> a<br />
country’s export relative to agriculture’s share <strong>of</strong> global exports. The ratios necessarily<br />
have a global average <strong>of</strong> unity (see Balassa, 1965).
158<br />
Naheed Zia Khan<br />
earnings from oil exports, while both Egypt and Singapore are now<br />
considered overwhelmingly service economies.<br />
Part II<br />
Since 1945, multilateral trade has been a greater engine for<br />
prosperity than any other form <strong>of</strong> international economic cooperation.<br />
However, tensions in the world trading system began to arise in the early<br />
1970s. A first attempt to shore up the system came with the Tokyo Round<br />
<strong>of</strong> GATT talks which continued from 1973 to 1979. As mentioned earlier,<br />
the UR was launched in 1986. It had 116 participants and it was originally<br />
supposed to end in 1990 but did not, and lasted for eight years. The UR<br />
began on a note <strong>of</strong> optimism with the exercise <strong>of</strong> opening markets<br />
including the markets for agricultural commodities. However, seven years<br />
later in 1993, the issue <strong>of</strong> the developed countries’ huge farm subsidies<br />
brought the UR close to desperation. After a protracted feud between the<br />
European Union (EU) and the United States (US), the UR ended<br />
successfully in the formal signing <strong>of</strong> the trade agreements in April 1994.<br />
The UR agreement was heralded as a watershed in the history <strong>of</strong> world<br />
trade and was expected to lead to huge welfare gains around the world.<br />
Table-3 lists the welfare gains, computed both for the developed and the<br />
developing countries, from removing trade barriers globally, in the post-<br />
UR world <strong>of</strong> 2005.<br />
It is interesting to note in Table-3 that not only are the welfare<br />
gains for the developed countries the largest in freeing international trade<br />
in agriculture and food, it is the only sector where the potential gains<br />
leave the current distribution <strong>of</strong> world income virtually unchanged<br />
between the two country groups. 5 All the more reason for developed<br />
countries to seriously consider the opportunity cost <strong>of</strong> their huge farm<br />
subsidies.<br />
During the first reform period, Pakistan has overdone the fulfillment<br />
<strong>of</strong> the UR commitments in freeing agricultural commodities trade. Table-4<br />
shows that the divergence between the average unweighted applied and<br />
bound tariff in agriculture has been widest in Pakistan amongst the four<br />
major South Asian countries.<br />
5 According to the World Bank’s estimates for 1997, the developing countries, with<br />
almost 80% <strong>of</strong> the world population, subsisted on less than 20% <strong>of</strong> the world’s income<br />
(See World Bank, 1998).
Implications for Economic Reforms in Pakistan and other Southern Countries 159<br />
Table-3: Welfare Gains from Removing Trade Barriers in the Post-<br />
Uruguay Round World <strong>of</strong> 2005<br />
(1995 US$ billions)<br />
Category<br />
Developed<br />
countries<br />
Developing<br />
countries<br />
Agriculture<br />
and food<br />
Other<br />
primary<br />
Textiles and<br />
clothing<br />
Other<br />
manufactures<br />
Total<br />
Total % Total % Total % Total % Total %<br />
122.1 48.0 0.0 0.0 3.3 1.3 14.2 5.6 139.7 54.9<br />
42.6 16.7 2.7 1.1 14.1 5.5 53.3 21.7 114.7 45.1<br />
World 164.7 64.8 2.8 1.1 17.4 6.8 69.5 27.3 254.3 100<br />
Source: Anderson et. al. (2001)<br />
Table-4: Uruguay Round Commitments in Agriculture: South Asia<br />
Country<br />
Average tariff rate (unweighted)<br />
(2000)<br />
Bound (%) Applied (%)<br />
Bangladesh 188 25<br />
India 124 19<br />
Pakistan 197 24<br />
Sri Lanka 50 27<br />
Source: Athukorala (2000) and WTO (2001).<br />
More importantly, even before the first reform package was<br />
announced, Pakistan has been gradually removing input subsidies since the<br />
early 1980s, which virtually ceased to exist by 2000. The input subsidies<br />
were to be phased out and replaced by the output support price system<br />
under the recommendations <strong>of</strong> the Pakistan Agricultural Prices Commission<br />
(APCom), established in 1981. However, the support price policy scarcely<br />
made the national exchequer dole out any funds to the country’s farmers,<br />
particularly after signing the UR commitments. The scenario presented in<br />
Table-5 supports the author’s position.<br />
The figures in Table-5 show that the support prices <strong>of</strong> both rice and<br />
cotton in Pakistan have been lower than the domestic market price in the<br />
post-UR period. Although the government was not restricted by the UR<br />
ruling <strong>of</strong> the WTO, it has never made any procurement <strong>of</strong> rice and cotton,<br />
except in the first year <strong>of</strong> implementation, 1994-95, when a very small
160<br />
Naheed Zia Khan<br />
quantity <strong>of</strong> rice, .06% <strong>of</strong> total production, was procured. On the other<br />
hand, the government has been procuring on average a little over 20% <strong>of</strong><br />
the total production <strong>of</strong> wheat annually, apparently going way beyond the<br />
limits permitted by the UR commitments. 6 However, the government’s<br />
wheat procurement in Pakistan is for food security reasons and not to<br />
support the wheat growers since the support price <strong>of</strong> wheat has been lower<br />
than its market price till 1998-99; the former being only marginally higher<br />
than the latter in 1999-2000. Such a small divergence does not warrant<br />
procurement in widely prevalent and successful support price models. 7<br />
Table-5: Support Price, Market Price and Procurement <strong>of</strong> Major Crops<br />
(Pakistan: 1994-00)<br />
Category <br />
Year<br />
1994-95 1995-96 1996-97 1997-98 1998-99 ♠ 1999-00<br />
1. Wheat<br />
Support price 160 173 240 240 - 300<br />
Market price 176 185 273 259 261 297<br />
Procurement (a) <br />
Procurement (b) 3.74<br />
22%<br />
3.45<br />
20%<br />
2.72<br />
16%<br />
3.98<br />
21%<br />
4.07<br />
23%<br />
8.55<br />
41%<br />
2. Rice <br />
Support price 211 222 255 310 330 350<br />
Market price 192 231 296 297 362 358<br />
Procurement (a) ▲<br />
Procurement (b) 21<br />
0.6%<br />
0.12<br />
-<br />
-<br />
-<br />
-<br />
-<br />
-<br />
-<br />
-<br />
-<br />
3. Cotton ♣<br />
Support price 423 423 540 540 - 825<br />
Market price 794 739 840 808 876 580<br />
Procurement (a) -<br />
Procurement (b) -<br />
-<br />
-<br />
Source: APCom (2001) and Pakistan Economic Survey (2002-03).<br />
-<br />
-<br />
-<br />
-<br />
-<br />
-<br />
-<br />
-<br />
6 Exactly 30 WTO members have commitments to reduce their trade distorting domestic<br />
support in the amber box as measured by their AMS. Members without these commitments<br />
have to keep within 5% <strong>of</strong> the value <strong>of</strong> production level, 10% in the case <strong>of</strong> developing<br />
countries (for further clarification <strong>of</strong> this point, see Part II and footnote 15 <strong>of</strong> this study).<br />
7 For example, the Common Agricultural Policy (CAP) <strong>of</strong> the EU has three interrelated<br />
components: price support, import control and export subsidies. The EU determines<br />
target prices for grains every year after intensive bargaining between the producing and<br />
the consuming interests. A target price and an intervention price is derived. The latter is<br />
set at 5-7 percent below the target price. When the market price in the Union falls to the<br />
intervention price level, procurement begins. In this sense the intervention price <strong>of</strong> a<br />
cereal represents the minimum support price for producers. In addition, for controlling<br />
grain imports the EU employs an import tax, variable levy, designed to equalize the<br />
import price with a decreed domestic price (see Kreinin, 1995, P. 186-7).
Implications for Economic Reforms in Pakistan and other Southern Countries 161<br />
<br />
All prices are in rupees per 40 kg.<br />
<br />
Procurement in million tonnes.<br />
▲ Procurement in million tonnes<br />
<br />
Procurement as percentage <strong>of</strong> total production.<br />
♠ No support price was announced for 1998-99 wheat crop.<br />
In all fairness, the figures listed in Table-5 show that APCom has<br />
been tinkering rather than fine tuning while calculating the support price<br />
mark up. The <strong>of</strong>ficial publications do provide the elaborate goals <strong>of</strong> the<br />
support price, but the information on its mechanism and implementation is<br />
very general and extremely vague. Also, empirical evidence shows that there<br />
has been a huge transfer <strong>of</strong> welfare gains from producers to the consumers<br />
(Ashfaq et. al. 2001; Niaz 1995). It may therefore be concluded that even<br />
during the first reform period, agricultural policies have been penalizing<br />
rather than rewarding the farmers in Pakistan.<br />
Part III<br />
The shortcomings <strong>of</strong> reform efforts by developing countries such as<br />
Pakistan are <strong>of</strong>ten escalated in a world <strong>of</strong> unequal trade partners, as the<br />
huge agricultural subsidies received by the developed countries’ farmers<br />
encourage overproduction and distort trade by making farm goods artificially<br />
cheap internationally.<br />
Farm protection is ubiquitous in developed countries. It has a<br />
formidable history which dates back to the Corn Laws that had protected<br />
British Farmers from imports <strong>of</strong> foreign grain for 200 years. 8 After an ugly<br />
struggle, the British Parliament eventually voted for reform in 1846.<br />
Powerful countries have found a pretext in every age to protect their<br />
farmers. In 19th century Europe, the pretext was unfair competition from<br />
cheap American and Australian imports. In the 1930s it was farm poverty.<br />
After the Second World War it was food security and later on it became<br />
preservation <strong>of</strong> the rural character. 9 With advancements in communication<br />
technology, the issue <strong>of</strong> farm support has now become a potent emotional<br />
and political force the world over. In the EU and US, the farm lobbies wield<br />
influence out <strong>of</strong> all proportions to the share <strong>of</strong> the farm sector in these<br />
countries’ GDP and the labor force.<br />
8 Adam Smith devoted Chapter 5 <strong>of</strong> Book IV to subsidies, called “bounties” in his time.<br />
Although he discussed bounties in the context <strong>of</strong> foreign trade, the main issues are the<br />
same (see Smith, 1776, pp. 398-408).<br />
9 See, ‘A Survey <strong>of</strong> Agriculture’, The Economist, December 12, 1992.
162<br />
Naheed Zia Khan<br />
Before exploring the implications <strong>of</strong> the size and significance <strong>of</strong><br />
agricultural subsidies <strong>of</strong> developed countries, it will be helpful to have an<br />
overall idea <strong>of</strong> the players’ stakes in the international market for agricultural<br />
products. Table-6 presents the share <strong>of</strong> leading exporters <strong>of</strong> agricultural<br />
products in the world receipts from agricultural exports between 1980-<br />
2002. The most significant development to be noted is that the US share<br />
declined by about 3% in 10 years to 1990, and the EU share increased<br />
markedly during the same period. This may be explained by Greece,<br />
Portugal and Spain, all having a comparative advantage in agriculture,<br />
joining the EU, then the European Community. 10<br />
Table-6: International Trade in Agricultural Products: Leading<br />
Exporters (1980-2002)<br />
World export <strong>of</strong> agricultural products<br />
Country/Group<br />
(% share in total export receipts)<br />
1980 1990 2000 2002<br />
EU15 32.8 42.4 39.6 40.1<br />
US 17.0 14.3 12.9 11.8<br />
Canada 5.0 5.4 6.3 5.6<br />
Brazil 3.4 2.4 2.8 3.3<br />
China 1.5 2.4 3.0 3.2<br />
Australia 3.3 2.8 3.0 2.9<br />
Argentina 1.9 1.8 2.2 2.2<br />
Thailand 1.2 1.9 2.2 2.0<br />
Indonesia 1.6 1.0 1.4 1.5<br />
Malaysia 2.0 1.8 1.5 1.5<br />
New Zealand 1.3 1.4 1.4 1.4<br />
Russia - - 1.4 1.3<br />
Chile 0.4 0.7 1.2 1.2<br />
India 1.0 0.8 1.2 1.1<br />
Source: WTO (2003)<br />
<br />
Russian Federation.<br />
10 This observation provides food for thought for why after 1990 the US became<br />
interested in the expansion <strong>of</strong> NAFTA. Also, on the issue <strong>of</strong> farm subsidies the two<br />
powers, EU and the US, were likely to make or break the UR negotiations. Each insisted<br />
that an unsatisfactory deal will be rejected, even if that means no deal at all (see “GATT:<br />
The Eleventh Hour” The Economist, December 4, 1993).
Implications for Economic Reforms in Pakistan and other Southern Countries 163<br />
Agricultural policies pursued by developed countries cause major<br />
distortions which seriously hinder market access for developing countries.<br />
Progress made in reducing protection in developed countries has remained<br />
unsatisfactory to the extent that the Doha Round, launched in November<br />
2001, was suspended in July 2006, after negotiators failed to reach an<br />
accord on agricultural subsidies and market access. The subject continued to<br />
lead to dispute and controversy even in the March 2-4, 2007, ‘miniministerial’<br />
meeting in Kenya. Figures listed in Tables 7-9 provide a<br />
backdrop to understanding the Doha Round stalemate.<br />
Table-7: Agricultural Support in OECD Countries<br />
Agricultural Support Estimates 1986-88 2001-03<br />
Total support (US$ b) 303.720 324.053<br />
Producer Support 241.077 238.310<br />
General Services Support 40.946 57.849<br />
Fiscal Transfers to Consumers 21.697 27.894<br />
Support per farmer (US$ thousands) 10 11<br />
Support per hectare (US$) 183 182<br />
Source: OECD, Agricultural Policies in OECD Countries, 2003.<br />
It is observed that, in nominal terms, the OECD countries together<br />
pay more subsidies to their farmers in the post-UR period. More<br />
importantly, although the producer support shows an overall decline, rather<br />
than decreasing, the support per farmer has increased. This trend, especially<br />
when compared with marginally reduced support per hectare, suggests that<br />
the progress <strong>of</strong> developed countries in reducing farm subsidies scarcely goes<br />
beyond a cosmetic exercise.<br />
Table-8: Agricultural Support in OECD Countries: Relative Shares<br />
Region/Country Percentage Share in Total OECD Support<br />
1986-88 2001-03<br />
EU 37 36<br />
United States 24 29<br />
Japan 20 17<br />
Korea 5 6<br />
Others 14 12<br />
Total 100 100<br />
Source: OECD, Agricultural Policies in OECD Countries, 2003.
164<br />
Naheed Zia Khan<br />
Figures listed in Table-8 and Table-9 provide a closer insight into<br />
the implications <strong>of</strong> OECD farm subsidies for the reform efforts <strong>of</strong><br />
developing countries.<br />
Table-9: Size <strong>of</strong> Agricultural Support in Major Developed Countries:<br />
2001-03<br />
Region/country<br />
Support Estimates<br />
Total Producer Averages<br />
support support Per farmer Per hectare<br />
US$ b US$ (000) US$<br />
OECD 324.053 238.310 11 182<br />
EU 114.720 102.708 15 670<br />
United States 95.128 44.239 19 112<br />
Japan 56.489 5.359 23 9828<br />
Others 57.716 86.004 - -<br />
Source: OECD, Agricultural Policies in OECD Countries, 2004.<br />
Table-8 provides information on the relative share <strong>of</strong> agricultural<br />
support provided by member countries <strong>of</strong> the OECD. The figures show that<br />
the EU’s share <strong>of</strong> the agricultural dole out is largest, followed by the US and<br />
Japan. Moreover, per farmer support, listed in Table-9, <strong>of</strong> the EU, US and<br />
Japan happens to be much above the OECD average. Japan appears to be<br />
contributing most in this scenario, followed by the US. However, the<br />
relative significance <strong>of</strong> Japanese and American farm subsidies needs to be<br />
considered taking account <strong>of</strong> the much larger relative size <strong>of</strong> the farm sector<br />
<strong>of</strong> the latter with a comparative advantage in agriculture in addition to<br />
technological competitive advantage, particularly when compared with the<br />
developing countries. Japanese farm subsidies, though contributing to global<br />
inefficiency, do not hurt farmers elsewhere as the country is not listed in<br />
the league <strong>of</strong> leading agricultural exporters (See Table-6). 11<br />
From the viewpoint <strong>of</strong> global efficiency, the scenario presented in<br />
Tables 7-9 is bad enough, but the worst part, particularly in the context<br />
<strong>of</strong> the argument <strong>of</strong> this study, is that rather than falling, as was required<br />
11 Most <strong>of</strong> the Japanese farm subsidies go to the rice growers for ensuring selfsufficiency<br />
in rice production. Rice is the staple food grain in Japan. For Japan, rice is a<br />
near-sacred product, deeply embedded in history, culture, economics, politics, and<br />
symbolism. For the Japanese the rice is the Christmas tree and rice producing land is<br />
reverently called our holy land (see Blaker, 1999).
Implications for Economic Reforms in Pakistan and other Southern Countries 165<br />
under the UR obligations, the developed countries’ farm subsidies have<br />
been increasing. The available estimates show that in 2001, the US had<br />
increased its subsidy to 21% <strong>of</strong> the gross farm receipts, while the EU was<br />
contributing 35% <strong>of</strong> gross receipts <strong>of</strong> its farmers (OECD 2002). 12 Finally,<br />
in May 2002, the US passed legislation to further increase the amount the<br />
government pays to farmers. The new Farm Act provides an additional $83<br />
billion in subsidies above the existing program during the next decade. 13<br />
These developments are in gross violation <strong>of</strong> the AoA which<br />
established commitments at the UR to limit and reduce baseline domestic<br />
support, as measured by the Aggregate Measure <strong>of</strong> Support (AMS). This was<br />
the most innovative element <strong>of</strong> the AoA because trade distortions arising<br />
from domestic support policies were for the first time formally recognized<br />
(Schluep and Gorter 2001). A key aspect <strong>of</strong> the reductions commitments in<br />
the domestic support was the distinction between domestic policies that<br />
distort trade and those that do not. This makes it possible to focus on trade<br />
distorting policies, negotiate reductions in their magnitude and provide an<br />
incentive for governments to re-instrument their domestic policies towards<br />
non-distorting measures (Schmitz and Vercammen 1995). However, most<br />
countries could circumvent their AMS commitments because <strong>of</strong> an<br />
extremely high base period upon which commitments were made and<br />
because <strong>of</strong> the sector-wide nature <strong>of</strong> the support commitments (OECD<br />
2000). Hence, the AMS has been the least binding element <strong>of</strong> the AoA<br />
commitments for most countries. Moreover, the establishment <strong>of</strong> the blue<br />
box and green box which were both exempted from reduction requirements<br />
further weakened the domestic support element <strong>of</strong> the Agreement. 14 Total<br />
support provided by amber policies on production was measured by the<br />
AMS, which countries agreed to reduce by 20 percent in the 1995-2000<br />
implementation period (OECD 1999).<br />
12 Also see “The Doha squabble,” The Economist, March 27 th 2003.<br />
13 See “Why U.S. Farm Subsidies Are Bad for the World” Philadelphia Inquirer, May 6,<br />
2002.<br />
14 In WTO terminology, “boxes” which are given the colors <strong>of</strong> traffic lights in general<br />
identify subsidies: green (permitted), amber (slow down — i.e. be reduced), and red<br />
(forbidden). The AoA has no red box, although domestic support exceeding the reduction<br />
commitment levels in the amber box is prohibited; and there is a blue box for subsidies<br />
that are tied to programs that limit production. Amber box policies include transfers from<br />
consumers such as administered price supports but also taxpayer-funded subsidies for<br />
both inputs and output. The accounting method is either government expenditures or<br />
price gaps using the “equivalent method <strong>of</strong> support” (EMS) measure. Green box policies<br />
include decoupled payments (that purportedly do not affect production decisions) and<br />
policies to correct for market failures such as environmental programs, research, food<br />
aid, and crop insurance and income safety net programs. This class <strong>of</strong> policies is<br />
generally taxpayer funded that does not involve transfers from consumers.
166<br />
Naheed Zia Khan<br />
As mentioned above, the AoA sought to define, quantify and reduce<br />
trade distorting policies. It included three areas, namely, import access,<br />
export subsidies and domestic support. However, the figures listed in Table<br />
7-9 suggest that the AoA cannot be rated as a success because, despite<br />
support reduction commitments, the absolute size <strong>of</strong> the developed<br />
countries’ subsidies has in fact increased over the implementation period. 15<br />
Part IV<br />
The Cancún Ministerial Meeting in September 2003 was the<br />
second disappointment for the WTO in four years. Before the Doha Round<br />
was launched in November 2001, its meeting in Seattle in December 1999<br />
broke down, largely because <strong>of</strong> the undue pressure exerted by the<br />
developed countries on extraneous issues. The trade round stagnated for<br />
22 months between the meetings in Doha and Cancún. After a long<br />
stalemate, and at the behest <strong>of</strong> many developing countries, the US and the<br />
EU drew up a framework in August 2003 for freeing farm trade. Though<br />
it involved some reform, the plan was much less ambitious than the Doha<br />
Round had implied. Export subsidies, for example, were not to be<br />
eliminated after all. 16 Angered by this lack <strong>of</strong> ambition, a new block <strong>of</strong><br />
developing countries emerged just before the Cancún meeting to<br />
denounce the EU/US framework as far too timid. Led by Brazil, China and<br />
India, this so-called G22 became a powerful voice at the Cancún<br />
Ministerial Meeting in September 2003. 17<br />
Given the analysis in Part III, developing countries were<br />
understandably dissatisfied at Cancún with the commitment <strong>of</strong> developed<br />
countries to agricultural reforms. Many demanded concessions on<br />
agriculture from the US and the EU before talks could move forward, and<br />
consequently refused to negotiate. Although it spanned diverse interests -<br />
India, for instance, is terrified <strong>of</strong> lowering tariffs on farm goods, while<br />
Brazil, a huge and competitive exporter, wants free trade as fast as<br />
possible-the G22 stood together and managed to effectively block the<br />
consensus required to do anything in the WTO. The Group’s initiative<br />
ought to be viewed in the light that farm trade is not some peripheral<br />
15 The European Union, Japan and the United States account for over 85 percent <strong>of</strong> total<br />
domestic support under the AMS [see, OECD 2002].<br />
16 For a better insight into the plan, see “More fudge than breakthrough,” The Economist,<br />
June 26 th 2003.<br />
17 The Group included Argentina, Bolivia, Brazil, Chile, China, Columbia, Costa Rica,<br />
Cuba, Ecuador, Egypt, Guatemala, India, Indonesia, Mexico, Nigeria, Pakistan,<br />
Paraguay, Peru, Philippines, South Africa, Thailand, Venezuela (see “The WTO under<br />
fire,” The Economist September 18 th , 2003).
Implications for Economic Reforms in Pakistan and other Southern Countries 167<br />
issue. It is central to the whole round. Being a development round, Doha<br />
Round was launched with much fanfare. Many developing countries felt<br />
they had a raw deal from the UR. They were dragged reluctantly into yet<br />
another set <strong>of</strong> trade negotiations largely by the promise <strong>of</strong> freer trade in<br />
farm goods.<br />
A group <strong>of</strong> four West African countries-Benin, Burkina Faso, Chad<br />
and Mali-managed to have cotton included as an explicit item on the<br />
Cancún agenda. Their grievances were simple and justified. West African<br />
cotton farmers are being crushed by the $3 billion-plus a year subsidy that<br />
US squanders on its 25,000 cotton farmers, helping to make it the world’s<br />
biggest exporter, depressing prices and wrecking the global market. 18 With<br />
low labor costs and small manageable plots, farmers in West and Central<br />
Africa are among the lowest-cost producers <strong>of</strong> cotton in the world. The<br />
International Cotton Advisory Committee puts the cost <strong>of</strong> producing a<br />
pound <strong>of</strong> cotton in Burkina Faso at 21 US cents compared to 73 cents in<br />
the US itself. However, state subsidies guarantee a minimum price to US<br />
farmers, regardless <strong>of</strong> what happens to world prices. US farmers also<br />
receive additional payments to augment their incomes to a target price<br />
level. As a result, they continued to expand cotton production, by 42 %<br />
between 1998 and 2001, oblivious to almost five years <strong>of</strong> depressed world<br />
prices. In 2002, partly due to the continuous flooding <strong>of</strong> the market by<br />
US cotton, world cotton prices fell to 42 cents per pound, far below the<br />
long-term average <strong>of</strong> 72 cents. During the 2001/02 season, the US<br />
government paid more to its cotton farmers in support than the value <strong>of</strong><br />
the harvested crop, $3.9 billion in subsidies for a crop valued at<br />
$3 billion. These subsidies were responsible for 65 per cent <strong>of</strong> the $300<br />
million loss in potential revenue in all <strong>of</strong> Sub-Saharan Africa in 2002.<br />
Benin, Burkina Faso, Mali, Cameroon and Côte d'Ivoire were hit hardest.<br />
According to another estimate, the US spends $10.7 million per day<br />
subsidizing its cotton farmers, which is three times the total aid given to<br />
Sub-Saharan Africa (UNDP 2003). As mentioned earlier, in May 2002, the<br />
US passed legislation to further increase the amount that the government<br />
pays farmers. The new Farm Act provides an additional $83 billion in farm<br />
expenditure, above the $100 billion spent on existing programs. Cotton<br />
growers, mainly comprising corporate agricultural companies, are expected<br />
to receive an additional $2.5 billion over a decade. 19 This has inflamed an<br />
18 See “The WTO under fire,” The Economist, September 18, 2003.<br />
19 See http://www.business-standard.com, August 7, 2003.
168<br />
Naheed Zia Khan<br />
already raging controversy around agricultural subsidies and has stirred<br />
anger in developing countries. 20<br />
The EU is no less harmful. Its farm reforms may be radical by the<br />
organization's undemanding standards but will not be enough to satisfy the<br />
rest <strong>of</strong> the world. For example, even though its production costs are more<br />
than double to that <strong>of</strong> Asian and Latin American countries having a natural<br />
comparative advantage, the EU is now the second largest sugar exporter<br />
from being a net importer 30 years ago. The EU spends about $3.3 billion<br />
annually in supports on sugar exports, and in mid-2002 was paying its<br />
producers a guaranteed price three times that was being <strong>of</strong>fered on the<br />
world market. Due to EU subsidies, prices on the world sugar market have<br />
fallen by 17%. 21 However, the sugar subsidy is only the tip <strong>of</strong> the iceberg.<br />
The annual dairy subsidy in the EU is $913 per cow, which is almost double<br />
the per capita income <strong>of</strong> Sub-Saharan Africa at $490 and 114 times the<br />
annual per capita aid given by the EU to this region. It gets worse when it<br />
comes to Japan, where each cow gets $2,700 to chew each year, a figure<br />
that is more than five times the per capita income <strong>of</strong> sub-Saharan Africa<br />
(UNDP 2003).<br />
Conclusion<br />
Being a developing open economy, the success <strong>of</strong> Pakistan’s<br />
agricultural reform efforts is conditional on the international market<br />
situation. Agriculture stands out as the most distorted part <strong>of</strong> the world<br />
economy. The most damaging feature <strong>of</strong> the Common Agricultural Policy<br />
(CAP) <strong>of</strong> the EU and <strong>of</strong> the US Farm Support Program is that agricultural<br />
subsidies are tied to production, with surpluses dumped on world markets<br />
via the payment <strong>of</strong> export subsidies. The sufferers are mainly developing<br />
countries, many <strong>of</strong> whose economies depend heavily on agriculture. For<br />
most developing countries, phasing out all farm-export subsidies is the<br />
biggest single objective <strong>of</strong> the Doha round.<br />
20 Indeed, Brazil has lodged a legal challenge against the US at the WTO, charging that it<br />
is in breach <strong>of</strong> the “peace clause” <strong>of</strong> the Organization's AoA. The clause, ironically<br />
introduced at the insistence <strong>of</strong> the US and EU during the UR trade negotiations, protects<br />
a country from challenge to its subsidy regimes as long as it does not raise them beyond<br />
levels set in 1992. No African or Asian nation has yet filed a legal suit at the WTO<br />
against the developed countries’ farm subsidies. Many are cash-strapped, dependent on<br />
aid and debt relief from the very countries they would be challenging. Many are also<br />
wary <strong>of</strong> the potential for retaliatory action.<br />
21 See http://www.business-standard.com, August 7, 2003.
Implications for Economic Reforms in Pakistan and other Southern Countries 169<br />
Ironically, the rules prohibiting subsidies were supported and<br />
organized within the WTO by the same countries that are violating the UR<br />
ruling on farm subsidies. Much <strong>of</strong> the blame lies with the AoA itself. In<br />
theory, the Agreement requires all member countries to reduce subsidies<br />
that hinder trade, but numerous loopholes and rules, the ‘peace clause’ for<br />
example, are weighted in favor <strong>of</strong> the more dominant members <strong>of</strong> the<br />
WTO, allowing them to avoid reducing agricultural subsidies and continue<br />
raising them in some cases.<br />
Lower tariff barriers and a big cut in the developed countries<br />
subsidies have strategic significance for the developing world as a whole. An<br />
estimated 96% <strong>of</strong> the world’s farmers live in developing countries, with<br />
some 2.5 billion people depending on agriculture for a livelihood. Over the<br />
years, unfavorable trade terms have been a major factor in the erosion <strong>of</strong> the<br />
market share <strong>of</strong> developing nations. According to the WTO, the share <strong>of</strong> the<br />
South in world agricultural exports fell from 40% in 1961 to 35% in 2002. 22<br />
The huge subsidies <strong>of</strong> developed countries depress farm prices and place the<br />
farmers <strong>of</strong> developing countries at a big disadvantage. US taxpayers, along<br />
with their European counterparts, bear a direct responsibility for poverty in<br />
the world.<br />
Finally, can any <strong>of</strong> the failures outlined in this study be effectively<br />
addressed and the Doha Round revived? Presently, there is little room for<br />
optimism in that the North lacks a holistic and farsighted approach to the<br />
interdependence and complimentarity <strong>of</strong> the world economy, while the<br />
South appears to be as divided and disorganized as ever. The G22, for<br />
instance, left Cancún determined to stick together and fight another day.<br />
Since after, quite a few member countries <strong>of</strong> the G22 alliance have been<br />
negotiating free trade agreements with the US. Their commitment to the<br />
free trade <strong>of</strong> farm goods and their interests in pursuing the strong market<br />
access commitments, requiring free trade agreements with the US, do not<br />
appear to be in harmony with each other. This leads to the final concluding<br />
remarks that in the previous rounds <strong>of</strong> the GATT and WTO, the<br />
negotiations by the developing countries have amply exhibited the<br />
unfortunate lack <strong>of</strong> leadership. Cancún provided some short-lived hope, as<br />
the subsequent developments suggest that it too has failed to pass the time<br />
test.<br />
22 http://www.business-standard.com, August 7, 2003.
170<br />
Naheed Zia Khan<br />
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WTO, 2003, International Trade Statistics 2003, Geneva: World Trade<br />
Organization.
The <strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong><br />
<strong>Special</strong> <strong>Edition</strong> (September 2007)<br />
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free<br />
Trade Agreement<br />
Samina Shabir * and Reema Kazmi **<br />
Abstract<br />
Factor endowments and cross country differences create regional<br />
disparities among states. The disparity in sizes between the Chinese and<br />
Pakistani economies can lead to the creation <strong>of</strong> trade patterns that can<br />
positively or negatively impact the latter’s economy. The present paper<br />
attempts to analyze the pros and cons <strong>of</strong> forming a Free Trade Agreement<br />
(FTA) with China given the size, structure and trade patterns <strong>of</strong> Pakistan’s<br />
existing economy. It also deals with the crucial questions <strong>of</strong>: Can the<br />
formation <strong>of</strong> an FTA with China benefit Pakistan? Will trade liberalization<br />
under an FTA with a neighboring country like China spur Pakistan’s trade<br />
and growth? Looking at trends and trade patterns <strong>of</strong> Pakistan, the<br />
potential <strong>of</strong> Pakistan’s existing economy is analyzed to enhance<br />
interregional trade and export diversification by further deepening<br />
cooperation with China. In the light <strong>of</strong> this analysis, the paper also<br />
outlines a number <strong>of</strong> recommendations to extract the maximum benefit for<br />
Pakistan’s economy from this recently signed FTA with an old economic<br />
partner, China.<br />
I. Introduction<br />
Free trade or globalization is a hotly debated phenomenon in the<br />
global village <strong>of</strong> today’s economic system. If the economic prosperity and<br />
growth <strong>of</strong> all the nations <strong>of</strong> the world could be brought at par with each<br />
other by the free flow <strong>of</strong> goods and services, regardless <strong>of</strong> borders, under<br />
the free trade banner, then it is a scenario for which every one <strong>of</strong> us should<br />
strive for. However, according to skeptics, this concept <strong>of</strong> Free Trade is<br />
nothing but a mirage. The observed reality is that the World Trade<br />
Organization (WTO) which is the international flag bearer <strong>of</strong> free trade has<br />
so far not been successful in bringing about trade liberalization around the<br />
globe. There is a perception that the WTO seems to be biased toward<br />
* Debt Office, Ministry <strong>of</strong> Finance Government <strong>of</strong> Pakistan, Islamabad.<br />
** Debt Office, Ministry <strong>of</strong> Finance, Government <strong>of</strong> Pakistan, Islamabad.
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Samina Shabir and Reema Kazmi<br />
industrialized and already developed countries, safeguarding and advancing<br />
their interests, thus further worsening the lot <strong>of</strong> the world’s poor. This<br />
failure or loss <strong>of</strong> credibility <strong>of</strong> the WTO has led developing countries to<br />
fend for their own interests in this increasingly integrated but regionalized<br />
world. Bilateral trading arrangements, although less preferred to multilateral<br />
ones, are one <strong>of</strong> the instruments employed by various countries, both<br />
developed and developing, to secure their export markets and to guarantee<br />
their trading activities in the future.<br />
Free Trade Agreements (FTAs) are a common type <strong>of</strong> bilateral<br />
arrangement between two or more countries. FTAs facilitate the free flow <strong>of</strong><br />
trade and investment and bring about closer economic integration between<br />
the binding parties by eliminating tariff/restrictions on each other’s<br />
commodities. More than 60% <strong>of</strong> global trade, at the moment, is being<br />
channeled through bilateral and regional trading arrangements. At present,<br />
almost 300 such arrangements exist globally. The purpose <strong>of</strong> these FTAs is<br />
not only to serve the economic needs <strong>of</strong> two countries, but to also<br />
accommodate political motivations, or in other words, legitimatize trade<br />
between two coalition allies (the recent US – Panama FTA is an example). A<br />
host <strong>of</strong> industrialized countries have already established bilateral<br />
arrangements (e.g., EU, NAFTA etc.), mostly among themselves. With the<br />
realization <strong>of</strong> the growing importance <strong>of</strong> FTAs, some developing countries<br />
have also entered into these arrangements. The recently signed Pakistan -<br />
China FTA is a move in the same direction. With the growing importance <strong>of</strong><br />
emerging economies in South and East Asia, Asia Pacific and South America,<br />
Pakistan is aiming at strengthening its trading relations with the economies<br />
<strong>of</strong> those regions. With the growing importance attached to China as the<br />
fourth largest economy <strong>of</strong> the world as well as an immediate neighbor <strong>of</strong><br />
Pakistan, it is about time for Pakistan to think about strengthening its<br />
economic ties, apart from their already strong strategic and military<br />
relations. It was with this enthusiasm and aim in mind that Pakistan laid the<br />
foundation for an FTA arrangement with China in July, 2006.<br />
China being the fourth largest economy <strong>of</strong> the world, with a trade<br />
surplus <strong>of</strong> $30 billion and foreign exchange reserve <strong>of</strong> $1 trillion, has<br />
strategically moved from being a centrally planned to a market based<br />
economy. At the end <strong>of</strong> 2006, China's global trade exceeded $1.758 trillion.<br />
Pakistan in comparison, is an emerging economy with nominal GDP <strong>of</strong><br />
$128.5 billion, a trade deficit <strong>of</strong> $8.51 and foreign exchange reserves in<br />
excess <strong>of</strong> $13 billion. Given the disparity in the sizes and economies <strong>of</strong> these<br />
two countries, entering into an FTA arrangement at this point in time can<br />
lead to some very crucial implications for both the countries, especially for<br />
Pakistan. Thus, this paper attempts to explore the implications <strong>of</strong> the FTA
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 175<br />
between China and Pakistan on Pakistan’s economy. A case in point is the<br />
textile sector <strong>of</strong> Pakistan which is an important contributor to the country’s<br />
overall exports, while China is also very competitive in this sector - leading<br />
to a clash in interests. Therefore, it is imperative to analyze the implications<br />
<strong>of</strong> the FTA for various sectors <strong>of</strong> Pakistan’s economy. Likewise, a huge<br />
historic trade deficit with China makes it necessary to see the impact <strong>of</strong> this<br />
FTA on trade with China and Pakistan in general. A number <strong>of</strong> Chinese<br />
firms were operating in Pakistan, even before the establishment <strong>of</strong> the FTA,<br />
so now this also requires us to explore the investment scenario in Pakistan.<br />
This study analyzes all these impacts in detail.<br />
The objective <strong>of</strong> the present paper is to examine the impact <strong>of</strong> the<br />
recently signed Pak-China Free Trade Agreement (FTA) on Pakistan’s<br />
economy. The paper has been structured as follows: Section II deals with<br />
Pakistan-China trade and economic ties; Section III looks at the already<br />
signed FTA <strong>of</strong> Pakistan and China with various other countries; Section IV<br />
analyzes the economic impact <strong>of</strong> FTA on Pakistan’s economy in detail and<br />
Section V presents the conclusions <strong>of</strong> the paper.<br />
II. Pakistan China Trade and Economic Relations<br />
The year 2006 marks the completion <strong>of</strong> 55 years <strong>of</strong> cordial relations<br />
between Pakistan and China. Over all these years, the two countries have<br />
been able to evolve a cooperative relationship at multiple levels, especially in<br />
the political, defense and diplomatic arenas. However, Pakistan and China<br />
have not been able to make substantial progress in their economic relations<br />
until recently.<br />
At the dawn <strong>of</strong> the 21st century and with the implementation <strong>of</strong> the<br />
WTO regime just around the corner, both the countries realized the<br />
missing economic dimension in their evolving strategic relationship. The<br />
two countries thus acknowledged the fact that in order to sustain a<br />
comprehensive cooperative relationship, substantive economic collaboration,<br />
in line with the level <strong>of</strong> political and strategic coordination, was imperative.<br />
Economic cooperation would not only consolidate the comprehensive<br />
bilateral relations between the two countries, but also help in achieving<br />
common aspirations for development, peace and stability in the region. In<br />
the last few years or so, the two governments have convened a number <strong>of</strong><br />
high-level conferences/forums, inaugurated by their respective leadership in<br />
Pakistan and China, to promote economic cooperation thereby exhibiting<br />
interest, resolve and patronage to the private sector business community <strong>of</strong><br />
the two countries. Pakistan and China have now successfully created a clear<br />
and shared vision <strong>of</strong> the direction <strong>of</strong> their economic relations. However, the
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results <strong>of</strong> this evolving economic cooperation would only be realized after<br />
the upcoming implementation <strong>of</strong> the agreements reached at various levels<br />
on trade and investment.<br />
Since the early 1950s, Pakistan and China have entered into trade<br />
relations; however, the first formal Trade Agreement was signed in January<br />
1963. Later, in October 1982, the two countries established the Pakistan-<br />
China Joint Committee on the Economy, Trade and Technology. Trade<br />
between China and Pakistan had generally been conducted under the 1963<br />
Trade Agreement, according to which both countries had granted MFN<br />
status to each other. Pakistan had, at that time, multi-modal trade with<br />
China i.e. barter trade and cash trade. However, at present trade with China<br />
is conducted almost entirely on a cash basis in convertible currency.<br />
Recently, the economic relationship between China and Pakistan has come<br />
to the forefront. Now the question arises as to why this sudden interest in<br />
trade between the two countries has suddenly been ignited. Amongst other<br />
reasons, one is that the Chinese government has persuaded its statecontrolled<br />
enterprises to import Pakistani products in order to improve the<br />
trade balance and make more project-specific investments. The private<br />
sector’s engagement, which would be the main engine for growth in<br />
bilateral economic relations in the future, is still at a low level. On the<br />
other hand, compliance with the WTO regime is imminent and thus<br />
countries are on the look out for the consolidation <strong>of</strong> ties with their most<br />
dependable trading partner. In the case <strong>of</strong> Pakistan, that dependable trading<br />
partner as well as a neighbor is China. Thirdly, logistically an all-reaching<br />
trading agreement with a neighborly state like China is economically<br />
rational and cost effective. Thus, with the rest <strong>of</strong> the world already well on<br />
its way towards economic integration with like minded allies, Pakistan has<br />
also started to follow this well treaded path.<br />
Traditionally, throughout its trade relations with China, Pakistan<br />
has had a chronic trade deficit. This is primarily because China is<br />
competing in almost all the major sectors <strong>of</strong> Pakistan’s potential export<br />
areas, which happen to be very limited. Secondly, the Pakistani business<br />
community remained content with their established export destinations<br />
i.e., the US and the Western Europe, and hardly made serious efforts to<br />
either diversify the export base or to explore other areas and regions for<br />
enhancing the volume <strong>of</strong> their exports. This fixation with Western markets<br />
and non-innovative export approach has consistently undermined the<br />
country’s export potential. Third, though it was feared initially that cheap<br />
Chinese products could take over the Pakistani market, this trend abated<br />
once people realized that they were <strong>of</strong> low quality, with almost no<br />
guarantee by the company. This was true for both small items, such as
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 177<br />
shoes, as well as bigger items, such as locomotives. Fourth, Chinese<br />
brands were not as famous as the western ones, so competition usually<br />
went against China. Fifth, despite being neighbors, there was a lack <strong>of</strong><br />
effective means <strong>of</strong> communication between Pakistan and China. The<br />
Karakorum Highway, which opened in 1978, could not be used to<br />
increase the volume <strong>of</strong> trade in any substantial manner. In addition, an<br />
underdeveloped shipping industry in Pakistan further limited the trade<br />
routes and discouraged the growth in trade volume. Sixth, Pakistan’s<br />
cotton based industry is the main pillar <strong>of</strong> its exports. Since China itself is<br />
a major textile manufacturer, the trade volume could not be raised.<br />
As a result <strong>of</strong> this renewed interest in trade relations, on May 12<br />
2001, Pakistan and China signed six agreements and one Memorandum <strong>of</strong><br />
Understanding (MoU). At that time, Chinese financial assistance for the<br />
agreed projects was estimated to be worth over one billion dollars. This<br />
signing <strong>of</strong> agreements can be termed as the first round <strong>of</strong> a substantive<br />
initiative for expanding economic cooperation. The agreements signed<br />
included: Economic and Technical Cooperation, Tourism Cooperation, Lease<br />
Agreement on Saindak Copper-Gold Project, Supply <strong>of</strong> Locomotives to<br />
Pakistan Railways, Supply <strong>of</strong> Passenger Coaches to Pakistan Railways, White<br />
Oil Pipeline and MoU between China’s ZTE and Pakistan<br />
Telecommunications Co. Ltd. Under the Agreement on Economic and<br />
Technical Cooperation, the Chinese government agreed to provide a grant<br />
<strong>of</strong> 50 million Yuan for the promotion <strong>of</strong> economic and technical<br />
cooperation between the two countries.<br />
China, meanwhile, also reiterated support for a project which is very<br />
close to the Pakistani people’s hearts. Thus, almost a year later, on March<br />
22, 2002, General Musharraf and the Chinese Vice Premier, Wu Bang Guo,<br />
attended the ground-breaking ceremony <strong>of</strong> the Gwader sea-port. Phase one<br />
<strong>of</strong> Gwader port was successfully completed in April 2005, and work on the<br />
second phase is in progress.<br />
In the following years, there has been a regular exchange <strong>of</strong> highlevel<br />
visits between the two countries and each visit added new dimensions<br />
and areas for economic cooperation. For example, President Musharraf’s visit<br />
in November 2003 resulted in the signing <strong>of</strong> a Joint Declaration on<br />
Direction <strong>of</strong> Bilateral Relations. It was in fact a road-map determining the<br />
direction and scope <strong>of</strong> overall Pak-China bilateral relations in the future.<br />
In December 2004, Pakistan and China again signed seven<br />
agreements in trade, communication and the energy sector and drew up a<br />
framework for greater cooperation. These agreements envisaged an increase
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in bilateral trade, further movement on the preferential trade agreement,<br />
the setting up <strong>of</strong> joint agro-based industries and increased Chinese<br />
investment in Pakistan. Pakistan announced Free Market Economy (FME)<br />
status for China. Also, China committed to provide $150 million for the<br />
Chashma Nuclear Power Plant (Phase II). It was part <strong>of</strong> the preferential<br />
buyers’ credit <strong>of</strong> $500 million to be provided by the Chinese government<br />
for investment through Chinese companies. China’s investment in Pakistan<br />
at present stands at US $4 billion plus, and at least 114 Chinese projects are<br />
underway. The Chinese side also agreed that the Joint Economic<br />
Commission should soon review Pakistan’s proposal to set up a Pakistan-<br />
China Joint Investment Company and the establishment <strong>of</strong> a Joint<br />
Infrastructure Development Fund for investment in Pakistan.<br />
The Chinese Prime Minister’s April 2005 visit was considered a<br />
landmark visit in which the two sides signed 21 agreements and MoUs on<br />
cooperation in economic matters, defense, energy, infrastructure, the social<br />
sector, health, education, higher education, housing and other areas. The<br />
two sides also signed a Treaty <strong>of</strong> Friendship, Cooperation and Good<br />
Neighborly Relations. Under the agreement on Early Harvest Program<br />
(EHP), which became operational on January 1, 2006, China has reduced<br />
tariffs to zero on 767 items. This was the first step towards establishing a<br />
free trade area between the two countries. It is envisaged that by the year<br />
2008, Pakistan and China would be fully able to implement the FTA,<br />
covering 90% <strong>of</strong> the commodities. The remaining 10% would remain on the<br />
sensitive list <strong>of</strong> commodities and tariffs might be removed, or at least toned<br />
down, during the second round <strong>of</strong> FTA negotiations scheduled to be held in<br />
2011 and be implemented in 2012. During the recent visit <strong>of</strong> the Chinese<br />
President to Pakistan in November 2006, the two countries signed 18<br />
agreements, including a free trade pact/agreement, which they hope will<br />
boost trade from $ 4.26 billion last year to $ 15 billion within the next five<br />
years. The two sides have also signed a pact on a five-year plan to set up a<br />
comprehensive framework for boosting economic ties. Pakistan provides the<br />
shortest possible route, from Gwader through the Karakorum Highway, to<br />
the Western regions <strong>of</strong> China, which are undergoing a huge economic<br />
transformation. This route is secure, short and can serve as an alternative to<br />
the sea route that passes through the Straits <strong>of</strong> Malacca. Both countries have<br />
been focusing on trade interaction through this route.
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 179<br />
As a result <strong>of</strong> the concerted efforts and determination to enhance<br />
economic cooperation between both sides, trade between the two countries<br />
has been registering constant growth: from $1.07 billion in 1997, to $3<br />
billion in 2004, to $4.26 billion in 2005, and the estimated trade volume in<br />
2006 is at $5 billion. Therefore, in a short span <strong>of</strong> eight years, the trade<br />
volume between China and Pakistan has increased by around $3.2 billion –<br />
not a paltry amount by any standards. Although the current trade balance is<br />
still heavily in favor <strong>of</strong> China, the opportunities for Pakistani exports to<br />
China are growing. According to the Chinese Customs Authority, “Pakistan's<br />
export to China showed an upward trend, registering an increase <strong>of</strong> about<br />
39.2% in 2005. The exports amounted to $832 million from January to<br />
December 2005, whereas it was at $594 million in the same period during<br />
the previous year (January-December 2004). Therefore, the increase in<br />
Pakistan’s exports to China in a period <strong>of</strong> one year has amounted to about $<br />
238 million.” It is expected that if Pakistan’s economy continues to achieve<br />
its current growth rate, bilateral trade would touch around US$ 8 billion by<br />
2008.<br />
During the President <strong>of</strong> Pakistan’s recent visit, the two sides inked<br />
13 agreements and one MoU, aimed at boosting bilateral economic<br />
cooperation while covering a wide range <strong>of</strong> issues, including trade and<br />
economic cooperation as well as cooperation on energy, transportation,<br />
agriculture, health, population, seismology and meteorology. A feasibility<br />
study is also being conducted to make Pakistan China’s “trade and energy<br />
corridor.” Thereby, upgradation <strong>of</strong> economic cooperation has become an<br />
integral part <strong>of</strong> the overall Pakistan-China strategic cooperation. The<br />
institutionalization <strong>of</strong> economic relations through the above-mentioned visits<br />
have laid the foundation and set the direction <strong>of</strong> the cooperative<br />
relationship <strong>of</strong> Pakistan-China.<br />
Although the two-way trade has increased, the volume <strong>of</strong> trade is<br />
still low. Traditionally, the trade balance has always been titled in favor <strong>of</strong><br />
China, except for a short while in 1952, owing to China’s involvement in<br />
the Korean War. For decades China’s constant increase in exports to<br />
Pakistan resulted in a persistent and growing trade imbalance. The main<br />
items <strong>of</strong> Pakistan’s imports from China are machinery and parts, iron and<br />
steel manufactures, sugar, chemical materials, chemical elements and<br />
medical and pharmaceutical products. The main items <strong>of</strong> Pakistan’s exports<br />
to China are cotton fabrics, cotton yarn, petroleum and its products, fish<br />
and its preparations, leather, fruits and vegetables. Unfortunately, the mix <strong>of</strong><br />
Pakistan’s products exported to China is very narrow. Almost around 80 %<br />
<strong>of</strong> its exports consist <strong>of</strong> cotton yarn and fabric.
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Pakistan’s exports to China lack diversity and both countries are<br />
competitors in the textile sector. Diversification <strong>of</strong> exports from Pakistan<br />
into non-traditional items will help minimize the trade imbalance. Another<br />
important factor in trade deficit with China is the growing exports <strong>of</strong><br />
Chinese products to Pakistan. Since these are more economical, businessmen<br />
are inclined to buy more from China. Pakistan therefore, should be looking<br />
at China not simply as an export market but as a primary source for the<br />
import <strong>of</strong> capital goods and industrial raw material.<br />
The two countries signed a Preferential Trade Arrangement (PTA) in<br />
November 2003, which has been operational since January 1, 2004. Pakistan<br />
and China instituted a Joint Study Group to negotiate a Free Trade<br />
Agreement between the two countries and have simultaneously negotiated<br />
an Early Harvest Programme (EHP), which became operational on January 1,<br />
2006.<br />
According to Pakistan’s Ministry <strong>of</strong> Commerce, Pakistan has given<br />
market access on 118 tariff lines <strong>of</strong> organic chemicals and 268 tariff lines <strong>of</strong><br />
machinery – 386 tariff lines in total. Except 30 tariff lines, 13 relating to<br />
organic chemicals and 17 relating to machinery, all the other tariff lines<br />
have an MFN rate <strong>of</strong> 5%. As per the agreed timeframe <strong>of</strong> the elimination <strong>of</strong><br />
tariffs, Pakistan was required to reduce the tariff only on 30 tariff lines by<br />
January 1, 2006. The tariff on the rest <strong>of</strong> the tariff lines i.e. 356 tariff lines<br />
was reduced to zero on January 1, 2007 i.e. no immediate revenue<br />
implications. Similarly, China has brought to zero all tariffs on 767 items.<br />
Pakistan-China Investment Relations<br />
Pakistan and China on February 12, 1989 signed a Bilateral<br />
Investment Treaty (BIT) that encourages the promotion <strong>of</strong> bilateral<br />
investment both in China and Pakistan, and covers all kinds <strong>of</strong> investments,<br />
protects investors and investments <strong>of</strong> both the countries against<br />
discrimination and expropriation, seeks fair and equitable treatment and<br />
provides a dispute resolution mechanism.<br />
The overall Foreign Direct Investment (FDI) in Pakistan has risen by<br />
over 600% in the last five years. However, the Chinese share in the overall FDI<br />
is still very low. Pakistan has been able to introduce and implement investor<br />
friendly policies as a result <strong>of</strong> which FDI has increased. Pakistan’s investment<br />
policy is very liberal which makes available all economic sectors for FDI. It<br />
provides equal treatment to local and foreign investors and allows 100% equity<br />
to foreign investors with no government sanction required. Full remittance <strong>of</strong><br />
pr<strong>of</strong>its, capital, dividends, royalties, technical and franchise fees is allowed.
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Complete legal cover is provided through Foreign Private Investment<br />
(Promotion & Protection) Act 1976, Protection <strong>of</strong> Economic Reforms Act<br />
1992, and Foreign Currency Accounts (Protection) Ordinance 2001.<br />
Similarly, the Chinese government encourages foreign investment in<br />
the Chinese market, and has continuously liberalized and expanded the<br />
fields for investment. In recent years, China has further liberalized the<br />
restrictions imposed on the proportion <strong>of</strong> foreign equity in investment<br />
projects and opened new sectors to foreign investment. The newly–opened<br />
sectors include telecommunications, urban water supply and drainage,<br />
construction and the operation <strong>of</strong> gas and heat distribution networks, which<br />
were all previously prohibited from any foreign investment. China has also<br />
opened such service sectors as banking, insurance, distribution, trading<br />
rights, tourism, telecommunications, transportation, accounting, auditing<br />
and legal services. Also, there are a number <strong>of</strong> laws protecting the interests<br />
<strong>of</strong> foreign investors as well.<br />
III Pakistan & China FTAs with other Countries:<br />
Both Pakistan and China are fully aware <strong>of</strong> the pitfalls <strong>of</strong><br />
regionalization as well as isolation. Thus, keeping in mind the current global<br />
scenario they have signed various FTAs mostly with other emerging<br />
economies and nearby states.<br />
Chinese FTA with ASEAN<br />
The conceptualization <strong>of</strong> the Chinese FTA with ASEAN, known as<br />
CAFTA can be traced back to as early as 1995 when Thailand for the first<br />
time proposed a special economic zone, similar to an FTA with China’s<br />
southern provinces. Later, the Asian Financial Crisis in 1997 and the U.S-led<br />
NATO bombing <strong>of</strong> China’s embassy in Belgrade in 1999 led to discussions <strong>of</strong><br />
the formation <strong>of</strong> an FTA from academic circles to the high policy-making<br />
level. Decision making by Chinese leadership to strengthen cooperation with<br />
ASEAN finally led to the Chinese tentative proposal <strong>of</strong> setting up an FTA<br />
with ASEAN in Singapore in 2000, and later a formal proposal in Brunei in<br />
2001. It was on December 2, 2004 that China signed a free trade agreement<br />
with ASEAN. Being the first ever signed FTA by China, it caught the world’s<br />
attention. The Chinese academia proposed a move beyond traditional modes<br />
<strong>of</strong> trade and tariff reduction to include cooperation in services (including<br />
financial, science and technology, including IT) electricity, agriculture, tourism<br />
and transportation (including air transport), non-traditional security and cross<br />
border crime (such as drug trafficking) and regional cooperation (such as GMS
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cooperation and building China’s Southwest International Corridor through<br />
Yunnan).<br />
In the view <strong>of</strong> some Chinese strategists, an FTA with Japan and<br />
Korea first would have better served the Chinese side because stronger<br />
economic complementarities would make them better partners than ASEAN.<br />
Fewer opportunities for domestic industries and more pressure will exist as a<br />
result <strong>of</strong> cooperation with ASEAN countries. Moreover, making further<br />
concessions to ASEAN as through CAFTA would increase the huge trade<br />
deficit with ASEAN which stood at $1.3 billion in 1993, $1.64 billion in<br />
1998, $2.7 billion in 1999 and $4.8 billion in 2000. However, despite these<br />
realities China did not have the confidence to open its market to economies<br />
that are bigger and far more advanced than its own. If China would have<br />
engaged in an FTA arrangement with Japan and Korea, thus reducing its<br />
current average tariff <strong>of</strong> 14% to the levels <strong>of</strong> Korea and Japan with the given<br />
huge bilateral trade volumes, the fear was that the final outcome would<br />
have been damaging. Moreover, the rise in the trade deficit because <strong>of</strong><br />
Chinese agricultural products not finding better access into Japanese and<br />
Korean markets would not have been fairly compensated. Since by 2015,<br />
China will be able to achieve full trade and investment liberalization it was<br />
better for it to choose ASEAN as a partner for an FTA. In addition to<br />
traditional areas <strong>of</strong> trade and investment, China’s FTA with ASEAN is more<br />
than just an economic deal to cover political and security issues as well.<br />
Using this new regionalism as a precautionary measure to dilute potential<br />
U.S unilateralism in the region shows that CAFTA was both strategically as<br />
well as economically motivated.<br />
According to analyst John Bishop (June 1, 2005) the CAFTA which<br />
was to be concluded by the end <strong>of</strong> June 2005 and implemented in 2010 will<br />
have significant implications for both China and ASEAN nations. China will<br />
benefit from improved trading access to the ASEAN customer base <strong>of</strong> 410<br />
million people and increased imports <strong>of</strong> much needed raw material and<br />
food. But this will lead to the export <strong>of</strong> low value agricultural products to<br />
China from ASEAN while ASEAN will absorb higher value manufactured<br />
products from China leading to higher trade deficits for ASEAN nations.<br />
Chinese FTA with Chile<br />
The China- Chile FTA was signed on November 18, 2005 in Pusan.<br />
Since January 2005, five rounds <strong>of</strong> negotiations on market access, rules <strong>of</strong><br />
origin, technical barriers to trade, SPS remedy, dispute settlement<br />
mechanism, and related legal and technical issues have already taken place.
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 183<br />
The China–Chile FTA will further deepen the partnership and the<br />
trade liberalization process will help unleash the potential <strong>of</strong> bilateral<br />
economic and trade cooperation and intends to set a new example in South-<br />
South cooperation. According to the Ministry <strong>of</strong> Commerce China, after<br />
going through the respective internal approval procedures, the China-Chile<br />
FTA will start comprehensive tariff concessions in the latter half <strong>of</strong> 2006.<br />
On the Chilean side, the import tariff rate <strong>of</strong> 74% <strong>of</strong> the tariff lines will be<br />
lowered to zero immediately after the Agreement takes effect, while on the<br />
Chinese side, 63% <strong>of</strong> the import tariff lines will have zero rate within 2<br />
years; the remaining import tariff lines <strong>of</strong> both parties will be zero rated in<br />
5 to 10 years after the Agreement becomes effective. Each party may keep<br />
only 3% <strong>of</strong> the tariff lines as exceptions with tariff rates unchanged. This<br />
means that in 10 years after the start <strong>of</strong> the tariff concession process, the<br />
import tariffs on 97% <strong>of</strong> the tariff lines <strong>of</strong> both sides will be zero.<br />
Furthermore, the Agreement provides that the two parties may accelerate<br />
the tariff concession upon consensus through consultation. In addition to<br />
the liberalization <strong>of</strong> trade in goods, the Agreement also states the two sides<br />
will strengthen cooperation in such areas as economic matters, small and<br />
medium sized enterprises, culture, education, science and technology,<br />
environmental protection, labor and social security, IPR protection,<br />
investment promotion, mining and industry 1 .<br />
The establishment <strong>of</strong> the China-Chile FTA has been seen as a milestone<br />
in the history <strong>of</strong> the China-Chile relationship, as Chile has always been an<br />
important trading partner <strong>of</strong> China in Latin America. The bilateral trade<br />
between the two countries has reached a level <strong>of</strong> US 5.4 billion during the<br />
period 2002-04, with a 22% annual average growth rate <strong>of</strong> Chinese exports to<br />
Chile and 42% <strong>of</strong> imports. Chile’s imports from China comprise such products<br />
as light industrial products, electromechanical products and plastic products<br />
and Chile’s exports to China are composed <strong>of</strong> such products as copper, fish<br />
powder, fruit and wine. The two economies have been strongly complementary<br />
to each other in industrial structure and import and export commodity mix. 2<br />
Pakistan - SAFTA 3<br />
The Agreement on the South Asian Free Trade Area is an agreement<br />
reached at the 12th South Asian Association for Regional Cooperation<br />
(SAARC) summit at Islamabad, Pakistan on January 6, 2004. It created a<br />
1 The Economic and Commercial Counselor’s <strong>of</strong>fice <strong>of</strong> the Embassy <strong>of</strong> People’s<br />
Republic <strong>of</strong> China, Nov. 18, 2005.<br />
2 ibid<br />
3 Wikipedia
184<br />
Samina Shabir and Reema Kazmi<br />
framework for the creation <strong>of</strong> a free trade zone covering 1.4 billion people<br />
in India, Pakistan, Nepal, Sri Lanka, Bangladesh, Bhutan and the Maldives.<br />
The seven foreign ministers <strong>of</strong> the region signed a framework agreement on<br />
SAFTA with zero customs duty on the trade <strong>of</strong> practically all products in the<br />
region by the end <strong>of</strong> 2012. The SAARC Preferential Trading Arrangement<br />
(SAPTA), with concessional duties on sub-continent trade, went into force<br />
on January 1, 1996. The new agreement i.e. SAFTA, came into being on<br />
January 1, 2006 and will be operational following the ratification <strong>of</strong> the<br />
agreement by the seven governments. SAFTA requires the developing<br />
countries in South Asia, that is, India, Pakistan and Sri Lanka, to bring their<br />
duties down to 20% in the first phase <strong>of</strong> the two year period ending in<br />
2007. In the final five year phase ending 2012, the 20% duty will be<br />
reduced to zero in a series <strong>of</strong> annual cuts. The least developed country<br />
group in South Asia consisting <strong>of</strong> Nepal, Bhutan, Bangladesh and Maldives,<br />
gets an additional three years to reach zero duty.<br />
Pakistan - Sri Lanka FTA (PSLFTA):<br />
The Pakistan – Sri Lanka FTA was signed on July, 2002 and came<br />
into effect in June 2005. Immediately after the FTA became operational,<br />
Pakistan <strong>of</strong>fered 206 items duty-free while Sri Lanka <strong>of</strong>fered 106 items duty<br />
free, hence giving a special and differential treatment to Sri Lanka. Sri<br />
Lanka has been given a five year time period to phase out tariffs as<br />
compared to three years given to Pakistan. The Sri Lankan negative list<br />
consists <strong>of</strong> 697 items as compared to 540 items in Pakistan’s negative list.<br />
Items in the zero duty list <strong>of</strong> Pakistan (subject to application <strong>of</strong> the<br />
mutually agreed rules <strong>of</strong> origin) include frozen fish, vegetables, spices,<br />
fruits/juices, polymers <strong>of</strong> vinyl chloride in primary forms, natural rubber<br />
(excluding latex), raw silk, tanned/crust skins, wool, some varieties <strong>of</strong> paper<br />
and board, carpet and floor covering, non-alloy aluminum, iron and steel<br />
products and toys/dolls.<br />
Sri Lanka’s no-duty items under the FTA include chickpeas, dates,<br />
oranges, benzene, toluene, apparel and clothing accessories, ballbearing,<br />
penicillin/streptomycin/tetracycline and their derivatives and vacuum flasks<br />
(excluding glass inners).<br />
Export markets for certain products are crucial for both Sri Lanka<br />
and Pakistan despite the fact that Pakistan and Sri Lanka have not been<br />
major trading partners over the years. For example, in order to benefit from<br />
duty free access <strong>of</strong> tea, Sri Lanka needs to create a strong marketing
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 185<br />
campaign to change the preference <strong>of</strong> the Pakistani consumers to bulk tea<br />
from CTS tea <strong>of</strong> which Kenya is a major producer.<br />
Currently, trade between India and Pakistan takes place mostly via<br />
Singapore or Dubai. If Sri Lanka can promote Indo-Pakistan trade by<br />
encouraging Pakistani investors to open operations in Sri Lanka in order to<br />
trade with India using the ISLBFTA and vice versa, then Sri Lanka can<br />
gradually acquire hub status in South Asia. 4<br />
IV. Analysis and implications <strong>of</strong> Pakistan-China FTA<br />
The military and strategic relationship between China and Pakistan has<br />
always been strong. However, economic relations between the two countries<br />
have, unfortunately, not been as robust (as illustrated in Section 2). Bilateral<br />
trade, mutual investment (direct/portfolio or both), joint ventures and<br />
aid/loans represent components <strong>of</strong> the economy which, although they have<br />
been previously coordinated upon by the two economies, the scope for<br />
cooperation in these fields remain untapped.<br />
Fig-1 Pakistan's Total Trade Volume with China ($<br />
Billion)<br />
4.<br />
4.2<br />
4<br />
3. 3.<br />
3<br />
2.4<br />
2.<br />
2<br />
1.<br />
1.<br />
1. 1.0 0.97 1.0<br />
0.91<br />
1<br />
0.<br />
0<br />
199 199 199 200 200 200 200 200 200<br />
Source: IPCS <strong>Special</strong> Report 30, September 2006<br />
China’s trade has mostly been concentrated in markets <strong>of</strong> developed<br />
countries such as ASEAN, JAPAN and the US. However, its trade with East<br />
Asian and South East Asian neighbors has also been considerable in volume.<br />
China’s exports to its six East Asian neighbors was $124.2 billion and $<br />
168.8 billion worth <strong>of</strong> goods in 2003 and 2004 as compared to the rest <strong>of</strong><br />
Asia (minus Japan and the Middle East) where it exported goods worth $28.6<br />
billion and $40.4 billion in the same time period. This includes many other<br />
4 Kalegama, S., “Sri Lanka's Free Trade Agreement with Pakistan”, Economic Watch.
186<br />
Samina Shabir and Reema Kazmi<br />
countries besides those <strong>of</strong> South Asia. So what share does Pakistan constitute<br />
and what is the importance <strong>of</strong> Pakistan as a market destination for China? As<br />
Table-1 shows, until 2000 China’s share in Pakistan’s external trade was less<br />
than 6% whereas it crossed the mark <strong>of</strong> 10% after 2003. Moreover, before<br />
Chinese trade agreements came into force with India, Pakistan’s share was<br />
only 20-25% on an average in terms <strong>of</strong> Chinese trade with South Asia,<br />
which has further declined at even the South Asia level.<br />
Table-1: China’s Total Trade Volume with Pakistan and Other Countries<br />
($ billion)<br />
Year 1997 1998 1999 2000 2001 2002 2003 2004 2005<br />
Pakistan 1.07<br />
(20.21)*<br />
0.915<br />
(18.74)<br />
0.971<br />
(17.21)<br />
1.09<br />
(18.88)<br />
1.30<br />
(19.93)<br />
1.80<br />
(19.47)<br />
2.43<br />
(23.38)<br />
3.1<br />
(27.90)<br />
4.26<br />
(34.98)<br />
India 1.83 1.92 1.98 2.77 3.60 4.94 7.6 13.6 18.73<br />
SAARC 3.9 3.89 4.15 5.35 6.43 8.31<br />
ASEAN 25.06 23.66 27.20 38.55 41.80 54.76 78.2 105.9 120<br />
Japan 60.81 58.02 66.16 83.20 87.88 101.97 130 167.9 200<br />
USA 49.03 54.99 61.49 83.30 80.61 97.31 126 169.4 211.63<br />
Source: IPCS, <strong>Special</strong> Report 30<br />
* Figures in brackets refer to the total external trade volume <strong>of</strong> Pakistan in<br />
billion dollars.<br />
Table-2 gives us China’s exports to and imports from Pakistan over<br />
the span <strong>of</strong> the last fifteen years. This has been done to analyze the<br />
burgeoning trade deficit <strong>of</strong> Pakistan between the two trading partners. Over<br />
the years, bilateral trade with China has been on a very small scale. The<br />
share <strong>of</strong> Pakistan’s exports to China in total exports was only in the range <strong>of</strong><br />
1-1.5% until the mid 90s. The table further shows that although the trade<br />
volume between the two countries has started to improve, it still remains in<br />
the range <strong>of</strong> 2-3% up to 2005-06. On the other hand, imports from China<br />
have always been substantial over the period under consideration. During<br />
the decade <strong>of</strong> the 90s, imports from China have fluctuated between 4-5%,<br />
and thereafter have steadily increased to 9.47% during 2005-06. The trade<br />
balance with China has always been negative for all time periods starting<br />
from the 1990s till 2005-06. However, it is important to note here that<br />
during the Korean War <strong>of</strong> the 60’s, Pakistan’s trade deficit actually<br />
registered a surplus with China.
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 187<br />
Table-2: China’s Export to and Import from Pakistan ($ million)<br />
Years Exports Imports Trade<br />
balance<br />
Share <strong>of</strong><br />
Exports to<br />
China in total<br />
exports<br />
Share <strong>of</strong><br />
Imports from<br />
China in total<br />
Imports<br />
Share <strong>of</strong> trade<br />
deficit with<br />
China in total<br />
trade deficit<br />
1990-91 60.83 386.12 -325.29 0.99 5.07 21.86<br />
1991-92 55.47 399.77 -344.31 0.80 4.32 14.66<br />
1992-93 41.60 420.96 -379.36 0.61 4.23 12.13<br />
1993-94 53.67 439.00 -385.33 0.79 5.13 21.88<br />
1994-95 90.63 458.03 -367.40 1.11 4.41 16.28<br />
1995-96 145.82 546.17 -400.35 1.67 4.63 12.92<br />
1996-97 103.38 542.91 -439.53 1.24 4.56 12.30<br />
1997-98 160.99 510.37 -349.39 1.87 5.04 23.45<br />
1998-99 159.71 416.47 -256.76 2.05 4.42 15.53<br />
1999-00 180.35 471.62 -291.26 2.10 4.57 16.74<br />
2000-01 304.14 525.14 -221.00 3.31 4.89 14.47<br />
2001-02 229.06 574.94 -345.88 2.51 5.56 28.70<br />
2002-03 244.57 838.42 -593.85 2.19 6.86 56.02<br />
2003-04 288.11 1153.69 -865.57 2.34 7.40 26.40<br />
2004-05 354.24 1842.91 -1488.67 2.46 8.95 23.98<br />
2005-06 463.99 2706.32 -2242.33 2.82 9.47 18.51<br />
Source: Pakistan Economic Survey, 2005-06<br />
Amongst others, one <strong>of</strong> the reasons for the huge deficit between<br />
China and Pakistan can be attributed to the fact that Pakistan’s exports have<br />
been highly concentrated in the markets <strong>of</strong> few a countries e.g., USA, Japan,<br />
Germany, Hong Kong, Dubai and Saudi Arabia. These countries alone<br />
account for almost 50% <strong>of</strong> Pakistan’s total exports. In addition, Pakistan’s<br />
exports are also excessively concentrated in a few items such as cotton,<br />
leather, rice, synthetic textiles, sporting goods, etc. Pakistan’s exports to<br />
China mainly consist <strong>of</strong> cotton textile material, leather, chromium, mineral<br />
and crude oil, and aquatic products. The exports <strong>of</strong> these products have<br />
been very small as shown by the share <strong>of</strong> Pakistan’s exports to China in total<br />
exports.
188<br />
Samina Shabir and Reema Kazmi<br />
Fig-2 Pakistan's Merchandize Trade with China 1990-2006<br />
50000<br />
40000<br />
30000<br />
20000<br />
10000<br />
0<br />
-10000<br />
1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03 2004-05<br />
Total Trade Exports Imports Trade Balance<br />
Source: Pakistan Economic Survey, 2005-06<br />
On the import side, Pakistan’s imports are mainly concentrated in<br />
the markets <strong>of</strong> a few countries, as 40% <strong>of</strong> imports continue to come from<br />
the USA, Japan, Saudi Arabia, Germany, U.K and Malaysia. Like exports,<br />
imports are also concentrated in a few products such as petroleum and<br />
petroleum products, machinery, chemicals, transport equipment, edible oil,<br />
iron and steel, fertilizers and tea. This concentration <strong>of</strong> imports has<br />
remained unchanged over the last one decade or so. Machinery, petroleum<br />
and petroleum products and chemicals alone account for almost 53% <strong>of</strong><br />
these imports. Over the years, this composition <strong>of</strong> imports has not witnessed<br />
any remarkable change. Among consumer and capital goods, the share <strong>of</strong><br />
raw material for consumer goods in total imports has been high while that<br />
for capital goods has declined. However, the share <strong>of</strong> capital goods has<br />
shown an increase, thereby representing an increase in investment in the<br />
country. The declining share <strong>of</strong> consumer goods, on the other hand,<br />
represents an increase in domestic production.<br />
The share <strong>of</strong> the trade deficit with China in the total trade deficit<br />
shows that although Pakistan’s exports to China have been very<br />
insignificant, the same is not true for imports from China. Pakistan<br />
mainly imports high tech products, chemicals, plastic products and house<br />
hold appliances, chemical materials, machinery, medicine, minerals, light<br />
industry products, native produce and animal byproduct from China.
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 189<br />
Under the recently signed Pakistan-China FTA, both countries have<br />
committed themselves to reducing or eliminating tariffs on all products in<br />
two phases starting from July 1, 2007. The first phase covers trade in goods<br />
and investment while the negotiations in the second phase i.e., trade in<br />
services will be held in mid 2007. An Early Harvest Programme (EHP) which<br />
has been operative since 1st January 2006 has been merged into this newly<br />
signed bilateral FTA. Under the EHP, China has brought to zero all tariffs<br />
on 767 items. For Pakistan, the overall package includes duty free access on<br />
industrial alcohol, cotton fabrics, bed-linen and other home textiles, marble<br />
and other tiles, leather articles, sports goods, mangoes, citrus fruit and<br />
other fruits and vegetables, iron and steel products and engineering goods.<br />
A 50% tariff reduction on fish, dairy sector products, frozen orange juice,<br />
plastic products, rubber products, leather products, knitwear, and woven<br />
garments will also be enjoyed by Pakistan under the FTA. China can get<br />
increased market access mainly on machinery, organic and inorganic<br />
chemicals, fruits and vegetables, medicaments and other raw materials for<br />
various industries including that <strong>of</strong> the engineering sector, intermediary<br />
goods for engineering sectors, etc.<br />
During Phase I, within five years <strong>of</strong> the agreement coming into<br />
force, both parties will reduce tariffs on 85% <strong>of</strong> the products based on<br />
different extents <strong>of</strong> tariff reduction and at least 36% <strong>of</strong> the products will be<br />
tariff free within the first three years. China will mainly reduce tariff on<br />
livestock, aquatic products, vegetables, mineral products and textiles,<br />
whereas Pakistan will reduce tariffs generally on beef, mutton, chemicals and<br />
machinery products. Phase II will start in the sixth year <strong>of</strong> implementation<br />
<strong>of</strong> the agreement. Further reduction <strong>of</strong> the tariffs on various products will<br />
be based on the review <strong>of</strong> the implementation <strong>of</strong> the agreement. In terms <strong>of</strong><br />
tariff lines and trade volumes, the intention <strong>of</strong> both countries is to eliminate<br />
tariffs on no less than 90% <strong>of</strong> the products, within a reasonable period <strong>of</strong><br />
time.<br />
In the preceding paragraphs we have already established the fact<br />
that Pakistan’s exports to China are negligible as compared to its imports<br />
from there. This raises the concern that granting additional market access<br />
to China, through a reduction <strong>of</strong> tariffs under the FTA arrangement,<br />
might lead to harming Pakistan’s economy rather than being beneficial<br />
e.g., Pakistan has agreed to reduce tariffs mainly on machinery, organic,<br />
and inorganic chemicals, fruits and vegetables, medicaments and other<br />
raw materials for various industries including that <strong>of</strong> the engineering<br />
sector, intermediary goods for engineering sectors, etc. Given the current<br />
export structure <strong>of</strong> Pakistan’s economy, it becomes imperative to analyze<br />
the prospective impact <strong>of</strong> this FTA on Pakistan’s economy.
190<br />
Samina Shabir and Reema Kazmi<br />
Presently Pakistani markets are heavily flooded with cheap Chinese<br />
smuggled goods – a major part <strong>of</strong> the illegal trade in the country. A legal<br />
channel for the trade <strong>of</strong> these commodities, even in the absence <strong>of</strong> an FTA,<br />
can make Pakistan’s trade volume double with China. Since smuggling<br />
normally takes place to save on custom duties/tariffs, the implementation <strong>of</strong><br />
the FTA makes such activities useless or non-pr<strong>of</strong>itable since tariffs/duties<br />
saved by the smugglers have largely been removed under the FTA. Legal<br />
documentation <strong>of</strong> these commodities will have a positive impact on<br />
Pakistan’s economy. Although the goods being shipped from China to<br />
Pakistan and vice versa will be duty free, they will still be registered thus<br />
enabling the government to collect revenue in the form <strong>of</strong> income/sales tax<br />
on them. As we see an influx <strong>of</strong> cheap Chinese products enter Pakistan<br />
under the FTA, this can be good for Pakistan’s economy in the sense that<br />
documentation leading to subsequent tax generation will increase CBR<br />
collection for the country.<br />
Besides the aforementioned products, there are other specific<br />
products in which China is more competitive than Pakistan. The<br />
procurement <strong>of</strong> many <strong>of</strong> these products is vital for the Pakistani economy<br />
as well e.g., textile, cotton yarn and garments represent a major share <strong>of</strong><br />
Pakistan’s total exports. Opening the Chinese economy to these sectors<br />
would obviously mean a replacement <strong>of</strong> domestic production by cheap<br />
imports from China. Since Pakistan is in the initial stages <strong>of</strong> development,<br />
it is trying to expand its industrial base through the expansion in its<br />
production <strong>of</strong> semi-finished and finished products. Therefore,<br />
strengthening its engineering sector, auto sub-sector, consumer durables<br />
mainly domestic appliances needs at least at this point in time some<br />
protection in order for the booming trend in the economy to be<br />
sustained.<br />
One <strong>of</strong> the most frequent and recurrent concerns regarding any<br />
FTA is that the impending FTA, allowing for an influx <strong>of</strong> various goods,<br />
might stifle the indigenous industry <strong>of</strong> the less developed country or the<br />
country having a smaller economy. In the case <strong>of</strong> Pakistan – China FTA<br />
similar reservations have been expressed by various strata <strong>of</strong> the society<br />
especially industrialists, small business operators as well as academia <strong>of</strong> the<br />
country. Pakistan being a smaller economy as compared to China is<br />
compelled to look out for its local industries. Since the removal <strong>of</strong> duty<br />
on almost 90% <strong>of</strong> tradable products between the two countries could have<br />
spelt disaster for the textiles, garments, and engineering industries, which<br />
although booming at present are still in their infancy and thus are in not<br />
a position to face a deluge <strong>of</strong> cheap Chinese goods. Realizing the dangers<br />
associated with the implementation <strong>of</strong> an FTA, both the countries have
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 191<br />
agreed to induct a separate clause in the agreement to abolish this<br />
concern once and for all. Article 25, a part <strong>of</strong> the newly signed<br />
agreement, related with both dumping and countervailing duties, states<br />
specifically that no dumping will be tolerated and thus steps to stop this<br />
practice have been finalized.<br />
The following sectors <strong>of</strong> the economy have been provided protection<br />
by Pakistan under the FTA.<br />
Cotton Yarn, Textile and Garment Sectors<br />
Cotton yarn is subject to a tariff <strong>of</strong> 5% which will remain at 5%<br />
during the first phase <strong>of</strong> the Pak-China FTA. The duty on textiles and<br />
garments, which is 25%, would be reduced to 20% in 5 years. The polyester<br />
sector, including fabrics and garments, have been put in the No Concession<br />
List and no duty reduction will take place in the first five years.<br />
Textile Sector<br />
The share <strong>of</strong> the textile industry in the economy along with its<br />
contribution to exports, employment, foreign exchange earnings, investment<br />
and value added makes it the single largest manufacturing sector <strong>of</strong> Pakistan.<br />
It contributes around 8.5% to GDP, employs 38% <strong>of</strong> the total<br />
manufacturing labor force, and contributes between 60-70% to total<br />
merchandise exports. Indeed, with exports reaching about $8.6 billion in<br />
2004-05, Pakistan is one <strong>of</strong> the largest textile exporters in the world. The<br />
variety <strong>of</strong> products ranging from cotton yarn to knitwear, garment made-ups<br />
and bedwear are the most important export products with an export value<br />
<strong>of</strong> about $1.35 billion each. Knitwear, ready made garments and cotton yarn<br />
also have important shares in total exports. Overall, the US and the EU are<br />
Pakistan’s largest trading partners accounting for 25% and 20% shares <strong>of</strong><br />
Pakistani exports respectively. Other major importers include China, the<br />
UAE and Saudi Arabia. The textile trade is classified into two broad<br />
categories i.e. textiles which include yarn, fabric and made-ups, and clothing<br />
which represents ready-made garments. 5<br />
5 Economic Survey <strong>of</strong> Pakistan 2005-06, Manufacturing, Mining and Investment Policies<br />
(Ch: 3).
192<br />
Samina Shabir and Reema Kazmi<br />
Fig-3 Composition <strong>of</strong> Pakistan<br />
Textile Exports 2004-05<br />
Tents &<br />
Canvas, 61<br />
Towels, 462<br />
Madeups<br />
Incl.<br />
Bedwear,<br />
1679<br />
Knitwear<br />
(Hosiery),<br />
1467<br />
Art Silk<br />
Syntax, 268<br />
Ready Made<br />
Garments,<br />
984<br />
Other<br />
textile, 137<br />
Raw Cotton,<br />
108<br />
Yam, 983<br />
Fabrics, 1924<br />
Source: Pakistan Economic Survey, 2005-06<br />
Ready Made Garments Sector<br />
Pakistan, with total exports <strong>of</strong> around US$ 1 billion, has a meager<br />
share <strong>of</strong> 1% in the global apparel market. The apparel export product mix<br />
from Pakistan is heavily tilted towards men's wear and knitted garments.<br />
The major thrust <strong>of</strong> garments and made-ups exports from Pakistan is<br />
towards the USA market. The European Union is the second largest market<br />
for garment manufacturers from Pakistan. The major markets that Pakistani<br />
manufactures have so far not been able to explore are the Japanese, Far East<br />
and Middle East markets. These markets demand high product standards<br />
and in return <strong>of</strong>fer higher unit price realizations. The shift towards newer<br />
product and non-traditional markets can only be brought about by more<br />
emphasis on synthetic garments, and the development <strong>of</strong> a marketing and<br />
research infrastructure for the industry.<br />
The production <strong>of</strong> garments and made-ups in Pakistan is<br />
concentrated mainly in <strong>Lahore</strong>, Faisalabad and Karachi. These three clusters<br />
have their own specialties. Faisalabad caters more to home textiles, <strong>Lahore</strong> is<br />
the home <strong>of</strong> knitwear and Karachi lives up to its reputation <strong>of</strong> being “mini<br />
Pakistan,” having established itself both in the knit as well as the woven side<br />
<strong>of</strong> the industry.
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 193<br />
Engineering Sector<br />
In the steel sector, the prime quality goals are subject to a 10% duty<br />
which will be reduced to 5% in 5 years and secondary goods subject to duty<br />
<strong>of</strong> 20% would be reduced to 16% in 5 years.<br />
The engineering sector accounts for a 63% share in world trade. To<br />
achieve any significant share <strong>of</strong> the world trade in engineering goods and<br />
services, Pakistan will have to do many things which include improving<br />
universities, polytechnics and factories for the kind <strong>of</strong> manufacturing<br />
prowess and design capabilities required by the world market, which now<br />
stands spoilt for choices. In this context, an important step has been taken<br />
by the restructuring <strong>of</strong> the Engineering Development Board.<br />
In Pakistan, large-scale manufacturing companies in the engineering<br />
sector lack export strategies as well as export development. While Japan,<br />
Korea and Malaysia rely on their large-scale companies to spearhead the<br />
export push, in Pakistan this is being conveniently left to the SME sector.<br />
The government needs to look at this deficiency and bring the strength <strong>of</strong><br />
the large scale manufacturing sector into play for a quantum jump in the<br />
export <strong>of</strong> engineering goods and services.<br />
Auto Sub-Sector<br />
Vehicles in CBU, SKD and CKD condition and auto parts classified<br />
under any <strong>of</strong> the headings <strong>of</strong> Pakistan Customs Tariff have been protected<br />
and no duty reduction has been committed to for the first five years.<br />
The auto industry is considered globally as the mother <strong>of</strong> all<br />
industries. The automobile industry has the largest segment in world trade.<br />
The annual size <strong>of</strong> automotive exports has grown over $600 billion, which<br />
accounts for about 10% <strong>of</strong> world exports. In today’s fast globalizing world,<br />
changing models, improving fuel efficiency, cutting costs and enhancing<br />
user comfort without compromising on quality are the most important<br />
challenges <strong>of</strong> the industry. The auto industry in Pakistan is growing fast and<br />
may soon begin to achieve economies <strong>of</strong> scale. This mechanical revolution<br />
has been aided in part by sound macro-economic policies pursued during<br />
the last seven years. Furthermore, the e-pass scheme for electronic goods,<br />
unchanged auto policy over the last few years, liberal adjustment <strong>of</strong> the tax<br />
regime to lower duties on raw materials and intermediate products have also<br />
helped in the rapid expansion <strong>of</strong> the auto sector. The tremendous rise in<br />
automobile demand has resulted in increased production, giving a healthy<br />
impetus to industrial output and generating over 150,000 direct
194<br />
Samina Shabir and Reema Kazmi<br />
employment opportunities besides contributing tax revenue to the national<br />
exchequer.<br />
Since 2001-02, the automobile market has been growing rapidly by<br />
over 40% per annum and if an average annual growth <strong>of</strong> 30% per annum<br />
is maintained, Pakistan’s market will cross the milestone <strong>of</strong> 500,000 units<br />
by the year 2010. Long-term investment friendly policies <strong>of</strong> the<br />
government and up-gradation <strong>of</strong> production facilities are considered as a<br />
pre-requisite by experts to achieve the automobile vision 2010 <strong>of</strong> 500,000<br />
units.<br />
Consumer Durables- Domestic Appliances<br />
All domestic appliances have either been completely protected or the<br />
duty will be reduced from 25% to 20% and 20% to 16% in 5 years.<br />
Riding high on rapidly growing demand, the home appliance<br />
industry in Pakistan is expected to double its capacity <strong>of</strong> producing TVs,<br />
refrigerators and deep freezers by 2009. Refrigerators lead the figure <strong>of</strong> the<br />
current year with 569,756 units. The production <strong>of</strong> TVs, refrigerators and<br />
deep freezers amounted to 372,192, 233,000 and 120,000 respectively in<br />
2000-01. The production <strong>of</strong> these items has almost doubled in a short span<br />
<strong>of</strong> three years. If this trend continues, the home appliance industry would<br />
double its production and will increase its contribution to GDP, and<br />
accordingly contribute revenue to the national exchequer. An added benefit<br />
is the increase in direct jobs in the industry and the vendor industry.<br />
Fig-4 CAGR Growth in Selected Markets from 2003-07<br />
Cellular<br />
93.87<br />
Motor<br />
26.70%<br />
Cars<br />
Van<br />
12.50%<br />
20.80<br />
Refrigirator 10.90%<br />
TV 7.50<br />
0.00 20.00 40.00 60.00 80.00 100.00<br />
Source: PRSP II
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 195<br />
The pace <strong>of</strong> growth in demand for home appliances is the direct<br />
result <strong>of</strong> the banks and leasing companies’ policy <strong>of</strong> consumer financing<br />
packages together with the relaxation through and e-pass schemes. Many<br />
dealers have initiated their own schemes <strong>of</strong> easy installments thus further<br />
escalating demand.<br />
The following sectors have also been protected by Pakistan in the<br />
contract:<br />
• Food basket<br />
• Cigarettes<br />
• Locally manufactured inorganic and organic chemicals<br />
• Plastic products<br />
• Edible products e.g., Edible oils<br />
• Paper and paper board<br />
• Engineering goods<br />
In order to boost trade ties between China and Pakistan, duties/tariffs on<br />
items <strong>of</strong> mutual interest have been reduced drastically. In some cases it has<br />
been decided that the duties be completely written <strong>of</strong>f over a period <strong>of</strong> 5<br />
years. The table given below shows the three stages <strong>of</strong> tariff reduction to be<br />
implemented under the FTA for both Pakistan and China.<br />
In the case <strong>of</strong> exports, as we have shown in Table-2, Pakistan’s<br />
exports to China are a very small proportion <strong>of</strong> the country’s total<br />
exports. If Pakistan can increase its exports to China through increased<br />
market access for commodities which were earlier under the high tariff<br />
lines, then it will be highly beneficial for Pakistan’s economy. As shown<br />
in Table-3 certain export items e.g., leather articles, cotton fabrics, bed<br />
linen and home textiles, marble and other tiles, sports goods, citrus fruits<br />
(kinoo, lemon, lime) and other citrus fruits will be rendered tariff free in<br />
three stages. However, we are well aware <strong>of</strong> the fact that the composition<br />
<strong>of</strong> Pakistan’s exports to China are primary in nature as they consist <strong>of</strong><br />
cotton, textile material, leather, chromium, mineral and crude oil, and<br />
aquatic products etc.
196<br />
Samina Shabir and Reema Kazmi<br />
Products<br />
Table-3: Tariff Structure<br />
MFN Tariff<br />
<strong>of</strong> China<br />
Tariff for Pakistan<br />
On 1/1/2006 On 1/1/2007 On 1/1/2008<br />
Cotton fabrics 10-14 5 0 -<br />
Bed-linen & home<br />
textiles<br />
14 5 0 -<br />
Synthetic yarn 10 5 0 0<br />
Polyester fabrics 10-15 5 0 0<br />
Polyester yarn 5 0 0 0<br />
Indentured industrial<br />
alcohol<br />
Dentured industrial<br />
alcohol<br />
4 10 5 0<br />
30 10 5 0<br />
Leather articles 10 5 0 -<br />
Marble & other tiles 24 10 5 0<br />
Table ware 18 10 5 0<br />
Sports goods 14 5 0 0<br />
Mangoes 15 5 0 0<br />
Citrus fruits (kinoo,<br />
lemon, lime etc.)<br />
12 5 0 0<br />
Other citrus fruits 30 10 5 0<br />
Source: Ministry <strong>of</strong> Commerce, Government <strong>of</strong> Pakistan<br />
Furthermore, increased exports <strong>of</strong> these products because <strong>of</strong><br />
enhanced market freedom can lead to increased revenue generation but will<br />
not necessarily diversify Pakistan’s exports and will also not strengthen the<br />
industrial base <strong>of</strong> the country. However, all is not lost; it must be<br />
remembered that since Pakistan’s exports are highly concentrated in cotton,<br />
leather, rice, synthetic textile and sport goods - a one billion consumer<br />
market <strong>of</strong> China will be advantageous for Pakistan and can diversify<br />
Pakistan’s exports in terms <strong>of</strong> destination.<br />
China being an emerging economy is trying to raise the living<br />
standard <strong>of</strong> its rural populace. Thus, it <strong>of</strong>fers huge potential for Pakistani<br />
exporters, especially in areas <strong>of</strong> agricultural, aquatic and leather products.<br />
According to the Chinese Feasibility Study on FTA, “The Pakistani
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 197<br />
commodities that have the greatest potential to be exported to China are<br />
tropical fruits. These fruits are widely planted in Pakistan, and China has<br />
already finished quarantine and inspection on Pakistani mangoes and citrus.<br />
After zero tariffs are levied, in North-west China, Pakistani fruits will enjoy<br />
certain advantages in both quality and price compared with the fruits grown<br />
in Southern China. Pakistan is also rich in fishery resources. With the<br />
adjustment <strong>of</strong> polices on fishery industry and the improvement <strong>of</strong><br />
technology, the potential <strong>of</strong> Pakistan’s fishery industry will be unleashed.<br />
After the zero tariff policy is adopted, Pakistan will see a rise in its exports<br />
to China.”<br />
These opportunities show that Pakistan can divert its exports from<br />
the markets <strong>of</strong> various other countries that have put high tariffs barriers on<br />
Pakistani imports and allow them to flow towards the Chinese borders under<br />
the guise <strong>of</strong> the newly formulated FTA. These advancements under the FTA<br />
will not only increase the trade volume with China but will also guarantee<br />
exposure to Pakistani products in the world’s second largest economy,<br />
thereby making Pakistan a force to be reckoned with in the region.<br />
In addition to market access, the FTA also covers clauses related to<br />
investments, including its promotion and protection, its treatment,<br />
expropriation, compensation for damages and losses and dispute settlement.<br />
The historic ties <strong>of</strong> investment between China and Pakistan have already<br />
been covered in detail in Section 2 <strong>of</strong> the paper.<br />
Bilateral trade between China and Pakistan in recent years has made<br />
considerable progress, - increasing with an annual average rate <strong>of</strong> 30% in<br />
the past 5 years and exceeding $4.2 billion in 2005. In the first 9 months <strong>of</strong><br />
2006, Sino-Pakistan trade amounted to $3.75 billion, thus, making China<br />
the third biggest trading partner <strong>of</strong> Pakistan.<br />
Over the course <strong>of</strong> the last six decades, China and Pakistan have<br />
witnessed a steady growth in mutual investments, however the scale <strong>of</strong><br />
investment is still relatively small. According to statistics released by the<br />
Board <strong>of</strong> Investment, out <strong>of</strong> a total FDI <strong>of</strong> $1524 million that was invested<br />
in Pakistan during 2004-05, the Chinese share was only $ 443,763. Chinese<br />
investment in Pakistan at the moment is concentrated mainly in Gwader<br />
port construction, exploration <strong>of</strong> coal and other resources, nuclear power<br />
stations, hydroelectric power stations, ship-building, machinery,<br />
infrastructure, construction, agriculture and manufacturing.
198<br />
Samina Shabir and Reema Kazmi<br />
Table- 4: Mutual Investment between China and Pakistan<br />
Pakistan’s Investment in China (10,000 $)<br />
2003 2004 By 2004<br />
Number <strong>of</strong> Projects 19 21 96<br />
Contractual Value 1949 3210 7148<br />
Actual Investment 343 454 1700<br />
China’s Investment in Pakistan (10,000 $)<br />
Number <strong>of</strong> Projects 4 3 34<br />
Contractual Value 930 7344 10411<br />
Source: Chinese Feasibility Study on Free Trade Agreement (March 15,<br />
2005)<br />
Chinese private as well as public sector corporations are launching<br />
big budget projects, especially in the manufacturing and construction<br />
sectors, all over the country. Some <strong>of</strong> the major Chinese companies<br />
operating in Pakistan are Heirs, ZTE, Howai Technologies, China National<br />
Petroleum Corporation, China State Construction Engineering Corporation,<br />
Dong Fang Electric Corporation, CMEs, China Ocean Shipping Corporation<br />
and Air China. The successful implementation by various Chinese joint<br />
ventures will encourage more Chinese as well as other foreign investment to<br />
step into Pakistan.<br />
The signing <strong>of</strong> the FTA is projected to be beneficial for both the<br />
countries. If Pakistan is going to benefit from increased investment flows<br />
to the country, Pakistan is an important market for China to engage in<br />
the project contracting business in South Asia. In recent years, the average<br />
value <strong>of</strong> signed contracts <strong>of</strong> labor services amounted to about US$ 500<br />
million per year. By the end <strong>of</strong> Sept. 2006, the total value <strong>of</strong> contracted<br />
engineering and labor service cooperation projects <strong>of</strong> China in Pakistan<br />
amounted to US$ 8.64 billion and the turnover was US$ 7.2 billion. By<br />
September 2006, the agreed investment <strong>of</strong> China in Pakistan was US$ 110<br />
million and the actual investment <strong>of</strong> Pakistan in China was more than<br />
US$20 million.
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 199<br />
Fig-5 Sector-wise Chinese Investment 2004-05 ($)<br />
Communications<br />
2228<br />
Others, 76194<br />
Metal<br />
521<br />
Transport<br />
Equipmen<br />
(Motorcycles<br />
Automobiles)<br />
15106<br />
Construction<br />
18900<br />
Source: Pakistan Board <strong>of</strong> Investment<br />
As shown above, Chinese investment in Pakistan is substantial,<br />
covering IT and telecom, oil and gas, power generation, engineering,<br />
automobiles, infrastructure and mining sectors. Yet Pakistan‘s investment in<br />
China is not on the same scale. During 2004, Chinese firms were involved<br />
in investment in Pakistan for a contractual value <strong>of</strong> approximately $ 10,411<br />
compared to Pakistani investment <strong>of</strong> only $1700 million. Signing <strong>of</strong> an FTA<br />
provides safeguards for the promotion <strong>of</strong> investment between the two<br />
countries but given the existing investment volume and investment friendly<br />
opportunities <strong>of</strong>fered by the Government <strong>of</strong> Pakistan, China will be in a<br />
better position to utilize the benefits being <strong>of</strong>fered, in lieu <strong>of</strong> yields<br />
including pr<strong>of</strong>its/dividend/capital gains as compared to Pakistani firms<br />
operating in China.. However, they can positively contribute to the<br />
development <strong>of</strong> Pakistan by generating new employment opportunities,<br />
transfer <strong>of</strong> technology, exposure to new products and markets; but it should<br />
be kept in mind that the primary aim <strong>of</strong> any multinational is to maximize<br />
pr<strong>of</strong>its and there are pros and cons associated with allowance <strong>of</strong> these<br />
investments to enter an economy.<br />
V. Conclusion<br />
Pakistan’s FTA with China is another strategic link in the chain<br />
which Pakistan initiated in order to negotiate bilateral and regional<br />
preferential/free trade agreements. Pakistan aims to seek enhanced market<br />
access, by addressing tariff/non-tariff barriers, facilitating and further
200<br />
Samina Shabir and Reema Kazmi<br />
promoting trade, improving investment and economic development,<br />
augmenting comparative value <strong>of</strong> its exports and build added capacity in<br />
specified targeted areas through technical cooperation and collaboration<br />
through entering into such an arrangement.<br />
The present paper undertakes a general analysis <strong>of</strong> the implications<br />
<strong>of</strong> the Pak-China FTA. The inferences drawn from the present analysis is<br />
that although Pakistan’s economy is much smaller than that <strong>of</strong> China’s in<br />
terms <strong>of</strong> GDP, trade, reserves etc., yet the FTA <strong>of</strong>fers a huge potential for<br />
Pakistan’s economy. Pakistan can change the trend <strong>of</strong> its chronic trade<br />
deficit with China by utilizing the increased market access given by China.<br />
Pakistan can also reduce its overall trade deficit by diverting its exports from<br />
traditional destinations to the new one billion consumer base <strong>of</strong> China; but<br />
for that Pakistan has to make its exports more competitive, more diversified<br />
and much better in quality. Increased investment flows will enhance the<br />
capacity <strong>of</strong> the existing industries, will help in technology transfer, and<br />
generate employment opportunities for the local population, thereby<br />
positively contributing to the economy <strong>of</strong> Pakistan. However, the Pakistani<br />
side would be less able to enjoy the concessions given by China for<br />
investment opportunities because the volume <strong>of</strong> investment to China from<br />
Pakistan is negligible. Nonetheless, we should not look at the FTA from this<br />
perspective, that if there are only positive implications for Pakistan, then<br />
why has China entered into such a deal? We know from the facts and<br />
figures that economy-wise China is already far along the road to<br />
development, and for big and developed economies, political and security<br />
matters much more than economic considerations in making such decisions<br />
<strong>of</strong> mutual cooperation. Pakistan’s strategic geographical location makes it a<br />
valuable ally which can act as a trade corridor for countries such as China.
Economic Effects <strong>of</strong> the Recently Signed Pak-China Free Trade Agreement 201<br />
References<br />
Ceylon Chamber <strong>of</strong> Commerce, “Sri Lanka – Pakistan Free Trade<br />
Agreement”.<br />
China Study Center, Institute <strong>of</strong> Strategic Studies. “Area Brief on China<br />
(2007)”,<br />
China Daily, “ASEAN-China FTA Benefits Both Sides”, April 3 2002.<br />
Chinese Feasibility Study on Free Trade Agreement, Online Search, March<br />
15, 2005.<br />
Economic and Commercial Counsellor’s Office <strong>of</strong> the Embassy <strong>of</strong> the<br />
People’s Republic <strong>of</strong> China in the Republic <strong>of</strong> Croatia., “China and<br />
Chile Signed FTA Agreement”, November 18 2005.<br />
Government <strong>of</strong> Pakistan. “Five Year Development Program on Trade and<br />
Economic Cooperation between Pakistan and China”, Economic<br />
Affairs Division.<br />
Government <strong>of</strong> Pakistan, “Pakistan – China Free Trade Agreement”,<br />
Economic Affairs Division.<br />
Government <strong>of</strong> Pakistan, Economic Affairs Division. Poverty Reduction<br />
Strategy Paper (PRSP) II 2007.<br />
Hong, H., 2004, “ASEAN and China Sign “Dirty” FTA”, Taipei Times, Dec. 18.<br />
IPCS, <strong>Special</strong> Report 30, September 2006.<br />
Kalegama, S., “Sri Lanka's Free Trade Agreement with Pakistan”, Economic<br />
Watch.<br />
Kumar, A., 2006, “China-Pakistan Economic Relations”, Institute <strong>of</strong> Peace<br />
and Conflict Studies, special report 30.<br />
Lijun, S., 2003, “China-ASEAN Free Trade Area: Origins, Development and<br />
Strategic Motivations”, ISEAS Working Paper, International Politics<br />
& Security Issues Series No. 1.
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Nag, B., 2005, “Trade Cooperation and Performance in East and South Asia:<br />
Towards a Future Integration”, South Pacific Development Journal,<br />
Vol. 12, No. 1, pp. 1-29.<br />
Pakistan Economic Survey, various editions.<br />
People’s Daily Online, “China Established Nine FTAs in Past Five Years”,<br />
February 9 2006.<br />
People’s Daily Online, “Sino-Pakistan Trade on Upward Trend”, August 13<br />
2000.<br />
Philippine Daily Inquirer, “China-ASEAN FTA to Boost Regional<br />
Integration”, June 1 2005.<br />
Website <strong>of</strong> General Administration <strong>of</strong> Customs China.<br />
Website <strong>of</strong> Pakistan Board <strong>of</strong> Investment.
The <strong>Lahore</strong> Journal <strong>of</strong> <strong>Economics</strong><br />
<strong>Special</strong> <strong>Edition</strong> (September 2007)<br />
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan<br />
An Empirical Analysis <strong>of</strong> PSLM (2004-05) Micro Data<br />
Mehak Ejaz ∗<br />
Abstract<br />
This paper seeks to identify the major determinants <strong>of</strong> female labor<br />
force participation in Pakistan, specifically with reference to rural and<br />
urban areas. Limited dependent variable techniques (Logit and Probit) are<br />
utilized to determine the factors affecting female labor force participation.<br />
This analysis uses data taken from the PSLM (Pakistan Social and Living<br />
Standards Measurement Survey, 2004-05) which measure individual and<br />
household characteristics <strong>of</strong> females between the ages <strong>of</strong> 15-49. Empirical<br />
results suggest that age, educational attainment and marital status have<br />
significant and positive effects on female labor force participation (FLFP).<br />
When women belong to the nuclear family and have access to vehicles, they<br />
are more likely are they to participate in economic activities, whereas a<br />
large number <strong>of</strong> children and the availability <strong>of</strong> home appliances reduces<br />
the probability <strong>of</strong> FLFP. The results imply that reducing the child care<br />
burden on females and facilitating educational attainment would lead to a<br />
higher labor force participation rate for females in Pakistan.<br />
I. Introduction<br />
The economically active population, or labor force, is a group <strong>of</strong><br />
people who produce goods and services to meet the requirements <strong>of</strong> society.<br />
Pakistan has a relatively low labor force 69 participation rate owing to the<br />
lower percentage <strong>of</strong> women in the work force. Therefore this is a major<br />
issue concerning the development <strong>of</strong> Pakistan.<br />
According to the Labor Force Survey, the female labor participation<br />
rate in 2004-05 was only 14.6%. According to the Economic Survey, the<br />
∗ The author is a Research Associate at the Centre for Research, <strong>Lahore</strong> <strong>School</strong> <strong>of</strong><br />
<strong>Economics</strong>, <strong>Lahore</strong>.<br />
69 In Pakistan, the labor force is defined as all persons ten years <strong>of</strong> age and above who are<br />
working or looking for work for cash or kind, one week prior to the date <strong>of</strong> enumeration.
204<br />
Mehak Ejaz<br />
female labor force participation rate has shown a considerable rise <strong>of</strong> 8%,<br />
over the past three decades. However, as compared to other South Asian<br />
countries, the LFP is still very low. 70<br />
Labor Force Participation Rates, 1973 - 2006<br />
90.00<br />
Percentage <strong>of</strong> Participation<br />
80.00<br />
70.00<br />
60.00<br />
50.00<br />
40.00<br />
30.00<br />
20.00<br />
10.00<br />
0.00<br />
1973<br />
1976<br />
1979<br />
1982<br />
1985<br />
1988<br />
1991<br />
1994<br />
1997<br />
2000<br />
2003<br />
2006<br />
Male Total Female<br />
There are several explanations for the low rate <strong>of</strong> female labor<br />
participation in Pakistan. A few <strong>of</strong> these reasons are the early age marriages,<br />
the strong negative social and cultural influences on the free movement <strong>of</strong><br />
women and the absence <strong>of</strong> an organized labor market. This paper is an<br />
attempt to highlight the major factors that hinder women from joining the<br />
labor force in Pakistan.<br />
Earlier studies have emphasized the decision making aspect in<br />
Pakistan though the focus on determinants is somewhat lacking. The main<br />
sources <strong>of</strong> labor force and employment statistics are the Population Census<br />
and Labor Force Survey, conducted by Federal Bureau <strong>of</strong> Statistics on an<br />
annual basis.<br />
The situation <strong>of</strong> women in Pakistan varies according to their<br />
geographical location and class. Women who belong to urban areas and the<br />
upper strata <strong>of</strong> society are in a better condition as they have greater<br />
opportunities for higher education and seeking pr<strong>of</strong>essional work. Almost<br />
75% <strong>of</strong> the female population belong to rural areas, and suffer from poor<br />
health issues, mainly due to constant motherhood. All Pakistani women<br />
70 According to the World Bank Report <strong>of</strong> 2002 the labor force participation rate was<br />
42% in Bangladesh, 32% in India and Bhutan, 41% in Nepal and 37% in Sri Lanka.
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 205<br />
remain structurally disadvantaged as a result <strong>of</strong> legal, social and cultural<br />
discrimination.<br />
On the basis <strong>of</strong> this background, women's economic activities and<br />
the determinants regarding paid employment are examined by analyzing<br />
different factors pertaining to the household.<br />
According to our knowledge, there is no specific study to date that<br />
has incorporated the socioeconomic and cultural issues as well as<br />
household related factors. This study explores the causal factors,<br />
determinants and issues that are major hurdles for women’s participation<br />
in the labor force and hence, the economic development <strong>of</strong> Pakistan. After<br />
the analysis on HIES (1999) data, no empirical study has analyzed such a<br />
large number <strong>of</strong> observations. In this study, the total number <strong>of</strong><br />
observations is 115,077, <strong>of</strong> which 72,099 come from rural areas and the<br />
rest <strong>of</strong> the 42,978 observations pertain to the urban areas <strong>of</strong> Pakistan. We<br />
believe that this study will prove to be a contribution towards the existing<br />
literature.<br />
The paper is divided into six sections. The next section presents a<br />
comprehensive literature review which highlights the main ideas, theory,<br />
findings and shortcomings <strong>of</strong> the relevant work conducted in this field. The<br />
third section provides the theoretical framework, based on which the<br />
methodology is developed. A detailed discussion <strong>of</strong> the Probit and Logit<br />
models is also included in this section. The fourth section explains the data<br />
source and the description <strong>of</strong> relevant variables, while empirical results and<br />
the findings <strong>of</strong> the study are discussed in the fifth section. This section also<br />
includes a brief comparison <strong>of</strong> the FLFP rates <strong>of</strong> Pakistan, India and<br />
Bangladesh. Section six concludes the paper, and deals with some policy<br />
implications.<br />
II. Review <strong>of</strong> Literature<br />
Over the years, many researchers have dealt with the issue <strong>of</strong><br />
female labor force participation. Estimating the labor supply curve and<br />
determinants <strong>of</strong> productivity has been a common topic <strong>of</strong> interest among<br />
many economists and sociologists. This section attempts to review the<br />
literature pertaining to the labor supply theory, as well as issues regarding<br />
female labor force participation. 71<br />
71 The literature entails cases both within and outside Pakistan.
206<br />
Mehak Ejaz<br />
Berndt (1990) states that the labor force participation rate <strong>of</strong><br />
women varies by age and has considerably increased for all age groups<br />
during the past three decades. He extends the neoclassical labor supply<br />
framework to encompass the household, while addressing issues such as the<br />
discouraged worker hypothesis, and the male chauvinist model. He points<br />
out that most first generation studies show that female labor supply is more<br />
responsive to changes in wage rates and property income, as compared to<br />
male labor supply. The second generation <strong>of</strong> studies points out that the<br />
elasticity <strong>of</strong> these estimates is greater. 72 Nakamura and Nakamura (1979)<br />
contradict some <strong>of</strong> these results. They find the female labor supply to be<br />
unresponsive to changes in wage rates. Hausman (1981) implies that<br />
progressive income taxes reduce a wife’s labor supply by decreasing the net<br />
after tax wage. Mroz (1987) essentially follows up on the Nakamura and<br />
Nakamura study relating to the responsiveness <strong>of</strong> female labor supply. He<br />
notes the large diversity <strong>of</strong> reported estimates <strong>of</strong> female labor supply<br />
responses to variations in wage rates and income. He concludes that the<br />
estimated uncompensated wage effect is positive but rather small. Moreover,<br />
he finds the income effect to be negative and fairly small. These results<br />
suggest that the modest sensitivity <strong>of</strong> married women’s labor supply is not<br />
very different from the labor supply <strong>of</strong> prime aged married males. The<br />
backward bending labor supply curve in essence holds true for females as<br />
well as males. 73 Hence the results are consistent with the view that a<br />
woman’s preference for work is an unobserved omitted variable that affects<br />
her current as well as previous labor market participation. Robinson and<br />
Tomes (1985) also support the conclusions <strong>of</strong> Nakamura and Nakamura<br />
(1981), as they conduct their study on Canadian women. The estimates<br />
obtained in this study are larger than those <strong>of</strong> the Nakamuras, suggesting<br />
that the income elasticity <strong>of</strong> demand for leisure is greater relative to the<br />
substitution effect for women, than that for men. These results indicate that<br />
the contrasting patterns <strong>of</strong> female and male labor supply curves correspond<br />
to the differential responsiveness <strong>of</strong> male and female participation to<br />
opportunities, rather than the hours worked.<br />
A major factor that reduces the female labor force participation<br />
rate relates to the fact that women essentially tend to concentrate more on<br />
providing services to the household after they get married. This is a crucial<br />
issue and has been dealt with by various researchers worldwide. Bradbury<br />
and Katz (2005), identify a recent decline in female labor force<br />
participation, specifically among well educated women with children. He<br />
72 Heckman, Killingsworth and Macurdy(1981).<br />
73 Nakamura and Nakamura (1981)
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 207<br />
finds that unobserved and unpredictable factors contribute towards a decline<br />
in the participation <strong>of</strong> women.<br />
Dynamic, lifetime models <strong>of</strong> labor supply have also been <strong>of</strong><br />
considerable debate in the economic literature. In such models, economic<br />
agents act in a way as to consider the future consequences <strong>of</strong> their present<br />
actions. Mincer (1962) attempted to reinterpret the static analyses <strong>of</strong> labor<br />
supply to include lifetime variables. 74 He finds that family income has no<br />
effect on the wife’s demand for leisure. His results also indicate that the<br />
number <strong>of</strong> children have a significant effect on a female’s lifetime labor<br />
supply curve. Moreover, he concluded that the probability <strong>of</strong> labor force<br />
participation is inversely related to lifetime wealth measures.<br />
Duleep and Sanders (1994) present similar results and examine<br />
the current labor supply <strong>of</strong> 25-44 year old married women in the United<br />
States. They are further classified into native-born whites, Asian<br />
immigrants, Hispanic immigrants, and European immigrants. The results<br />
<strong>of</strong> this study show that the employment rates <strong>of</strong> women are inversely<br />
proportional to the number <strong>of</strong> children and age <strong>of</strong> the youngest child,<br />
when no account <strong>of</strong> past work is taken. There are significant differences<br />
across the groups <strong>of</strong> women whereby native born white women are less<br />
responsive to the number <strong>of</strong> children and age <strong>of</strong> the youngest child.<br />
However, when women are classified according to whether they worked in<br />
1979, the number <strong>of</strong> children does not seem to be associated with the<br />
propensity to start or continue working.<br />
Heckman (1974) presents an interesting analysis <strong>of</strong> the value a<br />
woman places on her time (asking wage or shadow price <strong>of</strong> time). The<br />
results indicate that the estimated effect <strong>of</strong> one child less than six raises the<br />
asking wage by 15%. Increases in net assets, the husband’s wage rate and<br />
woman’s education has a positive effect on the asking wage.<br />
Several studies have been conducted on the situation <strong>of</strong> Pakistani<br />
women, and factors affecting their participation rate have been analyzed.<br />
Shah (1986) analyzed the changing role <strong>of</strong> women in Pakistan between 1951<br />
and 1981. He concluded that the labor force participation decision <strong>of</strong><br />
women is inversely related to the socio-economic status <strong>of</strong> the family. Shah<br />
et al (1976) examined some <strong>of</strong> the socio-economic and demographic factors<br />
that determine the labor force participation decision <strong>of</strong> women in Pakistan.<br />
They attempt to analyze results for all the four provinces <strong>of</strong> Pakistan. Their<br />
74 Variables such as consumption, leisure, work at home, wages, budget constraints and<br />
time were translated into lifetime variables.
208<br />
Mehak Ejaz<br />
results show that labor force participation has a significant and inverse<br />
relationship with the nuclear family, as well as the child-woman ratio<br />
However, a positive relationship has been found with marital status,<br />
dependency ratio and literacy rates. The positive relationship with marital<br />
status however, is in contrast to most <strong>of</strong> the earlier studies. Rashid et al<br />
(1989) present a case study <strong>of</strong> Pakistan in which they attempt to analyze the<br />
demographic and socio economic factors affecting the labor supply <strong>of</strong><br />
women. The results show that LFP is positively related to increases in<br />
expected earnings, wages and level <strong>of</strong> education. An interesting observation<br />
by these researchers is the fact that the presence <strong>of</strong> a male figure in the<br />
household reduces the likelihood <strong>of</strong> female participation in the labor force.<br />
However, the presence <strong>of</strong> other females in the house increases the<br />
probability that a woman will work.<br />
Ibraz (1993) confines his study to the rural areas <strong>of</strong> Pakistan, and<br />
observes that various cultural issues such as the observation <strong>of</strong> purdah in<br />
an Islamic society restrains a woman from active participation in the labor<br />
force.<br />
Naqvi and Shahnaz (2002) have conducted a similar study <strong>of</strong><br />
Pakistan and have identified the household related factors that lead to<br />
women’s participation in economic activities. The innovative aspect <strong>of</strong> the<br />
paper is that it relates women’s decision to participate in economic activities<br />
with their empowerment. The empirical findings <strong>of</strong> this paper suggest that<br />
the economic participation <strong>of</strong> women is significantly influenced by factors<br />
such as age, education and marital status.<br />
It can be inferred from the literature that various economic as well<br />
as sociological factors have a pr<strong>of</strong>ound effect on the labor force participation<br />
decision <strong>of</strong> women. However, it is felt that some important factors have<br />
been neglected in these studies, especially those relating to household<br />
issues. This study, therefore, attempts to identify and present a<br />
comprehensive analysis <strong>of</strong> all such factors.<br />
It is expected that this study will contribute to the economic<br />
literature in a significant way by improving upon the previous studies and<br />
also identifying the factors affecting LFP in Pakistan.
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 209<br />
III. Theoretical Framework and Methodology<br />
The Probit and Logit Models<br />
Economists frequently encounter the research problem whereby the<br />
dependent variable <strong>of</strong> the structural model is not directly observed. The<br />
actual value observed may be dependent on the values <strong>of</strong> other variables or<br />
alternatively may observe a variable that takes on values related to the<br />
underlying unobserved dependent variables. For these models, ordinary least<br />
squares or standard economic estimators are not appropriate, because <strong>of</strong> the<br />
limited or qualitative nature <strong>of</strong> the observed dependent variable.<br />
General equation<br />
Υ i = f ( Χ 1.......<br />
Χ i )<br />
where, Y i denotes female labor force participation (FLFP). Χ<br />
1<br />
......Χ<br />
n<br />
represent various determining factors leading to female participating in the<br />
labor force.<br />
y<br />
*<br />
i<br />
k<br />
= β + ∑ β χ + ε<br />
0<br />
j =1<br />
j<br />
ij<br />
i<br />
y i<br />
*<br />
where is not observed. It is a latent variable. What we observe is a<br />
dummy variable yi defined by<br />
*<br />
y = 1 if > 0<br />
i<br />
y i<br />
= 0 otherwise<br />
y is equal to 1 if the female participates in economic activity and equal to<br />
zero if she does not. β is a row vector <strong>of</strong> parameters and ε i<br />
is normally<br />
distributed with mean 0.<br />
The probit and logit models differ in the specification <strong>of</strong> the<br />
distribution <strong>of</strong> the error term u in the equation 75 , such that the former<br />
assumes that errors are normally distributed and the latter assumes that<br />
errors follow the logistic distribution.<br />
75 Maddala (2001), Gujrati (1995)and Berndt (1991)
210<br />
Mehak Ejaz<br />
Data Source<br />
The study is based on cross-sectional data from the Pakistan<br />
Social and Living Standards Measurement (PSLM) Survey - HIES (2004-<br />
05), concentrating on the sample <strong>of</strong> women aged 15-49. The total<br />
number <strong>of</strong> households were 73,429 76 <strong>of</strong> which 115,077 observations<br />
pertain to females aged 15-49. These observations are used in the<br />
empirical analysis.<br />
Given that the logistic postulates:<br />
1<br />
Prob [female in work force] =<br />
1 + e −<br />
z<br />
Z =<br />
β + β Χ + β Χ + ...........<br />
+ β<br />
0<br />
1<br />
1<br />
2<br />
2<br />
k Χk<br />
Each β<br />
i<br />
is shown to be:<br />
∂ log( oddsratio)<br />
∂χ<br />
i<br />
77<br />
= - βi<br />
78<br />
For continuous variables, it is possible to compute the change in probability<br />
when the variable, Χ j<br />
is increased by one unit. This change can be<br />
calculated using:<br />
∂P<br />
∂X<br />
j<br />
=<br />
B<br />
j<br />
e<br />
−z<br />
−z<br />
[ 1 + e ] 2<br />
76 Usman Sikander (Research Officer, <strong>Lahore</strong> <strong>School</strong> <strong>of</strong> <strong>Economics</strong>) helped in processing<br />
the micro level data<br />
77 Odds ratio =P [female in work force]/ P [female not in work force] =<br />
78<br />
β provides a measure <strong>of</strong> change in the logarithm <strong>of</strong> the odds ratio <strong>of</strong> the chance <strong>of</strong> the<br />
i<br />
female working to not working.<br />
e − z
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 211<br />
model:<br />
The following is the list <strong>of</strong> variables used in the estimation <strong>of</strong> the<br />
Notation and description <strong>of</strong> variables in the econometric model<br />
Dependent variable<br />
Labor force participation (LFP) = 1 if women<br />
worked/looking for work<br />
= 0 otherwise<br />
Independent variables<br />
Age<br />
Marital<br />
<strong>School</strong><br />
H-Income<br />
Children<br />
Infants<br />
W-people<br />
F-size<br />
F-type<br />
Location<br />
Asset-agric<br />
Tech<br />
Age <strong>of</strong> the female respondent<br />
Marital status (dummy variable)<br />
1 = unmarried; 0 = married women<br />
(Unmarried includes single, divorced and widowed<br />
women)<br />
Years <strong>of</strong> schooling<br />
Head’s income<br />
No. <strong>of</strong> children<br />
No. <strong>of</strong> children younger than 5 years<br />
No. <strong>of</strong> working people in the family<br />
Size <strong>of</strong> family (No. <strong>of</strong> family members including<br />
respondent)<br />
Type <strong>of</strong> family (dummy variable)<br />
1= nuclear family, 0 = otherwise<br />
Rural/Urban (dummy variable)<br />
1= urban, 0 = rural<br />
Ownership <strong>of</strong> agricultural land<br />
Weighted index <strong>of</strong> appliances<br />
Cycle Own cycle =1, 0 = otherwise
212<br />
Mehak Ejaz<br />
IV. Empirical Results<br />
Table-1: Labor Force Participation <strong>of</strong> Female<br />
Frequency<br />
Percent<br />
Rural Urban Total Rural Urban Total<br />
0.00 59243 39033 98276 82.2% 90.8% 85.4%<br />
1.00 12856 3945 16801 17.8% 9.2% 14.6%<br />
Total 72099 42978 115077 100.0% 100.0% 100.0%<br />
Table-2: Results <strong>of</strong> Overall Pakistan 79<br />
Variable Description Probit Logit<br />
Coefficients Marginal Coefficients Marginal<br />
Effects<br />
Effects<br />
Constant -1.878* -0.349 -3.266* -0.322<br />
Age <strong>of</strong> the female 0.017* 0.003 0.031* 0.003<br />
Married=1,Otherwise0 -0.214* -0.040 -0.425* -0.042<br />
Years <strong>of</strong> <strong>School</strong>ing 0.022* 0.004 0.046* 0.005<br />
No. <strong>of</strong> working people in family 0.511* 0.095 0.994* 0.098<br />
Family Size -0.134* -0.025 -0.289* -0.029<br />
Nuclear=1,Otherwise 0 0.097* 0.018 0.219* 0.022<br />
if own Car, Motorcycle,<br />
0.072* 0.013 0.119* 0.012<br />
Cycle=1,Otherwise 0<br />
Weighted index <strong>of</strong> home -0.235* -0.044 -0.428* -0.042<br />
appliances<br />
If Female head=1, Otherwise 0 0.497* 0.092 0.971* 0.096<br />
Infant+ children per female 0.365* 0.068 0.754* 0.074<br />
Infant+ children per female sqr -0.044* -0.008 -0.089* -0.009<br />
No. <strong>of</strong> observations 115077 115077<br />
R 2 0.2259 0.2361<br />
Scaled R 2 0.1687 0.1773<br />
Fraction <strong>of</strong> Correct Predictions 0.8719 0.8735<br />
*, **, *** presents significance at 1%, 5%, and 10% level respectively<br />
79 Sayed Kalim Hayder (Senior Research Fellow) helped in the econometric results
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 213<br />
Table-3: Results <strong>of</strong> Urban Areas<br />
Variable Description Probit Logit<br />
Coefficients<br />
Marginal<br />
Effects<br />
Coefficients Marginal<br />
Effects<br />
Constant -1.878* -0.340 -3.266* -0.31<br />
Age <strong>of</strong> the female 0.017* 0.004 0.031* 0.00<br />
Married=1,Otherwise0 -0.214* -0.062 -0.425* -0.06<br />
Years <strong>of</strong> <strong>School</strong>ing 0.022* 0.007 0.046* 0.01<br />
No. <strong>of</strong> working people<br />
in family<br />
0.511* 0.079 0.994* 0.08<br />
Family size -0.134* -0.022 -0.289* -0.02<br />
Nuclear=1,Otherwise 0 0.097* 0.028 0.219* 0.03<br />
If own car, Motorcycle,<br />
cycle=1,Otherwise 0<br />
Weighted index <strong>of</strong> home<br />
appliances<br />
If female<br />
head=1,Otherwise 0<br />
Infant+ children per<br />
female<br />
Infant+ children per<br />
female sqr<br />
0.072* 0.088 0.119* 0.08<br />
-0.235* -0.021 -0.428* -0.02<br />
0.497* 0.075 0.971* 0.07<br />
0.365* 0.056 0.754* 0.06<br />
-0.044* -0.007 -0.089*<br />
No. <strong>of</strong> observations 42978 42978<br />
R 2 2.13E-01 0.2188<br />
Scaled R 2 1.62E-01 0.1637<br />
Fraction <strong>of</strong> Correct<br />
Predictions<br />
9.14E-01 0.9153<br />
*, **, *** presents significance at 1%, 5%, and 10% level respectively
214<br />
Mehak Ejaz<br />
Table-4: Results <strong>of</strong> Rural Areas<br />
Variable Description Probit Logit<br />
Coefficients<br />
Marginal<br />
Effects<br />
Coefficients Marginal<br />
Effects<br />
Constant -1.756* -0.376 -3.039 -0.352<br />
Age <strong>of</strong> the female 0.013* 0.003 0.024 0.003<br />
Married=1,Otherwise0 -0.138* -0.030 -0.275 -0.032<br />
Years <strong>of</strong> <strong>School</strong>ing 0.014* 0.003 0.032 0.004<br />
No. <strong>of</strong> working people<br />
in family<br />
0.483* 0.103 0.923 0.107<br />
Family size -0.123* -0.026 -0.258 -0.030<br />
Nuclear=1,Otherwise 0 0.097* 0.021 0.223 0.026<br />
Own Agricultural asset 0.003* 0.001 0.004 0.000<br />
Ownership <strong>of</strong> cattle 0.001* 0.000 0.002 0.000<br />
If own Car, Motorcycle,<br />
Cycle=1,Otherwise 0<br />
Weighted Index <strong>of</strong> home<br />
appliances<br />
If female<br />
head=1,otherwise 0<br />
Infant+ children per<br />
female<br />
Infant+ children per<br />
female squared<br />
0.099* 0.021 0.163 0.019<br />
-0.206* -0.044 -0.367 -0.043<br />
0.481* 0.103 0.955 0.111<br />
0.341* 0.073 0.687 0.080<br />
-0.041* -0.009 -0.081 -0.009<br />
No. <strong>of</strong> observations 72099 72099<br />
R 2 0.2302 0.2413<br />
Scaled R 2 0.1782 0.1875<br />
Fraction <strong>of</strong> Correct<br />
Predictions<br />
0.8489 0.8506<br />
*, **, *** presents significance at 1%, 5%, and 10% level respectively
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 215<br />
V. Empirical Findings<br />
The empirical model highlights the major determinants <strong>of</strong> female<br />
labor force participation (LFP) in Pakistan. Further, in order to give due<br />
consideration to regional heterogeneity, the model is estimated for the rural<br />
and urban areas as well. A number <strong>of</strong> potential variables are included in the<br />
model on the basis <strong>of</strong> theoretical models that have been discussed in detail<br />
in the section on the literature review. In order to improve the model<br />
specification, region specific variables relating to the rural and urban areas<br />
are incorporated.<br />
Estimated parameters and mean probability derivatives <strong>of</strong> the Probit<br />
and Logit model for the overall model are reported in Table-2.2. The<br />
probability derivatives indicate the change in probability on account <strong>of</strong> a<br />
one-unit change in the given independent variable after holding all the<br />
remaining variables constant at their mean.<br />
Female characteristics such as age, marital status, years <strong>of</strong> schooling,<br />
and household characteristics such as the number <strong>of</strong> working people in the<br />
family, nuclear/extended family, ownership <strong>of</strong> vehicle, female headed<br />
household, family size, and availability <strong>of</strong> home appliances are the significant<br />
determinants <strong>of</strong> female labor force participation in Pakistan. The sample<br />
consists <strong>of</strong> females <strong>of</strong> the age cohort 15-49 years. The coefficient <strong>of</strong> age for<br />
the Probit and Logit model reflects that with an increase in age, there is a<br />
greater likelihood that a female will enter the labor market.<br />
The dummy variable that takes the value <strong>of</strong> 1 for married and 0<br />
otherwise proves that the significance <strong>of</strong> marital status affects the LFP. The<br />
results indicate that if a woman is married, there is less probability that she<br />
will enter the labor force. In Pakistan, married women are less likely to be<br />
involved in income generating activities due to their preferences for<br />
household activities. Education is also a very important factor in<br />
determining the probability that a female would enter the labor force, since<br />
education plays an important role in deciding whether to work or not by<br />
enhancing job prospects. Empirical studies found that for women, greater<br />
educational attainment leads to greater participation in the labor force, but<br />
also increases the productivity. As the years <strong>of</strong> schooling increase, the<br />
probability <strong>of</strong> women’s participation in the labor force also increases. Its<br />
coefficient is statistically significant. The results suggest that a female that is<br />
educated, unmarried and between the ages <strong>of</strong> 15 and 49 would have the<br />
greatest chance <strong>of</strong> being part <strong>of</strong> the labor force. In order to understand the<br />
participation decisions <strong>of</strong> women, household characteristics <strong>of</strong> the female are<br />
also included in the model.
216<br />
Mehak Ejaz<br />
The socioeconomic status <strong>of</strong> the household plays a very important<br />
role in the labor force participation decision <strong>of</strong> women. It is a general<br />
perception that women usually enter into the work force due to financial<br />
constraints faced by the household.<br />
Working people in the family also influence female labor force<br />
participation positively. This measures the earning capacity <strong>of</strong> the household<br />
as well as outward orientation <strong>of</strong> the family. As the number <strong>of</strong> working<br />
people increases in a household, members encourage their women to<br />
participate in economic activity as well. The greater the number <strong>of</strong> working<br />
people in the family, the higher would be the probability <strong>of</strong> women<br />
participating in the workforce. The demonstration effect may also be one <strong>of</strong><br />
the reasons for a positive relationship between working people in the family<br />
and LFP <strong>of</strong> females. It is reasonable to infer that owing to the lower income<br />
<strong>of</strong> other family members, a female would move towards the labor market<br />
because <strong>of</strong> financial needs.<br />
A negative association is found between family size and LFP which<br />
indicates that a unit increase in family size would decrease the log odd value<br />
by 0.134, signifying a lower incidence <strong>of</strong> women in the workforce. The<br />
existence <strong>of</strong> patriarchal relations also plays a vital role in hindering the<br />
activity <strong>of</strong> women, as they are dependent on their husband’s or father’s<br />
decisions. The greater the number <strong>of</strong> people in a household would lead to a<br />
higher workload for the female members, as they would be involved in<br />
household activities such as fetching water, doing the laundry, preparing<br />
food, and looking after the family members.<br />
Another household characteristic, “type <strong>of</strong> family”, also affects the<br />
female employment rate. This determinant is used as a dummy variable that<br />
takes the value <strong>of</strong> 1 for a nuclear family and 0 for an extended family. Since<br />
the extended family system still exists in Pakistani culture, it is imperative to<br />
incorporate this phenomenon by including two categories <strong>of</strong> families<br />
(extended or nuclear). It has been observed from the results that a woman<br />
living in a nuclear family is less restricted and more independent in decision<br />
making as compared to women living in joint or extended families. The<br />
coefficient <strong>of</strong> this variable is significant and positive which indicates that a<br />
woman is more likely to participate in the labor force, perhaps due to fewer<br />
dependent family members in a nuclear family.<br />
It is interesting to note that the provision <strong>of</strong> any kind <strong>of</strong> vehicle<br />
such as motorcycle, cycle or car increases the probability <strong>of</strong> women entering<br />
the labor force. The more you facilitate the women with a conveyance, the<br />
more she would feel secure while traveling from home to workplace. Hence,
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 217<br />
ownership <strong>of</strong> a vehicle by the household has a significant effect on women’s<br />
decision to participate in the labor force. The availability <strong>of</strong> home appliances<br />
such as a refrigerator, air conditioner, television, VCD/VCR/CD player, and<br />
computer has a negative impact on women to work. The impact <strong>of</strong> this<br />
variable can be explained by the financial status as well as the value placed<br />
on leisure. The availability <strong>of</strong> such goods implies higher earnings <strong>of</strong> the<br />
household, which may lead to a greater preference for leisure.<br />
If a household is headed by a female, other female members <strong>of</strong> the<br />
family may feel more empowered. Being a head <strong>of</strong> the family, she would<br />
encourage female participation in an economic activity. Realizing the<br />
responsibilities, she could be more likely to join the labor force depending<br />
upon the financial needs <strong>of</strong> her family. There is a positive relationship<br />
between female headed households and LFP.<br />
The proxy variable for the number <strong>of</strong> dependents is defined as the<br />
number <strong>of</strong> infants (children from age 0-5) and number <strong>of</strong> children (from 6-<br />
10 years <strong>of</strong> age) per female 80 . It is introduced to find out the impact <strong>of</strong><br />
dependent children on female participation. With the increase in the<br />
number <strong>of</strong> infants and children, a female is encouraged to participate in the<br />
labor force. However, the square <strong>of</strong> this variable has a negative impact on<br />
the probabilities <strong>of</strong> female labor force participation. The results indicate that<br />
for a small number <strong>of</strong> infants and children per female, the participation rate<br />
increases as the number gets larger but increases at a decreasing rate.<br />
Probit and Logit models estimated for urban regions have been quite<br />
similar to the results for Pakistan overall. However, an additional variable,<br />
technical education, defined as females having degrees in medicine,<br />
engineering, computer science, agriculture or M.Phil/Ph.D, has a positive<br />
and significant impact on women participating in the labor force in urban<br />
areas, mainly due to the fact that women living in urban areas are more<br />
likely to obtain technical education. Technical education is not found to be<br />
significant in overall Pakistan and its rural areas, whereas it has a significant<br />
effect on the urban areas.<br />
In a similar manner, sector specific variables such as ownership <strong>of</strong><br />
agricultural land and cattle are introduced in the model for rural areas. Both<br />
the variables are found to have a positive impact on LFP. The ownership <strong>of</strong><br />
agricultural land and cattle reflects their assets as well as a source <strong>of</strong> income.<br />
Earnings from agricultural land and cattle add to the household income, and<br />
80 As PLSM is unable to provide information on the infant or children <strong>of</strong> a specific<br />
female, therefore, this variable is a proxy <strong>of</strong> the number <strong>of</strong> infant and children per female<br />
in the household
218<br />
Mehak Ejaz<br />
the duty <strong>of</strong> looking after these assets is usually assigned to women. In this<br />
way, women are involved in the income generating process <strong>of</strong> the<br />
household. They also serve as a helping hand during the cutting and<br />
harvesting period, and are paid for these activities. This maximizes the<br />
probability <strong>of</strong> females working in the labor force. Ownership <strong>of</strong> agricultural<br />
land and cattle are therefore highly significant variables and has a positive<br />
impact on the rural female participation rate. These variables, however, turn<br />
out to be less significant in the case <strong>of</strong> overall and urban areas <strong>of</strong> Pakistan.<br />
Why is the Female Labor Force Participation Rate Lower in Pakistan?<br />
It is interesting to note that despite the same social and economic<br />
background, Pakistan, India and Bangladesh exhibit varying levels <strong>of</strong> female<br />
labor force participation rates. The FLFP for India and Bangladesh is more<br />
than twice that <strong>of</strong> Pakistan. It is rather surprising that in spite <strong>of</strong> being a<br />
conservative Muslim nation, Bangladesh has the highest level <strong>of</strong> FLFP in the<br />
region.<br />
One critical factor according to the Human Development for South<br />
Asia (2003) Report is the inclusion <strong>of</strong> data on casual workers. According to<br />
this report, India and Bangladesh are the only South Asian countries that<br />
include data on casual workers. Informal wage employment is estimated to<br />
account for 30-40% <strong>of</strong> informal employment in the non agricultural sector.<br />
Hence, it may be inferred that the reported levels <strong>of</strong> FLFP for India and<br />
Bangladesh are high due to this factor.<br />
One major determinant <strong>of</strong> FLFP is the literacy rate. 81 Interestingly,<br />
however, the female literacy rate <strong>of</strong> Bangladesh is lowest in the region. A<br />
trivial conclusion can therefore be that the female labor force participation<br />
is not strictly dependent on the female literacy rate. Hence it is important<br />
to analyze other factors that may account for the differing levels <strong>of</strong> FLFP.<br />
Bangladesh is a poor country, and has suffered major political and<br />
economic turmoil since the time <strong>of</strong> its independence. The level <strong>of</strong> poverty is<br />
considerably higher in this region. Women belonging to the poorer<br />
households are more likely to engage in economic activity particularly in<br />
Bangladesh. Bangladesh has 15% households that are headed by women,<br />
compared to 10% in Pakistan and 9.1% in India. It is evident from our<br />
empirical findings that FLFP is positively related to the incidence <strong>of</strong> female<br />
81 Female literacy rate: India 48.3%, Pakistan 35.2% and Bangladesh 31.8%. UNESCO<br />
(2003-2004)
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 219<br />
headed households. Hence, the greater FLFP in Bangladesh probably owes a<br />
lot to the greater number <strong>of</strong> households headed by females.<br />
The most important factor that accounts for high FLFP in<br />
Bangladesh may relate to the success <strong>of</strong> micro credit finance in the country.<br />
The outstanding success <strong>of</strong> the Grameen Bank has made it possible for many<br />
women, specifically in the rural areas, to earn a fair share <strong>of</strong> income. They<br />
use this income primarily for expenditure on food, clothes, health and the<br />
education <strong>of</strong> their children. Unfortunately, micro credit finance schemes<br />
have not been as successful in Pakistan as in Bangladesh. One factor<br />
responsible for this failure may be due to the non availability <strong>of</strong> donors, and<br />
the high default rate on the part <strong>of</strong> borrowers. Moreover, unlike<br />
Bangladesh, women may have shown less interest towards the micro credit<br />
schemes in Pakistan.<br />
The fertility rate is inversely proportional to FLFP. Over the years<br />
fertility rates have considerably decreased in India and Bangladesh. However,<br />
the fertility rate for Pakistan is still very high. Hence this might be a vital<br />
factor that accounts for the disparity between the FLFP in India, Bangladesh<br />
and Pakistan.<br />
VI. Conclusion and Policy Implications<br />
The paper has identified and analyzed the major determinants <strong>of</strong><br />
female labor force participation in Pakistan with special reference to rural<br />
and urban areas. For this purpose, data on women (aged 15-49), from the<br />
PSLM Survey (2004-2005), has been analyzed using the Probit and Logit<br />
regression models. The empirical results <strong>of</strong> the study suggest that for<br />
women, higher educational attainment leads to greater participation in the<br />
labor force. The results suggest that there is a greater probability that a<br />
woman with the characteristics <strong>of</strong> being educated and unmarried would be a<br />
part <strong>of</strong> the labor force. On the basis <strong>of</strong> the empirical results, it has been<br />
observed that if a woman belongs to a nuclear family, has access to a<br />
vehicle, and has fewer children, then she is more likely to participate in the<br />
labor force. On the other hand, if the family size is large and she belongs to<br />
an extended family, she would be less likely to enter into the labor force. If<br />
the number <strong>of</strong> infants and children per female is small, female participation<br />
increases, whereas with a large number <strong>of</strong> children the probability <strong>of</strong><br />
participating in the work force decreases. Moreover, the availability <strong>of</strong> home<br />
appliances reduces the probability <strong>of</strong> female participation in the labor force.
220<br />
Mehak Ejaz<br />
In light <strong>of</strong> the findings <strong>of</strong> this study, the following are some<br />
suggestions and policy implications to improve the social status <strong>of</strong> rural and<br />
urban female regarding the labor force participation:<br />
Reviewing the facts stated in the data regarding the proportion <strong>of</strong><br />
females participating in the labor market with respect to education level, it<br />
has been surprisingly observed that 70% <strong>of</strong> our female labor force is<br />
illiterate, they have never attended school and <strong>of</strong> the remaining 30%, 11%<br />
have completed education up to matric, 9% primary, 3% higher education<br />
and 7% up to graduation. It is an alarming situation and the need <strong>of</strong> the<br />
hour is to analyze the factors as to why female education is minimal.<br />
Education plays a vital role in the development <strong>of</strong> societies and only<br />
educated females can understand their rights since education empowers a<br />
woman to make decisions regarding labor force participation.<br />
As compared to urban areas, there are limited opportunities for<br />
education in rural areas. In rural areas women mostly work in the fields.<br />
Women should also be encouraged to obtain technical education. In<br />
this regard certain programmes should be initiated so that they can<br />
contribute towards development.<br />
The proper utilization <strong>of</strong> human and financial resources is lacking in<br />
our society. The solution to the problem lies in spreading awareness among<br />
the parents and husbands <strong>of</strong> females. The entry <strong>of</strong> females in the labor<br />
market fundamentally changes the status <strong>of</strong> females in their families as well<br />
as in society.
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 221<br />
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224<br />
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Appendix<br />
Overall Pakistan<br />
Table 2.1: Descriptive Statistics<br />
Number <strong>of</strong> Observations: 115077<br />
Mean Std Deviation Minimum Maximum<br />
Age 28.164 9.727 15 49<br />
Marital 0.665 0.472 0 1<br />
<strong>School</strong> 3.165 4.470 0 19<br />
W_People 2.015 1.419 0 15<br />
F_Size 8.105 3.843 1 54<br />
F_Type 0.629 0.483 0 1<br />
Vehic 0.837 0.931 0 2<br />
Tech 0.709 0.859 0 4<br />
F_Head 0.066 0.249 0 1<br />
INF_F 1.101 1.182 0 10<br />
INF_F2 2.608 5.347 0 100
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 225<br />
Table-2.2: Correlation Matrix<br />
Age Marital <strong>School</strong> W_People F_Size F_Type Vehic Tech F_Head INF_F INF_F2<br />
Age 1.000<br />
Marital 0.572 1.000<br />
<strong>School</strong> -0.230 -0.310 1.000<br />
W_People -0.067 -0.056 -0.054 1.000<br />
F_Size -0.083 -0.039 -0.059 0.470 1.000<br />
F_Type 0.096 -0.017 0.009 -0.288 -0.390 1.000<br />
Vehic -0.012 -0.043 0.138 0.109 0.101 -0.039 1.000<br />
Tech -0.011 -0.112 0.549 -0.048 0.052 -0.050 0.216 1.000<br />
F_Head 0.010 -0.095 0.049 -0.166 -0.111 -0.265 -0.066 0.044 1.000<br />
INF_F 0.156 0.373 -0.237 -0.146 0.086 0.134 -0.076 -0.190 -0.054 1.000<br />
INF_F2 0.134 0.273 -0.168 -0.151 -0.005 0.166 -0.063 -0.144 -0.038 0.917 1.000
226<br />
Mehak Ejaz<br />
URBAN<br />
Table-3.1: Descriptive Statistics(Urban)<br />
Number <strong>of</strong> Observations: 42978<br />
Mean Std Dev Minimum Maximum<br />
Age 28.038 9.778 15 49<br />
Marital 0.602 0.489 0 1<br />
<strong>School</strong> 5.600 5.007 0 19<br />
W_People 1.942 1.279 0 12<br />
F_Size 7.926 3.545 1 36<br />
F_Type 0.650 0.477 0 1<br />
Vehic 0.005 0.072 0 1<br />
Tech 1.190 0.957 0 3.6<br />
F_Head 0.070 0.256 0 1<br />
INF_F 0.908 1.093 0 10<br />
INF_F2 2.019 4.639 0 100
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 227<br />
Table-3.2: Correlation Matrix (Urban)<br />
Age Marital <strong>School</strong> W_People F_Size F_Type T_EDU Tech F_HEAD INF_F INF_F2<br />
Age 1.000<br />
Marital 0.621 1.000<br />
<strong>School</strong> -0.250 -0.297 1.000<br />
W_People -0.079 -0.064 -0.059 1.000<br />
F_Size -0.102 -0.033 -0.114 0.519 1.000<br />
F_Type 0.082 -0.018 0.013 -0.307 -0.384 1.000<br />
T_EDU 0.006 -0.015 0.153 -0.002 -0.023 -0.003 1.000<br />
Tech 0.014 -0.072 0.500 -0.038 0.001 -0.053 0.093 1.000<br />
F_Head 0.008 -0.113 0.032 -0.109 -0.104 -0.276 0.005 0.017 1.000<br />
INF_F 0.136 0.392 -0.242 -0.142 0.092 0.099 -0.022 -0.197 -0.076 1.000<br />
INF_F2 0.116 0.285 -0.180 -0.150 -0.004 0.139 -0.014 -0.157 -0.054 0.910 1.000
228<br />
Mehak Ejaz<br />
RURAL<br />
Table-4.1: Descriptive Statistics<br />
Number <strong>of</strong> Observations: 72099<br />
Mean Std Dev Minimum Maximum<br />
Age 28.238 9.697 15.000 49.000<br />
Marital 0.703 0.457 0.000 1.000<br />
<strong>School</strong> 1.714 3.362 0.000 19.000<br />
W_People 2.059 1.495 0.000 15.000<br />
F_Size 8.212 4.006 1.000 54.000<br />
F_Type 0.617 0.486 0.000 1.000<br />
Asset_AG 3.441 18.464 0.000 825.000<br />
Cattle 11.148 1740.926 0.000 411212.0<br />
Vehic 0.776 0.938 0.000 2.000<br />
Tech 0.422 0.641 0.000 3.600<br />
F_Head 0.064 0.244 0.000 1.000<br />
INF_F 1.216 1.217 0.000 9.000<br />
INF_F2 2.958 5.700 0.000 81.000
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 229<br />
Table-4.2: Correlation Matrix (Rural)<br />
Age Marital <strong>School</strong> W_People F_Size F_Type Asset_AG Cattle Vehic Tech F_Head INF_F INF_F2<br />
Age 1.000<br />
Marital 0.545 1.000<br />
<strong>School</strong> -0.257 -0.303 1.000<br />
W_People -0.062 -0.060 -0.030 1.000<br />
F_Size -0.073 -0.049 0.000 0.447 1.000<br />
F_Type 0.104 -0.011 -0.021 -0.278 -0.393 1.000<br />
Asset_AG 0.001 -0.005 0.027 0.007 0.060 -0.029 1.000<br />
Cattle -0.001 0.003 -0.003 0.007 0.005 -0.003 0.000 1.000<br />
Vehic -0.016 -0.043 0.117 0.126 0.102 -0.046 0.031 -0.004 1.000<br />
Tech -0.027 -0.080 0.382 -0.034 0.138 -0.091 0.080 -0.003 0.204 1.000<br />
F_Head 0.011 -0.082 0.065 -0.197 -0.114 -0.259 -0.028 -0.002 -0.074 0.068 1.000<br />
INF_F 0.168 0.351 -0.186 -0.157 0.078 0.161 -0.017 0.010 -0.061 -0.124 -0.041 1.000<br />
INF_F2 0.144 0.260 -0.134 -0.157 -0.010 0.185 -0.016 0.009 -0.051 -0.102 -0.030 0.921 1.000
230<br />
Mehak Ejaz<br />
Pakistan (Probit)<br />
Dependent variable: LFP<br />
Number <strong>of</strong> observations = 115077 Scaled R-squared = .168659<br />
Number <strong>of</strong> positive obs. = 16801 LR (zero slopes) = 19060.7 [.000]<br />
Mean <strong>of</strong> dep. var. = .145998 Schwarz B.I.C. = 38377.5<br />
Sum <strong>of</strong> squared residuals = 11136.7 Log likelihood = -38307.6<br />
R-squared = .225859<br />
Fraction <strong>of</strong> Correct Predictions = 0.871929<br />
Parameter Coefficients S. Error t-statistic P-value<br />
C -1.878 0.0265 -70.96 [.000]<br />
Age 0.017 0.0006 26.29 [.000]<br />
Marital -0.214 0.0150 -14.29 [.000]<br />
<strong>School</strong> 0.022 0.0015 14.75 [.000]<br />
W_People 0.511 0.0044 116.06 [.000]<br />
F_Size -0.134 0.0021 -65.33 [.000]<br />
F_Type 0.097 0.0128 7.54 [.000]<br />
Vehic 0.072 0.0055 13.04 [.000]<br />
Tech -0.235 0.0082 -28.66 [.000]<br />
F_Head 0.497 0.0221 22.49 [.000]<br />
INF_F 0.365 0.0123 29.74 [.000]<br />
INF_F2 -0.044 0.0025 -17.26 [.000]<br />
Note.<br />
β (C) = Estimated logistic coefficient <strong>of</strong> each variable (it can be interpreted<br />
as the changein the log odds associated with a one-unit change in the<br />
independent variable)<br />
S.E = Standard error <strong>of</strong> estimates<br />
Sig = Significance value or p value {this value is compared with the<br />
significance level(α ) to determine whether each independent variable is<br />
significant or not in the model. If the significance (p) value <strong>of</strong> a variable is<br />
less than the designated value <strong>of</strong> α (1% or 5% or 10%), the corresponding<br />
variable is significant}<br />
R<br />
I<br />
= partial correlation associated with the explanatory variable I, its value<br />
represents how much each variable contributes in this model.
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 231<br />
PAKISTAN (logit)<br />
Dependent variable: LFP<br />
Number <strong>of</strong> observations = 115077 Scaled R-squared = .177273<br />
Number <strong>of</strong> positive obs. = 16801 LR (zero slopes) = 20014.6 [.000]<br />
Mean <strong>of</strong> dep. Var. = .145998 Schwarz B.I.C. = 37900.6<br />
Sum <strong>of</strong> squared residuals = 10972.2 Log likelihood = -37830.7<br />
R-squared = .236099<br />
Number <strong>of</strong> Choices = 230154<br />
Fraction <strong>of</strong> Correct Predictions = 0.873511<br />
Parameter Coefficients S. Error t-statistic P-value<br />
C-1 -3.2658 0.0507 -64.45 [.000]<br />
Age-1 0.0309 0.0012 26.37 [.000]<br />
Marital-1 -0.4253 0.0279 -15.26 [.000]<br />
<strong>School</strong>-1 0.0462 0.0027 16.80 [.000]<br />
W_People-1 0.9936 0.0089 112.12 [.000]<br />
F_Size-1 -0.2892 0.0043 -67.13 [.000]<br />
F_Type-1 0.2193 0.0242 9.05 [.000]<br />
Vehic-1 0.1191 0.0102 11.67 [.000]<br />
Tech-1 -0.4283 0.0157 -27.25 [.000]<br />
F_Head-1 0.9708 0.0402 24.13 [.000]<br />
INF_F-1 0.7535 0.0231 32.58 [.000]<br />
INF_F2-1 -0.0892 0.0048 -18.46 [.000]
232<br />
Mehak Ejaz<br />
Urban (Probit)<br />
Dependent variable: LFP<br />
Number <strong>of</strong> observations = 42978 Scaled R-squared = .162052<br />
Number <strong>of</strong> positive obs. = 3945 LR (zero slopes) = 6601.35 [.000]<br />
Mean <strong>of</strong> dep. Var. = .091791 Schwarz B.I.C. = 9943.07<br />
Sum <strong>of</strong> squared residuals = 2819.15 Log likelihood = -9879.06<br />
R-squared = .213285<br />
Fraction <strong>of</strong> Correct Predictions = 0.913630<br />
Parameter Coefficients S. Error t-statistic P-value<br />
C -2.7199 0.0575 -47.32 [.000]<br />
Age 0.0321 0.0013 24.54 [.000]<br />
Marital -0.4953 0.0292 -16.98 [.000]<br />
<strong>School</strong> 0.0574 0.0024 23.54 [.000]<br />
W_People 0.6358 0.0099 64.53 [.000]<br />
F_Size -0.1777 0.0046 -38.85 [.000]<br />
F_Type 0.2203 0.0250 8.80 [.000]<br />
T_EDU 0.7066 0.0984 7.18 [.000]<br />
Tech -0.1717 0.0126 -13.58 [.000]<br />
F_Head 0.6031 0.0380 15.86 [.000]<br />
INF_F 0.4451 0.0257 17.30 [.000]<br />
INF_F2 -0.0551 0.0058 -9.48 [.000]
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 233<br />
Urban (logit)<br />
Dependent variable: LFP<br />
Number <strong>of</strong> observations = 42978 Scaled R-squared = .163745<br />
Number <strong>of</strong> positive obs. = 3945 LR (zero slopes) = 6666.41 [.000]<br />
Mean <strong>of</strong> dep. Var. = .091791 Schwarz B.I.C. = 9910.55<br />
Sum <strong>of</strong> squared residuals = 2798.93 Log likelihood = -9846.53<br />
R-squared = .218812<br />
Number <strong>of</strong> Choices = 85956<br />
Fraction <strong>of</strong> Correct Predictions = 0.915282<br />
Parameter Coefficients S. Error t-statistic P-value<br />
C-1 -4.8093 0.1135 -42.37 [.000]<br />
Age-1 0.0606 0.0025 24.35 [.000]<br />
Marital-1 -0.9739 0.0561 -17.35 [.000]<br />
<strong>School</strong>-1 0.1143 0.0048 23.90 [.000]<br />
W_People-1 1.2245 0.0196 62.35 [.000]<br />
F_Size-1 -0.3779 0.0097 -39.04 [.000]<br />
F_Type-1 0.4096 0.0485 8.45 [.000]<br />
T_EDU-1 1.2477 0.1705 7.32 [.000]<br />
Tech-1 -0.3332 0.0247 -13.51 [.000]<br />
F_Head-1 1.1017 0.0709 15.54 [.000]<br />
INF_F-1 0.9284 0.0511 18.16 [.000]<br />
INF_F2-1 -0.1156 0.0120 -9.66 [.000]
234<br />
Mehak Ejaz<br />
Rural (probit)<br />
Dependent variable: LFP<br />
Number <strong>of</strong> observations = 72099 Scaled R-squared = .178171<br />
Number <strong>of</strong> positive obs. = 12856 LR (zero slopes) = 12765.2 [.000]<br />
Mean <strong>of</strong> dep. Var. = .178310 Schwarz B.I.C. = 27497.3<br />
Sum <strong>of</strong> squared residuals = 8155.51 Log likelihood = -27419.0<br />
R-squared = .230158<br />
Fraction <strong>of</strong> Correct Predictions = 0.848888<br />
Parameter Coefficient S. Error t-statistic P-value<br />
C -1.7562 0.0308 -57.01 [.000]<br />
Age 0.0130 0.0007 17.40 [.000]<br />
Marital -0.1380 0.0179 -7.70 [.000]<br />
<strong>School</strong> 0.0138 0.0021 6.56 [.000]<br />
W_People 0.4832 0.0050 96.07 [.000]<br />
F_Size -0.1230 0.0024 -52.35 [.000]<br />
F_Type 0.0974 0.0154 6.33 [.000]<br />
Asset_AG 0.0027 0.0003 8.91 [.000]<br />
Cattle 0.0010 0.0002 4.88 [.000]<br />
Vehic 0.0992 0.0065 15.24 [.000]<br />
Tech -0.2062 0.0120 -17.25 [.000]<br />
F_Head 0.4812 0.0279 17.27 [.000]<br />
INF_F 0.3410 0.0143 23.77 [.000]<br />
INF_F2 -0.0407 0.0029 -14.03 [.000]
Determinants <strong>of</strong> Female Labor Force Participation in Pakistan 235<br />
Rural (logit)<br />
Dependent variable: LFP<br />
Number <strong>of</strong> observations = 72099 Scaled R-squared = .187476<br />
Number <strong>of</strong> positive obs. = 12856 LR (zero slopes) = 13427.2 [.000]<br />
Mean <strong>of</strong> dep. Var. = .178310 Schwarz B.I.C. = 27166.3<br />
Sum <strong>of</strong> squared residuals = 8025.56 Log likelihood = -27088.0<br />
R-squared = .241346<br />
Number <strong>of</strong> Choices = 144198<br />
Fraction <strong>of</strong> Correct Predictions = 0.850636<br />
Parameter Coefficients S. Error t-statistic P-value<br />
C-1 -3.0386 0.0580 -52.37 [.000]<br />
Age-1 0.0236 0.0013 17.50 [.000]<br />
Marital-1 -0.2754 0.0328 -8.40 [.000]<br />
<strong>School</strong>-1 0.0321 0.0039 8.28 [.000]<br />
W_People-1 0.9234 0.0100 92.35 [.000]<br />
F_Size-1 -0.2584 0.0048 -53.74 [.000]<br />
F_Type-1 0.2234 0.0286 7.82 [.000]<br />
Asset_AG-1 0.0041 0.0005 7.43 [.000]<br />
Cattle-1 0.0016 0.0007 2.23 [.026]<br />
Vehic-1 0.1632 0.0118 13.81 [.000]<br />
Tech-1 -0.3675 0.0226 -16.24 [.000]<br />
F_Head-1 0.9549 0.0502 19.03 [.000]<br />
INF_F-1 0.6873 0.0264 26.02 [.000]<br />
INF_F-21 -0.0807 0.0054 -15.04 [.000]
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