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Economic growth and stabilisation

19 November, 2013

By Dr M Tariq Majeed


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Our economy is facing the problems of high inflation, stagnant growth and balance of payments crises. These three problems are interconnected and share the same root. This is the reckless fiscal policy pursued by authorities over the years, which has led to excessive internal and external borrowing and mounted debt liabilities. The previous government accumulated debt in five years to such an extent (Rs 13.6 trillion) that the economy of Pakistan had not accumulated over 60 years. The present government is also following the same policy and adding to the internal and external debt burden.

As a result of excessive reliance on borrowing, the money supply expanded sharply. The increasing money supply led to high inflation, depreciation of the nominal exchange rate, depletion of foreign exchange reserves and decline in savings. Since economic growth depends on investment and investment on saving, all this caused a lower rate of economic growth.

In order to put the economy back on track, the problems of inflation, growth and balance of payments disequilibrium need to be addressed simultaneously. However, if resource constraint does not allow simultaneous solution then an efficient sequence of policy reforms is from stabilisation to growth and then the balance of payments.

Some analysts are of the view that there is a trade-off between economic growth and economic stabilisation. They argue that priority should be given to economic growth rather than to economic stabilisation. To some extent, their point is valid as economic growth is conducive to overcome many economic problems but achieving growth at the cost of stability is not an efficient solution because in this way growth cannot accelerate on a sustained basis. In effect, the viability of the balance of payments depends upon both growth and stabilisation.

Neoclassical growth theory suggests that capital formation must increase to enhance the growth process. The channels for capital formation are domestic private investment, public investment and foreign investment. It is ideal if all of these channels of investment function simultaneously. However, present circumstances are not favourable to attract foreign direct investment. International reports on governance show the poor ranking of Pakistan, which inhibits foreign investment decisions. For example, according to the Global Competitiveness Report 2012-13, Pakistan stands at 116 on property rights protection among a total of 185, and 129 on favouritism of officials in government decision-making, thus destroying the climate of investment.

Since the public sector is a net dis-saver and excessively relying on internal and external borrowing, little hope can be pinned on public sector investment. Public debt, which includes domestic and foreign debt, has surged from Rs 6 trillion in June 2008 to Rs 13.6 trillion by March 2013.

We cannot rely on external borrowing owing to the existing huge debt burden, low capacity for debt servicing and international perceptions about the security and solvency of the country. Consequently, we have to rely on domestic savings to boost investment and thereby increase economic growth.

Domestic savings are generated by both the public and private sector. However, as we already noted, the public sector is a net dis-saver. In this situation public sector investment via private savings will squeeze the latter, which are already at a low level. Therefore, a further squeeze on private savings to finance public investment will cost private investment. Without promoting investment, economic growth cannot be boosted. Thus, for investment and growth to take place, increase in private savings is the basic requirement.

In order to build a high level of domestic savings, in the first instance the government needs to eradicate its dis-saving by increasing its tax and non-tax revenue and reducing non-debt servicing current expenditures. For this, major tax reforms are required based on both horizontal and vertical equity principles. All incomes irrespective of source need to be taxed on equal bases and higher tax needs to be applied at high income levels. Landlords, managers in the underground economy, real estate tycoons, speculators and professional groups need to be brought into the direct tax net.

Financing of critical development projects in the public sector requires fiscal space, which can be created by austerity combined with fiscal reforms suggested on the above-mentioned lines. In the presence of a gap between total revenue and non-development expenditure and without replacing it by a surplus, the only way to finance public sector development spending is forced savings through printing money. This route will further deteriorate the deficit of the balance of payments, increase inflation and retard the economic growth process.

We cannot boost growth on a sustainable basis until inflation is brought under control. It is an established fact in economic theory that uncontrolled inflation discourages financial savings and economic growth. Therefore, controlling inflation is a fundamental prerequisite for the macroeconomic framework to promote growth.

The ongoing monetary policy is not compatible with the shortage of savings. The policy needs to be evaluated and conducted keeping in view the problem of dis-savings. In saving a deficit economy, an expansionary monetary policy benefits consumers and harms savers. In the case of our economy, an expansionary monetary policy has yielded a negative real rate of return. The negative real rate of return is an implicit tax on savers and a subsidy for borrowers.

In addition, incompatibility between factor prices and factor endowment causes inefficiency through misallocation of resources and reduces growth. Therefore, a tight monetary policy that yields a positive real rate of return is as much growth enhancing as economic stabilisation. An expansionary monetary policy in a saving-deficit and capital-scarce economy is not a pro-growth policy. This will simply redistribute income from poor savers to wealthy investors, thereby increasing inequality and poverty in society.

In sum, economic growth and stabilisation have a complementary relationship rather than a trade-off. Economic growth cannot sustain for a long time without stabilisation in the internal and external value of the Pak rupee. Similarly, it is difficult to maintain stability in prices and the exchange rate without high and sustained long-term economic growth.


The writer has a doctorate from the University of Glasgow, UK, and is an assistant professor at the School of Economics, Quaid-e-Azam University, Islamabad

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