Is Pakistan’s economy out of the woods?

Author: Mohsin Khan, the Atlantic Council

Looking back over 2015, there are two quite distinct views on how Pakistan’s economy has fared. The first, expounded frequently by the government of Prime Minister Nawaz Sharif and supported by the IMF, is that there has been a significant turnaround in the economy and Pakistan is now basically on track to become a vibrant and dynamic emerging market economy.

The second, voiced by many independent Pakistani economists, argues that on most counts the economy is still in the doldrums and that the data do not bear out the government’s or the IMF’s rosy view of the current state of affairs — or the prospects for 2016.

So what do the main macroeconomic indicators tell us? Tackling low growth and high inflation were two immediate challenges for the government. Some progress on these fronts is clearly evident in 2015.

According to the IMF, growth in 2015 increased very modestly to 4.2 per cent from 4 per cent the previous year and is projected to rise to 4.5 per cent in 2016. While this is a move in the right direction, the size of the increase is not much to brag about. This rate of growth is certainly not making a significant dent in the unemployment rate, which is still over 6 per cent. And youth unemployment is running at about twice that rate. The reality is that Pakistan must grow by over 7 per cent a year on a sustained basis just to absorb new entrants into the labour force.

Inflation is down significantly from 8.6 per cent in 2014 to 6 per cent in 2015 and is expected to fall further to 4.5 per cent next year. This is largely due to the fall in energy and food prices as monetary policy has remained relatively unchanged.

But these were not the only challenges.

Though reducing energy shortages was a high priority for the government, the power sector remains a major bottleneck for growth and a drain on public finances. The system is still operating below cost recovery levels, resulting in underutilisation of capacity and a build-up of arrears in government payments to the power companies.

The government hopes to increase physical capacity and therefore achieve supply–demand balance in energy by 2017–18. Whether this optimistic scenario will be realised is an open question. But it is clear that without a significant increase in energy supply, Pakistan will be stuck in a relatively low-growth equilibrium, unable to create sufficient jobs for a growing young labour force.

While the government was able to bring the fiscal deficit down to 5.3 per cent of GDP in 2014, this was achieved largely by one-off budgetary measures, foreign grants, and cuts in development spending. But there is considerable controversy among Pakistani economists on what the true fiscal deficit was in 2014 and 2015.

The overall fiscal deficit target has been met by treating privatisation receipts and foreign grants as ordinary revenues, putting the energy arrears — which were over US$6 billion in 2015 — outside the budget, delaying tax refunds and requiring pre-payment of certain taxes. It is estimated that without these adjustments, the fiscal deficit would have been closer to 8.5 per cent of GDP. That is not much different from what it was when the government came to office.

There has also been little progress in reducing energy subsidies despite the large fall in international oil prices, restructuring state-owned enterprises, and eliminating tax and customs duties exemptions. The government had committed to these reforms as part of the IMF agreement.

Correcting the external imbalances and generating external financing was another major issue the government had to address to avoid a balance of payments crisis. The government was successful in reducing the current account deficit largely because of the continued strong growth of remittances. The government also made major efforts to secure external financing from donors, international financial institutions and the international capital markets. The reduction of the current account deficit along with sizable capital inflows enabled the country to build up its stock of international reserves from US$6 billion in 2013 to over US$15 billion by mid-2015.

Yet the positive macroeconomic developments mask significant weaknesses in the Pakistan economy.

Energy shortages are likely to continue, public finances are still fragile and the claimed reduction in the fiscal deficit is suspect. Most of the increase in international reserves reflects borrowing and workers’ remittances rather than an improvement in underlying foreign trade flows or in foreign direct investment, which has continued to decline. And, despite lauding government policies and outcomes in 2015, Pakistan’s central bank (the State Bank of Pakistan) has highlighted a number of structural problems that are yet to be addressed.

The game-changer for Pakistan in the longer run could be the agreement reached with China to develop the China–Pakistan Economic Corridor (CPEC). The project is expected to bring in US$46 billion to be invested in transport infrastructure and energy-related projects, including roads, railways, pipelines and power plants over the next 15 years. CPEC has the potential to reduce infrastructural bottlenecks, stimulate domestic and foreign investment, increase energy supply, boost economic growth and create jobs.

The economic picture in Pakistan is not as bright as the government claims, but nor is it as dark as the critics suggest. Economic performance was mixed in 2015 and will in all likelihood remain mixed in 2016. The Pakistan economy is not in crisis, but it is not yet out of the woods.

Mohsin Khan is a Senior Fellow at the Rafik Hariri Middle East Center, the Atlantic Council.

This article is part of an EAF special feature series on 2015 in review and the year ahead.

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