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WorldOctober 1 2014

A glimmer of hope for Pakistan's economy

Dogged by a history of political instability, Pakistan has struggled to secure trading partners or attract much in the way of foreign investment, at the expense of its economy. However, a new pro-business government and a revival in GDP growth suggest that the country's economic fortunes might finally be on the up.
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A glimmer of hope for Pakistan's economy

National economies are inseparably intertwined with national politics the world over, but few countries demonstrate this principle better than Pakistan. Following the latest of many loans to the country from the International Monetary Fund (IMF), some much-needed economic reforms are being implemented by prime minister Nawaz Sharif’s new pro-business government. Not for the first time, however, political gymnastics have threatened to undermine any recovery.

Pakistan’s gross domestic product (GDP) growth rate last peaked at about 9% in 2005/06, under the presidency of army general Pervez Musharraf, who seized power in 1999. Military dictatorships have been the only stretches of enforced political stability in Pakistan, a fact which tends to be reflected in economic performance.

“It’s sad but true that we only ever see growth of 7% or 8% during periods of dictatorship,” observes one Karachi banker.

Balancing the books

There have been hopes that this might change, against a backdrop of evolving political maturity. The left-of-centre Pakistan People’s Party under president Asif Ali Zardari – the widow of former prime minister Benazir Bhutto – formed the previous administration from 2009 to 2013. It became the first civilian government in Pakistan’s history to serve its full five-year term without being ousted by the army or by public protest.

It did little for the economy, however. After collapsing in 2008/09 along with the global recession, real GDP remained at less than 4% until the last financial year, ending in June 2014 (FY14), when it was 4.1%, according to the State Bank of Pakistan (SBP), the country's central bank. “This was the first year in which there has been a revival of growth, when we have seen the economy heading in the right direction,” says Riaz Riazuddin, SBP’s chief economic advisor.

In fact, last year’s growth slightly undershot the official target of 4.4%. This year’s target is 5.1%, though the IMF has pencilled in only 4.3%. Consumer price index inflation in FY14 was 8.6%, up from the previous year’s 7.5%, but broadly as expected. “Some studies say that inflation of 8% or 9% is good for Pakistan [given targeted GDP], but I would like to see it at 5% to 6% after the next three or four years,” says Mr Riazuddin.

Pakistan’s foreign trade is structurally lopsided, and imports have exceeded exports for most of the country's history. Principal exports are cotton and rice, with all their attendant output and demand uncertainties. Fuel accounts for up to 40% of imports, and its price tends to move in one direction only. Pakistan has sometimes managed to balance the books with the help of external funding, notably US assistance after the Soviet invasion of Afghanistan in 1979. However, such subventions have dwindled over time, with one important exception – growing remittances from Pakistanis working abroad.

After Mr Sharif’s Pakistan Muslim League party (PML-N) was elected in May 2013 by the largest voter turnout in the country for more than 40 years, it had to address yet another balance of payments crisis. Though the trade deficit was small by emerging markets standards (at about 1% of GDP), it still had to be financed and foreign reserves were running low. The IMF approved a three-year $6.6bn loan under its extended fund facility. There were, naturally, strings attached.

Tax breaks

These IMF conditions have provided an externally sanctioned platform for the new government to set about its reform agenda. Some progress has already been made in cutting the budget deficit, now down from 8.5% to 5.8% of GDP. Here, the tax take, or lack of it, remains a crucial issue. At about 9%, Pakistan has one of the lowest tax-to-GDP ratios in the world, and less than 1% of the population – only 1.5 million out of 180 million people – actually pays tax. Non-payers include many wealthy members of parliament. The system is highly complicated, with scores of exemptions and, bizarrely, there is no federal tax on agriculture.

The authorities have promised to reduce tax loopholes and exemptions substantially, to broaden the tax base and reduce tax evasion. The retail sector is a particular target. A walk down the street is enough to tell a visitor that a vibrant informal economy fizzes away alongside the formal one, and may be twice its size.

As the deficit reduces, the government will need to borrow less. Public debt is targeted to fall from 62% of GDP in FY14 to 58.7% in FY15, and its maturity profile is being lengthened. Foreign reserves have risen from their critically low levels, helped by more than $15bn in remittances, an oversubscribed but expensive $2bn Eurobond and a $1.5bn 'gift' from Saudi Arabia, the reason for which is the topic of much speculation.

Fuel to the fire

Another priority in Pakistan is the largest single problem facing the industrial economy – an energy sector that has been catastrophically underfunded and mismanaged by successive governments. As a result, industry is plagued by chronic electricity brownouts and gas shortages.

Consumer prices have been heavily subsidised, but fiscal pressures have led to delays in subsidy payments to suppliers. Non-payment of electricity bills (by some government departments as well as by households) have also drained the cashflows of power companies. They cannot pay their fuel suppliers, who then stop supplying.

The result of this 'circular debt' is load-shedding which, alongside gas shortages, has noticeably reduced industrial productivity and helped to deter domestic as well as foreign investment. With a declining ratio of investment to GDP (from 15.1% in FY12 to 14% in FY14), this is a problem crying out to be fixed, though international investors such as Barrick, Antofagasta and Etisalat would testify that Pakistan is no walk in the park.

Tariffs have been raised, though not for the poorest, so that consumers will pay more but have greater certainty of supply. To keep banks lending to the sector, the previous government had swapped some outstanding loans for sovereign debt, but power cuts continue in spite of higher prices, making this government appear ineffectual. There will be no quick fix.

Over time, the fuel mix will be tilted away from furnace oil and gas to cheaper coal, as well as hydro, wind and solar. The government hopes to attract Chinese and Gulf investment into various coal-fired projects. Bankers, starved of infrastructure assets, look forward to some major lending opportunities.

On lockdown

The third in the triumvirate of ills besetting the Pakistani economy is terrorism, or law and order. Sudden outbursts of violence are not always caused by jihadists, but also by organised crime groups and, in Karachi, political activists of the disaffected but secular Muttahida Qaumi Movement party. The inherent threat has caused some foreign investors, including banks, to leave the country and has kept others away.

While the threat remains, the security situation in Karachi has improved noticeably, and the army has now taken the war to the jihadists. In June, it launched a major offensive against the Taliban in North Waziristan, near the Afghan border. So far it seems to be winning, and fears of retaliatory urban violence have not been realised. Government ministers make the point, however, that economic growth is just as important in combating extremism.

Not all foreigners have left. Multinationals such as Nestlé, Procter & Gamble and Unilever have held fast, attracted by continuing profits and gross margins deep into double digits. Miftah Ismail, an industrialist who chairs the government’s board of investment, says the annual target for foreign direct investment is 20% of GDP, against the current 14%.

Power generation is a key destination, offering generous returns, he says. “We would also like one more manufacturer of cars,” he adds, preferably a credible European brand to provide competition to the existing Japanese producers.

Since Pakistan must grow exports to earn more foreign currency, the government has identified potential new markets, such as eastern Europe, and new export products, such as chemicals. There was much satisfaction in December 2013 when the EU granted generalised system of preferences (GSP) plus status to Pakistan, extending duty-free treatment to products such as textiles, leather and agriculture products. It was estimated to be worth an extra $1bn a year, though an anticipated leap in textile exports has yet to materialise.

Clear vision

The EU bloc is Pakistan’s top export destination, followed by the US, the United Arab Emirates and Afghanistan. Since its US GSP programme has expired, there is less comfort there. The government is now placing its bets closer to home, and looking to regional trade as an engine of growth.

In August, professor Ahsan Iqbal, Pakistan's minister for planning and development, launched the 'Vision 2025' programme, which aspires to make Pakistan one of the world’s top 25 economies by that year. (Two years ago, Goldman Sachs forecast that the country would be in the top 20 by 2025.) Its goals include improving education (with the current literacy rate at 59%) and health, modernising the civil service, developing a knowledge economy and, importantly, pursuing more regional connectivity.

“We have a locational advantage, lying at the heart of three great engines of growth – south Asia, China and central Asia,” says Mr Iqbal. “And we are in the proximity of a fourth region, the Middle East.”

Pakistan has a long-standing military and political relationship with China, which is only now, slowly, evolving into an economic relationship. The two countries have agreed to create an economic corridor linking western China with the new south-western Pakistani port of Gwadar, the operation of which has already been handed over to China. New roads will eventually be followed by rail links, slashing delivery times for Chinese exports and oil imports from the Gulf.

If and when a workable peace comes to Afghanistan, the opportunities to expand trade there will be considerable. Afghanistan will also be a gateway to central Asia which could, in turn, offer energy security.

A passage to India? 

Most alluring, and most elusive, are the prospects of opening up trade with India. The present trickle of trade between the two countries is choked off at the borders whenever the diplomatic temperature rises, though more business is transacted via Dubai. Pakistan’s two main parties both favour normalisation of trade with India, unlike the army and the right-wing and religious parties. This difference of opinion partly explains PML-N’s poor relations with the army. One school of thought holds that, if the floodgates are opened, Indian goods will destroy Pakistani industry.

Trade talks with India’s previous Indian National Congress (INC) government had reached an advanced stage and included agreement on a better banking relationship between the two countries. Habib Bank and United Bank were each getting ready to open a branch across the border. But the INC did not want to go into the 2014 election boasting about trade with Pakistan, and it has since been replaced by the more lukewarm Bharatiya Janata Party government.

The regional potential is there, nonetheless, even if much of it remains outside Pakistan’s control. Foreign portfolio investors have already scented value in the small Karachi stock market.

“Net foreign portfolio investment in the Karachi Stock Exchange grew 50% in FY13 and almost 100% in FY14,” reports Nadeem Naqvi, the exchange’s CEO. He attributes this to a listed corporate sector which remains very profitable, and to this year’s resumption of privatisation (see story p88). Since Qatar and the UAE were promoted to the MSCI Emerging Markets Index, Pakistan’s weighting in the Frontier Index has doubled to more than 8%, which pulls in more investors.

Moreover, Moody’s recently changed the outlook on Pakistan's foreign currency government bond’s Caa1 rating from negative to stable. It cited a stabilisation in the country's external liquidity position, supported by the government's strong commitment to reforms.

In a Japan External Trade Organisation survey, Japanese companies ranked Pakistan second after Taiwan as the countries with the highest current profitability and expected sales growth. Deutsche Bank analysts, who resumed coverage of the Pakistani economy a year ago, say it is moving in the right direction, though risks remain.

Signs of change

In spite of recent parliamentary progress, one of those risks continues to be political. Two groups of political demonstrators, led by cricket legend Imran Khan and cleric Tahir-ul Qadri, have resorted to the political tactics of old, hoping to oust the government by public protest. They began blockading parliament and key government buildings in Islamabad in mid-August and, at the time of writing, were still there.

They are demanding, among other things, the prime minister’s resignation, though he is fully supported by other opposition parties and the Supreme Court. By halting government, the sit-in is costing the country $150m a day, according to one government source. Because of the protests, Chinese president Xi Jinping cancelled his much-anticipated trip to Pakistan, as did Sri Lankan president Mahinda Rajapaksa. These cancellations could cost even more, as potential investors will fear nothing much has changed.

But, perhaps it has. Only a few years ago the army would have intervened already. The prime minister stands accused of Lahore-centric cronyism, hoarding power within his closest circle and dragging his feet on reforms and key appointments.

Though these weaknesses may have allowed the crisis to gather, Mr Sharif has responded calmly and given the army little pretext to act. Yet, if Pakistan can survive this particular episode intact, perhaps its politics and its economy will continue to improve together. 

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Read more about:  Asia-Pacific , Pakistan