special edition-07

Special Edition ISSN 1811-5438

THE LAHORE JOURNAL OF

ECONOMICS Lahore School of Economics

Papers presented at The Third Annual Conference on

Management of the Pakistan Economy

Economic Reforms: The Road Ahead (2007 -2010)

2nd May to 3rd May, 2007 Lahore School of Economics, Lahore, Pakistan.

Ishrat Husain Reforming the Government in Pakistan: Rationale, Principles and Proposed Approach

A. R. Kemal Industrial Competitiveness of Pakistan (2000-10)

Shamyla Chaudry Increasing Global Competitiveness: A Case for the Pakistan Economy

Shahid Kardar Monetary and Fiscal Policies

Shakil Faruqi Pakistan Financial System - The Post-Reform Era - Maintaining Stability and Growth

Muhammad Arshad Khan & Sajawal Khan Financial Sector Restructuring in Pakistan

M. Ashraf Janjua Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?

Naheed Zia Khan Doha Round Baggage: Implications for Economic Reforms in Pakistan and other Southern Countries

Samina Shabir & Reema Kazmi Economic Effects of the Recently Signed Pak-China Free Trade Agreement

Mehak Ejaz Determinants of Female Labor Force Participation in Pakistan An Empirical Analysis of PSLM (2004-05) Micro Data

September, 2007

THE LAHORE JOURNAL OF

ECONOMICS

Editors Dr. Azam Chaudhry, Editor Dr. Theresa Thompson Chaudhry, Editor Ms. Nina Gera, Co-Editor

Editorial Advisory Board

Dr. A. Mushfiq Mobarak Dr. A. R. Kemal Dr. Ahmed Kamaly Dr. Ahmed M. Khalid Dr. Ajaz Hussain Dr. Akmal Husain Dr. Anwar Shah Dr. Ashish Narain Dr. Aslam Chaudhry Dr. Baoyun Qiao Dr. Gwendolyn A. Tedeschi Dr. Inayat Ullah Mangla Dr. Irfan ul Haque Dr. Jamshed Y. Uppal Dr. Jan Warner

Dr. Javier Arze del Granado Dr. Kaiser Bengali Dr. Kamal Munir Dr. Khalid Aftab Dr. Khalid Nadvi Dr. Lennart Erickson Dr. Mathew Andrews Dr. Michal Jerzmanowski Dr. Moazam Mehmood Dr. Munir Ahmad Dr. Nasim Hasan Shah Dr. Naved Hamid Dr. Nuzhat Ahmad Dr. Pervez Tahir Dr. Phillip Garner

Dr. Rashid Amjad Dr. Saleem Khan Dr. Salman Ahmad Dr. Sarfraz Qureshi Dr. Sarwat Jahan Dr. Sean Corcoran Dr. Sebastian Eckardt Dr. Serkan Bahceci Dr. Shahid Amjad Chaudhry Dr. Shahrukh Rafi Khan Dr. Sohail Zafar Dr. Tariq Siddiqui Dr. Umar Serajuddin Prof. Robert Neild Prof. Viqar Ahmed

Editorial Staff: Tele. No: 0092 – 42 - 5874385

Telefax: 0092 - 42 - 5714936 E-mail: [email protected]

Publisher: Lahore School of Economics, Lahore, Pakistan. Correspondence relating to subscriptions and changes of address should be sent to The Lahore Journal of Economics, 105-C-2, Gulberg III, Lahore - 54660 - Pakistan

Instructions to authors can be found at the end of this issue. No responsibility for the views expressed by authors and reviewers in The Lahore Journal of Economics is assumed by the Editors, the Associate Editor and the Publisher.

Copyright by: Lahore School of Economics

Special Edition2007

THE LAHORE JOURNAL OF ECONOMICS

Contents 2007 Editors’ Introduction i

Reforming the Government in Pakistan: Rationale, Principles and Proposed Approach Ishrat Husain 1

Industrial Competitiveness of Pakistan (2000-10) A. R. Kemal 17

Increasing Global Competitiveness: A Case for the Pakistan Economy Shamyla Chaudry 31

Monetary and Fiscal Policies Shahid Kardar 43

Pakistan Financial System - The Post-Reform Era Maintaining Stability and Growth Shakil Faruqi 67

Financial Sector Restructuring in Pakistan Muhammad Arshad Khan and Sajawal Khan 97

Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? M. Ashraf Janjua 125

Doha Round Baggage: Implications for Economic Reforms in Pakistan and other Southern Countries Naheed Zia Khan 153

Economic Effects of the Recently Signed Pak-China Free Trade Agreement Samina Shabir and Reema Kazmi 173

Determinants of Female Labor Force Participation in Pakistan An Empirical Analysis of PSLM (2004-05) Micro Data Mehak Ejaz 203

Editors’ Introduction The Lahore School’s Third Annual Conference on the Management of the Pakistan Economy, in May 2007, reflected on the economic reforms that have been implemented since the 1990s and on the prospects for additional reforms in both the near and long-term. A number of respected economists and other experts provided evaluations of the government’s past efforts, and offered advice on the direction that future reform efforts should take. The Conference focused on a few key areas which included Governance Reforms, Industrial Competitiveness, Monetary, Fiscal and Financial Sector Policies, Exchange Rate and Trade Policies, and Female Labor Force Participation. The key findings of the papers were as follows: Governance Reforms: Ishrat Husain presented a view of long-term governmental reform in Pakistan to take place over a period of 10 to 20 years. The need for such reform is great, given the demands of the “globalized world” that all economies, including Pakistan, increasingly face. He drew lessons from other developing countries that have been successful in their modernization efforts. He also reviewed recent developments in Pakistan that highlighted the need for change, including: i) the lack of equitable distribution of the benefits of economic growth and dysfunction in the delivery of public services, ii) the implications of public enterprise privatization for government ministries, iii) the devolution of powers and public finances to the provinces and districts, iv) the shift in the responsibilities of federal ministries toward policy making and monitoring and evaluation, v) the burgeoning of public-private and public-NGO partnerships, vi) uncertainty about the future of the civil service, and vii) developments in e-government. Mr. Husain discussed the broad principles that should underpin reforms in the civil service, the structures of federal, provincial and district government, and business process re-engineering. He concluded with suggestions regarding the timing and sequencing of reforms that would be most conducive to long-term change. Industrial Competitiveness: A.R. Kemal began by pointing out that Pakistan is currently internationally competitive in only a few products, demonstrating the need for dramatic improvements. He continued by examining in detail Pakistan’s performance in the various dimensions of the Global Competitiveness Index, in addition to a brief analysis of total factor productivity measures. Dr. Kemal concluded with suggestions on how Pakistan can increase its productivity and therefore competitiveness, in particular by attracting investment via a more favorable business environment, adapting and adopting new technologies, using industrial clusters to foster technological up-gradation, improving education, streamlining business regulation and dispute resolution mechanisms, and improving infrastructure (especially transport). Shamyla Chaudry also examined the ratings of Pakistan in various surveys of global competitiveness and compared Pakistan’s position in these rankings to that of India and China, two neighbors and competitors. She found that Pakistan has stagnated by most measures of industrial competitiveness, and is particularly weak in health and education and human capital development.

Monetary, Fiscal and Financial Sector Policies: Shahid Kardar evaluated Pakistan’s recent performance in monetary and fiscal management of the economy. While admitting that macroeconomic stability has been maintained, he argued that the situation remains precarious, given the level of inflation, current account deficit, and fiscal deficit. The economy has benefited from inflows from donors post-9/11, increased remittances of overseas Pakistanis, and privatization receipts, but the country may not be able to rely on these sources indefinitely. More recently, the government tightened monetary policy. Mr. Kardar also looked at the fiscal policies of the government. The government had been financing expenditures through borrowing from the State Bank, but changes were needed in order to reduce the inflationary pressures that this borrowing had created. With this view, the article presented suggestions for reforming both government expenditures and revenues. Shakil Faruqi began with a summary of the financial reform efforts that began in Pakistan in the early 1990s, in particular the privatization and consolidation of the banking sector. He assessed the current state of the banking system with regards to soundness, non-performing loans, intermediation costs and efficiency (spreads), profitability, banking and exchange rate risks, and sensitivity to shocks. Despite an impressive performance in several areas, he noted that shortcomings remain; among these is lack of credit access for large segments of the population, and lagging levels of financial intermediation as compared to other countries at similar stages of development. Muhammad Arshad Khan and Sajawal Khan also looked at financial sector reforms. The paper begins with a framework for the three major stages of financial sector reform. They divided Pakistan’s past reform efforts into three phases, starting in the late 1980s. They evaluated the effects of these sustained reform efforts by looking at the impacts on interest rates, bank solvency, credit and indicators of financial deepening, bank profitability, privatization, and corporate governance. Suggestions for a second generation of reforms were given, including a focus on macro-stability, governance, institutional capacity building and property rights, development of venture capital and private equity, and the legal infrastructure for finance. Exchange Rate and Trade Policies: M. Ashraf Janjua analyzed trends in Pakistan’s real exchange rate (REER) over the period 1978 to the present, and identified the domestic policies and events in the external environment that contributed to REER movements. The article also included an econometric analysis of the equilibrium real exchange rate (ERER), based on macroeconomic fundamentals. The estimated equilibrium real exchange rate was then compared to the actual REER to identify exchange rate misalignments over the last three decades. Naheed Zia Khan turned the discussion to international trade, by providing a detailed overview of the history of trade negotiations through GATT and the WTO. Given the current (stalled) round of trade negotiations in Doha, she paid particular attention to the issue of agriculture, focusing on Pakistan’s modest support policies toward agriculture and contrasting them with the strong agricultural support offered by the US, EU and other developed nations. Samina Shabir and Reema Kazmi gave a detailed account of the history of economic cooperation between Pakistan and China, describing the many agreements signed

since 2001 by the two countries on tariff reductions, investment, defense, energy, infrastructure, and other areas. These agreements (and future planned agreements) are intended to create a free trade area between Pakistan and China. The paper also took a detailed look at Pakistan’s exports and its trade deficit with China, and examined the recent performance of some key sectors of the Pakistani economy that will continue to receive protection under the FTA, including textiles, garments, engineering, automobiles, and consumer durables. Female Labor Force Participation: In the last paper of the special edition, Mehak Ejaz used recent data from the Pakistan Social and Living Standards Measurement Survey (PSLM) to conduct an empirical analysis of the determinants of female labor force participation. Using a limited dependent variable approach, she found that women were more likely to work outside the home when they belonged to a nuclear family, had greater education, were unmarried, and had access to a vehicle, and were less likely to work when there were a large number of children in the household and had access to home appliances. This Special Edition of the Lahore Journal of Economics has been compiled from the papers presented at the Third Annual Conference on Management of the Pakistan Economy. This Special Edition is meant to disseminate the findings of this conference more widely at both the national and international levels.

The Lahore Journal of Economics Special Edition (September 2007)

Reforming the Government in Pakistan: Rationale, Principles and Proposed Approach

Ishrat Husain*

Abstract

Though government reforms are viewed as important for most developing countries, the rationale for these reforms must be clearly understood if they are to be correctly designed and implemented. From an international perspective, government reforms in Pakistan must be developed to integrate Pakistan into a larger global economy and should be based on the lessons learned from other developing countries. From the domestic perspective, reforms are necessary for the Pakistani government to adapt to the changing domestic environment. The reforms must focus broadly on the Federal, Provincial and District governments, on civil service reform and on business process re-engineering. This paper details the rationale for government reform in Pakistan, focuses on critical areas of reform, and provides a framework for the proposed reform approach.

INTRODUCTION

A legitimate question that is often raised by those working for the government in Pakistan but not by outsiders is: Why reform the Government? Most of them believe that things are going well and the costs of bringing about these reforms will prove to be disruptive for the economy as well as for administration. We had inherited a strong, robust system from the British that has been tried and tested over time and there is hardly any compelling reason to bring about any major structural changes. In order to address this question we have to provide the rationale for bringing about reforms in the government which is done in Section I. Having established the business case for reforms, Section II lays down the principles that would underpin these reforms. Finally, the proposed approach to design the reforms will be discussed in Section III.

* Chairman, National Commission for Government Reform, and Former Governor, State Bank of Pakistan.

Ishrat Husain 2

SECTION I

Rationale for Reforms

It must be conceded at the outset that the time horizon for the consummation and impact of the proposed reforms is long term – the next 10 to 20 years and not immediate or short term. The rationale for this plan should therefore be viewed in the context of the long term vision of Pakistan, the external environment in which Pakistan will be operating as a country, the lessons learnt from other successful developing countries, the diagnostic studies including public opinion polls about government performance in Pakistan and the growing expectations of the public at large.

(A) Long Term Vision and External Environment

Vision 2030 prepared by the Planning Commission in consultation with the private sector, academia, civil society organizations, etc. envisages Pakistan to be a developed, industrialized, just and prosperous nation at the end of the next 20-25 years. This vision is to be achieved through rapid and sustainable development in a resource constrained economy by deploying knowledge inputs. The transition for achieving this objective is proposed to be managed by an intelligent and efficient exploitation of globalization through competitiveness. Pakistan is therefore opting to become an active participant in the globalized economy for goods, labor, capital, technology and services, and this option has serious consequences for the future governance of the country.

The imperative of integrating Pakistan in the larger global economy places certain essential demands and one of these demands is that the structures of the state and instruments of the government have to be redesigned to use knowledge and technology inputs to create opportunities for increased productivity and competitiveness within the constraints imposed by depleting resources. Among the 180 nations of the world which are Pakistan’s competitors for capturing market share in the ever expanding global economy, only those will survive that remain agile and adapt themselves to the changing demand patterns, supply value chain and technological upgradation. The main actors in a country that will together impinge upon its competitiveness and productivity are the state, market and civil society. The respective roles of these main actors and their interrelationships have therefore to be redefined and re-calibrated.

Structural economic reforms to improve Pakistan’s prospects for competing in the globalized economy require stable, functioning, competent

Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 3

and responsive institutions for implementation. But unfortunately, we are at present caught in a difficult logjam. While the economic reforms themselves create dislocation and displacement in the transition period, strong working institutions provide the wherewithal and armory to withstand these shocks thus minimizing the costs of adjustment and maximizing the benefits to the poor and neglected. The urgency to build strong institutions to implement these structural reforms is therefore quite obvious.

Following this logical sequence the various organs of the State – executive, judiciary and legislature – have to be assessed and evaluated to determine whether they are capable of meeting this new challenge or whether they need to be re-vamped to develop new capabilities and build up new response capacity. The task assigned to the National Commission for Government Reforms (NCGR) is limited to a review and examination of one of the organs of the State i.e. the Executive branch. The Commission has been asked to assess whether the government, its structures, processes and human resources can keep up with these new demands or need modification or alteration.

(B) Lessons from other Developing Countries

The role and limitations of governments in various developing countries have been analyzed at great length. The majority view is that governments should do what they are capable of doing better than in the past. A strong and effective government is needed rather than a weak and expansive government. The all wide-encompassing government has become too cumbersome and centralized with overlapping and competing interests, inefficient and unresponsive to the emerging needs of the public. Civil servants are poorly trained, sub-optimally utilized, badly motivated and ingrained with attitudes of indifference and inertia. It has been argued by development economists1 that effective government in developing countries is not only necessary due to abundant market failures but possibly even sufficient to achieve economic development.

A number of developing countries have successfully reformed their governments and tackled the market failures as well as achieved rapid economic development. How have they been able to transform the expansive government into a well focused, well functioning and result oriented effective government? The interpretation of the success of East Asian countries such as the Newly Industrializing Countries (NICs), ASEAN countries and China is a matter of serious debate among development economists. Neoclassical economists attribute the success to market friendly, private led growth and openness to trade with the governments providing

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macroeconomic stability, security of person and property, infrastructure services, promoting research and development, investing in education, health, science and technical training. Others such as Wade (1990) and Amsden (1989) have argued that an interventionist state which guided and steered a proactive industrial policy and picked the winners, was largely responsible for their success. By now, there is some consensus that if the labels and ideologies are set aside, the evidence suggests that countries that have tended to promote competition and avoided monopolies or oligopolies, ensured a level playing field and entry for new comers in the market, made privatized firms face competition, exercised regulatory vigilance (but eliminated inefficient and outdated regulations), opened up the economy to international trade, provided the way for judicial independence, provided dispute resolution mechanisms and enforced contracts, promoted transparency, observed the rule of law, have been relatively successful. In short, the government provided an enabling environment for private businesses to carry out production, distribution, trade of goods and services but did not indulge itself in these activities directly.

The other piece of empirical evidence that is beginning to gain wide acceptance is that decentralization and greater devolution of power, authority and resources to lower tiers of government also makes a difference through better allocation and a more efficient utilization of resources. Devolution also helps in moving towards a relatively more egalitarian outcome in the provision of basic public goods services.

Another way to promote human development and deliver social services to the poor segments of the population that has worked is through the wider participation of the private sector, communities and civil society organizations. Participation, besides being considered a means to further human capabilities a la Sen3 is also a way of choosing the right kind of projects and ensuring that development funds are used more judiciously. Private–public partnerships and public–NGO or Civil Society Organization partnerships are being successfully used in many countries for the provision of infrastructure, education, health and other social services. These partnerships not only supplement the limited public resources and counter the governance issues through monitoring, evaluation and corrective actions but also enable local communities to participate in decision making through their organizations. The reduced efficiency of public sector expenditure can also be corrected through these partnerships.


(C) Changes in Pakistani Scene

We now turn to the diagnostic studies and the changes that have taken place in the landscape in Pakistan in the past several years and are likely to affect the functioning of the government in the future. A number of commissions, committees, task forces, and working groups have examined and made recommendations about the changes in our administrative system. These recommendations and studies have been scanned and sifted and the proposals that are still relevant and useful will form part of the NCGR’s recommendations. But in addition to the historical reasons there have been at least seven new developments in the last few years that clearly point to the need for reforms in the structure, processes and human resource management policies and practices.

First, it is becoming increasingly apparent that the benefits of economic growth have not been distributed equitably among the lower income groups, backward districts, rural areas and women. Although the government has used the channels of devolution and poverty targeted interventions to spread these benefits, the results have been less than satisfactory. Almost all studies point out that the institutions of governance i.e. the governmental machinery at the Federal, Provincial and Local Governments have become largely dysfunctional due to the protracted neglect of our institutions. Almost all comparative country rankings, whether originating from the World Bank* or Global Competitiveness Report of the World Economic Forum or other think tanks and institutions consistently rate Pakistan quite low in Public Sector Management, Institutions and Governance. Along with the low Human Development Indicators this weak institutional dimension makes the task of poverty reduction, income distribution and delivery of public services quite difficult. The impact of good economic policies upon the lower strata of our society, particularly those who are illiterate and are not well connected, thus gets muted. The widespread hue and cry about the absence of a trickle down effect of good economic policies is a manifestation of the dysfunctional nature of our public sector governance. Government institutions have to be strengthened to meet this challenge.

Second, the responsibilities of the government in the field of owning, managing and operating public enterprises and corporations have undergone significant change both in the thinking as well as action during the last sixteen years. A large number of government owned corporations, businesses, industrial units, banks and financial institutions and service providers have either been privatized or are in the process of privatization. This will reduce the burden on the administrative apparatus at all levels of

Ishrat Husain 6

government. The shedding of these activities by the government has serious repercussions for the oversight function of the Ministries/ Departments in the post privatization period.

Third, the devolution of administrative, operational and financial powers to local governments since 2001 has introduced a completely new element in the governance structure that will require suitable modifications in other tiers of the government. The Federal Government is seriously considering the transfer of some functions listed in the concurrent list of the constitution to the Provincial Governments. The projected increased award of financial resources to the provinces under the National Finance Commission should provide some fiscal space to them for carrying out essential public services directly or through the District Governments. This implies a reallocation of administrative resources and the strengthening of capacity at the local government level.

Fourth, the unbundling of the policy, regulatory and operational responsibilities of the Federal ministries has shifted the focus on the policy making, monitoring and evaluation functions. But this transition has been incomplete, uneven and mixed across the ministries and needs to be firmly rooted. The lack of adequate competence and knowledge of regulatory functions would demand the development of expertise in this field as well as in policy formulation, implementation and evaluation.

Fifth, some limited success has been achieved by fostering private – public partnerships in the fields of infrastructure, education and health. But these partnerships can only be nurtured if the government departments and ministries have the adequate skills to design concession agreements, B.O.T or contractual arrangements, monitoring and evaluation tools and legal recourse to enforce the obligations and stipulations agreed by the private sector partners. Similarly, the NGOs and community organizations such as Rural Support Programs have been actively engaged in the delivery of public services in the fields of education, health, water supply etc. The government departments and ministries have to be reconfigured to develop the capacity to design and operate these partnerships.

Sixth, there is a great deal of uncertainty and anxiety among the members of the civil services of the country about their future career prospects. Those specialists serving in ex-cadre jobs such as scientists, engineers, medical doctors, accountants, etc. are demoralized because they have limited opportunities for career progression. They also feel that they are not treated at par with the cadre service officers in matters of promotion and advancement.


Seventh, the switch over from manual to automated processes and the government’s commitment to move towards E-Government would require a look at the skill mix and training requirements of the existing and future civil servants throughout the entire hierarchy. E-Government will itself flatten the hierarchical texture and make apparent the redundancies in the system. At the same time it will involve basic computer literacy at all levels and grades, digital archiving, storage and retrieval of all files and documents. Consequently, only a few of the clerical and subordinate staff positions can be utilized in the future government organization.

(D) Expectations-Delivery Gap

The recent political history of South Asia clearly points to the failure of successive governments to live up to the expectations of the majority of their population. This trend has become even more acute in the last decade or so with the advent and spread of the electronic media. Although all the countries in the region have performed well and attained respectable rates of economic growth, yet every incumbent government has been voted out of power at the time of elections. The benefits of growth may have filtered down but the speed and their distribution have not been able to satisfy the electorate. The ICT (Information Communication Technology) revolution that has touched even the remote areas of these countries has, in fact, tended to exaggerate the disparities and contributed to higher expectations of government. On the one hand, the capacity of the government institutions responsible for the delivery of public goods and services has rapidly eroded and is in a debilitating and feeble state, while a large variety of goods and services available, advertised and visually observed on the electronic media has whetted their appetite. They believe that the means through which they can acquire these goods and services for themselves and their children is through public sector employment, education and training and government transfers. In actual practice, the allocation of public goods, services, employment and subsidies is rationed by access to the government functionaries or by paying bribes. As these groups have neither the access nor the money to pay the bribes, they suffer from a relative sense of deprivation while observing that the influential and well-to-do segments of the population are preempting and enjoying the benefits of government jobs, contracts, permits, land, etc. Large, untaxed incomes are also accruing to the same privileged groups and individuals. The resentment of this poor and unconnected population is conveyed through the only instrument they possess i.e. the vote at the time of elections. This gap between expectations and delivery is one of the biggest challenges for Pakistan too.

Ishrat Husain 8

The popular perceptions as expressed in public opinion polls, media commentaries and editorials, articles and papers, seminars and discussions, observations of politicians and civil society actors, all convey with a few honorable exceptions, a negative image of the civil servants in Pakistan and a high level of dissatisfaction with the functioning of the Ministries, Departments, Corporations and Agencies of the different tiers of the government. These perceptions are in contrast to the views of the civil servants themselves who see themselves as poorly paid, highly demoralized and stressed out individuals. They feel that they have been unfairly treated by their political bosses and unappreciated by the general public. Empirical studies and casual observations show that the root cause of this disenchantment of civil society and the disillusionment of the civil servants can be traced to structural, procedural and motivational deficiencies in the overall system of governance. Any attempts to treat the symptoms in an isolated manner without coming to grips with the root causes will be counterproductive. The reform package should be comprehensive with a clear blueprint, but the introduction of each set of reforms could be phased and sequenced. The methodology adopted by the NCGR therefore follows with logic.

SECTION II

Broad Principles Underpinning the Reforms

In order to lay down the direction in which the reforms will be undertaken, it is essential that the broad principles that will underpin these reforms are clearly defined. The following broad principles are outlined under each area of the reforms.

Civil Services

i) Open, transparent merit–based recruitment to all levels and grades of public services with regional representation as laid down in the Constitution.

ii) Performance–based promotions and career progression for all public sector employees with compulsory training at post-induction, mid-career and senior management levels.

iii) Equality of opportunities for career advancement to all employees without preferences or reservations for any particular class.


iv) Replacement of the concept of Superior Services by equality among all cadres and non-cadres of public servants.

v) Grant of a living wage and compensation package including decent retirement benefits to all civil servants.

vi) Strict observance of security of tenure of office for a specified period of time.

vii) Separate cadre of regular Civil Services at the Federal, Provincial and District levels co-existing with contractual appointments.

viii) Creation of an All Pakistan National Executive Service (NES) for senior management positions drawn through a competitive process from the Federal, Provincial and District level Civil Servants and outside professionals.

ix) Introduction of four specialized cadres under the NES for Economic Management, Regulatory, Social Sector Management and General Management.

Structure of Federal, Provincial and District Governments

a) Devolution of powers, responsibilities and resources from the Federal to the Provincial governments.

b) Establishing inter-governmental structures with adequate authority and powers to formulate and monitor policy formulation.

c) Clear separation of policy making, regulatory and operational responsibilities of the Ministries/Provincial departments.

d) Making each Ministry/Provincial department fully empowered, adequately resourced to take decisions and accountable for results.

e) Streamline, rationalize and transform the attached departments/ autonomous bodies/ subordinate offices/field offices, etc. into fully functional arms of the Ministries for performing operational and executive functions.

f) Reduce the number of layers in the hierarchy of each Ministry/ Provincial department.

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g) Cabinet Secretary to perform the main coordinating role among the Federal Secretaries on the lines of the Chief Secretary in the Provinces.

h) Revival and strengthening of the Secretaries Committee at the Federal/ Provincial governments to become the main vehicle for inter-ministerial coordination and dispute resolution among various ministries.

i) District level officers interacting with the general public in day-to-day affairs should enjoy adequate powers, authority, status and privileges to be able to resolve the problems and redress the grievances of the citizens.

j) Police, Revenue, Education, Water Supply, and Health are the departments which are highly relevant for the day-to-day lives of the ordinary citizen of this country. The internal governance structures of these departments, public grievance redressal systems against these departments and checks and balances on the discretionary powers of the officials have to be introduced.

Business Process Re-Engineering

i) All laws, rules, regulations, circulars, and guidelines issued by any government ministry/department/agency should be available in its most up dated version to the general public free of cost in a user-friendly manner on the web page and in electronic and print forms at public places.

ii) Service standards with timelines for each type of service rendered at the District, Thana and Union level should be developed, widely disseminated and posted at public places in each department.

iii) Rules of business of the Federal, Provincial and District government should be revised to make them simple and comprehensible, empowering the Secretaries/Heads of Departments/District Coordination Officers to take decisions without multiple references, clearances and back and forth movement of files. Post-audit of the decisions taken should be used to ensure accountability rather than prior clearances.

iv) Delegation of financial, administrative, procurement, human resource management powers should be revisited and adequate


powers commensurate with the authority should be delegated at each tier of the hierarchy.

v) Estacode, Financial Rules, Accounting and Audit Rules, Fundamental Rules and all other rules in force should be reviewed systematically and revised to bring them in line with modern management practices.

vi) E-Government should be gradually introduced in a phased manner. Technological solutions, hardware and software applications are easy parts of the process, but the most difficult aspect is the training and change in the culture, attitude and practices. E-Government should be driven by business needs rather than crafted as an elegant technical solution.

SECTION III

Proposed Approach

There are several ways to approach the task assigned to this Commission. One option is to spend several years in preparing a comprehensive blueprint and plan for bringing about the desired changes covering all aspects of the structure, processes and human resource policies of government. This option has the disadvantage that by the time the report is ready, ground realities might have changed. Political support for reforms under this approach is most likely to wane as high costs are incurred upfront in pushing through complex, unpopular and difficult decisions, but the benefits of the reforms do not become visible in the lifecycle of the political regime in power. The advantage of this option is that all deficiencies and weaknesses are addressed simultaneously in a comprehensive manner.

The second option is to prepare a long term vision and direction in which reforms should aim and move, but combine this with an opportunistic approach whereby easy to implement changes are taken up first and the more difficult reforms are taken up later. The disadvantage of this option is that the changes introduced may be imperceptible and the time taken for the whole process to complete may be too long. But the advantage is that incremental changes that create a win-win situation for all the stakeholders including politicians have a much better chance of being accepted and implemented. It is suggested that the Commission may propose the second option as the modus operandi for its working.

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The preference for this option which is less elegant and imperfect lies in a dispassionate reading of the past history of reforms in this country. A large number of erudite Commissions and Committees have spent virtually thousands of man years in seeking out views and opinions from a diverse set of opinion makers and public at large, prepared elaborate diagnostic studies and presented a very sensible set of recommendations. But except for some tinkering here and there most of the recommendations were not implemented because of lack of political will and courage. The two exceptions to this trend are:

(a) The Civil Service Act. of 1973 which under the leadership of Mr. Z.A. Bhutto brought an end to the historical covenant between the government and higher civil servants.

(b) The Devolution Plan of 2001 under the leadership of President Musharraf which devolved powers from the Province to Districts.

These radical reforms uprooted the existing structures, processes and relationships but the transition period for their replacement by the new structures, processes and relationships has been quite long. In both these cases there was strong political will, but fierce resistance to these changes was equally strong. Learning from these two examples the second option appears more pragmatic. We have, at present, strong political leadership for the reform of the government and we need to develop a long term framework in which the direction of the reforms is clearly laid down. The movement towards the ultimate goal post will be more nuanced – by applying acceleration when the opportunity presents itself, through a brake or temporary reversal when the resistance is fierce, through second or third gears when the opposition is neutralized and the results achieved pacify the opponents.

The sequencing, phasing and timing of the various reforms and their implementation will be guided by the speed at which consensus is built among the stakeholders and the decisions are made by the top policy makers, but it is important to lay down the overall direction in which these reforms will move.

While the comprehensive reforms will be implemented incrementally, a second track will also be followed in which some quick win reforms will be implemented from time to time as an opportunity presents itself. For this purpose, the Commission will follow a more flexible route. For example, it has decided to focus on four major areas where the


interaction between the ordinary citizen and administrative machinery of the government is most intense. These four areas are:

1. Police and Enforcement of Laws.

2. Land Revenue Administration

3. Education

4. Health

The Commission has formed four sub-committees to review and examine the efforts being made by the government, private sector and civil society in each of these areas and come up with solutions that will make the existing system more efficient and responsive to the needs of the public in the immediate or short run. The Commission has also formed another sub-committee to recommend revision in the Rules of Business for removing impediments in the functioning of the government departments/ministries/ agencies and empowering the heads of the departments to deliver results.

The preliminary recommendations of the sub-committees will be presented to focus groups of stakeholders drawn from diverse segments of society – secretaries, committees, political leaders, businessmen, NGOs, academically refined civil servants, etc. – to solicit their feedback and views. Once this feedback is incorporated, the sub-committees will finalize their recommendations which will then be discussed by the Commission and then presented for consideration and decisions by the Steering Committee. The high powered Steering Committee is co-chaired by the President and Prime Minister and consists of the four Chief Ministers. The Committee has decided to provide a legal cover to the Commission so that the recommendations approved by the Steering Committee are implemented by the Federal and Provincial governments without further reviews.

The Commission will also act as a facilitator and conduit for the reforms formulated by the Federal Ministries/Provincial Governments and table them, after its own analysis for the decisions by the Steering Committee.

To conclude, those who agree that there is a need for these reforms have serious reservations about their implementation. They contend that these reforms cannot be implemented in the real sense unless we insulate bureaucratic actions from political interference. According to this school of thought, the problem of maladministration

Ishrat Husain 14

and poor governance stems from this interference. It must be recognized that in democratic forms of governance, elected leaders will have to respond to their political constituents and the associated vested interests. The accountability for results rests largely on these politicians and not on the civil servants. If the interference of the politicians is aimed at serving the narrow parochial interests of a few individuals or groups rather than the broader collective interests of their constituencies, they may end up paying a heavy price at the time of the next elections. Their opponents, the opposition parties and the media scrutiny will keep a watch on their actions and expose them before their constituents. The alignment of the civil servants with their political bosses in violating or circumventing laid down laws, rules, regulations and procedures would prove to be myopic as these civil servants will also become tainted and suffer in their career advancement. If the successive civil servants appointed to key positions refuse to carry out illegal, unlawful or irregular orders, how many times can a minster get them transferred or how many of them could be appointed as OSDs? The strong temptation to indulge in immediate gratification by keeping the political bosses happy and either ignore or go along with them is indeed the crux of the problem. The long term consequences of succumbing to such temptations should always be kept in mind by this category of civil servants. There is no substitute for personal integrity and character in public service.

However, to expect that we will be able to induct angels in the civil services is also unrealistic. The thrust of the proposed reforms is to limit the discretionary powers of the decision makers, simplify the cumbersome procedures and processes and make them transparent and realign the incentives of the individual civil servants with those of the organization. It is proposed, therefore, that the Commission should remain as a permanent body responsible for changed management in the government, but limit the term of the office of the Chairman and members to two years only.


References

Amsden A, 1989, Asia’s Next Giant: South Korea and Late Industrialization Oxford: Oxford University Press.

Government of Pakistan, 2007, Vision 2030 Draft, Planning Commission, Islamabad.

Husain I, 1999, The Economy of an Elitist State, Oxford: Oxford University Press.

Kaufmann D and Mastruzzi M, 2005, “Governance Matters IV,” World Bank.

Leipzeiger D, 1997, Lessons from East Asia, Ann Arbor: University of Michigan Press.

National Commission for Government Reforms, Concept paper (website www.ncgr.ov.pk 2006.

Sen. A.K. 1999, Development as Freedom, Oxford: Oxford University Press.

Stiglitz J and Yusuf S, 2001, Rethinking the East Asia Miracle, Oxford University Press. Bradhan P and Mookherjee D, 2001, “Decentralization Corruption and Government Accountability: An Overview” in Susan Rose-Ackerman, Handbook of Economic Corruption, Cheltenham: Edward Elgar.

Todaro, M.P and Smith, S.C, 2004, Economic Development, Pearson.

UNDP, 2003, Pakistan National Human Development Report.

Wade R, 1990, Governing the Market: Economic Theory and the Role of Government, Princeton: Princeton University Press.

World Bank, 1993, The East Asia Miracle: Economic Growth and Public Policy, Oxford University Press.

World Development Report 2000/2001, New York: Oxford University Press.


Industrial Competitiveness of Pakistan (2000-10)

A. R. Kemal*

Abstract

Though Pakistan’s exports have increased significantly, analyses have shown that Pakistan’s industrial competitiveness is limited to a narrow range of products. This paper looks at the factors affecting Pakistan’s competitiveness ranking and relates these various factors to trends in Pakistan’s total factor productivity. In addition to looking at the components of Pakistan’s competitiveness ranking, this paper details the steps required for Pakistan to increase its global industrial competitiveness.

I. Introduction

Whereas Pakistan’s exports have increased from $8 billion to $ 18 billion over the last few years, the level of exports is still just a fraction of the exports of various South East Asian countries1. The low levels of Pakistan’s exports may be attributed to its competitive edge in a few products and that, too, in low end technology products. Since the growth rate of exports has fallen to around 5% during 2006-07 following the double digit but falling growth rates over the 2003-06 period, the formulation of a strategy for the growth of exports over the medium and long run has assumed great significance. It needs to be underscored that just the provision of subsidies or devaluation of the rupee can hardly result in a continuous increase in the export level. If the country has to be a major player in international trade it must enhance its competitiveness through improved levels of total factor productivity.

David Ricardo a couple of centuries back on the basis of a 2-country, 2-product and 1-production factor model had suggested that even if a country is inefficient in the production of both the goods, it would be able to compete in the world market as long as it specializes in accordance with its comparative advantage. The inefficiencies in production, however, would be counterbalanced by the low wage rates and the cost of production of the

* Former Director Pakistan Institute of Development Economics (PIDE), Islamabad. 1 A few decades back their exports were lower than that of Pakistan.

A. R. Kemal 18

export product would be lower than that in the importing country. If the country improves the productivity levels, wages would rise without increasing the cost of production and jeopardizing the competitiveness.

Heckhsher-Ohlin suggests that the country would specialize in the activities that intensively use the abundant factor. They assumed the free availability of technology and no factor reversals but in practice neither is technology freely available nor is it the same across all the countries, and factor reversals do take place which may invalidate the theory. As the theory is based on factor endowments, any change in factor endowment would result in changes in comparative advantage over time. Moreover, in a seminal contribution, Professor Porter suggested that competitiveness may be derived from human resources and technological development resulting in innovation and reduction in the cost of production.

In recent years, a number of international agencies have ranked the competitiveness of each country on the basis of various indicators. The most important and oft quoted is the rankings by the Global Competitiveness Report of the World Economic Forum. For the last four years, it has also reported the competitiveness ranking of Pakistan, which falls below the median in most of the competitive indicators, indicating that Pakistan has to travel a long distance even to reach the average of the competitiveness indicators..

The Asian Development Bank and the World Bank have examined Pakistan’s industrial competitiveness. The Asian Development Bank Report on industrial competitiveness prepared by Lall and Weiss (2004) examines various technology indices and classifies exports and value added in accordance with them. They conclude that Pakistan’s competitiveness is not only restricted to a few products but that its competitiveness has also eroded over time. On the other hand, the World Bank’s Report (2006) on growth and export competitiveness suggests that, despite some improvements, the country can attain an average growth rate of 8% only if there are improvements in almost all the competitive indicators including institutions, human resource development and technology. It also suggests policy measures through value chain analysis for the various export products of Pakistan.

Kemal, Muslehuddin, and Qadir (2002) examined the Revealed Comparative Advantage of Pakistan and found that it has a comparative advantage in only a small number of products that are resource based, or at the lower end of technology. Similarly, Kemal, Mahmood and Ahmad (1994) found Pakistan’s comparative advantage in a narrow band of products, on the basis of Domestic Resource Cost.

Industrial Competitiveness of Pakistan (2000-10) 19

The country needs to improve its competitiveness in a large number of products and the present study examines the possibilities of enhancing competitiveness and the policies required for that. The plan of the paper is as follows: After this Introductory Section, the determinants of competitiveness and Pakistan’s competitiveness ranking are reported in Section 2. The significance of total factor productivity and its growth in Pakistan is analyzed in Section 3. The measures required for improving the competitiveness are discussed in Section 4. Major conclusions and policy recommendations are summarized in the concluding section of the paper.

II. Determinants of Competitiveness and Pakistan’s Competitive Ranking

Porter suggests that a country can develop competitiveness through the development of human resource activities including education, health, skills and technological development. The competitiveness is the ability of firms to compete with international firms of best practice. No doubt firms formulate and implement strategies to reduce the cost of production and improve the quality of products. However, due to market failures in various activities relating to competitiveness, government intervention becomes necessary. “The essence of a competitiveness strategy is to promote in-firms learning, skill development and technological effort, improve the supply of information, and coordinate collective learning processes that involve different firms in the same industry, or across related industries popularly known as ‘clusters’, geographic or activity-wise” (See ADB, (2004)).

Competitiveness and comparative advantage do change over time due to various factors which include among others “rapid technical change, shrinking economic distance, technical progress in information processing, changes in the form of industrial organizations, development of value chains, development of clusters.” The countries that develop technologies, access the markets, absorb and adapt the new technologies, and have an atmosphere that allows firms to move up the technological scale enhancing their competitiveness.

Pakistan ranks 91st in the competitive index out of 125 countries included in the Global Competitive index and its score is 3.7 on the scale from 1 for the poorest rank to 10 for the highest rank. While Pakistan’s score is poor, it is encouraging to note that the score has improved from 3.5 to 3.7 and the ranking from 94th to 91st.

There are three sub-sectors of the Global Competitiveness Index, viz. basic requirements, efficiency enhancers and innovation factors. In all the

A. R. Kemal 20

three indicators, Pakistan lags behind the median except for the indicator measuring innovation factors where it is around the median (See Table-1). It suggests that Pakistan is far behind in competitiveness and if Pakistan has to grow at a rate of 8% on average as envisaged in the Medium Term Development Framework (MTDF), its score in almost all the indicators must improve significantly and it should be among the top 25 countries of the world (See World Bank (2006)).

Table-1: Global Competitiveness Index for Pakistan

Rank Score 2006-07 91 3.7 2005-06 94 3.5 Basic Req. 93 4 1st pillar: Institutions 79 3.5 2nd pillar: Infrastructure 67 3.4 3rd pillar: macroeconomy 86 4.2 4th pillar: Health and Primary Education 108 4.8 Efficiency Enhancers 91 3.3 5th pillar: Higher Education and Training 104 2.8 6th pillar: Market Efficiency 54 4.2 7th pillar: Technological Readiness 89 2.8 Innovation Factors 60 3.7 8th pillar: Business Sophistication 66 4 9th pillar: Innovation 60 3.3

Source: Global Competitiveness Report 2006-07

Institutions are crucial for the growth process and Pakistan lags behind considerably in all the indicators relating to institutional development (See Table-2). While the institutions are also important for the indigenous investors, they are crucial for foreign private investment especially for the manufacturing sector. The government intends to implement second generation reforms but so far an improvement in this direction has been quite limited. Efforts in this direction shall have to be enhanced considerably.

Table-2: Institutions


Rank Score Efficiency of corporate boards 123 3.5 Business cost of terrorism 122 3.1 Property rights 95 3.7 Reliability of police services 85 3.5 Ethical behavior of firms 82 3.8 Judicial independence 80 3.3 Business cost of crime and violence 76 3.8


Inadequate and poor quality infrastructure increases transaction costs and erodes the competitive edge of industries. Over recent years there have been considerable improvements in infrastructure especially in the telecommunications sector, but that seems to not have found its way so far into the Global Development Report. Teledensity has improved considerably than that reported in Table-3, as it is now around 30 per 100 persons. Incorporating these developments would improve the ranking of Pakistan further; Pakistan has a reasonably good ranking in railroads, ports and air travel. However, it is the power supplies that pull down the ranking of Pakistan in terms of infrastructure.

Table-3: Infrastructure

Rank Score Overall infrastructure quality 67 3.4 Railroad infrastructure development 39 3.6 Quality of port Infrastructure 52 3.8 Quality of airport structures 59 4.6 Telephone lines 101 3 Quality of electricity supply 87 3.5


Pakistan has done better in some indicators of market efficiency including number of days required to set up businesses, hiring and firing practices and taxation and loans. Moreover, even though its score in easy access to loans has been low, its ranking is quite good. But despite its score around 5 in ownership restrictions of foreign firms and soundness of banks, its rank is low. In other indicators Pakistan ranks poorly (See Table-4).

Table-4: Market Efficiency

A. R. Kemal 22

Rank Score Efficiency of legal framework 91 3 Hiring and firing practices 26 4.6 Cooperation in labor-employer relations 77 4.4 Intensity of local competition 73 4.6 Brain drain 73 2.9 Foreign ownership restrictions 72 4.9 No. of procedures require to start a new business 70 11 procedures Time required to start a business 30 24 days Extent and effect of taxation 33 3.9 Soundness of banks 84 5 Ease of access to loans 42 3.8


Technological capabilities are determined by education, training, scientific and technological infrastructure and they are reflected in the innovations and patents. Table-5 shows various aspects of technological preparedness. The net enrolment rates at the primary and tertiary levels of education are 66.2% and 3.0% respectively, the poor quality of education and, except for market sophistication like value chains and local supplies, Pakistan ranks poorly in terms of technological development.


Table-5: Education and Technical Capabilities

Rank Score

Primary enrolment 112 66.2

Tertiary enrolment 106 3

Extent of staff training 91 3.1

Quality of math and science education 85 3.4

Local availability of research and training services 83 3.4

Quality of the educational system 74 3.2

Cellular telephones 115 3.3

Personal computers 113 0.4/100

Internet users 107 131.1/100000

Technological readiness 77 3.4

FDI and technology transfer 75 4.8

Firm level technology absorption 85 4.4

Value chain presence 47 4

Local supplier Quantity 61 4.7

Local supplier Quality 66 4.2

Production process Sophisticate 59 3.6

Nature of Competitive Adv. 54 3.5

Availability of scientists and engineers 78 4.2

Utility patents 78 -

Capacity for innovation 38 3.7

Govt. procurement of technology products 47 3.9

Secondary Event 112 27.2

Quality of public schools 79 29.2


III. Trends in Total Factor Productivity in Pakistan

It is generally believed that total factor productivity (TFP) in Pakistan has been small, but it has accounted for one-third of the growth for the period 1964-65 to 2000-01. TFP has grown at a rate of 1.66% for the entire economy, only 0.37% for agriculture but 3.21% for the manufacturing sector, accounting for about half of the growth in the sector. Nevertheless,

A. R. Kemal 24

while productivity growth is quite encouraging it needs to be noted that it reflects rather poor levels of productivity levels in the base year and has been just catching up through learning by doing. There has been hardly any growth in productivity arising from technological development and human resource development.

Table-6: Trends in Total Factor Productivity

(%age Growth Rates) Contribution of Sector

GDP* Capital Labour

TFP

Overall 5.31 2.48 1.17 1.66

Agriculture 3.89 2.70 0.82 0.37

Manufacturing 6.39 2.23 0.94 3.21

Contribution to Aggregate Growth 46.62 22.12 31.26

Agriculture Growth 69.33 21.11 9.57

Manufacturing Growth 34.99 14.74 50.27

Source: Kemal, Muslehuddin and Qadir (2002)

TFP growth in the manufacturing sector has shown wide variations. It has accounted for almost a 3% increase in output per annum in the 1960s and 1980s, but it was quite low in the 1970s and in the 1990s. In the 1990s it was just 0.78%. However, in the manufacturing sector it was 1.64%.

Table-7: Trends in Total Factor Productivity during 1990s (%)

Growth Rates Sector GDP Capital Labour

Residual

Overall 4.41 2.38 1.25 0.78

Agriculture 4.54 2.21 0.81 1.52

Manufacturing 3.99 2.09 0.25 1.64

Contribution to Overall Aggregate Growth 53.97 28.25 17.78

Agriculture Growth 48.63 17.83 33.55

Manufacturing Growth 52.54 6.26 41.20

Source: Kemal, Muslehuddin and Qadir (2002).


IV. Preparing for Technological Capabilities and Competitiveness

The Medium Term Development Framework (MTDF) 2005-10 calls for a growth rate of 8.2% in 2010, with an average growth rate of 7.6% over the 5 year period. It emphasizes improvements in the productivity levels by deploying knowledge inputs rather than focusing only on the accumulation of inputs. However, the MTDF neither provides for sufficient investment levels, nor for skill development and improvements in technological capabilities required to achieve the high growth rates envisaged in the MTDF.

Pakistan can realize the envisaged growth rates provided investment levels increase to 30% of GDP and total factor productivity increases through technological development and/or the adoption, adaptation and diffusion of new techniques. For an increase in investment and technological change the institutions, regulations, education, and technological personnel would have to increase and special efforts shall have to be mounted. A business friendly environment would foster both domestic and foreign investments resulting in both export competitiveness and diversification.

The World Bank (2006) suggests that if the quality of the investment environment in Pakistan matches that of the Shanghai investment climate, then the average productivity of Pakistan’s textile firms operating in Karachi would improve by 81%, the rate of return to capital would increase by 36%, and wages would rise by 23%. The increased profitability would encourage more investment and further improvement in competitiveness2. Technological capabilities develop slowly but once the process starts, it gains momentum and a virtual circle of growth, competitiveness and investment in new capabilities take place. This in turn helps in further technological capabilities and growth. On the other hand, if the economy is stuck in a low level equilibrium trap and is unable to fund technological development, it is caught in a vicious circle. However, it can break out of this circle through a concerted strategy by improving the human capital and technological base and improving the institutions and infrastructure.

The essence of the competitiveness strategy is to improve the supply of information, skills and technology and encourage firms to make an effort at the learning of skills and the adoption and adaptation of technology. Over the last couple of decades there have been rapid technological changes

2It also suggests that reforms carried out by Pakistan have been mainly responsible for the high growth rate of per capita incomes in Pakistan in recent years.

A. R. Kemal 26

across the globe which has rendered the old technologies obsolete even in the low wage economies3.

New technologies are not just new products and processes, but involve the firms supply chain, human resource development, technology linkages etc. It amounts to building new capabilities and promoting structural change in the production patterns, the upgrading of technologies in activities including finding new markets and marketing niches. Various industries may need to access, adapt, and add new technologies to remain competitive. Industrial leaders have to invest in technological innovations while the followers invest in absorbing and adopting the technology. Contrary to the general impression that the latter is easy, it needs to be noted that it is a complex process and involves the development of skills and technological personnel. The technical change affects all industries though they are more important in innovation-based industries4.

While technological development is absolutely necessary the capacity development for technological change is slow, costly and a risky learning process. The critical factor is not just addition to capacities but the ability to understand how to operate these at the optimum levels given local conditions and factor endowments and to upgrade the technologies to lower the cost of production and evolve new products.

It also needs to be noted that the competitiveness of a country undergoes changes in response to innovation and the relocation of processes or functions. The improvements in productivity do not necessarily involve innovation, but could involve the efficient use of existing technologies. The reduction in the dispersion of the use of technology across different firms through the diffusion of technology helps in improving the productivity levels of an industry. However, it may involve large amounts of investment, effort, time, risk and constrained interaction with other actors with whom information and skills are shared.

In most developing countries, firms are not aware of how to upgrade their technologies to the best practice levels. In general they fail to understand what new skills, technical knowledge and organizational techniques are generally available and how these can be accessed. Cooperation with other firms or institutions requires efforts in over-coming problems of linkage. Cluster development can be useful in this direction.

3 The enterprises had to use new technology to remain viable. 4 Such industries have grown at double the rate compared to the other industries.


Lack of skilled manpower is a major constraint to business activities in Pakistan and is critical to improving the productivity and competitiveness of Pakistani firms. With a view to improving education and skills, merely higher allocations to education and skill activities would not be sufficient, though it is absolutely necessary. Governance needs to be improved through the strengthening and ensuring of more effective recruitment, management and performance of teachers keeping in mind their competencies and absenteeism. It would help in the completion of education. Similarly, skill development calls for improved syllabi, teachers and laboratories and all the governance issues discussed in terms of education. Moreover, it needs to be ensured that intermediate and secondary education is more purposeful and linked to the economy and the changing needs of the labor market and careers. It also implies an upgradation and expansion of vocational and technical education capacity to train individuals who are completing matriculation, drop outs and the unemployed.

Whereas there have been significant improvements in the cost of doing business indicators over the last few years, the cost is still quite high. Corruption continues to be very high. The regulatory environment leaves much to be desired in all aspects of commercial laws and regulations. There is a need for operational rules, procedures and a monitoring system which are universally implemented. There is a need to develop a dispute resolution system for commercial adjudication outside courts. The infrastructure leaves much to be desired. In the power sector there are difficulties in obtaining electricity connections and the supply is unreliable, thus placing an enormous burden on business. The financial sector reforms need to be consolidated and expanded. The legal framework and judicial processes need to be improved.

Despite improvements in recent years, major problems in transport logistics remain. Long standing problems include the old and depleted conditions of the transport fleet, serious overloading of trucks, restrictions on the provision of bonded transport and the high cost for less than container load shipments. Pakistan Railways do not operate on a commercial basis and gives priority to passengers rather than cargo. The main problem at the ports is the congestion at the terminals and the turnaround time of ships is quite high. Pakistan lacks a coherent strategy for quality and SPS management in relation to its trade. Pakistan needs to better define and demarcate the role and responsibilities of different agencies, strengthen existing technical capacities for administrating science based SPS measures, and institutionalize and early warning or surveillance system for pest and disease contaminants etc.

A. R. Kemal 28

V. Conclusions

Pakistan’s exports, despite a sharp increase in recent years, are just a fraction of the exports of various South East Asian countries and the main factor behind the low level of exports is the lack of competitiveness and comparative advantage in limited products the demand for which is growing slowly in the world market. Exporters are once again asking for more subsidies and devaluation of the rupee rather than enhancing their competitiveness through improvement in total factor productivity. Competitiveness may be enhanced through the development of human resources including skills and technological development. If Pakistan wants to accelerate its GDP growth rate to around 8%, it will have to improve its ranking from 91st in the world.

Whereas total factor productivity over the long run in the industrial sector has contributed one-half to the growth, its contribution has fallen in the 1990s to just 0.8%. Moreover, improvements reflect low levels of productivity in the base year and they reflect just catching up through learning by doing and there has hardly been any growth in productivity arising from technological development and human resource development. Efforts need to be mounted to improve the skills and technological infrastructure in the country as has been suggested in the MTDF - that growth would be realized by deploying knowledge inputs.

Whereas there have been significant improvements in the cost of doing business indicators over the last few years, the cost is still quite high. Corruption continues to be very high. The regulatory environment leaves much to be desired in all aspects of commercial laws and regulations. The infrastructure leaves much to be desired. In the power sector there are difficulties in obtaining electricity connections and the supply is unreliable, thus placing an enormous burden on the business sector. Financial sector reforms needs to be consolidated and expanded. The legal framework and judicial processes need to be improved.


References

Kemal, A. R., Musleh-ud Din, Kalbe Abbas and Usman Qadir, 2002, “A Plan to Strengthen Regional Trade Cooperation in South Asia” in T. N. Srinivasan (ed.) Trade Finance and Investment in South Asia, Social Science Press, New Delhi,

Kemal, A.R., 2002, “Productivity Growth during the 1990s in Pakistan,” Asian Productivity Organization, Japan.

Kemal, A.R., Muslehuddin and Usman Qadir, 2005, “Exports and Economic Growth in South Asia” in Mohsin Khan (ed.) Economic Development in South Asia, New Delhi: Tata McGraw-Hill Publishing Company Ltd.

Kemal, A.R., Zafar Mahmood and Athar Maqsood Ahmad, 1994, Structure of Protection, Efficiency, and Profitability. Islamabad, Study prepared for the Resource Mobilization and Tax Reforms Commission, Karachi.

Lall, Sanjay A. and Jonh Weiss, 2004, Industiral Competitiveness: The Challenge for Pakistan, ADB, Islamabad.

World Bank, Pakistan: Growth and Export Competitiveness, 2006.

World Economic Forum, The Global Competitive Report 2006-07, Geneva.


Increasing Global Competitiveness: A Case for the Pakistan Economy

Shamyla Chaudry*

Abstract

The issue of global competitiveness is critical for developing countries. This paper looks at the drivers that influence industrial competitiveness and provides a comparison of these drivers for Pakistan, India and China. The analysis shows that Pakistan lags behind China and India in most of the main components of the industrial competitiveness index. The analysis also presents a series of micro and macro level policy recommendations aimed at increasing Pakistan’s industrial competitiveness.

I. Introduction

The aim of this paper is to explain global competitiveness and its implications for Pakistan. The paper examines international data on global competitiveness and tries to develop an analysis to help improve strategies for today. The paper’s focus is on the empirical literature on competitiveness using different composite indices. These include the following:

1. United Nations Industrial Development Organizations; World Industrial Development report (2002-2003)

2. World Economic Forums Global Competitiveness Report (up to WEF 2005-2006)

The principal objective of this study is to analyze factors that affect productivity and hence competitiveness and also to identify areas where Pakistan can strengthen its competitiveness so as to contribute to the overall growth performance. In order to do such an analysis, comparisons have been made with Pakistan’s neighbours, India and China, and their success in international standings has been evaluated. A question which probably

* Assistant Professor, The Lahore School of Economics, Lahore

Shamyla Chaudry 32

comes to everyone’s mind is why India and China, which enjoy the same geographic region with Pakistan, are well ahead of Pakistan in all aspects of competitiveness.

II. Global Competitiveness Today

The theme of competitiveness has remained the same; that is lower domestic costs hence lower the prices of goods. But ways to achieve this have changed over the years: from a pricing approach, that is the end user approach, there has been a shift to a costing approach, that is, the firm micro-level approach.

Competitiveness can be defined as sustainable growth in productivity that benefits the average person. Today, competitiveness in a global economy should not be confused with abundance of natural resources or cheap labor or continued exchange rate depreciations or, for that matter, protectionist policies to support local industries. Though these bring short term advantages, they do not facilitate the making of a dynamic economy. Professor Porter’s model for competitiveness is created by a stable macro economic, political, legal and social environment and also a continuous yet proactive stance to improve the micro economic environment in which local firms are taken to the forefront and strategies are developed to foster an environment for local competition.

A recent study in the Industrial Development Report attempts to explain the “drivers” that seem to influence a country’s ability to influence competitive industrial performance (CIP). Skills measured by the level of tertiary enrollment in technical subjects, research and development (R&D) which is financed by productive enterprises, foreign direct investment (FDI) which includes total FDI investment with no distinction between export-oriented or domestic-oriented flows in manufacturing, royalties and technical fees which include fees paid to imported technology, and lastly modern infrastructure (ICT) by the use of telephone mainlines, are the five “drivers.”

• CIP Score = 27.017 + 0.277 skills + 0. 036 R&D + 0. 009 ICT+ 0.021royalties + 0.008 FDI.

The equation shows the drivers that enhance the CIP- competitive industrial performance index (based on a data base of 51 countries for the year 2000). A 1% enhancement in skills, namely enrollment in technical subjects such as science, mathematics, computing, and engineering, will 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

royalties achieve consistent significance whereas skills and ICT fail to do so as skills are highly correlated with R&D. What this confirms is that technological efforts are positively related to the CIP, which are the bases for industrial success. FDI driven production and the export of high tech products affects competitive industrial performance positively. Royalties and technical fees are also positively related with industrial performance.

Table-I

Country Rank CIP Index Change in Rank for (2000) (2000) 1990-2000 1980-1990 1980-2000

Pakistan 49 0.235 -2 6 4

India 40 0.275 -4 2 -2

China 24 0.379 2 3 15

Source: UNIDO scoreboard of core sample database)

Starting with a CIP score of 0.192 (rank 53) in the 1980s to 0.219 (rank 47) in the 1990s to 0.235 (rank 49) in the 2000s, Pakistan has lost ground mainly due to exogenous shocks, political instability, poor macro management, policy liberalization and an over reliance on primary products. China started off with a score of 0.240 (rank 39) in the 1980s to 0.323 (rank 26) in the 1990s to a score of 0.379 (rank 24) in the 2000s showing a sustained improvement in each decade as there have been rapid rises in manufactured exports and a significant upgrading of technological structure of exports. But again policy liberalization has slowed the process of improvement in China’s global competitiveness. A number of studies conclude that China’s growth would have been relatively higher had policy liberalization not been forced on China. India’s performance amounted to a CIP score of .243 (rank 38) in the 1980s to 0.262 (rank 36) in the 1990s to 0.275 (rank 40) in the 2000s showing that it has upgraded its technology structure from a relatively low level and has a medium share of manufactured goods with a low per capita export value. The reason for the stagnation of Indian competitiveness can be attributed to slow medium and high technology (MHT) sector growth in the1990s which was a result of policy liberalization in the form of increased advertising budgets at the cost of R&D budgets. The small slip in the index also implies that the neighbouring country, namely China, has been doing better.

The World Economic Forum defines competitiveness as a set of factors, institutions and policies that underline the level of productivity; if one wants to increase productivity, hence competitiveness, one has to

Shamyla Chaudry 34

make better use of the available resources. The Global Competitiveness Index (GCI) incorporates nine factors that lead to increased productivity and competitiveness. The GCI incorporates the concept of stages of development, attaches different weights to different sub-indices and provides individual countries with a useful tool to identify the barriers to competitiveness. The pillars are divided into three broad categories, those being the basic requirements, efficiency enhancers and innovation and sophistication factors. These are then further sub-divided into the nine pillars, that is, institutions, infrastructure, macro economy, health and primary education, higher education and training, market efficiency (goods, labor, financial), technological readiness, business sophistication and innovation. Pakistan, India and China are classified as factor driven economies with a GDP per capita of less than $2000. For such economies the basic requirement sub-index is the most important as it has the highest weight attached to it in constructing the GCI. Economies with GDP per capita ranging from $3000 to $9000 are classified as efficiency driven economies, whereas countries with GDP per capita greater than $17,000 are classified as innovation driven economies. Naturally all three categories assign different weights to the three sub indices. Using the three weights the GCI has been constructed for Pakistan, India and China.

Table-II

Weights Pakistan India China

Factor driven 3.66 4.44 4.24

Efficiency driven 3.585 3.56 4.125

Innovation driven 3.594 4.461 4.029

Equal weights 3.629 4.47 4.067

Source: GCI index 2005-2006)

Using different weights we can see that for all the countries the GCI score deteriorates as we move from factor driven weights to innovation driven weights and only in the case of equal weights, does India show a minor improvement of 0.03 where as Pakistan and China both lose ground. This contradicts the report on the state of Pakistan’s competitiveness that asserted that by assigning equal weights to the sub-indices Pakistan’s score could have been relatively higher.

Referring to the Table-III one can see a stark contrast between the three economies that have been classified as factor driven economies. Analysis has been provided for such differences. Under the first four pillars


which make up the basic requirement category, except for infrastructure, health and education, Pakistan’s ranking has fallen. The fifth, sixth and seventh pillars that fall under the efficiency enhancer’s category have shown stagnation.

Considering the eighth and the ninth pillar that come under innovative factors, Pakistan has slid under the eighth pillar but has shown considerable improvement in the ninth pillar. Factor driven economies such as Pakistan define competition based on factor endowments such as unskilled labor and natural resources.

Today Pakistan lags behind in all the categories of the GCI index. Though the figures show an improvement in Pakistan’s rank from 98th to 91st, this does not indicate any improvement but merely the fact that more countries have been included in the index. Health and education when compared to India (5.9) and China (6.44) are weak areas for Pakistan (4.79). Human capital development is the weakest in Pakistan as indicated by the higher education and training (fifth pillar). Pakistan is a low wage, labor surplus economy with low productivity. However, firm-level comparisons suggest that while wages in Pakistan are low by international standards, they are often significantly higher than those in the Sub-continent. Slow growth in private investment in the large scale manufacturing sector has dampened Pakistan’s economic growth. Pakistan has liberalized trade but highly protected domestic markets have reduced the incentives to exports. Also high costs and poor functioning of infrastructure are considered to be harmful impediments for Pakistan’s growth.

Shamyla Chaudry 36

Table-III: Global Competitiveness Indexes: Cross-Country Comparisons 2006 – 2007)

China India PakistanRank Score Rank Score Rank Score

Basic Requirements 44 4.8 60 4.51 93 3.96 Institutions 80 3.51 34 4.55 79 3.51 Infrastructure 60 3.54 62 3.50 67 3.36 Macro economy 6 5.72 88 4.12 86 4.19 Health & Primary Education 55 6.44 93 5.90 108 4.79

Efficiency Enhancers 71 3.66 41 4.32 91 3.27 Higher Education & Training 77 3.68 49 4.35 104 2.82 Market efficiency (goods, labor, financial)

56 4.22 21 5.07 54 4.23

Technological Readiness 75 3.07 55 3.52 89 2.77

Innovation & Sophistication Factors 57 3.75 26 4.60 60 3.66

Business Sophistication 65 4.05 25 5.06 66 4.05 Innovation 46 3.44 26 4.14 60 3.27 Overall Index 54 4.24 43 4.44 91 3.66

(Source: Global Competitiveness Report (2005-2006))

India ranked 43rd overall with excellent scores in the capacity for innovation and sophistication of firm operations. Firm use of technology and rates of technology transfer are high, although penetration rates of the latest technologies are still quite low which reflects India's low levels of per capita income and high level of poverty. A lack of adequate health services and education as well as a poor infrastructure are limiting a more equitable distribution of the benefits of India’s high growth rates. When comparing the infrastructure pillar, India and China have very close figures which is highly debatable. Indian governments have been ineffective in reducing the public sector deficit, which is one of the highest in the world, and that would seem to cause their rankings to slide in the macro economy pillar.

China’s ranking has fallen form 48 to 54, characterized by heterogeneous performance. On the positive side, China’s growth rates coupled with low inflation, one of the highest savings rate in the world, and hence investment and manageable levels of public debt have boosted China’s ranking on the macro economy pillar of the GCI to 6th place. However, a number of structural weaknesses have arisen, including in the


banking sector that is mainly controlled by the State. China has low penetration rates for the latest technologies (mobile telephones, internet, personal computers), and secondary and tertiary school enrolment rates are still relatively low. There has been a drop in the quality of the institutional environment, a slide in the rankings from 60 to 80 in 2006, with poor results across all 15 institutional indicators, spanning both public and private institutions. China has created a much more competitive environment than India or Pakistan considering the tax structure, infrastructure, capital costs and labor legislation. China is well known for the low costs of its workforce and its investment rate which is one of the highest in the world. China invests enormously in education, infrastructure and technology, yet people mistake China’s competitiveness as a result of cheap labor and piracy. China’s competition is felt particularly in some sectors requiring a great deal of manual labor such as footwear, textiles and small appliances. But in the next five years China’s auto industry will pose to be a looming threat for other car manufacturing industries across the world. In China, local firms are gaining ground over foreign competitors. These companies are receiving a boost from government policies that require at lease 70% of new machines to be made at home in sectors such as energy. Such incentives are likely to increase its growth.

III. Conclusion and Recommendations

Pakistan started out a poor nation at independence with dependency on agriculture. The economy has seen ups and downs which have discouraged Pakistan’s growth. In the 60s there was major investment in infrastructure, huge sugar mills and textile industries, and import substitution was implemented. It was at this time that Pakistan was considered to be an economic player of the Sub–continent. By the 70s political hurdles dissuaded Pakistan’s progress and the nationalization of industry brought growth to a stand-still. In the next era of the military regime there was a heavy inflow of US aid and spending by the public sector was seen to be on the rise. The next decade, that is the 90s, can broadly be classified as a decade of lost opportunities with heavy borrowing both in the public and private sector that has resulted in being a burden on the economy today. Therefore, today prudence in economic management is crucial. But the trick that needs to be learned is to find means to support and accelerate rather than hinder enterprise development. For global competitiveness today is more reliant on the micro environment as opposed to the macro environment. A number of recommendations are being cited here with reference to the two neighbouring countries that have done better than Pakistan.

Shamyla Chaudry 38

Competitiveness today requires a strong base of human and technological resources. However, in Pakistan per capita R&D spending is amongst the lowest. Among the high growth newly industrialized economies, there have been substantial national variances in the way exports were promoted. The challenge for Pakistani governments will be to provide support, not direction, for the private sector. Also Pakistan needs to establish alliances with countries that have technological capabilities in sectors operating at lower technological levels. The essence of competitiveness is to promote in-firm learning, skill development and technological effort and to coordinate the collective learning process. To compete, Pakistani enterprises must adopt new technologies and organizational methods and link themselves to the global value chain. Coping with new technologies calls for new skills, innovative production structures, improved infrastructure and institutions. Today, competitiveness will involve the upgrading of technologies in all activities building new capabilities and finding new markets and market niches. Pakistan needs to reevaluate its exports, and even with Pakistan’s cotton resources and upgrading of textile facilities, will it remain a major player in textile and apparel market, where Pakistan has lost market share to countries like China, India, and recently to Bangladesh and Sri Lanka? In the long run export diversification is necessary. Pakistan’s wage rates are comparable those of India and China but its export structure is biased towards low technology products. Therefore, Pakistan’s scores are relatively low on export sophistication. That means that Pakistan specializes in the low value added section of the textile industry. Unfortunately, Pakistan is highly dependent on apparel products that are considered to be one of the most non dynamic exports; with sliding market shares and entry from other countries, that makes Pakistan’s position vulnerable. It also faces competition from China and India who are investing heavily in new technology, designs and skills which may out-perform Pakistan. Therefore specializing in textile and clothing is not recommended in the future. It needs to diversify into other sectors where it has a competitive edge. Should Pakistan switch its production from low tech goods to primary products? At this point we are not saying that Pakistan should never produce high tech products, but build on its capabilities to develop goods that provide value addition.

What should Pakistan do in the meantime? Recent examples of exports of various citrus fruit varieties, mangoes, flowers, dairy products and a number of other such products will provide the diversification needed to strengthen exports. Also a study conducted by the World Bank indicates the potential for more trade with India, especially light manufactured products such as bicycle components and fans. Pakistan has to reevaluate its stance on


its medical instruments product categories, one of its most dynamic exports, where Pakistan has been losing its world market share.

With low ranks in the basic requirements sub-index, Pakistan has to improve at the macro level so that an environment can be fostered for the individual firm. Pakistan has to improve in areas of health and primary education and also improve the higher education and training pillar. The investment climate, coupled with the uncertain national and regional situation, has kept foreign direct investment (FDI) inflows less than those of China. For competitiveness today a country requires adequate infrastructure, cheap labor and liberal economic policies. Therefore Pakistan requires export diversification, firm level technological upgrading and the development of clusters.

However, why are some industries in Pakistan doing well despite a low competitive rating? Are these the results of some ingenious ways of doing business? Is the Pakistani entrepreneur really proactive? Further research needs to be directed in this area. The Business Competitiveness Index addresses firm level operations and the national business environment with relatively higher weights given to the latter. Pakistan’s performance has improved over the years from 77th to 67th place where China stands at 57th and India is currently at 31st place. When these ranks are compared with other countries in the region, Pakistan has to strive hard to develop not only a strong national business environment, but also try to capture firm level ingenuity.

Certain high priority areas have been identified by a study conducted by the World Bank for accelerating Pakistan’s growth and hence its global competitiveness. Some of these measures require quick decisions whereas others require long term efforts. The measures include:

• Strengthening the macroeconomic framework (long term)

• Analyzing electricity pricing and structural issues

• Improving SME’s access to financing

• Serious commitment to human capital development and to increase the supply of skilled labor (long term)

• Improvements in the efficiency of the duty–drawback and sales tax rebates systems for new or small exporters and new exporting activities

Shamyla Chaudry 40

• Improvements in transport and trade logistics (long term)

• Enhancing food and safety standards


References

ADB Institute-Pakistan Resident Mission Seminar Paper, 2004, “Industrial Competitiveness: The Challenge for Pakistan”, ADB Institute, Asian Development Bank.

Ansari. Javed A., 2005, “Pakistan’s Industrial Competitiveness”, College of management Science, PAF-Karachi Institute of Economics and Technology.

Aw, Bee Yan; Chung, Sukkyun and Roberts mark J., 2000, “Productivity and Turnover in the Export Market: Micro-Level Evidence from the Republic of Korea and Taiwan (China)”, The World Bank Economic Review, Vol. 14, No. 1, pp. 65 – 90.

Balduf, Artur; Carvens, David W. and Wagner, Udo, 2000, “Examining Determinants of Export Performance in Small Open Economies”, Journal of World Business, Vol. 35, No. 1.

Britto, Jorge and Janeiro, Rio de Janeiro, “Industrial Competitiveness and Inter-Firm Co-operation: An Analysis of Stylized Models of Inter-Firm Networks”.

“Global Competitiveness Report 2003 / 2004”, World Economic Forum.




Government of Pakistan, Finance Division; “Pakistan Economic Survey 2005 - 2006”.

Katsikeas, Constantine S. and Leonidou, Leonidas C., 1996, “Export Market Expansion Strategy: Differences Between Market Concentration and Market Spreading”, Journal of Marketing Management, Vol. 12, pp. 113 – 134.

Khan, Mehmood – Ul- Hassan, “Exports in 2006: A Critical Review”, Business & Finance Review, the News International, Monday, January 8th 2007.

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Khan, Mehmood, Shazia; “Good Economic Indicators Pointing towards Sustainable Development”, Business and Finance Review, The News International, Monday, October 16th 2006.

Maskell, Peter and Malmberg, Anders, 1995, “Localized Learning and Industrial Competitiveness”, Ministry of Finance, Government of Pakistan, and USAID.

Nazar, Yousaf; “Economy: Challenges Ahead”, Economic and Business Review, the Dawn News, 1-7th January, 2007.

Omar, Kaleem, “The Ups and Downs of Pakistan’s Economic Scenario: A Review” Business and Finance Review, The News International, Monday, January 8th 2007.

Oral, Muhittin and Ozkan Alev O., Apr., 1986, “An Empirical Study on Measuring Industrial Competitiveness”, The Journal of the Operational Research Society, Vol. 37, No. 4, pp. 345-356.

Paulo, Sao; “barzils’, China’s Economies Compete”, Business and Finance Review, The Daily Times, Tuesday, April 3rd, 2007.

Porter, Michael, E.; ed, “Competition in Global Industries”, Harvard Business School Press, Boston

“UNIDO Industrial Development Report 2002 – 2003”, United Nations Industrial Development Organization.

Wignaraja, Ganeshan and Joiner, David, 2004, “Measuring Competitiveness in the Worlds Smallest Economies: Introducing the SSMECI”, Economic and Research Department Paper Series, N0.60.

World Bank Documents, 2006, “Pakistan Growth and Export Competitiveness”, Report No. 35499-PK, World Bank.


Monetary and Fiscal Policies

Shahid Kardar*

Abstract

Though the Pakistani economy had recently achieved some level of macroeconomic stability, at present there are fears that this stability could be threatened. This paper looks at monetary and fiscal reforms over the last decade and focuses on the areas that need to be addressed on both fronts. In particular, the paper looks at how present monetary policy needs greater clarity and how fiscal policy needs to focus on raising public savings and diversifying the sources of borrowing.

Introduction

With inflation still hovering around 8%-despite the monetary tightening over the last two years, a fiscal deficit threatening to cross 4.2% of GDP and the reversal of the current account surplus into a large deficit that could touch 5.5% of GDP, there are understandably fears that the macroeconomic stability achieved after a long and hard struggle, with a fair sprinkling of luck thrown in by the events of 9/11, has been lost. These macroeconomic imbalances are inducing pressures and new challenges for sustaining the present healthy rates of economic growth.

At a time when monetary policy was the easiest to handle, thanks to the surfeit of liquidity and the abundance of cheap money in the financial system (from donors in the form of aid and from overseas Pakistanis in the form of remittances), the State Bank did not perform its principal duty of controlling inflation with distinction. Inflation soared not simply because of the oil and food price inflation but largely because of a loose monetary policy5. The State Bank allowed a huge increase in money supply, well above the rate justified by the expansion in the economy. Resultantly, Pakistan has the dubious distinction of having the highest inflation rate in this region; inflation has also been outpacing that of its trading partners and * Former Finance Minister, Government of the Punjab. 5 See Khan and Schimmelpfennig (2006) and Qayyum (2006).

Shahid Kardar 44

competitors. A good part of the problem of inflation has been fuelled by the consumption (private and public consumption) and investment boom of recent years, well beyond the production capacity of the economy (a gap of almost 4% of the GDP). The widening current account deficit is a classic sign of overheating and excessive demand build-up as domestic output fails to keep pace with surging demand facilitated by easier availability of credit, especially in the form of consumer financing.

The gap between government expenditures and its tax revenues continues to be close to 7 percentage points of the GDP, the differential that existed in 1999/2000 with the tax to GDP ratio actually worsening from 13% of GDP in the early 1990s to under 11%. That some of this gap is presently being filled by non-tax revenues which are expected to decline as the more profitable enterprises are privatized, cannot be a source of comfort for the future in terms of sustainability.

Another worrying feature is the growing savings-investment gap. This is presently being financed through remittances and non-secure sources of funding such as FDI (largely as privatization proceeds), external financing from Eurobonds, GDRs, donors and remittances, which also enabled the government to keep bank borrowings lower than what they might have been otherwise. Maintaining this large and widening gap will not be possible over a longer period.

The scope of this paper is, however, limited to an examination of monetary and fiscal polices to date and to propose a strategy for the future.

Financial Sector and Monetary Policy Reforms

The key measures that lay at the heart of the financial sector reforms initiated in the early 1990s included the enhancement of competitiveness in the banking sector through the privatization of financial institutions (FIs) and the easing of market entry of new FIs, improvements in their capital adequacy, reduction in the fragmentation of financial markets through the deregulation of interest rates on deposits and loans, a partial switch over to indirect marked-based instruments for monetary management6, the gradual dismantling of the system of directed and concessional credit schemes, facilitating the flotation of new securities through legal, policy and other procedural and regulatory reforms, strengthening the health of the banking

6 The State Bank continues to buy government paper and use primary auctions for monetary management.


45

system through Prudential Regulations (PRs), and by strengthening the capability of the SBP to fulfill its functional obligations.

In the realm of monetary policy the benefits of the financial sector reforms are visible in the development of a somewhat competitive money market for government paper (reflected in the dealers’ market operating on narrow spreads between the bid and offer rates)7, and a well functioning secondary market for treasury bills, while the market for corporate debt, although thin, presently (owing to the lack of liquidity in the market and the time it takes to settle transactions) is beginning to show promise. Success has also been achieved in resource allocation by making lending based on sound economic and financial criteria, creating more developed money and capital markets that are mobilizing savings and making them available to the most efficient users, through appropriate incentive systems instead of discriminatory direct controls.

However, the bulk of the intermediary functions of the financial sector and the State Bank of Pakistan’s monetary stabilization efforts are performed for the government or essentially dictated by the government’s financing requirements. Even after the grant of autonomy to the State Bank, its principal activity has been to raise financing for the government. Since its monetary management is virtually driven by the borrowing needs of the government, 88% of its Net Domestic Assets (DNA) and 39% of total assets comprise advances to the government. In fact, in FY06, the SBP claims on the government increased by more than total government borrowings from banks-the main factor behind the increase in reserve money. Similarly, the banks hold close to 40% of their assets in the form of cash with the SBP, government securities or advances to it for commodity financing. Add to it the savings in the National Savings Schemes (at Rs. 860 billion, 11% of GDP) and we get an idea of the scale of the economy’s financial savings mopped up by the government

Moreover, the direct financing arrangements between the GoP and the SBP, whereby there is an automatic replenishment of the Government’s account with the SBP without any limit, by issuing treasury bills, has not been substantially altered. The SBP appears to be lending money to the government against securities, which it then offloads in the market. Although the potential inflationary impact of such government borrowings

7 Although the rate is being forced through the State bank’s intervention and its statutory liquidity requirements.

Shahid Kardar 46

becomes sterilized, the legal and practical autonomy of the SBP to apply its monetary management policies independently is compromised8.

It is also interesting to note that the State Bank’s prudential regulations with respect to capital adequacy requirements for commercial banks have also reinforced and strengthened the role of the banks in holding government securities. All commercial banks are required to maintain a minimum capital to total risk-weighted assets ratio of 8%9. Resultantly, along with having to bear the cost of funds for holding government securities, banks are also required to carry the burden of an additional charge on their activities, which in turn depends upon the categories of assets held in accordance with the risk-weights assigned to each. Presently, the risk weights assumed are zero for investments in government securities and 100% for practically all categories of loans including those to the most credit worthy corporations and businesses; even the balances held with scheduled banks are assigned a risk-weightage of 20%. With this difference in relative capital costs owing to these risk weights, the manner in which the capital adequacy norms are being applied has also created an incentive for banks in favor of investments in government guaranteed securities. In other words, the large sums invested by the banks in government paper are simply the natural outcome of these policies.

The author is aware that the State Bank is moving towards a refinement of these norms. However, even if these norms are changed, as they must be, it does not follow that when the commercial banks reduce their investment in government securities they will necessarily increase their loan portfolio at the same pace. As other financial institutions pick up these securities there would be a flow of household savings to them, resulting in a shrinking in the deposit base of banks with, perhaps, only a marginal increase in the total value of loans and advances made by them.

While some indicators, especially those pertaining to the availability of different products, efficiency and customer satisfaction have improved, other features depict less than satisfactory development. For instance, the money (M2) to GDP ratio, which is supposed to signify financial deepening, has risen by just 4 percentage points, from 40% to 44% between 1985 and

8 In India there is an agreement between the government and the Reserve bank of India that there will be no automatic replenishment as a result of which the central bank has acquired a semblance of independence. 9 The State Bank also has to sterilize large remittance inflows selling government securities in the absence of other paper for such activities. Thus the banks end up holding more government securities than what they would have if they had simply followed the requirements of the Prudential Regulations.


47

2006 (suggesting that a major part of the economy is still non-monetized). It is not clear how much of this increase can be attributed to the reforms. Similarly, although deposits as a percentage of GDP have declined from 42.4% in 1997 to under 39% in 2006 this is largely because of the GDP rebasing effect. In comparison with the ratio for 2002 it has increased by 4 percentage points10.

To eliminate the monetary overhang of the previous six years and to curb demand, the SBP has been following a tighter monetary policy in the last two years (only in FY06 was the growth in broad money less than the nominal growth in the GDP) to curb demand. The banking system which was flushed with funds provided consumer finance liberally resulting in a further increase in money supply. This contributed to the fuelling of inflation (Figure 1)11 and forced the SBP to intervene through open market operations to squeeze money supply, although it did so with an inordinate delay. This strong monetary growth reflected largely in the abrupt increase in private sector credit, has sharply raised the general price level and prices of assets - land and equities.

Money Supply Growth, Domestic Credit Growth and Inflation

-5.00.05.0

10.015.020.025.030.0

1996-97

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Figure 1: (right hand axis is for inflation and the left hand axis is for MSG and DCG)

To curb the stubbornly high inflation through a tighter monetary policy, the SBP raised the Reserve Requirements of banks from 5% to 7% 10 The low deposit to GDP ratio also raises questions about the efficiency of the banking system and the level of transaction costs that could be serving as a disincentive to the use and growth of the banking sector. 11 I am grateful to Wasim Shahid of PIDE for preparing all the graphs used in this report.

Shahid Kardar 48

and the Statutory Liquidity Requirement on time and demand liabilities from 15% to 18% and the discount rate by 50 basis points, which while achieving the objective of a tighter monetary policy also made government borrowing cheaper than it might have been otherwise if only the discount rate had been raised. Presently, however, real interest rates on deposits are negative (the high rate of inflation keeping them negative) which, following the recent decision to permit institutions to invest in NSS instruments, is likely to encourage disintermediation, thereby forcing banks to compete for deposits by raising rates, especially for the longer tenor ones. Interestingly, the spread between the average deposit and lending rates continues to be high, having widened since the huge inflow of remittances and the notable growth in the economy, reflecting poorly on the efficiency and competitive environment in the banking sector.

In conclusion, however, it could be argued that in view of some of the trade-offs there is admittedly a need to strike a delicate balance, but only in the short-term, between the excessive tightening for demand management reasons and the momentum in economic growth. However, the question remains if these should be the concerns of the State Bank or should it merely focus on controlling monetary growth to restrain inflation, since empirical research has shown that low and stable inflation is conducive to economic growth, partly by ensuring that the expected rate of inflation of the general price level ceases to be a factor in business decisions12.

Lack of Clarity on Objectives of Monetary Policy13

A conundrum is the lack of clarity on the objectives of the present monetary policy. In the absence of the clarity of signals one should be excused from assuming that the State Bank is still trying to keep interest rates low as well as maintain, if not fix, the exchange rate, although basic economics inform us that you can cannot fix both simultaneously over a long stretch of time.

In other jurisdictions the performance of the central bank is judged by its success in controlling inflation. In Pakistan, the State Bank’s previous leadership stoutly defended its monetary management aimed at pump priming of the economy resulting in inflation almost reaching double digits. It justified adopting an accommodating monetary policy that stimulated economic growth by keeping interest rates lower than the rate of inflation

8 See Feldstein (1997), Goldstein (1995), and Mishkin (1997). 13 This section of the paper has benefited enormously from discussions with Dr. Nadeem-ul-Haque.


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(especially hurting depositors in the process) and did not use the capital inflows from abroad to retire expensive debt. The pursuit of this strategy and a monetary policy that was working at cross purposes, however, compromised its role as an independent agent mandated to keep inflation in check through interest rate adjustment.

Loose monetary policy, partly owing to the fiscal dominance in influencing this policy (see below) has fuelled the rate of inflation as well as the recent widening of the trade deficit. Simple, well-known, economic propositions inform us that monetary expansion or contraction leads to an increase or decrease respectively of aggregate demand which in turn directly impacts on import demand. In other words, monetary contraction will reduce overall demand and import demand and facilitate the trimming of the trade deficit. In most cases monetary tightening does not affect exports since these normally respond to external demand. Contrary to claims that monetary contraction will raise interest rates and adversely affect export competitiveness if monetary tightening lowers the rate of inflation and thereby the cost of production, exports could actually increase. Therefore, monetary contraction should be the appropriate policy to reduce the trade deficit.

A contractionary monetary policy that reduces aggregate demand will tend to depress growth. But this is a price that will have to be paid to return to macroeconomic stability. However, the likelihood of its recessionary impact tends to get overstated. Empirical studies have shown that the interest elasticity of investment and GDP growth may not be that strong; it is issues such as poor governance, policy uncertainty and slow structural reforms that pose more fundamental problems. Even the Pakistani case shows lack of any significant increase in investment despite interest rates being negative in real terms for a significant period.

Allowing monetary policy to inflate the economy has long-term consequences as economic actors factor in inflationary expectations into their actions to address the uncertainty induced by decision makers. The State Bank has to earn for itself the credibility of a responsible monetary manager, which it lost through the footloose expansion that it had permitted earlier.

The State Bank can use a combination of interest and exchange rates to manage aggregate demand. The exchange rate policy facilitates switching of demand from foreign goods to domestic goods, with an undervaluation making domestic goods cheaper relative to foreign goods, thereby improving the external balance.

Shahid Kardar 50

Depreciation will also reduce the domestic cost of production and have a favorable impact on the trade balance. Hence to deal with a trade problem, depreciation is always a real policy choice. In any case, depreciation becomes necessary after a period of monetary expansion. During a longish period of monetary expansion, domestic inflation grows at a faster pace than inflation among our trading partners and competitors. This inflation differential will eventually have to be bridged by currency depreciation. Of course, a depreciation in the exchange rate will have an impact on the rate on inflation to the extent of the share of traded goods in the economy.

The rupee is currently overvalued. The standard, and hackneyed, argument of policy makers that the price of the rupee is no longer determined by the government but by the market and since capital inflows, most of which are non-debt creating in nature (foreign remittances, privatization receipts, donor grants and direct foreign investment) are largely financing the deficit on the external trade account, the value of the rupee continues to be steady. Even if their contention that the market is determining the value of the rupee were to be accepted, the question is whether allowing foreign exchange inflows (most of which are non-secure in nature) to keep the value of the rupee artificially higher (while also requiring monetary management to be more stringent) than it would be otherwise is a good strategy for the profitability of our exports, especially considering that our domestic rate of inflation is significantly higher than that of our trading partners and competitors. The lowering of the profitability rates and levels in the export and modern sectors of the economy is acting as a disincentive to invest in these sectors. Hence the movement into other activities like real estate and the stock exchanges, and to some extent in manufacturing for the domestic market in the more protected industries.

If China were to follow this advice, the value of the Yuan would be appreciating (since it has a huge trade surplus with the rest of the world and is also experiencing large capital inflows). China, by not choosing to sharply revalue its currency upwards and maintaining a highly competitive currency, has not only made it exceedingly difficult for the competitiveness of our exports, but has also kept profitability and investment high in its exporting industries. So, who is suffering on account of this reality? If, when we find our strategy unsustainable (especially when there are no privatization proceeds to finance part of the trade deficit), we decide to adjust the value of the rupee, some of our export markets would have been lost, having been captured by others, and our re-entry in these markets is bound to be awkward, if not impossible.


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The responsibility of the State Bank is to develop a credible monetary policy that neither inflates nor deflates the economy. This requires patient research and handling. Without a credible monetary policy, which lowers inflationary expectations, we could be supporting a vicious circle of exchange depreciation and inflation. In other words, a devaluation of the rupee will also have to be backed by a reasonably tight monetary policy to deal with a trade deficit/inflation problem.

In general, interest rates move slowly in response to changes in liquidity. According to the SBP Annual Review of the Economy, 2005/6 recent research on transmission lags suggests that monetary tightening impacts significantly on inflationary pressures over a 28 month period. If interest rates are to become a policy variable then the government should become neutral to them. And it will become neutral only if it reduces its borrowings considerably. This means that the fiscal deficit must come down for credit markets to function smoothly.

Fiscal Policy

As mentioned above in the introduction, the overall fiscal deficit has been rising14 (Figure 2). This expansionary fiscal stance of the government, given weak domestic resource mobilization, has not been consistent with the SBP’s tight demand management posture and has induced risks through the stoking of inflationary pressures and the stress it brings to bear on interest rates for managing demand. The degree of impact also depends upon the manner in which the government finances its fiscal deficit - its present monetization through heavy borrowings from the SBP directly rather than from the financial system.

14 However, to give the government its due, part of the borrowing was prompted by the expenditure requirements for earthquake relief and rehabilitation operations, which have contributed just under 1% of the GDP to the fiscal deficit

Shahid Kardar 52

Fiscal Deficit as a percent of GDP

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Figure 2:

In my view there has been an overemphasis on the revenue side of the equation and little has been said or examined about the level and efficiency of government expenditures, with good governance associated with transparency and accountability as the key drivers for improving the productivity and efficiency of government expenditures.

There have been no significant reforms in government spending and a huge problem lies unaddressed on the expenditure side. It is a big black hole and a great deal of adjustment needs to be made both in terms of the structure and the efficiency of public expenditures, particularly with respect to defence related expenditures; while absorbing a third of government revenues15, they are characterized by complete lack of transparency (it being reflected as a single line item in the budget). Despite our nuclear deterrent and the peace overtures to India there is no let up on defence expenditures. The current strategy is seemingly adamant that defence policy and its effectiveness cannot be compromised, whatever the costs. Confronted with such a hypothesis, it is difficult to have a meaningful debate even when our distorted priorities have resulted in 6 soldiers per doctor and 1 teacher for every soldier.

15 The expenditure is higher because military pensions, which are in excess of Rs. 30 billion per annum, are under civilian pensions, and expenditure supported by US military aid of more than US $700 million per annum for the fight against terrorism has also not been factored in.


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The composition of public expenditure has also become unbalanced because of inflexible expenditure commitments. Resultantly, much of the fiscal space created by the recent rescheduling and re-profiling of debt has been absorbed by the rigidities in non-development expenditures – particularly salaries of a bloated civil service with few relevant skills required to manage a modern economy in a highly globalized world.

This author is of the opinion that there is a need to downsize the government by means of its steady withdrawal, especially that of the federal government, from many of the functional responsibilities that it has taken upon itself. The functions so relinquished should either be organized by the private sector or should be hived off to lower formations of government by reducing the multiplicity of agencies engaged in similar activities. In particular, the government continues to devote a disproportionate share of its resources to activities that would be more efficiently provided by the private sector. All this, combined with endemic governance issues, has resulted in accumulated losses of public sector enterprises crossing Rs. 250 billion with an annual addition in excess of 1% of GDP16. Although some public sector enterprises and the CBR have been performing relatively better than other public sector entities, the woes of PIA, WAPDA, Railways, KESC (even after privatization based on written agreements with the private owner and operator) etc. continue to dog the contribution of the public sector to national savings, which are adding to the rapid growth in the quasi-fiscal deficit. In other words, there are hidden deficits because of losses of public sector enterprises that have not been accounted for in the fiscal deficit. Such “creative accounting” has resulted in lower fiscal deficits. The fiscal deficit would also be higher if the desirable amounts of funding were to be made available for improving service delivery in the social sectors.

Another persistent issue concerns the low efficiency of public sector expenditures in terms of the higher costs per unit of public sector construction projects because of corruption, poor competence of the government and other leakages. There is evidence that it would cost the government at least 50% less to fund schooling through privately managed institutions (and that too of better quality) instead of delivering education through the publicly run schools.17

16 These are estimates obtained from various reliable sources since the government does not report the financial results of public sector corporations regularly reflecting poorly on its claims of transparency. 17 The Punjab Education Foundation is funding private schools by providing Rs.300 per child enrolled (compared with more than Rs. 450 per child per month that it costs the

Shahid Kardar 54

To check the growth in the fiscal deficit and the level of debt, the GoP has adopted legal ceilings (as a percentage of GDP) for advances to the government through the Fiscal Responsibility and Debt Limitation Act. However, the legislation aimed at reducing the fiscal deficit has several weaknesses. Some of these are discussed below.

Whereas it proposes to pare the deficit on the revenue account, such a reduction and the lowering of the debt to GDP ratio could be achieved by different compositions of budgetary expenditures with sharply different outcomes. For instance, the same level of revenue deficit can be realized by cutting back much needed expenditure on the repairs and maintenance of installed infrastructure (as is happening in Sindh which claims that its overdraft with the State Bank has turned into a positive cash balance). This lowering of expenditure, and the resulting deferred maintenance, would eventually get reflected as development projects in future years- a strategy that successive governments have been guilty of adopting in the past. Such an outcome, obviously, cannot be the objective of the proposed enactment.

While the government has been able to lower the debt to GDP ratio to 60%, a target set for 2013 under the Fiscal Responsibility Act, and has also succeeded in sharply bringing down the ratio of interest payments to GDP from 6.9% in FY00 to just over 3% in FY06, the reduction can be achieved by the government cutting back on priority investment expenditures and on social safety nets (as is the case today, being barely 0.3% of the GDP) rather than raise taxes or rationalize user charges (as has been happening in recent years), with all its implications for economic activity in general. There would be little economic justification for restructuring government investment that could have a high social return, since there are externalities of some investments that need not contribute directly to government revenues.

Furthermore, although the stock of debt to GDP ratio has fallen dramatically, the debt profile has not improved to the extent that it should have, given that the financial system was flushed with funds, suggesting that the Federal Government has managed its debt poorly. When it could have borrowed long at low interest rates, for a while it stopped issuing 7 to 10 year Pakistan Investment Bonds. It chose instead to offload 6 month T-bills at 2% or so when inflation had begun to climb and there was every sign that the interest rate structure would change and rates would rise sharply.

government to educate a child in a government run institution) and running half-yearly quality assurance tests to ensure that assisted schools are providing a minimum acceptable level of education in terms of student learning outcomes.


55

This flawed strategy cost the government and the tax payers dearly as the debt profile became skewed in favor of short-term debt. The opportunity cost of this poor financial management has been massive – it could be as much as Rs.100 billion over the next 10 years. While the government would, and should, have raised more long-term relatively cheap debt, it took the bizarre decision to discontinue issuing bonds of longer term maturities and relied more on short-term bonds18.

Moreover, there is also a need to distinguish between the structural and cyclical components of the deficit, a need to improve the cost effectiveness of government expenditures and to raise the tax to GDP ratio over time. Without a stipulation separating the structural from the cyclical components of a deficit, the present government would not have been able to undertake the kind of capital restructuring of KESC, WAPDA and PIA that have been, or will be, forced upon it, which, in the past pushed the fiscal deficit beyond the targeted level.

Treasury bills and other government bonds held by the State Bank essentially serve the purposes of a monetary policy. This holding may increase or decrease based on open market operations conducted by the SBP19. Since one of the implicit aims of the proposed legislation is to grant greater independence to the SBP to conduct its monetary policy, then the SBP’s holdings of such government securities should be excluded from the purview of this legislation. This is because these bonds would not, in the true sense of the term, constitute a part of the government’s debt, since the SBP is in itself a part of the government and if a consolidated balance sheet were to be prepared, this debt would be cancelled as a contra item. This writer would, therefore, propose that, in keeping with the spirit of the Act, only that part of government debt held by households, companies, and financial intermediaries/institutions should be regarded as public debt, since the servicing of only this debt would generate a flow of funds (in the form of payments) from the government to the private sector of the economy.

Revenue Mobilization and Taxation Structure

18 As a result of poor monetary and debt management a huge opportunity has also been lost to develop a market for low cost housing finance, hitting the less affluent segments of society, already suffering from the ravages of inflation, even more. 19 Ideally this legislation should also prevent the government (on the basis of a phased program) from accessing the SBP for financing. Under the latter arrangement, the SBP would only function as an agent of the government in financial markets.

Shahid Kardar 56

Largely owing to the recent rebasing of Pakistan’s national income, the inclusion of new sectors to reflect the changing structure of the economy and the revision in the contribution of some sectors to this emerging pattern, Pakistan’s revenue performance now seems to be out of line with the tax efforts of other countries with similar per capita GDPs. An IMF cross-country comparison shows that:

a) Pakistan’s revenues from taxation are still hovering at under 11% of GDP (Figure 3), the lowest among regional countries, being at least 2 percentage points lower than the average for its South Asian counterparts Bangladesh, India, Nepal and Sri Lanka; and

b) The tax to GDP ratios of other comparator economies (such as Bolivia, Egypt, Indonesia, etc.) is 7 to 8 percentage points higher.

Total Tax as a percent of GDP

10.9 10.8 10.810.6 10.6

10.8

11.4

10.8

10.0

10.7

9.0

9.5

10.0

10.5

11.0

11.5

1996

-97

1997

-98

1998

-99

1999

-00

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

Figure 3:

A positive feature has been the reduced reliance on revenues from the taxation of foreign trade. However, since customs duty reductions to improve efficiency in production and trade were introduced at a rate faster than the corresponding reforms in GST and direct income tax, there was a loss of revenues as increased revenue from reforms in GST and direct taxes did not materialize at the projected pace. Resultantly, so far we have a narrow and concentrated tax base, almost half of the tax revenues are contributed by imports, and domestic taxes to GDP ratio continue to be below 5%. Even in the latter case just 6 items, particularly telecommunications, fuel and energy, motor vehicles and iron and steel, account for more than half of indirect tax collection.


57

While tax revenues have increased sharply in rupee terms in recent years, this growth has barely kept pace with the growth in the economy. The tax to GDP ratio has remained flat, if not having declined, partly because of continued tax reliefs (e.g of agriculture from income tax and of freight and services such as railway fares, professionals - lawyers, doctors, accountants, architects, engineers and tax and other consultants - from GST) and additional exemptions. The buoyancy in tax revenues has been substandard20, reflecting on the tax structure riddled with exemptions and administrative weaknesses in the collection machinery and compliance systems and procedures- the latter partly owing to express government policy to reduce the cost of doing business. In my opinion, the mobilization of tax revenues is also difficult because of the lack of faith of people that the government will honor its social contract to deliver basic services and utilize resources judiciously and prudently following generally accepted principles of propriety (as should be expected from a trustee of public funds) and not used to finance luxuries and junkets of the rulers and their cronies.

However, despite the narrow base, one key factor underlying the high cost of doing business in Pakistan is the system of taxes. Not only is the system characterized by both multiple taxation and agencies (e.g. GST on Services, professional tax by provinces and professional fees by district governments) and high rates of corporate and, until recently, personal income taxes, taxpayers have to contend with complex rules, procedures and mechanisms employed to implement tax policies, although much has improved since the institution of the new tax laws and the introduction of a universal self-assessment scheme.

As mentioned above, although we have a lower tax to GDP ratio, our income tax rates are, at 35%, higher than those of comparator countries and some OECD and ASEAN countries- where they range from 20% to 30% (although personal income tax rates are higher in Europe), indicating the need to broaden the narrow tax base by eliminating exemptions, lowering some of the tax rates and related charges (e.g. commercialization rates) and revising the tariff structures, and ensuring better documentation of transactions and improving administrative efficiencies. As illustrations of tariff structure revisions, we need to withdraw the exemption for capital gains on the trading of shares of listed companies21, extend the scope of 20 According to the SBP, although the tax buoyancy has improved from 0.8% in FY05 to 1.2% in FY06 it is still low compared with the average of 1.33% for other economies in the region. 21 Just in the last 2 years, the stock market index has jumped from around 6,000 to over 11,000 this month (April/May 2007) with market capitalization shooting up from Rs.1.7

Shahid Kardar 58

GST on services22, make rental income taxable in the same way as income from other sources23, consider taxing gifts and introducing an inheritance tax and lowering the high import tariffs to protect the assemblers of motor cars and motorcycles which results in these enterprises collecting, as corporate profits, what would have been tax revenues.

Moreover, countries with tax to GDP ratios of 20% and above, unlike Pakistan, run and manage social welfare systems for their populations; the mismatch is stark in the visible returns that developed societies and citizens obtain from the state on the taxes they pay.

Thirdly is the issue of multiple taxes, which raises the effective rate of tax even further. For instance, the manufacturing sector pays an additional 5% tax on profit as a contribution to the Workers Profit Participation Fund, a 2% tax on account of Workers Welfare Fund, a 5% levy on the wage bill for EOBI, a 7% levy for social security, one month’s salary as bonus for workers, excise duty (in the case of some industries), an Education Cess of Rs.100 per worker, a provincial professional tax and a district government professional fee over and above the GST on its products/services.

Furthermore, bonus shares/stock dividends and realized capital gains from trading in shares, debt instruments and property related transactions (unless these represent business income) continue to be exempt from tax, discouraging investment in the productive and real sectors all of which are taxable. This discriminatory fiscal treatment creates distortions by introducing a bias in favor of investment in certain instruments and sectors.

Therefore, the existing structure should be replaced with one that has lower rates - at most 30% for the corporate sector - but with very few

trillion to Rs.3 trillion indicating that a capital gain of more than a trillion rupees accruing to holders of listed shares escaped taxation because of a specific tax exemption for capital gains arising from trading in listed securities. 22 Under the Constitution, the GST on Services is a provincial subject and the Federal Government is reluctant to extend the scope of this tax to include in its ambit powerful lobbies like lawyers and other professionals and take political flak for no return, as the entire proceeds, except for a 2% percent collection charge would go to the provinces. To improve the incentive for the Federal Government to levy this tax which could contribute significantly to revenues (since services now have the largest share in the GDP) it is time to amend the Constitution accordingly so that the GST on Services becomes a part of the divisible pool to be shared in the same ratio as other taxes under the NFC Award. 23 A withholding tax at 5% represents full and final settlement of the tax liability from rental income instead of it being treated as a tax credit in determining the gross taxable income and accordingly the tax liability of the taxpayer.


59

exceptions (to check discretion), remembering that the principle of horizontal equity is violated through both exemptions and defective definitions of ‘taxable income’. To this end, therefore, the personal income tax structure can be further simplified by having just a handful of rates (ideally just two as proposed by the Kelkar Commission in India) to minimize the impact of ‘bracket creep’ as tax payers enter higher marginal tax brackets because of the inflationary increase in incomes (unless the tax slabs are also indexed). The structure should link the progression in tax rates with the standard exemption limit of income, which should be fixed at a level that would ensure a balance being struck between revenue considerations and the capability of the administrative machinery to exploit the full potential of the revenue base. Personal income tax should, therefore, be built around at most three rates (compared with more than 15 slabs today) with a higher exemption threshold, while ensuring that all realized capital gains and receipts as wages and salaries, benefits in kind (perquisites), interests, dividends, income from agricultural activities and rent earned on property form part of the base to be taxed.

In the budget for this year (FY07), the rates of income tax were reduced after the inclusion of perquisites in calculating taxable income. While it was a step in the right direction, the main beneficiaries are again the higher paid executives. Their tax liabilities have actually declined substantially, by as much as 23%, from the tax reliefs announced, since under the existing tax regime limits on the tax exemptions on salary related allowances were already operational and hence being taxed.

There is also a need for more effective audit systems rather than dependence on voluntary compliance, in view of the high degree of tax evasion, corruption and filing of fake claims for GST refunds in the country.

Through taxation, the state reduces the spending capacity of its citizens. Therefore, any effort to raise tax revenues evokes criticism and protest, even resistance. What is less important is the inherent merit of any proposal. It is its voter, and media, acceptability which carries more weight, since tax reform cannot benefit all citizens. The more vocal the losers the less likely will it be for a proposal to be accepted unless the overall package distributes the burden fairly and equitably. The government has lost much of the moral high ground for simplifying the system because of its failure to understand the imperatives of the political economy of tax reform. A good example of the weakness in the strategy is the decision to continue to treat government employees as a special group. The tax exemption that they continue to enjoy on their allowances results in the loss of moral legitimacy of the underlying conceptual framework to correct the distortions and the

Shahid Kardar 60

potential for abuse (their perquisites being exempted from tax on the plea that their salaries were not market driven). This matter should either be treated separately or the decision not to tax the perquisites of government employees should be explained in a more transparent manner. A better policy would be to monetize the entitlement of government employees to perquisites and benefits.

Since the rules for allowing tax deductions for certain expenses are much more stringent when it comes to salary incomes than for incomes from other sources, especially with regard to verification issues, a better alternative is to raise the standard/threshold income to be exempted from taxation. There is also a desperate need to bring some conceptual clarity between the deductions or exemptions that would be allowed for reasons of horizontal equity or would be treated as critical components of an incentive framework. An example of the latter case would be the deduction for medical insurance or medical treatment. These contributions should continue to be allowed since it is a cost of being healthy and fit so as to be able to earn – i.e., a cost to earn or to maintain human capital. Medical expenses are permitted up to certain specified limits in Italy, Japan, Netherlands, USA and Malaysia.

Moreover, much more needs to be done to enhance transparency and reduce taxpayer compliance costs by making judgments of income tax tribunals and higher courts more freely available on the internet, thereby reducing the role of the intermediaries, tax practitioners, who charge clients for what should be public information.

Moving on to another major revenue instrument, the customs/ import tariff, its structure remains complex and unwieldy even after several efforts to reform it since 1991. In almost every chapter there are multiple rates, several exemptions and several conditions and lists spread over hundred of pages of the book on tariff code/customs valuation. Then there are sector-specific or use-based exemptions, for which to avail of, necessitate queries of appraisers for literature and certificates, thereby not just providing an opportunity for exercising discretion but also slowing down the clearance of goods.

On the face of it, the division of all goods into three categories (raw materials, intermediate and finished goods) that has been made for developing the customs tariff looks good in theory. It is, however, difficult to implement in practice. The concept that raw materials should be liable for a lower rate is impossible to implement practically since a large proportion of goods, e.g., chemicals, are both finished goods as well as raw


61

materials. A similar problem arises when it comes to identifying intermediate goods that supposedly attract a lower rate than finished goods. In addition to the problem of dual use, it is also difficult to draw a line between the final, finished, consumer good and its sub-assemblies. A better alternative would be One – Chapter One – rate that would address considerations of revenue, the need for giving only reasonable protection24 to domestic industry and the need for simplification.

A few easily identifiable consumer goods such as air conditioners, expensive motor car brands, tobacco, liquor, generally viewed as goods for conspicuous consumption, could also be identified separately and made liable for a higher rate.

The import duty exemptions should be phased out quickly. Unless exemptions are withdrawn it will be difficult to achieve the objectives of simplification and the speedy clearance of imports. Only life-saving goods, goods of strategic interest and security or those for charitable purposes or those satisfying international obligations should be exempt from import duties. Otherwise, relief should be granted as a support through a budgetary allocation. This will have the added advantage of being transparent, being open and subject to parliamentary and public scrutiny. However, the free flow of goods should be permitted, with a focus on intelligence gathering and valuation checks to deter import duty evasion.

Finally, lest we forget, a computerized system of customs valuation can be user-friendly only when the tariff is computer-friendly. Automation alone cannot improve matters unless the tariff structures are decongested of numerous exemptions, conditions and lists.

Admittedly however, the reality is that there are no quick fixes. Exercises to simplify tax laws and ensure effective enforcement can take several years, as the experience of even developed countries shows – for instance, it took Canada 10 years to implement the proposals of the Carter Commission.

Conclusions

The primary objective of the State Bank should be the maintenance of price stability as a major policy contribution to sustained economic growth. Hence, tighter monetary and fiscal policies (especially since the

24 Rather than the high levels of protection provided to assemblers of motorcycles and motor cars that enable them to pocket, as private profits, what would have been tax revenues from a more rational import tariff structure.

Shahid Kardar 62

primary surplus of 1.7% of GDP in FY04 has become a deficit of around 0.5% of GDP in FY06) will be required over the medium-term. However, the domestic and external debt situation, despite the high debt to revenue and debt to export ratios (essentially because of low revenues and exports), will remain favorable, as will the interest rate and exchange rate risk (again despite the rupee being overvalued, by 10% according to the IMF and around 18% by the World Bank compared with the official admission of a misalignment by only 2-4%). The State Bank should clearly spell out its monetary policy and related objectives today to achieve its inflation target of around 5% over the next 8-12 months.

There is a need to not only to raise public savings through higher revenues and better expenditure control, there is also a need to diversify sources of borrowing, in particular, as argued above, to improve the mix of short-term and long-term borrowings. Moreover, unfortunately even when it decided to resort to long-term non-bank borrowings, the government chose to do so through NSS instruments by allowing institutional investors to opt for NSS, reversing an earlier decision that had closed this option for them. This has adversely affected the development of a capital market for long-term debt, critically required to evolve a robust housing finance system and draw private sector investment into long gestation infrastructure projects.

In conclusion I would like to emphasize that apart from macroeconomic stability, governance mechanisms, institutions and the institutional environment such as the rule of law, societal norms and values, work ethics, enforcement and related costs of property and contractual rights are important for facilitating economic growth and influencing economic efficiency.

Ratio to GDP FY02 FY06

Investment 16.8% 20%

National savings 18.6% 16.1%

Domestic Savings 17.0% 14.7%


63

Tax Revenues 10.9 10.5

Total Revenues 14.2 14

Expenditure 18.5 18.2

Development Expenditure 2.9 4.2

Current Expenditure 15.9 13.6

Overall Deficit 4.3 4.2

Growth % FY02 FY03 FY04 FY05 FY06

Monetary (M2) 15.4 18.0 19.6 19.3 15.2

Private Credit 4.8 18.9 29.8 34.4 23.5

Sources: IMF, December 2006 and State Bank Annual Report, 2005/06

Growth in Money Supply and Domestic Credit

-5

0

5

10

15

20

25

30

1996

-97

1997

-98

1998

-99

1999

-00

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

MSG DCG

Shahid Kardar 64

Total Revenue as percent of GDP 5.5

4.9 4.85.0

4.5 4.14.14.04.0

3.43.23.1 3.5

13.0 3.0 3.0

2.5

2.0

1.5

996-97 997-98 998-99 999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06


65

References

Feldstein, M, 1997. “The Cost and Benefits of Going from Low Inflation to

Price Stability,” National Bureau of Economic Research paper 5469.

Goldstein, M., 1995. “Acquiring and Maintaining Credibility for Low inflation, The US Experience”, in L. Leiderman and Lars Svenensson (ed.) “Inflation Targets”, Centre for Economic Policy Research, London.

Khan, Mohsin and Schimmelpfennig, Alex, 2006. Pakistan Development Review, 45(2): 185-202. Mishkin, F., 1997. “Strategies for Controlling Inflation,” in P. Lowe (ed.),

“Monetary Policy Inflation Targeting,” Proceedings of a Conference, Reserve Bank of Australia, Sydney.

Qayyum, Abdul, 2006. “Money, Inflation and Growth in Pakistan,” Pakistan Development Review, 45(2): 203-212.

State Bank of Pakistan, 2006. State Bank Annual Report, 2005/06.


Pakistan Financial System - The Post-Reform Era Maintaining Stability and Growth

Shakil Faruqi*

Abstract

The financial system of Pakistan has undergone a sea-change owing to reforms which were implemented over a period of a decade and a half, 1992-2006. The financial system has moved towards promoting theefficiency of financial intermediation while maintaining stability and fostering growth of the economy. Financial repression of the previous decades has receded though it has not been eliminated. Now a shift is warranted for the reform and restructuring of sectoral or sub-sectoral finance which has to be activity based, not institution based. Pakistan’s financial system has entered the post-reform era with all its potentials, complexities and challenges. How well the financial system performs in this era depends on how sustainable the financial regime is and how resilient it is in coping with change and financial shocks, both domestic and global.

I. Leading Concerns

The financial system of Pakistan has undergone a sea-change owing to reforms that were initiated in the early 1990s rather gingerly, but subsequently gathered momentum, culminating in accelerated change in the structure of the financial system and a revamping of the policy and incentive regime that governed its operations. The reform era lasted for nearly a decade and a half, 1992-2006. A great deal has been accomplished during this period as summarized in this paper. There has been a paradigm shift in the financial policy regime that prevailed prior to the reform era and also during the early 1990s. These achievements have occurred amidst powerful economic and financial constraints that have persisted for many years and unprecedented events that have occurred in-between, both domestic and foreign. The financial system has moved towards promoting the efficiency of financial intermediation while maintaining stability and fostering growth of the economy. It is an enviable record of accomplishments by any standard.

* Professor, The Lahore School of Economics, Lahore.

Shakil Faruqi 68

Currently, the financial system in its structure, functions and policy regime that governs it is drastically different from what it was a decade ago. With deregulation of the financial regime, financial repression of the previous decades has receded though it has not been eliminated. Purely solvency concerns that dominated much of the 1990s have yielded to concerns of efficiency of financial intermediation and stability of the financial system in the background of a structural shift as well as operational shift discussed below.

A Shift of Focus

In this sense, the task of macro financial reforms is over, almost, but the task of financial system development is not over and this phase will be no less demanding than the previous phase. Therefore, now a shift is warranted to reforms and restructuring of sectoral or sub-sectoral finance which has to be activity based not institution based. Front line reforms have been the centre of attention of policy makers in the past. The focus now has to be on financial system development under the reformed policy regime and new rules of the game in an environment vastly different from what prevailed before. This shift in focus is also needed because Pakistan’s financial system has entered the post-reform era with all its potentials, complexities and challenges. How well the financial system performs in this era depends on how sustainable the financial regime is and how resilient it is in coping with change and financial shocks, both domestic and global; and how good and forward looking is the management of the financial system.

There are two powerful implications concerning the functions and the operations of the financial system. One has to do with the efficiency of transfer of financial resources between suppliers and users within the economy. How well this transfer occurs and on what terms and how efficiently it is performed by the financial system is of immense significance to everyone, be they households, large corporate or small and medium size businesses, or the government and its entities. The second set of implications concern a distorted distribution of resources between various segments of the society resulting from the operations of the financial system, thereby aggravating income distribution patterns that are already stacked against the poorer segments of the society. The mechanisms of resource transfer by themselves are not neutral to the social implications of the transfer.

Challenges in the Post Reform Era – Stability and Solvency

In managing the financial system during the post-reform era, the main challenge will be that of maintaining stability and sustaining high

The Post-Reform Era Maintaining Stability and Growth

69

levels of economic growth both over the short run and the long run and sustaining solvency. Short term stability is to be interpreted rather broadly to mean both financial system stability as well as economic stability though both are intrinsically intertwined. Financial system stability encompasses a viable, market-based interest rate structure free of volatile movements, strength and resilience of financial institutions to withstand market swings and external shocks, and stable financial markets free of asset bubbles and gyrations in share prices. Economic stability is largely interpreted as price stability with acceptable levels of inflation, in addition to interest rate and exchange rate stability. It is difficult to argue which one of these is more important and peg the sequencing of corrective actions, though clearly it is difficult to think of economic stability in the face of unstable money and capital markets, or in the face of widespread distress among financial institutions, or both.

Generally, stability of the financial system is largely understood as stability of the banking system only, and seldom does it cross over to concerns of stability of financial markets. Perhaps one of the reasons is that while something can be done to maintain stability of the banking system, and to some extent stability of money and short term debt markets, hardly anything can be done to ensure that capital markets remain stable beyond creating the necessary conditions with routine monetary management, if that.

This is true of nearly all countries across the spectrum, not just developing countries. Monetary authorities find themselves saddled with their mainline responsibilities, and stay away from encroaching upon the operations of capital markets, known to be notoriously fickle and having a mind-set of their own. Further, with all the information flow, their analytical and predictive capabilities, computing prowess for risk and returns, sophisticated derivatives and hedge instruments, capital market participants everywhere find themselves upstaged time and again with large equity price corrections, exploding bubbles, and massive portfolio value losses. They have yet to discover ways to simply foresee market trends, much less devise ways to ensure stability.

The comparative experience demonstrates that in the post-reform era, among newly opened and liberalized financial systems with enhanced exposure to market-based forces, both domestic and foreign, sooner or later both the banking system and financial markets have faced the onset of instabilities that eventually degenerated into financial crises with a rapidity and severity that surprised everyone. The history of the past three decades of the post-reform era among many developing countries that have gone through reform processes, is replete with banking crises or foreign liquidity

Shakil Faruqi 70

crises, or both. The resolution costs of these crises have been unprecedented in the annals of financial systems. However, this is not to suggest that Pakistan’s financial system is ripe for a similar crisis.

Are Reforms Reversible?

Ordinarily, this would be a moot question, but in the light of historical processes, one can not be so sure. It is possible though unlikely. It is possible because there is a history of system reversals and grand reversals of unprecedented scale in Pakistan. In the 1970s, the government was nationalizing financial institutions including the State Bank of Pakistan (SBP), and ruthlessly rooting out every vestige of private corporation down to puny rice husking and cotton ginning shacks in remote rural areas in the name of socialism. Nearly three decades later, private corporations are being lionized and now the expectation is that they will conduct their business as per international norms of transparency and corporate governance. There remains a sense of uncertainty with investment and business decisions and there is not much commitment to enduring change.

Reversal is unlikely and does not seem to be in the cards given what has transpired and what has been accomplished thus far. It is difficult to think of a return to state intervention and ownership; control and allocation of financial resources that held sway up until the end of 1990s; or that the openness of foreign finance with increasing global linkages will be smothered; or that the structure and apparatus of market-based finance together with a regulatory and supervisory framework and its infrastructure created with such great efforts, will all be bundled up. Yet, an ominous development is the transplanting of centuries old and obsolete modes of finance, reminiscent of barter trade, amidst a modernized system of finance and heralding this as progress. Only time well tell.

II. Banking System and NBFIs--Evolving Structure in the Post Reform Era

There have been significant structural changes at the system level in ownership, organization and operations of the banking system and Non-Bank Financial Institutions (NBFIs) such that the current system hardly bears resemblance to what it was nearly a decade ago. This happened primarily due to deregulation and restructuring not only of the financial system but also of the leading sectors of the economy, restructuring of public sector enterprises (PSEs), the rationalization of prices, interest rates and the exchange rate, and opening up of foreign trade and capital accounts.


71

At the system level, changes in the structure of the financial system occurred mainly due to the privatization of financial institutions as reflected in the asset holdings of the public and private sectors over the CY90-05 period; the entry of new commercial banks, both domestic and foreign, new micro-finance banks, and Islamic finance institutions. Simultaneously, reforms and restructuring occurred among the clients of the banking system, mostly PSEs, which facilitated changes in the financial system. Changes in the operations occurred due to the revamping of the policy and regulatory regime governing financial intermediation and deregulation. The directed credit system that prevailed until the mid-1990s with layered allocative targets for specific sectors, sub-sectors or priority categories has been replaced by a market based credit system, and the role of DFIs and specialized financial institutions has been greatly reduced. The interest rate structure and foreign exchange regimes have been liberalized and are market-based, more or less.

Privatization and Deregulation

The dimensions of structural transformation owing to privatization can be gauged from changes in the ownership structure of assets together with changes in the patterns of financial intermediation and the participation of public and private sector financial institutions. At the system level, in CY90 the share of assets owned by public sector institutions, both banks and NBFIs in the total financial system assets was about 80%, and it dropped dramatically to about 26% in CY06. The converse holds true for the share of the ownership of private sector banks and private NBFIs over these years. Since the banking system is predominant in the financial system, this shift in the ownership structure was slightly more pronounced, but closely followed this pattern of change.

While the structure of asset ownership thus shifted towards the private sector, the share of the public sector in the use of total financial resources mobilized in the country did not decrease, and this is not reflected by the share of the public sector in banking credit or banking assets alone. The reason is that nearly half of the annual flows of financial resources – the annual flows of financial savings, are being channeled to the public sector. This is being done through public sector borrowings from the financial system, NSS operations which are outside of the banking system but are a part of financial system flows, currency seignorage, and the inflation tax through their own modalities and mechanisms. Consequently, the public sector is still able to garner a hefty share of total financial resources generated in the country through the operations of the financial

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system. The crowding out of the private sector has been mitigated, but only in banking credit, not for resources at the macro financial level.

Privatization, by itself, cannot be successful unless it is accompanied by major initiatives that have to be undertaken in parallel as part and parcel of the financial system reforms. The most important is deregulation involving the elimination of the system of directed credit to market based credit and liberalization of the interest rate and exchange rate regimes as happened in Pakistan during the reform period. To ensure that privatization succeeds, the government undertook the restructuring of financial institutions prior to their privatization, underwrote the massive costs of their restructuring embedded in asset revaluation and employee severance; cleaned up the balance sheet of the dead weight of non-performing loans and other assets of dubious value through massive loan write-offs and provisioning for the NPLs. The government also had to undertake legal reforms, enact new laws or modify the existing laws of exit and entry.

In the glow of the deregulated environment, there is a swing to the other extreme, where deregulation is being interpreted by some bankers as a state of free-for-all. This has made the task of the SBP more difficult. If anything, a deregulated regime has to be more stringent and elaborate in the body structure of its laws, regulations, directives and stipulations than a controlled regime for the reason that the task of maintaining order and stability in an open market environment and free of financial distress is more difficult. The rules of the game have to be charted out over and over in an iterative fashion in an ever-changing environment until they come to grips with market realities. A delicate balance has to be struck between lack of rules and over-regulation. It is a delicate and complex task.

Consolidation or Fragmentation?

The number of bank and non-bank financial institutions is still large even though there have been some buy-outs and mergers and the entry of new banks has become more difficult given substantially increased minimum capital requirements discussed below. The number of banks is roughly the same it was five years ago. In 2005, the banking system comprised 44 institutions. Among these, 35 were commercial banks including 4 state-owned banks, 20 local private banks, and 11 foreign banks. In addition, there were 5 micro-finance banks and 4 specialized banking institutions, ZTBL being the largest. The number of NBFIs, is much larger, 160 as of last count, and their number has increased over the past five years in spite of closures, mergers and buy-outs. These include five Development Financial Institutions (DFIs), 8 investment banks, 20 leasing companies, 31


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modarebas, 40 mutual funds, 52 insurance companies including 48 domestic owned and 4 foreign owned, 3 housing finance companies, 3 venture capital companies, 3 discount houses and more than 400 brokers.

The sheer number of financial institutions, therefore, remains unwieldy and it is not healthy for the structure since it has led to the fragmentation of the banking system and NBFIs. Entry into NBFIs continues unabated, such as the new banks or finance companies which are ensconced in their niche markets, providing housing finance, consumer finance or Islamic finance. These new and old entrants, together, are marginal players in the financial system given the size of their operations relative to the mainline banking institutions as discussed below. They have ended up enhancing fragmentation because they perform similar services to existing institutions, just more inefficiently, and have a potential for mismanagement or overexposure to various risks which may cause serious financial losses and ultimately become a source of instability at the system level.

Currently, the entry of Islamic finance and micro-finance institutions is being heralded as the start of a new era in Pakistani banking and in some ways it is, given that their entry is driven by societal preferences of one kind or the other. But it is not going to help with the diversification of the banking system given that they are likely to remain appendages of financial intermediation for a long time to come. Diversification does not occur just because the number of financial institutions has increased, rather it occurs primarily when new institutions or old ones launch new business operations, introduce new products such as term lending, and begin to cover new segments of clientele. Therefore, in open financial systems, what matters is activity-based rather than institution-based diversification.

Concentration or Competition?

A look at business shares shows that banking is concentrated among the top five commercial banks who dominate the banking system in every category while the remaining banks are small players. Four of these are: NBP, HBL, UBL, MCB. The fifth one was ABL until recently and has now been displaced from fifth position by Alfalah Bank. The dominance of these five banks has diminished over the past years; yet, their combined assets are slightly more than half of the assets of the banking system; so are the proportions of their deposits and advances in the banking system. But the combined NPLs of the original five banks were higher, about three fourths of total NPLs of the banking system until a couple of years ago.

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The financial strength of the banking system, therefore, is closely tied to the financial fortunes of these large five banks. They are the price setters; while at the same time in the past, many of them were loss leaders as well. Their profitability and solvency is of systemic significance to the banking system and hinges upon the efficiency of their operations and cost effectiveness, risk management, credit outreach and their business diversification. Impetus for future improvements will come from institution-specific initiatives concerning meaningful capacity building and change management. This will happen mainly owing to pressures of profitability and efforts to maintain their relative market shares. A direct role of the SBP or the government in this arena is no longer material as it was in the past.

Financial Intermediation – Structural Change and Growth

The core function of financial intermediation in Pakistan remains with the commercial banks, not the NBFIs, and this is unlikely to change in the future. The assets of the NBFIs, both state-owned and private, as a proportion of total assets of the financial system steadily declined from 24% in 1990 to 11% in 1995, mainly owing to the closure or privatization of DFIs, or because of a much faster growth of private banks as a group as compared to the growth of private NBFIs as a group, regardless of the spectacular growth of some segments of the NBFIs such as leasing companies or Islamic finance companies.

This decline in the asset share of the NBFIs is reflective of a faster decrease in the share of advances, since loans outstanding are the largest part of assets of a financial institution any time. In 1990, advances of the NBFIs were 27% of financial system advances, and declined to 7% last year. If we add Islamic finance, this proportion increases slightly. Currently, deposits of the NBFIs as a group are a minuscule proportion of the total financial system deposits, at about 2%. If we add the deposits of Islamic finance, this proportion increases to about 3%. For these reasons, the focus has to be on the operations of the banking system. The role of NBFIs has been marginalized no matter what indicator is used and they are not significant for the future of the financial system of Pakistan.

The deregulation of the interest rate structure occurred gradually and the regime has undergone a significant change during the reforms from administered rates to market-based rates. This transition was not smooth as there was periodic volatility in interest rates but not destabilizing movements. This is a considerable achievement of the monetary authority, the SBP, when observed in the light of comparative experiences of financial reforms in similar phases in other countries. The SBP discount rate has now


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firmly established itself as the anchor rate for the banking system after several iterations and fine tuning of auction mechanisms during the 1997-2002 period.

As regards the long term trend of interest rates on the lending side, the weighted average lending rate of commercial banks was rising throughout much of the 1990s and reached a peak of about 16-17% in the late 1990s, though this weighted average hides a significant variation of up to 20-22% on the high side. Thereafter, these rates began to decline and reached their lowest point of about 7-8% by CY04. Since then, lending rates began to rise again and currently they range between 10-12% for mainstream borrowers and 15-17% for fringe borrowers.

The trend of interest rate changes on the deposit side is similar. There was significant volatility over the reform period. The weighted average deposit rate through much of the 1990s ranged around 8%. Towards 1999, a slide of major proportions occurred and the weighted average deposit rate fell drastically to about 2% by 2004. Since then deposit rates have recovered to about 4% currently. Deposit rates of NSS have also fallen from 14% to 10% for long term mainline instruments over the same period and are about 9% currently.

Thus far, the banking system has withstood volatility of interest rates and has emerged with stronger earnings and profitability through managing associated interest rate risks. As for lending, it is unclear how much of the banking system loan portfolio has been rebalanced with the current structure of interest rates – the financial liability related turnover of credit, because borrowers effectively recycle the shorter loan maturities relatively easily than their medium to long term maturities, which are a small proportion of the commercial banks’ portfolio.

There has been a strong growth of deposit mobilization by the financial system, inclusive of NSS during 1995-2005 averaging at about 15% per year. The rate of growth of deposits during CY90-CY00 was 12%. Later on, during CY00-05, this rate slowed down to 11%. In part, this growth occurred because of phenomenal growth of NSS deposits at an average annual rate of 24%. As it was, banking system deposits also increased at the rate of 9% annually over the CY95-00 period. Subsequently, this situation reversed; during CY00-CY06 the annual growth rate of banking system deposits nearly doubled to 16% while that of NSS dropped to 7%. If NSS deposits are set aside, then practically deposit mobilization by the banking system is all that matters at the financial system level while shares of NBFIs and Islamic banks remain at about 3% and are inconsequential. Deposit

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taking activities of fringe segments such as finance companies, Islamic banks, micro-finance banks and NBFIs do not hold much potential for bringing about structural changes at the system level.

One could argue that NSS operations are not financial intermediation, NSS instruments are not deposit instruments, and deposits mobilized by the NSS are a part of government operations of unfunded debt, not deposit mobilization as such, and these deposits are an expensive way of debt financing. That is largely the case because as the SBP estimates show, if the government had borrowed Rs. 230 billion through the financial market instead of NSS during FY02, it would have saved about Rs 11 billion in borrowing costs per year. The NSS, therefore, is neither a low cost borrowing source, nor a debt management system but has led to distortions in savings mobilization because of its negative impact on banking system deposits, though institutional depositors are now banned from investing in NSS instruments.

There has been significant growth of financial system credit throughout the reform period, accompanied by structural changes in the sources of credit along the privatization patterns. During much of the 1990s, the rate of growth of credit remained fairly stable at around 9% per year, but during CY00-05, this rate increased to about 12% per year with significant volatility from year to year. This expansion of credit at the financial system level mirrored patterns of growth of banking credit but in an accentuated pattern in the late reform period. The average annual growth of banking credit during the decade of CY90-00 was about 11%, and thereafter rose to about 16% during CY00-05. Lately, there are signs of a slowing down of credit expansion amidst rising interest rates. Nonetheless credit expansion is occurring at a record rate of growth. The issue is whether these spectacular increases in banking credit can be sustained, and if so, does it represent an exception to the trend, or is it the vanguard of a structural change in bank lending that was the expected outcome of decade long financial reforms and dissipation of financial repression.

There has been a reversal both in the sources of credit and allocation of credit between the public sector and the private sector owing to privatization, deregulation and the elimination of a layered system of credit allocation that prevailed earlier. At the start of reforms, in CY90 the proportion of credit extended by public sector banks was 86%, while the share of credit extended by private sector banks was only 14%. Later on, the share of private sector banks began to rise and by CY00 it was about 42%, and then it jumped to about 80% in CY06 in the wake of the privatization of UBL and HBL. There was a corresponding decrease in the share of credit


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extended by public sector banks over the same period. As regards allocation and use of credit, the share of private sector borrowings from the financial system was 55% in CY90, and slowly rose to about 60% in CY00, and then jumped to 71% by CY06, representing a significant change in uses of credit over the patterns that prevailed before.

A major issue concerning the credit system is overdraft lending which is preponderant with short term maturities, and there is not much term lending in the system. One could argue that overdraft lending with variable interest rates is effectively term lending given the perpetual roll-over of loan maturities at call, but that is stretching the point. Overdraft borrowing has a higher repayment flow than contractual term-borrowing with or without variable interest rates. Hence, term lending is more conducive for promoting longer term investments. This is the same rationale that underpinned the DFIs’ era in Pakistan in the 1950s and 1960s and also in other developing countries.

Overdraft lending creates a bias in favor of large, well-heeled corporate borrowers – the premium borrowers with substantial cash flow potential. Almost all banks prefer premium borrowers to extend large loans, thereby keeping their banking risks and cost fairly low, and are averse to diversifying their client base in favor of small and struggling new borrowers who are left high and dry. This is why SME lending, or micro-credit has not made significant inroads in the mainline banking system, not only in Pakistan but in many developing countries as well. This has forced the authorities to revive SME banks, and offer incentives for the establishment of micro-finance institutions and to revive housing finance. These are issues of sectoral finance which need an in-depth evaluation.

As a result of the above, there is loan concentration since the large amounts of credit flow to premium borrowers, though it has diminished somewhat with the drive to bring in new borrowers whose number has increased substantially. By implication, the amount of banking credit extended to medium and small borrowers is fairly low. In this regard, lending practices of banks in Pakistan are similar to those in other countries. There is also sectoral concentration of banking credit which has always persisted both in the pre-reform and post-reform period. The textile sector is the major borrower as traditionally it has been, and its share in total banking system credit has ranged between 25-31%, followed by consumer credit whose share was about 10%. In contrast, the share of agriculture sector credit has been less than 10%, and the share of trade credit to exports and imports about 8% in recent years.

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In spite of attention given to housing finance, the proportion of house building finance remains an insignificant fraction at only about 2% of banking system credit as compared to 12-18% in Asian countries and 25-35% in advanced countries. Until some years ago, the housing sector was classified by many commercial banks as an unproductive sector, even though there are roughly 38 industries whose growth is directly linked to housing construction and is a leading indicator in advanced countries to gauge the performance of the economy over the short term. Mortgage lending is beset by two issues: the prime one is the bankability of property collateral tendered and the mismatch in the maturity structure of bank funding and house building loans of long term maturities.

III. Post Reform Era – Management of Financial System

The objectives of managing the financial system are to maintain stability, growth, soundness and solvency which boils down to maintaining the sustainability of the financial system. These issues have been front line concerns of the SBP and form the core of its strategic objectives. These are: maintaining price stability with growth, broadening the access of borrowers to banking credit and the provision of financial services, ensuring the soundness of the financial system, exchange rate and foreign exchange reserve management, and the strengthening of the payments system. Stability is the prime focus of monetary management, while soundness and solvency are the prime focus of banking supervision and regulation, though there is no hard and fast division as such. The practice turns out to be that way.

Review and analysis of financial reforms in Pakistan and their impact has already been done in an exhaustive fashion in the series of the Financial Sector Assessment (FSA) reports and Banking System Review (BSR) reports launched by the SBP nearly five years ago. These two annual series are unique in that hardly any central bank among developing countries has undertaken this task as systematically as the SBP has done over the past five years. At the start, the focus was on the impact of reforms on the financial system. It has now shifted to maintain the soundness of the banking system as viewed through CAMEL indicators, and the evaluation of improvements in the system of banking supervision and regulation.

The focus of maintaining soundness and solvency centers around what the banking system does, given that on the intermediation side its role is overwhelmingly significant. The front line issue is how the banking system has fared thus far regarding soundness and solvency, and what are the prospects in the post-reform era? In this sense, managing a financial system


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is more than simply monetary management, though it is a critical element in maintaining stability and fostering the growth of the economy.

For maintaining stability and fostering growth, the foremost issue is what are the remaining distortions or weaknesses in the financial system, how significant they are, and where do they originate from? The issue for the policymakers is what is the nature of future interventions, and how to balance them with economic and social priorities? What are the intervention points, and how effectively can those be managed in fast moving financial markets, both domestic and global. The complexity of these issues will grow, not diminish, as the financial system progresses and becomes more sophisticated in a fairly open and liberalized financial regime.

On the financial markets side, the main objective is to keep money and capital markets stable and avoid volatility, swings and market corrections, if that can be achieved, though markets have a way of surprising everyone. Financial market behavior is notoriously unpredictable and there is not much that can be done to avoid periodic episodes of swings or even volatility in financial market prices and transactions. Therefore, maintaining the stability of interest rates, prices and exchange rates is regarded as a necessary condition for the stability of financial markets; that is the role of the SBP, while maintaining orderliness, participation, transparency and the integrity of financial market operations is the role of the SECP at a time of open capital accounts and FDI inflows.

Financial Deepening and Growth

A widely used indicator of financial system growth is the M2/GDP ratio because M2 is a reflection of resource mobilization of the financial system, and are liabilities of the financial system. After all, M2 is basically currency, a statutory but non-binding liability of a central bank while deposits are liabilities of the banking system. The larger the M2, the larger is the magnitude of macro-financial resources mobilized. Conversely, in repressed financial regimes with relatively low levels of financial deepening roughly at one third of GDP, economic growth would be stifled compared to what it would have been otherwise. This is the prevailing view of financial deepening.

During the second half of the 1990s, the M2/GDP ratio in Pakistan was nearly stagnant at about 37%, then jumped to around 44% during the last five years. This is a reflection of the extraordinary growth of deposits over the last six years. This seven point move of the M2/GDP ratio within a relatively short period of five to six years does not imply that a structural

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change of this magnitude has erupted from within the economy. For one, a good deal of increase in this ratio owes to expansion of net foreign assets and a large part of the economy still remains undocumented and operates outside the financial system.

Currently, Pakistan’s M2/GDP ratio is much lower than that prevailing in other Asian countries. In 2005, this ratio in India was 67%; in the Philippines 53%; in Thailand 96%, and in Malaysia, 106%. Therefore, there is ample room for further increase in the M2/GDP ratio and growth. This shows that the necessary conditions for future development of the financial system have largely been taken care of and now is the time to tackle sufficient conditions through diversification and consolidation of the banking system, restructuring of priority sector financing at the sectoral level, capacity building, and corporate governance of financial institutions. The reliance on the M2/GDP ratio to gauge the depth of financial intermediation is weak and may be supplemented by looking at the trends on the asset side, the asset/GDP ratio, which has increased from 54% in the mid-1990s to about 62% currently. This ratio also reconfirms that financial deepening has a long way to go to reach levels observed in many countries where it exceeds 100%.

Monetary Management – Stability

It is in this background that we need to have a look at monetary management in Pakistan. Overall, the SBP has been very successful at monetary management over the past years and has been attuned to the needs of maintaining stability at a time of transformation within the banking system and volatility in financial markets. The SBP has achieved a skillful switch-over from a system of direct monetary controls that prevailed until the late 1990s to the deployment and calibration of indirect monetary instruments in a liberalized environment such as cash reserve requirements (CRR), statutory liquidity requirements (SLR), SBP discount rates, and open market operations. More importantly, reserve money has finally acquired the backing of large foreign exchange reserves, which was not the case some years ago. The role of the interest rate has been enhanced after the withdrawal of the Credit Deposit Ratio (CDR) as the leading instrument of credit control. Therein lies the shift from a direct to indirect system of monetary management.

The SBP has also been quite successful in steering a tight or easy monetary policy stance during the past four years as warranted by short term trends and has established good operational mechanisms. The movements in the structure of interest rates has followed a monetary policy


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stance over the past years, by and large, led by the SBP discount rate which has always been a powerful tool of monetary management. The banking system is responsive to signals conveyed by the monetary authority though there is periodic slack in the speed of adjustments and there are rigidities.

These elements have helped to keep inflation under control and maintain price stability over previous years, though the price level has been under severe pressure for the past couple of years. The rate of inflation declined steadily from about 13% in FY95 to about 3%, then to 9.3% in FY05. Since then, there has been some moderation in the levels of inflation but it remains a major concern as inflation currently is about 7%. Historically, inflationary pressures originated mainly from fiscal deficits and the consequent monetary expansion by the then banking system to meet public sector borrowing needs, and the same pattern prevails today given soaring levels of fiscal deficits from Rs 134 billion in FY04 to Rs 325 billion in FY06.

A good part of inflation during the 1990s occurred from imported inflation and steady depreciation of the exchange rate. These pressures were mitigated over the past few years but now have re-emerged as fiscal deficits and current account deficits have continued to rise substantially. The issue is: what are the threats to price stability and how serious are they? And how far will monetary policy be able to cope with these pressures in the future? In such circumstances, the SBP had no option but to pursue a tight monetary policy, which it has over the past couple of years, though the SBP realizes that it has to strike a balance between inflation and growth; has to moderate pressures on the exchange rate while keeping interest rates stable. However, in times of swiftly rising fiscal deficits and large inflows of FDI, a restrictive monetary stance can go only so far in maintaining short term price stability, together with exchange rate and interest rate stability.

In spite of an open foreign trade regime, liberal incentives for export, a market determined exchange rate and a large foreign exchange reserve position, current account deficits have returned with a vehemence that is reminiscent of the old days, to a record level of $5 billion in FY06 and is likely to be higher in FY07, since the trade deficit in the first nine months of this fiscal year is approaching nearly $9 billion. The silver lining is that foreign exchange reserves of about U$13 billion are sufficient for nearly a year of imports rather than for just a few weeks as in the past.

The SBP has been successful in maintaining exchange rate stability, 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 of US$ 1.35 billion in CY00, to around US$ 13 billion currently under the free floating foreign exchange rate and inter-bank foreign exchange market. There have been periodic ups and downs but in a narrow band. Recently, there has been a noticeable increase in the inflows of FDI, but nearly a third of it is in one-time foreign exchange privatization proceeds which will not recur. There is also growth of portfolio investment, but nowhere near the levels that occurred in East Asian or Latin American countries, whose abrupt return became the cause of a full blown crisis for them. There are no FDI induced bubbles to cause worry, though the capital market boom is beginning to look like a bubble situation.

Comparative experience has demonstrated that attempts to stabilize or to maintain some targeted level of the exchange rate by central banks have been unsuccessful. Some of the spectacular failures were in the early 1990s when the Bank of England tried to maintain the parity of the British pound and then had to withdraw after staggering losses within a matter of a few days. Subsequently, Bank Negara Malaysia tried to do the same, and suffered heavy losses with stunning rapidity. It is now firmly understood that foreign currency trading to corner the global currency market is suicidal which has a turnover approaching two trillion dollars per day. Therefore, maintaining the stability of the exchange rate through currency market manipulation when the Pakistani rupee is being traded actively is not an option available to the SBP except in a narrow band and for short duration.

This perception of monetary policy management amidst conflicting objectives is familiar among countries at similar stages of financial reforms. After the era of the control regime is over and the external sector is liberalized, the monetary authorities can pursue either domestic price stability or exchange rate stability, but not both with the same degree of success. Once the financial system is liberalized and financial markets begin to assert their role, and large inflows from overseas begin to occur with open trade and capital accounts, be they remittances or FDI, price and exchange rate stability then become difficult to maintain simultaneously, because the opening of capital accounts reduces the influence of the monetary authorities on interest rates and hence its capacity to affect aggregate spending.

If the authorities pursue exchange rate stability to stabilize foreign exchange inflows and keep the current account balance intact, the domestic interest rate and price stability comes under pressure because of the sterilization of FDI and other foreign currency inflows, no matter how it is done. Conversely, if they shift to maintain interest rate and price stability,


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sooner or later the exchange rate comes under pressure. For example, in times of inflation, if the monetary authority were to raise interest rates and they become higher than the international rates, it will encourage capital inflows and will depress the real exchange rates.

Banking Regulation and Supervision - Solvency

Improvements in the system of banking regulations and supervision at the SBP has been one of the leading items from the start of the reform period and it has paid rich dividends. Since then it has undergone a significant transformation and the system that prevails today is far superior than it was at the start of the reforms. Its procedures and practices have been modernized and these are as sophisticated as one would expect to find anywhere among the leading countries. The process is supported by the installation of an upgraded payments system, IT facilities at the SBP as well as at leading banks, thereby significantly improving the speed and accuracy of financial information flow so vital for banking supervision.

A major change from the old to the new is transparency in the processes of supervision and regulation as to what is being regulated and why and by whom. There hardly was any meaningful information flow in the public arena concerning the operations of financial institutions, much less on the state of their financial health or their relative standing with regard to impaired capital and other systemic weaknesses that were at the root of their financial distress. This information flow, together with the analysis and evaluation of financial institutions, started with the launching of annual series of FSA and BSR reports. This transparency is critical in the post-reform era if stability, soundness and solvency of the financial system are to be achieved.

Nearly all banking and financial crises that have erupted during the previous decades, occurred in countries which had a well established system of supervision and a full awareness of the potential for crisis. It seems that no amount of banking supervision is sufficient enough to prevent the emergence of crises, and that is a sobering thought. In times of financial distress, banks and quasi-banking institutions have a way of going belly-up, not because of any lack of supervision, but mainly because of excesses of placements, untenable risk exposure, and herd behavior in garnering golden opportunities of profit or large capital gains in a red-hot market, be it the loan market, financial market, exchange market, or real estate market. That is why there is such rapidity in the onset of the crises and its monumental dimensions, once it unravels. This has happened in developed countries such 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 folded up, in spite of an enviable system of information flow and a modern supervision system.

Similarly, the Mexican crisis of the mid-1990s and East Asian crisis of the late 1990s happened even though their banking supervision and regulation systems and the sophistication of bankers and financiers and their expertise in handling capital inflows was regarded at par with international standards. They also had the knowledge and experience of similar crises that erupted previously. What went wrong and why so swiftly? The post-crisis diagnosis reveals that one of the common elements is herd behavior and overexposure of a speculative variety in a few sectors in anticipation of more than normal market returns. As soon as the inflow began to dry out, the specter of foreign exchange illiquidity loomed large, and investors wanted to exit before imminent devaluation of the Mexican peso in the face of foreign currency illiquidity. This mass exit of foreign capital, the reverse flow, is akin to a bank run domestically. There is no safeguard against it, much the same way as there is no safeguard against a bank-run on any given day.

Further, good bankers have been known to become bad bankers, and this process unfolds right under the nose of bank examiners and supervisors. Spotting this trend is difficult; it is a matter of experience and ultimately it is a judgment call. This has happened time and again in developed and developing countries alike. How it happens is explained briefly below. Why it happens boils down to the inability of bankers or financiers to keep a lid on acceptable business risks, and tame these risks when they get out of line, but well before they are beyond any reprieve. This is a precarious rope walk. There is always an unwillingness to close losing operations, take early losses and quit in the early stages when these losses are still smaller than later on when the crisis erupts full scale.

The instinct of the bankers is to keep the borrowers alive through recycling and renewals of bad loans into loans, a window dressing exercise; or worse yet, advancing additional fresh loans to effectively insolvent borrowers to tide over what is perceived as cash flow problems and imminent illiquidity, thereby getting deeper into financial distress. In this sense, insolvency occurs first, illiquidity follows later. The borrowers are already in deep distress by then, and they are well past the stage of routine rescue operations because their illiquidity originates not from their routine business turnover and cash flows, but rather from structural weaknesses in their operations. The same occurred in the nationalized banking era in Pakistan when banks kept bailing out insolvent PSEs, lending more


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intentionally because of collusion or bad judgment, or on government directives, then writing off the loans while the banking supervision outfit was alive to these perils.

Soundness and Solvency – the Banking System

Maintaining soundness and solvency of the financial system has been the uppermost concern of the SBP. The BSR reports of SBP are focused on the latest developments in the leading indicators of soundness of the banking system, based on timely reporting by financial institutions, required under disclosure laws and regulations. The analytical approach is the CAMEL framework which is a rating system of financial institutions. The evaluation of the banking system’s soundness, as given in the SBP reports, clearly shows that financial strength and soundness of the banking system has considerably improved as evidenced by various soundness indicators at the system level, and its capability is fairly strong to withstand various types of shocks within plausible limits. It may, however, face difficulties in extreme situations, the probability of occurrence of which is largely remote.

Among the soundness indicators, the first one is capital adequacy inclusive of minimum capital requirements and an assessment of the ratio of capital to risk weighted assets. For years, the minimum paid up capital requirement was fairly low at around Rs. 500 million, and was raised to Rs. 1 billion in 2002 and again to Rs. 2 billion in 2004. This increase in paid-up capital together with cleaning up of the loan portfolio was the main element in reducing the risk factor in assets, and has led to a significant improvement in the risk weighted capital adequacy ratio, a statutory obligation for all banks regardless of their ownership.

Since the time the SBP began publishing soundness indicators in its FSA and BSR reports covering the period CY97-05, the data shows a significant improvement in the Capital Adequacy Ratio (CAR). In 1997, it was 4.5% for all banks, and jumped to 11% within a year, and since then has stayed at around the same level, though there have been variations from year to year. For state owned banks, private banks and foreign banks, the same pattern prevailed. There were annual variations in between, but the ratio remained fairly high and was not a cause for concern. In contrast, this ratio for specialized banks has never recovered from negative levels.

As part of the Basel II implementation, the banks are required to further increase their paid-up capital by Rs one billion per year until they reached Rs 6 billion by the end of 2009 by all banks and DFIs. This is an 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 levels of capital adequacy is the first insurance against the insolvency of financial institutions, and once the range is reached, solvency at the system level is assured. A swift rise of minimum capital requirements to such levels, however, would be a powerful barrier to entry for new banks seeking incorporation, though not for non-bank entities which are incorporated under the companies charter. These requirements will discourage not only the entry of new banks, but will also hurt competition, and will encourage non-bank companies to enter the NBFIs group which is likely to add to the fragmentation of the financial system.

Burden of NPLs - Asset Quality

The asset quality indicator revolves around the proportion of risk weighted assets or the proportion of non-performing loans (NPLs) in total assets. These ratios indicate that there are no threats to solvency of the banking system that loomed large during much of the 1990s mainly due to the rise of NPLs. The management of NPLs by the banking system has considerably improved over the past years, and the burden of NPLs does not pose a threat to the solvency of the banking system, large though it is. There has been a reduction in NPLs from an all time high of Rs 244 billion in CY01 to Rs 184 billion in CY06 largely because of the resolution of loan defaults, loan write-offs and several recovery drives. The proportion of NPLs in the total loans of the banking system has fallen from about 24% to about 8% in CY06. A great deal of provisioning has been done by the banks since the early 1990s and the total amount is estimated at Rs 139 billion in CY06. The amount of net NPLs, therefore, has decreased from Rs 92 billion in CY97 to Rs. 45 billion in CY06; their proportion in banking credit has likewise decreased significantly.

Hence, NPLs are no longer a systemic risk as they were in the 1990s. The solvency risk has been mitigated, though NPLs remain a drag on the profitability of leading banks and this situation will persist in the future. The resolution of problem banks, likewise, is no longer a pressing issue as it was during the 1990s when a large part of the banking system was in financial distress. There are now only three problem banks and they do not pose a systemic threat. Private banks are likely to impose a much tighter discipline on lending practices to prevent the incidence of loan defaults, but how far new NPLs will be contained remains a concern given the recently reported rise of defaults. The culture of default may have been weaned but has not disappeared. It will take a long time before good borrowing behavior is restored coupled with good lending behavior as well.


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Intermediation Costs and Spreads - Efficiency

The intermediation cost is not a CAMEL indictor, but it reflects the operating efficiency of banks though only on the funding side since it is the ratio of administrative expenses to the average amount of deposits and borrowings of a financial institution. BSR estimates show that intermediation costs during the late 1990s was about 3.5%, and then began to decline and is currently around 2.7%. This suggests that banking efficiency improved at least on the funding side over the late reform period, but still it is above the cost range prevailing in comparator countries at around 2.0%, and is much higher than the range of 1.5 to 2.0% observed in leading countries.

These intermediation costs are exclusive of provisioning costs for NPLs. Provisioning for NPLs adds close to one percent to banking intermediation costs over and above the current level of 2.7%. This is a major reason for high intermediation costs, especially for the recently privatized large banks. Part of the cost of provisioning and equity replenishments have been assimilated and recycled into the balance sheets of financial institutions thereby raising the costs of operations and thus intermediation costs, which refuse to be compressed beyond current levels.

Banking spreads have remained around 7% during most of the 1990s and have remained around the same over the recent period, even higher, at around 8%. This is not surprising because structural changes in the credit system occurred concurrently to significant volatility, both in the deposit rates and lending rates over the reform period discussed earlier. The concern that banking spreads are high is valid, but in a deregulated system there is hardly much that the monetary authority, the SBP, can do to help reduce the spread since it is embedded into the bank funding structure on one side, and into lending operations and investments on the other.

Profitability – Banking System

Recently, commercial banks have returned to profitability after persistent losses for many years, though specialized banks are still unprofitable. There has been an astounding increase in profitability which has mitigated but has not eliminated the specter of insolvency at the system level, though not at the institutional level. Nothing prevents a single financial institution becoming insolvent while the rest of the banking system is doing well and is profitable.

Profitability may be gauged through the return on asset (ROA) both before and after tax, or return on equity (ROE) before and after tax, or the

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ratio of net interest income to gross income, or the cost income ratio. All these indicators unanimously show a marked improvement during the CY97-05 period in the profitability of the banking system in Pakistan. After tax ROA for the banking system was negative until CY01 and then turned positive and swiftly rose to the current levels of about 2%, ahead of international benchmarks. After tax ROE likewise was negative until CY01, but thereafter it became positive and shot up to 26% in CY05. This jump is a one time phenomenon and is unlikely to be replicated in the future, though it is a broad indicator of a trend towards profitability. Net interest income as a proportion of gross income showed a remarkable increase from 49% in CY97 to 72% in CY05, owing to the scissor like pattern of interest rates on deposits and lending over this period discussed earlier.

A number of factors have contributed to enhanced profitability. Banks were able to lower their interest expenses faster than the decline in their interest income owing to low borrowing needs, re-pricing of their interest bearing liabilities and a large growth in non-interest income from investments and other assets over the past few years. In addition, improved operating and business practices and financial services, restructuring and reorganization and downsizing, staff reduction, branch closures, tightened internal costs, and controls on administrative expenses have helped to reduce their operating costs. Above all, a decline in the corporate taxes on banking business from 56% to 42% have improved after tax profits, and will get a further boost when the tax rate is lowered to 35%. Specialized banks have continued to suffer heavy losses throughout this period and their profitability indicators never returned positive. Lately, their losses have narrowed down but profitability remains as elusive as ever.

Managing Banking Risks

In the above context, the issue is how well the banks are able to manage banking risks with market-based interest rates, floating exchange rates and exposure in the foreign exchange reserve position, open external accounts, increased participation in FDI and capital inflows. The pattern of credit risk in routine bank lending to sectors of the economy has not changed much. If anything, it has increased owing to a move to new lines of lending such as consumer credit; but as long as exposure of the banks remains concentrated towards prime borrowers, this shift in the profile of credit risk will be manageable. If credit risk is not managed properly it eventually shows up in NPLs, or the concentration of banking credit in a few sectors of the economy, or in a few segment of borrowers, or a rising proportion of riskier loans in its portfolio during times of rapid expansion of banking credit.


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Exchange rate risk concerns the exposure of banks on their foreign exchange liabilities. The banking system was shielded from exchange rate risk in the past owing to a number of explicit and implicit safeguards extended to them by the SBP in return for their surrendering their foreign exchange inflows, be they on FCAs, remittances, or export earnings. All this has changed since then in the new foreign exchange regime whereby commercial banks are practically on their own with regard to foreign exchange risks on their reserves, exporters’ balances, foreign currency deposits, foreign exchange loans extended to the foreign companies or customers, and on their portfolio related operations in the foreign exchange markets.

The impact of interest rate risk is on the portfolio of the bank, both investment portfolio and loan portfolio, and is central to asset/liability management at the institutional level. The impact of interest rate changes is severe if there is a serious mismatch of maturity structure between the loan portfolio and deposit portfolio because of a significant divergence in interest rates associated with these maturities. Unless the bank is able to compensate on both the asset and liability sides of its balance sheet, it is likely to suffer a loss. Interest rates were falling during most of the CY95-03 period, and then they stabilized. During this period, the overall profitability of banks was not compromised. Thereafter, when interest rates began to rise over the past two years, this was accompanied by a significant growth in banking profits to record levels. This indicates that during both periods, banks were able to absorb the impact of interest rates on their portfolio, be it the investment portfolio or loan portfolio.

Likewise, banks have been able to manage the equity price risk over this period. The sustained fast growth of stock market and equity prices continues unabated, and it has further accelerated this year. The SBP placed a cap on the direct exposure of banks in stock market placements estimated at about Rs. 35 billion in CY05, though it has grown further since then. This exposure of the banking system in equity investment is not a cause for concern, because the share of direct exposure in total investments held by the banking system remains small. The indirect exposure through carry-over-transactions, badla financing, was about Rs. 8 billion in CY05, and since then it has decreased further owing to restrictions placed on badla financing. In view of this structure of the banking system’s exposure in the equity market, the degree of equity price risk is not a major concern.

From the point of view of soundness, the proposition that banks become insolvent first and illiquid later is likely to generate much debate among bankers and financiers. No matter how one perceives it, liquidity

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risk has to be managed well. Since the observance of liquidity levels is a statutory obligation, and the SLR is closely monitored by the SBP, the banking system has to keep adequate liquidity levels all times in compliance of the SLR. Observance of the SLR by itself does not eliminate liquidity risk which has emerged for the banking system partly from inflation, and partly from the rapid growth of banking credit. Currently, liquid assets are nearly one third of total assets, and this is a reasonably comfortable position for the banks; their liquidity position is in excess of the statutory requirement.

Banking System - Sensitivity to Shocks and Stress

The crux of the management of the soundness and solvency of the banking system, to the extent that it can be system analyzed, is to enhance its resilience so that it can successfully absorb moderate levels of financial system shocks and moderate levels of economic instability, while operating in the market environment with open capital accounts and a vibrant external sector. To assess the resilience of the banking system, the SBP conducted its own stress tests as reported in the BSR05 involving 12 largest banks. The exercise covered all three market risks, namely the interest rate, the exchange rate and equity price risks, and a fourth one as well, the liquidity risk. Four stress scenarios were developed for each of these risks and their impact was estimated on the combined profitability and capital of these banks as an approximation to the impact at the system level. The results show that among these four risks, the liquidity risk is relatively more worrisome and the impact of a shock is more severe because liquidity margins are thin if the liquid assets exclude near-liquid government securities. If these are included, the amounts of liquid assets with the banks increase and consequently liquidity shocks are not so severe.

Stress tests of credit risk shocks show that the degeneration of position of NPLs is not a material threat to their solvency; it is manageable and banks will be able to withstand a degeneration of their portfolio quality except for extreme situations which are unlikely to occur. The impairment of the quality of the portfolio is exhibited in rising levels of NPLs. Test results show that the capital adequacy of these banks will be unimpaired and they will be able to tolerate a 10% increase in their NPLs together with a 50% degeneration of their loan portfolio into classified loans. Further, if the ratio of NPLs to loans currently estimated at 6.7% were to degenerate to as much as 33.5%, only then will it wipe out the capital of these banks, meaning that banks are fairly strong and their solvency will be at stake only in extreme cases of far-out shocks.


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Similarly, the impact of shocks of upward interest rate movements together with parallel shifts of the yield curve on the value of the bank’s portfolio is tolerable, except for a large shock in the case when interest rate increases by 100 basis points or 200 basis points and there is a parallel shift and flattening of the yield curve. The impact on gross income is more pronounced and the percentage loss is substantial. The shock of a decrease in equity prices, that is, a fall in the stock price index in the range of 20-40% will also not have much of a negative impact on the banks, and banks will be able to ride out these adverse movements.

The shock of exchange rate movements is more manageable because the foreign assets of banks are larger than their foreign currency liabilities. Therefore, a depreciation of the exchange rate of as much as 25% does not have any negative impact on their capital; in fact their CAR appreciates. Their borrowers, however, will face difficulties in loan servicing of foreign credits; therefore the value of their foreign currency loan portfolio will decrease. If there were to be an appreciation of the exchange rate by 20%, it will lower the rupee value of their assets and their CAR will decline but only slightly. It seems that banks are resilient enough to absorb shocks of any combination of exchange rate movements within these ranges together with the counterpart impact of exchange rate changes on their clients. There is a corroboration of the central conclusion of these SBP tests with those of the IMF-WB FSA05 report based on its own sensitivity and stress tests. Their results show that Pakistan’s financial system is resilient enough to absorb various types of moderate shocks and there is no imminent threat, except in situations where several types of shocks may occur simultaneously and in combination, though the report does not elaborate upon the combination or their severity.

Looking Ahead

The future of financial system development will in good part depend on capacity building and improved corporate governance. Capacity building needs priority attention because it is not a once for all activity, rather it is a continuous process. As soon as one threshold is scaled, another one looms on the horizon owing to fast moving changes in the business world and also in the financial system owing to increasing global linkages. Hence, the need for continuous revival and rejuvenation from within at the institutional level will always be there if the dynamism of modern banking is to be internalized.

Further gains in efficiency and improvements in the operations of the banking system simply can not be achieved without adequate investment and efforts at capacity building. Frontline institutions have already gone

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through a few rounds of their capacity building led by the SBP, which embarked on this process some years ago with considerable success. Many small private banks and foreign banks went through capacity building efforts of their own and completed their transition earlier on during the late 1990s. Recently, privatized large banks embarked on their capacity building a few years ago and they are in the midst of catching up to their fast growing needs.

There are three main elements to capacity building. These are: improvements in management orientations and dynamism, investment in training, and investment in infrastructure such as IT facilities in parallel with IT training if this investment is to yield dividends. All the three elements are a relatively recent experience for Pakistani banks, but these are not unfamiliar or new to them. Investment in training, unfortunately is still regarded as an administrative expense rather than investment in human capital. That mind-set has not changed. Currently, most institutions spend only a fraction of their routine administrative budget on training, perhaps no more than 3% of their annual administrative outlays and it is not considered as investment in human capital.

Further, training is widely interpreted as improving basic skills or is regarded as improving abilities in procedures as compared with functional training. For example, training a branch manager is not the same as training a banker; or for that matter, training a central banker, say, in currency regulations is not the same thing as preparing someone to become a central banker. This involves the enhancement of capabilities, re-orientation of the mind-set and attitudes which are much harder to come by. Functional training was not needed in a nationalized system, directed as it was from the centre, or so it seems. That is why training came to a grinding halt and with it the culture of self-improvement at the institutional level disappeared. In the current business environment financial institutions cannot prosper without sustained efforts at capacity building.


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Diaz-Alejandro, Carlos, 1985, Goodbye Financial Repression, Hello Financial Crash Journal of Development Economics 19, pp 1-24.

Dooley, Michael, Globalization, Speculative Bubbles and Central Banking, pp 103-112 in Faruqi, S. (ed), 1992, Financial Sector Reforms in Asian and Latin American Countries; Lessons of Comparative Experience, EDI /World Bank, Seminar Series.

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Ezaguirre, Guillermo, Financial Crisis, Reforms and Stabilization: The Chilean Experience, in Hunter Caprio and Leipziger (eds.), Preventing Bank Crises: Lessons from Recent Global Failures,Federal Reserve Bank, Chicago, EDI/World Bank Development Studies, pp 147-162.

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Financial Sector Restructuring in Pakistan

Muhammad Arshad Khan and Sajawal Khan*

Abstract

In this paper an attempt has been made to review the financial restructuring process and its importance for economic growth and macroeconomic stability. The main focus is on the financial restructuring efforts undertaken by the government of Pakistan since 1990. We also analyze the impact of financial restructuring by using various financial indicators. The overall results suggest that the financial industry in Pakistan is showing remarkable and unprecedented growth. Unlike 1990, the performance of the financial sector is much better today. After the successful completion of first generation reforms, the introduction of second generation reforms is required, which will help to further strengthen the financial system and transfer the benefits of the first generation reforms to society.

I. Introduction

In a modern economy, an efficient financial system is essential to facilitate economic transactions, specialize in production, and establish investor-friendly institutions and competitive markets. A stable and efficient financial system not only reduces uncertainty and the cost of transactions but also improves overall economic efficiency through the efficient allocation of resources. A more balanced and vibrant financial system will contribute to economic growth and the stability of the economy. In contrast, regulated financial systems lead to underdeveloped and incompetitive markets, with a financial sector dominated by government owned financial institutions that impose constraints on economic growth. It is now widely recognized that weak and inefficient financial systems are more vulnerable to contagion, less able to cope with volatile capital flows and exchange market pressures, and more likely to propagate and magnify the effects of financial crises. This

* The authors are respectively Associate Professor Government Post-graduate College Muzaffarabad (Azad Kashmir) and Lecturer Government Degree College Ghazi, Haripur (NWFP) and both are currently working as Research Associates, Pakistan Institute of Development Economics, Islamabad.

Muhammad Arshad Khan and Sajawal Khan 98

recognition has highlighted the need for the global adoption of strengthened standards for banking supervision (IMF, 1996). The appropriate sequencing of financial sector restructuring and supervision policies have also become pressing issues in many LDCs, where a large part of the banking system is undercapitalized and insolvent, reflecting major macroeconomic shocks, large structural changes and weak banking supervision. The resulting distress in the financial system has, in turn, complicated monetary management and affected the effectiveness of stabilization policies (Sundararajan, 1996).

Since the early 1990s, many developing countries have started to restructure their financial sector as a part of broader Structural Adjustment Programs (SAP) which includes fiscal consolidation, reforms of the trade and exchange rate systems, price liberalization, deregulation of financial sector activities and other wide-ranging measures to enhance efficiency and supply responsiveness of the economy. These reforms were expected to bring about significant economic benefits, particularly through a more effective mobilization of domestic savings and efficient allocation of resources. Policies for restructuring the domestic financial system are aimed at strengthening the role of market forces and competition through liberalization of interest rates, adoption of indirect monetary instruments, strengthening of prudential supervision and related market information systems in order to deal effectively with interest rate and exchange rate risks and other banking risks, particularly in the context of capital account liberalization by enhancing banks’ soundness and by promoting equity markets (IMF, 1995). Moreover, the liberalization of current and capital account transactions are aimed at better integrating the domestic financial system into world financial markets.

During the pre-reform period, the financial sector in Pakistan mainly accommodated the financing needs of the government, public enterprises and priority sectors. Private sector investment remained modest, and efforts to mobilize savings lacked the dynamism of a competitive financial system. Financial intermediaries were insulated from competition in the domestic market through oligopolistic practices and barriers to entry in the sector, and from outside competition through tight restrictions on current and capital accounts transactions (Khan, 1995).

In such an environment, which was typical of many pre-reform situations, distortions were widespread, interest rates were generally negative in real terms, incentives were provided to inefficient investment, credit was rationedon the basis of government determined priorities and excessive regulations hindered the activities of financial intermediation. Consequently, economic efficiency remained low and growth suffered from relatively low savings and investment rates in the private sector.

Financial Sector Restructuring in Pakistan 99

Like many other developing countries, Pakistan undertook the process of financial restructuring through reforms in the early 1990s to establish a more market-based system of financial intermediation and government financing, conduct monetary policy more efficiently through greater reliance on indirect instruments and contribute to the rapid development of the stock markets. These reforms were primarily designed to correct the distortions implicit in the administered structure of rates of returns on various financial instruments, to abolish the directed and subsidized credit schemes, to allow the free entry of private banks in the financial sector in order to enhance competition and efficiency in the financial sector and to strengthen the State Bank of Pakistan’s (SBP) supervision.

The main objective of this paper is to examine the financial restructuring efforts undertaken by the government of Pakistan to gain efficiency in the financial sector. Moreover, the study also examines the outcomes resulting from financial restructuring and suggests further improvement in this regard. The rest of the study is structured as follows: Section 2 discusses the theoretical rationale of financial restructuring. Section 3 describes the financial restructuring process carried out so far in Pakistan, while Section 4 assesses the results of restructuring in Pakistan. Some concluding remarks are given in Section 5.

II. Theoretical Rationale of Financial Sector Restructuring

The theoretical support for financial restructuring as a policy goal can be traced back to the fundamental theorem in welfare economics and the efficient market hypothesis. The fundamental theorem suggests that competitive markets lead to Pareto optimal equilibria, while the efficient market hypothesis argues that the financial sector uses market information efficiently. A combination of these two ensures the efficiency in the financial sector. The reform of the financial system removes market distortions that impede free market conditions (Eatwell, 1996; Mavrotas and Kelly, 2001). Mckinnon (1973) and Shaw (1973) argued that financial deepening is an essential ingredient to the process of capital accumulation, which in turn enhances economic growth through savings and investment. They further stated that financially repressed economies remain below its market clearing values thereby generating less than the optimal amount of savings and thus detracting from the pool available for investment. The policy message is that both financial and real sector development requires a comprehensive package of financial restructuring that frees up interest rates to their market-clearing levels and eliminates administratively-determined selective credit allocation (Chowdhury, 2000).


There is now general agreement among economists that inappropriate regulatory and supervisory policies not only retard long-term economic growth but also increase the likelihood of a financial crisis that could spread beyond the country’s own borders. Table-1 provides the importance of prudential and related regulations in the efficient management of the financial system.

Table-1: Types of Financial Regulation: Objectives and Key Policy Instruments

Type of Regulation

Objectives Key Policy Instruments

Macro-economic

-To maintain control over aggregate economic activity. -To maintain internal and external balance

Reserve requirements, direct credit and deposit ceilings, interest rate controls, restrictions on foreign capital

Allocative -To influence the allocation of financial resources in favour of priority activities.

Selective credit allocation, compulsory investment requirements, preferential interest rates.

Structural

-To control the possible abuse of monopoly power by dominant firms.

Entry and merger controls, geographic and functional restrictions.

Prudential -To preserve the safety and soundness of individual financial institutions and sustain public confidence in systemic stability.

Authorization criteria, minimum capital requirements, limits on the concentration of risks, reporting requirements.

Organizational -To ensure smooth functioning and integrity of financial markets and information exchanges

Disclosure of market information, minimum technical standards, rule of market making and participation.

Protective -To provide protection to users of financial services, especially consumers and non-professional investors.

Information disclosure to consumers, compensation funds, ombudsmen to investigate and resolve disputes.

Source: Vittas (1992, p. 63)


It is clear from Table-1 that the debate relating to liberalization has

focused on the allocative aspect of the financial sector rather than prudential, organizational and protective regulations because of information problems. Barth, et. al. (1998) suggest that the following initial steps should be taken to reduce the likelihood of a financial crisis:

• Develop and improve legal systems and information disclosure;

• Impose rate ceilings on bank deposits;

• Establish limits on the rate at which banks can expand credit or on the rate of increase in their exposure to certain sectors, such as real estate;

• Required greater diversification of bank portfolios; and

• Reduce the restrictions on the range of activities in which banks can engage.

They maintain that it is not possible to determine a priori which combination is most appropriate for individual countries because of the different stages of development. Despite this, it would be essential to maintain that the central purpose of prudential and organizational regulations is to deal with failures associated with moral hazard while protective regulations focus on the need to design a fair financial system that protects the interests of the users of financial services.

Sheng (1996) defined financial restructuring as “the package or macroeconomic, microeconomic, institutional and regulatory measures taken to restore problem banking system to financial solvency and health”. The problem banking system may be defined in terms of non-performing loans (NPLs) and shortfall of credit requirements. Sheng states that “as a rule of thumb, banking distress is likely to become systemic when NPLs, net of provisions reached roughly 15% of the total loans”. The Narasimham Committee on Banking Sector Reforms (1998) defines that “a weak bank should be one whose accumulated losses and net NPLs exceed its net worth or one whose operating profits less its income on recapitalization bonds is negative for three consecutive years”. Practically, financial restructuring is a complex process but it strengthens the balance sheet structure of banks and non-bank financial intermediaries (NBFIs). It can be argued that appropriate efforts are necessary to reverse the insolvency and poor profitability of banks. Moreover, the regulatory environment and supervisory institutions must be modernized and restructured (Hoelscher, 1998). These steps are


necessary to ensure that banking failure does not jeopardize the stability of financial institutions. The process of financial restructuring consists of four phases i.e. diagnosis, damage control, loss allocation and rebuilding profitability and creating the right incentives. If the diagnosis is done correctly, it would help the banks to know the extent and causes of loss by applying uniform accounting and auditing standards ─ especially loan classifications and interest accrual standards ─ for all banks. Damage control is basically intended to stop the flow of future losses either by liquidating, enforcing hard budget constraints, changing management, etc. Loss allocation among different parties25 is the most difficult part of financial restructuring and successful restructuring depends on the loss allocation. Finally, rebuilding profitability and creating the right incentives requires good policies, reliable and efficient management and a strong institutional framework.

There are two types of restructuring mechanism: one is market based solutions such as shareholder capital injection, sale or merger, liquidation without deposit compensation, etc. and the other involves government intervention such as liquidation with deposit insurance, formation of asset recovery trust, supply side solutions, etc26. Dziobek and Pazarbasioughu (1988) propose two types of restructuring mechanisms: financial and operational restructuring. According to them, the aim of the restructuring program is to restore the solvency and profitability of the banks. Bank solvency would emanate from shorter-term financial restructuring measures such as capital injection, long-term loans, swapping bonds for NPLs, etc. While a return to profitability requires more difficult and longer-term operational restructuring such as improved cost effectiveness, better internal governance, effective risk management, etc. Hence, bank insolvency is dealt with by financial restructuring, while poor profitability is caused by some combination of NPLs and high operating costs. These problems are dealt with through operational restructuring.

Mishkin (1996) has noted that “a non-linear disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that the financial markets are unable to efficiently channel funds to economic agents who have the most productive investment opportunities”. There are four factors promoting a financial crisis: increases in interest rates, increases in uncertainty, asset market effects on balance sheets, and bank panics. Hence, a strong regulatory and supervisory system is necessary to cope with a financial crisis and promote the efficient functioning of financial

25 Such as, owners, borrowers, depositors, regulators and government. 26 See Sheng (1996), p. 36.


markets. Caprio and Klingebiel (1997) showed that a mixture of bad policies and bad banking causes bank insolvency. Furthermore, excessive expansion of credit is also one of the main causes of insolvency. Besides bad banking and excessive credit expansion, there are many causes which are cited in the literature such as asset-liability mismatches, insufficient diversification, directed lending, fraud, etc. Therefore, the challenge is to devise an appropriate regulatory framework that enables the banking system to be more resilient to insolvency. In addition, timing, sequencing, and speed of restructuring measures are very important for successful restructuring (Khatkhate, 1998 and Alawode and Ikhide, 1997).

The experiences of economies in transition illustrate that the sequencing of bank restructuring and supervision policies have had a great impact on macroeconomic performance and financial market development. In Eastern and Central Europe, bank restructuring policies-recapitalization with government funds (Hungary, Czechoslovakia, Poland), carving out bad loans (Poland, Czech Republic), conversion of enterprise debt-to-equity (Bulgaria and Croatia) - were implemented in varying degrees since 1991 (Sundararajan, 1996). The effectiveness of financial restructuring requires sustained efforts towards stabilization and proper design and the enforcement of bank restructuring and prudential supervision policies in order to avoid major disruption to growth and stability.

The sequencing of financial restructuring and prudential supervision policies may be divided into three stages (Sundararajan, 1994 and Alexander et al, 1995). These three stages (Table-2) can provide guidelines for every country, pursuing restructuring and financial liberalization policies.

Table-2: Financial Restructuring during the Various Stages of Financial Sector Reform

Stage 1: Preparatory

The preparatory stage include:

Introduction of a minimal program of financial restructuring policies to deal with fixed rate loans, selected nonperforming loans, capital adequacy and subsidized selective credit.

Review of legal and organizational arrangements for banking supervision.

Strengthen the licensing and entry regulations. Put in place a framework for orderly intervention and liquidation of banks.


Stage 2: Initiating Market Development

This stage includes the following measures:

Phase in the reform of commercial bank accounting and bank reporting systems, help to enforce prudential norms and facilitate monetary analysis.

Phase in the prudential regulations, particularly loan classification and provision, credit concentration limits, credit appraisal guidelines and foreign exchange exposure rules based on new accounting standards.

Strengthen and phase in the capital adequacy norms in line with bank restructuring strategy.

Introduction of a strategy to combine off-site, on-site, and external audit, and the balance among the components such as the availability of resources and technical assistance.

Active pursuit of institutional development of banks.

Formulation of a comprehensive program of bank restructuring, bank liquidations, loan recovery and loan workout arrangements. Implementation of simple financial restructuring policies for banks - supported by enterprise financial restructuring (e.g. policies to reduce debt-equity ratio of non-financial firms and recapitalize banks through portfolio restructuring) as a part of this program.

Stage 3: Strengthening Financial Markets

During this stage the following steps are needed:

Continuation of comprehensive reforms to foster bank and enterprise restructuring systematically in line with the program designed in stage 2.

Promotion of well-capitalized and well-supervised dealers in government securities (and money market instruments) as part of strengthening security market regulations and supervision.

Completion of reforms of bank accounting and prudential standards.

Strengthen financial risk management in payment systems.

Strengthen supervision of asset-liability management (interest rate risks, liquidity management), internal controls, and management systems of banks.


Achievement of appropriate balance between off-site supervision, on-site inspection and external audit through technical assistance and training.

Close monitoring of risk implications of financial innovations and internationalization.

III. Financial Restructuring in Pakistan

In Pakistan, banking sector reforms were launched in the early 1990s. The objective of these reforms was to make the financial industry more competitive and transparent by privatizing formerly nationalized commercial banks, liberalizing interest rates and credit ceilings, strengthening the supervisory capacity of the central bank and standardized accounting and auditing systems (Iimi, 2004).

Prior to the 1990s, the financial sector in Pakistan remained heavily controlled27. Interest rates were set administratively and usually remained negative in real terms. Monetary policy was conducted primarily through the direct allocation of credit. The money market was under-developed, and bond and equity markets were virtually nonexistent. Commercial banks often had to lend priority sectors with little concern for the borrowing firm’s profitability. Despite the opening of the non-bank financial sector for private investment in the mid-1980s, state-owned financial institutions held almost 93.8 % of the total assets of the entire financial sector at the end of the 1980s. Moreover, the status of financial institutions was precarious due to, inter alia, high intermediation costs resulting from overstaffing, a large number of loss-incurring branches, poor governance with low quality banking services, accumulation of non-performing loans and inadequate market capitalization. These inefficiencies and distortions caused severe macroeconomic difficulties in the late 1970s and 1980s and distorted economic growth. In order to remove these distortions and spur economic growth, the Government of Pakistan undertook a wide range of reforms in the early 1990s to strengthen its financial system and to provide an adequate macroeconomic environment.

The financial sector reforms included: (i) the liberalization of interest rates by switching from an administrated interest rate setting to a market based interest rate determination; (ii) the reduction of controls on credit by

27 All commercial banks were nationalized in January, 1974, with the aim of making credit availability to high priority sectors of the economy which previously had limited access to investable funds (see Haque and Kardar, 1993 for a detailed account).


gradually eliminating directed and subsidized credit schemes, (iii) the creation and encouragement of the development of a secondary market for government securities, (iv) strengthening the health and competition of the banking system by recapitalizing and restructuring the nationalized commercial banks (NCBs) increasing their autonomy and accountability, (v) improving the prudential regulations and supervision of all financial institutions, and (vi) allowing free entry of private banks in the financial market.

The financial sector reforms which were launched in the early 1990s can be classified in three phases. These three phases of financial sector reforms can be termed as the first generation of reforms.

III.A. First Phase of Financial Reforms (1988 –1996)

The first phase reforms were aimed at creating an efficient, productive, and enabling environment for operational flexibility and functional autonomy. The first phase of financial reforms28 included: first, the government liberalized the market entry of private and foreign banks29 in order to gain efficiency and enhance competition within the financial sector. Secondly, two of the state-owned commercial banks, i.e. Muslim Commercial Bank (MCB) and Allied Bank Limited (ABL), were partially privatized between 1991 and 1993. Thirdly, major state-owned commercial banks and DFIs were downsized in terms of branches and employees. Fourthly, credit ceiling as an instrument of credit control was abolished, the Credit Deposit Ratio (CDR) was also abolished and open market operations is now an instrument of monetary policy and the State Bank of Pakistan (SBP) at regular intervals has conducted auctions of government securities. Fifthly, the loan recovery process was strengthened by establishing banking courts and standardizing loan classification and accounting rules. Finally, the State Bank of Pakistan was granted full autonomy. However, the segmentation of financial markets continued owing to continuing controls on interest rates on government debts and specialized credit programs.

28 The early phase of financial reforms as a part of financial restructuring policies started in the late 1980s to early 1990s. 29 Ten new private banks started their operations in 1991 and 23 private domestic banks operating in the country including HBL, ABL, MCB and UBL. The process of liberalization started in the early 1990s and except NBP, more than 50 % shares of the public sector have been privatized. There are about 14 foreign banks that have been operating in the country.


III.B. Second Phase of Financial Reforms (1997-2001)

In late 1996 the financial sector was on the verge of collapse (Table-3) with about one-third of banking assets stuck in the form of Non Performing Loans (NPLs). Liquidity problems had begun to emerge as disintermediation spread and banking losses increased. Most cases of loan defaults remained unresolved because of the ineffective judicial system. These problems were rooted in a failure of governance and lack of financial discipline. Political interference had vitiated the financial intermediation function of the banking system and the borrowers expected not to repay loans they took, especially from National Commercial Banks (NCBs) and Development Finance Institutions (DFIs). NCBs and DFIs were the main loss makers because over 90% of their loans were in default. Excess manpower, large branch network and undue interference by labor unions resulted in large operating losses. Poor disclosure standards and corruption were widespread. These serious problems created a demand for further reforms. As a result, the second phase of banking sector reforms30 was introduced in early 1997. These reforms addressed the fundamental causes of crisis and corruption and strengthened corporate governance and financial discipline. In this regard, the cost structure of banks was first restructured through capital maintenance and increased by public funds. Secondly, partially privatized commercial banks were privatized completely. Thirdly, bank branches were fully liberalized which allowed private banks to grow faster and increase their market share. Fourthly, loan collateral foreclosure was facilitated and strengthened to reduce default costs and to expand lending to lower tier markets, including consumer banking. Fifthly, national savings schemes were reformed so as to integrate with the financial market. Sixthly, the mandatory placement of foreign currency deposits was withdrawn. Lastly, the SBP was strengthened to play a more effective role as regulator and guardian of the banking sector and phase out the direct and concessional credit programs to promote market integration.

30 The second phase of banking sector reforms started from 1997 to 2001.


Table-3: Selected Indicators of Vulnerability in Pakistan (Period ended 1996)

Macro Indicator

Inflation > 5% 10.7

Fiscal Deficit > 2% of GDP 6.5

Public Debt > 50% of GDP Yes

Current Account Deficit > 5% of GDP 7.4

Short-term Flows > 50% of the Current Account Deficit Yes

Capital Inflows > 5% of GDP Yes

Ratio of Short-term Debt to International Reserves >1 Yes

Financial Sector Indicators

Recent Financial Sector Liberalization Yes

Recent Capital Account Liberalization No

Credit to the Private Sector > 100% of GDP 17.1%

Credit to the Private Sector (real growth) > 20% No

Emphasis on Collateral when making loans Yes

Estimated Share of Bank Lending to the Real Estate Sector>20% No

Stock of Non-performing Loans > 10 % of Total Loans Yes

Stock Market Capitalization as %age of GDP 20.11%

Source: Lindgren et al (1999), p. 11

III.C. Third Phase of Financial Sector Reforms (2002-2004)

In this phase there were several major changes and significant positive shifts in the regulatory atmosphere to strengthen the financial system and introduce structural improvements. Some of the more important developments have been seen in the following areas:

Consolidation, Privatization and Regulation: During the 1990s, mushroom growth in commercial banks and non-bank financial institutions has been witnessed, a few of which have low capitalization, inadequate/inappropriate staffing, poor risk management practices and a marginal portfolio quality. The central bank sought out to consolidate the


banking sector by raising the minimum capital requirement. The minimum capital requirement was 1 billion for 2003, 1.5 billion for 2004 and was set at 2 billion for 2005. There have been 17 mergers and acquisitions and there are several in the pipeline. Weak entities have been eliminated. The average capital base of a commercial bank has risen from 1.8 billion in 2000 to 3.7 billion in 2003. Now all banks are required to maintain at least 8% of the risk weighted assets as capital requirement.

The regulatory oversight for a sizeable chunk of the financial system (such as leasing companies, modarabas, investment banks, mutual funds and insurance companies) has been moved to the Securities and Exchange Commission (SECP), but SECP failed to build capacity in order to handle this inflow. The SECP lacks on-site inspection capability.

Universal and Consumer Banking: Banks are allowed to form separate subsidiaries to function as mutual funds, asset management companies, venture capital, foreign exchange companies, etc. Furthermore, banks are encouraged to expand their lending operations to middle and lower income groups. A large range of consumer asset products such as credit cards, auto loans, clean installment loans, housing finance, etc., are being marketed aggressively. The NPLs in this sector are significantly lower than that of the corporate sector. Similarly, Small and Medium Enterprise (SME) financing has also become part of the lending toolkit. However, several banks shy away from this sector because of high-risk perception.

Automation and Prudential Regulations: ATM coverage is relatively low and on-line banking is offered by most of the banks. The Central Bank itself is making significant progress in this area. Credit information data and credit rating agencies data are now available on line.

Similarly, the Central Bank has been steadily moving away from its tradition of intrusive regulation and directed lending. Unlike the late 1980s, a much more permissive regulatory atmosphere prevails today. The Central Bank also modernized and revised prudential regulations for corporate and commercial banking, SME financing, microfinance institutions and consumer financing.

Banking Audit, Supervision and Corporate Governance: The SBP’s compliance with the Basle Core Principles is generally high. The SBP now conducts comprehensive on-site inspections using a standardized


CAMELSS31 for rating the overall condition of a bank. The SBP is also developing an early warning system called IRAF32. For corporate governance, both the SBP and SECP issued codes of corporate governance. Corporate disclosure standards have improved. However, there is a need to reform the taxation structure and the tax collecting institutions.

Out-of-Court Settlement of NPLs: Two thirds of the stock of NPL involve a single lender. Recovery of NPLs involves internal and external hurdles. The pressure from influential borrowers is often exerted through the government. To reduce the level of NPLs, the government and the SBP established the committee for the revival of sick industrial units (CRSIU) and corporate and industrial restructuring corporation (CIRC). The committee claims that it has revived 172 industrial units involving outstanding NPLs of Rs. 46 billion. However, the World Bank concluded, regarding the assessment of CIRSU, that “in the absence of operational analysis, there would generally appear little increment in the value of the project. Future viability and renewed distress of these projects are of concern. No track is kept of financial or operational details of the projects after revival.” In 2002 because of growing NPLs and the failure of CIRC, the National Accountability Bureau (NAB) and CIRSU, the SBP issued guidelines whereby banks are actively encouraged to settle NPLs with borrowers at the Fore Sale Value (FSV) of the underlying collateral. Under this scheme, borrowers were required to deposit 10% down payment at the time of signing the settlement agreement and repay the remaining amount in 12 quarterly installments. This scheme encourages a lot of defaulters to come forward and settle their long-standing liabilities. Similarly, under the debt recovery program, EDR (Excess Debt Recovery) had a write-off efficiency ratio of 5:1(i.e. for each of the provisions written off it would generate a cash recovery of Rs. 5). Under these guidelines Rs. 52 billion of NPL have been settled at the cost of around Rs. 35 billions.

IV. Results of the Financial Restructuring

The objectives of financial restructuring policies were to forestall a collapse of the generalized banking system and to establish a viable banking system in the country. It was expected that financial and operational restructuring policies strengthened the microeconomic foundations of the banking system. However, commercial banks have been slow to mobilize

31 CAMELSS indicate Capital, Assets, Management, Earnings, Liquidity, and Sensitivity to Market Risk, Systems. 32 IRAF indicate Institutional Risk Assessment Framework.


deposits, which play a significant role in financial intermediation. As Akhtar (2007) pointed out, the successful transformation and restructuring of the financial industry depends on some critical factors such as: (i) promoting a higher degree of depth and efficiency in the financial intermediation process by effective resource mobilization and channeling these resources to promote economic growth, (ii) improving the financial performance and strengthening the soundness of financial institutions, and (iii) extending the outreach of financial services to the poor segment of society.

We therefore, briefly discuss the impact of the financial sector reforms under the following headings:

IV.A. Interest Rate Policies

Interest rates directly affect business conditions and economic activities and thus represent a powerful policy instrument. In Pakistan, before financial reforms, interest rates were set administratively and were often negative in real terms. For example, deposits were paid negative real return, thus discouraging savings in the country. Ceilings on interest rates were imposed with the desire to provide low-cost financing to encourage investment, particularly in the priority sectors. However, restrictions on interest rates led to financial disintermediation, as savers and investors sought alternative outlets outside the formal financial system. Consequently, financial deepening was hindered, and financial resources were not directed into productive activities.

After liberalization, the price of financial services was intended to be determined by the banks on a competitive basis, with little intervention from the SBP. To achieve the twin objectives of reducing the government’s cost of borrowing on domestic debt and encouraging private sector credit expansion, the SBP had been pursuing a relatively easy monetary policy from July 1995 to July 2000. The weighted average lending rate gradually came down from 15.6% in 1998 to 8.81%33 in June 2005, but the real interest rate increased from 3.6% in 1996 to 10.9% in 2000 and then following a declining trend, reached –0.49% in June 2005 (see Table-4). This reduction in the lending rate indicates little improvement in the profitability of the banks but is purely ad hoc and not in the line with liberalization. Similarly, the weighted average deposit rate declined from 6.8% in 1998 to 1.37% in June 2005; the real deposit rate remained negative except for the period 1999-2002. This reduction in the deposit rate will reduce savings even further.

33 Although in 2004 the rate fell to 7.28 %.


Table-4: Interest Rate Behavior in Pakistan

Weighted average Lending Rate

Weighted average Deposit Rate

Interest Rate Spread

Year Inflation Rate

Nominal Real Nominal Real Nominal Real

1990-95 10.57 12.55 1.98 6.53 -4.05 6.02 5.95

1996 10.8 14.4 3.6 6.4 -4.4 8.00 8.00

1997 11.8 14.6 2.8 6.8 -5.0 7.8 7.8

1998 7.8 15.6 7.8 6.8 -1.0 8.8 8.8

1999 5.7 14.8 9.1 6.5 0.8 8.3 8.3

2000 3.6 13.52 10.9 5.47 1.9 8.05 9.00

2001 4.4 13.61 9.21 5.27 0.87 8.34 8.34

2002 3.5 13.19 9.69 3.61 0.11 9.58 9.58

2003 3.1 9.40 6.3 1.61 -1.49 7.79 7.79

2004 4.6 7.28 2.68 0.95 -3.65 6.33 6.33

2005 9.3 8.81 -0.49 1.37 -7.93 7.44 7.44

Source: SBP Annual Reports (various issues).

The interest rate spread34 is an important indicator for the financial sector’s competitiveness, profitability and efficiency. Spread typically declines when competition among banks increases to access the financial market to increase their customer’s base. But in Pakistan, the high lending rate and low deposit rate have generated a large spread35 nearing 7.44% in June 2005 as against 6.33% in 2004. The high lending rate will increase the cost of borrowing and hence discourage investment. The low deposit rates discourage savings, resulting in a high debt/GDP ratio, deterioration of the banks balance sheets, lowering economic growth, and increasing poverty. Furthermore, the large spread also reflects a perceived sovereign risk (Khan, 2003). However, the efforts of the SBP to enhance competition helped to narrow the spread to 6.33% in 2004. But this trend was reversed and the spread rose again to 7.44% by the end of June 2005 and the commercial

34 Interest Rate Spread = (Average Lending Rate – Average Deposit Rate). 35 High interest rate spread is generated by factors such as high administrative costs, overstaffing and unavoidable burden of non-performing loans (for further detail, See SBP’s financial sector assessment 2003-2004).


banks re-priced their loans in line with the upward adjustment in the SBP repo rate in the wake of high inflation without any rise in deposit rates. Hence, measures should be taken to bring down the interest rate spread close to zero in order to enhance both savings and investment in the country.

IV.B. Performance and Efficiency of Financial Institutions The performance and efficiency of a financial institution involves two aspects, namely, solvency and sustainable profitability. Solvency improving measures affect the bank's balance sheet while profitability measures affect the bank's income. The improvement in the banking performance emanates from financial restructuring operations. NPLs can be used as an indicator to measure the performance of financial institutions. In Pakistan, the NCBs and the DFIs have been facing the problem of NPLs, which increased from Rs. 25 billion in 1989 to Rs. 128 billion in June 1998, or 4% of GDP. Moreover, the NPLs increased from Rs. 230.7 billion in December 1999 to Rs. 240.1 billion in December 2000. However, some significant efforts were made by the government to recover default loans. As a result, NPLs, in gross as well as net terms have followed a declining trend since 2001 showing an improvement in loan appraisal standards and market discipline. Furthermore, as the banking sector registered a growth in advances, the ratio of NPLs to advances showed a sharp declining trend (Table-5).

Table-5: Non-performing Loans of the Banking System

Year NPL’s (in Billions)

Gross NPLs to Advances (in %)

Provisions to NPLs (in %)

Net NPL to Net Advances (in %)

1997

1998

1999

2000

2001

2002

2003

2004

2005

173.0

183.0

230.7

240.1

244.1

231.5

222.7

211.2

177.3

23.5

23.1

25.9

23.5

23.4

21.8

17.0

11.6

8.3

46.6

58.6

48.6

55.0

54.7

60.6

63.9

70.4

76.7

-

11.1

15.3

12.2

12.1

9.9

6.9

3.8

2.1

Source: SBP Annual report (various issues)


The financial institutions succeeded in bringing down NPLs from 25.9% to 8.3% of the total advances of the banks and DFIs at the end of 2005. The net NPLs (net loan ratio), which is a more appropriate measure, was still about 2.1%. These indicators reveal a very impressive performance by the banking sector because in late 1996, the banking system was on the verge of a crisis with about one-third of its assets stuck in the form of default and NPLs. IV.C. Money and Credit Policies

In the late 1980s and early 1990s, Pakistan conducted its monetary policy through direct control on credit and interest rates. The banking system was not generally competitive and major banks were owned by the state. In addition, banks and other financial institutions were required to hold part of their portfolios in government debt at below market rates. The government directed bank loans to state owned-enterprises. The range of financial instruments available to banks and the public was intended to be narrow with maturity structures and yields unrelated to risk and liquidity. In recent years, Pakistan has started to reform its monetary policy by using indirect or market-based instruments to achieve macroeconomic stability. In 1995, the SBP shifted the emphasis from direct to indirect instruments i.e. open market operations including a rediscount window, liquidity auctions, repurchase agreements and overdraft facility. The monetary authorities have sought to reduce direct government intervention and strengthen the role of market forces in allocating financial resources in order to improve the capacity of institutions to mobilize domestic savings, improve the effectiveness of monetary policy, enhance competition among banks and strengthen the banks’ financial soundness. To measure the improvement in the financial intermediation capacity of the banking system following the financial restructuring process, the standard indicators used in this paper include the ratios of currency to broad money (M2), ratio of currency to GDP, M2/GDP, M3/GDP, M1/M2, the ratio of private sector credit to GDP and market capitalization36. Table-5 presents the entire situation after the introduction of financial sector reforms.

36 M1 is the currency in circulation plus demand deposits. M2 is M1 plus time deposit, foreign currency deposits. M3 is M2 plus other type of deposits, as well as short-term money market instruments such as certificates of deposits. In the case of Pakistan M3 includes M2 plus NSS, NBFIs.


The ratio of currency to broad money (M2) would tend to fall in the financial environment where market forces dominate, where there are alternative saving investment instruments (stocks, bonds, mutual funds etc.) that raise the real rate of return, where there is confidence in the banking system and where access to the banking system has expanded. The ratio fell from 37.56% in 1990 to 23% in 2005. This implies the dominance of market forces and retains the confidence of the customer in the banking system. Furthermore, the low ratio of currency to money mainly reflects advancement in the payment system, which heavily relies on credit cards, the development of the banking system and that money can be transferred between checking and savings accounts easily without any significant cost.

Table:- Indicators of Financial Deepening (in %)

Indicators 1961-70 1971-80 1981-90 1990 2000 2001 2002 2003 2004 2005

Currency/M2 45.13 32.29 32.28 37.56 27.80 26.02 25.30 25.04 23.99 23.00

Currency/GDP 16.06 13.53 13.29 14.73 10.82 10.31 11.08 11.77 11.84 11.18

Broad Money (M2)/GDP

34.03 33.90 41.24 39.24 38.93 39.64 43.80 46.99 49.36 48.61

M3/GDP - - 51.60 60.63 57.98 55.90 60.8 64.36

M1/M2 - - 67.10 76.01 59.32 58.48 58.01 61.23 61.78 72.48

Private Sector Credit/GDP

19.60 19.24 21.45 19.92 22.33 22.02 21.92 24.87 29.30 28.44

Stock market capitalization/ GDP

8.42 4.08 3.75 4.68 10.24 8.15 9.26 15.48 24.05 30.95

Sources: Calculated by authors using IFS and SBP data

During the financial restructuring process, the ratio of M2 to GDP tends to rise as access to banking and saving instruments spreads. But as markets mature, the ratio M2/GDP tends to decline as other financial instruments outside the M2 aggregate become available. The ratio M2/GDP which was 39.24% in 1999, touched 48.61% at the end of 2005. This is mainly due to the improvement of the domestic financial system. The ratio of currency to GDP has decrease from 14.73% in 1990 to 11.18% in 2005 implying that the banking system is relatively developed. There are significant foreign currency deposits in the banking system and substantial real rates of interest on saving accounts in domestic currency.


The ratio of M1/M2 provides a proxy for the extent to which the financial system of a country has succeeded in mobilizing savings. In 1990, the ratio was 76.01, which came down to 58.01% in 2003. This is mainly due to the development of the banking sector, a significant increase in foreign currency deposits and substantial real interest rate on savings. It started increasing from 58.01% from 2003 and touched 72.48% at the end of 2005. This implies a reduction of savings due to the negative real rate returns on deposits.

The share of private sector credit to GDP is one of the important indicators of allocative efficiency when compared with that of the government sector. Credit to the private sector would be expected to expand when banks are successfully restructured. In addition, this ratio also reflects whether the private sector receives sufficient resources to carry out its economic activities. It has fuelled economic activity, revived and enhanced industrial capacity and supported steady growth in the services sector, the contribution of which to GDP is nearly 52.3%. The ratio of private-sector credit to GDP increased from 19.92% in 1990 to 28.44% in 2005. In addition, fiscal adjustment efforts, privatization of some public enterprises and the liberalization of interest rates had all clearly enhanced the private sector's access to the banking system.

Stock market capitalization, which was 4.68 % of GDP in 1990, is 30.95 % of the GDP in 2005. This indicates the promotion of trading activities. However, the secondary market is not yet operating efficiently and remains very thin and bank financing remains the main source of funds for productive investment. Furthermore, foreign access to the stock market is limited because of a number of factors including macroeconomic weaknesses, inadequate transparency and accounting standards and a cumbersome and opaque regulation environment. In addition, there are some restrictions on the capital movements for non-residents and also ceilings on non-residents’ shares in companies’ equity. Moreover, bond markets barely constitute 5-7% of GDP and there is low pension and insurance coverage.

IV.D. Profitability and Financial Soundness

After years of poor profitability, the returns on assets and equity are beginning to increase. Net interest income decreased from 69% in 2001 to 58.2% in 2003. This reduction of net interest income is mainly due to a contraction in interest margin. As a result, the share of net interest income in gross income declined to 58.2% (Table-6).


Table-6: Banking Sector Earnings and Profitability.

Earning and Profitability 1999 2000 2001 2002 2003

Return on assets after tax -0.2 -0.2 -0.5 0.1 1.0

Return on equity after tax -6.2 -0.3 -0.3 13.8 22.1

Net interest income to gross income 54.3 61.2 68.9 67.4 58.2

Non-interest expenses to gross income 76.9 71.6 62.7 57.3 50.4

Personnel expenses to non-interest expenses

57.0 54.3 52.6 51.4 50.1

Non-interest income to total income 17.6 16.5 14.5 18.1 30.9

Source: State Bank of Pakistan

Akhtar (2007) has pointed out that the profits of commercial banks crossed over $1 billion for the first three quarters of 2006. She further noted that from 2000-2006, the returns on assets of banks rose from -0.2% to 2.1% and return on equity from -3.5% to 26.1%. This increase in profit may be attributed to many factors such as: (i) a rise in earning assets of commercial banks to 85% in September 2006 which is significantly above the pre-reform period and a rise in advances to total assets from 49.1% in 2000 to 55.1% in September 2006, (ii) a decline in total and operating expenses, (iii) a rise in the SME, consumer finance and agriculture sector lending which constitutes over one third of total outstanding advances, (iv) a high share of non-interest bearing deposits and declining share of fixed deposits, and (v) a growth of service charges by the use of electronic banking. Furthermore, it can be argued that the privatization of the financial industry has had a distinct impact on the profitability of the banking sector, though its impact on efficiency is relatively weak37. However, it is expected that over a period of time there will be more progress in these areas.

IV.E. Privatization Policy

The structure of the financial sector in Pakistan has substantially changed following privatization of the state-owned commercial banks. In 1990, the financial system was fully dominated by five state-owned commercial banks. During the first round of financial sector reforms, two state-owned commercial banks ─Muslim Commercial Bank (MCB) and Allied Bank Limited (ABL) ─were privatized between 1991 and 1993. The reform process was subsequently delayed for several years and again resumed in the

37 State Bank of Pakistan (2005).


early 2000s. With the privatization of the third largest commercial bank, United Bank Limited (UBL), in 2002, the domination of the state-owned commercial banks was ended. As of September 2003, the asset share of domestic private banks and public sector commercial banks was 47% and 41% respectively. Furthermore, when the privatization of Habib Bank Limited (HBL) was completed in 2004, the share of the assets of the banking system held by public sector commercial banks decreased to less than 25%. Today, the National Bank of Pakistan (NBP) is the only state-owned commercial bank with a market share of approximately 20%.

The privatization of nationalized commercial banks and DFIs poses a serious challenge to the government. The government facilitated bank restructuring process by recapitalization of banks through (i) equity injection of Rs. 46 billion in some of the public sector banks and write offs equivalent to Rs. 51 billion, (ii) lay-off of close to 35,000 employees in two phases38 from public banks, and (iii) the closing of over 2000 loss incurring bank branches.

IV.F. Corporate Governance

The efforts of SBP helped in bringing a positive change in the corporate governance standards of banks. Banks and other financial institutions are now managed by a better cadre of professionals and stakeholders now play an active role in the affairs of banks. Regular board meetings, financial reporting standards, disclosure and transparency helped to improve corporate governance. Improvement in corporate governance helped to ensure a high degree of financial stability.

From December 2002 to December 2005, the balance sheet of the banking system has recorded a growth of 64.5%, which is quite significant. Since 2002, the deposits of the banking system registered a growth of 69%. Returns on assets after tax increased from 0.1% in 2002 to 1.9% in 2005 and further increased to 2.1% by the end of September 2006. The loan portfolio of the banking system doubled in the last three years. Credit growth is now fairly diversified. All these achievements have resulted owing to good governance policies.

On the basis of the above analysis, we reached the following conclusions:

• Financial markets have now become more competitive and relatively efficient but still remain shallow. There are many financial

38 In 1997 almost 24000 employees were laid off and in the second phase around 11,700 employees were relieved (Akhtar, 2007).


instruments available for transactions but the evolution of new instruments has to remain on track.

• Although financial infrastructure has been strengthened, the legal system is still complicated, time consuming and costly for ordinary customers. Furthermore, the regulatory environment has been improved and the monitoring system is much better today but enforcement and corrective capabilities need to be further strengthened.

• The further development of long-term bond markets, further improvements of corporate governance, reinforcement of regulatory and supervisory arrangements, the expansion of investors’ base, improvement of equity market infrastructure, revaluation of market volatility-controlling mechanisms and sequencing the reforms also need to be enhanced.

The Second Generation of Reforms

The first generation of reforms launched in the early 1990s gained roots and the financial industry in Pakistan is now ready to shift its focus to a second generation of reforms. The second generation reforms will not only help in achieving macroeconomic stability but also create an enabling environment for sustainable economic growth. Institutional strengthening, macroeconomic stability, protection of property rights, and legal and financial infrastructure development should be the main pillars of the second generation of reforms. The main ingredients of second generation of reforms include:

(i) Macroeconomic Stability

It can be thought that the banking system could easily be weakened by high and volatile real interest rates, owing to inappropriate fiscal policies that entail excessive borrowing from the commercial banks, inefficiencies in the payment system that encourage fraud, and loss-incurring banks. In order to maintain stability within the liberalized financial system, it is necessary to ensure that the fiscal position should be sound, banks should be well capitalized, and the payment systems should be modernized. To achieve these objectives the authorities should ensure stable and enabling macroeconomic conditions because it is inadequate to promote financial liberalization when the structural and macroeconomic problems remain unresolved.

(ii) Improvement in Governance

An improvement in governance would ensure greater transparency and accountability, a more secure and predictable environment for domestic


and foreign investment, and promote greater ownership of the reform efforts. In Pakistan there is still a need to clarify rules related to governance. Hence, attention should be paid to clarification and rules should be conformed so that they are consistent with international standard.

(iii) Strengthen Institutional Capacity and Protection of Property Rights.

For economic stabilization and sustainable economic growth, institutional strengthening and the risk taking ability of economic agents is necessary. Macroeconomic stabilization requires strong institutional coordination between the monetary and fiscal authorities. Strong institutions and protection and simplification of property rights should be given an important place in the second generation reform agenda. Furthermore, up-gradation and the encouragement of institutions such as SMEs, microfinance, consumer finance, housing finance and rural banking will accelerate the momentum of the financial industry because of the access of the vast majority of the population to financial services. Hence, there is an urgent need to further develop and strengthen these institutions.

(iv) Streamline Venture Capital Funds and Private Equity Funds

Venture capital and private equity funds, private pension and provident funds and insurance companies are the most effective means for financing innovative firms in the economy. The authorities should streamline these funds and encourage their growth.

(v) Strengthen the Legal and Financial Infrastructure

The accountability and enforcement of financial contracts requires that we have a legal system that dispenses justice quickly and inexpensively. But our legal procedure is too lengthy. There is a need to review banking laws and procedures to make them simple and less abrupt. Hence, this area needs special attention.

V. Conclusions

Financial restructuring is a continuous process not an event. Prior to 1990, the financial sector in Pakistan was characterized by weakness in banking and corporate governance, weak accounting standards, lack of market discipline, weak prudential regulations and poor legal infrastructure. These problems increased the exposure of financial institutions to a variety of external threats, including a decline in the values of assets, market contagion, speculative attacks, exchange rate devaluation, and a reversal of capital flows. Furthermore, capital flight and disrupted credit allocation further caused a


deterioration in the efficiency of the banking sector. In the background of the arising situations of the financial sector in Pakistan, a number of restructuring measures were undertaken since 1990 with a view to restore financial discipline and improve the operational efficiency of the financial sector. The financial sector restructuring program was instituted in 1990 and was concluded in 2004. In response to financial restructuring measures, financial discipline and operational efficiency shows significant improvement today as compared to pre-1990. Pakistan has made considerable progress during the past one and half decades in reforming its financial sector. Financial restructuring and privatization have changed the landscape of the financial industry in Pakistan. However, the secondary market is relatively thin and as such the supply of corporate securities remains small but the change is more fundamental in banking relative to equity markets. The development of the capital market is related to a range of economic, financial, institutional and legal factors that need to be addressed properly.

Furthermore, the legal infrastructure must be developed for financial supervision, bankruptcy and foreclosure. Bank secrecy laws should be improved to enhance transparency and a deposit insurance scheme is needed to maintain confidence in the financial system. An early warning system and prompt corrective actions are needed. The study further concludes that without further improvement of corporate governance and expansion of the investor's base, capital markets cannot be developed. Moreover, until the equity markets are strengthened, the capital market cannot function well to complement the banking sector. More openness, together with more transparency and the disclosure of information, should contribute significantly to the financial restructuring of the economy and integration into the global economy. Although Pakistan restructured its financial sector successfully within a very short period, the sustainability and performance of financial sector reforms are required (Akhtar, 2007):

• Macroeconomic stability,

• A greater degree of consolidation should be necessary for strong and robust banking,

• Prudent regulatory and supervisory framework,

• Maturity and reorientation of financial industry,

• A well diversified and competitive financial system is still needed,

• Strong corporate governance, effective risk management system and mitigation, and


• The financial system should be socially inclusive and should facilitate access to financial services.

References

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Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?

M. Ashraf Janjua*

Abstract

This paper is primarily aimed at assessing the significance of the exchange rate on Pakistan’s foreign trade. It estimates the Equilibrium Real Effective Exchange Rate (ERER) and exchange rate misalignment for Pakistan using annual data from FY78 to FY06. The Engle Granger co-integration technique is used for the estimation of ERER depending upon various macroeconomic fundamentals as recommended by Edwards (1994). The results of the study are also used for the forecasting of ERER and misalignment up to the year 2010. The results of the study reveal that ERER is determined by variables such as: a) terms of trade, b) trade openness, c) net capital inflows, d) relative productivity differential, e) government consumption, and f) workers’ remittances.

The error correction term points to the gradual convergence of the real exchange rate towards the long-run equilibrium level which suggests that the prevailing Pak Rupee exchange rate has not deviated from the ERER and captures economic fundamental trends. Moreover, Pakistan’s foreign trade would depend significantly upon the state of economic fundamentals in the future. Improved economic fundamentals are likely to support trade besides paving the way for enhanced inflows of capital and financial receipts.

I. Introduction

The economic literature recognizes that exchange rate policy influences various parts of the balance of payments. It affects the balance of trade of a country mainly through improving international competitiveness which affects the supply and demand for exports and imports (i.e. the elasticities of supply and demand for exports and imports). In fact, exchange * Dean, College of Business Management, Karachi, and Former Deputy Governor, State Bank of Pakistan.

M. Ashraf Janjua 126

rate policy affects the international competitiveness of domestic products as: a) changes in the cost of production may raise the domestic price level; b) changes in domestic price may also affect production costs if changes in wages are in line with the changes in cost of living when imports become more expensive with depreciation; and c) if a large country depreciates its currency, the exports from small countries to the concerned country may be reduced. Keeping in view its significance, every government needs an exchange rate policy and has to make a strategic choice between a fixed exchange rate regime, a flexible exchange rate regime, or one of various in-between options. Each policy has its own advantages and disadvantages, and each country’s circumstances are different. Although many countries have pegged their exchange rates with hard currencies, there is a clear trend towards greater flexibility in exchange rate policy. Moreover, a central bank that is independent of the government is committed to maintaining low inflation and full employment does not finance budget deficits and often prefers a flexible exchange rate.

Historically, Pakistan pursued a policy of export-led growth, with the objective of achieving viability in her balance of payments. With a view to achieving this objective, the country had to adopt various exchange rate regimes at different times. A fixed exchange rate regime was followed from 1947 to 7th January, 1982. During the early 1980s, the dollar started appreciating in terms of the major currencies and as the Rupee was linked to the U.S. dollar, this affected the competitiveness of Pakistani products in international markets. Thus, with a view to maintaining the competitiveness of exports and thereby to bring a sustainable balance between the country's current receipts and current payments, it was decided to adopt the managed floating exchange rate system w.e.f. 8th January, 1982. Under this system the value of the Pak-Rupee was reviewed daily with reference to a trade weighted basket of currencies of the country's major trading partners/competitors. Necessary adjustments in the value of the Pak-Rupee were made as and when circumstances indicated a need for such an adjustment, keeping in view the relative changes in exchange rates and the prices of the country's major trading partners/competitors as well as major macro-economic indicators of Pakistan. The managed float continued to operate successfully till 21st July, 1998. In the wake of economic sanctions by major donors and the restraining stance adopted by multilateral financial institutions as a reaction to the nuclear tests on May 28, 1998, Pakistan had to take a number of measures to face the challenge. As a part of this strategy, the State Bank of Pakistan (SBP) introduced a New Exchange Rate Mechanism (NERM) on 22nd July, 1998, replacing the managed-floating-exchange-rate system. The underlying philosophy of the dual exchange rate was to pass on the advantages of devaluation to exporters, expatriate workers

Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 127

wishing to remit money to Pakistan and to compress non-essential imports. It was also intended to contain the cost of devaluation in terms of containing price increases of essential imports and repayments of the external debt thereby limiting the impact of inflation and the overall fiscal deficit of the government. The adoption of NERM was tantamount to a multiple currency practice. The multiple exchange rate system discriminated among different exporters and importers and led to a misallocation of resources with an adverse impact on output and growth. Further, under the I.M.F's Articles of Agreement, a member is not allowed, except temporarily, to engage in multiple currency practice. The two-tier exchange rate system was replaced with a market- based unified exchange rate system w. e. f. May 19, 1999. Under the unified exchange rate system, a floating inter-bank rate was applied to all foreign exchange receipts and payments both in the public and private sectors. However, the State Bank could intervene in the market for the sale and purchase of foreign exchange on its own account at rates and timing of its choice. On 20th July 2000, Pakistan set the Pak rupee on a free float.

Since the free float of the Pak rupee, monetary policy has played a dominant role in stabilizing the exchange rate in Pakistan. Significant ups and down in forex rates are now being monitored through effective instruments of monetary policy. Similarly, whenever speculative activities are observed in the market, they are tackled with proactive monetary policy measures of the State Bank. The Bank uses the instrument of the discount rate to control undue pressure on the exchange rate while Cash Reserve Requirements (CRR) or mopping up of excessive liquidity through purchases from the kerb market, to curb speculative activities in the forex market. The recent level of the nominal exchange rate appears to be controversial from the monetary policy angle. Although the SBP considers the current level of the exchange rate suitable for foreign trade, the IMF and other institutions have shown their concern recently over its suitability which is based on continuous deterioration of Pakistan’s external trade, particularly the current account.

One viewpoint is that the appreciation of the Pak rupee is the result of a host of other factors, thus it is difficult to assess the creditability of the recent level of the nominal exchange rate from a monetary point of view. The reason is that monetary policy simply helped exchange rate stabilization at a specific level. It is, therefore, difficult to say that the recent level of the exchange rate is close to the equilibrium level.

The prime objective of the current study is to evaluate the suitability of existing exchange rate policy for Pakistan’s external trade. It


will particularly pinpoint the magnitude if the exchange rate has deviated significantly from its equilibrium level. For this purpose, the paper is organized in the following way. The second section is about the history of exchange rate regimes and its significance for Pakistan’s external trade. The third section discusses the methodology used for assessing the deviation of the exchange rate from its equilibrium level. The fourth section pertains to concluding remarks.

II. Exchange Rate Regimes and Pakistan Foreign Trade

Pakistan pursued different exchange rate regimes in its history spreading over 60 years. Initially, the Pak rupee was pegged to the Pound Sterling. The Pak rupee was then pegged to the US dollar in 1971 and the new exchange rate parity was fixed at Rs.4.76 per US $. After the separation of erstwhile East Pakistan (now Bangladesh) in December 1971, Pakistan had problems in absorbing the surplus products which earlier used to be sent to former East Pakistan. Large amounts of raw cotton piled up during fiscal year 1971/72. Since its introduction on 15th January 1959, the Export Bonus Scheme (EBS) had become increasingly complex with all the adverse consequences of multiple exchange rates for resource allocation. Also, Pakistan experienced a high rate of inflation during this period. These events convinced policy makers to rationalize the exchange rate through adjustment. As a result, the Rupee was depreciated on 11th May, 1972 and the new exchange rate was set at Rs.11.00 per US Dollar.

Pakistan's Foreign Trade and Rupee/$ Parity

0

10,000

20,000

30,000

40,000

50,000

FY79

FY81

FY83

FY85

FY87

FY89

FY91

FY93

FY95

FY97

FY99

FY01

FY03

FY05

FY07

t

Milli

on U

S $

010203040506070

Rup

ees

Trade (LHS) Exchange rate


The new exchange rate was viewed by some people as excessive devaluation of the Rupee39. However, when the US$ was devalued by 10% in February 1973, the Pak Rupee, being linked with US$, automatically appreciated by 10% and the new exchange rate was the Pak Rupee 9.90 per US dollar. This exchange rate continued till 8th January 1982, when the fixed exchange rate was discarded, and the State Bank of Pakistan adopted a managed float based on a basket of 16 currencies of Pakistan’s trade partners.

Following the worldwide trend of deregulation of economies and exchange rates, Pakistan opted out of the fixed exchange rate regime and floated the value of the rupee against a basket of sixteen currencies under a managed exchange rate regime on 8th January 1982. As a result, the value of the rupee depreciated quite significantly after the adoption of the managed floating regime. During the 1990s, the value of the rupee was generally set in line with the inflation differential. In other words, the rupee had to be devalued to offset the adverse effect of domestic inflation on the real exchange rate. For the last decade, however, exchange rate depreciation has been undertaken more as a desperate attempt to control the rising Current Account Deficit (CAD) than to follow the Purchasing Power Parity (PPP) rule. The cumulative current account deficit during the period 1992/98 stood at about US$23-30 billion which was financed by the entire amount of US$11.0 billion of foreign currency deposits besides government’s additional external borrowings. Accumulation of large short-term liabilities in the absence of an equal rise in foreign exchange reserves was bound to lead to a crisis in a period of economic or political uncertainties. The economic crisis occurred when Pakistan exploded the nuclear bomb on May 28, 1998.

During the fixed exchange rate regime from FY73-82, the actual Real Effective Exchange Rate (REER) moved in tandem with the price differential and the movement of the US Dollar vis-à-vis major currencies. The Rupee regained competitiveness in real terms during 1976–79, because of the continued lower inflation differential and US Dollar depreciation vis-à-vis major currencies. During the early 1980s, the REER appreciated substantially due to the appreciation of the US Dollar against major currencies and higher domestic inflation as compared to its trading partners. Keeping in view this sharp appreciation, Pakistan adopted the managed floating exchange rate system on January 8, 1982. The period thereafter was

39 For details of discussion among the policy makers which led to new exchange rate, please see Janjua, “The History of State Bank of Pakistan, Volume-III, (1977-88),” pp 409 – 413.


characterized by more frequent and small adjustments in the Rupee against the US Dollar, keeping in view the relative changes in exchange rates and the prices of the country's major trading partners/competitors as well as the various macroeconomic indicators of Pakistan.

With the transformation of the economy from a semi-closed to a more open or market-oriented economy in the beginning of the 1990s, the exchange rate saw a much larger devaluation in nominal terms, which was just offset by a higher level of inflation in Pakistan as compared to its trading partners. The imposition of economic sanctions following the nuclear tests in May 1998 created a crisis-like situation and the State Bank of Pakistan introduced a number of measures including the implementation of a two-tier exchange rate system40 among others, from 22nd July 1998, to steer the economy out of the crisis. On May 19, 1999, the SBP moved from multiple exchange rates to the dirty float by defending the exchange rate within a narrow band up to 20th July 2000 by channeling the foreign exchange from the kerb market to the inter-bank market through kerb purchases. In July 2000, the SBP moved away from the managed exchange rate to a floating exchange rate regime.

Trend in Nominal and Real Effective Exchange Rates

50

70

90

110

130

150

170190

210

230

250

FY-7

8FY

-79

FY-8

0FY

-81

FY-8

2FY

-83

FY-8

4FY

-85

FY-8

6FY

-87

FY-8

8FY

-89

FY-9

0FY

-91

FY-9

2FY

-93

FY-9

4FY

-95

FY-9

6FY

-97

FY-9

8FY

-99

FY-0

0FY

-01

FY-0

2FY

-03

FY-0

4FY

-05

-18

-15

-12

-9

-6

-3

03

6

9

12

perc

ent

App/Dep in REER (RHS) NEER REER

40 The new mechanism was based on: a) official exchange rate, b) floating inter-bank exchange rate, and c) composite rate.


Bilateral RER (2000:100)

20.00

40.00

60.00

80.00

100.00

120.00

140.00

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

RS/yen RS/PSt

Initially, the rupee dollar parity witnessed a sharp nominal depreciation of 18.5% during Fiscal Year 2001, which shows the market correction of the cumulative overvaluation that took place during Fiscal Year 1999 and Fiscal Year 2000. In the new exchange rate regime, monetary instruments act as a nominal anchor to curb the anticipated high volatility of the exchange rate. This, coupled with the build-up of forex reserves, led to stability in the nominal exchange rate after the sharp depreciation in Fiscal Year 2001. The substantial surge in workers’ remittances in the inter-bank market following the international crackdown on informal channels after the September 11, 2001 incident reversed the downward trend in the exchange rate. The excess liquidity in the foreign exchange market, following the post September 11, 2001 surge in workers’ remittances in the formal banking channel, induced the SBP to purchase US$ 8.2 billion from October 2001 to March 2004 to preserve the competitiveness of exports from abrupt exchange rate appreciation. The increased demand of foreign exchange from importers dried up excess liquidity in the inter-bank market, which not only prompted the SBP to scale down its purchases from the inter-bank market; SBP also had to start providing market support by financing lumpy oil payments. Interestingly, in real terms, the Rupee continued to maintain the compositeness due to the fact that the basket of currencies appreciated against the Dollar more than the Rupee and relatively higher inflation compared to that of trading partners.


Exchange Rate

Date / Period Exchange Rate Regime (Pak Rupee per US Dollar)

App(+)/ Dep(-)

Prior to August,1955 3.31 8/1/1955 (i) Fixed Exchange Rate 4.76 -30.46 5/11/1972 from 14-8-1947 to 07-01-1982 11 -56.73 13-Feb-73 9.9 11.11 8-Jan-82 10.1 -1.98 1981-82 10.5535 -4.30 1982-83 12.7063 -16.94 1983-84 13.4838 -5.77 1984-85 15.1668 -11.10 1985-86 16.1391 -6.02 1986-87 17.1795 -6.06 1987-88 17.5994 -2.39 1988-89 19.2154 -8.41 1989-90 (ii) Managed Float 21.4453 -10.40 1990-91 from 8th Jan. 1982 to 21st July 1998 22.4228 -4.36 1991-92 24.8441 -9.75 1992-93 25.9598 -4.30 1993-94 30.1638 -13.94 1994-95 30.8507 -2.23 1995-96 33.5684 -8.10 1996-97 38.9936 -13.91 1997-98 43.1958 -9.73 1998-99 - (iii) Two tier Exchange Rate System 50.0546 46.7904 -13.70 (Multiple Exchang Rate) from 22nd July 1998 to 18th May 1999 1999-00 - (iv) Dirty Float: SBP defending the 51.7709 -3.32 exchange rate within a narrow band from 19th May 99 to 20th Jul 2000 2000-01 (v)from Managed Float to Floating 58.4378 -11.41 2001-02 Exchange Rate regime 61.42580 -4.86 2002-03 Since July 20, 2000 58.49950 5.00 2003-04 57.57450 1.61 2004-05 59.35760 -3.00 2005-06 59.85660 -0.83


1) The two-tier exchange rate system was introduced on July 22, 1998. The new mechanism was based on: a) official exchange rate, b) floating inter-bank exchange rate, and c) composite rate.

2) The exchange rate system was unified on May 19, 1999.

Since the free float of the rupee, the monetary policy has played a dominant role in stabilizing the exchange rate in Pakistan. Significant ups and downs in forex rates are now being monitored through effective instruments of monetary policy. Similarly, whenever speculative activities are observed in the market, they are tackled with proactive monetary policy measures taken by the State Bank. The Bank uses the instrument of discount rate to control undue pressure on the exchange rate while the CRR or mopping up of excessive liquidity through purchases from the kerb market are used to curb speculative activities in the forex market. According to the SBP, the following considerations are generally taken into account while looking at the level of the exchange rate from the monetary policy side:

1. The existing level of the exchange rate has helped improve the build-up of forex reserves. There is a continuous increase in forex reserves, which is also a positive sign for the economic stability of the country.

2. The existing exchange rate level has sufficiently discouraged speculative activities in the forex market.

3. The rate has also helped discourage inflows of foreign remittances from illegitimate channels. Now there are less incentives for remitters to transmit their money through Hundi or other illegal channels.

4. The rate has helped strengthen the role of the inter-bank market. The two forex markets are expected to integrate if the existing rate prevails for a longer period.

5. The existing level of the exchange rate has smaller pass-through, which is evident from the lower inflation rate.

6. The rate is also providing an incentive to capital inflows. Some positive developments are also witnessed on the private foreign investment front.


Pakistan's Exports and Rupee App/Dep

02,0004,0006,0008,000

10,00012,00014,00016,00018,00020,000

FY79

FY81

FY83

FY85

FY87

FY89

FY91

FY93

FY95

FY97

FY99

FY01

FY03

FY05

FY07

t

Mill

ion

US$

-20

-15

-10

-5

0

5

10

In P

erce

ntApp/Dep Exports

Like other economies, the September 11, 2001, incident had significant consequences for the Pakistani economy. The process of appreciation of Rupee-Dollar parity not only started but quickened primarily during the month of October 2001 in the wake of increasing capital inflows from the international community and donor agencies and easing of quota restrictions imposed on some Pakistani exportables to the Euro zone and the United States. The strengthening of the Rupee resulted from a variety of factors, these included the lifting of US sanctions, easing of quota restrictions by the European community, rescheduling of external debt, a positive response by the IMF in terms of approval of credit lines, an increase in foreign exchange reserves and diversion of investment funds from the currency market to the stock market.

As regards Pakistan’s exports, it may be noted that Pakistan’s export structure has a very narrow base, both in terms of products and markets, and most of the exportable items are of low value addition. The composition of exports mainly consists of textile manufactures and food items, largely originating from the agricultural sector where the incidence of uncertainty is quite high and the market is highly competitive. Although, the textile sector constitutes over 65% of our total exports, its production and exports have attained almost maximum capacity and there is a need to shift the focus to other exportable items. The external shocks taking the form of depressed demand and decreasing price of export products in the international market have made the external sector most vulnerable. As for the destination of Pakistan’s exports, about 70% of exports are directed to


only 13 countries including the USA, UK, Hong Kong, Germany, Dubai, France, Japan, South Korea and Canada, etc.

The structure of the country’s exports calls for a policy shift to diversify exports across different products and also to move towards higher value-added items. The objective of diversification and value addition can be achieved through consistent and well-defined strategies. Due to limited resources, a piece-meal strategy should be adopted to enhance the export base. Initially, there is a need to explore the products in which the country has a comparative advantage and certain low cost measures will help boost the exports, thereby enhancing productivity. In spite of the fact that fruits, vegetables and fish are produced in abundance in Pakistan, the processing industry is not developed. One of the major reasons for Pakistan's poor performance in this field is a lack of storage and canning facilities. Non-traditional agro-based products such as fruits, vegetables, dairy products and fish offer vast scope in augmenting domestic production and exports through crop substitution, the introduction of modern technology for storage, processing and packing, etc. The Export Promotion Bureau should plan cold storage houses at different points in the fruit growing areas to handle farm products for export purposes. These storage houses should also serve as places where training for the packaging of fruits, vegetables and fish for export should be imparted to the exporters.

The textile sector, which is the single largest contributor to the nation’s export earnings, has remained concentrated in the relatively low value-added segment of the market, which has retarded the realization of Pakistan’s true potential in textile exports. Thus, the need is both to diversify exports across different product categories and also to move to higher value-added textile exports. The slowdown in exports from this sector exerts a dampening effect on the overall export growth. For export diversification through higher value added products, there is a need to upgrade technology, which involves: 1) tailoring the existing technology and processes to specific production requirements; 2) improving processes within the existing technology design; 3) improving the quality of textile products. Information Technology and other hi-tech sectors also require special attention for development according to potential. Due to the economic recession in major industrial economies and enhanced competition, the country may also explore new markets for its products, particularly in the Central Asian Republics, East Asian countries and the African region.

In a changing international environment, Pakistan also needs to diversify exports towards its industrial base. This objective can be achieved by attracting Foreign Development Investment (FDI) selectively in such


export-oriented industries that correspond to and utilize the dynamic comparative advantage of the country. This will proactively create linkages between domestic firms and Transnational Corporations (TNCs), enabling local firms to tap the technological expertise of TNCs and move into integrated international production systems, as indirect or direct exporters.

III. Exchange Rate Misalignment and Future Outlook

In 1994, John Williamson observed that he “cannot see how the Fund could be expected to play a central role in the international monetary system without the analytical capacity to judge whether exchange rates were consistent with satisfactory macro-economic outcomes.” Propounding the concept of the Fundamental Equilibrium Exchange Rate (FEER), he defined it as the real effective exchange rate that is consistent with macro-economic balance (which requires the simultaneous attainment of both the internal and external balance).

To make the Real Effective Exchange Rate (REER) based assessments comparable with other variants of equilibrium, the behavior of REER is decomposed into permanent and temporary components and the movements in each is explained in terms of certain determinants. Some studies try to explain the REER appreciation / depreciation through certain identifiable fundamental determinants and any movement in REER that remains unexplained by the fundamentals is ascribed to cyclical / temporary shocks (both internal and external) and interpreted as misalignment. Deviation of the actual REER (based on observed inflation rates) from the equilibrium REER (derived on the basis of fundamental determinants) – the sign of misalignment – is not easy to identify. This is because there could be two types of real exchange rate misalignment. Macroeconomic induced misalignments occur mainly due to inconsistent macro polices (particularly monetary policy). On the other hand, structural misalignment results when changes in real determinants (such as technical progress and shifts in terms of trade) alter the equilibrium REER, but the actual REER does not change (Edwards, 1992). Sachs, Tornell and Velasco (1996) offered two reasons to explain why the market agents also take into account the leading information embodied in the REER.

a) Firstly, the higher the degree of appreciation of the REER and the lower the extent to which tradables respond to REER depreciation, the market receives the signal that a large REER depreciation may be necessary to restore external balance, and accordingly initiates action to ensure a sharp fall in the nominal exchange rate.


b) Secondly, the more vulnerable an economy is to sudden and large demand compression when demand management measures are instituted to correct the external imbalance, the market perceives that the authorities may prefer depreciation to recession and such market perceptions often trigger the attack. Besides relating to the construction of REER and fixing a benchmark equilibrium level, several operational issues constrain any explicit policy pronouncement on REER.

Misalignment generally refers to deviation of the actual exchange rate from a path that is consistent with the economic fundamentals. Exact identification of the path that could reflect economic fundamentals has, however, proved elusive. The complexity of the issue has spawned an enormous volume of literature, each trying to offer an alternative approximation. For the purpose of identifying misalignment, various determinants of the exchange rate have been used in the literature. The earliest attempt on the subject dates back to 1945 when Ragnar Nurkse defined the equilibrium exchange rate as one that could give rise to an equilibrium in the balance of payments subject to:

1. the absence of any undue restrictions in trade flows,

2. the absence of special incentives to encourage inflow and measures to discourage outflows, and

3. the absence of excessive unemployment.

The recent theoretical and empirical literature on the determinants of the Equilibrium Real Exchange Rate (ERER) in developing countries include Bartolini et al (1994), Edwards (1994), Elbadawi (1994), Guerguil and Kaufman (1998) and Chinn (1998). Edwards (1994) constructed the ERER based on a theoretical model that features a sustainable long-run equilibrium in the nontraded goods and the external sector. The model recognizes the fact that the short-term and long-term determinants of the ERER may differ, and more specifically, only real factors determine the long-run behavior of the real exchange rate whereas both nominal and real factors influence short-run behavior. The model is very similar to Williamson's seminal work (Williamson 1985) except that it is constructed for a small, open economy, which is unable to influence its terms of trade. The construction of the ex-post ERER involves the estimation of the real exchange rate that preserves the internal and the external equilibria.


Here, we applied the Johansen’s full-information maximum-likelihood methodology of cointegrated systems (Johansen 1988) to estimate the ex-post ERER for Pakistan as pinpointing the factors that resulted in the misalignment of the real exchange rate in Pakistan, and could help investigating the aspects of current account sustainability and the appropriateness of exchange rate policies in Pakistan. The estimation procedure is very convenient since it incorporates the cointegration relation to show how the "fundamentals" influence the real exchange rate in the long run and derives the ERER as well as the error correction mechanism to model the short-run adjustment process. The explanatory variables used in the model capture fundamentals such as the fiscal stance, degree of economic openness, international terms of trade, and net capital flows.

The current study uses Engle Granger cointegration technique to estimate the ERER, based on various macroeconomic fundamentals suggested in the economic literature.

Empirical Framework

The methodology adopted in this paper has earlier been used by Hyder, Zulfiqar and Adil Mahboob (2006). The study has updated the estimates of their study and made forecasts41 of misalignment upto 2010. The paper estimates the degree of real exchange rate misalignment based on the model developed by Edwards (1988, 1989, 1994), Elbadawi (1994), and Montiel (1997). The reduced form REER equation is given as follows:

lreer= f ( ltrop, ltot, lgovc, lrigdp, lremg, capinf, tfpd/t) (-) (+/-) (+/-) (-) (+) (-) (+)

The variables included in the analysis are: the real effective exchange rate index (reer), trade openness (trop), terms of trade (tot), real investment to GDP ratio (rigdp), government consumption as % of GDP (govc), workers’ remittances as % of GDP (remg), long-term capital to gross domestic product (capinf), and total factor productivity differentials (tfpd) or time trend (t) representing the Harrod-Balassa Samuelson effect. All variables, except capinf and tfpd, are expressed in natural logs. The signs for each fundamental variable in determining the behavior of REER are explained below:

41 The forecasts are made under the assumption of the prevalence of a static environment in Pakistan which is likely to remain unchanged up to 2010 and we do not foresee the reversal of significant changes in the external economic front of the Pakistani economy during the period.


• Trade openness depreciates REER because trade liberalization and trade opening makes future consumption of importables very cheap which in turn makes consumers substitute non-tradable for tradable goods.

• The impact of terms of trade on REER is ambiguous and can take either sign depending on the substitution and income effects.

• The impact of government consumption on REER depends not only on the government inter-temporal budget constraints but also on the composition of government consumption. If government consumption contains a larger share of tradable goods, then the increase in government consumption will worsen the current account, and thus lead to a depreciation of REER.

• The sign of rigdp would be negative as the rise in rigdp means higher spending on tradables (imported machinery and raw materials).

• The sign of workers’ remittances to GDP ratio on the real exchange rate is positive which reflects that the rise in workers’ remittances to GDP ratio, remg, leads to appreciation of the real exchange rate.

• The impact of net capital inflows on REER depends on the magnitude of capital flows. The capital inflows over and above the current account deficit will lead to appreciation of the REER while the capital inflows matching or lower than the current account result in the depreciation of the REER.

• The inclusion of the tfpd or time trend (t) in the REER equation represents the well-known Balassa-Samuelson effect, which contends that productivity improvements will be generally concentrated in the tradable sector and thus lead to an appreciation of the REER.

The Engle-Granger two-step cointegration approach has been used to estimate a single equation REER model for Pakistan. The coefficients from the estimated models and sustainable values of the economic fundamentals are then used to compute the ERER, while the misalignments of the exchange rate are computed by taking the %age deviations of the actual REER from the ERER. Annual data from Fiscal Year 1978 to Fiscal Year 2006 have been used. The IMF trade-weighted REER index has been used for Pakistan while the rest of the data are taken from the SBP’s


Statistical Bulletin, Economic Survey, and Economic Report of the President on the US economy for the year 2006.

Results Interpretation

Firstly, the time series properties of data have been checked by testing the stationarity of the fundamental variables. The augmented Dickey-Fuller (ADF) criterion has been applied for unit root and the results of the ADF test suggest that all the variables are integrated of order one, i.e. I(1), which fulfills the criteria for estimating any long run relations.

The Ordinary Least Square (OLS) has been applied for the estimation of the results. The results are quite encouraging as coefficients and signs in all regressions except rigdp coincide with the earlier empirical studies. In the regression equation, five macroeconomic fundamentals [trade openness (trop), current government consumption to GDP ratio (govc), net capital inflows as % of GDP, real investment to real GDP ratio (rigdp), and total factor productivity differential (tfpd)] determine the REER. Trop, and the increase in govc and capinf caused depreciation in the REER while an increase in rigdp leads to appreciation of the REER. The improvement in tfpd leads to REER appreciation. The coefficient of tfpd is small in all three regressions, which is in line with the recent empirical work. In Pakistan’s case, workers’ remittances are an important source of foreign exchange earnings and finance a large portion of trade and services deficits in the current account balance.

Workers’ remittances turn out to be significant and have a positive sign, which reflects that the increase in the remittance inflows cause appreciation of the real exchange rate. Furthermore, the inclusion of the relevant variable, remg, positively affects the overall performance of the regression and causes tot (an important macroeconomic fundamental) to significantly explain the real exchange rate. The positive sign of tot shows that the improvement of tot leads to appreciation of the real exchange rate. However, rigap becomes insignificant with the inclusion of remg and the Wald Test supports the exclusion of rigdp.

The residuals generated from these regressions are tested for unit root to establish a long-run cointegrating relationship. These residuals are stationary, as reflected by the results of the unit root test reported, confirming that the above regression is showing a long-run cointegrating relationship between the REER and economic fundamentals.


LRERR = 7.7 - 0.61* LTROP - 0.94* LGOVC + 0.17* LREMG- (8.71) (-4.63) (-7.61) (5.91)

0.03*CAPINF1 + 0.34* LTOT + 0.03*TFPD (1) (-3.34) (3.49) (5.73)

R2 = 0.96 Adj R2 = 0.94 S.E Regression = 0.07 D.W Statistics= 1.60

Following are the major results of the regression:

• As trade openness increases by one %age point of GDP, this leads to real depreciation of 0.61% of the Pak rupee against the basket of currencies

• An improvement in terms of trade by one percent causes 0.34% real appreciation of the Pak rupee vis-à-vis the basket of currencies.

• An increase in government expenditure of one percentage point of GDP is associated with 0.94% real of depreciation of the Pak rupee against the basket of currencies.

• An increase in net capital inflows of one percentage point of GDP causes 0.03% real depreciation of the REER.

• An increase in workers’ remittances of one percentage point of GDP leads to a 0.17% real appreciation of the Pak rupee against the basket of currencies.

• A one unit reduction in total factor productivity differential relative to trading partners (i.e. US) causes a 0.03% real appreciation of the Pak rupee against the basket of currencies.

The estimated regressions also satisfied the diagnostic tests.


Actual Vs Equilibrium Real Effective Exchnage Rates (1992=100)

80.0

95.0

110.0

125.0

140.0

155.0

170.0

185.0

200.0

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Actual REER EREER3

The above long-term relationships can be used to compute the ERERs by evaluating these coefficients at sustainable values of macroe

presents the actual REER and the ERER derived by evaluating the coefficients at the HP filter series of economic fundam

conomic fundamentals. The rationale of using sustainable economic fundamentals is to eliminate short run fluctuations in the explanatory variables and only use long-term equilibrium values of the variables. The Hodrick-Prescott (HP) filter is used to remove the short-term variations from the explanatory variables.

The Figure (above)

entals. The estimated ERER reflects a divergence in both directions from the actual REER in the first part of the sample while the behavior of the actual REER remained close in the latter part of the sample. More specifically, the rupee remained overvalued from 1978 to 1980 relative to the ERER due to a lower price differential and real depreciation of the US dollar against the major currencies. During the period 1981-86, the trend of the actual REER and ERER reveals that the rupee remained undervalued due to the real appreciation of the US dollar against hard currencies. This figure also reflects that the actual REER appears to have been close to its estimated equilibrium REER during the last five years. However, the spread between the forecasts of the REER and ERER appears to have widened during the period up to 2010 mainly on account of real appreciation of the Pak rupee against trading partners and competitors currencies.


Short-term dynamics of the REER are examined through the estimation of error correction models (ECMs) which show that some of the long-term fundamentals such as trop, capinf, and govc are statistically significa

ge rate policy, fiscal policy and monetary policy may impact the REER in the short run. We investigated the impact of macroeconomic polices and fou

nt and affect the short-run dynamics of the real exchange rate in the same direction as the variables did in the case of the long run. The estimated regressions also satisfied the post-diagnostic tests such as of no autocorrelation, homoskedasticity, normality of the residuals and stability of parameters.

As described in the economic literature, macroeconomics policies such as the exchan

nd that excess domestic credit was insignificant while a rise in fiscal deficit as a percentage of GDP and depreciation of the nominal exchange rate (ndev) led to depreciation of the REER in the short run. Monetary policy is statistically insignificant in all the short-run regressions which may reinforce the established view that monetary policy in Pakistan was subservient to fiscal policy. Since monetary policy remained subservient to fiscal policy due to the heavy reliance of the government on financing the fiscal deficit from the banking system, the direct impact of monetary policy in the short term is statistically insignificant. The impact of net devaluation on the ERER turned out to be negative as expected which indicates that nominal devaluation/depreciation of the Pak Rupee against the US $ depreciates the REER. As the coefficient of the error correction term is negative and has absolute values smaller than one, this not only indicates the stability in the long-term ERER but also reflects the gradual convergence of the exchange rate towards long-run equilibrium.


We have also derived a misalignment of the exchange rate which is percentage deviations of the actual REER from its equilibrium level. The misalignment is based on the model of the ERER. Negative and positive deviations reflect real appreciation/ depreciation of the actual REER from its equilibrium level.

Misalignment (in percent)

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

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FY10

Mis1

The exchange rate misalignment ranged between -12.1% to 25.2% with zero reversion mean during the year 1978 and 2006. Furthermore, the actual REER in 2006 reflects an appreciation of the REER relative to the ERER. This suggests that the current exchange rate is away from the ERER.

These results yield the following important policy implications for exchange rate policy in Pakistan:

a) ERER is not fixed and is subject to variability as a result of changes in economic fundamentals.

b) Fiscal policy is crucial to exchange rate stability in Pakistan.


c) The appreciation of the actual REER due to higher price differentials relative to the ERER would lead to exchange rate misalignment.

d) A flexible exchange rate regime responds better in case of real shocks more than other exchange rate regimes. This suggests that the SBP should continue with its current stance of a flexible exchange rate regime and intervene in the interbank market only to smooth unwarranted movements in the exchange rate by keeping in view the ERER and exchange rate misalignment.

To strengthen the viewpoint on exchange rate policy, bi-lateral REER and ERRER has been computed for Yen and Pound Sterling. Both the estimates of ERRER exhibit a completely different picture. The bi-lateral REER and ERRER and computed misalignment against both the currencies is given in the Appendix.

IV. Where do we go from here?

1. There has to be identification of and emphasis on the indicators of fundamental equilibrium in the medium term.

2. Policy has to be a more flexible exchange rate to maintain a competitive position in the world market.

3. Policy measures should be identified and if needed, should be introduced immediately to correct any actual or even potential misalignments of the exchange rate.

V. Policies and Ground Realities

Apart from a theoretical approach there is a need for greater (and more intensive) coordination among the stakeholders: the SBP and the government, the latter Comprising Finance, Commence, Export Promotion Bureau, Board of Investment and Planning Commission.

Constraining policy hurdles should be removed at the macro and micro level:

- Export industries

- Meeting the requirements of SMEs (fisheries, no bank credit, fishers, do not have any collateral) – the case of tiles.


- Availability of specific facilities at the Federal, Provincial and Local level. There is a need for improvement in the quality of imports: all those factors which are related to productivity. It is not too early to talk of a knowledge based economy – The role model is Singapore’s medium and long term issues.

- The SBP should restrict its role to financial flows and price stability: there should be adequate credit facilities to make full use of the export potential.

- The government should provide incentives to help maintain competitiveness.

- Diversification of exports.

Concentration of exports in commodities: textiles, carpets, leather products, sports goods, surgical instruments, rice etc. There is a need for diversification towards services including I.T., dairy products, cottage industry products, plants and machinery and jewelry.

We must also expand inter-regional trade with India, Bangladesh, Sri Lanka, and China. With over 25% of our exports going to the U.S.A. we have become extremely vulnerable. Any sanction could spell disaster for us.

VI. Concluding Remarks

1. Information about the causes of fluctuations in the real exchange rate is important for central banks, as some fluctuations may require immediate corrective actions by them while others may not require this. It is essential to know what kind of movements in the real exchange rate signal a loss in the external competitiveness of the economy. If appreciation of the real exchange rate is due to an improvement in the “fundamentals” such as an increase in the rate of productivity growth in the tradable goods sector of an economy, the central banks in this case need not take any corrective action. However, if the real exchange rate deviates significantly from its equilibrium level, also known as a “misalignment”, the competitive stance of the Pak economy would be jeopardized and require immediate “corrective action” by the SBP.

2. The real exchange rate responds to real as well as nominal (monetary) variables. At any given moment, the real exchange rate depends on economic fundamentals (e.g. tariffs, international prices,


real interest rates, etc.) and aggregate macroeconomic pressures, generated by an excess supply of money or a fiscal deficit or both.

3. In order to achieve sustainable macroeconomic equilibrium, monetary and fiscal policies must be consistent with the chosen nominal exchange rate regime. Further, the misalignments in the real exchange rate can be used as a guideline for policy interventions by the SBP.

4. Pakistan’s Balance of Payments (BoP) is characterized by persistent large external financing needs with weak economic activity in the country. This has cast doubt on the possibility of exchange rate misalignment in Pakistan.

5. The CPI-based REER index suggests that the Pak. rupee has been depreciating over the period of the study. However, the rate of real depreciation of the Pak rupee was lower than the actual need which is evident by the widening of Pakistan’s trade deficit. Moreover, Pakistan’s export base remained stagnant and did show significant diversification in the last decades, which is reflected in a constant export market share and deteriorating trade balances.

6. There are some signs of external financial vulnerability and the country’s real exchange rate appears to be somewhat overvalued, a situation that could be best addressed through increased fiscal discipline.

7. The BOP statistics show that despite continued devaluation, the Current Account Deficit (CAD) in Pakistan has deteriorated. This does not necessarily mean that the exchange rate polices do not work. The exchange rate policy in Pakistan failed due to a number of factors. The most important reason is that devaluation was accompanied by poor monetary management. In particular a continued growth in money supply resulted in a high inflation rate which neutralized the favorable affects of devaluation on the real exchange rate and Pakistan could not achieve any competitive advantage from devaluation. What really matters is to improve the BOP position through adjustment in the real exchange rate. To influence the real exchange rate through devaluation, Pakistan should have adopted a tight monetary policy. Thus, except for the intervention in the foreign exchange market the State Bank of Pakistan should have held tight control on money supply.


8. In a changing international environment, Pakistan also needs to diversify exports towards its industrial base. This objective can be achieved by attracting FDI selectively into such export-oriented industries that correspond to and utilize the dynamic comparative advantages of the country. This will proactively create linkages between domestic firms and Transnational Corporations (TNCs), enabling local firms to tap the technological expertise of TNCs and move into integrated international production systems, as indirect or direct exporters.

9. The structure of the country’s exports suggests the need for a policy shift, to diversify exports across different products and also to move towards higher value-added items. The objective of diversification and value addition can be achieved through consistent and well-defined strategies. Due to limited resources, a piece-meal strategy should be adopted to enhance the exports base. Initially, there is a need to explore the products in which the country has a comparative advantage and certain low cost measures will help boost exports, thereby enhancing productivity. In spite of the fact that fruits, vegetables and fish are produced in abundance in Pakistan, the processing industry is not developed. One of the major reasons for Pakistan's poor performance in this field is lack of a storage and canning facility. Non-traditional agro-based products like fruits, vegetables, dairy products and fish offer vast scope to augment domestic production and exports through crop substitution, the introduction of modern technology for storage, processing and packing, etc. The Trade Development Authority of Pakistan (TDAP), formerly the Export Promotion Bureau, should plan cold storage houses at different points in the fruit growing areas to handle farm products for export purposes. These storage houses should also serve as places where training for the packaging of fruits, vegetables and fish for export should be imparted to the exporters.

10. The variables such as trade openness, government consumption and capital inflows lead to depreciation of the REER index, while workers’ remittances, terms of trade, and total factor productivity vis-à-vis trading partners lead to an appreciation of the REER index.


References

Arslaner, F. and G. Erlat, 1997, “Measuring Annual Real Exchange Rate Series for Turkey”, Yapi Kredi Economic Review Vol. 8, No. 2, pp. 35-61.

Black, S., 1994, “On the Concept and Usefulness of the Equilibrium Rate of Exchange”, in J. Williamson (ed.), Estimating Equilibrium Exchange Rates, Institute for International Economics, Washington, DC.

Bartolini, L., P. Clark, T. Bayoumi, and S. Symansky, 1994, “Exchange Rates and Economic Fundamentals: A Framework for Analysis”, IMF Occasional Paper No. 115.

Chinn, M., 1998, “Before the Fall: Were East Asian Currencies Overvalued?” NBER Working Paper No. 6491.

Economic Report of the President, 1999, “International Capital Flows, Their Causes, and the Risk of Financial Crisis,” Chapter 6, United States Government Printing Office, Washington, 1999.

Edwards, S., 1994, “Real and Monetary Determinants of Real Exchange Rate Behavior: Theory and Evidence from Developing Countries”, in Estimating Equilibrium Exchange Rates, ed. by J. Williamson, Institute for International Economics, Washington, DC.

Elbadawi, I., 1994, “Estimating Long-Run Equilibrium Real Exchange Rates”, in J. Williamson (ed.), Estimating Equilibrium Exchange Rates, Institute for International Economics, Washington, DC.

Feyzioglu, T., 1997, “Estimating the Equilibrium Exchange Rate: An Application to Finland”, IMF Working Paper No: 97/109.

Guerguil, M. and M. Kaufman, 1998, “Competitiveness and the Evolution of the Real Exchange Rate in Chile”, IMF Working Paper No. 98/58.

Hyder, Zulfiqar and Adil Mahboob, 2006, “Equilibrium Real Effective Exchange Rate and Exchange Rate Misalignment in Pakistan”, SBP Working Paper Series, 2006.

Johansen, S., 1988, “Statistical Analysis of Cointegration Vectors”, Journal of Economic Dynamics and Control, No. 12, pp. 231-254.


Johansen, S., 1991, “Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models”, Econometrica, Vol. 52, pp. 389-402.

Kwiatkowski, D., P. Phillips, P. Schmidt, and Y. Shin, 1992, “Testing the Null Hypothesis of Stationarity Against the Alternative of a Unit Root: How Sure are We that Economic Time Series have a Unit Root?” Journal of Econometrics Vol. 44, pp. 159-178.

Rogoff, K., 1996, “The Purchasing Power Parity Puzzle”, Journal of Economic Literature 34, no. 2, pp. 647-668.

Saygili, M., G. Sahinbeyoglu and P. Ozbay, 1998, “Competitiveness Indicators and the Equilibrium Real Exchange Rate Dynamics in Turkey”, in Macroeconomic Analysis of Turkey: Essays on Current Issues, Research Department, The Central Bank of The Republic of Turkey.

Williamson, J., 1985, “The Exchange Rate System” Policy Analyses in International Economics 5, Institute of International Economics, Washington, D.C.


Appendix

Bilateral Misalignment

Bilateral Actual and Equilibrium RER vis a vis Pound Sterling

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Bilateral Actual and Equilibrium RER vis a vis Yen

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Actual BRER EBRER


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Depreciation


Doha Round Baggage: Implications for Economic Reforms in Pakistan and other Southern Countries

Naheed Zia Khan*

Abstract

This study is based on the premise that agriculture remains the key issue in all reform efforts of Pakistan and the Doha Round of trade talks has strategic significance for the second round of the country’s farm sector reforms. It is argued that although there are differences among the individual developing countries, the majority have a comparative advantage in agricultural production and removing farm sector export subsidies and trade-distorting, domestic subsidies is their common concern. Evidence is provided to support the view that the Uruguay Round negotiations on agricultural subsidies are not a done deal, because although signed by the members, the Agreement on Agriculture is not ‘ratified’ by the recent farm bills of the developed countries which continue to defy economic logic and the WTO (World Trade Organization). On the other hand, the evidence provided from Pakistan shows that the governments of developing countries are not fighting the farmers’ cause since they are poorly managing agricultural policy and have been overly compliant with respect to the Uruguay Round ruling on reducing farm subsidies and increasing trade liberalization. The analysis shows that although the developed countries stand to gain far more from the liberalization of trade in agricultural commodities than the developing countries, the handful of farmers in developed countries are the stumbling block to the regeneration of world trade. It is argued that to alleviate world poverty, the developed countries need to demonstrate their willingness to gradually remove both the absolute value of subsidies provided to their farmers and the tariff and non-tariff barriers that protect agriculture. Finally, the author maintains that at world trade forums, the developing countries have exhibited poor representation due to lack of leadership.

Introduction

The external sector is a fundamental policy concern of both the first and second generation economic reforms in Pakistan. In an economic * Professor of Economics, Fatima Jinnah Women University, Rawalpindi.

Naheed Zia Khan 154

world dominated by trade, the rules of the World Trade Organization (WTO) prevail. These rules are the outcome of the Uruguay Round (UR) of trade talks. The UR began in 1986 and culminated in converting the ‘interim’ Secretariat of the General Agreement on Tariffs and Trade (GATT) into the WTO. The UR was the eighth round of GATT and it included agriculture and services in the trade talks for the first time.1 With 150 member countries in January 2007, the WTO enforces the 1993 UR agreement; the Agreement on Agriculture (AoA), the General Agreement on Trade in Services (GATS), the agreement on Trade Related Intellectual Property Rights (TRIPs) and Trade Related Investment Measures (TRIMs). The members are required to abide by the WTO rules which are prolific, running into thousands of pages. Following an aborted attempt in Seattle in late 1999, the Ministerial Meeting of the WTO in Doha, the capital city of Qatar, launched the next comprehensive round of multilateral trade negotiations in November 2001. The Doha Round aims at reducing tariffs, subsidies and other barriers to global commerce in order to boost progress, apparently, in the underdeveloped parts of the world. Like its predecessor, the UR, agricultural subsidies remain the sticking point also in the Doha Round of trade talks, causing the suspension of the process in July 2006, as the multilateral negotiation on this thorny issue failed to reach agreement even after a five-year effort.

There is a broad range of issues that are of important concern for economic reforms in developing countries such as Pakistan. One key issue relates to the extent to which they have so far benefited from the UR reforms, most notably the commitments to liberalize trade in agriculture. In the wake of the break down of the trade talks in July 2006, this study takes a hard look at developments in agricultural policies since the UR agreement. The analysis is divided into four parts. Part 1 discusses the importance of agriculture in Pakistan’s economy relative to the economies of selected Asian and African countries. Part II presents the estimates, found in the literature, of the welfare gains from removing trade barriers globally. Pakistan’s performance in reforming its agricultural sector is also discussed in this part. Part III analyzes the size and significance of the developed countries’ farm subsidies in the Post-UR agreement period. Finally, before presenting the conclusion of this study, Part IV discusses the factors relating to agricultural subsidies hindering the reform efforts in developing countries.

Part I

1 The earlier Rounds were Geneva 1947; Annecy 1948; Torquay 1950; Geneva 1956; Dillon 1960-61; Kennedy 1964-67; and Tokyo 1973-79.

Implications for Economic Reforms in Pakistan and other Southern Countries 155

During the first reform period, Pakistan’s economic performance compared favorably with most of its Asian counterparts. This is supported by the last century’s scenario presented in Table-1. The figures listed in Tables-1 show that Pakistan fared well in comparison against the averages of low income/ middle income countries and the world, and also with the individual countries included in the list. However, many of its counterparts, both in Asia and Africa, are much ahead on the literacy front where Pakistan lags behind even the low income countries and markedly behind the middle income countries.

Table-1: Economic and Social Indicators of Selected Developing Countries (Asia and Africa)

National Income (growth rate)

1965-99 (% per annum)

Social Indicators 1999

Category

GDP GDP Per Capita

Life Expectancy (years)

Adult Illiteracy Rate (%)

1. Country Bangladesh 3.8 1.3 61 59 Egypt 5.6 3.3 67 45 Kenya 4.7 1.2 48 29 India 4.6 2.4 63 44 Indonesia 6.9 4.8 66 5 Iran 1.7 -1.0 71 24 Malaysia 7.0 4.3 72 13 Mauritius 5.2 3.9 71 16 Oman 9.5 5.0 73 30 Pakistan 5.6 2.7 63 55

Singapore 8.3 6.3 78 8 South Africa 2.3 0.0 48 15 Sri Lanka 4.6 3.0 73 9 Thailand 7.3 5.1 69 5 2. Country Group Low Income 4.1 1.8 59 39 Middle Income 4.2 2.4 70 15 3. World 3.3 1.6 66 n.a.

Source: World Bank (2001a).

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Pakistan’s economic performance is mainly dependent on the performance of its agricultural sector, the lifeline of the country. Table-2 presents the contribution of Pakistan’s agricultural sector in its economy relative to the developing countries included in the comparisons listed in Table-1. All countries included in the list had overwhelmingly agrarian economic structures about two generations ago. However, the drive for modernization and industrialization which began in the later half of the 20th century has varyingly affected different countries. The indicators listed in Table-2 show the relative importance of agriculture in the countries’ economies during the part of the first reform period of the 20th century.

Table-2: Agriculture’s Contribution to the Internal and External Sectors of the Economy

(Selected Developing Countries of Asia and Africa)

Agricultural external sector indicators

Agricultural internal sector shares and growth rate (%) Indices (1995-99)

Country

Labor force 1990

GDP 1999

Growth rate

1965-99

Grain self-

sufficiency (%)

1995-99

Merchandise exports

(% share) 1995-99

Comparative advantage

index

Net export index

Bangladesh 66 25 2.1 88 11 1.07 -0.49

Egypt 39 17 2.8 110 15 1.45 -0.78

Kenya 19 23 3.4 85 64 6.06 0.46

India 69 28 2.8 99 20 1.88 0.28

Indonesia 56 19 3.8 89 17 1.56 0.20

Iran 26 21 4.5 130 6 0.70 -0.49

Malaysia 26 11 2.9 27 13 1.26 0.36

Mauritius 16 6 0.3 0 28 2.63 0.08

Oman 45 3 n.a. n.a. 5 0.44 -0.50

Pakistan 51 27 4.1 101 72 1.39 -0.33

Singapore 1 0.2 -1.5 0.00 4 -1.00 -1.00

South Africa 14 4 2.0 146 14 1.33 0.27

Sri Lanka 48 21 2.7 59 23 2.18 0.40

Thailand 64 11 3.9 142 23 2.15 0.45

Source: World Bank (2001a) and FAO (2001).

Agriculture’s share of the country’s exports relative to its share of global merchandise exports. Agricultural exports minus imports as a ratio of agricultural exports plus

imports.


The comparisons show that during the first reform period agriculture played a very important role in Pakistan’s economy, both in the internal and external sectors. Two of the three components of internal balance are full employment and economic growth. It is normal for agriculture’s contribution to production and employment to decline in relative importance as an economy grows. However, the process is slow in labor abundant countries such as Pakistan, starting from a low industrial base and facing the acute shortage of both human and physical capital. Table-2 suggests that for the upkeep of the internal balance of Pakistan’s economy, agriculture appears to remain the most important sector also during the second reform period; more than half of the country’s labor force is still engaged in agriculture and the sector’s contribution to Gross Domestic Product (GDP) is well above a quarter of the total.2 Thus, agriculture remains the major source of Pakistan’s economic growth. More importantly, the agricultural sector is also to be credited with achieving the strategic target of grain self-sufficiency which must be maintained in the future, as it is one of the prerequisites for sustainable development.

Although the history of Pakistan’s external balance happens to be a sorry affair, agriculture has always provided it a saving grace through the farm sector’s huge direct and indirect contribution to the country’s merchandise export earnings.3 During the first reform period, a low comparative advantage index of Pakistan in agriculture, relative to Thailand, Sri Lanka and Kenya, must be adjusted for the huge share of its textiles sector in export earnings which largely depends on the raw cotton produced in the country.4 Another index, registered in the final column of Table-2, accounts for the imports of agricultural products. It ranges between -1 and +1, for net importers and exporters respectively. The sign and the size of Pakistan’s index, -0.33, indicates that during the first reform period the country has been fairly open in the domestic market to competition from the rest of the world. The same cannot be maintained for Iran and Oman whose economies are largely dependent on the

2 The agricultural share of labor force declined to 48.42 percent in 2002 (see, Pakistan Economic Survey, 2002-03, Statistical Appendix, Table 12.11, p. 121). 3 The indirect contribution of agriculture to export earnings comes from the textile sector which contributed about 60 percent of the export earnings during 1978-94. Pakistan is the fifth largest cotton producer in the world and most of its textile export earnings depend on the raw cotton produced in the country (see Khan, 1998). 4 The agricultural competitiveness listed in Table 2 is based on the computation of Balassa’s index of ‘revealed’ comparative advantage, which is agriculture’s share of a country’s export relative to agriculture’s share of global exports. The ratios necessarily have a global average of unity (see Balassa, 1965).

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earnings from oil exports, while both Egypt and Singapore are now considered overwhelmingly service economies.

Part II

Since 1945, multilateral trade has been a greater engine for prosperity than any other form of international economic cooperation. However, tensions in the world trading system began to arise in the early 1970s. A first attempt to shore up the system came with the Tokyo Round of GATT talks which continued from 1973 to 1979. As mentioned earlier, the UR was launched in 1986. It had 116 participants and it was originally supposed to end in 1990 but did not, and lasted for eight years. The UR began on a note of optimism with the exercise of opening markets including the markets for agricultural commodities. However, seven years later in 1993, the issue of the developed countries’ huge farm subsidies brought the UR close to desperation. After a protracted feud between the European Union (EU) and the United States (US), the UR ended successfully in the formal signing of the trade agreements in April 1994. The UR agreement was heralded as a watershed in the history of world trade and was expected to lead to huge welfare gains around the world. Table-3 lists the welfare gains, computed both for the developed and the developing countries, from removing trade barriers globally, in the post-UR world of 2005.

It is interesting to note in Table-3 that not only are the welfare gains for the developed countries the largest in freeing international trade in agriculture and food, it is the only sector where the potential gains leave the current distribution of world income virtually unchanged between the two country groups.5 All the more reason for developed countries to seriously consider the opportunity cost of their huge farm subsidies.

During the first reform period, Pakistan has overdone the fulfillment of the UR commitments in freeing agricultural commodities trade. Table-4 shows that the divergence between the average unweighted applied and bound tariff in agriculture has been widest in Pakistan amongst the four major South Asian countries.

5 According to the World Bank’s estimates for 1997, the developing countries, with almost 80% of the world population, subsisted on less than 20% of the world’s income (See World Bank, 1998).


Table-3: Welfare Gains from Removing Trade Barriers in the Post-Uruguay Round World of 2005

(1995 US$ billions)

Agriculture and food

Other primary

Textiles and clothing

Other manufactures

Total Category

Total % Total % Total % Total % Total %

Developed countries

122.1 48.0 0.0 0.0 1.3 14.2 5.6 139.7 54.9

Developing countries

42.6 16.7 2.7 1.1 14.1 5.5 53.3 21.7 114.7 45.1

World 164.7 64.8 2.8 1.1 17.4 6.8 69.5 27.3 254.3 100

3.3

Source: Anderson et. al. (2001)

Table-4: Uruguay Round Commitments in Agriculture: South Asia

Country

Average tariff rate (unweighted) (2000)

Bound (%) Applied (%)

Bangladesh 188 25

India 124 19

Pakistan 197 24

Sri Lanka 50 27

Source: Athukorala (2000) and WTO (2001).

More importantly, even before the first reform package was announced, Pakistan has been gradually removing input subsidies since the early 1980s, which virtually ceased to exist by 2000. The input subsidies were to be phased out and replaced by the output support price system under the recommendations of the Pakistan Agricultural Prices Commission (APCom), established in 1981. However, the support price policy scarcely made the national exchequer dole out any funds to the country’s farmers, particularly after signing the UR commitments. The scenario presented in Table-5 supports the author’s position.

The figures in Table-5 show that the support prices of both rice and cotton in Pakistan have been lower than the domestic market price in the post-UR period. Although the government was not restricted by the UR ruling of the WTO, it has never made any procurement of rice and cotton, except in the first year of implementation, 1994-95, when a very small

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quantity of rice, .06% of total production, was procured. On the other hand, the government has been procuring on average a little over 20% of the total production of wheat annually, apparently going way beyond the limits permitted by the UR commitments.6 However, the government’s wheat procurement in Pakistan is for food security reasons and not to support the wheat growers since the support price of wheat has been lower than its market price till 1998-99; the former being only marginally higher than the latter in 1999-2000. Such a small divergence does not warrant procurement in widely prevalent and successful support price models.7

Table-5: Support Price, Market Price and Procurement of Major Crops (Pakistan: 1994-00)

Category Year 1994-95 1995-96 1996-97 1997-98 1998-99♠ 1999-00

1. Wheat Support price 160 173 240 240 - 300 Market price 176 185 273 259 261 297 Procurement (a) Procurement (b)

3.74 22%

3.45 20%

2.72 16%

3.98 21%

4.07 23%

8.55 41%

2. Rice

Support price 211 222 255 310 330 350 Market price 192 231 296 297 362 358 Procurement (a)▲ Procurement (b)

21 0.6%

0.12 -

- -

- -

- -

- -

3. Cotton♣ Support price 423 423 540 540 - 825 Market price 794 739 840 808 876 580 Procurement (a) Procurement (b)

- -

- -

- -

- -

- -

- -

Source: APCom (2001) and Pakistan Economic Survey (2002-03).

6 Exactly 30 WTO members have commitments to reduce their trade distorting domestic support in the amber box as measured by their AMS. Members without these commitments have to keep within 5% of the value of production level, 10% in the case of developing countries (for further clarification of this point, see Part II and footnote 15 of this study). 7 For example, the Common Agricultural Policy (CAP) of the EU has three interrelated components: price support, import control and export subsidies. The EU determines target prices for grains every year after intensive bargaining between the producing and the consuming interests. A target price and an intervention price is derived. The latter is set at 5-7 percent below the target price. When the market price in the Union falls to the intervention price level, procurement begins. In this sense the intervention price of a cereal represents the minimum support price for producers. In addition, for controlling grain imports the EU employs an import tax, variable levy, designed to equalize the import price with a decreed domestic price (see Kreinin, 1995, P. 186-7).


All prices are in rupees per 40 kg. Procurement in million tonnes.

▲Procurement in million tonnes Procurement as percentage of total production.

♠No support price was announced for 1998-99 wheat crop.

In all fairness, the figures listed in Table-5 show that APCom has been tinkering rather than fine tuning while calculating the support price mark up. The official publications do provide the elaborate goals of the support price, but the information on its mechanism and implementation is very general and extremely vague. Also, empirical evidence shows that there has been a huge transfer of welfare gains from producers to the consumers (Ashfaq et. al. 2001; Niaz 1995). It may therefore be concluded that even during the first reform period, agricultural policies have been penalizing rather than rewarding the farmers in Pakistan.

Part III

The shortcomings of reform efforts by developing countries such as Pakistan are often escalated in a world of unequal trade partners, as the huge agricultural subsidies received by the developed countries’ farmers encourage overproduction and distort trade by making farm goods artificially cheap internationally.

Farm protection is ubiquitous in developed countries. It has a formidable history which dates back to the Corn Laws that had protected British Farmers from imports of foreign grain for 200 years.8 After an ugly struggle, the British Parliament eventually voted for reform in 1846. Powerful countries have found a pretext in every age to protect their farmers. In 19th century Europe, the pretext was unfair competition from cheap American and Australian imports. In the 1930s it was farm poverty. After the Second World War it was food security and later on it became preservation of the rural character.9 With advancements in communication technology, the issue of farm support has now become a potent emotional and political force the world over. In the EU and US, the farm lobbies wield influence out of all proportions to the share of the farm sector in these countries’ GDP and the labor force.

8 Adam Smith devoted Chapter 5 of Book IV to subsidies, called “bounties” in his time. Although he discussed bounties in the context of foreign trade, the main issues are the same (see Smith, 1776, pp. 398-408). 9 See, ‘A Survey of Agriculture’, The Economist, December 12, 1992.

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Before exploring the implications of the size and significance of agricultural subsidies of developed countries, it will be helpful to have an overall idea of the players’ stakes in the international market for agricultural products. Table-6 presents the share of leading exporters of agricultural products in the world receipts from agricultural exports between 1980-2002. The most significant development to be noted is that the US share declined by about 3% in 10 years to 1990, and the EU share increased markedly during the same period. This may be explained by Greece, Portugal and Spain, all having a comparative advantage in agriculture, joining the EU, then the European Community.10

Table-6: International Trade in Agricultural Products: Leading Exporters (1980-2002)

World export of agricultural products (% share in total export receipts)

Country/Group

1980 1990 2000 2002 EU15 32.8 42.4 39.6 40.1

US 17.0 14.3 12.9 11.8

Canada 5.0 5.4 6.3 5.6

Brazil 3.4 2.4 2.8 3.3

China 1.5 2.4 3.0 3.2

Australia 3.3 2.8 3.0 2.9

Argentina 1.9 1.8 2.2 2.2

Thailand 1.2 1.9 2.2 2.0

Indonesia 1.6 1.0 1.4 1.5

Malaysia 2.0 1.8 1.5 1.5

New Zealand 1.3 1.4 1.4 1.4

Russia - - 1.4 1.3

Chile 0.4 0.7 1.2 1.2

India 1.0 0.8 1.2 1.1

Source: WTO (2003) Russian Federation.

10 This observation provides food for thought for why after 1990 the US became interested in the expansion of NAFTA. Also, on the issue of farm subsidies the two powers, EU and the US, were likely to make or break the UR negotiations. Each insisted that an unsatisfactory deal will be rejected, even if that means no deal at all (see “GATT: The Eleventh Hour” The Economist, December 4, 1993).


Agricultural policies pursued by developed countries cause major distortions which seriously hinder market access for developing countries. Progress made in reducing protection in developed countries has remained unsatisfactory to the extent that the Doha Round, launched in November 2001, was suspended in July 2006, after negotiators failed to reach an accord on agricultural subsidies and market access. The subject continued to lead to dispute and controversy even in the March 2-4, 2007, ‘mini-ministerial’ meeting in Kenya. Figures listed in Tables 7-9 provide a backdrop to understanding the Doha Round stalemate.

Table-7: Agricultural Support in OECD Countries

Agricultural Support Estimates 1986-88 2001-03

Total support (US$ b) 303.720 324.053

Producer Support 241.077 238.310

General Services Support 40.946 57.849

Fiscal Transfers to Consumers 21.697 27.894

Support per farmer (US$ thousands) 10 11

Support per hectare (US$) 183 182

Source: OECD, Agricultural Policies in OECD Countries, 2003.

It is observed that, in nominal terms, the OECD countries together pay more subsidies to their farmers in the post-UR period. More importantly, although the producer support shows an overall decline, rather than decreasing, the support per farmer has increased. This trend, especially when compared with marginally reduced support per hectare, suggests that the progress of developed countries in reducing farm subsidies scarcely goes beyond a cosmetic exercise.

Table-8: Agricultural Support in OECD Countries: Relative Shares

Percentage Share in Total OECD Support Region/Country 1986-88 2001-03

EU 37 36 United States 24 29 Japan 20 17 Korea 5 6 Others 14 12 Total 100 100


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Figures listed in Table-8 and Table-9 provide a closer insight into the implications of OECD farm subsidies for the reform efforts of developing countries.

Table-9: Size of Agricultural Support in Major Developed Countries: 2001-03

Support Estimates Averages Total

support Producer support Per farmer Per hectare

Region/country

US$ b US$ (000) US$ OECD 324.053 238.310 11 182

EU 114.720 102.708 15 670

United States 95.128 44.239 19 112

Japan 56.489 5.359 23 9828

Others 57.716 86.004 - -


Table-8 provides information on the relative share of agricultural support provided by member countries of the OECD. The figures show that the EU’s share of the agricultural dole out is largest, followed by the US and Japan. Moreover, per farmer support, listed in Table-9, of the EU, US and Japan happens to be much above the OECD average. Japan appears to be contributing most in this scenario, followed by the US. However, the relative significance of Japanese and American farm subsidies needs to be considered taking account of the much larger relative size of the farm sector of the latter with a comparative advantage in agriculture in addition to technological competitive advantage, particularly when compared with the developing countries. Japanese farm subsidies, though contributing to global inefficiency, do not hurt farmers elsewhere as the country is not listed in the league of leading agricultural exporters (See Table-6).11

From the viewpoint of global efficiency, the scenario presented in Tables 7-9 is bad enough, but the worst part, particularly in the context of the argument of this study, is that rather than falling, as was required

11 Most of the Japanese farm subsidies go to the rice growers for ensuring self-sufficiency in rice production. Rice is the staple food grain in Japan. For Japan, rice is a near-sacred product, deeply embedded in history, culture, economics, politics, and symbolism. For the Japanese the rice is the Christmas tree and rice producing land is reverently called our holy land (see Blaker, 1999).


under the UR obligations, the developed countries’ farm subsidies have been increasing. The available estimates show that in 2001, the US had increased its subsidy to 21% of the gross farm receipts, while the EU was contributing 35% of gross receipts of its farmers (OECD 2002).12 Finally, in May 2002, the US passed legislation to further increase the amount the government pays to farmers. The new Farm Act provides an additional $83 billion in subsidies above the existing program during the next decade.13

These developments are in gross violation of the AoA which established commitments at the UR to limit and reduce baseline domestic support, as measured by the Aggregate Measure of Support (AMS). This was the most innovative element of the AoA because trade distortions arising from domestic support policies were for the first time formally recognized (Schluep and Gorter 2001). A key aspect of the reductions commitments in the domestic support was the distinction between domestic policies that distort trade and those that do not. This makes it possible to focus on trade distorting policies, negotiate reductions in their magnitude and provide an incentive for governments to re-instrument their domestic policies towards non-distorting measures (Schmitz and Vercammen 1995). However, most countries could circumvent their AMS commitments because of an extremely high base period upon which commitments were made and because of the sector-wide nature of the support commitments (OECD 2000). Hence, the AMS has been the least binding element of the AoA commitments for most countries. Moreover, the establishment of the blue box and green box which were both exempted from reduction requirements further weakened the domestic support element of the Agreement.14 Total support provided by amber policies on production was measured by the AMS, which countries agreed to reduce by 20 percent in the 1995-2000 implementation period (OECD 1999). 12 Also see “The Doha squabble,” The Economist, March 27th 2003. 13 See “Why U.S. Farm Subsidies Are Bad for the World” Philadelphia Inquirer, May 6, 2002. 14 In WTO terminology, “boxes” which are given the colors of traffic lights in general identify subsidies: green (permitted), amber (slow down — i.e. be reduced), and red (forbidden). The AoA has no red box, although domestic support exceeding the reduction commitment levels in the amber box is prohibited; and there is a blue box for subsidies that are tied to programs that limit production. Amber box policies include transfers from consumers such as administered price supports but also taxpayer-funded subsidies for both inputs and output. The accounting method is either government expenditures or price gaps using the “equivalent method of support” (EMS) measure. Green box policies include decoupled payments (that purportedly do not affect production decisions) and policies to correct for market failures such as environmental programs, research, food aid, and crop insurance and income safety net programs. This class of policies is generally taxpayer funded that does not involve transfers from consumers.

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As mentioned above, the AoA sought to define, quantify and reduce trade distorting policies. It included three areas, namely, import access, export subsidies and domestic support. However, the figures listed in Table 7-9 suggest that the AoA cannot be rated as a success because, despite support reduction commitments, the absolute size of the developed countries’ subsidies has in fact increased over the implementation period.15

Part IV

The Cancún Ministerial Meeting in September 2003 was the second disappointment for the WTO in four years. Before the Doha Round was launched in November 2001, its meeting in Seattle in December 1999 broke down, largely because of the undue pressure exerted by the developed countries on extraneous issues. The trade round stagnated for 22 months between the meetings in Doha and Cancún. After a long stalemate, and at the behest of many developing countries, the US and the EU drew up a framework in August 2003 for freeing farm trade. Though it involved some reform, the plan was much less ambitious than the Doha Round had implied. Export subsidies, for example, were not to be eliminated after all.16 Angered by this lack of ambition, a new block of developing countries emerged just before the Cancún meeting to denounce the EU/US framework as far too timid. Led by Brazil, China and India, this so-called G22 became a powerful voice at the Cancún Ministerial Meeting in September 2003.17

Given the analysis in Part III, developing countries were understandably dissatisfied at Cancún with the commitment of developed countries to agricultural reforms. Many demanded concessions on agriculture from the US and the EU before talks could move forward, and consequently refused to negotiate. Although it spanned diverse interests - India, for instance, is terrified of lowering tariffs on farm goods, while Brazil, a huge and competitive exporter, wants free trade as fast as possible-the G22 stood together and managed to effectively block the consensus required to do anything in the WTO. The Group’s initiative ought to be viewed in the light that farm trade is not some peripheral

15 The European Union, Japan and the United States account for over 85 percent of total domestic support under the AMS [see, OECD 2002]. 16 For a better insight into the plan, see “More fudge than breakthrough,” The Economist, June 26th 2003. 17 The Group included Argentina, Bolivia, Brazil, Chile, China, Columbia, Costa Rica, Cuba, Ecuador, Egypt, Guatemala, India, Indonesia, Mexico, Nigeria, Pakistan, Paraguay, Peru, Philippines, South Africa, Thailand, Venezuela (see “The WTO under fire,” The Economist September 18th, 2003).


issue. It is central to the whole round. Being a development round, Doha Round was launched with much fanfare. Many developing countries felt they had a raw deal from the UR. They were dragged reluctantly into yet another set of trade negotiations largely by the promise of freer trade in farm goods.

A group of four West African countries-Benin, Burkina Faso, Chad and Mali-managed to have cotton included as an explicit item on the Cancún agenda. Their grievances were simple and justified. West African cotton farmers are being crushed by the $3 billion-plus a year subsidy that US squanders on its 25,000 cotton farmers, helping to make it the world’s biggest exporter, depressing prices and wrecking the global market.18 With low labor costs and small manageable plots, farmers in West and Central Africa are among the lowest-cost producers of cotton in the world. The International Cotton Advisory Committee puts the cost of producing a pound of cotton in Burkina Faso at 21 US cents compared to 73 cents in the US itself. However, state subsidies guarantee a minimum price to US farmers, regardless of what happens to world prices. US farmers also receive additional payments to augment their incomes to a target price level. As a result, they continued to expand cotton production, by 42 % between 1998 and 2001, oblivious to almost five years of depressed world prices. In 2002, partly due to the continuous flooding of the market by US cotton, world cotton prices fell to 42 cents per pound, far below the long-term average of 72 cents. During the 2001/02 season, the US government paid more to its cotton farmers in support than the value of the harvested crop, $3.9 billion in subsidies for a crop valued at $3 billion. These subsidies were responsible for 65 per cent of the $300 million loss in potential revenue in all of Sub-Saharan Africa in 2002. Benin, Burkina Faso, Mali, Cameroon and Côte d'Ivoire were hit hardest. According to another estimate, the US spends $10.7 million per day subsidizing its cotton farmers, which is three times the total aid given to Sub-Saharan Africa (UNDP 2003). As mentioned earlier, in May 2002, the US passed legislation to further increase the amount that the government pays farmers. The new Farm Act provides an additional $83 billion in farm expenditure, above the $100 billion spent on existing programs. Cotton growers, mainly comprising corporate agricultural companies, are expected to receive an additional $2.5 billion over a decade.19 This has inflamed an

18See “The WTO under fire,” The Economist, September 18, 2003. 19 See http://www.business-standard.com, August 7, 2003.

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already raging controversy around agricultural subsidies and has stirred anger in developing countries.20

The EU is no less harmful. Its farm reforms may be radical by the organization's undemanding standards but will not be enough to satisfy the rest of the world. For example, even though its production costs are more than double to that of Asian and Latin American countries having a natural comparative advantage, the EU is now the second largest sugar exporter from being a net importer 30 years ago. The EU spends about $3.3 billion annually in supports on sugar exports, and in mid-2002 was paying its producers a guaranteed price three times that was being offered on the world market. Due to EU subsidies, prices on the world sugar market have fallen by 17%.21 However, the sugar subsidy is only the tip of the iceberg. The annual dairy subsidy in the EU is $913 per cow, which is almost double the per capita income of Sub-Saharan Africa at $490 and 114 times the annual per capita aid given by the EU to this region. It gets worse when it comes to Japan, where each cow gets $2,700 to chew each year, a figure that is more than five times the per capita income of sub-Saharan Africa (UNDP 2003).

Conclusion

Being a developing open economy, the success of Pakistan’s agricultural reform efforts is conditional on the international market situation. Agriculture stands out as the most distorted part of the world economy. The most damaging feature of the Common Agricultural Policy (CAP) of the EU and of the US Farm Support Program is that agricultural subsidies are tied to production, with surpluses dumped on world markets via the payment of export subsidies. The sufferers are mainly developing countries, many of whose economies depend heavily on agriculture. For most developing countries, phasing out all farm-export subsidies is the biggest single objective of the Doha round.

20 Indeed, Brazil has lodged a legal challenge against the US at the WTO, charging that it is in breach of the “peace clause” of the Organization's AoA. The clause, ironically introduced at the insistence of the US and EU during the UR trade negotiations, protects a country from challenge to its subsidy regimes as long as it does not raise them beyond levels set in 1992. No African or Asian nation has yet filed a legal suit at the WTO against the developed countries’ farm subsidies. Many are cash-strapped, dependent on aid and debt relief from the very countries they would be challenging. Many are also wary of the potential for retaliatory action. 21 See http://www.business-standard.com, August 7, 2003.


Ironically, the rules prohibiting subsidies were supported and organized within the WTO by the same countries that are violating the UR ruling on farm subsidies. Much of the blame lies with the AoA itself. In theory, the Agreement requires all member countries to reduce subsidies that hinder trade, but numerous loopholes and rules, the ‘peace clause’ for example, are weighted in favor of the more dominant members of the WTO, allowing them to avoid reducing agricultural subsidies and continue raising them in some cases.

Lower tariff barriers and a big cut in the developed countries subsidies have strategic significance for the developing world as a whole. An estimated 96% of the world’s farmers live in developing countries, with some 2.5 billion people depending on agriculture for a livelihood. Over the years, unfavorable trade terms have been a major factor in the erosion of the market share of developing nations. According to the WTO, the share of the South in world agricultural exports fell from 40% in 1961 to 35% in 2002.22 The huge subsidies of developed countries depress farm prices and place the farmers of developing countries at a big disadvantage. US taxpayers, along with their European counterparts, bear a direct responsibility for poverty in the world.

Finally, can any of the failures outlined in this study be effectively addressed and the Doha Round revived? Presently, there is little room for optimism in that the North lacks a holistic and farsighted approach to the interdependence and complimentarity of the world economy, while the South appears to be as divided and disorganized as ever. The G22, for instance, left Cancún determined to stick together and fight another day. Since after, quite a few member countries of the G22 alliance have been negotiating free trade agreements with the US. Their commitment to the free trade of farm goods and their interests in pursuing the strong market access commitments, requiring free trade agreements with the US, do not appear to be in harmony with each other. This leads to the final concluding remarks that in the previous rounds of the GATT and WTO, the negotiations by the developing countries have amply exhibited the unfortunate lack of leadership. Cancún provided some short-lived hope, as the subsequent developments suggest that it too has failed to pass the time test.

22 http://www.business-standard.com, August 7, 2003.

Naheed Zia Khan 170

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Economic Effects of the Recently Signed Pak-China Free Trade Agreement

Samina Shabir* and Reema Kazmi**

Abstract

Factor endowments and cross country differences create regional disparities among states. The disparity in sizes between the Chinese and Pakistani economies can lead to the creation of trade patterns that can positively or negatively impact the latter’s economy. The present paper attempts to analyze the pros and cons of forming a Free Trade Agreement (FTA) with China given the size, structure and trade patterns of Pakistan’s existing economy. It also deals with the crucial questions of: Can the formation of an FTA with China benefit Pakistan? Will trade liberalization under an FTA with a neighboring country like China spur Pakistan’s trade and growth? Looking at trends and trade patterns of Pakistan, the potential of Pakistan’s existing economy is analyzed to enhance interregional trade and export diversification by further deepening cooperation with China. In the light of this analysis, the paper also outlines a number of recommendations to extract the maximum benefit for Pakistan’s economy from this recently signed FTA with an old economic partner, China.

I. Introduction

Free trade or globalization is a hotly debated phenomenon in the global village of today’s economic system. If the economic prosperity and growth of all the nations of the world could be brought at par with each other by the free flow of goods and services, regardless of borders, under the free trade banner, then it is a scenario for which every one of us should strive for. However, according to skeptics, this concept of Free Trade is nothing but a mirage. The observed reality is that the World Trade Organization (WTO) which is the international flag bearer of free trade has so far not been successful in bringing about trade liberalization around the globe. There is a perception that the WTO seems to be biased toward * Debt Office, Ministry of Finance Government of Pakistan, Islamabad. ** Debt Office, Ministry of Finance, Government of Pakistan, Islamabad.

Samina Shabir and Reema Kazmi 174

industrialized and already developed countries, safeguarding and advancing their interests, thus further worsening the lot of the world’s poor. This failure or loss of credibility of the WTO has led developing countries to fend for their own interests in this increasingly integrated but regionalized world. Bilateral trading arrangements, although less preferred to multilateral ones, are one of the instruments employed by various countries, both developed and developing, to secure their export markets and to guarantee their trading activities in the future.

Free Trade Agreements (FTAs) are a common type of bilateral arrangement between two or more countries. FTAs facilitate the free flow of trade and investment and bring about closer economic integration between the binding parties by eliminating tariff/restrictions on each other’s commodities. More than 60% of global trade, at the moment, is being channeled through bilateral and regional trading arrangements. At present, almost 300 such arrangements exist globally. The purpose of these FTAs is not only to serve the economic needs of two countries, but to also accommodate political motivations, or in other words, legitimatize trade between two coalition allies (the recent US – Panama FTA is an example). A host of industrialized countries have already established bilateral arrangements (e.g., EU, NAFTA etc.), mostly among themselves. With the realization of the growing importance of FTAs, some developing countries have also entered into these arrangements. The recently signed Pakistan - China FTA is a move in the same direction. With the growing importance of emerging economies in South and East Asia, Asia Pacific and South America, Pakistan is aiming at strengthening its trading relations with the economies of those regions. With the growing importance attached to China as the fourth largest economy of the world as well as an immediate neighbor of Pakistan, it is about time for Pakistan to think about strengthening its economic ties, apart from their already strong strategic and military relations. It was with this enthusiasm and aim in mind that Pakistan laid the foundation for an FTA arrangement with China in July, 2006.

China being the fourth largest economy of the world, with a trade surplus of $30 billion and foreign exchange reserve of $1 trillion, has strategically moved from being a centrally planned to a market based economy. At the end of 2006, China's global trade exceeded $1.758 trillion. Pakistan in comparison, is an emerging economy with nominal GDP of $128.5 billion, a trade deficit of $8.51 and foreign exchange reserves in excess of $13 billion. Given the disparity in the sizes and economies of these two countries, entering into an FTA arrangement at this point in time can lead to some very crucial implications for both the countries, especially for Pakistan. Thus, this paper attempts to explore the implications of the FTA

Economic Effects of the Recently Signed Pak-China Free Trade Agreement 175

between China and Pakistan on Pakistan’s economy. A case in point is the textile sector of Pakistan which is an important contributor to the country’s overall exports, while China is also very competitive in this sector - leading to a clash in interests. Therefore, it is imperative to analyze the implications of the FTA for various sectors of Pakistan’s economy. Likewise, a huge historic trade deficit with China makes it necessary to see the impact of this FTA on trade with China and Pakistan in general. A number of Chinese firms were operating in Pakistan, even before the establishment of the FTA, so now this also requires us to explore the investment scenario in Pakistan. This study analyzes all these impacts in detail.

The objective of the present paper is to examine the impact of the recently signed Pak-China Free Trade Agreement (FTA) on Pakistan’s economy. The paper has been structured as follows: Section II deals with Pakistan-China trade and economic ties; Section III looks at the already signed FTA of Pakistan and China with various other countries; Section IV analyzes the economic impact of FTA on Pakistan’s economy in detail and Section V presents the conclusions of the paper.

II. Pakistan China Trade and Economic Relations

The year 2006 marks the completion of 55 years of cordial relations between Pakistan and China. Over all these years, the two countries have been able to evolve a cooperative relationship at multiple levels, especially in the political, defense and diplomatic arenas. However, Pakistan and China have not been able to make substantial progress in their economic relations until recently.

At the dawn of the 21st century and with the implementation of the WTO regime just around the corner, both the countries realized the missing economic dimension in their evolving strategic relationship. The two countries thus acknowledged the fact that in order to sustain a comprehensive cooperative relationship, substantive economic collaboration, in line with the level of political and strategic coordination, was imperative. Economic cooperation would not only consolidate the comprehensive bilateral relations between the two countries, but also help in achieving common aspirations for development, peace and stability in the region. In the last few years or so, the two governments have convened a number of high-level conferences/forums, inaugurated by their respective leadership in Pakistan and China, to promote economic cooperation thereby exhibiting interest, resolve and patronage to the private sector business community of the two countries. Pakistan and China have now successfully created a clear and shared vision of the direction of their economic relations. However, the


results of this evolving economic cooperation would only be realized after the upcoming implementation of the agreements reached at various levels on trade and investment.

Since the early 1950s, Pakistan and China have entered into trade relations; however, the first formal Trade Agreement was signed in January 1963. Later, in October 1982, the two countries established the Pakistan-China Joint Committee on the Economy, Trade and Technology. Trade between China and Pakistan had generally been conducted under the 1963 Trade Agreement, according to which both countries had granted MFN status to each other. Pakistan had, at that time, multi-modal trade with China i.e. barter trade and cash trade. However, at present trade with China is conducted almost entirely on a cash basis in convertible currency. Recently, the economic relationship between China and Pakistan has come to the forefront. Now the question arises as to why this sudden interest in trade between the two countries has suddenly been ignited. Amongst other reasons, one is that the Chinese government has persuaded its state-controlled enterprises to import Pakistani products in order to improve the trade balance and make more project-specific investments. The private sector’s engagement, which would be the main engine for growth in bilateral economic relations in the future, is still at a low level. On the other hand, compliance with the WTO regime is imminent and thus countries are on the look out for the consolidation of ties with their most dependable trading partner. In the case of Pakistan, that dependable trading partner as well as a neighbor is China. Thirdly, logistically an all-reaching trading agreement with a neighborly state like China is economically rational and cost effective. Thus, with the rest of the world already well on its way towards economic integration with like minded allies, Pakistan has also started to follow this well treaded path.

Traditionally, throughout its trade relations with China, Pakistan has had a chronic trade deficit. This is primarily because China is competing in almost all the major sectors of Pakistan’s potential export areas, which happen to be very limited. Secondly, the Pakistani business community remained content with their established export destinations i.e., the US and the Western Europe, and hardly made serious efforts to either diversify the export base or to explore other areas and regions for enhancing the volume of their exports. This fixation with Western markets and non-innovative export approach has consistently undermined the country’s export potential. Third, though it was feared initially that cheap Chinese products could take over the Pakistani market, this trend abated once people realized that they were of low quality, with almost no guarantee by the company. This was true for both small items, such as


shoes, as well as bigger items, such as locomotives. Fourth, Chinese brands were not as famous as the western ones, so competition usually went against China. Fifth, despite being neighbors, there was a lack of effective means of communication between Pakistan and China. The Karakorum Highway, which opened in 1978, could not be used to increase the volume of trade in any substantial manner. In addition, an underdeveloped shipping industry in Pakistan further limited the trade routes and discouraged the growth in trade volume. Sixth, Pakistan’s cotton based industry is the main pillar of its exports. Since China itself is a major textile manufacturer, the trade volume could not be raised.

As a result of this renewed interest in trade relations, on May 12 2001, Pakistan and China signed six agreements and one Memorandum of Understanding (MoU). At that time, Chinese financial assistance for the agreed projects was estimated to be worth over one billion dollars. This signing of agreements can be termed as the first round of a substantive initiative for expanding economic cooperation. The agreements signed included: Economic and Technical Cooperation, Tourism Cooperation, Lease Agreement on Saindak Copper-Gold Project, Supply of Locomotives to Pakistan Railways, Supply of Passenger Coaches to Pakistan Railways, White Oil Pipeline and MoU between China’s ZTE and Pakistan Telecommunications Co. Ltd. Under the Agreement on Economic and Technical Cooperation, the Chinese government agreed to provide a grant of 50 million Yuan for the promotion of economic and technical cooperation between the two countries.

China, meanwhile, also reiterated support for a project which is very close to the Pakistani people’s hearts. Thus, almost a year later, on March 22, 2002, General Musharraf and the Chinese Vice Premier, Wu Bang Guo, attended the ground-breaking ceremony of the Gwader sea-port. Phase one of Gwader port was successfully completed in April 2005, and work on the second phase is in progress.

In the following years, there has been a regular exchange of high-level visits between the two countries and each visit added new dimensions and areas for economic cooperation. For example, President Musharraf’s visit in November 2003 resulted in the signing of a Joint Declaration on Direction of Bilateral Relations. It was in fact a road-map determining the direction and scope of overall Pak-China bilateral relations in the future.

In December 2004, Pakistan and China again signed seven agreements in trade, communication and the energy sector and drew up a framework for greater cooperation. These agreements envisaged an increase


in bilateral trade, further movement on the preferential trade agreement, the setting up of joint agro-based industries and increased Chinese investment in Pakistan. Pakistan announced Free Market Economy (FME) status for China. Also, China committed to provide $150 million for the Chashma Nuclear Power Plant (Phase II). It was part of the preferential buyers’ credit of $500 million to be provided by the Chinese government for investment through Chinese companies. China’s investment in Pakistan at present stands at US $4 billion plus, and at least 114 Chinese projects are underway. The Chinese side also agreed that the Joint Economic Commission should soon review Pakistan’s proposal to set up a Pakistan-China Joint Investment Company and the establishment of a Joint Infrastructure Development Fund for investment in Pakistan.

The Chinese Prime Minister’s April 2005 visit was considered a landmark visit in which the two sides signed 21 agreements and MoUs on cooperation in economic matters, defense, energy, infrastructure, the social sector, health, education, higher education, housing and other areas. The two sides also signed a Treaty of Friendship, Cooperation and Good Neighborly Relations. Under the agreement on Early Harvest Program (EHP), which became operational on January 1, 2006, China has reduced tariffs to zero on 767 items. This was the first step towards establishing a free trade area between the two countries. It is envisaged that by the year 2008, Pakistan and China would be fully able to implement the FTA, covering 90% of the commodities. The remaining 10% would remain on the sensitive list of commodities and tariffs might be removed, or at least toned down, during the second round of FTA negotiations scheduled to be held in 2011 and be implemented in 2012. During the recent visit of the Chinese President to Pakistan in November 2006, the two countries signed 18 agreements, including a free trade pact/agreement, which they hope will boost trade from $ 4.26 billion last year to $ 15 billion within the next five years. The two sides have also signed a pact on a five-year plan to set up a comprehensive framework for boosting economic ties. Pakistan provides the shortest possible route, from Gwader through the Karakorum Highway, to the Western regions of China, which are undergoing a huge economic transformation. This route is secure, short and can serve as an alternative to the sea route that passes through the Straits of Malacca. Both countries have been focusing on trade interaction through this route.


As a result of the concerted efforts and determination to enhance economic cooperation between both sides, trade between the two countries has been registering constant growth: from $1.07 billion in 1997, to $3 billion in 2004, to $4.26 billion in 2005, and the estimated trade volume in 2006 is at $5 billion. Therefore, in a short span of eight years, the trade volume between China and Pakistan has increased by around $3.2 billion – not a paltry amount by any standards. Although the current trade balance is still heavily in favor of China, the opportunities for Pakistani exports to China are growing. According to the Chinese Customs Authority, “Pakistan's export to China showed an upward trend, registering an increase of about 39.2% in 2005. The exports amounted to $832 million from January to December 2005, whereas it was at $594 million in the same period during the previous year (January-December 2004). Therefore, the increase in Pakistan’s exports to China in a period of one year has amounted to about $ 238 million.” It is expected that if Pakistan’s economy continues to achieve its current growth rate, bilateral trade would touch around US$ 8 billion by 2008.

During the President of Pakistan’s recent visit, the two sides inked 13 agreements and one MoU, aimed at boosting bilateral economic cooperation while covering a wide range of issues, including trade and economic cooperation as well as cooperation on energy, transportation, agriculture, health, population, seismology and meteorology. A feasibility study is also being conducted to make Pakistan China’s “trade and energy corridor.” Thereby, upgradation of economic cooperation has become an integral part of the overall Pakistan-China strategic cooperation. The institutionalization of economic relations through the above-mentioned visits have laid the foundation and set the direction of the cooperative relationship of Pakistan-China.

Although the two-way trade has increased, the volume of trade is still low. Traditionally, the trade balance has always been titled in favor of China, except for a short while in 1952, owing to China’s involvement in the Korean War. For decades China’s constant increase in exports to Pakistan resulted in a persistent and growing trade imbalance. The main items of Pakistan’s imports from China are machinery and parts, iron and steel manufactures, sugar, chemical materials, chemical elements and medical and pharmaceutical products. The main items of Pakistan’s exports to China are cotton fabrics, cotton yarn, petroleum and its products, fish and its preparations, leather, fruits and vegetables. Unfortunately, the mix of Pakistan’s products exported to China is very narrow. Almost around 80 % of its exports consist of cotton yarn and fabric.


Pakistan’s exports to China lack diversity and both countries are competitors in the textile sector. Diversification of exports from Pakistan into non-traditional items will help minimize the trade imbalance. Another important factor in trade deficit with China is the growing exports of Chinese products to Pakistan. Since these are more economical, businessmen are inclined to buy more from China. Pakistan therefore, should be looking at China not simply as an export market but as a primary source for the import of capital goods and industrial raw material.

The two countries signed a Preferential Trade Arrangement (PTA) in November 2003, which has been operational since January 1, 2004. Pakistan and China instituted a Joint Study Group to negotiate a Free Trade Agreement between the two countries and have simultaneously negotiated an Early Harvest Programme (EHP), which became operational on January 1, 2006.

According to Pakistan’s Ministry of Commerce, Pakistan has given market access on 118 tariff lines of organic chemicals and 268 tariff lines of machinery – 386 tariff lines in total. Except 30 tariff lines, 13 relating to organic chemicals and 17 relating to machinery, all the other tariff lines have an MFN rate of 5%. As per the agreed timeframe of the elimination of tariffs, Pakistan was required to reduce the tariff only on 30 tariff lines by January 1, 2006. The tariff on the rest of the tariff lines i.e. 356 tariff lines was reduced to zero on January 1, 2007 i.e. no immediate revenue implications. Similarly, China has brought to zero all tariffs on 767 items.

Pakistan-China Investment Relations

Pakistan and China on February 12, 1989 signed a Bilateral Investment Treaty (BIT) that encourages the promotion of bilateral investment both in China and Pakistan, and covers all kinds of investments, protects investors and investments of both the countries against discrimination and expropriation, seeks fair and equitable treatment and provides a dispute resolution mechanism.

The overall Foreign Direct Investment (FDI) in Pakistan has risen by over 600% in the last five years. However, the Chinese share in the overall FDI is still very low. Pakistan has been able to introduce and implement investor friendly policies as a result of which FDI has increased. Pakistan’s investment policy is very liberal which makes available all economic sectors for FDI. It provides equal treatment to local and foreign investors and allows 100% equity to foreign investors with no government sanction required. Full remittance of profits, capital, dividends, royalties, technical and franchise fees is allowed.


Complete legal cover is provided through Foreign Private Investment (Promotion & Protection) Act 1976, Protection of Economic Reforms Act 1992, and Foreign Currency Accounts (Protection) Ordinance 2001.

Similarly, the Chinese government encourages foreign investment in the Chinese market, and has continuously liberalized and expanded the fields for investment. In recent years, China has further liberalized the restrictions imposed on the proportion of foreign equity in investment projects and opened new sectors to foreign investment. The newly–opened sectors include telecommunications, urban water supply and drainage, construction and the operation of gas and heat distribution networks, which were all previously prohibited from any foreign investment. China has also opened such service sectors as banking, insurance, distribution, trading rights, tourism, telecommunications, transportation, accounting, auditing and legal services. Also, there are a number of laws protecting the interests of foreign investors as well.

III Pakistan & China FTAs with other Countries:

Both Pakistan and China are fully aware of the pitfalls of regionalization as well as isolation. Thus, keeping in mind the current global scenario they have signed various FTAs mostly with other emerging economies and nearby states.

Chinese FTA with ASEAN

The conceptualization of the Chinese FTA with ASEAN, known as CAFTA can be traced back to as early as 1995 when Thailand for the first time proposed a special economic zone, similar to an FTA with China’s southern provinces. Later, the Asian Financial Crisis in 1997 and the U.S-led NATO bombing of China’s embassy in Belgrade in 1999 led to discussions of the formation of an FTA from academic circles to the high policy-making level. Decision making by Chinese leadership to strengthen cooperation with ASEAN finally led to the Chinese tentative proposal of setting up an FTA with ASEAN in Singapore in 2000, and later a formal proposal in Brunei in 2001. It was on December 2, 2004 that China signed a free trade agreement with ASEAN. Being the first ever signed FTA by China, it caught the world’s attention. The Chinese academia proposed a move beyond traditional modes of trade and tariff reduction to include cooperation in services (including financial, science and technology, including IT) electricity, agriculture, tourism and transportation (including air transport), non-traditional security and cross border crime (such as drug trafficking) and regional cooperation (such as GMS


cooperation and building China’s Southwest International Corridor through Yunnan).

In the view of some Chinese strategists, an FTA with Japan and Korea first would have better served the Chinese side because stronger economic complementarities would make them better partners than ASEAN. Fewer opportunities for domestic industries and more pressure will exist as a result of cooperation with ASEAN countries. Moreover, making further concessions to ASEAN as through CAFTA would increase the huge trade deficit with ASEAN which stood at $1.3 billion in 1993, $1.64 billion in 1998, $2.7 billion in 1999 and $4.8 billion in 2000. However, despite these realities China did not have the confidence to open its market to economies that are bigger and far more advanced than its own. If China would have engaged in an FTA arrangement with Japan and Korea, thus reducing its current average tariff of 14% to the levels of Korea and Japan with the given huge bilateral trade volumes, the fear was that the final outcome would have been damaging. Moreover, the rise in the trade deficit because of Chinese agricultural products not finding better access into Japanese and Korean markets would not have been fairly compensated. Since by 2015, China will be able to achieve full trade and investment liberalization it was better for it to choose ASEAN as a partner for an FTA. In addition to traditional areas of trade and investment, China’s FTA with ASEAN is more than just an economic deal to cover political and security issues as well. Using this new regionalism as a precautionary measure to dilute potential U.S unilateralism in the region shows that CAFTA was both strategically as well as economically motivated.

According to analyst John Bishop (June 1, 2005) the CAFTA which was to be concluded by the end of June 2005 and implemented in 2010 will have significant implications for both China and ASEAN nations. China will benefit from improved trading access to the ASEAN customer base of 410 million people and increased imports of much needed raw material and food. But this will lead to the export of low value agricultural products to China from ASEAN while ASEAN will absorb higher value manufactured products from China leading to higher trade deficits for ASEAN nations.

Chinese FTA with Chile

The China- Chile FTA was signed on November 18, 2005 in Pusan. Since January 2005, five rounds of negotiations on market access, rules of origin, technical barriers to trade, SPS remedy, dispute settlement mechanism, and related legal and technical issues have already taken place.


The China–Chile FTA will further deepen the partnership and the trade liberalization process will help unleash the potential of bilateral economic and trade cooperation and intends to set a new example in South- South cooperation. According to the Ministry of Commerce China, after going through the respective internal approval procedures, the China-Chile FTA will start comprehensive tariff concessions in the latter half of 2006. On the Chilean side, the import tariff rate of 74% of the tariff lines will be lowered to zero immediately after the Agreement takes effect, while on the Chinese side, 63% of the import tariff lines will have zero rate within 2 years; the remaining import tariff lines of both parties will be zero rated in 5 to 10 years after the Agreement becomes effective. Each party may keep only 3% of the tariff lines as exceptions with tariff rates unchanged. This means that in 10 years after the start of the tariff concession process, the import tariffs on 97% of the tariff lines of both sides will be zero. Furthermore, the Agreement provides that the two parties may accelerate the tariff concession upon consensus through consultation. In addition to the liberalization of trade in goods, the Agreement also states the two sides will strengthen cooperation in such areas as economic matters, small and medium sized enterprises, culture, education, science and technology, environmental protection, labor and social security, IPR protection, investment promotion, mining and industry1.

The establishment of the China-Chile FTA has been seen as a milestone in the history of the China-Chile relationship, as Chile has always been an important trading partner of China in Latin America. The bilateral trade between the two countries has reached a level of US 5.4 billion during the period 2002-04, with a 22% annual average growth rate of Chinese exports to Chile and 42% of imports. Chile’s imports from China comprise such products as light industrial products, electromechanical products and plastic products and Chile’s exports to China are composed of such products as copper, fish powder, fruit and wine. The two economies have been strongly complementary to each other in industrial structure and import and export commodity mix.2

Pakistan - SAFTA3

The Agreement on the South Asian Free Trade Area is an agreement reached at the 12th South Asian Association for Regional Cooperation (SAARC) summit at Islamabad, Pakistan on January 6, 2004. It created a

1 The Economic and Commercial Counselor’s office of the Embassy of People’s Republic of China, Nov. 18, 2005. 2 ibid 3 Wikipedia


framework for the creation of a free trade zone covering 1.4 billion people in India, Pakistan, Nepal, Sri Lanka, Bangladesh, Bhutan and the Maldives. The seven foreign ministers of the region signed a framework agreement on SAFTA with zero customs duty on the trade of practically all products in the region by the end of 2012. The SAARC Preferential Trading Arrangement (SAPTA), with concessional duties on sub-continent trade, went into force on January 1, 1996. The new agreement i.e. SAFTA, came into being on January 1, 2006 and will be operational following the ratification of the agreement by the seven governments. SAFTA requires the developing countries in South Asia, that is, India, Pakistan and Sri Lanka, to bring their duties down to 20% in the first phase of the two year period ending in 2007. In the final five year phase ending 2012, the 20% duty will be reduced to zero in a series of annual cuts. The least developed country group in South Asia consisting of Nepal, Bhutan, Bangladesh and Maldives, gets an additional three years to reach zero duty.

Pakistan - Sri Lanka FTA (PSLFTA):

The Pakistan – Sri Lanka FTA was signed on July, 2002 and came into effect in June 2005. Immediately after the FTA became operational, Pakistan offered 206 items duty-free while Sri Lanka offered 106 items duty free, hence giving a special and differential treatment to Sri Lanka. Sri Lanka has been given a five year time period to phase out tariffs as compared to three years given to Pakistan. The Sri Lankan negative list consists of 697 items as compared to 540 items in Pakistan’s negative list.

Items in the zero duty list of Pakistan (subject to application of the mutually agreed rules of origin) include frozen fish, vegetables, spices, fruits/juices, polymers of vinyl chloride in primary forms, natural rubber (excluding latex), raw silk, tanned/crust skins, wool, some varieties of paper and board, carpet and floor covering, non-alloy aluminum, iron and steel products and toys/dolls.

Sri Lanka’s no-duty items under the FTA include chickpeas, dates, oranges, benzene, toluene, apparel and clothing accessories, ballbearing, penicillin/streptomycin/tetracycline and their derivatives and vacuum flasks (excluding glass inners).

Export markets for certain products are crucial for both Sri Lanka and Pakistan despite the fact that Pakistan and Sri Lanka have not been major trading partners over the years. For example, in order to benefit from duty free access of tea, Sri Lanka needs to create a strong marketing


campaign to change the preference of the Pakistani consumers to bulk tea from CTS tea of which Kenya is a major producer.

Currently, trade between India and Pakistan takes place mostly via Singapore or Dubai. If Sri Lanka can promote Indo-Pakistan trade by encouraging Pakistani investors to open operations in Sri Lanka in order to trade with India using the ISLBFTA and vice versa, then Sri Lanka can gradually acquire hub status in South Asia.4

IV. Analysis and implications of Pakistan-China FTA

The military and strategic relationship between China and Pakistan has always been strong. However, economic relations between the two countries have, unfortunately, not been as robust (as illustrated in Section 2). Bilateral trade, mutual investment (direct/portfolio or both), joint ventures and aid/loans represent components of the economy which, although they have been previously coordinated upon by the two economies, the scope for cooperation in these fields remain untapped.

Fig-1 Pakistan's Total Trade Volume with China ($ Billion)

4.24.4

3. 3.3 2.4

2.1.2

1.1. 1.01.0 0.970.911

0.0

199 199 199 200 200 200 200 200 200

Source: IPCS Special Report 30, September 2006

China’s trade has mostly been concentrated in markets of developed countries such as ASEAN, JAPAN and the US. However, its trade with East Asian and South East Asian neighbors has also been considerable in volume. China’s exports to its six East Asian neighbors was $124.2 billion and $ 168.8 billion worth of goods in 2003 and 2004 as compared to the rest of Asia (minus Japan and the Middle East) where it exported goods worth $28.6 billion and $40.4 billion in the same time period. This includes many other

4 Kalegama, S., “Sri Lanka's Free Trade Agreement with Pakistan”, Economic Watch.


countries besides those of South Asia. So what share does Pakistan constitute and what is the importance of Pakistan as a market destination for China? As Table-1 shows, until 2000 China’s share in Pakistan’s external trade was less than 6% whereas it crossed the mark of 10% after 2003. Moreover, before Chinese trade agreements came into force with India, Pakistan’s share was only 20-25% on an average in terms of Chinese trade with South Asia, which has further declined at even the South Asia level.

Table-1: China’s Total Trade Volume with Pakistan and Other Countries ($ billion)

Year 1997 1998 1999 2000 2001 2002 2003 2004 2005

Pakistan 1.07 (20.21)*

0.915 (18.74)

0.971 (17.21)

1.09 (18.88)

1.30 (19.93)

1.80 (19.47)

2.43 (23.38)

3.1 (27.90)

4.26 (34.98)

India 1.83 1.92 1.98 2.77 3.60 4.94 7.6 13.6 18.73

SAARC 3.9 3.89 4.15 5.35 6.43 8.31

ASEAN 25.06 23.66 27.20 38.55 41.80 54.76 78.2 105.9 120

Japan 60.81 58.02 66.16 83.20 87.88 101.97 130 167.9 200

USA 49.03 54.99 61.49 83.30 80.61 97.31 126 169.4 211.63

Source: IPCS, Special Report 30

* Figures in brackets refer to the total external trade volume of Pakistan in billion dollars.

Table-2 gives us China’s exports to and imports from Pakistan over the span of the last fifteen years. This has been done to analyze the burgeoning trade deficit of Pakistan between the two trading partners. Over the years, bilateral trade with China has been on a very small scale. The share of Pakistan’s exports to China in total exports was only in the range of 1-1.5% until the mid 90s. The table further shows that although the trade volume between the two countries has started to improve, it still remains in the range of 2-3% up to 2005-06. On the other hand, imports from China have always been substantial over the period under consideration. During the decade of the 90s, imports from China have fluctuated between 4-5%, and thereafter have steadily increased to 9.47% during 2005-06. The trade balance with China has always been negative for all time periods starting from the 1990s till 2005-06. However, it is important to note here that during the Korean War of the 60’s, Pakistan’s trade deficit actually registered a surplus with China.


Table-2: China’s Export to and Import from Pakistan ($ million)

Years Exports Imports Trade balance

Share of Exports to

China in total exports

Share of Imports from China in total

Imports

Share of trade deficit with

China in total trade deficit

1990-91 60.83 386.12 -325.29 0.99 5.07 21.86

1991-92 55.47 399.77 -344.31 0.80 4.32 14.66

1992-93 41.60 420.96 -379.36 0.61 4.23 12.13

1993-94 53.67 439.00 -385.33 0.79 5.13 21.88

1994-95 90.63 458.03 -367.40 1.11 4.41 16.28

1995-96 145.82 546.17 -400.35 1.67 4.63 12.92

1996-97 103.38 542.91 -439.53 1.24 4.56 12.30

1997-98 160.99 510.37 -349.39 1.87 5.04 23.45

1998-99 159.71 416.47 -256.76 2.05 4.42 15.53

1999-00 180.35 471.62 -291.26 2.10 4.57 16.74

2000-01 304.14 525.14 -221.00 3.31 4.89 14.47

2001-02 229.06 574.94 -345.88 2.51 5.56 28.70

2002-03 244.57 838.42 -593.85 2.19 6.86 56.02

2003-04 288.11 1153.69 -865.57 2.34 7.40 26.40

2004-05 354.24 1842.91 -1488.67 2.46 8.95 23.98

2005-06 463.99 2706.32 -2242.33 2.82 9.47 18.51

Source: Pakistan Economic Survey, 2005-06

Amongst others, one of the reasons for the huge deficit between China and Pakistan can be attributed to the fact that Pakistan’s exports have been highly concentrated in the markets of few a countries e.g., USA, Japan, Germany, Hong Kong, Dubai and Saudi Arabia. These countries alone account for almost 50% of Pakistan’s total exports. In addition, Pakistan’s exports are also excessively concentrated in a few items such as cotton, leather, rice, synthetic textiles, sporting goods, etc. Pakistan’s exports to China mainly consist of cotton textile material, leather, chromium, mineral and crude oil, and aquatic products. The exports of these products have been very small as shown by the share of Pakistan’s exports to China in total exports.


Fig-2 Pakistan's Merchandize Trade with China 1990-2006

50000

40000

30000

20000

10000

0 -10000

1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03 2004-05

Total Trade Exports Imports Trade Balance


On the import side, Pakistan’s imports are mainly concentrated in the markets of a few countries, as 40% of imports continue to come from the USA, Japan, Saudi Arabia, Germany, U.K and Malaysia. Like exports, imports are also concentrated in a few products such as petroleum and petroleum products, machinery, chemicals, transport equipment, edible oil, iron and steel, fertilizers and tea. This concentration of imports has remained unchanged over the last one decade or so. Machinery, petroleum and petroleum products and chemicals alone account for almost 53% of these imports. Over the years, this composition of imports has not witnessed any remarkable change. Among consumer and capital goods, the share of raw material for consumer goods in total imports has been high while that for capital goods has declined. However, the share of capital goods has shown an increase, thereby representing an increase in investment in the country. The declining share of consumer goods, on the other hand, represents an increase in domestic production.

The share of the trade deficit with China in the total trade deficit shows that although Pakistan’s exports to China have been very insignificant, the same is not true for imports from China. Pakistan mainly imports high tech products, chemicals, plastic products and house hold appliances, chemical materials, machinery, medicine, minerals, light industry products, native produce and animal byproduct from China.


Under the recently signed Pakistan-China FTA, both countries have committed themselves to reducing or eliminating tariffs on all products in two phases starting from July 1, 2007. The first phase covers trade in goods and investment while the negotiations in the second phase i.e., trade in services will be held in mid 2007. An Early Harvest Programme (EHP) which has been operative since 1st January 2006 has been merged into this newly signed bilateral FTA. Under the EHP, China has brought to zero all tariffs on 767 items. For Pakistan, the overall package includes duty free access on industrial alcohol, cotton fabrics, bed-linen and other home textiles, marble and other tiles, leather articles, sports goods, mangoes, citrus fruit and other fruits and vegetables, iron and steel products and engineering goods. A 50% tariff reduction on fish, dairy sector products, frozen orange juice, plastic products, rubber products, leather products, knitwear, and woven garments will also be enjoyed by Pakistan under the FTA. China can get increased market access mainly on machinery, organic and inorganic chemicals, fruits and vegetables, medicaments and other raw materials for various industries including that of the engineering sector, intermediary goods for engineering sectors, etc.

During Phase I, within five years of the agreement coming into force, both parties will reduce tariffs on 85% of the products based on different extents of tariff reduction and at least 36% of the products will be tariff free within the first three years. China will mainly reduce tariff on livestock, aquatic products, vegetables, mineral products and textiles, whereas Pakistan will reduce tariffs generally on beef, mutton, chemicals and machinery products. Phase II will start in the sixth year of implementation of the agreement. Further reduction of the tariffs on various products will be based on the review of the implementation of the agreement. In terms of tariff lines and trade volumes, the intention of both countries is to eliminate tariffs on no less than 90% of the products, within a reasonable period of time.

In the preceding paragraphs we have already established the fact that Pakistan’s exports to China are negligible as compared to its imports from there. This raises the concern that granting additional market access to China, through a reduction of tariffs under the FTA arrangement, might lead to harming Pakistan’s economy rather than being beneficial e.g., Pakistan has agreed to reduce tariffs mainly on machinery, organic, and inorganic chemicals, fruits and vegetables, medicaments and other raw materials for various industries including that of the engineering sector, intermediary goods for engineering sectors, etc. Given the current export structure of Pakistan’s economy, it becomes imperative to analyze the prospective impact of this FTA on Pakistan’s economy.


Presently Pakistani markets are heavily flooded with cheap Chinese smuggled goods – a major part of the illegal trade in the country. A legal channel for the trade of these commodities, even in the absence of an FTA, can make Pakistan’s trade volume double with China. Since smuggling normally takes place to save on custom duties/tariffs, the implementation of the FTA makes such activities useless or non-profitable since tariffs/duties saved by the smugglers have largely been removed under the FTA. Legal documentation of these commodities will have a positive impact on Pakistan’s economy. Although the goods being shipped from China to Pakistan and vice versa will be duty free, they will still be registered thus enabling the government to collect revenue in the form of income/sales tax on them. As we see an influx of cheap Chinese products enter Pakistan under the FTA, this can be good for Pakistan’s economy in the sense that documentation leading to subsequent tax generation will increase CBR collection for the country.

Besides the aforementioned products, there are other specific products in which China is more competitive than Pakistan. The procurement of many of these products is vital for the Pakistani economy as well e.g., textile, cotton yarn and garments represent a major share of Pakistan’s total exports. Opening the Chinese economy to these sectors would obviously mean a replacement of domestic production by cheap imports from China. Since Pakistan is in the initial stages of development, it is trying to expand its industrial base through the expansion in its production of semi-finished and finished products. Therefore, strengthening its engineering sector, auto sub-sector, consumer durables mainly domestic appliances needs at least at this point in time some protection in order for the booming trend in the economy to be sustained.

One of the most frequent and recurrent concerns regarding any FTA is that the impending FTA, allowing for an influx of various goods, might stifle the indigenous industry of the less developed country or the country having a smaller economy. In the case of Pakistan – China FTA similar reservations have been expressed by various strata of the society especially industrialists, small business operators as well as academia of the country. Pakistan being a smaller economy as compared to China is compelled to look out for its local industries. Since the removal of duty on almost 90% of tradable products between the two countries could have spelt disaster for the textiles, garments, and engineering industries, which although booming at present are still in their infancy and thus are in not a position to face a deluge of cheap Chinese goods. Realizing the dangers associated with the implementation of an FTA, both the countries have


agreed to induct a separate clause in the agreement to abolish this concern once and for all. Article 25, a part of the newly signed agreement, related with both dumping and countervailing duties, states specifically that no dumping will be tolerated and thus steps to stop this practice have been finalized.

The following sectors of the economy have been provided protection by Pakistan under the FTA.

Cotton Yarn, Textile and Garment Sectors

Cotton yarn is subject to a tariff of 5% which will remain at 5% during the first phase of the Pak-China FTA. The duty on textiles and garments, which is 25%, would be reduced to 20% in 5 years. The polyester sector, including fabrics and garments, have been put in the No Concession List and no duty reduction will take place in the first five years.

Textile Sector

The share of the textile industry in the economy along with its contribution to exports, employment, foreign exchange earnings, investment and value added makes it the single largest manufacturing sector of Pakistan. It contributes around 8.5% to GDP, employs 38% of the total manufacturing labor force, and contributes between 60-70% to total merchandise exports. Indeed, with exports reaching about $8.6 billion in 2004-05, Pakistan is one of the largest textile exporters in the world. The variety of products ranging from cotton yarn to knitwear, garment made-ups and bedwear are the most important export products with an export value of about $1.35 billion each. Knitwear, ready made garments and cotton yarn also have important shares in total exports. Overall, the US and the EU are Pakistan’s largest trading partners accounting for 25% and 20% shares of Pakistani exports respectively. Other major importers include China, the UAE and Saudi Arabia. The textile trade is classified into two broad categories i.e. textiles which include yarn, fabric and made-ups, and clothing which represents ready-made garments. 5

5 Economic Survey of Pakistan 2005-06, Manufacturing, Mining and Investment Policies (Ch: 3).


Fig-3 Composition of Pakistan Textile Exports 2004-05

Art Silk Syntax, 268 Other

textile, 137

Raw Cotton, 108

Yam, 983

Tents & Canvas, 61

Towels, 462

Knitwear (Hosiery),

1467 Ready Made Garments,

984

Fabrics, 1924

Madeups Incl.

Bedwear, 1679


Ready Made Garments Sector

Pakistan, with total exports of around US$ 1 billion, has a meager share of 1% in the global apparel market. The apparel export product mix from Pakistan is heavily tilted towards men's wear and knitted garments.

The major thrust of garments and made-ups exports from Pakistan is towards the USA market. The European Union is the second largest market for garment manufacturers from Pakistan. The major markets that Pakistani manufactures have so far not been able to explore are the Japanese, Far East and Middle East markets. These markets demand high product standards and in return offer higher unit price realizations. The shift towards newer product and non-traditional markets can only be brought about by more emphasis on synthetic garments, and the development of a marketing and research infrastructure for the industry.

The production of garments and made-ups in Pakistan is concentrated mainly in Lahore, Faisalabad and Karachi. These three clusters have their own specialties. Faisalabad caters more to home textiles, Lahore is the home of knitwear and Karachi lives up to its reputation of being “mini Pakistan,” having established itself both in the knit as well as the woven side of the industry.


Engineering Sector

In the steel sector, the prime quality goals are subject to a 10% duty which will be reduced to 5% in 5 years and secondary goods subject to duty of 20% would be reduced to 16% in 5 years.

The engineering sector accounts for a 63% share in world trade. To achieve any significant share of the world trade in engineering goods and services, Pakistan will have to do many things which include improving universities, polytechnics and factories for the kind of manufacturing prowess and design capabilities required by the world market, which now stands spoilt for choices. In this context, an important step has been taken by the restructuring of the Engineering Development Board.

In Pakistan, large-scale manufacturing companies in the engineering sector lack export strategies as well as export development. While Japan, Korea and Malaysia rely on their large-scale companies to spearhead the export push, in Pakistan this is being conveniently left to the SME sector. The government needs to look at this deficiency and bring the strength of the large scale manufacturing sector into play for a quantum jump in the export of engineering goods and services.

Auto Sub-Sector

Vehicles in CBU, SKD and CKD condition and auto parts classified under any of the headings of Pakistan Customs Tariff have been protected and no duty reduction has been committed to for the first five years.

The auto industry is considered globally as the mother of all industries. The automobile industry has the largest segment in world trade. The annual size of automotive exports has grown over $600 billion, which accounts for about 10% of world exports. In today’s fast globalizing world, changing models, improving fuel efficiency, cutting costs and enhancing user comfort without compromising on quality are the most important challenges of the industry. The auto industry in Pakistan is growing fast and may soon begin to achieve economies of scale. This mechanical revolution has been aided in part by sound macro-economic policies pursued during the last seven years. Furthermore, the e-pass scheme for electronic goods, unchanged auto policy over the last few years, liberal adjustment of the tax regime to lower duties on raw materials and intermediate products have also helped in the rapid expansion of the auto sector. The tremendous rise in automobile demand has resulted in increased production, giving a healthy impetus to industrial output and generating over 150,000 direct


employment opportunities besides contributing tax revenue to the national exchequer.

Since 2001-02, the automobile market has been growing rapidly by over 40% per annum and if an average annual growth of 30% per annum is maintained, Pakistan’s market will cross the milestone of 500,000 units by the year 2010. Long-term investment friendly policies of the government and up-gradation of production facilities are considered as a pre-requisite by experts to achieve the automobile vision 2010 of 500,000 units.

Consumer Durables- Domestic Appliances

All domestic appliances have either been completely protected or the duty will be reduced from 25% to 20% and 20% to 16% in 5 years.

Riding high on rapidly growing demand, the home appliance industry in Pakistan is expected to double its capacity of producing TVs, refrigerators and deep freezers by 2009. Refrigerators lead the figure of the current year with 569,756 units. The production of TVs, refrigerators and deep freezers amounted to 372,192, 233,000 and 120,000 respectively in 2000-01. The production of these items has almost doubled in a short span of three years. If this trend continues, the home appliance industry would double its production and will increase its contribution to GDP, and accordingly contribute revenue to the national exchequer. An added benefit is the increase in direct jobs in the industry and the vendor industry.

Fig-4 CAGR Growth in Selected Markets from 2003-07

93.87

26.70%Motor

20.80Cars

12.50%Van

Refrigirator 10.90%

TV 7.50

0.00 20.00 40.00 60.00 80.00 100.00

Cellular

Source: PRSP II


The pace of growth in demand for home appliances is the direct result of the banks and leasing companies’ policy of consumer financing packages together with the relaxation through and e-pass schemes. Many dealers have initiated their own schemes of easy installments thus further escalating demand.

The following sectors have also been protected by Pakistan in the contract:

Food basket

Cigarettes

Locally manufactured inorganic and organic chemicals

Plastic products

Edible products e.g., Edible oils

Paper and paper board

Engineering goods

In order to boost trade ties between China and Pakistan, duties/tariffs on items of mutual interest have been reduced drastically. In some cases it has been decided that the duties be completely written off over a period of 5 years. The table given below shows the three stages of tariff reduction to be implemented under the FTA for both Pakistan and China.

In the case of exports, as we have shown in Table-2, Pakistan’s exports to China are a very small proportion of the country’s total exports. If Pakistan can increase its exports to China through increased market access for commodities which were earlier under the high tariff lines, then it will be highly beneficial for Pakistan’s economy. As shown in Table-3 certain export items e.g., leather articles, cotton fabrics, bed linen and home textiles, marble and other tiles, sports goods, citrus fruits (kinoo, lemon, lime) and other citrus fruits will be rendered tariff free in three stages. However, we are well aware of the fact that the composition of Pakistan’s exports to China are primary in nature as they consist of cotton, textile material, leather, chromium, mineral and crude oil, and aquatic products etc.


Table-3: Tariff Structure

Tariff for Pakistan Products MFN Tariff of China On 1/1/2006 On 1/1/2007 On 1/1/2008

Cotton fabrics 10-14 5 0 -

Bed-linen & home textiles

14 5 0 -

Synthetic yarn 10 5 0 0

Polyester fabrics 10-15 5 0 0

Polyester yarn 5 0 0 0

Indentured industrial alcohol

4 10 5 0

Dentured industrial alcohol

30 10 5 0

Leather articles 10 5 0 -

Marble & other tiles 24 10 5 0

Table ware 18 10 5 0

Sports goods 14 5 0 0

Mangoes 15 5 0 0

Citrus fruits (kinoo, lemon, lime etc.)

12 5 0 0

Other citrus fruits 30 10 5 0

Source: Ministry of Commerce, Government of Pakistan

Furthermore, increased exports of these products because of enhanced market freedom can lead to increased revenue generation but will not necessarily diversify Pakistan’s exports and will also not strengthen the industrial base of the country. However, all is not lost; it must be remembered that since Pakistan’s exports are highly concentrated in cotton, leather, rice, synthetic textile and sport goods - a one billion consumer market of China will be advantageous for Pakistan and can diversify Pakistan’s exports in terms of destination.

China being an emerging economy is trying to raise the living standard of its rural populace. Thus, it offers huge potential for Pakistani exporters, especially in areas of agricultural, aquatic and leather products. According to the Chinese Feasibility Study on FTA, “The Pakistani


commodities that have the greatest potential to be exported to China are tropical fruits. These fruits are widely planted in Pakistan, and China has already finished quarantine and inspection on Pakistani mangoes and citrus. After zero tariffs are levied, in North-west China, Pakistani fruits will enjoy certain advantages in both quality and price compared with the fruits grown in Southern China. Pakistan is also rich in fishery resources. With the adjustment of polices on fishery industry and the improvement of technology, the potential of Pakistan’s fishery industry will be unleashed. After the zero tariff policy is adopted, Pakistan will see a rise in its exports to China.”

These opportunities show that Pakistan can divert its exports from the markets of various other countries that have put high tariffs barriers on Pakistani imports and allow them to flow towards the Chinese borders under the guise of the newly formulated FTA. These advancements under the FTA will not only increase the trade volume with China but will also guarantee exposure to Pakistani products in the world’s second largest economy, thereby making Pakistan a force to be reckoned with in the region.

In addition to market access, the FTA also covers clauses related to investments, including its promotion and protection, its treatment, expropriation, compensation for damages and losses and dispute settlement. The historic ties of investment between China and Pakistan have already been covered in detail in Section 2 of the paper.

Bilateral trade between China and Pakistan in recent years has made considerable progress, - increasing with an annual average rate of 30% in the past 5 years and exceeding $4.2 billion in 2005. In the first 9 months of 2006, Sino-Pakistan trade amounted to $3.75 billion, thus, making China the third biggest trading partner of Pakistan.

Over the course of the last six decades, China and Pakistan have witnessed a steady growth in mutual investments, however the scale of investment is still relatively small. According to statistics released by the Board of Investment, out of a total FDI of $1524 million that was invested in Pakistan during 2004-05, the Chinese share was only $ 443,763. Chinese investment in Pakistan at the moment is concentrated mainly in Gwader port construction, exploration of coal and other resources, nuclear power stations, hydroelectric power stations, ship-building, machinery, infrastructure, construction, agriculture and manufacturing.


Table- 4: Mutual Investment between China and Pakistan

Pakistan’s Investment in China (10,000 $)

2003 2004 By 2004

Number of Projects 19 21 96

Contractual Value 1949 3210 7148

Actual Investment 343 454 1700

China’s Investment in Pakistan (10,000 $)

Number of Projects 4 3 34

Contractual Value 930 7344 10411

Source: Chinese Feasibility Study on Free Trade Agreement (March 15, 2005)

Chinese private as well as public sector corporations are launching big budget projects, especially in the manufacturing and construction sectors, all over the country. Some of the major Chinese companies operating in Pakistan are Heirs, ZTE, Howai Technologies, China National Petroleum Corporation, China State Construction Engineering Corporation, Dong Fang Electric Corporation, CMEs, China Ocean Shipping Corporation and Air China. The successful implementation by various Chinese joint ventures will encourage more Chinese as well as other foreign investment to step into Pakistan.

The signing of the FTA is projected to be beneficial for both the countries. If Pakistan is going to benefit from increased investment flows to the country, Pakistan is an important market for China to engage in the project contracting business in South Asia. In recent years, the average value of signed contracts of labor services amounted to about US$ 500 million per year. By the end of Sept. 2006, the total value of contracted engineering and labor service cooperation projects of China in Pakistan amounted to US$ 8.64 billion and the turnover was US$ 7.2 billion. By September 2006, the agreed investment of China in Pakistan was US$ 110 million and the actual investment of Pakistan in China was more than US$20 million.


Fig-5 Sector-wise Chinese Investment 2004-05 ($)

Metal 521 Transport

Equipmen(Motorcycles CommunicationsAutomobiles)

2228 15106

Construction18900

Others, 76194

Source: Pakistan Board of Investment

As shown above, Chinese investment in Pakistan is substantial, covering IT and telecom, oil and gas, power generation, engineering, automobiles, infrastructure and mining sectors. Yet Pakistan‘s investment in China is not on the same scale. During 2004, Chinese firms were involved in investment in Pakistan for a contractual value of approximately $ 10,411 compared to Pakistani investment of only $1700 million. Signing of an FTA provides safeguards for the promotion of investment between the two countries but given the existing investment volume and investment friendly opportunities offered by the Government of Pakistan, China will be in a better position to utilize the benefits being offered, in lieu of yields including profits/dividend/capital gains as compared to Pakistani firms operating in China.. However, they can positively contribute to the development of Pakistan by generating new employment opportunities, transfer of technology, exposure to new products and markets; but it should be kept in mind that the primary aim of any multinational is to maximize profits and there are pros and cons associated with allowance of these investments to enter an economy.

V. Conclusion

Pakistan’s FTA with China is another strategic link in the chain which Pakistan initiated in order to negotiate bilateral and regional preferential/free trade agreements. Pakistan aims to seek enhanced market access, by addressing tariff/non-tariff barriers, facilitating and further


promoting trade, improving investment and economic development, augmenting comparative value of its exports and build added capacity in specified targeted areas through technical cooperation and collaboration through entering into such an arrangement.

The present paper undertakes a general analysis of the implications of the Pak-China FTA. The inferences drawn from the present analysis is that although Pakistan’s economy is much smaller than that of China’s in terms of GDP, trade, reserves etc., yet the FTA offers a huge potential for Pakistan’s economy. Pakistan can change the trend of its chronic trade deficit with China by utilizing the increased market access given by China. Pakistan can also reduce its overall trade deficit by diverting its exports from traditional destinations to the new one billion consumer base of China; but for that Pakistan has to make its exports more competitive, more diversified and much better in quality. Increased investment flows will enhance the capacity of the existing industries, will help in technology transfer, and generate employment opportunities for the local population, thereby positively contributing to the economy of Pakistan. However, the Pakistani side would be less able to enjoy the concessions given by China for investment opportunities because the volume of investment to China from Pakistan is negligible. Nonetheless, we should not look at the FTA from this perspective, that if there are only positive implications for Pakistan, then why has China entered into such a deal? We know from the facts and figures that economy-wise China is already far along the road to development, and for big and developed economies, political and security matters much more than economic considerations in making such decisions of mutual cooperation. Pakistan’s strategic geographical location makes it a valuable ally which can act as a trade corridor for countries such as China.


References

Ceylon Chamber of Commerce, “Sri Lanka – Pakistan Free Trade Agreement”.

China Study Center, Institute of Strategic Studies. “Area Brief on China (2007)”,

China Daily, “ASEAN-China FTA Benefits Both Sides”, April 3 2002.

Chinese Feasibility Study on Free Trade Agreement, Online Search, March 15, 2005.

Economic and Commercial Counsellor’s Office of the Embassy of the People’s Republic of China in the Republic of Croatia., “China and Chile Signed FTA Agreement”, November 18 2005.

Government of Pakistan. “Five Year Development Program on Trade and Economic Cooperation between Pakistan and China”, Economic Affairs Division.

Government of Pakistan, “Pakistan – China Free Trade Agreement”, Economic Affairs Division.

Government of Pakistan, Economic Affairs Division. Poverty Reduction Strategy Paper (PRSP) II 2007.

Hong, H., 2004, “ASEAN and China Sign “Dirty” FTA”, Taipei Times, Dec. 18.

IPCS, Special Report 30, September 2006.

Kalegama, S., “Sri Lanka's Free Trade Agreement with Pakistan”, Economic Watch.

Kumar, A., 2006, “China-Pakistan Economic Relations”, Institute of Peace and Conflict Studies, special report 30.

Lijun, S., 2003, “China-ASEAN Free Trade Area: Origins, Development and Strategic Motivations”, ISEAS Working Paper, International Politics & Security Issues Series No. 1.


Nag, B., 2005, “Trade Cooperation and Performance in East and South Asia: Towards a Future Integration”, South Pacific Development Journal, Vol. 12, No. 1, pp. 1-29.

Pakistan Economic Survey, various editions.

People’s Daily Online, “China Established Nine FTAs in Past Five Years”, February 9 2006.

People’s Daily Online, “Sino-Pakistan Trade on Upward Trend”, August 13 2000.

Philippine Daily Inquirer, “China-ASEAN FTA to Boost Regional Integration”, June 1 2005.

Website of General Administration of Customs China.

Website of Pakistan Board of Investment.


Determinants of Female Labor Force Participation in Pakistan An Empirical Analysis of PSLM (2004-05) Micro Data

Mehak Ejaz∗

Abstract

This paper seeks to identify the major determinants of female labor force participation in Pakistan, specifically with reference to rural and urban areas. Limited dependent variable techniques (Logit and Probit) are utilized to determine the factors affecting female labor force participation. This analysis uses data taken from the PSLM (Pakistan Social and Living Standards Measurement Survey, 2004-05) which measure individual and household characteristics of females between the ages of 15-49. Empirical results suggest that age, educational attainment and marital status have significant and positive effects on female labor force participation (FLFP). When women belong to the nuclear family and have access to vehicles, they are more likely are they to participate in economic activities, whereas a large number of children and the availability of home appliances reduces the probability of FLFP. The results imply that reducing the child care burden on females and facilitating educational attainment would lead to a higher labor force participation rate for females in Pakistan.

I. Introduction

The economically active population, or labor force, is a group of people who produce goods and services to meet the requirements of society. Pakistan has a relatively low labor force69 participation rate owing to the lower percentage of women in the work force. Therefore this is a major issue concerning the development of Pakistan.

According to the Labor Force Survey, the female labor participation rate in 2004-05 was only 14.6%. According to the Economic Survey, the

∗ The author is a Research Associate at the Centre for Research, Lahore School of Economics, Lahore. 69 In Pakistan, the labor force is defined as all persons ten years of age and above who are working or looking for work for cash or kind, one week prior to the date of enumeration.

Mehak Ejaz 204

female labor force participation rate has shown a considerable rise of 8%, over the past three decades. However, as compared to other South Asian countries, the LFP is still very low.70

Labor Force Participation Rates, 1973 - 2006

0.00

10.00

20.00

30.00

40.0050.00

60.00

70.00

80.00

90.00

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

Per

cent

age

of P

artic

ipat

ion

Male Total Female

There are several explanations for the low rate of female labor participation in Pakistan. A few of these reasons are the early age marriages, the strong negative social and cultural influences on the free movement of women and the absence of an organized labor market. This paper is an attempt to highlight the major factors that hinder women from joining the labor force in Pakistan.

Earlier studies have emphasized the decision making aspect in Pakistan though the focus on determinants is somewhat lacking. The main sources of labor force and employment statistics are the Population Census and Labor Force Survey, conducted by Federal Bureau of Statistics on an annual basis.

The situation of women in Pakistan varies according to their geographical location and class. Women who belong to urban areas and the upper strata of society are in a better condition as they have greater opportunities for higher education and seeking professional work. Almost 75% of the female population belong to rural areas, and suffer from poor health issues, mainly due to constant motherhood. All Pakistani women

70 According to the World Bank Report of 2002 the labor force participation rate was 42% in Bangladesh, 32% in India and Bhutan, 41% in Nepal and 37% in Sri Lanka.

Determinants of Female Labor Force Participation in Pakistan 205

remain structurally disadvantaged as a result of legal, social and cultural discrimination.

On the basis of this background, women's economic activities and the determinants regarding paid employment are examined by analyzing different factors pertaining to the household.

According to our knowledge, there is no specific study to date that has incorporated the socioeconomic and cultural issues as well as household related factors. This study explores the causal factors, determinants and issues that are major hurdles for women’s participation in the labor force and hence, the economic development of Pakistan. After the analysis on HIES (1999) data, no empirical study has analyzed such a large number of observations. In this study, the total number of observations is 115,077, of which 72,099 come from rural areas and the rest of the 42,978 observations pertain to the urban areas of Pakistan. We believe that this study will prove to be a contribution towards the existing literature.

The paper is divided into six sections. The next section presents a comprehensive literature review which highlights the main ideas, theory, findings and shortcomings of the relevant work conducted in this field. The third section provides the theoretical framework, based on which the methodology is developed. A detailed discussion of the Probit and Logit models is also included in this section. The fourth section explains the data source and the description of relevant variables, while empirical results and the findings of the study are discussed in the fifth section. This section also includes a brief comparison of the FLFP rates of Pakistan, India and Bangladesh. Section six concludes the paper, and deals with some policy implications.

II. Review of Literature

Over the years, many researchers have dealt with the issue of female labor force participation. Estimating the labor supply curve and determinants of productivity has been a common topic of interest among many economists and sociologists. This section attempts to review the literature pertaining to the labor supply theory, as well as issues regarding female labor force participation.71

71 The literature entails cases both within and outside Pakistan.

Mehak Ejaz 206

Berndt (1990) states that the labor force participation rate of women varies by age and has considerably increased for all age groups during the past three decades. He extends the neoclassical labor supply framework to encompass the household, while addressing issues such as the discouraged worker hypothesis, and the male chauvinist model. He points out that most first generation studies show that female labor supply is more responsive to changes in wage rates and property income, as compared to male labor supply. The second generation of studies points out that the elasticity of these estimates is greater.72 Nakamura and Nakamura (1979) contradict some of these results. They find the female labor supply to be unresponsive to changes in wage rates. Hausman (1981) implies that progressive income taxes reduce a wife’s labor supply by decreasing the net after tax wage. Mroz (1987) essentially follows up on the Nakamura and Nakamura study relating to the responsiveness of female labor supply. He notes the large diversity of reported estimates of female labor supply responses to variations in wage rates and income. He concludes that the estimated uncompensated wage effect is positive but rather small. Moreover, he finds the income effect to be negative and fairly small. These results suggest that the modest sensitivity of married women’s labor supply is not very different from the labor supply of prime aged married males. The backward bending labor supply curve in essence holds true for females as well as males.73 Hence the results are consistent with the view that a woman’s preference for work is an unobserved omitted variable that affects her current as well as previous labor market participation. Robinson and Tomes (1985) also support the conclusions of Nakamura and Nakamura (1981), as they conduct their study on Canadian women. The estimates obtained in this study are larger than those of the Nakamuras, suggesting that the income elasticity of demand for leisure is greater relative to the substitution effect for women, than that for men. These results indicate that the contrasting patterns of female and male labor supply curves correspond to the differential responsiveness of male and female participation to opportunities, rather than the hours worked.

A major factor that reduces the female labor force participation rate relates to the fact that women essentially tend to concentrate more on providing services to the household after they get married. This is a crucial issue and has been dealt with by various researchers worldwide. Bradbury and Katz (2005), identify a recent decline in female labor force participation, specifically among well educated women with children. He

72 Heckman, Killingsworth and Macurdy(1981). 73 Nakamura and Nakamura (1981)


finds that unobserved and unpredictable factors contribute towards a decline in the participation of women.

Dynamic, lifetime models of labor supply have also been of considerable debate in the economic literature. In such models, economic agents act in a way as to consider the future consequences of their present actions. Mincer (1962) attempted to reinterpret the static analyses of labor supply to include lifetime variables.74 He finds that family income has no effect on the wife’s demand for leisure. His results also indicate that the number of children have a significant effect on a female’s lifetime labor supply curve. Moreover, he concluded that the probability of labor force participation is inversely related to lifetime wealth measures.

Duleep and Sanders (1994) present similar results and examine the current labor supply of 25-44 year old married women in the United States. They are further classified into native-born whites, Asian immigrants, Hispanic immigrants, and European immigrants. The results of this study show that the employment rates of women are inversely proportional to the number of children and age of the youngest child, when no account of past work is taken. There are significant differences across the groups of women whereby native born white women are less responsive to the number of children and age of the youngest child. However, when women are classified according to whether they worked in 1979, the number of children does not seem to be associated with the propensity to start or continue working.

Heckman (1974) presents an interesting analysis of the value a woman places on her time (asking wage or shadow price of time). The results indicate that the estimated effect of one child less than six raises the asking wage by 15%. Increases in net assets, the husband’s wage rate and woman’s education has a positive effect on the asking wage.

Several studies have been conducted on the situation of Pakistani women, and factors affecting their participation rate have been analyzed. Shah (1986) analyzed the changing role of women in Pakistan between 1951 and 1981. He concluded that the labor force participation decision of women is inversely related to the socio-economic status of the family. Shah et al (1976) examined some of the socio-economic and demographic factors that determine the labor force participation decision of women in Pakistan. They attempt to analyze results for all the four provinces of Pakistan. Their

74 Variables such as consumption, leisure, work at home, wages, budget constraints and time were translated into lifetime variables.

Mehak Ejaz 208

results show that labor force participation has a significant and inverse relationship with the nuclear family, as well as the child-woman ratio However, a positive relationship has been found with marital status, dependency ratio and literacy rates. The positive relationship with marital status however, is in contrast to most of the earlier studies. Rashid et al (1989) present a case study of Pakistan in which they attempt to analyze the demographic and socio economic factors affecting the labor supply of women. The results show that LFP is positively related to increases in expected earnings, wages and level of education. An interesting observation by these researchers is the fact that the presence of a male figure in the household reduces the likelihood of female participation in the labor force. However, the presence of other females in the house increases the probability that a woman will work.

Ibraz (1993) confines his study to the rural areas of Pakistan, and observes that various cultural issues such as the observation of purdah in an Islamic society restrains a woman from active participation in the labor force.

Naqvi and Shahnaz (2002) have conducted a similar study of Pakistan and have identified the household related factors that lead to women’s participation in economic activities. The innovative aspect of the paper is that it relates women’s decision to participate in economic activities with their empowerment. The empirical findings of this paper suggest that the economic participation of women is significantly influenced by factors such as age, education and marital status.

It can be inferred from the literature that various economic as well as sociological factors have a profound effect on the labor force participation decision of women. However, it is felt that some important factors have been neglected in these studies, especially those relating to household issues. This study, therefore, attempts to identify and present a comprehensive analysis of all such factors.

It is expected that this study will contribute to the economic literature in a significant way by improving upon the previous studies and also identifying the factors affecting LFP in Pakistan.


III. Theoretical Framework and Methodology

The Probit and Logit Models

Economists frequently encounter the research problem whereby the dependent variable of the structural model is not directly observed. The actual value observed may be dependent on the values of other variables or alternatively may observe a variable that takes on values related to the underlying unobserved dependent variables. For these models, ordinary least squares or standard economic estimators are not appropriate, because of the limited or qualitative nature of the observed dependent variable.

General equation

).......( 1 ii f ΧΧ=Υ

where, Yi denotes female labor force participation (FLFP). nΧΧ ......1 represent various determining factors leading to female participating in the labor force.

iij

k

jjiy εχββ ++= ∑

=10

*

where is not observed. It is a latent variable. What we observe is a dummy variable y

*iy

i defined by

iy = 1 if > 0 *iy

= 0 otherwise

y is equal to 1 if the female participates in economic activity and equal to zero if she does not. β is a row vector of parameters and iε is normally

distributed with mean 0.

The probit and logit models differ in the specification of the distribution of the error term u in the equation75, such that the former assumes that errors are normally distributed and the latter assumes that errors follow the logistic distribution.

75Maddala (2001), Gujrati (1995)and Berndt (1991)

Mehak Ejaz 210

Data Source

The study is based on cross-sectional data from the Pakistan Social and Living Standards Measurement (PSLM) Survey - HIES (2004-05), concentrating on the sample of women aged 15-49. The total number of households were 73,42976 of which 115,077 observations pertain to females aged 15-49. These observations are used in the empirical analysis.

Given that the logistic postulates:

Prob [female in work force] =ze −+1

1

Z = kkΧ++Χ+Χ+ ββββ ...........22110

Each iβ is shown to be:

i

oddsratio

χ∂∂ )log( 77= - iβ

78

For continuous variables, it is possible to compute the change in probability when the variable, is increased by one unit. This change can be

calculated using: jΧ

[ ]21 z

zj

j e

eB

X

P−

−

+=

∂∂

76Usman Sikander (Research Officer, Lahore School of Economics) helped in processing the micro level data 77 Odds ratio =P [female in work force]/ P [female not in work force] = ze−

78 iβ provides a measure of change in the logarithm of the odds ratio of the chance of the female working to not working.


The following is the list of variables used in the estimation of the model:

Notation and description of variables in the econometric model

Dependent variable Labor force participation (LFP) = 1 if women worked/looking for work = 0 otherwise

Independent variables

Age Age of the female respondent

Marital Marital status (dummy variable) 1 = unmarried; 0 = married women (Unmarried includes single, divorced and widowed women)

School Years of schooling

H-Income Head’s income

Children No. of children

Infants No. of children younger than 5 years

W-people No. of working people in the family

F-size Size of family (No. of family members including respondent)

F-type Type of family (dummy variable) 1= nuclear family, 0 = otherwise

Location Rural/Urban (dummy variable) 1= urban, 0 = rural

Asset-agric Ownership of agricultural land

Tech Weighted index of appliances

Cycle Own cycle =1, 0 = otherwise

Mehak Ejaz 212

IV. Empirical Results

Table-1: Labor Force Participation of Female

Frequency Percent

Rural Urban Total Rural Urban Total

0.00 59243 39033 98276 82.2% 90.8% 85.4%

1.00 12856 3945 16801 17.8% 9.2% 14.6%

Total 72099 42978 115077 100.0% 100.0% 100.0%

Table-2: Results of Overall Pakistan79

Variable Description Probit Logit Coefficients Marginal

Effects Coefficients Marginal

Effects Constant -1.878* -0.349 -3.266* -0.322 Age of the female 0.017* 0.003 0.031* 0.003 Married=1,Otherwise0 -0.214* -0.040 -0.425* -0.042 Years of Schooling 0.022* 0.004 0.046* 0.005 No. of working people in family 0.511* 0.095 0.994* 0.098 Family Size -0.134* -0.025 -0.289* -0.029 Nuclear=1,Otherwise 0 0.097* 0.018 0.219* 0.022 if own Car, Motorcycle, Cycle=1,Otherwise 0

0.072* 0.013 0.119* 0.012

Weighted index of home appliances

-0.235* -0.044 -0.428* -0.042

If Female head=1, Otherwise 0 0.497* 0.092 0.971* 0.096 Infant+ children per female 0.365* 0.068 0.754* 0.074 Infant+ children per female sqr -0.044* -0.008 -0.089* -0.009 No. of observations 115077 115077 R2 0.2259 0.2361 Scaled R2 0.1687 0.1773 Fraction of Correct Predictions 0.8719 0.8735

*, **, *** presents significance at 1%, 5%, and 10% level respectively

79 Sayed Kalim Hayder (Senior Research Fellow) helped in the econometric results


Table-3: Results of Urban Areas

Variable Description Probit Logit

Coefficients Marginal Effects


Constant -1.878* -0.340 -3.266* -0.31

Age of the female 0.017* 0.004 0.031* 0.00

Married=1,Otherwise0 -0.214* -0.062 -0.425* -0.06

Years of Schooling 0.022* 0.007 0.046* 0.01

No. of working people in family

0.511* 0.079 0.994* 0.08

Family size -0.134* -0.022 -0.289* -0.02

Nuclear=1,Otherwise 0 0.097* 0.028 0.219* 0.03

If own car, Motorcycle, cycle=1,Otherwise 0

0.072* 0.088 0.119* 0.08

Weighted index of home appliances

-0.235* -0.021 -0.428* -0.02

If female head=1,Otherwise 0

0.497* 0.075 0.971* 0.07

Infant+ children per female

0.365* 0.056 0.754* 0.06

Infant+ children per female sqr

-0.044* -0.007 -0.089*

No. of observations 42978 42978

R2 2.13E-01 0.2188

Scaled R2 1.62E-01 0.1637

Fraction of Correct Predictions

9.14E-01 0.9153


Mehak Ejaz 214

Table-4: Results of Rural Areas

Variable Description Probit Logit



Constant -1.756* -0.376 -3.039 -0.352

Age of the female 0.013* 0.003 0.024 0.003

Married=1,Otherwise0 -0.138* -0.030 -0.275 -0.032

Years of Schooling 0.014* 0.003 0.032 0.004

No. of working people in family

0.483* 0.103 0.923 0.107

Family size -0.123* -0.026 -0.258 -0.030

Nuclear=1,Otherwise 0 0.097* 0.021 0.223 0.026

Own Agricultural asset 0.003* 0.001 0.004 0.000

Ownership of cattle 0.001* 0.000 0.002 0.000

If own Car, Motorcycle, Cycle=1,Otherwise 0

0.099* 0.021 0.163 0.019

Weighted Index of home appliances

-0.206* -0.044 -0.367 -0.043

If female head=1,otherwise 0

0.481* 0.103 0.955 0.111

Infant+ children per female

0.341* 0.073 0.687 0.080

Infant+ children per female squared

-0.041* -0.009 -0.081 -0.009

No. of observations 72099 72099

R2 0.2302 0.2413

Scaled R2 0.1782 0.1875

Fraction of Correct Predictions

0.8489 0.8506



V. Empirical Findings

The empirical model highlights the major determinants of female labor force participation (LFP) in Pakistan. Further, in order to give due consideration to regional heterogeneity, the model is estimated for the rural and urban areas as well. A number of potential variables are included in the model on the basis of theoretical models that have been discussed in detail in the section on the literature review. In order to improve the model specification, region specific variables relating to the rural and urban areas are incorporated.

Estimated parameters and mean probability derivatives of the Probit and Logit model for the overall model are reported in Table-2.2. The probability derivatives indicate the change in probability on account of a one-unit change in the given independent variable after holding all the remaining variables constant at their mean.

Female characteristics such as age, marital status, years of schooling, and household characteristics such as the number of working people in the family, nuclear/extended family, ownership of vehicle, female headed household, family size, and availability of home appliances are the significant determinants of female labor force participation in Pakistan. The sample consists of females of the age cohort 15-49 years. The coefficient of age for the Probit and Logit model reflects that with an increase in age, there is a greater likelihood that a female will enter the labor market.

The dummy variable that takes the value of 1 for married and 0 otherwise proves that the significance of marital status affects the LFP. The results indicate that if a woman is married, there is less probability that she will enter the labor force. In Pakistan, married women are less likely to be involved in income generating activities due to their preferences for household activities. Education is also a very important factor in determining the probability that a female would enter the labor force, since education plays an important role in deciding whether to work or not by enhancing job prospects. Empirical studies found that for women, greater educational attainment leads to greater participation in the labor force, but also increases the productivity. As the years of schooling increase, the probability of women’s participation in the labor force also increases. Its coefficient is statistically significant. The results suggest that a female that is educated, unmarried and between the ages of 15 and 49 would have the greatest chance of being part of the labor force. In order to understand the participation decisions of women, household characteristics of the female are also included in the model.

Mehak Ejaz 216

The socioeconomic status of the household plays a very important

role in the labor force participation decision of women. It is a general perception that women usually enter into the work force due to financial constraints faced by the household.

Working people in the family also influence female labor force participation positively. This measures the earning capacity of the household as well as outward orientation of the family. As the number of working people increases in a household, members encourage their women to participate in economic activity as well. The greater the number of working people in the family, the higher would be the probability of women participating in the workforce. The demonstration effect may also be one of the reasons for a positive relationship between working people in the family and LFP of females. It is reasonable to infer that owing to the lower income of other family members, a female would move towards the labor market because of financial needs. A negative association is found between family size and LFP which indicates that a unit increase in family size would decrease the log odd value by 0.134, signifying a lower incidence of women in the workforce. The existence of patriarchal relations also plays a vital role in hindering the activity of women, as they are dependent on their husband’s or father’s decisions. The greater the number of people in a household would lead to a higher workload for the female members, as they would be involved in household activities such as fetching water, doing the laundry, preparing food, and looking after the family members.

Another household characteristic, “type of family”, also affects the female employment rate. This determinant is used as a dummy variable that takes the value of 1 for a nuclear family and 0 for an extended family. Since the extended family system still exists in Pakistani culture, it is imperative to incorporate this phenomenon by including two categories of families (extended or nuclear). It has been observed from the results that a woman living in a nuclear family is less restricted and more independent in decision making as compared to women living in joint or extended families. The coefficient of this variable is significant and positive which indicates that a woman is more likely to participate in the labor force, perhaps due to fewer dependent family members in a nuclear family.

It is interesting to note that the provision of any kind of vehicle such as motorcycle, cycle or car increases the probability of women entering the labor force. The more you facilitate the women with a conveyance, the more she would feel secure while traveling from home to workplace. Hence,


ownership of a vehicle by the household has a significant effect on women’s decision to participate in the labor force. The availability of home appliances such as a refrigerator, air conditioner, television, VCD/VCR/CD player, and computer has a negative impact on women to work. The impact of this variable can be explained by the financial status as well as the value placed on leisure. The availability of such goods implies higher earnings of the household, which may lead to a greater preference for leisure.

If a household is headed by a female, other female members of the family may feel more empowered. Being a head of the family, she would encourage female participation in an economic activity. Realizing the responsibilities, she could be more likely to join the labor force depending upon the financial needs of her family. There is a positive relationship between female headed households and LFP.

The proxy variable for the number of dependents is defined as the number of infants (children from age 0-5) and number of children (from 6-10 years of age) per female80. It is introduced to find out the impact of dependent children on female participation. With the increase in the number of infants and children, a female is encouraged to participate in the labor force. However, the square of this variable has a negative impact on the probabilities of female labor force participation. The results indicate that for a small number of infants and children per female, the participation rate increases as the number gets larger but increases at a decreasing rate.

Probit and Logit models estimated for urban regions have been quite similar to the results for Pakistan overall. However, an additional variable, technical education, defined as females having degrees in medicine, engineering, computer science, agriculture or M.Phil/Ph.D, has a positive and significant impact on women participating in the labor force in urban areas, mainly due to the fact that women living in urban areas are more likely to obtain technical education. Technical education is not found to be significant in overall Pakistan and its rural areas, whereas it has a significant effect on the urban areas.

In a similar manner, sector specific variables such as ownership of agricultural land and cattle are introduced in the model for rural areas. Both the variables are found to have a positive impact on LFP. The ownership of agricultural land and cattle reflects their assets as well as a source of income. Earnings from agricultural land and cattle add to the household income, and

80 As PLSM is unable to provide information on the infant or children of a specific female, therefore, this variable is a proxy of the number of infant and children per female in the household

Mehak Ejaz 218

the duty of looking after these assets is usually assigned to women. In this way, women are involved in the income generating process of the household. They also serve as a helping hand during the cutting and harvesting period, and are paid for these activities. This maximizes the probability of females working in the labor force. Ownership of agricultural land and cattle are therefore highly significant variables and has a positive impact on the rural female participation rate. These variables, however, turn out to be less significant in the case of overall and urban areas of Pakistan. Why is the Female Labor Force Participation Rate Lower in Pakistan?

It is interesting to note that despite the same social and economic background, Pakistan, India and Bangladesh exhibit varying levels of female labor force participation rates. The FLFP for India and Bangladesh is more than twice that of Pakistan. It is rather surprising that in spite of being a conservative Muslim nation, Bangladesh has the highest level of FLFP in the region.

One critical factor according to the Human Development for South Asia (2003) Report is the inclusion of data on casual workers. According to this report, India and Bangladesh are the only South Asian countries that include data on casual workers. Informal wage employment is estimated to account for 30-40% of informal employment in the non agricultural sector. Hence, it may be inferred that the reported levels of FLFP for India and Bangladesh are high due to this factor.

One major determinant of FLFP is the literacy rate.81 Interestingly, however, the female literacy rate of Bangladesh is lowest in the region. A trivial conclusion can therefore be that the female labor force participation is not strictly dependent on the female literacy rate. Hence it is important to analyze other factors that may account for the differing levels of FLFP.

Bangladesh is a poor country, and has suffered major political and economic turmoil since the time of its independence. The level of poverty is considerably higher in this region. Women belonging to the poorer households are more likely to engage in economic activity particularly in Bangladesh. Bangladesh has 15% households that are headed by women, compared to 10% in Pakistan and 9.1% in India. It is evident from our empirical findings that FLFP is positively related to the incidence of female

81 Female literacy rate: India 48.3%, Pakistan 35.2% and Bangladesh 31.8%. UNESCO (2003-2004)


headed households. Hence, the greater FLFP in Bangladesh probably owes a lot to the greater number of households headed by females.

The most important factor that accounts for high FLFP in Bangladesh may relate to the success of micro credit finance in the country. The outstanding success of the Grameen Bank has made it possible for many women, specifically in the rural areas, to earn a fair share of income. They use this income primarily for expenditure on food, clothes, health and the education of their children. Unfortunately, micro credit finance schemes have not been as successful in Pakistan as in Bangladesh. One factor responsible for this failure may be due to the non availability of donors, and the high default rate on the part of borrowers. Moreover, unlike Bangladesh, women may have shown less interest towards the micro credit schemes in Pakistan.

The fertility rate is inversely proportional to FLFP. Over the years fertility rates have considerably decreased in India and Bangladesh. However, the fertility rate for Pakistan is still very high. Hence this might be a vital factor that accounts for the disparity between the FLFP in India, Bangladesh and Pakistan. VI. Conclusion and Policy Implications

The paper has identified and analyzed the major determinants of female labor force participation in Pakistan with special reference to rural and urban areas. For this purpose, data on women (aged 15-49), from the PSLM Survey (2004-2005), has been analyzed using the Probit and Logit regression models. The empirical results of the study suggest that for women, higher educational attainment leads to greater participation in the labor force. The results suggest that there is a greater probability that a woman with the characteristics of being educated and unmarried would be a part of the labor force. On the basis of the empirical results, it has been observed that if a woman belongs to a nuclear family, has access to a vehicle, and has fewer children, then she is more likely to participate in the labor force. On the other hand, if the family size is large and she belongs to an extended family, she would be less likely to enter into the labor force. If the number of infants and children per female is small, female participation increases, whereas with a large number of children the probability of participating in the work force decreases. Moreover, the availability of home appliances reduces the probability of female participation in the labor force.

Mehak Ejaz 220

In light of the findings of this study, the following are some suggestions and policy implications to improve the social status of rural and urban female regarding the labor force participation:

Reviewing the facts stated in the data regarding the proportion of

females participating in the labor market with respect to education level, it has been surprisingly observed that 70% of our female labor force is illiterate, they have never attended school and of the remaining 30%, 11% have completed education up to matric, 9% primary, 3% higher education and 7% up to graduation. It is an alarming situation and the need of the hour is to analyze the factors as to why female education is minimal. Education plays a vital role in the development of societies and only educated females can understand their rights since education empowers a woman to make decisions regarding labor force participation.

As compared to urban areas, there are limited opportunities for

education in rural areas. In rural areas women mostly work in the fields.

Women should also be encouraged to obtain technical education. In this regard certain programmes should be initiated so that they can contribute towards development.

The proper utilization of human and financial resources is lacking in our society. The solution to the problem lies in spreading awareness among the parents and husbands of females. The entry of females in the labor market fundamentally changes the status of females in their families as well as in society.


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Mehak Ejaz 224

Appendix

Overall Pakistan Table 2.1: Descriptive Statistics

Number of Observations: 115077

Mean Std Deviation Minimum Maximum

Age 28.164 9.727 15 49

Marital 0.665 0.472 0 1

School 3.165 4.470 0 19

W_People 2.015 1.419 0 15

F_Size 8.105 3.843 1 54

F_Type 0.629 0.483 0 1

Vehic 0.837 0.931 0 2

Tech 0.709 0.859 0 4

F_Head 0.066 0.249 0 1

INF_F 1.101 1.182 0 10

INF_F2 2.608 5.347 0 100


Tab

le-2

.2:C

orre

lati

on M

atri

x

Age

Mar

ital

Scho

olW

_Peo

ple

F_Si

zeF_

Typ

eVe

hic

Tec

hF_

Hea

dIN

F_F

INF_

F2

Age

1.00

0

Mar

ital

0.57

21.

000

Scho

ol-0

.230

-0.3

101.

000

W_P

eopl

e-0

.067

-0.0

56-0

.054

1.00

0

F_Size

-0.0

83-0

.039

-0.0

590.

470

1.00

0

F_Ty

pe0.

096

-0.0

170.

009

-0.2

88-0

.390

1.00

0

Vehi

c-0

.012

-0.0

430.

138

0.10

90.

101

-0.0

391.

000

Tech

-0.0

11-0

.112

0.54

9-0

.048

0.05

2-0

.050

0.21

61.

000

F_Hea

d0.

010

-0.0

950.

049

-0.1

66-0

.111

-0.2

65-0

.066

0.04

41.

000

INF_

F0.

156

0.37

3-0

.237

-0.1

460.

086

0.13

4-0

.076

-0.1

90-0

.054

1.00

0

INF_

F20.

134

0.27

3-0

.168

-0.1

51-0

.005

0.16

6-0

.063

-0.1

44-0

.038

0.91

71.

000

Mehak Ejaz 226

URBAN

Table-3.1: Descriptive Statistics(Urban)


Mean Std Dev Minimum Maximum

Age 28.038 9.778 15 49

Marital 0.602 0.489 0 1

School 5.600 5.007 0 19

W_People 1.942 1.279 0 12

F_Size 7.926 3.545 1 36

F_Type 0.650 0.477 0 1

Vehic 0.005 0.072 0 1

Tech 1.190 0.957 0 3.6

F_Head 0.070 0.256 0 1

INF_F 0.908 1.093 0 10

INF_F2 2.019 4.639 0 100


Tabl

e-3.

2: C

orre

lati

on M

atri

x (U

rban

)

Age

Mar

ital

Scho

olW

_Peo

ple

F_Si

zeF_

Type

T_E

DU

Tec

hF_

HEA

D

INF_

F IN

F_F2

Age

1.00

0

Mar

ital

0.62

11.

000

Scho

ol-0

.250

-0.2

971.

000

W_P

eopl

e-0

.079

-0.0

64-0

.059

1.00

0

F_Si

ze-0

.102

-0.0

33-0

.114

0.51

91.

000

F_Ty

pe0.

082

-0.0

180.

013

-0.3

07-0

.384

1.00

0

T_ED

U0.

006

-0.0

150.

153

-0.0

02-0

.023

-0.0

031.

000

Tech

0.01

4-0

.072

0.50

0-0

.038

0.00

1-0

.053

0.09

31.

000

F_Hea

d0.

008

-0.1

130.

032

-0.1

09-0

.104

-0.2

760.

005

0.01

71.

000

INF_

F0.

136

0.39

2-0

.242

-0.1

420.

092

0.09

9-0

.022

-0.1

97-0

.076

1.00

0

INF_

F20.

116

0.28

5-0

.180

-0.1

50-0

.004

0.13

9-0

.014

-0.1

57-0

.054

0.91

01.

000

Mehak Ejaz 228

RURAL Table-4.1: Descriptive Statistics


Mean Std Dev Minimum Maximum

Age 28.238 9.697 15.000 49.000

Marital 0.703 0.457 0.000 1.000

School 1.714 3.362 0.000 19.000

W_People 2.059 1.495 0.000 15.000

F_Size 8.212 4.006 1.000 54.000

F_Type 0.617 0.486 0.000 1.000

Asset_AG 3.441 18.464 0.000 825.000

Cattle 11.148 1740.926 0.000 411212.0

Vehic 0.776 0.938 0.000 2.000

Tech 0.422 0.641 0.000 3.600

F_Head 0.064 0.244 0.000 1.000

INF_F 1.216 1.217 0.000 9.000

INF_F2 2.958 5.700 0.000 81.000


Tabl

e-4.

2: C

orre

lati

on M

atri

x (R

ural

)

Age

Mar

ital

Scho

olW

_Peo

ple

F_Si

zeF_

Type

Asse

t_AG

Catt

leVe

hic

Tec

hF_

Hea

dIN

F_F

INF_

F2

Age

1.00

0

Mar

ital

0.54

51.

000

Scho

ol-0

.257

-0.3

031.

000

W_P

eopl

e-0

.062

-0.0

60-0

.030

1.00

0

F_Size

-0.0

73-0

.049

0.00

00.

447

1.00

0

F_Ty

pe0.

104

-0.0

11-0

.021

-0.2

78-0

.393

1.00

0

Asse

t_AG

0.00

1-0

.005

0.02

70.

007

0.06

0-0

.029

1.00

0

Cat

tle-0

.001

0.00

3-0

.003

0.00

70.

005

-0.0

030.

000

1.00

0

Vehi

c-0

.016

-0.0

430.

117

0.12

60.

102

-0.0

460.

031

-0.0

041.

000

Tec

h-0

.027

-0.0

800.

382

-0.0

340.

138

-0.0

910.

080

-0.0

030.

204

1.00

0

F_Hea

d0.

011

-0.0

820.

065

-0.1

97-0

.114

-0.2

59-0

.028

-0.0

02-0

.074

0.06

81.

000

INF_

F0.

168

0.35

1-0

.186

-0.1

570.

078

0.16

1-0

.017

0.01

0-0

.061

-0.1

24-0

.041

1.00

0

INF_

F20.

144

0.26

0-0

.134

-0.1

57-0

.010

0.18

5-0

.016

0.00

9-0

.051

-0.1

02-0

.030

0.92

11.

000

Mehak Ejaz 230

Pakistan (Probit) Dependent variable: LFP Number of observations = 115077 Scaled R-squared = .168659 Number of positive obs. = 16801 LR (zero slopes) = 19060.7 [.000] Mean of dep. var. = .145998 Schwarz B.I.C. = 38377.5 Sum of squared residuals = 11136.7 Log likelihood = -38307.6 R-squared = .225859 Fraction of Correct Predictions = 0.871929

Parameter Coefficients S. Error t-statistic P-value

C -1.878 0.0265 -70.96 [.000]

Age 0.017 0.0006 26.29 [.000]

Marital -0.214 0.0150 -14.29 [.000]

School 0.022 0.0015 14.75 [.000]

W_People 0.511 0.0044 116.06 [.000]

F_Size -0.134 0.0021 -65.33 [.000]

F_Type 0.097 0.0128 7.54 [.000]

Vehic 0.072 0.0055 13.04 [.000]

Tech -0.235 0.0082 -28.66 [.000]

F_Head 0.497 0.0221 22.49 [.000]

INF_F 0.365 0.0123 29.74 [.000]

INF_F2 -0.044 0.0025 -17.26 [.000]

Note. β (C) = Estimated logistic coefficient of each variable (it can be interpreted as the changein the log odds associated with a one-unit change in the independent variable) S.E = Standard error of estimates Sig = Significance value or p value {this value is compared with the significance level(α ) to determine whether each independent variable is significant or not in the model. If the significance (p) value of a variable is less than the designated value of α (1% or 5% or 10%), the corresponding variable is significant}

IR = partial correlation associated with the explanatory variable I, its value represents how much each variable contributes in this model.

Determinants of Female Labor Force Participation in Pakistan

231

PAKISTAN (logit) Dependent variable: LFP Number of observations = 115077 Scaled R-squared = .177273 Number of positive obs. = 16801 LR (zero slopes) = 20014.6 [.000] Mean of dep. Var. = .145998 Schwarz B.I.C. = 37900.6 Sum of squared residuals = 10972.2 Log likelihood = -37830.7 R-squared = .236099 Number of Choices = 230154 Fraction of Correct Predictions = 0.873511


C-1 -3.2658 0.0507 -64.45 [.000]

Age-1 0.0309 0.0012 26.37 [.000]

Marital-1 -0.4253 0.0279 -15.26 [.000]

School-1 0.0462 0.0027 16.80 [.000]

W_People-1 0.9936 0.0089 112.12 [.000]

F_Size-1 -0.2892 0.0043 -67.13 [.000]

F_Type-1 0.2193 0.0242 9.05 [.000]

Vehic-1 0.1191 0.0102 11.67 [.000]

Tech-1 -0.4283 0.0157 -27.25 [.000]

F_Head-1 0.9708 0.0402 24.13 [.000]

INF_F-1 0.7535 0.0231 32.58 [.000]

INF_F2-1 -0.0892 0.0048 -18.46 [.000]

Mehak Ejaz

232

Urban (Probit) Dependent variable: LFP Number of observations = 42978 Scaled R-squared = .162052 Number of positive obs. = 3945 LR (zero slopes) = 6601.35 [.000] Mean of dep. Var. = .091791 Schwarz B.I.C. = 9943.07 Sum of squared residuals = 2819.15 Log likelihood = -9879.06 R-squared = .213285 Fraction of Correct Predictions = 0.913630


C -2.7199 0.0575 -47.32 [.000]

Age 0.0321 0.0013 24.54 [.000]

Marital -0.4953 0.0292 -16.98 [.000]

School 0.0574 0.0024 23.54 [.000]

W_People 0.6358 0.0099 64.53 [.000]

F_Size -0.1777 0.0046 -38.85 [.000]

F_Type 0.2203 0.0250 8.80 [.000]

T_EDU 0.7066 0.0984 7.18 [.000]

Tech -0.1717 0.0126 -13.58 [.000]

F_Head 0.6031 0.0380 15.86 [.000]

INF_F 0.4451 0.0257 17.30 [.000]

INF_F2 -0.0551 0.0058 -9.48 [.000]


233

Urban (logit) Dependent variable: LFP Number of observations = 42978 Scaled R-squared = .163745 Number of positive obs. = 3945 LR (zero slopes) = 6666.41 [.000] Mean of dep. Var. = .091791 Schwarz B.I.C. = 9910.55 Sum of squared residuals = 2798.93 Log likelihood = -9846.53 R-squared = .218812 Number of Choices = 85956 Fraction of Correct Predictions = 0.915282


C-1 -4.8093 0.1135 -42.37 [.000]

Age-1 0.0606 0.0025 24.35 [.000]

Marital-1 -0.9739 0.0561 -17.35 [.000]

School-1 0.1143 0.0048 23.90 [.000]

W_People-1 1.2245 0.0196 62.35 [.000]

F_Size-1 -0.3779 0.0097 -39.04 [.000]

F_Type-1 0.4096 0.0485 8.45 [.000]

T_EDU-1 1.2477 0.1705 7.32 [.000]

Tech-1 -0.3332 0.0247 -13.51 [.000]

F_Head-1 1.1017 0.0709 15.54 [.000]

INF_F-1 0.9284 0.0511 18.16 [.000]

INF_F2-1 -0.1156 0.0120 -9.66 [.000]

Mehak Ejaz

234

Rural (probit) Dependent variable: LFP Number of observations = 72099 Scaled R-squared = .178171 Number of positive obs. = 12856 LR (zero slopes) = 12765.2 [.000] Mean of dep. Var. = .178310 Schwarz B.I.C. = 27497.3 Sum of squared residuals = 8155.51 Log likelihood = -27419.0 R-squared = .230158 Fraction of Correct Predictions = 0.848888

Parameter Coefficient S. Error t-statistic P-value

C -1.7562 0.0308 -57.01 [.000]

Age 0.0130 0.0007 17.40 [.000]

Marital -0.1380 0.0179 -7.70 [.000]

School 0.0138 0.0021 6.56 [.000]

W_People 0.4832 0.0050 96.07 [.000]

F_Size -0.1230 0.0024 -52.35 [.000]

F_Type 0.0974 0.0154 6.33 [.000]

Asset_AG 0.0027 0.0003 8.91 [.000]

Cattle 0.0010 0.0002 4.88 [.000]

Vehic 0.0992 0.0065 15.24 [.000]

Tech -0.2062 0.0120 -17.25 [.000]

F_Head 0.4812 0.0279 17.27 [.000]

INF_F 0.3410 0.0143 23.77 [.000]

INF_F2 -0.0407 0.0029 -14.03 [.000]


235

Rural (logit) Dependent variable: LFP Number of observations = 72099 Scaled R-squared = .187476 Number of positive obs. = 12856 LR (zero slopes) = 13427.2 [.000] Mean of dep. Var. = .178310 Schwarz B.I.C. = 27166.3 Sum of squared residuals = 8025.56 Log likelihood = -27088.0 R-squared = .241346 Number of Choices = 144198 Fraction of Correct Predictions = 0.850636


C-1 -3.0386 0.0580 -52.37 [.000]

Age-1 0.0236 0.0013 17.50 [.000]

Marital-1 -0.2754 0.0328 -8.40 [.000]

School-1 0.0321 0.0039 8.28 [.000]

W_People-1 0.9234 0.0100 92.35 [.000]

F_Size-1 -0.2584 0.0048 -53.74 [.000]

F_Type-1 0.2234 0.0286 7.82 [.000]

Asset_AG-1 0.0041 0.0005 7.43 [.000]

Cattle-1 0.0016 0.0007 2.23 [.026]

Vehic-1 0.1632 0.0118 13.81 [.000]

Tech-1 -0.3675 0.0226 -16.24 [.000]

F_Head-1 0.9549 0.0502 19.03 [.000]

INF_F-1 0.6873 0.0264 26.02 [.000]

INF_F-21 -0.0807 0.0054 -15.04 [.000]

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