Pakistan's economy after 9/11

The News, May 15, 2005
Pakistan's economy after 9/11
External interest
A lot of similarities exist between what is happening now and what took place during the 1960s and 1980s in terms of economic activity. Will the end be different this time around?

By S Akbar Zaidi

There is no denying the fact that Pakistan's core macroeconomic indicators over the last three years, since 2002-03, have shown remarkable improvement compared to the end of the 1990s and the first two years of this decade. Moreover, growth rates for the current financial year 2004-05 are projected to be close to, if not in excess of, 7 per cent, which will be the highest since 1991-92. Foreign exchange reserves have risen to their highest levels in recent years and continue to stay high; export levels set new records every year surpassing targets. Investment which had been a poor performer towards the end of the 1990s, has now also reached levels reminiscent of the 1980s and early 1990s. The stock market breaks a new record almost ever day. Clearly, most sets of key economic data show that the economy is buoyant and with at least three years of continuing and substantial improvement for each of those three years, there is a feeling that there has been a turnaround in the economy and that Pakistan is set, once again, as it was in the 1960s and 1980s, on a path of sustained high growth.

This paper examines the reasons, extent and nature of the turnaround, and identifies some persistent, though not unsolvable, problems that still afflict the economy. While clearly accepting that there has been a turnaround, it also tries to assess the sustainability of the turnaround, identifying possible problems that lie ahead. The paper begins with a very brief recent history of trends and patterns in the economy before it begins to assess and analyse the issues highlighted above.

Past and recent trends

Table 1 below gives a good picture of the performance of key sectors in the economy which shows growth rates over nearly six decades. Pakistan has had, for the most part high growth for much of this period, and particularly in the decade of the 1960s and 1980s, growth rates over a ten year period were particularly impressive. The decade of the 1990s has been Pakistan's worst in many regards, not least because of the economy performing particularly poorly. Explanations for the poor performance in the 1990s range from (i) issues related to poor governance; (ii) the fact that there were eleven governments over the period 1988-99 resulting in frequent political changes and an environment of instability, something which is not conducive to investment and growth; (iii) the debt burden accumulated over the buoyant Zia period of 1977-88 which finally came home to roost, resulting in annual interest payments to be made -- equivalent to 60 per cent of the budget each year, with another 25 per cent allocated to defence -- which did not leave much for development; (iv) sanctions imposed on Pakistan in the early 1990s related to nuclear proliferation; and, (v) the IMF and World Bank managed structural adjustment programme which resulted in all Pakistani governments having to make substantial structural interventions in the economy, many of which had a seriously deleterious impact on growth, distribution, social sector investment and on poverty.

Added to all this, was the severely deteriorating law and order situation in Karachi, Pakistan's main economic and financial centre, which surely made matters far worse. The economic costs and implications of Pakistanis carrying out jihad in different parts of the region and globe, perhaps even supported by state institutions, and the rise of religious fundamentalist forces, gave Pakistan an image which would not have been very favourable to attract foreign (or even local) investors. Moreover, this jihad factor was a core reason why Pakistan, while not at war with India throughout the nineties, was certainly not at peace with its neighbour. Interestingly, once we look at the more recent past, since 1999, and certainly since September 11, 2001, many of these constraints on the economy have been removed.

Source: Government of Pakistan, Pakistan Economic Survey, various issues, Islamabad

Recent macroeconomic developments 1998-2005

The first sentence of the Pakistan Economic Survey 1998-99 of the Government of Pakistan, released in June 1999, states that "the outgoing fiscal year 1998-99 has been the most difficult and challenging year for Pakistan's economy". The Annual Report of the State Bank of Pakistan for 1998-99, released in December 1999 under radically different circumstances, concurs and begins with almost exactly the same statement: "The year 1998-99 was one of the most difficult years in the history of Pakistan". Both 1998 and 1999 were years in which significant domestic and regional events took place. These included India and Pakistan conducting nuclear tests and the peace initiative of February 1999 between them foiled by Kargill a few weeks later and followed by the dismissal of the elected Nawaz Sharif government in October that same year.

Although both the State Bank of Pakistan Annual Report of 1998-99 and the Pakistan Economic Review of the same year believe that this year was one of the most 'difficult' in Pakistan's history, it was certainly not one of the worst, in terms of economic outcomes. In fact, as Table 2 shows, in terms of GDP growth, 1998-99 was far better than the two previous years and the three subsequent years, although no one will deny that after 1998, the situation did deteriorate on account of developments of that momentous year. In fact, the growth rate for 1998-99 was only marginally lower than the average for the preceding eight years 1990-98.

Note: * This data is for 1986/87.

Source: Government of Pakistan, Pakistan Economic Survey, various issues, Islamabad, and State Bank of Pakistan, Annual Reports, various issues, Karachi

While the May 1998 nuclear tests did have major consequences on the economy, as we discuss below, the economy prior to 1998, cannot be claimed to have been doing much better. In fact, the nineties as a whole were the decade of under-developing Pakistan, especially compared to the 1980s.

Soon after the nuclear tests, the developed countries, the G-7, imposed a wide range of economic sanctions against Pakistan. The Japanese, for example, because of having experienced the outcome of nuclear lunacy, do not do business with any country which conducts nuclear tests. As a consequence, the Japanese government stopped all funding of projects and aid, both to India and Pakistan. Other governments also castigated Pakistan (more so than India which was also in the firing line) for undertaking the tests and cut aid and assistance on which the Pakistani economy and government had become most dependent. The IMF also suspended its ESAF and Extended Fund Facility programmes as well as new Official Development Assistance. On all accounts, Pakistan was squeezed by western donors and governments as a consequence of undertaking these nuclear tests. The State Bank of Pakistan Annual Report for 1997/98 summarised the issues as follows:

"Developments in May, 1998 had a major impact on balance of payments, net foreign assets of the banking system, stock market and the exchange rate. The nuclear blast by India immediately affected the investors' confidence and the stock market declined, free market exchange rate depreciated, and foreign currency deposits were withdrawn significantly during May 11-28, 1998. Pakistan's response on May 28, 1998 to the Indian detonation, followed by economic sanctions by the United States, and a restraining stance adopted by the G-7 countries with regard to the lending by the international financial institutions, further contributed towards the erosion of confidence and weakening of the budget and the balance of payments."

Nevertheless, one specific action by the Government of Pakistan, was probably more responsible for starting a domino effect than anything else.

While the nuclear tests were bad enough, the freeze on Foreign Currency Accounts (FCAs) by the Nawaz Sharif government made matters far worse and caused major problems. The Indian nuclear tests were undertaken on May 11, and until May 28 when Pakistan tested its own, some foreign currency was withdrawn. Fearing a run on the rupee and a rush by Pakistanis to withdraw their deposits, the government of Nawaz Sharif, put a freeze on foreign currency deposits not allowing the deposit holders to withdraw their own money. This caused what is, for sure, Pakistan's greatest crisis of confidence: All the trust that had been accumulated over many years, evaporated by this one gesture. The crisis of confidence had a particularly strong impact on investors, both local and foreign, and with sanctions imposed, and credit ratings very low, the general trend was most unfavourable towards the economy.

September 11, 2001: The day the world changed

Pakistan had enough political and economic problems as it was, prior to 9/11. The nuclear test-related sanctions were still in place, democracy had been overthrown by a military coup, Pakistan's debt burden was still huge and as Table 2 shows, the downturn in the economy had already set in prior to 9/11. There were two sets of outcomes with regard to 9/11 which were related to Pakistan's economic fortunes.

The first set included issues which emerged as a response to world economic growth slowing down more generally. This meant that with world growth slowing down, demand for world exports from the developed markets also slowed down. Consumption and incomes fell in developed countries, and so did imports from other countries. Moreover, there was a sense of shock and insecurity, which meant that Americans were less enthusiastic to spend and were holding back. Second, there was a huge fear concerning Muslims, Islam, and people from other countries, particularly Middle Eastern ones. Pakistan was also included in this category, so most US businesses and firms, treated Pakistanis and Pakistan with distrust if not with contempt. This meant that foreign investors would neither be willing to invest in Pakistan nor even visit possible exporters and markets in the country. Travel advisories were issued which persuaded US and other western businessmen not to visit places like Pakistan. By all accounts, Pakistan was a no-go area for foreigners, particularly Americans, whether they were donors or businessmen. In addition, many countries were no longer eager to deal with Pakistani businessmen, and industry suffered. This was the earlier consequence on Pakistan's economy. However, as Pakistan yet again became a front-line state, things changed once again, this time fortuitously.

Nevertheless, in the medium and longer term, things changed dramatically, particularly for the military government of General Musharraf. From being labelled a rogue Islamic military state with nuclear pretensions, General Musharraf was welcomed back into the comity of civilised nations fighting the War Against Terror. Overnight, he became the darling of the West, with dozens of leaders and dignitaries from the developed countries visiting him in Islamabad -- the very same people had denounced his coup two years earlier. While this ensured his political longevity at least for some time, the economic returns of siding with the Americans were unprecedented.

The biggest problem that had plagued Pakistan's government for many years since the profligate 1980s under General Zia, was that of excessive and growing debt (both domestic but particularly international) and annual interest payments. Pakistan's economy was struggling under debt -- half of it being foreign debt -- equivalent to its GDP. As a return for Pakistan's support to the US in particular and the West in general, huge amounts of debt were either written off, or rescheduled under very easy and comfortable terms relieving the pressure on Pakistan's foreign exchange situation. In addition, the quota for Pakistani exports to the US and the European Union was increased to compensate for earlier cancelled orders and costs. Equally important was the signal to the IMF, the World Bank and numerous other donors to re-enter the field and begin supporting Pakistan again. For example, even USAID returned to Pakistan after nearly a decade. The aid agency had exited Pakistan once nuclear-related sanctions were enforced under the Pressler Amendment in the early 1990s. Pakistan was no longer no-go territory, and as a consequence of Pakistan's role in the War Against Terror and War Against Afghanistan (and subsequently, in the US' War Against Iraq later in 2003), it was repaid handsomely. Another consequence was the huge increase in remittances, particularly from the US, which came to Pakistan, particularly in 2002-03 ... see below.

What happened to the debt crisis?

Even a cursory reading of any government document or academic study by economists at any time during the 1990s, reveals that Pakistan was faced with a 'crippling', 'devastating' debt crisis for the entire duration of that decade. Both external and domestic debt had reached astronomical, unsustainable levels, as had the budget deficit and interest payments which continued to give rise to further debt, both domestic and foreign. Add to this, the fact that the economy was doing particularly poorly in terms of investment, growth and revenue generation, and one could understand the nature of a real and growing economic crisis. The external debt and interest payments had reached such astronomical proportions that there was a real fear that Pakistan would default on its international commitments and be declared bankrupt, in addition to being called a rogue or pariah state. However, in December 2001, but more specifically by 2002, the external debt crisis had become, for the moment at least, forgotten and 'resolved', and the Government of Pakistan had in fiscal year 2003-04 even voluntarily retired $1.2 billion before its due date. How did this dramatic turnaround take place?

In order to gauge the extent of the crisis and the gravity of the situation, it is important to know the amount of external debt owed and interest payments being made each year. Table 3 presents key ratios and data which give a clear picture.

Source: State Bank of Pakistan, Annual Report 1999-2000, Karachi, 2000.

Table 3 shows that by 1998-99, external debt was more than half the size of the GDP, and with domestic debt around the same amount as well, Pakistan's total domestic and external debt was greater than the size of the GDP. While Pakistan was paying back around a third in export earnings in the form of debt servicing, it was still adding on to the stock of overall total external debt. Clearly, this trend was not particularly helpful for Pakistan's economy and is one of the reasons for the very poor economic growth and social statistics during the 1990s.

After 9/11, to repay Pakistan for its role in the war against terror, the debtors offered to reschedule Pakistan's debt equivalent to around $12.5 billion, in December 2001. Not only was this amount far larger than any such rescheduling in the past, but more importantly, it was the terms of this agreement which set it apart from earlier endeavours. As the State Bank Annual Report states: "The Paris Club offered very generous terms; in contrast to the previous two rescheduling agreements that provided relief only in terms of debt flows (as per Houston terms), the existing arrangement is applicable to the entire stock of US $12.5 billion of Pakistan's bilateral debt owed to the Paris Club creditors. Consequently, this provided an implied debt reduction without Pakistan having a HIPC (Heavily Indebted Poor Country) status, which is generally associated with Naples terms".

Basically, the entire bilateral debt of Consortium countries has been rescheduled, and this rescheduling has been for a far greater period than in the past; Official Development Assistance (ODA) debt, which is 68 per cent of the total rescheduled, will be repayable after 35 years, with 15 year grace period, and non-ODA debt is to be repaid over a 25 years period, with a five year grace period. Moreover, there has been a 're-profiling of the debt in such a way that it takes into consideration the country's capacity to pay'. This rescheduling allows relief of between $1.2-1.5 billion annually in payments of debt servicing on external debt during the years 2001-05. Add to this the fact that Pakistan has not just had a debt rescheduling, but an actual debt write-off by many friendly countries, and we have an extraordinarily fortuitous situation resulting from Pakistan's support for the US invasion of Afghanistan.

The growing forex reserves

Pakistan's debt situation has improved considerably over the last three years, so has the country's foreign exchange reserves. In 1999-2000, Pakistan's total forex reserves were $2.77 billion, but rose to $7.07 billion at the end of fiscal year 2001-02, and by the next year in June 2003, were $11.48 billion, expecting to rise even further. Moreover, in 2003-04, the Government of Pakistan was able to retire some of its foreign debt to the tune of $1 billion. While the substantial increase in foreign exchange reserves has allowed Pakistan's international credit rating to improve, allowing further private and public inflows, the most important consequence has been the stabilisation and in fact, appreciation, of the Pakistani rupee. In 2001-02 the average US $/Pakistan Rupee rate was $1 equal to Rs 61.43, which had improved to Rs 58.50 by the end of the next fiscal year. Moreover, the difference between the official and market rates, which had always been high, had more or less disappeared bringing both rates in line. Clearly, compared to a near bankrupt Pakistan in 1998-99, much has changed.

There have been two or three factors which have resulted in an unprecedented growth in foreign exchange reserves, showing quite phenomenal increase of 120 per cent within one year: between 2001-02 and 2002-03 State Bank of Pakistan's reserves rose from $4.33 billion to $9.52 billion. One factor has been an increase in Pakistan's exports, which crossed $10 billion for the first time ever in 2002-03. With a rebound of the global economy and with greater access to European and US markets as quotas increase, this was likely to happen and continue. A second important reason has been the State Bank's purchase of foreign currency from the kerb market. The State Bank became one of the most important buyers of foreign exchange. It has bought substantial amounts in the years since 1999-2000. Thirdly, with debt rescheduling, interest payments have also been reduced, allowing the State Bank to hold on to and increase its reserves. It is important to point out that more reliable and traditional forms of inflows, such as foreign direct investment, have had little significance on increasing foreign exchange reserves, as they have in many other countries. Perhaps this is a matter of concern as far as sustaining the increase is concerned.

Remittances have been a reliable source of foreign exchange earnings for Pakistan since the late 1970s. In the 1980s, particularly, remittances rose to very substantial levels equivalent to around 7 or 8 per cent of GDP in single years. Since the early 1990s, however, after the first Gulf War and due to structural shifts in labour demand in the Gulf States, remittances fell substantially -- see Table 2. Traditionally, the Gulf States have been the main sources of remittances into Pakistan. Saudi Arabia sent between 35-45 per cent of remittances in the 1990s, the UAE about 17 per cent in 1999-2000 and Kuwait 15 per cent in 1999-2000; Britain provided about eight per cent of total remittances, and the US a maximum of 13 per cent in 1996-97, which had begun to fall thereafter, and was 8.75 per cent in 1999-2000. However, following 9/11 there was a dramatic change in both volume and composition of remittances.

In 2002-03, the Pakistanis in the US sent in $1.7237 billion, which was fifteen times the amount sent from the US just three years ago, in 1999-2000. This trend of substantially increased remittances from the US had begun in 2001-02, with $778 million sent, which was ten times higher than the paltry $79 million sent in 1999-2000. In 2002-03, the US with this substantially increased amount of remittances provided as much as 29.53 per cent in a total of $4.236 billion, the highest amount ever received by Pakistan on this count. Another significant development was that Saudi Arabia's contribution had fallen markedly in 2002-03: from providing almost half of Pakistan's total remittances in the past, it now provided a mere 13 per cent.

The reasons for this unprecedented amount sent by Pakistanis from the US followed by Pakistanis in the UAE (20 per cent of the total remittances in 2002-03), was a result purely of post-9/11 developments. The US government started scrutinising accounts of Pakistanis and Muslims in the US, investigating funding for al-Qaeda type organisations. In order to avoid such investigations and fearing that their savings might be wiped out, many Pakistanis sent back money to Pakistan which they otherwise would have preferred to keep in the US. The same sort of scrutiny had also begun in the UAE, hence the increase in remittances from there. Moreover, the informal foreign exchange transfer mechanism, hundi, which has been providing the main share of remittances to Pakistan from the Middle East, also came under scrutiny. To appear legal and to avoid complications with the authorities, many Pakistanis sent back money through the formal banking sector. Also, it must be added, the State Bank of Pakistan and other commercial banks also took additional measures to capture the hundi market. Since the differential between official and market exchange rates had been largely eliminated, they were able to divert some funds away from the hundi market. Nevertheless, the main reason for this huge surge in remittances, was 9/11-related developments.

Can we be sure that the turnaround is sustainable?

Most of the factors that resulted in the poverty stricken nineties decade, delineated earlier, have all disappeared. The debt burden has been lifted creating fiscal space; there has been no change in government and leadership since 1999, suggesting perhaps a sense of stability; Karachi is no longer at war with itself; the jihadis have been reigned-in on account of which there is talk of serious peace and economic cooperation with India; sanctions have not only been lifted but debt write-off and large amounts of aid have been made available to the government due to its support for the war on terror. One needs to emphasise that, had the New York attack not taken place, it is quite improbable that Pakistan would have been able to get out of the post-nuclear tests' and post-military coup scenario, both of which had been damaging to the economy.

With growth rates at 6.4 per cent in 2003-04 -- at their highest levels since 1995-96 -- with the fiscal deficit at its lowest in almost two decades, with remittances at their highest levels ever, with exports crossing the $10 billion mark for the first time and showing signs of further growth, the government is claiming that the economy has rebounded, that there has been a 'turnaround' and that good times have returned. Even the stock market has soared to inconceivable levels, setting new records every week. We are finally out of the ruinous decade of the 1990s and set on course for growth and development.

There is no disagreement over the claim that the economy has done far better in the last two or three years, since 2000-01, than it has for many years. In fact, one can add that it is very probable that this trend will continue into the next two or three years as well. The growth rate is likely to be above 5 per cent for the next few years, exports will probably not fall below the $10 billion mark, and with substantial fiscal space created on account of the Paris Club rescheduling, the pressure on the economy, at least for a few years, has been eased. There is also no denying the fact that these change have taken place on account of the developments taking place globally, and particularly regionally, because of 9/11. What is questionable, however, is the claim that Pakistan is out of the woods, headed for sustained development and growth.

The reasons for scepticism stem from an number of factors. One reason is that the recovery that has taken place in Pakistan has been on the back of high remittances, which are likely to subside to far lower levels than those in the fiscal year 2002-03. This means that the additional foreign exchange reserves are likely to have slower rates of increase, since remittances are a key factor causing the increase. A second reason is that once the WTO regime takes fuller effect, with a quota-free textile world, Pakistan will be faced with greater competition and will not be allowed the privileged access it has been granted after 9/11 to the US and to Europe. This may result in the growth rate of exports slowing down resulting in a possible deterioration of the much improved current account balance. Besides, with 67 per cent of Pakistani exports being textiles-based, a more serious crisis may have been overlooked by the increase in exports in 2002-03.

Poverty in Pakistan continues to be a major concern, with almost a third of the population living below the poverty line. High growth rates are necessary to reduce the poverty levels and do work with a lag of a few years. Moreover, unless the GDP growth rate stays above the 5.5 per cent level for a number of years, it is improbable that Pakistan will see much decrease in poverty levels. One of the main problems facing Pakistan is that of job creation and poverty alleviation based on active private sector investment. This is particularly important because the public sector has been withdrawing from productive activities and has been cutting down, as well as privatising, its assets. But the government still insists on further reducing the fiscal deficit to below 4 per cent of GDP, restricting resources for development.

Moreover, Pakistan's human capital profile has deteriorated over the nineties. In a comparison with China, Sri Lanka, Vietnam, India, Bangladesh, Ghana and Nigeria over the 1993-2003 period, Pakistan's economic and social and human profile over the last decade, looks increasingly like that of African countries, rather than that of South or East Asia. Most countries in this sample saw their per capita income rise in this period, except for the two African countries -- Nigeria and Ghana -- and Pakistan. The GDP per capita rank of these three countries has also fallen. Pakistan's literacy rate is abysmally low; with the exception of Bangladesh, all countries in the sample, including Ghana and Nigeria -- both of which have lower per capita incomes than Pakistan -- have better literacy rates. Pakistan's performance is better in terms of health, although with one of the highest population growth rates in the world, problems may occur in the future. Almost all indicators regarding women show Pakistan as the worst performer, revealing excessive and unacceptable levels of gender discrimination. Clearly, despite the high recent economic growth rates, Pakistan is not ready for the high-skill 21st century.

A re-emerging phenomenon in Pakistan is that of inflation, having already reached double digits this year. Much of this inflation has been imported on account of higher oil prices globally and poor agricultural output last year. It has filtered into many of the domestic sectors as well, a factor that may cause growth rates to come down. While poverty still persists at high levels and may fall once the recent (and if it is persistent) growth of GDP kicks-in, the government acknowledges that unemployment and income and regional disparity continue to be on the rise in recent years. Growing unemployment and rising prices may give rise to a heady cocktail reminiscent of the late 1960s. The recent upheaval in Balochistan reminds us of the consequences of the regional and income disparity of another province in that bygone decade.

While structural weaknesses continue to plague Pakistan's economy, and will take time to be sorted out, issues of domestic political uncertainty do not ensure stability either. For example, many of the reforms undertaken and the global bonhomie that Pakistan has felt in recent years, have been centred around the person of one individual, General Pervez Musharraf. Through his own personality and his interaction with world leaders and by making better use of a particular situation -- 9/11 -- he has been able to draw considerable mileage out of world events. The political consequences of siding with the Americans, however, have also had negative consequences, with General Musharraf being the target of a number of assassination attempts. What will happen if he is replaced? Probably the greatest failure of the institutions in Pakistan -- democratic, bureaucratic, civil society -- has been that they have been largely individual-centric and personality driven. What happens when individuals are replaced, is anyone guess.

In some ways there are many patterns in the decade underway since 2000 which are a repetition of the 1960s and 1980s. There were military governments in place then as there are now, albeit, each military regime has been very different from the other. Also the world (and Pakistan) is far more different now than it was in 1960 or 1980. There is a great deal of apparent stability now, as there was for much of the reign of the earlier two generals. All three generals have been generously supported by the US and other western powers. The growth rates seen since 2002 also look very similar to those of the 1960s and 1980s. Yet, the end of both General Ayub's and General Zia's decades saw the unravelling not just of high economic growth rates, but had serious social and political repercussions to contend with, such as the separation of East Pakistan in the first case, and the rise of state-sponsored fundamentalism and ethnic violence in the other. In both cases, what was perceived to be 'stability', after some years, gave rise to a noticeable degree of complacency on the part of the rulers, while the shining growth rates of economic indicators blinded policy makers to what was really going on underneath, politically and socially. While there are clear signs of an economic turnaround at present, perhaps half way through a probable Musharraf decade, one is forced to ask the following question: will the Musharraf era, when it comes to an eventual end, have an ending any different from the Ayub and Zia decades?