PAKISTAN: The price of stability

04/05/2010 | Farhan Bokhari

Drawing in more revenue is the critical challenge facing Pakistan’s economic future. Its new finance adviser, Abdul Hafeez Shaikh, hopes to succeed where others have failed

Abdul Hafeez Shaikh faces a complex set of challenges.

Appointed mid-March as principal adviser on finance to Pakistan’s prime minister – a role that makes him Pakistan’s de facto finance minister – Shaikh is eager to back smart taxes, rather than demanding more tax, ahead of this June’s annual budget.

But his scope for action is limited.

Pakistan has been forced to accept tough conditions under a $11.5 billion loan programme with the IMF, agreed towards the end of 2008 to stave off a balance of payments crisis amid plummeting investor confidence and a sharp depletion of foreign currency reserves.

At the same time Shaikh, a former privatization minister for ex-president Pervez Musharraf, is under pressure from the country’s mainstream population to provide economic incentives. In recent weeks, public protests have taken place in some of Pakistan’s larger cities against long duration electricity cuts, caused by the failure of the government to keep up supply with the pace of demand from consumers. The electricity issue is among the most vivid examples of a challenge where the Pakistani government just doesn’t have the financial space to respond quickly at a time when it must also try to keep its budget deficit close to limits agreed with the IMF.

The juggling act that is central to any finance minister’s brief in Pakistan is far from easy. As a country with south Asia’s lowest tax to GDP ratio, at around 9%, Pakistan’s economic future lies in part in its ability to revamp the tax collection system and arm its government with enough revenue to undertake pressing infrastructure and social development and social needs. These include raising expenditure in areas such as education and healthcare.

Meeting the challenge of drawing in more revenue to fill the coffers is central to a multitude of issues surrounding Pakistan’s economic future. These range from ensuring an improvement in badly needed internal stability to gaining favour for preferential access for exports to key foreign markets, such as the EU and the US, as a step to revive local industries. Representatives of Pakistan’s large textile sector, the country’s largest industrial employer, say that a combination of issues ranging from falling output due to long power cuts and failure to secure preferential access to foreign markets, are undermining prospects for their industry. “We badly need a shot in the arm for our textiles especially. If we don’t succeed, textile factory owners will have to lay off people and they [laid-off employees] will feel compelled to protest on the streets,” says an official at the textile ministry in Islamabad, who asked not to be named.

Shaikh is cautiously optimistic: “There is a lot of inner resilience in Pakistan, and there is a lot of potential. Right now, foreign investment and privatization are down, and one has to jump-start these processes,” he tells Emerging Markets in an interview. “Growth is fairly modest. These are difficulties, but they can be overcome with a great deal of effort.”

While Pakistan may have enjoyed periods of rapid economic growth in its history, the past three years have been ridden with widespread insecurity linked to the activities of Taliban militants, who have carried out suicide and bomb attacks targeting scores of privately owned and government facilities across Pakistan. The security crisis has eaten into large parts of the economy. Economic confidence has been hit hard as a result, as businessmen hold back on large investment decisions, until conditions normalize.

FDI FIGURES

As a result, new foreign direct investment has dried up. This is in sharp contrast to the mood during the July 2007–June 2008 financial year, when Pakistan received about $8.4 billion in foreign direct and equity investment and earnings from the country’s privatization plans – the highest investments in these areas in any given year.

The once emerging privatization programme, cited as a model for the developing world, is at a standstill. While foreign investors are not interested in making long-term commitments to Pakistan, the economy is expected to grow this financial year ending June 30 by just 3% on official data – substantially down from 8% in 2005.

One part of the government’s response has been to seek special access from its foreign partners for Pakistan’s exports to enter markets in Europe and the US. During talks in Washington on March 24 with a US delegation led by US secretary of state Hilary Clinton, a high-powered Pakistani delegation raised the issue of more access for Pakistan’s fledgling exports, notably textiles, to enter the US market.

The US so far remains non-committal, though its officials say they are looking at other – still unspecified – ways to provide further economic support to Pakistan.

The plea in Washington followed a public call from Prime Minister Yusuf Raza Gilani, seeking international support for Pakistan’s war economy as its military fights against militants from the Taliban and Al-Qaeda in areas along the Afghan border.

Gilani has sought an acceleration of $15 billion in international assistance promised to Pakistan through a club of bilateral donors under the ‘Friends of Democratic Pakistan’ grouping, as well as bilateral US assistance and money owed by the US to refund Pakistan for its expenditure on internal anti-terrorist operations.

As a follow-up to Pakistan’s request in Washington, the country has sought similar preferential access to European markets. The underlying theme in these recent initiatives has been ‘trade not aid’ – a phrase heard frequently in the power corridors of Islamabad.

The drive for enlarging Pakistan’s exports is in large measure fuelled by anxieties over possible unrest across the main cities of Pakistan, driven by unemployed young people who are angered by the lack of opportunities and the absence of basic services such as electricity. For the past two years, increasingly long power cuts have triggered public riots in parts of the country.

Critics, however, say the government’s failure to translate its policies into successful economic reforms heightens

global concerns over the country’s direction. For many observers, reforming the tax collection system is the key to reviving Pakistan’s international credibility.

RAISING TAXES

Less than 1% of Pakistan’s population of 180 million pays income tax, creating a widespread impression of continued official tolerance for evasion. “Global market access will come in part if the players outside Pakistan are convinced of its determination to turn itself around and become more serious about reforming its economy,” says Sarfraz Qureshi, a widely respected economist and former head of the government-run Pakistan Institute of Development Economics.

“If people outside Pakistan do not see enough reforms taking place within the country, it is not reasonable to expect them to be conciliatory towards calls for major incentives such as access to foreign markets,” adds Qureshi.

One immediate challenge is a government promise made to introduce VAT from July 1, when the new financial year begins. VAT is meant to clamp down on widespread tax evasion on the collection of indirect tax, by introducing a mechanism which Pakistani officials say will eventually emulate some of the world’s more successful models in this area.

Shaikh says he remains committed to VAT and its introduction in July. “Our president and prime minister have already committed themselves to VAT from the new fiscal year,” he says, referring to the financial year that begins in July.

But western economists in Islamabad say there is disagreement between the government and the IMF after the fund found the federal tax collection agency – the Federal Bureau of Revenue (FBR) – was unready to introduce the tax. The gap in the FBR included a failure to establish a system to identify tax evaders followed by steps to investigate them and, depending on the evidence, to eventually prosecute them under the country’s tax evasion laws.

The issue of VAT has led to accusations that Pakistan is again dragging its feet on a key tax-related reform. In the past two decades since Pakistan enrolled on an IMF loan programme, the fund has repeatedly urged the country to adopt tougher measures against tax evaders. Part of the complacency, according to senior government officials, comes from concern among the country’s leaders over a possible backlash from business and industry leaders who are opposed to tax reforms.

“This is an example of the government failing to see through a reform that it had promised. The evidence is that of the ruling regime not being prepared to take unpalatable measures,” says Omar Ayub Khan, a former junior finance minister and now an opposition leader. “The reform agenda has suffered because the political direction is not clear. Our leaders are not capable of selling their reform plans to ordinary people.”

Western economists tend to agree, although they argue that Pakistan will not be able to delay progressive economic reforms indefinitely. “Frankly, many people outside Pakistan are becoming very tired of Pakistan. If we don’t see a VAT introduced by July 1 this year, a tax which had the backing of the country’s top leaders, then the IMF will probably have to apply lots of pressure on Pakistan,” says a western economist in Islamabad who asked not to be named. The country’s position as the frontline state bordering Afghanistan has brought it squarely under the global spotlight.

A number of western countries, notably the US, are keen to discuss the long-term economic direction of the country. These discussions are built on the intention of promoting a progressive partnership with Pakistan whereby the country becomes a bulwark against Al-Qaeda and Taliban militants.

POWER TO THE POOR

In the past year, Pakistan’s military has won recognition from the US and other western countries after an unprecedented push against Taliban militants, first in the northern Swat valley and later in areas along the Afghan border. However, the government’s determination to fight Taliban militants will not, of itself, block the flow of young Pakistanis joining ideologically charged Islamic zealots: internal economic incentives are vital.

“It is all about reforming the state, the systems of internal governance and principally the economy,” says one western economist in Islamabad. “The fight will eventually be won only if you... provide reason to the young and poor, through fresh economic opportunities, to feel empowered.”

Shaikh, armed with his previous experience as privatization minister, agrees with the need to reform the economy. The difference, however, between his previous tenure and today is mainly that of a different set of parameters. The robust growth of the economy a few years ago allowed Pakistan to undertake unprecedented steps such as privatization of its state-owned telecom company, but nowadays the persistent security challenge undermines prospects. That is mainly because the insecurity has prompted many investors – domestic and foreign, with a long-term interest in Pakistan – to delay their investment plans indefinitely.

Hopes for the future come from international commitments for foreign assistance and a growing pressure in private discussions in Washington and elsewhere for Pakistan to rebuild key areas that will sustain its economic revival.

As the countdown continues to the annual budget, Shaikh says his optimism is based on a combination of Pakistan’s previous economic history and the international support that the country can expect to receive as foreign aid. “The opportunity is there,” says Shaikh. “And we are convinced of the need to build on that and revitalize our economy. We can still act and set the direction for a progressive recovery.”

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