Inspite of the government’s claims of an economic turn around,
the fact is that growth continues to persist at a level inconsistent with
economic revival, while poverty continues to increase. As I have argued
(see for example the UNDP, National Human Development Report, Chapter
2), the key factors that will determine economic revival and poverty reduction
in Pakistan are the level and composition of investment. Over the last
decade (1993 to 2003), investment as a percentage of GDP has continued
to stagnate at a low level, and its composition has been such that the
resultant poor quality of GDP growth has benefited the few at the expense
of the many. Therefore the government needs to come to grips with the
problem of investment, which lies at the heart of Pakistan’s current
economic malaise. In this article I will briefly indicate some of the
empirical and theoretical issues that would need to be considered in the
context of an investment policy.
Let us start with the two economic indicators the government is using
as a basis for its claim that it has achieved an economic turn around:
(1) The State Bank reserves have increased to a historically unprecedented
level. (2) The budget deficit has been significantly reduced.
It is true that the State Bank reserves have risen above 10 billion dollars,
yet unless they are used to finance new investment they will wither on
the vine. After all the reserves are kept mainly in US treasury bonds
at about half percent interest rate, which means that in terms of opportunity
cost, the government is actually losing money by keeping it in the form
of State Bank reserves. The challenge is to achieve a sharp increase in
productive investment (government plus private) so as to make a quantum
leap in the GDP growth rate to over 7 percent. Such a growth rate must
be achieved quickly and then maintained. This high growth trajectory is
necessary if Pakistan is to overcome its serious economic problems of
poverty, inadequate social and economic infrastructure and the resultant
severe pressures on society and state.
While the budget deficit has been reduced, this achievement can at best
be expected to induce stability in the government’s finances. It
certainly cannot be expected to stimulate economic growth. On the contrary
reduction in public expenditure would in itself, tend to reduce the GDP
growth rate. What both the IMF and the government have failed to understand
is that it is not just the level of the budget deficit that needs to be
addressed, but more importantly the composition of the budget deficit
with respect to development and non development expenditure. On October
27, 1991 when the Managing Director of the IMF, Mr. Michel Camdessus was
in Lahore for a seminar with independent economists, I had pointed out
to him that the IMF’s single-minded emphasis on budget deficit reduction
was likely to prove counterproductive in Pakistan’s case. My argument
was that the government would reduce development expenditure rather than
non-development expenditure in its attempt to meet the public expenditure
targets stipulated by the IMF. This was likely to slow down growth and
the resultant low government revenues would generate the same budget deficits
in the future. I also argued that the IMF policy package at the time was
infeasible since it did not take into account issues of GDP growth and
poverty. (reported in the Frontier Post, October 28, 1991). Ten years
later this criticism has proven true. The development expenditure as a
percentage of the GDP was reduced from over 6 percent in the late 1980s
to about 3 percent in the year 2000. At the same time GDP growth fell
sharply and poverty increased dramatically. Mr. Camdessus during the Lahore
debate (1991) of course pointed out that “IMF was not in the business
of GDP growth”, since it was only responsible for doing “battlefield
surgery” on countries in crisis.
In the last two years in Pakistan the budget deficit has been reduced
essentially because of a sharply reduced debt-servicing burden resulting
from the debt rescheduling following Pakistan’s sagacious decision
to join the war against terrorism. Nevertheless it is important to recognize
that the fiscal space afforded by the debt rescheduling is not enough
to enable an increase in development expenditure large enough to jumpstart
the economy. Thus, inspite of the government’s claims of a “historically
unprecedented increase in development expenditure” this year, as
a percentage of GDP, it is still only 4.1 percent, which is far below
the 7 percent level of the 1970s.
For Pakistan to reach the GDP growth rate consistent with substantial
poverty reduction (over 7 percent), a much higher scale of development
expenditure is required. This is necessary if urgently needed construction
of infrastructure projects such as, water reservoirs, highways, port facilities,
health and education projects are to be undertaken. These would not only
directly accelerate GDP growth through an increase in public sector investment
but would also do so indirectly, by stimulating private sector investment.
The government’s policy of inducing an increase in private sector
investment is fragmented, and lacks a sound theoretical basis. For the
last three years the government’s economic managers have believed
that if they could somehow reduce interest rates and stabilize the exchange
rate, that private sector investment would increase. They have reduced
the interest rates substantially and stabilized the exchange rate (at
least for the present), yet total investment as a percentage of GDP continues
to stagnate at about 14 percent. The question is why?
It can be argued that the government’s theoretical proposition
that a lowered interest rate would increase investment, is fallacious.
A lowered interest rate would marginally reduce the cost of investment
projects. However this consideration does not determine investment and
comes into play only after the entrepreneur decides to take the risk of
investment. In the same way a stable exchange rate enables reliable cost
estimates to be made (with respect to imported inputs) by a prospective
investor. This may be a facilitating factor, but cannot determine his
investment decision. It is not surprising therefore that in a situation
where private investors in Pakistan are not willing to take long run risks
associated with new projects, they are putting their money into real estate
and speculative operations in the stock market. The key to an investment
decision is the investor’s judgment that the likelihood of an acceptably
high, income stream in the future is greater than the risk of losing his
money. This brings us to the issue of historical time and uncertainty
in the context of economic theory.
Alfred Marshall, the 19th century economist points out in the preface
of his Principles of Political Economy, “The element of Time is
the center of the chief difficulty of almost every economic problem”.
Keynes, in his General Theory (1936) attempts to explain the functioning
of the modern economy by working out the implications of the uncertainty
generated by historical time. The issue of time and uncertainty became
important for Keynes because of his paradigmatic proposition that it is
investment that determines the level of output and employment. His analysis
is based on the fact that we live in the movement of time, and therefore
objective and subjective changes that occur at any moment in time, feedback
to alter our future investment behaviour. Rather than investment being
governed by savings as in the orthodox neo classical model, Keynesians
like Michal Kalecki (1966) argued that investment in part generates the
profits necessary to finance itself.
While expectations of profits in the future determine the amount of investment
that will be undertaken today, this expected return cannot be determined
simply in terms of present interest rates. This is because the future
is inherently unknowable. Professor Joan Robinson, my teacher at Cambridge,
during my first year as an undergraduate, explained to me the role of
future expectations in present investment decisions. She pointed out in
October 1969 during a lunch of bread and cheese, at the Anchor, a pub
beside the River Cam, “investment decisions are made in the present
where the past is irrevocable, and the future is unknown”. This
remark echoed the importance of what Keynes had called “animal spirits”
of the entrepreneurs in the investment process and the independence of
investment from savings decisions.
In an econometric study on the constraints to private investment in Pakistan,
Dr. Ali Cheema and Dr. Faisal Bari of LUMS, (2003), have shown that governance
variables such as tax administration, law and order, and contract enforcement
are major constraints to investment in Pakistan.
In conclusion it can be suggested that investment in Pakistan today
depends upon a variety of factors, which go into investors’ expectations
of the future: These include not just interest rates and exchange rates
that impact present costs of production, but also infrastructure, law
and order conditions, relations with India (which could affect future
security), and the establishment of institutions such as a free judiciary
and representative government. All these factors together could influence
the functioning of markets, costs and profits in the future. Such factors
related with economic, social and political conditions come into play
to varying degrees for entrepreneurs who invest today, on the basis of
their individual assessment of what the future holds for them. Given these
determinants, the government can lead the investment process from the
front by undertaking the necessary investment in infrastructure, pursuing
peace with India, and establishing the institutional conditions for the
rule of law and representative government. Only then can entrepreneurs
start put the fear of the past behind them and invest in a better future.
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