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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
Editorial Staff:
Telefax:
E-mail:
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
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Publisher: Lahore School of Economics, Lahore, Pakistan.
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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
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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
*
Chairman, National Commission for Government Reform, and Former Governor, State
Bank of Pakistan.
2
Ishrat Husain
principles that would underpin these reforms. Finally, the proposed
approach to design the reforms will be discussed in Section III.
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
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 3
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
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.
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Ishrat Husain
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 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
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 5
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,
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Ishrat Husain
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
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.
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 7
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
8
Ishrat Husain
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.
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
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 9
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 postinduction, 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.
10
Ishrat Husain
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.
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-today 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
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 11
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 userfriendly 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. EGovernment should be driven by business needs rather than crafted
as an elegant technical solution.
12
Ishrat Husain
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.
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.
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 13
(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
14
Ishrat Husain
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
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
Reforming the Government in Pakistan: Rationale, Principles & Proposed Approach 15
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.
16
Ishrat Husain
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.
The Lahore Journal of Economics
Special Edition (September 2007)
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 2country, 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
*
1
Former Director Pakistan Institute of Development Economics (PIDE), Islamabad.
A few decades back their exports were lower than that of Pakistan.
18
A. R. Kemal
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 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.
Industrial Competitiveness of Pakistan (2000-10)
19
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.
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,
20
A. R. Kemal
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 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
2006-07
2005-06
Basic Req.
1st pillar: Institutions
2nd pillar: Infrastructure
3rd pillar: macroeconomy
4th pillar: Health and Primary Education
Efficiency Enhancers
5th pillar: Higher Education and Training
6th pillar: Market Efficiency
7th pillar: Technological Readiness
Innovation Factors
8th pillar: Business Sophistication
9th pillar: Innovation
Source: Global Competitiveness Report 2006-07
Rank
91
94
93
79
67
86
108
91
104
54
89
60
66
60
Score
3.7
3.5
4
3.5
3.4
4.2
4.8
3.3
2.8
4.2
2.8
3.7
4
3.3
Industrial Competitiveness of Pakistan (2000-10)
21
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
Efficiency of corporate boards
Business cost of terrorism
Property rights
Reliability of police services
Ethical behavior of firms
Judicial independence
Business cost of crime and violence
Rank
123
122
95
85
82
80
76
Score
3.5
3.1
3.7
3.5
3.8
3.3
3.8
Source: Global Competitiveness Report 2006-07
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
Overall infrastructure quality
Railroad infrastructure development
Quality of port Infrastructure
Rank
67
39
52
Score
3.4
3.6
3.8
22
A. R. Kemal
Quality of airport structures
Telephone lines
Quality of electricity supply
59
101
87
4.6
3
3.5
Source: Global Competitiveness Report 2006-07
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
Rank
Efficiency of legal framework
91
Hiring and firing practices
26
Cooperation in labor-employer relations
77
Intensity of local competition
73
Brain drain
73
Foreign ownership restrictions
72
No. of procedures require to start a new business
70
Time required to start a business
30
Extent and effect of taxation
33
Soundness of banks
84
Ease of access to loans
42
Score
3
4.6
4.4
4.6
2.9
4.9
11 procedures
24 days
3.9
5
3.8
Source: Global Competitiveness Report 2006-07
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.
Industrial Competitiveness of Pakistan (2000-10)
23
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
112
27.2
79
29.2
Secondary Event
Quality of public schools
Source: Global Competitiveness Report 2006-07
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
24
A. R. Kemal
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, 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
Sector
GDP*
(%age Growth Rates)
Contribution of
TFP
Capital
Labour
2.48
1.17
1.66
Overall
5.31
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 (%)
Sector
GDP
Growth Rates
Capital
Labour Residua
l
2.38
1.25
0.78
Overall
4.41
Agriculture
4.54
2.21
0.81
1.52
Manufacturing
3.99
2.09
0.25
1.64
Industrial Competitiveness of Pakistan (2000-10)
25
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.
2
It 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.
26
A. R. Kemal
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 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
3
4
The enterprises had to use new technology to remain viable.
Such industries have grown at double the rate compared to the other industries.
Industrial Competitiveness of Pakistan (2000-10)
27
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 overcoming problems of linkage. Cluster development can be useful in this
direction.
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
28
A. R. Kemal
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.
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.
Industrial Competitiveness of Pakistan (2000-10)
29
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.
30
A. R. Kemal
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.
The Lahore Journal of Economics
Special Edition (September 2007)
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
*
Assistant Professor, The Lahore School of Economics, Lahore
32
Shamyla Chaudry
have been made with Pakistan’s neighbours, India and China, and their
success in international standings has been evaluated. A question which
probably 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.
Increasing Global Competitiveness: A Case for the Pakistan Economy
33
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
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
(2000)
49
CIP Index
(2000)
0.235
India
40
0.275
-4
2
-2
China
24
0.379
2
3
15
Pakistan
Change in Rank for
1990-2000 1980-1990 1980-2000
-2
6
4
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
34
Shamyla Chaudry
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
Increasing Global Competitiveness: A Case for the Pakistan Economy
35
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 subindices Pakistan’s score could have been relatively higher.
36
Shamyla Chaudry
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 Subcontinent. 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.
Increasing Global Competitiveness: A Case for the Pakistan Economy
37
Table-III: Global Competitiveness Indexes: Cross-Country
Comparisons
2006 – 2007)
Basic Requirements
Institutions
Infrastructure
Macro economy
Health & Primary Education
Efficiency Enhancers
Higher Education & Training
Market efficiency (goods,
labor, financial)
Technological Readiness
Innovation & Sophistication
Factors
Business Sophistication
Innovation
Overall Index
China
India
Pakistan
Rank Score Rank Score Rank Score
44
4.8
60 4.51 93
3.96
80
3.51
34 4.55 79
3.51
60
3.54
62 3.50 67
3.36
6
5.72
88 4.12 86
4.19
55
6.44
93 5.90 108 4.79
71
77
3.66
3.68
41
49
4.32
4.35
91
104
3.27
2.82
56
4.22
21
5.07
54
4.23
75
3.07
55
3.52
89
2.77
57
3.75
26
4.60
60
3.66
65
46
54
4.05
3.44
4.24
25
26
43
5.06
4.14
4.44
66
60
91
4.05
3.27
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,
38
Shamyla Chaudry
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
Increasing Global Competitiveness: A Case for the Pakistan Economy
39
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.
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
40
Shamyla Chaudry
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:
Increasing Global Competitiveness: A Case for the Pakistan Economy
41

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

Improvements in transport and trade logistics (long term)

Enhancing food and safety standards
42
Shamyla Chaudry
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 InterFirm Networks”.
“Global Competitiveness Report 2003 / 2004”, World Economic Forum.
“Global Competitiveness Report 2004 / 2005”, World Economic Forum.
“Global Competitiveness Report 2004 / 2006”, World Economic Forum.
“Global Competitiveness Report 2006 / 2007”, 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.
Increasing Global Competitiveness: A Case for the Pakistan Economy
43
Khan, Mehmood – Ul- Hassan, “Exports in 2006: A Critical Review”,
Business & Finance Review, the News International, Monday,
January 8th 2007.
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
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Paulo, Sao; “barzils’, China’s Economies Compete”, Business and
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Porter, Michael, E.; ed, “Competition in Global Industries”, Harvard
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Export
The Lahore Journal of Economics
Special Edition (September 2007)
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.
*
5
Former Finance Minister, Government of the Punjab.
See Khan and Schimmelpfennig (2006) and Qayyum (2006).
44
Shahid Kardar
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 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
Monetary and Fiscal Policies
45
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
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
6
The State Bank continues to buy government paper and use primary auctions for
monetary management.
7
Although the rate is being forced through the State bank’s intervention and its statutory
liquidity requirements.
46
Shahid Kardar
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 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
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.
Monetary and Fiscal Policies
47
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 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.
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.
48
Shahid Kardar
percent
Money Supply Growth, Domestic Credit
Growth and Inflation
30.0
12
25.0
10
20.0
8
15.0
10.0
6
5.0
4
2
0.0
-5.0
1996- 1997- 1998- 1999- 2000- 2001- 2002- 2003- 2004- 200597
98
99
00
01
02
03
04
05
06
MSG
DCG
0
Inflation
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%
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
Monetary and Fiscal Policies
49
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 (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,
8
See Feldstein (1997), Goldstein (1995), and Mishkin (1997).
This section of the paper has benefited enormously from discussions with Dr. Nadeemul-Haque.
13
50
Shahid Kardar
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.
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,
Monetary and Fiscal Policies
51
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 reentry in these markets is bound to be awkward, if not impossible.
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
52
Shahid Kardar
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.
Fiscal Deficit as a percent of GDP
9
percent
7
5
3
19
90
-9
19 1
91
-9
19 2
92
-9
19 3
93
-9
19 4
94
-9
19 5
95
-9
19 6
96
-9
19 7
97
-9
19 8
98
-9
19 9
99
-0
20 0
00
-0
20 1
01
-0
20 2
02
-0
20 3
03
-0
20 4
04
-0
20 5
05
-0
6
1
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
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
Monetary and Fiscal Policies
53
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.
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
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.
54
Shahid Kardar
in excess of 1% of GDP 16. 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
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
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
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.
Monetary and Fiscal Policies
55
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 Tbills 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. 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.
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.
56
Shahid Kardar
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
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
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.
Monetary and Fiscal Policies
57
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
11.4
11.5
11.0
10.9
10.8
10.8
10.6
10.8
10.8
10.7
10.6
10.5
10.0
10.0
9.5
20
05
-0
6
20
04
-0
5
20
03
-0
4
20
02
-0
3
20
01
-0
2
20
00
-0
1
19
99
-0
0
19
98
-9
9
19
97
-9
8
19
96
-9
7
9.0
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.
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
58
Shahid Kardar
revenues has been substandard 20, 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 GST on services22, make rental income
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
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.
Monetary and Fiscal Policies
59
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
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.
60
Shahid Kardar
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
Monetary and Fiscal Policies
61
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 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.
62
Shahid Kardar
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 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
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.
Monetary and Fiscal Policies
63
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
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.
64
Shahid Kardar
Ratio to GDP
FY02
FY06
Investment
16.8%
20%
National savings
18.6%
16.1%
Domestic Savings
17.0%
14.7%
Tax Revenues
10.9
10.5
Total Revenues
14
14.2
Expenditure
18.5
18.2
Development Expenditure
2.9
4.2
Current Expenditure
15.9
13.6
Overall Deficit
4.2
4.3
Growth %
FY02
FY03
FY04
FY05
FY06
Monetary (M2)
15.4
18.0
19.6
19.3
15.2
4.8
18.9
29.8
34.4
23.5
Private Credit
Sources: IMF, December 2006 and State Bank Annual Report, 2005/06
Monetary and Fiscal Policies
65
Growth in Money Supply and Domestic Credit
30
25
20
15
10
5
0
MSG
20
05
-0
6
20
04
-0
5
20
03
-0
4
20
02
-0
3
20
01
-0
2
20
00
-0
1
19
99
-0
0
19
98
-9
9
19
97
-9
8
19
96
-9
7
-5
DCG
Total Revenue as percent of GDP
15.5
14.9
14.8
15.0
14.5
14.0
14.1
14.1
14.0
13.5
13.4
13.0
13.1
13.2
13.0
13.0
12.5
12.0
11.5
1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06
66
Shahid Kardar
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.
The Lahore Journal of Economics
Special Edition (September 2007)
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 the
efficiency 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
*
Professor, The Lahore School of Economics, Lahore.
68
Shakil Faruqi
the efficiency of financial intermediation while maintaining stability and
fostering growth of the economy. It is an enviable record of
accomplishments by any standard.
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
The Post-Reform Era Maintaining Stability and Growth
69
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
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.
70
Shakil Faruqi
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 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.
The Post-Reform Era Maintaining Stability and Growth
71
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 NonBank 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.
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
72
Shakil Faruqi
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 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 nonperforming 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
The Post-Reform Era Maintaining Stability and Growth
73
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 buyouts. These include five Development Financial Institutions (DFIs), 8
investment banks, 20 leasing companies, 31 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
74
Shakil Faruqi
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 activitybased 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.
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
The Post-Reform Era Maintaining Stability and Growth
75
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 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
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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 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
The Post-Reform Era Maintaining Stability and Growth
77
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 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
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variable interest rates is effectively term lending given the perpetual rollover 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 microcredit 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.
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
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79
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 is more than simply monetary management, though it is a critical
element in maintaining stability and fostering the growth of the economy.
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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
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81
a relatively short period of five to six years does not imply that a structural
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.
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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 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
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83
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$13 billion are
sufficient for nearly a year of imports rather than for just a few weeks as in
the past.
The SBP has been successful in maintaining exchange rate
stability, over the past five years together with a strong foreign exchange
reserve position which began building up from a modest level of US$ 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
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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, 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.
The Post-Reform Era Maintaining Stability and Growth
85
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 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
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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 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
The Post-Reform Era Maintaining Stability and Growth
87
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
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
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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.
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
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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
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.
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Shakil Faruqi
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.
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
The Post-Reform Era Maintaining Stability and Growth
91
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 CY9503 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
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.
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Shakil Faruqi
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.
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
The Post-Reform Era Maintaining Stability and Growth
93
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 2040% 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
94
Shakil Faruqi
already gone 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.
The Post-Reform Era Maintaining Stability and Growth
95
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The Lahore Journal of Economics
Special Edition (September 2007)
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
*
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.
98
Muhammad Arshad Khan and Sajawal Khan
able to cope with volatile capital flows and exchange market pressures, and
more likely to propagate and magnify the effects of financial crises. This
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).
Financial Sector Restructuring in Pakistan
99
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.
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
100
Muhammad Arshad Khan and Sajawal Khan
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 administrativelydetermined 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
Objectives
Regulation
Macro-To maintain control over
economic
aggregate economic
activity.
-To maintain internal and
external balance
Allocative
Structural
Prudential
Key Policy Instruments
Reserve requirements, direct
credit and deposit ceilings,
interest rate controls,
restrictions on foreign
capital
-To influence the allocation Selective credit allocation,
of financial resources in
compulsory investment
favour of priority activities. requirements, preferential
interest rates.
-To control the possible
abuse of monopoly power
by dominant firms.
Entry and merger controls,
geographic and functional
restrictions.
-To preserve the safety and
soundness of individual
financial institutions and
sustain public confidence in
Authorization criteria,
minimum capital
requirements, limits on the
concentration of risks,
Financial Sector Restructuring in Pakistan
systemic stability.
101
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
Information disclosure to
consumers, compensation
funds, ombudsmen to
investigate and resolve
disputes.
-To provide protection to
users of financial services,
especially consumers and
non-professional investors.
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.
102
Muhammad Arshad Khan and Sajawal Khan
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
25
26
Such as, owners, borrowers, depositors, regulators and government.
See Sheng (1996), p. 36.
Financial Sector Restructuring in Pakistan
103
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 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-toequity (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
104
Muhammad Arshad Khan and Sajawal Khan
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.
Financial Sector Restructuring in Pakistan
105
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.
106
III.
Muhammad Arshad Khan and Sajawal Khan
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 underdeveloped, 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 nonperforming 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 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
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).
Financial Sector Restructuring in Pakistan
107
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.
108
Muhammad Arshad Khan and Sajawal Khan
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 reforms 30 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.
Financial Sector Restructuring in Pakistan
109
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
Capital Inflows > 5% of GDP
Yes
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%
Stock of Non-performing Loans > 10 % of Total Loans
Stock Market Capitalization as %age of GDP
No
Yes
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
110
Muhammad Arshad Khan and Sajawal Khan
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
Financial Sector Restructuring in Pakistan
111
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
31
CAMELSS indicate Capital, Assets, Management, Earnings, Liquidity, and Sensitivity
to Market Risk, Systems.
32
IRAF indicate Institutional Risk Assessment Framework.
112
Muhammad Arshad Khan and Sajawal Khan
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 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
33
Although in 2004 the rate fell to 7.28 %.
Financial Sector Restructuring in Pakistan
113
(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.
Table-4: Interest Rate Behavior in Pakistan
Year
Inflation
Rate
Weighted average Weighted average
Lending Rate
Deposit Rate
Real
1.98
Nominal
6.53
Interest Rate
Spread
199095
10.57
Nominal
12.55
Real Nominal Real
-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
Interest Rate Spread = (Average Lending Rate – Average Deposit Rate).
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).
34
35
114
Muhammad Arshad Khan and Sajawal Khan
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
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 Gross NPLs to
Billions)
Advances (in
%)
Provisions to Net NPL to Net
NPLs (in %) Advances (in %)
Financial Sector Restructuring in Pakistan
115
1997
173.0
23.5
46.6
-
1998
183.0
23.1
58.6
11.1
1999
230.7
25.9
48.6
15.3
2000
240.1
23.5
55.0
12.2
2001
244.1
23.4
54.7
12.1
2002
231.5
21.8
60.6
9.9
2003
222.7
17.0
63.9
6.9
2004
211.2
11.6
70.4
3.8
2005
177.3
8.3
76.7
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
116
Muhammad Arshad Khan and Sajawal Khan
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.
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/GD
P
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
-
-
51.60
60.63 57.98 55.90 60.8 64.36
M3/GDP
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.
Financial Sector Restructuring in Pakistan
M1/M2
117
-
-
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
118
Muhammad Arshad Khan and Sajawal Khan
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
Financial Sector Restructuring in Pakistan
119
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 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
37
State Bank of Pakistan (2005).
120
Muhammad Arshad Khan and Sajawal Khan
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:
38

Financial markets have now become more competitive and
relatively efficient but still remain shallow. There are many
financial 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
In 1997 almost 24000 employees were laid off and in the second phase around 11,700
employees were relieved (Akhtar, 2007).
Financial Sector Restructuring in Pakistan
121
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.
122
Muhammad Arshad Khan and Sajawal Khan
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
Financial Sector Restructuring in Pakistan
123
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.
124
Muhammad Arshad Khan and Sajawal Khan
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The Lahore Journal of Economics
Special Edition (September 2007)
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 cointegration 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
*
Dean, College of Business Management, Karachi, and Former Deputy Governor, State
Bank of Pakistan.
126
M. Ashraf Janjua
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 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 PakRupee 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
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?127
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-floatingexchange-rate system. The underlying philosophy of the dual exchange
rate was to pass on the advantages of devaluation to exporters, expatriate
workers 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.
128
M. Ashraf Janjua
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
70
40,000
60
50
30,000
40
20,000
30
10,000
20
10
0
0
Trade (LHS)
Exchange rate
Rupees
50,000
FY
79
FY
81
FY
83
FY
85
FY
87
FY
89
FY
91
FY
93
FY
95
FY
97
FY
99
FY
01
FY
03
FY
05
FY
07
t
Million US $
Pakistan's Foreign Trade and Rupee/$ Parity
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?129
Dollar.
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
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.
130
M. Ashraf Janjua
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 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
40
NEER
REER
12
230
9
210
6
190
3
170
0
150
-3
130
-6
110
-9
90
-12
70
-15
50
-18
percent
App/Dep in REER (RHS)
250
FY-78
FY-79
FY-80
FY-81
FY-82
FY-83
FY-84
FY-85
FY-86
FY-87
FY-88
FY-89
FY-90
FY-91
FY-92
FY-93
FY-94
FY-95
FY-96
FY-97
FY-98
FY-99
FY-00
FY-01
FY-02
FY-03
FY-04
FY-05
The new mechanism was based on: a) official exchange rate, b) floating inter-bank exchange
rate, and c) composite rate.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?131
Bilateral RER (2000:100)
140.00
120.00
100.00
80.00
60.00
40.00
RS/yen
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
20.00
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.
132
M. Ashraf Janjua
Exchange Rate
Date / Period
Exchange Rate Regime
Prior to August,1955
8/1/1955 (i) Fixed Exchange Rate
5/11/1972 from 14-8-1947 to 07-01-1982
13-Feb-73
8-Jan-82
1981-82
1982-83
1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90 (ii) Managed Float
1990-91 from 8th Jan. 1982 to 21st July
1998
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99 - (iii) Two tier Exchange Rate
System
(Multiple Exchang Rate)
from 22nd July 1998 to 18th May 1999
1999-00 - (iv) Dirty Float: SBP defending the
exchange rate within a narrow band
from 19th May 99 to 20th Jul 2000
2000-01 (v)from Managed Float to Floating
(Pak Rupee per
US Dollar)
3.31
4.76
11
9.9
10.1
10.5535
12.7063
13.4838
15.1668
16.1391
17.1795
17.5994
19.2154
21.4453
22.4228
24.8441
25.9598
30.1638
30.8507
33.5684
38.9936
43.1958
50.0546
App(+)/
Dep(-)
-30.46
-56.73
11.11
-1.98
-4.30
-16.94
-5.77
-11.10
-6.02
-6.06
-2.39
-8.41
-10.40
-4.36
-9.75
-4.30
-13.94
-2.23
-8.10
-13.91
-9.73
46.7904
-13.70
51.7709
-3.32
58.4378
-11.41
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?133
2001-02 Exchange Rate regime
2002-03 Since July 20, 2000
2003-04
2004-05
2005-06
61.42580
58.49950
57.57450
59.35760
59.85660
-4.86
5.00
1.61
-3.00
-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.
134
M. Ashraf Janjua
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.
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
20,000
18,000
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
10
0
-5
-10
In Percent
5
-15
-20
FY
79
FY
81
FY
83
FY
85
FY
87
FY
89
FY
91
FY
93
FY
95
FY
97
FY
99
FY
01
FY
03
FY
0
FY 5
07
t
Million US$
Pakistan's Exports and Rupee App/Dep
App/Dep
Exports
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.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?135
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
136
M. Ashraf Janjua
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
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?137
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.
138
M. Ashraf Janjua
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 maximumlikelihood 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
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?139
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
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 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.
140
M. Ashraf Janjua

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
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?141
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)
142
M. Ashraf Janjua
0.03*CAPINF1 + 0.34* LTOT + 0.03*TFPD
(-3.34)
(3.49)
(5.73)
(1)
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.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?143
Actual Vs Equilibrium Real Effective Exchnage Rates (1992=100)
Actual REER
EREER3
200.0
185.0
170.0
155.0
140.0
125.0
110.0
95.0
FY09
FY10
FY05
FY06
FY07
FY08
FY01
FY02
FY03
FY04
FY97
FY98
FY99
FY00
FY92
FY93
FY94
FY95
FY96
FY88
FY89
FY90
FY91
FY84
FY85
FY86
FY87
FY80
FY81
FY82
FY83
FY78
FY79
80.0
The above long-term relationships can be used to compute the
ERERs by evaluating these coefficients at sustainable values of
macroeconomic 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 shortterm variations from the explanatory variables.
The Figure (above) presents the actual REER and the ERER
derived by evaluating the coefficients at the HP filter series of economic
fundamentals. 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
144
M. Ashraf Janjua
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
significant 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 exchange rate policy, fiscal policy and monetary policy may
impact the REER in the short run. We investigated the impact of
macroeconomic polices and found 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.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?145
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)
Mis1
25.0
20.0
15.0
10.0
5.0
0.0
-5.0
-10.0
FY78
FY79
FY80
FY81
FY82
FY83
FY84
FY85
FY86
FY87
FY88
FY89
FY90
FY91
FY92
FY93
FY94
FY95
FY96
FY97
FY98
FY99
FY00
FY01
FY02
FY03
FY04
FY05
FY06
FY07
FY08
FY09
FY10
-15.0
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.
146
M. Ashraf Janjua
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 bilateral 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
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?147
-
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
148
M. Ashraf Janjua
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
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?149
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
150
M. Ashraf Janjua
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.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?151
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.
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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.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan?153
Appendix
Bilateral Misalignment
Bilateral Actual and Equilibrium RER vis a vis Pound Sterling
Actual BRER
EBRER
140.0
120.0
100.0
80.0
60.0
40.0
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
20.0
Misalignment (in percent)
30.0
20.0
Depreciation
10.0
0.0
-10.0
Appreciation
-20.0
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
-30.0
-20.0
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
Actual BRER
1983
1982
1981
1980
1979
1978
154
M. Ashraf Janjua
Bilateral Actual and Equilibrium RER vis a vis Yen
EBRER
110.0
100.0
90.0
80.0
70.0
60.0
50.0
40.0
30.0
20.0
Misalignment (in percent)
40.0
30.0
20.0
Depreciation
10.0
0.0
-10.0
Appreciation
-30.0
The Lahore Journal of Economics
Special Edition (September 2007)
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 nontariff 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
*
Professor of Economics, Fatima Jinnah Women University, Rawalpindi.
154
Naheed Zia Khan
The external sector is a fundamental policy concern of both the
first and second generation economic reforms in Pakistan. In an
economic 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
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
and significance of the developed countries’ farm subsidies in the PostUR 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
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)
Category
1. Country
Bangladesh
Egypt
Kenya
India
Indonesia
Iran
Malaysia
Mauritius
Oman
Pakistan
Singapore
South Africa
Sri Lanka
Thailand
National Income
Social Indicators
(growth rate)
1999
1965-99 (% per annum)
GDP
GDP
Life Expectancy Adult Illiteracy
Per Capita
(years)
Rate (%)
3.8
5.6
4.7
4.6
6.9
1.7
7.0
5.2
9.5
5.6
8.3
2.3
4.6
7.3
1.3
3.3
1.2
2.4
4.8
-1.0
4.3
3.9
5.0
2.7
6.3
0.0
3.0
5.1
61
67
48
63
66
71
72
71
73
63
78
48
73
69
59
45
29
44
5
24
13
16
30
55
8
15
9
5
156
Naheed Zia Khan
2. Country Group
Low Income
Middle Income
3. World
4.1
4.2
3.3
1.8
2.4
1.6
59
70
66
39
15
n.a.
Source: World Bank (2001a).
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)
Country
Agricultural internal
Grain
Agricultural external sector
sector shares and
selfindicators
growth rate (%)
sufficiency Merchandis
Indices (1995-99)
(%)
e
Labor GDP Growth
Comparativ
Net
1995-99
exports
force 1999 rate
e
export
(% share) advantage index
1990
1965-99
1995-99
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
Implications for Economic Reforms in Pakistan and other Southern Countries 157
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
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).
158
Naheed Zia Khan
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 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
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).
Implications for Economic Reforms in Pakistan and other Southern Countries 159
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.
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).
5
160
Naheed Zia Khan
Table-3: Welfare Gains from Removing Trade Barriers in the PostUruguay Round World of 2005
(1995 US$ billions)
Category
Agriculture
and food
Total
%
Other
primary
Textiles
and
clothing
Tota % Total %
l
Developed 122.1 48.0 0.0
countries
0.0
Developin 42.6 16.7 2.7
g countries
1.1 14.1 5.5
53.3 21.7 114.7 45.1
World
1.1 17.4 6.8
69.5 27.3 254.3 100
164.7 64.8 2.8
3.3
1.3
Other
Total
manufacture
s
Total % Total %
14.2
5.6
139.7 54.9
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.
Implications for Economic Reforms in Pakistan and other Southern Countries 161
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
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
1. Wheat
Support price
Market price
Procurement (a)
Procurement (b)
2. Rice
Support price
Market price
Procurement (a)▲
6
Year
1994-95 1995-96 1996-97 1997-98 1998-99♠ 1999-00
160
176
3.74
22%
173
185
3.45
20%
240
273
2.72
16%
240
259
3.98
21%
261
4.07
23%
300
297
8.55
41%
211
192
21
222
231
0.12
255
296
-
310
297
-
330
362
-
350
358
-
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).
162
Naheed Zia Khan
Procurement (b) 
3. Cotton♣
Support price
Market price
Procurement (a)
Procurement (b) 
0.6%
-
-
-
-
-
423
794
-
423
739
-
540
840
-
540
808
-
876
-
825
580
-
Source: APCom (2001) and Pakistan Economic Survey (2002-03).

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
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).
8
Implications for Economic Reforms in Pakistan and other Southern Countries 163
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.
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)
Country/Group
1980
World export of agricultural products
(% share in total export receipts)
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
See, ‘A Survey of Agriculture’, The Economist, December 12, 1992.
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).
9
10
164
Naheed Zia Khan
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.
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, ‘miniministerial’ 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
Total support (US$ b)
1986-88
303.720
2001-03
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$)
183
182
Source: OECD, Agricultural Policies in OECD Countries, 2003.
It is observed that, in nominal terms, the OECD countries together
pay more subsidies to their farmers in the post-UR period. More
importantly, although the producer support shows an overall decline,
rather than decreasing, the support per farmer has increased. This trend,
especially when compared with marginally reduced support per hectare,
Implications for Economic Reforms in Pakistan and other Southern Countries 165
suggests that the progress of developed countries in reducing farm
subsidies scarcely goes beyond a cosmetic exercise.
Table-8: Agricultural Support in OECD Countries: Relative Shares
Region/Country
EU
United States
Japan
Korea
Others
Total
Percentage Share in Total OECD Support
1986-88
2001-03
37
36
24
29
20
17
5
6
14
12
100
100
Source: OECD, Agricultural Policies in OECD Countries, 2003.
Figures listed in Table-8 and Table-9 provide a closer insight into
the implications of OECD farm subsidies for the reform efforts of
developing countries.
Table-9: Size of Agricultural Support in Major Developed Countries:
2001-03
Region/country
OECD
Support Estimates
Total
Producer
Averages
support
support
Per farmer Per
hectare
US$ b
US$ (000)
US$
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
-
-
Source: OECD, Agricultural Policies in OECD Countries, 2004.
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,
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Naheed Zia Khan
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
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
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).
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.
Implications for Economic Reforms in Pakistan and other Southern Countries 167
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).
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
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.
15
The European Union, Japan and the United States account for over 85 percent of total
domestic support under the AMS [see, OECD 2002].
14
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Naheed Zia Khan
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 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,
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).
18
See “The WTO under fire,” The Economist, September 18, 2003.
16
Implications for Economic Reforms in Pakistan and other Southern Countries 169
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 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
19
See http://www.business-standard.com, August 7, 2003.
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.
20
170
Naheed Zia Khan
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.
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.
21
See http://www.business-standard.com, August 7, 2003.
Implications for Economic Reforms in Pakistan and other Southern Countries 171
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.
172
Naheed Zia Khan
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The Lahore Journal of Economics
Special Edition (September 2007)
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
*
Debt Office, Ministry of Finance Government of Pakistan, Islamabad.
Debt Office, Ministry of Finance, Government of Pakistan, Islamabad.
**
174
Samina Shabir and Reema Kazmi
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
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
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
175
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 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,
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Samina Shabir and Reema Kazmi
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 statecontrolled 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.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
177
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.
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Samina Shabir and Reema Kazmi
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 seaport. 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 highlevel 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,
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
179
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.
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Samina Shabir and Reema Kazmi
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.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
181
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
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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.Sled 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
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
183
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
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Samina Shabir and Reema Kazmi
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 ChinaChile 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 Economic and Commercial Counselor’s office of the Embassy of People’s Republic
of China, Nov. 18, 2005.
1
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
185
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 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,
2
3
ibid
Wikipedia
186
Samina Shabir and Reema Kazmi
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
4
Kalegama, S., “Sri Lanka's Free Trade Agreement with Pakistan”, Economic Watch.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
187
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)
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
4.26
3.1
2.43
1.8
1.07
0.915
0.971
1.09
1997
1998
1999
2000
1.3
2001
2002
2003
2004
2005
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 $40.4 billion in the same time
period. This includes many other countries besides those of South Asia. So
what share does Pakistan constitute and what is the importance of Pakistan
as a market destination for China? As Table-1 shows, until 2000 China’s
share in Pakistan’s external trade was less than 6% whereas it crossed the
mark of 10% after 2003. Moreover, before Chinese trade agreements came
into force with India, Pakistan’s share was only 20-25% on an average in
terms of Chinese trade with South Asia, which has further declined at even
the South Asia level.
Table-1: China’s Total Trade Volume with Pakistan and Other
Countries ($ billion)
Year
Pakistan
India
1997
1998
1999
2000
2001
2002
2003
2004
2005
1.07
0.915 0.971 1.09
1.30
1.80
2.43
3.1
4.26
(20.21)* (18.74) (17.21) (18.88) (19.93) (19.47) (23.38) (27.90) (34.98)
1.83
1.92
1.98
2.77
3.60
4.94
7.6
13.6
18.73
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Samina Shabir and Reema Kazmi
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.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
189
Table-2: China’s Export to and Import from Pakistan ($ million)
Years
Exports Imports
Trade
balance
Share of
Share of
Share of trade
Exports to Imports from
deficit with
China in total China in total China in total
exports
Imports
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
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Samina Shabir and Reema Kazmi
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
Source: Pakistan Economic Survey, 2005-06
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
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
191
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
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Samina Shabir and Reema Kazmi
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.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
193
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-
194
Samina Shabir and Reema Kazmi
ups and bedwear are the most important export products with an export
value of about $1.35 billion each. Knitwear, ready made garments and
cotton yarn also have important shares in total exports. Overall, the US
and the EU are Pakistan’s largest trading partners accounting for 25% and
20% shares of Pakistani exports respectively. Other major importers
include China, the UAE and Saudi Arabia. The textile trade is classified
into two broad categories i.e. textiles which include yarn, fabric and madeups, and clothing which represents ready-made garments. 5
Fig-3 Composition of Pakistan
Textile Exports 2004-05
Tents &
Canvas, 61
Art Silk
Syntax, 268
Other
textile, 137
Raw Cotton,
108
Towels, 462
Yam, 983
Madeups
Incl.
Bedwear,
1679
Knitwear
(Hosiery),
1467
Fabrics, 1924
Ready Made
Garments,
984
Source: Pakistan Economic Survey, 2005-06
Ready Made Garments Sector
Pakistan, with total exports of around US$ 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
5
Economic Survey of Pakistan 2005-06, Manufacturing, Mining and Investment Policies
(Ch: 3).
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
195
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.
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Samina Shabir and Reema Kazmi
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
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
197
benefit is the increase in direct jobs in the industry and the vendor
industry.
Fig-4 CAGR Growth in Selected Markets from 2003-07
Cellular Subscribers
93.87%
Motor Cycles
26.70%
Cars
20.80%
Vans
12.50%
Refrigirators
TV Sets
10.90%
7.50%
0.00%
20.00%
40.00%
60.00%
80.00%
100.00%
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
198
Samina Shabir and Reema Kazmi
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
Products
Cotton fabrics
MFN
Tariff for Pakistan
Tariff of On 1/1/2006 On 1/1/2007 On 1/1/2008
China
10-14
5
0
-
Bed-linen & home
textiles
14
5
0
-
Synthetic yarn
10
5
0
0
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
Polyester fabrics
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
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
199
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
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Samina Shabir and Reema Kazmi
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.
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
201
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$20 million.
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Samina Shabir and Reema Kazmi
Fig-5 Sector-wise Chinese Investment 2004-05 ($)
Others, 76194
Metal Products,
5214
Communications,
22287
Transport
Equipment
(Motorcycles &
Automobiles),
151068
Construction,
189000
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
Economic Effects of the Recently Signed Pak-China Free Trade Agreement
203
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.
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Samina Shabir and Reema Kazmi
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The Lahore Journal of Economics
Special Edition (September 2007)
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

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.
204
Mehak Ejaz
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 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
Percentage of Participation
90.00
80.00
70.00
60.00
50.00
40.00
30.00
20.00
10.00
Male
Total
20
06
20
03
20
00
19
97
19
94
19
91
19
88
19
85
19
82
19
79
19
76
19
73
0.00
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.
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
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
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
206
Mehak Ejaz
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
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.
71
The literature entails cases both within and outside Pakistan.
Heckman, Killingsworth and Macurdy(1981).
73
Nakamura and Nakamura (1981)
72
Determinants of Female Labor Force Participation in Pakistan
207
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
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.
74
Variables such as consumption, leisure, work at home, wages, budget constraints and
time were translated into lifetime variables.
208
Mehak Ejaz
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 results show that labor force participation has a significant
and inverse relationship with the nuclear family, as well as the childwoman 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.
Determinants of Female Labor Force Participation in Pakistan
209
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.
210
Mehak Ejaz
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
i  f (1....... i )
where, Yi denotes female labor force participation (FLFP). 1 ...... n
represent various determining factors leading to female participating in the
labor force.
k
*
yi   0    j  ij   i
j 1
where y i* is not observed. It is a latent variable. What we observe is a
dummy variable yi defined by
yi = 1
=0
if y i* > 0
otherwise
y is equal to 1 if the female participates in economic activity and equal to
zero if she does not.  is a row vector of parameters and  i 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.
75
Maddala (2001), Gujrati (1995)and Berndt (1991)
Determinants of Female Labor Force Participation in Pakistan
211
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 73,429 76 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] =
1
1  e z
Z = 0  11  22  .......... .  k k
Each  i is shown to be:
 log(oddsratio) 77
= - i
 i
78
For continuous variables, it is possible to compute the change in
probability when the variable,  j is increased by one unit. This change
can be calculated using:
B j e z
P

X j
1  e z


2
76
Usman Sikander (Research Officer, Lahore School of Economics) helped in processing
the micro level data
77
78
Odds ratio =P [female in work force]/ P [female not in work force] = e
z
 i provides a measure of change in the logarithm of the odds ratio of the chance of the
female working to not working.
212
Mehak Ejaz
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
Determinants of Female Labor Force Participation in Pakistan
213
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
Constant
Age of the female
Married=1,Otherwise0
Years of Schooling
No. of working people in
family
Family Size
Nuclear=1,Otherwise 0
if own Car, Motorcycle,
Cycle=1,Otherwise 0
Weighted index of home
appliances
If Female head=1, Otherwise 0
Infant+ children per female
Infant+ children per female sqr
No. of observations
R2
Scaled R2
Fraction of Correct Predictions
Probit
Logit
Coefficient Margina Coefficient Marginal
s
l Effects
s
Effects
-1.878*
-0.349
-3.266*
-0.322
0.017*
0.003
0.031*
0.003
-0.214*
-0.040
-0.425*
-0.042
0.022*
0.004
0.046*
0.005
0.511*
0.095
0.994*
0.098
-0.134*
0.097*
0.072*
-0.025
0.018
0.013
-0.289*
0.219*
0.119*
-0.029
0.022
0.012
-0.235*
-0.044
-0.428*
-0.042
0.497*
0.365*
-0.044*
115077
0.2259
0.1687
0.8719
0.092
0.068
-0.008
0.971*
0.754*
-0.089*
115077
0.2361
0.1773
0.8735
0.096
0.074
-0.009
*, **, *** presents significance at 1%, 5%, and 10% level respectively
79
Sayed Kalim Hayder (Senior Research Fellow) helped in the econometric results
214
Mehak Ejaz
Table-3: Results of Urban Areas
Variable Description
Constant
Probit
Logit
Coefficients Marginal Coefficient Marginal
Effects
s
Effects
-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
Determinants of Female Labor Force Participation in Pakistan
*, **, *** presents significance at 1%, 5%, and 10% level respectively
215
216
Mehak Ejaz
Table-4: Results of Rural Areas
Variable Description
Probit
Logit
Coefficients Marginal Coefficient Marginal
Effects
s
Effects
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
*, **, *** presents significance at 1%, 5%, and 10% level respectively
Determinants of Female Labor Force Participation in Pakistan
217
218
Mehak Ejaz
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
Determinants of Female Labor Force Participation in Pakistan
219
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.
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
220
Mehak Ejaz
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 610 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
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
Determinants of Female Labor Force Participation in Pakistan
221
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 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.
222
Mehak Ejaz
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 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
81
Female literacy rate: India 48.3%, Pakistan 35.2% and Bangladesh 31.8%. UNESCO
(2003-2004)
Determinants of Female Labor Force Participation in Pakistan
223
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.
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.
224
Mehak Ejaz
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.
Determinants of Female Labor Force Participation in Pakistan
225
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228
Mehak Ejaz
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
1.000
0.572
-0.230
-0.067
-0.083
0.096
-0.012
-0.011
0.010
0.156
0.134
Age
Marital
School
W_People
F_Size
F_Type
Vehic
Tech
F_Head
INF_F
INF_F2
Age
0.273
0.373
-0.095
-0.112
-0.043
-0.017
-0.039
-0.056
-0.310
1.000
Marital
-0.168
-0.237
0.049
0.549
0.138
0.009
-0.059
-0.054
1.000
-0.151
-0.146
-0.166
-0.048
0.109
-0.288
0.470
1.000
-0.005
0.086
-0.111
0.052
0.101
-0.390
1.000
0.216
1.000
1.000
Tech
0.166
0.134
-0.063 -0.144
-0.076 -0.190
-0.265 -0.066 0.044
-0.050
-0.039
1.000
School W_People F_Size F_Type Vehic
Table-2.2: Correlation Matrix
-0.038
-0.054
1.000
0.917
1.000
1.000
F_Head INF_F INF_F2
Determinants of Female Labor Force Participation in Pakistan
229
230
Mehak Ejaz
URBAN
Table-3.1: Descriptive Statistics(Urban)
Number of Observations: 42978
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
-0.064
-0.033
-0.250
W_People -0.079
-0.102
0.082
0.006
0.014
0.008
0.136
0.116
School
F_Size
F_Type
T_EDU
Tech
F_Head
INF_F
INF_F2
0.285
0.392
-0.113
-0.072
-0.015
-0.018
-0.297
0.621
Marital
1.000
1.000
Marital
Age
Age
-0.180
-0.242
0.032
0.500
0.153
0.013
-0.114
-0.059
1.000
School
-0.150
-0.142
-0.109
-0.038
-0.002
-0.307
0.519
1.000
-0.004
0.092
-0.104
0.001
-0.023
-0.384
1.000
0.139
0.099
-0.276
-0.053
-0.003
1.000
-0.014
-0.022
0.005
0.093
1.000
W_People F_Size F_Type T_EDU
Table-3.2: Correlation Matrix (Urban)
-0.157
-0.197
0.017
1.000
-0.054
-0.076
1.000
0.910
1.000
Tech F_HEAD INF_F
1.000
INF_F2
Determinants of Female Labor Force Participation in Pakistan
231
232
Mehak Ejaz
RURAL
Table-4.1: Descriptive Statistics
Number of Observations: 72099
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
1.000
0.545
-0.257
-0.062
-0.073
0.104
0.001
-0.001
-0.016
-0.027
0.011
0.168
0.144
Age
Marit al
School
W_People
F_Size
F_Type
Asset_AG
Cattle
Vehic
Tech
F_Head
INF_F
INF_F2
Age
0.260
0.351
-0.082
-0.080
-0.043
0.003
-0.005
-0.011
-0.049
-0.060
-0.303
1.000
Marital
-0.134
-0.186
0.065
0.382
0.117
-0.003
0.027
-0.021
0.000
-0.030
1.000
School
1.000
-0.157 -0.010
-0.157 0.078
0.185
0.161
-0.197 -0.114 -0.259
-0.034 0.138 -0.091
0.126 0.102 -0.046
0.007 0.005 -0.003
0.007 0.060 -0.029
-0.278 -0.393
0.447 1.000
1.000
Cattle
Vehic
Tech
-0.016 0.009 -0.051 -0.102
-0.017 0.010 -0.061 -0.124
-0.028 -0.002 -0.074 0.068
0.080 -0.003 0.204 1.000
0.031 -0.004 1.000
0.000 1.000
1.000
W_People F_Size F_Type Asset _AG
Table-4.2: Correlation Matrix (Rural)
-0.030 0.921
-0.041 1.000
1.000
1.000
F_Head INF_F INF_F2
Determinants of Female Labor Force Participation in Pakistan
233
234
Mehak Ejaz
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
Coefficient
s
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.
 (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(  ) to determine whether each independent variable is
significant or not in the model. If the significance (p) value of a variable is
Determinants of Female Labor Force Participation in Pakistan
235
less than the designated value of  (1% or 5% or 10%), the corresponding
variable is significant}
RI = partial correlation associated with the explanatory variable I, its
value represents how much each variable contributes in this model.
236
Mehak Ejaz
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
Parameter
Coefficient
s
S. Error
t-statistic
P-value
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]
Determinants of Female Labor Force Participation in Pakistan
237
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
Parameter
Coefficient
s
S. Error
t-statistic
P-value
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]
238
Mehak Ejaz
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
Parameter
Coefficient
s
S. Error
t-statistic
P-value
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]
Determinants of Female Labor Force Participation in Pakistan
239
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]
240
Mehak Ejaz
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
Parameter
Coefficient
s
S. Error
t-statistic
P-value
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]
Determinants of Female Labor Force Participation in Pakistan
241
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